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ECONOMIC INSIGHT GREATER CHINA Quarterly briefing Q2 2013 WITH SLOWING GROWTH CHINA IS IN GOOD COMPANY 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 also focus on the Hong Kong and Macau Special Administrative Regions. Globalisation is taking a breather. World trade growth has been at the lowest level since the late 1990s, if we exclude the dotcom recession and the global financial crisis. A major reason for this is the eurozone’s drawnout recession that is likely to stay through 2013. Another factor is an apparent slowing of the US labour market following the sequestration of public spending. Japan has taken steps to overcome its long-term stagnation with aggressive monetary policy, but it’s doubtful if this will resolve the country’s fundamental problems. Key emerging markets have also suffered a growth slump. Russia is the latest of the BRICS economies to come off a fast growth trajectory, joining India, Brazil and South Africa. Global growth thus continues to be muted, resulting in a drop in commodity prices from their elevated levels. Better harvests are bearing down on agricultural goods prices and new supplies of mineral resources are contributing to a price fall in products such as metals and petrochemicals. The deceleration of China’s economy has played an important part in this price decline. We now take a closer look at the reduction in growth. BUSINESS WITH CONFIDENCE icaew.com/economicinsight Investment props up growth A soft landing appears to be in progress in China. Figure 1 neatly illustrates the gradual downwards trajectory of key indicators. Most importantly, industrial production growth is decelerating. However, fixed asset investment, the motor of the Chinese economy, was still forging ahead at an impressive rate of 26.5% year-on-year growth, but that is 5.2 percentage points lower than the figure in early 2010. It should be noted, of course, that 2010 was a year of strong growth following the dislocations of the financial crisis. China’s manufacturing base faces substantial wage increases and trading partners wounded by the aftermath of the Great Recession are not ramping up purchases as before. On the consumer side a steady reduction in the pace of retail sales growth has been evident. Sales, which are not inflation-adjusted, were 12.4% higher in Q1 2013 than a year earlier, compared with annual growth of 23.7% in early 2010. The reduction comes despite the above mentioned rise in gross wages and suggests that the much-vaunted turn towards consumption-led growth is at best in its infancy. Another pointer in that direction is the remarkable stability of investment in fixed assets, such as machinery and equipment or buildings. Growing at a faster rate than GDP, investment is propping up growth and helped the economy to expand by 7.7% year on year in the first three months of this year. The following section explores where the capital for the rising amount of investment comes from. Figure 1: Annual growth rates of nominal GDP, urban investment in fixed assets, retail sales and industrial value added This elementary fact becomes interesting when we consider the huge amount of money saved in China each year. Figure 2 shows just how big the cash pile is: with its US$ equivalent of $4.1 trillion in 2012, China accounted for almost one in every four dollars saved around the globe (23.7%). That share has risen about four-fold since 2000, testament to the astonishing wealth creation that has occurred here. By comparison, China’s share of global output rose from 3.7% in 2000 to 11.5% in 2012 (at market exchange rates). That surge is changing the world and it owes much to the growing abundance of resources squirreled away each year. Savings are calculated here as the amount of national output that is not consumed by households, firms or the government. The public sector runs a budget deficit, meaning that companies and consumers accumulate the savings. Though declared profits are often low for tax reasons, the business sector plays a big role in the accumulation of wealth. Managers, some with government connections, may gain from retaining earnings amid weak corporate governance. Recent moves to raise dividend pay-outs of state-owned enterprises look like an attempt to curb such tendencies. Households also have good reasons to add to their nest eggs, namely the need to provide funds for retirement in a fast-aging population and a limited social safety net. Figure 2: Chinese savings and value added as share of world total at market prices % 25 20 15 % 40 10 30 5 0 20 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Savings share 10 GDP share Source: IMF, Cebr 0 Q1 Q2 2010 Real GDP Q3 Q4 Q1 Q2 Q3 2011 Industrial production Q4 Q1 Q2 Q3 Q4 2012 Fixed asset investment Q1 2013 Retail sales Source: China National Bureau of Statistics Huge savings push investment First-year economics students learn that savings must equal investment when there’s no money crossing the border. Of course, China has been a major beneficiary of foreign investment, both in terms of capital and of technology. Within the constraints of its industrial policy regime, the country is open to foreign business, but local funds don’t travel so easily. A closed capital account means that neither firms nor individuals can just invest money abroad – most of the resources stay in the country and get invested in China. That may change as the country’s firms enlarge their global footprint, but that process will take years and for now most money gets recycled into new housing, infrastructure or productive capacity. icaew.com/economicinsight cebr.com China’s credit surge continues In practice, the straightforward theoretical relationship between savings and investment is anything but simple or direct. Transforming savings is the task of capital markets and the banking system and China is no exception. Most importantly, banks and other monetary financial institutions take short-term deposits and convert them into long-term loans. The stock and bond markets are the other two major parts of the financial system that make capital out of savings. In 2012, CNY15.8 trillion passed through the system and Figure 3 indicates the extent of growth in financial intermediation. In the decade from 2002 to 2012, the nominal value of capital annually dispensed by the financial system went up nearly eight times. The largest increase happened during the financial crisis: the amount of money provided doubled when the government ordered banks to open the credit taps all the way. ECONOMIC INSIGHT – GRE ATER CHIN A Q2 2 013 Bank loans are a major tool of Chinese economic policy that can be seen as a form of monetary stimulus. The predominantly state-owned banking sector provided money at low interest rates, often to state-owned companies or to local government projects. The money was used for investment, explaining why China was able to keep cash flowing while the rest of the world saw its financial system teeter on the verge of collapse. The numbers given here are for ‘social financing’, a broad term that includes equity raisings and other forms. The next section takes a closer look at non-bank-loan financing, which is becoming increasingly important. A rising share of social financing in output is a mirror image of the rising investment share of GDP that many consider excessive. Since 2002, social finance has grown from 16.7% of GDP to 30.3%. The current level is higher than during the credit splurge of 2009 and 2010, but its size in relation to overall output has fallen. Figure 3: Change in social financing and social financing as a share of nominal GDP (%) CNY 20,000 % 50 Non-loans Social financing/GDP Loans 15,000 40 10,000 30 5,000 20 0 10 Source: China National Bureau of Statistics New forms of lending are taking hold China’s economy is diversifying at an impressive pace, moving up the value chain at a probably unmatched pace and scale. As the industrial structure is becoming more complex, financial services are racing to keep up with the times. Financial liberalisation is proceeding steadily, albeit at a measured pace. Regulation of the demand for and supply of financial services is moving towards the creation of a modern financial industry, with Shanghai as the main onshore centre. The diversification of financing options is evident in the make-up of social financing exhibited in Figure 4. In 2002, the bulk of credit came from renminbi bank loans that accounted for 91.9% of the total. Figure 4 gives an indication of the magnitude of social financing over time. This item had shrunk to 52.0% by 2012. One of the reasons that forms of finance other than bank loans are proliferating is that banks offer paltry returns to depositors. Interest rate caps mean that real returns on deposits are negative, pushing those with money to invest into other products. The recent proliferation of wealth management products that offer a higher rate of return has allowed new players to gain market share. Loans by trusts are a growth area in this regard, providing 8.2% of financing. The bond market had become the second largest means to raise funds, providing 14.3% of funds now compared with just 1.8% back in 2002. icaew.com/economicinsight cebr.com Figure 4: Composition of social financing 2002 2012 % % Non-financial institutions equity financing 3.1 1.6 Loans in foreign currencies 3.6 5.8 Loans in local currency 91.9 52.0 Bank’s acceptance bills -3.5 6.7 Entrusted loans 0.9 8.1 Trust loans 0.0 8.2 Corporate bonds net financing 1.8 14.3 Source: People’s Bank of China Do artificial transactions evade capital controls? Financial repression, the distortion of market mechanisms with a policy purpose, reigns in China’s financial sector. Capital controls, interest rate ceilings, state-directed lending and restrictive market entry requirements combine to give the government a large degree of control over the capital market. In China, financial repression is mainly exercised via two restrictions. The first is capital controls that force firms and households to keep their money in the country rather than moving it abroad. Therefore, savings can be used to grow the capital stock of the domestic economy without regard for the profit outlook. Secondly, interest rate ceilings keep borrowing costs for banks low and guarantee profits due to consistently higher lending rates. The two measures combine to provide large amounts of cheap money for industry. China’s foreign exchange policy of keeping the value of the renminbi low is another weapon in the economic policy armoury. A low exchange rate brings in export revenues, helping producers make profits in the global market. What is good for sellers is bad for buyers. Households end up paying more for their purchases produced abroad or featuring internationally traded inputs. Figure 5: Reported trade from China to Hong Kong USD 50 40 30 20 10 0 1993 1998 2003 China exports to Hong Kong 2008 2013 Hong Kong imports from China Source: Hong Kong Census & Statistics Department ECONOMIC INSIGHT – GRE ATER CHIN A Q2 2 013 The purpose of the system has been to provide funds for industrialisation, with astonishing success. However, capital market distortions provide incentives to circumvent them as profit can be made doing so. Trade data provide an indication that money is moving across borders to circumvent currency controls. As Figure 5 shows, China reports much higher exports to Hong Kong than Hong Kong registers in imports from the Mainland. In other words, goods are being sold but never get delivered. The transaction is paid nonetheless, moving money to China, presumably to avoid declaring its purpose. It would seem that virtual trade in the other direction – moving money out of the Mainland – would be more obvious, but the figures imply this direction. Growth to slow across Greater China in 2013 Hong Kong’s economy is focused on the Mainland Meanwhile, quickly rising wages should provide a solid basis for consumption growth and in the absence of a global economic slump, export growth (excluding the Hong Kong effect discussed previously) is expected to pick up. Nevertheless, the large size of the economy means that further income gains will be harder to achieve and a shrinking workforce will further exacerbate the growth decline. For 2013, the annual rise in GDP is expected to fall to 7.4%, followed by a further deceleration to 7.2% in 2014 and 7.0% in 2015. The use of trade transactions to shift funds between Mainland China and Hong Kong would make sense as the two economies are closely interwoven both in the financial and the trade sector. The single largest industry in Hong Kong is the import and export trade. Much of this is based on close business relationships with manufacturers in the Pearl River Delta across the border, but exporters to China also use Hong Kong as a base. In addition to the need for capital equipment to produce China’s industrial output, the rising might of the Chinese consumer is pushing this sector. Overall, more than a fifth of Hong Kong’s economy is based on this trade. The public sector is the second-largest part of the economy with 16.5% of value added produced there. That is a fairly small proportion by international standards, reflecting the Special Administrative Zone’s history of laissez-faire governance. Finance follows closely behind and represents the other key industry that is linked to % China. Providing 16.1% of Hong Kong’s value added, OtherChina, sectors but also a it 100 provides a basis for investment into services platform for Chinese firms lookingOther to go abroad. 80 Construction The third sector, which actually consists of property Real estate services & ownership 60 services as well as income from property ownership, accounts for 21.5% of output. Adding the 3.4% of the Financial sector 40 construction sector, almost a quarter of Hong Kong’s Public sector economy is based on real estate. This, too, is influenced 20 by the Mainland as many rich people have snapped Import & export trade up properties in Hong Kong, driving up prices but also 0 providing income to the sector. Figure 6: Hong Kong sector contributions to value added, 2011 Other sectors 3.5% Other services 17.9% Construction 3.4% Real estate services & ownership 21.5% Financial sector 16.1% Public sector 16.5% Import & export trade 21.1% Source: Hong Kong Census & Statistics Department icaew.com/economicinsight cebr.com Turning now to our regular economic growth projections for the People’s Republic and its Special Administrative Regions (SARs), the economy of Mainland China has been slowing as we have described above. Investment continues to drive the economy and the risk of a credit boom turning into a credit bust is heightened by the increasing prevalence of non-bank financing that isn’t as amenable to mandated lending as the state-owned banks. While it seems highly possible that the credit flood may turn into a drought, the system of financial repression should ease this risk and allow the country to manage the inevitable rise in bad loans festering in the system. Figure 7: Greater China GDP growth forecasts % 10 8 6 4 2 0 Mainland Hong Kong 2013 2014 Macao 2015 Source: Cebr Limited world growth is affecting Hong Kong’s import/ export sector due to its position as the world’s busiest port. In addition, curbs on property transactions should temper activity in an important sector for the economy. Still, output should expand at a faster rate than last year as government provides stimulus and trade picks up towards the end of 2013, bringing GDP growth to about 2.9% this year. For 2014, a rebound to 4.0% is projected as globalisation gathers pace again, moderating to about 3.7% in 2015. As Hong Kong relies on the Mainland for its trade and finance industries, Macao’s customers also predominantly come from its large neighbour. There has been a remarkably close relationship between Mainland GDP growth and gaming revenues in the SAR, though as time goes by this correlation is likely to become looser. The more austere tone of the new Communist leadership, which eschews grand banquets and other conspicuous displays of wealth, may hurt Macao’s tourism/gambling industry. On the other hand, it’s also conceivable that rich Chinese will come to the territory to splash out in a way that is increasingly frowned on at home. A major risk ECONOMIC INSIGHT – GRE ATER CHIN A Q2 2 013 for the economy revolves around travel restrictions and the new rulers in Beijing may be less inclined to allow a freewheeling vice that is outlawed in other parts of the People’s Republic. that result in such an unsustainable situation. Current non-performing loan rates suggest that there’s no problem, but an economic downturn is inevitable at some point and this will expose those swimming naked. Our central forecast is that there will be some let-up in gaming revenue growth as the Mainland economy slows and sobriety becomes the rule. Lower growth prospects are also likely to weigh on capital investment in the medium term. The current slowing cycle is expected to run through 2013, leaving GDP up by about 7.5% year on year. In 2014 and 2015, Macao is projected to pick up some speed, resulting in growth rates of 8.5% and 9.2% respectively, once gaming revenues grow faster again and new casinos are built. The role of the government in propagating the current credit boom obligates it to deal with the fallout if there is a credit bubble that bursts. Fitch Ratings estimates that general government debt currently amounts to about 50% of output, a manageable amount. Bank credit amounted to roughly 130% of GDP at the end of 2012. Even if a third cannot be repaid and the government assumes the resulting debt burden in order to save the banking system, then its debt burden rises to about 90% of output, which is fairly thin ice. Such an extreme scenario is unlikely, but it illustrates that China’s capacity for bail-outs is limited. The earlier the credit cycle turns the better We have argued in this report that Chinese savings are resulting in massive amounts of investment and that the expansion of credit is a side effect of this process. The joint direction of travel – savings, investment and credit move together in a closed economy – may be logical, but that is not to say that it happens at the right pace. Investment in productive capacity is a positive in terms of raising output and ultimately living standards. Problems only arise when the return of the new capital is insufficient to cover its cost in terms of interest and loan repayment. The continued provision of plentiful credit allows borrowers that have invested in failed projects to borrow new money to meet their financial obligations and stave off collapse in the hope of turning fortunes. The widely reported empty apartment blocks, shopping malls and roads are the most obvious examples of investments icaew.com/economicinsight cebr.com An explicit bail-out of banks’ bad debt will probably be necessary at some point. That will prove costly and many lenders to non-banks may not benefit from having their deposits protected. More risk – in this case a high probability of some loss of capital – is the flipside of higher interest rates for wealth management products. However, depositors will also have to bear the burden of the current system. Negative real interest rates represent a transfer of resources from savers to borrowers. More financial repression is on its way and, as with an undervalued renminbi, households will bear the cost of China’s industrial policy. While a crash may be avoided thanks to the availability of abundant domestic savings, heavy credit losses are likely to be on their way. They may be the catalyst that will lead China to get serious about changing its growth model towards more domestic consumption and take the painful but necessary steps to do so. ECONOMIC INSIGHT – GRE ATER CHIN A Q2 2 013 For enquiries or additional information, please contact: Vivian Yu T +86 10 8518 8622 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 140,000 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 706, Tower E1, Oriental Plaza No.1 East Chang An Avenue Dong Cheng District Beijing100738, China icaew.com/china ICAEW Chartered Accountants’ Hall Moorgate Place London EC2R 6EA UK icaew.com © ICAEW 2013 MKTPLN12257 05/13