NOMURA Global Markets Research European Perspectives 17 February 2023 Sy Research Analysts China’s reopening: Implications for Europe European Eoonor ‘George Buckley -Niple + With China reopening we take a look at how this might affect the European growth, _goorge bucney@nomucacom inflation and policy outlook. China's increased importance inthe global economy over +44 (0) 2074021600 ‘recent decades has been felt by some countries more than others ~ in Europe, ‘Andrzej Szezepaniak -Niple Germany, for example, could stand to benefit by more to the extent that its share of _anrzoiszezepanik@nomuracom GOP exported to China has risen among the fastest and to higher levels than most 442071023187 countries. But with Germany being large global preducer of manufactured goods, George Moran = Niple and consequenty importer of commodities, this may mean more resilient price george mran@remura.com pressures in Europe if China's reopening leads to significantly higher global “vaz071023220 commodity prices. This in tum could hamper growth. + Indeed, there are a number of reasons that we should be cautious about how Important China’s reopening might prove in terms of European activity growth. First, central bank (ECB, BoE) models suggest that a 1% adjustment to China's growth rate should affect European growth by just 0.1-0.15%. Second, our recent revisions fo China’s growth outlook are limited, with our China team having raised 2023 growth (by 0.5pp), but simultaneously lowering that of 2023 (by over 1pp). And third, as indicated, higher commodity price inflation owing to China's reopening could undo some of the positive effects on European growth, particularly if more sustained inflation leads to a greater degree of policy tightening than we currently expect, or @ prolonging of above-neutal interest rates. + Our conclusion: China's reopening is a positive for global and European growth, with Germany standing to benefit the most. However, our upward revisions to our US growth forecasts will almost certainly be more positive for European growth than our China revisions. Inflation may prove more sticky should commodity prices respond positively to China's reopening, especially with China being such a large global ‘consumer. But the fallin household energy bills is more likely to dominate Europe's CPI data over the coming year. As a resul, at the margin China's reopening supports the case for higher-for-longer when it comes to European monetary policy, and our view that rate cuts will be only modest and not come until mid-2024, The view from China Let's begin by looking at our recently revised China growth forecasts. The combination of stronger actual GDP prints atthe end of last year and a swifter-than-expected transition to herd immunity following the ting of Covid restrictions led our China team to recently raise its forecast for GDP growth this year from 4.8% to 5.3% (which is the result of bringing forward the quarter in which GDP bounces most significantly trom 3 to Q1 2023). For the: following year, however, it cut its China growth forecast from 5.5% to 4.4%. We see consumer spending rebounding in part due to stronger tourism demand, though we are more circumspect about the prospects for spending on goods (notably cars), ‘export growth and the property market, The early days of the recovery could therefore be dominated more by domestic services rather than intemational goods trade. Looking on the positive side, while the revision up to our China GOP growth forecast this year is only 0.5pp, perhaps the more important statistic is that 5.3% growth would be much stronger than the 3% recorded in 2022. After all, forecasts had already been taking into account a iting of China's Zero Covid Strategy (ZCS), just not as quickly as we now expect ‘On the negative side, our latest forecasts have actually revised down economic growth ‘over a thrao-year period, relative to aur forecasts published for the same period in our Global Outlook at the end of last year. Indeed, our latest forecasts for 2022-24 (3%, 5.3% ‘See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.Nomura [European Porspectves 17 February 2028, ‘and 4.4% for the three years respectively) produce total growth of 13.2% over that period versus our end-2022 view (2.8%, 4.8%, 5.5%), which implied stronger total growth of 13.7%. Fig, 4: China 2023 growth revised up, but 2022-24 down Fig, 2: Few changes to our China inflation forecasts Nomura China GDP forecasts, % yoy E Nomura China PPI Torecasts, se y-o-y 6 4a 53 55 Fy a 3) ue 7 cleat As of Doc mAs of Dec 2022 E ‘2022 4 29 8 27 25 25 3 3 2 2 2 2022 2023, 2024 ‘Average 022 2023 2028 Average ‘Soren Naver onion Norm Sowoo: Haver Aravics Nomura China’s increased importance There are various ways to show the increased importance of China to the global — and European — economies. Figure 3 shows how China's share of world merchandise exports has generally taken off over the past quarter century, rising from around 4% in 2001 (when China acceded to the World Trade Organisation) to around 15% 20 years later, atthe ‘expense of many other developed economies, While that chart gives some idea of China as a world producer, Figure 4 — which shows the proportion of GOP exported to China by various developed market economies ~llustrates China's importance as a global consumer. Among the big beneficiaries of China's rising scale are Japan and Germany, where merchandise exports to China are now worth around 3-3.5% of those countries’ respective GDP (from 0.5% or less during the 1990s). Fig. : China's 20-yoar rise to becomo a Key global exporter Fig, 4: Gormany the biggost European beneficiary of China 18) Shaeotwold = == GER. FRA 3s Merchandlise exports to China merchandise ma, ‘SPA seo! GOP 16 | “cxports, % NET us a0 eos ven 14 FRA 2s ITA SPA 12 NET us 7 20 8 18 . 10 4 os 2 f on = 190 1908 2000 2005 2010 Bois zo20 -«N980-—«1985 «2000-2005 aNIO AOI 2020 ‘Sere Raver nates, Nona ‘Another way of looking at these figures is to rank Europe's merchandise export markets, which we show in Figures 5 and 6 (for the euro area and UK respectively). China is the ‘ouro area's third largest market for merchandise exports (after the US and UK), while itis the sixth largest merchandise export market for the UK, according to IMF data,Nomura | European Perspectives 17 February 2028, Fig. 5: Euro area top 10 export markets (China=#3) Fig. 6: UK top 10 export markets (China=#7) eS Euro area merchandise exports to 7 UK merchandise exports, 2021, Son ‘countries outside the gure area, 2021, $bn 400 A 360 50 300 20 7 200 20 50 Ee 100 10 50 0 ° US UK CHI POL SWI CZE SWE RUS HUN TUR US GER NET IRE FRA SWI CHI BEL ITA SPA ‘Aside from trade, inward investment from China is another important way in which China's ‘economic prospects can influence European economic growth (and, for that matter, possibly trend growth too). Figure 7 shows the extent to which China had invested in European countries between 2000 and 2021 in €bn and as a % of each country's 2021 nominal GDP. China is far more invested in the UK than any other European country, in both nominal terms and relative to the size of the economy among Europe’s six largest ‘countries (UK, Germany, France, Italy, Spain, Netherlands). Among the smaller ‘economies, Finland and to a lesser extent Portugal stand out as being large recipients ~ relative to the size of their economies ~ of Chinese foreign direct investment, ‘Another channel through which China can influence European prospects is through the latter's banking claims on the former (Figure 8). However, this is likely to be a more important factor when China is weakening than recovering — in other words, the r'sk of ‘cross-border loan delinquencies is larger on the downside than loans simply not turning ‘sour during an uptum in the economic cycle. Fig, 7: UK is the largest beneficiary by some way of China FDI Fig. 8: The UK stands out in terms of bank claims on China 20 6 250 Claims on China by banks in c on (hs) ‘selected counties, Son 70 2021 GOP 7 5 200 © China FO! into Europe, 7 ‘cumulative 2000 202% ly sen (ns) 50 4 150 4 ol each county's GDP (hs) i 404 t3 100 90 | 2 20 50 1 10 ° a fo UK GER ITA FRA NET FIN SWE IRE POR SPA TTA. SPA CAN GER FRA JPN US UK ‘Sec Sat, Nema Soar BS Fever Anes, Nome Which countries respond most to China? When it comes to export trade, Germany and the Netherlands are most exposed to China within Europe ~ as we saw in Figure 4. For FDI, the UK and Germany have been the biggest beneficiaries of China's global reach, as Figure 7 shows. ‘Another way to see how important China is to Europe's largest economies Is to consider the empirical relationship between indicators of activity in those economies and China. WeNomura | European Perspectives 17 February 2028, ‘show this in Figure 9 below, which suggests that the French, German and Italian manufacturing PMls are more closely correlated with — and are led by ~ China's manufacturing PMI than is the case for Spain and the UK (also see Figure 14 towards the ‘end of this note, which shows the close relationship between China's crecit impulse and ‘Germany's manufacturing PMI orders index), These relationships should account for the fact that China's performance spills over into other non-European countries, which in turn indirectly affects European growth through that channel too. Fig 6 Chinas srangost cade aro with Gormany and France” Fig 1: Chines eaponing sould cavea commodity price Hoo ™ Mapulcing PML condaton eng 5c =: 7 oer ca SF tT 06 | SPA \ UK e os et _ ot 2 a et 0 3: a Yn: TT ss 0 | . Chinas share ee on comets o: 7 consumption, % a2! Chnamenty leads Cina ment ge ee 3 Pot a oa 8 8 ° 2 wo ‘ Negative effects of China’s growth ‘As well as the positives we discuss above, there are some potential negative ‘consequences of stronger Chinese economic growth and demand in Europe and the global economies. The most obvious are the following: Being a significant consumer of raw materials and energy (see Figure 70), China's, reopening could act to drive up commodity prices, which in turn could make production ‘and consumption more expensive in European economies. * China represents an alternative, lower cost, source of merchandise goods supply than European countries. Reopening could lead to China taking an increased share of world trade at the expense of Europe. Official research quantifying the effect of China on Europe Both the Bank of England and the ECB have published research papers that aim to «quantify the impact ofa shock to Chinese GOP on the UK and euro area economies, Two were written at atime when the most likely shock to China's growth outlook was negative, ‘whereas we are currently considering the impact of a more positive China narrative based ‘on the economy's swift reopening post-Covid, Stil, being linear models the impact ofa positive rather than negative shock should be simiary sized, justin the opposite direction + A.scenario in which China undergoes some economic rebalancing, involving a slowdown in China of cumulatively 3.3% of GDP after three years, would depress euro ‘atea GDP by around 0,3%", ECB 2018 Occasional Paper 206, The transition of China to sustainable growth — implications for the global economy and the euro area. + The ECB finds that “The empirical evidence suggests that shocks emanating from China have a noticeable effect on global financial markets. although the impact is smaller than in case of shocks originating in the United States or global risk shocks”, However, “shocks originating in China have larger spillover effects on commodity markets, which in some cases are even larger than those of shocks originating in the inited States", Box in the July 2022 Financial Stabiliy Report BoE staff ran a global VAR and used an ECB spillover model, which indicated that a hock to the lavel of Chinese GDP (2pp in Year 1, tpp in Year 2) affects UK GDP. to the tune of 0.2-0.3% after a vear and a total of 0.4-0,Spp after two years (Figure 12). This compares with a direct mechanical trade impact of around 0.03%,Nomura [European Porspectves 17 February 2028, ‘suggesting much of the impact of a China shock on UK growth is felt indirectly (i. ‘through its impact on third countries) or through channels other than trade, BoE Quarterly Bulletin 2018 Q2, From the Middle Kingdom to the United Kingdom: spillovers from China. Fig. 1: China growth better, but not vs. longterm trends Fig. 12: Modelling the GDP impact of China on the UK & ina, ree a Impact on UK GDP of a 3% yey tana shot o China GOP (of which i 045 ‘2po in Vear 1, 1pp in Year 2) o4o mater t year Peak ie 0.35 10 030 02s 8 020 7 015 4 010 0: 2 005 00 ° ECE model BoE VAR 1970 1975 1980 1985 1930 1995 2000 2005 2010 2015 2020 ‘Sere Have Pain, Nomura What's interesting about these BoE and ECB papers is that the two central banks suggest roughly similar rules of thumb in terms of the impact of a change in China GOP, ie, that a 11% shock to China GDP leads to around a 0.15% impact on UK GOP and a 0.1% impact ‘on euro area GDP. Fig. 13: China's contribution to world GDP growth Fig. 14: China credit impulse vs German PMI 2 a Contributions to world 6 GOP growth ia erin creat impuiee, flead ths) —cerman Po manut 5 ew orders (ms) 0 5 ° 5 china pp yoy 2 me Rest of wold, pp yoy 10 Both series yo-y 7 World GDP % y-oy \ 15 4 20085 2010 2015 2020 900 1985 1980 1995 2000 2005 B010 2015 208 5 ask abate Heer Arion Navace ‘Sere MF Raver aio, Norra Conclusion China's reopening wil almost certainly be a boon to the global - and European economies, some (Germany, for example) more than others. Central bank models ‘suggest that a 1% boost to China's GDP will add between around 0.1% (ECB) and 0.15% (BoE) to euro area and UK GDP respectively. These estimates account for the various ‘channels through which China’s influence percolates through the global economy. However, there are reasons to be circumspect. These 0.1% and 0.15% rules of thumb imply relatively small effects from our 0.5pp upward revision to this year’s China GDP forecasts, Moreover, we have rovised our 2024 forecast down by more than we have revised 2023 up. As a result, what should prove to be more significant is our largerNomura [European Porspectves 17 February 2028, Upward forecast revisions to US GDP growth . A final point that could suggest limits t China's influence on Europe is that while it is clear how much more important China is to the global economy now than ever before, its growth rate is likely to be far lower than has been the case over recent years (Figure 11 shows how China's growth rate has slowed, and Figure 13 shows China's contribution to global growth). ‘On top of that, a China recovery that is focused (inthe intial stages) on services rather than more intemationally tradable goods will inevitably have a smaller spillover effects globally. Moreover, as our Asia team argues here, the build-up of savings in China has been less than that in the US (relative to incomes) which could also limit pent-up spending, In short, we expect a stronger China (over 5% GDP growth in 2023 versus 3% in 2022) to boost growth in Europe, but it may already be accounted for in consensus forecasts and may not have the blockbuster impact hat some are expecting. At the margin, stronger European growth generated by China's reopening, alongside the potential for higher ‘commodity prices that comes with it present upside risks to our ECB view (3.50% peak by June) and how long the central bank may keep rates above neutral. This should support ‘our view that rate cuts will not happen until atleast a year after the last hike (Nomura: - 100bp in H2 2024 for the ECB, -75pp in mid-2024 for the BoE),Nomura | European Perspectives 17 February 2028, Appendix A-1 Analyst Certification We, George Buckley, Andrzej Szczepaniak and George Moran, hereby certify (1) that the views expressed in this Research report accurately reflect our personal views about any or all ofthe subject securities or issuers referred to in this Research report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views ‘expressed in this Research report and (3) no part of our compensation is tied to any specific Investment banking transactions performed by Nomura Securities International, Inc., Nomura Intemational ple or any other Nomura Group company. 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