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Top 7 FAQ on Chinas slowdown

Theme: Top 7 FAQ on Chinas slowdown. Weve been bombarded with many questions on the anatomy of Chinas slowdown and what it means for the rest of the world after the surprise contraction in Januarys Markit PMI. Here are the top 7 questions and our responses. 1) 2) 3) 4) 5) 6) 7) Can we write off the weak PMI as a Lunar New Year effect? What is the current state of the Chinese economy and the outlook? What does the slowdown in China mean to the world? What does the slowdown in China mean to the developed world? Whats the impact on emerging markets? What is the latest on Chinas debt problem? How do you invest in this environment?

THURSDAY 6 FEBRUARY 2014

EDITOR Sean Yokota


Head of Asia Strategy

sean.yokota@seb.se + 65 6505 0583

Macroeconomic and market charts: Besides the PMI, what stands out this month is the slowdown in house price appreciation (Chart 16). House prices were rising 1%MoM for most of 2013 but in November and December, the pace has halved to 0.5%MoM. The minor property tightening measures introduced in October are working. Therefore, we expect construction activity and domestic demand to weaken in 1H 2014.

Tidbit: We often hear about the severe pollution in China and the pollution is now impacting agriculture output. A government official has stated that more than eight million acres of Chinas farmland is too polluted with heavy metals and other chemicals to use for growing food. Pollution has now implications for Chinas food security policy and may get more attention over the next several years. Reducing metal pollution was included in the latest five year plan but so far little has been done. Furthermore, pollution problem worsens over the Lunar New Year since fireworks are often used and increase particle levels.

You can also find our research materials at our website: www.mb.seb.se. This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any director consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.

China Tracker

Theme: Top 7 FAQ on Chinas Slowdown


Weve been bombarded with questions on the anatomy of Chinas slowdown and what it means for the rest of the world after the surprise contraction in Januarys Markit PMI. Here are the top 7 questions and our responses.

1) Can w e w rite off the w eak PMI as a Lunar New Year effect?
We should be very cautious about extrapolating Chinas growth based on January and February data. The two China PMI series are seasonally adjusted but the statistical models are still not good enough to adjust for the movements of the moon. Chart 1 shows the average and median month over month change in the national PMI since 2005. January and February are typically weak followed by a big boost in March, when we get a full and clean reading post the Lunar New Year. Often, Marchs rebound is large enough to compensate for the downturn in January and February and market worries disappear. The economy will slow in 2014 but not like the pace we saw in January PMI.
Chart 1: China National PMI seasonality
7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 PMI seasonality % MoM since 2005

Average

Median

10

11

12

Source: CEIC, SEB

2) What is the current state of the Chinese economy and the outlook?
Chinas economy has two engines, exports and domestic demand and the charts in the Macroeconomic Tracker section below will help us explain the developments. Domestic demand has been strong as you can see from Chart 13 where construction activity has been accelerating. However, going forward domestic demand and construction activity is likely to slow since monetary policy has tightened in 4Q (Chart 23) and the pace of increase in property prices have slowed (Chart 16). We are not so concerned about the slowdown in domestic demand since this is a consensus, long term, structural view and authorities can always restart this engine by loosening monetary policy since inflation is low and likely to fall. The bigger concern is the export engine. As Chart 11 shows, exports have been recovering from improved demand in US and Europe. Exports are important for domestic demand as well since they generate income for households who consume and for businesses to invest. The recent PMI data has us and markets questioning the outlook on exports since export orders subcomponent has been weak and US ISM (manufacturers sentiment) has tumbled. Cold weather may explain the weak US demand and SEBs view is that the US economy remains healthy. However, downside risk to our China 2014 real GDP forecast of 7.4% has increased, especially since export slowdown is harder to tackle with Chinese policy adjustment. China can delay currency appreciation to support exports but that has negative consequences abroad (e.g. trade tensions). In addition, exports in Asian economies are much more influenced by volume changes rather than currency adjustments.

3) What does the slow dow n in China mean to the w orld?


On the whole, not much is the short answer. China contributes about 30% of total global growth. As you can see from Chart 2, in 2012, global real GDP growth was 2.1% and China added 0.6 percentage point of the total (green bars). That may sound a lot on the surface but you need to put that in context to how much China can slow. For example, SEBs China forecast for 2014 is 7.4%, which is slightly less than consensus. If we are wrong and China slows to 6.4%, global growth using 2012 figures would be 2.0% instead of 2.1%. That is not much of a concern.
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China Tracker Chart 2: Contribution to global real GDP growth


5 4 3 2 Contribution to world real gdp growth, ppt

3.6 2.3

3.0 0.5

3.4

3.2 0.8 0.6

3.3 2.1 1.5 0.6

1 0 -1 China -2 -3 Rest of World

0.4

0.4

0.6

0.8

0.6 -2.7

0.7

0.7

03

04

05

06

07

08

09

10

11

Source: CEIC, Macrobonds, SEB; real GDP data is from World Bank, WDI USD at constant 2000 prices

4) What does the slow dow n in China mean to the developed w orld?
Not much is the answer again looking at it from the causality angle. For example, if we look at the US, exports to China are less than 1% of US GDP (Chart 3). Slowdown in Chinas demand wont hurt US exports and the US economy. Even for EU, exports to China are just 1.7% of GDP and will have limited impact. Where we are more concerned is that the slowdown in China and weak PMI are signaling weaker developed market growth ahead. Chinas national PMI for January slowed to 50.5 from 51.0 but the export order component is slowing and have been below 50 for two months in a row (below 50 means contraction). Chinese manufacturers dont believe that the US economy is as strong as the Federal Reserve expects. Our US bearish clients remind us that a) good news on US economy is already priced in where Citi US economic surprise index are at the peaks and heading lower and b) high inventory in the US will be a drag on growth (Chart 4). The movement in financial markets are also pointing to possible weaker growth where the market sell-off in EM is pushing US 10 year yield lower. China wont cause the developed world to slow but China may be a barometer of developed markets growth outlook.
Chart 3: Exports to China as % of GDP is small for DM
30 Export to China as % of GDP 25 20 15 10 5 0
0.0 -0.5 1.0 0.5

Chart 4: High inventories will be a drag on growth


1.5 US Inventory % of GDP

Hong Kong

Thailand

Japan

Taiwan

Russia

Korea

Chile

Singapore

Germany

Malaysia

Brazil

Italy

US

South Africa

Indonesia

Australia

UK

EU

France

Turkey

-1.0 -1.5 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Source: CEIC, Macrobonds, SEB

5) Whats the impact on emerging markets?


Impact on emerging market (EM) growth is bigger than developed markets (DM), especially on BRICS and Asian economies.

Chart 5 shows that China provides about half of the growth in emerging markets (green bars) and for BRICS (Chart 6), China contributes to two-thirds of the growth. Just on sheer size, Chinas economy is now US$9trn whereas Brazil is the next largest BRICS economy at just 25% of the size at US$2.3trn. At the country level, we look back at Chart 3 above and it shows emerging Asia to be the most reliant on Chinese demand led by Taiwan, Malaysia, Korea and Thailand followed by specific commodity exporting economies such as South Africa and Chile. Of the big EM economies, Turkey is the safe haven from a China slowdown.

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China Tracker Chart 5: China is big driver of EM growth


12 10 8 6.4 6 5.0 4 2 2.5 0 -2 2.6 3.2 3.0 3.5 4.0 4.2 2.8 3.4 4.7 4.4 3.3 2.0 2.8 -0.8 3.1 2.7 Contribution to EM real gdp growth, ppt China Rest of EM

Chart 6: BRICS is China


12% 10% 8% 6% 4% 2% 0% -2% China -4% India Brazil Russia South Africa Contribution to BRICS GDP growth

2.8

03

04

05

06

07

08

09

10

11

03

04

05

06

07

08

09

10

11

Source: CEIC, Macrobonds, SEB; CEIC, Macrobonds, SEB; real GDP data is from World Bank, WDI USD at constant 2000 prices

6) What is the latest on Chinas debt problem?


Chinas debt problems have been getting more attention from two events. First, default on China Credit Trust Cos principal payment emerged. The default talk spurred contagion worries in other trust products and the possibility of reduction in lending through trust products. However, the worries later subsided when unidentified buyers provided offers to bailout investors in whole. Second, the government released new local government debt figures, which were higher than before. To understand Chinas debt issue, most investors focus on the size of Chinas debt. Chart 7 below shows the aggregate debt separated into households, private corporates and general government as a percentage of GDP. With the revision in Chinas local government debt, general government debt is now 43% of GDP. Some would say that Chinas government has implicit guarantees and the debt figure should include contingent liabilities. If we do that the new figure is listed as China* in Chart 7 and government debt would rise to 55% of GDP, which is larger but still small by international standards. Another debated topic in Chinas debt is that it doesnt include shadow banking and total debt is under-reported. If we include our estimate of shadow banking or total social financing as private corporate debt, it will double from 100% of GDP to 207% of GDP (included in China* in Chart 7) and total debt will be bigger than the US. However, we have some issues with this approach. First, our shadow banking debt figure is on the high side and is purely an estimate. The government has yet to publish the stock on shadow banking debt and many China watchers including ourselves, estimate based on the published flow data. Using flow data has the potential for double counting especially in entrusted loans (e.g. if company A gives a $100 loan to company B and company B gives that $100 to company C as a loan, total loans would be $200 instead of $100). Second, if we are going to go look for contingent liabilities in China, we should do a similar exercise to all countries. For example in the US, the Congressional Budget Office calculates an alternative fiscal scenario that estimates the size of the government debt at US$205trn instead of the often cited US$12trn (uses the net present value of future liabilities from social security, Medicaid, etc. 1 ). That would make US aggregate debt at over 1300% of GDP instead of the current 245%. Instead of debating about the size of the debt, we find it more useful to understand when the debt would become a problem. Long time investors shorting Japanese government bonds will tell you that timing is what matters. So when is having large debt a problem? Debt is about the ability to service it or pay interest and that risk arises when you get a big shock in the economy that reduces your income or interest payments rise from higher inflation and rates. Currently, with the global economy on a moderate recovery, income shocks are unlikely. In addition, Chinas inflation is benign and rapid interest rate hikes look unlikely. Also, Chinas debt is domestically funded with sticky deposits and it is not sensitive to international rapid capital flows. Chinas debt doesnt look like a risk in 2014.

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China Tracker

This doesnt mean that you should ignore Chinas debt problem. The biggest and immediate implication of high debt is a slower growth rate. Debt by definition brings growth and consumption forward by borrowing from future income. This is the main reason why our China forecast declines into 2015 to 7.0% despite a more aggressive US growth forecast that accelerates to 3.7% in 2015.
Chart 7: Debt as % of GDP
450 400 350 300 250 200 150 100 50 0 debt % of GDP Households Corporates 41 Gen govt

207

41 100

55

43

Japan

Thailand

Korea

Singapore

China

Brazil

India

US

Indonesia

China*

Source: CEIC, Macrobonds, SEB; China* includes our scenario analysis

7) How do you invest in this environment?


The implications on Chinese assets are mixed. We expect looser monetary policy in reaction to the recent slowdown where the 7 day repo fixing will start averaging 4.0% instead of the current average of about 5.0%. That translates into more optimistic outlook for the Chinese equity market with looser policy. For currencies, USD/CNY may stop appreciating and move sideways. One reason we liked CNY this year was because PBoC was tightening faster than the Feds pace of tapering and US yields. That factor is removed with a quicker domestic slowdown and creates less pressure for CNY appreciation. In addition, we are starting to see a slowdown in hot money inflows (Chart 15) and a slower increase in property prices may also stall inflows. For impacts on global financial markets, we think it will be limited since Chinas slowdown will be gradual and have limited impact on DM economies (see questions #3 and 4 above). Global markets will be more sensitive to developments in US growth and monetary policy.

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Australia

EU

Phil

China Tracker

MACROECONOMIC TRACKER
50 40 30 20 10 0 -10 -20 -30 08 09 10 11 12 13 14
EU US Asia Total

China exports by destination % yoy 3mma

Chart 11: Exports are rebounding from improved demand from US and Europe but it is still moderate. Demand from Asia is weak from over-billing in 2013.

66 62 58 54 50 46 42 38 34 07 08 09 10 11 12 13 China PMI New Order Markit

Chart 12: PMI has declined, especially in Markit PMI that has less exposure to large companies. Markets react to Chinas PMI but looking at the chart, we dont see how it helps you forecast, except may be exports. In addition, some commentators say that the new order sub index is a leading indicator but we dont see the evidence.

50 40 30 20 10 0 -10 -20 -30

% yoy 3mma

SEB China construction indicator

Chart 13: This is our favourite indicator of domestic demand and points to strength. Targeted policy easing in infrastructure projects and healthy house prices has helped. However, going forward, tighter monetary policy and slightly weaker house price increases will slow the pace in construction activity.

07

08

09

10

11

12

13

14

100 80 60 40 20 0 -20 -40 -60

Vehicle Sales % yoy 3mma

US China

100 80 60 40 20 0 -20 -40 -60

Chart 14: Consumption - vehicle sales have gained momentum after a slowdown from the anti-corruption campaign.

07

08

09

10

11

12

13

Source: CEIC, Bloomberg, Soufun, SEB

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China Tracker

100 75 50 25 0 -25 -50 2008

China Non-trade flows 3mma USD bn

Chart 15: Hot money inflows are slowing and put less pressure for CNY to appreciate. The chart below is 3 month moving average but in December outflow started.

2009

2010

2011

2012

2013

2014

1.5 1.0 0.5 0.0 -0.5 -1.0

Average house price MoM %

Chart 16: Average property prices continue to rise and likely helping the rebound in construction activity. However, the pace of increase is slowing from approximately 1%MoM to 0.5% from property measures reinstated in first tier cities.

Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13
2.0 RMB trn 3mma New Total Financing New Bank Lending 1.5 1.0

Chart 17: Crackdown in total social financing (bank and non-bank lending) and recent rise in interbank rates had tightened monetary conditions. With inflation low, monetary conditions can be loosened if growth decelerates faster than expected.

0.5

0.0

Jul-09

Jul-10

Jul-11

Jul-12

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jul-13

80 60

Wholesale Pork Prices % yoy CPI % yoy (RHS)

12 10 8

Chart 18: Inflation has peaked and decline in pork prices signal very little inflation pressure. We are forecasting CPI to be 3.1% in 2014.

40 20

6 4 2

0 -20

0 -2 -4

-40

-6

07

08

09

10

11

12

13

Source: CEIC, Bloomberg, SEB

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China Tracker

MARKETS TRACKER
6.40 6.35 6.30 6.25 6.20 6.15 6.10 6.05 6.00 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 USDCNH spot USDCNY fixing USDCNY spot

Chart 19: Stabilization in exports, reluctance to intervene and accumulate more FX reserves and return of hot money inflow will push USDCNY lower. Our 2013 year-end target is 6.08 and 5.90 for end 2014.

0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6

USDCNY fixing seasonality MoM % since Aug 2005

Chart 20: Seasonality is difficult to see in USDCNY since it has been a one way bet. However, we focus on the changes relative to the month before and February usually leads to a flat or slightly strong fixing. We are short USDCNY I month NDF in our Asia FX Portfolio but we are aware that the short term drivers are slowly fading.

Average 1 2 3 4 5

Median 6 7 8 9 10 11 12

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

UDSCNY spot spread to fixing %

Chart 21: USDCNY spot has been able to fully use the daily allowed +/- 1% band. The movement lower in USDCNY fixing has now started to impact spot to come off the bottom of the band. We also expect a widening of this trading band to +/- 1.5% or 2% in the coming quarters.

CNY

High

Low

Jun-11

Jun-12

Dec-10

Dec-11

Dec-12

Jun-13

Sep-10

Sep-11

Sep-12

Sep-13

Dec-13

Mar-11

Mar-12

Mar-13

6.15

USD vs RMB markets

Chart 22: Recent move lower in fixing is flattening the front end of the forward curve. It is better to short USD/CNY in the 6-12 months part of the curve currently.

6.10

6.05

NDF Onshore CNH

6.00 Spot 1M 3M 6M 9M 12M

Source: CEIC, Bloomberg, SEB

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China Tracker

MARKETS TRACKER
10 9 8 7 6 5 4 3 2 7day repo rate % 20d mvavg

Chart 23: Liquidity conditions are easing after a spike in January but we expect it to settle closer to 4% than 3% previously.

Jun-12

Jun-13

Dec-11

Aug-12

Dec-12

Aug-13

Dec-13

Oct-11

Oct-12

Apr-12

Feb-12

Feb-13

Oct-13

Apr-13

Feb-14

110 108 106 104 102 100 98 96

CNH Bond Index (BoC HK)

Chart 24: The CNH bond performance is recovering after a general global bond market sell-off from the rise in US yields. Move lower in USD/CNY fixing will keep CNH and the bond market stable.

Jun-11

Jun-12

Jun-13

Dec-11

Aug-12

Dec-12

Aug-11

Aug-13

Dec-13

Oct-11

Oct-12

Feb-12

Feb-13

Oct-13

Apr-12

Apr-13

800 700 600 500 400 300 200 100 0

CNH deposits in HK (bn)

Chart 25: CNH deposits in Hong Kong have been rising and can continue to rise with a stronger move in CNY.

Jan-09

Jan-10

Jan-11

Jan-12

Sep-09

Sep-10

Sep-11

Sep-12

Jan-13

May-09

May-10

May-11

May-12

May-13

Sep-13

100 90 80 70 60 50

China A Share / US S&P

Chart 26: Domestic equity market had been underperforming the US S&P market. Higher rates have not helped and IPO pipeline is large and limits upside. Looser monetary policy will be a catalyst to get equity markets higher.

40 Jan-11

Jul-11

Jan-12

Jul-12

Jan-13

Jul-13

Jan-14

Source: CEIC, Bloomberg, SEB

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China Tracker

FORECASTS
FX USD/CNY USD/CNH USD/HKD USD/IDR USD/INR USD/KRW USD/MYR USD/PHP USD/SGD USD/THB USD/TWD EUR/USD USD/JPY EUR/SEK EUR/NOK AUD/USD Policy Rates CH lending CH deposit Korea India Indonesia Malaysia Philippines Thailand Taiwan US EU SW NO AU Spot 6.06 6.03 7.76 12,194 62.6 1075 3.31 45.3 1.27 32.8 30.3 1.35 102 8.83 8.43 0.90 Current 6.00 3.00 2.50 8.00 7.50 3.00 3.50 2.25 1.88 0.25 0.25 0.75 1.50 2.50 1Q 6.05 6.05 7.80 12,500 62.5 1090 3.35 45.5 1.30 34.0 30.5 1.34 105 8.85 8.35 0.88 1Q 6.00 3.00 2.50 8.25 8.00 3.00 3.75 1.75 1.88 0.25 0.25 0.75 1.50 2.50 2Q 6.02 6.02 7.80 12,200 61.5 1070 3.30 44.5 1.26 33.8 30.3 1.31 106 8.80 8.40 0.88 2Q 5.75 3.25 2.50 8.25 8.25 3.25 4.00 1.75 1.88 0.25 0.25 1.00 1.50 2.50 3Q 5.98 5.98 7.80 12,000 60.0 1050 3.20 44.0 1.24 33.5 29.4 1.30 108 8.65 8.45 0.87 3Q 5.75 3.25 2.75 8.25 8.25 3.50 4.00 1.75 1.88 0.25 0.25 1.00 1.75 2.50 4Q2014 5.90 5.90 7.80 11,500 59.0 1020 3.17 43.5 1.21 32.5 29.0 1.28 112 8.50 8.50 0.85 4Q2014 5.50 3.50 2.75 8.00 8.00 3.75 4.00 1.75 2.00 0.25 0.25 1.00 1.75 2.50

Real GDP % yoy China India Indonesia Korea Singapore US Euro zone Sweden Norway CPI % yoy China India WPI Indonesia Korea Singapore US Euro zone Sweden Norway

2011 9.3 7.5 6.5 3.6 5.3 1.8 1.6 3.7 1.2 2011 3.3 9.5 5.1 4.2 2.8 3.1 2.7 3.0 1.2

2012 7.7 5.4 6.2 2.0 1.3 2.8 -0.7 1.0 3.1 2012 3.5 6.5 4.3 1.4 4.5 2.1 2.5 0.9 0.8

2013 7.7 4.7 5.6 2.8 3.2 1.7 -0.4 0.7 0.9 2013 2.7 6.2 7.2 1.3 2.4 1.6 1.5 0.0 2.2

2014 7.4 5.0 5.3 3.6 4.0 3.3 0.8 2.5 2.4 2014 3.1 5.6 6.8 2.2 2.9 1.6 1.0 1.0 2.1

2015 7.0 5.4 5.5 3.5 3.8 3.7 1.6 3.2 2.1 2015 3.2 5.2 5.5 2.3 2.6 2.2 0.9 2.0 2.3

Source: Bloomberg, CEIC, SEB

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China Tracker

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