China Economic Outlook, October 28, 2015

China Economic OutlookBilal Hasanjee, CFA®, MBA, MScFinance

October 28th, 2015

Disclaimer

NOTICE & DISCLAIMER: This publication has been prepared for informational purposesonly. Opinions, estimates and projections contained herein are my own and alsoextracted from third party sources and as of the date hereof and are subject to changewithout notice. The information and opinions contained herein have been compiled orarrived at from sources believed reliable, but no representation or warranty, express orimplied, is made as to their accuracy or completeness and neither the information northe forecast shall be taken as a representation for which the author or his employer incurany responsibility. The author does not accept any liability whatsoever for any lossarising from any use of this information. This publication is not, and is not intended to beconstructed as, an offer to sell or solicitation of any offer to buy any financial instrumentreferred to herein, nor shall this publication be construed as an opinion as to whether youshould enter into financial transaction or trading strategy involving any financialinstrument.

China Economic Outlook

China Economic Outlook China’s third quarter real GDP growth of 6.9% year-over-year

(yoy) was weaker than last quarter, as growth from the tertiary(services) industry was unable to offset weakness in thesecondary (manufacturing) industry

Stable labor market conditions and rising household incomeshould lift consumption in the short-term, but further fiscal andmonetary policies are much needed as disinflationary pressureintensifies in China

Investors need to accept lower economic growth as the “newnormal” for China as the economy continues to rebalance awayfrom the manufacturing sector and into the service-orientedsector

In China, there is concern about the possibility of a sharpslowdown in economic growth amid falling property prices andslower growth in investment spending

Recent PBOC Moves

Effective October 24th, PBOC cut the benchmark 1-year lending and deposit rates by25bp, and RRR by 50bp

There is also an extra cut for certain institutions, which in total will mean the measureslikely release RMB600-700bn of liquidity

In addition, the formal deposit rate ceiling will be abolished

These moves come after clear signs of weakness in theeconomy in recent months. Amid continued capitaloutflow and falling CPI inflation, these cuts may bewere necessary to avert a tightening of financialconditions and recessionary pressures

The elimination of the deposit rate ceiling is a majorstep in interest rate deregulation. From a messagingperspective, it sends a clear signal that that economicand financial reforms are not being halted despitemarket volatility in recent months

Goldman Sachs (GS) recent research suggestsexpectation of further policy easing before year-end(one more 50 bp RRR cut) to offset the impact ofongoing capital outflows

Recent PBOC Moves

According to GS research, other policy tools, especiallyfiscal and quasi-fiscal policies, will also be used. Theonly policy move not likely to be used in the near termis further currency depreciation

GS research expects the Chinese economy will showmodest sequential recovery in 4Q, helped by

(1) the policy loosening,

(2) dissipation of negative effects from the shutdowns and

(3) stabilization in equity market and FX flows.

Key monthly economic indicators should showevidence of this in the next 1-2 months

Recent PBOC Moves

Key Misplaced Market Fears about China

Chinese economy is in deep trouble

Emerging markets are susceptible to a full blown financial crisis- reminiscent of 1997currency crisis

Factors that Assuage Misplaced Fears

Chinese Economy in Deep Trouble?

Real Estate Market

Chinese real estate market is far more important to the economy than the stockmarket. Real estate contributes 25% to the GDP

Also, Chinese banking system is far more leveraged on the real estate than on thestocks

Residential assets and land constitute the majority of bank loans collateral

Last quarter both prices and volumes of real estate transactions have shown healthytrends

Real Estate Market

On the downside, though, it’s unlikely that this rebound will result in a wideconstruction boom

Chinese developers still face the a pile of unsold properties, a haunting legacy ofrecent years

However, stabilization of prices mitigates the risk of a real estate crash – which couldbe a serious systemic risk to the Chinese economy

The Stock Market

The market is still relatively small compared to more developed bourses. Its tradingvalue accounts for less than 33% of GDP against over 100% in developed economies

Stock market performance does not necessarily reflect the economic fundamentals incase of China

When share prices tripled in 2015 up to June, it did not show an extraordinary economicperformance

Nor did the recent collapse in stock market show a sudden weakening of the economy

The Stock Market

Less than 1/5th of Chinese wealth is invested in stocks

Stock market boom contributed little to the consumption and its bust will unlikelyhave a significant negative effect on consumption

Yes, speculators incurred large amounts of debt to speculate in the stocks, however,stock-based lending constitutes less than 1% of total bank lending asset base

So, stocks-based margin lending will create bad debts on banks’ balance sheet but willhardly create a systemic risk

Growing Incomes and Consumption

China is undergoing a structural change

It’s being transformed from an export oriented economy to a consumer and servicesoriented economy

It’s services sector, incomes and whole sale and retail consumption has seen healthytrends

Fiscal & Monetary Flexibility

In a worst case scenario, the Peoples’ Bank of China can afford far more monetaryflexibility than its Western counterparts

After a cut in interest rates last week, the one year discount rate still stands at 4.35%(vs 0.25% in the US and 0.05% in the EU)

Chinese government has shown prudent fiscal management by turning out a surplusYTD 2015 against a planned budget deficit of 2.3% of GDP

This means PBOC and the Chinese government has solid arsenal in its chest to fight offrecessionary pressures

Factors to Alleviate Misplaced Fears

Re-run of Emerging Markets Crisis (1997-98)Real or Misplaced Fear?

Emerging Markets

Fears of repeat of 1997-98 emerging markets (EM) crisis are over played

Although, Fed rate increase imminent in near future can cause flight of capital awayfrom EM, but the hard lessons of 1997-98 were well-learned

Many EM currencies are now free float rather than a fixed peg

Most Asian EMs now boast healthy FX reserves and current account surpluses

Their central banks, fiscal managers and the banking system are now far less relianton international creditors

The Real Fears“Trickle-down-effect” of Chinese slow-down

Emerging Markets’ Slow-Down

China has been importing from emerging markets like Brazil, Indonesia, Zambia,Russia and MENA for its coal, iron ore, copper and energy

Chinese demand will now be more driven by its services sector and will be supplied todomestically

Over supply of oil is as much due to extra output of Saudi Arabia and the resilience ofUS shale producers, as it is to reduced Chinese demand

Emerging Markets’ Slow-Down

Downward spiral in EM currencies is weighing on the EM firms with local currencyrevenues and dollar denominated debts

Fundamentally speaking, EMs have been slowing down since 2010

Whilst earning bumper GNPs on the back of Chinese and EM boom, countries likeBrazil, India and Russia lost the golden opportunity to enhance productivity(production efficiencies) in the economy

The Real FearsThe Developed Economies

Developed Economies

US exports to China constitute less than 1% of GDP. However, its stock markets arehardly invulnerable to EM stock markets

Germany , the largest EU economy exports more to China than any other EU state

Share prices in the developed economies are vulnerable to jitters in EMs and speciallyChina because:

The largest developed economies’ companies are global

Of total sales of S&P500 companies, nearly 50% were international

The US Dollar is rising against the trading partner currencies

The stock-markets in developed economies have enjoyed a bull-run since 2009 and PEratios far exceed their long-term averages

The Real FearsThe US Stock Market and its Monetary and Fiscal Inflexibility

The US Stock Market and its Monetary and Fiscal Inflexibility

The US PE ratios are well above their long-term averages

And mean reversion of stock price multiples is an established empirical fact

If a severe fall in stock markets happens, we have seen in past weeks how vulnerablethe Fed and the EU Central bank were in terms of monetary policy tools

Fed’s ability to cut rates is at all-time low, whilst US government deficit is at all-timehigh!

Hence US’s ability to fight a recession through monetary or fiscal policies is verylimited

Conclusion

Conclusion

Key drivers of global economic developments for the next 6 months:

Drop in commodity prices

Weakness in emerging market growth

Appreciation of the US dollar

US Growth

Euro Zone Problems

EMEs and DEs are projected to slow for the fifth year in a row!

4 Key risks to the Canadian Economy:

Correction in house prices

Sharp increase in long term interest rates

Stress emanating from China and EMEs

Financial Stress from Euro area

Conclusion

US productivity growth and consumer spending are key engines to the globaleconomic growth

US higher interest rate cycle is asynchronous to most of the developed economies(except UK) and may force them to move in tandem

China’s PBOC has plenty of fiscal and monetary flexibility to fight off any recessionarytail winds