The Deloitte Research Monthly Outlook and Perspectives
7 August 2020
Key questions on China's V-shaped recovery & policy responses
Would 2H growth be way above-trend growth (assuming trend growth around 5% for argument's sake) in China? Has the RMB moved into a strengthening trajectory (6.94 this week compared to 7.13 in May) on the back of dollar's general weakness? If so, what would be the implications? What would be the next step taken by the Trump Administration against China in the run up to the election? Does once highly touted phase one trade deal between China and the US remain relevant? Would "internal circulation" take the form of a greater supply side reform to further unlock domestic demand potential or serve as a temporary policy amid trade tensions and weak external demand, or a greater degree of self-reliance inevitably undermine efficient resource allocation?
The above questions are clearly on the minds of both investors and policymakers, and yet they are also interconnected. Let's begin with China's recovery prospect this year. We have been of the view, since late March, that the economy is more resilient than conventional wisdom dictates (please refer to Voice of Asia which came out in late March). In a simplistic way, China's economic resiliency could be explained as a consumption boom at nascent stage and a gradual supply-side reform in recent years (e.g., implementation of registration-based IPO system and introduction of foreign competition of financial services). Covid-19 has not dampened consumer psyche because the society at large has endorsed the government's approach of containing virus at all cost, and low interest rates have kept housing market steady (although policymakers continue to send the unwavering signal of "homes are for living in, not for speculation"). In 2H of 2020, we do expect continued stimulus (both fiscal reliefs and monetary easing) and unleashed pent-up demand. Barring an uncontrollable second wave of Covid-19 (recent upticks of cases in Xinjiang and Dalian are expected, and should not be viewed with excessive concerns), the economy could easily grow at 7% in both Q3 and Q4, which will put the growth rate for the whole year to be around 3%. Therefore, we stand by our bullish call on the economy which was made in late March.
If a V-shaped recovery is in the bag, why would policymakers emphasize the importance of internal circulation, a notion that has drawn much interest in policy circle and investment community? The term was initially floated in a Politburo meeting in May and was highlighted by Vice Premier Liu He at Lujiazui Forum in June. This term was recently modified with duel circulation including the element of external circulation (international trade) which underscores policymakers' desires of slowing recent worrying trend of de-globalization. In our view, the notion has reflected leadership's judgement that China would face many challenges on the trade front in the medium term, and therefore domestic demand could be a more reliable driver of growth, compensating external shocks. In fact, despite recent consumption boom, consumption/GDP ratio in China remains low compared to developed countries. A concrete example of internal circulation is to promote domestic tourism when cross-border travel will be missing in the next few months or even longer. Of course, to drive domestic consumption will require more spending on social safety net such as healthcare on sustainable basis. In any case, a tactic move to increase internal or domestic circulation by no means imply a retreat from China's long-held open-door policy. More self-reliance (e.g., core technology) will cause frictions and duplications. Therefore, financial sector liberalization ought to be accelerated, offsetting lost efficiency from resource allocation.
Chart: Consumption/GDP ratio in China remains low
On the RMB exchange rate, the picture is less clear than 1H of 2020 when a strong greenback was underpinned by investor's extreme risk aversion, market concerns of Eurozone's struggle to put together a credible fiscal stimulus, and woes of many emerging markets. Thanks to a strong leadership of Germany and France, Europe's Recovery Fund of EUR750bn has turned out to be a game changer, with EUR/USD rocketing to almost 1.20, a level not seen since 2018. Bullish sentiment of global equity markets and investors' renewed appetite for yields have brought back animal spirits. As a result, the dollar has corrected on a broad basis. An orderly correction of the dollar is a respite because many emerging markets whose currencies have been battered could see a pullback of inflation and allow their interest rates to fall. However, it is probably too premature to say that the dollar would head to a bear market, because there is a long way for the Euro to challenge the dollar unless we see a true “Hamiltonian moment,” defined as the deal engineered by U.S. Treasury Secretary Alexander Hamilton in 1790 to assume the Revolutionary War debts of the various U.S. states, and thereby binding them to the federal government. Europe's Recovery Fund is a very positive step towards a fiscal union but the market will test European leaders' resolves from time to time. Against this backdrop, it is probably safe to assume that the dollar could give back some of its earlier gains but its position as the dominant reserve currency will stay intact in the foreseeable future. Meanwhile, the PBOC who has been targeting the RMB with a basket currencies since December 2015 with some discretions would prefer not to have a too strong currency when major economies' recoveries lag China's by a couple of quarters. There is no doubt that changed sentiment towards the dollar will allow more central banks to join the monetary easing bandwagon but China is in a slightly different situation. First of all, policymakers definitely do not want to resort to reflating property market unless it is absolutely imperative when risks of hard landing loom large. Second, based on PBOC currency basket, the RMB has been appreciating against the basket which the PBOC is targeting even though it depreciated mildly against the dollar in 1H of 2020. Therefore, PBOC is expected to hold off upward pressure when the dollar is weakening. Third, other than cutting reserve requirement ratio, the PBOC really can't lower short term interest rates much, which means a strong exchange rate ought to be avoided so that monetary condition can stay loose. Of course, exchange rate always can be politicized especially during election season. Would the US blame China for not living up to the expectations of phase one trade deal, specifically import targets. In our view, Covid-19 has indeed made buying $200bn worth of additional American products in 2020 and 2021 less attainable. But such target is not necessarily a binding target. Precisely due to the fact that bilateral relations have worsened significantly since outbreak, trade talks have become even more important as such negotiations could be the only meaningful dialogue between Washington and Beijing. According to Reuters, China has made the largest single order of 1.937 million tonnes in U.S. corn for delivery in 2020/21 as its U.S. crop buying spree continues. Next US-China trade talk meeting will take place on August 15.
If China could step up its purchases of US goods and implement pledged liberalizations (recently released negative investment list is a good example), perceptions of manipulating exchange rate would become a non-issue.
In conclusion, the Chinese economy's resilience remains underrated thanks to its domestic market. So far, the Chinese government's management of economy has won accolade of investors as evidenced by recent bull run of A-shares and a firm RMB. However, notwithstanding low consumer leverage and young consumers' confidence, it is also important to recognize the fact that recovery of consumer sector trails that of industry sector in 1H of 2020 (total retail sales of social consumer goods declined by 11.4% YoY whereas value-added industrial output only down by 1.3% YoY). As such, it will be prudent for fiscal support more geared towards SMEs, fresh graduates and consumers in 2H so that growth could be more balanced. Chief risk remains on geopolitical front because China bashing in the run up to the election could reach new heights. How to quantify some risks stemmed from geopolitical flashpoints? Many countries will be forced to choose sides on issues such as 5G even as they try not to do it. Chinese financial institutions are likely to be under much closer scrutiny by US regulators and supervisory oversight. But it will be highly unlikely for the US to use SWIFT as a blunt tool to block Chinese banks simply because that would be seen as a nuclear warhead. Part of US-China rivalry is also about the dominant position of the USD, which has been weaponized by Washington. However, it is not in the best interest of the US to apply it excessively. Recent trend of de-dollarization, which has already been started by some countries in an effort to break free from US dollar hegemony, could accelerate. And finally, we would like to reiterate our long-held view on the HKD peg – it is rock solid.
China's capital markets are maturing
On July 8, the Shanghai Composite Index broke through the 3450 point mark and since then, China's A-share market has been skyrocketing. In fact, such large amounts of money began flooding the market that some brokerages' trading apps actually crashed. By mid-month it seemed a trading frenzy was underway and as of July 15, the total margin balance on the Shanghai Stock Exchange and Shenzhen Stock Exchange hit a five year high of RMB 1.35 trillion.
Is this the result of the stabilization of the Covid-19 pandemic situation coupled with the accelerated recovery of China's economy? Will the A-share market remain bullish? More importantly, can we say that the past few years of slowing economic growth coupled with serious efforts to upgrade stock quality has finally made it possible for capital markets to function more effectively as `barometers’ of the economy? Interestingly, 2020 marks the 30th anniversary of the establishment of the Chinese capital market.
Economic transformation requires increasing direct financing
As the Chinese economy shifts from a reliance on traditional infrastructure, manufacturing, and real estate to innovative industries in the consumption and service sector and in technology, the ability of the banks to service the real economy has declined. This is because these emerging industries take a shorter period of time to develop with asset ownership being of the more `intangible’ variety (intellectual property rights, technological content, etc.) rather than collateral assets. Because they are so new they also have insufficient internal financing and certain operational risks attached to them which makes them difficult customers for banks to lend to as bank’s lending standards favor collateral assets with low risk. Hence direct financing through the capital markets is probably the best solution for them. An added benefit is that it also improves the efficiency of market resource allocation.
However, we still have a long way to go in this regard. People's Bank of China data shows that, in the first half of this year, two direct financing categories (corporate debt and domestic equity financing for non-financial enterprises) accounted for 17% of the increase in the scale of total social financing, growing 5.6% yoy but at the same time, indirect financing (bank loans) accounted for 59% of the increases. This shows that the imbalance in the financing structure still prevails, which will directly limit the ability of the financial system to service the real economy.
Reform has been even more intensive
The epidemic has caused severe challenges to the real economy but global liquidity, which has always run on virtual rails, has not been affected.
In order to alleviate the negative impact of the epidemic on the real economy and to support corporate financing, China's regulatory authority has accelerated capital market reform, explicitly stating that “the matured capital market should be normative, open, dynamic and resilient, and its "barometer" function should be effective and fully protect the rights and interests of investors.”
The promulgation of the new "Securities Law" at the beginning of this year signified that market-oriented, rule-of-law reforms have begun and regulators have dived into “deep end of the pool”, cracking down on capital market violations and crimes, and generally showing a clear "zero tolerance" attitude. As the financial sector fully opens up, the business environment will gradually improve and this will bolster investor confidence.
Table 1: Recent reform measures in capital markets
Market-based registration system replaces regulatory approval system
The Shenzhen-Hong Kong Stock Connect, Shanghai-Hong Kong Stock Connect and Shanghai-London Stock Connect are launched.
Line of limits
Quota limits of QFII and RQFII are cancelled;
Proportional limit on equity investment by insurers is raised from 30% to 45%
Threshold for foreign investors to invest strategically in listed companies will be lowered
"Class Action Law Suit" system is established in line with international standards
Delisting index and delisting procedures are established
Source: public information
The attractiveness of equity investment is increasing
However, at present there remains a pattern of "strong stocks and weak bonds" in the capital markets. First, due to the impact of the COVID-19 pandemic, the risks of corporate and government debt have increased and debt expansion has reached its limit. In an easy money environment, bond prices have fallen and yields have risen (10-year Treasury yields recently topped 3%) while bond markets have weakened and fixed-income investments have become less attractive. Second, the recent continuous rally in the stock market has attracted capital, causing it to flow from the bond market into the stock market, which is, to some extent, conducive to the easing of debt risks. Since investment return from the stock market has been much higher than from the bond market lately, the “seesaw effect” of stock and bond markets triggered by the trend of capital diversion will continue.
China's huge domestic market and its economic vitality has created a suitable environment for equity investment. First of all, due to its successful epidemic control and policy support, China’s GDP grew by 3.2% in Q2 2020, making it the first major economy to demonstrate a V-shaped economic recovery. Second, reform measures will make capital markets mature and resource allocation more effective, which will help unleash further growth in the real economy. The reforms will also help the market perform its "barometer" function more efficiently and bring greater returns to medium and long-term investors. Proof of this newfound confidence in Chinese capital markets lies in the fact that both Morgan Stanley and Goldman Sachs have recently decided to continue to increase their holdings of A shares.
The willingness of Chinese residents to move money into the equity market is also increasing. In the past few years, Chinese residents have invested mainly in real estate. In 2019, of total Chinese residents' assets, equity investment accounted for a paltry 2%, and housing took up the lion’s share at 59%. Th situation was worse when it came to bank’s wealth management products (WMPs). Among the RMB 23 trillion worth of bank wealth management products (WMPs), equity allocation accounted for only 0.34%. In the first half of this year, the total scale of newly issued public funds was RMB 1.07 trillion (123% growth yoy), nearly 70% of which are equity funds. Industry insiders have been quick to view this as a signal of renewed confidence in capital markets. Another factor that could have contributed to the shift in investment strategy is the acceptance of the idea that “a house is to live in not to speculate with”. In summary, what we are seeing is there is a re-allocation of residents' asset happening in which the share of equity financial assets (as opposed to fixed income) has gradually been increasing.
Table2: (Estimated) fixed income funds move into stock market
The capital inflow amount (RMB10 billion per month)
Fixed income (funds + banks WMPs)
Resident deposits into the stock market scale
Source: CITIC Securities estimation
Liberalization of licenses of securities business
It was recently reported that the China Securities Regulatory Commission plans to issue securities licenses to commercial banks. There are quite probably two main considerations behind this: one is to break down the barrier between indirect financing and direct financing, thus strengthening coordination in order to better finance private companies; the other is to build comprehensive or all-around banks with mixed operation patterns in order to enhance the competitiveness of securities firms. There is a huge gap between domestic securities firms and large international investment banks in terms of scale and business capabilities (in 2019, CITIC Securities' total assets were RMB 79.17 billion; Morgan Stanley's total assets were USD 89.54 billion). With the strong capital strength of the Chinese banking system and faced with competition from overseas all-around financial institutions, it is important for banks to step in, improve standards, and thus help the securities companies and banking groups in China to become more competitive.
China has the world's second largest bond and stock market, but currently foreign holdings make up only 2%-4%. With the opening up of the financial sector, the time has finally come for this to change. Coincidentally, this year, China's capital market celebrates its 30th birthday, a rite-of-passage year where “getting rid of the stale and taking in the fresh” is considered a necessary rite in the path to maturity. Capital from institutions and residents and foreign capital will inject vitality into the market, and will usher in a market with long-term, healthy development prospects.
The quest for IC import substitution
China is the world’s largest Integrated Circuit (IC) consumer but its domestic IC production lags far behind. According to IC Insights, in 2019, domestic Chinese companies produced only 6.1% of the USD 19.5 billion in ICs manufactured in China. While MNCs such as TSMC, SK Hynix, Samsung, Intel, with IC wafer fabs in China produced the rest, revealing that China has long relied on MNCs for its IC production.
Figure: IC market vs IC production in China
The trade war and entity list restrictions between US and China could give China the impetus it needs to develop its own semiconductor industry. An avalanche of events last year exacerbated China's sense of crisis, and it began to worry that its semiconductor import was in jeopardy. China is therefore expected to accelerate the structural adjustment of its semiconductor industry, something that has been underway for many years.
China's demand for non-imported semiconductors is expected to grow and will eventually lead to an increase in domestic investment in the semi-conductor sector. That said, the road to self-sufficiency will not be easy, and it will require a huge amount of capital, talent and time to catch up.
More R&D spending needed
In the semiconductor industry, size matters. This is because firms need to continuously invest to stay competitive. R&D is of paramount importance and companies with higher revenue can invest more in new technology and innovation. In terms of available capital, China’s "Big Fund" which has upwards of USD 150 billion aims to accelerate the development of its domestic semi-conductor industry. But this often focuses on manufacturing capacity and acquiring existing technology (instead of original R&D) and does not adequately investment in tools and equipment (for chip manufacturing), and software (for design) in the value chain.
In contrast, many top global semiconductor companies spend more than one billion US dollars on R&D every year, so the "Big Fund" might not be big enough to provide the needed capital in the long run. For example, the top 10 US semiconductor companies spend more on R&D each year than the spending by all other industries and government put together. It will be difficult to catch up with industry leaders when they spend much more on R&D to maintain their technological advantage.
Talent shortage an issue
China will also need to grow its IC talent pool by strengthening education services for new graduates. Benefits for engineers conducting basic research also need to be improved. According to China's Ministry of Industry and Information Technology, the country needs at least 400,000 more people working in China's IC industry to reach its goal of growing the industry fivefold before 2030. Currently, remuneration for engineers working on chip-related hardware research is low. Not many universities in China can train microelectronics engineers and remunerations compare quite poorly to internet companies.
Closing the gap on all fronts
The semiconductor industry’s global value chain spans materials, equipment, design, manufacturing, assembly and testing. The technology level of Chinese companies lags behind that of the global leaders in most fields.
Figure: Semiconductor revenue distribution along the value chain in Asia Pacific
Equipment: Many different types of equipment are needed to manufacture semiconductor chips. These include lithography machines, ion implantation machines, deposition, etching and cleaning equipment, and testing equipment - most of which is either manufactured in the US, Japan or the Netherlands. In lithography equipment, the most advanced maker, ASML, is based in the Netherlands. Its only competitors in the Asia Pacific are Japan's Nikon and Canon. In deposition equipment, Japan is the regional leader. In China's domestic market, NAURA is the largest semiconductor equipment manufacturing company.
EDA & IP: The Electronic Design Automation (EDA) software market in China is dominated by global giants like Cadence and Synopsys. There are some domestic EDA companies but their offerings and capabilities lag behind their overseas peers. China also lacks core IP (Intellectual Property), which is the crucial building block for chip design. Most IC design companies use their own and third-party IPs to design IC chips. For example, most smartphones today use ARM architecture. ARM continues to sell IP licenses to China even though it has now developed some local Chinese IP. China could use open source architecture such as RISC-V, which is not yet export controlled and many Chinese companies have begun to do this, some claiming their RISC-V IP has the world's most powerful design.
Fabless & IDM: Fabless design & IDM (In-House Chip Design and Manufacture) is the largest segment of the semiconductor value chain. Including large design companies such as HiSilicon (owned by Huawei, it designs smartphone chips, GPU and server chips) and Unis (part of the Tsinghua Unigroup ecosystem; owns fabless, foundries and OSAT companies). Chinese consumer electronics company Xiaomi has also been active in chip design. It recently focused on the development of AI and IoT chips. Xiaomi has also invested in IP provider VeriSilicon and is the second biggest shareholder after the "Big Fund".
Figure: Share of Chinese domestic chips
The outlook for home-grown China design is positive. China has recently developed a domestic x86 CPU, which is an important step in its plans to reduce dependence on foreign technology. It may not be competitive in the consumer market, but it is good enough for government use. Other domestic companies have also created RISC-V based CPUs, AI inference chips and flash memory chips. Meanwhile, HiSilicon has become one of the biggest semiconductor companies by revenue.
Foundry: The semiconductor foundry market is dominated by Taiwan’s TSMC. The Chinese Mainland's largest foundry is SMIC. China has made rapid progress over the years and is capable of mass producing 14nm chips, although it still lags behind industry leaders such as TSMC and Samsung, which are rolling out 5nm processes. Although China does not yet have state-of-the-art processes, it is making important steps towards self-sufficiency.
OSAT: China has recently caught up in this segment, and has a good chance of making a breakthrough. It now has more than 20% of the global OSAT market, and three of the top six OSAT companies, whereas not too long ago there was only one Chinese company in the top 10. This demonstrates the rapid progress of Chinese OSAT firms, but China's semiconductor industry is not yet mature. For example, Chinese manufacturers' yields and quality in packaging and testing lags behind those of other "Big 4" manufacturers.
Looking at the semiconductor value chain as a whole, China is still a relatively small player in the global semiconductor industry, particularly in the mid-to-high end products, such as those for semiconductor equipment and EDA & IP. Given the small, underdeveloped base of Chinese IC production, and the increasing difficulty of purchasing advanced semiconductor manufacturing equipment, there is still a long way to go before China can catch up and lead industry innovation. To achieve its goal, China will need to invest heavily in research, create more favorable policies for Chinese chipmakers, and attract more high-end talent.
Will the new dual-credit policy give a push to China’s sagging NEV market?
As the replacement of upfront cash rewards (financial subsidy), dual-credit policy as well as the credit trading mechanism behind it, is perceived as the major policy tool that will guide the next-phase development of China’s new energy vehicle market. But since it was first implemented in 2019, the policy has backfired as some of the rules are in great contrast to what the policy is initially intended.
Thus, this revised edition, after one and a half years of consultation and thorough evaluation of policy effectiveness, is designated to address all these controversy. It will go into effect on January 1st 2021. There is little surprise in it as almost all the changes made in the last draft were preserved in the new version. However, the new policy does address certain disturbing trends that emerged after the dual credit policy was first implemented a year and a half ago. Market players can benefit by paying attention to the following four key points.
- Stipulating targeted NEV (new energy vehicle) credit requirements for the next three years (14%, 16%, 18%, respectively)
- Lowering maximum credit per single NEV can earn
- Incentivizing “low emission vehicles” by giving beneficial exemptions
- Offering automakers more leeway by allowing the previous year’s NEV credits to be carried forward
2019 marked the first year China officially started to implement a dual credit policy. By 2020 certain disturbing trends had begun to emerge. First, there was a growing deviation between actual vehicle fuel consumption levels and the numbers used for compliance purposes. Here is an example. An automaker who sells a large number of heavily polluting SUVs is still able to offset his negative fuel emission credits simply by producing a small number of electric vehicles in the same year. The previous policy gave too much leeway to NEVs in the calculation of carmakers’ fuel consumption for compliance purposes so car makers were able to be generous in their calculations of fuel efficiency. As a result, with little incentive to seriously address the problem of emissions, most automakers shunned traditional technologies to increase fuel economy as they felt that these were both costly and time-consuming. Overall, in the last five years, carmakers made an overall improvement of just 2% in fuel efficiency.
The new policy tries to address these problems in a variety of ways. One is to bolster the credit trading market through a reduction of the supply of NEV credits. In contrast to a few years ago when NEV credits were in great surplus, the reduced subsidy, along with overall sagging auto demand in 2019, put a dent in China’s NEV market as sales declined by 4%. This time around, a reduced supply of NEV credits helps pave the way for the credit trading market which has so far played only a minor role in incentivizing EV makers since it was first launched in 2018.
The biggest breakthrough of this new policy lies in two aspects: one is to increase the market value of NEV credits by controlling the supply. For instance, the maximum credit a BEV (battery electric vehicle) can get has been rolled back from 5 points to 3.4 points. But, in exchange, automakers are allowed to defer up to a full-year’s positive credits to the following year. Taken together, this will be able to mobilize NEV credits that have been wasted previously. The other breakthrough is to address the concern that China’s longstanding policy initiatives to encourage the development of pure electric vehicles (which surprisingly contributed little in reducing overall fuel consumption in the past few years). The new policy seeks to strike a balance between NEVs and traditional vehicles. From 2021 on, automakers which employ strong fuel efficiency technologies to drive down fuel consumption will be rewarded.
With the new policy, each carmaker will face different compliance pressures and will have to take different approaches. We’ve identified four categories of auto OEMs based on their regulatory CAFC (corporate average fuel consumption) and NEV credits in 2019 (see chart below). Chinese domestic carmakers are undoubtedly the biggest winners as they have an abundant amount of NEV credits which can be traded. But, as production volume continues to climb and SUVs make up the majority (or a larger share) of their sales, domestic carmakers have been faced with a widening deficit in CAFC credits. Japanese carmakers (mainly Toyota) are notably one of the few carmakers that accumulated positive CAFC credits without the help of NEVs. Most foreign car companies will have to deal with deficits in both NEV and CAFC credits.
Chart: Auto OEMs’ dual-credit compliance in 2019
Automakers have tailored their strategies to suit their specific needs. Japanese carmakers, for example, are bringing in mild-hybrid technologies to earn positive CAFC credits while taking advantage of face-lift models based on their domestic partners’ electric vehicles to offset negative NEV credits. European car companies (mainly German carmakers) are betting on plug-in electric vehicles and pure battery vehicles to meet their compliance requirements. US carmakers are also taking a two-pronged approach by launching HEV-based models in short-term and at the same time expediting mass production plans of EVs in long-term.
We believe automakers with impressive fuel efficiency technologies will become the biggest beneficiary of this new policy. Japanese carmakers, for instance, with their growing HEV sales(equivalent to low fuel emission vehicles), won’t need to worry about CAFC compliance for at least 3-5 years. And NEV credit requirement is also made much lower given their massive hybrid vehicle line-ups which help reduce their calculation bases.
But in the long run, producing and selling NEVs is seen as the best solution to meet the dual credit requirements. We suggest carmakers weigh the trade-offs by taking into full account the followings factors: available credits among related companies, costs of external purchases, mix of NEV models, production progress and so on, to form a strategy to meet the new compliance regime, a regime that is no less stringent than the one currently in existence in Europe.