The Deloitte Research Monthly Outlook and Perspectives

Economy

Cutting reserve requirement rate does not imply further easing

Speculation has been rife over the past few months on whether or not the PBOC would cut the reserve requirement rate. There are several reasons for this. First, the Chinese RRR is high compared to international standards. Second, given the hectic pace of growth in the 1st half of 2017, the economy will have to slow down a little in the second half and therefore, a slight boost of liquidity through a lower reserve requirement rate next year will encourage banks to lend. Third, bank profits have taken a hit from policymakers’ efforts at reducing financial sector leverage (please see our August 2017 macro viewpoint, Can the punch bowl really be taken away?). Therefore, it was clear that a lower reserve requirement rate was needed in order to free up banks’ non-interest bearing assets.

Chart: Reduction of RRR aims at promising inclusive finance

Of course, the recent cut of RRR and especially its timing (September 30, right before the national day holidays and the long-awaited 19th party congress) did give an important signal to the economy which has been resilient. Moreover, the cut has an intriguing twist: such RRR cut only applies to those financial institutions who have done enough lending to SMEs and to poverty alleviation schemes. The central bank has made it clear that further reductions of RRR will only be applicable to those who are actively promoting inclusive finance. There can be no doubt that the PBOC’s intentions are to help SMEs and those who have little access to credit. But the question is: despite its immense power to influence bank lending, can the central bank really succeed in channelling credit into socially desirable sectors? The answer to this question, intuitively, is yes. But it might come at the cost of credit quality because banks' lending criterion might be compromised.

Uppermost in people’s minds, however, is another question: will the RRR cut lead to monetary easing? Here, I should point to Zhou Xiaochuan governor of the PBOC’s bold proclamation that GDP growth in the second half of 2017 could be even higher than 7% (Q3 growth came in at 6.8%).  At first glance, such a forecast seems counter-intuitive given that the strong performance of 1H means that the economy really doesn’t need to perform in 2H as hitting the target of "around 6.5%" is now more or less a certainty. Our reading of Governor Zhou's optimistic forecast is that the central bank is trying to subtly dampen expectations of monetary easing.

The reality is that high RRR is the result of financial repression, not a tight monetary condition. But a cut of RRR is not necessarily a signal of monetary easing.  On the contrary, we are of the view that China will probably be forced to embark on some mild monetary tightening as major central banks are on their way to withdraw liquidity next year unless the PBOC is willing to accept a more flexible RMB exchange rate. Over the weekend, Governor Zhou pledged to open up China’s financial sector. Would renewed initiatives in liberalizing China’s financial sector allow policymakers to have more leeway with monetary policy?

The 8th consecutive month of increases in foreign reserves should have given China reason and a window of opportunity to relax many of the restrictions on the RMB that were imposed in 2016. Of course, one might ask why easing such restrictions is a priority when things are going well? After all, it is now clear that China can easily achieve a GDP growth rate which is higher than the official target of “around 6.5%”. The stock market has rallied while housing markets in major cities are buoyant.  But 2018 might present several challenges. It would be more prudent for the government to at least partially fulfil market expectations on RMB depreciation before the Fed starts hiking interest rates. On the focused easing by the PBOC, it is more efficient for policymakers to cut SME taxes rather than lower the RRR selectively based on banks’ lending practices.

In conclusion, in the run up to the 19th party congress, the policy framework centered around “stability”. But the focus may change in 2018, simply because there won’t be any need to surpass the official growth target. As a result, curtailing financial sector risk will inevitably become the top item on policy agenda in 2018 which suggests that a boost of liquidity from the cut of RRR could well turn out to be an aberration. (In our view, lowering the GDP growth target would be a good first step in embracing controlled deleveraging.) Lack of access to formal bank credit is occurring in many countries. Such problems might be more acute in China due to the fact that banks tend to favour SOEs. Added to this, the overarching goal of cutting excess capacity and higher levels of environmental awareness have meant that smaller firms have had to bear the brunt of structural adjustment this year. It is important to promote inclusive finance, but a more potent fiscal lever (e.g., tax cuts) is called for. Meanwhile, exchange rate misalignment should be avoided at a time when most economies in the world prefer to keep their exchange rates low.

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Financial Services

The time of digital inclusive finance has arrived

Early evening on September 30, prior to the start of the 9-day National Holiday, the People’s Bank of China (PBOC) announced that it would reduce the reserve requirement ratio (RRR) with effect from 2018. The move is designed to provide relief to banks hamstrung by continued financial deleveraging and improve liquidity (August M2 growth was 8.9%), as well as to nudge financial institutions towards more inclusive finance. The inspiration behind the PBOC’s surprise move is a paper produced by China’s State Council entitled “Plan to Promote Inclusive Financial Development 2016-2020” which points to the need to channel capital into the real economy. As a result, inclusive finance has been elevated to the level of national strategy and the large state-owned banks have been charged with implementing it.

Promotion of inclusive finance is fast becoming the cornerstone of the market. At the same time, regulators have adopted a series of policy measures to keep financial risks under control by curbing shadow banking activities and banning ICO issues. By the end of June this year, the Big Four banks had already set up inclusive financial divisions and also signed strategic cooperation agreements with Fintech giants BATJ (Baidu, Alibaba, Tencent, and Jingdong).

Digital financial inclusion is the overarching direction of Fintech

Against a backdrop of policy “focusing on financial risk prevention” initiated at the National Financial Work Conference in July this year, digital inclusive finance has become a prime means to service the real economy.

The Economist magazine recently pointed out that China is the world leader in Fintech adoption as China's digital consumption far outstrips the rest of the worlds'. Digital inclusive finance just refers to the development of inclusive finance by adapting digital financial technologies to the needs of those who, traditionally, have not been covered by financial services. The core components of digital finance are - a digital platform where transactions can be made, the retailer, and a device most commonly a mobile phone. Fintech and inclusive finance have similar characteristics such as sharing, ease of use, low cost and few barriers. Moreover, recent advances in big data analysis, cloud computing and artificial intelligence (AI) can provide commercial banks with the technological tools (online risk analysis & control process, on-line small loans / credit cards application & approval, AI investment advisers, precision marketing, e-business and supply-chain finance etc.) to bring benefits to many so called “long-tail” customers. Partly in recognition of China's outstanding development in Fintech, the World Bank has recently selected it as a case study country for the promotion of digital financial inclusion along with Egypt and Mexico.

There is a global consensus around the need for and importance of digital inclusive finance. At the 2016 G20 summit in Hangzhou, a document entitled "G-20 High-level Principles for Digital Financial Inclusion" was released. The document lays out a framework for digital inclusive finance, the core principles of which can be summarized as the following: to balance innovation and risks, create legal regulatory framework, expand the infrastructure ecosystem, boost consumer protection / financial knowledge education/KYC (know your customer) and implement process monitoring.

Banks' cooperation with BATJ to boost the transitional innovation

In the first half of this year, the five state-owned banks quickly set up Inclusive Financial Divisions of their own. ICBC, CCB, BOC, ABC and BoCom entered into strategic alliances with the Big Internet companies (BATJ and Suning) to co-develop Fintech labs and to cooperate intensively in big data risk control, precision marketing, e-payment and the like.

Table: Deployment of digital inclusive finance by cooperation of the five banks with Fintech companies in 2017

Source: Public information, Deloitte Research

Through a greater integration of digital technologies, traditional banks can enhance their digital and electronic capabilities in order to reach more customer groups (including small and micro businesses, and agri-businesses) and promote innovation and entrepreneurship amongst their customers through e-business and social media platforms. Greater integration of financial technologies will also lower service costs and boost bank revenues. In August, the Baixin Bank, which is co-founded by Citic Bank and Baidu, opened formally with the regulator's approval. The bank has since been positioning itself as the smart inclusive bank. Meanwhile, the Agriculture Bank of China and Baidu launched their first online lending product in September. More and more banks (CMB, CITIC, CIB, CMBC etc.) are entering into cooperation with tech companies and the trend will undoubtedly continue.

Multi-level organizational system and risk protection

In addition to the big state-owned banks' Inclusive Financial Divisions, financial institutions including internet banks, rural banks, rural credit cooperatives which are closely related to business operations in the three rural issues (agriculture, rural areas, farmers) and small and micro business which operate at the grass-root level are all important components in the inclusive finance ecosystem. Without their co-operation, big banks will not be able to substantially enhance access to financial services and lower financing cost.

The process of transformation is inevitably accompanied by risks. Keeping a balance between inclusive finance, safety and benefit has become the main preoccupation of senior management in banks. The announcement of a targeted cut in RRR will provide encouragement to bank officials to travel further down the road to inclusive finance. In the future, the government should gradually expand on the policy framework on digital inclusive finance. For example, it could 1) establish an assessment indicator framework and give tax preferential policy support, 2) establish a small and micro credit guarantee scheme led by provincial or municipal governments to improve the risk compensation environment, and 3) improve the basic infrastructure regime and establish a related credit reporting system.

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Energy

Solving China's gas price puzzle: a further step towards reform

In accordance with the National Development and Reform Commission's (NDRC) newly released gas price guidelines, CNPC and Sinopec announced their pipeline tariff for long distance cross-province gas transportation in September. This is part of a wider price reform to cut gas supply costs and raise demand by liberalising gas prices.

Natural gas price reform

In China, demand for natural gas is extremely price sensitive.  If one doesn’t take into account environmental costs, the price of natural gas is much higher than that of coal. China's natural gas prices are basically "administered" by both central and local governments. However, the timing and magnitude of government intervention in natural gas prices is not always predictable. The reason for this unpredictability is that the government has a difficult balancing act to pull off. On the one hand, the natural gas price needs to be competitive to encourage consumption and on the other hand, the price needs to be high enough to attract investment.

It is in recognition of the latter that, under the new gas pipeline tariff system, the government has allowed pipeline companies to gain a "reasonable profit". At the same time, the NDRC has reduced the return on gas pipeline investment from an estimated 12% to a cap of 8% for pipelines operating at a utilization rate of no less than 75%. The guiding principle here is to increase transparency around pipeline operating costs, encourage third party participation and reduce gas prices. As a result, the benchmark price at urban natural gas stations for non-residential use was reduced by 100 yuan per thousand cubic meters in August 2017.

Figure: Recent development of natural gas price reform 

Source: Deloitte Research

Third party access

One of the most significant implications of the new pricing system reform is the further opening of oil and gas pipeline networks and facilities for third parties.

Currently, CNPC holds almost 80 percent of China’s main natural gas pipelines. Sinopec has the second-biggest share, while CNOOC operates many of China’s LNG receiving terminals.

The new pipeline tariff mechanism allows a maximum of 8% return for pipelines operating at a utilization rate of no less than 75%. If the rate falls below 75%, the corresponding return will also fall to less than 8%. Hence, pipeline companies are incentivized to open their networks to third parties in order to secure a higher rate of return for their investment. Shanxi Tongyu Coalbed Methane Pipeline Company and some other pipeline operators have already opened up their pipelines to third parties.

Another positive effect of the enhanced transparency and predictability of the tariff mechanism is that it will improve the stability of pipeline operators in terms of cost recovery and volume risk reduction, making them more attractive to potential investors in the future.

A bigger role of natural gas

The price reform will also hasten the growth of the natural gas market. There are two main reasons for this - one economic and one environmental. As the environmental costs of coal and oil get increasingly factored in, natural gas becomes more attractive and more affordable. As a result, larger numbers of consumers are turning to clean energy sources – provided the cost remains reasonable. For example: 

• Non-residential natural gas price dropped 15% after the new pricing mechanism was implemented;

• Sales of LNG heavy trucks surged 540% in the first seven months of the year as government started to curb diesel consumption.

China plans to increase the share of natural gas as the primary energy mix from 6% to 8.3%~10% by 2020.  To achieve this goal, it has decided to open infrastructure access to third parties, lower the threshold for storage capacity, and extend natural gas pipelines to all cities with a population of 500,000 residents or above.

Figure: China's natural gas demand grows faster than oil, coal and renewables

The missing piece

So far the intra-provincial transmission lines are exempted from the new tariff guidelines. So the provincial pipeline companies are not required to follow the same-tariff rules nor are they subject to the same supervision by central government as national oil companies are. This may be a practical choice as implementation at the provincial level is difficult. However, if China is to establish an independent national gas pipeline company, this is no doubt a challenge the central government will have to wrestle with. 

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Auto

Foreign automakers given more time to comply with strict NEV credit system rules

Source: Wind, CAAM

The long-awaited NEV dual credit system has been finalized and is scheduled to go into effect as of April 1, 2018. Different from the previous draft, the latest mandate has incorporated certain changes, including a waiver of the mandatory assessment of auto makers’ NEV quota in 2018 and postponement of the enforcement date to sometime in 2019, a move which is widely regarded as a concession by the Chinese government to foreign auto makers.

Under the quota system, auto makers are required to sell a substantial number of NEVs (pure electric vehicle, hybrids and fuel-cell powered vehicles) and to obtain a matching amount of NEV credits (10% and 12% in 2019 and 2020 respectively) in order to avoid being penalized for non-compliance which includes the halting of production of traditional combustion engine vehicles. This gives foreign OEMs a crucial one-year breathing space to ramp up production and increase sales so as to be compliant with the NEV credit system.

The new mandate made two other significant changes. It lowered the threshold of NEV compliance from 50,000 vehicles in annual production to 30,000 and allowed negative NEV credits in 2019 to be carried over to 2020, effectively easing the pressure on OEMs.

So, what are the implications for the industry as a whole? The new mandate signals the Chinese government’s firm commitment to increase NEV penetration, and highlights the centrality of the NEV business to auto makers’ long-term plans. The credit system, nevertheless, is likely to spook market players despite a well-publicized warning in June this year. Auto makers with millions of annual production will face an uphill task. Take for example Volkswagen. With about 4 million vehicles produced annually, it has to sell no less than 80,000 pure electric vehicles (maximum 5 points for each standard NEV sold) to meet its stipulated NEV credit requirement for the year 2019. Due to overwhelming concerns over technology transfer, disagreement on skewed policies as well as a lack of investment incentives, foreign OEMs have been reluctant to introduce their top-selling EV/PHEV models into China, giving up market share to their domestic counterparts. But in the end, the urgent need for compliance led Volkswagen to secure a joint venture with JAC, - a leading player with surplus NEV credits - to purchase credits from its partner at negotiated prices. In the wake of the VW-JAC alliance, Ford formed a JV with Zotye, a local NEV manufacturer known mostly for its two-door, low-speed electric vehicles, to alleviate its own compliance pressure. It is likely that more foreign OEMs will follow suit in the months to come.

A price war in the NEV market is unavoidable. With diminishing subsidies and more NEV products than ever before in the pipeline, OEMs start to fret that consumers may not be interested in buying zero-emission cars. Given the downsides of owning an EV – not only is it less economically competitive compared to gasoline cars but there is also a lack of charging infrastructure – can end-user demand really support a rapidly expanding market? A price war cannot be avoided if demand remains sluggish, casting a shadow over the prospect of the NEV business’s profitability.

Domestic players' first-comer advantage may not translate into core competitiveness. Domestic auto makers are the first-comers in China’s NEV market, benefiting from skewed policies, hefty financial subsidies, not to mention the favourable investment stimulus terms from local governments which have been luring NEV plant projects to dress up their political achievements. With the absence of foreign OEMs, domestic brands have long dominated China’s NEV market. But given an escalated competition from foreign rivals and a fast phase-out of subsidies, the dominance enjoyed by domestic brands won’t last long enough before JVs start to gain ground.

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Life Science & Healthcare

Biosimilar tsunami is not far behind

The world’s top-selling prescription drug Humira (Adalimumab, a biological drug of AbbVie) remained No.1 in the first half of 2017. It will be the sixth year in a row that Humira leads the market and the third time that Humira breaks sales records if the trend continues in the second half. So far, nothing can shake Humira off its throne, except, maybe, for a potential "Patent Cliff", which dethroned the last long-time world No.1 selling drug "Lipitor" right after its patent expired in 2011.

 Figure: 2002-2016 sales revenues of Lipitor & Humira

Biosimilar battle over Humira is a valuable case for the entire sector

Given that Humira's patent portfolio has already started to expire, many Pharmaceutical MNCs including Amgen and Boehringer Ingelheim are starting to attack Humira's market by launching biosimilar products. Meanwhile, AbbVie has kept on extending current patents and applying for new patents to build up its legal protection mechanisms.

Humira is the first USD 100 billion biological drug ever to face what is called a "Patent Cliff". We believe that the fight over Humira biosimilars will be the most significant battle in the history of biological drugs and will provide valuable insights to all the players in this sector on future strategy.

Biosimilar battle is also happening in China

As a major market of chemical generic drugs, China is also leading the world in biosimilar development. Data from Thomson Reuters shows that China has the most biosimilar pipelines. Although none of them have been approved by CFDA yet, many are already in phase III clinical trials and expect to come to market in 2018. We believe that a biosimilar `tsunami’ will hit China in the near future, the effects of which will also provide interesting material for study.

Figure: Countries ranking by the number of biosimilar pipelines

Taking Humira as an example, in China there are 21 companies that are developing Humira biosimilars, two of which (Innovent and Bio-Thera Solutions) have already been in phase III clinical trials. Given the support by Chinese policy makers to the development of biosimilar drugs and the relatively weak legal mechanisms in China, we can expect to see Chinese Humira biosimilars hitting the market in the near future.

On the other side, AbbVie is also working on expanding the clinical applications of Humira in China.  This June, Humira was approved for use on psoriasis patients, which is the third approved clinical indication in China. It will not only increase Chinese contribution to Humira’s global sales revenue but also reinforce its patent barrier in China.

China could well be the frontier market for biosimilars

To summarize, compared to the strong patent barriers built by pharmaceutical MNCs in the US and EU, the Chinese market is friendlier to biosimilar players. So China has the potential to become the frontier market for biosimilar drugs, especially for the six major Therapeutic Monoclonal Antibodies (TMA, a type of biological drug) including Humira. As there are already more than 90 biosimilar pipelines of these six TMAs in China owned by more than 20 companies, building a healthy competitive environment will be another major challenge for policy makers and market players in this sector.

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