The Deloitte Research Monthly Outlook and Perspectives
18 July 2017
All eyes on credit growth in the second half of 2017
The Chinese economy performed better than expected in the first half of 2017. GDP growth of 6.9% exceeded the official target of “around 6.5%” while inflation was well within the target of 3%. Consumers are resilient while the trade sector is recovering strongly. Yet the issue is not whether China can or cannot achieve “around 6.5%” GDP growth, but rather the cost of maintaining such growth. For it has become increasingly clear that pushing for growth will create instability in the financial sector and weaken the economy ultimately.
But policy makers are aware of this and financial sector stability has begun to be given greater priority in the policy agenda. Except for a significant correction in housing prices, the general trend of managed economic deceleration remains intact and as such, the growth rate of the 2nd half of the year is likely to be lower than that of the 1st half of the year.
Preventing systemic risk has been underscored by the PBOC repeatedly in recent weeks. To paraphrase President Xi Jinping on housing, “homes are meant to be used as shelters, not for a quick flip”. Commercial banks are under strict quota guidance on mortgage underwriting. In practical terms, this means previously qualified home buyers might be either priced out of the market, often due to a much higher down-payment requirement (could be as high as 60% of the notional amount of the homes), or be forced to pay higher financing cost (making the cost of informal lending prohibitively high). The reality of the situation is that most Chinese consumers still regard housing as the most reliable vehicle of investment; and despite such lofty valuations, demand for housing in major cities remains strong.
And yet, it is also becoming clear that housing valuation in major cities is extremely high by conventional measures (e.g., rental yields and affordability, etc.).The Chinese economy is extremely sensitive to changes in demand for housing as housing accounted for 8% of GDP growth in 2016. This year however, mortgage underwriting came down sharply from Q1 (see chart). Much reduced housing transactions caused by tightening (more through quotas less by higher financing cost) will eventually weigh on housing prices which could deter further buying (Chinese consumers are prone to chasing a rising market). Policy-induced housing sector slowdown is one of the reasons for us to envisage a slowdown in the 2nd half of 2017. Auto, another bellwether, has also shown signs of slowdown (we recently revised 2017 car sales to between 1-3% yoy from about 5%). How will these effect growth? Will 2017 GDP growth be on track of “around 6.5%”, the highly touted official target? We think so mainly because the cushion in H1 in terms of GDP growth could give policymakers more wiggle room in H2. In the grand scheme of things, there is little difference between 6.4% and 6.6%. To quote Premier Li Keqiang’s remarks in Davos this summer, “1% of GDP is as much as 1.5% five years ago and 2% ten years ago”. From our perspective, 6.4% is better than 6.6% for a simple reason – a slower growth rate is a precondition for de-leveraging. Therefore, tolerance of a slower growth rate implies a greater commitment to de-leveraging.
Chart: Mortgage underwriting down sharply on strict quotas
More importantly, if policymakers could gradually guide public expectations on GDP growth rate lower, they could focus more on other goals. For example, the RMB exchange rate, another `bone’ of some contention. For five straight months, China’s foreign reserves rose, ending up at $3.06 trn in June 2017. By any yardstick, such a massive reserve is more than what China needs from the perspective of serving external debt ($1.44 trn in March, according to the SAFE under the PBIC) and meeting needs of imports. Meanwhile, China continues to generate a healthy current account surplus of around $30-40bn a month, which further reduces the need for accumulating reserves. Such a significant increase in reserves implies that capital outflows were largely mitigated by inflows. Indeed, the announcement of “bond correct” which was created as a mechanism for foreign institutional investors to invest in China’s vast fixed income market is another boost for future capital inflows.
Despite improved sentiment, we would like to reiterate our long held view that China would be better off if the PBOC does not draw a line in the sand at around 6.80 RMB to the dollar (effectively making a quasi-fixed exchange rate regime a policy objective). Of course, the decline of the USD index, and the appreciation of several major currencies (e.g., EURO, Yen and the Canadian dollar etc.) has made PBOC’s intervention fairly painless. The question is whether PBOC’s interventions will compromise other policy goals when the greenback begins to rally. To buck the trend in the Foreign Exchange market is not easy even for the most powerful Central Bank and to do so when interest rates are not moving in your favor is doubly difficult. In the US, a record making equity market is putting the Fed on a course of steady tightening. In Canada, the Bank of Canada has hiked interest rates for the first time since 2010. In Australia, last summer’s interest rate cuts by the RBA have turned out to be a mistake in light of a red-hot housing market, further tightening is imminent. In the Euro zone, the ECB could unwind quantitative easing sooner than expected with a recovering economy and buoyant asset markets. If history is any guide, monetary tightening by the Fed tends to expose risky assets and increase vulnerability.
Will the PBOC hike rates in response to a less dovish Fed next year? In China, it is difficult to argue conclusively that the bond market is bearish (notwithstanding a few financial jitters, e.g. shadow banking) as inflation is under control (June CPI came in at 1.5% yoy) and a cooling housing market can only have an even more dampening effect on inflation in the future. But the widening interest rate differentials between China and the US could well result in downward pressure on the RMB, ceteris paribus. At this juncture, a stable RMB and rising reserves are being perceived as an important sign of stability in the run up to the 19th Party Congress (dates have not been announced yet but it will most likely be in early October). In other words, any important changes in the RMB exchange rate are unlikely to happen in the next three months. On the other hand, the Fed is almost certain to hike Fed Fund Rates this September. To complicate the situation, potential trade spats between the US and China could be worsened by geopolitical risks in North Asia. The 100-day program which was aimed at reducing trade imbalances between China and the US following the heralded Xi-Trump meeting in Mar-a-Lago has had mixed results. Disregarding economic theory on how misleading bilateral trade figures are, the Trump Administration continues to harp on reducing trade imbalances with China. The efforts made by China to import US beef and to open the market for US rating agencies appear piecemeal from the perspective of the Trump Administration.
Chart: Sino-US trade imbalance continues to widen
What should China do in order to avert an escalation of trade disputes (tariffs on China’s steel imports are unreasonable but not unexpected)? Previously tried remedies such as voluntary reductions of exports, as done by Japan and Korea in 80s and 90s of last century, are hardly solutions for China.
The win-win situation, in our view, is for China to improve market access significantly to the US companies who are eager to explore unfulfilled demand in consumer and service related sectors in China. To enhance market access should not be viewed as a concession to the US but rather a catalyst for reforms in sectors where competition is lacking. In addition, China could leverage its competitive advantage in building infrastructure and its surplus of savings by participating in the upgrading of roads, bridges and grids in the US. Such “grand bargains” would significantly mitigate trade friction and allow China to adjust the RMB exchange rate based on domestic economic conditions rather than geopolitical ones. On geopolitical risks in North Asia we see an impasse because China tends to favor the status quo but such a “status quo” from the US perspective, is a moving target. If the US puts “sanctions on steroids” (to quote a former State Department official) on Pyongyang, Chinese firms could also face penalties. Market access is no silver bullet, but it is important to recognize the fact that reduction of trade imbalance is far beyond ad hoc exports of US commercial aircrafts and agriculture produce.
Looking ahead, if the primary policy focus in the 2nd half of 2017 is to be preventing financial risk, then it really boils down to policymakers’ commitment to reining in credit growth. June saw M2 growth moderate to 9.4% yoy (against 9.6% yoy in May), which is encouraging. The challenge is how to force SOEs to reduce leverage without lowering GDP targets. On monetary policy, the obvious choice is for China to maintain a loose monetary stance so that firms’ de-leveraging exercises can proceed smoothly. But with rising global interest rates, could the PBOC stabilize both the RMB exchange rate and level of foreign reserves? There are no easy answers to any of these questions. What China could and should do is to make the business environment friendlier so that the private sector (including foreign firms) and consumers could increase demand against a backdrop of economic moderation.
Grocery industry is entering into a new era
While market pundits have been predicting the demise of traditional retailing for the last several years, what has happened is in fact the opposite. Amazon, on June 16, announced it would spend $13.7 billion to acquire Whole Foods, the largest natural and organic food supermarket in the US. This will be Amazon’s largest acquisition to date and it lies firmly in the brick and mortar world. According to L2 Consulting, the deal could make Amazon the fourth largest grocer in the North American grocery market, taking competition in the US food retail sector to ever greater heights. Traditional retailers already face huge competition from domestic giants such as Target, Costco and even Wal-Mart. The entry of Amazon in this sector means that traditional businesses that lag behind in last-mile services, category combinations and pricing strategies will have to fight to survive.
Amazon’s acquisition is an admission that physical stores are still essential in the grocery retail business. In China, where e-commerce penetration ranks higher than anywhere else, online giants have been one step ahead of the game, buying into the retail sector since 2015. JD, for example, invested RMB 4.3 billion in Yonghui supermarkets in August 2015. JD then purchased a 5% stake in Yihaodian in June 2016 and introduced Wal-Mart as its strategic partner. Wal-Mart in turn increased its holdings of JD's shares and became JD’s third largest shareholder. Alibaba, on the other hand, invested in Hema and opened its first store in Shanghai in January 2016. Since then, the store has become an important element in the offline grocery market for Alibaba. Later the same year, in November 2016, Alibaba invested RMB 2.15 billion in Sanjiang Group (an A share-listed company with Alibaba investment) and in May this year obtained an 18% stake of Lianhua Supermarkets. Alibaba’s rapid expansion into the grocery sector is very significant and quite possibly the reason why others followed suit. This knowledge of the Chinese market has provided Deloitte research with a unique viewpoint for analysing the impact of the entry of e-commerce companies like Amazon into local retail markets. Here are a few of our conclusions:
- Investment in offline retailers will aid e-commerce firms tap into offline retail markets, where more than 80% of total consumption happen, and promote the Omni channel development of these e-commerce firms. Grocery purchases create enormous amount of data which can reveal behaviour patterns and propensities of offline consumers but the penetration rate of e-commerce in this category remains low. At the same time, physical retailers can also help e-commerce enterprises to rapidly expand their offline footprints. Whole Foods will bring 450+ physical stores to Amazon and help the former move into states they have no prior access. Yonghui supermarket and Wal-Mart, Sanjiang Shopping and Lianhua supermarket also brought JD and Alibaba respectively thousands of offline stores. These physical stores will become important components of logistics networks, last-mile services, and experience innovation for e-commerce enterprises.
- The entry of China's e-commerce giants into brick and mortar retail has been very successful, pioneering many innovations and transforming the industry. It is likely that something similar will take place in the US. For more than two years now, China's leading e-commerce companies have been expanding their footprint in offline food retail. Alibaba’s Hema is regarded as the pioneer of a new retail format which integrates food retail with catering services. Equipped with advanced technology, hardware and manpower, Hema has cut its delivery time to half an hour and the automation rate has been significantly enhanced. Alibaba’s investment in the Sanjiang Group, a regional retailer headquartered in Ningbo, made it possible for Alibaba’s Hema to enter the Ningbo market. Hema shared Sanjiang's resources during its expansion in Ningbo, creating a synergy between the two. JD shared its online and delivery resources with Yonghui and Walmart, while at the same time tapping into their offline stores to open up JD's own physical stores.
- The invasion of e-commerce enterprises into traditional retail will force traditional retailers to transform themselves. Enterprises that are lagging in last-mile services, category combinations and pricing strategies will find it difficult to survive. In China, traditional food retailers launched their own innovative formats to counter imminent threats. Yonghui and Bailian launched in-house brands Super Species (a small retail format which integrates boutique supermarket with catering services) and RISO (a large retail format which integrates catering services with food retail and recreational services), respectively. These two new formats both focused on supply chain optimization, retail and catering services integration and the integration of online and offline services. Online and offline retailers’ efforts, taken together, are transforming China's retail market at an incredible pace. The acquisition of Whole Foods by Amazon should have a similarly galvanizing effect, but such changes in China can be more entrenched.
Falling off the bike wheel
This past June, a niche start-up named Wukong Bike shut down to become the first casualty in the red hot shared-bike industry. Shortly afterwards, the Chongqing-based start-up 3Vbike also halted its services and exited. These recent casualties illustrate the cut-throat competition that now besets the shared-bike industry in China. Smaller players are barely able to survive, while established giants such as OFO and Mo-bike which have a combined market share of 90% are further reinforcing their dominance, signalling that the inflection point of the shared-bike industry has almost been reached. Therefore, niche players had better rethink about their strategy.
Chart: Market share trend of the shared-bike industry
Cut-throat competition has given rise to a whole set of challenges and hurdles, such as difficulty in raising capital, questionable product quality, and immature operation capability. First and foremost, the shared-bike industry in China is a game of capital. Whosoever can roll out new bikes the fastest has a higher chance to succeed. The inability of niche players to raise capital reduces their platform's appeal to new users, which in turn restricts the firms' ability to increase market share and profits. Second, lack of sufficient fund leads to an inferior shared-bike experience. Small start-ups typically offer bikes that are not equipped with important features such as Smart Locks and GPS systems. This gives rise to difficulties in locating available bikes and a higher theft rate, which further drives up operation and maintenance costs. Third, small companies have relatively immature operation models as many of them insist upon entering tier-one cities where the market is the most competitive instead of first trying smaller cities where competition is less fierce.
To tackle these, niche companies need to follow a three-pronged strategy that will differentiate them from the established players.
- First, they need to make their bikes specialized and intelligent. Bluegogo, for example, has equipped its bikes with Derailleur and Beidou Navigation Systems, substantially raising pedal efficiency, ride speed and positioning accuracy. The specialized intelligent bikes allowed the newly-founded start-up to stand out. As a result, Bluegogo's monthly active users have reached over a million, making it a leader amongst the second tier of competitors.
- Second, they should acquire new users through differential positioning. Hellobike, yet another emerging shared-bike company, specifically aims at tier-two, tier-three and tier-four cities to fill the remaining market void. This differential market positioning has proved to be highly effective. Thus far, Hellobike has marched into cities such as Ningbo, Fuzhou, Xiamen, with daily transactions up to 5 million.
- Third, they should strengthen their user base through differentiated marketing incentives. For example, both Youon Bike and Bluegogo have entered into an agreement with Sesame Credit to waive the required deposit. Bluegogo also provides a "Half-year Ride Free Card" that reimburses a rider the card fee after the rider has used Bluegogo bicycle service for at least 6 times.
We believe that the industry will continue to consolidate, and by 2020 there will be little to no room for small players. Only those companies that have a differentiated strategy and solid market share or a niche market will be able to survive. Those who do not is expected to vanish. The future prospects of small shared-bike companies depend upon how well they can differentiate themselves and at the same time create a sustainable business operation model. Ultimately, they will have to become attractive acquisition targets for shared-bike giants.
Life Science & Healthcare
Precision medicine could well be the future of sequencing companies
On June 22, BGI (Beijing Genomics Institute), Intel, Alibaba Cloud and Inspur jointly announced the launch of GATK (The Genome Analysis Toolkit) Chinese Association for precision medicine. It marks the beginning of an era of "Bioinformatics + High-performance Computer + Artificial intelligence" as a combined entity moving into precision medicine. Actually, the relationship of BGI, Intel and Alibaba Cloud began in November 2015 when they initiated a cloud platform for precision medicine.
As the global leader of genetic sequencing, BGI has been interested in precision medicine for years, and has been exploring avenues to enter and lead China’s precision medicine industry. Two factors are driving sequencing companies like BGI towards precision medicine as a strategy on a corporate level: the continuous profit margin decline from sequencing services and the large amount of Omics data that sequencing companies already have.
Significantly declining sequencing cost is turning genetic sequencing into a low-margin market
The human genome sequencing cost was about USD 1,000 in 2015, which was approximately one 100,000th of the cost in 2001. By 2017, the cost per genome has further declined to about USD 600. Illumina, the global leader of genetic sequencing devices, which just launched a new generation of sequencing devices, is pledging to further reduce the cost to about USD 100 in the near future.
Chart: Human genome sequencing cost trend
The decline in sequencing cost has been brought about by the highly competitive nature of the market and this in turn has meant a steady decrease in profit margins for players in genetic sequencing services. According to BGI’s filing for its recent IPO, its current value is 20% lower than 2015.
Upgrade path for genetic sequencing companies
BGI became aware of this issue since 2012, to build and grow its business in personalized genetic sequencing services, the foundation of precision medicine. In 2016, BGI generated 77% of its total revenue from personalized sequencing services. This indicates that BGI is well-prepared and well-positioned to enter the precision medicine market. Other sequencing companies, especially "BGI relative companies", are also developing personalized sequencing services to catch up with BGI.
Chart: Trends of Human genome sequencing cost
Strengths of genetic sequencing companies on precision medicine
Obtaining genomics data of large populations as well as gleaning key messages from genetic information are the basis of precision medicine. With years of data gathering and cooperation with academic institutions, sequencing companies have been building up their core competencies in this sector. Their perception of and insight in molecular diagnostic sector are far more advance relative to other potential players.
Many challenges ahead
For sequencing companies, the next step is to link genetic information with disease mechanisms, targeted therapy and personalized prognosis to perform accurate diagnosis and personalized clinical treatments. The latter will be the next big challenge for sequencing companies.