Current Risks of China 's Economy · 2017. 6. 7. · Emerging Markets 179.3 136.8 33.1 103.6 42.3...

Current Risks of China 's Economy

Cao Yuanzheng May, 2017

The Structural Problems of China 's Economy

The 22 indexes and 8 obligatory targets

in the 11th Five-Year Plan have been

met. Of the 14 anticipated targets, 11

targets have been completed.

On the morning of March 5, 2011 when

delivering the Report on the Work of

the Government at the Fourth Session

of the 11th National People's Congress,

Premier Wen Jiabao pointed out that

the proportion of the added value of

the serv ice indust ry , the service

employment proportion and the share

of budget for R&D in GDP haven't met

the set target.

Directions for the China's Economy Structural Adjustment In the process of the 11th Five-Year Plan, the arising problems have highlighted the two

characteristics of China's economic structure:

1. China's economic growth is still mainly driven by the manufacturing industry. The service sector is lagging behind.

2. China's industry is export-oriented with great dependence on external demand, and highly sensitive to world economy.

The key areas of economic restructuring

put forward in the 12th Five-

Year Plan

develop

services

vigorously

expand domestic demand

promote the balanced development of primary,

secondary and tertiary industries with focus on

the development of tertiary industry

Both domestic and overseas demand should be e x pan ded. The core of

expanding domestic demand lies in

expanding consumption, which could be achieved by increasing the income

of residents.

Prominent Achievements of China's Economy Structural Adjustment

Urban and Rural Residents Income Growth Rate Budget Share of the R&D in GDP

nominal growth rate(%)

disposable income growth

rate of urban family

disposable income growth

rate of urban family

Source: Wind info and BOCI Group

The 11the Five-

Year Plan

The 12the Five-

Year Plan


Budget Share of R&D in

GDP

Added Value of Secondary and Tertiary Industry

GDP Growth Rate of China's Provinces

Prominent Achievements of China's Economy Structural Adjustment

(100 million)

Tertiary Industry Secondary Industry

Source: Wind info and BOCI Group Source: Wind info and BOCI Group

on year-on-year basis (%)

Emerging Industries are Growing

The initial success of China's economic restructuring indicate that new economic growth points are emerging.

The increase of the

residents income , esp.

the rural residents.

01 The consumption expansion of the

communications equipment, furniture

and decorating materials .

02

Consumption shifts to service

industry. The development of

health, education, finance,

elderly care, tourism and other

industries are speeding up.

04

Meanwhile, in addition to the technological progress of the automobile and other traditional manufacturing industries, new competitive advantages of the high-speed rail, electricity transmission and other equipment manufacturing industry has taken shape. Central and West China have become the emerging areas of industrial development.

03

New

economic

growth

points

Macro regulation has fostered a favorable environment for these emerging industries.

The 13th Five-Year Plan

1

2

3 4

5 The Goal of

the 13th Five-Year Plan

Maintain a medium-high rate of

economic growth. Maintain a minimum

economic growth rate of around 6.5%.

Advance the urbanization rate. Increase

the proportion of the service industry

and residential consumption to achieve

the industrial upgrading.

Increase people's living standard and

quality. Realize relatively full employment.

Improve the public service systems, such

as employment,education,culture, social

security,healthcare and housing.

Markedly improve the nationals quality and

social civilization. Public cultural systems will

be basically built. Develop the culture industry

into a pillar industry for the national economy.

Further improve the environment quality，

which includes increasing the exploitation and

utilization rate of the energy resources, the

gathering momentum of the green and low

carbon way of life and work， the

improvement of the functional zoning system

and the mechanisms for compensating for

ecological conservation efforts。

Systems of various fields become more

mature and institutionalized, which

covers all aspects of social development,

such as SOE reform, finance, fiscal and

tax system, government actions and

opening up.

The Medium-high Rate of Economic Growth and the Optimization of Economic Structure

According to the target set in the 13th Five -Year Plan, China's GDP will double by 2020 compared with that of 2010. To meet this target, in the next five years the average GDP growth rate should reach at least about 6.5%. In addition to maintaining high-speed economic growth, the urbanization rate and service industry proportion as a share of GDP also need to increase .

The Targeted Average GDP Growth Rate in the Next Five Years

Contribution of Major Sectors to GDP Growth (100 million CNY)

Source: Wind info and BOCI Group Left axis: constant-price GDP in 2010 Right axis: GDP growth rate Agriculture Secondary Industry Service Industry

The 13th Five -Year Plan has underlined that in the process of economic transition, we should pay attention to industrial upgrading, regional collaborative development and energy conservation and environmental protection.

Consumption is the foundation

Consumption upgrading

Increase consumption rate

Develop cross-border e-

commerce

Investment is important

Infrastructure investment, including

urban underground corridors and

information technology networks

Introduce private capital through

PPP

Regional Integration

The Beijing-Tianjin-Hebei

integration

The Yangtze Economic Belt

Industrial Upgrading

The Made in China 2025

initiative

The Internet Plus action plan

New Energy

Reforms

The reform of SOEs: modern corporate system and mixed ownership structures

The reform of fiscal, tax and government budget systems.

The reform of finance: improve the direct financial ratio, reduce financing costs

Opening up

FDI Deregulation and ODI

expansion

Gradually open the capital account

The Belt and Road Initiative.

Strengthen the regional

cooperation and trade

liberalization

The Medium-high Rate of Economic Growth and the Optimization of Economic Structure

The Transformation of China's Economy

Given the current development trend of China's economy, in the aspect of demand structure,

the consumption proportion in the GDP will be more than 50% by 2020. In the supply structure,

the service sector will account for more than 55% of GDP. This means that China's economy will

develop into a consumer-oriented service economy with long-term sustainable economic and

social development . The 13th Five -Year Plan period will be the vital moment of this

transformation. The so-called supply side structural reform is to establish and improve the new

system to support this transformation in order to cultivate the new drivers of economic growth.

In the real economy, China's imports, especially imports of service products will increase. China

will shift from the opening up of the manufacturing industry to the service industry, of which

building bilateral and multilateral free trade zone systems is the foundation, while the Shanghai

Free Trade Zone development is the focus. China's financial market opening will accelerate.

The core of The Belt and Road Initiative is inclusive development, which reflects the traditional

Chinese philosophy of “Harmony matters”. This idea has underlined China's vision to build a

free trade system. China's announcement of joining the TPP negotiations is a practical action to

uphold the economic globalization.

The Leverage Changes of the China's Economic Sector Over the Past Decade

The International Ratios of Leverage Released by the BIS

The overall leverage is low, but the risk of local government debt is increasing.

Corporate leverage is higher than the international average, exacerbating the fragility of the financial system;

In terms of the industry, the leverage of coal industry and most of the heavy industries are higher. In terms of the regions, in China's northeast, north,

southwest and other heavy industrial areas, the leverage are relativley higher.

Currently, China's debt risk is mainly concentrated in the local government and enterprises, where there is also the deleveraging pressure.

Given that macro economy has almost bottomed out, financial risk prevention should be an important priority of 2017 economic policy, of which

orderly deleveraging is the direction. The main approaches are:

(1) adjust and optimize the leverage of the central government, local governments and enterprises. Increase the proportion of the central government and

residents leverage appropriately.

(2) multi-pronged approach to reduce corporate debt levels.

Proportion in GDP（%）

Non-Financial Sector

Private Non-Financial Sector

Famlily

Non-Financial Enterprise Sector

Government

Japan 388.2 167.2 65.9 101.3 211.6 France 290.2 181.4 56.5 124.9 96 Canada 287.6 209.8 97.6 112.2 70.9 Developed Countries 268.2 161.2 75.2 86 99.7 The United Kingdom 265.5 160.3 87.3 73 89.4 China 254.8 210.4 39.5 170.8 44.4 USA 250.6 150.5 79.2 71.2 97.3 Austrialia 243.8 206.6 124.3 82.3 33.5

All Countries in the BIS Report 235.3 152.1 59.6 92.5 78.4

Germany 184.3 106.4 53.6 52.7 71.2 Emerging Markets 179.3 136.8 33.1 103.6 42.3 Brazil 148.5 75.7 25.5 50.1 72.8 India 129.1 60.6 10.1 50.6 68.4 South Africa 126.2 73.7 37 36.7 52.5 Russia 92.4 75.6 16.6 59 16.9 Mexico 76.7 40.9 15.6 25.3 35.8


Government Family Non-financial sector

China's high leverage risk has attracted international attention

China's high leverage risk has attracted international attention in 2016, IMF and BIS published a report to discuss China's high leverage risk, but the calculation of debt ratio in the international organization is considered too general, especially the judgment method to determine the pressure of China's non-financial enterprises through the credit / GDP indicators is worthy of discussion.

China‘s financial system takes the indirect financing as the principal thing, which will undoubtedly heighten the macro leverage of enterprises.

The macro debt ratio can not be equated with the corporate solvency.

The most appropriate debt level in theory and practice is not conclusive. Corporate debt levels are not the same in different countries and at different developmental stages.

In spite of this, it is an indisputable fact that the pressure of debt repayment for China's non-financial enterprises is increasing.

Debt ratio of Non - financial corporate sector：According to BIS statistics,the number rose from 79.3% in 2007 to 170.8% in 2015

Corporate solvency：China's industrial enterprises'profit had a year-on-year growth of 8.5% in 2016 which is significantly decreased compared to the average annual growth rate of 17% over the past decade. The appropriate level of debt in theory and practice is not conclusive. Corporate debt levels are not the same in different countries and at different developmental stages.

China's debt risk is mainly concentrated in three aspects: the bank's bad assets; the shadow banking default; the sustainability of local government debt.


Noteworthy economic and financial risks (2)

Positive financial challenges

On the basis of the controllable financial and debt risk, the deficit level is raised on the foundation of 2016, and the adjustment of the deficit rate is continued.

On the one hand, reducing the macro tax would promote the development of enterprises and reduce the financial revenue. On the other hand, the ensurance of people's livelihood would increase the financial expenditure. Only if public finance relies on other channels, we could set up the infrastructure investment with a certain scale.

For the current local government, not only the fiscal revenue declines, but also there is a high pressure of debt repayment in some areas.

The new deficit will be mainly used to compensate for the reduction and ensure the government's responsibility of expenditure. Infrastructure funds are very limited.

Special financial debt Government investment

fund PPP project

Quasi fiscal means

Commercial banks' bad assets do not lead to the emergence of systemic financial risks

Bank's bad debts have increased since 2013

Cushion: as long as it does not exceed the loan provision

ratio.

Currently, the provision coverage ratio of China's commercial banking

sector is 176%, and the capital adequacy ratio is 13%.

Mortgage loans accounts for the highest proportion

Cushion：As long as the housing price does not

fall below 30%

Source: Wind info and BOCI Group Source: Wind info and BOCI Group

commercial bank's provision coverage ratio(left axis)

commercial bank's NPL ratio (right axis)

property development loans (%)

real estate development loans (%)

individual housing loan (%)

Changes in non-performing loan balances

Commercial banks' bad assets do not lead to the emergence of systemic financial risks


QoQ of non-performing loan balance YoY of non-performing loan balance

Shadow Bank 's Supervision

The balance sheet incorporates non-

standard assets CBRC Balance of assets

and liabilities

Transparency of standard assets CSRC Principles of risk

disclosure

Shadow Bank 's Supervision

Play the basic similarly functions of commercial banks.

Including maturity transformation, credit conversion,

liquidity transformation and so on

There is a higher risk. Funds are mainly from wholesale financing,

a large number of over-the-counter transactions, opaque

information, and a generally higher leverage ratio.

The core issue: not subject to regulation or only less regulated, poor degree of information disclosure.

Shadow bank

(system)

basic

characteristic

The positive meaning of the shadow bank: financial disintermediation It began to securitization in the primary market, and has not formed a transaction in the

secondary market.

Asset securitization is a new idea of shadow bank transparency

The proportion of shadow banks in total social financing is increasingly shrinking


New foreign currency loans Off-balance sheet financing Securities financing

( billion CNY)

The Characteristics of China 's Local Government Debt

China's government debt, including local government debt, accounted for a lower level of GDP in

the world with 44.4% in 2015. At the same time, China is unitary state, the central government bear

the obligations of local finance.

About half of the China's local government debt is local financing platform debt. The local

government only bears the guarantee responsibility, and local financing platform enjoys some

income in considerable projects, covering some repayment of debt.

There is a severe vulnerability in China's local government debt

Serious term mismatch. According to the audit report released by the National Audit Office in

2012, 48.85% of local government debt occurred after the 2008 global financial crisis. Deposits are

short-term, but loans are long-term.

Debt occurs mainly at the grassroot government. According to the audit report released by the

National Audit Office in 2012, China 's 2179 county - level governments, only 54 are not in debt.

Although the amount of debt is not large, but they have a numerous liabilities which increases the

difficulty of debt management.

The basic idea of resolving local debt

Financial and

taxation system

reform, re-

distinguish central

and local

authorities

Strengthen fiscal

discipline

Local financing

platforms operate as

enterprises. Debts as

corporate liabilities,

not to be repaid

with fiscal revenue.

Separation of debt and fiscal

revenue

Real public finance debt

local government

bond

The issue of extension, to have a debt restructuring in the period of extension, implement the PPP.

Asset securitization, solve the issue of bank debt through the development of bond market.

Core

RMB exchange rate and the rising risks of cross-border capital flows

Economic fundamentals

The US economic recovery process accelerated in the second half of 2016

China's economy is entering a new stage of speed shift

Financial factors

The process of interest rate increase for Federal Reserve is started.

Emerging markets generally arise the intensified capital outflows,and the new phenomenon of increasing pressure of exchange rate devaluation.

Balance of payments

Double surplus replaced by a narrowing current account surplus and a capital account deficit.

The RMB exchange rate is more susceptible to volatile and variable cross-border capital flow

Future uncertainty

The US dollar strengthens .

The follow-up effect of Brexit

Currently, RMB depreciates against the U.S. dollar

Exchange rate of U.S. dollar against the RMB


Exchange rate of RMB against the U.S. dollar

offshore and onshore exchange rate spreads(right axis)

onshore exchange rate(left axis) offshore exchange rate(left axis)

While other currencies remained stable and increased slightly

RMB exchange rate against major currencies USD exchange rate against major currencies

Source：Wind Info and BOCI Group Source：Wind Info and BOCI Group

The exchange rate of USD against RMB (left axis) The exchange rate of EUR against RMB (right axis) The exchange rate of 100 JPY against RMB (right axis)

USD index(weighted index to six main currencies) (left axis) The exchange rate of EUR against USD (right axis) The exchange rate of 100 JPY against USD (right axis)

USD strengthens against other currencies

USD index and RMB exchange rate RMB exchange rate index


index USD against RMB index

USD index(left axis) USD against RMB(right axis) CFETS RMB exchange rate index BIS RMB exchange rate index

SDR RMB exchange rate index

RMB has not yet seen significant devaluation signs in fundamentals

In the long run, if a country's labor productivity continues to increase compared to other countries, the

currency will show an appreciation trend (Balassa-Samuelson effect). China’s labor productivity is improving

slowly, which is estimated at 3% per year, due to the economic transformation and the development of the

service industry. This not only determines the foundation of the RMB ROA, but also means that there is no long-

term devaluation basis although the RMB cannot appreciate quickly.

In the medium term, China currently does not form the cost-driven inflation of price trend although the

economy deflation ended and the PPI gained a positive growth which pushed up the CPI correspondingly. The

CPI of 2017 is expected to be around 2.5%. In other words, the RMB purchasing power is relatively stable which

contributes to a stable one basket exchange rate.

In the short term, the exchange rate fluctuations of the RMB against the USD mainly depend on the trend of

the USD, especially the Fed's rate hike frequency and amplitude as well as its expectations on the USD.

The stability of a country’s currency depends on labor productivity and determines purchasing power parity.

The current reason for the volatility of the RMB exchange rate – offshore RMB guides onshore RMB

Offshore RMB exchange rate


3-month premium or discount of offshore RMB exchange rate(right axis)

Middle rate of RMB against USD(left axis)

overnight CNH HIBOR(left axis) spot exchange rate(right axis)

offshore rate(right axis)

the exchange rate of USD against RMB

The current reason for the volatility of the RMB exchange rate - the interest rate starts to guide the exchange rate

U.S. treasury securities rate China treasury debt rate


Yield to maturity of China treasury debt:10-year

Yield to maturity of China treasury debt: 2-year US: treasury yields: 2-year US: treasury yields: 10-year

Currently the formation of RMB exchange rate – needs two markets, three forces and multiple transmission

Institutional investors, residents and monetary authority（central bank） Three

forces

Offshore market（CNH）and onshore market（CNY） Two markets

1.When institutional investors of offshore market expect the RMB to depreciate, their reaction

will immidiately affect onshore market, causing the spot exchange rate to change and return to

offshore market. Measures taken by monetary authority(central bank) are to increase market

interest rate and tighten RMB liquidity on the offshore market, such as limiting the net outflow

of RMB to raise overnight interest rate and stabilize the exchange rate, and then the interest rate

parity appears.

2.When the spot exchange rate of onshore market changes, residents see the spreads between

foreign currency and local currency increase, with the absence of actual using of foreign currency,

they will speculate more on foreign currencies to earn spreads like trading stocks, so the foreign

currencies in their household balance sheets increase, but there is actually no physical outflow.

At this point, the monetary authority can only sell foreign currencies to stabilize the market and

prevent the speculation, and then exchange rate equalization appears.

Transmission

mechanism

Currently the formation of RMB exchange rate – different acts to common point

China's international balance of payments capital account and financial account have undergone new changes

apart from those current account and capital account which use foreign currencies normally: on the one hand:

foreign institutional investors driven by the zero-risk and high-return of RMB asset began to return to the

mainland. In the second quarter and third quarter of 2016, the net inflow of securities investment was $ 7.7

billion and the net outflow was $ 10.5 billion, significantly down from the first quarter which has a net outflow of

$ 40.9 billion. On the other hand, domestic residents are showing a keen interest in buying foreign currencies

which demonstrates a net outflow of central bank’s foreign currencies reserve(a decrease in the reserve), the

net outflow was up to 69.06 billion US dollars in November, 2016.

However, different acts have a common point - the RMB asset return rate. Chinese residents’purchasing of

foreign currencies lead to a sharp increase in the Chinese bank residents foreign currencies deposits, but they

did not remit abroad significantly in the expectation of exchanging USD to RMB when the RMB devaluate

substantially. Different acts and common point indicate that interest rate parity is accelerating its formation. The

RMB interest rate, especially the zero-risk and high-return RMB asset has become a new exchange rate control

means to the monetary authority (central bank) .

Future policy trends: speed up the reform of exchange rate formation mechanism

In the short term, a previous guidance is the point for China’s monetary authority. The USD overvaluation accounts directly for the volatility of RMB exchange rate currently and market predicts that Federal Reserve System may raise the interest rate 2-3 times in 2017. While strengthening the international macroeconomic coordination, the central bank will intensify its anticipated management of RMB trend, promoting the RMB closing price to be normal through the operation of foreign currency parity and deepened communication with the market. At the same time, according to the demand of residents for currency purchasing, the consideration for actual background of exchanging currencies will be consolidated by the central bank to restrict the speculation unless that is an actual using of currencies, the main measures are to control the channels of foreign currency outward remittance, such as a compliance review on residents’buying a house abroad or investment of financial asset to avoid the self-realization of prediction on exchange rate fluctuation.

In the medium term, the central bank will implement prudent monetary policy in 2017 with M2 expected to grow by 11.5%. At the same time, the deleveraging of non-financial enterprises will start substantially. All these will tighten the liquidity and raise the short-term interest rates, and the long-term steep yields will be affected correspondently. It objectively contributes to attracting capital inflows, thus helping stabilize the RMB exchange rate.

In the long term, “One Belt, One Road" as well as the RMB’s participation to the SDR emphasize the RMB exchange rate parity. It is imperative to break the barriers between offshore and onshore markets, so as to achieve the conformity of domestic and international interest rates. China comprehensively opened the domestic inter-bank bond market to foreign institutions in 2016, allowing them to largely release Panda bond, Shenzhen and Hong Kong’s no-limit on the total amount is an example.

Currently the RMB interest rate is about 300 basis points higher than the USD interest rate, it’s cost-effective to hold RMB assets as long as the exchange rate of USD appreciate against RMB is no more than 3%.

Comparison of Sino - US Spreads

The deposit and lending rate in China The 10-year national debt spreads between

the US and China


1-year deposit rate 1-year lending rate China’s 10-year national debt yields

Comparison of Sino - US Spreads

National debt rate and spreads between America and China

America’s 10-year

national debt yields

Prospects

At present, the disparity of the economic cycle to each country determines the division of monetary policy,

inducing the uncertainty of international short-term capital flows and intensifying the risk of financial unsteadiness

which urgently needs all countries to strengthen their macroeconomic coordination, But it has become more and

more difficult to adopt such policies when confronted with deglobalization. If not careful, it can not be ruled out

the possibility of a new economic crisis like Asian financial crisis in 1998 when short-term capitals flock to America,

increasing the imbalance of international balance of payments in countries that capitals flow abroad.

If so, the RMB will be expected, as in 1998, not to devalue. On the one hand, it may lead to a dramatic increase in

China’s imports, pushing the country’s enterprises to suffer more competitiveness and a weakened earnings

prospect. On the other hand, the non-devaluation RMB will serve as a anchor currency to the exporting countries

to China especially the Asian countries. Under this circumstances, RMB will be likely to give up keeping a close

watch at USD exchange rate while correspondently links to One Basket currency, and then the RMB exchange rate

is fully converted to a interest rate issue. From this perspective, it appears to be very essential that the yield rate

curve which is represented by national debt yield rate be complete. An interest rate market of diversity and

coherence with a reasonable term structure can be expected.

Doctor Cao Yuanzheng

Address：Fuxingmen Avenue 1,Beijing,100818

Telephone：8610-66594785

Fax：8610-66594040

E-mail：[email protected]

Thank you！

Current Risks of China 's Economy · 2017. 6. 7. · Emerging Markets 179.3 136.8 33.1 103.6 42.3...

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Transcript of Current Risks of China 's Economy · 2017. 6. 7. · Emerging Markets 179.3 136.8 33.1 103.6 42.3...