Macro-Policy and Sovereign: Balancing Growth, Reform and Stability

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1 Macro-Policy and Sovereign: Balancing Growth, Reform and Stability MARIE DIRON, ASSOCIATE MANAGING DIRECTOR SOVEREIGN RISK GROUP LILLIAN LI, VICE PRESIDENT SENIOR ANALYST CREDIT STRATEGY AND STANDARDS DECEMBER 2016

2 Agenda 1 Global economic environment unsupportive to growth in China 2 Progress and hurdles in reforms implementation 3 Credit implications of policy support and reforms 2

3 1 Global economic environment unsupportive to growth in China 3

4 Near-term Global Growth Stabilizes at Low Levels Real GDP Growth Annual % change China EM Asia (ex China) Advanced Economies Latin America Source: Moody s Investors Service 4

5 Weak Trade Value and Volume Growth 130 Trade/GDP Pre-crisis Trade trend x2: Trade grows twice as fast as GDP x1: Trade grows at the same pace as GDP or slower World trade: average of global imports and exports of goods, 2016 is based on Q1 and Q2 data Sources: Central Planning Bureau, Moody s Investors Service, Haver Analytics 5

6 Downside Risks for Asia» Implications of US policies including potentially less engagement in global trade and security» Disorderly response to Fed tightening involving a sharp fall in capital inflows in APAC» EU developments including Brexit and Italian constitutional referendum which could create further uncertainty about the future of Europe» Slowdown and changes in the composition of growth in China involving a further prolonged and marked fall in Chinese imports.» Rising leverage in many Asian economies either in the private or public sector could exacerbate spending retrenchment in response to negative shocks 6

7 High-Value Exporters Exposed to Potential US Onshoring» High-value manufactures likely to be focus of potential US domestic orientation Korea, Malaysia, Taiwan most exposed Exports to US by Type (% of GDP) 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% High Value Manufactures Low Value Manufactures Commodities Source: National Sources and Moody s Investors Service 7

8 Potential Shift in US Policies Fuelling Capital Outflows Non-resident Portfolio Flows in Asia $ billion, 4-week average 4.0 Equity Flows Debt Flows Sources: Moody s Investors Service, IIF 8

9 % y/y Multi-Pronged Policy Supports Growth in the Near Term China s GDP growth % year F 2017F Source: Haver Analytics, Moody s Investors Services 9

10 RMB Billion 12-month moving average % y/y ytd Including Proactive Fiscal Policy Public Fiscal Deficit on the Rise RMB Billion 12MMA, Annual % change, year-to-date Public Fiscal Balance (LHS) Growth of Public Fiscal Revenue (RHS) Growth of Public Fiscal Expenditure (RHS) Oct-11 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Sources: Moody s Investors Service, National Bureau of Statistics, Wind 10

11 % y/y ytd And SOE Investment Declining Private Investment* with Different Interpretation Annual % change, year-to-date Distribution of New FAI %, January October Overall Fixed Assets Investment State-owned and State-holding Enterprises Investment Private Investment State-owned and State-holding Enterprises 36% Others 3% Private Enterprises 61% 0 * As defined by National Bureau of Statistics, SOEs include State-owned and State-holding enterprises, the latter include absolutely state-holding enterprises, relatively state-holding enterprises and consultatively state-holding enterprises. Private enterprises include collective, private, personal domestic enterprises and institutional units as well as the enterprises controlled (including absolutely controlled and relatively controlled) by these units. Sources: Moody s Investors Service, National Bureau of Statistics, Haver Analytics 11

12 2 Progress and Hurdles in Reforms Implementation 12

13 China s Structural Reforms Defined Gradually» 2013 Plenum focus on structural reforms» Vast reform agenda becoming increasingly focused Social reforms, e.g. urbanization, two-child policy Financial reforms, e.g. interest rates liberalization SOE reforms, including corporate governance and deleveraging: from very broad guidance to more specific measures Contingency plan for regional and local governments debt risks» Reform intentions emanate from the central government Local implementation yet to be tested 13

14 Reforms on Corporate Deleveraging Now Outlined» State Council guidelines published on 10 October» Focus on a range of financial measures to address high corporate leverage Breadth of measures illustrates complexity of the task» Implementation challenges Near-term negative growth impact of deleveraging Incomplete institutional and legal framework» Implementation likely to be gradual 14

15 Costs of Deleveraging Likely to Be Spread Across Sectors Government (policy stimulus, financial support) Households (jobs and income losses) Highly leveraged SOEs Financial sector (debt-equity swaps, securitisations) Source: Moody s Investors Service Other SOEs (M&A, take-over of social responsibilities, supply-chain linkages) 15

16 Contingency Plan for Local Government Debt Risk» State Council announcement on 15 November» Further evidence of central government s commitment to reducing moral hazard risk for debt of regional and local governments (RLGs)» If new reporting system effectively reduces moral hazard, it will be credit positive for the sovereign Encourages greater fiscal discipline by RLGs; reduces the risk that localized contingent liabilities crystallize.» In case of systemic crisis, government support remains With it broader contingent liability risks for the sovereign remain. 16

17 Reforms to Remain Gradual With Implementation Challenges Growth and Stability» Incentives of main stakeholders not always aligned Faster reform progress where there are less conflicts of interests of stake owners» Effectiveness of reforms dependent on implementation of a range of interlinked measures State-owned economy s dominance role Reform Promote market s role» Institutional structure complicates reform implementation. Central government designs; RLGs implement Balance interests of stake owners Divergent local economic and fiscal conditions and social responsibilities affect incentives and ability to implement reforms 17

18 3 Credit implications of policy support and reforms 18

19 Q3 % y/y % y/y Return on Assets, % SOE Leverage Poses Contingent Liability Risks Growth of GDP and credit Return on Assets for Industrial Corporates 15 Nominal GDP growth (LHS) Outstanding total social financing* growth (RHS) 25 14% SOEs Private Sector % 10% % % 3 5 4% 2% 0 0 0% * Total social financing (TSF) is an official measure of broad credit in the financial system consisting of formal bank loans, shadow banking activities, direct financing (bond and equity issuance) and others (e.g. microcredit). The series shown above reflects our adjustments from May 2015 onwards to account for distortions from the local government debt swap program. Sources: Moody s Investors Service, WIND 19

20 Debt Servicing Ratio, % Incremental Capital Output Ratio Effectiveness of Policy Stimulus May Erode Incremental Capital-Output Ratio and Debt- Servicing Ratio % Debt Servicing Ratio, % Incremental Capital-Output Ratio 25% 7.0x 20% 6.0x 15% 5.0x 10% 4.0x 5% 3.0x 0% Note: ICOR calculated as gross capital formation divided by the annual increase in real GDP. A higher value represents a lower productivity of capital. Sources: Moody s Investors Service, Institute of International Finance, Haver Analytics 2.0x 20

21 % y/y Credit Conditions Continue to Deteriorate, As Banks Face Rising Contagion Risks» Asset quality of banking sector continues to deteriorate with increasing non-performing loans (NPLs) (1.7% at 2016 Q4 ) and rising credit costs. Risk could further rise from small and midsize banks activities, such as increasing reliance on wholesale funding.» Shadow banking size doubles in last 5 years with shadow banking assets over 80% of GDP. 40 Nominal GDP Outstanding total social financing* Core shadow banking^ * Total social financing (TSF) is an official measure of broad credit in the financial system consisting of formal bank loans, shadow banking activities, direct financing (bond and equity issuance) and others (e.g. microcredit). The series shown above reflects our adjustments from May 2015 onwards to account for distortions from the local government debt swap program, resulting in an upward revision to the series of 3.5ppts in year-over-year growth as of September ^ Core shadow banking activities include entrusted loan, trust loan and undiscounted bankers acceptances in TSF. Sources: Moody s Investors Service and PBOC 21

22 Year-on-Year Change Unintended Consequences Pose Risks to Financial Stability Property Prices in First-Tier and some Second-tier Cities Continue to Rise Rapidly Annual % change First-tier cities Second-tier cities Lower-tier cities 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% Sources: Moody s Investors Service, National Bureau of Statistics 22

23 China's Capital Account USD billion And Sustained Capital Outflows Challenge Policy Effectiveness China s Capital Account USD Billion 800 Outward Direct Investment Inward Direct Investment Portfolio Investment: Assets Portfolio Investment: Liabilities Other Investments: Assets Other Investments: Liabilities Total Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 Source: Haver Analytics 23

24 Policy Support and Reforms: Too Much, Too Slow, Just Right? Credit positive scenario of combination of policy support and gradual reforms» Robust growth, in part because of policy support, provides time and space for SOE restructuring that allows eventual deleveraging» Reforms imply that policy support is increasingly geared towards higher productivity (and debt carrying capacity) sectors Robust growth keeps reform implementation orderly Gradual reforms enhance effectiveness of policy support 24

25 Policy Support and Reforms: Too Much, Too Slow, Just Right? Credit negative scenario of combination of policy support and gradual reforms» Policy support maintains artificial and unsustainable demand conditions for nonviable SOEs» Reforms ineffective as concerns about negative economic impact dominate» Effectiveness of policy support erodes as leverage increases further Policy support keeps non-viable SOEs afloat Reforms so gradual that become ineffective 25

26 Key Messages 1 Global GDP and trade growth stabilize at low levels, with downside risks China s short-term growth outlook supported by policy 2 Formulation of structural reforms is advancing Implementation likely gradual 3 Polarized credit implications depending on whether Policy support provides time for reform Policy support inflates demand, fuels unproductive leverage and effectiveness erodes 26

27 BACKUP 27

28 Reform Definition and Implementation Progress So Far Reform Area SOE reform Public finances Financial reform Social reform Others Progress So Far Corporate deleveraging guidelines Sector classification Capacity reduction targets of 2016 in steel and coal achieved Intra-government fiscal framework VAT reform Contingency plan for RLGs debt risk Local government bond swap Interest rates liberalization Off-balance sheet risk provisions Opening up of interbank market, CDS More market determination of exchange rate Slower Progress Clarity on market implementation of reforms Alignment of incentives among stakeholders Relevant supporting systems, incl. bankruptcy process, transparent and predictable legal system Practical implementation in individual tax, environmental tax, property tax Alignment of location of revenue generation and spending needs Improve professional management to avoid periodical emergence of capital bubbles and popup controls Two-child policy Social security regional transfer Fiscal supports to urban migrants Resource distribution for health care and education Rural land ownership certification expanded Pension fund management Pension fund investment and operation kickoff Alignment of objectives in urbanization Pilots electricity price reforms Resource tax reform expanded nationwide Anti-corruption campaign Streamline administrative process Oversight from governments on resource and environment protection 28

29 Michael Taylor Managing Director, Chief Credit Officer Credit Strategy and Research Marie Diron Associate Managing Director Sovereign Lillian Li Vice President Credit Strategy and Research

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