Expert eye on China Q QUARTERLY REVIEW CAUGHT BETWEEN REFORMS AND TIGHTENING LIQUIDITY

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1 1 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 For Professional Investors Use Only and Not for Public Distribution - Q1 214 Expert eye on China Quarterly Review and Outlook 1 IS CHINA S CREDIT RISK A TIME BOMB? 3 CLEARING THE AIR ON environmental POLICY IN CHINA 4 The benefits of short duration RMB Bond exposure in EXPANSION AND GROWTH OF (R)QFII SCHEMES IN 213 BUT IT TAKES TWO TO TANGO In partnership with 7 QUARTERLY REVIEW CAUGHT BETWEEN REFORMS AND TIGHTENING LIQUIDITY Chinese onshore markets had a range-bound fourth quarter and finished the year in the red. The A shares-market lost 2.98% over the quarter in CNY terms, underperforming the offshore market by far (by 5.66% in USD terms). After a decline in October and early November due to profit-taking in the small-cap universe, the market rebounded slightly until early December on the back of the reform outlined by the government during the Third Plenary session of the communist party leadership. The session outlined ambitious and broad reform s for the next five to 1 years. The priority economic reform areas include administration, finance as well as land and resource pricing. Resource allocation should be more market-oriented. Marking the first time the Chinese leadership has used such words; the s said the role of the market would switch from basic to decisive. However, later in December, market gains were eroded by concerns over a fresh cash crunch on the interbank bond market. The onshore yield curve saw almost no positive impact from the reform agenda and was volatile over the quarter. Overall, yields rose due to tighter liquidity given the more handsoff approach of the People s Bank of China (PBoC) in managing liquidity in the interbank market. Another liquidity squeeze was the result, pushing the seven-day repo rate to above 8%. The yield on the Shanghai Treasury Bond rose by 63bp, while the Corporate Bond Index lost.3% in local currency terms. The Chinese renminbi appreciated over the quarter by 1.14% to end at 6.5/USD. Back to macroeconomics, indicators showed the good economic momentum that started last summer had persisted. Industrial production and retail sales remained strong, while exports rose over the quarter on the back of improving global activity, growing by 12.7% YoY in November. However, at the end of December, the National Auditing Office said that China s local government debt had jumped by 67% in two-and-a-half years and total government debt stood at 56% of GDP. n

2 2 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 QUARTERLY OUTLOOK MAY THE MARKET FORCE BE WITH YOU In 214, we expect the government to maintain GDP growth at 7% to 7.5% and to respect the upper and lower limits of this band so as to keep growth stable while promoting large-scale structural reforms. The Third Plenum in November signalled 214 would be a year of progress on reforms towards a more market-oriented model. We acknowledge that execution and coordination remain critical for a positive impact on the economy. Overall, we believe aggregate demand remains solid and the trend of rising consumption and falling investment is consistent with the long-term rebalancing of the economy. We think a sharp slowdown in GDP growth is less likely as consumption is rebounding and external demand is solid. As the reforms and policy changes begin to be implemented, we believe there will be selective investment opportunities over the coming years. Market valuations remain historically low and Chinese A shares are now trading at 9x 214 earnings, which is around 5% below their five-year historical average. The resumption of the IPO process could drain some liquidity from the market, but we will have to wait and see whether the first companies to issue stocks are successful. With interest-rate liberalisation, macroeconomic fundamentals should be less sensitive to yield changes than before. Chinese yields have been rising structurally as the country moves out of financial repression. Cyclically, they are likely to remain relatively high in the short to medium term due to tighter liquidity and the fact that the market has priced in some of the financial reform impact. The PBoC has to strike a delicate balance between avoiding cash crunches in the course of the financial reforms and ensuring the system s deleveraging continues. Money market rates are likely to remain volatile in 214 compared with the previous years as the financial system restructures. As for the RMB, we believe the currency will continue to slowly appreciate. As long as China s balance of payments remains in surplus, which is likely in 214, the RMB should experience underlying appreciation pressure. Volatility is expected to rise as the PBoC widens the trading band gradually as part of financial reforms. Beijing s currency policy has become more market-based recently, which is a marked departure from its controlled model in the past.n Bloomberg is the source for all data in this article, as of January 214 Does another cash crunch lie in the horizon, or would PBoC be able to avoid this scenario? us your thoughts now.

3 3 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 IS CHINA S CREDIT RISK A TIME BOMB? China s credit risk has been rising fast since 21. Shadow banking and local government debt (LGD) have mushroomed, leading to market concerns about a looming financial crisis. While this risk is real, in our opinion, it is not yet fatal. Chart 1: Growth of local government debt 8% 7% 61.9% 67.% YoY growth 6% 4% China's government debt load is below world average; its total debt load is not excessive 1% total debt gross govt debt In a di y il ce az an an Br rm Fr e G UK US n pa Ja Sources: CEIC, IMF, BNPP IP (Asia), January % 2% % 45 a a ia ia ld nd in re es or e ss la Ch Ko W rag Ru ai on h d e T In av 5% 3% Chart 2: Debt-to-GDP ratios % of GDP On 3 December, the National Audit Office (NAO) released its comprehensive report on local government finances. It put total LGD at RMB 17.9 trillion at the end of June 213, up by 67% from 21 when the last audited data was available. Indeed, LGD has been rising by more than 6% a year since 28, suggesting that the rate of accumulation has gone ballistic in the past five years (chart 1). We believe this is an unsustainable trend H213 Sources: CEIC, NAO, BNPP IP (Asia), January 214 Using China Banking Regulatory Commission s (CBRC s) special audit data in June 213, we estimated that the risk-weighted Tier-1 capital ratio of the Chinese banking system stood at 1.6% at the end of 212 when LGD totalled RMB 12.1 trillion. This was well above the 7.% Basel III minimum requirement. Non-performing loans (NPLs) in the banking system amounted to RMB billion (.96% of total loans) at the end of June 213, with loan loss reserves at RMB 1.5 trillion. This implies a loss provision ratio of 278%, which is quite high by international standards. With this and other known data on bank exposure to LGD, such as potential loan losses and a bad debt recovery rate of 25% (as per the China Banking Regulatory Commission data, June 213), we estimate that the RMB 17.9 trillion LGD would cut the banking system s risk-weighted Tier-1 capital ratio to about 7.% from 1.6%. This means that, unless banks have increased their risk-weighted assets in the past year, the system s risk cushion may have been significantly thinned. In our view, the LGD s rapid rate of increase has raised systemic risk sharply. But the risk is not yet fatal, for several reasons: a) China s closed capital account; b) Beijing s implicit guarantee policy; c) the ample financial resources that the central government can mobilise; d) liabilities are domestically-owned and RMB-denominated; and e) the fact that the overall debt burden is small. As chart 2 shows, total government debt is about 53%, and total economy-wide credit is about 19% of GDP, which is not excessive, considering China s under-developed capital market. Crucially, Beijing is not sitting on its hands. It has been moving slowly to address the LGD problem by keeping a tight monetary policy bias to force deleveraging and to rein in local government borrowing from both the banks and shadow banks. Separately, recent CBRC data showed that wealth management products (WMPs) totalled RMB 9.1 trillion in Q2 213, with non-standard assets (i.e. the opaque and illiquid assets that have no secondary market and are little disclosed to investors) amounting for RMB 2.8 trillion. We estimated that WMPs amounted to RMB 7.5 trillion, with RMB 1.9 trillion of that in dodgy assets as of the end of 212. This would suggest that WMPs rose by 21% and dodgy assets by 47% in the first six months of 213! In the grand scheme of things, the problem does not look too alarming. The new data for the WMP and dodgy assets implies that they equate to some 16.3% and 5%, respectively, of estimated 213 GDP. When compared with the substantial financial resources that Beijing can mobilise to contain any potential fallout from this problem (e.g. FX reserves amount to over 4% of GDP), they should be manageable. In a nutshell, Beijing has time to resolve the LGD problem. Together with rising shadow banking activities which represent financial liberalisation by stealth, though it must be carefully managed the NAO audit results add to pressure on President Xi Jinping, who was recently named the head of a Communist Party leading group to push through structural reforms.n Do you think that the LGD issue is under control or a fatal time-bomb waiting to explode? us your thoughts now.

4 4 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 CLEARING THE AIR ON environmental POLICY IN CHINA A stronger approach drives long-term growth Environmental concerns are receiving more public and political attention as China grapples with balancing its economic growth while seeking to reduce strain on the environment. In particular, air pollution has been a point of social discontent and the more high profile incidents have been publicly debated and acknowledged at all levels of government. For example, on 6 December 213, Shanghai s Air Quality Index (AQI) hit 484, while Nanjing reached 331 (anything over 15 is classified as unhealthy ). In response to such conditions, China s new leadership has been addressing environmental issues in an unprecedented manner by acknowledging that enforcement was too limited in the past. Beijing has actively been reforming environmental laws and ensuring more stringent compliance. Although these initiatives could slow growth in the near term, it is certainly a long-term positive for business, the people of China and for Fixed Asset Investment (FAI). In fact, environmental FAI spending has been on the increase. FAI spending as a % of GDP RMB Billion % Environment FAI Environmental FAI as % of GDP (RHS) 1.18% 1,4% 1.3% 1.1%.85% 2 1.%.9% 15.65%.68% 5 1.4% 1.2% %.8%.7%.6% 7th 5-year 8th 5-year 9th 5-year 1th 5-year 11th 5-year 12th 5-year.5% Source: China International Capital Corporation, April 213 China s action for air pollution, published in September 213, requires 25% cuts in PM 2.5 (particulate matter aerodynamic diameter smaller than 2.5 µm) levels in the Beijing-Tianjin-Hebei area, 2% in the Yangtze delta and 15% in the Pearl River delta, all by 217. The lists 33 measures, including further incentives for new-energy vehicles, fuel quality improvements, dealing with small coal furnaces and reductions in coal use in the three key regions. There is also a ban on new coal-fired power stations in three regions surrounding Beijing, Shanghai and Guangzhou, with the exception of combined heat and power ts. Reduction % Provinces & municipalities 25 Beijing, Tianjin, Hebei Shanxi, Shandong, Shanghai, 2 PM 2.5 annual Jiangsu, Zhejiang reduction targets 15 Guangdong, Chongqing 1 Inner Mongolia levels and a cut in the percentage of coal use in total energy consumption. In addition, by 215, 15 billion cubic meters of new natural gas pipeline capacity will come online in the three key regions. Clearly, these policies will have broad ramifications that are positive for some industries and detrimental to others. FAI environmental spending breakdown RMB Trillion 4. Waste water treatment 3.5 Emission reduction % 14% % 4% 13% 4% 43% 42% 1th 5-year 11th 5-year 22% 3% 32% 12th 5-year Source: China International Capital Corporation, April 213 The usual suspects The high-energy, high-polluting industries are naturally a focus of concern. They include iron and steel, cement, chemicals, petrochemicals, non-ferrous metals and other key industries. These are the industries which consume the most coal. In addition to the elimination of excess capacity, new emission limits were imposed on new projects from April 213 in these industries. The new limits apply in the key regions during the 12th Five-Year Plan and will likely be expanded during the 13th Five-Year Plan (216-2). Coal and the industries which use coal have been impacted the most by the initiatives to reduce air pollution. The central government is working on setting both a relative and absolute cap. The relative cap aims for coal to account for less than 65% of national energy consumption by 217. The absolute cap is being studied at various levels with the aim of developing a national coal consumption target. Capping coal is already being tried out in Beijing, Tianjin, Hebei, Shanxi, Shandong and Inner Mongolia, which surround the capital. Beijing, Tianjin and the Yangtze and Pearl River Deltas must aim for an absolute decline in coal consumption by 217 by changing the fuel mix, using external transmission, non-fossil fuels and gas. This is an ambitious goal as the percentage of coal as a source of power generation is quite high. Sources of power generation 212 Gas 2% Nuclear 2% Other 2% Hydro 17% Coal 77% Source: Chinese Ministry of Environmental Protection, KGI, January 214 Other quantified targets for 217 include a reduction of around 2% in energy intensity of industrial added value on % Solid waste treatment Others Source: CEIC, HSBC, June 213

5 5 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 China has gas a cleaner solution, but extraction is the challenge In the medium-term, China is opting to phase down coal in favour of gas. The catch is that the country does not have enough immediately extractable gas and must import. Replacing coal with gas would involve more imports from Russia as well as domestic development from shale and coal-to-gas. However, gas infrastructure in China is still being developed. Shale gas extraction, despite the government s strong push, is still quite immature. Transport initiatives The government is ning several initiatives to improve transport. For example, Beijing will limit its number of vehicles at six million and other cities such as Shanghai and Guangzhou may follow. Cities such as Tianjin are already auctioning new vehicle registration plates with some even issuing them via a lottery system. Other cities are likely to do the same with alternate day driving, limiting new licences and restricting total vehicle numbers. There may also be an accelerated phase-out of older, pre-25 vehicles. China became a net natural gas importer in 27 and imports have since increased. Data by the National Development and Reform Commission, the country s leading economic ning body, shows that China produced 18 billion cubic metres (bcm) of natural gas in 212, up 6.5% YoY, while imports of natural gas were 42.5 bcm, up 31% YoY. The nation s dependency on imported natural gas for 212 was 28%, up from only 2% in 27. In addition, there has been a renewed focus on new energy vehicles (EVs and hybrids). There were fewer than 3, new energy vehicles at the end of 212 in China and very few of them were private passenger vehicles. In fact, most were part of bus fleets. According to the Ministry of Public Security, this represents a fraction of the 12 million private vehicles on the road in 212. Recently, 28 cities jointly announced a programme to promote new energy vehicles with subsidies for both manufacturers and consumers. More details on the subsidies and their subsequent impact are expected in 214. China s natural gas import dependency 35% 3% 25% 2% 15% 1% 5% % H13 Source: CEIC, HSBC, September 213 Although China may be home to the world s largest reserves of shale gas, the challenge is how to extract it. Exploration is at an early stage and it is unlikely that significant levels of production will be possible in the near-term. In short, the shale gas industry in China is still some years away from having a material commercial impact on the country s energy supply. China also lacks the pipeline infrastructure necessary to transport shale gas from where it is found to the most populated areas. The first shale gas pipeline is being built in Sichuan province which started work in June 213. Many more branch pipeline systems will be needed to carry the gas to the main distribution centres. Wind farms and solar to benefit According to the Third Plenary Session s decision, the government will promote an open and free market for the direct purchase of electricity, which will indirectly benefit renewable energy as wind farms and solar farms will be able to sell their power directly to end-users. With industry consolidation almost over in the solar industry, solar product prices have stabilised somewhat. Meanwhile, construction of two ultra-high-voltage (UHV) lines was completed in 213. Six lines are still under construction, which will provide more transmission capacity for new renewable energy installations. A positive outlook As the Chinese government continues to promote environmental protection and pollution controls, we believe the alternative energy sector is well positioned to outperform in the longterm given the increase in clean energy capacity, more policy incentives and better grid connections. We see an abundance of additional long-term opportunities as the country grapples with balancing growth and responsible development.n With a set of environmental initiatives in the pipeline, do you think socially responsible investing could be the next big investment trend in China? us your thoughts now.

6 6 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 The benefits of short duration RMB bond exposure in 214 Attractive yield, low currency volatility and less vulnerable to rising rates Since investors were caught off guard last May by Federal Reserve chairman Ben Bernanke s statement that the policy-setting Federal Open Market Committee (FOMC) had discussed tapering the US central bank s quantitative easing programme, interest rates have risen globally and are expected to continue to do so in 214. Increase in interest rates in % since 22 May % increase in swap curves The average credit quality of offshore RMB bonds is A-/BBB+, based on ratings by external agencies and estimates using our internal model, with more than 8% of issues being investment-grade. The concerns over Fed tapering have also led to increased currency volatility, in particular for emerging market currencies. The RMB has bucked this trend and maintained its appreciation trend, rising by more than 1.2% versus the USD over the period2. Since 26, the CNY, which we use as a proxy for the offshore RMB due to its longer trading history, has appreciated by more than 25%, or about 3% annualised, versus the USD CNY appreciation versus US remains intact -.2 typically in the range of 15bp to 2bp versus bonds issued in their home currency. Examples of such European issuers include household names such as Volkswagen, Renault, BP and Lloyds. 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 1Y 8.5 CNY/USD 8 Source: Bloomberg January 214 A rising interest rate environment creates demand for shorter duration products, as the shorter the duration, the less the impact of an increase in rates. The HSBC Offshore RMB Bond index has a relatively short average duration of only 2.7 years, but provides an average index yield of 4.1%. Hence it can offer a higher yield on lower duration than its European and US counterparts1. Yield (%) Duration Y/D Ratio HSBC China Offshore RMB Index 4.1% BOA Merrill Lynch US Corporate Index 3.3% BOA Merrill Lynch Europe Corporate Index 1.9% /1/26 1/1/28 1/1/21 1/1/212 1/1/214 Source: Bloomberg January 214 We expect the CNY to continue its appreciation trend in 214. We see little downside for the currency, given that the People s Bank of China wants to internationalise it by making it attractive to external demand. The central bank is thus unlikely to let it depreciate. The currency s implied volatility in relation to the USD is less than 3% for n Source: ML, Bloomberg, January 214 This attractive yield is not limited to Chinese issuers, as the offshore RMB market includes many international issuers who issue offshore RMB bonds (bonds denominated in Hong Kong or other offshore-traded renminbi) to fund their Chinese operations. For such international issuers, the yield pickup is Source: ML, Bloomberg, January 214 Source: Bloomberg, from 22 May 213 to 31 December 213 the CNH appreciated by 1.22% Source: Bloomberg, from 1 January 26 to 31 December month USD/CNY option volatility is % (as of 31 December 213) Are you convinced that short-duration RMB Bonds is an attractive asset class in 214? Share your thoughts now.

7 7 - Expert eye on China - BNP Paribas Investment Partners - Q1 214 EXPANSION AND GROWTH OF (R)QFII SCHEMES IN 213 BUT IT TAKES TWO TO TANGO 213 The year of bigger and better QFII & RQFII schemes In 213, we saw significant regulatory changes and the expansion in both size and scope of the two major qualified foreign institutional schemes in China, RQFII and QFII. In the last 12 months, the Chinese government has passed significant milestones in its long-term strategic intention to open up the capital markets and further liberalise the capital account. It has increased the QFII & RQFII schemes investment capacity, granted RQFII quotas to London and Singapore markets and made the programmes more flexible for investors. It is worth mentioning that China s and Hong Kong s regulators might finally announce the long-awaited regulatory framework for the mutual fund industry s cross-border mutual recognition scheme. This would allow mutual funds domiciled either in China or Hong Kong to be sold to retail investors based in China or Hong Kong. Hong Kong s SFC representative announced in November that the deal was close to completion and could be announced in Q Fig. 2 - QFII & RQFII total size still small compared with the Chinese capital markets USD 8.1 trn 8 13 The QFII scheme began 213 with USD 37 bn of quota granted and during the year added a further USD 12.4 bn. Meanwhile, the RQFII scheme, which started 213 with USD 11 bn of quota granted, saw the equivalent of more than USD 15 bn added during the year, in fact expanding by 145% compared with 212. It is worth highlighting the great expansion of the QFII s sister pilot scheme in just two years, having only started out in 211 with an initial quota of USD 1.7 bn. QFII quota granted RQFII quota granted Quota in USD bn RQFII Hong Kong RQFII London RQFII QFII & RQFII Total quota Singapore quota ceiling granted Source: SAFE, CSRC, HFT Investment Management, 3 December QFII Scheme Fig. 1 QFII & RQFII quotas granted 5 Total QFII & RQFII quota ceiling (USD bn equivalent) Source: SAFE, CSRC, HFT Investment Management, 3 December 213 In July 213, Chinese regulator CSRC almost doubled the allowable QFII ceiling from USD 8 bn to USD 15 bn, lifting the odds that the process of opening up the capital markets to the international community would accelerate. In October 213, the Chinese government announced the international expansion of the RQFII scheme to Singapore and London, granting those financial centres initial quotas of RMB 5 bn and RMB 8 bn, respectively. Just a few months on from that, the government has already in January granted the first foreign RQFII licence to Ashmore Group (which brings to mind Mark Twain s adage that actions speak louder than words, but not nearly as often ). But it takes two to tango All these measures should pave the way for fresh money from international institutional investors being invested in the Chinese equity and debt capital markets. They should also facilitate a broader range of products, more innovation, efficiency and liquidity, and wider cross-border investment options. Yet we believe the market might have to express its view, too. In 214, we will see whether investor appetite is equally optimistic and whether QFII & RQFII product subscriptions match the government s expectations, as inferred from its generous expansion of the schemes. Considering that the Shanghai stock market ended the year as the worst performer in Asia, down by 7.6%, and that it has dropped by almost 39% from its July 29 peak, we will have to wait and see whether it will be a good year for the markets to move in line with the government s expectations. n Do you think investor appetite will meet the generous supply of QFII and RQFII quotas? Share your thoughts with us now!

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