The Deloitte Research Monthly Report
19 January 2017
Time to remove certain policy objectives
The most fitting word to describe the Chinese economy in 2016 is resilience. The Housing market epitomises this quality. At the beginning of last year many had taken a rather dim view of its prospects for growth. But, surprising all forecasters, both prices and sales of residential properties have risen significantly in 2016.
The automobiles market has posted another year of strong growth. Sales have grown by 13.7% in 2016 from a high base: The sale of 24.6 million automobiles in 2015 had prompted pervasive speculation that auto sector growth in 2016 was at best likely to track the growth of GDP. This pessimism has been belied.
Not surprisingly, therefore, there has been a reversal of sentiment in the market. The PPI (Producer Price Index) which had been falling for more than 4 years changed direction in September 2016. This could be a sign that China’s industrial sector, which has long been plagued by over-capacity, is showing signs of a cyclical upturn. As a result, the economy has been able to sustain its 6.7% per cent growth rate.
However, 2016 also ended with heightened volatility in domestic bond and foreign exchange markets. As the US stock market is being buoyed by the increasing prospect of tax cuts and fiscal expansion, the Fed is likely to step up its tightening (probably at least 3 times in terms of Fed Fund rates in 2017) in order to arrest higher inflation caused by a strengthening economy and limit the fiscal deficit. Bond yields are likely to rise further in China in sympathy with the US rates and more importantly due to stress in the financial sector (caused, for example, by a decline in the value of financial assets being managed by banks).This, indeed is why policymakers have made financial sector stability one of their main goals. This means that closing zombie companies and writing off non-performing loans will be given priority as the interest rate environment becomes more challenging.
Will the PBOC raise interest rates in 2017? Clearly it would prefer to keep them low to give financial institutions a chance to repair their balance sheets in a relatively benign environment. But it will have to balance this against the need to stabilize both the exchange rate and the level of foreign reserves, which will become more difficult if the interest rate differential between China and the US continues to widen in 2017 (Reserves stand at around $3trn at the end of 2016).
In 2016, in spite of running down its foreign exchange reserves the PBOC had found it difficult to stabilise the exchange rate against the dollar, and had been able only to do so against the entire basket of currencies. It will find it even more difficult to keep interest rates down if the policy makers ask it to keep both the RMB/ dollar exchange rate and foreign reserves stable?
Heightened volatility in domestic bond and foreign exchange markets
These difficult policy choices aside, China also expects to face some tough tests from the new administration in the US. According to Dr Zhu Min, former Vice President of IMF, Trump’s decision to restart negotiations on NAFTA is a sure indicator that he intends to impose tariffs on selected imports from China.
Policy makers find it inconceivable that the Trump administration will be able to follow through on the promise he made during his presidential campaign to designate China as a “currency manipulator,” because China has been trying hard to prop up the RMB by running down its reserves and implementing stringent controls on overseas asset acquisitions and residents’ purchases of foreign exchange.
A full-blown trade war between China and the US is unlikely, but frictions over trade with the US do loom large on the horizon, especially after the appointment of Peter Navarro to head the newly created National Trade Council.
All in all, 2017 will be challenging for both emerging markets and China due to a hawkish Fed, rising protectionism in the US, and continued political uncertainty in Europe. Unforeseen events there could cause a persistent capital outflow to the US, which is increasingly being perceived as a safe haven against market jitters elsewhere. On balance, we foresee the following trends in the Chinese economy in 2017:
- It will be increasingly difficult for China to boost GDP growth by higher leverage (increased resort to debt finance), mainly due to financial sector stress. This implies that policymakers may well accept a lower growth target. We therefore forecast a GDP growth rate of 6.2%.
- The RMB to dollar exchange rate will remain a key focus especially as many residents may want to use up their annual quota of $50,000 per head in the beginning of 2017, in case this is reduced later in the year. We are of the view that a one-time adjustment of USD/RMB remains the best policy option, but the bias within the government remains in favour of a muddle-through mixture of exchange rate management and ad hoc administrative controls in the short run. The reality is that a depreciation of the RMB remains the most convenient tool for reflating the economy given that the PBOC won’t be able to cut interest rates in 2017. We therefore forecast an RMB to USD exchange rate of 7.3 to 7.4 in 2017.
In conclusion, China still has many policy options, but given the imminent rise in US interest rates and the uncertain political climate in Europe, it would be wise to limit the number of policy objectives in its bid to rebalance the economy. If the GDP growth target could be modified, say to 5%, it would greatly increase its flexibility in the choice of policies.
Transformed retail industry will have trickle-down effect in 3rd and 4th cities
The National Bureau of Statistics reported that the total retail sales of consumer goods registered a year-on-year increase of 10.4% to reach RMB30 trillion in the first 11 months of 2016. For the same period, national online retail sales of goods and services topped RMB4.6 trillion, a year-on-year increase of 26.2%, with the ratio of online retail sales of goods to total retail sales of consumer goods rising a substantial 0.7% sequentially to account for 12.5% of the total. Monthly sales of one hundred large retail enterprises in the month of November recorded a year-on-year increase of 0.6%. The monthly sales growth of one hundred large retail enterprises exhibited stability, hovering around the flatline since July. As traditional retail enterprises are undergoing a comprehensive transformation, sales at these one hundred large retail enterprises are likely to rebound one way or another.
At the beginning of 2017, Deloitte Research reviewed the retail landscape and extracted some key trends of China's retail market. The core insights are as follows:
- With further globalization and integration of the world economy, global competition of electronic commerce becomes increasingly fierce. Chinese Internet enterprises (with Alibaba leading the way) play a key role in this as they meet domestic consumers' active demands with high quality foreign goods as well as provide opportunities and platforms for Chinese manufacturing enterprises and brands to go abroad. Cross-border online retailers have been experiencing explosive growth in the last two years. Even though a new policy published in 2016 dampens the cross-border online retailers' growth, it helps the entire industry move towards deeper integration and optimization, providing an opportunity for the industry to grow along a consistent and healthy path. Represented by YMatou.com, a number of cross-border online retailers tried to integrate their resources, broaden the type of merchandise and coverage of related countries, and improve the cross-border logistics system. As a result, YMatou.com registered growth as much as three times in the winter of 2016. Similar integration of broad industry resources will facilitate the continuous advancement of globalization in the future.
- In lockstep with the theme of China's economic transition, the retail industry is undertaking an unprecedented transformation. Retailers started to defy traditional wisdom and initiate reforms that focus on demand creation and demand satisfaction. The new retail industry is all about putting the consumer at the center and building a consumer-centric model with eco-system building and advanced supply chain system creation as its core components. In order to promote industry development, retailers will focus on three aspects. First, retailers will attempt to optimize commodity supply chains in order to provide consumers with more valuable goods, services and experiences. Second, through innovation, retailers will improve existing retail formats and create new formats that can better satisfy needs of the consumers. Third, retailers will work together to blaze new trails of innovation and transformation to create a new retailing landscape. In this Gome is leading the way. By promoting Gome Purchasing, Gome Butler, Anxun Logistics and Horizontal Alliance, Gome successfully integrated internal and external resources and recorded sustained growth.
- Consumer group differentiation has been on the rise while spending power in tier 3 and 4 cities and rural areas will be further unleashed. From 2015, rural e-commerce kicked into high gear. Rural market reached RMB353 billion RMB in size in 2015 according to CECRC, becoming an important new growth driver. The potential spending power of the aforementioned areas is attracting retail giants, leading high-profile companies and capital to tap into those markets. As the supply chain network improves, purchasing power in these area will be further unleashed. Alibaba integrated Taobao, Ant financial and Cainiao to promote the rural partnerships and logistics. Suning employed different platforms and strategies to boost the development of agricultural products brands while JD focused on the perfection of the trading infrastructure in rural areas. With the efforts of these leading companies, such areas will undoubtedly enjoy higher consumption growth.
- More capital will be flowing into the retail industry. From 2014, mergers and acquisitions in retail industry have been on the rise. As a matter of fact, the relentless pursuit of growth on the part of traditional retailers in the face of adversity and rampant expansion by online retailers contributed to acceleration of M&A activities. On one hand, traditional retailers actively seek to transform themselves into multi-channel and multi-format diversified retailers through mergers and acquisitions. On the other hand, online retailers motivated by the build-up of an Omni-channel and consumer closed-loop ecosystem are encouraged to broaden their businesses through mergers and acquisitions. As for PE/VC investments, it appears that capital becomes more targeted as total investment amount registered a whopping year-on-year 30% increase to reach US$13.1 billion even though the number of enterprises which obtain financing by the middle of December 2016 dropped to around 500 from 820 in the comparable period in 2015. Among all the primary investments, relatively successful online retailers in different market segments obtained sustained investments, For instance, Meilishuo and Mogu Street (which target female consumers) and Fruitday and Yiguo (which are in fresh products business) all have received follow-on investments. The deeper involvement of investment capital guarantees the continuously expansion of those enterprises.
- As change in the retail market is closely connected to technological advancements, the adoption of technology and innovation is a key driver to the transformation of retailers. Represented by emerging technology such as big data, Internet of Things (IOT), artificial intelligence (AI) and AR/VR, technological advancement will lead to a new wave of industry changes on the heels of the era of mobile Internet. For the online retailers, the big data-based customer and operation analyses have been broadly used, which propelled AI and AR/VR to be the harbingers of next round of experience optimization which IOT, VR/AR, big data will be broadly adapted by brick-and-mortar retailers as well. They are being used to improve the consumer experience, to optimize the supply chain as well as to enhance the advancement and innovation of the retailing formats, becoming significant impetus for the transformation of the brick-and-mortar retailers. Introducing technologies such as robots, VR equipment and hand-held UAV, Funtalk store in Beijing Aegean Sea Shopping Centre combined its unique products with scene-based services to create a new retailing format. In addition, in line with the location information of Amap LBS and AR scenario application, AR red packets were launched by Alipay at the end of 2016. All of them are new efforts that lead to retail market transformation through technology. A new generation of technology has been deployed by retailers to various degrees. Although time is required before the technologies can become mature and be ready to take off, the significance of adopting technology to bring about retail market transformation has become pronounced.
The year of technology breakthroughs
Prints charming: beyond password recognition
Billions of smartphones and tablets are expected to be capable of processing and collecting multiple types of biometric inputs in 2017, but usage of fingerprints is likely to lead the way. We predict that about 40% of all smartphones in developed countries will incorporate a fingerprint reader as of end-2017 of which at least 80% of the users with a fingerprint reader-equipped smartphone will use this sensor on a regular basis. China's fingerprint identification development rate was significantly higher than developed countries as the proportion of smart phones installed fingerprint identification has reached 49%. And following rapid growth in 2016, fingerprint identification is expected to become the primary authentication method of smart phones in 2017.
DDoS attacks enter the terabit era
We predict that in 2017 Distributed Denial-of-Service (DDoS) attacks will become larger in scale, harder to mitigate, and more frequent. First, the installed base of insecure Internet of Things (IoT) devices (such as connected cameras and digital video recorders) that are usually easier to incorporate into botnets than other devices such as PCs, smartphones and tablets is growing. Second, the online availability of malware methodologies allows relatively unskilled attackers to corral insecure IoT devices and use them to launch attacks. Rapid growth of cell phone and computer users also causes rapid rise in the number of potential weapons. Besides, the availability of ever faster bandwidth speeds (including the growth in the range of Gbit/s and other ultra-fast consumer and business broadband products) means that each compromised device in a botnet can now send a lot more junk data.
5G: rapid development
We predict that further steps towards the launch of 5G will take place in 2017: more than 200 carriers globally are likely to be offering LTE-Advanced (LTE-A), which incorporate many of the core 5G network components, across some of their 4G network by the end of 2017 while global operators accelerate commercial deployment. Meanwhile, China’s Big Three telecommunication operators are actively promoting 5G network with China Mobile being the fastest after ratcheting up development timeline. Faster speed, low latency and high capacity will drive the development of 5G in three major areas. For video, 5G effectively solve the unsmooth display caused by slow speed and instability under crowd-intensive scenes. For VR (Virtual Reality), they achieve smooth interaction among VR devices. For autonomous vehicles, they greatly reduce end-to-end delay to 1 millisecond, which is a substantial increase for the safety of unmanned vehicle.
Brains at the edge: machine learning goes mobile
We predict that over 300 million smartphones will have on-board neural network machine-learning capability. Brain-inspired chips will be an important direction of machine-learning hardware, with the development of compact neural network algorithm. China has made headways in brain-inspired chips which mimic aspects of the human brain’s structure and function, with elements representing neurons and their interconnections, allowing smartphones to perform machine-learning tasks even when they are not connected to a network. Compact neural network suited for mobile will enable tasks such as voice recognition, handwritten symbol recognition and language translation to be performed better on mobile phones in 2017.
TV advertising: programmable purchase and multi-screen marketing to become the norm
Two factors make it possible for programmable purchase and cross-screen marketing to become the norm. First, Smart TV's big screen has obvious advantages as an advertising platform. Smart TV has already become one of the most commonly used household appliances with more than 90% penetration rate and large-screen TV advertising has much stronger impact on audio-visual experience to enhance the brand image than other screens. Second, multi-screen data will be able to connect Internet TV with the programmable purchase to achieve cross-screen data and obtain precise profiles and more labels to create consumers’ profile. In 2017, we will see more cross-screen marketing driven by programmable purchase.
Have we reached peak tablet?
We predict that 2017 sales of tablets will be fewer than 165 million units, down by about 10%. The data in developed countries shows lower levels of penetration and usage for tablets compared to the “big three” consumer devices, namely, smart phones, PCs and TVs. Likewise, China's Tablet PC market sales are on gradual decline largely due to competition from large-screen smartphones and light-weight laptops as well as the lack of replacement incentive. Two-in-one tablets introduced by Microsoft, Lenovo, Huawei and other manufacturers has so far failed to revert disappointing sales because they have less portability than traditional tablets and are lower in performance than computers. Tablets may likely have another sales boom in the future if they incorporate the latest breakthrough technologies, such as OLED flexible display screen and VR. OLED can further expand the portability and screen display area while VR combining with tablets can cover more usage scenarios to stimulate the consumption of tablets.
Life Science and Healthcare
China’s efforts to provide affordable healthcare are changing firms’ business models
The entire industrial chain of life science has been impacted by the medical reform centring on cost control. With production process, the government has released a policy on quality consistency evaluation for generic drugs so that more original-research, brand name drugs could be replicated and replaced by qualified generic drugs. This measure will not only lead to the higher industry concentration, but also will bring about price pressure to original-research, brand name drugs which are less cost-effective in a long time to come. With distribution system, the "two-invoice system" (an enforced system which is stipulated by the Government in limiting invoices to two between drug producers and hospitals) has changed the base price sales model into high price sales model, resulting in compliance and tax pressure to pharmaceutical enterprises. The twin-invoice system is aimed at cutting cost of drugs. However, based on Deloitte’s investigations, the measures of limiting numbers of invoices to two have not resulted in much reductions of drug prices. In addition, traditional pharmaceutical marketing model is under mounting pressure as a result of the increasingly strict supervision on downstream hospitals and the policy on removal of medicine mark-ups and proportion on sales on drugs under tight control.
In the context of medical reform, the drug sales channels will inevitably move downstream in the long run due to the hierarchical medical system, the combination of New Cooperative Medical System and Urban Residence Basic Health Insurance, the gradually disintegrating Essential Drug Scheme and the increasingly strict cost control over general hospitals. Local pharmaceutical enterprises have advantages of channels of primary hospitals and retail pharmacies, an indication they are more likely to gain sales growth in this trend. Meanwhile, multinational pharmaceutical enterprises also begin to focus on the deployment in downstream markets, including county-level hospitals, community health service centers and drug stores. However, these multinationals are faced with challenges of thin profit margins in the downstream market.
Changes in the industry are underway as a result of policy trends and market competition. For local enterprises, a large number of inferior enterprises will be forced out of the market while the superior ones with competitive products and/or sales channels will become stronger, leading to an increase of M&As and integration activities. Multinationals which will come under revenue pressure are, on the other hand, transferring low-margin and non-core business to local enterprises or outsourcing teams. Such development is expected to accelerate in the future. However, for those multinational enterprises which are willing to reduce drug prices in exchange for larger market, opportunities do exist in consideration of supplemental health insurance in pilot cities and commercial insurance programs.
Overseas M&As will continue to accelerate. Overseas M&As have become a significant method for domestic pharmaceutical enterprises to break out of the domestic funk against the backdrop of tighter cost control pressure, operating pressure of consistency assessment, inadequate R&D capability, overvaluation of potential domestic target companies and depreciation of RMB. There will be more Chinese enterprises acquiring overseas companies with advanced technology to promote efficient innovation, and this trend is expected to continue in the future. In particular, the assets from the US (pharmaceuticals), Israel (medical devices), Europe (medical services) and Australia (medical services) will be particularly appealing to Chinese pharmaceutical companies.