The Deloitte Research Monthly Outlook and Perspectives
21 March 2018
China's bolder financial liberalization will defuse trade tensions
To many China-watchers’ surprise, the Chinese government’s reactions to President Trump’s announcement of higher tariffs on steel and aluminum were quite muted. There are several reasons for this. First, China's direct exposure in terms of steel exports to the US is small. Second, though China's efforts in cutting over-capacity in steel have achieved admirable results over the past two years, the reality is there is still some distance to go (e.g., 30m tons of steel capacities were set as a policy target in 2018). Policymakers are aware of the challenges ahead and though a robust external demand could buy China some time in terms of the pace of over-capacity reduction, the steel industry need to be shrunk further, which could also weigh on other sectors (e.g., coal). A certain amount of external pressure (e.g., higher tariffs in the US and anti-dumping cases in Europe) would not be a bad thing as it would prevent steel SOEs (whose profits have improved immensely recently) from ramping up production again.
Steel and Aluminum tariffs aside, the real issue is this: how should China react to a more broad-based set of tariff increases, as well as the nascent trend of more countries resorting to investment restrictions and a probable visa restriction touted by the US? According to the Washington Post, at present the Trump Administration is mulling over a package of $60bn in annual tariffs on China's exports of electronics and telecom equipment. To add to this, a US trade official was heard touting a figure of $100 billion per annum in terms of bilateral trade imbalance reduction. The situation remains fluid, as Trump appears to have lost patience and has shown a willingness to unilaterally follow through on this specific set of tariffs, even amid objections from advisors warning against a global trade war. Does such an arbitrary number merely reflect the Trump Administration's negotiation style or does it show a growing desire to push China to open up its domestic market in the name of "reciprocity”?
We are of the view that most of these acts of protectionism against Chinese exports and Chinese overseas investment stem from the external perception that China has not lived up to the promises it made before the WTO accession in 2001. Such reception has also festered certain views that China's gains from the globalization have outweighed the cost of social dislocations in the West. Therefore, the best policy response would not be tit-for-tat tariffs but rather concrete steps in opening up domestic markets (service sectors especially) within a clearly defined timetable. In the past, China tended to react with greater purchases of US products in order to mitigate the threat of trade sanctions and/or protectionism. But in the present situation, should China adopt a carrot-and-stick approach? It could, for example, increase its imports of US natural gas and/or divert imports of agricultural produce from the US to other countries. However, our opinion is that this would be counter-productive because protectionism and pushback on China's investment are also rising in other countries. A case in point is Australia. Despite a more moderate view towards Chinese companies with its economy complementary to that of China, Australian government’s decision to rule out China's State Grid acquiring a majority share in Ausgrid has therefore drawn much attention. Indeed, it would be wiser for China to recognize the frustration with regard to the lack of reciprocity and limited market access as this is a feeling that is widespread even among those who are not necessarily China hawks. Reciprocity has almost become a buzz word in the recent speeches of the Kenyan President Uhuru Kenyatta who has called on China again and again to do more to tackle the widening trade deficit and rebalance an increasingly skewed China-Africa trade relationship. Linked to this, Liu He, China’s deputy prime minister, has promised at Davos this year to surprise people by liberalizing the market "much more than expected". But subdued reaction to the financial liberalization package that was announced in the wake of Trump's visit last November suggests that liberalization ought to be bolder. Against this backdrop, the surprising appointment of Yi Gang as governor of the PBOC should be viewed as a strong signal that the pace of market-oriented reform in the financial sector will pick up. (Dr Yi, deputy governor and a well trained economist, was appointed during the recently terminated Two Sessions in Beijing.) What Dr Yi is expected to do is to make curtailing financial sector risk a top priority. Specifically, the PBOC is expected to cap M2 growth below 10% so that the debt/GDP ratio can peak and eventually trend down. In addition, Dr Yi will have to gradually ease restrictions on the capital account but without losing control of it. Conceptually, bolder financial liberalization than what has already been announced is needed in order to compensate for a "dirtier" (tightly managed) float of the RMB as the latter could well deter portfolio inflows if not handled carefully. In the medium term, if China can gently deflate real estate or other bubbles by continued economic growth, an RMB clean float could be achieved. Such a clean float is needed as otherwise China will be perpetually accused by the US of manipulating the exchange rate.
Chart: Increasing pressure on market access
Q: What action can the US government take to help foreign businesses in China?
Apart from the capital account question, the PBOC also faces several other challenges. First, can China keep the RMB exchange stable as the Fed ratchets up short term interest rates? Second, the economic impact of protectionism (whether China retaliates or not) will be inflationary, which could make the Fed even more hawkish about tightening. Third, there are very few precedents of successful de-leveraging in history where brute force has not been exerted by some external power.
China could re-ignite a true strategic dialogue with the US (the current one only exists in name). However, since it appears that President Trump disdains policy briefings, greater-than-expected market access in service sectors is more likely to succeed, as it will align China's national interest with that of US companies, whose executives are likely to have greater influence with the Trump Administration than pundits and career diplomats. At the same time, improved market access will also defuse trade tensions between China and other countries.
Tighter regulation on asset management leads to further deleveraging
Between 2014 and 2016 Wealth Management Products (WMPs) from Chinese banks helped fund the explosive growth of China's asset management (AM) sector, an important driver of the debt, bond and stock markets in China. WMPs were also partly responsible for the ballooning of shadow banking in China. However, with the new set of Asset Management Rules (the Rules) drafted under the leadership of the Financial Stability Development Commission that is scheduled to go into effect in the near future, financing channels will be cleansed, and the sector whose assets under management (AUM) have already reached more than RMB102 trillion will be better regulated. Once the Rules go into effect, around RMB 29.5 trillion worth of bank WMPs business will need transitioning. Also, some off-balance-sheet businesses will have to be brought back onto the balance sheet. This will reign in shadow banking and accelerate financial deleveraging.
AM subsidiaries will emerge
Under the new set of Asset Management rules, pledging a guaranteed investment principal and income will no longer be allowed (it is explicitly banned). The `Rules’ also stipulate the adoption of a net worth approach for product management. Additionally, WMPs that pledge to produce high yields and guarantee the return of investment principals would be considered as fraudulent. The net worth approach conforms to the generally-accepted principle of fair value, which makes Chinese investors bear the responsibility of their investment profits and losses. As a result, the existing WMP mode with guaranteed profits will be brought to an end.
In 2017, enhanced regulation significantly curbed the high growth rate of banks' WMPs. As a result, WMPs only rose 1.7%, plunging 22 percentage points when compared with the same period in 2016. Interbank WMPs have also been falling for 12 consecutive months. Hence, in 2018, liquidity continues to be tight, weakening banks' capacity to raise money. As a result, funding sources for shadow banking continue to be inadequate, accelerating financial deleveraging.
As WMPs under the net worth approach require high-quality management capability, active management capacity will become the cornerstone of competitiveness. As banks aspire to manage products on their own, those with excellent product management capabilities and a high ratio of WMPs under the net worth approach will see better growth. In accordance with third-party independent hosting requirements, regulators will allow banks to establish subsidiaries as independent legal entities to operate their AM businesses. Banks can host products issued by their own AM subsidiaries or they can entrust their subsidiaries to manage investment products. These moves signal the end of channel businesses as banks will no longer need to entrust their AM business to external institutions. Banks establishing their own AM subsidiaries will be the direction of development in the future.
Shadow banking activities will be turned into on-balance-sheet items
The Rules explicitly forbid multi-tier nesting and channel businesses in order to put an end to shadow banking activities. The massive AM businesses are the key drivers in the rising property markets and capital markets. In the past, large amounts of `off-balance sheet’ capital from WMPs were made available through a complicated network of securities and trust companies in the form of loans (shadow banking) to investors who speculated in leverage operations, creating asset bubbles in the secondary markets. In 2017 enhanced regulation slowed down the growth of entrusted loans, trust loans, AUMs of securities firms and mutual funds, forcing money that would have otherwise gone into shadow banking activities back on to the balance sheets. In the future, enterprises will gradually clear redundant funds from shadow banking and rely on on-balance sheet bank loans and/or corporate bond issues.
Chart on left: Entrust loan, trust loan sustain negative growth or micro-growth (yoy)
Chart on right: AUM growth (securities and fund) continues to fall down
Asset growth decreases as profitability continues to improve
As strong financial regulation and deleveraging have slowed down the growth of bank assets or even reduced their assets, profitability, however, has improved. CBRC announced that the net profit of commercial banks reached RMB 1.75 trillion in 2017, a 6.0% growth yoy (2.5% higher than 2016). CMB, the king of retail banks in China, reported a net profit in 2017 of RMB 70.15 billion, a 13% increase yoy.
Chart on left: Asset growth of banks (Chinese banks) continues to slow (total assets yoy)
Chart on right: Commercial banks earnings will continue to improve
The net profit of banks is expected to continue to improve in 2018, for three reasons. First, the Rules and enhanced regulation will speed up financial deleveraging. As tight liquidity continues, market interest rates will potentially rise, leading to wider interest rate spreads, which will in turn increase profitability. Second, banks will likely deal with their non-performing loans by continuing to reduce credit cost through debt-to-equity swaps and asset securitization. Third, on the demand side, macroeconomic stabilisation and credit demand in various sectors continues. Industry insiders have estimated an optimistic 6.6% net profit growth in 2018. However, in light of the non-performing loan ratio (1.74) showing no improvement in 2017 from 2016, the Rules' impact on banks’ WMPs and regulatory uncertainties (CBRC has of late officially launched a review of the qualifications of bank shareholders), we believe banks will continue to be under a certain amount of pressure. Therefore we foresee that in 2018 the banking sector’s net profit growth will be closer to 6.3%.
Mixed signals for private oil and gas enterprises
Despite growing participation by private enterprises in China’s oil and gas sector, doubts remain as to whether private investment can secure a firm footing. Recent government crackdowns on several heavily indebted private conglomerates have given rise to heated discussion about the current financial and business environment China's private enterprises face.
At one level, the ongoing liberalization effort in the previously State-dominated oil and gas industry is paying off. In line with the government's broader privatization drive, five oil and gas exploration licenses in the Tarim basin will be offered to non-State operators to promote competition in upstream. The five blocks have a combined area of more than 9,000 square kilometres and will be opened to bidders through five-year exploration permits. In addition, private gas distributor ENN will start to operate China's first privately owned LNG import terminal which is located in Zhoushan, Zhejiang Province. It has an annual capacity of 3 million tons and should be operational within the year. ENN also plans to form a joint-venture with Australia's Santos to cope with the ever-rising LNG demand in China.
On the other hand, a non-State-owned oil conglomerate in China, CEFC, who plans to buy a $10 billion (14.16 %) stake in Russia's oil major Rosneft, has currently come under tight government scrutiny. According to media reports, a task force headed by Shanghai vice-mayor Wu Qing, also a former chairman of the Shanghai Stock Exchange, is assessing CEFC's debt risks and has been tasked to formulate a debt reduction plan for the company. This is part of the government's efforts to prevent and curtail financial risks, especially considering the scale of leveraged buyouts and outsized overseas acquisitions by private conglomerates with excessive borrowing. Many private enterprises still continue to harbour the illusion that by bulking up and becoming "too big to fail", they will continue to be able to secure bank lending or other financing. However, if history is any guide, governments don’t always come to the rescue of big companies. It pays to remember how the purchase of iconic American brands and landmark properties such as the Rockefeller Center by Japanese companies in the late 1980s and early 1990s ended in disaster.
We believe that the signals from the government are that private companies in the oil and gas sector will have an increasing stake throughout value chain. However, they should not prioritize speed of investment over quality of investment, as the myth of "too big to fail" is fast fading away.
Return of physical retail
After experiencing a prolonged industrywide recession, traditional retailers were faced with two choices: transform proactively or collaborate with E-commerce companies. Against such a background, mainstream players began to experiment with new ideologies, new models and new experiences, starting in 2017. According to the Ministry of Commerce, physical retailers demonstrated a progressive improvement in their sales in 2017. Total sales of the 2700 typical retail companies tracked by the Ministry increased by 4.6%, a 3 percent rise in growth rate over the same period the previous year. Total profit also increased by 7.1% with a growth rate of 11% on a year-on-year basis. Format innovation, omni-channel development, supply chain restructuring, and channel sinking are the main catalysts for accelerated growth in 2017. With physical retailers being the ultimate and irreplaceable connectors with customers, the newly transformed retailers expect to attract more and younger consumers under the new consumer-centric technology-linked business model.
China raises the bar with tougher NEV subsidy rules
For some time now, the Chinese government has been using the carrot approach to stimulate demand for NEVs. They have been offering hefty subsidies of as much as half the price of a car and free registration of license plates, thus eclipsing the price advantages of gasoline-fuelled cars. But as sales of NEVs hit a new record of 779,000 last year, China is anxious to transform its subsidy-stimulated electric vehicle market into an independent market that is not driven by subsidies but by market need and merit.
The long-awaited new rule on NEV subsidies for 2018 has, at last, been finalised. Apart from a four-month transition period that provides automakers with some relief, the 2018 scheme is in line with market expectations of declining subsidies. Meanwhile, technical requirements for NEVs are tightening. The two in tandem will have a profound impact on China’s booming electric vehicle market. In the short term, NEV manufacturers will face a tough time as they need to dump old and low-tech electric cars, hurting their cash flow and profitability in the process. In the long run, the renewed policy points to a shift in the underlining concept of how to cultivate the domestic EV industry - from providing benefits for all participants to tailoring benefits to target the technologically-advanced automakers. It also requires automakers to swiftly respond to market changes, upgrade their battery technologies and secure the supply chain of key components.
The new rules reward long-range and high energy density electric vehicles
The most significant change in the 2018 subsidy scheme is the removal of travel range as the single deciding factor on the amount of financial subsidy that will be awarded. Under the new rule, subsidies will be calculated by factoring in two additional values - “energy density” and “vehicle consumption”, a move that is viewed by carmakers as a reward for technology upgrades. Unlike in past years when EV makers simply boosted ranges by adding more battery cells in order to qualify for more subsidies, the new rule shall require local carmakers either to alter their vehicle designs or change for a better battery supplier with higher energy density technology.
The 2018 scheme raises the minimum range required for qualifying for any kind of subsidy from 100 kilometers (km) to 150 km. Electric vehicles with a range of less than 300 kms have a lot to lose, especially the ones with a range of 150-200 km which will see a reduction in their subsidies by more than 50% (from RMB 36,000 to 15,000). But EVs with over 300 kms in range will get a boost as the policy clearly favors vehicles with longer ranges.
Energy density will start to play an increasingly important role too. Currently, a large portion of the most popular EV models on the market have an energy density of lower than 105 wh/kg - a benchmark that has become the prerequisite to qualify for a 100% subsidy. From now on, for EVs below the benchmark the subsidy will be capped at 60%.
Inexpensive EVs with short range will be hit the hardest
Small-sized (class A00) electric cars which have been extremely popular in China because of their low price and reasonable travel range, have until now captured more than 50% of the battery-powered passenger vehicle market. A major cut in subsidy may impact their price-sensitive customers adversely.
These inexpensive and short-range EVs will face a major cut in subsidies. For some models, subsidies will go down to zero. Domestic carmakers who have been focusing on this segment, will have to re-tool their product strategy, either by increasing ranges which will make their cars less price competitive, or by pivoting their focus to mid-sized and large sedans, and SUVs. Among the affected carmakers, BAIC, JAC, Chery and Zotye will suffer the most. EC series by BAIC, Zhidou by Zoyte and eQ by Chery, all of which have a range of less than 200 km, were the three best-selling EV models last year.
A mounting Controversy
The four-month transition period is designed to smooth any volatility in the market and provide automakers with some relief, but it also creates a distortion in pricing. For instance, some long-range electric vehicles with high tech specifications will have two different prices during the transition, which may cause some consumers to wait it out until the new subsidy scheme actually goes into effect.
Another change is the removal of certain local protective measures (for example, if an EV manufacturer plans to sell his products in another city, he will have to invest and build a plant there first) which have long been acting as implicit incentives for local carmakers, guaranteed by municipal governments. However, judging by the latest subsidy schemes issued by the Beijing and Shanghai governments, local authorities will still have an important role to play.
Life Science & Healthcare
Payment reform remodels healthcare services
A generalized fund deficit in basic medical insurance has always been one of the greatest challenges facing China's healthcare sector. With the aging of the population and the dependency ratio increasing, the government is aware that funding pressure can only become more serious in the future. Although multiple cost control policies in the past several years have been partially successful in alleviating the pressure, issues like insurance fraud, over-treatment and patient discrimination still exist. Payment reform has therefore emerged as one necessary approach to solve these problems.
In June 2017, the General Office of the State Council released a guideline which designated payment reform as a major task for medical insurance reform. More specifically, total budget control, single disease payment, mobile payment & reimbursement are, in turn, going to be the major tasks of payment reform. Predictably, payment reform will have a significant impact on the way healthcare services are delivered in the future.
More details on total budget control with wider coverage
Total budget control as the foundation of payment reform will shift its focus from controlling the budget of an individual healthcare institution to controlling the budget of the region within which healthcare institutions operate. In addition, policy makers are going to put in place a new "point method" which is a disease-based value calculation method. This will replace the old method of simply putting a cap on the total amount of money reimbursed. These proposed changes will push healthcare service providers to proactively keep medical costs under control and improve their performance.
Meanwhile, basic medical insurance will be extended to cover outpatient surgery. But, given that outpatient surgeries have always involved expensive minimum-invasive technologies and high-value disposables, issues like reimbursement rate and cost control need to be carefully studied.
"Single disease payment" is the core of payment reform
The "point method" depends upon the implementation of a "single disease payment" measure, which is also at the heart of payment reform. The objective of "single disease payment" is to standardize diagnosis & treatment procedures and charges for certain diseases, thus making it difficult for providers to resort to unnecessary and over-priced drugs & disposables.
But since the standardization of complicated medical service procedures is challenging, some pilot trials on relatively simple diseases are necessary at the onset. Just last month, the Ministry of Human Resources and Social Security (MOHRSS) requested that hospitals pick no less than 100 from its published list of 130 diseases to start pilot trials of "single disease payment". Such a move will probably negatively impact brand-name products and adjuvant drugs.
Promote mobile payment & reimbursement
The last prong of payment reform is the introduction of mobile payment and reimbursement. In a recent document, MOHRSS stated that medical insurance funds would be permitted to work with commercial banks and make third-party payments. On the heels of the announcement, Alibaba, Tencent and Pingan started signing mobile payment & reimbursement contracts with local governments and hospitals in the hope of securing a firm foothold in the market.
Close attention should be paid, however, to the potential risk of data breach when promoting this digital platform. According to a survey conducted by IBM and the Ponemon Institute, healthcare data breach costs an average of $380 per record, more than 2.5 times the global average across all industries. Therefore, as policy makers are proceeding with extra caution in this area, there could be the risk of policy rollbacks in the future.