The Deloitte Research Monthly Outlook and Perspectives
23 July 2018
Fiscal and monetary levers needed for growth stabilization
The U.S.-China trade spat has dominated the headlines this year with the most recent development being the Trump Administration’s decision to impose a 10% tariff on an extra $200 billion worth of Chinese imports (effective from 30 August). Given that another round of trade negotiations between the U.S. and China is likely to take place, our baseline scenario remains the same – Chinese concessions, at least in the short run, will prevent an escalation of the trade conflict. So what has changed? Perhaps the place to look is to see whether the trade spat has changed the Chinese government’s deleveraging game plan. And if so, what will be the implications?
There is a delicate trade-off between growth and deleveraging as, by default, the latter entails an economic slowdown. At best, one can use policy to lessen the pain of deleveraging, but one cannot make it painless. Either way, deleveraging requires a conducive environment – low interest rates (in real terms) and a robust external demand. The question we must ask ourselves is whether the adverse effects of U.S.-China trade conflict, felt strongly in the A-share market, has reduced tolerance for deleveraging. Concessions by China such as greater imports from the U.S. and further improvement of market access will reduce the trade surplus this year but it will also undermine policymakers' commitment to reducing corporate leverage as many firms will need additional relief.
As evidenced by the various forms of liquidity being injected into the Chinese economy recently, the direction of policy seems to be shifting away from deleveraging already and moving towards growth stabilization. The most recent cut in the reserve requirement ratio (RRR), which took effect on 5 July, targeted those financial institutions that have helped enforce debt/equity swaps. The policy intention is to bail out some of those enterprises whose financial positions have worsened due to deleveraging, but who do not yet face sovereign default risks. In theory, eased credit provided by banks will lead to lower financing cost of the private sector, and hence, targeted monetary easing will result in a win-win situation for banks and firms who are in financial difficulties but are not ‘zombie’ firms yet.
In practice, however, this can be difficult. Sometimes the boundary between liquidity risk and sovereign default risk can be blurred. More RRR cuts are expected in the second half of this year simply because the RRR is still quite high. By the same token, a more effective measure for monetary easing could be a managed RMB exchange rate depreciation. In the past two weeks, the PBOC has engineered a fairly speedy RMB revaluation (5.7% against the USD). In stark contrast to the PBOC's surprise move on 11 August 2015, RMB's depreciation did not result in a panic this time. One reason is that the key objective of moving from a dollar-peg to a dirty float is to have firms get used to exchange rate fluctuation. But one should also acknowledge that a transition from dirty float to clean float will take China a long time, for the latter has its exchange rate entirely determined by demand and supply. In practical terms, however, this implies that the PBOC is likely to minimize any additional RMB depreciation this year (between 6.7 and 7.0, against the dollar). 7.0 is clearly being viewed as a key psychological threshold in terms of confidence, which means that the impact of monetary levers via either reduction of RRRs or adjustment of the RMB exchange rate, or both, will be limited.
Chart: Persistent weakness eased somewhat by liquidity infusion
So what are the other policy tools available to policymakers? There are plenty of reasons for China to turn to expansionary fiscal policies while avoiding a repeat of the ill-devised fiscal stimulus of RMB4 trillion in late 2008. With tax revenues outpacing GDP growth in the 1st half of 2018, a meaningful tax cut, for both consumers and firms, could and should be envisaged. This would offset the effect of President Trump's tax overhaul while improving the business environment. Given that the fiscal deficit/GDP ratio of 2018 was set at 2.6%, China has ample room to unveil a supply-side reform. The heightened urgency for a tax cut would have a positive impact on the bearish stock market whose reaction to PBOC's monetary easing this year was very cautious. The reason for their caution is that while such liquidity might provide a floor to the market, at the same time, it means that further deleveraging, which is what equity investors really want to see, has been delayed.
Chart: Tax cuts, not pump priming, are called for
PBOC regulations target structural deleveraging
After a mid-year assessment, the third reduction of the reserve requirement ratio (RRR) formally went into effect on 5 July. The People's Bank of China (PBOC) reduced the RRR for the big five state-owned banks, joint-stock banks, the Postal Savings Bank, city, rural and foreign banks by half a percentage point. This is expected to release about RMB700 billion of liquidity into the economy through market-based debt-to-equity (D/E) swaps (RMB500 billion), and small and micro enterprise (SME) financing (the remainder). Moreover, records of banks' use of funds will be used in their macro-prudential assessment (MPA).
This kind of targeted RRR reduction comes as no surprise. It is very much in line with the "structured deleveraging" first proposed by the Chinese government this April, i.e. sector-wide regulation taking into account different types of debt. Given the current environment – turbulence in the A-share market, a wave of bond defaults, bank off-balance-sheet business reverting to balance sheets, credit crunch and trade conflict – we believe PBOC will continue to reduce RRR till the end of the year, creating "tight credit, loose currency" monetary conditions to lessen the pain of deleveraging. This targeted release of liquidity will have the following effects:
1. Reduce excessive deleveraging
In today’s volatile conditions, excessive deleveraging will lead to a liquidity crunch, corporate bankruptcies, bad debts and severe economic depression. A set of guidelines for the asset management industry implemented in April this year dealt a body blow to shadow banking, with balance sheet financing channels simultaneously tightened and now closely regulated.
For example, in the first five months of this year, although total social financing (TSF), a widely accepted measure of credit and liquidity in the Chinese system that includes off-balance sheet financing, increased by RMB7.9 trillion, in reality, there was a fall of RMB1.47 trillion year on year. Simultaneously, a wave of defaults has hit the market. There were 25 bond defaults involving 14 parties, with the total amount reaching a whopping RMB25.087 billion. In this difficult scenario, the central bank had to act, so reduced RRR in three stages with the objective of shoring up medium- and long-term growth through an injection of liquidity into the right sectors. Data shows PBOC has released RMB2.8 trillion so far this year, more than the total RMB1.76 trillion it injected 2017. With expanding medium- and long- term funding sources for financial institutions and lower market interest rates, short-end 14-day SHIBOR has fallen to 3.18% from 3.94% at the beginning of the year and the yield on 10-year treasury bonds has dropped to 3.49% from 3.97%. The banking system is flush with funds and funding costs have fallen, which should ease the pain of financial tightening.
Chart on the left: weak TSF growth
Chart on the right: declining market rates
2. Accelerate D/E swap implementation
Since the launch of the debt-equity (D/E) swap program in 2016, take-up has been poor at best. As of June this year, the big five state-owned banks had signed RMB1.6 trillion of contracts of which only RMB230 billion – a mere 14% – were implemented.
On June 29, long-awaited administrative rules on D/E swaps was finally released by regulators. The rules, coupled with the RRR cut on July 5, are designed to encourage implementing institutions to leverage social capital at a ratio no less than 1:1, and thus participate more fully in the D/E swaps program. Policy and funding support should reverse the unsatisfactory implementation so far, accelerate bank debt write-downs and help enterprises regain confidence.
3. Make SMEs the focus of differentiated competition
To implement the deployment of finances outlined at a recent State Council meeting, on 25 June this year China's five major regulators issued specific guidelines to encourage financial institutions to increase financial support for SMEs. PBOC Governor Yi Gang pointed out that SMEs have already become the new growth drivers for the economy, contributing more than 60% of GDP and over 50% of tax revenue in 2017. However, given their non-performing loan (NPL) ratio is as high as 2.75%, 1.7 percentage points above that of large enterprises, it is difficult for financial institutions to lend to them and completely cover their risk.
The recent RRR reduction will make the Postal Savings Bank, city banks, rural banks and foreign banks earmark RMB200 billion to develop and extend loans to the SME market. SMEs will become point of differentiated competitive advantage for banks. Moreover, reducing SMEs' financing costs will also alleviate market concerns about future credit defaults and improve willingness to invest in the sector.
4. Insolvency risk of real estate industry will be alleviated
Although the real estate sector is not the main beneficiary of eased liquidity, the overall loose liquidity environment will benefit real estate companies whose debt ratios were as high as 80% at the end of 2017. Improved liquidity will probably alleviate debt risk and financing dilemmas among property enterprises, given corporate bond repayments will peak in 2018.
With funding costs coming down in the banking system thanks to greater liquidity, home sales are likely to rise in those cities that have not implemented purchase restrictions. In the short run, as housing prices in most cities are already elevated, the RRR reduction will only maintain the property market status quo, stabilize market expectations, and avoid drastic market fluctuations and/or sharp adjustments.
In short, targeted regulation and improved liquidity will ease the pain of structural deleveraging, leading to a "tight credit and loose currency" market environment. We believe PBOC will continue using RRR reductions to ease market concerns about economic growth and improve investor confidence.
The Sino-U.S. trade spat could drive auto industry to destruction
The automotive sector, a pillar of both the U.S. and Chinese economies, has been used as a hefty bargaining chip in the U.S.-China trade talks. The U.S. decided to levy an additional 25% on vehicles as well as key components including electric engines and lithium batteries imported from China. In retaliation, China targeted U.S.-made vehicles, which support a large number of jobs in the U.S. The new tariffs that went into effect on 6 July are going to impact both parties, though in different ways.
U.S. automakers bear the brunt as German counterparts suffer collateral damage
- Latecomers such as Ford’s luxury `Lincoln’ brand and EV maker Tesla, which have not yet started local production in China, will be hit the hardest by Chinese tariffs. The other U.S. automakers, including Cadillac and Chrysler, whose best-selling vehicles started local production a few years ago, will be immune. As of 1 July, Lincoln and its peers can take advantage of the reduced tariff of 15% on imported vehicles China recently rolled out. But, five days later, their line ups became roughly RMB50,000 to RMB250,000 more expensive when a new tariff (40%) went into effect. If auto companies decide not to raise prices, they will have to bear the cost of higher tariffs themselves, squeezing the high margins of these premium automakers.
- The new tariffs do not target automakers' country of origin but only the location where a product is manufactured. As a result, German luxury carmakers BMW and Mercedes-Benz, which export a large number of U.S. made vehicles to China, will also be hit. For instance, BMW’s largest global factory, which is in South Carolina, exports 70% of its vehicles overseas, of which 30% (about 80,000) went to China. BMW exported 187,000 vehicles to China in 2017. It and other German premium vehicle makers would be priced out of the market if they hike prices in China, so could well shift production outside the U.S.
Chart: 2017 top 10 imported vehicle brands in China
China’s NEV industry, another victim of the trade war
- China’s auto component sector has a registered trade surplus with the U.S., but its auto sector has a trade deficit. This is an easily neglected fact. And, while it is true that the U.S. has remained the largest export market for China’s auto component suppliers in the last couple of years, the majority of exports, like tyres and alloy wheels, are low value added. In NEVs, many components are still imported from the U.S. Key parts such as DC/AC motors and storage batteries will be hit by higher tariffs. Domestic automakers will suffer if they cannot find alternatives to U.S. suppliers.
- As far as complete vehicles are concerned, Chinese domestic automakers have not been able to make inroads into the U.S. market, so the impact of sanctions is limited. That said, a few foreign automakers like General Motors and Volvo, which have started selling China-made vehicles back to the U.S., will be hit hard.
The worst is yet to come
- The U.S. Senate has been pushing legislation to give CFIUS – an institution that screens and vets foreign investments in the U.S. – greater approval authority and empower it to block minority-stake transactions in key infrastructure and technology segments. President Trump has even called on the Treasury Department to draft restrictive rules targeting Chinese investors. Both moves suggest Chinese companies seeking to invest in cutting-edge technologies will face much stricter scrutiny.
- Recent data backs this up. Greenfield investment (building factories overseas) by Chinese OEMs and auto parts companies tumbled in H12018, with total deal value down more than 60% year on year. We expect a tough year for Chinese automakers’ investment in the U.S.
Will China's crude oil futures disrupt the market?
Since the yuan-denominated crude oil futures were launched at the Shanghai International Energy Exchange (INE) on 26 March, it has outgrown the Oman market as the world 3rd largest crude oil trading exchange, thanks largely to the support of domestic investors and speculators. However, the yuan denominated oil price benchmark’s status as a global oil price benchmark will depend on acceptance by investors around the world.
Little variety in market participation
In 2017 China surpassed the U.S. to become the world's largest oil importer, making it useful and indeed necessary to have a local hedging tool. This is why the yuan denominated oil price benchmark was launched. The country also stands to derive benefits from having a benchmark reflecting the oil grades consumed by Chinese refineries. Moreover, as Asia-Pacific oil demand continues to grow, the region will need an oil price benchmark based on its regional supply and demand conditions. However, the Shanghai contracts will have to attract a wide variety of market participants to become an accepted regional benchmark. Unfortunately, so far, although participation from domestic companies has been quite active since the futures contract launch, participation from foreign investors has left much to be desired.
One reason for this may be the relatively strict capital controls exercised by the Chinese government. While foreign investors are allowed to invest in crude oil futures as the exchange is registered in Shanghai's free trade zone, taking money out of the country remains a major issue. Recently, the government has taken a number of steps to allay investor concerns, including income tax holidays, specific exemptions from capital controls and the exclusion of duties or taxes from the trading prices. David Millhouse, head of China research and strategy at Forsyth Barr, argues that oil futures could pave the way for removing capital controls. It remains too early though, to tell how fast and by how much the capital control rules will be relaxed.
Meanwhile the arbitrage window has faded for the traders who had hoped to take advantage of higher prices quoted in Shanghai. On 26 March, Shanghai's front-month September delivery contract closed at RMB433.8/b (USD68.64/b), 4.3% higher than the opening price of RMB416/b set by INE. This was USD2.39/b higher than the Dubai benchmark price on the day. Traders and investors saw the arbitrage window to buy at Middle Eastern exchanges and sell at the Shanghai exchange. However, the window of opportunity faded in April, with the front-month September Chinese futures contract flipping to a discount as compared to Dubai and Oman price indicators.
Chart: INE Futures vs. Middle Eastern Benchmarks
Long way to go for the petro-yuan
As China has become the largest crude oil importer, denominating oil contracts in yuan will promote the use of the Chinese currency in global trade, one of the country's long-term goals. Shanghai contracts are settled in yuan, which consequently reduces demand for U.S. dollars. It is, however, still premature to suggest that China has upset the strength of the U.S. dollar because China’s oil consumption accounts for only about 13% of the global total - even though it is the world’s single largest importer. This means China does not wield enough power to upstage the world’s current oil trading system which is based on the dollar.
But there are encouraging signs on the horizon. China is ready to be involved on a massive scale in the upcoming IPO of Saudi Aramco, Saudi Arabia's biggest oil company. This could encourage the oil giant to consider accepting the yuan for its oil contracts. Furthermore, an agreement has been put in place between China and Russia to transact using their local currencies.
It is ambitious for China to aspire to establish a regional oil price benchmark and promote the Chinese yuan in the global oil trade game. But given the size of the Chinese market, there is a strong possibility that crude sales into China will ultimately be priced off a Chinese benchmark, at which point there will be a strong incentive for global companies to participate in INE contracts. The caveat is, that it may take a number of years before the benefits of the contracts begin to be visible.
Life Science & Healthcare
New policy to reform 'Internet Hospitals'
On 28 April, the General Office of the State Council issued its Opinion on Promoting the Development of "Internet + Medical Health. The document provides guidelines for the construction of 'Internet Hospitals', whose development had been on hold for a year due to very stringent admission rules implemented to the letter by the National Health and Family Planning Commission (NHFPC) in May 2017. These rules have been revised in the latest document and important changes have been introduced which give all players more leeway to negotiate, while maintaining the importance of physical medical institutions.
More emphasis on the pivotal role of physical medical institutions
In addition to granting Internet Hospitals a legal identity and providing them with specific regulatory guidelines, the new policy's most important element is its emphasis on the pivotal role of physical medical institutions. First, the new policy stipulates that Internet Hospitals must build on physical medical institutions and their diagnostic and medical services must be identical to those at physical medical institutions. In addition, Internet Hospitals are strictly prohibited from examining patients on their first visit. Instead, they are encouraged to register appointments, schedule doctor appointments, payments, medical record reviews and subsequent visits for common and chronic diseases. Lastly, the principle of Internet Hospital supervision requires consistency between online and offline services. Most importantly, liability lies with the medical institution itself.
The Internet Hospitals will be natural offline-to-online extensions of traditional hospitals, with first visits – the most important element of healthcare services – still conducted offline.
The new policy calls for business model changes
There are two main models for Internet Hospitals. The first is "Hospital + Internet" initiated by medical institutions. Since the new policy encourages physical hospitals to take major responsibility in constructing Internet Hospitals, hospital information system suppliers and telemedicine companies stand to reap substantial benefits. Medical institutions, however, lack the motivation to develop online businesses and need further incentives from the market or policymakers.
The second model is "Internet + Hospital" initiated by internet companies and supported by government and medical institutions. Internet companies have to acquire or build partnerships with medical institutions to run internet hospitals, so the market entry threshold has risen and the sector will consolidate. In addition, as ever more players choose to acquire medical institutions through M&A, the value of the best medical institutions will rise.
Figure：The Internet Hospital models
Internet-based HMO model is the future
The future of Internet Hospitals will be shaped by the creation of a closed loop of healthcare service, pharmaceutical and insurance companies – a new Health Maintenance Organization (HMO) model. This refers to a framework wherein the HMO will completely fulfil a member's healthcare needs when they pay a certain membership fee (or insurance premium). In contrast to traditional HMO, internet or cloud-based HMO does not need to consider geological coverage of medical institutions and can apply limited medical resources to larger groups of patients. This is especially meaningful as it reduces medical expenses and increases efficiency.
Figure: Internet-based HMO model