How Can China Respond to Global Market Turmoil

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How Can China Respond to Global

Market Turmoil?With the markets in turmoil due to escalating worries about the global economic

outlook, many investors have been questioning what policy measures China

might be expected to implement in the event of a double dip recession in the US

and/or Europe. During the global downturn of 2008-9, China stood out as the

bright spot among major economies, contributing to over 50% of global growth in

2009 as spending on stimulus-related infrastructure projects got underway. We

do not think there is a high likelihood of another large-scale fiscal stimulus in the

event that external conditions deteriorate, considering that:

China has managed to maintain recent growth despite a negative

contribution from net-exports

Policymakers are focusing on containing the risks associated with local

government debt and an imbalanced property market (both issues that

were aggravated by the last stimulus campaign). A second large

stimulus program would exacerbate these risks and intensify the

economic imbalances that the government is trying to curb during the

12th

Five-year plan

There is some leeway for monetary easing when inflation has peaked,

particularly if the outlook for imported inflation is milder.

In the event of another global downturn, the government may support

households through more aggressive pro-consumption measures, and consider

improving the allocation of capital to the more efficient private sector. We would

also expect a higher degree of central government support to ensure adequate

funding for existing investment projects, especially in relation to affordable

housing.

China is relying less on exports for growth, but more is needed to boost

consumption

Chinese economic growth has become less reliant on net exports in recent

years, while the proportion of exports destined for the US and the Eurozone has

been declining (see Figure 1).

In 1H11, China’s economy maintained a reasonably strong pace of expansion

(9.6% YoY), even with net exports detracting 0.43 percentage points and 0.1

percentage points from headline growth in 1Q11 and 2Q11, respectively, as

compared to having contributed an 18.1% share to GDP growth in 2007 (see

Figure 2). The contribution to growth from consumption picked up from 36.8% in

2010 to 47.5% in 1H11, while the contribution from gross capital formation was

53.2% in 1H11 (vs. 54% in 2010). If China’s policymakers want to further shield

the country’s growth outlook from external shocks (without relying on elevatedfixed asset investments), more measures will be needed to boost domestic

consumption.

HANDS-ON CHINA REPORT

August 10, 2011

Jing Ulrich

Chairman, Global Markets, China

+852 2800 8635

[email protected]

Amir Hoosain

+852 2800 8641

[email protected]

Kelvin Wong

+852 2800 8962

[email protected]



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Jing Ulrich HANDS-ON CHINA REPORT – August 10, 2011

10%

12%

14%

16%

18%

20%

22%

24%

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

2 0 0 8

2 0 1 0

2 0 1 2

Figure 1: Chinese Exports by Destination

US

EU

EM

Source: CEIC

With China’s fiscal maneuverability somewhat constrained, the more constructive approach to solving

some of the current issues is to accelerate domestic reforms that aim to stimulate consumption. Many

pro-consumption initiatives have already been introduced, including a massive undertaking toincrease the availability of affordable housing, healthcare reforms to make basic services and drugs

more accessible, as well as an increase of the personal income tax threshold. These and other

initiatives will reduce precautionary savings in the medium- to long-term and liberate a greater portion

of disposable income. A more aggressive solution to unlock consumer spending would be to resume

the process of interest rate reform. Strict controls over interest rates have pushed real savings growth

into negative territory. This has forced the average citizen to seek out alternative (riskier) means to

preserve wealth, which in turn discourages spending, since personal net worth has become more

volatile. In a recent discussion, Nicholas Lardy of the Peterson Institute for International Economics

highlighted the 8% growth of household savings during the period from 2004 to 2010, reaching ~37%

of disposable income at a time when real interest rates were on average -0.3%.



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-7

-2

3

8

13

18

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1H11 2H11

Final Co nsump tio n Gross Capital Formatio n Net Exp orts

Figure 2: China’s GDP by Expenditure, percentage points

Source: CEIC

Division of central and local government fiscal responsibilities

Much of the investment projects that featured in China’s 2008 stimulus package had been planned for

some time, but were fast-tracked as a response to the external downturn. Existing fiscal policy

initiatives are already stimulative - according to the 12th Five-year plan, China will invest as much as

RMB7 trillion into the construction of urban public facilities in the next five years. With rising risks of an

external recession, the central government would probably focus on ensuring sufficient financing for

existing investment projects before contemplating a second major stimulus package.

There is a clear need in China for a redistribution of fiscal revenues and expenditures. Over 50% of

fiscal revenues are currently concentrated at the central level, however the expenditures of the central

government, account for only 20% of nationwide public spending (compared to 30% in Japan and

60% in other major economies). The funding issues associated with the affordable housing initiative

highlights the mismatch between a centrally-issued directive (requiring local governments to lease outland without charge and source the necessary funding) and the difficulty for local governments to

complete targets. On July 15, it was reported by the China Securities Journal that Chen Yuan,

Chairman of China Development Bank, gave an estimate of RMB500 billion for the size of the funding

gap with respect to this year’s affordable housing construction target of 10 million units. China’s

banking regulator has urged banks to extend credit at preferential rates to aid the construction of

affordable housing, while the NDRC said in June that local governments could issue bonds to fund

public housing construction.



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48.9%47.8% 47.6%

45.0% 45.4% 45.1%

47.7% 47.2%45.9%

46.7%47.6%

48.9%

68.5%

65.3%

69.5% 69.3% 69.9%

72.3%74.1%

75.3%77.0%

78.7%80.0%

82.2%

30%

40%

50%

60%

70%

80%

90%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Figure 3: Local governments’ share of revenues & expenditures

Share of Revenue

Share of Expenditure

Source: J.P. Morgan research by Samuel Chen

The current fiscal system gave rise to the recent episode of elevated borrowing by local government

financing vehicles (LGFV). Particularly in the last year, a lack of clarity on the health and magnitude of

LGFVs has raised concerns. Since 2002, local government-related debt has risen substantially from

about 12% of GDP to 27% of GDP by the end of 2010, or RMB10.7 trillion. The chief worry is that a

future increase in non-performing loans (NPLs) could hinder growth. Reports have cited varying levels

of high-risk loans, from a few percent to over a quarter of the total LGFV loan base. However, we are

not overly alarmed in this regard. According to J.P. Morgan’s China banks analyst Samuel Chen, most

of LGFV debt was spent on basic public infrastructure, transportation, and energy sectors, which

generate cash flow and forms a good asset base that can be sold if necessary. Also, based on debt-

to-GDP or debt-to-current fiscal strength ratios, debt affordability is still not stretched. Sam Chen

believes that the need for bailouts is unlikely, especially given that pre-emptive measures have

already been adopted by regulators in the past 18 months. More specifically, he argues that the local

government debt issue will not pose a systemic risk, given that:

1. There are sufficient fiscal revenues to enable the central government to prevent such a crisis,

and they likely will.

2. Owing to closed capital accounts, there will not be a trigger for an uncontrollable liquiditycrunch.

3. Strong fiscal revenue growth is expected in the next few years, which will boost debt

affordability. In particular, budget revenue (ex. land sales) may increase by 20% CAGR in the

next five years.

4. Over 70% of LGFV debt is used in transportation, infrastructure, and energy sectors, which

forms a good asset base that can be sold if necessary.

Going forward, it is highly unlikely for any one local government to default, as the central government

has implicit claim and responsibility on assets and liabilities held by subordinate governments.

However, local governments would still benefit from some degree of reform in the tax system that

would bring fiscal revenues and expenditures more in line.



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More efficient allocation of capital

At the corporate level, capital has historically been allocated inefficiently with an imbalance in accessto credit – i.e., large SOEs have the clout to obtain more favorable interest rates and terms, whereas

private companies (and especially SMEs, which account for 60% of GDP) lack the bargaining power

to access cheaper bank credit and have increasingly relied on alternative lending channels to meet

their frequent borrowing needs. There are signs that government efforts to optimize the loan structure

are having some effect. According to the PBoC, outstanding loans to small and medium enterprises in

2010 stood at RMB17.68 trillion, greater than outstanding loans to large enterprises of RMB13.42

trillion. Moreover, growth of loans to large enterprises was 13.3% during the year, compared to 29.3%

and 17.8% recorded by small and medium-sized enterprises respectively. The government has also

differentiated reserve requirements for Rural Credit Cooperatives and announced trial plans to allow

SMEs to issue bonds in private placements.

Some leeway for monetary easing

The 87% expansion in China’s M2 money supply since January 2008 has given rise to very stubborn

inflation, which has been exacerbated by food supply disruptions and rising commodity prices. As the

government is concerned that inflation could undermine social stability, we do not think that

policymakers will be inclined to unleash another torrent of credit, although there will be greater leeway

to ease policy once inflation is seen to be under control. With the aggressive hikes of reserve

requirement ratios, some RMB16 trillion of banks’ deposit base is still frozen (see Figure 4). A weaker

global economy should also translate into lower commodity prices, which would reduce (imported)

inflationary pressure. With CPI inflation likely to have reached a cyclical peak at 6.5% in July, J.P.

Morgan economist Grace Ng’s baseline scenario is that China’s central bank will likely take a pause

from further interest rate moves during 2H11.

4

6

8

10

12

14

16

18

20

22

24

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

Figure 4: Reserve requirement ratio (%)

Large banks

Small & mediumbanks

19.5%

21.5%

2005

Source: CEIC



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How Can China Respond to Global Market Turmoil