The Deloitte Research Monthly Outlook and Perspectives
11 November 2022
Big decisions looming on the horizon
The Chinese economy is recovering, as the Q3 GDP data has shown. Now moving forward, Q4 is likely to see marginal improvement on growth, assuming the policy focus will pivot towards economic reflation and that decisive action will be undertaken to stabilize the property market which holds the key to consumer confidence. So, 3.2-3.5% remains a very realistic goal of 2022 GDP growth. However, financial markets have been experiencing jitters and anxieties since mid-October because investors are unsure about the government's policy response. The drastic sell-off of property developers in both the equities and off-shore bond markets has suggested that financial distress plaguing the real estate sector may present a bigger risk to consumption than a few months ago. The ferocious rally of equities in both the mainland and Hong Kong, and a sharp rebound of the RMB after the German Chancellor Scholz's visit to Beijing has suggested that investors are banking on an easing of the zero-Covid policy (according to Wall Street Journal, China has agreed to approved BioNtech's vaccines for foreigners in China, which appears to be a step towards expanding it later down the road).
Chart 1: Poor performance of developers' stocks have constrained their financing
Source: Wind, Deloitte Research
Chart 2: Bond yield of developers in off-shore markets suggest severe default risks
Source: Eikon, Deloitte Research
The release of the Q3 GDP data was delayed by the 20th Party Congress, but at 3.9% yoy, growth was much stronger than the consensus of around 3.0% (our forecast ranged from between 2.5% to 3.2%). Growth was led by both consumption (e.g., auto) and net exports, which contributed 2.1 and 1.1 percentage points respectively. September export growth lost some momentum but remained steady at 5.7%. However, the property sector, once a key driver of growth, remained a drag on the economy in Q3. In fact, declining investment in the property sector, which began a year ago, has become even more pronounced, declining by over 12% in Q3. This has raised questions over the need for further measures to boost the real estate sector as previous moves such as lower mortgage rates and tax rebates have clearly been viewed as inadequate by the market.
While its role as a growth driver remains important in the short-term, the property market is likely to become a drag on the Chinese economy in the not-too-distant future. That is why the government is keen to boost confidence in the property sector through the implementation of new measures. Most recently, the Ministry of Finance, People’s Bank of China (PBOC) and China Banking and Insurance Regulatory Commission (CBIRC) announced a slew of support measures before the National Day celebrations got underway. The PBOC lowered the lending rate for housing provident fund loans by 0.15 percentage points to 2.6% and 3.1% for tenors less than five years and longer than five years respectively. At the same time, the CBIRC reduced mortgage rates for first-time home buyers in some cities, while the Ministry of Finance announced it will offer tax rebates to those purchasing new homes after selling their previous properties within a year.
Taken together, these measures serve to underscore the government's policy goal of reflating the economy through the property market. Why? Given the size of the real estate sector (it accounts for roughly one-quarter of the economy), it will be impossible to rely on other emerging sectors such as electric vehicles or advanced manufacturing to fill the gap left by the property market this year or even the next. More importantly, however, Chinese consumers can, if not should, still increase their leverage at a time when local governments and many firms must do the exact opposite. If all actors tighten their belts, an economic downturn will be unavoidable. In the long-run, local government fiscal revenues must be broadened out, but in the immediate future, other sources of revenue can’t move the needle given the sheer size of the contribution from land auctions. Notwithstanding the extraordinary level of consumer resilience, there is a risk of consumers becoming more cautious should the current bearish sentiment become more pervasive against a backdrop of several major global property markets showing signs of cracks (e.g., the US, the UK and Canada).
We have held the view that China’s property sector does not present a systematic risk on the basis of 1) high consumer savings rate; 2) low consumer leverage; and 3) most banks’ creditworthiness being perceived as sovereign risk by the general public. Indeed, the mortgage boycott is being forcefully addressed by the government. A relief fund has been set up to ensure that developers are able to finish their projects, and there have been subsequent assurances from policymakers on implementing further relief funds (e.g., PBOC Governor Yi Gang's pledge at the Finance Ministers and Central Bank Governors of the G20 meeting). However, financial distress among many large private developers owing to slumping home sales has been exacerbated by a strong dollar and rising global interest rates. All of these support measures will improve sentiment on the margins but their impact should not be overestimated. For example, tax rebates are only available to those who have sold their apartments within a year and such rebates will be calculated on an incremental basis. Net savings from tax rebates and reduced mortgage payments are therefore unlikely to be substantial. At the end of the day, the underlying motivation for most consumers moving up the property ladder is the expected appreciation of house prices, not marginal reductions to interest rate payments. Severe corrections incurred by major developers in term of both stock prices and offshore bond yields are so staggering. Financial distress suffered by developers could result in further difficulties of property investment, in turn, putting additional strain on local tax revenues.
Finally, with the conclusion of the Party Congress, core economic issues are expected to rise again to the fore, but whether or not to relax the zero-Covid policy has been perceived by investors as an acid test of striking a balance between economic development and safeguarding public health. First of all, will the zero-Covid policy be adjusted? Unconfirmed rumours of an imminent relaxation have led stock markets in both Shanghai and Hong Kong to rebound in the first week of November judged by reactions of bond market. The reality is that any drastic adjustment is unlikely, but incremental changes might well be possible as more international flights will be made available soon, such as direct flights between Beijing and Singapore. Secondly, the PBOC is expected to guide interest rates lower amid the Fed’s continued tightening. At least with the most recent rate hike by the Fed (75bps on Nov 2, 2022), the Fed might be getting closer to the end of its tightening cycle. But widening interest rate differentials, which are favoring the dollar, are expected to keep downward pressure on the RMB. Underperformance of both domestic A shares and the Hang Seng Index will result in further capital outflows. However, China continues to run a comfortable current account surplus. If a weaker RMB could bring down real interest rates, policymakers should not have any hesitation.
In conclusion, a continued cyclical recovery should not obscure the need for reviving the economy. Oct export data (-0.3%), a rare decline in dollar term in years, have highlighted potential risks on external demand caused by weakening economies in both the US and Europe, in turn, adding a sense of urgency on reflation. What China needs is not a 2008 type fiscal stimulus which has been repeated denied by policymakers, rather, a more focused reflation of the property sector and a more calibrated covid policy.
The US’s EV ambitions and its knock-on effects
In August 2022 the US government passed the Inflation Reduction Act, the largest climate investment bill in history. The bill plans to allocate $369 billion over the next ten years for energy security and climate change. So far, the US has been trailing behind the EU and China in terms of the sale of electric vehicles. The IRA is intended to reverse this trend. The bill also reflects the US’s geopolitical concerns, including a desire to reduce reliance on any single country for the production of key battery components and to establish an onshore supply chain for EV and battery manufacturing.
So how will the IRA impact the global battery landscape? What opportunities and challenges does the bill entail for Chinese EV players who want to export? Perhaps the answer lies in the details.
Decoupling from China
The most high-profile provision in the IRA is the EV consumer tax credit. It is intended to offer consumers a $7,500 tax credit upon the purchase of an electric vehicle. However, the new legislation comes with strict conditions. Here’s are some of them:
- Local Assembly: The consumer tax credit is only available for EVs that are assembled in North America. The provision takes effect immediately.
- Domestic sourcing: The bill introduces two criteria that will decide whether an EV producer gets partial or full credit: a limitation on where critical minerals for EV batteries can come from and a stipulation that a certain portion of battery components must be manufactured or assembled in North America. If a vehicle only meets one criteria, it qualifies for half of the credit ($3,750). If the vehicle meets both criteria, it qualifies for the full amount.
- One exception: The US administration also added a “foreign direct product rule”. This controversial clause states that if an electric vehicle is sourced from any foreign entities of concern (China is on that list), it will be immediately disqualified for the tax credit.
Figure 1: Summary of requirements to meet the EV tax credit
What this means is that to qualify for the maximum 7,500 consumer tax credit – which is big enough to be a game changer for the current EV industry as consumers are extremely sensitive - carmakers that operate in the US will have to not only shift their supply chain from offshore to onshore but to decouple from China.
However, decoupling from China could prove to be a challenge for most EV makers. The US EV sector, like its European counterparts, has relied heavily on imported raw materials and battery components from China. Presently it is home to a mere 10% of global EV production and 7% of battery production as over half of the processing and refining capacity for lithium, cobalt and graphite is located in China. China produces 75% of global lithium batteries and is responsible for 70% of cathode materials and 85% of anode materials around the world.
So how will the US manufacturers get their battery raw materials? They are hoping that countries who already have Free Trade Agreements with the US like Australia and South Korea will step in to fill the void. But it is doubtful that these countries will be able to ramp up fast enough and even if they were to do so there would be such a substantial increase in costs that it would probably negate the effect of the subsidy.
Among all the battery minerals, lithium is best prepared to meet the domestic content requirements given more than half of world’s lithium is extracted from Australia. Graphite is this most difficult to source as China dominates the production of this mineral. As for the sourcing of cathodes and anodes, we believe that the magnitude of additional cost and length of time required to shift suppliers has been largely underestimated.
The global processing and production capacity of battery materials is firmly concentrated in China, Japan, and South Korea. South Korea, which has 15% of cathode production, is the only country that has signed a free trade agreement with the US. But South Korea is highly dependent on China for battery materials. Last year, they imported about 73% of cathode, 55% of anode and 55% of separators imported from China. A hard decouple will lead to a substantial increase in production costs given the higher cost of inputs, labour and equipment in the US and its FTA partners. Therefore, we expect little change in the near-to-mid-term as it is not yet possible for EVs that are made in the US to be completely free of China-refined minerals and battery components.
Headwind or Tailwind?
In contrast to the current pessimistic market sentiment that Chinese suppliers will be permanently ruled out from the US EV boom, we believe that all is not lost for Chinese lithium battery and material makers. They can still take part in the US EV race, but there are certain risks that must be considered.
For battery makers who seek overseas expansion, the US’s advanced manufacturing credit certainly provides opportunities as the legislation stipulates a $45 per kilowatt-hour (kWh) tax credit for battery manufacturing. So, for example, an electric vehicle with a 60 kWh battery, can benefit from US$2,700 tax credit. This has substantially increased the interest of leading battery manufacturers to build plants in the US and sign sourcing contracts with key metal suppliers from the US or its FTA partners. For instance, three major Korean battery makers SDI, LG Chem and SK have announced their intention of establishing a total of 11 plants in the US by 2026, mostly in the form of joint ventures with American automakers. In order to overcome its dependence on Chinese suppliers, Korean battery makers have ramped up efforts to diversify their sourcing channels, mainly by investing in upstream mines and establishing strategic partnerships or long-term supply contracts with companies that process key battery materials in North America.
Figure 2: Summary of requirements to meet the advanced manufacturing credit tax
Chinese battery makers can benefit from these incentives as well, given there are no other restrictions around the provision. As for mid-stream battery material manufacturers, some companies have found novel approaches that allow them to circumvent IRA restrictions and make it to the supply list of global leading battery makers. For instance, a Chinese cathode precursor maker has become the major supplier to a Korean battery company who operates in the US by setting up a plant in South Korea.
As discussed before, neither the US nor or any of its FTA partners can provide a reliable, low cost supply chain for the EV industry before 2025. Therefore, we advise Chinese battery makers to take precautionary measures before making new investments, including measuring the extent of their company’s exposure to the IRA, closely monitoring the official interpretation of the detailed clauses, and assessing the feasibility of switching to local supply chains.
The IRA has been rolled out against the backdrop of a policy of regionalization of the global EV supply chain. Both the US and Europe are on track to establish a more secure, resilient and sustainable localised supply chain that supports their EV ambitions. For instance, a slew of battery manufacturers are emerging in the EU with the support of hefty subsidies and foreign battery counterparts are facing higher entry thresholds given the EU’s high standards on carbon emission and sustainability of batteries. In the case of the US, since the enactment of the IRA, substantial investments have been made by foreign battery makers to build new or expand existing plants in the US. With newly announced capacity going online after 2025, China’s position as global-leading lithium battery maker will be significantly challenged. We recommend that companies along the EV value chain should try to establish a stronger competitive advantage outside of cost and product performance. For instance, establishing a low-carbon, circular supply chain with an upper hand in patents surrounding next-generation battery technologies.
 IEA, Global Supply Chains of EV Batteries
Government & Public Services
Improved Funding Props up Infrastructure Investments
Local government special bonds accelerate infrastructure investment.
As downward pressure on the economy continues, the government is relying on infrastructure investment to stabilize the economy. According to the Bureau of Statistics, with the help of the local government special bonds and development financing, infrastructure investment has seen a YoY increase of 8.3% (January to August data) and growth rates are on a rebound for 4 consecutive months.
As planned, the quota of local government special bonds has been fully used. In August, the China Development Bank and the China Agricultural Development Bank completed the first issue of 300 billion RMB policy-based and project-based key instruments, which replenished capital for more than 900 infrastructure projects and helped to accelerate the construction process. In September, the State Council initiated a series of policies including the issue of another 500 billion RMB of local government special bonds and 300 billion RMB policy-based and project-based key instruments in order to attract more capital investment in infrastructure. Hence, in our opinion, investment in infrastructure construction will continue to grow in the fourth quarter.
Figure 1: Growth Rates in Infrastructure Investment in 2022
Data Source: National Bureau of Statistics of China
Investment in internet-based infrastructure projects has seen a huge increase. In May 2022, the State Council released a policy paper which addressed investments in the construction of new types of infrastructure financed by the local government special bonds. The number of such types of infrastructure projects in the first eight months of 2022 has reached 89 with an investment of 51.37 billion RMB, a huge increase comparing to 19 projects with an investment of 20.22 billion RMB in 2021. As these types of infrastructure projects commonly have a higher proportion of non-fixed assets and operate under an asset-light strategy, they often require a higher proportion of capital support in order to obtain bank credit. We expect that the issue of the two key credit instruments worth 600 billion RMB will replenish project capital and facilitate the construction of new types of infrastructure, thus benefiting the development of the digital economy and smart cities.
Table 1: Definition of the New Types of Infrastructure
Data Source: National Development and Reform Commission
When capital is in place ahead of schedule the process of infrastructure construction gets accelerated. According to the Bureau of Statistics, the number of the new infrastructure projects under construction in the first eight months of 2022 has reached 52,000, an increase of 12000 compared to 2021. In August alone, construction began on 8000 new projects. According to national regulations, the capital ratio of the project must reach 20% before construction. If the capital ratio does not reach 20%, the project cannot begin construction. At the end of June, the State Council proposed that the capital raised by policy-based and project-based key instruments could be used as the capital requirement for important projects including new types of infrastructure projects, but the proportion should be no more than 50% of the total capital. Moreover, the key instruments could be used as a mezzanine fund in order to accelerate the commencement of the project. Once the capital raised by the local government is in place, the mezzanine fund will be withdrawn. The bank will also provide loans for the project after construction. It is expected that the 600 billion RMB key instruments credit will leverage bank loans worth 600 billion RMB to 2400 billion RMB
Life Science & Healthcare
The future of Pharma Contract Organization
In the process of new drug development, China’s pharmaceutical companies have been regularly outsourcing some of the research and development as well as production to CXOs. A steady stream of technological breakthroughs supported by policy dividend benefits has meant that investment in the development and commercialization of innovative drugs is increasing steadily. This has meant that there has been a significant growth in the demand for services from Contract Organizations (CXOs). It is estimated that the global CXO market size will grow with a stable CAGR of 14.0% while the Chinese CXO market will grow by 31.3% from 2020 to 2025 respectively, significantly higher than the global average. However, recently, internal and external pressures are limiting the growth of Chinese Contract Organisations.
On the 12th of September 2022, the US announced the launch of the National Biotechnology and Bio-manufacturing Initiative, which aims to encourage the return of bio-manufacturing to the US. This has had and will continue to have a significant impact on Chinese CXO players who were relying heavily on overseas business (Figure 1). Domestically too, these companies are facing problems as the current patent protection environment in China has made many pharma companies wary of forming partnerships with CXO players. However, in the long run, with the steady development of relevant talent in China and the demand for R&D and production of new-generation therapies growing steadily, the future is bright for CXO players.
Figure 1: The Top 5 CXO Enterprises by Market Cap Accounted for Overseas Revenue in 2021
Note: Tigermed and Asymchem only revealed overseas revenue
Source: Annual report of listed company, Deloitte Research
Internal and external pressures on Chinese CXO players
On June 8, 2021, the US government released a report called Building Resilient Supply Chains, Revitalizing American Manufacturing and Fostering Broad-based Growth. This report was a comprehensive review of existing supply chains for pharmaceutical and API products with recommendations on how to encourage greater domestic production of pharmaceutical products and reduce reliance on overseas suppliers. On September 12, 2022, President Biden signed an executive order launching the National Biotechnology and Bio-manufacturing Initiative, which aims to bring manufacturing back to the US. The promotion of these two policies has had a tremendous impact on the Chinese CXO industry (Figure 2). On September 22, the closing prices of Chinese CXO players in the A-share market, US stock market and HK Stock Exchange all showed varying degrees of decline and reached their lowest value in the recent years, especially in the US stock market.
Figure 2: Monthly Closing Prices of CXO players (From Jun. 30,2021 to Sep. 22,2022, RMB)
Source: Wind, Deloitte Research
In the domestic market, despite the fact that the patent protection environment has been improved in recent years, there is still some way to go compared with other advanced countries. For instance, the Interim Opinions on the Implementation Measures for Data Protection of Drug Trials, which was issued in 2018, has regulated the data protection period of novel drugs yet the protection period of drug varieties was still shorter than the US. (Table 1)
Table 1: Comparison of data protection period of drug varieties in China and the United States
Note: Interim Implementation Measures for the Protection of Drug Test Data (Draft for Soliciting Opinions), ZHONGLUN Opinions
Compared with overseas biotech companies which tend to be acquired by multinational pharmaceutical companies, domestic biotech companies usually transform themselves into bio-pharma companies integrating R&D, production and commercialization capability. In recent years, driven by the favorable policy of government-enterprise cooperation, more and more local biotech companies have set up their own production lines. For example, since 2017, BeiGene, I-MAB Biopharma, and Zai Labs have increased their investment in production sites.
While growth may be limited in the short term, long-term development prospects remain bright.
In recent times, internal and external challenges have limited, to a certain degree, the development of Chinese CXO players. Some small and medium-sized CXO players in China have even lost orders. Lack of trust between CXO players and pharma companies as well as the cautious approach to biotech related investment in the capital market has affected the development of this sector considerably.
However, with continuous technological progress in the pharma industry, there will be higher demand for production technologies. With that, the demand for CRO and CDMO services will increase. In the long run, with the cultivation and growth of talent, and as the biotech investment market matures, the partnership model with CXO players can help biotech companies to develop and commercialize their key products more efficiently. Therefore, we remain optimistic about the future of the CXO market.
 From Frost Sullivan's data in Asymchem’ prospectus, A Growth Strategy Consulting & Research Firm | Frost & Sullivan