The Deloitte Research Monthly Outlook and Perspectives

Economy

Embracing a lower growth target

The closely-watched 19th Party Congress has resulted in some clarity on economic policy. As expected, certain landmark years (e.g., 2020, 2035, and 2050) were given additional weight with regard to economic and social welfare targets. However, the GDP growth target has been deemphasized. This is a welcome development given that de-leverage and SOE reforms can only proceed against a backdrop of slower growth. Looking at the contributions from the property sector and exports in 2017, it would be too much to expect a comparable performance in 2018. Therefore, it makes good sense for China to embrace a slower GDP growth target.

Chart: Base effect itself will cause exports and investment to lose stream

If economic growth can be achieved with few side effects, why try to arrest credit growth and allow zombie firms to fail? Indeed, the new mantra which was coined by President Xi regarding the `mismatch between uneven development and people's desire for a better life’, suggests that policymakers have had to abandon the notion that economic development can cure most problems. We have been of the view that China's economic resilience is extremely underrated while we are not subscribed to the notion that the current growth rate (around 6.5%) is sustainable in the medium term. China will be tested when the cyclical momentum starts losing steam. To put it differently, will the Government resort to stimulus as in the past when the housing sector cools off and the export machine starts sputtering simultaneously?

One could assume that in 2018 the synchronized recovery of OECD countries will continue and major central banks' tightening of the money supply will be gradual (both assumptions are sensible). It is also quite probable that the renewed strength of the dollar and event risk (e.g., a hard Brexit) could well keep a lid on any rally of the Euro, thus allowing the Fed to increase short term interest rates in a measured fashion. The above scenario, which is entirely plausible, would be positive for China. But since already in 2017 the vastly improved fortunes of the developed countries resulted in a favorable backdrop for China's external sector, can Chinese exporters really repeat their sterling performance in 2018, on a relatively strong base of 2017? We think this is challenging. In addition, the Trump Admiration's pressure on China in terms of bilateral trade deficit reductions will not go away.

The resilience of the Chinese economy stems from a combination of two things: unfulfilled demand of confident consumers (exactly as President Xi has alluded to in his address at the 19th Party Congress) and further room for consumers to take on debt which means that such unfulfilled demand will continue to be the envy of most economies in the near future. More importantly, China's consumption upgrade story, a secular trend, is unlikely to be derailed by higher interest rates. But it will be better for consumers not to increase leverage in 2018 so that corporates do not get a chance to procrastinate over their de-leveraging efforts. Following PBOC Governor Zhou Xiaochuan's sobering remarks on the Minsky moment (i.e. sudden collapses of asset value) during the 19th Party Congress there have been a slew of initiatives and products from major commercial banks and developers on long-term rentals. For example, qualified tenants can take loans up to RMB 1 million with around 4% interest compared to an outright mortgage rate of 5%. Developers are keen to explore such opportunities in order to reduce inventories (a sharp run-up in prices is not in their best interest) and not have buildings lying empty. Many residents would be interested in renting instead of buying expensive homes if they could get the same rights (e.g., access to schools) as homeowners. From the Chinese governments' perspective, a long-term rental market could serve two goals – 1) to satisfy pend-up demand for housing; 2) to deter speculation and not perpetuate “bubbles” by presenting an alternative to home buying. This fits the overarching policy guideline of "putting financial resources back into the real economy". If policymakers’ objective is to prevent excessive risk-taking in the property market, and to divert liquidity into areas where the cost of funding investment in the real economy is currently excessively high, a gradually rising stock market and a soft-landing of the property market is an essential prerequisite. For, not only would a booming stock market provide badly needed funds to many enterprises but it would also make corporate deleveraging easier. But would policymakers be able to tough it out should the property market undergo such adjustment?

It should certainly be possible provided a few pre-conditions are met. First of all, even if the property market is flat in 2018, it would be unlikely for property investment to register 7-8% of growth in 2018 as it did in 2017.  This would have a dampening effect on growth in other sectors as in China traditionally, the property sector has had a greater impact on many other sectors (furniture and autos etc.) of the economy than in most other economies. There are many reasons for this. For example, many Chinese consumers only buy cars if they buy apartments because their previous homes were not conducive for parking.

Second, unlike in developed countries, Chinese consumers can't easily hedge their interest rate exposures (there are almost no fixed mortgage products). If for whatever reason, the Fed surprises the market by being more hawkish, current offerings by commercial banks on long-term leases could change significantly. For example, if the Fed fund rate goes above 2%, (not a far-fetched scenario in 2018) yields of existing wealth management products must rise to 5% (at least), and accordingly mortgage rates could rise above 6% making rental an increasingly attractive option. Rising interest rates in the US will put downward pressure on the RMB and upward pressure on rental yields which are low in major Chinese cities by any yardstick. A pullback of property valuation would also result in higher rental yields. The question is whether the market could fall by more than what the Government wants to see as borrowing costs rise.

In our view, the Government might try to prevent a meaningful decline of property prices for social reasons. But as transaction volumes have dropped sharply, developers will scale back their investments. All in all, GDP growth has to become more moderate in 2018. And given the relatively tight labor market, China can afford to and should lower its GDP growth target. A hawkish Fed is the best possible excuse for China to embrace a GDP growth target of 6% or even less.  Fed tightening will surely be a constraint on domestic credit growth, and what China has signed up to in the wake of President Trump's visit as regards the next phase of liberalization (allowing foreign ownership up to 51% in banks, securities companies and insurance companies within 5 years) will make de-leveraging ever more urgent.   

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Retail

Ripple effect of checkout-free retail

When Amazon unveiled Amazon Go in late 2016, the new format of convenience store attracted huge amounts of attention from the public thanks to the advanced “grab-and-go” shopping experience. At the annual Taobao festival held in July of 2017, Alibaba officially rolled out Tao Café, its own version of the checkout-free store. The concept of checkout-free retail generated heated discussion. The rapid influx of capital into checkout-free retail has made it a red-hot zone on the Chinese retail market landscape.

Different forces are tapping into checkout-free retail

Advances in technology and a rapid inflow of capital have given rise to rapid growth in checkout-free retail this year. According to JingData (formerly 36kr venture capital assistant), 138 checkout-free retail enterprises have been established in China from 2003 to September 2017, of which vending machine businesses account for the highest portion. However, during the five months from April to August 2017, eight companies focusing on checkout-free convenience stores were established, accounting for one-third of all newly established checkout-free retail companies this year, signalling a possible shift in investment priorities.

Left Fig. Number of new start-ups

Right Fig. Distribution of formats

Compared with traditional vending machines, checkout-free retail activities offer a great deal more choice in the range of products, retail scenarios and payment methods. It also differs a great deal in terms of technology application, payment methods, and backroom management. In addition to labour cost reduction and efficiency enhancement through the use of new technology, this new business format pays more attention to consumer behaviour and experience while providing customers with a more diversified and yet personalized shopping experience.

So far, three types of players are tapping into this market.  Each approach the sector of checkout-free retail from different angles.

Main types of players tapping into this market

Source: public information 

The influx of capital accelerated in 2017. According to JingData, 57 enterprises received financing by the end of September 2017, 88% of which are still at the stage of the pre-A or A round of financing. This shows that business development is at a relatively early stage. However, as recent financing events have proved, the influx of capital is speeding up. In September alone, at least three checkout-free retail enterprises received financing. And on November 1st, Orangutan Convenience which was founded just 5 months ago, received RMB380 million yuan in A round financing, which clearly demonstrated the feverish enthusiasm of the financing community to invest in the field of checkout-free retail.

Typical Financing Events

Source: 36kr, Pedata 

Government support & industry guideline to promote checkout-free retail development

At its regular press briefing held on 21^st September 2017, the Ministry of Commerce publicly expressed support for checkout-free retail. The Ministry indicated that advances in technology are what have made checkout-free retail feasible and these same technological advances are also the main driver for the transformation of China's retail industry. Actually checkout-free retail is a beneficial attempt to push structural reform from demand to supply side in the field of commerce and trade. Against the backdrop of the approaching "11.11" shopping extravaganza and accelerating development in checkout-free retail by industry giants, China Chain Store & Franchise Association issued a paper entitled "Guideline to Operation of Checkout-free Stores". At the same time, the "Guideline to Operation of Checkout-free Business in China" issued by China Commerce Association for General Merchandise also entered the public-comment phase. These guidelines aim at fostering the healthy development of the industry and not only offer advice for product management, after-sales service, store safety, emergency response mechanism, site selection and other aspects but also provide policy support for a healthy and legal development of enterprises in the field.

Checkout-free retail will become an important force to drive the development of the retail industry

Although advances in technology and influx of capital provide strong support for the development of checkout-free retail, the industry is still at an early stage of development. Technologies, business models, regulations and other aspects still need to be further developed. As checkout-free retail matures as an industry it is expected that it will influence the retail industry in the following ways:

• Increase methods of consumption and enhance consumer experience. Checkout-free retail reduces costs, increases the ways in which people can buy things and better meets consumer demand by providing consumers with a more convenient and personalized shopping experience.
• Integrate with existing retail system. The development of the checkout-free retail business will also help technology based companies penetrate further into the retail market. Deepening co-operation between technology transfer companies and retailers in the form of checkout-free terminals will help the technology-transfer enterprises to better serve the retailers through the improvement of data collection and analysis. Overall, the retail industry and technology providers will be better able to serve consumers.
• Promote digital transformation of offline retail. The original aim of checkout-free retail was to reduce costs, improve efficiency and enhance the consumer experience. These objectives are shared by traditional retailers who are undergoing digital transformation. Therefore, it is foreseeable that the development of checkout-free retail will promote the advancement and popularization of digital technologies. The same technologies that are being used by checkout-free retail are expected to be adopted by the majority of retailers in a simple and inexpensive way and deployed to optimize their daily operations.

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Telecom

Mixed-ownership reform shows promise

China Unicom, once a market leader in the 3G era, has lagged behind the other two major carriers, China Mobile and China Telecom, in the 4G era.  To reverse this trend, China Unicom has invited private-sector investment in a test case of the country's reform of state-owned enterprises (SOEs).

Figure: Four Types of Strategic Investors 

Mixed-ownership reform is being pushed by the Chinese government with an aim to re-vitalize SOEs through capital injections from the private sector. The three largest telecom operators, China Mobile, China Unicom, and China Telecom, are all Stated-backed enterprises and have monopolized the market for decades.

The proceeds raised from the sale of shares will assist China Unicom to push forward in various business endeavours such as cloud, big data, and artificial intelligence. The operator added that funds injected will also be utilized to enhance its 4G mobile capability and conduct 5G technical trials in China.

The mixed-ownership reform scheme consists of four parts: 

• China Unicom Group: Prior to mixed-ownership reform, China Unicom Group held 62.7% of the shares of the company. After the mixed-ownership reform, its holdings have been reduced to 36.7%, which means China Unicom Group is no longer the majority shareholder.
• Public Shareholder: After the reform, percentage of shares held by the existing public shareholders decreased from 37.3% to 25.4%.
• Employee Stock Option Plan: China Unicom Group gives 850 million restricted shares to core employees, accounting for 2.7% of the total shares. This is the first time equity incentives have been awarded to employees to establish an effective corporate governance structure and market-based incentive policies to enhance the vitality of the enterprise.
• Strategic Investors: Fourteen enterprises were chosen from 4 industries: the Internet, vertical industry leaders, financial enterprises & industrial groups and industrial funds. A diversified mixed-ownership structure was formed by acquiring 35.19% of the China Unicom shares. 

The mixed-ownership reform has thus far produced positive results. In the first three quarters of 2017, China Unicom recorded a net increase of 55.73 million 4G users, narrowing the gap between it and China Telecom to 8 million. In project cooperation, significant progress has been made. China Unicom announced that it has cooperated with Tencent and Alibaba in many areas of cloud computing. In their cooperation with Alibaba, Ali Cloud will provide public cloud services and the two companies will form a partnership in proprietary cloud, such as government cloud. In the cooperation with Tencent, a cloud data centre has been set up providing products and services on the cloud industry chain and technical support for Wo Cloud. China Unicom also cooperated with Jingdong and turned the carrier’s brick-and-mortar stores into Smart Life Experience Centers, combining both daily products and delivery business to provide a one-stop service for consumers. As the cooperation between China Unicom and strategic investors deepens, areas of cooperation is expected to rise so that synergy can take place.

In view of the above, it is probably safe to say that China Unicom is a litmus test of mixed-ownership reform for State-owned enterprises. The lessons learned will certainly affect the reform process in other telecom companies in the future. Some conclusions can be drawn already:

• Proof of deepening reform. The telecom industry used to be a monopolistic industry where SOEs must hold no less than 50% of all shares. However, the mix-ownership reform of China Unicom broke away from the existing norm and has proved successful so far -- which bodes well for future of SOE reform.
• Strategic investors’ right to voice opinions enhanced. After the mix-ownership reform, China Unicom no longer holds majority share. What's more, the idea of “Same Share, Same Right” was introduced and recognized. Different from the past, the right to voice opinions of strategic investors are guaranteed in the reform. That is why many strategic investors are attracted to participate in mixed-ownership.
• Focus on employee incentives. Equity incentive is given to core employees in the reform in order to facilitate the reform and create a market mechanism where rewards and risks are shared with employees. In the subsequent mixed-ownership reform, companies should pay more attention to employee incentives and roll out employee incentive schemes to stimulate employees enthusiasm for work.
• Push for business innovation. After reform, China Unicom cooperates with BATJ (Baidu, Alibaba, Tencent, Jingdong) and is likely to make breakthroughs in business using cloud computing, big data and AI, creating new service models and improving efficiency. 

Although the reform is unprecedented, it is difficult for China Unicom to pull itself out of its big hole within a short period of time. Many issues are still waiting to be resolved such as the guarantee of fairness in the reform and the ways in which cross-sector businesses are handled. What is more, industry regulations need to be updated to cope with post-reform issues. For example: How is the balance going to be maintained relative to anti-monopoly policies and industry regulations? How is a proper industry-wide management and supervision system to be created - by combining various policy-making government bodies? These questions need to be addressed.

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Logistics

New retail spawn new logistics

The next five years is a crucial period

On  November 11(A well-known shopping festival in China), the turnover of T-mall(Alibaba’s retail e-commerce platform)  hit a new record of RMB 168.2 billion yuan, of which wireless transactions accounted for 90% of the total. The transactions covered 225 countries and regions in the world. According to the statistics of the State Post Bureau, the total order volume of logistics for major e-commerce platforms in China was 850 million on the same day, an increase of 29.4% over the same period of last year. Increasing demand for incremental sales forces the logistics industry to iterate at a high speed.

To further promote its new retail strategy, Alibaba Group announced in September 2017 that it will increase its stake in Cainiao (a well-known logistics company which also is an Alibaba subsidiary company) and will continue to invest RMB100 billion yuan in the next five years on the heels of tens of billions of yuan already invested to accelerate the construction of a logistics network. The investment will be mainly used for the construction of key technologies such as big data technology, intelligent warehouses, intelligent distribution and a global hub of super logistics. Meanwhile, JD Logistics (another noted logistics company which is owned by JD Group) also plans to build up its Asia No.1(JD's national logistics centre) in more than 30 core cities over the next five years so that its intelligent warehousing will radiate in the seven major regions of the country. This year both Ali and JD have made more investment in intelligent equipment and hub transportation resources, and both have strengthened supply chain platforms powered by big data.

Figure: The investment and financing trend in logistics industry by VC/PE

Actually, this trend is not that new. The scale of investment and financing in China's logistics industry has been expanding since 2012 and after 2015, it has accelerated sharply. ChinaVenture data shows, with VC / PE financing approaching USD9 billion in 2016, an increase of 368% over 2015. This is because, since 2016, one courier company after another went public, including STO Express, YTO Express, ZTO Express, YunDa Express and BES Express. Which is why we predict that in the next five years, the overall market size and efficiency of China's logistics industry is bound to reach a new height.

Development directions of new logistics

With the arrival of a new retail wave, the logistics behind the new retail will undergo a complete revamp. Different from traditional logistics, the new logistics will integrate big data into the societal storage system to achieve its development goals of automation, intelligence, socialization and fully-integrated supply chain (the series of processes involved in the production and supply of goods, form when they are first made, grown, etc. until they are bought or used). The future development of new logistics will show three important characteristics. 

1. Increase localization delivery

The new retail will enable online and offline integration and the offline physical stores will further form a supply and demand system within a radius of 30 minutes. Many goods can be obtained from a nearest physical store without having to be shipped by couriers. So these physical stores will become a front-end fulcrum of future logistics and distribution. An enterprise's logistics resources will be integrated into the societal logistics system, which is one of the future directions of the new logistics.

2. Optimize supply chain

The new logistics will be integrated into the daily production and operation of enterprises in such a way as to enable total supply chain optimization. The big data analysis will systematically calculate sales planning, and then guide stock management, eliminating inventory issues. This is a major change that we can expect with the coming data-driven supply chain model.

3. Competition in an ecosystem way

In the future, competition will not be so much about the competition of one enterprise against the other, but about competition amongst ecosystems or groups of technologically integrated enterprises. Logistics companies without the capabilities of data capture and data application will easily be replaced by the shared economy in the future.

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