The Deloitte Research Monthly Report
18 November 2016
How should China cope with uncertainties from the U.S. election?
The result of the US election presents many challenges and also opportunities for China. Not only did it come as a surprise to all, especially the media pundits (many of them are still in shock), but also the reaction of financial markets, which quickly began to discount the potential impact of tax cuts and deregulation which could be encouraging. Stock markets have been rallying strongly since Election Day while bond markets have seen substantial sell-offs. Commodity prices have risen and the USD dollar has gone from strength to strength. How does one make sense of all this? More importantly, how should China be prepared itself for a Trump presidency?
First of all, the unexpected election of Donald Trump has created a fair amount of uncertainty in financial markets across the globe. Financial markets, as we all know, do not like uncertainty. However, it is still too early to know what Trump's position on key issues in international policy (such as trade issues other than scrapping TPP, and a threat of imposing 45% of tariffs on Chinese imports and etc.,) will be. Second, Trump’s explicit messages on deregulation and improving infrastructure are being viewed positively as a bullish factor by financials, cyclicals and drug companies. Third, the pledge of tax cuts and a greater spending on infrastructure implies fiscal overruns, which have resulted in higher bond yields. Trump’s tough stance on immigration (building a wall or some sort of fence on the Mexican border) and trade (his promise of “bringing jobs back to the US”) has given support to the greenback because, at least in the short run, protectionism might indeed benefit the dollar.
Financial markets in Asia have reacted in a mixed fashion since the US Election Day, with equities rising and currencies falling for the most part. The RMB has depreciated steadily since the election, extending the fall that started earlier this year. On November 18th it touched 6.88 to the dollar, an 8-year low. However, the RMB has more or less tracked its basket of currencies, suggesting that the People’s Bank of China has taken a more relaxed approach by allowing the RMB to depreciate in light of declining foreign reserves (Oct reserves at $3.12 trn, comparing to $3.17trn in September) and the dollar’s outright strength. Other than continued implicit monetary easing (the RMB has weakened about 10% since 2014) because a lower exchange rate achieves the same effect in terms of monetary easing as interest rate cuts. How should China approach President elect Trump who is known for having said that “anything is negotiable” and has claimed that he would label China as “a currency manipulator” after he gets into the office?
First and foremost, China and the US are economically complementary, and this goes far beyond trade. Any excessive protectionism measures by the US would surely invite retaliation from China. Unlike the period of 2005 to 2010 when China was purposefully holding the RMB exchange rate low, causing economic overheating, today with an economic deceleration and economic rebalancing, China has tried very hard to guide the RMB exchange gradually lower, but more in sympathy with the overall currency basket. Therefore at present one would be hard put to fault China on grounds of currency manipulation. On the other hand, as the largest provider of global liquidity, China’s surplus of savings has lowered global interest rates, effectively making both consumption and investment cheaper in developed countries than they would otherwise have been. Therefore it seems logical to say that the label of “currency manipulator” is not credible today. That said, China should also take Trump’s vague threat seriously. Trump’s victory is another setback for globalization and a reminder that globalization has not benefited all stakeholders evenly. Even in the absence of a trade war between the world’s two largest economies, more trade friction can be expected. This makes it even more urgent for China to slow its economic growth rate and place greater emphasis on rationalizing the sectors of industry that are plagued by over-capacities. For if China tries to export its over-capacity, it will encounter both protectionism and nationalism in the US (and other developed countries).
Second, in the face of Trump’s known flexibilities (he has changed his position on many issues often) and the perception that he does not care ideology, China should be more proactive in seeking mutual grounds with the US. For example, there is no need for China to hold a grudge against the US on the Asian Infrastructure Investment Bank (AIIB) whose birth was undermined by the US. If Trump is indeed willing to take a more positive view on AIIB, China and the US could join forces in such way that investment projects could be diversified into the US where many bridges, roads, highways and etc. need upgrading. The US could also help China in mitigating some of the inherent risks in investments in many emerging markets.
Even with Hillary Clinton in the White House, the Trans-Pacific partnership would have had a hard sell in the US. The stalling of the TPP will give China a much needed respite - because in the final analysis, it is not in China’s best interest to have reduced access to the US, the deepest market in the world. In recognition of this, perhaps China could lower the domestic market barriers to American financial institutions and drug companies as a gesture of goodwill. This will go some way towards easing potential trade tensions. On China’s economic transition, which boils down to shrinking certain industries (steel, shipping, and coal etc.) and promoting services and consumption, China requires a comfortable economic environment (read monetary easing and fewer trade conflicts). As such, the most effective way for China to champion free trade is to engage the US in key initiatives such as AIIB and “one-belt, one-road” and to rebalance the economy.
Finally, on the RMB exchange rate, our 2016 forecast of 6.80-7.0 is more or less being met. Should the Fed decide to tighten interest rates at a faster pace because it expects a higher rate of inflation in 2017 (the hike in December now appears a foregone conclusion), the RMB is likely to remain weak next year. A cheaper RMB will deter capital outflows and improve liquidity eventually, which in turn will spur investment. However, if the US cuts taxes drastically, more investment will go to its manufacturing sector (which has already benefited from competitive prices of energy and land) and the pressure on China to unveil meaningful supply-side reform will intensify.
Integration and innovation are changing the retail landscape
The National Bureau of Statistics of China reported that the total retail sales of consumer goods registered a year-on-year increase of 10.3% to reach RMB26.96 trillion in the first 10 months of 2016, with September showing a 10.7% rise, the year’s highest single-month growth to date. For the same period, national online retail sales of goods and services topped RMB3.9 trillion, a whopping 25.7% year-on-year increase. The ratio of online retail sales of goods to total retail sales of consumer goods rose one tenth of a percentage point to account for 11.8% of the total. Monthly sales growth of one hundred large retail enterprises topped 2.1% in September, the highest single-month growth rate in 2016, 3.7% higher than the growth rate for the first 9 months of 2015. For these enterprises, sales growth of apparel, jewellery and household appliances showed a marked increase in September.
The following are Deloitte Research’s findings and core insights on the 5th Brand Conference and 2016 China National Retail Congress:
- In accordance with the theme of China's economic transition, the retail industry is undertaking an unprecedented transformation. Starting last year, retailers defied traditional wisdom and initiated reforms that focused on demand creation and demand satisfaction in response to the changing needs of China's consumers. Consequently, new patterns are emerging. The new retail industry is all about putting the consumer at the center and building a consumer-centered model with an eco-system and advanced supply chain system as its core components. In order to promote industry development, retailers will focus on three aspects. First, retailers will target commodity and supply chain optimization in order to provide consumers with more valuable goods, services and experiences. Second, through innovation, retailers will improve existing retail formats and come up with new formats that can better satisfy the needs of consumers. Third, retailers will work together to explore the path of innovation and transformation and to build a new retailing landscape.
- To retailers, innovation means changing their way of thinking and implementing while keeping the essence of the business model unchanged. To that end, retailers will focus their efforts on developing, integrating and improving channels, thematic staging and connectedness. Retailers will first try to provide integrated services to consumers with fragmented needs through an improved Omni-channel system and then overhaul the traditional retail model. Second, through thematic staging which offers more experience-oriented services, retailers will build greater connectedness with the consumers. Such interactions between retailers and consumers will become a new source of two-way innovation. Third, retailers will try to strengthen their connectedness with different resources, partners and consumers. Through the enhanced connectedness, retailers will build their own consumer-oriented eco-system. Gome is a good example of a business which has developed a new retail model by integrating resources with the supply chain system. As a result, it has registered growth over a period of fourteen consecutive quarterly cycles. From 2012 to 2015, Gome recorded a CAGR of 17.3%, almost twice the industry average. Gome now has 399 new format retail stores which have been revamped with experience-oriented facilities. These new stores attracted around 30 million visitors in 2015.
- After a period of explosive growth, the online retail market is growing at a much slower pace. Fierce competition and excessive investments have begun to take their toll, squeezing the profits of online retailers and brand companies alike. In response, some internet brand companies have resorted to re-building and revamping their own platforms or eco-systems based on their mature brands and operation capabilities. Handu, for instance, is building its own eco-system by integrating internal and external resources, its own brands, offline brands and emerging brands and providing them with customized operating services. Internet brand companies are also exploring omni-channels as a path forward. Huimei (INMAN) started its Omni-channel development about one year ago and now Huimei (INMAN) is in the process of optimizing its channels which consist of physical stores, online stores and WeChat stores. Online retail giants have already been heavily investing in the new omni-channel model. In the past year, Alibaba and Suning finished their cross shareholding plan while JD reached agreements with Yonghui and Walmart. Online retail giants are also building their own consumer-centered eco-systems through integration of online resources with supply chain resources, store networks and after-sale services of brick-and-mortar retailers.
Modest growth expected for virtual reality (VR) devices
Deloitte's 2016 Global Mobile Consumer Survey found that only 15% of Chinese consumers own Virtual Reality (VR) devices, a percentage which is much lower than traditional digital devices such as computers (93%), mobile phones (87%) and tablets (53%). Demand for VR is still far lower than wearable devices (47%) which has seen rising demand in the last few years. The result indicates that VR's development is still at an early stage. Even though there are certain hardware and content available, the technology has not matured, and the hardware and software integration issue has not been resolved, which limits the ways in which consumer's may use the devices. Since less than 30% of consumers surveyed intend to purchase VR devices in the next 12 months, it is unlikely that VR will gain rapid momentum in the market.
For manufacturers therefore, it is imperative to improve the existing VR technology, enhance user experience and create product differentiation in order to enhance the interaction of devices with consumers. On the anvil are several revolutionary innovations. In the future, VR devices will have a more comprehensive perceptual system, such as touching, smelling and even 360-degree sensing system. In addition, another development direction is using a faster processor to enhance battery performance and heat reduction. This will make VR devices smaller and more mobile.
For content providers, VR content involves high production costs and skilled professionals. At present, VR content is dominated by games. But as production costs decrease and equipment becomes more affordable and easier to use we expect that content will become more diversified. With the introduction of social content, more consumers will participate in content creation, enabling consumers to be content producers as well.
In addition to software and hardware, network speed is also crucial for VR to become popular in the future. For example, a VR content cloud requires high network bandwidth to achieve real-time interactivity. Therefore, VR technology will push telecom operators and cloud storage providers to speed up technical innovation and force them to upgrade their services.
In the long run, as the VR industry chain matures, chip and sensor manufacturers, equipment manufacturers, content service providers and operators will all benefit. However, the price value of hardware will be weakened just like today's mobile phones, and VR content and services will become the key profit generator. In this regard, VR manufacturers need to develop a twofold strategy - accelerating deployment of strategic plans for the content and service markets as well as coming up with solutions to the VR hardware and connectivity problems as soon as possible.
Life Science & Healthcare
Online prescription drug sales: a long way to go
The Internet Market Access Negative List (the First Batch, for Trial Implementation) recently formulated and announced by the National Development and Reform Commission (NDRC) shows online prescription drug sales are unlikely to be permitted in the short term. According to the Negative List, pharmaceutical manufacturing and trading enterprises are not allowed to sell prescription drugs directly to the public through postal mail or Internet.
Regarded as the most promising sector in medical e-commerce, online prescription drug sales have been highly anticipated by the market. Such a move will help eliminate hospitals' monopoly in the field of drug circulation and sales. Not only will it cut drug prices, but it will also create a huge market for pharmaceutical merchandising enterprises. In the US, the mature market for online drug sales, online prescription drug sales account for 30% of total drug sales. In China, the fact that prescription drug sales in 2015 touched RMB1.18 trillion in revenue shows that there is a huge market potential here.
The government has tended to be more cautious with medical e-commerce, as online prescription drug sales will lead to potential challenges in terms of implementation and regulatory issues. Prior to the Negative List, in July 2016 CFDA also halted drug sales via third party online platforms (Yao.Tmall, Yihaodian and 800 Pharma) altogether. Taking into consideration the work that remains to be done on drug traceability systems and prescription outflow policies, we still have a long way to go before the ban on online prescription drug sales is lifted.
However, hopes still remain for online prescription drug sales as the Negative List is still a draft seeking public comments and NDRC has classified the prohibition of online prescription drug sales as an item that should be finalized only after pilot trials. From a policy point of view, there have been several favourable policies on online prescription drug sales in recent years (see the table below). In conclusion, in the long run online prescription drug sales will receive permission (in line with the general trend worldwide) and benefit medical e-commerce but this is unlikely to happen in the near future.
Related policies on online prescription drug sales in recent years