CHINA ECONOMY Corporate FX & Structured Products

China: Be Prepared for a New China

Friday, November 16, 2012 Highlights: •

China ended its leadership transition with no major surprises. The new Standing Committee, as China’s top policy making body, will guide China through the global economic turbulence for the next five years while Mr. Xi and Mr. Li are expected to lead China for the next decade.

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Chinese economy has grown rapidly for the past decade. Nevertheless, the side effects of the investment led growth model have been more visible recently. As such, the economic reform is more urgently needed than before in order for China to sustain its superior growth for the next decade.

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China’s economic growth slowed further to 7.4% yoy in Q3, down from 7.6% yoy in Q2, lowest since Q1 2009. Given most leading and coincident indicators are improving; we expect the Chinese economy to reaccelerate in Q4.

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Nevertheless, the recovery is unlikely to be significant as what we saw in 2009 due to the weakening core Euro zone economies and looming US fiscal cliff concerns.

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We expect China’s GDP to expand modestly at 7.8% yoy in Q4 and 8.2% yoy in Q1 2013. Our full year forecast for 2012 and 2013 are at 7.7% and 8.1% respectively.

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As highlighted by the outgoing President Hu Jintao in China’s 18th Party Congress, “four new izations” including industrialization, urbanization, informatization and agricultural modernization will become China’s new growth engines.

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Among China’s four “new izations”, urbanization is likely to be the major driver to Chinese economy for the next decade. A 1% increase in China’s urbanization rate will transfer 13 millions populations from rural areas to urban areas. Urbanization is important in the sense that it will help China boost its domestic demand to rebalance its economy.

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Urbanization is a big topic which we are not going to expand in details in this article. Three key questions remain to be answered when we assess China’s urbanization. First, where will the funding for urbanization from given local government’s currently excessive leverage? Second, how can China avoid the so called urbanization trap as seen in Latin America and Africa and avoid unproductive slums in the big cities? Third, can

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16 November 2012

Ch i n a urbanization create enough jobs as industrialization did in the past decade to accommodate migrant workers?

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Funding is the least concern in our view given China’s high saving ratio.

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To conclude here, we think China will benefit from the urbanization dividend for the next decade. A successful urbanization is likely to boost domestic consumption and help China rebalance its economic structure. Meanwhile, given the focus of China’s urbanization is on building tier 2-3 cities and new townships; we should not downplay the role of investment in China’s growth. As such, 7-8% potential growth for China is achievable for the next decade in our view.

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Last but not least, the impact of a new China on ASEAN is likely to be from two angles including service and financial flows and changing commodity dynamics.

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16 November 2012

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China ended its leadership transition with no major surprises. As widely expected, Xi Jinping and Li Keqiang are elected as President and Premier to replace outgoing Hu Jintao and Wen Jiabao. The number of Politburo Standing Committee is streamlined to seven from nine previously. The new Standing Committee, as China’s top policy making body, will guide China through the global economic turbulence for the next five years while Mr. Xi and Mr. Li are expected to lead China for the next decade. The Chinese economy has grown rapidly for the past decade. The economic size recorded an almost fourfold increase, up from CNY12tn in 2002 to CNY47.3tn in 2011. The GDP per capita rose even more rapidly to US$5443 in 2011 from US$1135 in 2002, partly thanks to RMB appreciation. Nevertheless, the side effects of an investment-led growth model have been more visible recently. Take China’s GDP structure for example, China’s private consumption as percentage of GDP fell further to about 35% in 2011 down from 44% in 2002 and 52.4% in 1981. Meanwhile, China’s M2 outstanding reached US$14.9tn, 40% higher than that in the US, although China’s GDP size is only about half of the US GDP size. This has led to rapid asset inflation for the past decade. Chart 1: China’s changing GDP structure

Chart 2: Rapid increase in Chinese money supply 14

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Capital formation as % of GDP

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Source: CEIC, OCBC

As such, economic reform is more urgently needed than before in order for China to sustain its superior growth for the next decade, given that China’s investment driven growth model is no longer sustainable. The commitment to economic reform from the new leadership will be closely monitored by the market going forwards. A bottom has been formed China’s economic growth slowed further to 7.4% yoy in Q3, down from 7.6% yoy in Q2, lowest since Q1 2009. Nevertheless, the economy showed signs of stabilization growing 2.2% quarter-on-quarter in Q3, up from 2.0% in Q2. China’s official PMI went back above 50 in October, a sign of improving manufacturing activity. Electricity production growth also speeded up to 7.1% yoy in October, up from 1.2% yoy in September. Money supply M2 growth surged to 14.8% in September above central bank’s target of 14% for the first time this year and stabilized around 14.1% in October.

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Ch i n a Chart 4: Electricity production showed sign of improvement

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Source: CEIC, OCBC

Local government investments are picking up Meanwhile, China’s total social financing hit CNY13tn in the first ten months, up 23% yoy, outpacing loan growth, which is a sign that China’s funding channel is more diversified. The record high total social financing is likely to provide funding support to growth in Q4. For example, trust loan, which is not captured in new Yuan loan but captured in total social financing, surged for the past three months. This is the sign that local government investments are picking up. Chart 5: Total social financing hit a record high year to date 2500

Chart 6: Trust loan picked up strongly suggesting increasing investments from local government

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Recovery is unlikely to be significant Given most leading and coincident indicators are improving; we expect the Chinese economy to reaccelerate in Q4. Nevertheless, the recovery is unlikely to be significant as what we saw in 2009 due to the weakening core Euro zone economies and looming US fiscal cliff concerns.

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China’s exports grew 11.5% yoy in October, beating market expectation. The stronger than expected export was mainly due to increasing intra regional trade. China’s export to ASEAN jumped 45% yoy, partially offsetting the still weak demand from EU. Nevertheless, the unexpected decline in export growth in Taiwan in October was a reminder that exporters in Asia may still face challenges as a result of weak demand from G3 economies. Given that the German economy is likely to slow more noticeably as warned by both ECB and German Economic Minister, we expect China’s export growth to also slow in the coming months. As such, a strong recovery in Q4 is unlikely in our view. We expect China’s GDP to expand modestly at 7.8% yoy in Q4 and 8.2% yoy in Q1 2013. Our full year forecast for 2012 and 2013 are at 7.7% and 8.1% respectively. Chart 7: Strong demand from ASEAN partially offset weak demand from EU

Chart 8: A modest recovery is expected

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New growth engines for the next decade Industrialization has been the key driver for China for the past decade, nevertheless, industrialization and infrastructure led investment demand has crowded out China’s consumption. Meanwhile, the changing demographics and rising labor costs also suggest that China’s industrialization may have already passed its peak. As such, new growth engines are needed for China to sustain its superior growth. China’s “four new izations” to support the growth As highlighted by the outgoing President Hu Jintao in China’s 18th Party Congress, “four new izations” including industrialization, urbanization, informatization and agricultural modernization will become China’s new growth engines. Among China’s four “new izations”, urbanization is likely to be the major driver to Chinese economy for the next decade, although industrialization is expected to continue to contribute to Chinese growth as China will retain its world factory status following the manufacturing relocation from coastal areas to western and central areas. China’s urbanization rate rose to 51.47% in 2011, above 50% for the first time in history. However, it is still below 70-80% at advanced economies. China’s urbanization rate is expected to rise further to reach about 70% by 2030. A 1% increase in China’s urbanization rate will transfer 13 millions populations from rural areas to urban areas.

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Urbanization is important in the sense that it will help China boost its domestic demand to rebalance its economy. According to China’s National Bureau of Statistics, on average, migrant workers spend almost three times more than farmers. Urbanization is the key Urbanization is a big topic which we are not going to expand in details in this article. Three key questions remain to be answered when we assess China’s urbanization. First, where will the funding for urbanization from given local government’s currently excessive leverage? Second, how can China avoid the so called urbanization trap as seen in Latin America and Africa and avoid unproductive slums in the big cities? Third, can urbanization create enough jobs as industrialization did in the past decade to accommodate migrant workers? Chart 9: China’s urbanization rate

Chart 10: China’s high saving ratio

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Urbanization Rate

Investment as % of GDP

2010

Saving as % of GDP

Source: CEIC, OCBC

Funding is the least concern in our view given China’s high saving ratio. China’s saving ratio is estimated to be the highest in the world around 51%, enough to cover China’s unprecedented high investment ratio. Since we don’t expect China’s saving ratio to fall significantly for the next five years, we think China’s high saving ratio will meet funding needs from urbanization. We don’t have good answers to the third question on job creations under the context of urbanization. For the second question, as highlighted by 18th Party Congress, instead of squeezing all migrant workers into big cities, China is likely to develop the tier 2 and 3 cities and small townships to accommodate migrant workers and allow them to access to public service more easily. As such, the satellite style urbanization is likely to create more infrastructure led investment demand, which may support Chinese GDP for the next decade. China’s Ministry of Housing and Urban-Rural development estimated in September that China is going to invest 60 trillion Yuan for the next eight years to meet urbanization demand. To conclude here, we think China will benefit from the urbanization dividend for the next decade. A successful urbanization is likely to boost domestic consumption and help China rebalance its economic structure. Meanwhile, given the focus of China’s urbanization is on building tier 2 and 3 cities and new townships; we should not downplay

Treasury & Strategy Research

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the role of investment in China’s growth. As such, 7-8% potential growth for China is achievable for the next decade in our view. Implications of a new China on ASEAN Last but not least, the impact of a new China on ASEAN is likely to be from two angles including service and financial flows and changing commodity dynamics. First, ASEAN is likely to benefit from a rising China from both tourism and investment perspectives. The Share of China’s direct investment in ASEAN rose to 6% in 2011, up from only 1% in 2006. According to the United Nation, Chinese tourist’s per capita spending remains low despite China has been the third largest spenders after Germany and US in 2011. China is likely to export more tourists to the world including ASEAN, supported by rapidly rising income and GDP per capita. Chart 11: China’s tourism expenditure per capita remains low Global tourism expenditure in 2011

Chart 12: China’s Increasing direct investment in ASEAN 90%

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Source: CEIC, UN, OCBC

Second, we expect Chinese demand for metals to remain strong given the focus of China’s urbanization on building tier 2-3 cities and new townships. Nevertheless, since China has already consumed more than 40% of global base metals according to IMF, we think the impact of China’s urbanization on agricultural products and energy could be more visible than base metals. In the first nine months of this year, China has imported 4.1 million tons of corn (vs.1.75 millions tons in 2011), 3.2 millions tons of wheat (vs. 1.25m in 2011) and 1.88 millions tons of rice (vs. 0.59 millions in 2011). Although agricultural modernization has been named one of China’s “four new izations”, there are growing signs that China’s food consumption demand may outpace food production. This may benefit ASEAN exporters but have visible impact on global consumers including us in ASEAN.

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This publication is solely for information purposes only and may not be published, circulated, reproduced or distributed in whole or in part to any other person without our prior written consent. This publication should not be construed as an offer or solicitation for the subscription, purchase or sale of the securities/instruments mentioned herein. Any forecast on the economy, stock market, bond market and economic trends of the markets provided is not necessarily indicative of the future or likely performance of the securities/instruments. Whilst the information contained herein has been compiled from sources believed to be reliable and we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee and we make no representation as to its accuracy or completeness, and you should not act on it without first independently verifying its contents. The securities/instruments mentioned in this publication may not be suitable for investment by all investors. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. This publication may cover a wide range of topics and is not intended to be a comprehensive study or to provide any recommendation or advice on personal investing or financial planning. Accordingly, they should not be relied on or treated as a substitute for specific advice concerning individual situations. Please seek advice from a financial adviser regarding the suitability of any investment product taking into account your specific investment objectives, financial situation or particular needs before you make a commitment to purchase the investment product. OCBC and/or its related and affiliated corporations may at any time make markets in the securities/instruments mentioned in this publication and together with their respective directors and officers, may have or take positions in the securities/instruments mentioned in this publication and may be engaged in purchasing or selling the same for themselves or their clients, and may also perform or seek to perform broking and other investment or securities-related services for the corporations whose securities are mentioned in this publication as well as other parties generally.

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