The Deloitte Research Monthly Outlook and Perspectives

Economy

Can the punch bowl really be taken away?

The pace of de-leveraging remains an all important issue for the Chinese economy. However, policymakers have decided to start with the financial sector where irregularities are pervasive and profits of banks are widely seen as “excessive”. Even some of most successful Chinese entrepreneurs have complained that “they are laboring only to service bank loans”. Therefore, a reduction of the financial sector’s leverage seems both sound economics and good politics.

Chart: Significantly high returns of financial sector

As a result, banks are being forced to rein in activities which are not included in their balance sheets which means that interest rates will inexorably creep up. In fact, they have already begun to do so. Last Friday, banks in several major cities hiked mortgage rates to 15% above benchmark rates.

Slowing credit growth is the acid test of policymakers’ commitment to de-leveraging (a commitment that will remain firm as long as the economic growth rate holds up). Barring any major external shocks (e.g., geopolitical risks and trade protectionism), we expect policymakers to stay on course, deflating all “bubbles” gently. However, if the housing market experiences a major downturn (for example, a greater than 20% drop in prices which in turn would cause a broad and sharp economic slowdown), authorities might push the panic button and turn on the liquidity tap. This, of course would be highly unfortunate but not inconceivable given the kind of pressure policymakers come under. A high GDP growth target, therefore, could increase the odds of a knee jerk policy reaction. If history is to be any sort of guide, credit booms most often end in a bust for sadly. It is rare for any government to “take the punch bowl away when the party is getting good”. This is as true for developed countries as it is for emerging markets. However, history has also shown that financial crises in emerging markets tend to cause far greater social dislocation. The Asian Financial Crisis, which started by a forced devaluation of Thai Baht in July 1997, is a case in point. Thailand's trouble quickly spread to the Philippines, Malaysia, Indonesia and Korea. Moreover, the sheer magnitude of the Asian Financial Crisis in terms of adjustment of financial variables (stock prices, property valuation, exchange rates etc.) and the real economy far exceeded most economist’s estimates.

Also, the speculative attacks against Asian currencies twenty years ago fundamentally changed the psyche of most Asian policymakers. As a result many of them have adopted so-called clean float policies (flexible exchange rate with some interventions) but the bias for intervention has been to set the currencies at competitive levels. Today, none of the economies who suffered during the crisis has an over-valued currency. On the contrary, all Asian economies have a comfortable balance of payments. At the same time, emerging Asia is significantly relying on China to be a key economic player in the region, providing liquidity support and funding to neighboring economies.

In the past two decades, there has been no shortage of analyses of the Asian Financial Crisis. What are the lessons that should have been drawn by policymakers, especially in the context of the rise of China? What if China were hit by a financial crisis today, would the contagion effect be greater than that of the Asian Financial Crisis? Or perhaps a more pertinent question would be: what lessons can Chinese policymakers draw from the Asian Financial Crisis to avoid having something similar occur?

In essence, the Asian Financial Crisis happened because of a lending boom fuelled by hot money which was underpinned by fixed exchange rates. The sharp appreciation of the USD exposed the vulnerability of fixed exchange rates and corporate profit squeezes prompted sudden capital outflows. One could also argue that the IMF packages were perceived as hugely favoring creditors, exacerbating social dislocations. Given this, with hindsight we believe, first, emerging economies, unlike developed countries who have had mature and deep capital markets, should not liberalize their financial sectors too quickly. A corollary of this is that even if financial liberalization is gradual, sequences of deregulation matter. Second, it is dangerous to have a prolonged period of exchange rate misalignment. This is particularly true if the economy is overheating as was the case in Thailand, Korea and Indonesia in 1996. Third, it is important not to mix up sovereign risk with corporate risk. “Too big to fail” has proved to be fatal to many of the economies who suffered during the crisis. In Korea for example, conglomerates, known as chaebols, would expand with little regard to financial discipline. The costly bailout of chaebols which were considered to be "too big to fail" by the government, was disavowed by the market (as the contingent liabilities of the chaebols were far greater than Korea’s foreign reserves) causing a further run on the Korean won. These lessons have been taken to heart by most Asian economies. Fixed exchange rates were largely abandoned in emerging Asia since the outbreak of the crisis. In fact, exchange rates in most emerging economies have been at a relatively under-valued level, resulting in a healthy level of foreign reserves and current account surplus. From China’s perspective, to overcome the “fear of float” is no small feat with initial de-peg from the USD in 2005 and a mild devaluation in August 2015. Despite the jitters that followed, the policy of shifting from a fixed exchange rate to a more flexible one has remained intact. So even though the RMB has been under persistent downward pressure for nearly a year and a half, there has been no change in policy and as a result sentiment changed for the better in 2017.

What the PBOC is practicing today is a combination of targeting a basket of currencies and policy discretion. Meanwhile, the PBOC deliberately keeps sizeable foreign reserves in excess of import needs and external debt servicing. Such a war-chest has provided necessary confidence to domestic savers whose confidence in the banking system is unlikely to waver. However, Chinese savers’ entrenched faith in their domestic financial system has also created a certain kind of "moral hazard". The latter boils down to the belief that the Chinese Government would bail out all financial institutions at any cost. The fact that long term government bonds (China’s sovereign risk) are yielding rates which are barely lower than money market rates precisely underscores my point. The best way to mitigate moral hazard is to let some insolvent financial institutions fail. But to engineer “directional blasting”, or to keep failures within a confined environment, requires some relaxation of the doctrine of maintaining stability at any cost.

Chart: Vanishing risk premium

Unlike most Asian economies prior to 1997, financial liberalization in China is slow. For example, the Chinese Government created the Bond Connect between the mainland and Hong Kong, but only allows one-way flows into the Chinese bond market. The stock market, the 2nd largest in the world based on market capitalization, is only open to foreign investors through schemes of QFII (Qualified Foreign Institutional Investors) and the Shanghai-Hong Kong Stock Connect. In addition, the fact that China has preferred to first liberalize the bond market where foreign participation is more long term and less fickle shows that the government would like to avoid big swings of portfolio flows. And even on the much touted RMB internationalization, policymakers have reoriented their efforts towards greater use of the currency in international trade and as a funding vehicle for belt-and-road initiatives rather than pushing for full internationalization. This is because the strength of the RMB has become a pre-condition for further internationalization of the currency.

Going forward, financial liberalization is likely to be very gradual in China. The cautious pace of liberalization implies that control of capital account transactions (e.g., residents’ purchases of overseas securities and real estate are not allowed) may stay in place for longer than previously anticipated. Is capital control the right policy during a financial crisis? One country that took that route in late 1998 was Malaysia which decided to fix the ringgit at 3.80 to the dollar while the market price was 4.20. The decision was controversial but was later vindicated when Asian economies started on the road to recovery in 2000. The reasoning behind Malaysia’s unorthodox implementation of capital controls was that it would prevent a free fall of the market; and that the market has a short memory. One should not forget that Malaysia’s capital control came at the tail-end of the Asian financial crisis which means most Asian markets were unlikely to invite further attacks from speculators given stressed asset valuation. The moral of the story is that while capital controls are by no means a panacea, the timing of imposing capital controls for Malaysia was good as they only did it when the worst of the crisis had passed. From this perspective, China’s measures of strict capital controls are implemented against the backdrop of a weakening USD (against most major currencies) and a temporary pause of Federal Reserve tightening which makes PBOC’s interventions easier. The weakening dollar has partially explained six consecutive months of rise in foreign reserves in China. Forcing financial sector to lower leverage indicates that policymakers are taking potential financial sector risks very seriously. The one-way Bond Connect has sent a clear signal that the policy framework will continue to address “reckless” overseas investment. The PBOC’s efforts at replenishing reserves (at more than necessary levels) have underscored its commitment to maintaining a creditable war-chest.

In the short run, some obstacles are likely to emerge. What if the dollar starts rallying, say on the back of geopolitical tensions? Would the PBOC continue to buck the trend? Would rising interest rates cause the housing market to weaken significantly? In the past, the PBOC has behaved quite predictably when there were visible signs of economic slowdown or jitters in the markets. Can the PBOC resist the pressure of loosening the liquidity tab should interest rates be pushed up further because of de-leveraging? In our view, lowering the GDP growth target after the 19th Party Congress will make it easier for policymakers to take away the punch bowl. Reserves too do not need to be so high. In the medium term, to maintain excessive amount of reserves is counter-productive, because it requires either a persistently under-valued RMB (not feasible before a meaningful revaluation) or strict capital controls, or both. The real question remains whether the heart of supply-side reform, SOE reform, can regain traction. A breakthrough in SOE reform will bring down corporate leverage and spur private investment. As a result, credit policy will be positive to a stable RMB, which further reduce the need of accumulating reserves. Finally, on the political front, the risk for China to resort to retaliations should the Trump Administration up the ante on the trade front (beyond focused measures of anti-dumping) should not be discounted.

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Financial Service

Big banks benefit from curtailed shadow banking

This year’s heightened supervision and regulation of China’s shadow banking industry has started to show results. For one thing, a good part of credit loans are being transferred back to banks’ balance sheets and asset growth of small to medium-sized banks has also slowed down. This is quite an achievement for, apart from the elimination of risk, improvement in the operating environment will be conducive to the development of the banking industry, and especially benefits big banks which are market liquidity providers. But the industry needs to guard against problems resulting from regulatory and policy adjustments.

Shadow banking, according to the People’s Bank of China (PBOC), refers to entities or quasi entities that engage in financial intermediation, with credit limit or liquidity conversion functions similar to those of traditional banks. Such entities and their activities are not subject to regulations and supervisions based on the "Basel III" agreement or equivalent protocols. Different from U.S. shadow banking activities that are highly securitized, Chinese shadow banking mainly refers to activities by banks that resort to the use of off-balance-sheet financing and other types of wealth management products to achieve "off-balance-sheet lending". This money is then invested in higher yielding but much riskier projects in sectors such as real estate, ‘two-highs-one-over’ (highly-polluting, highly-energy-intensive and over-capacity creating) industries and the like. Shadow lending includes non-standard credit loans (non-standard) extended by banks with trusts, securities and funds operated jointly by banks and mutual funds as well as debt investment under the disguise of equity investment. These activities are attached to the banks just a shadow is attached to the human body but they exist in a regulatory no-man’s land, not having been included in the statistics of the total social financing (TSF) structure. On the balance sheets, they are not recorded as loans but rather as account receivables from investments, interbank assets or off-balance-sheet financing. As a result, shadow banks can get away with less capital and provisions than those required of regular banks by regulatory authorities and can therefore derive more profit from these types of arbitrage opportunities. According to UBS estimates, by the end of 2016, shadow lending increased to RMB 60-70 trillion, accounting for 33% of total credit compared to 10% in 2006.

However, since 2016 regulation has tightened. On the one hand, macro prudential assessments (MPA) have been implemented to curb off-balance-sheet financial growth. On the other hand, after Mr. Guo Shuqing assumed the commission's chairmanship, the CBRC issued a series of “penetrate and supervise” guidelines to curb “violations, arbitrages and other misconduct”. In July, the Financial Stability Development Committee (FSDC) was established, marking the first step of cross-industry supervision by financial regulatory authorities. With M2 growth going down below 10% in May, actions to curb financial risks have started to show results.

Growth of shadow credit has been cooling down

The slowdown in the creation of new wealth management products (WMPs) and the change of TSF structure confirms that tightened supervision has been effective. Bank WMPs, after surging rapidly in recent years, slowed down to RMB 28.4 trillion at the end of May, a drop of RMB 70 million from the end of 2016. Recent TSF data shows that bank credit loans have increased and are returning to the balance sheets. At the same time, non-loan TSF has slowed down, of which the decrease in bond issuance indicates that banks' willingness to invest in corporate bonds and other non-loan financial products has declined. Entrusted loans also decreased, which shows that shadow lending is finally being contained.

Charts: Policy is aimed at reining in non-conventional loans (RMB trillion)

Asset growth slows and capital levels improve

The “penetrate and supervise” guidelines have made it difficult for banks to resort to the use of ‘other channels’ as intermediaries for shadow lending, which cut the operational space of manipulating leverage in financial system and reduced the interconnection degree amongst institutions. All these effects would obviously increase banks' asset transparency and therefore, gradually, Chinese banks' real risk exposure level will be revealed, which boost the level of banks' capital adequacy and provision coverage and benefits banks' prudent operation.

Tightening liquidity inhibits small and medium-sized banks from using short-term funds (wholesale financing) to support long-term investments (most recorded as assets on balance sheets) and their asset growth slows down. By the end of June, assets of joint-stock banks and city commercial banks has grown respectively by 8.4% and 18% yoy, falling 6.5 percentage points in comparison to the same period of 2016. However, large banks with a strong deposit base as market liquidity providers will benefit from the increase of funding cost under tightening environment thus their net interest margins will finally improve.

Vigilance policy adjustment risk and a new round of "blood infusion" for banks

A credit crunch and decline in profits are potential risks of the greater regulation of banking activities. A credit crunch will reduce financing for the real economy, resulting in increases in defaults and/or downward pressure on GDP. Bank earnings will also decline and refinancing risks will increase for banks. Recently, Ping An Bank, Bank of Nanjing, and other listed banks have announced plans to refinance to the tune of a combined total of RMB520 billion through issuance of preferred stocks, convertible bonds, and non-public offerings as the main recapitalizing vehicles.

Obviously, regulators are well aware of the adjustment risks coming out of policy changes and they actually have delayed implementation of relevant policies to balance deleveraging and sustain economic growth. For instance, CBRC has only required banks to conduct trial assessment for the negotiable certificate of deposit (NCD) with MPA interbank liabilities but has not yet formally implemented (would make formal assessment in some banks from Q1 2018). Also, CBRC recently granted banks a grace period, allowing them to delay the submission of self-assessment reports for the interbank and entrusted businesses which was originally scheduled for June.

In short, regulators have deployed a multi-faceted approach to prevent financial risk from endangering the economic system. As the explosive growth of China's banking industry has been brought under control, the `tight balance’ will become the new normal. Along with the establishment of FSDC, we can expect more measures by regulators in future. But the regulatory intent is not to limit the development of all shadow banking businesses but rather to emphasize oversight and allow moderate growth and regulatory compliance.

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Automotive

Chinese automakers’ renewed interest in overseas expansion

Source: Wind, CAAM

Southeast Asia, boosted by the One-Belt-One-Road (OBOR) Initiative, has once again become the ‘crown jewel’ for Chinese automakers anxious to reinforce their global footprint. In the wake of Geely’s acquisition of a 49.9 percent stake in Malaysian auto conglomerate Proton, another Chinese carmaker, SAIC-GM Wuling, announced that its USD 700 million plant officially goes into production, rolling out Wuling’s best-selling minivans in Indonesia. Chinese auto brands whose sales have rallied at home over the past few years due to the boom in SUV sales have long been neglecting overseas expansion. The recent moves by some Chinese automakers signal a renewed interest in the overseas market, especially given the intensified competition and shrinking manufacturing margin in the home market as well as the low capacity utilization. Chinese automakers are betting big on the prospect of Southeast Asian market despite the formidable presence of Japanese carmakers in the region. They certainly don't want to be caught off-guard due to production constraints when demand takes off, let alone the huge potential that they have not tapped into in the ASEAN countries.

Chinese automakers have increased their chips in ASEAN countries thanks to a higher purchasing power, a friendlier environment for foreign investments and local governments’ desire for a manufacturing upgrade. ASEAN, home to 600 million people, has seen the size of its middle class growing by six times in the last ten years while its vehicle penetration rate lags behind other regions in Asia. (Indonesia has one of the lowest vehicle densities of any Asian country - 55 passenger vehicles per 1,000 people).

Chart: PV penetration in ASEAN and auto sales growth in selected regions in 2017 H1

Southeast Asia has been a rising star amid a broadly flat global auto sales growth, with vehicle sales in ASEAN as a whole climbing to a three-year high in the first half of 2017. Among which, Thailand continued its upward momentum and enjoyed a 11% yoy increase and Philippines, the fledging market, has seen its car sales surged 17% in 2017 H1.

Neighbouring India is another bright spot where auto sales recorded a remarkable yoy growth of 6%. Meanwhile, the Indian government rolled out the Automotive mission plan 2016-2026 to revive the faltering auto manufacturing industry and to make India one of the top three automotive manufacturing hubs. Foreign OEMs, on the other hand, have ramped up their investment in India, not only to capture a slice of the domestic market but also to leverage India’s supply chain strength and geographical advantage in a bid to transform the country into an export-oriented hub. But the ongoing military standoff between China and India as well as the newest imposition of anti-dumping duties on 93 China imported products have clouded the prospect of bilateral trade and investment of the two countries.

Given the fierce competition in the ASEAN region, Chinese OEMs have been forced to take a novel approach. The ASEAN market has long been dominated by Japanese automakers who, together, hold nearly 90 percent of market share. Ten years since their first entry into the market, Chinese car companies hold less than 1 percent of the market. This is because most Chinese companies targeted export and assembly manufacturing, leaving quality control, service and branding issues unaddressed. Even worse, the majority of vehicles exported to ASAEN were cheaply priced, low-end models, a marketing strategy that has long tarnished the reputation of Chinese auto brands in the region. But the two recent deals have marked the beginning of a new phase of overseas expansion - Chinese automakers have finally embarked on the journey of localization.

Japanese automakers enjoy dominance in the ASEAN auto market because their product strategy, parts sourcing and service is highly localized. Even General Motors has suffered setbacks in ASEAN region; it recently announced it would exit India where its market share has decreased to less than 1 percent. All GM’s production facilities are being shifted to an export-only hub. This is the second defeat for GM which shut down its Indonesia factory back in 2015. Taking into account the lessons from GM, we believe the key to success for Chinese automakers lies in pricing and capitalizing on niche segments.

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Life Science & Healthcare

CAR-T therapy opens new doors for the oncotherapy industry

On July 12th, the FDA's Oncologic Drug Advisory Committee (ODAC) endorsed Novartis's lead CAR-T cell therapy by a 10-0 vote, making this the first-ever CAR-T approval from the FDA. This may well propel the industry of cell immunotherapy into a new era. Market forecasts estimate that the global CAR-T market will reach USD 10 billion within 10-15 years, with a further future market potential of USD 35-100 billion.

To be optimistic yet cautious, "eliminating" cancer still has a long way to go

Many believe that CAR-T therapy will eventually help human beings "eliminate" cancers. This, we believe, is a bit too optimistic a view – especially at the moment. Although it is true that CAR-T is making huge progress in the field of oncotherapy, many challenges remain. First, the narrow clinical indication of each CAR-T therapy makes it possible only for patients at a certain age, with certain cancer types and at a certain cancer stage. This means that, in effect, thousands if not tens of thousands of CAR-T therapies are required to treat all cancer patients. Second, most current CAR-T therapies are only for haematological tumors as it is much more difficult to make progress on solid tumors. In addition, the cost of CAR-T therapy can be up to USD 650,000, making price a significant barrier for widespread clinical application.

The next Pharma/Biotech giant may rise from the oncotherapy sector

Currently, the market leaders of CAR-T/TCR-T therapy are Novartis, Kite Pharma and Juno Pharma. Although Novartis was the first company to obtain CAR-T approval from the FDA, it has no other CAR-Ts in the pipeline and its cell and gene therapy unit was dissolved in 2016. It reflects a fact that the difficulty of industry giants to participate in the development of cutting-edge technology is too high due to their high operating costs. A smarter approach for industry giants is to participate in this sector through strategic investment or M&As.

After the gradual exit of Novartis, Kite Pharma emerged as the leader in this field on the strength of its 21 on-going CAR-T/TCR-T pipeline products, one of which has already been filed with the European Medicine Agency (EMA) for Marketing Authorization on August 1. Juno Pharma, on the other hand, has been lagging behind since 2016 after its lead CAR-T therapy was halted by the FDA. Beside Kite and Juno, Cellectis and Bluebird Bio are also making headway in their CAR-T/TCR-T pipelines but they are still lagging behind the three industry leaders.

Table: Pipeline progresses of global leading companies

Source：Company official websites, Deloitte Research

What emerges from the above chart is that this sector is currently dominated by small- and mid-sized biotech companies. Market value of Kite, the largest one of them all, is only worth USD6.4 billion. However, we believe that the huge growth potential of this sector is such that it could quite possibly produce the next industry giant in much the same way that Gilead emerged as a giant from the HIV/HCV treatment revolution in the last 25 years.

Chinese players are chasing global leaders

There are also many Chinese players that are dedicated to the R&D of cell immunotherapy. From the data of ClinicalTrials.gov, an American organization, there are 100 CAR-T/TCR-T pipelines in China, surpassing the US which has 88. Other countries have only 20.

Chart: Regional CAR-T/TCR-T research pipelines

Cell immunotherapy players in China are also small to mid-sized biotech companies. Some of the main players include GeneChem, CARsgen, HRAIN Biotech, Cellular Biomedicine Group (CBG), Unicar-Therapy and Innovative Cellular Therapeutics (ICT). 

Table: Pipeline progresses of Chinese companies

Source：Company official websites, Deloitte Research

However, the pipelines of most Chinese companies are stuck in Phase I of development due to the tremendous cost and difficulty in recruitment for CAR-T/TCR-T clinical trials. But after the latest FDA approval of Novartis CAR-T therapy we believe that this sector will draw more and more attention from investors.

Given that Novartis is fading away from this sector, and Juno is facing a huge challenge as a result of its failed clinical trial, Chinese players are presented with an excellent opportunity to catch up with global leaders. In addition, Chinese pharmaceutical companies WuXi AppTec and Fosun Pharma have built up collaborative relationships with Juno and Kite, establishing "JW Biotech" and "Fosun Kite Biotech" respectively through which they are able to leverage global leaders' expertise and platforms on cell immunotherapy to develop their own competitive edge. Plus the cost advantage, in time, and with adequate investment, we believe that Chinese players could well catch up with today’s global leaders.

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