China Economic Quarterly Q2 2018

Transcription

1 August 2018 Major economic indicators p1 /Policy updates p10 /Hot topic analysis p12 China Economic Quarterly Q Despite the complicated environment both at home and abroad, China s Q2 GDP has not disappointed the market.

2 Content Ⅰ. Major economic indicators 1 Ⅱ. Policy updates China is opening up more sectors for foreign investment China s proactive fiscal policy and prudent monetary policy will be more forward-looking, flexible, and effective. 11 Ⅲ. Hot topic analysis 12 The outlook of RMB exchange rate in the second half of

3 I Major economic indicators Figure 1: Quarterly GDP values and quarterly and annual GDP growth rate % 6.90% 6.70% 6.90% 8.00% 7.00% 6.00% GDP (Trillion yuan) % 4.00% % 1.80% 1.80% 1.70% 1.90% 1.60% 1.70% 1.80% 1.80% 1.60% 2.00% % 1.80% 2.00% 1.80% 1.80% 1.80% 1.30% 1.50% 1.40% 1.00% % Quarterly GDP value Quarterly growth Annual GDP growth rate Source: National Bureau of Statistics of China; Wind For the second quarter in 2018, China s GDP growth has increased 6.7% yearon-year, staying at the range of 6.7%-6.9% for 12 quarters or three years. As a result, total GDP reached trillion yuan for the first half year. Although overall economic performance did not miss the market expectation, the Shanghai and Shenzhen stock indexes dropped about 14% and 15% respectively during the first half year, especially in Q2. It was triggered by tight liquidity caused by monetary policy and the trade tension between China and the US. This has impacted investors confidence, RMB exchange rate and business sentiment, also creating downward pressure on the economic growth in the future. Furthermore, IMF Managing Director Christine Lagarde recently warned that the recent wave of trade tariffs would harm global growth. In the worst case scenario, it would reduce world GDP by 0.5%. If the trade tension were to persist between China and the US, there s likely to be pressure on the economy as a whole next year, not withstanding all the measures that the Chinese Government has introduced. On the other hand, China s employment market is doing quite well as the unemployment rate in urban areas stayed below 5% during the second quarter. This is the lowest level since the National Bureau of Statistics of China started to collect the data in Fortunately, both fiscal policy and monetary policy will adjust to better serve economic growth goals. These will definitely hedge against the risk of economic slowdown due to trade friction and other reasons. More specifically, according to the recent meeting of the Political Bureau of the Communist Party of China (CPC) Central Committee, the top leaders have decided that in addition to firmly curbing the rise of housing prices, China will maintain steady growth with a (forward-looking, flexible, and effective) proactive fiscal policy and prudent monetary policy in the second half of Source of data: Unless otherwise stated, economic data is from the National Bureau of Statistics, Wind and financial data from the People s Bank of China. PwC 1

4 For the first half year, the output of the primary, secondary and tertiary industry was 2.21, 16.93, and trillion yuan respectively. The tertiary industry or service sector, accounting for 54.3% of total GDP, grew by an impressive rate of 7.6% year-onyear, while the growth rates for the primary (5.3% of total GDP) and secondary industry (40.4% of total GDP) were 3.2% and 6.1% respectively. More specifically, the tertiary industry has contributed 60.05% to total economic growth in the first half year, increasing by 2.8% compared to the overall level last year. Comparatively, the secondary industry and primary industry have contributed 36.7% and 2.8% respectively. On the other hand, for the first half year, the final consumption expenditure amounted to 78.5% of total GDP growth, and continues to be the most important driver of China s economy. Meanwhile, gross capital formation (formerly gross domestic investment) contributed 31.4% and net exports of goods and services had negative contribution of 9.9%. Figure 2: GDP composition % 80.00% 42.69% 44.79% 44.34% 44.36% 45.54% 47.23% 48.11% 50.37% 51.82% 51.90% 52.30% 60.00% Proportion 40.00% 20.00% 48.56% 46.89% 47.65% 47.73% 46.65% 45.24% 44.45% 42.22% 40.82% 41.45% 41.71% 0.00% 8.75% 8.32% 8.01% 7.91% 7.81% 7.53% 7.45% 7.41% 7.36% 6.65% 5.99% Primary industry Secondary industry Tertiary industry 2

5 Figure 3: Fixed Asset Investment Accumulated growth rate 13.50% 11.40% 10.30% 10.00% 10.70% 9.00% Total fixed asset investment reached trillion yuan, expanding by 6.0% year-on-year in the first half year, 1.6% less compared to the previous quarter. Deleveraging by the government and corporates is the key reason for slower investment growth. With reversed policy support, total fixed asset investment is expected to have a higher growth rate in the coming quarters, perhaps a few percentage points higher than current levels. Though total investment is slightly lower than GDP growth, private investment increased by 8.4% and reached to trillion yuan, or 1.2% more than the same period last year (or 2.9% more than the whole of 2017). As we often emphasise, private investment accounts for nearly 60% (58.9%) of total investment, which contributed 81.5% of investment growth in the first half year. It is much more sensitive to the economic outlook, and also reflects strong confidence in the market. Since China will continue to open up more state controlled sectors to 8.20% 8.10% 9.20% 8.60% 7.50% 7.20% 7.50% 6.00% private companies this year, we expect private investment will keep growing in the second half year or even longer. By sectors, fixed asset investment of the primary (worth 0.99 billion yuan), secondary (10.99 billion yuan) and tertiary industry (17.76 billion yuan) went up by 13.5%, 3.8% and 6.8% respectively during the first half year. More specifically, although overall fixed asset investment in the secondary industry increased by only 3.8%, investment from manufacturing grew by 6.8%, (Q2 is 3% more than Q1). Over the same period industrial sector investment went up by 3.9%, mining rose by only 0.2% and investment of electricity, gas, water and etc. fell by 10.3%. Probably due to the slowdown of infrastructure investment, as government policy has recently been adjusted, utility investment is likely to rebound in the coming two quarters. On the other hand, fixed asset investment in the tertiary industry (service sector) still dominates and accounts for about 60% of total investment. Of which infrastructure investment went up by 7.3% in the first half year (compared to 13.4% in Q1), much less than the same period last year. Particularly due to an uptick in consumption, in the first half year, investment in culture, sport and entertainment went up by 17.5%. Investment in computers, communications and other electronic equipment manufacturing went up by 19.7% and investment in education went up by 11.2%. These industries enjoyed a much higher growth rate compared to overall total fixed asset investment. PwC 3

6 Figure 4: Growth rates in real estate 20.0% 16.3% 15.8% Growth rate 15.0% 10.0% 5.0% 9.9% 9.1% 9.3% 8.8% 8.1% 5.7% 5.3% 10.1% 12.9% 11.2% 11.1% 12.2% 8.8% 9.7% 9.0% 8.0% 7.8% 8.5% 7.9% 7.9% 8.1% 7.4% 7.7% 8.2% 7.5% 7.0% 9.9% 9.7% 10.4% 10.3% 10.2% 7.2% 5.1% 4.6% 4.8% 3.1% 2.1% 0.0% 0.5% 2.1% -1.2% -2.1% -5.0% Growth rate of land purchased Growth rate of sources of funds Growth rate of investment Despite macro controls and policy tightening across the country, property prices continue to rise. For instance, in the first half year, total floor space sold went up by 3.3% (or million square meters) and the sales value of commercial buildings went up by 13.2% (or 6.69 trillion yuan), of which residential housing sales rose by 14.8%. As a result, at a recent meeting of the Political Bureau of the Communist Party of China (CPC) Central Committee, the top leaders stressed to firmly curb the rise in home prices. It is the first time this type of language has been used for property prices since general secretary Xi Jinping took power. More specifically, investment in real estate development grew by 9.7% (nominal growth) year-on-year to 5.55 trillion yuan during the first six months of this year, 3.90 trillion yuan or 70.2% of this investment is in residential buildings. Meanwhile, triggered by rising property prices, the growth rate of land purchased and growth rate of sources of funds increased by 7.2% (compared to 0.5% in Q1) and 4.6% (3.1% in Q1). Sources of funds has also slightly improved for developers in Q2. From January to June, it increased by 4.6% (compared to 3.1% growth in Q1) yearon-year, to 7.93 trillion yuan. Of the total funds, domestic loans (1.23 trillion yuan) accounted for 15.5% (18.9% in Q1), and dropped by 7.9%. This means under the macro control policy, bank financing is getting worse for developers. This trend will not change in the second half year. Self-financing (2.55 trillion yuan) constituted 32.2% (31.1% in Q1), and increased by 9.7% (5.1% in Q1) in the first half year. Other funds including deposit and advance payment (2.61 trillion yuan), increased by 12.5%. But personal mortgage loans (1.15 trillion yuan) continued to fall by 4.0% year-on-year. Since the China s top leaders have emphasised control over the rising property prices, we expect real estate regulations will become much tighter in the second half year. Therefore, it is very likely that investment and floor sales of property will decline and perhaps the prices as well. 4

7 Figure 5: Purchasing Managers Index 56.00% 54.40% 54.50% 55.10% 54.90% 55.40% 55.00% 54.60% 55.00% 54.00% 53.80% 53.40% 53.80% 53.70% 53.70% Percentage 52.00% 50.00% 50.20% 49.80% 49.70% 50.20% 50.00% 50.40% 51.40% 51.80% 51.70% 52.40% 51.60% 51.50% 51.50% 48.00% 46.00% Non-manufacturing Manufacturing 50% breaking point China s Purchasing Managers Index (PMI) for the manufacturing sector in the past three months of April to June has increased to 51.4%, 51.9%, and 51.5% respectively. The PMI in June was slightly lower than May, but the overall PMI in Q2 was higher than Q1. These indicate the manufacturing sector is still expanding. The escalating China- US trade dispute will affect the PMI in the coming months. However, domestic economic performance is still the key factor in determining the development of the manufacturing sector. The PMI of large enterprises stayed at 52.9% in June and the PMI of medium and small enterprises fell just below the threshold at 49.9% (50.4% in March) and 49.8% (50.1%). As always, the PMI of small and medium manufacturing enterprises was about 3% lower than their large counterparts. The production index and new order index slightly increased to 53.6% (53.1% in March) and maintained 53.2% (53.3% in March) respectively in June. These are much higher than other indexes. However the raw materials inventory index and employed person index continued to be below the threshold at 48.8% (49.3% in March) and 49.0% (48.1% in March) in June. Just as with Q1, this means that the raw material inventory and the number of employees in the manufacturing sector did not increase very much in the past few months since the last quarter of On the other hand, the nonmanufacturing PMI still remained at a higher level than manufacturing, as the business activity index reached 55.0% in June (54.6% in March). The non-manufacturing PMI of the service sector was 54.0% in June (53.6% in March), slightly improved compared to March. This is in line with the strong performance of the service sector. The index of business activity of railways, air transport, telecommunications, satellite transmission services, financial services, and construction surged to 60% at a much higher level (55.0% in March). Meanwhile, the index of business activity of road transportation and capital market services (due to a sharp fall in stock prices in both Shanghai and Shenzhen) dropped below 50% in June. For the second half year, it is likely that the manufacturing PMI will remain above the threshold, but probably at a lower level than the second half year. For the non-manufacturing PMI, it will maintain the current positive trend. PwC 5

8 Figure 6: Industrial Added Values 7.60% 7.60% 6.80% 5.70% 5.90% 6.80% 6.20% 6.10% 6.00% 6.60% 6.20% 6.00% 6.00% Growth rate The growth of Industrial Added Values for companies over certain scales went up by 6.7% (6.8% in Q1, in real terms) year-on-year in the first half year. But in June, it only increased by 6.0%, or 0.8% less than in May. The growth rate has been very solid, there has not been much fluctuation compared to the same period last year, as well as since 2016 and We expect no surprise for the growth of industrial added values in the second half year, and the growth rate will be similar to now. In June, industrial added values of manufacturing went up by 6.0% year-onyear, the utilities sector went up by 9.2%, and the mining sector increased by 2.7%. In June, 37 of the 41 major industries enjoyed year-on-year growth. Of which, the automobile industry (14.0%), special equipment (11.5%), and computers, communications and other electronic equipment manufacturing (10.9) had double digit growth. It is worth mentioning that manufacturing of the overall automobile industry went up by 10.1% in the first half year, much higher than Q1. More specifically, the production of automobiles (14.30 million) increased by 3.5%, of which passage cars (5.83 million) went up by 5.6% and SUVs (4.83 million) went up by 3.6%. Though it has been much slower than Q1, new energy car sales still surged 88.1% in the first half year to million units. But growth of sales in June slowed down to 36.6%. Stable production of the automobile industry indicates the stability of the overall economy for the first half year. It is also likely to maintain the current trend in the next few quarters. On the other hand, profits of industrial enterprises over certain scales rose by 17.2% year-on-year in the first half year. Mostly because prices rose while the costs and expenses for production continued to decline. Second, the leverage ratio continued to drop. Similar to Q1, as domestic and international economic growth is comparatively strong, we still expect the growth of industrial added values and profits to continue in the second half year. 6

9 Figure 7: Retail Sales of Consumer Goods 10.70% 10.56% 10.50% 10.41% 10.30% 10.30% 10.40% 10.40% 10.40% 10.40% 10.20% Accumulated growth rate 10.00% 9.80% 9.40% Overall consumption continued to be the largest driver of economic growth, contributing 78.5% (61.6% in Q1) to China s GDP in the first half year, increasing by 9.4% compared to the same period last year. It contributed 47.1% more than gross capital formation (contributed 31.4% and net exports of goods and services had negative contribution of 9.9%. ) to the GDP growth. Total retail sales of consumer goods went up by 9.4% (9.8% in Q1, 9.0% in Q2) year-on-year to 18.0 trillion yuan in the first half year. In terms of types, catering consumption grew by 9.9% year-on-year, while goods retail sales went up by 7.6% (9.8% in Q1). Sales of cosmetics went up by 14.2% (16.1% in Q1) and home appliances grew by 10.6% (11.4% in Q1) year-on-year. Sales of clothes, groceries. foodstuffs (include cooking oil) went up 10.1%, 12.6% and 9.8%. In addition, similar to the past few years, total online sales reached 4.08 (1.93 in Q1) trillion yuan in the first half year, growing by 30.1% year-on-year. It accounts for 17.4% of total retail sales of consumer goods, 3.6% more than the same period of last year. Among online sales, material goods, accounting for 17.4% of total retail sales (3.6% more than the same period of 2017), stood at 3.12 (1.46 in Q1) trillion yuan, up by 29.8% (34.4% in Q1). In comparison, per capita disposable nominal income increased by 8.7% (after adjusting for inflation, 6.7% real growth) in the first half year over the same period last year to 14,063 yuan. As a result, the per capita consumption expenditure increased by 8.8% to 5,162 yuan. Obviously, the growth rate (8.7% ) of overall consumption matched with growth (8.8%) of income. Compared to Q1, consumers are starting to spend a little more than what they can earn. As the backbone of China s economic development, we believe both total retail sales of consumer goods and per capita disposable income will stay stable in the second half year and even in a much longer period. PwC 7

10 Figure 9: Quarterly Balance of Trade % -1.50% % -8.62% -1.17% 8.99% 20.83% 9.74% 10.50% 3.36% 8.64% -2.31% -1.59% 1.25% 0.80% 12.46% 7.08% 2.18% Growth rate 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% % % % % % 0.95% % % -7.89% 1.95% 30.27% 16.43% 11.90% -6.05% 12.71% 4.90% -5.44% -4.26% 0.34% 10.47% 7.66% 6.43% (Billion yuan) 1,200 1,100 1, Net Export Export Growth Import Growth The escalating trade dispute between China and the US has not influenced China s total trade yet, as the first round of tariffs was imposed in early July. But still, in the first half year, growth of China s imports and exports has been much slower than Q1. Total imports and exports reached (6.75 in Q1) trillion yuan, increasing by 7.9% (compared to 9.4% in Q1) over the same period last year. Among them, exports went up by 4.9% (7.4% in Q1) year-on-year to 7.51 (3.54 in Q1) trillion yuan, and imports grew by 11.5% (11.7% in Q1) year-on-year to 6.61 (3.21 in Q1) trillion yuan. As a result, net surplus in the first half year was 0.90 (0.33 in Q1) trillion yuan, and dropped by 26.7% compared to the same period last year. 8 As usual, general trade accounted for 59% of total trade, which increased by 12.2% in the first half year or 2.3% more than the same period last year. Meanwhile, machinery products continued to dominate China s exports (accounting for 58.6%), growing by 7% year-on-year during the first half year. However, more recently, in June, the growth of total imports and exports slowed down to 4.3% compared to the same period last year. For the first half year, in addition to the three major trading partners, the EU (with 5.3% trading growth), US (5.2% ), and ASEAN (11%) which accounts for 41% of China s total trade, China s trade with some countries along One Belt and One Road has increased substantially. For instance trade with 16 CEE countries (Central and Eastern Europe) surged 14.7%. On the other hand, imports and exports from China s private companies accounted for 39.1% of total trade in the first half year, which went up by 1.2% compared to the same period last year. Furthermore, private companies generate 47.5% of China s total exports, remaining the largest contributors. Furthermore, China s trade with the US was 1.93 trillion yuan (or roughly 13.7% of China total trade), which increased by 5.2% over the same period last year. Exports to the US was 1.39 trillion yuan and rose by 5.7%, and imports from the US was 0.54 trillion yuan and increased by 4%. Since trade friction between China and the US has been getting worse recently, this would significantly affect the total exports and imports to the US. China s trade would definitely face uncertainty in the second half year. As a result, its negative influence to overall GDP growth is inevitable. But in a longer term, it would not seriously damage China's economic development.

11 Growth (contraction) rate Figure 10: Producer Price Index and Consumer Price Index 8.00% 7.60% 6.90% 6.00% 4.00% 5.50% 5.50% 4.90% 4.70% 3.10% 1.38% 1.39% 1.60% 1.60% 2.30% 1.88%1.92% 2.08% 1.90% 1.50% 1.60% 1.80% 2.00% 0.90% 2.10% 0.10% 0.00% -2.00% -2.60% -4.00% -6.00% -4.56% -4.30% -4.81% -5.95% -5.90% -8.00% CPI PPI Compared to the moderately high levels of PPI, growth in the consumer price index (CPI) was still fairly stable. CPI increased by 2.0% year-on-year in the first half year. For June, CPI grew by 1.9% year-on-year and slightly dropped by 0.1% on monthly basis. For the first half year, in addition to the price of fuel for transport (due to oil price hikes) increasing by 9.4% year-on-year, the price of healthcare rose by 5.5%. Additionally, the price of pork dropped by 12.5%. Given this is the most popular meat in China this will curb the food price and overall CPI in the second half year. But egg prices increased by 17.5% year-on-year. As a result, total food prices only grew by 1.2%. The price of consumer goods went up by 1.5%, of which the price of services increased by 2.7%. The Producer Price Index (PPI) went up by 3.9% year-on-year in the first half year, returning to a more reasonable level compared to last year. In April, May and June, PPI increased by 3.4%, 4.1%, 4.7% respectively yearon-year. More specifically, during the first half year, the price for means of production rose by 5.1% (6.1% in June) which pushed up total PPI. For instance, the price of mining and quarrying products rose by 5.1% (11.5% in June) and raw materials rose by 6.7% (8.8% in June). Meanwhile, the price of consumer goods only increased by 0.3% (0.4% in June). These price hikes were triggered by oil prices (extraction of petroleum and natural gas) which increased to 17.0% in the first half year (32.7% in June). Although the current level of around US $70 (equivalent to 476 yuan *) a barrel is a reasonable price for oil, some analysts predict the US sanctions on Iran will push the oil price higher in the second half year. If so, the PPI in China might remain at a higher level. To conclude, total CPI will remain at the current level in the second half year, though the price of fuel might rise again. The continued rise in healthcare prices might not be sustainable. * Conversion based on market rates on 27/08/2018 PwC 9

12 Ⅱ Policy Updates 10 China is opening up more sectors for foreign investment, especially finance and the manufacturing of automobiles, meanwhile, some of the implementing regulations is expected to be released soon. As a follow-up measure, the National Development and Reform Commission (NDRC) and the Ministry of Commerce, jointly released the latest shortened negative list for foreign investment in the end of June, which became effective on July 28, According to NDRC, under the negative list-based approach, foreign investment in the fields not subject to the negative list, will be administered by filing for record management. The number of items on the new negative list were cut from 63 to 48, and 22 sectors including finance, transportation, professional services, infrastructure, energy, resources, and agriculture are now either more or fully open to foreign investment. More specifically, service sectors including finance, infrastructure construction, transportation, commercial and trade distribution, culture and entertainment are more open to foreign investment. For instance, the government has fully opened up (removed foreign shareholding ratio restrictions) the banking industry, increased the foreign shareholding ratio limit to 51% in security companies, security investment fund management companies (mutual funds), futures companies, life insurance companies, and professional services; in 2021, the government plans to fully open up (remove all shareholding ratio limit restrictions) for foreign investment in the financial industry. Subsequently, a large number of foreign banks are looking to set up a branch or entity in China, mostly in Shanghai. Foreign banks with operations in China will invest more to expand their business in order to win more market share.

13 Second, the government has opened up the whole manufacturing industry to foreign investment, major sectors include the manufacturing of automobiles, ships and aircraft. Particularly, in automobile manufacturing, they have fully opened up new energy vehicles and special vehicles to foreign companies (they have eradicated a foreign shareholding ratio limit) and there are plans to fully open up commercial vehicle manufacturing in 2020 as well as passenger-car manufacturing in This means by 2022, there will be no restrictions on China s automobile manufacturing industry for any foreign players. As a result, Tesla recently announced they are setting up a factory (known as Gigafactory 3) in Shanghai to produce 500,000 electric cars a year, the largest plant outside of the US. Third, the government has provided more access for foreign investment in the sectors of agriculture and energy, which includes removing restrictions on crop seeds, except for wheat and corn, restrictions on exploration and mining of precious and rare coal, and restrictions on exploration and mining of graphite, smelting and separation of rare earth, and smelting of tungsten. China s proactive fiscal policy and prudent monetary policy will be more forward-looking, flexible and effective. In order to keep its economy on a stable and healthy development track, on July 31, the top leaders called for stronger policy support at a meeting of the Political Bureau of the Communist Party of China (CPC) Central Committee. More specifically, fiscal policy will play a more effective (and more important) role to boost domestic demand and structural readjustment. Monetary policy will keep liquidity at a reasonable and ample level. In addition, the word stabilise has been used six times in the released government meeting minutes by Xinhua News Agency, namely to stabilise employment, finance, foreign trade, foreign direct investment (FDI) and domestic investment, and expectation. Other economic policies that have been emphasised include: deepening supply-side structural reform, cutting excess capacity, improving infrastructure (probably meaning greater investment in infrastructure), lowering the cost and expenses of enterprises, continuing to reduce the leverage ratio but cautiously watching the level and speed ( so it does not affect the current growth of the overall economy), rolling out major effective reform measures, firmly curbing the rising of housing prices (more strict macro prudential controls on the real estate sector), Consequently, while government policy will heavily influence China s economic growth, these measures will ensure that the GDP of Q3 and Q4 is not likely to decline further. PwC 11

14 Ⅲ Hot topic analysis The outlook of RMB exchange rate in the second half of 2018 The RMB exchange rate against the USD has declined sharply since mid-june due to factors such as the interest rate hike by the US Federal Reserve (FED), the strong USD Index, China-US trade friction and the volatility on the Chinese stock market. Although the RMB exchange rate against the USD rebounded over several business days at the beginning of July, the RMB has become a market focus again. So what is the outlook of RMB exchange rate in the second half of 2018? Figure 1: Central Parity Rate : USD to RMB (July 6, 2017 to July ) (Daily) Source: Wind To begin with, despite the recent drop in the RMB exchange rate against the USD, the RMB depreciated against USD by as much as 3.95% for a dozen days between June 15 and July 4. Over a longer timeframe of one month to three months, as of July 9, the depreciation of the RMB exchange rate against USD remained at a high point at 3.2% and 4.7% respectively. But if we judge from a six to 12-month timeframe, the RMB exchange rate against the USD only devalued mildly by 1.28% and appreciated by 2.79% respectively. Over even longer time periods of three years, five years and 10 years, the RMB exchange rate against USD devalued by about 8%, about 5% and appreciated by about 4% respectively. 12

15 Figure 2: Central Parity Rate: USD to RMB (July 6, 2006 to July ) (Daily) Source: Wind Therefore, if we consider the recent fluctuation of the RMB exchange rate against the USD in the context of a longer time frame, the current central parity rate of about 6.6:1 is not surprising, and many analysts even believe the overall RMB exchange rate is still on the high side. For instance, although the RMB devalued by 3.46% against the USD over a 2-year period, it appreciated by 10.80% against the Euro over the same time. The exchange rate dropped slightly against the JPY, GBP, CAD, and the currencies of other key developed economies, but the overall exchange rate remained basically stable. PwC 13

16 Figure 3: Central Parity Rate: Major Currencies to RMB (July 6, 2006 to July 6, 2018) (Daily) Central Parity Rate: EUR to RMB Central Parity Rate: JPY100 to RMB Central Parity Rate: GBP to RMB Central Parity Rate: AUD to RMB Central Parity Rate: CAD to RMB Source: Wind Despite the decline in mid and late-june, the CFETS RMB Exchange Rate Index, officially released by the China Foreign Exchange Trade System (CFETS) on December , showed that the exchange rate of the RMB to a basket of currencies was on a general rise in the past year. The small-scale depreciation of the RMB against USD in the past year and the recent larger devaluation has not altered the upward trend of the RMB Exchange Rate Index. Figure 4: CFETS RMB Exchange Rate Index (Weekly) Source: Wind Firstly, it is important to correctly understand that the reform in the marketbased RMB exchange rate formation mechanism is still at its initial stage, which means that the previous market expectation on the unilateral appreciation or unilateral depreciation of the RMB exchange rate over a certain period of time will become a thing of the past, and that the RMB exchange rate against the currencies of major developed economies 14 will demonstrate two-way fluctuations on a regular basis. In the meantime, the initial stage of the reform has defined that it needs to take a longer time to improve the market-based RMB exchange rate formation mechanism, and policy intervention remains rather necessary at a time when speculators try to manipulate the market to profit. Furthermore, when market events significantly shock the exchange rate and the market mechanism is insufficient or not responsive, stabilising and cultivating the market-based formation mechanism appears more important than the reform process. What has happened in the 40 years of reform and opening-up tells us that the great achievements of China s economic development can be attributed to key progressive measures rather than measures undertaken overnight. This is also true for the exchange rate reform.

17 Figure 5: Actual Monthly USD Index: Major Currencies (March 1973 = 100) (June 2006 to June 2018) Source: Wind Secondly, the higher-than-expected economic growth of the US and the increase in the USD Index once again driven by the FED interest rate hike are some of the key factors behind the depreciation of RMB against the USD. As the USD Index has been at its historical high, the likelihood of a further rise in the second half of the year is rather limited. In addition, US President Donald Trump has previously emphasised that an ultra-high USD exchange rate does not help the continuous recovery of the US economy. Moreover, against the backdrop where the US government is paying more attention to trade deficit and even initiating protectionist measures against several countries simultaneously. The stronger USD exchange rate not only goes against the effort to reduce their trade deficit, but also undermines the price competitiveness of US exports. In other words, it is unlikely for the Trump administration to support the further appreciation of USD; rather, it is more likely to expect the depreciation of the currency. However, the market-based pricing power of the USD is still very strong (it is often more powerful than US government policy) and should not be underestimated. Figure 6: US Federal Funds Rate and the USD Index in the same period (Daily) (July 6, 2014 to July 6, 2018) Source: Wind US Federal Funds Rate (Daily) USD Index The market predicts that the FED may increase the interest rate two times in the second half of the year, which may drive up the USD exchange rate against the RMB, thus leading to the larger fluctuation of the RMB exchange rate against USD. That said, the basis of mid-to-long-term exchange rate volatility still lies in economic growth. In fact, the recent interest rate hikes of the FED have not pushed up the USD Index. Thirdly, when the US government announced imposing additional tariffs on Chinese goods, it has triggered the depreciation of the RMB exchange rate against USD, exacerbated the slump in the Chinese stock market, and in turn stimulated the RMB exchange rate. If the Trump administration insists on imposing additional tariffs on US $200 billion (equivalent to 1.63 trillion yuan *) worth of Chinese goods in the near future, the continuous downtrend of the RMB exchange rate against the USD will be expected. If the Chinese government steps up efforts to retaliate, the RMB exchange rate against the USD may be subject to larger volatility in the second half of the year as the China-US trade friction intensifies. Of course, driven by market forces and the RMB exchange rate formation mechanism, the large-scale depreciation of RMB to USD will relieve the additional burden of the tariffs imposed by the US on Chinese products. If the RMB Index demonstrates a large decline on the whole, i.e., the depreciation of RMB to a basket of currencies, this may alleviate the shock of the US imposition of tariffs on the Chinese products. PwC 15

18 Figure 7: Central Parity Rate of USD to RMB and the trend of the Shanghai Composite Index in the same period (Daily) (July 1, 1996 to July 1, 2018) ,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Source: Wind Shanghai Composite Index Central Parity Rate: USD to RMB 16

19 In summary, in addition to the performance of the USD Index, the degree and scale of the China-US trade conflict represents an important factor that affects the RMB exchange rate against the USD. If the US government collects additional tariffs on US $200 billion (equivalent to 1.63 trillion yuan *) worth of Chinese products and if China retaliates to a greater degree the exchange rate may fluctuate on a larger scale. Furthermore, the strong performance of the US economy and the continuous interest rate hikes from the FED will attract more capital to flow to the US and may stimulate the outflow of the Chinese capital, which may also lead to the depreciation of RMB. In this case, the RMB exchange rate against the USD still has room to decline in the second half of the year due to the said factors; if the depreciation case intensifies, it is likely to see a sharp decline, thus causing the scenario that the CFETS RMB Exchange Rate Index may shift from an upward trend in the past year to a downward one. On the other hand, the China-US trade friction may drag down China s economic growth rate, but this is not enough to affect the general growing trend of the overall economy and is unlikely to lead to a recession in the Chinese economy. Meanwhile, besides the RMB exchange rates, the effect of the China-US trade friction on the Chinese economy calls for greater vigilance as it has accelerated the level and speed of the stock market decline, shaken the confidence of investors, affected the purchasing behavior of consumers, and added to the pressure of guarding against financial risks. Beyond that, consumption is, after all, a key driving force that boosts economic growth. For example, consumption expenditure contributed to 77.8% economic growth in the first quarter of this year. And as China deepens reforms and further opens financial services and other sectors to foreign capital, the current lower valuation of the Chinese stock market will attract international capital to enter into China on a large scale. Together, these factors will underpin the relative stability of RMB exchange rate. Therefore, we believe that the frequent two-way fluctuation of the RMB exchange rates against the currencies of key developed economies including the USD will become more regular, and the China-US trade conflict will also evolve into an important point that tests the market-based RMB exchange rate formation mechanism in the medium and long run. For example, the People s Bank of China did not intervene when the RMB depreciated against USD for more than 10 days, pointing to the bigger step taken towards the marketbased process of the RMB exchange rate. PwC 17

20 Author G. Bin Zhao Senior Economist PwC China +86 (21) Acknowledgements Special thanks to Sanjukta Mukherjee, Lan Lan and Research teams (led by Tiffany TK Wong) for their contributions to the report. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors PwC. All rights reserved. PwC refers to the China member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. CN C1