GavekalDragonomics. March The Long Hangover. China and the world after the commodity boom. Arthur Kroeber

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1 GavekalDragonomics March 2015 The Long Hangover China and the world after the commodity boom Arthur Kroeber

2 Part I: The global context The commodity boom is over Collapse of oil price is permanent: expect US$40-60 oil for the next several years Oil reflects the situation for all commodities: excess supply, and slowing marginal demand from China Growth leadership shifts to those who can make most effective use of low energy/technology costs QE baton passes from US to EU Sharp euro devaluation is basically deflationary; US-led re-inflation is still some years off We remain in a basically disinflationary environment GavekalDragonomics 2

3 The most important event of 2014: the oil price plunge GavekalDragonomics 3

4 The most important event of 2015 so far: the falling euro GavekalDragonomics 4

5 On average, the New Normal differs little from the Old Normal Global GDP is growing at close to its average. But the average disguises important compositional changes: Stagnation in EU/Japan is offset by stronger EM, whose share of global GDP is far larger than a decade ago EM growth, though, is much weaker than in the boom Unlike the shared growth of , EM growth is now skewed in favor of manufacturers and against commodity exporters GavekalDragonomics 5

6 Key conclusions The EM/DM dichotomy is of limited use. Instead, think of: Ø Oil consumers vs oil producers Ø Weak-euro beneficiaries and weak-euro victims Emerging Asia is in a strong position Ø Low currencies / low oil price Ø Strengthening US demand Ø Decent balance sheets (except China) Ø One downside: little prospect of strong export growth US is also well placed Ø Low energy / technology costs play to its strengths Ø Strong employment should feed into wages in months GavekalDragonomics 6

7 Major risks What to worry about Ø Europe stays stuck in a disinflationary, low-growth trap, much like Japan in the 1990s Ø Russia/Ukraine conflict goes out of control Ø Greek restructuring goes off the rails, and encourages more right-wing anti-euro political activism in Portugal, Spain, France and Italy. Ø Further QE/yen devaluation in Japan increases deflationary pressure in Asia, and especially in China Ø China fails to make its tricky transition to more sustainable, less leveraged growth, and hits a financial crisis or hard landing (sustained growth of <5%) GavekalDragonomics 7

8 Part II: How to think about China in 2015 and beyond Secular outlook Slower growth: the construction boom is over Leverage is a problem: significant financial stress but no crisis Rebalancing from capex/industry to consumption/services Policy outlook Structural reform is happening, but impact on growth in will be limited Rate cuts ahead but RMB will stay stable Short-term issues Growth will slow again in H1; low oil price doesn t help Anti-corruption drive is part and parcel of the reform agenda GavekalDragonomics 8

9 Growth is in secular decline GavekalDragonomics 9

10 With reforms, sustained growth of 6-8% is possible GavekalDragonomics 10

11 We are past peak housing and into a long-term decline GavekalDragonomics 11

12 Urbanization is not enough to support housing demand GavekalDragonomics 12

13 Housing will be a drag on growth for the next several years GavekalDragonomics 13

14 An expanding balance sheet means greater financial risk GavekalDragonomics 14

15 Debt is high in relative terms GavekalDragonomics 15

16 Growth slows when balance sheets stop expanding GavekalDragonomics 16

17 Why no crisis: bank loans finance the real economy, not property Most of China s bank loans fund corporations 24% Households 32% Manufacturing Transportation Wholesale & retail 18% Property development 6% 9% 10% Other nonmanufacturing People s Bank of China (2012 data) China s property exposure of 20-25% is low by world standards. In the US, about half of bank loans go to the property sector and in the UK the share is close to 70%. In Asia, the ratio is usually 30-40%. As in other predominantly bank-funded Asian economies, banks support a broad range of non-property related economic activity. GavekalDragonomics 17

18 Why no crisis: private sector leverage is still modest GavekalDragonomics 18

19 Structural change is already happening, slowly Services now is a larger share of GDP than industry, for the first time Heavy industry profits have flatlined since 2011 but consumer goods sectors are still going strong GavekalDragonomics 19

20 Reform must focus on shifting resources from state to private firms GavekalDragonomics 20

21 State sector returns just keep getting worse GavekalDragonomics 21

22 The big challenge is to accelerate the private sector s rise GavekalDragonomics 22

23 There is lots of room for deregulation in service sectors Transport, rail Transport, air Transport, road Healthcare Telecoms Education Utilities, electric Insurance Transport, pipelines Utilities, water Transport, water Finance Sports Construction Broadcasting Internet Utilities, gas Mining Postal services Leasing and business services All-industry average Software and IT Agriculture Entertainment Real estate Hotels and restaurants Wholesale and retail Manufacturing Private investment is still blocked in many service sectors Private-sector share of fixed-asset investment, by industry 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% GavekalDragonomics 23

24 While waiting for reforms to kick in, monetary policy must be eased GavekalDragonomics 24

25 Chinese lending costs are high by previous standards GavekalDragonomics 25

26 It is possible to ease without doing wasteful stimulus GavekalDragonomics 26

27 RMB devaluation is not a serious option The record capital account deficit in Q3 is nothing to worry about. For the first time, China is recycling its big current account surpluses through outbound private investment, rather than official reserve accumulation. RMB depreciation in early 2014 was engineered to stop capital inflows. Since June PBOC has kept the central fixing stable despite depreciation in the yen and won. We expect PBOC to maintain a stable RMB to keep current and capital accounts on an even keel. GavekalDragonomics 27

28 Terms of trade improve: devaluation unnecessary to sustain trade growth The trade surplus swelled in Q4 thanks to lower commodity prices. Export growth weakened a bit but we still see 5-10% trend export growth especially as the US recovery gains momentum. Price effects accounted for most of the trade surplus increase. Export prices are rising smartly, while import prices (reflecting commodities) weakened. GavekalDragonomics 28

29 Short-term outlook: weak commodity prices are initially BAD for profits GavekalDragonomics 29

30 Less profitable employers will give smaller wage hikes GavekalDragonomics 30

31 Concluding thoughts: reform agenda is credible Reform agenda has already seen good progress Ø Fiscal reform package to restructure local debts by 2016 Ø Abolition of pre-registration requirements for new businesses: private company formation up 45% in 2014! Ø Imposition of ad valorem coal resource tax on Dec 1 Ø Bigger floating band for deposit rates Ø Release of draft rules on deposit insurance Ø Release of rules for deregulation of pharmaceutical prices Ø Hukou reform to improve labor mobility Ø Shanghai-HK Connect stock linkage Ø Plans in most provinces for mixed-ownership SOE reform GavekalDragonomics 31

32 Concluding thoughts: anti-corruption drive is part of the reform effort Changing the bargain Ø Old growth model allowed corruption in exchange for growth Ø New, efficiency-oriented growth model requires cleaner government Ø Anti-graft drive and fiscal reform go hand in hand Destroying the vested interests Ø Anti-corruption prosecutions are essential for crushing resistance to reforms in local governments and heavy industry/energy SOEs Palace politics Ø To complete key reforms by 2020, Xi needs to destroy the influence of potential rival kingmakers (Jiang Zemin and Hu Jintao) before the 2017 party congress when five of seven Politburo standing committee seats fall vacant GavekalDragonomics 32

33 Contact and disclaimer Thank you! This presentation was prepared by Arthur Kroeber, head of research All research is available online at: research.gavekal.com Copyright Gavekal Ltd. Redistribution prohibited without prior consent. This report has been prepared by Gavekal mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. GavekalDragonomics 33

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