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Economic Insight: Greater China Welcome to ICAEW’s Economic Insight: Greater China, a quarterly forecast for the region prepared specifically for the finance profession. Produced by Cebr, ICAEW’s partner and acknowledged experts in global economic forecasting, it provides a unique perspective on the prospects for China over the coming years. In addition to mainland China, we look at the Hong Kong and Macau Special Administrative Regions (SARs). Quarterly briefing Q4 2015 In this issue of Economic Insight: Greater China, we explore the connections between the events currently shaping the world economy and economic performance in Greater China. Given China’s size and importance, these connections have causal links operating in two directions. We discuss both − how global events impact the outlook in China and also how recent developments in China are affecting the global economy. Following on from this, we reassess the risk of a hard landing in China and present our latest forecasts for the Chinese economy. Findings: • The likelihood of a global recession has risen, with the slowdown in China spreading panic to much of the rest of the world economy. This time round, restoring growth will be difficult given that central banks have already exhausted their arsenal and the world has not yet recovered fully from the wounds of the financial crisis. • A significant risk ahead is the monetary policy tightening expected from the US Federal Reserve. This has already led to a depletion of global foreign currency reserves. Further reversals put Asian economies at risk, particularly Hong Kong and Thailand. • China’s renminbi continues to ascend as it overtakes Japan to become the world’s fourth-largest currency. Inclusion in the IMF’s Special Drawing Right (SDR), an international reserve asset, is expected to be one of the key events of this year. Despite recent alarm bells coming from the stock market, we find that China’s economic rebalancing continues apace. Demand for some commodities such as cement or steel has taken a blow, but other sectors are growing. The cinema market, for example, is booming and is expected to become the world’s largest in the next three years. Demand for soft commodities such as coffee and gasoline is also on the rise. We conclude that policymakers face significant challenges in terms of deflating China’s credit stock, but our baseline scenario is for a soft and managed landing. BUSINESS WITH CONFIDENCE icaew.com/economicinsight Will policymakers be able to prevent another recession? The global economy has had to sail through rough seas in 2015. Despite a promising start to the year for the eurozone, with the European Central Bank’s (ECB) quantitative easing (QE) programme providing some boost, the region has failed to make a return to sustained and robust growth. The economy has remained anaemic with even the currency’s core economies, Germany and France, struggling to expand. While an agreement has been reached for a third bailout for Greece, the lack of cooperation and loss of trust among eurozone member states during negotiations has reignited fears over the future of the common currency. In the UK, the victory of the Conservative party in the General Election that took place in the spring, eliminated some concerns in the business community, but its promised vote on UK membership of the EU raised others. Policy uncertainty has become a major issue in the US, with huge question marks over the timing of a Federal Reserve interest rate rise. A rise, if it comes, risks triggering capital outflows from a range of emerging markets. China itself returned to the economic spotlight this summer after posting a wave of weak economic data and seeing its stock market correct sharply. Policymakers responded quickly with expansionary measures which have contained the damage somewhat, but fears remain that a sharp slowdown in the world’s second-biggest economy could kick off a significant global downturn. This would be especially damaging now given the fragile state of the global economy, with many countries still recovering from the 2007/08 financial crisis. Strong dollar impacts global currency reserves One important realm of the global economy that has been particularly active this year has been monetary policy. In some respects, this is not really ‘new news’. After all, monetary policy was the main lever employed by policymakers to help their economies return to recovery after the recession. Hints that this may be reversing – at least by the US Federal Reserve – sparked panic in emerging markets when the Central Bank decided to start tapering its asset purchases back in December 2013. This so-called ‘taper tantrum’ put significant pressure on emerging markets’ Central Banks which began raising interest rates to defend their currencies. In order to do so, they had to gradually make use of their foreign exchange reserves. As shown in Figure 1, the total level of global foreign exchange reserves has been following a downward trend since mid-2014. It is important to note, however, that reserves do not simply represent quantities of money: their value is also determined by exchange rates. Figure 1 shows reserves expressed in US dollar terms. This means that the higher the value of the dollar, the lower the value of total reserves reported. Conversely, a falling dollar would lift the value of reserves. The trend of a strengthening dollar throughout much of 2014 and 2015 partly explains the fall in reserves. One important event of 2015 in this context was the ECB’s decision to launch a QE programme. This put downward pressure on the euro in relation to the US dollar and icaew.com/economicinsight cebr.com the pound sterling. Given the euro’s role as the secondmost important global reserve currency, this was a key factor behind falls in the value of reserves in late 2014 when investors and traders started pricing in the ECB’s hints of QE. Several other central banks also loosened policy last year, including many emerging markets such as India, Turkey, Indonesia, Thailand and of course, China. The People’s Bank of China (PBOC) took numerous steps to stimulate the economy, including cuts in interest rates, cuts in the reserves requirement ratio and the savings ratio as well as a devaluation of the yuan. Figure 1: Currency composition of official foreign exchange reserves, global total, US$ trillions-equivalent US$ trillion equivalent 14 12 10 8 6 4 2 0 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014 2015 2015 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Unspecified US dollars Pounds sterling Japanese yen Euros Other currencies Source: International Monetary Fund (IMF), Cebr analysis FOCUS Impact of potential US rate hikes on Hong Kong Despite high expectations of a rate rise in September, the US Federal Reserve kept monetary policy on hold. Part of the reason behind this hesitation is the persisting trend of low inflation, as well as concerns about the weakness of the global economy. Rhetoric remains focused on building expectations for a rate hike this year – the consensus is that it will come in December 2015. A US rate rise, if it happens, could have major implications for emerging markets, leading to capital outflows and negatively impacting companies with US dollardenominated debts. A recent study compiled by Bloomberg Economics examines 10 indicators of growth, inflation and financial risks in emerging Asian markets, in order to assess the level of vulnerability to a US rate hike.1 The results showed Hong Kong at the top of the list as the economy most at risk. This is because of a high level of leverage – domestic credit, for example, stands at over 230% of GDP according to the latest data for Q1 2015 from the Bank for International Settlements. External debt is nearly twice as high. Excessive demand for, and availability of, credit has led to sustained positive trends in the Hong Kong equity and housing markets. Despite the slowdown in the equivalent markets in neighbouring mainland China this year, house prices in Hong Kong have been trending upwards since 2012. The HKFE Hang Seng Index remains above pre-crisis averages despite a recent correction. ECONOMIC INSIGHT – GRE ATER CHINA Q 4 2 015 Overall, Hong Kong is identified as an economy particularly vulnerable to an interest rate rise in the US given its profile as a mature and globally interconnected economy, and the important role played by the financial sector. The Bloomberg study further identifies Thailand as an economy at significant risk given its high levels of private credit and the profile of its property market, while the Philippines and India are identified as being relatively resilient when judged on the same metrics. Mainland China, however, is not seen as particularly vulnerable given its high level of foreign reserves, low levels of external debt, and low levels of foreign-held public debt. Still, overall, Asian countries are identified as being less vulnerable today compared to the ‘taper tantrum’ period: with lower inflation allowing room to keep rates low and stronger current accounts, these economies now seem better prepared to weather a US rate rise storm. Renminbi rises to become world’s fourth most used currency It is notable that the renminbi is absent from the list of the world’s most important reserve currencies presented in Figure 1. The IMF recently reported that the renminbi’s share of global reserves was about 1.1% (equivalent to $120bn).2 This is lower than the Australian and Canadian dollars, but above the Swiss franc’s global (specified) reserves at 0.3%. This is puzzling at first sight, given China’s economic importance. But the tides are shifting. According to data from global payments provider SWIFT, the renminbi is catching up significantly in terms of its status as a world payments currency. In the past three years alone, the renminbi overtook seven currencies to rise from twelfth to fourth place in the ‘premier’ league of global currencies. As shown in Figure 2, this shift has recently picked up strong momentum: the renminbi’s share of the global total of customer-initiated and institutional payments3 has more than doubled between January 2014 and August 2015, rising from 1.4% to 2.8%. This has been at the expense of the euro, the pound sterling, and the Australian dollar which have lost ground by 19%, 10%, and 9% respectively. Figure 2: Customer initiated and institutional payments, top 10 currencies’ share of global total – change between January 2014 and August 2015 CNY HKD USD CHF JPY THB CAD AUD GBP Within Asia alone, between 2014 and 2015,4 the renminbi has risen to become the number one currency for payments sent to or received from China and Hong Kong, overtaking the Hong Kong dollar. The Asia-Pacific region generally represents the most important region in terms of renminbi used for international payments sent to and received from China and Hong Kong, with renminbi users claiming a 39% share. The number of financial institutions using renminbi for payments in the region has climbed to 555 in August 2015 from 471 in the same month last year. This compares to 379 in Europe, 118 in the Americas and 52 across Africa and the Middle East. Moreover, China is actively trying to promote the renminbi’s use in international markets. As noted in the last edition of this report, a key example in this respect is the ambition to include the renminbi in the IMF’s currency basket, the Special Drawing Right (SDR). This currently consists of four currencies: the US dollar, the euro, pound sterling, and the yen. For this to become reality, it is important that China continues to liberalise and promote transparency (of which its recent decision to report the breakdown of its reserves to the IMF is a good example). However, a point that is often missed is that SDR inclusion is not a black and white issue: the weighting of the yuan within the SDR is a topic that deserves equal merit given the likelihood of its inclusion towards the end of this year. In this respect, two criteria that determine the weight come to mind: the importance of its exports and its role as a reserve currency. China currently ranks high on the former but low on the latter. One strategy to increase the renminbi’s attractiveness as a reserve currency is through keeping its value strong and stable. SDR adoption not the only motivation for renminbi strength After a continuous verbal beating from China’s global peers for intentionally keeping its currency weak to support export competitiveness, the situation has at last shown signs of change. In its 2015 Article IV Consultation Mission to China, the IMF stated that ‘while undervaluation of the renminbi was a major factor causing the large imbalances in the past, our assessment now is that the substantial real effective appreciation over the past year has brought the exchange rate to a level that is no longer undervalued’.5 This appreciation has mainly been the product of central bank intervention, with the People’s Bank of China drawing down its foreign exchange reserves in order to keep the renminbi value aloft. This was briefly interrupted when the Bank decided to devalue the yuan in mid-August, a move that was widely perceived as part of an effort to stimulate the economy in the face of deteriorating market confidence. Still, despite this recent blip, the renminbi’s value in relation to the US dollar is higher than the averages prevailing in the pre-financial crisis period. China’s foreign exchange reserves have also fallen back − from a peak of just under $4 trillion in June 2014, they have now declined to $3.7 trillion.6 EUR -20 0 20 40 60 80 Source: SWIFT Watch, Cebr analysis icaew.com/economicinsight cebr.com 100 120 % At first glance, the long-term strategy of currency appreciation may seem puzzling as it harms the export sector − one of China’s most important industries and sources of employment. However, in recent years, trade ECONOMIC INSIGHT – GRE ATER CHINA Q 4 2 015 has faded into the background as a source of demand for the yuan. More and more of the investment flowing into China has been motivated by speculation for further appreciation. Apart from self-reinforcing the yuan’s appreciation, these inflows also provide liquidity in the banking system and hence push down borrowing costs. With this in mind, allowing the yuan to drop risks a reversal in this kind of investment, which in turn could drain cash from the financial system. Figure 3: CNY per US$ CNY per US$ 8.5 8 7.5 Aug 2015: PBOC devalues the yuan 7 6.5 6 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Macrobond In contrast, keeping the yuan strong will continue to lure global capital into China’s stock and bond markets. It will also help contain wage demands in the increasingly important Services sector, by keeping import prices down. Currency appreciation will support a continued rebalancing of the Chinese economy away from exports and investment towards consumer spending. Looking ahead, we expect a gradual appreciation of the renminbi to extend beyond the IMF SDR review, which will determine renminbi inclusion in this currency basket. However, this is not to say that SDR adoption of the renminbi is guaranteed − a number of obstacles remain. The key criterion that the renminbi fails to meet is that of full convertibility, given the restrictions that are still in place in China’s capital markets. In that respect, efforts to open up the capital account and deepen financial markets should help the renminbi to become a stronger candidate. While the IMF can also decide to change its rules for inclusion into the SDR, this would require a 70% to 85% majority ruling by the 24-member executive board. China’s rebalancing – is it still happening? The downturn in China’s economy which shook the world this year, has dominated China-related global headlines. The need to prevent a ‘hard landing’ has become more prominent in the news than any discussion of the longer-term need to rebalance the economy away from investment and towards consumer spending. It is interesting to observe what is happening in China as far as rebalancing is concerned. This Economic Insight report series has continuously observed, documented, and discussed the slowdown in China’s export and investment sectors. We have argued that the slowdown in these sectors, and its effect of dragging down China’s overall economic performance, is neither a reason for concern nor conclusive proof that China’s economy is heading for a hard landing. On the contrary, it is a natural ‘bump in the road’ of China’s transition to a more consumer-oriented economy. icaew.com/economicinsight cebr.com Given the importance of these sectors in China’s economy (exports, for example, still make up around a quarter of GDP and investment makes up 44% of GDP) commentators can be partly forgiven for focusing on these sectors to draw conclusions about China’s economy and consequently worrying over a Chinese crash. However, it is important that China is understood as an economy in transition. In this respect, it is interesting to observe what has been happening not only in the export- and manufacturing-intensive sectors of the economy in the past year, but also the consumer- and domestic demanddriven sectors. The data on the increasingly important consumer sector are mixed at present. Burberry, the British luxury fashion house, saw its shares fall by 8% in mid-October 2015 after reporting a fall in revenue in Asia. Even though group revenue stayed flat in the first half of 2015, there was a dip in sales in China and the company stated that trading there was becoming ‘increasingly challenging’.7 Macau, which depends heavily on the leisure and tourism industry, has also been heavily hit by similar challenges. Gross revenue in the island’s gaming industry has been declining at an average pace of 35% year on year over the first nine months of this year. In February alone, an important month given the Chinese New Year, gaming sales fell by almost 50% compared to the year before. Yet, despite these dismal statistics that make big headlines, other indicators suggest that the middle class in China is steadily emerging, setting the ground for a rebalancing towards a consumer-driven economy. An interesting example in this respect is the cinema industry. Although this is a small part of any economy, it serves as a good indicator for the health of the consumer market and for the growth of the middle class. According to data from the State Administration of Press, Publication, Radio, Film and Television, as of September 2015 China’s box office for that year had already exceeded the 2014 total of 29.6bn yuan ($4.6bn) with a total of 30bn yuan ($4.7bn).8 This represents a 48.5% growth compared to the same period a year ago. In July alone, the box office totalled 5.5bn yuan, more than the whole of 2008. Forecasts see the Chinese box office, already the second largest globally, overtaking North America within the next three years.9 Figure 4: Box office markets for global top 10 in 2014, in current US$ bn 10.4 US/Canada 4.8 China Japan 2.0 France 1.8 India 1.7 UK 1.7 South Korea 1.6 Germany 1.3 Russia 1.2 Australia 1.1 Mexico 0.9 0 2 4 6 8 10 12 US$ bn Source: Motion Picture Association of America, Cebr analysis ECONOMIC INSIGHT – GRE ATER CHINA Q 4 2 015 Oil and commodity prices in 2015 – what can we learn from China? Mainland China to continue cooling, with negative impacts on Hong Kong and Macau Another key event of 2015, and one that can be traced closely to China, has been the persistence of low oil and commodity prices. In September, Brent traded at $47 a barrel – roughly the same price level as in January and less than half the $95 per barrel average price in September 2014. Forward-looking indicators suggest that the economy of mainland China is slowing down. Recent data for Q3 2015 confirm this with annual growth coming in at 6.9%, the lowest seen in six years. We expect that by the end of this year, the economy will be shown to have expanded by 6.8% – impressive for advanced economies but low for China compared to the recent past. Looking ahead, a dilemma emerges: policymakers have to tread a fine line keeping growth and employment levels afloat while at the same time managing the transition towards a more mature economy with a greater role for the services and domestic consumption. If policymakers broadly focus on rebalancing over short-term growth, we expect to see a sharper slowdown in the short term with growth stabilising close to 5-6% towards the end of the decade. This is the recommended scenario, which we call ‘fast landing’. However, it is possible that policymakers may fall for the temptation of sustaining high growth rates now by easing policy and providing credit – something that would be unsustainable for the long term. We call this scenario ‘slow landing’, as it delays the necessary and inevitable slowdown further into the future. This scenario is far from desirable as it is a case of avoiding short-term pain but taking away from the potential for long-term gain. In this scenario, we expect growth to slow more sharply in the medium term, with even a recession on the cards within the next decade. The chances for this would rise significantly if China’s credit bubble is fuelled so much that it explodes, rather than being helped to gradually deflate. A combination of supply- and demand-side factors have contributed to this trend: on the supply side, American shale extractors, record production in regions such as Iraq, and the lifting of international sanctions against Iran are all positively boosting supply, now and for the foreseeable future. On the demand side, China’s industrial slowdown is curbing demand for oil and other commodities. The downward price pressures from reduced demand and increased supply are further reinforced by a strengthening dollar, given that oil and commodities are usually priced in dollars. Figure 5: China’s commodity demand, 2015 year to date vs same period in 2014, annual % change Kerosene Gasoline Aluminium Soybean Coffee Copper Oil (total) Zinc Sugar Cotton Diesel Corn Steel Wheat Coal Cement -10 -5 0 5 10 15 20 25 % Annual % change Source: JODI, OPEC, USDA, RUSAL, WSA, Cebr analysis Many have rushed to proclaim China’s declining demand for commodities as yet another piece of evidence in building the case for a hard landing. However, a closer observation of China’s patterns of commodity consumption reveals some rather interesting conclusions. As shown in Figure 5, not all of China’s demand for commodities is in decline. In particular, we notice an important distinction between so-called ‘CapEx’ and ‘OpEx’ commodities.10 The former category includes commodities such as iron ore or cement, which are heavy inputs for construction and other infrastructure. High demand for such commodities acts as a signal that a country is going through a period of industrialisation. These were the commodities at the forefront during the years of China’s demand-fuelled market boom. But now demand for such commodities is slumping. Demand for cement, for example, declined by 5.8% year on year in Q2 2015, compared to 4.4% growth seen in the same period a year ago. The latter category presents a more positive picture. China’s demand for the ‘operational expenditure’ type of commodities, such as gasoline and coffee, is soaring. This suggests that behind the scenes and the dismal headlines, China is nurturing a growing middle class that is starting to spend more on things such as food and personal travel. As mentioned earlier, it is important that China is understood as an economy in transition. The way China is consuming commodities further reinforces our conclusion that the country’s enormous economic transition is continuing, not faltering. icaew.com/economicinsight cebr.com Hong Kong is expected to be negatively impacted by the vagaries of the international economy in 2015 and beyond. While the slowdown in mainland China itself is not expected to be the main driver, a rate hike in the US (Cebr forecast for 2016) is expected to take a toll on Hong Kong’s financial services industry. We expect to see growth of below 2% prevailing throughout the forecast horizon (See Figure 6). Macau’s leisure and tourism industry has already taken a heavy toll from efforts in the mainland to contain corruption. This is expected to drag growth down this year with the economy contracting by 17%. Further ahead we expect to see a modest return to expansion supported by the growing middle class in mainland China. This should be bolstered by the opening of the Hong Kong-Zhuhai-Macau bridge. The annual pace of growth is expected to accelerate to about 5% by 2017. Figure 6: Greater China GDP growth forecasts, annual % change % 10 5 0 -5 Mainland China (fast landing) Mainland China (slow landing) Hong Kong Macau -10 -15 -20 2015 2016 2017 Source: Cebr forecasts ECONOMIC INSIGHT – GRE ATER CHINA Q 4 2 015 ENDNOTES 1Source: http://www.ejinsight.com/20150528-hong-kong-seen-hardest-hit-by-us-rate-hikes/ 2Source: http://www.imf.org/external/np/pp/eng/2015/071615.pdf 3 Messages exchanged on SWIFT; based on value. 4 This change is noted when comparing payments over Jan-Aug 2014 and those over Jan-Aug 2015. 5Source: https://www.imf.org/external/pubs/ft/scr/2015/cr15234.pdf 6 Latest data are for June 2015. 7Source: http://www.bbc.co.uk/news/business-34536578 8Source: http://news.xinhuanet.com/english/2015-09/08/c_134602012.htm 9Source: http://www.hollywoodreporter.com/news/china-box-office-exceeds-2014-820883 10 CapEx is short for ‘Capital Expenditure’. OpEx is short for ‘Operational Expenditure’. Source: Goldman Sachs For enquiries or additional information, please contact: Juni Ngai, Director, Hong Kong T +852 2287 7277 / 6381 1687 E [email protected] Cebr The Centre for Economics and Business Research is an independent consultancy with a reputation for sound business advice based on thorough and insightful analysis. Since 1993 Cebr has been at the forefront of business and public interest research. They provide analysis, forecasts and strategic advice to major multinational companies, financial institutions, government departments and trade bodies. ICAEW is a world leading professional membership organisation that promotes, develops and supports over 144,000 chartered accountants worldwide. We provide qualifications and professional development, share our knowledge, insight and technical expertise, and protect the quality and integrity of the accountancy and finance profession. As leaders in accountancy, finance and business our members have the knowledge, skills and commitment to maintain the highest professional standards and integrity. Together we contribute to the success of individuals, organisations, communities and economies around the world. Because of us, people can do business with confidence. ICAEW is a founder member of Chartered Accountants Worldwide and the Global Accounting Alliance. www.charteredaccountantsworldwide.com www.globalaccountingalliance.com ICAEW Greater China Room 1103, Tower C1, Oriental Plaza, No. 1 East Chang An Avenue Beijing 100738, China icaew.com/china ICAEW Chartered Accountants’ Hall Moorgate Place London EC2R 6EA UK icaew.com © ICAEW 2015 MKTDIGI14550 11/15