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CIO Insights Special China after the NPC – Fast forward to the future?

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CIO Office, Deutsche Bank Wealth Management, Deutsche Bank AG - Email: [email protected] 1

CIO Insights Special

China after the NPC Fast forward to the future?

March/April 2018




NPC institutional reforms and appointments should encourage further reforms.

Deleveraging will remain the key immediate policy objective, but the focus here is changing.

The Chinese economy will continue to restructure, against a background of higher volatility and inflation.

Some Chinese equity sectors seem well placed but we would take a rather cautious approach to Chinese credit overall.

Future reforms may not fully resolve demographic, geopolitical and other long-term challenges for China – but per capita GDP looks set to rise.

Authors:Jason Liu Head of CIO Office AsiaMarkus Müller Global Head CIO OfficeTuan HuynhCIO Asia and Head of Wealth Discretionary Asia

The Chinese characters on our cover read as Zhong Guo Meng — The Chinese Dream. Xi Jinping first emphasized this phrase in 2012 and it has since become emblematic of his political and social objectives.

In summary

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Introduction

New economic targets

Three brief scenarios for the Chinese economy

Investment outlook for 2018

Please click here or use the QR code to access the previous CIO Insights China Special.

Conclusion

Institutional reforms

Deleveraging remains key

Six key investment themes for 2018

Longer-term economic and investment issues

China after the NPC

https://deutschewealth.com/content/deutschewealth/en/articles/Demystifying-China-Full-EN.html




The decision by the National People’s Congress (NPC) in March to remove the two-term limit to presidency had immense symbolic as well as practical importance. With President Xi now set to stay in power beyond 2023, when his current five-year term expires, he has a clear slate to implement long-term economic and social reforms.

But what way will President Xi decide to go? Recent appointments made at the NPC suggest a pro-reform stance, but under an umbrella of policy continuity.

Recent structural reforms to government bureaucracies also suggest a desire to reform within a carefully-controlled environment, with state activities brought into even closer connection with the Chinese Communist Party. The aim is both to improve efficiency and implementation of central decisions, as well as to give the party a greater role in day-to-day decision-making. At the centre of this process is the newly elevated National Supervision Commission that will bring a wider range of government staff within the party’s disciplinary controls, new ministries (for the environment and

Ministries are rationalized

During the NPC, the Chinese government announced significant institutional reforms. They have reduced the number of ministries by 15 to 26. The most notable institutional reform in financial sector is the merger of the CBRC (the banking regulator) and CIRC (the insurance regulator). The CSRC (the security market regulator) stays unchanged. Meanwhile, the role of People’s Bank of China (PBoC, the central bank) will expanded to set rules

natural resources) and some merging of regulatory responsibilities in the financial sector. Such rationalization should make it easier for corporates to deal with the government – but it also could strengthen the hand of officialdom. Above all, it reflects a continuing belief that the party is still best-placed to lead the Chinese economy through change ahead.

Is this belief correct? In our last special report on China, "Demystifying China - A question of perspective", published in October 2017, we looked at issues around control and the CCP’s attempt to create an alternative system to open democracy. In our view, recent institutional reforms show a belief that economic management is best done through a centralized and controlled process, rather than through a process of debate. In the short and medium term, as we argue, this approach could yield a number of benefits. But over the longer term, issues around the transfer of power and government legitimacy could eventually reappear. Technology will be one important factor allowing China to fast forward to the future: what this future will look like politically is unclear.

for banking and insurance sectors and will take charge of macro-prudential regulations.

One key institutional reform was the establishment of a new National Supervisory Commission, to serve as a powerful authority tasked with combating corruption and with a status on a par with the government administration. The current Ministry of Supervision will be moved out of the State Council and merged into this new commission.

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Introduction

Institutional reforms




Other important institutional changes include the establishment of a Ministry of Natural Resources (replacing the current Ministry of Land and Resources and a few other related organizations), a Ministry of Agriculture and Rural Affairs (replacing the current Ministry of Agriculture and taking over management of agriculture investment programs from the National Development and Reform Commission) and a National Health Commission (replacing the current National Health and Family Planning Commission). The main purpose of these large-scale institutional reforms is to raise the government’s efficiency in policy delivery and regulation: in this context, they should therefore be seen as a positive development to cope with China’s changing economic structures and needs.

Presidential term is now open-ended

On March 11, the National People’s Congress approved amendments to the Constitution. One notable change was the removal of the clause that limits the presidency (and vice presidency) to two terms. This restriction had been written into China’s Constitution in 1982, and the constitutional amendments in 2018 will therefore pave the way for a change in a

Figure 1: Institutional reforms under the State CouncilSource: Xinhua Net, JP Morgan Research, Deutsche Bank Wealth Management. Data as of March 16, 2018.

New ministries / agencies Replaced ministries / agencies

China Banking and Insurance Regulatory Commission China Banking Regulatory Commission, China Insurance Regulatory Commission

State Administration of National Market Supervision State Administration for Industry & Commerce, General Administration of Quality Supervision, Inspection and Quarantine, Food and Drug Administration

State Administration of Radio, Film and Television State Administration of Press, Publication, Radio, Film and Television

State Administration of Grain and Material Reservation

State Administration of Grain

State Forestry and Grassland Administration State Forestry Administration

Ministry of Natural Resources Ministry of Land and Resources, National Oceanic Administration, National Bureau of Surveying Mapping and Geoinformation

Ministry of Ecological Environment Ministry of Environmental Protection

Ministry of Agriculture and Rural Affairs Ministry of Agriculture

Ministry of Culture and Tourism Ministry of Cultural, National Tourism Administration

National Health Commission National Health and Family Planning Commission, Office of the Leading Group for Deepening Reform of the Medical and Health Care System

Ministry of Emergency Management State Administration of Work Safety

Ministry of Veteran Affairs

State Agency for International Development Cooperation

State Administration for Medical Insurance

State Administration of Immigration Management

Ministry of Supervision (merged into the New National Supervision Commission)

Key NPC appointments relevant to financial marketsThe following four appointments are particularly important.

– Liu He: vice premier; expected to head the Financial Stability and Development Committee

– Dr. Yi Gang: PBoC Governor

– Liu Kun: Finance Minister

– Guo Shuqing: expected to head the newly established banking and insurance regulatory committee

The above appointments of the senior leadership in charge of China’s economic affairs sent positive messages of policy continuity and pro-reform stance. Liu He, Dr. Yi Gang and Guo Shuqing all have academic training in top UK and U.S. universities. They have long been involved in China’s key economic policy decisions. Liu He is the principal economic advisor for President Xi and was involved in the formulation of China’s reform agenda. Dr. Yi Gang has been the deputy governor of PBoC since 2007 and he has been supporting Governor Zhou in daily operations and all important financial reforms. Guo Shuqing was a well-respected reformer in China and

has been the deputy PBoC government. He was also the chairman of China Construction Bank, the chairman of China Securities Regulation Commission and the chairman of China Banking Regulatory Commission1.

With the reform-minded governors in key positions, we can expect more reform policies in China in the years ahead. We think China’s leadership will be committed to free trade and market economy principals and we are likely to see more liberalization of China’s service sectors, especially in the areas of financial services and capital markets.

1 “China: The future of monetary & financial stability policies”, JP Morgan Research, March 19 2018.




system of handing over power that has been in operation for three decades.

With this constitutional revision, President Xi can continue his presidency beyond 2023 when his second five-year term will end. While the amendment could potentially create some uncertainty around the transition of power in China in the long term, we think that it should be constructive overall for China’s economy in the short and medium term, for the following reasons:

Continuation and improved execution of current economic

policies. With President Xi in power for an additional one or more terms, key economic policies such as “one belt, one road”, regional rebalancing, supply-side reforms, financial deleveraging, investment in technology (such as artificial intelligence) will continued to be executed.

Established economic teams. In addition to facilitating domestic

policy execution, established economic teams should make it easier for the government to respond swiftly and effectively to externally-generated volatility.

More comprehensive longer-term economic and political reforms.

With a stable leadership for the next five or more years, we think that the Chinese government could formulate policies more targeted to the long-term benefits of the country. On the economic front, we think the government could implement more reform policies to stimulate more balanced growth, reduce poverty, raise labor productivity through technology, and contain risks in financial sector debt. On the political front, we think the government could enhance anti-corruption policies through institutional reforms. Raising the status of the

supervisory authority is one step towards achieving a cleaner and more efficient government.

We think that stable government leadership in coming years will help Chinese corporates and capital markets as well. Chinese corporates will be able to expect consistent economic policies in the domestic market. On the external front, Chinese companies might receive more support from Chinese government, especially through a more forceful implementation of the “one belt, one road” initiative. We think the Chinese leadership will stay committed to further adoption of free trade and market economy principles over the longer-term and believe that we are likely to see more liberalization in China’s capital markets and service sectors.

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Key changes to the targets

The 2018 Government Work Report delivered to the National People’s Congress included a number of small but important changes to government forecasts and the language around them. This year’s GDP growth target is set at “around 6.5%”, equivalent to the target in 2017. However, the report removed the phrase “will try to achieve better results in practice” used last year. This was a reminder that China’s government had already adjusted the GDP growth target slightly lower this year, in line with market and our expectations. The report did however say that 6.5% growth target could achieve full employment in the economy.

The government has also cut the fiscal deficit target to 2.6% in 2018 from 3%

in 2017. This lower-than-expected fiscal deficit target is intended to signal the government’s fiscal tightening bias this year. With China’s economy already on a solid growth path, we think that the Chinese government will be able to reduce its fiscal support to the economy. In particular, the spending on infrastructure could see quite a meaningful slowdown this year, in our view.

The government has set the CPI inflation target this year at 3%, the same as last year. This was in line with market expectations. China’s inflation was unusually low in 2017 due to low food prices, but seems likely to increase this year. We think higher inflation could potentially become a risk factor to China’s economy this year.

03 New economic targets




Chinese government now plans to spend CNY1.11 trillion (US$175 billion) on defense in 2018, up 8.1% from the previous year. This is the highest target growth rate in three years, coming after a target of 7% growth in 2017 and 7.6% in 2016. Premier Li Keqiang said in an address in parliament that China’s military spending should increase in the face of “profound changes in the national security environment”. We think the fast growth in spending is driven by a need to modernize (as well as extend) China’s military capability. China’s defense spending was around a quarter of U.S. defense spending in 2017.

Key growth drivers

Overall, the 2018 economic targets emphasized putting the quality of growth first and the government is willing to

tolerate slower growth this year. The growth target of 6.5% in 2018 is much lower than actual GDP growth of 6.9% in 2017. The reduction of the fiscal deficit target suggests that the government could reduce fiscal stimulus during 2018 when economic momentum is assured. We think the government would be willing to see both consumption and exports as key growth drivers in 2018 and could reduce its support for debt-intensive infrastructure and property investments, in an effort to stabilize leverage levels in the economy.

At the start of 2018, China’s economic growth momentum was strong. China’s industrial production (IP) increased 7.2% YoY in January-February, much higher than 6.2% growth in Q4 2017, driven by resilient exports and higher heating demand amid the colder-than-

usual weather. Fixed asset investment increased 7.9% YoY in Jan-Feb, again higher than 6.5% growth in Q4 2017, with the backlog of strong land acquisition by developers leading to an acceleration in property investment growth. With the strong growth momentum at the start of the year, we think the government would be ready to reduce stimulus later this year. Given the lower fiscal deficit target, we think they would intentionally lower their support to infrastructure and property sectors, which are the traditional sectors heavily reliant on debt buildup.

Figure 2: Official Chinese government forecast targets for 2018 and results for 2017Source: Deutsche Bank Wealth Management. Data as of March 9, 2018.

CPI inflation(%)

3.0

1.6

3.0

Real GDP growth(%)

6.5

6.9

6.5

Local government special bond issuance (billion CNY)

800 8001,350

M2 growth (%)

12.0

8.2 n/a

Total social financing (growth %)

12.0 12.0

n/a

Urban new job creation(million)

11.0

13.5

11.0

Fixed asset investment(growth %)

9.0

7.2 n/a

Retail sales(growth %)

10.010.2

10.0

Industrial production(growth %)

6.0

6.6

n/a

Fiscal deficit(billion CNY)

2,380

3,043

2,380

Fiscal deficit (% of GDP)

3.0

3.7

2.6

2017 Official Target 2017 Actual 2018 Official Target




Deleveraging focus is changing

In 2017, the focus of Chinese deleveraging was mainly on the reduction of capital market leverage, and led to higher interbank rates and bond yields. This year, we think the deleveraging focus will shift to containing the rising household leverage and infrastructure-related credit demand, both of which saw noticeable growth in 2017.

Some types of credit growth still a concern

China’s broad credit growth was at 12.7% YoY in February 2018, down from the recent peak of 16.9% YoY in early 2016. The decline was mainly caused

by lower capital markets leverage, including the decline in non-bank financing or shadow banking loans. Entrusted loans (previously an important way of circumventing regulatory restrictions) declined quite substantially by CNY146.4bn in the first two months of 2018, compared to the rise of CNY776.9bn in 2017 and CNY2,185.4bn in 2016. On the other hand, the less-transparent infrastructure-related loans and consumer credit (especially short-term non-mortgage loans) have increased rapidly over the past year. We think the government is already alarmed about their recent growth and they would shift their deleveraging attention to these two sectors this year.

China’s infrastructure investment increased quite significantly by 15.8% in 2017, another year of strong growth after the rise of 16.1% in 2016 and 18% in 2015. Infrastructure-related credit mainly came from the sources of bank loans and corporate bonds. While infrastructure-related bank loans increased steadily over the past two years, the issuance of infrastructure-related corporate bonds from local government showed significant growth to fuel the investment drive. Infrastructure-related corporate bond increased from only CNY4,500bn in 2015 to CNY7,500bn in 2017. The Chinese government was already aware of its fast growth and they cautioned that this could be another source of non-performing debt in China’s economy.

Household leverage is high

China’s household leverage is getting higher after the rapid increase in the recent years. In particular, China’s non-mortgage household credit (credit cards, auto loans, etc.) increased by CNY4.5 trillion in 2017, up from an increase of CNY2.5 trillion in 2016. Non-mortgage household credit was already 16% of GDP in 2017, compared to 20% in the U.S., one of the highest globally2.

04 Deleveraging remains key

Figure 3: Debt to GDP ratios by sectorSource: JP Morgan Research, Deutsche Bank Wealth Management. Data as of March 16, 2018.

300%

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2009 2010 2011 2012 2013 2014 2015 2016 20172008

98%

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23%

50%

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127%

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134%

33%

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139%

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153%

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164%

44%

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166%

56%

48%

17%

Government Debt Household Debt Corporate Debt

2 “China’s Financial Cleanup: Why slower growth is better for banks this time”, Morgan Stanley Research, February 28 2018.




The Chinese government has already announced measures to slow down infrastructure project approvals, as well as increased scrutiny over online consumer lending. With these deleveraging measures, we think China’s infrastructure investment will slow down and non-mortgage lending will also moderate.

Consensus expectations are for stable and positive growth in 2018. Most economists’ views are close to this consensus. However, it is worth touching briefly on some alternative outcomes.

We think the near-term risk to China’s debt problem should be containable, with the government’s continual efforts to deleverage the economy. This will form the backdrop to our base case economic scenario, which we think there is 70% possibility. In the base case scenario, we think Chinese economy would grow 6.5% this year with stable growth in consumption and exports. Fixed investment growth will moderate with government’s reduced support to infrastructure and property sectors. In 2019, we see a further slight slowdown in GDP to 6.3%. The renminbi is expected to ease back from its current levels against

the U.S. dollar over the next 12 months, to 6.50 at end March 2019.

However, we do think that inflation remains a key risk in China’s economy. An alternative “bear case” scenario (which we give a 20% probability) has inflation rising faster than expectations, meaning that China’s PBoC would have to tighten monetary policy aggressively. In this situation, there would be a risk of higher corporate defaults as a result of speedy interest rate rises.

A third “bull case” scenario (10% probability) envisages a reappearance of the goldilocks situation like that which prevailed for much of 2017, with low inflation and ample liquidity supporting the equity market.

05 Three brief scenarios for the Chinese economy

Figure 4: Non-mortgage household debt to GDPSource: Morgan Stanley Research, Deutsche Bank Wealth Management. Data as of March 16, 2018.

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U.S

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5% 6% 7% 10%

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Traditional economy sectors continue to slow

We believe that China’s GDP growth in 2018 will be dragged by the slowdown of the traditional sectors such as the debt-reliant areas of infrastructure and real estate. China’s infrastructure investment increased by 15.8% in 2017 and we think some moderation in growth is likely this year. The government slowed up new project approvals late last year in response to the quick debt buildup. Project pipelines are likely to shrink as infrastructure investment growth decelerates this year.

Real estate investment growth is also likely to ease with the cooling property market. Real estate investment increased by 7% in 2017 overall but had already started to moderate in the second half of the year in response to government tightening measures. As the government continues to deleverage the economy, we think that property sales will slow

in a higher interest rate environment. We think the government is not likely to loosen the strict property market rules this year because they will want to continue to be seen as vigilant on speculation. The construction of rental housing will be a focus this year.

New economy sectors remain the key growth drivers

On the other hand, we remain constructive on the new economy sectors (e.g. e-commerce, internet, healthcare, consumption upgrade) as we think they are still on a secular growth path. Chinese consumers are changing their consumption patterns, shifting part of their purchases from physical stores to online stores. This consumption pattern change is irreversible and ongoing. Besides, as households’ disposable income rises with higher wage growth, there is an obvious trend upgrading the sort of goods (or services) bought. Chinese consumers are now preferring higher-quality and more individualized products and they are spending more on healthcare and insurance.

Further deleveraging to reduce financial risks

Reducing financial risk remains the top priority this year and the government will continue to push financial deleveraging and SOE deleveraging. China’s debt growth moderated recently and credit growth generally improved with rebound in industrial profits. In December 2017, 85% of China’s steel companies made profits, compared to two years ago in December 2015 when only 5% of steel companies made profits3. Corporates have used the higher profits and better free cash flows to fix their balance sheets as industrial companies have seen their liability to asset ratios declining in 2017.

06 Six key investment themes for 2018

3 China equity strategy: Buy the dips”, JP Morgan Research, February 20 2018.

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Jan ‘10 Jan ‘11 Jan ‘12 Jan ‘13 Jan ‘14 Jan ‘15 Jan ‘16 Jan ‘17 Jan ‘18Jan ‘09

Figure 5: Infrastructure and real estate investment growth is already slowingSource: Morgan Stanley Research, National Bureau of Statistics, Deutsche Bank Wealth Management. Data as of March 16, 2018.

Infrastructure, YoY% 3 month moving average (3MMA) Real Estate, YoY% 3MMA




China’s AI pushChina is embarking on an unprecedented effort to master artificial intelligence (AI). The government released the New Generation Artificial Intelligence Development Plan (AIDP) in July 2017 and then major Chinese government bodies began implementation of the plan by issuing documents, organizing meetings, and setting up new agencies to guide and support AI development in China. In President Xi’s 2018 New Year greeting video, there were two leading books on AI in the bookshelf behind him. This was a subtle signal that the top leadership was placing a major emphasis on AI development.

There are a number of obstacles to overcome. China’s AI development lags behind the United Stations in the areas of university AI programs, qualified faculty, the overall number of AI companies and international AI patents, and so

on. The recent data showed that in the area of Deep Learning in AI, the top five companies with most international patent applications are Microsoft, Google, Samsung, Qualcomm and IBM. Their total patents account for more than 50% of the total global applicants in this area. The top 15 companies include three Chinese companies, Baidu, Tencent and Shanghai Zhaoxin Semiconductor. Their total patents constitute 8.3% of global total patents in this area.

However there is little doubt that China’s AI has large upside potential. The advantages for China’s AI development are the government’s immense investment, large available data resources, strong market demand, and the large quantity of technology graduates each year. China’s AI push includes strong commitment from the government calling for homegrown AI to

match that of the developed countries in three years. The government also intends to help Chinese researchers to make major breakthroughs by 2025 and make China’s AI “the envy of the world” by 2030. Many Chinese academics believe that AI could become an area where Chinese technology soon overtakes developed economies’.

In China’s domestic market, the e-commerce companies like Alibaba and JD.com, are exploring the possibility of using AI technology in novel ways in their retail services. They already opened some self-service department stores and convenience stores based on their AI technology applications. Compared with the U.S., China’s retail market has shown more technology intensity, with the emergence of widespread use of mobile payments through phones in recent years.

We believe these positive developments will be supportive of large banks as they will be benefit from the better credit quality of industrial corporates and they are less likely to be affected by financial deleveraging and regulatory tightening than smaller institutions. Higher market interest rate amid financial deleveraging environment will also support the NIM (net interest margin) expansion of the large banks, in our view.

Industrial consolidation

In 2018, we believe the tight monetary environment will benefit the industry leaders due to their better access to low-cost funding, especially in the property sector. Industry leaders should gain more market share because of their better pricing power this year, as they are also not likely to be affected by government’s environmental inspections to clean up capacity with higher pollution.

Higher CPI inflation but lower PPI inflation

China’s consumer price inflation (CPI) inflation was low at 1.6% in 2017 due to the unusually-low food price. However, we believe China’s inflation will rise in 2018 driven by higher food prices, increased wage growth and higher raw material prices. We think higher CPI inflation will benefit consumer staples. On the other hand, producer price inflation (PPI) will likely fall back from its high of 6.3% in 2017, which may affect the profit growth of upstream industrial sectors.

Higher volatility due to external factors

China’s economy benefited from a strong export recovery in 2017. However, a number of risks related to the external environment exist this year. Volatility in global financial markets seems likely to

rise, particularly if the Fed hikes rates faster than expectations and the ECB’s monetary policy will also be in transition. Besides, the U.S. and China may see more trade friction this year as trade protectionism is on the rise. If there is a slowdown in external demand this year (which we do not expect), we think the government may consider loosening tight deleveraging measures in place to support domestic demand.

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07 Investment outlook for 2018

Equity sectors

Based on investment themes in the previous section, we like the IT/e-commerce, Banks, Healthcare, Insurance and Consumer Staples sectors. Meanwhile, we hold a neutral view on the Property sector. We are relatively cautious over the Industrials sector.

IT/e-commerce

Chinese e-commerce companies should benefit from the monetization efforts of their non-current revenue sources. China’s online retail market should continue to grow on a secular trend.

Banks

Chinese large banks should see wider Net Interest Margin as a result of the government’s deleveraging efforts which could lead to higher interest rates. The overall positive economic environment should cap the downside in the corporate balance sheet of their borrowers.

Healthcare

The healthcare sector should benefit from the stronger demand for better medical services amid the rising household disposable income. The demand for healthcare product and services should continue to rise with ageing population.

Insurance

China’s insurance sector should see continual and stable growth in 2018, driven by the rising demand for insurance protection from consumer as well as the expansion of distribution capacity.

Consumer staples

China’s consumer staples should benefit from the higher CPI inflation in China this year. Higher household income should drive the trend of premiumization in consumer staples space.

Property

We expect slower sales growth in Chinese property companies given the tight monetary environment and government’s intensions to slow down property investment. However, any significant price decline in China’s property price is unlikely, in our view. Industry consolidation will be visible in China’s property industry.




USD/CNY

The CNY has appreciated 2.7% YTD against USD to 6.33 (as of March 22, 2018). This followed a 6.3% appreciation of CNY against USD in 2017. We think that CNY appreciation

was mainly driven by three factors. Firstly, it was due to the unwinding of Chinese corporate positions in USD encouraged by policy guidance and a turnaround of market expectations. Secondly, Chinese corporates may have converted their proceeds from the USD bond insurance into CNY for domestic use. Thirdly, the USD has been weak with the U.S. Dollar Index (DXY) down 2.1% YTD as of March 22, 2018.

CNY may however start to ease later in the year, on the back of 1) a likely stronger USD after Fed delivers rate hikes; 2) China’s likely lower current account surplus, given strong import demand and higher oil prices, and; 3) policymakers’ worries over the impact of a strong CNY on export growth. We forecast USD/CNY to ease to 6.5 by end-March 2019, compared to its current level of 6.33.

Key risks in 2018Slower growth spills over

As China reduces support to the traditional sectors of infrastructure and property, China’s economic growth is likely to moderate in 2018 compared to previous year. One risk is that the side effects of this on many parts of the economy, such as labor market, consumer demand and corporate profitability, turn out to be more marked than expected. In this scenario, the equity market could see higher volatility and even correction because of lower corporate profitability.

Inflation risks

If consumer price inflation (CPI) moves up more quickly than expected this year, the PBoC will have to hike interest rates to curb inflation. Quickly rising interest rates may hurt economic growth and could lead to corporate defaults. In this scenario, the Chinese credit market could be affected by defaults and the

equity market could decline with lower corporate profitability in a high-interest rate environment.

Higher volatility in global financial markets

Global financial markets are likely to see higher volatility this year compared to 2017 with the tightening bias of the Fed and the ECB. Even the Bank of Japan could adjust its ultra-accommodative monetary policy slightly by raising the 10Y JGB yield target. External financial market volatility could lead to higher volatility in China’s equities and credit market.

Housing market uncertainty

Property investment could, as noted above, slow down further this year and have some negative spillover effects on the economy. Uncertainty could be exacerbated, if the government responds by adjusting relevant policies this year,

which could lead to volatility in the economy. As property sector is a pillar in Chinese economy, any significant volatility in the sector could affect the overall economy. China’s credit market would see more bond issuance from property companies due to their rising financing needs in the deleveraging environment.

Trade frictions with the U.S.

Trade frictions have intensified this year since President Trump announced import tariffs over steel and aluminum products. While the impact of these tariffs are minimal on China, we think there is the possibility of escalation of trade friction. A “trade war” scenario is not in the interest of China, particularly given that its economic growth should already be moderating with slower infrastructure and property investment growth.

Industrials

We are relatively cautious over China’s industrial sector, due to the slowdown of infrastructure and property investments this year. Government already slowed the approvals

of many PPP (private-public-partnership) infrastructure projects.

Chinese credit

Chinese credit moved lower at the start of 2018 due to increased U.S. Treasury yields and heavy bond supplies. The secondary market also felt the drag from primary market supply

due to more generous primary premiums. We think US yields could continue to be a headwind to China credit this year with likely further Fed rate hikes. With China’s tight onshore credit conditions and large upcoming bond maturities, the new supply of China credit will be very strong this year. Therefore, we have on relatively cautious view on Chinese credit, given higher U.S. yields and large primary market supplies.

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08 Longer-term economic and investment issues

Demographic challenges

China is facing demographic challenges. China’s total working-age population peaked in 2014-15 and it is expected to decline by 2-3 million each year between 2018 and 2022. Besides, despite government’s efforts to relax the “one child policy” into a “two child policy”, the fertility rate remains low. Based on government data, there were 17.23 million newborns in China in 2017, even lower than 17.86 million in the previous year. China’s ageing population will become a severe issue in the years to come, when the people born in the births peak period of 1962-1972 retire over the next 10-15 years. Declining labor force population could significant push up China’s wage inflation, particularly in service sectors. In our view, this highlights the need for China to raise labor productivity through technology investment to offset the loss in labor force population.

Stuck in a middle income trap?

China’s GDP per capita in 2017 was US$8,583 and there is an expectation that China could become a high-income country in next five years with GDP per capita above US$13,700. However, getting stuck in a middle income trap has always been a fear due to 1) China’s declining demographic dividends (lower labor inputs), 2) deceleration in capital inputs with a lower savings rate amid ageing population, and 3) lower marginal productivity improvements through technology if China is already approaching the technological frontier.

Despite these concerns, we think it is likely that China’s economy will remain on a positive growth path and that we are likely to see China’s economy transitioning to high-income in five years. The characteristics of a high-income country are a higher growth contribution from consumption instead of investment, stronger growth of service sectors than manufacturing, more technological breakthroughs to support labor productivity growth, and effective management of debt cycles. China seems well placed to cope on these fronts.

Geopolitical stresses with Japan and the U.S.

China is already the world’s second largest economy. There is possibility that China overtake the US to become the world’s largest economy in 10-15 years’ time. With a stronger economy, China could reshape the future global geopolitical landscape in a significant way. With the “one belt, one road” initiative, China is trying to build stronger economic ties with the less developed economies in Asia, Africa and Europe. However, with China’s economic rise, it will challenge the geopolitical influence of Japan in the region and the geopolitical influence of the U.S. globally. While we are not expecting any major conflicts between China and Japan or the U.S., we think some geopolitical frictions on economic and political fronts will be more likely and they may become the “new norm”.

1

2

3




With reform-minded leaders in charge of China’s economic affairs, we think that the government will remain committed to moving towards free trade and market economy principles. We are likely to see more liberalization in China’s service sectors, especially financial services and capital markets.

With the constitutional amendments in the NPC, President Xi could stay in power beyond 2023. We think that this is, on balance, positive for Chinese economy due to it helping assure policymaking continuity and the likely upcoming comprehensive longer-term economic and political reforms.

Deleveraging remains the key in government policy in 2018. However, the deleveraging focus is likely to shift from the financial sector to the real economy, especially the less-transparent infrastructure-related credit and the non-mortgage household loans.

With the positive economic momentum since the start of the year, we think the government is now ready to reduce fiscal stimulus to the economy, as is shown in the lower fiscal deficit target for 2018. We think consumption and exports will be the key growth drivers to the economy. The debt-intensive infrastructure and property investment should see growth deceleration.

We think the key investment themes in 2018 are 1) traditional economy sectors continue to slow; 2) new economy sectors

remain the key growth drivers; 3) Further deleveraging to reduce financial risks; 4) industrial consolidation; 5) higher CPI inflation but lower PPI and 6) higher volatility due to external factors.

Based on the themes above, we like the IT/e-commerce, Banks, Healthcare, Insurance and Consumer Staples sectors. We have a neutral view on Property sector. We hold a cautious view overall on Chinese credit this year, because of the likely higher U.S. yields and heavy new supplies in the market. We think CNY is likely to weaken against the USD later this year, as the Fed delivers rate hikes and China’s current account surplus narrows.

Key risks to China’s economy in 2018 include 1) the spillover effect of slower economic growth, 2) higher inflation risks, 3) higher volatility in global financial market, 4) housing market uncertainty, and 5) trade frictions with the US.

The longer-term issues facing China are 1) the demographic challenge, 2) how to exit the middle-income trap, and 3) how to deal with geopolitical stresses with Japan and the U.S. given its growing economic capability. But we think that China is well-placed to face these challenges and believe that it could transit into a high-income economy in next five years’ time: vindication for President Xi, if he needs it.

09 Conclusion




Bibliography

Glossary

“China Equity Strategy: Buy the dips”, JP Morgan Research, February 20 2018.

“China’s Financial Cleanup: Why slower growth is better for banks this time”, Morgan Stanley Research, February 28 2018.

“China: The future of monetary & financial stability policies”, JP Morgan Research, March 19 2018.

“China 2018 Outlook: Striving for a new growth model”, Deutsche Bank Research, December 11 2017.

"China: pleasant surprise in February exports", Deutsche Bank Wealth Management, March 8 2018.

“China Politics: A new era”, JP Morgan Research, February 26 2018.

“China Economics: Resilient growth at the year start”, Morgan Stanley Research, March 14 2018.

“China Macro: Messages from NPC”, Deutsche Bank Research, March 5 2018.

“China Economics: Is the Yuan back to a trend of appreciation?” Morgan Stanley Research, February 19 2018.

“China: Blue Paper Revisit: Why we are still bullish on China”, Morgan Stanley Research, November 14 2017.

The Chinese National People's Congress is the Chinese national legislature.

CNY is the currency code for the Chinese Yuan.

The consumer price index (CPI) measures the price of a basket of products and services that is based on the typical consumption of a private household.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.

Leverage refers to the amount of debt used by companies or individuals to finance assets.

The U.S. Dollar Index (DXY) is a weighted index based on the value of the U.S. dollar versus a basket of six other currencies.

“China Macro: Preview of National People’s Congress”, Deutsche Bank Research, March 2 2018.

"China: Update on the National People's Congress", Deutsche Bank Wealth Management, March 12 2018.

"Demystifying China - A question of perspective", Deutsche Bank Wealth Management, October 27 2017.




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