Please refer to page 12 for important disclosures and analyst certification, or on our website

www.macquarie.com/research/disclosures.

CHINA

Inside

A quick review of 2016 2

1. How will the economy evolve? 3

2. How far will the current reflation cycle go? 4

3. What will be the policy stance in 2017? 5

4. What will capital outflows look like? 6

5. What is the outlook for RMB in 2017? 8

6. How about the property and auto sectors? 9

7. What is the reform outlook? 10

8. What are the major risks? 10

Forecast table 11

Chart 1: Breakdown of net FX settlement

Source: CEIC, Macquarie Research, January 2017

Chart 2: Earnings growth could peak in 1H17

Source: CEIC, Macquarie Research, January 2017

Analyst(s) Larry Hu PhD +852 3922 3778 larry.hu@macquarie.com Jerry Peng +852 3922 3548 jerry.peng@macquarie.com

9 January 2017

Macquarie Capital Limited

China Macro 2017 outlook: What could surprise? Politics to define the year: After the US Presidential inauguration, the most

important political event in 2017 is the political transition in China. It’s

unsurprising that China’s policy-makers put stability as the top priority for this

year, so that they could focus on politics. What could surprise is whether and

how the market reassesses China’s growth and reform outlook after the

transition, when the power and the responsibility for China’s top leader could

both reach the highest point in the past forty years.

RMB – Likely the biggest surprise in 2017: The biggest surprise in 2016

came from the commodity market, about which most people felt so negative

12 months ago. The biggest surprise in 2017 might come from the RMB,

about which most people are feeling so negative now. And both surprises

could be triggered by non-market mechanisms: supply controls the former and

capital controls the latter. Note that foreign debt repayment is done and the

drop in FX reserves narrowed to US$320bn in 2016 (2015: US$510bn).

However, large FX leakage still exists in goods and service trade (Chart 1 on

the left). For instance, China had a goods trade surplus of US$1.1tn over the

past two years, but Chinese banks only saw US$0.1tn net FX inflows through

the channel. With tighter regulations aiming to reduce such leakage, the

decline in FX reserves could narrow to around US$200bn in 2017. Given

lower capital outflows, we hold the non-consensus view that the Yuan could

surprise on the strong side in 2017. While the volatility of the USD/CNY will

rise in 2017, our end-2017 forecast is 6.9, i.e. no depreciation from end-2016.

The economy to slow in 2017: Amid the hard landing and deflation fears

early last year, we made the non-consensus call that China would grow at

around 6.7% every quarter in 2016 and corporate earnings growth would rise

thanks to property and reflation. But we also pointed out then that these

cyclical drivers could not be sustained, and growth would slow to 6.5% in

2017. We still maintain these views. The property sector is likely to have a

down-cycle in 2017. GFA property sales could drop 10% after rising 22% in

2016. National home prices could start falling in 2H17. Nonetheless, the two

bright spots in 2017 could be exports and infrastructure FAI.

Liquidity – A year of two halves: Monetary policy has tightened substantially

in the recent months to deleverage the bond market. After all, the last thing

policy makers want to see in 2017 is a market crash. At this moment,

monetary policy, regulation, inflation and the rising yields globally are all

negative to liquidity. That said, monetary policy could shift around mid-year to

support growth. At that time, bond yields could reverse on lower economic

growth and inflation. For the whole year, we expect no change in benchmark

interest rate but two RRR cuts (total 100bp). What could surprise us more

RRR cuts than expected. After all, the current 17% RRR is still way too high.

Inflation and other risks: 12 months ago, the major concern for China was

prolonged deflation but it has shifted to inflation. We think both are overdone.

Our view for 2017 is a modest reflation. CPI inflation could average 2.4% in

2017 vs. 2.0% in 2016. PPI inflation would peak in 1Q17 then trend down

afterward. As such, the current corporate earnings up-cycle, which is driven

by reflation and property, could also peak in 1H17 (Chart 2 on the left). For

inflation, oil price is a major uncertainty to watch. Other than inflation, a black

swan is the US-China relationship under the new governments on both sides,

in various areas such as trade, currency, geopolitics and others.

-30-20-10

0102030405060

Mar-

10

Ju

l-10

No

v-1

0M

ar-

11

Ju

l-11

No

v-1

1M

ar-

12

Ju

l-12

No

v-1

2M

ar-

13

Ju

l-13

No

v-1

3M

ar-

14

Ju

l-14

No

v-1

4M

ar-

15

Ju

l-15

No

v-1

5M

ar-

16

Ju

l-16

No

v-1

6

GoodsServiceDirect InvestmentSecuritiesOthers (incl. foreign debt repayment)

US$ bn, 6mma

-8

-6

-4

-2

0

2

4

6

8

10

-10

0

10

20

30

40

Ja

n-1

1

Ju

l-11

Ja

n-1

2

Ju

l-12

Ja

n-1

3

Ju

l-13

Ja

n-1

4

Ju

l-14

Ja

n-1

5

Ju

l-15

Ja

n-1

6

Ju

l-16

Ja

n-1

7

Ju

l-17

Industrial profits

PPI (RHS)

%, yoy %, yoy

f'cast

Macquarie Research China Macro

9 January 2017 2

2017 outlook: What could surprise? In this report, we begin with a quick review of 2016, then discuss eight key questions for the

Chinese economy in 2017.

A quick review of 2016

The past 2016 is a memorable year for all China watchers. The market focus changed rapidly

every few months.

In 1Q16, the markets focused on the risks of hard landing, sharp RMB depreciation and

capital outflows.

In 2Q16, weak dollar eased currency concerns. But with rising credit defaults, the focus

shifted to the most common concern on China: Debt.

In 3Q16, as surging home prices in a dozen of cities caught all eyes, the market focus

switched again to property bubbles.

In 4Q16, RMB depreciation and capital outflows returned to the center of the stage.

As China economists, market interests naturally determine what we write. Our best reports

written in 2016 all aim to address these concerns: capital flows, debt ，property and various

trends at the micro level.

Given the above concerns, along with all the black swans in the US, UK and elsewhere in the

world, one might think the year of 2016 was a terrible one for the Chinese economy and

markets. Not really. The past year turns out to be much better than what the market

consensus expected at the beginning of 2016. At that time, the most popular question was

whether China’s hard landing had already happened, the most popular word was “deflation”

and the most favourite asset class was bonds and the least favourite was commodities. All

these turned upside down later on.

Interestingly, in our 2016 Outlook, we discussed the four surprises from 2015: (1) Resurfaced

hard landing fears; (2) More rate and RRR cuts than expected; (3) Deeper-than-expected

contraction in PPI; (4) Slow transmission from property sales to investment.

The first three reversed in 2016. China’s economy in 2016 was much better than expected,

mainly supported by three things: the Supply-side reform, property up-cycle and

accommodative monetary/fiscal policy. Meanwhile, after 125bp rate cut and 250bp RRR cut

in 2015, only 50bp RRR cut took place in 2016, much fewer than expected. Moreover, the

escape of PPI deflation was much faster than expected. Only the last one, the divergence

between property sales and investment, persisted in 2016. Although new home sales rose 22%

yoy in 2016, property investment only rose 7%.

With that, we will discuss eight key questions for the year ahead.

Fig 1 Annual real GDP growth forecast Fig 2 Quarterly real GDP growth forecast

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, January 2017

8.5 8.39.1

10.010.1

11.4

12.7

14.2

9.7 9.4

10.6

9.5

7.9 7.87.3 6.9 6.7 6.5

6.0

0

2

4

6

8

10

12

14

16

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

20

16

F

20

17

F

20

18

F

% , yoy Real GDP growth

Forecast

7.5

7.9

7.6

7.47.5

7.17.2

7.0 7.06.9

6.86.7 6.7 6.7 6.7

6.66.5 6.5 6.5

6.0

6.2

6.4

6.6

6.8

7.0

7.2

7.4

7.6

7.8

8.0

2Q

13

3Q

13

4Q

13

1Q

14

2Q

14

3Q

14

4Q

14

1Q

15

2Q

15

3Q

15

4Q

15

1Q

16

2Q

16

3Q

16

4Q

16

1Q

17

2Q

17

3Q

17

4Q

17

%, yoy

Forecast

Macquarie Research China Macro

9 January 2017 3

1. How will the economy evolve?

For China’s policy-makers, the single most important thing in 2016-17 is the ongoing political

transition, which could change the current political governance structure substantially.

Unsurprisingly, a stable economic backdrop is most desirable. In the Central Economic Work

Conference held last Dec, “stability” is the most frequently mentioned word. Stability has two

implications. The first is growth stability and the second is market stability. The last thing

policy makers want to see in 2017 is the kind of market crash in summer 2015. That’s why

they tightened monetary policy recently to reduce financial risks. But when investors

panicked, they also injected liquidity to prevent another credit crunch from happening.

To be sure, growth stability is not an easy task. The better-than-expected growth in 2016 is

based on +22% property sales and +16% auto sales growth, which are unsustainable. Given

a high base and demand frontloading, for 2017, we expect 10% drop in GFA property sales.

And our auto team forecasts 5% growth in auto sales in 2017. Since mortgage is an important

source of new credit in 2016, the slowdown in property could negatively impact credit growth.

As such, we expect annual GDP growth to slow to 6.5% in 2017 from 6.7% in 2016. More

headwinds would hit the economy in 2Q17, especially from the property side. Overall, the

6.5% growth seems achievable, but the uncertainty after 2017 could be huge under the new

political power structure.

The Chinese economy has had a go-stop pattern since 2012 (see our report, Mini-cycle,

China Style: Lessons from the Near Past, May 2014). It helps generate a less bumpy

deceleration, but also leads to fast debt accumulation and falling investment returns. Such

strategy could not last forever and it could start changing from 2018.

The tailwinds in 2017 include exports and infrastructure investment. Real exports would

improve thanks to better global demand. Along with higher price, the headline export growth

could pick up to 3% in 2017 (-6% in 2016). However, trade policies under the new US

president could be an uncertainty.

More importantly, infrastructure investment could accelerate to over 20% in 2017 (17% in

2016), funded by various sources such as fiscal money, government bonds, commercial

banks, policy banks, the central bank (PSL) and Public–private partnership (PPP). Out of the

RMB18tn infrastructure investment, 5-10%, or RMB1.8tn, could be supported by PPP.

Fig 3 Property sales could fall 10% in 2017 Fig 4 Auto sales growth could slow to 5%

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, January 2017

22

11

25

-15

44

11

42

17

-8

7

22

-10

-20

-10

0

10

20

30

40

50

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

20

17

F

% yoy

21

30

22

7

53

33

57

16

107

16

5

0

10

20

30

40

50

60

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

F

% yoy

Macquarie Research China Macro

9 January 2017 4

2. How far will the current reflation cycle go?

The biggest delta in 2016 is the PPI reflation, which changed from -5.2% in 2015 to -1.4% in

2016. To be sure, it’s mostly driven by commodity prices, as about 30% of the swing came

from steel and 10% from coal. Meanwhile, CPI inflation is relatively stable, rising from 1.4% in

2015 to 2.0% in 2016. The transmission from PPI to CPI is very limited. The rise of CPI is

much more driven by surging vegetable prices than commodity prices.

The price reflation in 2016 has benefited profit growth (see our strategy report: Inflation

Nation). Earnings growth for A-share non-financial companies jumped from -15% in 2015 to

+50% in 3Q16. Upstream sectors such as coal and steel are the main beneficiaries of the

commodity price recovery. As a result, cyclical/value outperformed growth in the stock market

last year.

Given the low base, PPI inflation is likely to creep up further in the next few months, reaching

5% in Jan/Feb. Going into 2Q17, however, PPI inflation could trend down due to higher base

and lower commodity prices. The spectacular commodity price rally we’ve seen last year is

not likely to repeat, especially given the upcoming property down-cycle. Meanwhile, the

supply controls would be eased as well to preventing prices from rising too fast.

Factoring in a modest pull back in commodity prices, we forecast PPI inflation to ease from

5% in 1Q17 to 0% in 4Q17, with an annual average of +2.6% for 2017 (2016: -1.4%). As

such, we expect industrial earnings growth to peak in 1H17.

Meanwhile, CPI inflation could edge up to 2.4% in 2017 from 2.0% in 2016. Due to the

different timing of the Chinese New Year holidays, CPI inflation could surpass 2.5% in Jan

and markets might feel uneasy about it. However, it could fall back afterward but rise again in

2H17. Overall, the year of 2017 is still a year of healthy reflation with higher annual inflation

rate than 2016.

Fig 5 CPI and PPI trajectory Fig 6 Earnings growth rebounded in 2016

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Wind, Macquarie Research, January 2017

-8

-6

-4

-2

0

2

4

6

8

10

Ja

n-1

0

Ju

n-1

0

No

v-1

0

Apr-

11

Sep

-11

Feb

-12

Ju

l-12

De

c-1

2

May-1

3

Oct-

13

Mar-

14

Aug

-14

Ja

n-1

5

Ju

n-1

5

No

v-1

5

Apr-

16

Sep

-16

Feb

-17

Ju

l-17

De

c-1

7

CPI

PPI

% yoy

Forecast

-40

-30

-20

-10

0

10

20

30

40

50

1Q

11

2Q

11

3Q

11

4Q

11

1Q

12

2Q

12

3Q

12

4Q

12

1Q

13

2Q

13

3Q

13

4Q

13

1Q

14

2Q

14

3Q

14

4Q

14

1Q

15

2Q

15

3Q

15

4Q

15

1Q

16

2Q

16

3Q

16

Industrial profits

A-share non-financials earnings

%, yoy

Macquarie Research China Macro

9 January 2017 5

3. What will be the policy stance in 2017?

We expect monetary policy to remain neutral in 1H17 but ease again in 2H17. Like 2016,

policy makers would continue to keep the benchmark 1-year deposit rate on hold.

China started the current rate cutting cycle from Nov 2014. In the six cuts over the next 11

months, the benchmark 1-yr deposit rate was lowered from 3.0% to 1.5%. However, the

PBoC has stopped cutting interest rate since Oct 2015. Even if the economy was under

strong headwinds at the beginning of 2016, policy makers still refrained from cutting rates.

We believe there are probably four reasons for that.

First, policy makers are concerned that rate cuts could be too strong as an easing signal,

which could exacerbate financial risks.

Second, the RMB has been under strong depreciation pressure since Aug 2015. More rate

cuts could worsen the situation.

Third, after the interest rate liberalization finished in Oct 2015, the PBoC now relies more

on interbank rates such as 7-day repo rate to signal monetary policy direction.

Fourth, both economic growth and inflation has picked up since 2H16.

For RRR, we expect two RRR cuts with 100bp in total in 2H17. The current RRR cutting cycle

started from Feb 2015. In the next twelve months, it’s cut by 300bp, from 20% to 17%. The

PBoC has also stopped cutting RRR since Feb 2016.

In our view, the best policy is to cut RRR 4-5 times a year, as the current 17% RRR is still

quite distortionary. As we commented in Feb 2015, “China should cut RRR at least 20 times

(50bp each) in the next five years”. The PBoC did cut RRR very aggressively in 2015.

However, they changed strategy in 2016 mainly because the PBoC views RRR as another

easing signal which is too high-profile.

Instead of cutting RRR more, the PBoC has chosen to lend to banks directly through reverse

repo, MLF and PSL. The three added up to only RMB729bn in 2015, but jumped to RMB5.5tn

in 2016. One surprise in 2017 is the PBoC could cut RRR more than twice amid an economic

slowdown.

In sum, liquidity could be tight in 1H17 as monetary policy, regulation, inflation and the rising

yields globally are all negative. But it could ease again on stabilized inflation and decelerated

economic growth.

Fig 7 Benchmark interest rate and RRR Fig 8 China vs. US 10y Treasury yields

Source: CEIC, Macquarie Research, January 2017 Source: Wind, Macquarie Research, January 2017

5

7

9

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13

15

17

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21

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1.0

1.5

2.0

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3.0

3.5

4.0

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De

c-0

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Ju

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6

De

c-0

6

Ju

n-0

7

De

c-0

7

Ju

n-0

8

De

c-0

8

Ju

n-0

9

De

c-0

9

Ju

n-1

0

De

c-1

0

Ju

n-1

1

De

c-1

1

Ju

n-1

2

De

c-1

2

Ju

n-1

3

De

c-1

3

Ju

n-1

4

De

c-1

4

Ju

n-1

5

De

c-1

5

Ju

n-1

6

De

c-1

6

One-year deposit rate RRR (RHS)% %

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

2.5

2.7

2.9

3.1

3.3

3.5

3.7

3.9

4.1

No

v/1

4

Ja

n/1

5

Mar/

15

Ma

y/1

5

Ju

l/15

Sep

/15

No

v/1

5

Ja

n/1

6

Mar/

16

Ma

y/1

6

Ju

l/16

Sep

/16

No

v/1

6

Ja

n/1

7China 10y treasury yield

US 10y treasury yield (RHS)

% %

Macquarie Research China Macro

9 January 2017 6

4. What will capital outflows look like?

At the beginning of 2016, investors were deeply concerned about capital outflows. In Jan

alone, the headline FX reserves slumped around US$100bn. Investors worried that a rapid

drop of FX reserves could lead to a sizable depreciation of the RMB. It turns out that in 2016,

China’s FX reserves dropped by US$320bn, much less than the fall of US$513bn in 2015. It’s

even better than our forecast of US$400bn in 2016 outlook.

Why? In a thematic report written in April 2016, we find that hot money outflows had largely

finished by end-2015. Indeed, from 2Q16, capital outflows from foreigners have turned to

inflows again (Fig 9). Meanwhile, China’s foreign debt started rising from 2Q16 as well (Fig

10), implying that the repayment of foreign debt is largely done. Now the key is the outflows

from domestic residents.

The FX settlement data by China banks (Fig 11) shows that currently the biggest deficit in FX

comes from the service trade. In the first 11 months of 2016, it amounted to US$274bn. When

individuals use the annual US$50k quota for stated reasons such as education or tourism,

such transactions are recorded under the service trade. In view of that, recently the PBoC has

significantly tightened the grip on households in converting Yuan into US$. Goods trade is

another big issue (Fig 12). China had goods trade surplus of US$1.1tn in goods trade, only

US$129bn, or 12% is converted into RMB!

What it tells us is simple. Under a strong depreciation expectation, exporters are reluctant to

sell dollars they have earned, but importers are keen to buy dollars.

The task for the PBoC in 2017 is clear. In Fig 11, they need to push the red line and the black

line up. It’s not an easy task though, given the strong depreciation expectation now. One way

is to strengthen the RMB by intervening the FX market. But it might cost FX reserves. Another

solution is to tighten capital controls and that’s what they are doing now.

In some sense, it’s very similar to the supply controls last year in the commodity market. To

be sure, both are non-market mechanisms and maybe distortionary. But the key question is

whether it works or not. Our view is that capital controls are far from perfect and much harder

to enforce than supply side reform to the commodity market, but it could still work to some

extent. Overall, we expect the drop in FX reserves to narrow further to US$200bn in 2017 (Fig

13-14).

Fig 9 Capital outflows driven by domestic residents Fig 10 Foreign debt repayment has done

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, January 2017

-250

-200

-150

-100

-50

0

50

100

150

200

250

1Q

13

2Q

13

3Q

13

4Q

13

1Q

14

2Q

14

3Q

14

4Q

14

1Q

15

2Q

15

3Q

15

4Q

15

1Q

16

2Q

16

3Q

16

Residents

Non-residents

US$ bn

Inflows to China

Capital account flows: Residents vs. Non-residents

-100

-80

-60

-40

-20

0

20

40

60

80

Mar-

10

Ju

n-1

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Sep

-10

De

c-1

0

Mar-

11

Ju

n-1

1

Sep

-11

De

c-1

1

Mar-

12

Ju

n-1

2

Sep

-12

De

c-1

2

Mar-

13

Ju

n-1

3

Sep

-13

De

c-1

3

Mar-

14

Ju

n-1

4

Sep

-14

De

c-1

4

Mar-

15

Ju

n-1

5

Sep

-15

De

c-1

5

Mar-

16

Ju

n-1

6

Sep

-16

Domestic residents paying down foreign debtUSD bn

Outflows

Macquarie Research China Macro

9 January 2017 7

Fig 11 Breakdown of net FX settlement Fig 12 Goods trade balance vs. net FX settlement

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, December 2016

Fig 13 Less decline in FX reserves in 2016 Fig 14 Changes in FX settlement and FX reserves

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, January 2017

-30

-20

-10

0

10

20

30

40

50

60

Mar-

10

Jul-10

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v-1

0

Mar-

11

Jul-11

No

v-1

1

Mar-

12

Jul-12

No

v-1

2

Mar-

13

Jul-13

No

v-1

3

Mar-

14

Jul-14

No

v-1

4

Mar-

15

Jul-15

No

v-1

5

Mar-

16

Jul-16

No

v-1

6

GoodsServiceDirect InvestmentSecuritiesOthers (incl. foreign debt repayment)

US$ bn, 6mma

Foreign debt repayment

almost done

FX surplus

FX deficit

-100

0

100

200

300

400

500

600

20

09

20

10

20

11

20

12

20

13

20

14

20

15

1-3

Q16

Trade balance: goods

Net FX settlement: goods trade

US$ bn

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

-600

-400

-200

0

200

400

600

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

201

4

201

5

201

6

Thousands

Change in FX reserves

FX reserves (RHS)

US$ bn US$ tn

-100

-80

-60

-40

-20

0

20

40

60

80

100

Mar-

10

Ju

l-10

No

v-1

0

Mar-

11

Ju

l-11

No

v-1

1

Mar-

12

Ju

l-12

No

v-1

2

Mar-

13

Ju

l-13

No

v-1

3

Mar-

14

Ju

l-14

No

v-1

4

Mar-

15

Ju

l-15

No

v-1

5

Mar-

16

Ju

l-16

No

v-1

6

Change in FX reserves

Net FX settlement

US$ bn, 6mma

Macquarie Research China Macro

9 January 2017 8

5. What is the outlook for RMB in 2017?

Under the current regime, the RMB exchange rate is determined by two things: supply and

demand in the onshore CNY market and the strength of US dollar. The section above

discussed capital flows and we believe the supply-demand imbalances in the CNY market

would be lower in 2017. However, the strength of US$ is hard to forecast and beyond our

capacity as China economists.

In any case, the pressure for 1Q17 could be high, as the new US$50k FX conversion quota

becomes available. But things could improve in 2H17. Our USD/CNY quarter-end forecasts

for 1Q-4Q17 are 7.15, 7.05, 6.95 and 6.90.

In other words, while the market consensus is expecting 5-10% depreciation by end-2017

(7.3-7.6), we expect the USD/CNY to end 2017 at 6.9, i.e. no depreciation vs. end-2016. The

forecast is based on two considerations. First, the supply-demand imbalance in the FX

market would narrow further. Second, the strength of the US$ is similar to last year.

We see the chance for a one-off devaluation is small. In the Central Economic Work

Conference in Dec, policy makers set stability as the priority for policy. As such, they will most

likely maintain the current currency policy framework.

That said, they might create higher two-way volatility for the RMB. In 2016, when the dollar

index dropped from 100 to 93 in 1H, the USD/CNY remained quite stable. But when the dollar

strengthened back to above 100, the RMB weakened against the dollar. This kind of

asymmetric depreciation would surely worsen the expectation and the PBoC might not want

to repeat it again.

Since the fixing reform in Aug 2015, China has been mired in a self-strengthened vicious

cycle of depreciation expectation, capital outflows and actual depreciation. To be sure, we

never worry about a Balance-of-Payment crisis, given the size of FX reserves and capital

controls. But it’s still a highly uncomfortable situation. With lingering capital outflows pressure,

capital controls are increasingly tightened and the RMB internationalization has retreated.

At this moment, the PBoC is keeping a tight grip on capital flows to improve the supply-

demand imbalances in the FX market. The hope is that as the imbalances narrow, the RMB

could stabilize. Other than capital controls, another important thing is to dampen the

depreciation expectation, through better communication and unexpected market intervention.

It’s another front China’s policy-makers should consider.

Fig 15 RMB has had an almost one-way depreciation against US$ since Aug 15

Fig 16 RMB weakened against a basket of currency in 1H16 but stabilized in 2H16

Source: Wind, Macquarie Research, January 2017

*Staff estimate using the currency basket published by CFETS.

Source: Wind, Macquarie Research, January 2017

6.00

6.10

6.20

6.30

6.40

6.50

6.60

6.70

6.80

6.90

7.00

May-1

4

Ju

l-14

Sep

-14

No

v-1

4

Ja

n-1

5

Mar-

15

May-1

5

Ju

l-15

Sep

-15

No

v-1

5

Ja

n-1

6

Mar-

16

May-1

6

Ju

l-16

Sep

-16

No

v-1

6

Ja

n-1

7

Fixing Spot

USD/CNY

90

92

94

96

98

100

102

104

106

De

c-1

4

Feb

-15

Apr-

15

Ju

n-1

5

Aug

-15

Oct-

15

De

c-1

5

Feb

-16

Apr-

16

Ju

n-1

6

Aug

-16

Oct-

16

De

c-1

6CFETS RMB index*

Dec 14 = 100

95Weaken

Macquarie Research China Macro

9 January 2017 9

6. How about the property and auto sectors?

The property sector is heavily influenced by government policies. All previous down-cycles

were driven by government policies, especially credit tightening and property curbs. For

instance, the year of 2013 was the year of property up-cycle. After the government tightened

policy, 2014 became a year of down-cycle. Then policy eased, 2015 was a year of recovery

and 2016 was a year of strong up-cycle.

Unsurprisingly, rapid home prices increases forced the government to tighten again. Last Oct,

20+ cities tightened property policies. Also given the demand frontloading, 2017 would be a

year of property down-cycle again.

Put into numbers, GFA new home sales, new starts and property investment were up 24%,

8% and 7% in 2016, while their growth for 2017 could be -10%, -5% and 2%, respectively.

We expect the slowdown in property investment is more moderate than new home sales.

China’s property market has become an extremely polarized one and a few high-tier cities

vastly outperformed the rest of the country in this cycle. As a result, most developers only

want to enter these cities, so the pick-up of investment growth is much more moderate

compared with sales. As such, the slowdown of investment in 2017 could also be less

dramatic.

Similar to the property market, the automobile sector staged a decent rebound in 2016, with

passenger vehicle sales growth (in volumes) improving from 7% in 2015 to ~16% in 2016.

Other than the purchase tax cut (from 10% to 5% for small engine vehicles) in Sep 2015, the

most important driver is the pick-up of property sales. The last time auto sales grew at

double-digits was in 2013, and it also coincided with the previous property up-cycle. Property

sales lead auto sales, probably because people tend to buy a car after buying an apartment.

Looking into 2017, we expect the auto sector growth to moderate due to a high base, reduced

tax incentive and a property down-cycle. The tax incentive will be extended into 2017, but the

rate will be raised to 7.5% from 5%. Our auto team forecasts passenger vehicle sales to slow

to 4.5% in 2017. The weaker auto sales will also translate into slower auto production, putting

downward pressure on industrial production growth.

Fig 17 Property sales leading property investment Fig 18 Auto sales growth is set to slow down in 2017

Source: CEIC, Macquarie Research, January 2017 Source: CEIC, Macquarie Research, January 2017

-30

-10

10

30

50

70

-5

0

5

10

15

20

25

30

35

40

Sep

-07

Mar-

08

Sep

-08

Mar-

09

Sep

-09

Mar-

10

Sep

-10

Mar-

11

Sep

-11

Mar-

12

Sep

-12

Mar-

13

Sep

-13

Mar-

14

Sep

-14

Mar-

15

Sep

-15

Mar-

16

Sep

-16

Property investment Property sales (RHS)%, yoy %, yoy

-20

-10

0

10

20

30

40

50

60

-5

0

5

10

15

20

25

30

35

May-1

0

No

v-1

0

May-1

1

No

v-1

1

May-1

2

No

v-1

2

May-1

3

No

v-1

3

May-1

4

No

v-1

4

May-1

5

No

v-1

5

May-1

6

No

v-1

6

Auto sales

Property sales (RHS)

% yoy, 3mma

% yoy, 3mma

Macquarie Research China Macro

9 January 2017 10

7. What is the reform outlook?

The most important reform in 2016 was of course the supply side reform, which has led to a

strong rally in commodity prices. It will continue in 2017. That said, given the rising PPI

especially in 1Q17, supply controls could be eased to reduce the cost pressure for the down-

stream industries (see the report on supply side reform from our commodity team).

Regarding other reforms, hard reforms might take a back seat amid the power transition.

Back in 2013, during the heady period after the 3rd Plenum, we commented the four major

economic reforms: “In our view, fiscal and financial reforms would gain traction after the third

Plenum, while a breakthrough in land and SOE reform will wait until the 2nd 5-year term for

the new government.”

It’s because “SOE and land reforms could lead to strong push-backs from China’s most

powerful vested interests, while financial and fiscal reforms could be more technical and the

confrontation with vested interests could be much less direct.” (link)

In the past three years, we do see limited progress in SOE and land reforms, but quite

aggressive movements in the financial area including the interest rate liberalization and RMB

internationalization. In the fiscal area, the local government debt swap and the VAT (value

added tax) reform are also quite impressive.

However, it has become clear that financial and fiscal reforms could not go too far without

SOE and land reforms. Since the priority in 2017 is the power transition, we don’t expect big

progress in reforms in 2017. But the uncertainties from 2018 and beyond are high. After that,

both the power and the responsibility for China’s top leader will reach the new high in the past

forty years. Markets would start reassessing China’s growth and reform outlook from later

2017.

8. What are the major risks?

We see lots of uncertainties after the power transition. But for 2017, the visibility is relatively

high. The recent Politburo meeting set stability as the priority. To be sure, as the economy

would slow down, the fear of hard landing and property bubble burst would rise again. In the

three thematic reports on capital flows, debt and property written in 2016, we discussed why

these factors are not likely to cause a systemic crisis in 2016-17.

In our view, the biggest risk over the next couple of years comes from how the new

governments in the US and China will recalibrate the relationship between these two

countries, in the areas of trade, currency, geopolitics and others.

For 2017 alone, inflation is something to watch. Our baseline is a modest reflation. CPI

inflation could average 2.4% in 2017 vs. 2.0% in 2016. PPI inflation would peak in 1Q17 then

trend down afterward. But inflation is always tricky to forecast.

Lastly, if the inflation rate and the US yields continue to trend up, the bond market would be

under more pressure. While we don’t doubt that policy makers would do their best to prevent

another credit crunch from happening, it’s still a risk to watch.

.

Macquarie Research China Macro

9 January 2017 11

Fig 19 China economic forecasts

Macquarie China Economic forecasts

Unit 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 2015 2016 2017 2018

Growth

GDP YoY, % 6.7 6.7 6.7 6.7 6.6 6.5 6.5 6.5 6.9 6.7 6.5 6.0

GDP QoQ,% 1.2 1.9 1.8 1.6 1.1 1.9 1.8 1.6 -- -- -- --

Inflation

CPI YoY, % 2.1 2.1 1.7 2.2 2.3 2.3 2.4 2.5 1.4 2.0 2.4 2.6

PPI YoY, % -4.8 -2.9 -0.8 3.0 4.9 3.2 2.2 0.0 -5.2 -1.4 2.6 1.0

Activities

Industrial production YoY, % 5.8 6.1 6.1 -- -- -- -- -- 6.1 6.0 5.8 --

Retail sales YoY, % 10.3 10.2 10.5 -- -- -- -- -- 10.7 10.4 10.6 --

Fixed asset investment (ytd) YoY, % 10.7 8.2 7.0 -- -- -- -- -- 10.0 8.2 8.5 --

Manufacturing YoY, % 6.4 1.8 2.8 -- -- -- -- -- 8.1 3.6 5.0 --

Property YoY, % 8.2 6.6 5.2 -- -- -- -- -- 2.5 6.5 2.0 --

Infrastructure YoY, % 19.2 20.8 14.6 -- -- -- -- -- 17.3 17.2 20.0 --

Trade

Exports YoY, % -9.3 -4.3 -6.7 -- -- -- -- -- -2.6 -6.0 3.0 --

Imports YoY, % -13.3 -6.7 -4.7 -- -- -- -- -- -14.4 -6.0 6.0 --

Trade balance US$ bn 126 143 144 -- -- -- -- -- 602 550 530 --

Monetary

M2 (period-end) YoY, % 13.4 11.8 11.5 -- -- -- -- -- 13.3 11.2 11.5 --

1-yr deposit rate (period-end) % 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.50

RRR (period-end) % 17.0 17.0 17.0 17.0 17.0 17.0 16.5 16.0 17.5 17.0 16.0 16.0

Exchange rate (spot, period end) USDCNY

6.47 6.66 6.67 6.95 7.15 7.05 6.95 6.90 6.49 6.95 6.90 6.70

Note: Numbers in bold are forecast values.

Source: CEIC, Wind, Macquarie Research, January 2017

Macquarie Research China Macro

9 January 2017 12

Important disclosures:

Recommendation definitions

Macquarie - Australia/New Zealand Outperform – return >3% in excess of benchmark return Neutral – return within 3% of benchmark return Underperform – return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield

Macquarie – Asia/Europe Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie – South Africa Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie - Canada

Outperform – return >5% in excess of benchmark return Neutral – return within 5% of benchmark return Underperform – return >5% below benchmark return

Macquarie - USA Outperform (Buy) – return >5% in excess of Russell 3000 index return Neutral (Hold) – return within 5% of Russell 3000 index return Underperform (Sell)– return >5% below Russell 3000 index return

Volatility index definition*

This is calculated from the volatility of historical price movements. Very high–highest risk – Stock should be

expected to move up or down 60–100% in a year – investors should be aware this stock is highly speculative. High – stock should be expected to move up or down at least 40–60% in a year – investors should be aware this stock could be speculative. Medium – stock should be expected to move up or down at least 30–40% in a year. Low–medium – stock should be expected to move up or down at least 25–30% in a year. Low – stock should be expected to move up or down at least 15–25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only

Recommendations – 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations

Financial definitions

All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards).

Recommendation proportions – For quarter ending 30 September 2016

AU/NZ Asia RSA USA CA EUR Outperform 47.26% 55.50% 38.46% 45.47% 59.09% 48.21% (for US coverage by MCUSA, 8.20% of stocks followed are investment banking clients)

Neutral 38.01% 29.31% 42.86% 48.77% 37.88% 36.79% (for US coverage by MCUSA, 8.25% of stocks followed are investment banking clients)

Underperform 14.73% 15.19% 18.68% 5.76% 3.03% 15.00% (for US coverage by MCUSA, 8.00% of stocks followed are investment banking clients)

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William Montgomery (Japan) (813) 3512 7864

Corinne Jian (Taiwan) (8862) 2734 7522

Abhishek Bhandari (India) (9122) 6720 4088

Aiman Mohamad (Malaysia) (603) 2059 8986

Kervin Sisayan (Philippines) (632) 857 0893

Patti Tomaitrichitr (Thailand) (662) 694 7727

Resources / Metals and Mining

Polina Diyachkina (Asia, Japan) (813) 3512 7886

Coria Chow (China) (852) 3922 1181

Anna Park (Korea) (822) 3705 8669

Sumangal Nevatia (India) (9122) 6720 4093

Technology

Damian Thong (Asia, Japan) (813) 3512 7877

George Chang (Japan) (813) 3512 7854

Daniel Kim (Korea) (822) 3705 8641

Allen Chang (Greater China) (852) 3922 1136

Jeffrey Ohlweiler (Greater China) (8862) 2734 7512

Patrick Liao (Greater China) (8862) 2734 7515

Louis Cheng (Greater China) (8862) 2734 7526

Kaylin Tsai (Greater China) (8862) 2734 7523

Telecoms

Nathan Ramler (Asia, Japan) (813) 3512 7875

Danny Chu (Greater China) (852) 3922 4762

Soyun Shin (Korea) (822) 3705 8659

Prem Jearajasingam (ASEAN) (603) 2059 8989

Kervin Sisayan (Philippines) (632) 857 0893

Transport & Infrastructure

Janet Lewis (Asia) (852) 3922 5417

Corinne Jian (Taiwan) (8862) 2734 7522

Azita Nazrene (ASEAN) (603) 2059 8980

Utilities & Renewables

Patrick Dai (China) (8621) 2412 9082

Candice Chen (China) (8621) 2412 9087

Alan Hon (Hong Kong) (852) 3922 3589

Inderjeetsingh Bhatia (India) (9122) 6720 4087

Prem Jearajasingam (Malaysia) (603) 2059 8989

Karisa Magpayo (Philippines) (632) 857 0899

Commodities

Colin Hamilton (Global) (44 20) 3037 4061

Ian Roper (65) 6601 0698

Jim Lennon (44 20) 3037 4271

Lynn Zhao (8621) 2412 9035

Matthew Turner (44 20) 3037 4340

Economics

Peter Eadon-Clarke (Global) (813) 3512 7850

Larry Hu (China, Hong Kong) (852) 3922 3778

Tanvee Gupta Jain (India) (9122) 6720 4355

Quantitative / CPG

Gurvinder Brar (Global) (44 20) 3037 4036

Woei Chan (Asia) (852) 3922 1421

Danny Deng (Asia) (852) 3922 4646

Per Gullberg (Asia) (852) 3922 1478

Strategy/Country

Viktor Shvets (Asia, Global) (852) 3922 3883

Chetan Seth (Asia) (852) 3922 4769

David Ng (China, Hong Kong) (852) 3922 1291

Erwin Sanft (China, Hong Kong) (852) 3922 1516

Peter Eadon-Clarke (Japan) (813) 3512 7850

Chan Hwang (Korea) (822) 3705 8643

Jeffrey Ohlweiler (Taiwan) (8862) 2734 7512

Inderjeetsingh Bhatia (India) (9122) 6720 4087

Jayden Vantarakis (Indonesia) (6221) 2598 8310

Anand Pathmakanthan (Malaysia) (603) 2059 8833

Gilbert Lopez (Philippines) (632) 857 0892

Conrad Werner (Singapore) (65) 6601 0182

Alastair Macdonald (Thailand) (662) 694 7753

Find our research at Macquarie: www.macquarieresearch.com/ideas/ Thomson: www.thomson.com/financial Reuters: www.knowledge.reuters.com Bloomberg: MAC GO Factset: http://www.factset.com/home.aspx CapitalIQ www.capitaliq.com Email macresearch@macquarie.com for access

Asia Sales Regional Heads of Sales

Miki Edelman (Global) (1 212) 231 6121

Jeff Evans (Boston) (1 617) 598 2508

Jeffrey Shiu (China, Hong Kong) (852) 3922 2061

Sandeep Bhatia (India) (9122) 6720 4101

Thomas Renz (Geneva) (41 22) 818 7712

Riaz Hyder (Indonesia) (6221) 2598 8486

Nick Cant (Japan) (65) 6601 0210

John Jay Lee (Korea) (822) 3705 9988

Nik Hadi (Malaysia) (603) 2059 8888

Eric Roles (New York) (1 212) 231 2559

Gino C Rojas (Philippines) (632) 857 0861

Regional Heads of Sales cont’d

Paul Colaco (San Francisco) (1 415) 762 5003

Amelia Mehta (Singapore) (65) 6601 0211

Angus Kent (Thailand) (662) 694 7601

Ben Musgrave (UK/Europe) (44 20) 3037 4882

Christina Lee (UK/Europe) (44 20) 3037 4873

Sales Trading

Adam Zaki (Asia) (852) 3922 2002

Stanley Dunda (Indonesia) (6221) 515 1555

Sales Trading cont’d

Suhaida Samsudin (Malaysia) (603) 2059 8888

Michael Santos (Philippines) (632) 857 0813

Chris Reale (New York) (1 212) 231 2555

Marc Rosa (New York) (1 212) 231 2555

Justin Morrison (Singapore) (65) 6601 0288

Daniel Clarke (Taiwan) (8862) 2734 7580

Brendan Rake (Thailand) (662) 694 7707

Mike Keen (UK/Europe) (44 20) 3037 4905

This publication was disseminated on 09 January 2017 at 08:30 UTC.