Swedbank Asia Analysis - November 21, 2012

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Swedbank Asia Analysis No. 14 21 November 2012

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740e-mail: [email protected] Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720.

Magnus Alvesson +46 (0)8-5859 3341, Jrgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897

Chinas strained economy the new political leaders shouldfocus on reforms rather than stimulus

After a massive stimulus through the banks in 2008-2010, China is struggling withovercapacity and bad loans. The situation in the financial sector seems worse thanstatistics indicate. Many lenders are rolling over loans and hoping that the Chinesecentral bank again opens the spigot. In recent years China has borrowed from thefuture, and the question is whether it will choose the easy route with newinfrastructure investment or whether it will accept slower growth driven more byhousehold consumption. If the investment fervor continues, there will be a hardlanding down the road.

The economic turnaround now being talked about is based on meager gains andhopes of a new stimulus. A bottom may have been reached, but the recovery willbe cautious and vulnerable. We are revising our GDP growth forecast downwardfrom 7.9 percent to 7.7 percent this year and still expect it to stay below 8 percentin 2013 and 2014, in line with Chinas goal of 77.5 percent in the coming decade.

The new political leadership is facing major challenges: corruption, a rebalancingof China's growth model from investments to consumption, a shrinking workforce

and concerns about a middle income trap in the absence of innovation. Energyand the environment, urbanization and demographics, and international relations(including maritime conflicts) are also challenging the party and the military.

Chinas leaders should show some backbone and reform rather than resort tomore stimulus. The question is whether the new leaders have enough interest inreforming or whether special interests will be allowed to maintain control andprotect the status quo. This applies especially to the continued deregulation of thefinancial sector. This report reviews why it is important and what could preventfurther development.

The global economy would benefit if Chinese growth were lower and more

sustainable and if financial deregulation were fully implemented. Countries andcompanies that are stuck in the old business model will face increasing difficulty,while others could benefit from increased demand from Chinas consumers asthey place greater value on quality and other long-term considerations.

Contents PageChinas critical questions 2Chinas economic outlook just hopes? 3Challenges facing the new political leadership 7Deregulation of the financial sector: Why, why not and how? 12Consequences for the global economy 19


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2 Swedbank Asia Analysis No. 14 21 November 2012

1. Chinas critical questions

It is easy to presume that Chinas economic position is strong andthat the outlook is good, since GDP growth is relatively high (despitefalling from 9-10 percent to 7-8 percent in the last year). It also has a

low debt level (reportedly about 30 percent of GDP) and hugecurrency reserves (USD 3 300 billion). However, the situation isprobably much worse than most analysts in the West realize.

First of all, it can be difficult to interpret Chinese data, if they are evenavailable. The economy has probably grown more weakly or shrunkof late, and after the massive stimulus in 2008-2010 bad loans areprobably closer to 15-20 percent of outstanding bank loans than the 1percent reported. Now property companies, local governments andstate-owned enterprises have to be rescued and their debtsassumed. Companies arent getting paid and lenders are rolling overcredits, which hides the bad loans for a while longer. In the wake of

strong credit growth, the shadow banking system has grown. In theabsence of transparency, there is a risk of Ponzi schemes.

Secondly, it is common to say that China, with its low inflation, cannow pump new liquidity into the system to reinvigorate demand. TheChinese central bank will not repeat the mistakes from 2008-2010,which led to overcapacity and financial instability. The problem isntconsumer prices. Its the debt buildup and bad loans owing to thedeclining quality of the lending and underlying assets.

Thirdly, China borrowed from the future and built too much capacity.The construction industry is reporting that some production has

increased so much that nothing more has to be built for the next 7-8years to keep pace with demand. This will restrict growth in comingyears.

Fourthly, China's economy has been painted into a corner. Whenloans are rolled over, resources aren't available for new investment.By starting the printing presses and pumping in new liquidity,investment will increase more and more, which is a must to generatethe same growth as before. At the same time Chinas leadership hadplanned to rebalance to lower, more sustainable and greener growthdriven more by consumption than investment. A new recession in therest of the world may force China to return to its proven recipe.

Infrastructure investments are already in the pipeline not as large asin 2008-2009, but still just over 2 percent of GDP in the next four-yearperiod.

Instead of stimulating and driving the economy through moreinvestment, China needs reforms. This report focuses on the financialsectors deregulation as a key to a better functioning economy. Itwould reduce corruption and the influence of state-owned enterprisesand would facilitate a rebalancing in favor of household-drivengrowth. Other important reforms involve fiscal policy (taxes, socialinsurance), the hukou system for migrant workers and corruptionfighting. Challenges also include demographics, urbanization and

relations with the rest of the world, especially as conflicts with Asianneighbors grow. A huge agenda for the new political leadership!

Lies, damned lies, andstatistics!

Lower inflation is noreason to open thespigots

China has borrowedfrom its future

China has to find thecourage not to take theeasy way out: newinvestments

Less stimulus, morereforms!


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2. Chinas economic outlook just hopes?

Still no clear trend in economic data

In 2012 the Chinese economy slowed significantly, probably morethan statistics indicate. The reasons for the slowdown can be found in

weaker global demand, which has impacted Chinas export outlook,but primarily in its own austerity policies, which followed the majorstimulus in connection with the global financial crisis and recession in2008-2009. Credit growth peaked at 30 percent in November 2009and contributed to an overheating, which authorities today regret andwant to avoid repeating.

Inflation and monetary policy

When inflation rose significantly (at most to 6.5 percent in July 2011)after authorities stimulated demand through state-owned bankslending, it launched a period of higher reserve requirements andlending rates in 2010-2011, which slowed credit growth.

About a year ago the central bank began to loosen monetary policyby cutting cash requirements, but by then the effects on land andproperty sales and prices were already clearly negative, and worriesabout an economic hard landing had increased. In Chinas situation, itwould be enough for GDP growth to fall below 6-7 percent to causeeconomic and political instability.

A hard landing can be generated by tightening economic policy duringan overheating, but can also happen if capacity in the economycontinues to expand, the financial and real estate sectors becomemore unstable, and demand fails to keep pace. The first reason is themain concern at this point, but in a few years the bigger risk is thatoverinvestment will lead to excessive capacity, which could latercreate a financial and real economic hard landing.

The question domestic and foreign experts are now asking is whether

the Chinese economy has hit bottom and a turnaround has begun?

External and internalreasons for Chinas

slowdown

Monetary policy hasbeen eased to avoid ahard landing


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Growth in industrial production has also begun to rise (to 9.2 percentin October against 8.9 percent in August), but the upswing is marginaland the purchasing managers index hasnt shown a clear trend. Thepurchasing managers index from the National Bureau of Statistics(NBS), which mainly measures industrial conditions for large state-owned enterprises, is fairly good at identifying turning points. HSBC is

more focused on small and medium-sized businesses and provides abetter indication of the current situation.

In reality, the slowdown seems to have been greater than thepurchasing managers index indicated. An upswing in industrialproduction is consistent with the index, even if it is below or near areading of 50, which suggests slightly higher production growth. Notethat the annual rate isnt always a good indicator. Measured at amonthly rate growth has been weak or negative. Moreover,unchanged or slightly rising electricity production suggests weakermanufacturing conditions. The outlook is for conditions to improveslightly as a result of the stimulus, and eventually stronger external

demand as well.

Change in industrial production and purchasing managers index (from HSBCand NBS)

While private investment is falling, private consumption continues torise. Retail sales gained 14.5 percent in current prices in October,compared with 13.1 percent in July. In October auto sales also rose(5 percent), after having slumped in September for the first time in ayear (apart from Chinese New Year).

Household confidence according to the Conference Board doesntgive a clear signal that stronger confidence would support higherconsumption. Leading indicators as a whole are rising, but theincrease is too marginal to be interpreted as proof of a turnaround.

Slight upturn inindustrial productiongrowth

Householdconsumption is rising,but with no clear trendin future confidence


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Change (%) in retail sales, in current prices, and index of leading indicators(total and household confidence)

... but the coming upswing should be cautious and fragile

In our latest forecast from October we predicted GDP growth of 7.9percent this year, and that it would slow to 7.8 in 2013 and 7.6percent in 2014. Now it seems difficult to reach 7.9 percent this year,which would require growth of 8.5 percent in the fourth quarter.Instead, it is reasonable to expect a slight increase from the currentrate of 7.4 percent to 7.6 percent, with the annual number reaching7.7 percent.

What's in the cards for 2013 and 2014? Several factors suggest thatGDP growth will stay below 8 percent:

The political goal is GDP growth of 7.5 percent, so it is likelythat the final number will be close to that. This goal includesgreener, more sustainable growth, at the same time that thetarget is to double GDP (and GDP per capita) by 2020 (about 7percent growth), which wouldn't help the rebalancing toconsumption-driven growth.

Central political authorities don't want to repeat the mistakesthat led to an overheated real estate market and put local

authorities and stability in jeopardy. Infrastructure investmentsof 2 percent of GDP during a four-year period won't stimulatethe economy enough to return to 9-10 percent growth.

Even if the US also continues to slowly recover and emergingmarket demand is relatively good, China faces a deterioratingoutlook due to its other key export market, Europe, which iswrestling with major economic and structural problems.

We therefore expect GDP growth to rise from 7.7 percent this yearto 7.9 percent next year, but that the financial sectors imbalanceswill gradually impede growth prospects, limiting GDP growth in

2014 to 7.5 percent.

Our GDP forecast for2012 has to be reviseddownward


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3. Challenges facing the new politicalleadership

The party has appointed Chinas new leaders1

After the Communist Partys 18th Congress concluded in Beijing, weknow who will take over control of the country. Former President HuJintao and Prime Minister Wen Jiabao have handed the baton to XiJinping and Li Keqiang. This particular power shift had been expectedfor years, though it was less clear who the other members of thePolitburo's Standing Committee would be.

We now know that the Standing Committee has been trimmed fromnine members to seven and that five new members had to beappointed for age reasons. We also know that Xi Jinping will not haveto wait two years to take over responsibility for the military, as hispredecessor had to do when Jiang Zemin (and even Deng Xiaoping)retained the position after stepping down as president. ConsequentlyXi has consolidated his power. However, both Jiang Zemin (86) andHu Jintao (69) are still alive and will influence Xis policies frombehind the scenes. Of the two, Jiang would appear to be the stronger.The presidency is probably less significant today than when MaoZedong, Deng Xiaoping and even Jiang Zemin held it. During HuJintaos time it became something of a chairmanship, and the eightor so fractions/families with political influence were concerned withfinding a candidate who represented compromise, moderation andpredictability.

The latter was hardly a description of crown prince and former partyboss in Chongqing Bo Xilai, who was expelled from the NationalPeoples Congress and Politburo after having made his mark as ahard-driving populist who flirted with the West. Whether his dismissalwas the result of his (and his wifes) criminal actions and/or hispolitical opponents recriminations is still unclear. That this powerstruggle has been fought out in the open is something new to Chinaand is probably due in part to social media and the growing difficultyin reconciling the various factions within the party, all of whom havespecial interests to protect.

What do we know about the seven members of the Politburospowerful Standing Committee?

1. Xi Jinping

Xi (59) has already been named the partys new secretary generaland chairman of the partys Central Military Commission, but willhave to wait until the parliaments annual meeting in March to besworn in as president. He is considered a cautious reformist.

1The party consists of around 80 million members and in practice does not

choose its leaders. The Party Congress has 2,270 delegates and selects acentral committee comprised of 200 members and 150 alternates. This is thecommittee that elects the Politburo, comprised of around 25 members (24now that Bo Xilai has been forced to step down). It is unclear how the

Standing Committee the real power in China is chosen. It is probablydone more informally. The government and parliament are part of a parallelpower structure, but the Standing Committee ranks above it.

Better decisions withfewer members of theStanding Committee?

An unusually eventfullead-up to the PartyCongress

Xi consolidates power


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Together with Li, he is the only member to have previously sat onthe Standing Committee and, like a number of others, is alliedwith Jiang Zemin. As a princeling, or heir to a former senior leader(Xi Zhongxun was purged by Mao but later rehabilitated), Xi couldattain a stronger position in the party than his predecessor Hu.His ascent within the party began in an impoverished agricultural

region in Shaanxi province, after which he became governor ofFujian province in 1999 and party boss in eastern Zhejiangprovince in 2002. In 2007 Xi was given the opportunity to takeover in Shanghai when the man he replaced was convicted ofcorruption, and later the same year was elected to the PolitburosStanding Committee. As a leader, he is seen as more charismaticand open than his predecessor.

2. Li Keqiang

In March Li Keqiang (57) is expected to take over as PrimeMinister. He is also considered a cautious reformist and is allied

with Hu Jintao, who would have preferred seeing Li as president.Both rose through the Communist Youth League, in contrast withthe princelings. Li is well-educated in both law and economics(where he received a PhD in 1982), so he presumably has abetter understanding of the role of the market, and as PrimeMinister will be responsible for the economy and reforms. Asgovernor of Henan province, he waged a hard-line campaignagainst activists protesting an HIV scandal before being namedparty chief in the industrial province Liaoning in 2004 and later amember of the Politburos Standing Committee in 2007.

3. Zhang Dejiang

It was Zhang Dejiang (65) who took over as party chief inChongqing when Bo Xilai lost the partys confidence due to hisclose connection with Jiang Zemin. He earned his stripes in NorthKorea and is considered conservative. He will ascend to thepowerful position of chairman of the Standing Committee of theNational Peoples Congress. Besides the Bo Xilai affair, Chinasaw another corruption scandal unfold in 2012 when railwayminister Liu Zhijun was forced to step down, which also hurtZhang, though he retained his position. His career was alsoblemished by his handling of the SARS epidemic, but on the otherhand he managed to achieve high growth when he was partychief in Guangdong province.

4. Yu Zhengsheng

Yu Zhengsheng (67) is party chief in Shanghai and is considereda cautious reformist. He will be appointed chairman of theChinese Peoples Political Consultative Conference. Yu has closeties to Deng Xiaopings son Deng Pufang, which saved him fromdisgrace when his brother defected to the US. He has been amember of the Politburo since 2002, but hadnt succeeded inrising to the Standing Committee until now. He considers theCultural Revolution a personal mistake on Maos part.

5. Liu Yunshan

Li has shown interestin the reform agenda

Zhang will becomechairman of theNational PeoplesCongress

Yu feels that theCultural Revolutionwas a personalmistake on Maos part


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Liu Yunshan (65) will take over as chief of propaganda. He hasexperience as a reporter for Xinhua in Inner Mongolia. Liu hasserved as director of the propaganda department since 2002 andhas tried to control the Internet (which today has an estimated500 million users, though some may have more than oneaccount). He has been a member of the Politburo since 2002.

Lius political background was in the youth movement, whichexplains his close contacts with Hu Jintao.

6. Wang Qishan

As one of four Vice Premiers, Wang (64) is the most experiencedpolitician to be appointed. He previously served as mayor ofBeijing in 2004-2008 and governor of the China ConstructionBank in 1994-97. Wang is considered a reformist, especially inthe financial sector, and has managed international traderelations, including with the US. He is a princeling and son-in-lawof a former member of the Standing Committee, Yao Yilin. Wang

will now assume responsibility for fighting corruption, one of thebiggest challenges facing the party.

7. Zhang Gaoli

While Zhang Gaoli (66) has Jiang Zemins confidence, he alsohas Hu Jintaos. As party chief in the northern port city of Tianjinhe has welcomed foreign direct investment and was previouslyresponsible for reforms in expansive Shenzhen. Zhang studiedeconomics and is regarded as a financial reformist. It doesntappear that he will have a specific portfolio, but could become oneof the highest ranking Vice Premiers.

What does this power shift mean in practice?

There are signs of cautious reform within the new StandingCommittee, but at the same time a conservative streak is evident aswell. Because of the Bo Xilai scandal, cautiousness may haveincreased, and compromise and moderation carry greater weight. Itwouldnt be worth risking new scandals by selecting a more radicalperson. Five of seven members will be replaced at the next partycongress for age reasons. Only Xi and Li will serve another five-yearmandate.

The 12th development plan, which took effect in 2011 and extendsthrough 2015, already spells out the political goals. It will take at leasta year or two before the new members make any significant changes,if at all.

While most experts have an idea of what is needed for Chinas furtherdevelopment, there are big differences exactly how it will be done andwhen. Special interests that benefit from state-owned enterprises willcertainly want to put a stop to further liberalization, where the partywould also lose control. In the political arena, Hu Jintaos speechappears to be a sign of the current direction. Democratization can be

seen within the party, but not the Western model.

Liu will becomepropaganda chief in aworld of social media

Wang will now fightcorruption

Zhang has experiencewith financial reforms

The 12thdevelopmentplan remains firm

Special interests couldstop the reform work


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Politicians, especially the future president, will be able to expressthemselves more freely, skip the jargon and demonstrate morecharisma. But while the way of communicating and leadership stylemay change, it doesnt mean that the political substance will.

Important challenges face the new political leadership. Will they

manage to address the problems?

Though Hu Jintao and Wen Jiabao were able to avoid criticism whenthey oversaw the previous market reforms during a decade whenChinas GDP grew by a factor of 2.7 times in fixed prices (just overfour times in current prices) and currency reserves rose from nearlySEK 300 billion to SEK 3 300 billion similarly cautious reforms couldcreate an economic, social and political collapse in the comingdecade. Chinas politicians cannot risk future development by restingon their laurels.

Chinas GDP development in fixed prices and growth rate (%)

The Chinese growth model is losing momentum and the countrycould face a middle income trap if innovation fails to raise value-added and the standard of living. Slower growth globally, at the sametime that Chinese export and investment gains arent repeated andthe workforce peaks before starting to fall within a five-year period,

will create challenges. Significantly slower growth would lead tounemployment and potentially to social and political unrest. Moreconsumption-led (and environmentally sustainable) growth would belower than the nearly 10 percent annual average we have seen sincethe early 1980s.

In fact, consumption has fallen during the decade despite the goal ofrebalancing growth. The 200 million or so migrant workers have tosave more than other urban residents, since they have less access tosocial security. Consumption could potentially grow if faster reformswere made to the hukou system, which regulates urban populations.

Hu and Wen have hadit too easy

but the country is atrisk of a middleincome trap

Reforming hukouwould benefit thecountry socially andeconomically


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Various demand components as a share of GDP

In his address at the Party Congress, outgoing President Hu Jintaosaid that the target is to double Chinas GDP and GDP per capitawithin a ten-year period. If the environment takes a backseat to theeconomy, that growth wont be sustainable. A growing, well-educatedurban middle class wont begrudge others success, as long as it isdone without corruption and abuse of natural resources. But whenexecutives become rich by poisoning milk and local politicians bystealing and selling land, cynicism spreads. At the same time incomegaps, which are already sizable, have increased. The number ofdemonstrations was estimated at 180 000 two years ago, compared

with 40 000 ten years ago. The publics anger is also noticeable onWeibo (Chineses Twitter) and other social media.

Prime Minister Li Keqiang was one of the men behind the reportChina 2030 Building a Modern, Harmonious, and Creative High-Income Society, which was prepared jointly by the World Bank andChinas Development Research Center of the State Council inNovember 2010 - September 2011. The report describes andanalyzes in detail the challenges for Chinas development in the next20 years:

1. Implement structural reforms that strengthen the transition to a

market economy

2. Accelerate the pace of innovation and an open innovationsystem

3. Utilize opportunities to create green development

4. Expand opportunities and social services for all people

5. Strengthen the fiscal system, not least at the local level

6. Seek mutually beneficial relations with the rest of the world.

Corruption has led tocynicism and socialunrest


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These six priority reforms have goals formulated for both the shortand long term. Now strategies are required for how and when toimplement them.

China isnt yet a market economy on the production side. Marketsmust be given more leeway to set the price of production factors such

as land and capital. Accepting this will force the party to relinquishcontrol and reduce opportunities for corruption. State-ownedenterprises will be the biggest losers, as will many of the politiciansclosely allied with them who personally profit.

Production by state-owned enterprises has grown and accounts forbetween one third and half of Chinas GDP, but they shrunksignificantly in number in the 1990s. Lending was expanded throughthe state-owned banks in connection with the financial crisis in 2008-2009, allowing state-owned enterprises to grow in size andimportance both in China and abroad. Now they are instead putting abrake on Chinas economic future and generating a smaller share of

jobs. Because smaller private companies dont have access tocapital, it isnt being correctly allocated and the country is not growingas fast as it could be. The International Monetary Fund has estimatedthat if the state monopoly were opened to competition, the total factorproductivity in China would rise and per capita income could increaseby a factor of 10 in the long term.

Below we show why deregulation of the financial sector would help inthe reform of state-owned enterprises and why the Chinese economyas a whole would benefit from successful financial reform.

4. Deregulation of the financial sector: Why,why not and how?

There are many parts to financial deregulation, and China has beenderegulating its financial markets for decades, but slowly andpartially. At the same time there are signs of accelerated reforms.Many politicians understand how important financial reform would be,but there is a lack of consensus about the order in which the reformsshould be implemented and how quickly. The uncertainty stems fromhow rarely other countries have succeeded in deregulating withoutcreating financial instability and bubbles, but also whether it is worth itfor the party to give up control over a production factor as important

as the price of money. It is often said that Chinas situation wouldhave been significantly worse today if it hadnt kept control over thefinancial sector during the global financial crisis in 2008-2009.

China now has to make progress in a number of areas: loosening itsexchange rate, liberalizing the fixed income market, reforming thebond market, strengthening the domestic banking sector,deregulating the capital account, and developing financial andcommodity-related derivative trading.

Additional reforms are needed to improve the functioning of theeconomy: fiscal reform (mainly tax-related but also in terms of socialinsurance), changes to the hukou system for migrant workers, andgiving opportunities to private actors to invest in markets that arecurrently controlled by monopolies.

China may be amarket economy on

the demand side, butnot in terms ofproduction

State-ownedenterprises must bereformed and declinein importance

Risky to deregulate thefinancial sector butriskier not to


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Below we list ten reasons why China should continue its financialreforms. This is an important key to correcting the imbalances andmeeting challenges in several areas. Studies2 show that financialderegulation produces higher GDP per capita, lower inflation andlarger capital flows, but that it also increases the risk of financialinstability by encouraging higher returns on capital and lower capital

adequacy requirements for banks. Different countries are on differentlevels, however, and face different conditions. Financial reform inChina would:

1. Transform China into a market economy on the productionside by letting the market set the price of money andincreasing competition for financing domestically and with theforeign market.

2. Improve capital allocation, which today is skewed and isimpeding growth in certain sectors at the same time thatgrowth is exaggerated in others.

3. Facilitate the rebalancing from export-investment-led growthto consumption-led growth.

4. Reduce debt problems among local governments, in part byshifting from bank financing to capital markets and byderegulating the fixed income market.

5. Change the role of banks so that they provide less financingfor state-owned enterprises and local governments and moreto small and medium-sized companies and households.

6. Reduce or eliminate the repression of savers by settingmarket-based interest rates, while at the same time reducingexcess lending.

7. Improve opportunities for the Chinese to invest abroad andforeigners to invest in China by deregulating the capitalaccount.

8. Reduce opportunities for corruption.

9. Reduce the discrepancy between the size of Chinas economy

and Chinas importance in the global financial markets.

10. Reduce or eliminate the global economys savings imbalances.

What would a perfectly executed financial reform look like, and whatcan China learn from other countries mistakes?

China has to strengthen its domestic banking sector to continue toopen up to foreign competition and capital flows. In addition, fixedincome markets have to be deregulated and bond marketsdeveloped. Only then should exchange rates be made fully

2IMF Working Paper 12/275: Effects on Capital Flow Liberalizatoin What

is the Evidence from Recent Experiences of Emerging Market Economies?

The rebalancing toconsumption will behard without reformingthe financial sector


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convertible. Lastly, there are opportunities to deregulate the capitalaccount.

China can learn from other countries mistakes mainly by studying thesequence in which they deregulated their financial markets. InSweden we saw regulated rate setting (a low interest rate policy that

occasionally produced negative real rates) and quantitative regulationof commercial lending until the so-called November Revolution in1985, when the credit market was deregulated. This led toconsiderable credit growth. With a fixed exchange rate and liberalizedcapital account, capital outflows increased as Swedish finance andreal estate companies invested in property abroad. An internal realestate and financial bubble built up as well. There was overheatingwith high inflation, and the underlying fiscal weakness was hidden byhigh tax receipts produced from debt-financed growth. The taxreform of the century adopted in 1990-91, together with considerablylower inflation, contributed to a significant rise in real after-tax interestrates. Debt-financed investment was no longer encouraged, and

instead the Swedes became more willing to save. This real interestrate shock, along with the recession and German reunification, whichresulted in higher interest rates, as well as speculation about thekrona, battered asset values, and the bubble burst.

Financial crises in other countries illustrate the difficulty in combiningcapital mobility with fixed (but adjustable) exchange rates. Financialderegulation often leads to a rise in asset prices, investments andconsumption, at the same time that savings decline. This is followedby a shock of sorts where capital flows reverse course and the creditexpansion comes to an end, bursting the bubble. Officials usually tryto defend against currency speculation with higher interest rates

before having to give up and let the currency fluctuate freely.

The Mundell-Flemming model shows that no single country canachieve the following three policy goals at the same time: a fixedexchange rate, unrestricted capital mobility and an independentdomestic monetary policy, but that a combination of two goals is fullypossible. China has to avoid this macroeconomy trilemma byultimately finding the right combination of goals to suit its particularneeds. Sweden, just like the US, Canada, Australia and the UK, has aflexible exchange rate, unrestricted capital mobility and an

independent monetary policy. Denmark has a fixed exchange rateand capital mobility, but no independent monetary policy. The eurozone has a currency union, but the euro otherwise fluctuates just like

2

Fixed Exchange rate

Free capital

capital movementIndependentMonetary Policy

Sweden is a goodexample of how not toderegulate thefinancial sector

China has to avoid thetrilemma and is nowworking on all threeparts


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the dollar and pound, and thus has unrestricted capital mobility andan independent monetary policy through the ECB. China is workingon all three parts, and as a major economy should move toward theAnglo-Saxon (and euro zone) solution.

How far has China come with deregulation? What are the obstacles?

What type of results can be expected in the coming decade?

1. Interest rate deregulation

In the current system, Chinas central bank (PBoC) sets a ceiling forsavings rates and a floor for lending rates. This generates a highinterest rate margin, which produces good profits for (state-owned)banks. The return savers receive is usually less than inflation, whichmeans they are paying the bank to let them borrow their money.

Interest rate deregulation would benefit the bond markets as well,since the one-year savings rate is used to price bonds. It would also

be easier to remove capital controls and internationalize the currency.Deregulation is mentioned in the 12th Development Plan, and itsimportance has been stressed by outgoing Central Bank GovernorZhou Xiaochuan. He believes that Chinas commercial banks cannow manage on their own and that they have to sell other financialservices to maintain their market shares, that they have becomebetter at pricing rates and managing risk, and that the ShanghaiInterbank Offered Rate (Shibor) has now been established as abenchmark for pricing financial products. Many problems remain,since it takes time to develop financial skills, Shibor says less aboutrates with maturities longer than three months, and there is nobenchmark yield curve, which makes it harder for the financial market

to project short-term trends and inflation.

Bank lending and deposit rates as well as interest rate margin

Interbank rates and interest rates tied to foreign currencies have beenderegulated. The hard part now is to follow up by deregulating 29other rates set by PBoC. On the positive side, banks can now offer 20percent discounts on lending rates, compared with 10 percent before.For the first time they can now also offer savings rates that are 10percent above the benchmark. About 70 percent of total bank loans

Interest ratederegulation isrequired to eliminatesavers repression

An important step is tolet the lending anddeposit be priced

under and over thebenchmark


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have been granted at rates higher than the benchmark, comparedwith about 40 percent in 2008-2011.

Special interests that benefit from high interest rate margins bothbig banks, which get 70-80 percent of their profit from net interestincome, and state-owned enterprises, which have had access to

cheap financing want to prevent this from happening.

2. Bond market development

In China, banks are primarily responsible for financing, while the bondand equity markets play a secondary role. This trend wasstrengthened by the huge stimulus packages in 2009-2010, whenbank lending rose as a share of GDP from 97 percent in 2008 to 120percent in 2010.

In the wake of the stimulus, bad loans are increasing, especially forlocal governments. Numbers aren't available, since most loans are

rolled over when there isnt enough liquidity. The difficulty for localgovernments is that the capital may have been allocated incorrectly toprojects which may not be viable and that it will take time before thereis a return on long-term infrastructure projects. With differentmaturities on savings and lending as well as insufficient tax financingof local government budgets, bank financing really isn't the right wayto go. It would be better if local governments were allowed to issuetheir own bonds.

According to the China Development and Research Foundation, atleast RMB 100 000 in urban infrastructure investment is required forevery new person who moves to Chinas cities from the country. It is

estimated that around 15-20 million people migrate to cities everyyear, which translates into an annual investment need of RMB 2-3trillion during the next decade. Loan costs would be lower and riskdiversification better if the bond market were allowed to develop.

China represents about 10 percent of the global economy, but itsbond market accounts for only 5 percent. That makes it smaller thanhalf of lending from banks. Its market capital constitutes 45 percent ofChinas GDP. Trading is mainly limited to government bonds (Ministryof Finance) and bonds issued by state banks, the central bank andlarge (state-owned) enterprises. Whenever possible, localgovernments issue with the help of the Ministry of Finance. What are

needed are better opportunities for small and medium-sizedcompanies to obtain financing in the bond market.

Local government debt represents 23 percent of GDP, and that'saccording to very conservative estimates. The real number isprobably much higher. The stimulus that came through the banks andflowed to local governments will come back to the central level whenit is forced to take over the bad loans. It could just as well have beena fiscal stimulus that wound up on the central debt account from thebeginning. In addition to bank loans, there are so-called LGFV bonds.After a decline in 2010, the latter rose by 160 percent during the firsthalf of this year. The risk of default is considered high.

Bad loans by localgovernments are

increasing, but thus farthey have been hiddenby rolling them over

The bond market couldeasily double within afive-year period


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17

Cities and local governments will be allowed to begin issuing bondson a larger scale. At present pilot projects are under way in the citiesof Shanghai and Shenzhen, as well as the provinces of Guangdongand Zhejiang. They will spread throughout the rest of the country.This means that more loans will be taken up and that it will become away to resolve the liquidity problem at the same time that a more

long-term financing solution is put in place. Note that if the capital isallocated to projects that are not viable and only lead to overcapacity,the problems will persist and could even worsen. The biggestobstacle to strengthening Chinas bond market is the multitude ofregulators and supervisors and that the market is fragmented.

3. Exchange rate reform

Making the Chinese renminbi, or RMB, a global currency was apriority during the financial crisis, when the value of the US dollar felland the Federal Reserve introduced quantitative easing, whichcreated the risk of higher inflation and an erosion of the dollar. Since

China had built up USD 3 300 billion in currency reserves, it had aninterest in making RMB fully convertible.

Back in 2005 China decided to introduce a managed float, i.e., anexchange rate regime controlled by the central bank. Later, in 2007,bonds were listed in RMB on the Hong Kong Stock Exchange. A yearlater the central bank added a department for exchange rate policy,and in late 2008 China began, as a result of the financial crisis, toagree to swap contracts with foreign central banks (Russia, SouthKorea, etc.). In the summer of 2009 a pilot project was launched touse RMB for trade settlements, and in 2011 foreign direct investment(FDI) with RMB was allowed. In April of this year PBoC expanded the

daily interval for currency trading from 0.5 percent to 1 percent,probably not because RMB is significantly undervalued, but to speedup the internationalization.

There are three steps in this internationalization, and China has partlytaken the first two: use of RMB in trade and investment settlements.The third and final step is for RMB to become a reserve currency.There is a long way left until China is there. The currency could fullyconvertible within a ten-year period, however, if the other financialreforms are implemented.

Since 2005 the real effective exchange rate has appreciated by 27

percent and the nominal rate by 21 percent. Against both the USdollar and euro, the renminbi has appreciated by about 25 percent.After a lengthy period of criticism of PBoC for keeping the exchangerate undervalued, it now seems to be closer to its equilibrium rate(though its hard to say exactly). The current account surplus shrunkfrom about 7 percent of GDP to about 3 percent between 2007 and2011.

Trading quoted in RMB doubled in 2011 and reached RMB 2 100billion (USD 330 billion) or 9 percent of total trading last year.Expectations are that the renminbi will further strengthen as Chinasmarket orientation continues. Further internationalization could be

prevented if concerns about speculative inflows increase when thecurrency is expected to appreciate, if reforms affecting interest rates,banks, bond markets, etc. are not pursued sufficiently, or if the

Fragmentation and toomany uncoordinatedregulators could be astumbling block,however

The currency has

appreciated by nearly30 percent and nolonger seemsundervalued

Will Chinas Ministry ofCommerce oppose astronger currency?


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Chinese Ministry of Commerce opposes reforms that wouldstrengthen the value of the currency and therefore hurt exports.

Exchange rates

4. Opening the capital account

Now that Chinese companies are investing abroad, reversing foreigndirect investments, Chinese banks have to be more sophisticated andfollow their customers. Chinese banks already have 150 branches

outside the country, with more sure to follow (Bank of China has justover 60 percent of them). Last year 13 500 Chinese companies wereinvolved in more than 18 000 foreign companies in 177 countries andregions, mainly in Asia. More than 90 percent of Chinas investmentoutflow comes from state-owned enterprises. They can now use RMBin their investments, thereby reducing their exchange rate risks.

Liberalization of Chinas current account was the first step (back in1996), but now the capital account has to be liberalized as well. Thiswould allow foreigners to make investments in Chinas capitalmarkets and Chinese to invest abroad. It would also increasecompetition for the Chinese, who would have to compete for financing

with foreigners.

Chinas capital account is partially open. Foreigners can buy Bshares, while A shares are limited through a quota system (QFII).Chinese investors can buy foreign shares through the so-called QDIIfund. The quotas are gradually increased. A pilot project currentlyunder way in Wenshou which allows individuals to invest abroad willprobably spread throughout the country.

Progress could be derailed if other financial reforms lag. Furthermore,Chinese politicians have the global financial crisis fresh in theirmemories. Many feel that capital controls saved China from the

volatile capital flows other Asian countries suffered from during theAsian crisis in 1997-98 and again during the global financial crisis in2008-09. Nevertheless, the 12th development plan promised a

The current accountbalance was mucheasier to deregulatethan the capitalaccount

Chinese politiciansclaim that capitalcontrols have been

good for stability


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liberalization of the capital account by 2015, as well as expandedRMB convertibility. This will probably still include some capitalcontrols, certainly to prevent speculative capital flows.

5. Consequences for the global economy

The global economy as a whole would benefit if China instead chosea path of slower, more sustainable economy growth, relied onconsumers to drive the economy, and continued the gradual, cautiousderegulation of its financial sector.

For countries and companies with a business model that requirescontinued investment-led Chinese growth, such a correction towardslower growth would naturally have an impact. This also applies toSwedish companies that focus on commodities and manufacturing.

Companies that have adopted a long-term attitude and focus onquality, sustainable (organic) products for both producers and

consumers have more to look forward to. China has to transition to avalue model that raises quality, abandon its throw-away mentality andbecome more environmentally conscious. The middle class isgrowing in size and becoming better educated. They can graduallybegin to dip into their high savings (as already seen among theyounger generation, who would rather spend on capital goods thankeep their money in worthless bank accounts).

All foreign companies have to stay informed about the acceleratingchanges that are coming in connection with the deregulation of thefinancial sector. It could mean the expansion of quotas for foreigninvestors, interest rate reforms, new forms of financing, etc.

Companies that are now active may feel growing price pressure afterthe economy has slowed, liquidity has dried up and overcapacity is anissue.

If China opens up its financial sector and creates a greater marketorientation of production factors such as land, capital, etc., we couldexpect to see lower savings imbalances in the global economy.

It is important, however, not to be overconfident how quickly andeasily the financial sector can be deregulated. For one thing, it isextremely hard to rebalance an economy. For another, manycountries have found it difficult to deregulate without the risk ofcreating bubbles. In China's case it is likely that the risk of financialbubbles would grow over time if the financial sector isnt deregulated.

It will take time before the renminbi becomes a reserve currency. Itstill has a long way to go. China would have to reduce its dependenceon exports, so that it no longer has to accept the US dollar, euro oryen and can dictate payment terms in renminbi. The renminbi alsohas to become more liquid, which could be done by expandingChinas capital market from todays 4 percent of the global capitalmarket (compared with the US with 38 percent and the euro zonewith 22 percent). It is also important that China begins to export its

currency, e.g., by importing more and letting Chinese invest abroad,so that capital not only flows in but also out.

The world should hopefor slower, morebalanced growth

Companies with oldbusiness models are

hurting, while thosewith more modernmodels are benefiting

Overcapacity couldlead to increased pricepressure

China will continue itscautious financialreforms

Little likelihood that therenminbi will become areserve currency atthis point


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To develop a reserve currency, there has to be confidence in theeconomy and probably the political system as well. China is on itsway to developing the world's third largest bond market, but there isno track record of a dictatorship that enjoys such confidence in thefinancial market. We dont know how decisions are made andwhether investors can be sure their investments are safe. It takes

time to build such confidence. Deregulation of the financial sector isone step. Democratization is probably also necessary, includingfighting corruption and developing a robust justice system.

The steps mentioned in this report as evidence that financialderegulation is on the way in China are still small ones. Specialinterests will want to slow down the reform process for their personalbenefit. Another question that has to be asked if whether China is infact prepared to shoulder responsibility for the global financialmarkets. The party would have to give up control over the economy,address the trilemma described above, and would no longer be ableto hide the level of bad loans in the banking system.

If China chooses to take a back seat, the US, euro zone, Japan andother developed countries would have to continue to bear more of theresponsibility for the global capital supply than their economic sizewould suggest. As a result, the Federal Reserve would have toaccept generating more liquidity than the US needs domestically.

When China passes the US as the worlds biggest economy later thisdecade (in terms of purchasing power, not in dollar terms), there willbe plenty of room for differences in opinion and potentially conflicts aswell. A new political leadership interested in reforms and internationalrelations is therefore high on the wish list.

Cecilia Hermansson

Economic ResearchDepartment

SE-105 34 StockholmTelephone +46-08-5859 [email protected]

Legally responsible publishersCecilia Hermansson,+46-8-5859 7720

Magnus Alvesson, +46-8-5859 3341Jrgen Kennemar, +46-8-5859 7730

ISSN 1103-4897

Swedbank Asia Analysis is published as a service to our customers. Webelieve that we have used reliable sources and methods in thepreparation of the analyses reported in this publication. However, wecannot guarantee the accuracy or completeness of the report and cannotbe held responsible for any error or omission in the underlying material orits use. Readers are encouraged to base any (investment) decisions onother material as well. Neither Swedbank nor its employees may be heldresponsible for losses or damages, direct or indirect, owing to any errors oromissions in Swedbank Asia Analysis.

Does China really wantthe renminbi to be areserve currency withall that implies?

Swedbank Asia Analysis - November 21, 2012

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