A blip in growth or more slowdown to come?

Welcome to our first publication of the “SEB China Tracker”- one stop shop on what’s happening in China macro and markets and what you need to watch going forward. The publication is split into 2 sections – 1) thematic focus piece and 2) macroeconomic and market charts and comments, which we think as the most important for China watchers.

THURSDAY 25 APRIL 2013

EDITOR Sean Yokota
Head of Asia Strategy

sean.yokota@seb.se + 65 6505 0583

Theme - In this first edition, we will provide our general economic and market outlook since the two most frequently asked question over the last month are a) will the economy continue to slow after the weak Q1 GDP and b) why is the currency strengthening and will that continue with a weaker growth? Our conclusion is that growth will hit a soft patch from overextended exports but will reaccelerate into 4Q to hit our 8.1% growth forecast for this year. Construction activity and accommodative monetary stance will put a floor on growth. The currency will continue its gradual appreciation from structural and cyclical factors and we still see USDCNY hitting 6.10 by year end.

Macroeconomic and market charts – what stands out the most this month is the rapid rebound in hot money inflows (Chart 8) that supports a stronger CNY after 10 months of straight outflow. We think the rebound in the housing prices are keeping flows at home. For people with access, going long CNY onshore is the mot favorable of the 3 separate CNY markets (Chart 12).

Tidbit – One reason why we aren’t extrapolating the recent PMI weakness into something bigger is that key exporting cities like Dongguan, a hub for manufacturing in Guangdong Province in Southern China is reporting good growth. Q1 real GDP growth was 8.6% yoy, compared to the 7.7% growth nationally. Dongguan’s authorities have raised 2013 GDP forecast to 10% from 7%.

You can also find our research materials at our website: www.mb.seb.se. This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any director consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.

China Tracker

Theme – A blip in growth or more slowdown to come?
The two most frequently asked question over the last month are a) will the economy continue to slow after the weak Q1 GDP and b) why is the currency strengthening and will that continue with a weaker growth? Our conclusion is that growth will hit a soft patch from over-extended exports but will reaccelerate into 4Q to hit our 8.1% growth forecast for this year. The currency will continue its gradual appreciation from structural and cyclical factors. Below is why we think so.

The Framework
Before we move forward, here is a brief background on the framework on how we analyze the Chinese economy. We focus on three main drivers 1) external demand 2) internal or domestic demand and 3) policy, mostly monetary, which accelerates or decelerates domestic demand. We focus on these three for the following reasons. First, China remains the manufacturing center of the world and external demand (exports) creates big cyclical swings. Exports generate income for businesses and households and they influence domestic demand by spending that income on investment and consumption. Second, China has domestic or internal demand and here we focus on investment rather than consumption since as many of you know, China’s investment is much bigger than consumption (almost 50% of GDP compared to 35%). In addition, investment swings are more volatile than consumption and is the main driver of cyclicality since consumption includes more “necessities” and cannot be cut drastically in economic downturns. Third, we classify monetary policy as the third main driver since in a world of low external demand, many economies, including China are relying on credit growth or leverage to generate higher growth. Furthermore, in China, much of the investment growth is supported by borrowing and change in monetary policy alters investment growth substantially. Now, many other factors impact the Chinese economy but we see these three as the biggest drivers and the others would be sub-drivers that fit within them.

So how are these drivers looking?
The biggest change we see is weaker short term export outlook. Our US economist, Mattias Bruér sees slowdown in Q2 and Q3 this year, led by large inventory accumulation in Q1 (pulls growth forward) and fiscal tightening from sequestration (see Economic Insights, US economy 8 Apr 2013). We are already seeing some signs of this from weaker US ISM data and softening in China PMI. In addition, China’s exports are already at elevated levels, growing at almost 20% yoy, which are as strong as pre-Lehman crisis levels in 2008 (Chart 1). This is difficult to sustain with lingering European risks and US going through a soft patch. Japan is turning around and can generate some demand but as Chart 2 shows, it is a much smaller export market compared to US and Europe. Exports will likely level out or slow down over the next quarter or two before we see it accelerate towards year end. We do not see a major slowdown since our SEB China Financial Survey tells us that on the ground CEOs and CFOs in mainland are becoming more optimistic about the business climate for the coming six months (China Financial Index, Rebound in China Confidence, 5 Mar 2013). Our index has jumped to 60.8 in March from 56.1 in September and profit expectations and fixed asset investment plans have substantially improved. On domestic demand, we focus on construction activity as the main driver of investment. The SEB China Construction Indicator continues to be strong (Chart 3). The question is more on the outlook since authorities have introduced new measures to control rising house prices in March. We think the measures will slow the pace of acceleration in construction activity and stabilize around 20% yoy compared to the 40% yoy growth we saw in 2009. We do not envision a collapse in construction activity from the tightening measures. As you can see from Chart 4, the property price acceleration is concentrated in first tier cities (e.g. Beijing, Shanghai, Shenzhen) and the most of the country, which are in third tier cities and below are not experiencing similar price increases. The measures are targeted at decreasing speculation and activity in first tier cities and the impact on the overall construction activity and economy will be muted in our view. Thirdly, monetary policy still remains accommodative. Real rates are barely positive at 0.9% (Chart 5, 1 year deposit rates are 3% minus March CPI of 2.1%). In addition, as our regular readers know, we have been talking about growth in non-bank lending acting as another form of monetary stimulus (Asia Strategy Comment, China Trip Notes, 12 Dec 2012) and it continues to accelerate (Chart 6). Recently, the authorities passed measures to control wealth management products that may slowdown the pace of non-bank lending growth. However, we think non-bank lending will continue to grow until we see two key changes, which we have yet to see. One, we’re looking for multiple defaults on domestic corporate bonds or trust/wealth management products that will teach investors that these higher yielding assets come with higher risk and dampen demand. So far when these products miss payments, typically a government, bank, asset manager or a company has come to the rescue. Until investors are taught lessons, we think money will continue to pour into this area. Two, we need to see the central bank hike deposit rates.

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China Tracker

While deposit rates are low, households and corporates will continue to look for alternate means to store their savings, whether it be in housing, trust products or corporate bonds. If the authorities want to seriously curtail growth in non-bank lending, they will hike deposit rates continuously and we don’t see that risk emerging until Q4 when we think a hiking cycle will start. In the meantime, we think monetary policy will be accommodative and continue to support China’s growth. To summarize our growth outlook, we think the economy will remain around current levels and balanced as exports hit a soft patch and become head winds, while construction and loose monetary stance keeps the economy anchored around 8%.

Impact on Markets
So how will this macro outlook impact markets and especially the path of CNY? For CNY our view hasn’t changed and we still expect gradual appreciation for USDCNY to hit 6.10 by year end. As long as China runs a current account surplus, we think the authorities will stick to the structural, strategic policy to gradually strengthen CNY to encourage exporters to move up the value chain. In addition, the self induced slowdown in domestic activity in 2012 (back to Chart 3) where the construction activity slowed to similar degree as the Lehman crisis, gives us more confidence that the government is serious about restructuring. The recent move lower in USDCNY fixing has shown that China is willing to appreciate CNY despite the weakness in the Japanese Yen. Furthermore, flow also supports a stronger CNY. Before April, CNY hadn’t moved for five months since the inflows created by the current account surplus were offset by equal amount of hot money outflow and kept the currency stable as you can see from Chart 8 below. China’s FX reserves also did not increase during this time. However, starting in March, the hot money flow has reversed to inflows and creates pressures for CNY to appreciate. We think stabilization in domestic house prices also encourage more inflow (or prevent outflow) as holding CNY denominated houses again becomes a profitable form of saving and investment. With loose monetary policy, house prices will be supported, encourage hot money inflow and pressure CNY to continue appreciating. For interest rates, we still expect interest rates to start rising this year towards Q4. We see inflation gradually rising towards year end from loose monetary policy and rising non-bank lending. Salaries are rising faster than the 2.1% CPI rate where over 70% of respondents from our China Financial Index survey expect salaries to increase by 8-9%. Return of hot money inflow will also add to inflationary pressures. We don’t see an immediate need for interest rate hikes as the soft patch in exports over the summer will slow the pace in inflation but this environment of loose monetary policy and steady growth will lead to a beginning of a hiking cycle by year end. Lastly, equity markets have a period of 4-5 months to perform well. We are in steady growth and low inflationary environment short term, which is favorable for equity market performance. Positioning and expectations are low from poor performance, especially in relative to global equity markets that have performed well over the last 6 months (Chart 16). China equity has also been hit by the new property tightening measures but as mentioned above we think the impact will be limited and allow for a recovery. But, going into Q4, we do see inflationary pressures picking up and introduction of monetary tightening risk will weigh on market’s performance.

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China Tracker

MACROECONOMIC TRACKER
Chart 1: External demand has peaked
60 50 40 30 20 10 0 -10 -20 -30 07 08 09 10 11 12 13
5 0 Europe US Asia Other HK ASEAN Japan Latam Africa Others 10

Chart 2: US and Europe matters the most for exports
25 % of total expors by destination 19 17 16 16

China exports by destination % yoy 3mma EU US Asia Total

20 15

10 7 7 4 4

Chart 3: On the other hand, domestic demand remains resilient Chart 4: Property measures are targeted at 1st tier cities
50 40 30 20 10 0 -10 -20 07 08 09 10 11 12 13 % yoy 3mma

SEB China construction indicator

110 109 108 107 106 105 104 103 102 101 100

Property Price 2010=100

1st tier

2nd tier

3rd tier

Jan-11

May-11

Sep-11

Jan-12

May-12

Sep-12

Jan-13

Chart 5: Monetary policy remains accommodative
8 6 4 China Real rates (1yr deposit rates minus CPI)

Chart 6: And boosts non-bank lending and growth
RMB trn 3mma 1.5

1.0
2 0 -2

0.5

0.0 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10
-4 -6 98 00 02 04 06 08 10 12

New Total Financing

May-10 Sep-10

New Bank Lending

Chart 7: Matter of time before inflation starts rising
80 60 40 20 0 -20 -40 12 11 07 08 09 10 13 Wholesale Pork Prices % yoy CPI % yoy (RHS) 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5

Chart 8: Return of hot money inflow adds to CNY pressure
100 China Non-trade flow s 3mma USD bn

50

0

-50 2007 2008 2009 2010 2011 2012 2013

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Jan-13

China Tracker

MARKETS TRACKER
6.40 6.35 6.30 6.25 6.20 6.15 Jan-12 Apr-12 Jul-12 Oct-12 USDCNY fix ing Jan-13 Apr-13 USDCNY spot USDCNH spot

Chart 9: USDCNY fixing had hardly moved since October of 2012 since the flows were balanced (current account surplus - inflow was offset by hot money outflow) and the government likely wanted little volatility during the political transition. However, with the return of hot money inflow (Chart 8) and end to political transition, fixing has been moving lower. We expect that to continue and for USDCNY spot to reach 6.10 by year end.

1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Jan-10

UDSCNY spot spread to fix ing %

Chart 10: Despite little move in USDCNY fixing, USDCNY spot has been able to fully use the daily allowed +/- 1% band and has been hugging the low end since October. Markets think that the USDCNY fixing is too high and need to move lower. We also expect a widening of this trading band to +/- 1.5% in the second quarter.
High Oct-11 Low Oct-12

CNY Oct-10

Apr-10

Apr-11

Apr-12

Jan-11

Jan-12

Jan-13

Apr-13
106 104 102 100 98 96

Jul-10

Jul-11

Jul-12

105 104 103 102 101 100 99 98

Index Jan 2012=100

Chart 11: China is doing its part in appreciating the currency. CNY has strengthened by almost 6% in trade weighted basis since early this year, despite a stronger USD. They are losing competitiveness on the currency.

Nov-12

Dec-12

Feb-12

May-12

Feb-13

Jul-12

Oct-12

Jan-12

Jun-12

Mar-12

Jan-13

Aug-12

Sep-12

Mar-13

Apr-12

CNY NEER USDCNY Fixing

USDCNY spot Dollar Index (RHS)

Apr-13

6.35 6.30 6.25 6.20 6.15

USD v s RMB markets NDF 6.26 Onshore 6.28 6.24 6.24 6.19 6.24 CNH 6.30 6.24 6.24 6.24 6.17 Spot 1M 6.18 6.26 6.25 6.32

6.18

6.22 6.24

Chart 12: For people who have access to onshore market, it is best to hedge against stronger CNY on the onshore market since it offers the best carry and pricing. For offshore players, we are looking for a bound higher in USDCNY NDF in 3-6M to enter into USDCNY NDF shorts. We like NDF better than CNH because even though CNH may experience more gains in the widening of the daily trading band (Chart 10), we also think that increases your downside as well. The risk reward favors NDFs at the moment.

3M

6M

9M

12M

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China Tracker

MARKETS TRACKER
8 7 6 5 4 3 2 Jan-12 Mar-12 May -12 Jul-12 Sep-12 Nov -12 Jan-13 Mar-13 7day repo rate % 20d mv av g

Chart 13: Interest rates have hardly changed. However, heading into year end, we think it will slowly rise and expect a 25bp hike in deposit and lending rate in Q4.

650 600 550 500 450 400 350 300 250 200 150 100 50 0

CNH deposits in HK (bn)

Chart 14: CNH deposits in Hong Kong are again on the rise, which typically means that sentiment towards CNY appreciation has turned for the better.

Jan-07 May-07 Sep-07 Jan-08

May-08 Sep-08 Jan-09 May-09 Sep-09

Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

Jan-12 May-12 Sep-12 Jan-13

106 104 102 100 98 96 94 92

CNH Bond Index (BoC HK)

Chart 15: The CNH bond performance remains resilient, which is positive for the CNH currency. People want to do more with CNH rather than just sit in deposits and growth in CNH bond market and CNH loans will enhance the use of CNH to be more than just a speculative play on CNY appreciation.

Aug-11

Oct-11

Jun-12

Jun-11

Aug-12

Dec-11

Feb-12

Dec-12

Apr-12

Oct-12

Feb-13

Apr-13

120 110 100 90 80 70 60 50 10

China A Share / US S&P, 2010=100

Chart 16: After underperforming S&P for over 2 years, the A shares started outperforming until the new property measures were announced last month. The recent weakness in incoming data has also hurt Ashares.

11

12

13

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China Tracker

FORECASTS
FX USD/CNY USD/CNH USD/HKD USD/IDR USD/INR USD/KRW USD/MYR USD/PHP USD/SGD USD/THB USD/TWD EUR/USD USD/JPY EUR/SEK EUR/NOK USD/SEK USD/NOK AUD/USD Policy Rates CH CH RRR KR IN ID MA PH TH TW
US EU SW NO AU

Spot 6.18 6.17 7.76 9719 54.4 1118 3.05 41.3 1.24 29.0 29.8 1.30 99.42 8.61 7.67 6.61 5.90 1.03 Current 6.00 20.00 2.75 7.50 5.75 3.00 3.50 2.75 1.88
0.25 0.75 1.00 1.50 3.00

1M 6.16 6.16 7.80 9750 54.1 1130 3.09 41.5 1.24 29.2 29.7 1.29 100.00 8.55 7.55 6.63 5.85 1.04 4/25/2013 6.00 20.00 2.75 7.50 5.75 3.00 3.50 2.75 1.88
0.25 0.75 1.00 1.50 3.00

3M

6M

9M

12M

6.15 6.15 7.80 9800 54.0 1120 3.05 42.0 1.24 29.0 29.0 1.28 101.00 8.45 7.50 6.63 5.87 1.01 3M 6.00 20.00 2.75 7.25 5.75 3.00 3.50 2.75 1.88
0.25 0.75 0.75 1.50 3.00

6.12 6.12 7.80 9750 53.5 1115 3.00 40.1 1.23 28.8 28.8 1.26 102.00 8.35 7.45 6.63 5.91 0.99 6M 6.00 20.00 2.50 7.00 6.00 3.00 3.50 2.75 1.88
0.25 0.75 0.75 1.75 3.00

6.10 6.10 7.80 9650 51.0 1110 2.90 39.0 1.22 28.3 28.4 1.24 106.00 8.25 7.40 6.66 5.96 0.96 9M 6.25 20.00 2.50 7.00 6.00 3.25 3.75 3.00 1.88
0.25 0.75 0.75 1.75 3.00

6.10 6.10 7.80 9650 51.0 1060 2.90 39.0 1.21 28.5 28.4 1.22 110.00 8.15 7.35 6.68 6.02 0.92 12M 6.25 20.00 2.50 7.00 6.25 3.25 3.75 3.00 2.00
0.25 0.75 0.75 1.75 3.00

Real GDP % yoy China India Indonesia Korea Singapore US Euro zone Sweden Norway CPI % yoy China India WPI Indonesia Korea Singapore US Euro zone Sweden Norway

2011 9.3 7.5 6.5 3.6 5.3 1.8 1.6 3.7 1.2 2011 3.3 9.5 5.1 2.9 2.8 3.1 2.7 3.0 1.2

2012 7.8 5.4 6.2 2.0 1.3 2.2 -0.6 0.8 3.2 2012 3.5 6.5 4.3 2.2 4.5 2.1 2.5 0.9 0.8

2013 8.1 5.7 6.4 2.8 2.6 2.1 -0.4 1.2 2.3 2013 3.7 6.3 5.0 2.6 3.3 1.9 1.5 0.2 1.5

2014 7.7 6.0 6.1 3.6 4.1 3.0 0.8 2.5 2.4 2014 3.7 7.0 4.8 2.6 3.5 1.5 1.3 1.0 1.6

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China Tracker

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