The Deloitte Research Monthly Outlook and Perspectives
16 September 2019
Will the RMB rebound on the back of trade talks?
The recent weakness of the RMB in relation to the dollar has sparked heated discussion on where China's monetary policy is headed and the global implications thereof. From China's policymakers' point of view, a weaker RMB is a natural hedge to trade friction as well as the perfect tool to reflate the economy (though not necessarily to improve China's competitiveness). This is particularly relevant when global interest rates are being pushed down by fears of a potential US recession, a synchronized slowdown of the world’s major economies (China, Germany, the UK and even India etc.,) and jitters in some emerging economies (though Argentina seems to be an outlier). However, external perceptions on a weaker RMB have changed in recent months. On one hand, the PBOC's timing of letting the RMB weaken coincided with the escalation of US-China tensions in August. However we are of the opinion that, it is the strength of the US equity market (Dow at all high at 27137 in mid-September 2019) and President Trump's confidence in the US economy in the short run that is behind his pledge to raise tariffs on all of China's exports. As the trade war looks likely to drag on with back-and-forth moves, this mentality has surely raised the risk of exchange rate overshooting, or the risk of a currency war. At this juncture, we are far away from exchange rate overshooting territory, therefore, financial markets have taken a weaker RMB in stride.
The RMB's surprising slide (to almost 7.20 against the dollar) has led to a flurry of financial institutions revising forecasts on the RMB exchange rate with the lowest being 7.50 in 2019. Some external observers believe that China's tit-for-tat moves on the exchange rate are warranted, should average tariffs of exports to the US be hiked to 20%. But, were the USD/CNY exchange rate falling to 7.50 in the short run, this could cause a severe backlash abroad on the grounds that China is weaponizing the RMB.
Let us, for argument’s sake, try to see this from another point of view. The PBOC's big moves on the USD/CNY since August 5, 2019 can be compared to the sudden adjustment of the RMB exchange rate four years ago that resulted in a less than 2% depreciation against the dollar, widely known as the "forex exchange rate reform". The move took financial markets by surprise (USD/CNY tumbled by 1.8% on the day of August 11, 2015) because the PBOC's policy bias had long been exchange rate stability, which is being viewed as an indicator of social stability. Today however, external perceptions on China's exchange rate policy have changed significantly mainly due to trade tensions and Beijing's reluctance to unveil massive fiscal stimulus. Hence this time the market has reacted quite differently and even Asian currencies (Korean won, New Taiwan dollar, Thai baht, Indonesia Rupiah alike) which are extremely sensitive to movements of the RMB have been remarkably stable since August 2019. In the end, if China could sustain its GDP growth at around 6.2% albeit with a weaker RMB exchange rate, it would still be a boon to most regional economies. In our view, given the profound changes of cost structures in China (mainly land and labor), 4-5% depreciation of the RMB against the dollar is unlikely to reverse the trend of China's labor-intensive industries migrating to some regional economies (e.g., Vietnam, Thailand and Indonesia). Essentially, our views on USD/CNY remain more or less the same – we foresee a mild and controlled deprecation against the dollar in the medium term (say, on a 3-5 year time horizon) even in the absence of US-China trade war. However, to forecast short term exchange rate movements can be a mug's game. USD/CNY could shore up overnight to 7.0 on a truce. In the same vein, 7.5 can't be ruled out should US and China raise tariffs across the board to 20-25%. The outcome hinges on the resumption of trade talks in early October.
Chart 1: Asian occurrences have been stable
But are we banking too much on a resumption of talks? According to USTR, China's vice-premier Liu He and US officials including the US Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin will meet in Washington DC in early October. On September 5, China's MOFCOM stated that both sides would strive for "meaningful results". If such "meaningful results" are to be achieved, to put it simply, both sides will need to make concessions. On the American side, if the US could delink trade talks from broader issues such as national security or economic growth models, the likelihood of a truce will probably increase. By the same token, if China can show progress specifically on IPR protection perhaps by coming up with some kind of a credible monitoring mechanism, it would also spur innovation and industrial upgrade in China. If market access could be improved in a meaningful way in sectors related to services and consumers, the added competition from foreign entrants would spur China's economic rebalance (in essence, to shift from an investment-led growth model to a consumer-driven economy), something that is particularly important today. Against the backdrop of a global economic slowdown, China could be pressured by other key trading partners (European industrial countries) to scale back subsidies to SOEs. So "meaningful results" do require China's commitment on the thorny issues of IPR, market access and state subsidies. All in all, we still see a truce before 2020.
Chart 2: PBOC's RRR reduction paves the way for a rate cut
We are of the view that the PBOC's monetary easing must be seen in the context of the imminent global slowdown. Not only could the Fed ease interest rates in September and December 2019, but the ECB too is being pressured by the market (German government bond yields are in negative territory across maturities) to restart a "quantitative easing" program which means that the ECB will start to purchase government bonds, a quasi-fiscal expansion. Against the backdrop of such widespread global easing, it was to be expected that the PBOC too would jump onto the bandwagon. But for China, the monetary policy easing will certainly be carefully calibrated so as to cause the least possible disruption to neighboring economies and major trading partners.
On Sept 6, the PBOC cut Reserve Requirement Rates of all financial institutions by at least 50bps (and by 100bps for city commercial banks whose asset quality is less sound than that of the major commercial banks). Furthermore, short-term interest rates are likely to be cut soon in the run-up to the October National Day celebrations. Other growth stabilization measures are likely to entail eased restrictions on car purchases and property investment. Unlike most economies, the saving grace in China is that in many areas of the economy, demand has not been met. That is why we also foresee an easing of restrictions in both auto and property sectors.
Opening-up will help develop direct financing
On July 20, the Financial Stability and Development Commission of the State Council introduced 11 measures to promote the development of direct financing, covering such fields as banks, insurance companies, securities firms, funds, futures and credit rating. Over the years, the direct financing has not been developed well in spite of the fact that it is often mentioned as a priority in government work reports and speeches by regulatory authorities. China's financial industry, as it is well known, remains dominated by the banks as indirect financing, namely bank loans, continues to be the predominant financing method. For these reasons, the share of direct financing in the capital market has stayed low. So, how much does the new round of opening-up actually help the development of direct financing and how will it affect the banking system?
Greater direct financing will help strengthen the structure of Total Social Finance (TSF), improving liquidity in the real economy
Total Social Finance refers to the aggregate amount of funds provided by China’s financial system to the real economy within a given timeframe. Maintaining a rational and stable TSF structure has been the goal of the government's economic work and financial supervision.
According to the PBOC's statistics, among the TSF, direct financing is taken to mean stocks and bonds of non-financial enterprises (bonds issued by local governments have also been included in the statistics since September 2018) that are traded in public capital markets. In a broader sense, equity investments such as venture capital (VC) and private equity (PE) also fall into the basket of direct finance but since VCs and PEs conduct their fund-raising operations in the private market, they are currently not included in the scope of TSF through there are indications that this may change in the future.
China’s TSF structure has remained virtually unchanged over the years. Currently, bank loans make up nearly 70 percent of TSF while direct financing accounts for less than 20 per cent. The third major component includes a small number of off-balance-sheet activities (shadow banking). CSRC research shows that the proportion of direct financing in G20 countries is generally 65-75% while China's level of direct financing is much lower.
Chart: Little changes in direct financing (%)
Chart: Indirect financing remains predominant (%)
As direct financing is underdeveloped, enterprise financing is difficult and expensive, giving rise to the prevalence of other kinds of financing activities such as high-risk P2P and shadow banking operations. The best way reduce such highly risky financial operations is to increase the proportion of direct financing and to wean companies away from depending overly on bank loans. To that end, there has to be more supply side reform in order to strengthen funding channels so that the funding needs of enterprises can be met through the capital market. A strong, well structured capital market will ensure that high-quality enterprises with good management practices will come to the fore and this will in turn strengthen the capital market. Healthier companies will help reduce the risk of non repayment of loans, benefiting the indirect finance sector as well.
Therefore, an increase in the share of direct finance in overall TSF will benefit both enterprises and financial institutions. And the economic and regulatory objectives of the government will be well served.
The `opening-up’ will help to improve the supply capacity of direct financing
A mature capital market needs a sound operating structure, proper regulation and fair competition. While a sound operating structure primarily depends on the institutional structure of supervision and regulation by the government, fair competition flourishes when the system uses the resources and know-how of other entities, such as investment banks, asset management companies and other supporting intermediary organisations, to improve the direct financing service system.
"Financial opening-up" has two important components: the opening up of the financial services industry and the opening up of capital markets. The former involves the removal of limits to foreign ownership in financial service institutions and brings with it several important benefits, namely the diversification of financial services and institutions. For example, allowing the entry of foreign-controlled wealth management companies will bring in the best practices of international capital management as more foreign-controlled brokerages can partake in stock offering and bond issuance services. The opening up of the capital market will make possible the gradual integration of the stock and bond markets into the international mainstream indexing system. As of the beginning of 2019, the international rating agency Standard and Poor’s has been allowed to rate domestic bonds and the government is trying to attract other foreign rating agencies to participate in bond ratings. The entrance of international credit ratings agencies will improve rating credibility and applicability and facilitate more foreign investment. China's bond market is now the second largest in the world with a size of RMB 90 trillion (about USD 13 trillion). But foreign investment accounts for only 2%, significantly lower than the level of foreign investment in other countries, thus there is much room for growth.
To sum up, the opening up of the economy to foreign capital is not just about inviting a few foreign institutions to establish subsidiaries in China and attracting more foreign investments, it is really about getting foreign intermediaries and foreign investors to participate wholeheartedly in the capital market, so as to diversify the market, increase competition, and improve efficiency.
Banks need to be alert, the sunshine days are over
The days of making easy money without much hard work are gradually fading away. In the future, banks will face spread reductions and financial disintermediation as customers pull their money out of the banks and invest directly in the capital markets. On the one hand, the PBOC has encouraged inclusive finance, improved loan prime rate (LPR) quotation and reined-in property loans (development loans and individual housing loans), all of which will result in the reduction of banks' spread; Banks’ profit margins will be further squeezed as high-quality enterprises which are capable of raising funds independently on the capital market will cause banks to lose their most valued loan customers. Digital transformation, wealth and asset management will therefore be the key to differentiated competition in the future.
In short, against a backdrop of supply-side reform, opening up is an important part of the strengthening of credit supply lines to the economy. It is our belief that with these changes, the business environment will improve as the diversified investment scenario and capital market dividends will benefit more investors. However, as trade friction persists, achieving the desired results will test the resolve of policy makers. We believe China's financial sector is already large enough to carry out reforms through opening up despite the difficulties. We look forward to the arrival of new "sources of fresh water" which will stimulate the market and sustain the vitality of "evergreen canals" in the future.
NEV sales stalling after the removal of subsidies
In July, China’s NEV sales showed their first sign of weakness since 2017 as sales suffered a 6.9% y-o-y decline. Despite being one of the few segments in the automotive sector that managed to keep growing steadily over the past few years, bucking the industrywide trend, the NEV market seems finally to have succumbed to the ills of sagging consumer confidence. But the more immediate cause for this decline can be attributed to the fact that before July, sales ballooned artificially, as people indulged in panic purchases in anticipation of a significant drop in financial subsidies for NEVs. This anticipatory buying pushed up sales artificially while putting a dent in future demand.
We believe that China’s highly inflated NEV market is set to dial down its fast pace of growth. Not only will industry players and investors turn less bullish, but also consumers will tend to be more wary of purchasing electric vehicles given the growing concerns around safety issues and resale uncertainty. We identified three main ramifications of the phase-out of subsidies.
First: EV battery makers have been under a lot of pressure to lower costs since the government announced the reduction of its financial support. In the last three years, due to their failure to keep cost competitive, their lack of R&D and production skills, and the lack of access to credit, more than half of the 150 battery firms in the market have either gone bankrupt or been bought out. Market consolidation made it possible for leading battery firms to secure greater control of the market with the top 5 companies taking more than 70 percent of the market share. The surviving firms are striving to achieve economies of scale and hence, continue to invest and produce despite the fact that EV demand does not look as promising as it did two years ago, especially in the absence of subsidy incentives.
Second: compared with their large gasoline-car peers, NEV start-ups are much more vulnerable to the removal of subsidies as few of them can afford to pass on the additional costs to upstream suppliers in the face of a market where competition is heating up. As a result, only a few hardy NEV manufacturers have raised prices even at the expense of losing potential customers. On the investment side, wary investors and a cooling capital market have added to the difficulties of EV start-ups seeking a new round of funding.
Third: although the rollback of subsidies has had a sweeping impact on the supply chain, there still exists an upside. China used to incentivize electric vehicles with long-range and high energy density. These cars normally require high-voltage batteries. However, higher energy-density batteries are much more complex to develop and produce on a massive scale and China’s domestic battery makers vary widely in the ability to ensure battery safety. In order to become eligible for higher levels of subsidies, EV makers opted for longer ranges over reliability and safety. As a number of electric vehicles caught fire in the last few months, consumers were getting seriously concerned with the issue of EV safety. With financial subsidies having a less significant role to play, the silver lining here is that competition amongst electric vehicle producers will once again focus on the basics -- safety and reliability.
Green light for foreign investment in the upstream sector
Not long ago, the Chinese government announced a series of measures doing away with restrictions on foreign investment in the exploration and exploitation of oil and gas blocks in China. As of July 30th 2019, foreign companies can now have wholly-owned companies which can hold licences to explore and exploit oil and gas blocks in China. What are the opportunities and practical challenges for foreign investors under the new regime as China opens up more sectors to foreign investment, including upstream oil and gas?
Previously, foreign investment was required to be in the form of an equity joint venture (EJV) or a cooperative joint venture (CJV) to operate upstream exploration and exploitation businesses in China. Foreign companies and Chinese NOCs usually cooperated in the form of a Petroleum Contract (a.k.a production sharing contract). However, this will no longer be necessary. From now on, foreign companies may, in principle, hold a 100% stake in upstream oil and gas blocks in China.
China became the world's largest oil importer in 2017, surpassing the US. The lifting of such restrictions allows foreign E&P companies to have direct access to the biggest oil and gas consuming country in the world with a ready market.
The Chinese government is attempting to arrest falling domestic production and, at the same time, reduce the country’s reliance on imported oil and gas. The opening up of the sector will certainly benefit China as it will allow foreign investors to bring in capital and advanced technologies, particularly for areas with unconventional and deepwater hydrocarbons.
Process for obtaining licenses remains uncharted
Despite restrictions to ownership having been lifted, a lot still remains to be done before foreign companies can fully participate in China’s upstream oil and natural gas sector. For example, at the time of the announcement, there was still no known process for foreign oil & gas companies to obtain licences directly from the government. Nor was there any mention of how this process will be managed. Currently, two channels are in place for non-NOCs to obtain licenses:
- Bidding through “the oil and gas work program commitment”
- "Rules on the Assignment of State-owned Land Use Right by Bidding, Auction and Quotation"
While the international oil & gas companies are familiar with the working mechanism of bidding through work program commitment, they need to familiarize themselves with government rules on bidding for State-owned land use rights.
Limited access to upstream oil and gas data
Access to upstream oil & gas data is a challenge that E&P companies face all over the world. In China’s context, the government maintains strict control over this information, to the point that certain upstream data are classified as State secrets. This practice presents two challenges for IOCs. First, it is difficult to obtain data required to make investment reviews and decisions before full commitment. Second, there are risks in the understanding and handling of data when operating as a company in China.
Looking down the line…
Under the new regime, the options now available to foreign investors include:
- Production sharing contracts (PSC) or JVs with Chinese NOCs
- JVs with Chinese partners who are non-NOCs
- Wholly-owned foreign enterprises
In the near term (1-3 years), we believe the current production sharing contracts may still dominate, given that they are widely accepted and have been in use in China for some time. However, the cost recovery and profit sharing terms and conditions under PSCs are not friendly to foreign companies, as the foreign party is required to provide the investment to carry out exploration and bear all the risks. Moreover, the NOC has the right to claim a 51% stake in any discoveries during the development and production phase.
In the medium term (3-5 years), foreign companies may seek to amend the terms of their partnerships with NOCs. If the NOCs are flexible, a different kind of partnership may develop where IOCs will be willing to bring in financial capital and advanced technological skills/equipment to advance oil & gas exploration and production in China.