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Asia China
15 December 2011
China Outlook 2012
Policy easing to accelerate in
H1
Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
MICA(P) 146/04/2011.
Market Update
Research Team
Linan LiuStrategist
(+852) 2203 8709
Jun Ma, Ph.DChief Economist
(+852) 2203 8308
Dennis TanStrategist
(+65) 6 423-5347
FixedIncome
GlobalMarketsResea
rch
Stra
tegy
Economic outlook: We expect annual GDP growth to slow from 9.1% thisyear to 8.3% in 2012, and to recover to 8.6% in 2013. We expect the
economy to be featured by 1) disinflation, 2) initial growth deceleration
followed by a recovery, and 3) policy easing in 1H followed by a more
cautious stance towards the end of the year. On monetary policy, we expect
3-4 RRR cuts in 2012, which should permit average monthly RMB lending to
rebound to RMB800-900bn/month in 1H, and annual lending to reach around
RMB8.4tn in 2012. We expect a modest fiscal easing in 2012. Fiscal priorities
should include public housing, completion of on-going infrastructure projects,
SMEs, services, and consumption.
Main risks: The two most important shocks to the economy in the comingmonths are property FAI deceleration and export slowdown. We expect
property FAI growth to slow from the current 30%yoy to 14%yoy in the first
few months of 2012. We expect export growth to decelerate from the current
15%yoy to 8% in 1Q 2012. For 2012 as a whole, we revised down our export
growth forecast to 8% from the previous 10%.
Local markets strategy: We are constructive on CNY fixed income market inthe first half of 2012. We expect net liquidity inflow to the interbank market to
help bring money market rates 50-100bps lower from where they are now
before the middle of 2012 and we recommend entering Repo IRS/NDIRS or
Shibor IRS/NDIRS 2Y/5Y steepeners about 10bps (target exit 40bps and stop
loss -5bps) and -20bps (target 20bps and stop loss -35bps) respectively. We
recommend overweight CGB bonds.
Currency strategy: We think part of the shift in policy stance by the Chineseauthorities would be to slow down the pace of appreciation of the RMB.
While we still like core short positions in 1Y USD/CNH and/or NDFs (given that
they pricing in more than 1% depreciation of the RMB); we also see value in
buying CNY vols via straddles, given the risk of further squeeze in NDFs in
early 2012 as the economy slows down.
CNH strategy:implementation of RMB FDI and ODI programs; more enterprises will be
allowed to participate in the RMB cross border trade settlement scheme; thelaunch of RMB-QFII program, the RMB cross currency swap arrangement will
likely be expanded with more trading partners, in particular with ASEAN
countries; and the offshore RMB market to expand to more regional trading
centres. The key downside risk to our forecasts is the pace of RMB
appreciation and the possibility of further volatility in the CNH-CNY spot basis.
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15 December 2011 China Outlook 2012
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Economics
We foresee a deeper qoq GDP trough in
1Q of 2012 than our earlier projection
We cut our 2012 GDP growth forecast to 8.3% as early as
in August 2011, and has since maintained this forecast.
Despite many changes in DBs global economic forecasts
and recent developments in China, we continue to believe
our 8.3% annual forecast remains reasonable.
DBs European economists downgraded their 2012
Eurozone GDP forecast twice in the past four months. The
most recent revision reduced their 2012 Eurozone GDP
forecast from 0.4% to the current -0.5%. As we (DBsChina economics team) took a more bearish view on
Europe as early as in August, the recent European
forecast changes only marginally worsened our annual
outlook for Chinas export growth.
The following table produces our updated yoy and qoq
(saar) GDP growth forecasts for 2012. The slight change
we made is to further cut our qoq GDP growth
forecast for 1Q 2012 to 6.4% from the previous 6.8%,
for two reasons. First, we now expect a sharper
slowdown in real estate FAI growth in the coming months
due to weakness in property sales. Second, the
contraction in European GDP in 1Q is likely to be 1.6% on
qoq saar basis, vs the previous forecast of 0.4%.
China: yoy and qoq GDP growth forecast
yoy % qoq (saar) %2011Q1 9.7% 8.7%
2011Q2 9.5% 9.1%
2011Q3 9.1% 9.5%
2011Q4F 8.5% 7.3%
2012Q1F 7.7% 6.4%
2012Q2F 7.5% 9.0%
2012Q3F 8.7% 10.0%
2012Q4F 8.7% 9.7%
Source: SSB and DB forecast
Three factors are behind our projection of a sequential
growth trough in 1Q 2012. First, we believe that the
European economy is already in recession and its
economic contraction will like to be the worst in 1Q. This
implies that Chinas export growth will suffer the most
from European demand weakness in 1Q. Second, Chinas
real estate sales have slowed sharply since September
2011, and developers will thus likely rein in their
construction activities. Sequential slowdown in
construction should last until Q1 next year, before
property prices and sales may stabilize. Third, Chinas
monetary easing, which began only at the end of
November (as marked by the RRR cut on November 30),
will likely become more visible in 1Q. With a one-quarter
lag, monetary easing should begin to support domestic
demand, especially investment activities, from 2Q.
Note that the qoq GDP growth rates before (and
including) 3Q 2011 are estimates from the National
Bureau of Statistics (NBS). Our estimates differ from
theirs as we use a different seasonal adjustmentmethodology. The NBS uses its own methodology but the
agency does not release its details and original data, and
therefore it is not possible to replicate its estimates. We
believe its estimates are problematic as their yoy and qoq
growth rates appear inconsistent. In particular, the NBS
estimate of a sequential acceleration of GDP growth in 3Q
of 2011 is contradictory to most other indicators which
became visibly weaker in that quarter these include the
PMI, monetary and loan growth rates, commodity prices,
as well as the qoq change in power consumption. In
particular, the PMI fell to around 50 in 3Q and during the
quarter monetary conditions appeared to be the tightest in
two years.
Given this difference in methodologies, we ask readers to
take our qoq GDP estimates as indicative (of our view of
the momentum of the economy), rather than something
that could be verified by NBS data releases in the future.
We expect GDP growth to accelerate to
8.6% in 2013
In this monthly note, we for the first time publish our
forecasts of 2013 economic indicators. We expect GDP
growth to rise to 8.6% in 2013, up from 8.3% in 2012.This is largely reflecting our view that US and Eurozone
GDP growth will be stronger in 2013 than 2012. The
rationales for this forecast include: 1) the worst part of
bank deleveraging, which causes the contraction of the
real economy, would be in 2012; 2) the fiscal contraction
(measured by the reduction in cyclically adjusted fiscal
deficit/GDP ratio) was as much as 1.4ppts in 2012, but
would improve in 2013. In other words, the impact of
fiscal contraction will become less of drag for the
Eurozone economy in 2013.
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Stronger US and Eurozone growth would enhance
Chinese growth via stronger exports. So, for example,
based on historical correlations, a 1% increase in US&EU
growth would increase Chinese export growth by about
6ppts. We thus forecast acceleration of China export
growth from 8% in 2012 to 14% in 2013. In volume
terms, Chinas export growth will likely accelerate byabout 3-4ppts. This should translate to a 0.5ppt increase in
Chinas GDP growth. However, given that monetary and
fiscal policies will likely become a bit more restrained, we
expect GDP growth in 2013 to accelerate only by 0.3ppts
to 8.6%.
Other changes to the key components of the Chinese
economy should largely offset each other in terms of
impact on GDP. For example, we expect some modest
deceleration in real gross capital formation (as the
corporate profit margin will drop due to the long-term
structural trend of higher wage growth), but real privateconsumption will likely accelerate a bit on better income
growth and higher government spending on social
services and welfare.
On the latter point, the recent unfortunate school bus
accident in Gansu province is illustrative. This accident,
which killed 21 preschool students, provoked a massive
wave of public criticism (in the form of tens of thousands
of Internet and press commentaries) that put pressure for
the government to improve safety standards. A week
later, the State Council decided to allocate additional
budgetary resources for purchasing school buses that
meet safety standards on a nationwide basis. This case
demonstrates the significant rise in the role of public
opinions in influencing policy making in China, and that the
government will likely have no choice but to increasingly
steer its fiscal priority towards social spending.
China: Macroeconomic Forecasts
2010 2011F 2012F 2013FReal GDP (YoY%) 10.3 9.1 8.3 8.6
CPI (YoY%) ann avg 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit (YoY%) 19.9 15.0 15.5 14.0
Budget surplus (% of GDP) -1.7 -2.0 -2.2 -1.5
FX rate (eop) CNY/USD 6.59 6.35 6.13 5.86
Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0
Retail sales (nominal) 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD nominal) 31.3 20.0 8.0 14.0
Merch imports (USD nominal) 38.7 24.0 9.0 16.0
1-year deposit rate (%) 3.50 3.50 3.50 3.50
Source: CEIC and DB forecasts.
Source: CEIC and DB forecast
We expect property FAI growth to slow
rapidly in the first few months of the
year
It appears that the weakening of property investments by
developers is becoming the most serious challenge to the
economy in the coming few months, even more so than
export deceleration. This is because the average property
price in 35 major cities has declined by about 13% in the
past two months according to Soufun, and sales and floor
space started have both decelerated sharply. In terms of
floor space started a leading indicator of real estate FAI
its growth fell from 30%yoy in Jan-Aug to only 10%yoy
in September and -1% in October. Based on historical
correlation, the deceleration in floor space started will
likely translate into a visible slowdown in real estate FAI
(correlation at 0.5-0.6). We thus expect real estate FAI
growth to decelerate from 30%yoy in the current quarter
to 14%yoy in 1Q next year. On a qoq basis, we expectreal estate FAI to slow to zero in 1Q of 2012.
Real estate FAI growth forecast
yoy qoq (saar)1Q 11 75% 34%
2Q 11 35% 32%
3Q 11 17% 31%
4Q 11F 7% 30%
1Q 12F 0% 14%
2Q 12F 18% 7%
3Q 12F 25% 11%
4Q 12F 20% 19%
Source: CEIC and DB forecast
Estimated composition of FAI by type of real estate
investments, Jan-Oct 2011
Commodity
residential
housing,
60%Office, 4%
Commercial
property,
12%
Public
housing,
14%
Others, 10%
Source: CEIC and DB estimates
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Yoy % change in residential floor space started
-50%
0%
50%
100%
150%
200%
250%
Feb-08
May-08
Aug-08
Nov-08
Feb-09
May-09
Aug-09
Nov-09
Feb-10
May-10
Aug-10
Nov-10
Feb-11
May-11
Aug-11
Source: CEIC
Some readers have wondered why with residential
property sales declining sharply, real estate FAI can still be
growing at positive rates. One thing to clarify here is thatwe are projecting total real estate FAI growth, rather than
commodity housing FAI growth (i.e., investment by
developers for sale at market prices). This is the part of
FAI that will be substantially affected by the slowdown in
property sales. It accounts for about 60% of total real
estate FAI in the first 10 months of this year according to
our estimates. The other components of real estate FAI
include public housing (about 14%), commercial and
office property FAI (16%), and others (including
investments by rural residents and urban work units). The
growth of these components is largely unaffected by the
weakness of property sales in the private market. When
qoq total real estate FAI growth falls to zero in 1Q of
2012, it actually implies that qoq commodity housing FAI
growth declines by 20% (given that the FAI of other real
estate components is growing at 30%yoy).
It is also important to distinguish between yoy and qoq
growth of real estate FAI. The qoq FAI growth can indeed
fall very sharply (e.g., to zero in 1Q next year) due to the
recent decline in property sales, but FAI can remain
positive on a yoy basis as the yoy number reflects the
impact of the cumulative change over past four quarters.
In addition, we expect by Q2 next year property sales and
FAI to pick up on improving affordability and possiblysome government policy support. Therefore, the annual
FAI growth can still be at a positive rate for 2012 as a
whole.
As for impact on GDP, given that real estate sectors
capital formation accounts for about 10% of GDP, we
estimate that a 7ppt deceleration in qoq (saar) real estate
FAI growth could reduce qoq (saar) GDP growth by 0.7ppt
in 1Q next year.
We revised down our 2012 export
forecast to 8% from 10%
Our European economists are projecting the Eurozone
economy will be in recession for the current quarter and
first half of next year. The trough is projected in 1Q of
2012. The driving forces for further deterioration of
sequential growth in Q1 include bank deleveraging, fiscal
contraction, as well as the negative wealth effect arising
from weaker consumer confidence. However, over the
coming months, we expect some progress of the
Eurozone towards fiscal consolidation, which will permit
the ECB to further loosen monetary policy and support the
debt market, and to help lift market and consumer
confidence. The benefits for the real economy are
expected to kick in from Q2 next year.
Given this European growth trajectory and a relatively
steady pace of US economic growth (at around 2.5%annualised rates for most quarters), we expect Chinas
qoq and yoy export growth to look like the following:
China export growth forecast, yoy and qoq %
China export(yoy) China export(qoq saar) EU/US GDP(qoq saar)1Q 11 26% 16.0% 2.0%
2Q 11 22% 7.7% 1.0%
3Q 11 21% 10.2% 1.3%
4Q 11F 15% 6.1% 0.7%
1Q 12F 8% 2.2% 0.3%
2Q 12F 6% 3.0% 0.4%
3Q 12F 6% 12.1% 1.5%
4Q 12F 11% 14.6% 1.9%
Source: DB forecast
According to our estimates, Chinas qoq (saar) export
growth will slow sharply to only 2.2% in 1Q next year,
down from 6.1% in 4Q this year. As a result, yoy export
growth will likely decelerate to 8% in 1Q, stay weak for
2Q and 3Q, before recovering in 4Q 2012. For the year as
a whole, we now forecast export growth at 8% (vs
previous expectation of 10%). We also revised down our
import growth forecast by 2ppts to 9%.
Ceteris paribus, the qoq export deceleration will lead to a
reduction in qoq (saar) GDP growth by about 0.4ppts in
1Q of 2012. We expect only a small part of the GDP
impact from the deceleration of real estate FAI and
exports to be offset by monetary easing in that quarter.
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CPI inflation to drop sharply to 3% in Q2
and 2.8% for 2012 as a whole
We continue to expect CPI inflation to decline sharply to
4.2% in November and 3.8%yoy in December, and to 3%
in 2Q next year. This reflects the significant decline in
wholesale agriculture prices in the past two months (by 7-
8%) and its gradual pass-through to retail food prices.
Based on historical correlation, the food component of
CPI should fall by at least 5% cumulatively between the
peak September and the next trough. Even if the power
tariffs are raised by 5% and refined oil prices are raised by
10%, their boost to CPI is only 0.3ppts, a small fraction of
CPI reduction (by 1.5%) due to a 5% food price drop.
Based on normal seasonality, we assume a 5% rise in
food prices in January and February to reflect the Chinese
New Year effect. Even with this sequential rise in food
prices, yoy CPI inflation will still likely fall to 3% in 2Q andthe full year CPI inflation will likely be at 2.8% for 2012.
Other key assumptions we made in this CPI projection
include a modest decline in PPI in the coming few
months, with a recovery from Q2 next year. For the year
as a whole, we see PPI inflation at about 4%, significantly
lower than the recent peak of about 8%. This projection is
supported by the recent trend of declining input price
index in the PMI report.
Another important contributor to disinflation is the fall in
property prices, which will over time translate to a decline
in the housing component (which includes rents and
imputed rents) of CPI. We estimate that a 10% drop in
physical property prices (Soufun property price index) will
eventually after about 6 months reduce the housing
component of CPI by 1%.
We expect 3-4 RRR cuts to support 15-
16% M2 growth in 2012
We expect M2 growth to accelerate marginally to 15-16%
next year, up from the current 13%. Experience tells us
that M2 growth is typically set at 2-3ppts above nominal
GDP growth. This time, given the consensus forecast of
8.5 for real GDP growth and about 3.5% for CPI inflation,
14% will likely form the bottom for the discussion for next
years M2 growth range. However, arguments for some
additional monetary expansion will likely be made in the
coming months to allow 1-2ppt additional M2 growth in
order to offset the global demand shock and the
weakness in the real estate sector. Thus, the final
outcome will likely be 15%-16% for M2 growth. A M2
growth rate of 15% should be applicable if GDP growth is
running safely above 8%, but 16% is more likely when
yoy GDP growth slips below 8% for two quarters (which
is our forecast).
At this moment, we do not see strong reasons why loan
growth will be much different from M2 growth in 2012.
This implies that new RMB lending will be around
RMB8.4tn next year (i.e., loan growth at around 15.5%),up from this years estimated RMB7.4tn.
We estimate that it may require 4 RRR cuts to generate
enough liquidity (deposit growth) in the banking system to
support 16% loan growth in 2012. Our assumptions in
this calculation include: 1) in 2012 the net purchase of FX
reserves by the PBOC would be USD300bn, about half of
that in 2010; 2) there is no change in outstanding PBOC
bills in 2012; and 3) there are no major changes in reserve
money due to other open market operations. Under these
assumptions, the increase in reserve money due to
PBOCs FX purchase can generate an increase in M2 byRMB7.3tn. Given the fact that each RRR cut by 0.5% can
increase the money multiplier by about 0.07 and boost M2
eventually (after a time lag) by RMB1.4tn, 4 RRR cuts will
be needed to provide additional M2 of about RMB5.8tn.
An increase in M2 by RMB13.1tn (7.3+5.8) is needed to
support 16% loan growth in 2012. Therefore, 3-4 RRR
cuts are likely if loan growth will be in the range of 15-
16%.
As for timing of the RRR cuts, we believe they are likely
be front-loaded for several reasons. First, the capital
outflow due to weak RMB expectation will continue to
restrain domestic liquidity growth due to limited FX
purchase by the central bank in the coming months.
Second, economic growth will likely be weak in 1H (worst
in 1Q on a qoq basis, and worst in 2Q on a yoy basis), and
thus should prompt the government to be relatively more
aggressive in policy easing in 1H, compared with 2H.
Third, the global quantitative easing (by the Fed and ECB)
in the coming months will likely begin to pose upward
pressure on commodity prices in 2H of 2012. Therefore,
towards the end of 2012, Chinas monetary policy stance
may become somewhat more cautious again, due to the
re-emergence of inflationary pressure.
We expect the RMB to resume
appreciation from 2Q next year
The recent depreciation of the RMB vs the USD -- by
about 0.3% in November -- reflected the short-term
change in market expectation of the RMB as well as the
reduced PBOC intervention in our view. We think China
should be pleased to see that the market force is finally
generating some two-way volatility for the RMB. This two-
way volatility has at least two benefits. First, it provides an
argument for China in its debate with the US that China is
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Page 6 Deutsche Bank AG/Hong Kong
not manipulating its currency. Second, it is an important
warning to short-term speculators that they can lose
money in any period of time by betting on RMB
appreciation, and thus helps deter some speculative
activities and reduce hot money inflows. We have shown
in our previous study that if the RMBs volatility
(annualised daily volatility) rises from 1.5% to 3.5%, it candrastically reduce the Sharpe ratio of investing in the RMB
to 0.22 from 0.57. We believe China is now moving in this
right direction1 of raising the RMB volatility.
We expect the short-term weakness of the RMB to
persist for a few more months, as long as the market
expectation of Chinas growth deceleration and export
contraction remains. However, as soon as sequential GDP
growth begins to show signs of a recovery as indicated
by, for example, a rise in the PMI and a pick up in the
export orders index, the RMB should begin to resume its
appreciation trend. We think this will likely occur from 2Qnext year. On a medium-term basis, we still believe that
Chinas trade balance (including merchandize and services
trade) will remain in surplus for a few more years. Our
projection, based on a CGE model, is that Chinas trade
surplus will decline steadily in the coming few years, and
turn to a deficit in 2016 2 . Given that the RMB
internationalization and capital account liberalization
process may also permit some net capital inflows, this
implies that the despite greater short-term volatility, the
RMB will likely continue its overall trend of appreciation
for the coming four years. For 2012, we expect the RMB
to appreciate by 3.5% against the USD, but it will likely to
be back-loaded (i.e., most of the appreciation taking place
in the last three quarters of next year).
Modest fiscal easing in 2012
We expect some modest fiscal easing in 2012. Despite
the official rhetoric that fiscal policy will remain pro-active,
we think the reality is that there will be only limited fiscal
expansion in 2012 relative to 2011. Our baseline forecast
is that the deficit-GDP-ratio will rise slightly to 2.2% in
2012 (vs 2.0% in 2011). Specifically, we forecast that total
government fiscal deficit will rise to RMB1.1tr (including
RMB300bn for local government deficit/bond financing) in2012, vs RMB900bn in 2011 (including RMB200bn for
local government deficit/bond financing).
Within the fiscal budget for 2012, we expect some
modest tax cuts to support SMEs, exporters,
1See Jun Ma, China should adopt a flexible basket-based RMB exchange
rate mechanism, February 2010 (in Chinese).2See Jun Ma, Mingzhi Xiao, and Yandong Jia, A quantitative analysis of
Chinas trade surplus, published in Jun Ma, The Locus of Money, China
Economic Press, August 2011 (in Chinese).
consumption, and services. These tax cuts may be in the
forms of a reduction in the business tax, more
exemptions/deductions from the VAT, and some increase
in VAT rebate for exporters. Broader-based personal
income tax cuts and VAT cuts are likely to be proposed
but unlikely to get approved in the near future.
On the expenditure side, we expect priorities be given to
support public housing, infrastructure (e.g., resumption of
railway projects, repair of reservoirs and dams), social
services, and consumption. There will likely be some
significant increase in governments funding for public
housing and for railway projects. As a result of the
increased bank, bond, and government funding, we
expect railway FAI to rise 30% in 1H of 2012 from 2H this
year, and public housing investment to rise 20-30% in
2012.
Real estate policy: incentive for firsthome buyers may be needed
The recent sharp decline in property sales is generating
some serious downward pressure on the economy. First,
real estate FAI will likely slow significantly and become a
major drag on the economy. Second, land sales have also
slowed remarkably as a result of weaker property sales
and the funding stress faced by developers. According to
Centaline property agency, land sales in 130 major cities
slumped 30.6%yoy in the first 11 months of 2011. As
local land revenues are a major funding source for local
infrastructure and public housing projects, the decline in
land sales implies local sponsored FAI may be significantly
curtailed at least in the early part of next year even if bank
lending recovers.
We think it is important that property sales recover to a
healthy level from 2Q of 2012 to avoid a hard landing of
the economy. Otherwise, the risk of GDP growth falling
below 7% for two consecutive quarters will become
material (we know it is most likely to be below 7% on qoq
basis in 1Q already), and by then the government will be
concerned about its implication for social stability.
We see two scenarios under which property sales canrebound from 2Q:
First, a 20% drop in property prices will significantly
improve affordability and thus begin to boost demand.
Over the past two months, property prices in 35 major
cities have already declined by 13% according to Soufun,
and another 5-7% drop is quiet easy to achieve within 1Q.
Taking into account the fact that the average wage has
been rising at 13% per year, it means that affordability will
improve by 33% compared with a year ago. This could be
a powerful reason for a meaningful resumption of
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property sales. This is what we call an automatic
stabilizer.
Second, consider the case that the automatic stabilize
does not work, and property prices continue to spiral
downwards after a 20% drop. The resulting further
decline in property sales, property FAI, land sales willbegin to lead to sizeable lay-offs by developers,
construction companies, property agencies, cement and
steel mills, as well as construction machinery companies.
This will force the government to take actions to stabilize
the property market. We do not think the government will
take any major actions in the immediate future, as the
hard landing fear and social pressure are not yet obvious.
But by 2Q, if the property downward spiral is becoming
visible, we think the government will act. To deal with that
situation, our advice to the government is to provide
incentives for first home buyers with a specific expiration
date such as the end of 2012. These incentives caninclude a reduction in the stamp duty, a reduction in the
business tax, a reduction in the down-payment ratio for
mortgage loans, and a discount to mortgage interest
rates, all for first time buyers. The government should
continue to keep the home purchase restrictions in place
to prevent another property bubble driven by speculative
purchases. We think this strategy will work effectively to
boost property sales and to ensure a recovery of the
overall economy.
Jun Ma, Hong Kong, (852) 2203 8308
China: Deutsche Bank forecasts
2010 2011F 2012F 2013F
National Income
Nominal GDP (USD bn) 5879 7031 8141 9516
Population (mn) 1374 1383 1389 1395
GDP per capita (USD) 4279 5084 5860 6819
Real GDP (YoY%)1 10.3 9.1 8.3 8.6
Private consumption 9.0 8.4 8.4 8.8
Government consumption 8.0 9.0 8.5 9.0
Gross capital formation 11.6 10.7 9.0 8.5
Export of goods & services 22.0 12.0 6.4 12.5
Import of goods & services 23.0 14.0 7.8 13.0
Prices, Money and Banking
CPI (YoY%) eop 4.6 3.8 2.8 3.5
CPI (YoY%) ann avg 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit (YoY%) 19.9 15.0 15.5 14.0
Fiscal Accounts (% of GDP)
Budget surplus -1.7 -2.0 -2.2 -1.5
Government revenue 21.3 22.7 22.5 22.5
Government expenditure 17.8 24.7 24.7 24.0
Primary surplus -1.2 -1.3 -1.5 -0.8
External Accounts (USD bn)
Merchandise exports 1578.0 1893.6 2045.1 2331.4
Merchandise imports 1395.0 1729.8 1885.5 2187.2
Trade balance 183.0 163.8 159.6 144.2
% of GDP 3.1 2.3 2.0 1.5
Current account balance 306.0 283.8 269.6 244.2
% of GDP 5.2 4.0 3.3 2.6
FDI (net) 124.9 100.0 70.0 50.0
FX reserves (USD bn) 2847.0 3270.0 3600.0 3900.0
FX rate (eop) CNY/USD 6.59 6.35 6.13 5.86
Debt Indicators (% of GDP)
Government debt2 20.3 19.4 19.1 18.3
Domestic 19.7 18.8 18.6 17.8
External 0.6 0.6 0.5 0.5
Total external debt 9.3 10.4 10.2 9.8
in USD bn 549.0 730.0 830.0 930.0
Short-term (% of total) 68.0 70.0 65.0 60.0
General (YoY%)
Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0Retail sales (nominal) 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD nominal) 31.3 20.0 8.0 14.0
Merch imports (USD nominal) 38.7 24.0 9.0 16.0
Financial Markets Current 3M 6M 12M
1-year deposit rate 3.50 3.50 3.50 3.50
10-year yield (%) 3.63 3.40 3.30 3.30
CNY/USD 6.35 6.35 6.27 6.13
Source: CEIC, DB Global Markets Research, National Sources
Note: (1) Growth rates of GDP components may not match overall GDP growth rates due to
inconsistency between historical data calculated from expenditure and product method. (2) Including
bank recapitalization and AMC bonds issued
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Strategy
Local Markets Strategy
We are constructive on CNY fixed income market in
the first half of 2012 as disinflation, growth
deceleration and the lack of capital inflow will allow
the central bank to fine-tune its monetary condition
towards easing more proactively. As macro indicators
and policy environment will likely stabilize in H2,
technical factors such as liquidity and bond supply
and demand balances (other than trend factors) will
become more important drivers for rates market
performance.
There are three fundamental factors underpinning our core
constructive outlook on CNY rates market in the H1 of
2012. First, sequential real GDP will decelerate to 7.7%
YoY and 7.5% YoY in Q1 and Q2, before recover to 8.7%
in H2; second, we expect CPI inflation to decline sharply
to 3% YoY in Q2; thirdly, capital inflow is unlikely to be as
strong as in 2011 as export growth will decelerate, and if
coupled with speculative outflow, will likely tighten
domestic liquidity. With our projected balance between
growth/inflation and risk of capital outflows, we believe
monetary policy which has shifted towards easing in
December with a 50bps cut in RRR, likely will accelerate
in the next two-quarters.
We believe PBoC will primarily employ quantitative tools
such as RRR cuts and open market operation to release
liquidity and manage money supply growth. We expect
about 150-200bps RRR cuts, taking the required reserves
for large financial institutions from 21% at present to 19-
19.5% in the first half of next year. Any cut in the policy
interest rates will have to be justified by much faster pace
of disinflation, and for the time being, our base case view
is no change in the policy rates.
Outlook on interbank liquidity: We expect at least a50bps cut in RRR in January (possibly as early as the end
of December 2011) and another one in February. In
addition to reasons such as the risk of capital outflow and
weak growth momentum Q1, there are two more
considerations: (a) PBoC bill redemption in January and
February will be quite low (total CNY 25bn) relative to
other months of the year, and CNY 115bn repo
redemption in January; (b) additional required reserve on
margin deposit for medium and smaller size banks to drain
CNY 320bn in the next nine weeks: the next remaining
three scheduled payment will fall on December 15 th for
Monthly OMO redemption profile in 2012 (CNY bn)
0
20
40
60
80
100
120
140
160
180
200
Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec
PBoC bills Repo
Source: Deutsche Bank, PBoC
RRR vs. the stock of PBoC bills
0
5
10
15
20
25
0
1000
2000
3000
4000
5000
6000
Nov-03 Nov-05 Nov-07 Nov-09 Nov-11
PBoC bill outsta nding CNY bn
RRR
Source: Deutsche Bank, CEIC
1Y PBoC bill yield vs RRR and 1Y policy deposit rate
1
1.5
2
2.5
3
3.5
4
4.5
14
15
16
17
18
19
20
21
22
May-08 Mar-09 Feb-10 Jan-11 Dec-11
RRR (LHS) 1Y PBOC 1Y Depo
Source: Deutsche Bank, Bloomberg Finance LP
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about CNY 80bn, and January 15 th for CNY 120bn and
February 15th for another CNY 120bn. That is to say in
order to keep lending growth and M2 growth at 15-16%,
at the beginning of the year, PBoC has to provide base
money growth of at least RMB 287bn average per month
(assume multiplier of 3.8, was 3.74 by the end of
September), and if we assume FX purchase (capital inflow)grew at USD 25bn per month (as it did in 2011), it is still
insufficient to prevent the system liquidity from net
draining unless PBoC cuts RRR. In the event of capital
inflow at less than USD 25bn per month or capital outflow,
more liquidity injection is necessary to keep the system
liquidity stable. The timing of next 50-100bps cuts in RRR
is more likely in Q2 which will allow PBoC to roll over
OMO redemption from March - May to June- August to
maintain a decent cushion on liquidity operation.
Note in 2011, PBoC reduced the outstanding PBoC bills
by about CNY 2trn, and switched to RRR hikes (six RRRhikes in 2011), which were more effective in reducing
money multiplier which then directly slowed down money
supply growth. In the next few months, we expect PBoC
to use a combination of RRR cuts and increasing bill
issuance to smooth out the impact on domestic liquidity
and to keep money supply growth at a reasonable pace.
However, if liquidity condition becomes more volatile, it is
possible for PBoC to reduce or pause long-dated bill
auctions (1Y or 3Y), and switch to predominantly 3M PBoC
bills to manage liquidity with desired flexibility.
We believe the 1Y PBoC bill yield should not deviate
much (-10-20bps) from the 1Y policy deposit rate
(3.5%) in the first half of 2012, as we do not call for
policy rate cut for now, downward adjustment on the
auction yield of 1Y PBoC bill is only possible when liquidity
becomes more abundant unless PBoC intends to signal
rate cuts.
We expect net liquidity inflow to the interbank market
to help bring money market rates 50-100bps lower
from where they are now (overnight repo at 2.95%
and 7D repo rate at 3.51%)before the middle of 2012.
Currently 1Y Repo swap curve is pricing in 3MMA of 7D
repo rate at 2.63% by the end of 2012, which is in linewith our expectation. However, in the near-term, the
relative stickiness of the 7D repo fixing rate given the
year-end seasonal liquidity demand, and the extent of
liquidity easing being priced in on the Repo IRS curve
argues for the outright level of CNY IRS curves to be
relatively range bound (within 10-15 bps range).
We expect 3M Shibor rate to fall towards 4.75-4.5% in
H1 next year. It will remain stubbornly sticky in the near-
term because of its higher term premium than money
market rates, which means it tends to fluctuate with
changes in policy deposit rates (which we call for no
change in 2012), rather than with short-term liquidity. If
and when Shibor fixing banks get more comfortable with
outlook for liquidity easing, they will price in less term
premium on 3M Shibor fixing.
3M Shibor fixing vs. RRR and 1Y policy deposit rate
(%)
5
7
9
11
13
15
17
19
21
23
1
2
3
4
5
6
7
Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11
1Y Depo 3M Shibor RRR (LHS)
Source: Deutsche Bank, Bloomberg Finance LP
CNY rates trade recommendation: We think the risk
reward of outright receiving Repo rates is unfavorable and
costly in carry. We believe Repo swap or Shibor swap
curve steepeners are more suitable for investors sharing
our view. We recommend entering Repo IRS/NDIRS or
Shibor IRS/NDIRS 2Y/5Y steepeners about 10bps (target
exit 40bps and stop loss -5bps) and -20bps (target 20bps
and stop loss -35bps) respectively.
Bullish on cash bonds in H1. We retain our bullish view
on CGB cash bonds and believe 10Y CGB can rally by 20-
30bps over the next one to two quarters if CPI falls
CGB yields and CPI YoY (%)
-4
-2
0
2
4
6
8
10
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
Nov-03 Nov-05 Nov-07 Nov-09 Nov-11
5Y CGB
10Y CGB
CPI Y/Y (RHS)
Source: Deutsche Bank, Bloomberg Finance LP
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sharply towards 3%. Supply risk is low in Q1 which
should provide good technical support. We recommend
overweight CGB bonds.
Net financing to increase by 21% in 2012. We expect
modest fiscal expansion to result in the total government
fiscal deficit to rise to CNY 1100bn, which implies netfinancing for next year will increase by CNY 200bn, 21%
YoY from CNY 900bn (700bn central government financing
and 300bn local government financing) in 2011. 2012
Gross government bond issuance will increase by 23%.
The increase in net financing reflects CNY 300bn local
government deficit financing to partially roll over bank
loans. As we discussed in the November 25 th edition of
Asia Local market weekly, about CNY 1837bn local
government bonds/bank loans will mature and some loans
could be replaced with market placement of local
government bonds.
The term structure of CGBs will be similar to 2011 with an
average duration of roughly 10Y. Duration of local
government debt is likely to be shorter, roughly 5Y on
average.
Local government debt redemption schedule (CNY
bn)
Source: Deutsche Bank, the National Audit Office of China
In 2011, commercial banks net bought CNY 466bn of
CGBs and remained the largest buyers of the bond market.
Assuming CNY deposit and loan growth at 16% in 2012,we estimate commercial banks net allocation for bond
investment in 2012 at approximately CNY 1.8trn, of which
about 35%- 40% can be invested in CGBs. This would be
equivalent to CNY 640bn -730bn net demand for CGBs or
58-66% of our forecast net financing need for 2012.
Insurers, fund houses, security firms will absorb the rest
of the supply, and we expect demand from fund houses
and security firms to be stronger in H1 when equity
market likely will stay volatile than H2.
YTD purchase of CNY bonds by investor type (CNY
bn)
-400
-200
0
200
400
600
800
1,000
1,2001,400
1,600
1,800
Commercial
Bank
Trust
Cooperative
Securities
Company
Insurance
Company
Fund House
CGB Policy bank bonds Corp bonds CPs MTNs
Source: Deutsche Bank, CEIC
Monthly purchase of CGBs by investor type (CNY bn)
-40
-20
0
20
40
60
80
100
120
140
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-1
Commercial Bank Insurers
Source: Deutsche Bank, CEIC
Wait for stability in the credit market. We remain
cautious on the onshore credit market in the next few
months and will wait till credit outlook stabilizes before
considering increasing allocation.
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Currency Strategy3
The RMB has been the top performing Asian currency this
year and has risen close to 5% against the USD. However
China has started to ease its policy stance, although a
major reversal is unlikely. We think the policy shift
would likely include a slower pace of RMBappreciation in 2012.
Inflation is falling, and so should the rate of RMB
appreciation
Our view remains that China regards exchange rate as a
monetary policy tool part of a broader policy toolkit that
includes RRR, interest rates, credit guidance and
administrative measures for managing inflation. China
has tended to change the pace of RMB appreciation (with
some lag) in line with inflation trends (see first chart). Our
view of a slowdown in the pace of RMB appreciation is
mostly predicated on the fact that inflation has alreadypeaked for this cycle, and is likely to fall below 3% by Q2
next year. With weaker commodity prices and moderating
tradable goods inflation, the case for a rapidly appreciating
currency has clearly weakened. In y-o-y terms, the pace of
RMB appreciation peaked at around 6% in August, and
has since slowed to about 4.5%. A 3% y-o-y appreciation
at end-June would imply a USD/CNY (fixing) rate of closer
of 6.28 (vs. latest fixing of around 6.33).
Inflation is falling, and so should the rate of RMB
appreciation
Sources: Deutsche Bank, Bloomberg Finance LLP
Downside risks to exports are growing
Chinese exports are slowing but the recent trend of
negative surprises in regional exports suggests more
downside risks for China. For instance Singapores NODX
show that G2 demand for Asian products is weakening
fairly rapidly, particularly for electronics and other capital
3Part of this report was first published in Asia FX Strategy NotesRMB:
Shifting into lower gear on 18 November
goods. Chinese exports have tended to lag regional
exports figures by a few months, and it is likely that more
pronounced weakness shows up in numbers there in the
coming months (second chart).
Regional exports are slowing down, and China
typically lags by a few months
Sources: Deutsche Bank, Bloomberg Finance LLP
BoP pressures are easing
To be sure, BoP pressure is not a major concern at this
stage, as Chinas current account surplus will likely narrow
this year and next. Our third chart shows that China
seems to have in fact allowed more RMB gains this year
than what the current account surplus would have
suggested. Meanwhile, FX reserves show a more
balanced flows picture lately, with ex-valuation reserves
accumulation in the month of September having gone flat.
China appears to have allowed more RMB
appreciation this year than what the current account
would have suggested
Sources: Deutsche Bank, CEIC
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China FX reserves accumulation has slowed
Sources: Deutsche Bank, CEIC
But CNY weakness does not reflect capital flightSome market observers have argued that the recent fall in
FX reserves and weakness in the onshore RMB spot rate
relative to the daily fixings reflects broader capital flight
out of China, and one should start to worry about bigger
declines RMB weakness ahead. We would however point
out that this weakness of the RMB in its trading band
likely reflected arbitrage activities between the onshore
and offshore spot rates when the CNH-CNY spot basis
widened. With the offshore USD/CNH spot rates trading
at higher levels relative to the onshore spot rate, Chinese
corporates have turned to selling dollars in the offshore
market, while most USD buying transactions continue to
take place in the onshore market. The drying up of USD
selling flows in the onshore market has thus been the
reason for onshore spot bumping against the top of its
+/-0.5% FX band.
A buildup in anti-appreciation rhetoric
Growing headwinds for exports has prompted some
government authorities to expressed concerns over
continued RMB appreciation. Not surprising, the Ministry
of Commerce has been most vocal about this. The
MoCom Minister argued at the recent G20 conference
that RMB is now at a more reasonable level, while other
MoCom officials have over the course of this week raisedconcerns over the impact of RMB appreciation on the
Chinese SMEs. We think it is likely that MoCom exerts
more influence over next years FX policy forum.
Onshore spot relative to daily spot fixings, vs. CNH-
CNY spot spreads
Sources: Deutsche Bank, Reuters
Policy easing: Last-in-first-out principle?
As we have previously noted, a typical Chinese hiking
cycle has involved the following sequence: window
guidance first, followed by RRR hikes, then interest rate
hikes and finally faster RMB appreciation. At the same
time, the 2008 experience suggests that China could
possibly adopt a last-in-first-out principle while easing
policy. In mid-2008, PBoC started to slow the pace of
RMB appreciation before cutting rates in October. The
first RRR cut took place later in December, while the
Chinese government ordered a more aggressive credit
easing only in 2009. This year, the easing cycle has
broadly followed a similar sequencing. The pace of RMBappreciation started to slow in November, before PBoC
the cut RRR in early December.
A last-in-first-out principle in policy easing?
0
5
10
15
20
25
02 03 04 05 06 07 08 09 10 11
1y depo rate
cash reserve ratio
3m chg in USD/CNY, annua lized
CPI inflation
%
Deposit ra tecut: Oct 08
RRR cut: Dec 08
Slows pace of
RMB appreciation:
Jun 08
RRR cut: Dec 11
Sources: Deutsche Bank, Bloomberg Finance LP
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External political pressures are unlikely to deter China
To be sure, international pressures on Chinas FX policy
are unlikely to fade any time soon. Obamas comments at
the recent APEC meeting reveal growing impatience in
the US policy circle, and this will likely only get furthered
in the election year. Brazil has escalated the currency
issue to the WTO, and members will soon start to explorepossible punitive measures against currency manipulators.
That said, while it may be politically difficult for China to
put a complete halt to RMB appreciation; domestic
economic concerns have historically been more important
in influencing Chinas FX policy than external political
pressures. Therefore, China is unlikely to be deterred from
slowing RMB gains if policymakers deem this to be critical
in protecting domestic interests. The sharp increase of the
RMB REER recently would add to the argument.
CNY has appreciated sharply in trade-weighted terms
this year
Sources: Deutsche Bank, BIS
Conclusion and trade recommendations
In sum, we retain a structurally bullish view on the RMB
tied to its long term plan for capital account liberalization,
and the need to reduce its undervaluation). Howver, a
more pronounced cyclical slowdown in its appreciation
path, to nearer 3% by H1 2012 can also be expected. We
however see low chances of authorities allowing a sharp
and persistent depreciation in the RMB, as we think that
authorities would in the worst case repeg the RMB to theUSD if China were to experience an economic hardlanding
and/or a severe banking crisis.
Note however that NDFs behave differently from the
onshore spot rate. In fact, we see risks of USD/CNY NDFs
squeezing higher still as the Chinese economy slows in
coming months. The chart below shows how closely
NDFs (3m changes) have been tracking the official
manufacturing PMI series over the past year. Just this
relationship alone would suggest that if the Chinese PMI
were to fall towards 45 over the coming months, it is
possible that we see 12M outrights rally towards 6.60
6.65 (from current levels of around 6.44).
Downside risks to PMI suggest NDFs have room to
rally
Sources: Deutsche Bank, Bloomberg Finance LP
As such, considering the risk of further volatility in the
NDFs, our preferred strategy is to be long vols via
straddles, even though we also think that being short in
the 1Y USD/CNH or NDFs still makes sense given that
the outrights in both markets are pricing in more than
1% depreciation of the RMB. Relative to other regional
currencies, CNY vols have been most well-behaved and
remain near the lower-year of their 12-month ranges (see
chart). The 1Y breakeven ranges for an ATMF straddle is
around 6.63 and 6.13 (3.9%), which stands in contrast to
most other currencies for which straddles are implying a
broader range in 2012 than that in 2011.
Asia FX implied vols (current vs. 12m ranges)
Sources: Deutsche Bank
Linan Liu, Hong Kong, (852) 2203 8709
Dennis Tan, Singapore, (65) 6423 5347
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CNH Strategy
Outlook for 2012
In retrospect, offshore RMB market in 2011 saw
substantial growth in the breath and the depth of the
market thanks to the launch of a series of new
regulations/policies. In the following table, we review a
few key regulations which have been launched or
announced this year.
Review of key regulation milestones announced in
2011
Regulation to support the development of offshore RMB market
Date Regulation
6-Jan-11 RMB ODI (outward bound direct investment)
program launched
23-Jun-11 PBoC and Russia central bank signed bilateral local
currency settlement agreement
18-Aug-11 Vice Premier Li Keqiang announced 10 new
measures including RQFII program
22-Aug-11 RMB cross border trade settlement program
expanded nationwide
12-Oct-11 RMB FDI (foreign direct investment) program
formalized
RMB Cross currency swap agreement
Date Country
18-Apr-11 New Zealand (RMB 25bn)
19-Apr-11 Uzbekistan (RMB 7bn)
6-May-11 Mongolia (RMB 5bn)
13-Jun-11 Kazakhstan (RMB 7bn)
26-Oct-11 Renew and double the cross currency swap
agreement with Bank of Korea (RMB 360bn)
22-Nov-11 Renew and double the cross currency swap
agreement with HKMA (RMB 400 bn)
Opening up CNY interbank bond market to foreign investors
Jan - October 2011 PBoC granted onshore interbank bond market
access to over 37 participating banks, Clearing
Bank and a few foreign central banks
Regulation to support the development of offshore RMB market by
HKMA
Date Regulation
9-May-11 RMB Fiduciary Account Arrangement
27-Jun-11 Spot USD/CNY (HK)Fixing launched by TMA of
HKMA
28-Jul-11 Position squaring with the Clearing Bank and net
open position
1-Oct-11 RMB cross border trade settlement quota doubled
to RMB 8bn in Q4 2011
8-Nov-11 Requirements on position squaring with the RMB
clearing bank
Source: Deutsche Bank, PBoC, HKMA, Ministry of Commerce
The above positive and supportive policy steps provide
fertile ground for the development of the offshore RMB
market in 2011, and the market has achieved several key
development milestones this year.
(a) RMB cross border trade settlement likely to
register a 300% YoY growth from 2010. RMB cross
border trade settlement volume reached RMB 1.5trn in
the first three quarters of this year, and likely for the full
year of 2011, about 9% of Chinas international trade can
be settled in RMB, which is approximately RMB 2trn. It
represents 300% from year 2010 during which cross
border trade settlement was RMB 506bn, approximately5% of Chinas global trade, and back in 2008, only 2% of
Chinas global trade was settled in RMB. Hong Kong
China RMB cross border trade settlement volume
averaged at RMB 149bn/month from Jan-Oct 2011, 157%
growth from an average of RMB57.8bn/month in H2 2010.
RMB cross border trade settlement and deposit
growth
161.50
-3.70
100
200
300
400
500
600
700
-50
0
50
100
150
200
250
Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11
Size of HK-China cross-border settlementMonthly increase in RMB deposit baseRMB Deposit base (rhs)
RMB bnRMB bn
Source: Deutsche Bank, Bloomberg Finance LP
(b). Offshore RMB deposit grew by 185% YoY as of
October. Cross border trade settlement has been the key
driver of offshore RMB liquidity in the past 18 months. By
the end of October, offshore RMB deposit base in Hong
Kong was RMB 618.5bn, vs. RMB 314.9bn by the end of
last year, if we include RMB deposit in Singapore, total
offshore RMB deposit would be close to RMB 670bn as
of October and to RMB 700bn by the end of December
this year. The year-end CNH deposit base would still be
lower than our previous forecast (RMB 750bn initially and
revised up to RMB 1trn around the mid of 2011), and we
think the deterioration in global risk environment and
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Deutsche Bank AG/Hong Kong Page 15
volatilities in the USDCNH exchange rate have led to a
sharp deceleration in the offshore deposit base and are
key risk to offshore RMB deposit growth next year.
(c) CNH FX spot and forward trading volume grew by
two to threefold from 2010. CNH FX market has been
fairly active in 2010 with average daily trading volumereached USD 2bn in September this year (according to
HKMA), vs. just USD 500mn at the end of 2010. The
implementation of new rule of RMB position squaring
announced by HKMA in November and global risk
reduction in recent months caused daily FX spot and
forwards trading volume to drop to roughly USD 1.5bn
USD 1.75bn or so.
(d) Two-way volatilities in the CNH-CNY spot basis. In
2011, perhaps the most surprising development in the
CNH FX market was the reversal in the CNH - CNY spot
basis from negative to significantly positive -- CNH tradedas wide at 1200pips above CNY spot during September
October. Contributing factors are risk reduction in the
CNH market, unwinding flows related to RMB Letter of
Credit discounting, and fear of CNH liquidity squeeze due
to unavailability of the RMB cross border trade settlement
quota etc.
CNH CNY spot basis vs. NDF implied yield
-2000
-1500
-1000
-500
0
500
1000
1500
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
Sep-10 Feb-11 Jul-11 Dec-11
12M NDF implied appre CNH-CNY spot basis
Source: Deutsche Bank, Bloomberg Finance LP
We see risks that the spot basis remains volatile in early
2012. As we discussed in an earlier CNH Monitor
publication4, there are risks that USD purchases by RMB
LCs discounting banks extend well into Q1 or Q2 next
year based on our estimates of the maturity profile of
RMB LCs, exerting upward pressure on the offshore
USD/CNH spot rate. Unsettling volatilities in the global FX
market and a slowdown in RMB appreciation in H1 would
also limit inflows into the CNH market.
4See Why are RMB spot rates not converging?, 21 October 2011
Maturity profile of RMB LCs suggests that volatility of
spot basis is like extend into early 2012
Source: Deutsche Bank, Bloomberg Finance LP
That said, we note that onshore corporates/MNCs havebecome active in taking advantage of the differences in
the onshore and offshore exchange rates more recently.
Specifically, we believe that Chinese exporters/corporate
with USD receipts have started to shift more of their USD
sales to the offshore CNH market, while dollar purchases
continue to take place mostly in the onshore market. This
has been reflected by the recent weakness in the onshore
RMB exchange rate relative to the daily PBoC fixings.
Notice in the chart below that the onshore USD/CNY spot
rate has tended to trade closer to the upper bound of the
+/-0.5% policy band whenever the spot basis (USD/CNH
less USD/CNY) is positive. This, we think, reflects the
drying up of USD selling flows in the onshore FX market.
Therefore, we think that the increased USD selling flows
by onshore corporate/MNC in the offshore market will
likely dampen volatility in the spot basis and help narrow
the spot basis more quickly whenever LCs-related flows
drive a widening of the basis.
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Weakness in the onshore spot rate (relative to PBoC
fixings) reflect arbitrage activities
Source: Deutsche Bank, Bloomberg Finance LP
(e) Size of CNH fixed income market grew by 267% in
2011. At the time of writing, the YTD gross issuance in the
CNH bond/CD market amounts to RMB 189bn, 330%
growth from 2010. Bond issuances from foreign banks,
Chinese commercial banks, Chinese corporations and
foreign corporations have been among the strongest with
four times to 10 times growth over the past year.
Geographically, issuers from 19 countries have tapped the
CNH bond market, and there has been increasing
diversification among issuers particularly by non-Asia
corporations and banks.
YoY issuance growth
150%
-54%
573%
690%
467%
1040%
-46%
330%
-200%
0%
200%
400%
600%
800%
1000%
1200%
Source: Deutsche Bank, Bloomberg Finance LP
Gross issuance by issuer type (RMB bn)
0
20
40
60
80
100120
140
160
180
200
2007 2008 2009 2010 2011
Foreign Corp Corporat ion
Supranational Foreign Banks
Commercial Banks Policy Banks
Sovereign
Source: Deutsche Bank, Bloomberg Finance LP
Distribution by issuers country of origin
Greater China,
90.32%
Other Asia,
3.53%
Europe, 3.88% America, 1.60%Surpranational,
0.67%
Source: Deutsche Bank, Bloomberg Finance LP
(f) Liquid CNH bonds tracked by DB ORBIT index
delivered a YTD total return of 2.08% to USD-based
investor and -1.28% to CNH based investor (Dec 9 th).
Since July this year, the CNH bond market suffered from a
broad-based risk reduction in the global FX and the credit
market and the average yield of CNH bonds rose from
2.5% in June to peak at 3.95% in mid October, and
retraced slightly to 3.92% in December. Comparing with
other USD-denominated Asia IG and HY credits, which
lost 3.28% and 5.21% YTD (hedged out UST return), CNH
bonds have outperformed so far this year.
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15 December 2011 China Outlook 2012
Deutsche Bank AG/Hong Kong Page 17
CNH Total Return Index (DB ORBIT)
97
98
99
100
101
102
103
104
105
J an- 11 F eb -11 Ma r- 11 Apr- 11 Ma y- 11 J un- 11 J ul -11 Au g- 11 Se p- 11 O ct- 11 Nov- 11 Dec -11
DB CNH bond index (CNH total return) DB CNH bond index (USD total return)
DBCNH Index for CNH based total return and DBCNHA Index for USD based total return (
Source: Deutsche Bank
While most of the development milestones have been
impressive and showed the vitality of the young offshore
RMB market which came to life only 17 months ago, the
surprisingly high volatilities of CNH FX demonstrated that
the market is still fledging and has yet to strengthen both
its market infrastructure as well as regulatory
infrastructure.
Looking ahead, we believe the offshore RMB market will
continue to thrive in 2012. On the policy front, we are
likely to see solid progress in the following areas:
Implementation of RMB FDI program and ODIprogram. Both programs have been officially
launched, specifically for RMB FDI program which
was formalized in November; so far only a handful ofcases have been approved. We have seen a growing
number of offshore corporations having expressed
interests in the program and we expect regulators to
grant more approval of FDI in 2012. In particular, we
expect about RMB 150-200bn CNH bond issuance for
RMB FDI purpose next year.
More enterprises will be allowed to participate inthe RMB cross border trade settlement scheme.
By the end of 2010, there were 67724 Mainland
Designated Enterprises (MDE) who were eligible to
participate in the RMB cross border trade settlement
scheme. Although the scheme was expanded
nationwide in August of 2011, the list of MDE has yet
to be expanded. In 2012, we expect key regulators to
grant MDE status to a much broader range of
domestic enterprises and in order to make it more
manageable, regulators are likely to draft a list of
exclusion (those who are not permitted in the
scheme) to make the program more manageable.
Launch of the RMB-QFII program. The RMB-QFII(RQFII) program was announced in August 2011
during Vice Premier Li Keqiangs visit to Hong Kong
and the size of the program was set initially at RMB
20bn. It is possible that the program will be officially
launched next year and RQFII quota to be allocated to
CNH fund managers.
Expand RMB cross currency swap arrangementwith more trading partners in particular withASEAN countries. We believe RMB cross currency
swap line is a necessarily arrangement to facilitate
RMB cross border trade settlement. In 2011, PBoC
signed a total of RMB 804bn cross currency swap
agreement with six foreign central banks and
currently PBoC has RMB cross currency swap
agreements with a total of 12 foreign central banks in
the amount of RMB 1.22trn. In November this year,
Premier Wen expressed Chinas interest in
broadening the use of RMB in regional trade
settlement in the ASEAN summit and PBoC has since
then renewed and doubled its RMB cross currency
swap agreements with HKMA and BOK respectively.
In 2012, we are likely to see a continuation of such
efforts with Chinas trade partners.
Outstanding RMB Cross Currency Swap Agreement
(RMB bn)
Malaysia
Belurus
Indonesia
Argentina
Iceland
Singapore
New Zealand
Uzbekistan
Mongolia
Kazakhstan
Korea
HKMA
0
50
100
150
200
250
300
350
400
450
RMB cross currency swap agreement
Source: Deutsche Bank, PBoC
(a) The Offshore RMB market to expand to moreregional trading centres and we do not rule out
the possibility of appointing another offshore
RMB Clearing Bank in Singapore. We are likely to
see more CNH products to be traded in more regional
financial centres such as Singapore, London etc.
Moreover, in order to promote RMB cross border
trade settlement with Chinas trading partners in
ASEAN countries, it is possible PBoC will consider
appointing another offshore RMB Clearing Bank, (in
addition to the Clearing Bank in Hong Kong) in 2012,
most likely in Singapore. To boost RMB as a potential
commodity pricing currency, China has started
settling imports (especially commodities) with Russia
(bilateral local currency trade settlement), next year
RMB is likely to be used for settlement and
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15 December 2011 China Outlook 2012
Page 18 Deutsche Bank AG/Hong Kong
potentially pricing for more commodity imports
(crude oil, iron ore and agriculture products), although
we think it will take at least another 2-3 years for a
broader adoption of RMB in commodity pricing.
On the market development, with the set of policies
currently in place to promote RMB trade settlement andmore channels for RMB repatriation (RMB FDI), we expect
RMB trade settlement volume to increase by 67% next
year to RMB 3.7trn. Besides, the potential appointment of
another offshore Clearing Bank will likely grow the daily
CNH FX trading volume to USD 3.5-4trn. Offshore RMB
loan growth and accumulation of RMB trade surplus will
contribute to the growth of the offshore RMB deposit
base to RMB 1.5trn. A combination of CNH bond supply
from domestic corporations/financial institutions, foreign
corporations, third party issuance of RMB bonds for
funding (cross currency swapped back to local currency),
we expect net issuance of CNH bonds/CDs at RMB 240bn(RMB 280bn gross issuance) in 2012.
We expect CNH bond market performance to remain
choppy in H1 next year and to recover fully in H2, and our
base case assumption is for total return to be primarily
driven by carry and currency gain on the bonds rather than
capital gain. We project the total return of the liquidity
CNH bonds (tracked by DB ORBIT index) at about 3.9%
next year to CNH based investors and 7.4% for UST
based investors based on 3.5% annual appreciation of
RMB against the USD.
2012 forecast of key performance indicators in theoffshore RMB market
RMB appreciation 3.50%
RMB cross border
trade settlement
RMB 3.7trn or 15% of China's global trade volume
Average daily FX
trading volume
USD 3.5-4bn
Offshore deposit base
(HK+Singapore)
RMB 1.5 trn
RMB net bond supply RMB 240bn
CNH Bond Total Return
Forecast
3.9% (CNH) 7.4%(USD)
Source: Deutsche Bank
The key downside risk to our forecast is the pace of RMB
appreciation and the directional risk as well as volatility of
the CNH-CNY spot basis. We believe the risk will be more
acute in the first two quarters of 2012 if we see an
extended period of risk aversion in the global markets and
its negative impact on the global growth. Should it
happen, the bearish case of our forecasts would be a
30% trim in our projected growth of the offshore market.
Linan Liu, Hong Kong, (852) 2203 8709
Dennis Tan, Singapore, (65) 6423 5347
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15 December 2011 China Outlook 2012
Deutsche Bank AG/Hong Kong Page 19
Appendix 1
Important Disclosures
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this report. Linan Liu/Jun Ma/Dennis Tan
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15 December 2011 China Outlook 2012
Page 20 Deutsche Bank AG/Hong Kong
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David Folkerts-LandauManaging Director
Global Head of Research
Guy Ashton
Head
Global Research Product
Marcel Cassard
Global Head
Fixed Income Research
Stuart Parkinson
Associate Director
Company Research
Asia-Pacific Germany Americas Europe
Fergus Lynch
Regional Head
Andreas Neubauer
Regional Head
Steve Pollard
Regional Head
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Regional Head
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