Q For professional and institutional investors only. The asset manager for a changing world

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1 EXPERT EYE ON CHINA Q For professional and institutional investors only The asset manager for a changing world

2 2 EXPERT EYE ON CHINA - Q1 2016

3 EXPERT EYE ON CHINA - Q CONTENT IN RETROSPECT: EXTREME VOLATILITY IN THE STOCK MARKET; A BULL-RUN FOR BONDS CHINA S NEW ECONOMY IS UNDER-APPRECIATED BOND OUTLOOK: THE ONE-INCH PUNCH WATCH FOR THE INCH TO AVOID THE PUNCH CHINESE EQUITIES 2016 OUTLOOK: EXPECT ANOTHER BUMPY YEAR, BUT THERE ARE SILVER LININGS TO RM-BE OR NOT TO RM-BE: THAT IS THE QUESTION FOR 2016 MSCI CHINA INDEX: AN UPGRADE PROXY OF CHINA S NEW ECONOMY ACCESS TO THE INTERBANK MARKET: HOW WILL THE NEWLY EASED REGULATIONS BENEFIT OFFICIAL INSTITUTIONS? Bloomberg is the source for all data, as of end December 2015 In partnership with

4 4 EXPERT EYE ON CHINA - Q IN RETROSPECT EXTREME VOLATILITY IN THE STOCK MARKET; A BULL-RUN FOR BONDS 2015 was a roller-coaster ride for the Chinese equity market. Fuelled by the government s monetary easing policies and high levels of borrowing, the Shanghai Composite Index soared by about 60% from January 2015 to 5178 on 12 June After multiple regulations on margin financing, investors had to sell off their exposure. This had a roll-on effect and led to an overall bear market. The Shanghai Composite nose-dived by more than 30% in just three weeks and continued to plunge in the third quarter before rallying towards the year end when the government cut interest rates. The recovery, however, was lopsided. Property developers share prices soared in December as money from insurance companies poured in. Most state-owned blue-chip companies, including banks and large industrial companies, also found strong support and benefited from the recovery, while many others lost ground. Overall the A-shares market finished up by 5.58% YoY in CNY terms. Overseas Chinese stocks (represented by the MSCI China index) were much less volatile than A-shares and rose by 0.9% in USD terms over the year. The MSCI China benefited from the inclusion of American Depositary Receipts (shares of foreign stocks owned and issued by US banks), which means that more emerging economy stocks are now included within the Index. The Chinese bond market, in contrast, had a bull-run in 2015 due to slower economic growth and a rapid increase in money supply after several interest rate cuts and reserve ratio requirement cuts by the People s Bank of China. Moreover, the A-share market crash in June along with the suspension of IPOs in July prompted stock investors to channel their money into the less volatile bond market. Government bond prices were flat in the first half of 2015, but rose significantly in the second half of the year. Credit bonds performed well throughout the year as credit spreads approached historical lows despite increased credit risk. The Chinese economy was mixed in 2015 but reforms momentum is increasing for this third year of the current Chinese leadership. We believe GDP growth for 2015 will be close to or below 7%. Official PMI readings were weak (below 50) from August to December, indicating softening manufacturing activities. CPI inflation remained low and PPI was falling. The bright spot in the macroeconomic picture was domestic consumption. We believe retail sales probably rose by more than 10% year-on-year, with a spectacular surge of 30% in online retail sales. In addition, the service sector contributed more to China s GDP than agriculture and manufacturing combined. This is a clear sign that the economy is shifting toward emerging industries and away from traditional ones, e.g. cement, building materials and iron and steel manufacturing. It is therefore perfectly normal that China should go through some growing pains as it progresses towards more sustainable growth in the future. Looking ahead, we expect the government to continue its efforts to transform the economy by launching supplyside reforms. If such reforms prove successful, resources will be more efficiently allocated, residents and enterprises will have more money to spend, and aggregate demand should pick up as a In 2016, do you expect the volatility in equities and a bull-run for bonds in the Chinese market to continue? us your views now.

5 EXPERT EYE ON CHINA - Q CHINA S NEW ECONOMY IS UNDER-APPRECIATED While the official Chinese government line is that China s economy is growing at 7% a year, major macroeconomic indicators including those of industrial output, electricity consumption and freight traffic are only growing at 3%-4% (Chart 1), and output of industrial materials such as steel and cement is actually contracting. This apparent discrepancy is leading critics to argue that China s true GDP growth rate is lower than it is claimed to be. Chart 1: Major macro indicators growing well below offical GDP growth rate* Industrial output Electricity consumption Freight trafic volume reported GDP growth rate 7% %YoY Jan-05 Jul-06 Jan-08 Jul-09 Jan-11 Jul-12 Jan-14 Jul * 3-mth moving avg Sources: CEIC, BNPP IP (Asia), December 2015 The irony is that such sceptics are failing to recognise the changes underpinning the structural rebalancing of the Chinese economy. The traditional major economic indicators do not capture these changes, so when one only focuses on the old China economy, which has entered a structural decline, the traditional data paints a dire economic picture. The previous China economy relied on exports and industrial expansion, and it has suffered an economic hard landing due to structural rebalancing towards a new economy based on services and household consumption. This can be seen in the fast-growing tertiary sector, which overtook the secondary sector in Meanwhile, industrialisation has been migrating westward (Chart 2), suggesting a redistribution of growth from the rich east to the poor central and west regions. The same migration also implies a division of labour between the wealthy but more costly eastern part of the country focusing on higher value-added tertiary production and the less-developed and cheaper inland provinces taking over manufacturing and industrial production. This rebalancing process should support an overall medium-term GDP growth rate much higher than 3%-4%.

6 6 EXPERT EYE ON CHINA - Q Chart 2: Industrialisation migrating inland* share of secondary industry in local GDP 60% 55% 50% 45% 40% 35% 30% 25% 1982 Deepening industralisation in the inland provinces provides an inherent growth momentum * represented by Henan, Sichuan, Chongqing, Hunan, Jiangxi Sources: CEIC, BNPP IP (Asia), December 2015 Evidence shows that the new economy has been growing briskly. For example, railway passenger traffic (related to booming domestic tourism and personal travel) has been growing at double-digit rates, compared to a steady decline in the growth of railway freight traffic related to the old economy of transporting industrial goods and materials. New forms of consumption, such as online shopping, banking, booking for journeys and moviegoing, has been rising at more than 30% a year (Chart 3). These new spending activities are not included in the traditional official retail sales data. However, the strength of the new economy has, so far, not been sufficient to offset the contraction in the old economy. The shift from heavy industry to consumption implies less output per worker and less control from the central government towards boosting output. Meanwhile, the urgent need to improve China s air and water quality will impede growth. In addition, the ongoing anti-corruption campaign will continue to delay decision-making and inhibit aggregate spending. Chart 3: Online sales growth shopping banking booking for journeys Movie box-office revenues %YoY Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Sources: CEIC, BNPP IP (Asia), December 2015

7 EXPERT EYE ON CHINA - Q China s working population has also started to contract. The recent relaxation of the one-child policy to allow two children per couple will not guarantee a boost in the labour force, as it depends on how many Chinese couples want two children. In principle, the effective labour force can still in the meantime be increased by moving workers from rural to urban areas. However, to facilitate urbanisation, Beijing needs to dismantle the migration barriers imposed by the household registration, or hukou, system, and to implement land reform to allow farmers to sell their land rights at fair market prices and thus enable and incentivise them to move to the cities. But these are deep-rooted changes that will take a long time to implement. China also has to deal with a variety of other macroeconomic problems, including excess capacity, local government debt and bad bank loans. Fortunately, the authorities have recognised these problems and have started to deal with them. In a nutshell, China s economy will not grow as strongly in the future as it has done in recent decades, but neither will it slow to 3%-4% any time soon, in our view. The medium-term growth rate will likely be around 6%-7% a year and the structural rebalancing process will deliver a new growth model of rising consumer spending. Are you of the view that China s medium-term growth rate will be around the range of 6-7%? us your thoughts

8 8 EXPERT EYE ON CHINA - Q BOND OUTLOOK: THE ONE-INCH PUNCH: WATCH FOR THE INCH TO AVOID THE PUNCH Just as kung-fu is an art, so predicting the bond market for 2016 starts to be one, too. In kung-fu the one-inch punch can be severe when mastered, as it involves being able to strike hard from only one inch away when fighting close to the opponent. For investors in Chinese bonds, we believe that watching out for the inch to avoid the punch will be critical in FIRST ROUND: WIN WITH MONETARY EASING Chinese growth continues to slow and as we expect further downward pressure on inflation, renminbi bonds aren t likely to be supported by economic fundamentals in 2016, but rather by further monetary easing. We expect additional monetary policy moves, especially through reserve requirement ratio cuts, to facilitate liquidity injection into the economy. The People s Bank of China (PBoC) has already cut the interest rate six times since November 2014, and real interest rates have not fallen much since then. Nominal and real rates in China: Lending rates still at more than 10% on the back of PPI deflation % 16 1 Yr Nominal Deposit Rate 1 Yr Nominal Lending Rate 14 1 Yr Real Deposit Rate 1 Yr Real Lending Rate Jan-00 Jul-02 Jan-05 Jul-07 Jan-10 Jul-12 Jan-15 Source: Bloomberg, 30 December 2015 In particular, money-market interest rates may move downward to reduce real interest rates, and this downward movement would create room for the yield curve to decline. SECOND ROUND: AVOID THE ONE-INCH PUNCH, INVEST IN THE BRUCE LEES OF THIS WORLD There have been about 10 cases of defaults in China over We believe these have not yet impacted on credit spreads, which have stayed more or less flat across the year. In fact, credit spreads for AA rated corporate bonds actually hit their lowest level in November. In 2016, we expect the Chinese bond market to see more defaults and spread to adjust.

9 EXPERT EYE ON CHINA - Q Corporate bonds spreads (in basis points) at their lowest historical levels (local ratings 5 years) Corporate AA Corporate AAA Spreads at their lowest historical level despite further default 0 06/01/09 06/01/10 06/01/11 06/01/12 06/01/13 06/01/14 06/01/15 Source: Wind, onshore Chinese credit rating agencies, 30 December 2015 The PBoC s monetary easing has triggered a hunt for yield in onshore China, which is not used to a low yield environment, and we believe as a result that corporate spreads have not properly priced in the embedded risk. Looking ahead, a strong priority for the government is to implement supply-side measures to combat overcapacity issues. The government s willingness to pursue this was reaffirmed during the Central Economic Work Conference, the annual meeting held in December to set the objectives for China s economy. This will likely force further defaults, which in turn implies more volatility in spreads for lower quality bonds. Corporate leverage has increased, especially for lower quality bonds. For AAA-rated bonds, we are seeing the opposite trend, with increasing cash positions and greater reimbursement of short-term debt. As a result, we believe that as 2016 progresses, we will see even more differentiation in quality and spreads. To achieve a stable return, we believe investors should concentrate on what we call Bruce Lees, meaning government-backed bonds, or bonds issued by high quality state-owned enterprises. These should continue to see further gains throughout the year, backed by sound financials. On average they are currently yielding between 3% and 4% on 3-year maturities. Policy bank bonds should be favoured, in our view, and their issuance should increase since policy banks are a major financing tool for Beijing in the implementation of the One Belt-One road policy.

10 10 EXPERT EYE ON CHINA - Q THE SHOW MUST GO ON? INCREASING ISSUANCE IN 2016, TO BE MET BY FURTHER DEMAND Bond issuance has risen sharply in 2015 and, given low corporate spreads, this has worried investors. What the market has misunderstood in our view is the fact that the issuance has been mostly of local government bonds, not corporate bonds, due to the implementation of the local government bond swap. Treasury issuance has also expanded. We believe the government clearly wants to limit further leverage in the corporate world. Gross issuance (in renminbi, billions): the major increase in issuance has been in local government bonds Local Government Bonds Corporate Bond Enterprise Bond Financial Bonds Treasury Bills Source: Wind, 30 December 2015 We expect bond supply to at least meet, if not exceed, the government s target for As to local government debt, we estimate that total 2016 gross issuance will come in at around RMB 3.5 trillion. We assume all local government direct debt maturing in 2016 (around RMB trillion) will be swapped into local government bonds. The spread between Treasury and AAA-rated bonds should remain quite stable or even continue to fall on the back of healthy demand for such high quality assets. This is likely to be further supported by rising demand from foreign investors who especially given the recently relaxed regulations and the impending inclusion of the renminbi in the IMF s Special Drawing Rights (see article on page 20) should in our view consider investing in Treasury and policy bank bonds as well as in high quality AAA-rated bonds. In 2016, would you consider increasing your exposure to bonds? Why? Share your thoughts now.

11 EXPERT EYE ON CHINA - Q CHINESE EQUITIES 2016 OUTLOOK: EXPECT ANOTHER BUMPY YEAR, BUT THERE ARE SILVER LININGS 2015 turned out to be a roller-coaster year for China equity investors, so it is understandable that some investors may question whether they should remain on the side lines in While market volatility may likely persist over the near term, we believe the volatility provides opportunities for fundamentally-focused investors to pick up good companies at more attractive valuations. Market Outlook from BNP Paribas Investment Partners, Greater China Equity Team Faced with moderating external demand in recent years, China has been forced to address the challenging task of rebalancing the economy by bringing forward reforms to upgrade China s value chain to promote more sustainable growth. To this end, reform was a key theme in 2015, and we expect it to remain a priority for the Chinese government in China s grand plan over the long term is to unlock new sources of growth by fostering innovation and technology, upgrading its manufacturing base, deregulating more service sectors to promote competition, and increasing investment in public goods and services to secure social harmony (and thus political stability). As a result, the country s future growth engine will be powered to a greater degree by consumption and services industries. We saw the start of this trend in recent years reflected in the rising contribution of the tertiary sector to overall GDP. China: nominal GDP share by industry 60% 50% 40% 30% Secondary industry Tertiary industry 51% 41% 20% Primary industry 10% 0% Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 8% Source: Wind, Goldman Sachs research, December 2015 Within the past year, reforms have mostly focused on modernising the fiscal system and financial market deregulation. Milestones included the introduction of the local government debt-swap programme and deposit insurance scheme; the launch of Shanghai-Hong Kong Stock Connect; interest rate liberalisation; the expansion of the Free Trade Zones; and the opening up of the domestic interbank market. These reforms undoubtedly helped to secure the renminbi s position within the International Monetary Fund s Special Drawing Rights basket, making it one of only five world currencies to hold a reserve currency status.

12 12 EXPERT EYE ON CHINA - Q The process of reforming inefficient state-owned enterprises (SOEs) continued to progress throughout last year. In 2016, the government is hinting they will direct focus towards supplyside structural reforms targeting zombie companies in energy-intensive and overcapacity industries. While implementation will certainly be challenging as they will have to strike the right balance between taking loss-making companies off life-support while at the same time keeping employment stable for the general population. Over the long run, this is a necessary measure to facilitate more effective allocation of capital to industries offering growth longevity. Beijing is also set to implement demand-side structural reforms to counter slowing GDP growth during this transition period. These could include accelerating growth-supportive reforms such as the deregulation of previously protected services sectors to boost domestic consumption, as well as ramping up public services such as health care and education. At the recent Economic Work Conference, the government emphasised the need to support the property sector to mitigate a hard-landing risk to the economy. The measures here could include accelerating the reform of the hukou system of household registration to encourage urbanisation, as well as social benefits such as subsidised housing allocations for migrant workers. The removal of home purchase restrictions across more cities could also boost property demand and reduce property inventories, which should eventually draw in more investment in the coming years. Tangible results from reforms typically take time to be fully realised. Meanwhile, we expect the government to continue funding infrastructure projects to counter the economic slowdown, particularly in areas such as hospitals, schools, sewage systems and other environmentalrelated projects. The One Belt One Road initiative should also help address China s industrial overcapacity and improve relations (as well as raise its political influence) with its trading neighbours. The People s Bank of China will likely continue loosening credit conditions until macroeconomic conditions improve. We remain cautiously optimistic that China will experience a cyclical recovery in 2016 if the property sector continues to improve, aided by expansionary fiscal and monetary policies. In terms of global asset allocation, H-shares offer good value. In light of recent market events, we are also seeing more opportunities in some onshore-listed names. The MSCI China index is trading below 8x price to earnings multiple (based on Fiscal Year 2016 consensus earnings estimates as of 15 January 2016), well below its 5-year historical average of 10.2x. Our portfolio s core positions are concentrated in stocks that offer sustainable top-line earnings growth and positive cash flow. In the coming weeks, we will start to have a closer look at some of the deep-valued cyclical names which may be potential beneficiaries of supply-side reforms. Preferred sectors for H include: select health care and consumer discretionary (skewed towards the automobile sector), insurance, property, and technology. Underweight sectors include: energy, utilities, materials / mining, banks, and select consumer staples (underweight retailers and department stores). KEY TAIL RISKS: Armed with USD 3.3 trillion foreign exchange reserves (as of 31 December 2015), we believe China still has sufficient fiscal capacity to keep systemic risk under control. Even though China will allow for greater volatility of the RMB exchange rate (especially versus the USD depending on the pace of the US rate hike cycle), we don t believe China will allow for a large devaluation of the traded weighted exchange rate as this would pose capital flight risk that would far outweigh the benefits of a cheapened currency. Over the medium and long term, we believe the RMB will be more closely linked to the trade-weighted basket of currencies and China s overall economic health. Deflation pressure is another tail risk if commodity prices and China s overcapacity industries continue to push asset prices lower. These two factors have contributed to the global deflationary trend in recent years, and could exert further pressure if China faces a more substantial economic slowdown.

13 [ EXPERT EYE ON CHINA - Q A-shares Market Outlook from HFT Investment Management A-SHARES: AT A CROSSROADS After the volatility they saw in 2015, we believe China A-shares are at a crossroads between stability and continuing volatility, which for us is synonymous with freer access for foreign investors coupled with the inclusion of A-shares in global indices. CSI 300 Index level: two possible roads for [ 2016 OUTLOOK the free Source: Bloomberg, December 2015 but bumpy road the stable road ROAD 1: FOR THE STABLE ROAD, PICK QUALITY AND GROWTH We believe A-shares will benefit from the government s objective of economic stability. The official GDP growth target is set at 6.8%. We do not expect further fiscal easing as long as employment remains stable. In our view, monetary easing will be the main driver of stock market performance. The main goal for the government is now to improve how money flows into the real economy and we think reserve requirement rate (RRR) cuts will be key to this, as well as the continuing transformation of the IPO system. The implementation of a registration-based system will definitely help to position demand in front of supply. Stability is key in implementing reforms, so we will probably continue to see measures to support pensions and help longterm investors maintain their stock holdings. On the corporate front, we expect earnings growth for the non-financial sectors to remain in high single-digit territory and at about 5% for financials. In this context, investors need to be selective. Specific companies, for example those exposed to Industrial Revolution 4.0 (automation, manufacturing technologies) or new energy vehicles manufacturers, will continue to see earnings growth of more than 20%, in our view. Media, entertainment and tourism continue to grow and are our best long-term picks. As an example, we are seeing improved profitability and growth in the movie industry. Movie box-office annual growth is at about 40%. Chinese people watch on average 0.45 movies at a cinema per year. This compares to 3.88 films in the US, 4.12 in South Korea and 3.44 in France, so there remains much potential growth. Overall, we still expect positive returns for investors, but definitely less volatility compared to last year. ROAD 2: THE FREE (BUT POTENTIALLY BUMPY) ROAD The key event that might lead us to change this scenario of stability is the potential inclusion of A-shares into MSCI, which will be reviewed in June After the Shanghai-Hong Kong Stock Connect went live at the end of 2014, the Shenzhen- Hong-Kong stock connect is set to be launched in This will make all of the market accessible to foreign investors: a free road to China, which is likely to trigger the inclusion of A-shares in global indices. As an example, as at November 2015, USD 34 trillion are benchmarked to the MSCI Emerging Markets index, which means that if there is a partial inclusion of A-shares with a 5% free-float adjuster factor, USD 451 billion might have to rebalance toward A-shares. Opening the market up will likely lead to volatility and the situation could change rapidly, but over the long term it should benefit investors, in our view. Do you think China will have a better year in 2016 than us your thoughts

14 14 EXPERT EYE ON CHINA - Q TO RM-BE OR NOT TO RM-BE? THAT IS THE QUESTION FOR : TO RM-BE FOR THE IMF BUT NOT TO RM-BE FOR INVESTORS 2015 was an eventful year in the internationalisation of the renminbi, with greater usage of the renminbi for trade and for wealth/reserve management purposes. Unfortunately, it did not pay off for investors, who became collateral damage resulting from the strong drive by the Chinese authorities to include the currency into the International Monetary Fund s (IMF) Special Drawing Rights (SDR) basket. Both onshore and offshore renminbi fell by 4.42% and 5.41%, respectively, over the year versus the US dollar. Still, the renminbi became the fifth most used currency for international payments in 2015, according to SWIFT, which indicates its rapidly increasing usage - it had been the seventh most used in 2014 and only the thirteenth in Aiming both for greater currency flexibility and for the renminbi s eligibility for the SDR basket, the People s Bank of China had to pursue further liberalisation and reform to establish the midpoint rate (the reference rate) determination mechanism. As this happened earlier than the market expected, it caused a sudden depreciation, contributing to most of the overall depreciation during the year. However, by further liberalising the currency market in September, for example, the authorities gave free access for official institutions to the foreign exchange market the likelihood of the renminbi s inclusion in the SDR basket rose, confounding the pessimistic consensus forecasts in early In late November, the IMF announced that the renminbi is to be included within the SDR basket in 2016 with a weight of more than 10%. IMF Managing Director Christine Lagarde said: [We recognise] the progress that the Chinese authorities have made in reforming China s monetary and financial systems. The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy. We recognise] the progress that the Chinese authorities have made in reforming China s monetary and financial systems. The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy. In December, the China Foreign Exchange Trade System (CFETS) started publishing a new trade-weighted exchange rate index (TWI) which measures the strength of the renminbi against a broader basket of 13 currencies (as shown in Table 1). Targeting the TWI is a way to allow more flexible renminbi movement by severing its tie with the US dollar and should in our view, definitely be helpful in 2016 and beyond. Table 1: The weight of each currency in the Trade-Weighted Index basket CURRENCY WEIGHT CURRENCY WEIGHT USD GBP 3.68 EUR MYR 4.67 JPY CAD 2.53 SGD 3.82 THB 3.33 RUB 4.36 HKD 6.55 AUD 6.27 CHF 1.52 NZD 0.65 Source: CFETS, December 2015

15 EXPERT EYE ON CHINA - Q RMB: 2015 major events for the RMB Dec.2014 Feb.2015 Apr.2015 Jun.2015 Aug.2015 Oct.2015 Dec USD/CNY Depreciation August: The People s Bank of China (PBOC) introduced a new daily fixing mechanism for USD/CNY exchange rate, resulting in the rate weakening by 2%. New daily fixing is based on the previous day s closing rate (vs moving average of 10 previous days before) in conjunction with supply/demand factors Source: Bloomberg, BNPP IP, January 2016 November: International Monetary Fund announced the inclusion of RMB into the SDR basket December: China Foreign Exchange Trade System started publishing a new trade-weighted exchange rate index (TWI) which measures the strength of the renminbi against a broader basket of 13 currencies Overall the year was eventful for the renminbi, and we are expecting the same in However, as investing purely in the currency did not pay off in 2015, the question remains for 2016: To RM-Be or not to RM-Be? 2016, OUR ANSWER TO THE DILEMMA: THE HIBERNATION OF RMB For 2016, we expect a potential depreciation. Short-term, we believe the RMB might continue to soften against the US dollar because the Chinese economy has not yet bottomed. Additionally, the RMB/USD cross rate will largely depend on federal fund rate movements. The prevailing expectation that the US Federal Reserve (the Fed) will make four rate hikes in 2016 might place more downward pressure on the Chinese currency. Nonetheless, Beijing is clearly seeking to stabilise its currency. Since August, the central bank has introduced measures designed to deflect attention from the RMB/USD rate, such as the launch of the TWI in December, and the extended onshore trading hours of the RMB starting in January When necessary, the central bank could also resort to direct market intervention. THE AFTER-LIFE OF THE RENMINBI Despite the possibility of China s currency weakening against the US dollar, we believe the renminbi will eventually stabilise over the long run. The launch of TWI is not a sign of major devaluation, although in our view, it is a risk. Targeting a stable TWI means when other currencies weaken against the US dollar, the renminbi would also weaken against it. In the same way, when the dollar weakens against other major currencies, the renminbi would strengthen against it. Moreover, the central bank has not declared that it would manage the renminbi strictly in accordance with the TWI. Presumably, its announcement of the TWI only suggests that a currency basket would be a crucial reference for the renminbi s movement. Investors will need to look across the whole TWI basket rather than just the narrow RMB/US dollar rate.

16 16 EXPERT EYE ON CHINA - Q Renminbi against the TWI basket of currencies, and versus the US dollar The renminbi was actually reasonably stable versus the basket of currencies during 2015 USD/CNY 09/01/ /01/ /01/ /01/ Depreciation USD/CNY Currency Bloomberg CFETS RMB index, based on TWI valuation (RHS) CFETS RMB Index based on the TWI valuation Source: Bloomberg, BNPP IP, January 2016 Another factor to consider is China s ongoing reform of its exchange rate regime. When Beijing eventually establishes a more market-oriented exchange rate mechanism to replace its current system, the renminbi exchange rate is likely to stabilise due to less uncertainty and regulatory risk. Most importantly, the long-term currency outlook ties back to the relative strength of economic fundamentals. In our view, the Chinese economy might regain its momentum as domestic consumption recovers, especially as demand for education, sports, and tourism picks up. In addition, Beijing still has some tools at its disposal to boost the economy. China could, for example, cut taxes to stimulate demand and introduce further supply-side and state-owned enterprise reforms to optimise resource allocation. The combined effect of such measures should help to support healthy economic growth. Last but not least, the renminbi will benefit from its inclusion in the IMF s SDR basket and its increased versatility as a result of China s efforts to establish the renminbi as a global currency. SO TO RM-BE-OR NOT TO RM-BE? The volatility of the renminbi remains low compared to that of A-shares, and the return offered by renminbi bonds. As a result, long-term renminbi-denominated asset holders should keep an eye on the currency s movements but more importantly focus on the broader factors that could influence their investment s performance. What is your mid-term and long-term view of the renminbi s movement? Share your thoughts now.

17 EXPERT EYE ON CHINA - Q MSCI CHINA INDEX: AN UPGRADED PROXY OF CHINA S NEW ECONOMY While well publicised last year ahead of the November 2015 MSCI index rebalancing schedule. what may be less understood by many investors is the implication of this significant event. especially for investors with exposure to Chinese equity funds. After the completion of the second phase of the index enhancement in May 2016, it is estimated that China s new economy sectors will comprise nearly 40% of the MSCI China index and be viewed by most as an improved proxy of China s future growth engine. In October last year, MSCI released the details of the November 2015 revisions, confirming the inclusion of 14 US-listed Chinese companies into the MSCI emerging market, regional and country indices. The index rebalancing will be implemented in two steps, with 50% of the freefloat market capitalisation of the new constituents added with effect from 1 December 2015 and the other half from 1 June As the 14 new entrants are all Chinese companies, the change will have the greatest impact on the MSCI China index. China was already the biggest country in MSCI Emerging Markets, with a 25% weight. The net effect of the inclusion will increase China s weight to around 29% by June The MSCI Asia Pacific ex-japan index will also see a China weight increase from 22% to roughly 26%. For the Asia regional index, the countries whose allocation in the index will be subject to the largest decline via the rebalancing are Australia, Taiwan and South Korea. Within MSCI China, the estimated index weight of the technology sector could more than double to over 28% from 14% after the second phase of rebalancing by 1 June Offsetting this, the financials, telecommunications services, industrials and energy sectors will see the biggest decline. Financials will fall from 40% to roughly one-third of the overall MSCI China weight. Chart: Pro-forma sector weight of MSCI China (%) Sector Before Rebalancing (1 November 2015) 1 June 2016 (full inclusion) Weight Increase / Decrease Technology 14% 28.4% 14.4% Cons. Discretionary 5% 7.6% 2.6% Health Care 2% 1.9% -0.1% Div. Financials 3% 2.6% -0.4% Real Estate 6% 5.3% -0.7% Utilities 4% 3.3% -0.7% Materials 2% 1.1% -0.9% Cons. Staples 4% 2.7% -1.3% Insurance 10% 8.2% -1.8% Energy 8% 6.0% -2.0% Industrials 9% 6.7% -2.3% Telecom 11% 8.4% -2.6% Banks 22% 17.6% -4.4% Source: MSCI, Datastream, Bloomberg, JP Morgan research, November & December 2015

18 18 EXPERT EYE ON CHINA - Q In essence, the index weight representing the new economy in the MSCI China index will be raised to around 40% by 1 June 2016 from its current composition of approximately 25% of the benchmark weight prior to the November 2015 rebalancing. The new index will have a higher component in the technology, insurance, health care, media, consumer, and diversified financials sectors. The enhanced MSCI China index will in our view offer a better representation of China s future growth engine when compared to the HSCEI index. For those seeking to capitalise on the areas in China offering sustainable growth potential, we would argue that passive instruments linked to the HSCEI index may likely disappoint, as nearly 75% of the HSCEI index constituents consist of old economy stocks mostly skewed towards financials and the primary industries whose growth is trending down. Chart: Upgraded MSCI China index: a better proxy for China s new economy 100% 80% 60% Index weight 77% 74% 60% 'New economy' 'Old economy' 40% 20% 0% 23% 26% 40% HSCEI MSCI China (before US ADR addition) MSCI China (after US ADR addition) Source: Bloomberg, BNPP IP, January 2016 As China progresses with its economic transformation from a frontier market just three decades ago to a more mature emerging market today, the evolution of growth drivers over time continues to morph. Challenged by rising domestic wages and moderating global external demand in recent years, China has been forced to address the tough task of rebalancing the economy by bringing forward reforms to upgrade its value chain and promote more sustainable growth drivers. As a result, the country s future growth engine will be powered to a greater degree by consumption and services areas, which is what the upgraded MSCI China index reflects.

19 EXPERT EYE ON CHINA - Q Evolution of MSCI China sector weights (%) Sector Year 2000 Year 2005 Year nov-15 Weight Increase/ Decrease (Nov 2015 vs Yr 2000) Banks 0.0% 8.9% 22.8% 22% 22% Insurance 0.0% 6.7% 8.7% 10% 10% Technology 6.4% 3.5% 5.4% 14% 8% Real Estate 0.3% 2.0% 5.6% 6% 6% Cons. Staples 0.4% 2.0% 5.2% 4% 4% Energy 4.4% 26.5% 18.1% 8% 4% Cons. Discretionary 1.9% 4.8% 5.5% 5% 3% Div. Financials 0.0% 0.2% 0.3% 3% 3% Utilities 2.1% 4.3% 1.8% 4% 2% Health Care 0.2% 0.1% 0.8% 2% 2% Materials 1.1% 4.7% 6.2% 2% 1% Industrials 21.7% 14.0% 8.4% 9% -13% Telecom 61.5% 22.3% 11.3% 11% -51% Source: MSCI, Datastream, Bloomberg, JP Morgan research, November & December 2015 For investors of Chinese equities, we view this index enhancement strategy as very positive. Does the new index composition influence any changes you will make to your asset allocation decision? Share your views now.

20 20 EXPERT EYE ON CHINA - Q ACCESS TO THE INTERBANK MARKET: HOW WILL THE NEWLY EASED REGULATIONS BENEFIT OFFICIAL INSTITUTIONS? As part of the progress made towards the renminbi being included within the International Monetary Fund s (IMF) Special Drawing Rights (SDR) basket, the People Bank of China (PBoC) has eased numerous regulations in order to open up the interbank bond market and foreign exchange market to foreign official institutions. The main improvements include easier market access, the removal of the quota system, simpler procedures, and more agents permitted to trade the onshore markets for foreign institutions. More than 145 official institutions (as end of June 2015) have quotas to access the interbank market. Thirty-eight central banks hold renminbi-denominated assets, representing about 1.1% of total official foreign currency assets. As the Chinese authorities accelerate the renminbi internationalisation process, we expect official institutions to make use of the new registration system to more easily invest in the Chinese interbank market in NO QUOTA The removal of quota restrictions is one of the important advances arising from the latest regulation changes, but it is on condition that relevant overseas institutional investors shall act as long-term investors. The PBoC highlighted that this requirement was not inconsistent with these institutions making short-term investments and adjusting their positions based on their liquidity management needs. The regulator confirmed there were no requirements on what maturities are held and no minimum holding amount as the targeted investors are already considered to be long-term investors. EASY AND FASTER APPLICATION PROCESS The notice highlights that there is just one two-page application form to complete and that this can be sent directly to the PBoC by the institution or by its representative agent. The PBoC is committing to a timeframe of ten working days by which the institution or its agent should receive an answer. As highlighted in the chart on page 22, after the application process, the agent or the institution should open accounts at China Central Depository & Clearing (CCDC), with Shanghai Clearing House (SHCH) and register with the China Foreign Exchange Trade System (CFETS). A notice released in mid-september highlights that these entities need to respond within three working days of the account opening form having been received. NEW INSTRUMENTS TO FACILITATE HEDGING Prior to the latest changes, bond instruments were those that were the most accessible to official institutions. Most central banks using the type-c quota were accessing sovereign and policy bank bonds (also called financials bonds). The new regulation directly addresses some central banks need to hedge in order to maintain a neutral exposure when investing in overseas assets. In addition, with the inclusion of the renminbi in the SDR effective from 1 October 2016, some central banks will have to hedge their SDR allocation. The IMF has highlighted the need to hedge with reasonable precision and without excessive costs so as to mitigate exchange-rate and interest-rate risks.

21 EXPERT EYE ON CHINA - Q The newly eased regulation responds to this need as it allows: Access to bond derivatives such as bond forwards, interest rate swaps or forward rate agreements Bond repurchase agreements Bond lending The regulation released in July did not include the hedging of foreign exchange, but the PBoC issued a further notice tackling the foreign exchange market in late September. ACCESS TO THE INTERBANK FOREIGN EXCHANGE MARKET The second notice released on 30 September authorised investments in FX spots, forwards, swaps and options. In this case again, there is no quota and a strong willingness to simplify the registration process. The application process is similar to the interbank-bond market application, but a new status has been introduced member of the China interbank FX market which facilitates members trading. Those choosing to directly participate in the inter-bank FX market as foreign members can start trading once CFETS connects them with the CFETS trading system. We believe these new regulations facilitate the easier allocation of official institutions renminbi-denominated assets. From October 2016, the renminbi will be included in the SDR with a weight of 10.92%, which is higher than foreign central bank ownership in Japanese Treasuries, and is thus set to change the landscape in terms of reserve assets management.

22 22 EXPERT EYE ON CHINA - Q Application process under the notice of the People s Bank of China (PBoC) on issues concerning investment by foreign central banks, international financial institutions and sovereign wealth funds with renminbi funds in the inter-bank market Foreign Central Banks International Financial Organ Sovereign Sovereign Wealth Funds STEP 1 STEP 2 Filing with PBoC Complete the Chinese Interbank Market Investment Registration Form and submit to PBoC via post or Agent Bank Entrust PBoC directly as settlement agency Entrust a qualified agency in the interbank bond market. An agreement between the offshore investor and its agent bank needs to be signed and filed with the PBoC Shanghai office if the agent bank is not the PBoC Open Special RMB Account STEP 3 STEP 4 CCDC Special RMB Account SHCH Indirect Settlement Member Account Bond Investment CFETS CFETS Settlement Account Source : PBoC, BNPP IP, 2015 Although these new regulations facilitate the easier allocation of official institutions renminbidenominated assets, do you think there are other factors holdings back these official institutions? Share your thoughts now.

23 EXPERT EYE ON CHINA - Q This material has been prepared by HFT Investment Management (HK) Limited and BNP Paribas Investment Partners Asia Limited* and is issued by BNP Paribas Investment Partners Singapore Limited ( BNPP IPS )** and BNP Paribas Investment Partners Asia Limited, members of BNP Paribas Investment Partners (BNPP IP)***. The content has not been reviewed by the Monetary Authority of Singapore ( MAS ) or the Hong Kong Securities and Futures Commission. In Australia this material is made available by BNP Paribas Investment Partners (Australia) Limited ABN , AFSC It is produced for general information only and does not constitute financial product advice. Opinions included in this material constitute the judgment of HFT Investment Management (HK) Limited and BNP Paribas Investment Partners Asia Limited or its relevant affiliate(s) at the time specified and may be subject to change without notice. BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited are not obliged to update or alter the information or opinions contained within this material. Such opinions are not to be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient and are not intended to provide the sole basis of evaluation of any strategy or instrument discussed herein. The contents of this material are based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Investments involve risks. Investments in emerging markets involve above-average risk. Given the economic and market risks, there can be no assurance that the Financial Instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instrument(s) may have a significant effect on the results portrayed in this material. Past performance is not a guide to future performance and the value of the investments in Financial Instrument(s) may go down as well as up. Investors may not get back the amount they originally invested. Any reference to past performance of any market or instrument should not be taken as an indication of future performance. Neither BNP Paribas Investment Partners Singapore Limited, BNP Paribas Investment Partners Asia Limited nor any BNP Paribas Group company accepts any liability whatsoever for any loss arising, whether direct or indirect, from the use of any part of such information. A BNP Paribas Group company may, to the extent permitted by law, have acted upon or used the information contained herein, or where relevant the research or analysis on which it was based, before its publication. This material is for the use of the intended recipients only and may not be delivered or transmitted to any other person without the prior written consent of BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited. Furthermore, any translation, adaptation or total or partial reproduction of this document, by any process whatsoever, in any country whatsoever, is prohibited unless BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited has given its prior written consent. * BNP Paribas Investment Partners Asia Limited, 30/F Three Exchange Square, 8 Connaught Place, Central, Hong Kong. ** BNP Paribas Investment Partners Singapore Limited, 10 Collyer Quay, #15-01 Ocean Financial Centre, Singapore *** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.

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