The Deloitte Research Monthly Outlook and Perspectives
25 May 2018
China – looking beyond the bilateral trade deficit with the US
A US-China trade war seems to have been averted for now. China has pledged to increase imports from the US over the next two years and in return, US officials have promised to ease investment restrictions on Chinese firms investing in the US. This is in line with our long-held view that an out and out trade war between the US-China is highly unlikely but minor `trade skirmishes’ will be the New Normal in the medium term. This is because economic codependency between China and the US is now so firmly entrenched that any significant tariffs by the US and potential tit-for-tat responses by China will have a catastrophic impact on the global supply chain. So the pressure is on policymakers on either side to come up with an acceptable compromise each time there is a trade conflict. Geopolitics in North East Asia could be one trigger. On the latest development of the much-hyped Singapore summit, President Trump has cancelled his meeting with Kim Jong Un, suggesting that certain conditions laid out by the US to North Korea for the summit have not been met, and yet he might be outplayed by the North Korean leader. According to Max Baucus, the former US ambassador to China, President Donald Trump is mixing three issues that should not be mixed: trade, foreign policy and enforcement. There is no doubt that China’s critical role on the Korean peninsula can't be discounted, but any setback on President Trump's efforts of denuclearization in North Asia might bring about fresh demands on trade towards China.
But for the moment, China promising to substantially increase US imports is killing two birds with one stone. It satisfies the US’s desire for so-called fairer trade and bolsters domestic consumption. As a recent People's magazine editorial pointed out, greater imports of US goods are real and concrete ways to satisfy Chinese consumers' desire for a better quality of life. China clearly would not want to scale back its exports to the US, a lose-lose situation for both countries. Therefore, if the bilateral trade surplus with the US must come down significantly (China has never agreed to the amount of $200bn in 2 years), increased purchases of US goods is the only viable option. Against the backdrop of China's ongoing corporate sector de-leveraging, to be forced to have a stronger RMB would be an even worse policy response.
If import tariffs were cut across the board, would bilateral trade imbalances between China and the US be reduced substantially? For the sake of argument, let’s say China was to increase imports from the US by $200 billion in the next two years (China's total imports from the US in 2016 and 2017 have amounted to $288.34bn). This would be practically impossible just by buying more agricultural and energy products from the US. What is indeed possible is that China would reduce imports from Europe and other markets to compensate for increased imports from America.
Chart: Substantial trade-deficit reduction unattainable if only increase food and energy imports
Would this result in greater pressure from the EU on market access in China? So far, the EU has taken a much stronger stance towards "Made in China 2025" than the US because leading European economies especially Germany do compete with China in certain industrial sectors. So it is indeed likely that outstanding issues between China and Europe regarding China's industrial policies combined with the potential substitution effect on imports (due to greater imports from the US) will bring to the fore issues of market access with the EU.
Looking ahead, on the domestic front, the 2018 GDP target of "around 6.5%" remains on track. This means the PBOC's main objective of preventing financial sector risks remains intact. But the repercussions of a hawkish Fed is perhaps not being fully appreciated by China. Recent sell-offs of some emerging market currencies (notably Argentine peso and Turkish lira) are a case in point. Despite a flexible exchange rate and relatively sensible macro policies in Argentina, the sudden flip in investor sentiment, which was trigged by stronger-than-expected US economic data, has caused interest rates to surge. The reality is that the Fed's tightening is more motivated by a need to normalize interest rates in the wake of the global financial crisis of 2007 to 2008, rather than cooling off a potentially overheated US economy. Therefore, another three hikes of the Fed Fund Rates in 2018 are almost a done deal. The policy dilemma faced by China is whether to hold a steady RMB or to follow the Fed's rate hikes. We would like to reiterate our long-held policy recommendations – to significantly improve market access so as to mitigate trade tensions (including but not limited to the ones with the US), and to have a more flexible RMB exchange rate to buffer higher US interest rates.
The journey to a more comprehensive and effective regulatory framework in China
After the conclusion of the Two Sessions, China has taken long awaited and much needed steps to coordinate policy-making and administration in the financial sector. To do this it has merged two long-existing regulatory commissions entrusted with overseeing banking and insurance into a single new administration called the China Banking and Insurance Regulatory Commission (CBIRC). Alongside this it has retained The China Securities Regulatory Commission (CSRC) albeit with amended powers. Under the leadership and direction of the Financial Stability and Development Committee (FSDC), which will operate in the important capacity of interagency financial coordinator, China has basically established a new regulatory framework consisting of "One Committee (FSDC), one Bank (People's Bank of China - PBOC) plus Two Commissions (CBIRC and CSRC)".
China's super "Central bank" will play a bigger role (as the most senior policymaker)
The PBOC has been vested with more power to lead future financial regulation at a macro level and will be responsible for drafting many of the critical policies and rules (which were formerly the responsibility of banking and insurance regulatory commissions), to foster an overall environment of "prudent macro-economic regulation".
It remains to be seen how the PBOC plays its re-defined roles. It is expected to see a stronger and more direct connection between the supervision and operation of markets and market participants with the overall policy objectives currently being pursued by the central bodies of the Chinese government.
In our view, if the reforms have the desired effect, the PBOC is likely to further reduce the reserve requirement ratio (RRR), raise market rates (PBOC's lending rate & mortgage rates), issue new regulations and continue to increase regulatory pressure and oversight of shadow banking, internet finance and financial holding companies.
Two Commissions to provide effective and practical oversight as independent regulators
The two Commissions will be charged with focusing on policy execution and the supervision of market activity. The supervision of risk-bearing investment will become more market oriented, and will seek to foster a "mixed operation" environment, moving away from a compliance-based "individual institution" supervision approach. This is because the latter was more in line with the traditional "segregated operation" approach which was found badly wanting after the global financial crisis.
The merged CBIRC will be able to focus on the similarities between prudential and market supervision of banks and insurance companies and set appropriate standards for measuring financial strength. It will also be setting requirements such as capital adequacy and solvency ratios for both sectors in order to enhance protection for consumers as they make decisions on where and how to invest their wealth and savings. The merged CBIRC will also make it possible to focus on minimizing the gaps and overlaps that have contributed to the growth of the so called "shadow banking” and “wealth management products” sectors.
The CSRC, by contrast will concentrate on framing measures that will ensure due diligence and financial oversight in order to ensure the safety and protection of investors' interests. This function will gain in importance rapidly as the depth and breadth of the Chinese capital market increases.
Chart: Shifting towards function supervision for mixed operation
Chart: New framework - FSDC, PBOC plus two Commissions
At a more practical level, the clarification of the roles of the two commissions will enhance the operating efficiency and effectiveness of supervision within the Chinese financial services industry. Both commissions now have a fantastic opportunity to reduce the overall cost of supervision through the removal of redundant and potentially costly overlaps and duplications in processes, whilst at the same time being able to combine their knowledge and experience of front-line market activities to create better regulation systems.
Interagency coordination with unified regulatory approaches should support financial stability and create opportunities for opening-up
These reforms will fulfil the Chinese Government's pledge to reinforce the capacity of the markets and their participants to manage contagion risk in a unified way.
We should therefore expect to see a continuing stream of regulation focusing on this area. The recently released far-reaching new Asset Management Regulations (on 27 April) give a foretaste of the future. Also included in this are other policies such as measures designed to regulate ” non-financial enterprises' investment in financial institutions" that emphasize transparency with regard the supervision of "shareholders" in financial institutions. Furthermore, the Central Government has recently, for the first time, indicated its commitment to simultaneously accelerate the development of five major areas within the Financial Services Industry through the credit, equity, bond, foreign exchange and property markets.
Interestingly, these reforms in the regulatory regime come at the same time as the earlier mentioned relaxation of rules governing the participation of foreigners in the Chinese Financial Services Industry that were re-emphasized and expanded on during the recent BOAO Forum. Commencing with imminent effect, foreign entities will be able to own a majority (e.g. 51%) of shares in participant companies operating in the previously restricted Securities business. It has been indicated that this will be extended to 100% ownership progressively over the coming 3 to 5 years and that these changes will also be progressively applied to the Banking, Asset Management and Life Insurance markets over a similar timeframe.
Collectively, these policy and regulatory changes provide an unprecedented opportunity for both growth and participation in an ever-more critical area of the overall reform agenda in China. As markets grow in both depth and complexity, the role of regulators, policy makers, market makers and market participants will require a platform that balances the challenge of growth and stability. For the future, there are clearly signs that behind the rhetoric lies strength and resolve, and that we are going to see more actions that will bolster the continued opening up of the China Financial Services industry – albeit in a controlled and methodical manner.
Life Sciences & Healthcare
Is the "Super Hospital" a shot in the arm for healthcare reform?
On March 31, Boao Super Hospital in the Hainan Boao Lecheng International Medical Tourism Pilot Zone opened to the public. This `Super Hospital’ enjoys multiple preferential policies and is a pilot project for healthcare reform and is being watched closely by all players in the healthcare industry as its operational outcome may significantly alter the wider implementation of such institutional innovations.
"New Drug Pilot Zone" will help to accelerate approval process
The single most important innovation at Boao Super Hospital is that it is the only place in China where doctors are allowed to use medicines and medical devices accredited by foreign governments that have not yet received official approval from Chinese Food and Drug Administration (CFDA). CFDA data reveals that only 29 new drugs were approved in China in the past 10 years which is much less than the EU and the US. Because new medicines normally take 5-7 years to be approved in China after being approved in the EU and the US, many patients have to go overseas for treatment should they need cutting edge therapies or medication. This innovation in Boao Super Hospital may accelerate the approval process of innovative products in China which will benefit the R&D drug/device companies, especially MNCs.
A good example of how the super hospital scheme is changing the health care sector is MSD's (9-Valent HPV Vaccine GARDASIL®9. This was used in Boao Super Hospital as soon as the hospital was opened even though the drug had not been approved by CFDA at the time. One month later, by the end of April, the drug was given a conditional green light by CFDA and the whole process took only 8 days.
The “Sharing platform + Clinical centers” model is hard to replicate
The unique "Sharing platform + Clinical centres" model is yet another innovation at Boao Super Hospital. The platform is operated by hospital management but all clinical centres including diagnostic imaging centre, surgery centre, outpatient centre and pharmacy operate independently of one another and have their own legal entities. This model reflects the thinking of policy makers, i.e. to provide support to third-party service providers. In August 2017, NHFPC released a policy directive encouraging private investment in 10 types of third-party service provision fields.
Figure: 10 types of third-party service provision that private capitals are encouraged to enter
However, due to the geographical particularity of Boao, this unique service model is hard to replicate in other locations. So it is still unclear to what extent the Boao Super Hospital will facilitate the entry of the private sector.
Attendant risks require stronger regulatory supervision
Radical experiments in reform come with attendant risks. Will unsupervised use of unregistered drugs raise safety issues? Will there be any drug abuse or illegal trading in these new drugs? Will all the third-party service providers be qualified? These, and other issues are bound to arise and will of course require greater regulatory supervision. In the interim period, major players (be they device or drug manufacturers) would be well advised to take a conservative approach to exploiting the opportunities that will arise, lest an untimely kills a bold and creative regulatory innovation.
Prepare for the worst-case scenario in the post-JV era
In less than two months, two state-level government departments have followed through on China’s commitment to open up in the wake of a surprise announcement by President Xi at Boao Forum concerning lowering China’s tariff on imported cars and eliminating restrictions on foreign stakes.
On April 17th, the NDRC issued a detailed timetable for the removal of foreign ownership caps on automobile joint ventures. In 2018 China will first remove ownership restrictions on electric vehicle and special purpose vehicle producers, followed by a relaxation on commercial vehicle (trucks & buses) manufacturers by 2020. The most significant change comes by 2022 when foreign automakers will be allowed to have full control over their local joint ventures and form JVs with more than two local partners. After a five-year transition period, the country will lift all the restrictions (first imposed in early 1990s) that aimed at nurturing its then-fledgling domestic auto industry.
One month after the announcement, the Ministry of Finance said it would cut import duties on complete vehicles from 25% to 15%, the policy will come into effective since July 1st. China hasn’t changed its import duties on cars since 2006. Tariffs on imported components will also be lowered to 6%.
China’s decision to open up the auto market came much earlier than the market was expecting. Despite reassurances given to local partners by a majority of their foreign OEMs that the latter would like to maintain the status quo within the existing JV structure (a few of them even pledged additional investment), it is widely expected that foreign automakers will seek to increase their stakes and even buy out their joint venture partners in order to maximize returns on their investments.
We attempt to define and examine to what extent this shift of policy will reshape China’s auto industry as a whole under three different scenarios.
Chart: China’s path toward opening up its auto industry
Baseline scenario: maintain the status quo, in this case continue the exiting JV structure and play by the book. Most foreign OEMs only renewed their Joint Venture contracts a few years ago. There’s an average of 19 years remaining before these contracts expire. Under the framework of the existing contracts the two parties have unequal roles, with foreign OEMs taking full control of production, technology transfer and supply chain establishment whereas domestic firms barely have any role to play in the aforementioned decision-making processes and are mainly responsible for the build-up of local marketing networks. Regardless of their limited influence over JVs, local automakers (most of which are state-owned enterprises) have played a crucial part in liaising with local government agencies, securing financing from banks and sharing their knowledge of the preferences of Chinese consumers with their foreign counterparts. Thus, retaining the relationship with existing partners is in the best interest of foreign OEMs.
`Mild’ scenario: foreign automakers will incrementally increase their stakes and eventually buy out the joint venture partners. By securing the position of majority shareholder, foreign OEMs will no longer have to share profits and technology with their partners and instead can eventually book all operating incomes generated in joint ventures. The move will be fatal to domestic automakers who have been relying on the profit stream from their JV operations and whose independent businesses can barely stand on their own two feet. Apart from potential losses, Chinese domestic automakers will inevitably suffer from a technology vacuum as foreign OEMs may cease technology licensing activities or even block technology transfers. As a result, home-grown automakers will only remain as OEMs.
Extreme scenario: foreign automakers will pull out of the exiting JVs and establish a wholly-owned subsidiary that runs its Chinese business independently. In this case, foreign automakers can keep on developing their most cutting-edge technologies in-house and not share. However, given their entwined interests (a few foreign auto companies have given up their majority shareholder positions in the joint venture in exchange for a shareholder position in their local partner’s businesses), an outright separation from the existing business pattern seems less likely.
Besides, there’s not much to be gained from pulling out and the risk is substantial as most foreign OEMs lack of the capabilities to engage successfully with governments and setting effective marketing strategies to reach out to Chinese consumers.
We expect the exiting JV manufacturing structure will be in place for the next few years. But in long run, foreign OEMs will take a gradual approach to test the water.
On the whole, the removal of the cap on foreign ownership coupled with the reduction on import duties will have a compounding effect on China’s auto industry. Not only the existing pricing scheme but also the competition landscape will fall apart. First, mass market foreign automakers will no longer be able to charge a premium price for their products in a market with intense competition, which, to a large extent, will dampen the growth potential of China’s domestic automakers in the lower-to-mid end of the market. Since imported vehicles will become more competitive, luxury carmakers, especially those with relatively low localization ratios, may postpone their local production plans (they’ll have to compare the overall cost) or shift to an import-driven model.
Secondly, state-owned auto companies who will no longer be unable to keep a large share of the profits generated from JVs will probably lose out. We expect those domestic automakers whose products remain uncompetitive and have posted several consecutive years of losses will be hit hardest. On the other hand, for private automakers, elimination of this notorious protectionism means having at last the level playing field they’ve long demanded.