China economy - WikiLeaks · Nomura | Asia Special Report November 2011 3 Foreword We are pleased to present Nomura‟s Anchor report on China, in which our economists, strategists,

China risks

We attach a one-in-three probability to China

experiencing a hard economic landing commencing before the end of 2014.

We define “hard landing” as an abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters.

We discuss six key reasons why the risk of a China hard landing happening in the next three years appears to have increased.

We launch Nomura’s China Stress Index (CSI), which uses 18 indicators to summarize the macro risks in a single measure.

Our global strategy teams conduct a “what if” exercise, discussing trading recommendations and stock ideas for this non-trivial risk scenario.

GLOBAL ECONOMICS AND

STRATEGY

Novem ber 2011

AN

CH

OR

RE

PO

RT

Any portion of this report that has

been prepared by a trading desk

analyst is not a product of the

Fixed Income Research

Department and is not covered by

the Research Analyst certification

provided in Appendix A-1. For

additional information concerning

the role of Trading Desk Analysts,

please see the important conflicts

disclosures beginning at page

101 of this report.

November 2011

Research analysts

Economist

Rob Subbaraman

[email protected]

+852 2536 7435

Strategist

Kevin Gaynor

[email protected] +44 (0) 20 710 27800

China economy

Nomura | Asia Special Report November 2011

2

Foreword ........................................................................................................... 3

Executive summary ......................................................................................... 4

Introduction – Six reasons to worry .............................................................. 5

Defining a hard economic landing ................................................................. 8

Defining a “hard landing” ................................................................................ 8

Triggers and timing ........................................................................................ 8

Policy responses ............................................................................................ 8

Perceived likelihood ..................................................................................... 10

Nomura’s China Stress Index (CSI) ............................................................. 11

1. Overinvestment and excessive credit ..................................................... 13

Box 1: Fuzzy numbers .............................................................................. 14

Box 2: China‟s challenging GDP arithmetic .............................................. 17

Box 3: Lessons from Japan on the return and cost of capital .................. 19

2. Rudimentary monetary architecture ........................................................ 22

Box 4: Shadow banking in the US and China compared ......................... 26

3. The privileged state-owned enterprises .................................................. 28

Box 5: Investment is high, but savings are even higher ........................... 30

Box 6: The Akerlof market for lemons problem applied to China ............. 31

4. Unintended consequences of financial liberalization ............................ 33

Box 7: A chronology of China‟s capital account liberalization .................. 34

Box 8: Risks associated with financial liberalization: lessons from Japan 38

5. The Lewis turning point ............................................................................ 39

6. The setting in of growing pains ............................................................... 43

Demographic challenges .............................................................................. 43

Box 9: China‟s hukou household registration system .............................. 46

Rising inequality and an aspiring middle class ............................................ 46

Resource and environmental strains ........................................................... 51

Pricing a China hard landing – Strategy perspectives .............................. 56

Global macro perspectives ........................................................................... 59

Global equity perspective ............................................................................. 64

Asia-ex Japan FX perspective ..................................................................... 67

Implications for Asia regional equities…………………………………………69

China equities – the risk…………………………………………………….......73

Chinese credits – already reflecting the risks of a China hard landing ........ 91

References ...................................................................................................... 94

Appendix: The Construction of Nomura‟s China Stress Index ....................... 97


3

Foreword

We are pleased to present Nomura‟s Anchor report on China, in which our

economists, strategists, equity and political analysts assess the medium-term

risk of a hard landing – a critical issue for today‟s global economy.

At Nomura, we pride ourselves in producing research of the highest standard.

Historically, we have had a strong presence across Asia, and in recent years

we have increased our footprint in Europe and the United States to become

Asia‟s leading global investment bank. Our roots in Asia allow us to see first-

hand the breakneck speed at which the region‟s economies are emerging –

and contributing over half of global GDP growth.

China leads the world in the growth stakes, but the risks in our view have risen

and should no longer be ignored. Our base case is that China's economy will

average growth of about 8.5% in 2012-14, but we judge that the risks of a

temporary interruption that pushes growth far below potential are rising. We

define a so-called “hard landing” as an abrupt slowdown in real GDP growth to

average 5% or less for at least one year. This report discusses six key factors

that lead us to attach a one-in-three likelihood that China‟s economy

commences a hard landing before the end of 2014.

How would this non-trivial risk of a hard landing in China impact global

financial markets? Our global and Asian equity, FX, rates and credit strategy

teams assess the macro implications and present trading recommendations

and specific stock ideas to this risk scenario.

How can investors calibrate the risk of this hard landing scenario? In this

report we launch Nomura‟s China Stress Index (CSI) which we will update

quarterly. The exact probability of a hard landing is necessarily a matter for

investor judgment, but the CSI will give investors an important indication of risk.

Nomura‟s Anchor series of reports underscore our dedication to produce

thematic, long-term studies, involving cross-region and cross-division

collaboration among our global markets research teams.

We welcome your feedback as we continue our tradition of collaborative work

to deliver unique investment insight and ideas to our clients.

Hideyuki Takahashi Paul Norris

Head of Global Research Head of Global Markets Research


4

Executive summary1

This study takes China‟s still enormous economic development

potential as a given and focuses on the risks and challenges that lie

ahead – for the economy‟s meteoric rise has been associated with a

build-up of fundamental imbalances.

We define a hard economic landing in China as an abrupt slowdown in

real GDP growth to an average of 5% y-o-y or less over four

consecutive quarters.

While our base case is that China's economy will average growth of

about 8.5% in 2012-14, we discuss six compelling reasons why the

risk of a hard landing has increased. We attach a one-in-three

likelihood that a hard landing commences before the end of 2014.

Overinvestment and excessive credit. China's investment is almost

half of GDP, while domestic credit is nearly 1.5x GDP, or 1.8x if the

shadow banking sector is included. Empirical literature shows that

investment booms are more likely to trigger a crisis if they are

associated with credit booms. China ticks both of these boxes.

A rudimentary monetary architecture, centered on controlling the

exchange rate is not very effective in managing an economy that is

rapidly becoming more open and sophisticated, and has resulted in a

cost of capital that is too low and a financial sector that is repressed.

The privileged state-owned enterprises receive preferential

government subsidies and bank financing, yet they are capital

intensive, inefficient and crowd out smaller private enterprises.

Unintended consequences of financial liberalization.

Internationalization of the renminbi is adding pressure for China to

accelerate financial liberalization, but this is not without risks, such as

falling credit standards as banks overly compete with one another.

The Lewis turning point, associated with a dwindling supply of

surplus labour from the countryside, is likely upon China, which could

trigger a serious outbreak of inflation.

The setting in of growing pains from worsening demographics and

increasing strains on natural resources and the environment. These

growing pains will almost certainly cause the economy's growth

potential to slow over this decade, making it more challenging to

implement structural reforms and address high income inequality.

China's economy is now so big and complex that many of its structural

problems are becoming more interrelated. Also, many of its critical

reforms are becoming unavoidably connected, making it more difficult

to continue undertaking individual reforms gradually and in isolation.

The government would no doubt do all in its power to respond, but the

question is how large, quick and effective a policy stimulus would be.

On all three counts, we judge that it would be less than in 2008.

We are well aware that picking the exact timing of a hard landing is

devilishly difficult. The key will be whether the risk of a hard landing

rises or falls in the future. Enter Nomura's new proprietary tool, our

China Stress Index, which uses 18 indicators to summarize the macro

risks in a single measure.

Please refer to the summary pages 56-58 for strategy perspectives,

trading recommendations and stock ideas should the non-trivial risk of

a China hard landing impact global financial markets.

1 The authors of particular parts are accredited in their respective sections, but specific mention should be made

of Zhiwei Zhang, Chi Sun, Alastair Newton, Simon Flint, Pradeep Mohinani, Michael Kurtz, Ian Scott, Chien-hua Chen and Qilong Zhang. We are grateful to Candy Cheung and Wendy Chen for data analysis; David Vincent and Kenneth Persing for editing; and Jay Chandrasekharan for coordinating the equity analysts. We are also indebted to Zhiwei Zhang, Paul Sheard and Paul Norris for providing helpful comments on early drafts.


5

Introduction – Six reasons to worry

China has made remarkable achievements in development, but it

remains the largest developing country in the world. Population,

resources and the environment have put great pressure on our

economic and social development, and there is lack of adequate

balance, coordination or sustainability in our development.

President Hu Jinato, Boao Forum for Asia, Hainan, China, 15 April 2011.

China‟s economy has averaged 10% real growth since it launched its reforms

and began to open up in 1978. In 2010 it surpassed Japan to become the

world‟s second-largest economy (Figure 1).2 Yet China is still a poor country:

its nominal GDP per capita of USD4,400 in 2010 is similar to that of Japan in

1975, suggesting that there is still lots of room to urbanize, industrialize and

move up the value-added ladder (Figure 2).3 However, as China‟s leaders

readily admit, the economy‟s meteoric rise has been associated with a build-up

of fundamental problems: the export- and investment-led growth model is

reaching its limits; macro and industrial policies need a major overhaul; the

once seemingly endless supply of cheap rural labour migrating to the cities is

diminishing; and there are the growing challenges of worsening demographics,

high income inequality, resource shortages and environmental degradation.

Fig. 1: China’s long-run real GDP growth

Source: CEIC and Nomura Global Economics.

Fig. 2: Nominal GDP per capita: China vs Japan


This study takes China‟s still enormous economic development potential as a

given and focuses on the macro risks and challenges that lie ahead.

Our base case is that China's economy will average growth of about 8.5% in

2012-14, but we judge that the risks of a temporary interruption that pushes

growth far below potential are rising. We define a so-called economic “hard

landing” as an abrupt slowdown in real GDP growth to an average of 5% y-o-y

or less over four consecutive quarters. Six factors lead us to attach a one-in-

three likelihood that a China hard landing commences before the end of 2014.

1. Overinvestment and excessive credit

2. Rudimentary monetary architecture

3. The privileged state-owned enterprises (SOEs)

4. Unintended consequences of financial liberalization

5. The Lewis turning point

6. The setting in of growing pains

2 To compare the sizes of economies we convert nominal GDP into USD at market exchange rates.

3 GDP per capita in constant prices is a more appropriate yardstick to compare real purchasing power, but such

data on a consistent basis are only available back to 1960. World Bank data show that in 1960, Japan's real GDP per capita (USD7,241) was still higher than China's real GDP per capita (USD2,423) in 2010, suggesting that China's current real average standard of living is more on par with Japan's before the 1960s.

-30

-20

-10

0

10

20

30

1950 1960 1970 1980 1990 2000 2010

% y-o-y

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

1970 1975 1980 1985 1990 1995 2000 2005 2010

China

Japan

USD

China's economy still has lots of room to develop, but fundamental problems have built up

Six factors lead us to attach a one-in-three likelihood that a China hard landing commences before the end of 2014


6

While there may be many tell-tale warning signs that a hard landing is coming,

the trickiest part is getting the timing right. The conventional wisdom seems to

be that, because of political incentives, a hard landing, should there be one,

would not occur until after the transition to China‟s fifth generation of leaders in

early 2013.4 The analysis of Eichengreen, Park and Shin (2011) adds some

support to this view. They analyse a sample of 41 fast-growing economies

over the period 1957 to 2007 and find that on average these economies slow

significantly when GDP per capita on a purchasing power parity basis hits

USD16,740 – which China is unlikely to reach until 2015, at the earliest.5

However, they also show that a low consumption-to-GDP ratio, higher and

more volatile inflation, a rising old-age dependency ratio and an undervalued

exchange rate are important features that typically increase the chances of a

sharp slowdown – and China has all of these.

While we are well aware that picking the exact timing of a hard landing is

devilishly difficult, we find some compelling reasons why the risk of it

happening in the next three years should no longer be ignored.

The empirical literature on the causes of financial crises offers some pertinent

lessons to China. The first is that an extended period of high GDP growth can

mask the build-up of underlying financial problems, in part because the most

robust leading indicator of financial crises – the debt-to-GDP ratio – is flattered.

Lesson number two is that investment booms are more likely to trigger a crisis

if they are associated with credit booms. China ticks both of these boxes:

investment (public and private) comprises nearly half of GDP and domestic

credit is almost 1.5x GDP, or 1.8x if the shadow banking sector is included.

The second reason relates to China's stage of economic development – the

economy has become so big and complex that many of its structural problems

are becoming more interrelated. For example, a rudimentary monetary

architecture, centering on controlling the exchange rate, has resulted in a cost

of capital that is too low and a financial sector that is severely repressed. The

too-low cost of capital has fueled overinvestment, while the financial

repression has given rise to a flourishing shadow banking sector. Another

example is the generous government and bank support given to the less

efficient and capital-intensive state-owned enterprise (SOE) sector, which

leads to wasteful investment of scarce resources, environmental degradation

and credit rationing to private small to medium-sized enterprises (SMEs).

Rather than any one of these factors alone, we believe it is the combination of

various imbalances and interactions among them that increases the likelihood

of a major setback.

Third, increasing strains on natural resources and the environment, together

with demographic changes rapidly turning unfavorable, are causing growing

pains to set in that will almost certainly cause the economy's potential growth

to slow over the course of this decade and inflation to be structurally higher. In

an environment of slowing trend growth and higher structural inflation,

structural problems festering below the surface can bubble up to the surface,

and implementing reforms can be more challenging. For instance, removing

the generous government subsidies to SOEs, can become politically more

divisive as power and economic privilege needs to be wrested from local

governments, the SOEs and the banks.

Fourth, historically the government has implemented reforms incrementally.

However, China has reached a stage of development at which many of its

critical reforms are unavoidably connected, making it more difficult to

undertake individual reforms gradually and in isolation. For example,

internationalizing the renminbi and moving to a more flexible exchange rate

4 For example, according to a Bloomberg global survey on 29 September 2011, 1,031 of its subscribers were

asked about the chances of China‟s economy slowing below 5% growth: 12% of respondents believed it will happen within the next year, 47% within the next 2-5 years and the remainder thought longer than 5 years, or that it would never happen. 5 Specifically, the authors identify 43 cases where rapidly growing economies slow significantly – that is, real

GDP growth shifts down by at least 2 percentage points – and calculate that, on average, the tipping point is when GDP per capita (on a purchasing power parity basis) is USD16,740.

The empirical literature on the causes of financial crises offers some pertinent lessons to China

China‟s economy has become so big and complex that many of its structural problems are becoming more interrelated

Increasing strains on natural resources, the environment, and demographics are causing growing pains to set in

It is becoming more difficult to undertake individual reforms gradually and in isolation


7

regime are adding pressure on China to press ahead with capital account

liberalization and interest rate deregulation. But without adequate safeguards,

financial deregulation can pressure banks to engage in overly aggressive

competition, lowering overall credit standards. Another example is China‟s

shrinking supply of young, rural surplus labour which is starting to accelerate

wage growth. One proposed reform is to relax the rigid hukou household

registration system, giving city migrants the same rights as locals so as to

encourage greater labour mobility and faster urbanization. But without other

reforms this could exacerbate other problems, such as environmental

degradation and social tensions. We see the pressure building to make more

broad-based wholesale reforms, but given growing inter-linkages of various

reforms, big changes will carry greater risks. Politically, it is hard to envisage

substantial change before the next generation of leaders takes the helm in

March 2013.


8

Defining a hard economic landing

The term “China hard landing” is too often a throw-away line that means

different things to different people. We provide a precise definition of what we

regard as a hard economic landing in China. In addition – and with a large

dose of humility – we present our views on the likelihood, timing and

description of a hard economic landing, were it to occur.

Defining a “hard landing”

We define a hard economic landing in China as an abrupt slowdown in real

GDP growth to an average of 5% y-o-y or less over four consecutive quarters.

In economists‟ parlance we would regard this as a deep recession. On our

estimate of China‟s potential GDP growth being around 8%, our hard landing

definition means GDP growth being at least 3 percentage points (pp) below

potential, which we would regard as equivalent to a contraction in real GDP in

the US, on average, over four consecutive quarters. Note that under our

definition, China‟s real GDP growth could average 4.9% y-o-y for four quarters

in a row, or it could plunge to negative year-on-year growth in one quarter (a

low probability event, but one that we do not rule out) before rebounding to

over 5% y-o-y in subsequent quarters – but for the four quarters, averaging

below 5%. The last time China experienced a hard economic landing by this

definition was when real GDP growth slowed from 11.3% y-o-y in 1988 to

4.1% in 1989 and 3.8% in 1990, before rebounding to 9.2% in 1991. From Q4

1999, China started publishing quarterly real GDP data, and since then the

lowest average growth on a four-quarter rolling basis was 7.5% y-o-y in Q4

2001.

Triggers and timing

Although the advanced economies falling back into recession would hurt

China‟s exports, the economy is too domestic driven, in our view, for external

shocks to directly cause a hard landing. The more likely cause would be a

major pullback in investment from its current very high share of almost half of

GDP. Within gross capital formation, investments in property (24% of total)

and infrastructure (28% of total) appear the most vulnerable components.

Examples of potential triggers of an investment-led downturn include: 1) a

correction in what appears to be an overheated property market; 2) policy

mistakes, for instance the People‟s Bank of China (PBC) underestimating

inflation and having to play catch-up via aggressive tightening; 3) unforeseen

shocks, such as social unrest or a deadly pandemic; and 4) simply “investment”

fatigue setting in. Whatever the trigger, a major pullback in investment would

be likely to cause a steep rise in non-performing loans (NPLs) given that

China‟s domestic credit-to-GDP ratio is also at an extraordinarily high 1.5x, or

1.8x once the shadow banking sector is taken into account. Through losses of

wealth, confidence and jobs there would likely be large indirect knock-on

effects to household consumption.

It terms of timing, there is an argument that, because of political incentives, a

hard landing would not be allowed to happen until after the leadership

transition in March 2013. However, we would not rule out it happening earlier,

given: 1) the ratios of investment to GDP and credit to GDP are so high; 2)

support from exports is likely to be less than before; 3) the economy has

become so large and complex that many of the structural problems are

becoming more interrelated; and 4) policy responses are likely less effective

than before.

Policy responses

In response to the global financial crisis China implemented a RMB4trn (13%

of 2008 GDP) fiscal stimulus; put the steady appreciation of the CNY/USD

exchange rate, that has been in train since July 2005, on hold; cut the bank

Our definition is an abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters

The most likely cause would be a major pullback in investment, but there are many potential triggers


9

reserve requirement ratio (RRR) by 250bp; and cut the benchmark 1yr lending

rate by 216bp. We have no doubt that the government would again do all in its

power to respond to signs of a hard landing, but the question is how large,

quick and effective a policy stimulus would be. On all three counts, we judge

that it would be less than in 2008.

On monetary policy, we would expect aggressive cuts in the bank RRR and

CNY/USD appreciation to once again be halted (if there were to be large net

capital outflows rather than allowing CNY/USD depreciation, we would expect

the PBC to drawdown its USD3.2trn of FX reserves to keep CNY/USD stable).

On the other hand, we see a higher hurdle than in 2008 for the PBC to cut the

benchmark 1yr lending rate aggressively. One reason is because of greater

inflation pressures today, with CPI inflation currently much higher (6.1% y-o-y

in September 2011) than the 2.5% in 4Q 2008. Moreover, core CPI inflation,

which excludes food and energy items, has also risen steadily over the past

two years to 2.4% y-o-y in Q3 2011, the highest since the government began

publishing the data in 2005, suggesting that a structural inflation problem is

emerging (see Asia Special Report, China: The case for structurally higher

inflation. 21 September 2011). Another reason is what we believe is growing

recognition among China‟s policymakers that interest rates were set

fundamentally too low in the past, and that this cheap cost of capital

contributed to overinvestment. As such, we would expect to see greater official

resistance to rate cuts than in the past.

On fiscal policy, we would expect another stimulus package and, to avoid the

economy becoming more unbalanced, there would likely be more focus on

consumption-boosting measures. However, fiscal stimulus aimed at

consumption tends to be less effective than public investment, because any

increase in household income can be saved rather than spent.

Therefore, we would expect a fiscal stimulus package to again be dominated

by public investment, but again believe it would be less effective than that

seen in 2008-09, for three reasons.

First, while China certainly has room for fiscal stimulus, it has less room than it

did before. Central government debt is still low at around 20% of GDP, but the

build-up of local government debt in recent years has lifted general

government debt (central plus local) to around 50% of GDP. On top of this are

the government‟s contingent future liabilities, including future losses related to

NPLs and unfunded pension liabilities which, if all were to be recognized in

2011, would lift the general government debt to 85% of GDP, according to the

IMF (2011a, p.47).

Second, the speed of implementation would likely be slower than in 2008-09.

Before the global financial crisis, the economy was overheating, forcing the

National Development Reform Commission (NDRC) to turn down a large

number of new investment projects by SOEs and local governments. So when

the global financial crisis hit, China had many large off-the-shelf investment

projects ready to go and so could boost investment quickly. This is no longer

the case.6

Third, given that government-influenced investment comprises about one-third

of total investment, to avoid a fall in total investment public investment must

grow by twice as much as any decline in private investment growth. The

government “doubling up” with another public-led investment boom could

heighten concerns over misallocated, wasteful investment, increasing fears of

an even bigger hard landing further out – the private response could be to pull

back investment even more.

6 The growth of newly started fixed-asset investment projects was 28.7% y-o-y in 2007, but the NDRC‟s rejection

of new projects caused the growth rate to plunge to -2.9% y-o-y in Jan-July 2008; the NDRC reversed course after the global financial crisis hit, and the pent-up demand caused the growth rate to rebound to over 80% y-o-y in Jan-Oct 2009. The growth of newly started fixed-asset investment projects was 23.1% y-o-y in Jan-Aug 2011, and there is now much less pent-up demand.

We see a higher hurdle than in 2008 for the PBC to cut the benchmark 1yr lending rate aggressively

Another public-led investment boom could heighten concerns over misallocated, wasteful investment

The speed of implementation would likely be slower than in 2008-09

China still has room for fiscal stimulus, but less than in 2008

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=463995



10

Perceived likelihood

Drawing together the strands of the analysis we have done on the six main

macro risks in China, our overall assessment is that the chance of a hard

economic landing has increased in recent years. We attach a one-in-three

probability of real GDP growth falling to an average of 5% y-o-y or less over

four consecutive quarters sometime between now and the end of 2014. While

our baseline modal (i.e., most likely outcome) forecast – to which we attach

the residual two-third probability – is for China‟s real GDP to grow by an

average of 8.5% in 2012-14. We are aware of the non-trivial tail risk of a much

worse outcome which, as we explain in the final chapter, would have severe

repercussions for the global economy and financial markets.

Interestingly, this year there has been a significant sell-off in China‟s equity

and credit markets, yet most China economists have not significantly

downgraded their GDP forecasts. For example, the latest 10 October survey of

18 market economists by Consensus Economics Inc. shows that the

consensus forecast of China‟s real GDP growth is 8.5% in 2012 and 8.4% in

2013, while the IMF‟s latest forecast (released in September) is 9.0% in 2012.

The way we would reconcile this gap is that economists forecast the modal, or

most likely, outcome, whereas the financial market tends to take a weighted-

average probability of different possible outcomes. If we apply our baseline

and hard-landing probabilities to the market method {(8.5*0.66)+(5.0*0.33)}, it

gives a weighted-average GDP growth forecast of at most 7.3% in 2012-14. In

other words, like-for-like, our forecasts are probably not that dissimilar to what

the market is pricing in – the key will be whether the risk of a hard landing rises

or falls going forward, which brings us to Nomura‟s new proprietary tool – our

China Stress Index (CSI).

We attach a one-in-three probability to our definition of a hard landing commencing sometime between now and the end of 2014


11

Nomura‟s China Stress Index (CSI)

To more closely monitor the risks of a hard landing in China‟s economy, we

have constructed a macro China Stress Index, or CSI for short. The CSI is

made up of 18 indicators that quantify the macro risks in China into one

summary measure. We selected the 18 indicators by using two main criteria:

• Importance: Each indicator signals an important risk factor that we

believe is not fully captured by other indicators in the CSI. We try to capture,

among others, the risks associated with over- and mal-investment, particularly

in the property market; excessive credit and the problems created by the

rudimentary monetary architecture; structural inflation risks associated with the

Lewis turning point; and the increasing challenges arising from high income

inequality and environmental degradation.

• Availability: A challenge not only in China, but in all developing

economies is the paucity of the data. We chose indicators that are sourced

from official statistics and that have a time series of over a decade, so that the

CSI has a reasonably long history for statistical inference (the CSI begins in

January 2000). For the indicators that are available only on an annual or

quarterly basis, monthly series were interpolated from the longer-frequency

data.

To construct the CSI, the 18 indicators are first standardized and then

weighted. The weights, to some extent, are subjective, but they are grounded

in our analysis in the following chapter and international experience of the

common causes of emerging market crises. Most variables have weights of 3-

5%, while two have 8% weights (property loans/total loans and residential

property price index/long-run trend) and three have 10% weights (gross capital

formation/GDP, domestic credit/GDP and new shadow banking funding/ new

total social financing). The CSI is indexed to 100 in January 2000. For more

technical details on the methodology in constructing the CSI, please see the

Appendix: The construction of Nomura‟s China Stress Index.

The CSI indicates that risks in China‟s macro economy have been on a broad

uptrend, and more noticeably since the global financial crisis. In Q2 2011, the

CSI rose to its highest level since it was first compiled, but in Q3 it eased

slightly, mainly because of a decline in the flow of new shadow banking

funding (Figure 3). One limitation of the CSI is that it does not give a

probability of a hard economic landing. To do so would require a reference

variable measuring past episodes of hard economic landings in China, the

obvious one being real GDP. Yet in the past 20 years China‟s GDP growth has

not fallen below 5% and before then the causes of hard landings in GDP were

influenced heavily by social and political unrest.

We could have used panel data on GDP from other countries showing hard

economic landing experiences internationally, but in our view China‟s economy

is too special for this exercise to give credible results. So what the CSI tells us

is: 1) the direction of overall macro risk; and 2) how fast the risk has changed

compared to history.

The CSI is made up of 18 indicators that quantify the macro risks in China into one summary measure

The CSI indicates that risks in China‟s economy have been on a broad uptrend, more noticeably since the global financial crisis


12

Fig. 3: Nomura’s China Stress Index

Note: The last data point is September 2011. Source: PBC; National Bureau of Statistics and Nomura Global Economics. For details of construction, see the Appendix: The construction of Nomura‟s China Stress Index

A closer look at the components reveals that rapid increases in residential

housing starts relative to sales, residential property prices, gross capital

formation, property loans and domestic credit have been the main recent

drivers (Figure 4). We are under no illusions that the CSI has its limitations and

needs to be treated with caution. The results of the CSI, which we will update

on a quarterly basis, should always be open to interpretation, and used as a

tool among many others for analysis of China macro risks.

Fig. 4: The five biggest drivers of the CSI over Jan 2007-Sep 2011 (contribution to the increase in the CSI index over this period)

Note: Unit is percentage point. Source: PBC; National Bureau of Statistics and Nomura Global Economics. For details of CSI construction, see Appendix: The construction of Nomura‟s China Stress Index.

Fig. 1

99.5

100.0

100.5

101.0

101.5

102.0

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Jan 2000=100

0 0.05 0.1 0.15 0.2

Residential housing starts less sales

Residential property price deviation from long-run linear trend

Gross capital formation/GDP

Property loans/total loans

Domestic credit/GDP

Housing starts relative to sales, property prices, gross capital formation, property loans and domestic credit have been the main recent drivers


13

1. Overinvestment and excessive credit

Since the early 1960s the share of total investment (public and private gross

capital formation) in China‟s GDP has trended upwards, a normal course of

economic development as poor countries start with a small capital stock

ensuring a high return on capital and hence a high rate of investment. Former

leader Deng Xiaoping endorsed this trend during his famous South China tour

in 1992, by espousing the benefits of an open economy, setting China firmly

on the path of export- and investment-led growth. China‟s share of investment

in GDP rose from 35.3% in 2000 to a relatively high 43.9% in 2008, before

surging to 47.5% in 2009 and to 48.6% in 2010 (Figure 5). By the end of 2010,

we estimate that more than half of China‟s total gross capital formation was

related to property (23.8%) and infrastructure (27.7%). This year, property

investment has continued to surge, to 13% of GDP in Q3 2011 (Figure 6).

Fig. 5: Investment and consumption shares of nominal GDP


Fig. 6: Property investment share of nominal GDP

Source: China's NBS and Nomura Global Economics.

In international and historic terms, China is now an outlier: no other large

economy has had such a high investment-to-GDP ratio for so long. The

highest investment ratio in the US since 1929 was 26.2% in 1941. Surveying

Japan, Korea, Singapore and Thailand, four Asian countries that have

experienced rapid economic take-offs, their highest investment ratios typically

lasted seven to eight years – and none ever reached the levels seen in China

(Figure 7). 2011 will be the ninth consecutive year that China‟s investment

ratio has been over 40%. Undoubtedly there are questions marks over the

quality of Chinese data – some claim that China‟s official investment ratio is

overstated because the services sector and hence consumption are likely

underestimated; on the other hand, aggregating the investment data for

China‟s 31 provinces suggests that the official national investment-to-GDP

ratio could be 7pp too low (see Box 1: Fuzzy numbers).

10

20

30

40

50

60

70

1954 1962 1970 1978 1986 1994 2002 2010

Investment

Household consumption

% GDP

3

6

9

12

15

Sep-97 Sep-99 Sep-01 Sep-03 Sep-05 Sep-07 Sep-09 Sep-11

% of GDP

The share of investment in China‟s GDP has risen to almost half

China is now an outlier: no other large economy has had such a high investment-to-GDP ratio for so long


14

Fig. 7: Asian investment-to-GDP ratios – during economic take-off periods

Note: t=numbers of years from the starting year, eg. For China, the starting year is 2002. The data are in nominal terms and investment is the sum of public and private gross capital formation. Source: China Statistical Yearbook; CEIC and Nomura Global Economics.

Fig. 2

Box 1: Fuzzy numbers

The quality of China‟s statistics is improving, but large gaps remain. Following the completion of its first Financial

Stability Assessment Program (FSAP) of China in July 2011, the IMF noted that a “full assessment of these various

risks is, however, hampered by serious data gaps, weakness in the infrastructure and constraints on the FSAP

team‟s access to confidential data”, IMF (2011a, p.11). Some of the glaring examples include the official urban

unemployment rate hovering within such a tight range of 4.0-4.3% for the past nine years, and how in 2010 real

GDP growth in 29 of the 31 provinces was above the national GDP growth of 10.3%. There have also been several

sizable upward revisions to China‟s GDP, mainly due to under-reporting of the size of the services sector and

hence consumption. The biggest revision was in 2005 after the first national economic census, when 2004 nominal

GDP was revised up by 16.8% in one fell swoop, with the share of services in GDP revised up from 31.9% to

40.7%. It is possible that the services sector and consumption will be revised up again, and the investment-to-GDP

ratio revised down, but then again it is also possible that the starting position is a higher investment-to-GDP ratio

than officially reported. GDP data are available by province and aggregating the gross capital formation and the

GDP data for the 31 provinces, we arrive at an investment-to-GDP ratio of 55.7% in 2010, a full 7pp higher than the

national investment-GDP ratio (see Figure 8).

Fig. 8: An alternative measure of the investment-to-GDP ratio


Fig. 3

The recent jump in China's investment ratio to almost half of GDP was driven

by a conscious policy response to the global financial crisis, but the

fundamental reason why the investment ratio has been so high for so long has

more to do with serious factor cost distortions.

The high priority on internal rebalancing of the economy – that is, lowering the

investment ratio and raising the consumption ratio – is not a new initiative; in

fact it was a key goal of the 11th Five-Year Plan (2006-10) unveiled in early

20

25

30

35

40

45

50

t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10

China, 2002 -11e

Japan, 1966 -75

Korea, 1988 -98

Singapore, 1978 -88

Thailand, 1989 -98

% of GDP

0

10

20

30

40

50

60

1954 1962 1970 1978 1986 1994 2002 2010

Sum of provinces

National

% GDP


15

2006. However, the global financial crisis of 2008 was a huge unexpected

shock, causing China‟s export performance to swing from 23% y-o-y growth in

Q3 2008 to a 24% y-o-y contraction in Q2 2009. Fearing major knock-on

effects to the domestic economy from firms cutting jobs and capex, the

authorities gave the go-ahead to a credit-financed investment boom. China's

real estate developers, SOEs and local governments took heed, ramping up

investment in property and infrastructure, putting rebalancing efforts in China

firmly on the back burner.

However, the more fundamental reason for China's persistently high

investment-to-GDP ratio is the large difference between the return on, and

cost of, capital. The bank lending rate has historically been artificially

controlled far below the return on capital needed to support an industry-led,

export-orientated growth model. A simple approximation of the return on

capital is nominal GDP growth, which averaged 18.5% in the 1990s and 14.6%

in the 2000s, compared with the benchmark 1yr bank lending rate of 9.4% in

the 1990s and 5.8% in the 2000s. This large gap gave producers a big

incentive to invest. To more formally estimate China's return on capital, we

follow a similar methodology to the Bank of Japan (2011) and Bai et al (2006).

Qualitatively, the results are similar to that of using nominal GDP growth,

indicating the large wedge between the return on, and cost of, capital of over

10pp over the past three decades (Figure 9). Even five years ago, Aziz (2006)

found that China‟s low cost of capital was quantitatively an important factor in

explaining why the investment-to-GDP ratio was high, and back in 2006 the

ratio was “only” 42%.7

Fig. 9: The difference between the return on, and cost of, capital

Note: The aggregate return on capital is measured using approximated data on the share of capital in total income, the capital stock-to-output ratio and the depreciation rate of capital. The cost of capital is estimated using the 1yr bank lending rate. Source: CEIC; China Statistical Yearbook; Development and Research Center under the State Council; and Nomura Global Economics.

The big question is not if, but when, China‟s investment and consumption

ratios re-balance – and will it happen in a gradual, policy-controlled way, or will

the process involve one or more episodes that are abrupt and beyond the

control of policymakers, causing major disruptions to the economy and

markets? International experience shows that rebalancing is never easy, as it

usually means redistributing income and power from vested interests that have

benefited from the old model – in China, notably large SOEs and local

governments (see chapter: The privileged state-owned enterprises). Of all the

main components in GDP, investment is typically the largest swing factor and

in most Asian countries it usually contracts at least one year each decade. Yet

7 The flipside of China's high investment-to-GDP ratio is a low consumption-to-GDP ratio, which is partly

because Chinese households have a high motive for precautionary saving, but also the share of wages in national income is low relative to profits. SOEs historically provided generous social welfare benefits to their workers, so the downsizing of SOEs in the late 1990s meant that workers needed to save more of their income to pay for their own healthcare, education and pensions. Also, while urbanization has boosted incomes of rural migrant workers, the stringent hukou household registration system has provided them with scant social welfare benefits in the cities where they live, increasing their precautionary savings. The very low or negative real interest rate on bank saving deposits has also forced households to save more than they otherwise might have.

0

5

10

15

20

25

30

% Difference (percentage points)

Return on capital

Cost of capital

The fundamental reason for the high investment-to-GDP ratio is the large difference between the return on, and cost of, capital

At almost half of GDP, China‟s investment is now so large that were it to stop growing it would cut real GDP growth in half


16

China's investment has not fallen since 1990 in volume terms and not since

1976 in value terms (Figure 10). At almost half of GDP, China‟s investment is

now so large that were it to stop growing, let alone turn negative, it would cut

real GDP growth in half (see Box 2: China‟s challenging GDP arithmetic). The

timing of rebalancing is also now less favourable for China, as besides

investment and consumption, the third engine of growth – exports – is unlikely

to be firing on a full cylinder given the crisis-scarred economies of the US and

Europe.

Fig. 10: Identifying the years when real gross capital formation contracted

1940s 1950s 1960s 1970s 1980s 1990s 2000s

China Nominal n.a. 1955: -2% 1967:-25% 1976:-7%

1960-62:-95% 1972:-3%

Real* n.a. 1955:-2% 1967-68: -27% 1976: -9% 1981: -2% 1990: -1%

1960-62:-109% 1972: -2%

Hong Kong Real n.a. n.a. 1966-68: -38% 1989: -5% 1998-99: -32% 2008: -1%

1985: -5% 1996: -3% 2005: -1%

1982-83: -7% 2001: -5%

India Real n.a. 1957-59: -8% 1967-68: -9% 1979: -10% 1981: -4% 1996: -1% 2008: -6%

1952: -26% 1961: -2% 1974: -10% 1991: -16% 2000-01: -6%

Indonesia Real n.a. n.a. n.a. 1988: -5% 1998-99: -62% 2002: -4%

Japan Real n.a. 1974-75: -12% 1983: -3% 1998-99: -16% 2008-09: -23%

1980: -1% 1992-94: -10% 2001-03: -13%

Korea Real n.a. n.a. n.a. 1975: -4% 1980: -17% 1997-98: -32% 2009: -13%

1972: -10% 1992: -1%

Malaysia Real n.a. n.a. n.a. n.a. 1985-87: -32% 1998-99: -47% 2008-09: -17%

2005: -2%

2003: -2%

2001: -9%

Philippines Real 1956: -1% 1962: -1% 1970: -4% 1984-85: -69% 1998-99: -29% 2009: -9%

1952: -3% 1960: -11% 1980: -4% 1991: -17% 2006: -15%

1949-50: -30% 2004: -2%

Singapore Real n.a. n.a. 1964: -3% 1977: -4% 1988: -3% 1998: -24% 2009: -19%

1975: -5% 1985-86: -18% 2001-03: -57%

Taiwan Real n.a. 1955: -15% 1975: -7% 1985: -8% 2007-09: -30%

1982: -5% 2001: -24%

Thailand Real n.a. n.a. n.a. n.a. 1985-86: -8% 1997-98: -73% 2009: -25%

1982: -7% 2006: -4%

Source: CEIC and Nomura Global Economics. Note: The shaded areas are decades when real gross capital formation falls. For China, official data on real gross capital formation are not available and so Nomura‟s proxy is nominal gross capital formation deflated by the fixed-asset investment deflator back to 1990 and before that, deflated by the GDP deflator.


17

Box 2: China’s challenging GDP arithmetic8

With investment making up almost half of GDP, China‟s economy is vulnerable to an investment slump for

whatever reason: a banking crisis; the central bank hiking aggressively having fallen behind the curve in fighting

inflation; unforeseen shocks, such as social unrest or a deadly pandemic; or simply because “investment” fatigue

sets in. To illustrate China‟s challenging GDP arithmetic consider the numbers. We expect real investment to grow

by 11.3% in 2011, contributing 5.5pp to GDP growth of 9.2%. However, if real investment were to grow by only 5%

it would contribute 2.4pp and, assuming (conservatively) unchanged contributions from net exports and

consumption, GDP growth would be just 6.1%. If real investment growth were to slow to 0%, it would make no

contribution to GDP and so GDP growth would more than halve to 3.7%.

However, carefully calibrating a rebalancing of GDP growth toward consumption is no easy feat. To illustrate, for

the share of household consumption in GDP to rise, consumption growth must outpace GDP growth. Yet we

estimate that real household consumption has grown at a double-digit rate in only three of the past 14 years and

over the past decade has averaged about 9% growth, whereas real GDP has averaged 10.3% growth. To raise the

household consumption-to-GDP ratio from 34% in 2010 to 40% by 2020, and assuming real GDP grows 8% pa this

decade, then real household consumption would need to grow consistently by 10% pa over 2010-20. To turn

consumption into an engine of growth, China needs to do more than simply beef up social welfare spending to

reduce precautionary household savings. It needs to transfer a massive amount of income from the still heavily

state-subsidized corporate sector to households (see chapter: The privileged state-owned enterprises) and end

financial repression, which has given rise to negative real deposit rates (see chapter: Rudimentary monetary

architecture).

As Japan's experience shows, the large positive gap between the return on,

and the cost of, capital does not last forever (see Box 3: Lessons from Japan

on the return and cost of capital). China‟s large gap could soon start to narrow,

possibly quite sharply, because of a simultaneous fall in the return on capital

and a rise in the cost of capital. The return on capital could start falling simply

because the enormity of investment is causing the capital stock to accumulate

at such a rate that capital is rapidly becoming less scarce. Total nominal

investment (i.e. gross capital formation) is set to total some USD3.5trn in 2011,

3x larger than in 2006 and 7x larger than in 2001. Another reason to expect

the return on capital to soon start to fall is the strong international evidence

that investment booms are often associated with a misallocation of capital,

especially in emerging markets. This seems a particular risk in China given: 1)

the banking sector does not have much experience in gauging credit risk; 2) a

massive shadow banking sector has emerged, which is difficult to measure, let

alone regulate; and 3) the fact that much of the investment in recent years has

been government-led, which tends to be less productive than private

investment, and in big infrastructure projects, which can take many years to

break even.9 A third reason is that China's heavy investment can also run into

diminishing returns from a social perspective, as capital intensive industries

pollute the environment and create fewer job opportunities.

Meanwhile, China's cost of capital has been increasing and we expect it to rise

further. The benchmark 1yr bank lending rate has risen from 5.31% in October

2010 to 6.56%, and this likely understates the effective cost of capital as banks

are charging a record 61.2% of their new loans above the benchmark lending

rate; in the shadow banking sector borrowing costs can be several times

higher. While the central bank has paused its rate hiking cycle, we expect it to

resume hiking in 2012. China needs higher interest rates to contain what we

see as structural inflation problems caused by accelerating labour costs (see

chapter: The Lewis turning point); the urgent need for the government to

8 The phrase “China‟s challenging GDP arithmetic” was coined by Paul Sheard, Nomura‟s global chief economist,

back in 2009 (see the Global Letter, “China‟s challenging GDP arithmetic” in the Global Economic Weekly Monitor, 25 September 2009). 9 A good micro example is China building – in just three years – the world‟s longest and fastest high-speed rail

network, which according to data from the International Union of Railways extends to 6,300km, an achievement that had produced considerable national pride. The collision of two new high-speed trains outside the city of Wenzhou on 23 July, which killed 40 and injured 191, stoked public anger and a media frenzy that the breakneck development of high-speed rail had cut corners – indeed, China‟s Railways Ministry is the manufacturer, operator and regulator of the network. As a result, Beijing has suspended approvals of new high-speed lines and its original ambitious program of having a further 4,339km of high-speed rail under construction by 2012 – more under construction over this period than that of the rest of the world put together – is now unlikely to be achieved.

As Japan's experience shows, the large positive gap between the return on, and the cost of, capital does not last forever


18

unwind generous subsidies to SOEs and to stop underpricing factor inputs

such as land, water and energy; and a likely continued multi-year surge in food

prices (see our Special Report, The coming surge in food prices, 8 September

2010). Higher interest rates would also be a natural result of accelerating the

evolution of China's monetary policy framework, from administrative measures

to more market-price-based instruments (see chapter: Rudimentary monetary

architecture). A key risk is policy errors, for example falling behind the curve in

fighting inflation and needing to catch up via aggressive rate hikes, leading to

a sharp rise in the cost of capital at a time when the return on capital could be

falling.10

10

Firms should adjust their capital stock so that its marginal productivity equals its user cost. As interest rates increase, firms scale back investment for which the expected return is insufficient to cover the higher financing costs. Using micro data on listed Chinese firms over 2002-07, Conway, Herd and Chalaux (2010) found empirically that capital spending is negatively influenced by higher interest rates.



19

Box 3: Lessons from Japan on the return and cost of capital

Similar to China in the last two decades, Japan achieved high GDP growth over the period 1955 to 1970, averaging

9.7% and, like China today, Japan‟s economy became increasingly unbalanced, with a rising investment-to-GDP

ratio and falling consumption-to-GDP ratio, reaching 35.5% and 59.7% respectively in 1970 (Figure 11). Domestic

rebalancing in Japan began after 1970. According to a recent study by researchers Fukumoto and Muto (2011) at

the Bank of Japan, the main trigger of rebalancing was a decline in the return on capital and a rise in the cost of

capital. In the 1950s, Japan had a small capital stock and so the return on capital was higher than 20%, but the

rapid accumulation of capital drove down the marginal productivity of capital. An undeveloped financial sector led to

some misallocation during the investment boom, while the development “catch up” to advanced foreign technology

was virtually complete in the early 1970s. All these factors contributed to a decline in the return on capital in the

late 1960s and early 1970s.

Meanwhile, the bank lending rate was highly regulated in the 1950-60s and was kept very low to support an

industry-led growth model. However, in the early 1970s Japan experienced an outbreak of inflation, in part driven

by the 1973-74 oil crisis, but also the flow of surplus rural labour moving to the cities started to diminish in the

1960s, leading to increased worker bargaining power and a surge in real wages, the so-called Lewis turning point

(Minami, 1973). All this led to monetary policy tightening and a rise in bank lending rates and the cost of capital. So

in the early 1970s, Japan faced a marked narrowing in the difference between the return and cost of capital,

significantly reducing firms‟ incentives to maintain high rates of investment (Figure 12).

Fig. 11: Japan's investment and consumption shares of GDP

Source: Bank of Japan (2011).

Fig. 12: Japan’s difference between the return and cost of capital

Source: Bank of Japan (2011).

What accentuates the macro risks of China's investment boom is the credit

boom associated with it. One of the relatively few robust findings to emerge

from the empirical literature on leading indicators of banking crises is that rapid

domestic credit growth increases the likelihood of a problem (Kaminsky and

Reinhart, 1999). In a survey of credit booms in 28 emerging market economies

during 1970-2002, the IMF (2004) estimates that about 75% of the credit

booms were associated with a banking crisis. More pertinent to China, Borio

10

20

30

40

50

60

70Gross fixed capital formation

Consumption

% of nominal GDP

0

5

10

15

20

25

30

35

%Difference (percentage points)

Return on capital

Bank lending rate

What accentuates the macro risks of China's investment boom is the credit boom associated with it


20

and Lowe (2002) use annual data since 1960 for 34 countries to show

empirically that an investment boom by itself may pose little threat to the

stability of the financial system. Rather, it is the combination of various

imbalances, in particular the simultaneous interactions of rapid credit growth,

rapid increases in asset prices and an investment boom – rather than any one

of these alone – that increases the likelihood of problems.

Analysis of China's recent credit boom has tended to focus on local

government borrowing, where the data are opaque. Local governments are not

allowed to directly incur debt, and so finance infrastructure projects by

borrowing from banks. To do so, they set up over 6,500 Local Government

Financing Vehicles (LGFVs). The latest official estimate of local government

debt outstanding was RMB10.7trn, or 27% of 2010 GDP, as at June 2011 by

the State Audit Office, although some private estimates are much higher.11

Whatever the true figure of local government debt is, a broader analysis can

be gleaned from IMF data which show that total domestic credit (private and

government) surged from 121% of GDP in Q4 2008 to 147% in Q2 2011, a

level that is not far from the peak in 2003 (Figure 13). Moreover, China's

credit-to-GDP ratio stands as an outlier compared with other countries of a

similar income level (Figure 14).

Fig. 13: Domestic credit-to-GDP ratio

Source: IMF; CEIC and Nomura Global Economics.

Fig. 4

Fig. 14: Credit-to-GDP ratio versus GDP per Capita

Source: IMF Global Financial Stability Report, September 2011.

Fig. 5

China's credit boom over 1998-2003 led to a banking crisis. As far as we know,

the earliest official data on the NPL ratio of the major commercial banks was

23.6% in 2002, but this excludes a large volume of bad loans, of over 15% of

GDP, that were carved out and transferred to newly created asset

management companies a few years earlier.12

Since 2002, the official NPL

ratio has steadily declined and by June 2011 stood at just 1.0% for all

commercial banks. However, given that China's credit-to-GDP ratio has

surged to just shy of the record high in 2003, there is little doubt that the NPL

ratio will rise again –the question is by how much.

Reflecting the paucity of data and the uncertainties involved, estimating how

high NPLs may rise and the potential fiscal cost of recapitalizing the banks can

vary widely.13

To be sure, compared to a decade ago China‟s banks today are

better capitalized, have higher loan-loss provisioning and face more stringent

11

In July 2010, the China Banking Regulatory Commission (CBRC) first estimated total local government debt outstanding at RMB7.7trn but raised its estimate in November 2010 to RMB9.1trn. The latest estimate in June 2011 by the State Audit office was even higher, at RMB10.7trn, or 27% of 2010 GDP – albeit still far short of the RMB20trn projected by Professor Victor Shih at Northwestern University. 12

Before the establishment of asset management companies, unofficial estimates put the peak NPL ratio in 1999-2000 at about 40%, or higher. The OECD estimates that the total cost to the government of recapitalizing the banking sector in the early 2000s was some 30% of GDP (OECD 2005). 13

The State Audit Office sent a warning in June 2011, when after a lengthy audit of the five major banks it found that RMB58bn, or 17% of total loans outstanding, violated regulations, such as new loans granted for unapproved projects or used to repay existing debt. Rating agency Moody‟s expects China‟s NPL ratio to rise to 8-12% in coming years. In July 2011, the official auditor of Liaoning province reported in a speech that 85% of LGFVs in Liaoning had insufficient income in 2010 to cover debt-servicing payments.

50

60

70

80

90

100

110

120

130

140

150

160

Jun-81 Jun-86 Jun-91 Jun-96 Jun-01 Jun-06 Jun-11

% of GDP

China

Cyprus

0

50

100

150

200

250

300

350

0 10 20 30 40 50 60 70

Cre

dit to

GD

P, e

nd

-2010

(%

)

GDP per capita, 2009 (PPP, thousands of US$)

China's credit-to-GDP ratio stands as an outlier compared with other countries of a similar income level

China‟s banks today are better capitalized, have higher loan-loss provisioning, but…

There is little doubt that the NPL ratio will rise again – the question is by how much


21

regulations and supervision.14

But on the other hand, we see two important

reasons for concern: 1) a big and largely unregulated shadow banking sector

has emerged in recent years, estimated to be almost as large as the official

banking sector (see chapter: Rudimentary monetary architecture); and 2) this

time, both local governments and property developers are heavily indebted,

which raises the risk of a vicious spiral if there is a major correction in property

prices given that 30-40% of local government revenue is made up of proceeds

from land sales and other property-related activities.15

According to official

data, nationwide property prices have risen 60% since the end of 2006 (IMF

2011c). This has fueled speculative property investment and an ominous sign

is the large gap that has opened up between the combined floor space of

residential, office and commercial property that builders have started work on,

compared to the floor space sold (Figure 15).16

In a back-of-the-envelope exercise simply to illustrate how much estimates can

vary, if we assume that China's NPL ratio rises from 1% to 10% and that 70%

of these loans could be recovered, then the cost to the banking sector – or

failing that, the government – would be RMB1.6trn, or 3.6% of 2011 GDP

(Figure 16). However, under more drastic scenarios of higher NPLs and lower

recovery rates, it is possible that the total cost could be over 30% of 2011 GDP.

Fig. 15: Difference between floor space started and floor space sold:


Fig. 16: Assessing the cost of potential financial sector problems, % of GDP

Loan recovery rate, %

30 40 50 60 70

NPL

ratio,

%

10 8.3 7.1 5.9 4.7 3.6

20 16.6 14.2 11.8 9.5 7.1

30 24.9 21.3 17.8 14.2 10.7

40 33.1 28.4 23.7 18.9 14.2

50 41.4 35.5 29.6 23.7 17.8

Note: % of estimated 2011 GDP. Source: CEIC and Nomura Global Economics.

14

In May 2011, the CBRC ordered systemically important banks to have bad-loan provisions that are no less than 2.5% of total outstanding credit by the end of 2013 and 150% of non-performing debt. 15

This year, tighter credit conditions have led property developers to seek other, more expensive, forms of financing in the shadow banking sector, notably new entrusted loans. Lucy Fung, Nomura‟s China Bank analyst, estimates that of the RMB702.8bn of new entrusted loans in Jan-Jun 2011, 46% were granted to property developers at an average interest rate of 15.8% and at an average duration of 11.3 months. Stress tests by ratings agency Standard & Poor‟s (2011) estimate that the property developers could absorb a 10% decline in property sales in 2012. But if property sales fell by 30% in 2012, more than half of the 30 developers rated by S&P would have “weak liquidity”, which according to S&P‟s definition means overarching credit risk and an issuer credit rating at the “B” level or lower. 16

The increasing use of desperate sales gimmicks by property developers is one micro-level sign that property supply has moved ahead of demand. For example, at this year's Shanghai Autumn Property Exhibition, to exploit the law which prohibits the purchase of more than two residential apartments, so-called “Soho” apartments – offices equipped with private bathroom and kitchens – have been marketed as they are not classed as homes (South China Morning Post, 6 October 2011).

0

500

1,000

1,500

2,000

2,500

Dec-96 Dec-99 Dec-02 Dec-05 Dec-08 Dec-11

Floor space started

Floor space sold

Millions of Sq. meters, 12m rolling sum

… a big and largely unregulated shadow banking sector has emerged in recent years


22

2. Rudimentary monetary architecture

China‟s monetary policy, by evolving too slowly toward market price-based

instruments, is losing its effectiveness in managing an economy that is rapidly

becoming more open and sophisticated. In the words of the OECD, “after three

decades of liberalization, product markets have become increasingly

competitive and market forces are now generally the main determinant of price

formation and market behaviour”, OECD (2005, p.102). The PBC needs to

place less emphasis on quantity-based instruments such as the bank reserve

requirement ratio (RRR), central bank bill issuance, credit quotas and bank

window guidance, and instead adopt the interest rate as the primary policy tool.

A precondition for this is a more flexible exchange rate. Market-based

instruments are less distortionary and can have powerful indirect economy-

wide effects by enhancing competition, efficiency and risk management.

At the root of the problem is China‟s inflexible exchange rate, which

significantly hinders the PBCs ability to tailor monetary policy to domestic

objectives. The essential problem stems from Professor Robert Mundell‟s

“Impossible Trinity”: that a country can simultaneously choose two, but not all

three, of a managed exchange rate, an open capital account and monetary

policy autonomy. With capital flowing more freely, China risks losing more

control over its monetary policy if it continues to heavily manage the exchange

rate. A rigid exchange rate reduces the central bank‟s ability to use market

instruments such as interest rates to manage aggregate credit growth and

instead perpetuates a reliance on administrative measures such as credit

quotas, hindering efforts to make the banking system more commercially

orientated.

China‟s inflexible exchange rate regime requires the PBC to conduct

substantial open market operations to sterilize, or “mop up” excess domestic

liquidity arising from FX intervention, which has increased FX reserves to an

extraordinary USD3.2trn as at September 2011.17

The sterilization measures

include aggressively issuing low-yielding central bank bills and raising the

RRR of large banks 12 times since January 2010, from 15.5% to 21.5%, an

all-time high.18

Meanwhile, the benchmark 1yr bank lending interest rate has

been increased only five times, from 5.31% to 6.56% (Figure 17). While the

PBC is successfully sterilizing its FX intervention, it is repressing the free-

functioning intermediation role of the banking sector.

Fig. 17: Bank reserve requirement ratio and the benchmark bank lending rate


17

The massive accumulation of FX reserves to USD3.2trn is not necessarily costless. The larger the stock of FX reserves the greater the potential quasi-fiscal cost if the return earned on the foreign assets is less than the interest paid on the PBC‟s sterilization bills. The PBC could also incur substantial capital losses on its balance sheet if USD was to crash, leaving it with negative capital. The PBC could try and recapitalize itself by earning profits from increased seigniorage, i.e. printing more currency; or it could be recapitalized by the government but at the cost of losing some of its monetary policy independence and heightening the risk of a major inflation problem. 18

Combining these two sterilization measures, we estimate that the PBC has effectively "locked up" nearly one-quarter of total bank deposits that otherwise could have been used for more profitable commercial business, such as lending.

0

5

10

15

20

25

Oct-91 Oct-95 Oct-99 Oct-03 Oct-07 Oct-11

Benchmark 1yr bank lending rate

Bank reserve requirement ratio

%

China‟s monetary policy is losing its effectiveness in managing an economy that is rapidly becoming more open and sophisticated

While the PBC is successfully sterilizing its FX intervention, it is repressing the free-functioning intermediation role of the banking sector

At the root of the problem is China‟s inflexible exchange rate


23

Fig. 6 The PBCs sterilization operations impose considerable cost on the banking

sector. China maintains an interest rate ceiling on bank deposits, which

currently ranges from 3.50% for 1yr savings deposits to 5.50% for 5yr deposits.

So, the requirement that 21.5% of deposits for large banks be reserved at the

PBC earning only 1.62% interest is akin to an implicit tax on the banking sector,

restricting banks from allocating a larger portion of their portfolios to higher-

yielding loans and investments.

One way to help ease this financial repression is to allow a wide margin

between the benchmark bank lending and deposit rates, which traditionally is

what China has done. In the last decade, the spread between the 1yr bank

lending and saving deposit rates averaged 3.4% – substantially higher than

the 1.4% average in the 1990s. However, fat margins simply shift the cost of

financial repression from the banks to depositors, which means most

households given a lack of alternative investment opportunities. This has been

particularly onerous on depositors in the past year because of the sharp rise in

inflation. For a third time in the past eight years (after 2004 and 2008) the real

rate of return on 1yr bank saving deposits has sunk deep into negative territory,

averaging -2.5% in Jan-Sep 2011 (Figure 18). The IMF (2011a, p.34) finds that

a 1pp increase in the real rate of return on bank deposits lowers the urban

household saving rate by 0.6pp.

Fig. 18: 1yr inflation-adjusted real deposit rate


Fig. 7

It should come as no surprise then, that despite waves of macro-prudential

tightening measures, it has proved difficult to cool speculation in the property

market. Moreover, with negative inflation-adjusted returns, banks have been

finding it more difficult to attract deposits and so are turning to wealth-

management products, which typically are loans repackaged as short-term

investment vehicles and are held off-balance sheet. These products are

typically short term, maturing within one month, and can offer annualized

returns of about 8%, more than double that on 1yr bank deposits. According to

Xinhua news agency, by mid-2011 China had RMB7trn in outstanding wealth

management products, triple the amount at the end of 2010. With bank assets

mainly tied to longer-term loans, there is a growing problem of duration

mismatch between bank assets and liabilities.

Perhaps in response, in this latest tightening cycle the PBC has hiked interest

rates on longer-term bank deposits by a larger magnitude, which has shifted

some of the costs of financial repression back to the banks. For example,

since September 2010 the 1yr bank deposit rate been increased by 125bp,

and the 5yr rate by 190bp, while the benchmark 5yr or longer lending rate has

been increased by only 114bp. Interestingly, this seems to be forcing banks to

price credit risk more actively by charging borrowing rates that are higher than

official benchmark rates on more of their loans: in June 2011, a record-high

61.2% of loans were priced above benchmark rates, versus 44.3% in

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

Sep-97 Sep-99 Sep-01 Sep-03 Sep-05 Sep-07 Sep-09 Sep-11

% p.a.

One way to help ease this financial repression is to allow a wide interest rate margin, but this shifts the repression from the banks to depositors

Negative real bank deposit rates have contributed to property market speculation and the explosion of wealth-management products


24

September 2010 (Figure 19).19

Yet with an obligation to lend to large SOEs,

banks are increasingly rationing credit to private companies, forcing them to

borrow in the shadow banking sector at punitively higher interest rates (see

chapter: The privileged state-owned enterprises).

Fig. 19: Proportion of new bank loans charged above the benchmark lending rate


Fig. 8

Financial repression is also encouraging off-balance sheet bank activities,

disintermediation and other less-regulated activities outside the official banking

system. In an attempt to monitor informal financing activities, the PBC

introduced a new statistic in February 2011 called “total social financing”,

which in addition to net new bank loans includes net new trust loans, bank

acceptance bills, corporate bonds, non-financial corporate equity and funding

from insurers (see Box 4: Shadow banking in the US and China compared).

The total social financing statistic likely still does not capture all informal

financing activities, but even so, the results are revealing. Outside net new

bank loans, the sum of other forms of financing more than tripled from

RMB1.9trn in 2008 to RMB6.3trn in 2010 – although the annualized rate in

Jan-Sep 2011 had eased to RMB5.5trn. Add on net new bank loans, which

totaled an annualized RMB7.6trn in Jan-Sep 2011 and total social financing

was RMB13.1trn, with the shadow banking sector comprising a stunning 42%

of the total. A sign of the costs of financial repression, movements in the bank

RRR are closely correlated with the aggregate data on net new non-bank

financing activities (Figure 20).

Fig. 20: Bank RRR and net new bank loans and other forms of financing

Note: Jan-Sep 2011 is an annualized figure. Source: CEIC and Nomura Global Economics.

19

On 1 January 2004, the PBC deregulated commercial bank lending rates, allowing banks to charge 0.9-2.0x the benchmark 1yr lending rate. On 29 October 2004 the ceiling on commercial bank lending rates was scrapped altogether (except for credit cooperatives).

30

35

40

45

50

55

60

65

Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11

% share

0

5

10

15

20

25

0

3

6

9

12

15

18

2002 2003 2004 2005 2006 2007 2008 2009 2010 Jan-Sep 2011

Net new bank loans, lhs

Net new other forms of financing, lhs

Bank reserve requirement ratio, rhs

RMBbn %

Financial repression is also encouraging off-balance sheet bank activities and other less-regulated activities outside the official banking system


25

Utilizing the new social financing statistics, which is a net flow of funds concept

(new issuance less redemptions and write-offs), we have attempted to tally the

stock of total funds outstanding in China‟s economy; that is the official banking

and shadow banking sectors combined. Data are available on outstanding

RMB bank loans, which nearly doubled from RMB26.2trn at the end of 2007 to

RMB52.9trn by September 2011, and outstanding corporate bonds, which

increased more than five-fold from RMB0.8trn at the end of 2007 to RMB4.5trn

by September 2011. To gauge total funds outstanding in the shadow banking

sector, we simply accumulate the other components of the social financing

statistics, of which the data first began in 2002, and assume that the

outstanding amount before 2002 was zero for each component.

The result is a more than four-fold rise in total funds outstanding in the shadow

banking sector, from RMB4.5trn at the end of 2007 to RMB18.2trn by

September 2011. Summing up outstanding bank loans, corporate bonds and

funds in the shadow banking sector gives a grand total of RMB75.6trn, or

177% of GDP, as at September 2011 – a 57% of GDP increase since the

global financial crisis in 2008, revealing just how explosive the growth in

economy-wide financing has been (Figure 21).20

Fig. 21: Our estimate of total banking and shadow banking funds outstanding


Fig. 9

20

FitchRatings (2011) arrives at a similar number, estimating that total economy-wide financing would increase to 185% of GDP by the end of 2011. These estimates are also more in line with the broad money supply, which in September 2011 equaled 175% of GDP.

100

110

120

130

140

150

160

170

180

0

10

20

30

40

50

60

70

80

2002 2003 2004 2005 2006 2007 2008 2009 2010 Sep-11

Shadow banking, lhs

Corporate bonds, lhs

RMB loans, lhs

Total as a % of GDP, rhs

RMBtrn % of GDP

We estimate that total banking and shadow banking funds outstanding totaled 177% of GDP as at September 2011


26

Box 4: Shadow banking in the US and China compared

To the best of our knowledge, McCulley (2007) coined the term “shadow banking system”. To quote Pozar, Adian,

Ashcraft and Boesky (2010, pp,13-14) “the shadow banking system decomposes the simple process of deposit-

funded, hold-to-maturity lending conducted by banks into a more complex, wholesale-funded securitization-based

lending process that is performed by a variety of non-bank financial intermediaries, or shadow banks. Shadow

banking transforms risky, long-term loans into seemingly credit-free, short-term, money-like instruments through a

granular set of steps (Figure 22), which in the US includes loan origination, loan warehousing, ABS issuance, ABS

warehousing, ABS CDO issuance, ABS intermediation and wholesale funding”. On the eve of the global financial

crisis, the volume of credit intermediated in the US by the shadow banking system was nearly USD20trn, nearly

twice as large as the USD11trn of credit intermediated by the traditional banking system. Even today, the US

shadow banking system is about the same size as the traditional banking system.

In China, non-bank financial intermediation occurs through credit-related trust products, wealth management-

related trust products, lease financing and credit guarantees. But the biggest form of shadow banking is in

entrusted loans, in which a bank acts as an agent on a third-party loan between a depositor and a borrower, and

books a fee.

Figure. 22: Illustrative examples in the US of the steps, entities and funding techniques involved in shadow credit intermediation

Function Shadow banks Shadow banks' funding*

Step (1) Loan origination Finance companies CP, MTNs, bonds

Step (2) Loan warehousing Single and multi-seller conduits ABCP

Step (3) ABS issuance SPVs, structured by broker-dealers ABS

Step (4) ABS warehousing Hybrid, TRS/repo conduits, broker-dealers' trading books

ABCP, repo

Step (5) ABS CDO issuance SPVs, structured by broker-dealers ABS CDOs, CDO-squareds

Step (6) ABS intermediation LPFCs, SIVs, securities arbitrage conduits, credit hedge funds

ABCP, MTN, repo

Step (7) Wholesale funding 2(a)-7 MMMFs, enhanced cash funds, securities lenders, etc.

$1 NAV shares (shadow bank "deposits")

Source: “Shadow banking”, Federal Reserve Bank of New York Staff Report No. 458, July 2010.

Fig. 10

The growth of shadow banking presents new challenges for China‟s

policymakers. One is that the bank RRR, loan quotas and other quantitative-

based monetary policy instruments aimed at the official banking sector are

becoming less effective as they target what is a shrinking share of the overall

financial system. Another is that, almost by definition, the different types of off-

bank balance sheet or non-bank financial activities are less regulated,

heightening the risk of too much credit being generated and of credit being

misallocated.

Adding to these challenges is the opaqueness of the data, suggesting that

China‟s shadow banking sector could be a lot larger than the official social

financing statistic suggests. FitchRatings argues that the official social

financing statistic fails to fully capture some RMB3.5trn of shadow banking

activity, including letters of credit from domestic trust companies, lending by

domestic non-bank financial institutions and financial claims on mainland

entities by Hong Kong-based banks.21

The latter has mushroomed in recent

years as Chinese companies and banks seek cheaper funding overseas. We

estimate that Mainland China-related exposure of Hong Kong financial

institutions has nearly tripled from HKD1.1trn in 1Q 2009 to HKD3.7trn in Q2

2011, equivalent to 27.2% of the total assets of Hong Kong banks (Figure

23).22

21

A micro example of the flourishing "underground market" for loanable funds can be gleaned from the advertisements on the back pages of city newspapers, often listing only a single mobile phone number next to names such as "Easy Heaven Investments" and "Treasure Beautiful Gold Credit", Financial Times, 10 October 2011. 22

To put this surge in Hong Kong bank mainland-related claims into perspective, from 1Q 2009 to 2Q 2011, domestic property-related lending by Hong Kong banks rose by HKD410bn to HKD1.7trn, or 13% of the total assets of Hong Kong banks.

The growth of shadow banking presents new challenges for China‟s policymakers

Adding to these challenges is the opaqueness of the data


27

Fig. 23: Hong Kong financial institutions’ exposure to the mainland

Source: HKMA and Nomura Global Economics.

Fig. 11

0

5

10

15

20

25

30

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11

HK financial institutions' external claims on banks in the mainland (LHS)

Hong Kong financial institutions' mainland-related non-bank exposure (LHS)

Hong Kong financial institutions' mainland-related exposure as a % of total assets (RHS)

HK$bn %


28

3. The privileged state-owned enterprises

At their peak in 1978, state-owned enterprises (SOEs) produced 78% of total

industrial output and employed 60% of the non-farm workforce. While the

authorities closed thousands of SOEs in the late 1990s, thousands remain,

including many of China‟s largest companies with oligopoly power in many

important sectors. By 2009, despite accounting for only 4.7% of the total

number of firms, SOEs employed 21% of the total non-farm workforce,

produced 27% of gross output in the industrial sector and controlled an eye-

popping 44% of the stock of fixed assets, highlighting their capital intensity

(Figure 24). The massive fiscal stimulus following the global financial crisis

seems to have benefited SOEs more than non-SOEs, given that most large

construction and transportation companies – and the steel and cement

companies supplying them – are SOEs.

Fig. 24: The SOE share of total urban employment and stock of fixed assets


Fig. 12

The performance of China‟s SOEs is puzzling in two respects. One is that

labour productivity, or output per worker, in the SOE sector has been much

stronger than in the private sector, whereas in most other countries it is the

opposite. In 1999 to 2007, labour productivity averaged 5.6% per year in the

SOE sector, versus 3.6% per year in the private sector (OECD, 2005, p.110).

However, the SOE sector‟s high labour productivity is misleading, as it is

driven by: 1) large declines in employment and 2) massive capital

accumulation (Figure 25).

By contrast, growth in total factor productivity (TFP) – measuring output gains

over and above increases in inputs of labour and capital – has been relatively

weak in China‟s SOE sector, at less than two-thirds of that in the private sector

(OECD, 2005, p.111). TFP is driven by innovation by new technologies and

managerial skill and is a better gauge than labour productivity of real efficiency

gains.

0

10

20

30

40

50

60

70

80

90

1950 1960 1970 1980 1990 2000 2010

Share of total urban employment

Share of total stock of assets of industrial enterprises

% share

The massive fiscal stimulus following the global financial crisis seems to have benefited SOEs more than non-SOEs

The SOE sector‟s growth in total factor productivity has been relatively weak

The SOE sector‟s high labour productivity is misleading, as it is driven by: 1) large declines in employment and 2) massive capital accumulation


29

Fig. 25: Industrial structure of SOEs and private firms – a comparison

1998 2003 2007

Employment Average number of employees

Public sector 662.1 716.8 887.9

Non-state sector 250.0 229.0 200.0

Capacity intensity 000 yuan per employee

Public sector 82.2 193.5 364.0


Inventory % of annual sales



Long-term liabilities % of total assets



Exports % of total exports by sector



Subsidies % of value added



Source: Product Market Regulation and Competition in China” - OECD Economics Department Working Papers No. 823, 2010

Fig. 13

A related puzzle is that, despite relatively low TFP, the SOE sector as a whole

has remained profitable, with high retained earnings to plough back into new

investments. This is because after almost 30 years of economic reforms, while

nearly all product markets have been liberalized, the factor markets remain

heavily distorted through a raft of generous government subsidies to SOEs

(see Box 5: Investment is high, but savings are even higher). Subsidies

include low effective tax rates; under-pricing key inputs, such as energy, water,

land, and capital; keeping the RMB undervalued;23

allowing low or no dividend

payouts; charging little or no royalties on resource extraction; barriers to entry

in some industries; and only lightly enforcing environmental protection,

workers rights and work place safety (e.g., coal mines).24

One study estimates that these factor market distortions could be costing the

economy almost 10% of GDP in terms of lost efficiency (Huang 2010). Another

study of a sample of over 3,000 firms shows empirically that private firms,

where managers have complete de facto autonomy in corporate decisions

from the state, do indeed have better operating efficiency under various

metrics (Gan et al, 2008). In contrast, despite preferential treatment, many of

the smaller SOEs still make losses or barely break even – in 2007, one in five

SOEs earned a negative return (Conway, Herd, Chaalaux, 2010, p.19).

Government support for the massive yet inefficient use of capital by SOEs is

likely contributing to wasteful investment of scarce resources and

environmental degradation, and goes completely against efforts to rebalance

GDP growth from investment to consumption (see chapter: The setting in of

growing pains).

23

The latest estimates of the IMF‟s Consultative Group on Exchange Rates indicate that the RMB is undervalued by 3-23%, IMF (2011a, p.18). 24

In China, all land belongs to the state and local governments who have the discretion to sell industrial land use rights to companies for up to 50 years. In many cases the industrial land is provided cheaply or even free to companies in order to attract investment. The price of water in China is about one-third of the global average, while the cost of electricity is also relatively low (IMF 2011a, p. 20).

Despite relatively low total factor productivity, SOEs as a whole have remained profitable due to a raft of generous government subsidies

Government support for the capital-intensive goes completely against efforts to rebalance GDP growth from investment to consumption


30

Box 5: Investment is high, but savings are even higher

China‟s gross domestic investment rose from an already high 35.3% of GDP in 2000 to 48.6% in 2010, but gross

domestic savings rose even more, from 37% of GDP to 53.9% over the same period.25

China‟s saving rate is the

highest in the world, and on IMF estimates, gross savings can be roughly decomposed into three sectors: that done

by households (23% of GDP), by corporates (21%) and by government (10%). Household savings have been high

for decades, the causes of which are relatively well known: a high precautionary motive to save because of

inadequate social welfare, including healthcare, pensions, unemployment benefits and education; a low return on

bank deposits and the lack of diversification opportunities for financial assets.

On the other hand, saving in the corporate sector, which reflects retained earnings and hence corporate

profitability, has increased markedly in the past decade, to almost the same level as household savings. The rise in

corporate saving reflects oligopoly or monopoly power in some industries and government intervention to artificially

repress the prices of labour, land, capital, resources and environmental protection. A low dividend policy also

explains a high level of retained earnings.

Government saving has also been rising and is high by global standards, reflecting robust fiscal revenues and land

sales. Given that the current account surplus is, by a GDP accounting identity, the excess of gross domestic saving

over investment, from the above analysis it follows that China needs to reduce corporate and household savings to

narrow its current account surplus (5.2% of GDP in 2010). RMB appreciation is just one of many reforms available

to achieve this.

China‟s potential output growth looks set to slow this decade, because of a

shrinking labour force and limited room to increase an already very high

contribution of capital (see chapter: The setting in of growing pains). To ensure

that the slowdown in potential growth is gradual, China needs to focus more

on TFP improvements by reducing SOE subsidies and creating a more

competitive business landscape, particularly given that the low-hanging fruit of

productivity gains from surplus rural labour migrating to the cities is set to

diminish (see chapter: The Lewis turning point). However, after the 2008

global financial crisis, the authorities did the reverse, resorting to even greater

interventionist policies to quickly revive the economy by instigating a massive

credit-fueled investment boom. These interventionist policies were to the

advantage of the less efficient, capital intensive, SOE-related sectors, and so

have exacerbated China‟s structural industry problems.

A more enduring challenge to reforming China‟s industry structure relates to

an asymmetric information problem in the banking sector, which is being

exacerbated by the recent tightening of monetary policy. Unlike past monetary

policy tightening cycles, this one differs for China‟s banks in two respects: 1)

the bank RRR is at a record high 21.5% and the interest rate margin squeeze

is more severe, indicating a larger-than-usual impact on the banks; but 2)

commercial bank lending rates, which started being gradually deregulated in

2004, are no longer subject to a ceiling.26

The second point is important

because it provides a valve to ease the financial repression facing banks by

allowing them to price credit risk more actively, charging higher lending rates

for riskier customers. And for the first time they are starting to do so: in June

2011, a record-high 61.2% of new loans were priced above benchmark lending

rates. However, the problem is that China‟s banks are pricing credit in an

increasingly distortionary way, creating a loan market that is segmented

between SOEs and non-SOEs.

China‟s four largest banks, which are still majority state-owned, maintain a

strong bias to lend to SOEs, largely irrespective of credit risk (Yeung 2009,

Podpiera 2006). Rightly or wrongly, the SOEs are still perceived by the banks

to have implicit government backing. So, it has been the mostly private SMEs

that have borne the brunt of the credit tightening – and even more so than in

25

From the accounting identity, gross domestic savings is equal to gross domestic investment plus the current account balance. Hence China‟s savings are higher than investment because of a current account surplus of 5.2% of GDP in 2010. 26

Until 2004, interest rates set by commercial banks were not permitted to be more than 10% above the benchmark lending rate, but the band has been progressively widened and commercial bank lending rates are now only subject only to a floor, while deposit rates are subject to a ceiling.

China‟s potential output growth looks set to slow this decade, increasing the urgency to boost total factor productivity

China‟s four largest banks, which are still majority state-owned, maintain a strong bias to lend to SOEs, largely irrespective of credit risk

A more enduring challenge to reforming China‟s industry structure relates to an asymmetric information problem in the banking sector


31

the past as banks are more actively starting to price credit risk. Yet at the

grassroots level, China‟s bank loan officers still lack the skill and experience to

properly assess credit risk – a task compounded by opaque company

reporting data.27

This is creating a serious asymmetric information problem for

China‟s lenders who are under increasing pressure not to make bad loans. As

a result, creditworthy SMEs are being charged too high borrowing rates in

relation to what they perceive to be their credit risk, thereby encouraging them

to opt out of the loanable funds market and hence lowering the overall credit

standard of the non-SOE loan market. This can have a snowballing effect.

Nobel Prize laureate George Akerlof‟s famous “market for lemons” effect is

starting to appear in China‟s non-SOE loans market (see Box 6: The Akerlof

market for lemons problem applied to China).

Box 6: The Akerlof market for lemons problem applied to China

George Akerlof won the Nobel Prize in economics in 2001 for his work showing how markets can break down in the

presence of asymmetric (or unequal) information. The example Akerlof used was of the used car market, where

sellers have better knowledge of whether their car is a good or a bad one (a “lemon”). This kind of asymmetric

information also exists in China‟s bank loan market. Many of China‟s bank loan officers do not have the expertise

or information to properly price risk. The best guess of the car buyer (the China bank) is that the car (the loan) is of

average quality, and so he/she will only be willing to pay the price (charge an interest rate) of a car (loan) of

average quality. This means, however, that owners of good cars (borrowers of high credit standard) will not place

their cars (seek loans) in the used car market (in the banking sector). But that in turn lowers the average quality of

cars (loans) in the market (banking sector), causing buyers (China banks) to revise downward their expectations of

quality. Now even owners of moderately good cars (borrowers of good credit standard) are unable to sell (borrow)

at a fair price, causing, in the worst case, the market to seize up.

Meanwhile, a growing number of SMEs with very low credit standards have

been denied bank credit altogether, and not being able to access the debt or

equity markets, this leaves them no choice than to turn to the less regulated

shadow banking sector, where the asymmetric information problem is even

more lopsided. A growing number of SMEs have to rely on non-formal

financing sources, such pawn loans, micro credit companies and even loan

sharks, which bear much higher funding costs. According to the PBC, the

average informal lending rate in the city of Wenzhou – the country's SME hub

– rose to 25.4% pa in September 2011 from 13.0% pa in December 2009

(Figure 26), while local media report that the uncollateralized black market

lending rate is as high as 10% per month, up from 5% per month last year.28

27

Perhaps the most publicized Chinese company accounting fraud case this year was Sino-Forest, which listed on the Toronto stock exchange in 1994, overstating its forestry holdings in Yunnan province by some USD900m. But this is one example of more than two dozen listed Chinese companies that have shown accounting discrepancies or seen their auditors resign so far this year, according to an article by David Pilling in the Financial Times, 1 September 2011. 28

According to the PBC's Wenzhou branch office, underground banking in the city is estimated to have reached RMB110bn by June 2011, equivalent to 18% of formal bank loans outstanding, see http://zj.people.com.cn/GB/15228039.html.

A growing number of SMEs have been denied bank credit altogether and have to turn to the less regulated shadow banking sector


32

Fig. 26: Informal lending rate in Wenzhou vs. official benchmark lending rate

Source: CEIC; www.wenzhou.gov.cn; Nomura Global Economics estimates.

Fig. 14

The segmentation of China‟s credit market, through priority lending to large

SOEs at the expense of SMEs, poses serious risks to the economy. For not

only are the SMEs, on average, more productive than SOEs, they are also in

many ways the life and blood of the economy: in 2009, China‟s 431,000 SMEs

generated two-thirds of total industrial output, paid two-thirds of tax revenues

and employed over three-quarters of the workforce (Figure 27). In recent

months, the government has urged banks to relax credit standards to SMEs

but the quid pro quo could be higher bank NPLs.29

Fig. 27: Gauging the importance of SMEs to the economy, 2009

Number of Enterprises

Gross industrial

output value

Total Assets

Revenue Total

profits Employment

unit current prices RMB bn RMB bn RMB bn „00 persons

Total 43,4364 54,831 49,369 54,252 3,454 8,831

Large enterprises 3,259 17,581 19,312 18,070 1,090 2,044

Medium enterprises

38,036 15,937 15,796 15,505 1,137 2,788

Small enterprises 393,074 21,313 14,261 20,677 1,228 4,000

SME 431,110 37,250 30,057 36,182 2,365 6,788

% of total: SME 99 68 61 67 69 77

*Note: SMEs are classified on the official definition which is based on employment, revenue and total capital size, which varies by industry. For example, SMEs by employment size are defined as <2,000 persons for industry, <3,000 for construction, < 200 for wholesale, <500 for retail sales, <3,000 for transportation, <1,000 for postal service and <800 for accommodation and catering. Source: China Statistical Yearbook 2010.

Fig. 15

29

In late September 2011, the city government of Wenzhou set a ceiling on the interest rate of loans made by non-bank financial institutions at 4x the benchmark lending rate (6.56%), while for banks the ceiling for the interest rate on loans to SMEs was set at 1.3x the benchmark lending rate. More significantly, the State Council on 12 October 2011 ruled that nationwide bank loan growth to small enterprises should not be lower than overall loan growth; bank loans of RMB5m or less to small enterprises can be treated as retail loans in determining credit risk weights and can be excluded from the banks aggregate loan-to-deposit calculation.

0

5

10

15

20

25

30

Sep-07 Sep-08 Sep-09 Sep-10 Sep-11

Wenzhou informal lending rate

Benchmark official bank lending rate

% p.a.

The segmentation of China‟s credit market, through priority lending to large SOEs at the expense of SMEs, poses serious risks to the economy


33

4. Unintended consequences of financial liberalization

Based on international experience, the conventional view (see Johnson, 1998)

is that financial liberalization serves to enhance competition, increase the

efficiency of capital allocation and support long-term growth, but the

sequencing and initial conditions are important: if it happens too fast and

without a strong banking system and efficient accounting, regulatory,

supervisory and corporate governance frameworks, it can cause financial and

economic crises. China will go through a series of financial sector reforms in

the next five years. One advantage is that China can learn from the

experiences of financial crises in other emerging markets and, indeed, this has

likely contributed to its gradualist approach to financial liberalization so far. On

the other hand, pressures are building for China to accelerate financial

liberalization, as it is linked with other reforms, despite structural problems and

challenges in the domestic economy.

China's 12th Five-Year Plan, unveiled in March 2011, listed capital account

liberalization, renminbi internationalization and interest rate deregulation as

policy priorities. While these reforms are interrelated and indeed necessary for

China to make its financial system more efficient and its monetary policy more

effective, they do entail macro risks given the unbalanced domestic economy,

with excessive investment and credit, including the flourishing shadow banking

sector.

In recent years, China has made progress on capital account liberalization,

particularly in relation to the internationalization of the renminbi. This, in some

ways, is a natural development given the sheer size of China‟s economy and

the exponential rise in its international trade (China‟s combined exports and

imports totaled USD3.3trn in 2010, 6x larger than in 2000). Indeed, with a

more open and rapidly growing economy, together with the, albeit gradual,

move to a more flexible exchange rate, it has become a challenge to restrict

non-FDI, or so-called “hot money” capital inflows.30

In 2009-10, simply by

subtracting the current account surplus and net FDI inflows from the balance

of payments surplus, we estimate that other forms of net capital inflows totaled

USD108bn. These loopholes are not easy to control as the “desirable” flows

are mingled with the “undesirable” flows, and it may be difficult to distinguish

the two. Meanwhile, perhaps motivated by recently becoming the world's

second-largest economy, or perhaps over concerns of its exposure to foreign

financial assets (China‟s FX reserves totaled USD3.2trn in September 2011),

China seems to have made a clear policy shift to accelerate the use of the

renminbi in international trade and finance (see Box 7: A chronology of China‟s

capital account liberalization).

30

For instance, firms can move capital to China by overstating export receipts and/or understating import expenses. Expectations of CNY/USD appreciation can also fuel speculative hot-money capital inflows.

Zhiwei Zhang

+852 2536 7433

[email protected]

Chi Sun

+852 2536 7705

[email protected]

Pressures are building for China to accelerate financial liberalization

China seems to have made a clear policy shift to accelerate the use of the renminbi in international trade and finance

mailto:[email protected]



34

Box 7: A chronology of China’s capital account liberalization

Date announced Liberalization measure

1980 Liberalized FDI in four Special Economic Zones

1996 Current account transactions were liberalized

1999 FDI liberalization extended to all provinces, but subject to limits varying by sector

2001 Under WTO commitment, the services sector is opened up to FDI, including the financial sector

2002 Opening the domestic capital market for selected Qualified Foreign Institutional Investors (QFII)

2004 The approval requirement for firms' overseas investment was repealed

2004 Allowing Hong Kong residents to open RMB deposit accounts at Hong Kong banks

2005 RMB de-pegged from USD; daily trading range of CNY/USD is set at 0.3%

2006 Opening investment abroad for selected Qualified Domestic Institutional Investors (QDII)

2007 CNY/USD daily trading range expanded to 0.5%

2007 Domestic financial institutions allowed to issue RMB-denominated bonds in Hong Kong subject to

approval

2008 Domestic commercial banks allowed to provide loans to firms for use in cross-border M&A

2009 Local firms allowed to register the source of their foreign exchange financing after their investment overseas rather than requiring approval in advance

2009 Introduced RMB as a cross-border trade settlement currency, but restricted to trade between five Chinese cities (Shanghai, Shenzhen, Guangzhou, Dongguan and Zhuhai) and Hong Kong, Macau and ASEAN countries (open to all Chinese importers but only a small number of exporting firms)

2010 RMB as cross-border trade settlement currency program was expanded to include trade transactions between Chinese firms in 20 provinces and cities and the rest of the world. The number of Chinese exporting firms who may participate in the program was also expanded

2010 Foreign companies were authorized to issue RMB-denominated bonds in Hong Kong

2010 Renminbi transactions in Hong Kong were further relaxed to allow: 1) renminbi lending for any purpose; 2) renminbi remittance to mainland by companies subject to approval by China's government

2010 Hong Kong banks involved in renminbi cross-border trade settlement allowed to access the on-shore interbank bond market

2010 Allowed export companies to keep their export revenues overseas (introduced to export companies in Beijing, Guangdong, Shenzhen, Shandong, Jiangsu first in October 2010 and expanded nationwide on 1 January 2011)

2011 US companies and residents can trade renminbi in US branches of Bank of China. Individual accounts can convert US$4000 a day into renminbi (annual quota is US$10,000)

2011 Introduced pilot scheme on allowing qualified foreign institutions to make private equity investment in China

2011* To launch Renminbi QFII, which would allow foreign investors to invest in mainland securities with an initial quota size of RMB20bn

To expand the renminbi trade settlement scheme nationwide

To allow Hong Kong firms to invest directly into mainland China using renminbi

To expand Treasury bond sales in Hong Kong

To launch an ETF linked to Hong Kong stocks in mainland China

2011 Allowed Hong Kong listed companies to raise renminbi through share placements or rights issues. Investment banks are also allowed to issue RMB-denominated derivative warrants based on renminbi shares

Note: * These planned measures were announced by Vice Premier Li Keqiang during a special visit to Hong Kong on 17 August 2011, but have yet to be fully implemented.

Source: Nomura Global Economics.


35

Over the past year, the offshore use of the renminbi has grown tremendously.

Renminbi trade settlement has surged from almost zero in 2009 to 10% of

China‟s total trade in June 2011 (Figure 28), while trade settled in renminbi

through banks in Hong Kong has increased 35x from RMB27bn (USD4bn) in

H1 2010 to RMB953bn (USD146bn) in H1 2011, comprising one-third of total

trade between Hong Kong and China (including offshore trade). At the same

time, renminbi deposits in Hong Kong have grown exponentially from

RMB103.7bn (USD15bn) in July 2010 to RMB609bn (USD95bn) in August

2011, equivalent to 6.8% of total deposits in Hong Kong (Figure 29).

Fig. 28: RMB usage for trade settlement


Fig. 16

Fig. 29: RMB deposits in Hong Kong


Fig. 17

However, the range and accessibility of renminbi financial instruments outside

China is still small relative to the volume of renminbi that is building up

offshore, leaving much of the renminbi being deposited at the Hong Kong

clearing bank earning a low return. As a result, internationalization of the

renminbi is adding pressure for China to accelerate capital account

liberalization. China‟s government has allowed about RMB50bn (USD7bn) in

Hong Kong to be invested in China‟s interbank bond markets, a similar amount

to return as inward FDI and plans are underway to launch an RMB-based QFII

(Qualified Foreign Institutional Investors) scheme of RMB20bn (USD3bn) to

invest in China‟s capital markets (IMF, 2011a, p.14). However, if the renminbi

is to become truly an international currency, China‟s capital controls will have

to be eliminated so that foreign investors can freely invest in RMB-

denominated assets and easily repatriate their capital and income.

Yet even following the best practice of carefully sequencing capital account

liberalization31

, the lessons from other emerging markets, including those in

Asia in the late 1990s, is that foreign capital can come pouring in, whether it be

foreign portfolio investment or China's banks and companies stepping up

borrowing from overseas. Without a strong regulatory infrastructure and

appropriate safeguards, capital can be misallocated, fueling rapid credit growth,

asset price bubbles and an overheated economy. The economic boom can

then turn to bust, through diminished competitiveness, a worsening current

account, rising NPLs and a loss of investor confidence triggering capital flight.

With a war chest of FX reserves and a large current account surplus, China is

not, in our opinion, vulnerable to a balance of payments crisis, but that does

not rule out the possibility of large net capital outflows and a drawdown in FX

reserves – particularly given that China's M2 money supply has swelled to

175% of GDP as of September 2011. Indeed, a freer capital account amid

severe financial repression can increase the incentive for China's savers to

flee negative real bank deposit rates in favour of higher returns abroad.

31

Although certain rules about sequencing capital account liberalization – for example, countries should liberalize long-term flows before short-term flows, and foreign direct investment before portfolio investment – have the appeal of simplicity, the fungibility of capital makes their practical application difficult.

0

2

4

6

8

10

12

Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11

% of China's total trade

0

200

400

600

800

0

1

2

3

4

5

6

7

Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11

Total amount of RMB deposits in

Hong Kong, rhs

RMB deposits as a % share of total

Hong Kong deposits, lhs

RMB bn%

Internationalization of the renminbi is adding pressure for China to accelerate capital account liberalization

Based on international experience, if capital account liberalization happens too fast, without appropriate safeguards, it can cause financial crises

Renminbi deposits in Hong Kong have grown exponentially from USD15bn in July 2010 to USD95bn in August 2011


36

Faster capital account liberalization can also speed up domestic financial

deregulation. With freer capital movement it will become more difficult for the

PBC to both manage the exchange rate and have autonomy over monetary

policy. With the exceptions of small and very open economies, like Singapore

and Hong Kong, the conventional macro policy approach under a freer capital

account is to gradually relinquish control over the exchange rate and focus

instead on setting domestic interest rates. Indeed, quantitative-based

monetary policy instruments, such as credit quotas, are easier to circumvent

under a freer capital account (for example, by companies increasing borrowing

from overseas), undermining their effectiveness.

However, if the primary instrument of monetary policy is to be the policy

interest rate, to be effective in influencing the price of money and credit it

becomes necessary to deregulate bank deposit and lending rates.32

China still

imposes a floor on bank commercial lending rates (0.9x the benchmark 1yr

lending rate) and a ceiling on bank deposit rates. While deregulating these

interest rates should increase the efficacy of monetary policy, it is not without

risks. Without strong regulatory and supervisory frameworks, interest rate

deregulation can pressure banks to engage in overly aggressive competition to

attract customers and maintain market share.33

By raising deposit rates and

cutting lending rates it can shrink the profit margins of banks; worse still, it

could also encourage them to start taking on riskier loans to compensate for

the drop in profits. The overall loan quality in the banking system would decline,

heightening the risk of a financial crisis.

Another risk related to financial liberalization can stem from developing the

local private debt markets. Until 2004, China‟s private debt market was small

and heavily regulated, but since then regulations have been relaxed and debt

issuance by non-finance firms more than tripled to RMB1.5trn (USD226bn) in

2010 (Figure 30).

There are a number of advantages in deepening the debt market in tandem

with capital account liberalization and interest rate deregulation. Deeper debt

markets can: 1) help absorb larger capital inflows; 2) develop a yield curve and

increase the potency of monetary policy; and 3) diversify credit risks away

from the banks. However, developing the private bond market can increase

competition between banks, as large companies choose to increase borrowing

directly from investors by issuing debt. Without adequate supervision, losing

market share of high-grade corporate customers to the bond market could

pressure banks to lower their credit standards to attract new customers. This

happened in Japan in the 1980s and contributed to its unprecedented asset

price bubble (see Box 8: Risks associated with financial liberalization: lessons

from Japan).

32

In China's current credit tightening cycle there has been a surge in mainland institutions borrowing from Hong Kong banks and debt issuance in Hong Kong's bond market. 33

Rather than interest rate deregulation, the risk could stem from other forms of financial deregulation, such as relaxing controls on the issuance of new lending products which can be counterproductive when complimentary factors – such as commercially orientated loan officers and consumer familiarity with the risks of new financial products – are lacking. For example, domestic financial liberalization in Korea resulted in a crisis in 2003 when credit card debt as a share of GDP more than tripled between 1999 and 2002, and the average number of credit cards for every adult in the country rose from one to three.

Faster capital account liberalization can also speed up domestic financial deregulation

Losing market share to the bond market could pressure banks to take on riskier loans to attract new customers

Another risk related to financial liberalization can stem from developing the local private debt markets

Interest rate deregulation can pressure banks to engage in aggressive competition, leading to a drop in credit standards


37

Fig. 30: Bond issuance by Chinese firms

Note: Commercial paper issuance was allowed from May 2005 for maturities of 1yr and below. Issuance of so-called medium-term notes was allowed from April 2008. Source: China Government Securities Depository Trust & Clearing Co. Ltd.

Fig. 18

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2004 2005 2006 2007 2008 2009 2010 Jan-Sep 2011

RMB bn

Middle-term notes Asset-backed securities

Commercial paper Corporate bonds


38

Box 8: Risks associated with financial liberalization: lessons from Japan

This box summarizes research by Tomo Kinoshita. See What Japan‟s 1980s experience means for China, Nomura

Asia Special Report, 19 October 2009.

Japan‟s financial liberalization experience was gradual in the 1970s but accelerated in the 1980s under US

pressure. Japan‟s bubble in the 1980s and its “lost decade” once the bubble burst in the early 1990s is usually

attributed to the Plaza Accord in September 1985 – a coordinated effort by the G5 to depreciate the USD – which

led to significant JPY appreciation, hurting Japan‟s exporters and caused the Bank of Japan to aggressively ease

monetary policy. However, bond market liberalization and interest rate deregulation were also important underlying

reasons for Japan‟s asset bubble in the 1980s.

Bond market liberalization

The Ministry of Finance deregulated the bond market aggressively in the early 1980s. Due to high minimum

standards, only two companies in the domestic market were allowed to issue convertible bonds (CBs) before

deregulation. This increased to 25 in 1983 and further to 175 companies in 1985. Furthermore, in 1985 unsecured

straight bonds were issued for the first time since the Second World War. The combination of rapid deregulation of

the bond market and rapidly rising stock prices meant that issuance of equity-linked bonds (e.g., CBs and warrants)

soared in 1989, resulting in a massive expansion of the primary market for corporate bonds. The annual average

amount of corporate bonds issued tripled from JPY2trn in 1975-80 to JPY6trn in 1985, peaking in 1989 at a yet-to-

be surpassed JPY19.6trn (Figure 31). The liberalization of the bond market enabled big companies to raise funds

more cheaply and to repay their earlier bank loans. Banks were forced to complete aggressively against each other

in seeking out a new client base, targeting SMEs, individuals and property developers. The proportion of total city

bank loans (excluding trust accounts) made to SMEs and individuals rose to around 70% in 1990 from 47% in

1980. In the fierce competition for new clients that ensued, lending standards often deteriorated. Financial

institutions often lacked information on the credit histories of their new clients. For borrowers, the relaxation of the

banks‟ lending stance created an opportunity to tap easy funds to speculate in property and stocks.

Fig. 31: Bond issuance by Japanese firms

Source: Japan Ministry of Finance and Nomura Global Economics.

Interest rate deregulation

Deregulation of interest rates made for another source of aggressive bank lending behaviour. Bank deposit rates

had long been set at low levels by the authorities to provide banks with sufficient interest rate margins. The interest

rate deregulation schedule started by removing the interest rate ceiling for large deposits of JPY1bn or more in

October 1985; for deposits of JPY500m or more in April 1986; for deposits of JPY50m or more in April 1988; and

for deposits of JPY10m or more in October 1989. Interest rates for certificates of deposit were also rapidly

deregulated in the 1980s. Abolishing the interest rate restrictions sparked fierce competition among banks to raise

deposit rates to attract new customers. To reduce interest rate margin pressure, financial institutions started to

seek out riskier customers that were willing to pay higher borrowing rates.

0

2

4

6

8

10

12

14

16

18

20

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Bond with Warrants (overseas)

Convertible Bonds (overseas)

Straight Bonds (overseas)

Bond with Warrants (domestic)

Convertible Bonds (domestic)

Straight Bonds (domestic)

Yen trn



39

5. The Lewis turning point

Over the past decade, China‟s urban population has increased by about 20m

per year while its rural population has fallen by 13m per year, largely through

migration. The seemingly endless supply of cheap rural labour migrating to the

cities has helped contain average wages. However, Nobel Prize-winning

economist Arthur Lewis (1915-91) observed that in developing economies a

point is reached when the supply of surplus rural labour starts to diminish,

strengthening the wage bargaining power of industrial workers. This has

become known as the Lewis turning point (LTP) and in a stylized chart can be

thought of as a “kink” in the labour supply curve when wages can take-off

(Figure 32). In the early stage of economic development, the manufacturing

labour supply curve can be elastic, that is flat – increased labour demand does

not affect the wage level – but as the economy develops there will be a point

when the manufacturing labour supply curve will kink because of a diminishing

supply of surplus rural labour.

Fig. 32: A stylized diagram of the Lewis turning point

Source: Nomura and inspired by Stephen Jen at SLJ Macro Partners

Fig. 19

Surveying the recent literature, empirical studies have reached no firm

conclusions on whether China is at the LTP.34

Taking a different approach, we

find an interesting pattern in countries that have already passed the LTP. In

Japan it was in 1965 when employment in the secondary sector

(manufacturing and construction) overtook that in the primary sector (mostly

agriculture) that real manufacturing wages started to surge (Figure 33). A

strikingly similar phenomenon happened in Korea in 1987. In China,

employment is still largest in the primary sector, but on current trends it will be

overtaken by employment in the secondary sector in 2015.

34

Knight, Deng and Li (2011), Zhang, Yang and Wang (2010) and Cai and Wang (2008) conclude that China is at, or near, the LTP. On the other hand, work by Minami and Ma (2010), Du and Wang (2010), Wang (2010) and Garnaut (2010) conclude that the LTP has yet to be reached.

Labour pool

Wages

D1

D2

Laboursupply

LewisPoint

The Lewis turning point is when the supply of surplus rural labour starts to diminish, raising the wage bargaining power of industrial workers

Empirical studies have reached no firm conclusions on whether or not China is at the LTP


40

Fig. 33: Primary, secondary and tertiary employment and real wage growth

Japan South Korea China

Source: Japan‟s Ministry of Internal Affairs and Communications and Ministry of Health and Labour; CEIC and Nomura Global Economics.

Fig. 20

At first glance it would appear that China is near, but not yet at, the LTP, and it

is true that lower-end manufacturing is moving inland to areas where labour is

more plentiful and cheaper. However, we believe that most of the recent

empirical studies have ignored three critical factors that, taken together,

suggest to us that the LTP is upon China.

The first is demographics (see chapter: The setting in of growing pains). Based

on projections by the United Nations, China‟s 15-24 year-old age cohort will

fall from 16.8% of the total population in 2010 to 14.6% in 2015 and 12.8% in

2020, resulting in there being fewer young, productive workers willing to leave

the countryside to work in factories. In contrast, the 15-24 age cohort was

20.3% in Japan in 1965 and 21.1% in Korea in 1985.

Second, the focus should be on total labour benefits, not just wages. China‟s

wages are growing strongly: in 2010, the average wage grew by 13.3% and

the average minimum wage jumped 22.9% and by a similar magnitude in 2011,

but other components of labour compensation have surged even more. As in

Japan in the early 1970s, there are signs that China‟s workers are becoming

increasing aware of their “fair share” of entitlements – from social welfare

benefits to better working conditions – as evidenced by the surge in the

number of labour disputes.35

It is intriguing that there was a structural break in

China‟s labour disputes in 2008, and the same pattern happened in Japan in

the early 1970s, coinciding with the wage surge there (Figure 34).36

35

According to research by Huang (2010), if companies strictly follow policies on social welfare contributions, commonly the payrolls of migrant workers would have to rise by at least 35-40%, including contributions to pensions (20% of payroll), medical insurance (6%), employment benefit (2%), work injury insurance (1%), maternity benefit (0.8%) and housing entitlements (5-10%). 36

In the early 1970s Japan experienced an outbreak of inflation, in part driven by the 1973-74 oil crisis, but also the flow of surplus rural labour moving to the cities started to diminish in the 1960s, leading to increased worker bargaining power, as evidenced by the surge in labour disputes, not only for higher wages but also better working conditions – the so-called Lewis turning point (Minami, 1973).

-10

-5

0

5

10

15

20

0

10

20

30

40

50

60

1954 1968 1982 1996 2010

Employment, Mn % y-o-y

-20

-15

-10

-5

0

5

10

15

20

25

0

2

4

6

8

10

12

14

16

18

20

1978 1986 1994 2002 2010


-20

-15

-10

-5

0

5

10

15

20

25

0

50

100

150

200

250

300

350

400

450

1953 1969 1985 2001 2017


F

-10

-5

0

5

10

15

20

0

10

20

30

40

50

60

1954 1962 1970 1978 1986 1994 2002 2010

Real wage growth, rhs Primary, lhs Secondary, lhs Tertiary, lhs


We believe that most studies have ignored three factors that, taken together, suggest to us that the LTP is upon China

The second is to focus on total labour benefits, not just wages

The first is demographics


41

Fig. 34: Number of labour disputes – Japan versus China

Source: Bank of Japan; China‟s Ministry of Human Resources and Social Security and Nomura Global Economics.

Fig. 21

This may have been triggered in part by China‟s new labour laws in 2008 and

the exponential increase in user-penetration of the internet and mobile phones.

The new labour laws have empowered low-paid workers by making it

mandatory to have written labour contracts, enforcing the payment of overtime,

paying salaries on time, and being enrolled in a social security program. It is

also now easier for workers to file complaints against employers in the

arbitration tribunals or courts. If we aggregate data measuring compensation

of labour in China‟s 31 provinces, which is based on the income measure of

GDP, it shows that this broader measure of firms‟ labour costs grew much

faster than average national wages in 2008-09, although both series returned

to a similar rate of still-fast growth of around 16-17% last year (Figure 35).

Fig. 35: Growth in wages versus total labour compensation


Fig. 22

The third reason is the rising opportunity costs of migrating from the

agricultural sector, if food prices keep rising, lifting incomes in the countryside.

Food prices have soared in recent years and we expect them to continue to

climb, underpinned by burgeoning demand from the world‟s rapidly developing

– and most populated – economies. In these economies, diets are changing

towards a higher calorie intake, while agricultural supply faces many

constraints and uncertainties, such as greater use of biofuels, global warming

and increasing water scarcity (see Special Report, The coming surge in food

prices, Nomura Global Economics, 8 September 2010).

The rigid hukou household registration system, by making it extremely difficult

for rural migrants to obtain a permanent urban resident permit and thereby

gain the same access to the deepening social welfare systems as locals, could

also become a growing constraint on urbanization, as costs in the cities rise.

-6

-3

0

3

6

9

12

0

2

4

6

8

10

12

1960 1970 1980 1990 2000 2010

No. of labour disputes in Japan in thousands, lhsNo. of labour disputes in China in 100 thousands, lhsJapan's real wage growth, rhs

Number % y-o-y

0

5

10

15

20

25

30

35

1994 1996 1998 2000 2002 2004 2006 2008 2010

Wages

Total labour compensation

% y-o-y

This may have been triggered in part by China‟s new labour laws in 2008

The third reason is the rising opportunity costs of migrating from the agricultural sector




42

A surge in wages is no doubt positive for household consumption and helps

facilitate internal rebalancing, but if it happens too fast, particularly if

productivity growth fades, then it can eat into profit margins, erode export

competitiveness and, if passed on to consumers, trigger a serious outbreak of

inflation. Indeed, because of the LTP, but also due to the need to deregulate

the government's underpricing of key natural resources and a likely multi-year

surge in food prices, our base case is that CPI inflation will average around 5%

from 2011 to 2015, compared to 2% over the past decade, see Asia Special

Report, China: The case for structurally higher inflation. 21 September 2011.



43

6. The setting in of growing pains

China is starting to face growing pains from worsening demographics and

increasing strains on natural resources and the environment. This will almost

certainly cause the economy's potential growth to slow over the course of this

decade, and inflation to be structurally higher. The combination of slower trend

growth but higher structural inflation creates a more challenging environment

to implement much-needed reforms. For example, it will likely become

politically more difficult to remove the myriad government subsidies to the

relatively less efficient, capital intensive SOE-related sectors. Yet failing to

reform the SOE sector will make it tougher to increase the efficient usage of

natural resources, reduce environmental degradation and rebalance GDP

growth away from investment towards consumption. This combination can also

make it more challenging to address China's high income inequality, while the

experience of other emerging economies is that slower trend growth can

cause problems festering below the surface – such as hidden bad debts – to

bubble up to the surface.

Demographic challenges

China is in the midst of a huge demographic shift. A rapidly ageing population,

a shrinking labour force and a sex ratio heavily skewed toward males are

creating new challenges (Figure 36). The one-child family policy37

was

introduced in 1978 and has brought the fertility rate down to about 1.6.

Because of low fertility and rising life expectancy, the UN projects the share of

people aged over 60 in the total population to rise from 12.3% in 2010 to

15.1% in 2015 and to 17.4% in 2020, increasing the number of 60+ year-olds

over this period by 76m. Meanwhile, the share of 15-24 year-olds in the total

population is projected to fall from 16.8% in 2010 to 14.6% in 2015 and to

12.8% in 2020, decreasing the number of 15-24 year-olds over this period by

47m. China‟s age pyramid is projected by the UN to change shape

dramatically in the next two decades (Figures 37 and 38), while the World

Bank (2011a) expects total employment to start to shrink from around 2015.

Fig. 36: Key demographics indicators and projections for China, by the United Nations

2000 2005 2010 2015 2020 2025 2030

Population, millions 1269 1308 1341 1370 1388 1395 1393

Working age population, millions 857 923 971 996 989 981 960

Median age, years 29.7 32.2 34.5 36.2 38.1 40.1 42.5

Young population aged 15-24, % total 15.5 17.0 16.8 14.6 12.8 11.7 11.4

Elderly population aged 60+, % total 10.2 10.9 12.3 15.1 17.4 20.2 24.4

Old age dependency ratio - aged 65+, % 15-64 10.4 10.7 11.3 13.0 16.8 19.9 23.9

Child dependency ratio - aged 0-14, % 15-64 37.7 31.0 26.9 24.5 23.5 22.3 21.2

Total dependency ratio - aged 0-14 and 65+, % 15-65 48.1 41.7 38.2 37.5 40.3 42.2 45.1

Fertility rate, child births per woman 1.80 1.70 1.64 1.56 1.51 1.53 1.58

Net reproduction rate, No. of daughters per woman 0.78 0.73 0.71 0.69 0.68 0.69 0.72

Population sex ratio, males per 100 females 107.5 107.8 108.0 108.0 107.8 107.5 107.1

Sex ratio at birth, No. of male births per one female 1.18 1.21 1.20 1.18 1.16 1.15 1.14

Source: United Nations and Nomura Global Economics.

Fig. 23

37

China‟s one-child policy officially restricts married, urban couples to having only one child, although it allows exemptions in several cases, including for rural couples, ethnic minorities and parents without any siblings themselves.

Alastair Newton

+44 20 710 23940

[email protected]

China is facing growing pains from worsening demographics and increasing strains on natural resources and the environment

China faces a rapidly ageing population, a shrinking labour force and a sex ratio heavily skewed toward males



44

Fig. 37: Age pyramid, 2010

Source: United Nations and Nomura Global Economics

Fig. 24

Fig. 38: Age pyramid, 2030

Source: United Nations and Nomura Global Economics 7, 2011

Fig. 25

China‟s rapidly ageing population will increase the strain on the country‟s

relatively undeveloped health and pension systems, and could increase

tensions in society (see section in this chapter: Rising inequality and an

aspiring middle class). Young urban couples, many of them without siblings,

will find themselves with four parents to look after and will themselves have

only one child (known in China as the 4-2-1 phenomenon). Perhaps the more

alarming concern for population sustainability is the large imbalance between

baby girls and boys. Women are bearing only 0.71 girls over their lifetime, well

below the replacement figure of just over unity. In 2010, there were 51m more

men than woman in the country. The sex ratio among newborns is 120 boys

for every 100 girls, the highest in the world (Figure 39). At this rate, there will

not be enough brides for as many as one-fifth of today‟s baby boys when they

get to marrying age, heightening the risk of social tensions.

Fig. 39: Country rankings of sex ratio at birth

Source: United Nations and Nomura Global Economics.

Fig. 26

As a result of China‟s ageing population, potential output growth looks set to

slow, possibly quite sharply in the next 5-10 years. The contribution of labour

to China‟s potential output growth is estimated by the World Bank to have

declined from an average of 3.3pp in 1978-94 to 1.0pp in 1995-2009, and is

projected to decline further to -0.5pp in 2016-20 (Figure 40). In the past two

decades, the decreasing contribution of labour to China‟s potential output

growth was not a major concern as it was offset by capital deepening, with

capital accumulation adding a hefty 5.8pp to potential growth in 1995-2009.

But capital deepening has lifted the investment-to-GDP ratio to an

extraordinarily high level of almost 50%, limiting the scope for further increases

in the contribution of capital to potential output growth. The implication is that

China‟s potential output growth, which has been remarkably stable in the last

three decades, could slow abruptly this decade unless total factor productivity

(TFP) can be boosted, i.e. unless China uses its labour and capital more

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The rapidly ageing population will increase the strain on the relatively undeveloped health and pension systems, and could increase tensions in society

The prospect of a shrinking workforce means that China‟s potential output growth is likely to slow, possibly quite sharply in the next 5-10 years


45

efficiently. The World Bank is not optimistic, projecting China‟s potential output

growth to slow from an average of 9.6% in 1995-2009 to 8.4% in 2010-15 and

to 7.0% in 2016-20. If potential growth slows too sharply, excess demand

could fuel runaway inflation and/or swing the current account into deficit.38

Fig. 40: Estimates of potential output growth – past and future

% y-o-y 1978-94 1995-2009 2010-15 2016-20

Potential output growth 9.9 9.6 8.4 7.0

Employment growth 3.3 1.0 0.2 -0.5

Labour productivity growth 6.4 8.6 8.2 7.5

- From total factor productivity (TFP) growth 3.0 2.7 2.3 2.3

- From capital deepening 3.4 5.8 5.9 5.2

Source: Kuijs, L., “China Through 2020: A Macroeconomic Scenario”, World Bank, China Research Working Paper No. 9, June 2009.

To try to avoid a shrinking workforce, new policies could be implemented. For

example, China‟s hukou household registration system, which discriminates

against the social rights of migrant workers, could be relaxed (see Box 9:

China‟s hukou household registration system). Relaxing the hukou system,

which links most health and education benefits to the area where the person is

registered rather than living, should help ease the wide income inequalities

and encourage more labour mobility and faster urbanization. In turn, this could

boost TFP given that productivity in agriculture is about 6x less than in the rest

of the economy. Urbanization also creates larger cities, which generate

economies of scale due to specialization, information spillovers and clustering.

In the countryside, it would also facilitate the much-needed consolidation of

farmland holdings, providing economies of scale and greater scope for

modernization, hence boosting agriculture productivity.

However, the challenge is that these reforms, while helping to encourage

urbanization and labour mobility, risk generating other negative externalities.

Already, with half of the 1.3bn population living in urban areas, the strain on

the bigger cities is intensifying in terms of resource constraints, environmental

concerns and social tensions. A good example is Beijing, the capital city,

where the population has soared from 15.4mn in 2005 to 19.6mn in 2010, a

cumulative increase of 27.5%, dwarfing the 2.5% increase in the nationwide

population over this five-year period (Figure 41). No surprise the authorities in

Beijing are introducing stringent measures to limit motor vehicle ownership,

and in August 2011 shut down 23 schools for migrants across the capital.

38

As economies develop it is common for the initial high rates of TFP growth to slow, as productivity “catch up” and the flow of surplus labour from the less productive agricultural sector to the more productive manufacturing and services sectors starts to ease. More specifically for China, the recent investment boom has been led by public infrastructure projects, of which the return on capital tends to be relatively lower than private investments and can take longer to be realized. One hope to lifting China‟s TFP is from a boost in human capital. The number of university graduates rose more than 6x between 2000 and 2010 to 384mn, although a large share are struggling to find jobs.

China could relax the hukou household registration system to encourage urbanization, but at the risk of generating other negative externalities


46

Fig. 41: Cumulative population growth, 2005-10


Fig. 27

Box 9: China’s hukou household registration system

China‟s household registration system, or hukou, was introduced in the 1950s to keep as many people as possible

in farming, in order to maximize food production. It was also an element of the government‟s social control

structure, in part to control the pace of urbanization. Starting in the late 1990s, restrictions were eased to allow

migrants to register as temporary urban residents and the right of police to expel unofficial migrants was abolished

in 2003. However, the main problem remains: migrants do not have the same social rights as locals with

permanent resident permits. Many migrants are not entitled to pensions or medical care; their children cannot

attend local public schools. They cannot enjoy a housing subsidy. Overall the hukou system is still very much in

force, acting as a major constraint on migration and hence on urbanization, attributing to income inequality.

Another reform could involve relaxing the 1978 one-child policy, but it would

take decades to have an impact on employment and risks exacerbating

China‟s social, resource and environmental problems. Allowing greater

immigration or increasing the official retirement age – which is currently 60 for

men and 50 for women, and has not been changed since 1951 – would likely

have a more immediate impact on employment. However, the former would

also strain China‟s resources and environment, while the latter would not be a

politically popular move ahead of the transition to the fifth generation of

leaders in early 2013.

Rising inequality and an aspiring middle class

Events in the Middle East and North Africa (MENA) at the start of this year

triggered a good deal of thought over other countries which could be

vulnerable to similar outbreaks of civil unrest. At the forefront of the protests in

Tunisia and Egypt in particular were middle-class, relatively well educated and

often un- or under-employed urban youth. However, despite comparisons

between Tahrir Square in 2011 and Tiananmen Square in 1989, we see major

differences between the MENA and contemporary China – and little, if any,

risk of “contagion”.

In essence, rising incomes and living standards have so far satisfied the

aspirations of China‟s growing middle class without the need for political

reform. However, if the gap between rich and poor and between cities and

countryside continues to widen, the government could find itself under

increasing pressure from the less well-off to distribute wealth more evenly,

particularly as social media has become a powerful tool for the underclass to

mobilise and to share its grievances.

Rising inequality could threaten social stability

Bo Xilai, Chinese Communist Party (CCP) chief in the municipality of

Chongqing, was described by British newspaper The Independent in 2010 as

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However, rising inequalities within China could spur increasing civil unrest…

There is little if any risk of contagion to China from the “Arab Spring”

Rising living standards have so far satisfied the aspirations of China‟s growing middle class


47

“China‟s most charismatic politician”.39

Certainly, he has proved himself to be

adept at striking a chord with “ordinary” Chinese through a combination of his

crackdown on corruption in Chongqing since he assumed his current post in

2007 and his media-savvy skills. So, it is in our view safe to assume that with

his July 2011 public statement in support of greater social equality – “dividing

the cake up well in addition to making the cake bigger” – he was again striking

a chord with many Chinese which, while arguably populist, nevertheless has a

firm foundation in contemporary China.

Indeed, President Hu Jintao seemingly made a similar point during his joint

press conference in Washington with President Barack Obama in January

2011. Asked about human rights in China, he placed great emphasis on

economic rights, highlighting the fact that China still has over 250mn citizens

living close to the poverty line despite the tremendous strides it has made in

poverty alleviation over the past three decades or so.

The data support these concerns. Notably, in a study published in 2002 not

long before the handover of power to the current (“fourth generation”)

leadership, Newton and Subbaraman (2002) noted that China‟s “Gini

coefficient – a common measure of income inequality – rose from 28.8 in 1981

to 38.8 in 1995, and has risen further to 39.0 in 1999, close to internationally

recognised danger levels”. According to the United Nations‟ 2010 Human

Development Report, as we look forward to the handover of power to the fifth

generation leadership a year or so from now, China‟s Gini coefficient has risen

still further to 41.5 in 2005 (latest data available).40

By a widely recognised

yardstick, inequality is therefore now at a level where it may pose a significant

risk to social stability. On simpler but more timely yardsticks of income

inequality, China‟s average household income in urban areas has increased to

more than three times that in rural areas; and within urban areas, average

income of households in the top 20% income decile have risen to more than

eight times that of households in the bottom 20% income decile (Figures 42

and 43).

Fig. 42: Urban-rural household income ratio


Fig. 28

Fig. 43: A gauge of urban household income inequality: the ratio of highest and lowest income deciles


Fig. 29

One way of addressing this issue would be through the adoption of more

redistributive policies – which some commentators (e.g. the Economist

Intelligence Unit (EIU) in an article published on 30 September 2011) have

suggested Bo Xilai (who is experimenting with a property tax in Chongqing)

was advocating as part of what has become known as the “Chongqing model”,

marrying leftist rhetoric/policies with a strong anti-corruption drive. This

approach is widely seen as an alternative to the so-called “Guangdong model”

promoted by, among others, Wang Yang, head of the CCP in Guangdong

39

“Bo Xilai, China's most charismatic politician, makes a bid for power” by Clifford Coonan, The Independent, 8 March 2010. 40

The Gini coefficient ranges theoretically from 0, when everyone has exactly the same income, to 100 when a single individual receives all the income of a society.

1.5

2.0

2.5

3.0

3.5

1978 1982 1986 1990 1994 1998 2002 2006 2010

Ratio

2

4

6

8

10

1985 1990 1995 2000 2005 2010

Urban income ratio: top 10%/bottom 10%

Urban income ratio: top 20%/bottom 20%

Ratio

… and standard measures support the view that there may be some risk to social stability

Calls for more redistributive policies in response do not enjoy universal support


48

province and Bo Xilai‟s predecessor in Chongqing, which adopts a more liberal

approach both politically and economically – but one which, in our view, has

the potential to generate greater public dissatisfaction.

In effect, with both Bo Xilai and Wang Yang widely seen as potential

candidates for promotion to the Politburo Standing Committee next year, these

contrasting approaches can be viewed as a de facto election issue.

Furthermore, with others, including Premier Wen Jiabao and his predecessor

Zhu Rongji (calling, respectively, for bolder political reform and faster

economic reform) recently weighing in, this appears to be an ideological

struggle which may be a key determinant in the make-up of the fifth generation

leadership and the policies it pursues.

But how extensive is social unrest in reality?

Gauging the true extent of “social unrest” in China is far from straightforward.

The international press frequently cites numbers from 80,000 upwards per

year for “mass incidents” – the majority historically revolving around

environmental issues (where the Green movement has emerged over the past

decade as the most notably organised manifestation of civil society in China).

However, the definition of “mass incident” is not clear-cut and official reporting

may not be entirely reliable; furthermore, the Ministry of Public Security has

not published data since it cited 87,000 incidents of “public order disturbances”

(a broader category than “mass incident”) in 2005.

However, as Will Freeman of GaveKal Dragonomics noted in an article

published last year:

“Anecdotal evidence over the last five years suggests a rise in „anger-venting‟ mass incidents – large-scale, often violent, riots that erupt from seemingly minor incidents and reflect general discontent rather than specific rights violations.”

41

Although we agree that there is no reason to believe that even the upper

estimates of social unrest pose an immediate threat to the CCP‟s grip on

power, we also accept that no government can be sure of its longevity in the

face of increasing unrest and a failure to address the underlying causes.

Stress in the city

According to China‟s 2010 census, around 670mn people now live in towns

and cities – almost exactly half the total population. History (including recent

events in the MENA) teaches us that it is urban, rather than rural, unrest to

which regimes are especially vulnerable. However, the continued existence of

the hukou household registration system (see Box 9: China‟s hukou household

registration system) means that in today‟s China there is a significant overlap

between “rural” and “urban” citizenship.

The hukou system officially restricts labour mobility thereby effectively

discriminating against farmers moving to work in the city. According to the

OECD (2011, pp.163-165), China‟s 2005 census estimated the total number of

rural-to-urban migrants without a local hukou at 74mn and unofficial migrants

in urban areas at 39% of the urban labour force in 2005 (Figure 44). Total

labour compensation of migrant workers without a hukou is sometimes only

half of that of urban residents, even if they perform the same job functions,

according to research by Huang Yiping (2010).

41

“The accuracy of China‟s „mass incidents‟”, Will Freeman, Financial Times, 2 March 2010.

Gauging the true extent of social unrest remains difficult…

… but we see no reason to believe that the CCP‟s grip on power is currently under threat

We believe that the hukou system helps perpetuate inequality in the cities…


49

Fig. 44: Origin and destination of unofficial migrants

Absolute number (millions)

Coming from urban areas

Coming from rural areas

Total

Population

Living in urban areas 52.6 73.6 126.3

Living in rural areas 5.2 18.1 23.4

Total 57.9 91.8 149.6

Employment



Total 50.1 76.7 126.8

As % of population or employment living in an area

Population



Total 7.0 11.4 4.4

Employment



Total 6.6 10.1 16.7

Source: "China" - OECD Economic Surveys, Volume 2010/6, February 2010.

Fig. 30

If the status quo persists, the tensions to which these inequalities inevitably

give rise look set to deepen. According to a report published early in 2011 by

China‟s National Population and Family Planning Commission, the next

decade will see a further 100mn Chinese migrate from rural to urban areas.

Indeed, another recent report – this one by the Hong Kong-based China

Labour Bulletin – claimed that the so-called “new generation” workforce, i.e.

workers born since 1980 who account for nearly half of the total number of

internal migrants, is the driving force behind increasing labour unrest and

strikes in an at least a partly successful quest for better pay and conditions.

In response, as the EIU notes in its May 2011 “Risk Briefing” on China, the

authorities have adopted a range of policies which are broadly supportive of

workers, at least in part to try to address discontent arising from socio-

economic inequality. These include: raising the minimum wage, improving

labour regulation and permitting local unionisation and a degree of collective

bargaining. There is some recent evidence that, despite the authorities‟ efforts

to prevent a mass labour movement from developing, modern communications

are facilitating wider cooperation (e.g. the recent case of industrial action by

cab drivers which spread to a number of cities). However, the EIU continues to

place only a “moderate probability” on a labour movement emerging in the

foreseeable future which could pose a significant challenge to the government.

No taxation without representation?

On the other hand, reform of the status quo – whatever its direction – stands to

run into headwinds from constituencies which benefit from, and therefore

favour, the current system.

Notable among these is China‟s burgeoning middle class, whose aspirations to

date have been satisfied without political reform. Indeed, it has long been our

view that the implicit understanding between China‟s leaders and its citizens is

that political reform would be a nettle to be grasped by the fifth generation

leadership, but not until the second half of its expected period of office, i.e.

from 2017 onwards – provided, that is, that the latter‟s expectation of

continuing economic betterment is fulfilled.

That said, as The Economist pointed out in its June 2011 special report on

China, the introduction of new and higher taxes on the middle classes – e.g.

as part of an overall more redistributive shift – may “stir demands for a say in

how their money is spent”.

… and that persisting with it risks increased labour and wider unrest…

… despite recent measures which are supportive of workers

Any reform of the status quo is likely to run into headwinds from vested interests…


50

“Stepping stones” prevail for now

For the time being at least, just as is the case with labour policy, we believe

that Deng Xiaoping‟s famous analogy of crossing the river one stepping stone

at a time is likely to prevail. In particular, as The Economist put it in its June

2011 special report on China: “For now the party would rather deal with angry

underdogs than with an embittered bourgeoisie”.

This may in part at least account for the recent boost in spending on internal

security which, according to the 2011 annual budget unveiled on 5 March 2011,

is now higher and growing faster than defence spending. Another reason

behind this could be China‟s demographics, discussed in the previous section.

A recent book by science journalist Mara Hvistendahl (2011) examining the

implications of the gender imbalance in China (and in India) pointed to a

possible link with the expansion over the past several years of the paramilitary

People‟s Armed Police, military service being a safety valve historically for the

pressures which surplus male populations can create. Ms Hvistendahl goes on

to suggest that such imbalances can be as destabilising as climate change,

potentially sparking crime, cross-border trafficking and even wider conflict.

Indeed, she finds statistical evidence that crime, including violent crime, is

rising already in cities in China where the gender skew is greatest.42

As the EIU‟s May 2011 “Risk Briefing” reflects, local protests over a whole

range of issues – notably inflation, pay, factory closures, environmental issues

and corruption – are set to continue. Especially with no official channels such

as elections through which citizens can register their opinions, these can and

do act as a valuable safety valve. Furthermore, as with labour disputes,

modern communications (which already facilitate the organisation of social

unrest at the local level) bring with them a greater risk of “copycat” action and

even the emergence of a regional or national protest movement of some sort.

Nevertheless, as the EIU concludes “… rapid economic growth and the lack of

a figurehead… make a national uprising unlikely for the time being”.

Less haste, more speed

All that being said, an accident (attributed by the head of the official inquiry to

an as yet unspecified “design flaw”) near the eastern city of Wenzhou on 23

July 2011 involving two high-speed trains, in which 40 people were reportedly

killed, may have significant consequences on the aspirations of the middle

classes in particular (as well as being something of a set-back to China‟s high-

speed rail (HSR) programme).

HSR is a high prestige project which has enjoyed the full backing of the top

leadership and which is supposed to showcase China‟s ability to absorb and

improve imported technologies. Compounded by what is widely perceived as

the authorities‟ clumsy handling of the aftermath of the crash, both the press

(including the state-controlled media), despite official warnings to desist from

“negative reporting”, and China‟s weibo networks (i.e. the domestic equivalent

of twitter) have repeatedly and strongly challenged official statements and

even openly criticised the government.

Some commentators have suggested that the slow official response may

reflect high-level disagreement over how to handle the matter; and even that

this could, in turn, spill over into the selection process for the fifth generation

leadership.43

If that is correct, it may, in turn, bear on the speed with which the

fifth generation feels able or obliged to initiate some sort of political reform

process.

Quite how China will evolve politically is far from clear. But what is clear is that,

compounded by growing inequalities, the status quo looks increasingly

unsustainable in the medium-term and that evolution there will have to be if

something more wrenching is to be avoided.

42

Unnatural Selection: Choosing boys over girls, and the consequences of a world full of men, Mara Hvistendahl (Oxford University Press, 2011). 43

See, for example, “Curiouser”, The Economist, 6 August 2011.

… so reform is likely to remain incremental

China‟s gender imbalance could also pose a threat to stability

Overall, however, a national uprising remains unlikely, for the time being at least

Nevertheless, political reform may come more quickly than previously expected


51

That is not to contradict our earlier suggestion that the “Arab Spring” was

unlikely to spread to China: indeed, far from it. But the chatter on the weibo

networks does appear to have been of a very different nature to the

established patterns of social unrest. It is, therefore, not impossible that the 23

July train disaster will be looked back upon in due course as a benchmark

moment in accelerating China‟s socio-political evolution.

Resource and environmental strains

Writing during the run-up to the handover of power to the 4th generation

leadership, Newton and Subbaraman (2002) noted that energy security would

be a top foreign policy priority for China in the following decade. Underpinning

this was the recognition that China‟s quest for “comprehensive national power”

(i.e. economic, political, military, technological, scientific and cultural) demands

continued high economic growth which, in turn, requires commodity security in

general and energy security in particular. As the fifth generation prepares to

take power, commodity security will, in our view, remain a very high foreign

and domestic policy priority for the foreseeable future. Critically, there is also

the added dimension of food – and therefore water – security, very much to

the fore. Furthermore, both energy and food/water security bear strongly on

yet another dimension – that of environmental security.

Food security to the fore

Guaranteeing food security for all its citizens confronts China with two

overarching challenges. First, even though it is one of the few countries on

track to meet its Millennium Development Goal target of halving hunger by

2015, the most recent food insecurity report of the Food and Agriculture

Organisation (FAO), for the period 2005-07, noted that around 10% of China‟s

population was affected by undernourishment. Second, in contrast to the early

1980s when food production was rooted in the subsistence level, rising

incomes over the past two decades in particular have stimulated increasing

demand – initially in urban areas, but now increasingly in the countryside too –

for non-staple foods.

Furthermore, food price inflation – the original cause of the protests in

Tiananmen Square in 1989 – remains a politically sensitive issue which, in our

view, stands to influence a raft of policy areas including agriculture,

environment, exchange rate and even defence. Reflecting at least some of

these challenges and speaking at a forum on urbanisation in March 2011, the

Secretary-General of China‟s National Development and Reform Commission,

Yang Weimin, commented that: “We should not excessively turn farmland into

urban areas. Grain security should be given priority.”

Official estimates put the minimum average requirement of grain per person

per year to meet not only subsistence but also animal feed and processing

requirements at 400kg. Coupled with its target of 95% self-sufficiency, this

suggests that China will need to produce at least 580mn tons of grain pa by

2020 (from 546mn tons in 2010). However, with 8.3mn hectares of arable land

lost to urbanisation since 1999 (i.e. around 6.5% of the country‟s total), as

Yang Weimin was suggesting, achieving this goal is being jeopardised by

urbanisation. Furthermore, loss of land to urbanisation is only part of the story.

Almost 30% of China‟s total land area is desert and, despite major efforts over

many years to counter land degradation, the rate of desertification nationwide

is currently running at (an admittedly significantly slower rate than was the

case a decade ago) a 250,000 hectares pa, largely due to human activities,

notably over-grazing.44

44

Furthermore – and directly related to the issue of food security – analysis of the composition of cereal production reveals that since the 1980s growth of output of corn (at 3.5% pa) – the key crop for the biofuel industry (as well as animal feed) – has been significantly faster than is the case for wheat (2.5%) and rice (1.2%). However, this growth in corn production has been achieved not simply through improved productivity but also through the reallocation of land out of rice and wheat into corn. Based on the experience of Japan, experts such as Robert Ash (2011) believe that China could be approaching a plateau in rice productivity and that switching

Commodity security, including food and water, remains a top priority

Undernourishment and dietary shifts both contribute to increasing food demand…

… and food price inflation remains a politically sensitive issue

China risks falling short of its target of 95% food self-sufficiency


52

Land reform – A boost to productivity but politically challenging

In its report on monetary policy in the first quarter of 2011, the People‟s Bank

of China opined that:

The agricultural sector is still a weak link in the national economy facing a lot of problems and challenges… agricultural infrastructure is relatively backward, and the land-output ratio, resource utilization ratio and labour productivity are still low… It is becoming increasingly difficult to guarantee national food security and to supply the major agricultural products.

When in October 2008, the CCP‟s Central Committee promised “a new

upsurge” in rural reform, some hoped that the party had come to see land

ownership as the key to modernizing and collectivizing agriculture. Currently,

although all land is state-/collectively-owned, there is a vibrant market in

(relatively long lease) urban land which contrasts starkly with the tepid market

in rural land, where leases are restricted to a maximum of 30 years, mortgages

are not permitted and selling land usage rights is very difficult. As The

Economist put it in an article published shortly after the Central Committee‟s

announcement:

Chinese academics have long argued that a freer and better-regulated rural property market is essential if peasants are to enjoy more of the fruits of growth. They say it would encourage the consolidation of tiny, inefficient plots of land leased to farmers by collectives and allow peasants to cash in on their land‟s market value, enabling them to use the capital to go into business in the cities. Academics also think that a proper land market would protect farmers from indiscriminate land grabs by local officials who often take collective ownership to mean

control by themselves.45

However, as The Economist reports in an article on urbanisation published in

mid-2011:

Thorough going land reform, of the sort that would… encourage larger-scale farming… remains stuck. One obstacle is ideological… many in the party still regard collectivism as a sacred principle.

46

Furthermore, as The Economist concedes, restricting the ability of farmers to

detach themselves from their land also protects a valuable social safety net.

When an estimated 20mn workers were laid off in early 2009 as a result of the

global financial crisis, many were able to return to their family farms

maintained by their relatives, thereby significantly reducing the risk of unrest

on the city streets. Thus, despite the potential boon it would offer to agricultural

productivity, we see little prospect of real progress on land reform unless, or

until, an alternative social safety net is in place.

Nature will play its part

Even so, especially given the impressive record of the Ministry of Agriculture in

both policy formulation and R&D, China could conceivably boost production

consistent with achieving 95% self-sufficiency for some years to come.

However, underlined by this year‟s severe drought in Hebei, Henan, Jiangsu

and Shandong (four provinces which accounted for almost two-thirds of total

wheat output in 2009), natural disasters continue to threaten steady progress.

Such periodic droughts compound the underlying problems caused by uneven

distribution of water supply nationwide – in very simple terms, too much in the

land from rice to corn may therefore prove to be increasingly difficult unless China is prepared to import an increasing proportion of its rice. 45

“Promises, promises: A „breakthrough‟ in land reform? Or a damp squib?” The Economist, 16 October 2008. 46

“Where do you live?”, The Economist, 23 June 2011.

Land reform could boost productivity but remains politically challenging…

…and could threaten social stability

Natural disasters, especially drought, pose a continuing threat to productivity


53

south (which is prone to flooding, although the incidence of drought is also

increasing in some parts) and too little in the North China Plain in particular, a

major cotton and wheat producing area where both surface and ground water

is being depleted to dangerous levels. The practical implications of this can be

illustrated by the fact that China went from being a net exporter of 1.9mn tons

of wheat in 2003 to a net importer of 6.5mn tons in 2004 due to drought

(Figure 45).

Fig. 45: China’s net imports of certain commodities in volume terms

Source: CEIC and Nomura Global Economics

Balancing priorities

In 2008, China consumed 43% of the world‟s coal (meeting 70% of its energy

demands) and 10% of its oil; it remains on target to overtake the US as the

world‟s largest consumer of energy within the next few years – and is already

the world‟s largest emitter of carbon (in volume terms, but if measured per

head of population, it is far from being the largest).

Sustaining economic growth without compromising the environment requires

leapfrogging to a low-carbon urbanisation model which focuses on clean

energy supply, compact city design, enhanced public transport, green

buildings and clean vehicles. Since anecdotal evidence consistently points to

environmental issues (which include air quality, water pollution and food

standards) as the biggest single cause of civil unrest throughout the past

decade, this also matters in terms of social stability. In response, China needs

to continue to increase energy efficiency and lift the share of low-carbon

technologies.

China already has the world‟s largest installed wind energy capacity, yet how

successful China is in meeting these challenges is of tremendous importance

both domestically and globally, a fact which is fully recognised by the

leadership – notably, as long ago as 2006 President Hu Jintao proposed a

“new energy security concept” at the G8+5 summit in St Petersburg noting the

need for “sustainable development of human society”.

Evidence from China itself over the past five years underlines that this is not

merely rhetoric. Good progress has been made toward a more resource-

efficient and environmentally friendly economy, and most targets are on track.

The efficiency of water use has increased; forest cover is expanding and the

long-standing uptrend of both SO2 and CO2 emissions has finally started to

reverse. However, with rapid economic growth, immense environmental

challenges remain. According to the World Bank, China accounts for 13 of the

world‟s 20 most polluted cities (admittedly down from 19 out of 23 in 2001).

Energy efficiency (the amount of energy per unit of output) has been improving,

but not by enough to achieve the targeted 20% reduction over 2006-10.

According to a study by the World Bank (2008), if China‟s economy grows by

7.2% pa and the average energy intensity remains around current levels for

the next 25 years, as experienced by other large economies during their early

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Tons

Balancing growth and environmental security poses major challenges…

… as China‟s leaders have been quick to recognize in concrete policy measures


54

stage of industrialisation, China‟s energy consumption would reach around

12,750 million tonnes of coal equivalent by 2030 – about 87% of the world‟s

energy demand today.47

Entering international markets

China‟s impact on “hard” commodity markets over the past decade, especially

energy, is well documented. If the 95% self-sufficiency target does indeed

prove increasingly unattainable, a similarly dramatic impact on international

trade in food – and global food prices – over the course of the next decade

cannot, in our view, be ruled out.48

In an essay published earlier this year, Robert F. Ash concluded:

The Chinese government will find it increasingly difficult to continue to

fulfil its long-held target of maintaining 95% self-sufficiency in the

provision of basic foodstuffs. As this target is abandoned, China's

engagement in international grain markets will increase. This will prove

to be a watershed for China, which has previously never wavered in its

pursuit of basic food self-sufficiency. It may also prove to be a

watershed for international food security through the impact on world

cereal prices and supplies of China's emergence as a significant

player in world cereal markets…

However, the cereal whose imports are likely to rise most sharply is

corn. It is true that since 1996 China has, remarkably, been a net

exporter of corn. But it is striking that the scale of such exports has

contracted dramatically (from 16.4 million tons to a mere 0.05 million

between 2003 and 2009). Accelerating demand for corn for both feed

and biofuel is almost certain to outstrip domestic output growth in the

coming years, thereby forcing China to resort to purchases from

overseas – especially from Latin America and the United States – as a

permanent feature of its agricultural trade.

Resource security and conflict

Throughout history, resource security has been a major source of conflict –

and it is one to which we are certainly not immune today. Peter Gleick (2008)

identified over 50 occasions since the start of the 21st century where water had

been an issue in some form of, often violent, conflict ranging from Afghanistan

to Yemen.

Without wishing to dismiss the importance of the conflict in the Darfur region of

Sudan, which has been described by UN Secretary General Ban Ki-moon as

the first climate change war of the 21st century, the impact of climate change

on already stressed and/or disputed water resources may pose even bigger

challenges for the international community as a whole in the foreseeable future.

Notably, in his recent book Water: Asia‟s New Battleground, Brahma

Chellaney (2011) notes that China and India between them account for 37% of

the world‟s population but command only 10.8% of its water resources.

Furthermore, much of India‟s water comes from the (China-controlled) Tibetan

plateau (which is, in fact, a key source for all the countries in an arc from

Afghanistan to Vietnam). Combined with the gender imbalance common to

India and China, one has to be concerned about the possibility that,

exacerbated by climate change, water could indeed be the cause of a literal

battleground between Asia‟s two emerging superpowers in the not too distant

future.

47

The World Bank (2011a) estimates that if business as usual continues with respect to China‟s economic growth and energy efficiency, then by 2030 China is expected to import 75% of its oil and half of its gas. 48

A second and related trend is China‟s purchasing and leasing of large tracts of farmland in, in particular, sub-Saharan Africa. Accurate data on the scale of such investments are hard to come by, but a 2009 study prepared on behalf of the FAO and the UN estimated that nearly 2.5mn hectares of farmland had been allocated to foreign-owned entities in the five-year period since 2004 in just five African countries which the study considered. See Land grab or development opportunity? Agricultural investment and international land deals in Africa, by Lorenzo Cotula, Sonja Vermeulen, Rebeca Leonard and James Keeley (IIED/FAO/IFAD, 2009).

A decline in self-sufficiency could have a dramatic impact on global food prices

Historically, both climate change and resource security have caused violent conflict…


55

Not that the definition of “conflict” should be restricted to acts of violence

and/or war. Ronald Findlay and Kevin O‟Rourke (2008) in their book Power

and Plenty note a close correlation historically between the end of hegemon

and rising protectionist pressures. While the economic justification – including

any possible link to competition for resources – to rising protectionist

pressures in the US is, at best, tenuous in our view, the recent passage

through the US Senate of the Brown-Schumer bill seeking to punish China for

its alleged “currency manipulation” clearly highlights the risk that history will

repeat itself.49

49

US presidential and congressional elections on 6 November 2012, which could encourage the House of Representatives to follow through on the Senate‟s recent action to pursue punishment of China over its alleged currency manipulation – and especially if US unemployment remains sticky.

… as well as rising protectionist pressures


56

Pricing a China hard landing – Strategy perspectives

We discuss market implications of the economic scenario laid out above from

the perspectives of:

Global macro strategy

Global equity strategy

Regional FX strategy

Regional equity strategy

Regional equity sector by sector and country by country implications, and

Regional credit strategy

The key conclusions for strategy from the economic discussion are:

The size of the growth decline – a true growth recession.

The nature of the growth slowdown – capex-led and balance-sheet

constrained.

The ineffectiveness of policy – no rapid recovery.

The persistence of some of the causes – true change may be required on

a number of fronts.

Global macro perspectives

Growth expectations: Naturally, the initial impact in terms of market pricing

will be a rapid reassessment of the growth outlook for those economies and

global sectors most linked to China's investment cycle. Sectors ranging

from aerospace through elevators via shipping would be in the front line.

Countries like Germany, Sweden and Japan, which have at the aggregate

growth level benefited the most from China's capital spending cycle, are

most at risk of a substantial fall in growth expectations. Countries like Hong

Kong, Singapore and the Netherlands would be marked down from the

impact of lower global trade volumes. Australia, Canada, the Gulf, LatAm,

parts of sub-Sahara Africa, Russia, Mongolia and others would be liable to

terms-of-trade and volume shocks as commodity markets re-think the

demand/supply picture and re-price accordingly.

Inflation expectations: While measures of economic slack would increase

as Chinese demand slows, leading to markets pricing in medium-term

disinflationary pressures, a faster impact will be felt through lower

“consumer” commodity prices – i.e., oil, and by extension food prices, and

the potential for inventory dumping into the EU and US.

Policy response – limited ammunition, but expect more central bank

balance sheet expansion.

Current account and government deficits deteriorate – implications for the

EU bailout.

Risk and uncertainty premia increase – not just business-cycle risk, but

business-model risk as investors question the post-crisis policy and supply

chain environment.

Naïve modelling suggests the following hierarchy for returns: EM equities

(in USD terms) and commodities underperform the most. G7 stocks are

half as bad, US high yield and EMBIG bond returns are similar to each

other, but are both outperformed by IG. The USD index does well (and our

C10 index correspondingly badly), and implied vol as proxied by the VIX

rises. Rates markets offer a safe haven.


57

Global equity market perspectives

Chinese stocks have already underperformed and de-rated markedly.

Despite this, global equity markets would be at risk and we highlight

consumer goods and commodity producing sectors (in particular, mining).

While Japanese stocks are not highly correlated to developments in China,

European markets are the most sensitive of the developed regions.

Asia ex-Japan FX perspectives

In a hard landing scenario, USD/CNY change is likely to be put on hold as

Chinese policymakers seek to avoid a tightening of monetary conditions.

However, depreciation is unlikely for a number of reasons: domestic capital

flight, being perceived as „exporting‟ their domestic economic strife (China

draws great credit from the fact that CNY was stable during both Asian and

global financial crises), undermining their efforts to internationalize CNY,

and of being provocative towards the US.

If a hard landing is taken as a globally important systemic event, the most

vulnerable currencies are unlikely to be those with the greatest

fundamental linkages with China (e.g. TWD), but those with inferior balance

sheets, the worst balance of payments profiles, and the least central bank

market power, of which Singapore ranks least vulnerable and India most

vulnerable on our analysis.

Asia ex-Japan equity perspectives

The hard landing scenario would undercut earnings expectations and

dramatically up-end investor confidence across the entire Asia region.

For earnings vulnerability, operational gearing is our guide, with India,

China itself, Malaysia and Australia at the higher end and Thailand,

Philippines and Vietnam at the lower.

In terms of valuations it is worth noting that the equity risk premium for Asia

ex-Japan stocks and a high China CDS spread suggests investors are

already discounting an extraordinary degree or risk. Nevertheless,

particular markets would still be quite vulnerable. Korea, Indonesia, Hong

Kong and Australia display a high beta to China equity risk, whereas Japan

would offer a relative regional safe haven.

Sector correlations with China are higher than country correlations, with

energy, materials and industrials sectors having the most linkage.

Classically defensive sectors such as utilities, staples and telcos show the

weakest betas.

Given the particular capital spending nature of the China scenario, one

would naturally also consider capital equipment names, construction

companies, banks and property companies.

We also run through each key regional equity market and sector risks on

separate pages.

Asia ex-Japan credit perspectives

From a credit perspective, we believe the four key areas of focus would be

the impact on the sovereign and its ratings, the banks and the availability of

credit with implications for the HY property sector and industrials, and lastly

the Chinese SOE space.

We would expect a significant underperformance of the highly levered

SOEs, whose investment grade ratings have been underpinned by

government support.


58

Chinese HY industrials would likely underperform the large cap HY

property credits, impacted by significantly weaker earnings and credit

profiles.

Expect significantly more scrutiny over the default risk of the smaller cap

property credits.

The Hong Kong banks that have extended their balance sheets to Chinese

banks and SOEs would likely be dragged to wider spread levels once again,

though we believe some of these issues could be unfairly penalized.


59

Global macro perspectives

It might be argued that the economic and policy scenario set out above has to

some extent already been priced into markets related to Chinese growth and

balance sheet health. Naturally, some downside skew has been attached to

China-linked assets since the risks we highlight are not, individually, new.

However, we would argue that our scenario is substantially more challenging

than the one generally set out to explain recent market moves and that market

participants have not fully thought through the implications of a persistent hard

landing for non-Asian assets. Moreover, disentangling the effects of the euro

area‟s crisis from market performance is non-trivial, and in some ways

Europe‟s impasse may be masking and diverting market concerns about China.

Given the inherent uncertainty around the timing and extent of our scenario,

specific trade recommendations are not sensible at this stage. Instead we

believe it appropriate to the tackle the issue from a largely top-down

perspective, following up with specific trade ideas on a regional and asset-

class basis as the nature, timing and extent of the risk evolves. But there is

much to think about even at a high level.

The key conclusions for strategy from the economic discussion are:

The size of the growth decline – a true growth recession.

The nature of the growth slowdown – capex-led and balance-sheet

constrained.

The ineffectiveness of policy – no rapid recovery.

The persistence of some of the causes – true change may be required on a

number of fronts.

From this perspective we can bunch the issues under four different exposure

headings:

1. Growth

Naturally, the initial impact in terms of market pricing will be a rapid

reassessment of the growth outlook for those economies and global sectors

most linked to China's investment cycle. Global growth estimates would be

reduced, but we would argue the timing of this increased hard landing risk

comes at a particularly difficult time for global activity – weaker than "normal"

post-crisis domestic demand growth in the West makes for a higher-than-

normal sensitivity to global manufacturing demand. Sectors ranging from

aerospace through elevators via shipping would be in the front line. Countries

like Germany, Sweden and Japan, which have at the aggregate growth level

benefited the most from China's capital spending cycle, are most at risk of a

substantial fall in growth expectations. Countries like Hong Kong, Singapore

and the Netherlands would be marked down from the impact of lower global

trade volumes. Australia, Canada, the Gulf, LatAm, parts of sub-Sahara Africa,

Russia, Mongolia and others would be liable to terms-of-trade and volume

shocks as commodity markets re-think the demand/supply picture and re-price

accordingly. Countries with relatively small manufacturing sectors as a ratio of

GDP and employment would be affected at the aggregate headline level

commensurately less, but even they – for example the US – have seen

important improvements in growth from global infrastructure growth, in

particular from China.

After the initial impact on these countries and sectors, markets would look

immediately to the policy response globally and from China. The scenario laid

out here suggests that while there would indeed be a policy response in China

it is unlikely to have a rapid or large positive impact on growth. A more serious

impact on risk assets would occur as medium-term growth expectations are

marked down. Moreover, it is not clear what conventional demand

management policy actions major Western economies could take, since fiscal

policy would appear to be unavailable and monetary policy is now almost

Kevin Gaynor

+44 (0) 20 710 27800

[email protected]

Martin Whetton

+61 (2) 8062 8611

[email protected]

Naka Matsuzawa

+81 3 6703 3864

[email protected]





60

wholly reliant on the vague benefits of QE-style balance sheet expansion.

Thus, the multiplier effects of a China hard landing could be bigger than one

may initially think for short- and medium-term Western growth forecasts.

2. Supply chains and inflation

A demand shock for China is also a supply shock for the countries it supplies.

While measures of economic slack would increase as Chinese demand slows,

leading to markets pricing in medium-term disinflationary pressures, a faster

impact would be felt through lower “consumer” commodity prices – i.e., oil, and

by extension food prices, and the potential for inventory dumping into the EU

and US. This happened during the Asian currency crisis and led to quite rapid

durable goods price declines. While this softens the growth blow for Western

consumers it is only temporary and it squeezes some corporate margins. We

would expect headline CPI inflation expectations, in any event, to fall across

developed markets initially from the fall in global traded goods and commodity

prices.

Fig. 46: OECD measures of economic slack

Source: Nomura, OECD.

What is more difficult to gauge is the medium-term impact on supply chains

from a China shock of this scale and duration. Investors would naturally fear

inventory dumping turning into competitive devaluations across the region in

an effort to take a larger share of a slower growing global demand pie. This

would no doubt increase investor concern about protectionist measures and

tariff increases.

It would be natural to expect investors to predict an initial increase in China‟s

trade surplus in this scenario, adding to global imbalances rather than helping

to close them. At the same time, we should probably expect capital outflows

from China by both domestic and foreign investors. To keep the currency peg

intact, as our scenario suggests, would require a slower pace of reserve

accumulation, although perhaps by not as much as might be priced in if the

trade balance improves. Nevertheless, reserve accumulation globally would be

expected to slow, which could prove crucial to funding of Western government

deficits in capital account deficit economies.

3. Balance sheets

Which brings us on to balance sheet considerations. Slower growth in the

OECD would naturally imply higher unemployment, slower profit growth and

lower income and consumption tax revenues The result would be forecasts of

larger government deficits at the same time as smaller trade surpluses, or

larger trade deficits. If this is a 2012 story, the timing really could not be much

worse. Countries that have already undertaken substantial fiscal tightening

would see headline deficit improvement stall or even reverse. And those taking

on responsibility for joint fiscal support in the euro area for example would see

their own fiscal accounts deteriorate, thus undermining market confidence in

their ability to support further periphery or bank sector needs.

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61

Of course, this increase in government bond supply expectations would apply

equally well to the US, UK, Canada, Sweden and Australia. However, the

starting points for debt are substantially different – for example, compare and

contrast Australian and Canadian government debt. One could imagine the

political complications of a widening US federal deficit during an election year,

especially if another debt ceiling increase had to be passed.

Combine this backdrop with slower reserve accumulation and one has a

perfect set of conditions to drive term risk premia higher on weaker fiscal

countries. By extension, one also sees markets price in a higher cost of capital

for weaker corporate and financial balance sheet entities. Without doubt, more

central bank activism would be priced in, leading to the belly of curves

flattening along with weaker BEIs from lower commodity prices. Wider credit

spreads in investment grade and high yield would seem probable.

Financials would remain a source of pressure in this environment. China‟s

official data for external USD borrowing has increased quite substantially since

the 2008 crisis and most of the increase is short-term debt. Part of this is in the

form of trade credits, but by no means all. Naturally, markets would consider

which entities are most exposed to China credit risk from these loans and

would price accordingly.

Fig. 47: China external debt (USDbn)

Source: Datastream, Nomura.

4. Risk and uncertainty premia

While the growth and inflationary implications of a China hard landing are

reasonably clear, the bigger uncertainties will be around future policy regime

changes and therefore supply chain risks. One might call this a distinction

between business-cycle risk and business-model risk. Clearly the global

imbalances that have grown over the past 15 years are contributing and have

contributed to domestic imbalances in the US, China and the euro area. A

China hard landing would raise legitimate questions about what sort of global

architecture for trade and currencies will hold after the event. This, we would

argue, will only add to heightened levels of macroeconomic uncertainty

already in place, with the result that high risk premia and uncertainty premia

should be attached to risky cash flows. A hard landing would only increase

those risks.

Strategic conclusions

Modeling can only get one so far in terms of predicting returns. But in

circumstances such as this it can at least give some guidance on what to focus

on. A very simple VAR (vector auto regression) model of changes in China‟s

PMI index, total returns for US Treasuries, US IG, US HY, a commodity index,

G7 and EM equities, the EMBIG index and changes in the VIX index, produces

results that fit with one‟s priors as to how changes in Chinese growth might

influence and feed back on those asset classes. The cumulative six-month

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62

change in annual returns (or changes in terms of the VIX index) is shown in

Figure 48.

Fig. 48: Six-month cumulative response to a 1sd negative shock to Chinese growth

Source: Datastream, Nomura.

Now, one should not place too much emphasis on the numerical outcomes of

this – it is an extremely naïve and simple model. However, the hierarchy

seems fairly sensible: EM equities (in USD terms) and commodities

underperform the most. G7 stocks are half as bad, US high yield and EMBIG

bond returns are similar to each other, but are both outperformed by IG. The

USD index does well, or put another way, our Nomura C10 index would be a

sell, and implied vol as proxied by the VIX rises by 10 points or so.

Interestingly, the UST index does not do very much, a result that we do not put

too much emphasis on. In any event, this provides a starting point to think

about positioning for a China hard landing, that we believe is not too

controversial.

More specifically, our global fixed income strategists provide the following

colour:

Government bond curves would flatten as forward monetary policy rate

expectations are reduced and BEI expectations fall. Weaker government

markets, however, may see higher embedded risk premia leading to

underperformance relative to the peer group. Principal safe havens are JGBs,

AUD, SEK and NOK bonds. Certainly USTs also benefit despite open issues

around future funding costs as reserve growth slows, or flow of funds change

(perhaps offset by QE3?). Bunds naturally receive a safe-haven bid, but again

open issues would be raised about fiscal union and support of peripheral

bonds.

European credit markets would experience broad-based weakness within a

more macro „risk-off‟ environment, but decent balance sheet health and low

refinancing risks generally should help credit to outperform equities in such a

scenario. That said, the effect on equity valuations could still particularly weigh

on the more levered issuers and levered products, which would see high

yield/leveraged loans underperform Investment Grade corporates and

Financials. On a more micro level, the greatest impact in terms of sectors will,

we believe, be felt in the spreads of the more cyclical corporates, especially

those directly affected such as Mining and Oil, which in turn would also impact

Shipping (a sector already under pressure). Indirect impacts would be felt by

sectors and issuers which have been offsetting the weak recovery in Europe

thus far with growth in Emerging Markets, such as Luxury Goods companies

or some of the Chemical companies for example, but the effect on spreads

could differ markedly depending on a wide range of balance sheet health

profiles – luxury goods companies, for example, tend to have relatively strong

balance sheets which would help absorb some of these pressures from a

credit perspective, whereas the credit metrics of chemical companies, say,

could be more vulnerable.

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63

The impact on Japan would be felt mostly through the economic channel (a

weaker economic outlook and further monetary easing) than the financial

channel. Chinese buying of JGBs has been increasing but is still too small to

affect the JGB market directly and Japanese bank lending exposure to China

is relatively small in their balance sheets. As such, we believe any negative

effects should be felt more by the equity market. As a result, banks‟ capacity to

buy the long- and super-long end of the curve would be hampered by valuation

losses on their equity holdings, so we would expect the yield curve to bull

steepen, kinked around the 7yr sector (=JGB futures).

Australia offers a particularly popular angle to address this risk. We would

expect AUD to take the first hit and is the most obvious trade, in our opinion.

After that, confirmation of a slowdown and the follow on effects of this should

cause the curve to steepen. More generally, USD, JPY and CHF all

outperform in the initial phase of a hard landing scenario, with the Nomura C10

index suffering commensurately.


64

Global equity perspective

Before examining a “what if” scenario for global equities in the case of a hard

landing in the Chinese economy, it is important to first recognise that the

market is already attaching a heavy discount to Chinese stocks. As Figure 49

demonstrates, Chinese stocks have underperformed the global index by 18%

since mid-April 2011, and one has to go back to 2007 to see a period of trend

outperformance.

Fig. 49: Chinese equity market relative performance*

Chinese stocks have underperformed

*Versus FTSE World Developed (US$). Source: FTSE, Nomura Strategy research

Fig. 31

This underperformance has not been matched by a similarly poor earnings

trend so that the market has been heavily de-rated to the point where the

discount now being applied to the Chinese market is the largest since late

2005.

Fig. 50: Chinese market multiple relative to global developed market multiple*

*12 month forward PE. Source: IBES, FTSE, Nomura Strategy research

Fig. 32

Compared with other emerging markets, the Chinese market is also trading on

a sizeable 28% discount, as Figure 51 demonstrates.

Fig. 51: Chinese market multiple relative to global EMs*

*12 month forward PE. Source: IBES, FTSE, Nomura Strategy research

Fig. 33

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Ratio

Ian Scott

+44 (0) 20 710 22959

[email protected]

Robertas Stancikas

+44 (0) 20 710 23127

[email protected]

Chinese stocks have underperformed the world index

The market trades on a 32% discount to the global market multiple…

… and an 18% discount compared with global emerging markets




65

That said, there is little doubt that a hard landing in China would have far

reaching consequences for global equities. Firstly, there are the stocks and

sectors with direct exposure. Here we would highlight Consumer Goods,

where stocks have been re-rated relative to their historic valuation norms

partly as a result of their exposure to China and other fast growing EM

economies.

Fig. 52: Global Consumer Goods sector 12M forward PE relative to market

The global consumer

Source: IBES, FTSE, Nomura Strategy research

Fig. 34

Elsewhere, commodity producing sectors have been the beneficiaries of

strong Chinese demand. Although the valuations attached to these commodity

producers are not as demanding as the global sectors exposed to the

consumer, there is little doubt that a hard landing in the Chinese economy

would have a detrimental impact on them.

Fig. 53: Relative performance of global oil and mining sectors

Source: FTSE, Nomura Strategy research

Fig. 35

Mining stocks have the most to lose, in our opinion. Mining companies have

invested heavily in recent years to expand capacity and if demand from China

is not forthcoming, those investments are unlikely to prove profitable. That said,

recent demand trends in China remain intact (Figure 54).

Fig. 54: Chinese copper import volumes and copper price

*Imports of copper ore and concentrate. Source: Datastream, Nomura Strategy research.

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The global consumer goods sector has been re-rated relative to historic norms, partly as a result of exposure to Chinese growth

Of the commodity producers, mining companies have shown the highest sensitivity to developments in China

Copper demand remains relatively strong


66

In the Oil sector, demand from China remains relative inelastic to movements

in the world price, so a hard landing would likely have much less impact on the

Oil sector than the miners.

Lastly, from a regional perspective, the Japanese market has the lowest

historic correlation to Chinese equities, typically acting as something of a safe

haven. US equities are the next least likely to be impacted, with European

stocks the most highly correlated of the developed markets outside Asia to

movements in Chinese stock prices. Figure 56 shows the relative performance

of a group of European companies heavily exposed to Chinese demand. Until

recently, the poor performance of Chinese stocks had little impact on the

relative performance of these China-linked companies. However, in recent

weeks they have become more closely correlated to the news flow from China.

Fig. 56: Relative performance of European stocks exposed to Chinese demand and the relative performance of Chinese equities

Source: FTSE, Datastream, Nomura Strategy research

Fig. 36 Despite their recent underperformance, the stocks described in Figure 56 also

trade on a substantial 24% premium to the wider European market. There is

little doubt that a hard landing in China would have far reaching consequences

for stocks well beyond the country itself.

Fig. 57: PE relative for Europe’s Chinese exposed stocks*

* PE for selected European stocks with high exposure to China relative to the European market Source: IBES, FTSE, Nomura Strategy research

50

70

90

110

130

150

Oct-07 Oct-08 Oct-09 Oct-10 Oct-11Asia Exposed European Stocks performance relative to Asia

Index, Oct 2007 = 100

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

Sep-95 Sep-99 Sep-03 Sep-07 Sep-11

Ratio

While Japanese stocks are lowly correlated with developments in China, European stocks show the highest sensitivity of any developed market outside Asia

European companies with strong links to China would be especially vulnerable since they trade on a significant premium to the European market


67

Asia-ex Japan FX perspective

Our baseline forecast is for the rate of CNY appreciation to slow to nearly 3%

p.a. in 2012 from about 6% in 2011. Economics aside, China‟s own political

calendar is likely to induce conservatism during 2012. As the 18th Party

Congress in Q4 approaches (the last before the leadership handover),

Chinese leadership will likely become more sensitive to internal criticism and

growth concerns, and thus more inured to external pressure.

More importantly, the poor economic performance of its trade partners as well

as its domestic challenges will likely act as an inhibitor to change in 2012.

In the more extreme scenario of a hard-landing, change in USD-CNY would

likely be put on hold. China will likely not wish to see any form of „tightening‟ in

monetary conditions, and will probably seek to minimize economic uncertainty.

This has certainly been past experience – 2008 most obviously, but also the

slower-than-expected move in early 2011, can be attributed to economic

uncertainty.

In the hard-landing scenario, CNY depreciation is also unlikely. China would

be wary of a number of risks: domestic capital flight, being perceived as

„exporting‟ their domestic economic strife (China draws great credit from the

fact that CNY was stable during both the Asian and global financial crises),

undermining efforts to internationalize the CNY, and of being seen as

provocative toward the US.

Indeed, the final point creates the greatest risk, both to our call for a „hold on

CNY appreciation in the event of slowdown‟, and of a trade conflict which

could affect broader markets. First, there is an argument in Chinese policy

circles (albeit we believe a minority one) that a) the USD-CNY FX is macro-

economically unimportant, and b) the wisest thing to do is placate the US in

2012 so that China can give its full attention to domestic challenges rather

than international conflicts. Second, if this view does not prevail, then the

probability of China and the US entering a trade conflict clearly increases,

especially given that the US is entering a tight Presidential race.

A Chinese hard landing would likely be of systemic global importance. Thus,

the most vulnerable currencies are not likely to be those with the greatest

fundamental linkages to China (e.g., TWD), but rather, those from countries

with inferior balance sheets, the worst balance of payment profiles, and the

least central bank market power50

, which is illustrated by our ranking in Figure

58.

Fig. 58: Asian FX vulnerability rankings (least vulnerable at top) 51

Short term external debt FX reserves and forwards Basic balance

USD bn % GDP USD bn % GDP USD bn % GDP

Singapore 731 328.1% 234 97.1% 80 32.3%

Hong Kong 701 312.3% 280 122.2% 14 6.1%

Taiwan 91 21.0% 389 83.5% 25 5.5%

Malaysia 29 12.1% 131 50.4% 26 10.0%

Thailand 51 16.1% 180 53.0% 13 3.8%

Philippines 7 3.8% 75 35.5% 10 4.9%

Korea 150 15.8% 303 27.9% 4 0.4%

Indonesia 36 5.2% 115 15.0% 16 2.1%

India 63 3.6% 277 15.1% -35 -1.9%

Note: As per the latest data available. Source: CEIC, Bloomberg, Nomura.

That said, it is worth having a sense of the relative Sino-Asian linkages, in the

unlikely event that the shock is non-systemic and/or a Chinese hard-landing

occurs while G3 prospects are improving. The schema gives very different

50

As gauged by FX reserves owned as a percent of country‟s GDP. 51

The ranking is based on the average of the basic balance and FX reserves as a percent of GDP. The order is from least vulnerable to the most vulnerable economy.

Simon Flint

+65 6433 6504

[email protected]

Craig Chan

+65 6433 6106

[email protected]

Prateek Gupta

+65 6433 6197

[email protected]





68

results, indicating that INR (for example) would be least effected, whilst TWD

would be most vulnerable (see Figure 59, which shows Chinese exports/GDP

for each Asian country).

Fig. 59: Asia rolling 12m exports to China / GDP

Note: As per the latest data available. Source: CEIC, Nomura.

Given a weaker-than-expected recovery and potential downside risk in

developed countries, external demand as a driver of China‟s growth now has

less of a boosting effect. Meanwhile, there are more domestic risks growing as

well, from local government debt issues to funding of micro, small and

medium-sized enterprises (MSME‟s) and the property market. China IRS

curves (deposit IRS, SHIBOR IRS and repo IRS) have all started to invert and

price in the potential for rate cuts – for example, the 5yr IRS indexed to the 1yr

deposit rate implies an average 1yr deposit rate in five years is 3.27%.

0%

5%

10%

15%

20%

TW KR MY SG TH PH ID HK IN

Latest 2004


69

Implications for Asia regional equities Given China‘s key role as a demand driver for Asian goods and underwriter of

regional current account surpluses – and particularly given investor hopes that

Chinese private consumption will ramp-up structurally to help supplant the US

consumption growth ―lost‖ due to household balance sheet repair – we would

expect a Chinese ‗hard landing‘ scenario to undercut earnings expectations and

dramatically upend investor confidence across the entire Asia-Pacific region.

• In assessing earnings vulnerability, Operating Leverage (OL) would be a key

determinant in projecting the degree to which a collapse in top-line revenues

would transmit through to bottom-line profits. In the Figure below we rank the

Asia-Pacific markets in terms of aggregate OL:

Fig. 1: Asia-Pacific operating leverage and gearing

* Note: Operating leverage calculated as (Revenue - COGS) / (Revenue – COGS - SG&A). Aggregated for all members of the respective MSCI index ex banks/insurance/diversified financials.

Source: Bloomberg, Nomura Strategy research

図表 1

Fig. 1

• In assessing the scope for damage to valuations, it is useful to keep in mind

that ex-Japan Asian stocks are already discounting an extraordinary degree of

risk, as illustrated by the ‗equity risk premium‘ (i.e. the differential between the

consensus 12-month forward earnings yield and the available ―risk-free‖ cost

of / opportunity return on capital in the 10-year US Treasury market).

• At currently 8.0%, this compensation for equity risk-bearing is fully 2.5

standard deviations above its long-term mean of 4.3%. While this by no means

would alone insulate regional stocks from further volatility, it does suggest the

degree to which Chinese structural concerns have already embedded

themselves into asset values.

Fig. 2: MSCI Asia ex-Japan: Equity Risk Premium

Source: DataStream, Nomura Strategy research

図表 2

Fig. 2

Operating Leverage* Net Debt / Equity (%)

Asia Pacific 3.9 39.1

India 7.1 34.0

China 5.7 24.6

Malaysia 4.6 28.4

Australia 3.8 27.0

HK 3.4 18.7

Japan 3.3 54.4

Singapore 3.1 25.5

Korea 2.7 43.9

Taiwan 2.0 12.0

Indonesia 2.0 28.0

Thailand 1.9 48.6

Philippines 1.8 34.9

Vietnam 1.3 34.7

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

May-0

1

Oct-

01

Mar-

02

Aug

-02

Jan

-03

Jun

-03

No

v-0

3

Ap

r-04

Sep

-04

Feb-0

5

Jul-

05

Dec-0

5

May-0

6

Oct-

06

Mar-

07

Aug

-07

Jan

-08

Jun

-08

No

v-0

8

Ap

r-09

Sep

-09

Feb-1

0

Jul-

10

Dec-1

0

May-1

1

Oct-

11

Equity Risk Prem (%) LT Avg.

+1 Std Dev. -1 Std Dev.

Research analysts:

Michael Kurtz +852 2252 2182 [email protected]

Mixo Das +852 2252 1424 [email protected]

Yiran Zhong +852 2252 1413 [email protected]





70

Similarly, China‘s sovereign credit default swap (CDS) spread, at currently

137bp, stands fully 62bp above its 75bp January 2010-July 2011 average –

suggesting China investor perceptions have already grown substantially more

cautious.

Fig. 3: China Credit Default Spread


図表 3

Fig. 3

• Still, comparing current Asian equity index multiples to trough levels of the

past decade does suggests particular markets would still be quite vulnerable

(Figure below). Because earnings themselves become less reliable in times of

greater demand uncertainty, the results below are ranked according to the

more tangible Price-to-Book Value measure:

Fig. 4: Asia ex Japan market valuations versus historical trough


図表 4

Fig. 4

50

70

90

110

130

150

170

190

210

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11

(bps)

Current % to Trough Trough

Date of

Trough Current % to Trough Trough

Date of

Trough

MSCI Asia ex-Japan 9.9 -21% 7.8 Oct-08 1.6 -25% 1.2 Sep-01

Indonesia 11.8 -69% 3.7 Apr-01 3.9 -79% 0.8 May-01

Philippines 13.4 -38% 8.4 Oct-08 2.6 -67% 0.9 Jan-03

Thailand 9.3 -40% 5.6 Oct-08 2.0 -50% 1.0 Nov-08

Taiwan 12.6 -24% 9.5 Aug-04 1.7 -37% 1.1 Jan-09

India 12.1 -32% 8.2 Oct-08 2.5 -36% 1.6 Sep-01

Korea 8.4 -29% 6.0 Mar-03 1.3 -35% 0.8 Dec-01

Malaysia 13.1 -28% 9.5 Oct-08 2.1 -34% 1.4 Jun-01

Singapore 11.5 -29% 8.2 Oct-08 1.5 -28% 1.1 Feb-09

China 7.7 -14% 6.6 Oct-08 1.5 -21% 1.2 May-03

HK 12.2 -26% 9.0 Oct-08 1.2 -21% 0.9 Feb-09

PER (since 2001) PBV (since 2001)


71

Fig. 5: Asia ex Japan sector valuations versus historical trough


図表 5

Fig. 5

A look at recent years‘ statistical correlation between Asia-Pac indexes and

China H-shares also offers insight into where the risk of equity market contagion

may be greatest. In most cases these correlations also comport with our

fundamental sense as to how the real and financial effects of a China rollover

would propagate through the rest of the Asia-Pac region.

• Based on US$-denominated weekly returns since 2007, Korea and Indonesia

exhibit the Asia-Pac region‘s two highest-beta relationships with China H-

shares. This is interesting given the substantial disparity between these two

economies and markets: the former largely a high-value-added manufacturer

of capital goods and consumer durables, vs the latter predominantly a provider

to China of primary goods such as coal, natural gas, and ore. Yet in both

cases, the risks appear justified by China‘s rapidly increasing role in recent

years as a key export growth market. Indonesia‘s broader sensitivity to any

presumptive downdraft in global energy and commodity prices also places it

squarely atop the ‗endangered list‘.

Fig. 6: Asia-Pacific Country Index Correlations w/ China H-shares

Source: DataStream, Bloomberg, Nomura Strategy research

図表 6

Fig. 6

Current % to Trough Trough

Date of

Trough Current % to Trough Trough

Date of

Trough

Asia ex-Japan 9.9 -20% 7.8 Oct-08 1.6 -24% 1.2 Sep-01

Fd/Staples Rtl 16.9 -82% 3.0 Feb-01 2.9 -88% 0.4 Aug-01

Cons Svs 13.7 -25% 10.2 Oct-02 3.0 -77% 0.7 Sep-01

Health Care Equip & Serv 21.5 -64% 7.8 Jan-02 3.3 -76% 0.8 Mar-01

Auto & Compo 8.8 -43% 5.0 Mar-03 2.3 -67% 0.8 Jan-01

Software & Services 16.9 -37% 10.6 Nov-08 6.8 -63% 2.5 May-03

Div Fin 12.0 -28% 8.6 Oct-02 1.7 -61% 0.7 Sep-01

Household & Pers Prod 25.2 -52% 12.0 Apr-03 8.9 -53% 4.2 Jun-04

Pharmaceuticals 17.5 -40% 10.4 May-03 3.4 -51% 1.7 Jun-02

Cons Dur/App 9.4 -39% 5.7 Oct-01 1.3 -50% 0.6 Sep-01

Materials 7.7 -34% 5.1 Oct-08 1.4 -46% 0.8 Sep-01

Retailing 13.6 -45% 7.5 Oct-08 2.5 -46% 1.3 Jan-01

Commerical Serv & Supp 12.8 -28% 9.3 Oct-08 2.7 -46% 1.5 Aug-01

Fd/Bev/Tob 14.4 -40% 8.6 Mar-03 2.4 -42% 1.4 Apr-03

Energy 7.9 -37% 5.0 Oct-08 1.7 -37% 1.1 Jan-01

Transpt 12.3 -50% 6.2 Oct-08 1.2 -37% 0.7 Sep-01

Tech Hardware & Equip 10.8 -26% 8.0 Jul-08 1.5 -35% 1.0 Jan-09

Cap Goods 8.7 -25% 6.5 Oct-08 1.3 -35% 0.8 Oct-02

Media 15.3 -34% 10.0 Oct-08 3.3 -35% 2.2 Apr-09

Real Estate 8.9 -13% 7.7 Oct-08 0.8 -31% 0.5 May-03

Utilities 13.5 -33% 9.1 Mar-03 1.4 -29% 1.0 Nov-01

Semiconductors 11.5 -40% 7.0 Jun-04 1.8 -29% 1.3 Jan-09

Banks 7.5 -8% 6.9 Oct-11 1.4 -23% 1.0 Feb-09

Telecom 11.8 -26% 8.7 Mar-03 2.0 -12% 1.8 Feb-09

Insurance 11.9 -17% 9.8 Mar-03 1.8 -3% 1.7 Aug-01

PER (since 2001) PBV (since 2001)

R^2 Slope

MSCI Korea 0.56 0.80

MSCI Indonesia 0.52 0.74

MSCI India 0.48 0.66

MSCI Australia 0.53 0.63

MSCI Hong Kong 0.74 0.60

MSCI Singapore 0.65 0.60

MSCI Thailand 0.45 0.60

MSCI Taiwan 0.50 0.54

MSCI Philippines 0.38 0.48

MSCI New Zealand 0.37 0.42

MSCI Malaysia 0.46 0.37

MSCI Japan 0.36 0.34

vs. HSCEI


72

• Although India offers the third-highest beta relationship with China over the

2007-11 period, this strikes us more as coincidental (based on generalized

BRICs risk tolerance/aversion) than fundamentally driven. Indeed, we would

be inclined to see India as comparatively more resilient in the Asian-regional

context to a China rollover, given still-modest trade linkages between the two

economies, and given prospective relief both on India‘s chronic current

account deficit / terms of trade, as well as on its recently problematic inflation

front if commodity prices were to recede.

• Also noteworthy as a potential comparative safe haven is Japan. Not only do

Japanese stocks exhibit the lowest-beta relationship with China H-shares

among the Asia-Pac markets, but Japan‘s domestic consumption-heavy GDP

composition may help insulate it from a Chinese demand slowdown.

Additionally – albeit tragically – the impact of 2011‘s Miyagi earthquake forced

markets already to substantially downgrade expectations for Japan.

• Among the riskiest markets in terms of historical return correlations are also

Australia and Hong Kong (i.e. the ‗pure‘ Hong Kong ex-China H-shares as found

in MSCI HK). Unlike in India‘s case, these seem explainable in terms of direct

real-economic (and in Hong Kong‘s case, also financial) linkages between those

geographies and China.

Of note, Asian equity China correlations are generally stronger at the sector

level than the country level (Figure below). Given China‘s predominant role as a

driver of global marginal demand for energy and commodities (as discussed

above in the Global context), within Asia-Pac it is the Energy, Materials and

Industrials sectors (at the GICS-1 level) that exhibit the strongest correlations

with H-shares.

• By contrast, lower-beta relationships (i.e. vs. H-share returns) are generally

found among the classically defensive sectors (e.g. Utilities, Staples, Telcos).

In other words, positive China-share performance should tend to be

associated with outperformance in ‗riskier‘ assets (as seems intuitively logical);

but a China-driven rollover could best be sidestepped within the Asian-regional

equity space through exposure in low-cyclical names (Staples, Health Care),

steady high dividend yielders (primarily among Asia‘s Telcos), and Utilities

where softer energy costs would offer the prospect of margin relief.

Fig. 7: Asia-Pacific Sector Correlations w/ China H-shares


図表 7

Fig. 7

R^2 Slope

Energy 0.79 0.83

Material 0.71 0.80

Industrial 0.75 0.79

Financials 0.82 0.72

MSCI Asia ex Japan 0.81 0.66

Consumer Disc 0.63 0.59

IT 0.48 0.54

Telco 0.70 0.51

Consumer Staples 0.62 0.48

Utilities 0.59 0.38

vs. HSCEI


73

China equities – the risk Within China specifically, given the predominance of the investment component

of GDP, a "China slowdown" scenario would have to equate with a Chinese

investment slowdown.

• With this, the sectors most immediately adversely impacted would be those

tied to China's investment cycle: Commodities and Basic Materials (e.g.

Metals & Mining incl. Steel, Cement, etc.) as well as the Capital Equipment

names and, possibly, the Construction Companies, depending on whether

policymakers saw room to expand infrastructure project spending as a

counter-cyclical tool as they did in 2008-10 (which we see as less feasible a

second time, as discussed elsewhere).

• A dramatic slowdown in China‘s aggregate growth – alongside the credit

constraints and rising real cost of capital discussed elsewhere – would also

undermine the quality of assets in the domestic financial system. This would

hurt asset-rich balance sheets, not least in China's large, state-owned Banks;

and as such, composition of individual institutions‘ loan books and breakdown

of their lending activity would be a key differentiator. By similar token, many

Chinese property developers would find themselves under substantial financial

stress from a combination of falling property prices and slumping sales

volumes.

• The simultaneous cashflow constraints from a weaker Chinese economy along

with higher real cost of capital would make corporate balance sheets a key

differentiator generally. We would expect the market to favor lower-geared (or

net-cash) companies within any given sector, whereas higher gearing would

be discounted. Similarly, companies with imminent capital needs such as

near-term debt rollovers or refinancings would be discounted relative to those

whose funding were mostly long-term secured.

• Given that one tipping-point for a Chinese growth slowdown would presumably

be ongoing/deepening weakness in the external sector (i.e. global double-dip

risks), we would not expect export-driven China names (e.g. Shipping, Ports,

Tech, Contract Manufacturing & Logistics) to be particularly defensive. Rather,

"traditionally" defensive domestic names in Utilities (including Gas), Telecoms,

Health Care/Pharma, and Fertilizer would likely be the outperformers among

HK-listed China names.

• One area where Chinese policymakers may find some room to exercise

stimulus different than the largely infrastructure project-driven approach of

2009-10, would be domestic private consumption (for example through

targeted credit growth, taxation, wage policy, etc). As such, we are inclined to

regard domestic Consumer-sector stocks (both Discretionary and Staple) as

comparatively defensive – although already high valuations diminish these

attractions somewhat.

• One key litmus test as to the leadership's willingness to empower the domestic

private consumer may be the path of the RMB in any sustained slowdown

scenario: Were Chinese policymakers to (unexpectedly) avoid the temptation

to fall back on a stable (or weaker) RMB but rather allow appreciation to

continue, we believe it would signal a commitment to press ahead with

restructuring toward a more domestic/consumption-driven growth mix.

Taking the above considerations into effect, we present in the following two

Figures a short list of key Chinese names that we would expect to prove

respectively more vulnerable and more resilient:

Research analysts:

Michael Kurtz +852 2252 2182 [email protected]

Mixo Das +852 2252 1424 [email protected]

Yiran Zhong +852 2252 1413 [email protected] And the China Research Team

IMPORTANT: The sensitivity table below does not assess just the impact of a China hard

landing on the mentioned stocks, rather it takes a look at an extreme scenario including

recessions in the US and Europe. None of this is in our macro or industry or company

forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.





74

Fig. 8: MORE VULNERABLE: Chinese companies in most-impacted sectors with high gearing*

*Excludes Level I sectors: Consumer Disc. Staples, Healthcare, Utilities, Telcos; Net D/E > 50% (in most cases)


図表 8

Fig. 8

Fig. 9: MOST RESILIENT: Chinese companies in least-impacted sectors with positive net cash*

*Excludes Level I sectors: Financials, Energy, Industrial, Materials, level II sector: Tech; Net D/E < -20%


図表 9

Fig. 9

IMPORTANT: Our sensitivity analysis does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company

forecasts. The extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) China‘s GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012.

Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2);

South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0).

TICKER Company Industry Group HK Market Cap ($mn) Sales ($mn) Net Debt / Equity

3323 HK CHINA NATIONAL BUILDING MA-H Building Materials 3,237 9,837 199

753 HK AIR CHINA LTD-H Airlines 3,610 13,376 174

1055 HK CHINA SOUTHERN AIRLINES CO-H Airlines 1,611 12,676 150

2777 HK GUANGZHOU R&F Real Estate 909 3,641 111

2600 HK ALUMINUM CORP OF CHINA LTD-H Mining 2,055 19,196 109

2883 HK CHINA OILFIELD SERVICES-H Oil&Gas Services 2,476 2,562 92

3333 HK EVERGRANDE REAL ESTATE GROUP Real Estate 5,824 8,677 88

267 HK CITIC PACIFIC LTD Iron/Steel 6,310 10,892 80

2318 HK PING AN INSURANCE GROUP CO-H Insurance 21,721 34,947 77

2007 HK COUNTRY GARDEN HOLDINGS CO Real Estate 6,144 4,480 59

1109 HK CHINA RESOURCES LAND LTD Real Estate 7,750 2,701 52

2866 HK CHINA SHIPPING CONTAINER-H Transportation 700 5,143 11

939 HK CHINA CONSTRUCTION BANK Banks 167,939 66,470 -

TICKER Company Industry Group HK Market Cap ($mn) Sales ($mn) Net Debt / Equity

1688 HK ALIBABA.COM LTD Internet 6,057 925 -169

700 HK TENCENT HOLDINGS LTD Internet 41,823 3,596 -77

168 HK TSINGTAO BREWERY CO LTD-H Beverages 3,683 3,183 -62

2238 HK GUANGZHOU AUTOMOBILE GROUP-HAuto Manufacturers 2,227 8,843 -61

2319 HK CHINA MENGNIU DAIRY CO Food 5,692 5,193 -58

489 HK DONGFENG MOTOR GRP CO LTD-H Auto Manufacturers 4,717 18,753 -55

941 HK CHINA MOBILE LTD Telecommunications 197,004 76,294 -45

1880 HK BELLE INTERNATIONAL HOLDINGS Retail 15,733 3,991 -30

151 HK WANT WANT CHINA HOLDINGS LTD Food 12,058 2,521 -24


75

China risk: Australia

Risks to our current overall view

The sensitivity of the Australian equity market to a ―hard landing‖ in China (GDP growth

of 5% which means US GDP of -3% and Eurozone of -5%) and a substantial fall in

commodity prices would be dramatic, notwithstanding the fall in the equity market we

have already seen this year. Such a scenario, should it eventuate, could see Australian

GDP growth drop back to around 0.5%, assuming a vigorous policy response and a

coincident weakening in the A$, which there would inevitably be.

Key areas of impact if China has a hard landing

One of the hardest hit would be the metals and mining sector, which would be heavily

affected by the drop in US$ commodity prices, only partly mitigated by the likelihood of a

much weaker A$. The effect of this would also inevitably flow onto volumes as well as

demand would dry up, which would see capex programs scaled back or stopped, which

would then have a major knock effect on the mining services sector. Sector earnings of

the majors would enjoy some relative support from their low positions on the cost curve

but all the same sector growth would decline in our view at least as much as commodity

prices, with the junior and intermediate sectors in particular very hard hit. Many could

disappear. The share prices of the major miners more than halved in the 2008 global

financial crisis.

Also caught in this web would also be the mining services sector, which would hit the

likes of DOW and UGL. BLY would not escape as junior mining activity would slow and

exploration spend generally would be scaled back materially. ORI and IPL are resource

volume rather than price linked but an extended economic downturn would flow onto

volume ultimately in our view and sentiment would inevitably also take a knock.

The other key sector in the Australian market is Banks. Given its homogenous nature,

our worst case stress scenario sees the major banks with broadly similar downside risks

to FY12 earnings (22% - 28%) and share prices (29% - 35%). We assume a significant

increase in BDD‘s (175bps to NHL, consistent with the global financial crisis experience)

and no margin benefit (unlike the GFC) given a significant slowdown in China will reduce

banks‘ ability to re-price margins. In a relative sense, however, we do not expect the

banks to materially underperform the broader market under the extreme case scenario,

given their strong capital positions, robust balance sheets and strong underlying

franchises and market positions.

Relative beneficiaries of this scenario may be parts of the Consumer sector, Healthcare,

and Telstra has historically been a relative safe haven. Consumer Staples could benefit

on a relative basis from an ‗Armageddon‘ scenario impacting global growth, although we

note the absolute benefit is likely to be subdued. A lower AUD particularly against USD

could result in higher costs of goods sold which might be difficult to pass on to

consumers suffering the effects of lower GDP. On a relative basis we believe Coca-Cola

Amatil and Woolworths are likely to outperform. Treasury Wine Estates could benefit

from better transaction and translation rates, however, the absolute benefit would likely

be mitigated by lower sales. Consumer Discretionary could be adversely impacted by

slowing sales at the same time as COGS increase.

Fig. 10: Potentially most vulnerable and most resilient companies in coverage in the extreme case*

Most vulnerable companies Ticker Industry Most resilient companies Ticker Industry

Boart Longyear BLY AU Drilling equipment and services Amcor AMC AU Packaging

Bluescope Steel BSL AU Steel solutions AGL Energy AGK AU Power and gas

Onesteel OST AU Steel long products Coca-Cola Amatil CCL AU Food & beverages

Orica ORI AU Diversified chemicals Tabcorp Holdings TAH AU Gaming

Rio Tinto RIO AU Resources Telstra TLS AU Telecoms

BHP Billiton BHP AU Resources Woolworths WOW AU Retail

Note: Base case represents our current forecasts and TP

* Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) China‘s GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012.

Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0)

Source: Nomura estimates

Research analysts:

Richard Johnson +612 8062 8412 [email protected] And the Australia Research Team

IMPORTANT: The sensitivity table below does not assess just

the impact of a China hard landing on the mentioned stocks, rather it takes a look at

an extreme scenario including recessions in the US and Europe. None of this is in our

macro or industry or company forecasts. Detailed assumptions are footnoted. See table in

appendix for our current ratings.



76

China risk: India


We have a constructive view on Indian equities, underpinned by our expectation of near-

term peaking of inflation and an ensuing turnaround in the rates cycle. A hard landing in

China, combined with a global growth collapse, would accelerate the fall in inflation and

rates, and alleviate concerns on the twin deficits, but equity prices would have to adjust

to a lower growth equilibrium, despite India‘s high growth and rate differentials.


A hard landing in China, combined with a collapse of growth in the US and euro area,

would likely also be accompanied by substantial risk aversion globally. We do not expect

a high-beta market such as India‘s to outperform in this scenario, especially when

domestic growth could potentially fall more than 4 percentage points to about 3% under

the extreme case, a depressed growth outcome we have not seen in India in the two

decades post liberalization. The market would have to contend with significant downside

risk to earnings; we estimate downside risk to the extent of 20% under the extreme case.

Sector-wise, defensives like FMCG, pharma, utilities and telecoms would be defensive

plays. Meanwhile, high beta, growth-oriented and global cyclical sectors such as real

estate, metals, capital goods and autos would likely underperform, in our view.

Where is potential for upside surprise?

A collapse in the commodities complex would be considerably positive for India‘s

perpetual twin-deficit problem which, along with elevated inflation, has loomed large as a

key overhang for market performance. An improvement in the current account on the

back of lower commodity prices, especially oil (oil imports are more than 30% of total

imports), and a normalization of the fiscal deficit on the back of lower government

subsidies would be key upsides. India‘s WPI basket is largely commodity-driven and we

estimate the fall in global commodities would eliminate inflation, despite a weaker rupee.

Another overhang on the market has been India‘s high interest rate regime underpinned

by high inflation and a high fiscal deficit. A turnaround in inflation and mitigation of fiscal

risk would be a major improvement in the macro backdrop for equities.

Fig. 11: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*

(INR) Ticker

China sales share

2011%

Base case Extreme case*

Comments EPS 2012 % y-y

Target price

EPS 2012 % y-y

Target price

Most affected

Tata Motors TTMT IN 16 29.4 7.1 200.0 (11.6) NA 31 Domestic CV and JLR volumes could come under pressure, causing sharp declines in EBITDA margins and profitability. Multiples would also come down.

TATA Steel TATA IN NA 82.5 28.9 653 (11.8) (118.4) 215 Assumed 65% utilization at European operations, steel prices falling by 40% and raw material prices by 60%. No direct China exposure but would be affected by global commodity fall.

Crompton

Greaves

CRG IN NA 12.21 (15.5) 240 8.02 (45) 100 Lower demand as well as intense competition from Chinese players in the power systems segment.

Least affected

Dr. Reddy‘s DRRD IN 1 90.76 24 1,911 81.4 24 1,911 Although exposure to US is high, pharma is a non-

discretionary expense and growth for generics will be

fuelled by the patent cliff.

ITC ITC IN 0 8.7 16.2 229 6.7 (10.1) 137 We assume cigarette volume growth going to 0% (vs. 6% base case) price impact 4% vs. base case of 12%. Multiple for cig business down from 23x to 15x.

Infosys INFO IN 1 159.1 14.3 3,100 148.1 6.5 1,750 We assume flat US$ revenue growth in FY13F (led by

a pricing cut of 5%), a US$/INR of 48 and no salary

hike in FY13F. P/E multiples down to 12x from 18x.


*Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) China‘s GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012.



Research analysts:

Prabhat Awasthi +91 22 4037 4180 [email protected]

Nipun Prem +91 22 4037 5030 [email protected] And the India Research Team







77

China risk: Indonesia


Despite the relatively closed economy and no sign of consumption slowdown to date, a

sharp fall in commodity prices would reduce disposable incomes in rural areas. This in

turn would hurt demand for discretionary items and lead to slower growth in

manufacturing. Under the extreme bearish scenario we would look toward staple

consumer plays such as Telkom Indonesia, Indosat, Gudang Garam, Jasa Marga, and

PGAS.


Domestic demand, especially for discretionary items such as cars, motorcycles and

clothing, would be hurt. There is also a risk of China products flooding the Indonesian

market at cheaper prices due to oversupply in China and the FTA with Indonesia.

A sharp fall in commodity prices could hit coal and plantation earnings hard.

Any disruption in funding due to a global liquidity crunch would be short term in nature.

Indonesian companies are low in leverage. The banking sector LDR is around 83%,

public debt to GDP is at 25% and banking system loans to GDP are less than 30%.

Policy response is likely to be easing through lowering interest rates (currently 6.5%

benchmark vs inflation of 4.6%), lowering reserve requirements (currently 8% and was

as low as 3% during the 2008 crisis), managed intervention in currency and bond

markets. Government can boost infrastructure spending given low fiscal deficit of 1.7%.

Expansion would slow and FDI would likely fall or be put on hold, as in 2008. Capital

formation accounts for about one-third of GDP. Credit underwriting would be tightened

and this would hurt consumption of large ticket items such as cars and motorcycles.


Telecom sector could surprise on the upside as people travel less and communicate

more through phone or internet. Consumer companies with pricing power and high

commodity proportion in COGS would also benefit from easing cost pressure.


(IDR) Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Bumi BUMI IJ 30 0.04 (USD)

154 4,750 Net loss N.A 750 High operating leverage to coal price plus geared balance sheet (280% net gearing) at high cost of funds.

Adaro

Energy

ADRO IJ 19 275 114 2,850 50 (61) 1,500 High operating leverage to coal price plus 43% net gearing.

Harum

Energy

HRUM IJ 26 924 61 11,000 350 (60) 5,000 High operating leverage to coal price. Net cash.

Astra Agro AALI IJ 0 2,013 2 28,400 425 (69) 9,000 High operating leverage to palm oil price. Net cash.

Astra

International

ASII IJ 0 4,821 16 72,000 2,500 (40) 35,000 Automotive sales could drop 30% or more if GDP growth slows to 2.5% and commodity prices collapse.

Least affected

Gudang

Garam

GGRM IJ 0 3,189 22 65,000 2,550 (2) 50,000 Demand proven to be relatively inelastic during crisis.

Telkom

Indonesia

TLKM IJ 0 629 4 8,700 598 (1) 6,000 Demand proven to be relatively inelastic during crisis.

Jasa Marga JSMR IJ 0 376 21 4,950 357 15 3,500 Demand proven to be relatively inelastic during crisis. Tariff increase is certain as it is regulated by law.





Research analysts:

Wilianto Ie +62 21 2991 3341 [email protected] And the Indonesia Research Team








78

China risk: South Korea


Although we currently remain positive on Korean equities‘ fundamentals and attractive

valuations, any sharp slowdown in the Chinese economy would likely affect the cyclical

Korean economy substantially, and in turn, the earnings growth of most Korean

companies. If a China hard landing scenario materializes a substantial drop in Korean

exports would not be avoidable, as 25% of Korean exports go to China and, at the same

time, the domestic industry would be hit too as 22% of tourists come from China. Under

the extreme case scenario, assuming a China hard landing and recession in the US and

Europe, our Korean economist‘s 2012F GDP forecast is expected to be cut from +5% to

-3%.

Historically, when the Korean economy was in or close to recession, the Korean equity

market got hit hard, plunging 42% in 1997 and 41% in 2008. We cannot rule out the

same magnitude of impact under the extreme case scenario as a substantial economic

downturn tends to come along with capital flight, weighing sharply on the Korean equity

market.


Our current sector recommendation focuses on earnings visibility as we believe

developed economies will grow slowly but not fall into a deep recession; also we don‘t

take account of a China hard landing in our base case scenario. However, under the

extreme case, we expect Korean telcos would be largely insulated from the economic

slowdown and domestic-consumption companies such as KT&G would be less

vulnerable to the downturn. At the same time, Korean financials would likely face lower

asset quality, low loan growth and high provisions, and hence would likely be affected

most.


(KRW) Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Woori FG 053000 KS 0 2,828 12 18,000 617 (70) 4,900 Due to inferior asset quality (high NPL and low coverage

ratio), severe recession should result in greater provisioning.

KB FG 105560 KS 0 6.561 13.4 62,000 2,623 (61) 23,400 Pressure from macro slowdown, increased loan loss

provisions, interest rate cuts.

IBK 024110 KS 0 2,492 (15) 16,000 702 (76) 5,500 With SME concentrated loan portfolio, greater impact on

asset quality than peers in the case of recession.

Hana FG 086790 KS 0 4,745 (9) 54,000 2,194 (52) 19,400 Pressure from macro slowdown, increased loan loss

provisions, interest rate cuts. NIM should be more vulnerable

due to weak deposit franchise.

KEPCO 015760 KS 0 52 na 35,000 -1,330 na 15,000 Export-oriented Korea‘s power demand is highly sensitive to

China and global economic slowdown.

Least affected

KT&G 033780 KS 3 6,380# 10 66,000 6,577 10 65,010 Tobacco demand is relatively inelastic in response to

economic cycle. # Recent currency moves would imply 6,677.

Dongbu

Insurance

005830 KS 0 6,464 26 71,000 3,031 25 70,000 Less sensitive to interest rate cycle and their main product,

medical insurance, is stable in nature.

SKT 017670 KS 0 22,496 (1) 178,00

0

22,47

0

(1) 178,000 Korean telcos are largely insulated from the economic

slowdown.

KT 030200 KS 0 6,101 15 53,000 6,070 15 53,000 Korean telcos are largely insulated from the economic

slowdown.

LGU 032640 KS 0 793 (6) 6,000 793 (6) 6,000 Korean telcos are largely insulated from the economic

slowdown.





Research analysts:

James Kim + 852 2252 6203 [email protected] And the Korea Research Team

IMPORTANT: The sensitivity

table below does not assess just the impact of a China hard landing on the mentioned

stocks, rather it takes a look at an extreme scenario including recessions in the US and

Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions

are footnoted. See table in appendix for our current ratings.



79

China risk: Malaysia


Malaysia is the third most open economy in Asia after Hong Kong and Singapore with

exports to GDP at 97% as at 2010. As part of the diversification strategy, Malaysia‘s

exports to Europe and the US have been tapering off with China becoming the largest

export destination in August. If China has a hard landing, we would see Malaysia‘s GDP

growth falling to -5.8% in 2012. In such a world, Malaysia would end up in a vulnerable

position. Its three key growth engines - the public/private sector economy, manufacturing

exports and commodity resources - would be in much weaker positions.


The hardest hit sector would be palm oil. The direct impact of any ST disruption could be

significant – China is the 3rd-biggest consumer of CPO, and has contributed 17% of the

growth in the past decade, with about a 60:40 split of usage for food and industrial. The

increasingly realistic prospect of a hard landing would also affect a whole bunch of

things: crude oil, currency, futures, all of which could cause CPO prices to move down

sharply in the ST either directly or via its substitutes. That said, PO will always have the

cost/yield advantage over soy oil (which the Chinese are also big consumers of and

which is far more expensive), and in tough times, people are more likely to switch to

cheaper oils, as was seen in 2009 — veg oil consumption growth remained steady, but

soy lost market share to palm. Industry average gross margin (upstream planters) has

never dipped below 25% in the past 20 years.

We are concerned about the impact on the banks too. In a severe slowdown, loans

growth could contract, margins squeezed (from a lower overnight policy rate) and credit

cost could rise. However, the direct impact is negligible. For example only 13% of Hong

Leong Bank‘s earnings are from China through Bank of Chengdu and 5% of Public

Bank‘s earnings are from its Hong Kong listed Public Financial Holdings.


(MYR) Ticker

China Earnings

share 2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Maybank MAY MK n/a 0.66 (2) 6.85 0.34 (49) 3.24 Assuming 2012 credit cost rises to 100bps (base case: 47bps) and OPR cut to 2.0%

CIMB CIMB MK n/a 0.57 4 6.00 0.30 (44) 3.16 Assuming 2012 credit cost rises to 90bps (base case: 35bps) and OPR cut to 2.0%

Least affected

Telekom T MK <2 0.15 12 4.80 0.147 10 4.72 TM‘s exposures to North Asia are under 2%, primarily from its global business and hence we believe impact should be limited.





Research analysts:

Wai Kee Choong +60 3 2027 6893 [email protected] And the Malaysia Research Team







80

China risk: Singapore


We remain cautious about the outlook for the Singapore market. We recently

downgraded our 2011 GDP forecast to 4.8% and are reviewing our 2012 number with a

downward bias. We continue to recommend a defensive portfolio amidst on-going

external risks and further pressure on earnings growth, especially for FY2012. We favor

telcos, conglomerates and REITs. A hard landing scenario in China against the backdrop

of a muted macro outlook for the US and EU could push Singapore‘s 2012 GDP growth

to minus 5%. China is important for Singapore as 9.5 % of its NODX is to China while

10.6% of tourist arrivals in 1H2011 were from China. In addition to the direct effects,

Singapore‘s trade with its regional trading partners could also be dampened if they also

suffer from a China slowdown. Many Singapore companies, listed and unlisted, have

operations in China. According to official statistics, the cumulative direct investments into

China was S$58b as at end 2009. Losses by Singapore companies in China may have a

dampening effect on Singapore.


Singapore‘s exports to China would likely be negatively affected

The services sector could be impacted if Chinese tourist arrivals slow down sharply.

With Chinese buyers forming an estimated 5-7% of property purchasers in Singapore

over the past three quarters, a pullback in demand could affect the property sector.

Companies who have direct exposure in China that could be negatively affected include

Wilmar, Keppel Land, Capitaland and DBS Bank.


(SGD) Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Capitaland CAPL SP 25.0 15.35c (4.7) 4.05 13.00c (19.3) 3.30 CMA is the biggest component of CAPL's NAV, representing 26.5% of which 32.4% is attributable to China. The China residential segment accounts for a further 14.1%.

Keppel Land KPLD SP 40.7 24.5c 8.2 4.90 19.00c (16.1) 3.21 KPLD has 32.5% of its NAV in China residential

projects. A slowdown in China GDP will have direct

impact and spillover effects on projects in SG as well.

Wilmar WIL SP 52.0 35c 12.3 5.90 29c 3.7 4.40 Volumes could decelerate mainly in Palm & laurics,

Oilseeds processing and consumer pack segments.

PE multiples may contract.

DBS Bank DBS SP 8# 130c 7.2 16.4 85.5c (34.2) 12.0 #7-8% of assets in China, 28% of assets in Greater

China. Loan growth could decelerate to 2% (from

12%) and credit charges rise to 100bps (from 45bps).

Sustainable ROE reduced to 10% (from 11%), cost of

equity edges up to 9.5% (from 9.1%).

Least affected

SingTel ST SP 0.0 23.93c 0.3 3.45 23.53c (1.3) 3.35 None of SingTel's subsidiaries/ associates have

presence in China. We expect the impact of 'worst

case' GDP growths of countries where it is present on

the subscribers' wallets to result in <1% decline in

SingTel's consolidated revenue.

A-REIT AREIT SP 0.0 13.5c 3.7 2.10 12.50c (3.7) 1.94 Minimal exposure to China. We believe that the REIT

will hold resilient through a downturn. Its STB portfolio

was fully occupied through the financial crisis whilst its

MTB portfolio reached a low of 90.5% before quickly

rebounding to 92.5% by end June 2011.





Research analysts:

Jitsoon Lim, CFA +65 6433 6969 [email protected] And the Singapore Research Team








81

China risk: Taiwan


Any hard landing in China would be rapidly transmitted into Taiwan through multiple

channels. Still, we see low risk of a domestic financial crisis. Firstly, Taiwan‘s banks now

command the best balance sheet quality in decades. The NPL influx should likely be

manageable, given Taiwanese banks have not started commercial operations in China,

and are thus little directly exposed to corporate China. Secondly, corporate Taiwan is

normally debt-averse, with strong balance sheets, despite historically-high dividend

payouts. Lastly, thanks to the government policy of the intended economic isolation from

the mainland during 1996-2008, China has yet to become a significant factor in Taiwan‘s

domestic economy. Chinese liquidity is little involved in Taiwan‘s property market while

Chinese tourists contribute to only low-single digits of Taiwan‘s retail sales. That said, we

would expect Taiwan‘s property prices to experience a healthy correction of 10% on

average, as Taiwan‘s developers have mostly de-leveraged since the Lehman crisis and

face little pressure of inventory liquidation in a low interest rate environment.


Earnings downgrades would soon unfold from the tech sector, as China now accounts

for 20% of global tech end consumption. We note that the negative beta could be higher

in the handset foodchains (China equals 25%+ of global demand), followed by PCs and

TVs (20%+) and NBs (15%+).

On the other hand, selective non-tech plays (i.e., Taiwan Cement, Asia Cement, Airtac,

Taiwan Glass, Cheng Hsin Rubber, Gourmet Master), which normally derive over 50% of

revenue from China, would also be significantly affected on the downside.


With Presidential elections on January 14th

2012, the KMT-led government will likely

react promptly and aggressively to boost the domestic economy, taking advantage of its

majority in the Legislative Yuan. We estimated that Taiwan‘s four major government

funds have maximum capacity of TWD1.2tn to engage in the share purchase program to

support the Taiex. More importantly, with little contingent liability from stable banking

system, Taiwan government also has well-reserved fiscal strength to launch counter-

cyclical infrastructure investments. Last but not least, we expect Taiwan to consider a

repeat of the issuance of shopping coupons to boost domestic consumption, if needed.


(TWD) Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Asia Cement 1102 TT 45 2.85 (10.0) 34.6 2.21 (30.0) 22.5 Significant earnings exposure to China.

Synnex 2347 TT 60 5.80 31.5 90.0 3.53 (20.0) 76.5 Significant earnings exposure to China.

AirTAC 1590 TT 86 11.58 19.5 300.0 7.27 (25.0) 240.0 Significant earnings exposure to China.

Least affected

Taiwan Mobile 3045 TT 0 5.08 14.0 93.0 4.28 (4.0) 89.3 Diversified revenue stream.

President Chain Store 2912 TT 4 7.60 8.3 205.0 6.60 (6.0) 192.7 Govt may support domestic consumption.





Research analysts:

Jesse Wang +886 2 2176 9977 [email protected] And the Taiwan Research Team







82

China risk: Asia banks


The financial sector will naturally be impacted by any seriously negative macro event

because of its large market capitalization, direct linkage to capital-intensive and export-

oriented industries and still fresh memories of the credit crunch in 2008-09. At the

moment, we are on average sitting on bullish recommendations spreads within most

markets in Asia, reflecting our house view that emerging markets should weather the

macro situation better and would potentially rebound strongly in the event of a short-term

shock. (We are Neutral in Australia where the drivers are different and bearish in

Malaysia on valuations.) A hard landing in China, accompanied by possible recessions in

the US and Europe, would – subject to valuation, obviously – see us turn very cautious.

Numbers would have to come down across the board to reflect loan growth concerns

and, especially in markets with high SME participation, rising credit costs. Our back-of-

the-envelope calculations are tabulated below:


Ticker



Target price

EPS 2012 % y-y

Target price

Most affected

Minsheng (HKD) 1988 HK 0.88 14.29 7.4 (1.2) (255.73) 3.7 589bps credit cost hike to 6.54%

BOC (HKD) 3988 HK 0.51 18.35 5.2 (0.51) (218.49) 2.3 539bps credit cost hike to 5.95%

Citic Bank (HKD) 998 HK 0.66 10 6.5 (0.71) (217.65) 2.8 527bps credit cost hike to 6.02%

CCB (HKD) 939 HK 0.76 18.07 7.02 (0.51) (179.78) 3.28 599bps credit cost hike to 6.61%

CRCB (HKD) 3618 HK 0.55 27.91 6.52 (0.33) (177.31) 1.52 694bps credit cost hike to 7.29%

ICBC (HKD) 1398 HK 0.69 23.21 7.5 (0.28) (150.82) 3.5 529bps credit cost hike to 5.69%

BEA (HKD) 23 HK 2.7 6% 24 (0.33) (113) 18 Weak profitability and thus big swing in earnings

WHB (HKD) 302 HK 6.52 -4% 84 (0.78) (112) 46 Weak profitability and thus big swing in earnings

DSF (HKD) 440 HK 4.3 8% 50 (0.09) (102) 18 Weak profitability and thus big swing in earnings

Woori FG (KRW) 053000 KS 2,828 12% 18,000 617 (70) 4,900 Due to inferior asset quality (high NPL and low coverage ratio), severe recession should result in greater provisioning

Least affected

CBA (AUD) CBA AU 4.43 5.4 53 3.36 (20) 36.72 Our worst case estimates incorporate i) a significant increase in BDD‘s (175bps to NHL which is consistent with the GFC experience) and we do not prescribe banks with any margin benefit (as they achieved throughout the crisis) given we expect a significant slowdown in China will reduce banks‘ ability to re-price margins.

WBC (AUD) WBC AU 2.13 4.6 24.5 1.64 (19.7) 17.4

NAB (AUD) NAB AU 2.63 7.5 30 2.05 (16.1) 20.91

BCA (IDR) BBCA IJ 416.2 7.9 6,700 322.7 (16.4) 5,200 135bps higher credit cost to 1.8%

Danamon (IDR) BDMN IJ 440.8 18.1 4,900 351.7 (5.8) 4,000 100bps higher credit cost to 3.5%

BRI (IDR) BBRI IJ 630.6 19.8 8,400 515.5 (2) 6,900 110bps higher credit cost to 3.5%

UOB (SGD) UOB SP 186c 11.8 21.9 162c (12.9) 19.7 4-5% of assets in China, 7% of assets in Greater China. Loan growth could decelerate to 6% (from 12%) and credit charges rise to 65bps (from 44bps). Sustainable ROE reduced to 12% (from 13%) while cost of equity remains at 9.6%.

Krung Thai Bank (THB)

KTB TB 2.04 15.4 23.2 1.79 (12.3) 20.3 Domestic. Loan growth could decelerate to 8% (from 12%) and credit charges rise to 65bps (from 48bps). Sustainable ROE reduced to 14% (from 15%) while cost of equity remains at 11.2%.

Kasikornbank (THB) KBANK TB 12.2 12.3 135.0 10.8 (11.5) 120.0 Domestic. Loan growth could decelerate to 5% (from 10%) and credit charges rise to 85bps (from 59bps). Sustainable ROE reduced to 15% (from 16%) while cost of equity remains at 11.5%.

Siam Commercial Bank (THB)

SCB TB 9.7 13.5 145.0 9.0 (7.2) 130.0 Domestic. Loan growth could decelerate to 8% (from 12%) and credit charges rise to 55bps (from 38bps). Sustainable ROE reduced to 16% (from 17%) while cost of equity remains at 10.5%.










Research analysts: The Asia Banks Team


83

China risk: Asia consumer-related


Domestic consumption is generally expected to be resilient in most markets in Asia in

the event of any negative macro event, reflecting our house view that emerging markets

should weather the macro situation better and would potentially rebound strongly in the

event of a short-term shock, aided by policy responses that would promote private

consumption as we saw in the 2008-09 crisis. However, there would be short-term

negative impact on earnings as consumer confidence will likely dip if markets go into a

tailspin in anticipation of a hard landing in China. Our forecasts would have to come

down across the board and we could see significant valuation multiple compression as

well. However, as the table below shows, there could be plenty of relative value in the

classic defensives of F&B, staples and tobacco. At the other end of the spectrum, high-

beta names may see their valuations change more dramatically than their earnings.


Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most vulnerable (earnings change)

Esprit (HKD) 330 HK 8 0.51 (52) 8.90 (0.09) (109) 4.60 European exposure hurts.

Melco Crown (USD) MPEL US 100 0.15 174 17.5 (0.02) (132) 8.2 Extreme case assumes gaming revenue down 12%y-y in 2012, contracted target multiple of 10x across the board. MPEL has low margin VIP-skewed earnings model.

Astra Agro (IDR) AALI IJ 0 2,013 2 28,400 425 (69) 9,000 High operating leverage to palm oil price.

Galaxy Entertainment (HKD)

27 HK 100 1.07 56 21 0.55 (20) 11 VIP-centric earnings stream. Assumptions same as Melco.

Samsonite (HKD) 1910 HK 12 0.97 21 19.70 0.50 (36) 12.60 Asia/China growth story.

Prada (HKD) 1913 HK 32 (Asia) 2.09 24 40.30 1.19 (28) 19.80 Asia/China growth story.

Noble (USD) NOBL SP 10 0.12 22.4 2.50 0.07 (30) 1.60 Global supply chain impact.

Li & Fung (HKD) 494 HK 6 0.72 24 14.10 0.45 (23) 7.40 US exposure.

SJM Holdings (HKD) 880 HK 100 1.21 21 23 0.81 (18) 13.3 Assumptions same as Melco.

Most resilient (earnings change)

Want Want (HKD) 151 HK >90 USD0.038 26.5 HKD6.6 USD0.034 13.6 HKD5.9 Not the most defensive as mainly discretionary foods (snacks).

Tsingtao Brewery (HKD) 168 HK 97 CNY1.23 1.9 HKD34.0 CNY1.11 (8.3) HKD31.0 Beer.

Woolworths (AUD) WOW AU n.a. 180 3.3 30 170 (2.9) 29 Main impact likely to be on discretionary COGS.

China Mengniu (HKD) 2319 HK >90 CNY1.58 30 HKD34.0 CNY1.55 27.3 HKD33.0 Liquid milk is becoming a daily habit for most of the Chinese people.

Coca-Cola Amatil (AUD) CCL AU n.a. 80 11.1 13.00 76 5.5 12 An affordable product in the key Australian market.

China Yurun (HKD) 1068 HK 100 1.66 13.4 21.0 1.62 10.8 20.3 Pork is an essential item in Chinese daily meals.

Huabao International (HKD)

336 HK 100 0.58 11.8 11.7 0.57 9.7 11.4 Tobacco.

KT&G (KRW) 033780 KS 3 6,380# 10 66,000 6,577 10 65,010 Tobacco. # Recent currency moves would imply 6,677.

Treasury Wine Estates (AUD)

TWE AU n.m. 21 26.7 3.30 22 37.5 3.4 Lower AUD/USD benefits transaction and translation, which should offset lower demand.










Research analysts: The Asia Consumer Team


84

China risk: Asia healthcare


Healthcare expenditure was RMD1,720bn in 2009. Reform of the public hospital system

is one of the major policy targets of ongoing healthcare reform in China. China targets to

invest approximately CNY850bn to reform the healthcare system from 2009 to 2011, of

which about CNY100bn could be used to invest in the expansion of hospitals and basic

healthcare institutions in rural areas. If China has a hard landing, we would see a

potential slowing the reform agenda for China. We currently forecast as much as

CNY60bn could be spent on purchasing of medical equipment in 2011-13. Healthcare in

the rest of the region should be much more defensive, with Australia the most insulated.


Supply-demand and pricing: According to a United Nations forecast, China's aging

population is expected to increase at a 3.7% CAGR to more than 166mn over the age of

65 by 2020. Given the increased need for tests and treatments, we believe demand for

medical devices will be strong. We think pricing declines are likely to be muted.

Impact on funding: At the top of China's hospital system hierarchy, there are over 1,200

class-3 hospitals, of which over 760 are class-3A. Funding to these hospitals (which use

relatively more devices) would likely be minimally affected.

Policy and regulations: We continue to believe reform of the public hospital system is a

major policy target of the Chinese government and hence is unlikely to be impacted to a

great degree should China suffer a hard landing;

Industry evolution/development: Should there be a Chinese hard landing, the medical

equipment manufacturers, like Mindray (MR US), would likely face a higher risk of

slowdown than other segments as some smaller hospitals with restricted financial

positions may delay equipment investment or replacement cycles. However, a hard

landing in the economy would accelerate market concentration, which should benefit the

domestic market leaders at the expense of some smaller manufacturers.


For 2011, we expect the market to benefit from the following major policy targets of the

NDRC and MOH: 1) the increase of two BMIS coverage ratios to over 90%; 2) increase

in per capital contribution in NRCMS to CNY200 a year; 3) increase in minimum

reimbursement ratio for in-patient treatment of not less than 70%; and 4) increase in the

maximum reimbursement amount equivalent to about 6x the average annual

salary/disposal income/ farmer income in the respective cities or counties. All this should

lead to volume growth in Chinese hospitals, and hence in Chinese medical device sales.


Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

Mindray (USD) MR US 40 1.82 20.1 34.0 1.59 7.0 25.50 50% revenues from exports.

United Labs (HKD) 3933 HK 70 0.41 (1.9) 6.4 0.38 (10.1) 5.94 30% revenues from exports.

Least affected

Primary Healthcare (AUD) PRY AU 0 0.24 16.9 3.8 0.24 16.9 3.80 No exposure to China.

Ramsay Health Care (AUD) RHC AU 0 1.29 18.7 21.0 1.29 18.7 21.00 No exposure to China.

Sonic Health Care (AUD) SHL AU 0 0.81 6.4 11.0 0.81 6.4 11.00 No exposure to China.





Research analysts:

Dr David Stanton +612 8062 8410 [email protected]

Gideon Lo, CFA +852 2252 6190 [email protected] And the Asia healthcare team









85

China risk: Asia power


In Asia, power companies in HK, India and Thailand enjoy fuel cost pass through and

fixed return on regulated asset bases, while firms in China, Korea and Malaysia do not

have that luxury, with earnings subjected to tariff, coal, demand and interest cost. HK

utilities should be defensive, whatever the economic situation. If China has a hard

landing, we would see a fall in fuel costs as a benefit for China and Indian IPPs, though

in general the fall in sales volume and margin in case of an unfavourable tariff response

shall be expected, apart from Perusahaan Gas Negara, whose volume depends more on

supply constraints, and Tenaga Nasional, which may be pleased to find itself relieved

partially from costly distillates to supplement supply shortfalls. Exchange movements

would pose a further impact on imported fuel, translated earnings and exports, to which

Korea is highly sensitive. Also, interest rates may fall; this could help high gearing stocks

like China IPPs and Korea Utilities, but the overall exposure on the sector appears to be

limited. In such a world, the impact on our investment stance might be largely neutral.


Fall in fuel prices benefiting China IPPs exposed to domestic fuel supply, and Tenaga

Nasional, Indian IPPs and Korea utilities exposed to imported fuel.

Slowing economic growth reduces power usage, and thus demand and sales.

Potential drop in interest rates: improve liquidity and cut interest expenses. Impact on

ability to secure funding appears limited unless situation persists and growth impairs.

Governments may hesitate to grant adequate tariff increases, leaving power generators

with no relief against weakened demand.

Little is expected to change in terms of the power industry and capacity structure.

Government unlikely to adjust plans for or influence over the industry for long term

stability. However if an economic slowdown persists, growth may be hurt as planned

capacity growth may not be fully implemented if power demand does not recover.


Favorable tariff, coal price and interest rate movements would offset impacts from

decline in demand.


(Local curr) Ticker

China sales share

2011%

Base case (Local $) Extreme case* (Local $)


Target price

EPS 2012 % y-y

Target price

Most affected

Kepco 015760 KS 0 52 NA 35,000 (1,330) NA 15,000 Export-oriented Korea‘s power demand is highly sensitive to China and global economic slowdown.

Adani Power ADANI IN 0 15.7 NA 115 10.3 NA 110 Utilization levels would drop as we see a slowdown in industrial demand

Lanco Infra LANCI IN 0 3.7 NA 30 2.7 NA 29 Utilization levels would drop as we see a slowdown in industrial demand

Least affected

Perusahaan

Gas Negara

PGAS IJ 0 252.24 NA 3,900 252.24 NA 3,900 Volumes vary as a function of supply constraints instead of demand-pull factors

Ratchaburi

Generating

RATCH TB 0 3.97 NA 41 3.97 NA 41 Highly insulated power purchase agreements

Electricity

Generating

EGCO TB 0 11.82 NA 110 11.82 NA 110 Highly insulated power purchase agreements





Research analysts:

Ivan Lee, CFA +852 2252 6213 [email protected]

Daniel Raats +852 2252 2197 [email protected]

Anirudh Gangahar +91 22 4037 4516 [email protected]

Keith Nam +82 2 3783 2342 [email protected]

Joseph Lam, CFA +852 2252 2106 [email protected]

And the Asia power team











86

China risk: Asia property

Three risks to consider

While property is perceived to be a local industry and driven by local demographics, past

crisis have shown that no markets are immune in the event of a system-wide correction.

Further, with increasing globalization, if China were to have a hard landing, we believe

demand across all asset classes and all regions would be affected. While demand would

be hit across the board, we believe some property markets would fare worse than

others. The three differentiating factors that would set the various markets apart are:

(1) Balance sheet strength – Would there be distress selling?

(2) Supply outlook – How much unproductive stock would need to be unloaded? and

(3) Valuations – Have stocks already priced in the downside?

Fig. 21: Gearing levels across the region

Source: Nomura Research Note: net-debt-to-equity for traditional property companies. For REITs gearing is defined as total debt-to-total assets

図表 10

Fig. 10

Fig. 22: How big is the supply overhang?

Source: Nomura Research

図表 11

Fig. 11

Fig. 23: Valuation: How much have current trailing PB already discounted?

Source: Nomura Research Note: Current PB as of October 14, 2011

図表 12

Fig. 12

Fig. 24: Most vulnerable, most resilient and best positioned

Source: Nomura Research

図表 13

Fig. 13

-12%

12% 16% 22% 27% 28% 33%

58% 62% 63%

-20%

0%

20%

40%

60%

80%

ID P

rop

ert

y

HK

Develo

pers

HK

Lan

dlo

rds

HK

RE

ITs

MY

Pro

pert

y

SG

RE

ITs

SG

Develo

per

s

IN P

rop

ert

y

CH

Pro

pert

y

TW

Pro

pert

y

Net gearing

2011 2012 Vs. Metric 2011 2012

HK office (mn sf) 0.86 1.01 20 Yr Avg 2.40 -64% -58%

MY housing (units) 72,054 86,733 8 Yr Avg 172,861 -58% -50%

HK retail (mn sf) 0.61 1.11 19 Yr Avg 1.23 -50% -10%

HK housing (units) 10,670 13,700 14 Yr Avg 19,064 -44% -28%

TW housing (Households) 70,610 63,549 5 Yr Avg 102,690 -31% -38%

ID office (mn sqm) 7.40 7.96 4 Yr Avg 6.63 12% 20%

ID retail (mn sqm) 5.27 5.56 4 Yr Avg 4.67 13% 19%

IN office (mn sf) 47.00 38.00 2 Yr Avg 41.50 13% -8%

SG housing (units) 9,469 10,407 17 Yr Avg 8,269 15% 26%

ID housing (ha) 181.96 185.46 4 Yr Avg 148.86 22% 25%

IN housing (mn sf) 250.00 250.00 2 Yr Avg 198.50 26% 26%

CH housing (mn sqm) 704.49 826.96 6 Yr Avg 523.61 35% 58%

SG office (mn sf) 2.80 1.41 30 Yr Avg 0.60 364% 134%

Surplus/Deficit to AvgCompletion

Average Avg PB

Hist. Avg SD

(x) Current P/B Vs. Avg +/- SD (x)

HK Landlords 20 Yr Avg 0.80 0.14 0.58 -28% -1.57

HK Developers 20 Yr Avg 1.17 0.28 0.78 -34% -1.40

CH Property 6 Yr Avg 2.24 1.15 1.25 -44% -0.86

SG Developers 10 Yr Avg 1.27 0.61 0.91 -29% -0.60

SG REITs 9 Yr Avg 1.03 0.20 0.96 -7% -0.36

IN Property 11 Yr Avg 3.17 4.25 1.73 -45% -0.34

ID Property 5 Yr Avg 2.31 0.57 2.22 -4% -0.15

TW Property 15 Yr Avg 1.26 0.64 1.28 2% 0.03

MY Property 11 Yr Avg 1.75 0.68 1.80 3% 0.07

Country Most vulnerable Most resilient Best positioned under base case

China Guangzhou R&F (2777 HK) China Overseas (688 HK) China Overseas (688 HK)

HK Wharf (4 HK) SHKP (16 HK) SHKP (16 HK)

India DLFLtd (DLF IN) Oberoi Realty (OBER IN) DLF Ltd (DLF IN)

Indonesia Agung Podomoro (APLN IJ) Bumi Serpong Damai (BSDE IJ) Ciputra Dev (CTRA IJ)

Malaysia Malaysian Resources (MRC MK) SP Setia (SPSB MK) Man Sing (MSGB MK)

Singapore CapitaLand (CAPL SP) A-REIT (AREIT SP) Keppel Land (KPLD SP)

Taiwan Huaku (2548 TT) Farglory (5522 TT) Farglory (5522 TT)

Research analysts:

Paul Louie +852 2252 6189 [email protected] And the Asia property team

IMPORTANT: Our sensitivity analysis does not assess just the impact of a China hard


recessions in the US and Europe. None of this is in our

macro or industry or company

forecasts. See table in appendix for our current ratings

The extreme case assumes (1) US real GDP falls 3% and euro

area GDP falls 5%; (2) China‘s GDP growth falls to 5%; (3) Substantial commodity price

declines by end 2012.

Base case and extreme case real GDP growth % assumptions: Australia (4.3,

0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia

(5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South

Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0).



87

China risk: Asia renewables

Risks to our overall current view

Current views: bearish on solar; neutral on wind, nuclear and natural gas.

Asia governments would likely not alter renewable capacity targets despite a slowdown,

given strategic plans to diversify from coal. China wind, natural gas and nuclear

industries are armed with a favorable fuel mix from FYP12 and capacity targets from

NDRC‘s Roadmap. However, the solar industry has seen sharp falls in ASP and volume

growth while near term upsides are limited from severe demand headwinds, likely

subsidy cuts and new market penetration. If China has a hard landing, we would see

tighter regulation of financing across the solar sector and a sharp cut in utilization, while

with backing of government policy and limited exports, china wind and nuclear would

meet with little impact. Therefore, FY12F earnings would likely fall 20~25% across the

solar industry, with a potentially sharper impact in the event of worsening investor

sentiments, but sectors like wind, natural gas and nuclear would not be affected.


Solar: Sharp utilization cuts at 30~40% for solar industry as demand declines continue

amidst high channel inventories; Utilization cuts reduce supply in solar industry, but

supply-demand mismatch persists with supply 20~30% over demand.

Wind, nuclear and natural gas: FYP12 capacity/consumption targets would not be

affected.

Approvals for government subsidy program may slow down for solar industry, while it is

unlikely for the government to revise wind installation capacity and FYP12 fuel targets.

Tighter regulatory control on refinancing possible for all renewable companies.


Sharper than expected drops in interest rates would favour valuation. Approvals for tariff

increases may relieve demand declines. Supply-side consolidation as higher-cost

producers are priced out of the market and demand elasticity may also remedy impacts

to the solar industry, given lower ASPs enabling stronger demand from new regions,

especially US, China, Japan, and India; albeit needs improved financing availability.


Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

LDK Solar

(USD)

LDK US 44 (0.78) NM 2.6 (1.00) NM 1.30 We see LDK‘s financing issues getting exacerbated in the extreme case.

Motech

(TWD)

6244 TT NA (5.30) NM 39.0 (7.00) NM 20.00 We expect pure play companies to bear the brunt in the extreme case.

JA Solar

(USD)

JASO US 52 (0.32) NM 2.0 (0.42) NM 1.05 We expect pure play companies to bear the brunt in the extreme case.

Least affected

GCL

(HKD)

3800 HK >90 0.20 (50.80) 2.5 0.16 (60.50) 1.50 GCL‘s lowest cost structure should help it remain breakeven in the extreme case.

Trina

(USD)

TSL US 9 (0.54) NM 7.0 (0.70) NM 4.00 Trina‘s lowest cost structure and good balance sheet could help the company through the downturn.

Yingli

YGE US 15 CNY

(5.61)

NM USD3.4 CNY

(7.00)

NM USD2.0 Yingli‘s lowest cost structure could help the company through the downturn.





Research analysts:

Ivan Lee, CFA +852 2252 6213 [email protected]

Nitin Kumar +65 6433 6967 [email protected] And the Asia renewables team









88

China risk: Asia technology


Basically, we expect 2012F IT industry growth in China to continue to outperform other

geographic markets due to still-low penetration of LCD TVs, PCs and smartphones. We

forecast China PC shipments will grow 11% y-y to 82mn units in 2012F vs. 4.7% y-y for

our global PC shipment growth forecast. We also expect 2012F LCD TV demand to grow

15% y-y to 49mn units in China, which is 5pps higher than global LCD TV demand

growth. In terms of handset demand in China, we expect 15% y-y growth to 550mn units

along with growing mobile subscribers. We expect 3G smartphone shipment volume to

grow 45% y-y, driven by operators‘ handset subsidy policies, accounting for 15% of

market volume in 2012F. We expect the white goods market to still see ~20% y-y volume

growth along with the rise of penetration rate in rural areas.


We expect PC and handset shipment growth would be 9% y-y, and 5% (similar to 2008),

respectively, which would extend the replacement cycle for PCs and handsets in

matured cities, although we expect rising demand from tier-4 to tier-6 cities should help

compensate. We see limited impact for smartphones in 2012 as the market is mainly

driven by operators‘ subsidy policies. LCD TV market growth could fall to 10%, the

lowest over the past several years, in our view. We expect white-goods market growth

could slow to around 10% due to the slower-than-expected income level growth.

LGD, the global no. 1 LCD panel maker, has cancelled its 8G line schedule and

Samsung has decided to move an existing 8G line in Korea to China rather than build a

new one as planned earlier. We could see other capex cuts along the supply chain.

We do not recommend any pure LCD names in the supply chain such as glass,

polarizer, and LED companies.

Two China LCD panel companies are ramping up their new 8G lines. However, we

anticipate that they may delay the full ramp up and all panel makers‘ profitability could be

negative in 2012F, following the big loss in 2011F.


Microsoft‘s new OS Windows 8 official launch and rising interest in ultrabooks should

help boost replacement demand in 2H12. China may introduce new subsidies to

stimulate home appliance and TV demand in rural areas.


Ticker

China sales share

2011%



Target price

EPS 2012 % y-y

Target price

Most affected

TCL (HKD) 2618 HK 10 1.04 30 8 0.89 11 7 Smartphone sales are driven by operator

subsidies rather than the macro environment.

ZTE (HKD) 763 HK 50 1.28 21 28 1 (6) 22 Sells equipment and phones to operators.

Lenovo 992 HK 48 US3.4c 26 HKD5.1 USD2.8c 2 HKD4.0 75% earnings from China.

LGD (KRW) 034220 KS 25 85 na 24,000 68 na 21,000 Supplies panels to Chinese set makers.

Least affected

Acer (TWD) 2353 TT 14 2.33 na 27 1.7 na 20 Small exposure to China.

Samsung SDI

(KRW)

006400 KS 5 10,698 9.4 160,000 8,558 7.5 120,000 Minimal exposure to China.

LG Innotek

(KRW)

011070 KS 5 1,861 na 71,000 1,303 na 58,000 Minimal exposure to China.





Research analysts:

James Kim +852 2252 6203 [email protected] And the Asia technology team







89

China risk: Asia telecoms


Overall we believe the Asian telecom sector should be relatively resilient to a macro

slowdown or a China hard-landing. YTD, Asian telcos is the only sector with positive

returns (up 3%) – although this may not continue (as the sector does not look

inexpensive at 14-15x P/E currently), but outperformance relative to other sectors and

markets would be likely. We continue to prefer liquid stocks, with stable yields and EPS

resilience. Our bias is also for stocks with network advantages, especially as data

economics can be challenging.


• Consumer spend on telcos could be adversely impacted – telco spend as a percentage

of GDP ranges from 3-6% across most Asian countries. The impact of a slowdown

could be more pronounced in the mid to low end pre-paid segment, both on net adds

and ARPUs. For China specifically, the impact could be more visible in factories along

the coastal areas which has a larger migrant population.

• There could be downward revisions to capex, although we are already anticipating a

drop in capex/sales from 20% in 2010 to 18% in 2012F. In the 2008 slowdown, there

weren‘t many downward revisions to capex or revenue/EBITDA guidance; however

now the penetration rates are 10-20% higher.

• We think telcos in China, India, Indonesia, Thailand and the Philippines could be more

exposed, while the rest should be more resilient.


Ticker

China sales share

2011%


Comments

EPS 2012

(CNY) % y-y

Target price

(HKD)

EPS 2012

(CNY) % y-y

Target price

(HKD)

Most affected

China Unicom 762 HK 100 0.56 79.5 18.50 0.51 62.9 18.20 Revenue vulnerable due to low-ARPU.

Least affected

China Mobile 941 HK 100 6.46 2.7 90.00 6.11 (3.0) 89.60 Have more high-ARPU subscribers.





Research analysts:

Sachin Gupta, CFA +65 6433 6968 [email protected]

Danny Chu, CFA +852 2252 6209 [email protected] And the Asia telecoms team








90

China risk: Asia transport


We currently have a negative view on shipping companies, a neutral to positive view on

airlines, expressways, and ports, and a positive view on airports. Our positive position on

airlines would be most at risk in a China hard landing scenario.


• Demand is expected to be impacted across the entire transport sector, nevertheless,

the impact to earnings is expected to be the largest for shipping companies and airlines

given thinner profit margins. Further, a hard landing may impact the pricing for both the

shippers and the airlines. In contrast, a hard landing is not expected to have any price

impact for airports and just minimal impact on the ports and expressways.

• While a hard landing may result in tighter funding, it is unlikely that the Chinese

transport companies would run into solvency issues given that most are state-owned

and historically had been bailed-out by the government in crisis situations.

• A hard landing may increase regulatory risk especially on pricing for the expressways.


We believe that there is the possibility for an upside surprise for the expressways should

toll-rate cuts (which have been at least partially priced in given the official announcement

of a nation-wide toll-rate review at the beginning of this year) not materialize by May-

2012.


Ticker

China sales share

2011%


Comments EPS 2012

(CNY) % y-y

Target price

(HKD) EPS 2012

(CNY) % y-y

Target price

(HKD)

Most affected

CEA 670 HK 80 0.39 (0.065) 4.65 (0.69) na 0.86 Target price of extreme case based on 2008's trough

valuation P/BV of 0.65x and assume CNY appreciation

to remain flat y-y in 2012F

CSCL 2866 HK na (0.19) na 1.20 (0.38) na 1.11 In a bear-case scenario, we assume overall 2012F

freight rates would decline by a further 5% on a y-y

basis while we assume all international freight rates in

2012F would decline by a further 10% from the base

case in an extreme bearish case.

Yang Ming 2609 TT na -TWD2.91 na TWD7.10 -TWD7.01 na TWD3.39 In a bear-case scenario, we assume overall 2012F

freight rates would decline by a further 5% on a y-y

basis while we assume all international freight rates in

2012F would decline by a further 10% from the base

case in an extreme bearish case.

Least affected

HHI 737 HK 100 HKD0.34 (3.5) 5.69 HKD0.29 (19.1) 3.18 Assuming the toll rate to remain stable post the toll rate

review in 2012 for calculating the extreme case's

earnings, while target price of extreme case to be

based on 2008's trough PE multiple of 11.2x and

assume earnings to decline by another 20% to reflect

the possible toll rate cut

BCIA 694 HK 100 0.27 53.6 5.85 0.17 (39.0) 2.86 Target price of extreme case to be based on historical

trough P/BV of 0.7x

Hopewell 54 HK 65 HKD2.00 52.3 32.60 HKD0.95 (28.1) 18.60 y-y chg% are calculated based on re-current earnings





図表 14

Fig. 14

Research analysts:

Jim Wong +852 2252 2195 [email protected]

Andrew Lee +852 2252 6197 [email protected] And the Asia transport team








91

Chinese credits – already reflecting the risks of a China hard landing

From a credit perspective, when considering the direct consequences of a

China hard landing, we believe the four key areas of focus are the impact on

the sovereign and its ratings, the banks and the availability of credit, with

implications for the HY property sector and industrials, and lastly, the

repercussions for the Chinese SOE space. We believe the risks of a slowdown

are already starting to show in the recent underperformance of Chinese credit

across both HG and HY relative to the rest of the Asian credit universe. This

underperformance has been seen right through the sell-off since August

through September, and the much less convincing participation in the rally that

subsequently followed. In our view, a China hard landing would have the

following consequences for Chinese credit:

Significant underperformance of highly levered SOEs, whose

investment grade ratings have been underpinned by government

support;

Chinese HY industrials would underperform the large cap HY property

credits;

Significantly more scrutiny of the default risk of smaller cap property

credits; and

Hong Kong banks that have extended their balance sheets to Chinese

banks and SOEs would likely be dragged to wider levels, though we

believe the space could be unfairly penalized.

Ahead of a China hard landing playing out, we believe the signs would be

borne through the ripple effects of the tightening of onshore credit with an

explosion in shadow bank lending followed by a focus on the government‟s

ability to manage the knock-on consequences. Another area that will be

closely tracked will be the property sector, which has been on an uninterrupted

upward trajectory in terms of supply and prices. The supply overhang that has

been created is finally starting to result in prices and transaction volumes

crashing, particularly in top-tier cities.

On the back of the above views and backdrop we lay out our trade ideas on

China:

Sovereign – We expect CDS to remain highly volatile and subject to macro

headlines with likely buyers on any meaningful tightening as we saw at the end

of last week, where CDS went from a recent peak of 207bp down to the

current 140bp. We do not see much in terms of downward pressure on foreign

credit ratings. If there is any pressure we would expect it to come from Fitch‟s

This portion of the Report has been prepared by a Desk Analyst and is not a research report under U.S. law. The desk commentary portion of this report is not a product of the Fixed Income Research Department and is not covered by

the research analyst certification provided in Appendix A-1.

To our U.K. clients: this portion of the Report has been produced by and for the primary benefit of a trading desk.

As such, we do not hold out this Desk Commentary as being impartial in relation to the activities of this trading desk.

For additional information concerning the role of trading desk analysts, please see the important conflicts disclosures beginning at page 101 of this report.

Desk Analyst

Pradeep Mohinani

+852 2536 7030 [email protected]



92

local currency ratings, the agency having put its AA- rating on Negative

outlook relative to its foreign currency rating of A+.

In High Grade, a number of Chinese state-owned credits like Sinochem,

China Metallurgical and China Resources Power have continued to benefit

from investment grade ratings based on the expectation of government

support. However, in a distressed macroeconomic scenario, we believe

support will vary based on the company‟s relative importance to the

government, especially as policy instruments, as well as the language of

support used for outstanding debt. Of these issuers, we note that China

Resources Power (Baa3/BBB-) and China Metallurgical (Baa2/BBB-) are both

already on the verge of an S&P downgrade and being pushed into non-

investment grade territory. China Resources Power has had its outlook revised

to Negative on the back of aggressive capex plans and a stressed balance

sheet, while China Metallurgical‟s credit metrics are only marginally better than

the downgrade triggers. Given that Citic Pacific‟s senior bonds traded in the

low-70s in the recent sell-off after being downgraded to non-investment grade,

we highlight the risk of these bonds seeing gappy downward movements.

In High Yield, the larger-cap Chinese property and higher quality China

industrial bonds are now trading between 12% and 15% yields, or at bond

prices in the 70s-90s, while the more defensive Indonesian corporates now

trade at 6-8%. With the recent market rally, we view high yield bond valuations

as fair at current levels. That said, we still see pockets of relative value trade

ideas, especially on longer-dated larger-cap Chinese property bonds and

switch trades among the China industrial and small-cap property space.

Switch ideas in China property: 1) Switch to SHIMAO 18s at 81.5 mid

(15.7%) from AGILE 17s at 82.25 mid (13.6%) to take out 0.75 cash points

and pick up 210bp. Agile is likely to miss its presales target on its

underperformance in Hainan. In contrast, we see better sales execution

and potential credit improvement in Shimao. 2) Switch to KWGPRO 17s at

79 mid (18.6%) from YLLG 17s at 82.75 mid (14.1%) to take out 3.75 cash

points and pick up 450bp. Yanlord‟s presales were slow in view of its

perilous market position and its presales collection period is longer than its

peers‟ due to attractive installment terms (up to 1 year) offered to cash

buyers. The group‟s recent RMB1.8bn land purchase in Zhuhai further

adds pressure to its weakened liquidity profile. With a similar business size,

similar market position but better liquidity profile, we believe KWGPRO

trading 450bp back of YLLG id unjustified. 3) Switch to HPDLF 16s at 60

mid (28.7%) from PWRLNG 15s at 71 mid (26%) to take out 11 cash

points and pick up 2.7% yield. Hopson has a longer operating history and

thus has better sales execution than Powerlong, as evidenced by its 70%

sales target achieved in 9M11 compared to the latter‟s 36%. Despite

marketing as a landlord, Powerlong‟s recurring income was not meaningful

(7% of EBIT in 1H11) and our street check indicates low occupancy rates

and poor traffic in its shopping mall.

Switch out of some expensive industrial names (exposed to the

infrastructure and property sectors) into property issues to pick up more

yield at flat or lower bond prices: Sell CHOGRP 2015 at 93, LONKIN 2016

at 89.5 or SHASHU 2016 at 92.75, and Buy SHIMAO 2017 at 81.5 or 2018

at 81.75; Sell LIANSU 2016 at 84 or WESCHI 2016 at 82.75 and Buy

ROADKG 2015 at 80.5.

Switch trades among the industrial names: Sell CHOGRP 2015 at 93 and

Buy HYVANL 2016 at 89 to pick up 165bp and 4 cash points, or Buy

MIEHOL 2016 at 88 to pick up 310bp and 5 cash points; Sell FUFENG

2016 at 82 or WESCHI 2016 at 82.75 and Buy WINSWY 2016 at 83.5 to

pick up 50bp or 65bp respectively; Sell LUMENA 2014 at 85.5 and Buy

TEXTEX 2016 at 76 to pick up 9.5 cash points or Buy GJTLIJ 2014 at 84.5

to pick up 1 cash point and obtain better security.


93

HK bank LT2 2020s will likely face high supply risk in the near term. A number

of banks such as Bank of East Asia and Citic Bank International have T2

refinancing needs in 1H12 and they recently established MTN programs

and/or conducted roadshows to prepare for any potential LT2 issuance to

refinance once the market stabilizes. There was even market speculation that

BOCHK was looking to issue a new 10yr LT2 earlier last week, according to

Reuters, although we do not see the rationale for such a move in the near term

given a solid total CAR of 17.6% and limited T2 refinancing needs until June

2013. The latest 3yr USD250 million CD issuance by China Merchant Bank

(BBB; the sixth-largest commercial bank in China) at MS+300bp could open

up the pipeline for more USD senior or LT2 issuance by other Chinese banks.

Against this backdrop of heavy supply pressure, we suggest investors take

advantage of the recent rally to switch out of the HK bank LT2 2020s

(particularly BNKEA 2020, CINDBK 2020, ICBCAS 2020 and FUBON 2020)

into short-dated HK bank UT2 Pnc12 or Pnc13 with reasonably attractive

YTCs (including BNKEA GBP 6.125% Pc12, CINDBK 9.125% Pnc12 and

WINHAN 9.375% Pnc13), which have lagged behind in the latest rally.


94

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97

Appendix: The Construction of Nomura‟s China Stress Index

From our analysis of China‟s macro challenges and risks, we identified 18

indicators to construct our China Stress Index, or CSI for short. The data are

monthly and start in January 2000. For the indicators that are available only on

a quarterly or annual basis, monthly series were interpolated from the longer

frequency data. CSI is then defined as a weighted average of standardized

indicators as follows:

Where CSIt is the composite CSI level at month t; wi is the weight for

the i-th indicator ; and σi are the sample mean and standard deviation of

the i-th indicator, respectively.

Notes: 1) The return on capital is estimated by % year-on-year nominal GDP growth and the cost of capital is approximated by the benchmark 1yr bank lending rate in % pa; 2) The real 1yr bank deposit rate is calculated by subtracting % y-o-y headline CPI inflation from the nominal 1yr bank deposit rate; 3) Average urban household income of the top 20% income decile as a

ratio to those in the bottom 20% income decile. Source: Nomura.

Indicators Data Frequency

Weighting Direction of increased risk

1 Gross capital formation, % of GDP Annual 10.0% Up

2 Difference between year-on-year growth rates of nominal fixed-asset investment and retail sales Monthly 5.0% Up

3 Real estate investment, % of GDP Monthly 5.0% Up

4 Residential housing starts less sales, 12-month rolling sum

Monthly 5.0% Up

5 Return on capital less cost of capital1 Monthly 5.0% Down

6 Real 1-year bank deposit interest rate2 Monthly 5.0% Down

7 Domestic credit, % of GDP Monthly 10.0% Up

8 Bank reserve requirement ratio, % Monthly 4.0% Up

9 Funding from shadow banking sector, % of total social financing Quarterly 10.0% Up

10 Property loans, % of total loans by official financial institutions

Quarterly 8.0% Up

11 Residential property price, % deviation from long-run linear trend Quarterly 8.0% Up

12 Lending attitude of banks as perceived by industrial enterprises, survey diffusion index Quarterly 3.0% Down

13 Industrial companies liability/asset ratio Quarterly 3.0% Up

14 CPI inflation, % year-on-year Monthly 5.0% Up

15 Inflation expectations, survey diffusion index Quarterly 5.0% Up

16 Industrial waste air emission per capita, cubic meters

Annual 3.0% Up

17 A gauge of urban income inequality3 Annual 3.0% Up

18 Number of nationwide labour disputes / total labor force

Annual 3.0% Up

Chien-Hua Chen

+852 2536 7429

[email protected]

Qilong Zhang

+852 2252 6191

[email protected]




98

Appendix: Companies mentioned and ratings

Company Name Bloomberg Ticker Price (LC) 26/10/2011 Rating Target Price (LC)

Australia Primary Health Care PRY AU 3.31 Buy 3.8

Ramsay Health Care RHC AU 18.5 Buy 21

Sonic Health Care SHL AU 11.02 Neutral 11

ANZ ANZ AU 21.59 Neutral 23.5

Commonwealth Bank CBA AU 49.11 Neutral 53

National Australia Bank NAB AU 24.95 Buy 31

Westpac Banking Corp WBC AU 22.3 Neutral 24.5

Boart Longyear BLY AU 3.08 Buy 4.26

Amcor AMC AU 7.36 Neutral 7.1

AGL Energy AGK AU 14.43 Buy 17.5

Coca-Cola Amatil CCL AU 12.12 Buy 13

Telstra TLS AU 3.15 Neutral 3.14

Woolworths WOW AU 24.15 Buy 30

Bluescope Steel BSL AU 0.85 Not Rated -

Onesteel OST AU 1.235 Not Rated -

Orica ORI AU 25.17 Not Rated -

Rio Tinto RIO AU 66.74 Not Rated -

BHP Billiton BHP AU 36.94 Not Rated -

Tabcorp Holdings TAH AU 2.87 Not Rated -

Wesfarmers WES AU 31.9 Buy 39

Myer MYR AU 2.57 Neutral 2.3

Pacific Brands PBG AU 0.58 Neutral 0.65

Treasury Wine Estates TWE AU 3.84 Neutral 3.3

Hong Kong / China LDK Solar LDK US 3.3 Reduce 2.6

JA Solar JASO US 2.19 Neutral 2

Trina Solar TSL US 7.4 Neutral 7

Yingli Green Energy YGE US 3.9 Neutral 3.4

GCL Poly Energy 3800 HK 2.16 Neutral 2.5

China Unicom 762 HK 16.2 Buy 18.5

China Mobile 941 HK 76.3 Buy 90

TCL Communication Tech 2618 HK 3.35 Buy 8

ZTE Corp 763 HK 21.05 Buy 28

Lenovo Group 992 HK 5.64 Neutral 5.1

China Eastern Airlines 670 HK 2.9 Buy 4.65

China Shipping Container Lines 2866 HK 1.45 Reduce 1.2

Hopewell Highway Infrastructure 737 HK 4.19 Neutral 5.69

Beijing Capital International Airport 694 HK 3.42 Buy 5.85

Hopewell Holdings 54 HK 19.98 Buy 32.6

Mindray Medical International MR US 25.1 Buy 34

United Laboratories 3933 HK 6.06 Neutral 6.4

Bank of East Asia 23 HK 28.35 Reduce 24

Wing Hang Bank 302 HK 69.1 Neutral 84

Dah Sing Financial 440 HK 23.2 Buy 50

BOC Hong Kong (Holdings) 2388 HK 18.4 Buy 28

Hang Seng Bank 11 HK 97.9 Neutral 120

China Minsheng Bank - H 1988 HK 6.48 Neutral 7.4

China CITIC Bank 998 HK 3.98 Buy 6.5

Bank of China - H 3988 HK 2.85 Buy 5.2

ICBC 1398 HK 4.57 Buy 7.5

Chongqing Rural Commercial Bank 3618 HK 3.1 Buy 6.52

China Construction Bank-H 939 HK 5.43 Neutral 7.02

Guangzhou R&F Properties 2777 HK 6.96 Reduce 10.46

China Overseas Land & Inv 688 HK 13.14 Buy 21.3

Wharf Holdings 4 HK 37.9 Neutral 53.1

Sun Hung Kai Properties 16 HK 102.9 Buy 166.5

Melco Crown MPEL US 10.91 Buy 17.5

Esprit 330 HK 11.26 Neutral 8.9

Samsonite 1910 HK 12.32 Buy 19.7

Prada 1913 HK 34.45 Neutral 40.3

Li & Fung 494 HK 13.96 Neutral 14.1

Galaxy Entertainment 27 HK 15.34 Neutral 21

SJM Holdings 880 HK 13.04 Buy 23

Sands China 1928 HK 22.1 Buy 30.55

Tsingtao Brewery 168 HK 43.7 Reduce 34


99

Huabao International 336 HK 4.53 Buy 11.7

China Yurun 1068 HK 12.2 Buy 21

L'Occitane 973 HK 16.5 Buy 22.9

Want Want 151 HK 7.09 Neutral 6.6

China Mengniu 2319 HK 25.1 Buy 34

Air China LTD - H 753 HK 6.15 Buy 11.95

China Southern Airlines CO - H 1055 HK 4.48 Buy 6.75

Ping An Insurance Group 2318 HK 53.95 Buy 97

Country Garden Holdings 2007 HK 2.86 Neutral 3.3

China Resources Land 1109 HK 10.34 Neutral 15.79

Alibaba.Com 1688 HK 9.42 Neutral 10

Tencent Holdings 700 HK 177.1 Buy 260

China National Building MA - H 3323 HK 8.74 Not Rated -

Aluminum Corp of China LTD - H 2600 HK 4.05 Not Rated -

China Oilfield Services - H 2883 HK 12.54 Not Rated -

Evergrande Real Estate Group 3333 HK 3.04 Not Rated -

Citic Pacific LTD 267 HK 13.44 Not Rated -

Guangzhou Automobile Group - H 2238 HK 7.82 Not Rated -

Dongfeng Motor GRP CO LTD - H 439 HK 12.84 Not Rated -

Belle International Holdings 1880 HK 14.5 Not Rated -

India Tata Motors TTMT IN 191.8 Buy 200

Tata Steel TATA IN 451.3 Buy 653

Crompton Greaves CRG IN 139.15 Buy 240

Dr Reddy's Laboratories DRRD IN 1593.1 Buy 1911

ITC ITC IN 212.2 Buy 229

Infosys INFO IN 2838.65 Buy 3100

Adani Power ADANI IN 84.65 Neutral 115

Lanco Infratech LANCI IN 15 Buy 30

DLF Ltd DLFU IN 229.75 Buy 270

Oberoi Realty OBER IN 231.9 Buy 284

Indonesia Perusahaan Gas Negara PGAS IJ 2900 Buy 3900

Bank Negara Indonesia BBNI IJ 4025 Buy 4500

Bank Mandiri BMRI IJ 6850 Buy 7900

Bank Central Asia BBCA IJ 8000 Reduce 6700

Bank Rakyat Indonesia BBRI IJ 6650 Buy 8400

Bank Danamon Indonesia BDMN IJ 4950 Neutral 4900

Bumi Resources BUMI IJ 2250 Buy 4750

Adaro Energy ADRO IJ 2000 Buy 2850

Harum Energy HRUM IJ 7850 Buy 11000

Astra Agro Lestari AALI IJ 20400 Buy 28400

Astra Internation ASII IJ 68400 Neutral 72000

Gudang Garam Tbk Pt GGRM IJ 58250 Buy 65000

Telkom Indonesia TLKM IJ 7400 Buy 8700

Jasa Marga JSMR IJ 3900 Buy 4950

Agung Podomoro APLN IJ 330 Neutral 330

Bumi Serpong Damai BSDE IJ 920 Buy 1200

Ciputra Dev CTRA IJ 500 Buy 690

Malaysia Maybank MAY MK 8.27 Reduce 6.85

CIMB Group Holdings CIMB MK 7.26 Reduce 6

Telekom Malaysia T MK 4.23 Buy 4.8

Public Bank PBKF MK 12.48 Neutral 11.5

Hong Leong Bank HLBK MK 10.36 Neutral 10.7

Malaysian Resources MRC MK 1.91 Reduce 1.75

SP Setia SPSB MK 3.85 Reduce 3.45

Mah Sing Group MSGB MK 1.94 Neutral 2.46

Singapore Capitaland CAPL SP 2.52 Buy 4.05

Keppel Land KPLD SP 2.69 Buy 4.9

Wilmar International WIL SP 5.19 Neutral 5.9

DBS Bank DBS SP 12.25 Buy 16.4

Singapore Telecom ST SP 3.19 Neutral 3.45

Ascendas REIT AREIT SP 1.98 Neutral 2.1

UOB UOB SP 17.03 Neutral 21.9

OCBC OCBC SP 8.35 Buy 11.1

Noble (US$) NOBL SP 1.48 Buy 2.5

mewah (US$) MII SP 0.42 Reduce 0.5

Olam OLAM SP 2.4 Buy 3.5


100

South Korea KEPCO 015760 KS 25100 Buy 35000

LG Display 034220 KS 24200 Neutral 24000

Samsung SDI 006400 KS 139000 Neutral 160000

LG Innotek 011070 KS 75200 Neutral 71000

Woori FG 053000 KS 10300 Buy 18000

KB Financial Group 105560 KS 42150 Buy 62000

Industrial Bank of Korea 024110 KS 14650 Neutral 16000

Hana Financial Group 086790 KS 39400 Buy 54000

KT&G Corp 033780 KS 76700 Neutral 66000

Dongbu Insurance 005830 KS 45900 Buy 71000

SK Telecom 017670 KS 161500 Buy 178000

KT Corp 030200 KS 37700 Buy 53000

LG Uplus Corp 032640 KS 7110 Neutral 6000

Taiwan Asia Cement 1102 TT 36.2 Reduce 32.6

Synnex Technology 2347 TT 73.1 Buy 90

AirTAC 1590 TT 167 Buy 300

Taiwan Mobile 3045 TT 86.5 Buy 102

Formosa International Hotels 2707 TT 455 Buy 550

President Chain Store 2912 TT 173 Buy 205

Motech Industries 6244 TT 59.2 Reduce 39

Acer Inc 2353 TT 35.65 Reduce 27

Yang Ming Marine 2609 TT 12.6 Reduce 7.1

First FHC 2892 TT 19.85 Buy 26.5

E. Sun FHC 2884 TT 14.75 Buy 20

Chinatrust FHC 2891 TT 19.35 Buy 28.3

Huaku Development 2548 TT 68.4 Buy 85

Farglory Land Development 5522 TT 50 Buy 67

Thailand Ratchaburi Generating RATCH TB 39.75 Buy 41

Electricity Generating EGCO TB 80 Buy 110

Bangkok Bank (BBL) BBL TB 143.5 Buy 188

Krungthai Bank (KTB) KTB TB 14.4 Buy 23.2

Kasikorn Bank (KBank) KBANK TB 118.5 Neutral 135

Siam Commercial Bank (SCB) SCB TB 108 Buy 145


101

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102

Disclosure Appendix A-1

Any Authors named on this report are Research Analysts unless otherwise indicated

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Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America for ratings published from 27 October 2008 The rating system is a relative system indicating expected performance against a specific benchmark identified for each individual stock. Analysts may also indicate absolute upside to target price defined as (fair value - current price)/current price, subject to limited management discretion. In most cases, the fair value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as discounted cash flow or multiple analysis, etc. Stocks A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of 'Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. 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In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A 'Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. Sectors A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks

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under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation. Explanation of Nomura's equity research rating system in Japan published prior to 6 January 2009 (and ratings in Europe, Middle East and Africa, US and Latin America published prior to 27 October 2008) Stocks A rating of '1' or 'Strong buy', indicates that the analyst expects the stock to outperform the Benchmark by 15% or more over the next six months. A rating of '2' or 'Buy', indicates that the analyst expects the stock to outperform the Benchmark by 5% or more but less than 15% over the next six months. A rating of '3' or 'Neutral', indicates that the analyst expects the stock to either outperform or underperform the Benchmark by less than 5% over the next six months. A rating of '4' or 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark by 5% or more but less than 15% over the next six months. A rating of '5' or 'Sell', indicates that the analyst expects the stock to underperform the Benchmark by 15% or more over the next six months. Stocks labeled 'Not rated' or shown as 'No rating' are not in Nomura's regular research coverage. Nomura might not publish additional research reports concerning this company, and it undertakes no obligation to update the analysis, estimates, projections, conclusions or other information contained herein. Sectors A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next six months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next six months. A 'Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next six months. Benchmarks are as follows: Japan: TOPIX; United States: S&P 500, MSCI World Technology Hardware & Equipment; Europe, by sector - Hardware/Semiconductors: FTSE W Europe IT Hardware; Telecoms: FTSE W Europe Business Services; Business Services: FTSE W Europe; Auto & Components: FTSE W Europe Auto & Parts; Communications equipment: FTSE W Europe IT Hardware; Ecology Focus: Bloomberg World Energy Alternate Sources; Global Emerging Markets: MSCI Emerging Markets ex-Asia. Explanation of Nomura's equity research rating system for Asian companies under coverage ex Japan published prior to 30 October 2008 Stocks Stock recommendations are based on absolute valuation upside (downside), which is defined as (Fair Value - Current Price)/Current Price, subject to limited management discretion. In most cases, the Fair Value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as Discounted Cash Flow or Multiple analysis etc. However, if the analyst doesn't think the market will revalue the stock over the specified time horizon due to a lack of events or catalysts, then the fair value may differ from the intrinsic fair value. In most cases, therefore, our recommendation is an assessment of the difference between current market price and our estimate of current intrinsic fair value. Recommendations are set with a 6-12 month horizon unless specified otherwise. Accordingly, within this horizon, price volatility may cause the actual upside or downside based on the prevailing market price to differ from the upside or downside implied by the recommendation. A 'Strong buy' recommendation indicates that upside is more than 20%. A 'Buy' recommendation indicates that upside is between 10% and 20%. A 'Neutral' recommendation indicates that upside or downside is less than 10%. A 'Reduce' recommendation indicates that downside is between 10% and 20%. A 'Sell' recommendation indicates that downside is more than 20%. Sectors A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation. Target Price A Target Price, if discussed, reflect in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates. Disclaimers

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