INVESTMENT MANAGEMENT. QE China-Style II The truth about China

Transcription

1 INVESTMENT MANAGEMENT QE China-Style II The truth about China MAY 2016 A

2 Convictions that run deep. Opportunities that matter. Macquarie Investment Management s culture attracts teams globally with specialised asset management expertise and strong investment convictions that are dedicated to client performance and opportunity. Important information For recipients in Australia This document is issued by Macquarie Investment Management Global Limited (Australian Business Number Australian Financial Services Licence Number ). For recipients in Asia This presentation is issued by Macquarie Funds Management Hong Kong Limited solely for general informational purposes. For recipients in EMEA This document has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Within the European Economic Area, this document is issued by Macquarie Bank International Limited (MBIL) only to Professional Clients or Eligible Counterparties defined in the Markets in Financial Instruments Directive 2004/39/EC. MBIL is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. MBIL is incorporated and registered in England and Wales (Company No , Firm Reference No ). The registered office of MBIL is Ropemaker Place, 28 Ropemaker Street, London, EC2Y 9HD. In Switzerland this document is distributed by Macquarie Bank Limited Zurich Representative Office. In Switzerland this document is directed only at qualified investors (the Qualified Investors ), as defined in the Swiss Collective Investment Schemes Act of 23 June 2006, as amended ( CISA ) and its implementing ordinance. The information in this document is not, and should not be construed as, an advertisement, an invitation, an offer, a solicitation of an offer or a recommendation to participate in any investment strategy or take any other action, including to buy or sell any product or security or offer any banking or financial service or facility by any member of the Macquarie Group. This document has been prepared without taking into account any person s objectives, financial situation or needs. Recipients should not construe the contents of this document as financial, investment or other advice. It should not be relied on in making any investment decision. Future results are impossible to predict. This presentation contains opinions, conclusions, estimates and other forward-looking statements which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements. Past performance information shown herein, is not indicative of future results. No representation or warranty, express or implied, is made as to the suitability, accuracy, currency or completeness of the information, opinions and conclusions contained in this presentation. In preparing this presentation, reliance has been placed, without independent verification, on the accuracy and completeness of all information available from external sources. To the maximum extent permitted by law, no member of the Macquarie Group nor its directors, employees or agents accept any liability for any loss arising from the use of this presentation, its contents or otherwise arising in connection with it. Other than Macquarie Bank Limited (MBL), none of the entities noted in this document are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of Macquarie Bank Limited (MBL). MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise. Macquarie is not an authorised securities firm or bank in the People s Republic of China ( PRC ) and does not conduct securities or banking business in the PRC. B The views expressed represent the authors assessment of the market environment as of the date indicated. International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

3 Contents Introduction 2 The truth about China 3 Quantifying the true financial sector risks and solutions 6 1. Asset quality 6 2. Monetary tools 9 3. Debt relief program NPL securitisation Other factors 17 Global implications qualitative exhaustion? 23 Burgeoning opportunities in China s rebalancing act 24 Summary 27 Appendix

4 Introduction Uncovering the real truth about China is a time consuming, frustrating and often fraught process. So much of what has been written about it to date, and of how it is understood from outside China s own territory, is misinformed. Seeking the truth necessitates a detailed study of the country s financial history and motivations of the central and local governments. Critically, and what is often overlooked, is a proper analysis of China s asset quality and the true magnitude of non-performing loans (NPLs) in its banking system. None of those who the Macquarie Asian Listed Equites team has spoken to, from People s Bank of China (PBOC) officials to various regulators and analysts within China have provided an absolute figure, however we calculate there are at least USD 1.76tn of NPLs in the system. For those accustomed to operating outside China, this figure seems to be an enormous warning sign. However, the central government is increasingly employing new regulation and unconventional monetary tools to manage the PBOC and policy banks balance sheets. It may not be the way a non-chinese government would tackle the problem, but for China with its co-dependent relationships between the central and local governments, banks, state owned enterprises (SOEs) and insurance companies it could work. Indeed, once you drill into the real truth about China, the result compels relief, rather than despair. Since late 2014 the central government has been steering away from an investment and export led economy to one driven by consumers. It is determined to keep a steady currency while also stabilising growth through easing monetary policies and significantly boosting liquidity, and to control systemic financial sector risks. That task may appear overwhelming, particularly given the volume of NPLs in the system, but we expect there will be further policy refinement and increased reliance on China s unconventional monetary tools to neutralise this. This paper is the result of numerous discussions with officials, banks and business owners in China. It details what investors might expect from forthcoming government policies, what the true risks are, particularly asset quality risks, and where to find investment opportunities while mitigating risk. It includes: where China s real growth has come from and what policy tools underpin its transition to consumption led growth what has changed in the new normal, including asset quality risks and capital outflows, and possible solutions investment opportunities and strategy, and global implications of China s risk environment. Critically, we are confident the central government s policy reform will enable a successful transition to consumer and services led growth. While we expect continued volatility and acknowledge the risks inherent in China s economy, we believe there are selective opportunities over the long term if a disciplined and risk-focus investment approach is applied. 2 THIS PAPER IS THE RESULT OF NUMEROUS DISCUSSIONS WITH OFFICIALS, BANKS AND BUSINESS OWNERS IN CHINA. IT DETAILS WHAT INVESTORS MIGHT EXPECT FROM FORTHCOMING GOVERNMENT POLICIES, WHAT THE NEW RISKS ARE, PARTICULARLY ASSET QUALITY RISK, AND WHERE TO FIND OPPORTUNITIES WHILE MITIGATING RISK.

5 The truth about China In mid-2015 the PBOC made one of its first moves towards the central government s end game, conducting a debt for equity swap with two of the country s policy banks, the Central Development Bank and the Export-Import Bank of China. We will show you the transaction and the impact on both balance sheets in the Monetary Tools section. We believe the next play to help support the cooling economy will be for the government to carve-out distressed assets into asset management companies (AMCs), and implement debt for equity swaps between certain SOEs. Then will come contagion. Once all movement between balance sheets has been exhausted, we expect distressed assets and NPLs in the banking system will be written off, the central government will bail out the policy banks, and finally, bail out the local governments. The mid-2015 equity injection referred to above is merely the beginning of the end. In our September 2015 paper, QE China Style: The intentions and impacts of Chinese monetary policy easing, we examined the new, unconventional tools the PBOC is using to help the economy to transition. In this paper we go one step further, to look at how capital outflows and the desire to maintain a steady currency could impact China s plans. The best place to start is with a look at China s history. The common understanding is that for over a decade, China s growth has been underpinned by investment spending from local governments and SOEs compelled to meet the central government s pre-set GDP targets. As a result, Fixed Asset Investment (FAI) grew exponentially. At the same time overseas capital poured in to China, with foreign companies lured by the promise of cheap labour. As large-scale, made-at-home operations in developed economies, particularly in Europe and the United States realised they could not compete on costs, capital inflows into China grew. Increasingly, that foreign capital began to demand higher and higher returns on investments. In reality this is the half-truth. The real growth in China came from sequential credit extensions granted by the PBOC to local governments who were borrowing to excess. The overambitious GDP targets set by the central government meant many local governments had to support economically unviable projects and operators. China is now slowing. The Chinese government calls it the new normal. Economic growth in 2016 is expected by the PBOC to drop to 6.5 per cent Year over Year (YoY). Industrial production growth could fall to 5.9 per cent and industrial profits growth has contracted to negative territory. Unsustainable low returns on invested capital across industrial sectors is sounding alarms within China. Over-capacity is a serious issue for many of the country s industries. And because local governments rely heavily on land sales to fund fiscal expenditures there are serious concerns about what may transpire if, or when, land prices fall. As media interest hones in on supply-side reforms and SOE reforms, and issues such as those outlined above become more apparent, it is clear that China has been left with no choice but to rebalance its economy towards consumption. China binged on cheap liquidity and is starting to feel the hangover. Fiscal stimulus is having limited effect and plans set up for future growth have been brought forward. Foreign capital has begun questioning the point of building more apparently unnecessary infrastructure in China. A massive corruption crackdown is underway: a luxury sector is suffering. Against a backdrop of those components, it becomes even clearer that monetary policy is what matters. Fortunately, the PBOC s tool box is enormous, meaning there is significant scope to defend any hard landing. THE REAL GROWTH IN CHINA CAME FROM SEQUENTIAL CREDIT EXTENSIONS GRANTED BY THE PBOC TO LOCAL GOVERNMENTS WHO WERE BORROWING TO EXCESS. 3

6 The truth about China Chart 1, below, illustrates the central government s current structure. It shows how easy it is for the PBOC and the Ministry of Finance to use new unconventional monetary tools to bail out local governments and dodge (or postpone) systemic risks. At no time has it been more necessary for investors to appreciate how close the links are between state owned parties and the PBOC, and how critical it is behind the veil of a slowing economy that they participate in their national service to the central government. Chart 1: The truth behind QE China Style USD 190bn at 2.85% p.a. USD 200bn at 1.5% p.a. PBOC Assets USD 4.9tn 3-yr CAGR +3% 1. PSL re-lending 2. Debt swap Policy banks Assets USD 2.9tn 3-yr CAGR +19% MOF Ministry of Finance LGFVs Issue USD 4.6tn 3-yr CAGR +24% 4. Risk diversification USD 500bn swapped from 8% to ~3.6% p.a. Unconventional tools to boost liquidity Lower rates across system Buying local governments time Diversifying but not resolving asset quality risks Insurers Assets USD 1.9tn 3-yr CAGR +19% Interbank rate/ RRR cuts Banks Assets USD 30.7tn 3-yr CAGR +14% NPL-ABS Size USD 1.3tn AMCs Assets USD 0.4tn 3-yr CAGR +40% 3. NPL securitization Real economy Sources: Macquarie Investment Management PBOC: People s Bank of China, CDB: Central Development Bank, LGFV: Local government financing vehicles, NPL-ABS: non-performing loans asset-backed securities, AMC: asset management companies CAGR = Compound Annual Growth Rate It appears that the central government needs to significantly increase liquidity to fund a bail out of its debt-laden local governments and SOEs. The crux of China s get-out-of-jail free card lies with stimulating the household consumer to spend, and borrow. If growth is to be driven by the consumer, rates need to be kept low to ensure cheap liquidity and avoid a potential financial crisis. Pension reforms and superannuation schemes are in their infancy in China. Maturing this part of the economy is likely to provide comfort to consumers about social security and encourage higher spending now. We believe that stimulating the consumer is the central government s most sensible option, and consequently favour investment linked to the consumer sector, where we see growth potential and a number of opportunities, see section Burgeoning opportunities in China s rebalancing act on page 24. 4

7 The truth about China In QE China Style we set out the unconventional tools being used by the PBOC and predicted the easing that has subsequently taken place. In the past 12 months, China has cut interest rates six times and cut the reserve requirement ratio (RRR) five times. It has issued RMB 3.84trillion of debt via local government debt swaps. China has lowered the cost of debt for corporates as well as local governments through its Medium-term Lending Facility (MLF) and Pledged Supplementary Lending (PSL) tools. Its policy tools continue to encourage abundant liquidity growth, as can be seen in chart 2. Movement in the Shanghai Interbank Offered Rate (SHIBOR) or lack of short-term liquidity has become less concerning as an issue since the SHIBOR has not spiked since It is almost the opposite: numerous reserve repo programs, Short-term Liquidity Operations (SLO) and Standing Lending Facilities (SLF) are providing more than sufficient short-term liquidity. Chart 2: China s liquidity growth with unconventional tools 30% M2 YoY MONEY SUPPLY GROWTH (M2) 25% 20% 15% 10% Introduction of SLO & SLE Intro of local SLF Intro of PSL Intro of MLF Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Source: CEIC, PBOC But while the expectation for some time has been that China is on track to inject a lot more liquidity into its economy, depreciation of the RMB has raised alarm bells. The currency adjustment that began in August 2015 means observers have been left wondering what happened, and what has changed to see such a drop. Is it timing, or structural? Will USD 2.3trn of excess FX reserve be enough to halt the RMB s fall? In the meantime, yes. However, reserves that size and the currency adjustment is more of a key to policy guidance. We have been told by policy makers that the number one objective for China right now is to maintain its stability across economic policies and also its currencies. We don t believe market rumours of a one off RMB depreciation are sound, however we cannot rule it out. But every hedge fund manager in the world wants to know the answers to these questions. Let s take a look The common assumption is that the PBOC will cut official interest rates further to keep the cost of funding low for corporates. The truth is, the price of money is already being lowered via existing unconventional policies such as the Standing Lending Facility (SLF), Medium-term Lending Facility (MLF) and Pledged Supplementary Lending (PSL). The problem is, these unconventional policies are only short and medium term boosts that do not result in any repayment of debt. Put another way, they allow China to kick the proverbial can down the road while it examines other options. What we do know, is that behind the silk curtain, the PBOC is executing what is arguably the largest shift of financial risk in history: working with the CDB, the Ministry of Finance and local governments, it will roll out an enormous NPL securitisation program, and an even bigger municipal bond debt-swap. We expect insurance companies with much longer liability duration (policies) than banks will absorb the bulk of it. Commercial banks meanwhile should be rewarded with lower Risk Weighted Assets (RWAs) for the same risk. This should enable banks to hold up to 5x capital on their balance sheets, which then enables more lending than they would otherwise. For those who have been watching China closely, this is not new. Bearish hedge fund managers are already betting on financial Armageddon in China s banking system. But be warned. China s financial history is very different to that of the developed world, as its future may be, so tread carefully. 5

8 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Quantifying the true financial sector risks and solutions As the magnitude of China s state owned debt becomes apparent, questions are being asked about whether existing policy solutions will be sufficient. To answer this requires significant analysis of the risks that we can see, and those that we assume exist. The following sections 1 5 analyse these risks. 1 Asset quality China may not have a debt problem but it does have a debt repayment problem. At year-end 2015, China had over RMB 125tn (USD 19tn) in bank deposits, more than the GDP of RMB 68tn (USD 10tn). This means China s Loan to Deposit Ratios (LDRs) are low. Consequently, there will not be an external debt crisis associated with any short fall in the need for wholesale funding. As of 3Q15, China has a debt/gdp ratio of 260 per cent. This may seem high, but investors need to realise that this debt exists at the corporate and local government level. Chart 3, below, shows the breakdown of China s debt, with households representing 28 per cent of total debt, local governments 42 per cent and corporates accounting for 185 per cent. How can China resolve this debt imbalance? China s household savings rate is at more than 57 per cent, compared to the global average of 37 per cent, which begins to explain why China needs to stimulate more household spending. China s banking system has grown from under USD 3tn to over USD 34.5tn in assets over the last 10 years alone. Whether you are China bear or China bull, this is worth your attention. Chart 3: Breakdown of China s debt as percent of GDP Households Non-financial corporates Central government Local government 300% 42% 250% 200% 150% 100% 20% 185% 50% 28% E % OF GDP Source: CEIC, Haver, Wind 6

9 FINANCIAL SECTOR RISKS AND SOLUTIONS However, the debt-repayment risk worsens the longer China has to grapple with slowing growth and eroding profitability due in part to high real rates from deflationary pressures (PPI -5.4 per cent YoY in January 2016). On this basis, China s ability to repay debt has become a very serious issue. While 95 per cent of debt funding sits within China (meaning little risk of offshore contagion), most of that is with the banks. This equates to about USD 30tn. Insurance companies hold about USD 2tn while AMCs hold less than USD 500bn. Mounting overdue loans are weighing on the banks, which still provide 81 per cent of total funding in China and this is the debt that the central government must resolve. Chart 4, below, shows the deteriorating NPL coverage. What can be done while growth continues to slow? This worsening trend appears to see no turnaround in sight. We believe further stimulus will only provide temporary respite, and is not a permanent solution. The market is already discounting Chinese banks for NPL risks and fear mongers are calling a systemic crisis. However, we need to properly quantify this risk. Chart 4 shows that the tipping point when coverage falls below what is required, has now occurred for both SOE banks as well as mid-sized banks. This means any bad debt would be a direct hit against capital and indicates that Chinese banks may need additional capital soon. The most likely solution is to carve out the NPLs to AMCs, and implement direct debt for equity swaps, which explains why this is now such a high priority of the central government. China s financial market reforms last year provided more diversified tools for financing and instruments to de-leverage. We expect more investment tools such as municipal bonds and project bonds will be used in this asset re-allocation program. Near term pain remains for financials such as banks and intermediaries as they remain key participants in the government s de-leveraging scheme. Despite chart 3 Chinese banks would be still required to lend to highly indebted state owned corporates and local governments. The truth is, it is not financially prudent to do so. For example equity financing accounted for less than 4% of overall financing and bond financing accounted for 10% last year. Chart 4: China s deteriorating NPL coverage Requirement SOE bank (excl ABC) Bank sector Mid-sized bank 400% 300% 200% 100% Q15 2Q15 3Q E 2016E 2017E 2018E % Source: CEIC, HSBC Research 7

10 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS In March 2016, Moody s downgraded China s sovereign credit outlook to negative from stable, also downgrading 38 SOEs and 25 commercial and policy banks as a consequence. This is in-line with our concerns over asset quality. However a sovereign rating downgrade is not likely just yet. Whether or not the central government can absorb the current debt burden would be determined by how effective China s policy options are. We believe China s policy makers are right in focusing on easing the debt burden by using their new unconventional monetary tools to keep downward pressure on rates, while maintaining ample liquidity in the system. What it needs to focus on next, is distributing the NPL risk across the balance sheets of insurance companies and AMCs. The following section details how China is doing this. In summary, there are concerning risks about the quality of assets held by Chinese banks, sufficient that we will not currently invest in them. However, the risk is not as drastic as the bearish view implies (below). The bearish hedge-fund manager s view A number of hedge funds have forecast that Chinese banks will lose approximately USD 3.5trn of equity if 10 per cent of loans in China s banking system are written off. By comparison, China lost 30 per cent of GDP during the NPL down-cycle in We believe there are risks to the banks assets but suggest those statements do not properly reflect the situation. Rather, China is in a phase of slowing growth, and is rebalancing away from an investment dominated economy. This is not a hard landing so we should put these figures and comments into context. There are 3 key points to address: 1 Major clarification needed FX reserves do not include CIC, Huijin and Central Development Bank investments. The adequacy of FX reserves should be assessed on fundamentals such as import coverage (20x) which is not alarming and should not be deducted. 2 China s banking sector assets rose by 7x from 2003 to Sept During the same period, GDP also rose by 5x to USD 10tn. While that level of banking asset growth sounds insanely high, China s economic growth was also unprecedented. So China s banking assets/gdp ratio increased from 2.0x to 2.9x in 12 years, which was significant, but not unprecedented. Globally, 3x banking assets/gdp is not unreasonable especially considering China s under-developed capital markets and high reliance on bank financing. 3 Loss is different from NPLs. Given 32 per cent of total banking assets are in cash and central bank assets, these should have minimum loss. Hence the figure of USD 3.5tn loss could be too bearish. Bad debt loss is different from the damage to equity. We need to be careful of different scope of losses. The estimated total losses from subprime is USD 15tn. Compared to this USD 15tn loss number then China s figure is much smaller. Note: We believe the last cycle in 1990s was not comparable, because then China s economy was comprised entirely of SOEs, bank loans were all to SOEs, benchmark lending rates were identical to time deposit rates and banks did not need to consider profitability and risks at all, because they were all Policy Banks. Now, China s economic mix, household wealth and earnings power are all very different

11 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS 2 Monetary tools Understanding China s monetary tools is about understanding that (1) Intermediaries such as the policy banks hold most of the debt, which the central government needs to move, and (2) liquidity always needs to be injected into the market to ensure stability. Interest rates have been cut six times since November 2014, and we do not expect further cuts for now, particularly given the risk of potential currency depreciation which the government wants to avoid at all costs. The key to interest rate movement is to watch whether funding costs, such as the interbank overnight rate at 2.0 per cent pa, remain stable and low. The interbank rate is like a risk barometer for the PBOC to gauge if more liquidity is needed. Chart 5: Liquidity easing to maintain stable interbank rates Aug 14 Oct 14 Dec 14 Feb 15 Apr 15 Jun 15 CHINA INTERBANK OVERNIGHT RATE (% PA) Aug 15 Oct 15 Dec 15 Feb 16 Source: Bloomberg THE KEY TO INTEREST RATE MOVEMENT IS TO WATCH WHETHER FUNDING COSTS, SUCH AS THE INTERBANK OVERNIGHT RATE AT 2.0 PER CENT PA, REMAIN STABLE AND LOW. 9

12 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS On March 1, 2016, the PBOC cut banks reserve requirements (RRR) by 50bps. It was a widely anticipated move, and expected to balance January s USD 100bn capital outflows (which according to PBOC Governor Zhou is not capital flight ). The RRR cut releases about RMB 680bn of liquidity to the banking system and keeps money supply growth buoyant at 12 to 13 per cent. The PSL was introduced to stabilise growth by hedging against further systemic risks in the financial system and avoiding credit contraction. The PSL is the primary tool for the BOC to lend funds to the policy banks. It is a re-lending tool, which means the funds are meant to be paid back to the PBOC at a later agreed date. In mid-2015, the PSL is said to have provided about RMB 1tn, at record low rates. Its application is also being expanded from Government Treasuries and Policy Bank bonds to commercial loans. The table below, gives some idea of what is really happening. At the time of writing, China s official lending rate was 4.35 per cent. It raises the question: how can these rates be so low? Table 1: China s unconventional lending rates Tools Collateral required Tenor Interest rate Most recent SLO No <7 days 2.25% Jan-16 SLF Yes 1 3 months 2.25% Feb-16 MLF Yes 3 months 2.50% Mar-16 MLF Yes 1 year 2.75% Mar-16 Re-lending Yes >1 year 2.95% Nov-15 PSL Yes >3Y 2.85% Nov-15 What is now occurring is that the policy banks issue bonds themselves, so they can use them as pledged collateral with the PBOC. It explains why the PBOCs total asset pool is not growing: Loans are the asset and bonds are the corresponding liability. This is often completely misunderstood in commentary on China. To see what s really happening, we need a detailed examination of the policy banks balance sheets. Looking at the Central Development Bank and the PBOCs balance sheets, we see they are rapidly increasing (see appendix one, page 28). Although this looks like one hand taking from the other, the interest rates are completely different. We see this as proof that cheap liquidity is flooding the market without any true PBOC policy rate cut. In any event, the problem China faces is that despite abundant liquidity, demand has not picked up, even with the PBOC dropping interest rates. What they hope is that by keeping the cost of capital low for both corporates and local governments, they can ease the debt burden and encourage more investments to be financed, thus ensuring the government s official growth target is met. They hope liquidity at commercial banks will also be more evenly distributed, to keep money supply stable. 10 PSL ESSENTIALLY ALLOWS BANKS TO PLEDGE LOANS AS COLLATERAL TO GET ADDITIONAL (AND CHEAPER) FUNDING FROM THE PBOC.

13 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS 3 Debt relief program Regional debt levels in China are a serious concern for the central bank. On the surface, it s being dealt with by green-lighting a debt swap for local governments. In 2015 the Finance Ministry allowed local governments to swap up to RMB 3.2tn of the local government Financing Vehicles high-cost debt that was due that year, to lower-yield municipal debt. We expect another RMB 5tn to be swapped this year and beyond. IMF estimates suggest the total LGFV outstanding debt is at least RMB 25tn. That s more than Germany s entire economy. The key observation about the debt swap is that while rates are lowered, so local government borrowing costs are lowered, high credit risk remains unchanged. The cost of local government debt through the LGFVs is 7 to 8 per cent. Once it is swapped out and given a credit rating, the cost of debt falls to under 4 per cent. It is the same debt packaged differently and trillions of debt cannot be repaid overnight. The truth is, this policy will only serve to ease the pain, rather than provide a cure. Policy makers are particularly keen to avoid rising defaults and NPL write offs, which the debt swap will help with, by manufacturing interest cost savings of about RMB 1.3tn a year for local governments. This is equivalent of ~2% of China s total GDP or a third of last year s GDP growth. Table 2: First batch of local government debt issued in 2015 Interest rates for different terms % Bond type Region 3 years 5 years 7 years 10 years National debt China Local government debt Jiangsu Local government debt Guizhou Local government debt Chongqing Local government debt Xinjiang Local government debt Hainan Local government debt Hebei Local government debt Shandong Local government debt Neimenggu Local government debt Shanxi Local government debt Guangxi Local government debt Henan Local government debt Tianjin Local government debt Yunnan Local government debt Liaoning Local government debt Anhui Local government debt Zhejiang Local government debt Jiangxi Local government debt Hubei Local government debt Shanxi Local government debt Jilin Local government debt Guangdong Local government debt Sichuan Local government debt Ningxia The Quote of chinabond.com.cn Source: Chinabond.com.cn But reading Table 3, below, like a P&L Statement shows a worrying trend. Central government debt to GDP is expected to drop from 21 per cent in 2009 to 14 per cent in Conversely, local government debt is forecast to increase from 24 per cent to nearly 52 per cent over the same period. 11

14 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Table 3: China general government debt RMB billions Actual Projection Central government debt 7,424 8,155 9,025 9,577 10,495 11,147 11,684 12,301 12,939 13,515 14,058 In percent of GDP Outstanding debt by Ministry of Finance 6,024 6,755 7,204 7,757 8,675 Domestic 5,974 6,699 7,141 7,675 8,584 Foreign AMCs and bank recapitalization funds 1,400 1,400 1,820 1,820 1,820 Local government debt 8,434 10,951 13,737 17,036 20,998 25,167 29,731 34,663 39,969 45,656 51,735 In percent of GDP Bank loans 6,972 8,468 9,510 10,470 11,738 LGFVs corporate bond issuance ,092 1,885 2,216 Trust loans Local government bonds Others (new funding sources since 2010) 500 1,757 3,049 4,731 Augmented debt 15,857 19,106 22,762 26,613 31,493 36,315 41,415 46,964 52,908 59,171 65,792 In percent of GDP Source: CEIC, China Ministry of Finance, NAO, IMF estimate China s banks are one major participant lending and then relending back to the local governments at half the asset yield under this program. They will need to start asking how the cost of funding for local governments can suddenly halve, particularly as the banks will experience Net interest margin (NIM) compression as a result. With growth remaining sluggish, repayment risk also rises, despite now having cheaper borrowing costs. Local governments generate about 40 per cent of their revenue from land sales, which fell more than 30 per cent YoY in The question is, what will happen if local governments can t even cover their interest payments (ie less than 1x operating profits/interest) but are still continuing to borrow, to fuel growth. 12 WITH GROWTH REMAINING SLUGGISH, REPAYMENT RISK ALSO RISES, DESPITE NOW HAVING CHEAPER BORROWING COSTS.

15 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS 4 NPL securitisation NPL securitisation is another new tool to help manage China s debt repayment problem. In February 2016 the PBOC announced a trial-program, that allows six banks to package RMB 50bn of NPLs into asset backed loans. However, given the central government is an owner of the commercial banks, the SOEs and also the policy banks, this is far more than just a trial. It is the start of the country s largest ever equity capital reforms. One cannot help but ask how many NPLs are truly in the Chinese market. Analysis of multiple channels, including the PBOC as set out in chart 6, below, suggests that there are actually RMB 11.4tn (USD 1.76tn) worth of NPLs in China, equating to an NPL ratio (NPLs over gross loans) of 7.8 per cent. Such a high NPL ratio evidences China s troubled financial history of commercial banks being forced to lend when imprudent to do so, simply to spur economic growth, for growths sake. And this isn t the first time this has happened. Chart 6: China s estimated NPL ratio PC/GDP Adj for shadow banking Private Credit/GDP Trend Credit/GDP % 225 NPL RATIO (%) % Dec 85 Dec 87 Dec 89 Dec 91 Dec 93 Dec 95 Dec 97 Dec 99 Dec 01 Dec 03 Dec 05 Dec 07 Dec 09 Dec 11 Dec 13 Private credit/gdp Balance (RMB bn) NPL ratio (%) Amount of NPL (RMB bn) Trend credit 114, ,721 Excess credit 17, ,170 Total credit 131, ,891 Shadow banking 15, ,529 Total credit (adj) 147, ,420 Source: PBOC, CEIC This latest NPL securitisation program has similarities to the early 2000 s, when commercial banks began listing using IPOs. Poor performing bank loans were carved off which essentially dressed up a bank s balance sheets by showing NPLs as a receivable asset instead of a loan. In many cases NPLs still sit as receivable assets today. Perhaps it s time to write them off? The true objective behind this NPL securitisation is to share credit risk between other financial institutions, spread the repayment problem and thereby limit the chance of a systemic crisis. It is an attempt to clean-up the system and put the risks on the table. Further evidence of the central government s intention to address asset risk is seen in its reform of off-balance sheet structures and the resulting decline in wealth management products, trust products and shadow banking. Banning the use of Trust Beneficiary Rights made considerable headway to bringing these structures under control. Now the focus of the PBOC is on its balance sheet. We believe banks will be incentivised to recognise NPLs. This is a 180 degree shift in direction from the previous mandate of government banks. Either the central government is acknowledging their previous strategy was fatally flawed, or the NPL issue has reached such extreme levels that the can no longer mask the magnitude and gravity of the situation. This has ramifications for more than just the banks. 13

16 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Passing risk to insurance companies We expect China s insurers will be forced to buy the securitised NPLs despite them being a risk. As a result, we have changed our fundamental view of Chinese insurers from positive to negative. Insurance premium growth has remained very strong (beating consensus) since our September However, savings and annuity products are being written with guarantees up to 4 per cent. This is fine for the moment, but negative spreads in the future present a serious concern. Life insurance policies are liabilities on the Insurers books, and investments in bonds and the stock market are its assets. The difference between asset yield and the cost of the liability is described as the interest rate spread. Where the problems arise is with the duration gap, with assets usually performing for 5 to 7 years while the insurance policies have an average 15-year duration, leading to a possible negative interest rate spread in the future. So can insurers maintain a healthy investment yield spread while interest rates are being cut heavily, capital is flowing out of China and overseas investment is limited? In our opinion, no, particularly because of non-participating products. Non-participating policies pay a holder the guaranteed benefit once the policy term ends. Don t underestimate the word guaranteed: if insurers are forced by the government to acquire very low yielding securitised bundles of NPLs, and debt swaps with the LGFVs, then the potential risk of negative spreads becomes even more real. However, this threat needs to be put in to perspective. Not all policies are guaranteed, nor all policies long-term savings and annuity products. Hedge funds managers looking to short will need to identify which insurers have written the highest guaranteed rates, and what percent of their liabilities are written with guarantees. In 2015, China introduced a new solvency regime, known as the China Risk Orientated Solvency System (C-ROSS), to stave off some of the worst potential issues. But one of the problems is that C-ROSS is a pure economic approach (ie mark to market) of cash flow matching for insurers, namely an amortised cost approach for assets that must be held to maturity. It is expected to cause volatility and uncertainty in the Chinese insurers solvency positions. While C-ROSS is intended to adopt risk based capital, and improve overall risk management for insurers, the reality is that an investor, C-ROSS will move the valuation metric away from Embedded Value (EV) to Price to Book (PB). The fall in the 750-day moving average for discounting the yield curve on the liability side is the reason why insurers have begun to make large provisions. Given the above, if it also becomes apparent that insurers cannot earn the 4 per cent guarantee on the liability side in the future, what is the real value of new business being currently written? Chart 7: Passing NPL risks to insurers We conservatively add excess credit to trend GDP to banks liabilities and assume 30% NPL ratio. This includes shadow banking credits in wealth management products, etc. NPL (RMB tn) NPL 7.8% (bear case) NPL 5.2% (recognised NPL + SML) NPL 1.7% (recognised NPL) Maximum NPL ABS capacity Spare NPL ABS capacity Annual NPL ABS capacity Bank sector NPL exposure Insurance sector NPL ABS capacity Source: PBOC, CEIC 14

17 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Asset Backed Securities Asset Backed Securities (ABS) have been used in China since 2005, but it has not been a significant policy tool to date, even in the lead up to the global financial crisis (GFC). That has now changed. Total issuance has ballooned in the past two years. Chart 8, below, shows the recent rise of ABS to RMB 770bn (0.5 per cent of total credit), while the second chart shows the yields ranging from 5.8 to 8.3 per cent. We emphasise that the spread in ABS is arguably not high enough to justify the associated risk. ABS are more about China trying to spread credit risk, rather than being investment products that provide any respectable returns. Stay away. Chart 8: ABS monthly outstanding amount (RMB bn) ABS OUTSTANDING (RMB Bn) Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Oct 13 Dec 13 Feb 14 Apr 14 Jun 14 Aug 14 Oct 14 Dec 14 Feb 15 Apr 15 Jun 15 Aug 15 Oct 15 Dec 15 Source: Wind, Morgan Stanley Research Chart 9: ABS loans weighted issuance rates Weighted issuance rates 10 8 RATES (%) Aug 11 Aug 12 Oct 12 Dec 12 Mar 13 Jun 13 Aug 13 Oct 13 Jan 14 Apr 14 Jun 14 Aug 14 Oct 14 Dec 14 Feb 15 Apr 15 Jun 15 Aug 15 Oct 15 Dec 15 Feb 16 Source: Wind, Morgan Stanley Research 15

18 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS NPL-ABS does diversify system credit risks across financial sectors and can perhaps become acceptable if traded at scale and allows for a secondary market to trade NPLs. But, as with the American experience of the sub-prime crisis and lack of risk transparency of credit default swaps, the principle here is the same. Essentially NPL-ABS shifts ownership of the debt from the original party to many parties. In February 2016, when the ABS program was piloted with, RMB 50bn quota of NPLs to be parcelled up. Less than three months later, that figure is expected to grow to RMB 1trn. Debt-Equity Swap The most recent attempt to move NPL risk has seen the PBOC allow banks to swap NPL for equity in SOEs that are already so credit strapped they cannot refinance and are barely able to service interest payments. We are sceptical of this development. It means the capital requirement of banks jumps from 100 per cent for loans to 400 to 1250 per cent for equity. This is counterproductive for banks that are already facing capital inadequacy risks. This is where national service could be a reason to help turn around SOEs instead of a debt write off. Or is the NPL situation that bad that China must justify the banks using more capital to relieve this NPL formation pressure? We therefore remain cautious. 16 THE MOST RECENT ATTEMPT TO MOVE NPL RISK HAS SEEN THE PBOC ALLOW BANKS TO SWAP NPL FOR EQUITY IN SOES THAT ARE ALREADY SO CREDIT STRAPPED THEY CANNOT REFINANCE AND AREA BARELY ABLE TO SERVICE INTEREST PAYMENTS.

19 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS 5 Other factors There is much, sometimes unjustified, fear mongering around the key risks in China. Investors regularly ask us about currency, and capital outflow. We believe future movements will be a reflection of US dollar appreciation, rather than RMB depreciation. Currency From the policy point of view, confidence and stability in the currency is needed. Policymakers and the PBOC face a difficult challenge negotiating a balance between continuing an easing bias while avoiding currency depreciation. In March, foreign reserve levels rose for the first time since October 2015, which is expected to relieve pressure on the PBOC to stage any aggressive intervention. Historically, China has been criticised for its large FX reserves, estimated at about USD 4tn. During its years of strong growth, investment capital flowed in to China and the UDS subsequently appreciated. The truth is that foreign flows into China required the PBOC to print RMB. As a result, the PBOC had to lift the reserve requirements for commercial banks from 8 per cent to more than 20 per cent at its peak. However, this all began to reverse and has accelerated in recent months. This is a primary result from China s currency fixing change. Chart 10: Are China s FX reserves adequate? 5000 International reserves in China IMF ARA reserve adequacy range 4000 (Bn USD) Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15 Source: Haver, IMF, Goldman Sachs Investment Research We expect RMB moves and capital outflows will stabilise. We have already seen capital outflows stabilise in September-October 2015 and following the Chinese New Year this year. 17

20 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Despite widespread concern from commentators, the RMB has actually been stable within a range against the relevant currency basket since August This policy of maintaining above average FX reserves is likely to shore up market confidence that the central government s policy decisions will ease further capital outflows. Further RMB-USD movements will be driven more by US dollar strength rather than RMB weakness, as shown in chart 11, below. Chart 11: CNY NEER Index, Dec 31, 2014= Aug CNY NEER INDEX Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15 Jul 15 Aug 15 Sep 15 Oct 15 Nov 15 Dec 15 Jan 16 Feb 16 Source: Bloomberg The question whether to short the RMB in the longer term does have merit. In our view, China is becoming less competitive and capital will continue to flow out of the country, albeit at a slower pace, seeking higher returns elsewhere. The truth is, for China to stabilise growth it must prioritise domestic liquidity and interest rate policy first. The key message from policymakers is that they declared they would defend the RMB at all costs. Shorting the RMB in offshore markets is risky and perilous given China has significant buying power and can stabilise the currency easily, meaning the banks can squeeze the speculator in a heart-beat. Investors need to understand the market dynamics and policy stance point to currency stability rather than one-off depreciation. 18 THE TRUTH IS, FOR CHINA TO STABILISE GROWTH IT MUST PRIORITISE DOMESTIC LIQUIDITY AND INTEREST RATE POLICY FIRST.

21 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Capital outflows The PBOC does not publish its capital outflows, so we are monitoring capital movements closely from a number of sources. Capital outflow greatly limits which policy tools the PBOC can use, and how. This includes whether the PBOC can cut official interest rates, which usually puts downward pressure on the country s currency, which in turn encourages more capital to be sent offshore. The apparent (and potentially alarming) volume of capital outflows from China in recent times may be why the PBOC has adopted new, unconventional policy tools to boost liquidity, ease the debt burden of governments and Chinese banks, and help shore up growth. We have completed a significant analysis on the Balance of Payments (BOP) and from that, estimate that USD 620bn of capital flowed out of China in We have attempted to cross reference our analysis with data from the State Administration of Foreign Exchange (SAFE), which uses banks FX settlement and FX reserves data; illustrated below. Table 4: Capital outflows (USD bn) SAFE FX Settlement SAFE: adjusted for forwards SAFE: Total adj outflows (#1+#2) PBOC reserve (change) Position for FX purchase of PBOC (change) Position for FX purchase of whole banking system Jan Feb Mar Apr May Jun July Aug Sep Oct Nov Dec TOTAL Source: SAFE, PBOC, Goldman Sachs Global Investment Research Verifying the accuracy of data in China is always a tiresome task, but the greater the detail, the more you realise the focus isn t just about the final figures, but the change. For example, we noticed the error and omission account in the BOP rose to USD 162bn in 1-3Q15, which accounts for 37 per cent of total capital flows. How can investors have confidence in the figures they read coming out of China when they discover a USD 162bn error? 19

22 QUANTIFYING THE TRUE FINANCIAL SECTOR RISKS AND SOLUTIONS Table 5: Estimated capital outflows in 2015 Capital flows (-ve means outflows, USD bn) 1H15 3Q15 1-3Q15 1-3Q15 (% of total flows) Domestic banks and corporate liabilities adjustment % Foreign entities withdraw money from China banks % Domestic entities pay down foreign debt % Domestic resident s foreign deposits and lending/claims % Domestic entities increase deposits in overseas banks % Domestic entities increase lending to foreign entities % Securities investment (equities and bonds) % Net direct investment % Others (error and omission) % Total % Source: State Administration of Foreign Exchange The PBOC wants to stabilise capital flows. To do this, its first tool is to communicate that all is under control. As part of that they will also attempt to stabilise currency expectations and possibly trip up negative speculators. In February, PBOC Governor Zhou Xiaochuan declared that recent levels of capital outflow was not indicative of capital flight, while the central bank has simultaneously been fixing the official RMB rate against the USD at an ever increasing pace this year. Behind the scenes, the PBOC would be tightening controls on capital outflows, as per the table below. When capital moves offshore, the central bank s FX reserves are reduced, while its RMB stores increase. So what are they doing with all the additional RMB in the system? If you think back to chart 1, it will all begin to make sense: were it not for the capital outflows, the PBOC would have had to print enormous amounts of money to support its PSL to debt ridden banks, and its other policy tools. Table 6: Examples of recent capital control measures Examples of recent capital control measures Sep 2015 Sep 2015 Dec 2016 Dec 2015 Jan 2016 Sep 2015 till now April 2015 till now PBOC announced that onshore RMB derivative transactions (including forwards) would be subject to 20% reserve requirement. PBOC set a limit (2016 full year 100 thousands RMB, Oct to Dec thousands RMB) to union pay overseas withdrawal. Media reported that SAFE had suspended RQDII (which allowed onshore investment in offshore RMB-denominated financial products). SAFE tightened restrictions on payment/receipt with FX bank notes. Media reported that household conversion of RMB to FX (quota at $50k/year) was rationed; but SAFE clarified there was not any tightening. PBOC applied standard reserve requirement ratios to CNH deposits placed onshore (previously the ratio was set at zero). CNH-CNY spot exchange rate interest rate spreads remain generally wide, reflecting tighter restrictions on cross-border RMB flows. Skynet campaign to catch corrupted officials, and also crack down underground channels for moving capital offshore. There are likely more measures but not announced/confirmed. 20