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Nomura

N O M U R A I N T E R N A T I O N A L

( H O N G K O N G ) L I M I T E D

Asia Special Report NOMURA GLOBAL ECONOMICS AND STRATEGY

China primed to surprise on the upside

We believe economic growth in China will rebound earlier, and

stronger, than the market currently expects. Consensus expects

growth to stay broadly flat in H2 from 7.6% y-o-y in Q2, but we expect

growth to rebound visibly in Q4 to 8.8%, driven by stronger

infrastructure and housing investment, which combined account for

half of total investment.

We believe CPI inflation bottomed in July and will rise to 4.2% in

2013, exceeding the consensus forecast of 3.4%, driven by a positive

output gap and the surge in global food prices. We expect the

People’s Bank of China to leave interest rates unchanged for the rest

of 2012 and hike twice in H2 2013, which should lead to slower GDP

growth of 7.9% for 2013 and to 7.2% in Q4 2013.

The rates market selloff is likely to continue as the economy

rebounds and inflation rises. We expect the curve to bear steepen on

less volatility in repo fixings and a macro backdrop supporting the

back end. We recommend exposure via a 3s5s steepener.

We are more optimistic on CNY in the short term and recommended

adding to our short USD/CNY position (fix 31 December), looking for

a move towards 6.30 by the end of 2012. In the medium term, we

believe scope for CNY appreciation will be limited, with USD/CNY at

6.25 by end-2013 and with some risk of depreciation into 2015.

China stocks have underperformed for six months as investor

confidence and earnings expectations slumped with the macro data

and political noise. But with earnings headwinds abating, stocks look

set for a firm year-end recovery – with a potentially strong boost from

short-covering.

14 September 2012

Principal authors

Economist, Asia ex-Japan

Zhiwei Zhang

[email protected]

+852 2536 7433

FX and Rates Strategists, Asia ex-Japan

Craig Chan

[email protected] +65 6433 6106

Kewei Yang


Equity Strategists, Asia ex-Japan

Michael Kurtz


Wendy Liu


See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

mailto:[email protected]



Nomura | Asia Special Report 14 September 2012

2

Table of contents

Executive summary 3

Economics: An investment boom will cause growth to rebound 4

Rates strategy: Fundamentals outweigh liquidity 12

FX strategy: Short-term positive on CNY; medium-term cautious 15

Equity strategy: Overweight China ahead of data improvements 19

Recent Asia special reports 21


3

Executive summary

Economics

We believe economic growth in China will rebound earlier, and stronger, than the market

currently expects. The consensus forecast for 2012 GDP has fallen to 7.7% from 8.1% three

months ago, and on a quarterly basis the consensus expects growth to slow from 7.6% y-o-y in

Q2 to 7.5% in Q3, before recovering slightly to 7.7% in Q4. We on the other hand expect growth

to rebound visibly in Q4 2012 to 8.8%, driven by stronger infrastructure investment and a

rebound in housing investment, which combined account for half of total investment.

We believe CPI inflation bottomed in July and will rise to 3.1% in Q4 2012. We expect CPI to

climb further to 4.2% in 2013, exceeding the consensus forecast of 3.4%. We believe the

economic recovery will open up a positive output gap. The surge in global food prices is also

likely to push up pork and edible oil prices in China.

We expect the People‟s Bank of China (PBOC) to leave interest rates unchanged for the rest of

2012 and hike twice in H2 2013 as inflation rises above 4%. Higher inflation and monetary

tightening should lead to slower GDP growth of 7.9% for 2013 and to 7.2% in Q4 2013.

Rates strategy

Given enhanced fine-tuning of its OMOs by the PBOC (especially through reverse repos),

liquidity has become stable. We expect macro fundamentals to gradually become the dominant

factor driving China rates in future.

Based on our above-consensus forecasts for growth and inflation, we see room for rates to

move higher in the wake of the sell-off since mid-July.

A relatively stable liquidity outlook, a positive economic outlook for China and reduced tail risk

globally (due to ECB and Fed action/QE), suggest the curve is likely to bear steepen. We

recommend investors take exposure via a 3s5s steepener.

FX strategy

Cyclical factors for CNY appreciation are beginning to strengthen, with domestic leading growth

indicators rising and inflation forecast to pick up in coming months. Indeed, our regression

analysis indicates that a pick-up in growth and inflation should lead to CNY appreciation. There

are also signs that net capital outflows are beginning to stabilise, which should help reduce

expectations of CNY depreciation.

We are more optimistic on CNY in the short term and recommended adding to our short

USD/CNY position (fix 31 December), looking for a move towards 6.30 by the end of 2012.

Risks include political uncertainty around China‟s leadership transition (expected in mid-

October) and the US presidential election in November.

In the medium term, we believe scope for CNY appreciation will be limited, with USD/CNY at

6.25 by end-2013 and with some risk of depreciation into 2015. Aside from CNY being only

marginally undervalued, the risk to CNY follows our macro view that China‟s current account

surplus will swing into deficit in 2014.

Equity strategy

China stocks‟ relative performance has remained weak through the summer as investor

confidence and earnings expectations slumped alongside the macro data and political noise.

But with substantial bottom-line relief via softer input costs and with macro data set to improve,

China stocks look set for a firm recovery into end-year.

Technical factors that would aid a sharp China stock rebound include large outstanding short

positions (creating pressure for covering and a „squeeze‟ higher) and region-low PER multiples

on now very conservative earnings forecasts.


4

Economics: An investment boom will cause growth to

rebound

China‟s GDP growth has been on a downtrend for six consecutive quarters (from Q4 2010 to Q2

2012). Market sentiment for China‟s growth outlook has been overwhelmingly negative as the

Shanghai stock market index hit a post-2009 low. The consensus forecast for 2012 GDP has

fallen to 7.7% from 8.1% three months ago, and on a quarterly basis consensus expects growth

to slow from 7.6% y-o-y in Q2 to 7.5% in Q3, before recovering slightly to 7.7% in Q41.

We disagree with the consensus view as we see several compelling reasons to expect a visible

upturn in growth in Q4, supported by infrastructure and housing investment. Indeed, our

disconnect with the market view is mainly because of the investment outlook. We expect fixed-

asset investment (FAI) growth to pick up to 21% y-o-y by December 2012 from 20.2% in August

on year-to-date basis, while consensus expects FAI growth to slow to 19.5%.

Infrastructure investment to rebound further in Q4

Both the central and local governments have sent clear signals over the past several months

that they intend to increase infrastructure investment to promote growth. These include:

The announcement by the central government that it approved several infrastructure

projects on 5 and 6 September, including 25 subways and 13 highways. We estimate

the total size of the investment at RMB1trn, or 2.1% of 2011 GDP (Figure 1).

The announcements by local governments of large investment plans that on our tally

total RMB11.6trn, or 23% of GDP, which dwarf the 2008 fiscal stimulus of RMB4trn or

13% of GDP (Figure 2).

President Hu Jintao‟s 8 September APEC speech, which acknowledged the downside

risks to the economy and indicated that fiscal support for infrastructure investment

should be strengthened.

Vice Premier Li Keqiang‟s speech on 12 September in favour of “energy saving

industries and urban facilities such as water supply and public transportation”. Widely

expected to take over the premiership in March 2013 when Premier Wen Jiabao retires,

Li also noted that “Under current conditions, we should focus on this kind of investment

with multiple spillover effects and increase spending, and take them as leverage to

help promote domestic demand”. We believe Li‟s comments reflect a subtle change in

his stance from previous speeches. As far as we are aware, he has not sounded such

a strong endorsement of infrastructure investment in the past.

Railway investment growth, which turned positive in August to 19% y-o-y after falling

for the first seven months in 2012. The Ministry of Railway has increased its

investment plan for 2012 twice since August. It was first revised from RMB406bn to

RMB470bn in early August and again to RMB496bn on 30 August. According to 21st

Century Economic News, the government may raise planned investment further.

We believe these signals suggest that the policy stance has become much more proactive. This

change may have occurred for two reasons. First, the important Communist Party leadership

transition, which will likely take place in mid-October, is fast approaching; hence government

leaders are incentivised to loosen policies so that growth rebounds after the transition. Second,

the risk of failing to meet the 2012 GDP growth target has become real as the economy slowed

further in July and August; thus there is more urgency to act.

The most commonly asked questions about these investment plans include:

1) How many of these projects are new, and how many were already part of previous

investment plans? If projects were already planned, are these announcements still

positive for growth?

2) What is the time lag between a project‟s approval and its implementation? When will

we see its impact on headline FAI growth?

3) How will these projects be financed?

4) Which indicators should be monitored to gauge the impact of the stimulus on

investment?

1 Consensus forecasts are from Asia Pacific Consensus Forecasts, compiled by Consensus Economics Inc.

Zhiwei Zhang

[email protected]

+852 2536 7443

Wendy Chen

[email protected]

+86 21 6193 7237


5

Fig. 1: Projects approved by central government

Source: CEIC, Nomura Global Economics

Date City/Province Project type RMB mn Construction years

April Chengdu Subway/ transportation 11,483.00 5

April Changchun Subway/ transportation 12,830.00 5

April Ningxia Power station 1,500.00 N/A

April Inner Mongolia Power station 3,466.00 N/A

April Shuozhou Wind farm 2,066.58 N/A

April Xinjiang Mining 2,482.00 1

April Heilongjiang Airport N/A

April Chongqing Airport 27,500.00 4

April Xinjiang Airport 515.00 N/A

April Gansu Airport 220.00 N/A

May Sichuan Water supply 210.00 N/A

May Sichuan Airport 900.00 N/A

May Jinsha Hydropower station N/A

May Jilin Power 420.00 1

May Xinjiang Power 9,556.00 1

May Zhengzhou Power 23,390.00 2

May Shandong Power station 2,632.83 N/A

May Anhui Power station N/A

May Liaoning Power station N/A

May Changzhou Subway/ transportation 33,650.00 5

May Xiamen Subway/ transportation 50,370.00 5

May Xi'an Line 3 Subway/ transportation 18,030.00 5

June Shenzheng Resources 8,000.00 3

June Hebei Wind farm 880.50 N/A

June Tianjing Line 6 Subway/ transportation 39,815.00 4

June Tianjing Line 5 Subway/ transportation 25,822.00 4

June Shenyang Subway/ transportation 61,038.00 5

June Harbin Subway/ transportation 56,220.00 5

June Shanghai Subway/ transportation 16,791.00 3

June Lanzhou Subway/ transportation 22,922.00 5

June Taiyuan Subway/ transportation 30,929.00 4

June Gantang to Wuwei Subway/ transportation 3,770.00 N/A

June Hebei Wind farm 1,764.42 N/A

July Harbin Airport 3,472.00 4

July Guangzhou Airport 18,854.00 8

July Inner Mongolia Airport 330.00 1

July Guangzhou Subway/ transportation 124,100.00 4

July Shijiazhuang Subway/ transportation 42,194.00 5

July Ningbo Line 1 Subway/ transportation 7,022.00 4

July Guangzhou Line 7 Subway/ transportation 9,467.00 4

July Hangzhou Line 1 Subway/ transportation 8,290.00 N/A

August Henan Sewage treatment N/A

August Gansu Sewage treatment N/A

August Inner Mongolia Sewage treatment N/A

August Inner Mongolia Sewage treatment 100.00 N/A

August Chongqing Waste incineration power plant N/A

August Chongqing Waste incineration power plant 4.40 N/A

August Shaanxi Seweage treatment 191.00 N/A

August Xinjiang Wind farm 16,182.51 N/A

August Hebei Power station 17,000.00 N/A

August Heilongjiang Power station 5,440.00 6

August Inner Mongolia Subway/ transportation 8

August Suzhou Line 2 Subway/ transportation 9,905.00 4

August Shenzhen Line 11 Subway/ transportation 33,322.00 5

August Shenzhen Line 7 Subway/ transportation 25,492.00 5

August Qingdao Line 2 Subway/ transportation 17,552.00 5

August Chengdu Line 1 Subway/ transportation 4,007.00 3

August Suzhou Line 4 Subway/ transportation 35,749.00 5

August Shaanxi Sewage treatment N/A

Total 847,847.23 Average: 4.08


6

Fig. 2: Local government investment plans


Fig. 3: Fixed asset investment growth by sectors


Fig. 4: Central government project approval


How many of these projects are new and how many were already part of past investment

plans? Some economists argue that most of these plans were already part of the 12th Five

Year Plan (FYP), and hence are not new. We disagree. First, none of the subway projects are

part of the national FYP. Some were mentioned in local FYPs (for instance, Changzhou's FYP

stated the aim of launching a subway project), but this does not necessarily mean that these

projects will be implemented as they still require central government approval. Note that in 2011

only nine subway lines were approved. The approval of 25 lines over three months is not

something we should dismiss as a non-event.

More importantly, even if the proposed subways were already slated for construction over the

next few years and the government merely decided to bring the schedule forward, the

implication for the growth outlook in the next few quarters is non-trivial. Therefore, we do not

see this question as relevant if ultimately we want to determine what the subway lines mean for

economic growth over the next 12 months.

What is the time lag between a project’s approval and its implementation? When will we

see the impact on headline FAI growth? We estimate the time lag between a project‟s

approval and its launch at about three to four months. When the RMB4trn stimulus package

was rolled out in 2008, project approval in mid-November saw project investment begin to pick

up sharply in January-February 2009. In this case, the stimulus may take longer to materialise

as the urgency is not as high as in 2008-09. Actually, FAI growth for infrastructure has already

picked up recently (Figure 3). We expect this trend to continue since project approvals rose

sharply in Q3 (Figure 4), with projects likely to start in Q4.

Investment plan

announcement

date

Province or City Summary Amount Time horizon

July Guangdong

Proposed to focus on reversing the downtrend in investment through increased efforts in the

construction of major projects, including the distribution of 44 key projects totalling

RMB235.3bn for private investment.

RMB400bn 1 year

July 16th Ningbo To actively encourage investment in major industrial projects of RMB2bn or more and new

strategic projects of RMB300m or more.N/A N/A

July 23rd Nanjing

Proposed to accelerate the construction of infrastructure projects and new industrial projects.

Promote real estate and automobile consumption, tourism, exhibitions, e-commerce and

green consumption.

N/A N/A

July 23rd Guizhou

Since May 2012, 2,382 projects have been screened, valued at RMB3.2479trn. These include

10 nationally ranked projects, 50 provincially ranked projects of high importance and 200

provincially ranked projects of high focus.

RMB3trn N/A

July 25th ChangshaAnnounced 195 projects totalling RMB829.2bn in 2012, including 40 major projects totalling an

investment value of RMB374.8bn.RMB830bn 5 years

August 7th Guangzhou

In H2, will focus on 101 major projects valued at RMB71.4bn and 76 new or ongoing projects

valued at RMB127bn. In addition, plans to initiate construction of seven newly approved

subway lines and the Baiyun Airport expansion.

RMB200bn 5 years

August 14th ChangchunWill set aside RMB2bn for the science and technology and services sectors, as well as for

infrastructure construction and maintenance. RMB2bn N/A

August 20th Chongqing Will invest a total of RMB1.5trn in industrial investment. RMB1.5trn 3 years

August 20th Shanxi

To host a conference to promote investment in the province, with a focus on the service

sector, new materials, equipment and advanced technologies. In H1 Shanxi attracted a total of

RMB258bn for investment purposes.

RMB2trn N/A

August 21st Tianjin Will invest RMB1.5trn over the next four years in major industrial production chains. RMB1.5trn 4 years

August 22th Guangdong Announced RMB1trn of investment to be spent on 177 marine projects. RMB1trn N/A

August 22th Zhejiang Has planned 490 major projects, totalling RMB1.2trn of investment. RMB1.2trn N/A

-10

10

30

50

70

Aug-08 Aug-09 Aug-10 Aug-11 Aug-12

% y-o-y Manufacturing FAI

Real Estate FAI

Infrastructure FAI

Policy easing in 2012

Policy easing in 2009

0

50

100

150

200

250

300

April May June July August

RMB bn Investment Amount


7

How will these projects be financed? We believe the government will rely on a more

diversified set of financing options than in 2008-09, including:

Central government expenditures. According to statements made by Premier Wen

on 12 September 2012 at the World Economic Forum, the central government has a

RMB1trn fiscal surplus that it intends to use, and can utilise its RMB100bn fiscal

stabilisation fund if necessary. The central government will not play as big a role as it

did in 2009, but it will likely support infrastructure investments in the provinces with less

developed economies.

Local government revenues. A main source of revenue for local governments is

derived from land sales, which were lackluster up to July but have risen sharply since

August (Figure 5). The surge in land sales reflects both supply-side and demand-side

improvements in the real estate market. On the supply side, since city authorities face

more and more pressure to increase spending and support growth, we have seen a

dramatic change in their stance. For example, the amount of land Beijing‟s local

authorities put on the market during the 20 August-10 September period is roughly

equivalent to the amount of land they put up for sale in the first seven months of 2012

combined! On the demand side, most large developers became much more aggressive

in August. The trend continued in early September as reported by financial media.

Local government and agency bonds. The quota for local government bond

issuance has been increased to RMB250bn from RMB200bn. The size of railway bond

issuance has also risen.

Asset-backed securities (ABS). China launched its ABS market on 7 August 2012.

The first three offerings were issued by local government financing vehicles

(RMB2.5bn, Figure 6). This allows local government financing vehicles (LGFVs) with

sufficient financial capacity to raise funds directly from institutional investors.

Corporate bond market. LGFVs in good financial condition can access the corporate

bond market to directly borrow from institutional and retail investors. New issuance in

the corporate bond market grew to RMB258bn in August this year from RMB90bn in

August 2011.

Bank loans. These include conventional bank loans as well as the trust loans that

banks arrange for companies to borrow from retail investors. New bank loans

increased to RMB704bn in August, surprising on the upside, with the share of medium-

and long-term loans rising to 40.6% from 38.9% in July. New trust loans have surged in

recent months to RMB118bn in August from 17.6bn in August 2011, as authorities

lifted restrictions on the shadow banking system to facilitate borrowing by LGFVs.

Infrastructure projects are a popular investment vehicle for trust loans (Figure 7).

The broadest statistic on financing, known in China as “total social financing” (TSF), clearly

shows that financing for corporate and local governments is both improving (Figure 8) and

becoming increasingly diversified (Figure 9), driven not only by bank loans, but also by bond

and trust loans. In fact, over the past three months traditional bank loans have comprised only a

little over half of TSF.

Which indicators should be monitored to gauge the impact of the stimulus on

investment? The key indicator we focus on is planned investment for newly started projects. It

is released alongside headline FAI each month and is a leading indicator as it can predict the

amount of new investment in the months ahead. This indicator has picked up from 25% y-o-y in

July to 33% in August (Figure 10). As more approved projects show up as "newly started

projects", this indicator will likely rise to above 40% in the coming months.


8

Fig. 5: Land purchased by developers


Fig. 6: Issuance of asset-backed securities (ABS)


Fig. 7: Breakdown of trust loans


Fig. 8: Total social financing


Fig. 9: Breakdown of total social financing (RMBbn)


Fig. 10: Planned investment for newly started projects


-100

-50

0

50

100

150

200

Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

% y-o-y Land purchased (value)

Land purchased (volume)

Announcement Date Issuer Volume (mn)

Issuance

Period

(Years)

Interest

%

August 8, 2012 Ningbo Urban Construction Investment Holding Co., Ltd 200 1 5.30

August 8, 2012 Shanghai Pudong Road & Bridge Construction Co., Ltd 120 3 5.35




August 8, 2012 Nanjing Public Holding Co., Ltd 1,000 5 5.85


-100

100

300

500

700

900

1,100

Mar-

10

Jun

-10

Sep

-10

Dec-1

0

Mar-

11

Jun

-11

Sep

-11

Dec-1

1

Mar-

12

Jun

-12

RMB bn

InfrastructureReal EstateIndustrial & Commercial EnterpriseSecurities Market, Financial Inst & others

0

400

800

1,200

1,600

2,000

Feb Mar Apr May Jun Jul Aug

RMB bn 2012 2011

Jul-11 Aug-11 Jul-12 Aug-12

Total social financing 537.7 1073.4 1040 1240

New loans 492.5 586 547.4 778.2

Trust loans -2.8 17.6 26.3 118

Coporate bonds 42.2 89.8 248.7 258.4

Banker's acceptance bills -172.6 165.2 22.2 -84.4

Non-financial enterprise

equity financing and

entrusted loans

148.4 175.9 159.5 125.4-40

-20

0

20

40

60

80

Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

% y-o-y Monthly investment in newly started projects

Investment in newly started projects, YTD


9

Housing investment may surprise on the upside too

Total FAI growth slowed from 24% in 2011 to 20.2% y-o-y over the first eight months of 2012, a

decline of 3.8 percentage points (pp). Housing (residential and commercial) investment, which

accounted for 27% of total FAI in 2011, registered a decline in growth from 29.7% y-o-y to

20.9% over the same period. We estimate weaker housing investment growth has accounted

for 2.2pp (or 59%) of the slowdown in total FAI growth.

The market consensus expects housing investment to remain weak and the housing cycle to

continue its downtrend for the rest of 2012. This view is inconsistent with the latest data.

Leading indicators in this sector picked up strongly in August. Land sales improved sharply, as

highlighted in Figure 5. New housing starts growth also improved to 14% y-o-y in August from a

27% decline in July (Figure 11). Property sold improved to 2.2% y-o-y in January-August from

-0.5% in January-July in value terms (Figure 12). All three indicators have performed well in the

past to forecast housing investment, hence there is a good chance that housing investment

rebounds in the coming months, which is earlier than the market expects.

The key risk to the housing sector recovery is government policy. Will the government tolerate

moderately higher housing prices in exchange for stronger housing investment and stronger

growth? Or will the government introduce further tightening policies to cool down housing prices

and sacrifice growth? We expect the government to choose the former, given the high urgency

to stabilise growth.

The GDP arithmetic is important to understand, as the expenditure components that we expect

to rebound are major components of GDP. Housing and infrastructure investments combined

account for half of total FAI, which in turn accounts for nearly half of GDP. If both improve in Q4,

we will likely see a visible rebound in both FAI and GDP growth. We estimate headline FAI

growth will rise to 21% by the end of 2012 in year-to-date terms, which implies year-on-year

growth picking up from 19.9% in Q3 to 22.6% in Q4.

Fig. 11: New housing starts growth


Fig. 12: Building sold and property investment


Output gap and food prices to drive up inflation

Due to both structural and cyclical factors, we expect CPI inflation to steadily rise from 2.0%

y-o-y in Q2 to 3.1% in Q4 2012 and to 4.5% in 4Q 2013, averaging 4.2% for the whole of 2013.

This would also be a major upside surprise to the consensus forecast of CPI inflation averaging

3.4% in 2013. We identified seven structural factors contributing to higher inflation in our Asia

Special Report China: The case for structurally higher inflation, 21 September 2011. These

reasons include, among others, the depletion of excess labour; reforms to liberalise energy

prices and impose environmental taxes; the government‟s tolerance for higher inflation and

loose global liquidity conditions. On top of these structural factors, we believe two cyclical

factors – widening of the output gap and higher food prices – will likely raise China's inflation in

2013 faster and to higher levels than the market currently expects.

From a cyclical perspective, China‟s inflation outlook depends not only on where headline

growth will be, but also on how it compares with potential growth (i.e., how the output gap will

evolve). Indeed China‟s CPI inflation is highly correlated with its output gap (Figure 13). We

-25

0

25

50

75

100

-50

0

50

100

150

200

Aug-08 Aug-09 Aug-10 Aug-11 Aug-12

% y-o-y, ytd

% y-o-y Floor space started

Floor space started, ytd

-2

4

10

16

22

28

34

40

-40

-20

0

20

40

60

80

100

Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12

% y-o-y, ytd% y-o-y, ytd Building sold

Property investment,rhs

http://intranet.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=463995&appname=GRP&cid=NTc5dkZmV1lJMms90


10

estimate that the output gap rose from -0.9% in Q4 2006 to 1.7% in Q3 2007, while inflation

climbed from 2.0% to 6.1% over the same period. The output gap dropped sharply in 2008 after

the global financial crisis, and reached -2% in Q1 2009, while inflation plummeted from 2.5% to

-0.6%. The RMB4trn stimulus package pushed growth above potential by 0.2% by Q4 2010,

and CPI inflation followed, rebounding from -0.6% in Q1 2009 to 4.7% in Q4 2010.

What is China‟s potential growth currently? We believe Q2 2012 GDP was actually fairly close

to potential, despite the decline in growth to 7.6% from 9.2% in 2011. We see three pieces of

evidence that support this claim. First, the output gap measure we estimate was very close to

zero by Q2. This estimate is based on statistical inference rather than economic models. We

utilise the Hodrick-Prescott filter to GDP to derive the potential output and output gap, which has

worked well in the past to determine whether the economy is overheating.

The second piece of evidence is the labor market. We believe that, when the economy is

growing at close to its potential, supply and demand in the labor market is broadly balanced. In

China the labor demand/supply ratio dropped to 1.03 in Q2 (Figure 14), which is close to its

equilibrium. Unfortunately, the labor demand supply ratio is only available on a quarterly basis,

so it does not provide a very timely picture of the labor market. More timely pieces of evidence

suggest that the labor market likely softened slightly in both July and August. The employment

sub-index of the PMI survey has fallen down from 50.5 in May to 49.1 in August. Anecdotal

evidence from the financial media also suggests that there have been sporadic layoffs at

several large companies, but there have been no widespread factory closures or massive

layoffs similar to those witnessed in 2008. Hence overall we believe the labor market may be

still close to its equilibrium in Q3.

Why has the labor market not weaken quickly when headline GDP growth dropped to 7.6% in

Q2 from its ten-year average of 10.5%? The answer is that the pace of labour supply growth

has slowed sharply since 2009. The labor demand and supply ratio suggests that there was a

chronic oversupply in the labor market before 2009, as farmers migrated to the industrial sectors,

which increased the labor supply. After 2009, the growth of migrant workers likely slowed, and

the labor supply-demand ratio has remained above 1 since 2009.

Fig. 13: GDP output gap and CPI inflation

Source: CEIC, Nomura Global Economics estimates

Fig. 14: Labour market demand and supply ratio


The third argument is based on inflation itself. When an economy is close to its potential growth

rate, inflation is likely to be moderate and close to its long term average. Non-food CPI inflation

was 1.5% in July 2012, higher than its long-term average of 1.1% (Figure 15). This suggests the

economy is not likely running much lower than its potential.

Another cyclical factor that we believe will drive up inflation in China is global commodity prices.

CPI inflation in China is correlated with global commodity prices (Figure 16). This may be

counter-intuitive at first glance, as Chinese consumers are not heavily dependent on imports.

Nor is China heavily reliant on imported gasoline, as the weight of energy-related items in the

CPI basket is low (we estimate 2%) and there are heavy price controls which segregate

domestic and international prices.

However, we believe the connection between global commodity prices and China‟s CPI likely

work through two indirect channels. First, higher commodity prices push up production costs,

which translate into higher prices for broad-based manufactured goods. Second, higher prices

-2.5

-1.5

-0.5

0.5

1.5

2.5

-2

0.1

2.2

4.3

6.4

8.5

2005Q

1

2005Q

3

2006Q

1

2006Q

3

2007Q

1

2007Q

3

2008Q

1

2008Q

3

2009Q

1

2009Q

3

2010Q

1

2010Q

3

2011Q

1

2011Q

3

2012Q

1

2012Q

3

2013Q

1

2013Q

3

%% y-o-y CPIOutput gap, rhs Forecast

0.80

0.85

0.90

0.95

1.00

1.05

1.10

Jun-04 Jun-06 Jun-08 Jun-10 Jun-12

x Labour demand-supply ratio


11

for soybeans and corn increase production costs for edible oil and pork. We estimate pork

accounts for 4% of the CPI basket. This effect is particularly worrying now because pig farms in

China are running at close to their breakeven point, and any further rise in corn prices will likely

cause some pig farmers to slaughter piglets (Figure 17). The weight for edible oil is likely much

lower but the rise of price can be sizeable so its impact should not be dismissed.

We expect GDP growth of 8.8% in Q4 2012 which, based on our projections of potential growth,

will drive the output gap up to 0.5%, a sharp rise from -0.4% in Q2 2012. If this occurs, the

historical relationship suggests that inflation will likely rise in 2013 as well.

Fig. 15: Non-food inflation


Fig. 16: Commodity prices and China’s CPI


Fig. 17: Pork price and pork-corn price ratio


Fig. 18: Nomura's forecast for CPI inflation in China

Source: CEIC, Nomura Global Economics estimates

-3

-2

-1

0

1

2

3

4

Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12

% y-o-yCPI: non Food

-4

-2

0

2

4

6

8

10

140

190

240

290

340

390

440

490

Aug-02 Aug-04 Aug-06 Aug-08 Aug-10 Aug-12

% y-o-yindex CRY index CPI,rhs

0

2

4

6

8

10

12

6

8

10

12

14

16

18

July-06 July-08 July-10 July-12

xRMB/kg Average pork price

Pork-corn price ratio, rhs

Pork-corn price ratio breakeven point

3.8

2.9

2.0

3.13.5

4.24.5 4.5

0

1

2

3

4

5

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13

CPIForecast


12

Rates strategy: Fundamentals outweigh liquidity

As we have discussed in the past, (see China: Dissociation of policy rate expectations and

liquidity premium, 18 February 2011), macro fundamentals and liquidity are two of the main

drivers of the 7-day repo IRS, the most actively traded China IRS market. Macro fundamentals

(especially growth/inflation and money supply growth) largely dictate the medium-term trend in

rates, while liquidity dynamics drive short-term trends. On the macro side, inflation is highly

influential on the broad trend of long-term rates. As we expect a rebound of growth in China due

to fiscal stimulus and higher inflation, the rates market is, in broad trend terms, likely to drift

higher, in our view. In the near term, we judge liquidity to be a relatively neutral factor. If the

authorities decide to cut banks‟ required reserve ratio (RRR), we believe that a temporary rally

driven by the front end could provide investors looking to pay rates with better levels of entry.

Overall, we believe that the macro dynamics is more likely to push the curve to bear steepen in

the coming months.

Reduced importance of liquidity dynamics

Liquidity dynamics are an important feature for investors in China‟s interest rate market. Recent

central bank (PBOC) operations seem to suggest that liquidity is becoming less important,

largely because the PBOC has managed to fine-tune liquidity so that the 7d repo fixings have

remained largely within a 2-4% range since the lunar new year, and 3m averages of the 7d repo

fixing have stabilised at 3.0-3.5% since the PBOC started actively utilising reverse repos. As FX

reserve accumulation – the most important liquidity driver in the last 10 years – slows, the

PBOC is likely to shift more towards open market operations (OMOs) to supply reserve

money/interbank liquidity to support bank lending and the economy. In order to supply sufficient

reserve money and bolster the stability of interbank liquidity and rates, the PBOC has actively

utilised the reverse repo since Q2 2012. Reverse repo rates have been increasingly focused on

by the market and have been increasingly influential in guiding money market rates. In some

sense the repo and reverse repo rates used by the PBOC signal a reasonable range for money-

market rates, especially the 7d repo fixing. Furthermore, the PBOC continues to enhance its

flexibility in OMOs by expanding tools from 7d and 14d reverse repos to include 28d repos,

which the PBOC has not used for a decade. As such, unless there is a significant shift in the

monetary policy stance, we would expect the repo fixing (especially when averaged) to remain

relatively stable compared to previous years.

The tone of the Q1 and Q2 monetary policy reports also make us comfortable with the idea that

the PBOC will continue to fine-tune liquidity; prior to this year the PBOC was not as specific

about the tools that it used to manage liquidity. In its quarterly reports, it explicitly stated that it

would utilise tools such as the reverse repo, repo, PBOC bill and RRR to flexibly adjust

interbank liquidity and guide stable market rates (note that the reverse repo and repo are put

ahead of the PBOC bill and RRR rates). This subtle change is in line with the medium-term plan

of interest rate liberalisation, in our view. Even though July saw strong seasonal factors such as

the change in government deposits held at the PBOC, liquidity conditions were managed

smoothly, in our opinion. With this relatively new-found level of money market stability, we

therefore believe that the macro outlook will now be the key factor driving the broader trend in

China rates (although we expect quarter-end and around major Chinese holidays to prove to be

exceptions).

Please see China: Dissecting interbank liquidity (14 March 2012) for a detailed discussion of the

liquidity dynamics in China.

Kewei Yang

[email protected]

+65 6433 6246

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=420218




13

Fig. 19: Liquidity premium priced in the front end

Source: Bloomberg, Nomura

Fig. 20: Deposit rate cut expectations


Supportive growth and inflation outlook for rates to drift higher

Although recent growth data remain rather weak, there are signs of stabilisation from some of

the leading economic indicators, as mentioned in the macro section of this report. More

importantly, reasons constraining the impact of stimulus measures taken so far, such as funding

issues and the change in political leadership, have been, or are being, addressed. On the fixed

asset investment (FAI) side, among all sources of funding for FAI, that from the fiscal budget

has already grown at a higher year-on-year rate of growth than in 2010 and 2011. Meanwhile,

funding from bank loans has picked up as well, which coincides with growth of other funding

sources. From a bank loan and total social financing perspective, overall funding is also growing

at a reasonable and measured pace, helping to stabilise the economy but not over-stimulating

short-term growth as in 2008-09.

On the other hand, inflation has started to rebound from its July low. Aside from long-term

structural factors, cyclical factors such as food prices are likely to push inflation back up to the

3% level by the end of 2012. Given the policy rate is currently 3.0% and tail risks have been

reduced globally, we see limited room for further rate cuts.

Express the view via a paying bias through a 3s5s steepener

We are bullish on the outlook for the Chinese economy and expect the rates market to be duly

affected. Even with relatively weak economic data in Q3, the rates market has bounced back

aggressively by nearly 70bp from recent July lows, while the US 10yr benchmark has sold off by

35bp during the same period. This recent selloff was largely driven by the normalisation of the

curve towards the 7d repo fixing due to disappointment on RRR cut expectations, the PBOC's

fine-tuning of its OMOs and stabilised liquidity.

Given that the curve has priced in monetary easing (which seems aggressive to us if the PBOC

maintains its prudent monetary policy stance), we believe that any impact of further easing (if

any) on the IRS curve would be temporary. More importantly, the pick-up in lending/bond

issuance, money supply and stabilised growth due to fiscal support and an eased credit policy

should help the back end of the curve to underperform (moving relatively higher). Given that it is

hard to accurately time any monetary policy easing, we believe that the best way to position for

our view of a growth rebound and higher inflation is via a 3s5s curve steepener. Such a position

would benefit from further easing and/or fiscal stimulus, with the benefit of the 3s5s steepener

usually having flat carry. For investors willing to stand a temporary shock caused by a monetary

easing move, outright paying 5y is a simple trade to which investor could add to on dips.

-1.00

-0.75

-0.50

-0.25

0.00

0.25

0.50

0.75

1.00

1.25

1.50

2008 2009 2010 2011 2012 2013

liquidity premium - 1y

1.50

1.75

2.00

2.25

2.50

2.75

3.00

3.25

3.50

3.75

4.00

4.25

4.50

Aug-04 Apr-07 Jan-10 Oct-12 Jul-15

1y deposit

current

1m ago


14

Fig. 21: Source of funding for FAI (y-o-y, 3mma)


Fig. 22: Fundamentals determine broad trends in China rates


-50%

-25%

0%

25%

50%

75%

100%

2008 2009 2010 2011 2012 2013

Overall Fiscal budget Bank loans Foreign funding Own capital Others

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013

CPI+IP 2y 5y


15

FX strategy: Short-term positive on CNY; medium-

term cautious

Cyclical factors for CNY appreciation are beginning to strengthen, with local leading growth

indicators rising and inflation forecast by Nomura Economics to pick up in coming months. In

addition, there are more signs that net capital outflows are beginning to stabilise (partly from the

fall in global risk premium2 due to recent Fed

3 and ECB

4 policy announcements), which should

help to reduce expectations of depreciation. There are also political risks for China over the

coming months, but we do not expect these to have much impact in the near term. Overall, we

are more optimistic in the near term and added to our short USD/CNY position (fix 31 December,

USD20mn, NDF ref 6.3570)5 looking for a move towards 6.30 by year-end. If our forecast

materialises, this position would gain 90bp and even if the fix is unchanged from current levels

(6.3317) it presents positive carry of 40bp.

However, in the medium term, we believe the scope for CNY appreciation will be limited, with

USD/CNY at 6.25 by end-20136 with some risk of depreciation into 2015. Aside from CNY being

only marginally undervalued, the risk to CNY follows Nomura Economics view that China‟s

balance of payments (both the current account surplus and net capital inflows) will weaken over

the medium term, swinging into deficit by 2015 (see China’s peaking FX reserves, 29 May 2012).

Additional risk ahead lies with the authorities shifting towards further FX liberalisation around a

trade-weighted CNY regime, which could imply greater net capital in/outflows and FX volatility.

Scope for near-term CNY appreciation has risen

Nomura Economics remains confident of a sharp economic rebound in 4Q12, taking China‟s

GDP growth to 8.8% y-o-y (from a forecast 7.7% in 3Q12). We believe this view is supported by

improvements in recent August data, including new bank loans (RMB704bn from RMB540bn in

July) and total social financing (RMB1.24trn from RMB1trn in July). Other leading indicators

such as property7 and infrastructure investment also improved sharply

8 in August, and should

strengthen further given the significant increase in projects (both in terms of volume and on a

value basis) in recent months (Figure 23).

Growth bottoming out is important for a resumption of CNY appreciation. Given that the

government‟s current focus is on growth, we believe there is likely to be a more relaxed stance

on CNY if there is further confirmation that the economy is bottoming out. Indeed, our

regression analysis indicates that a pickup in growth and inflation should lead to CNY

appreciation (see regression results in Figure 24).

Furthermore, after the RMB4trn fiscal stimulus package announced in November 2008,

indicators such as industrial production, new loans and the official PMI (for December)

rebounded sharply. A short 3M USD/CNY position initiated at any point between December

2008 and March 2009 (when growth bottomed out) returned on average about 110bp. The

current policy stimulus is arguably more measured than that in 2008-09, but the depth of the

current crisis is shallower. In addition, the cumulative stimulus is very large and accelerating (at

around RMB11.7trn9 since mid-May) as we start to see nascent signs of a recovery, as

discussed above. This bodes well for the prospects of CNY appreciation, in our view.

The other important macro variable is inflation, where Nomura Economics sees some upside

risk given a positive output gap in China and an expectation of higher commodity prices. With

inflation expected to rise to 3.1% y-o-y by end-2012 and 4.2% by mid-2013 (inflation was 2% in

August), policymakers could again start to view CNY appreciation as a tool to help offset rising

price pressures. As seen in Figure 25, CNY appreciation has been closely linked to rising

domestic inflation.

2) See The global risk premium trade, 7 August 2012 and Does Europe Matter?, 21 August 2012.

3) See FOMC to markets: ‘as long as it takes’, 13 September 2012.

4) See Policy response to buy 3 months at best, 7 September 2012.

5) See Adding to our short USD/CNY trade, 14 September 2012.

6 ) We revise our forecasts to 6.30 for end-2012 and 6.25 for end-2013 and end-2014

7) Developers‟ land purchases rose by 66% y-o-y in August (-39% in July), the first positive print since November 2011,

while new housing starts rose 14% y-o-y in August (-27% in July). 8) Total planned investment for new projects started in August grew by 33% y-o-y (25% in July). 9) We would not focus too much on the headline numbers of these investment plans as they are likely to be inflated as local

governments play a competitive game of one-upmanship. That said, we would not dismiss the plans altogether just because the headline numbers are incredibly large.

Craig Chan

[email protected]

+65 6433 6106

Prashant Pande

[email protected]

+65 6433 6198

Prateek Gupta

[email protected]

+65 6433 6197

Wee Choon Teo

[email protected]

+65 6433 6107

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=522883&appname=GRP&cid=ekRwNXZ2SjVEYXM90


http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=544881&cid=K3FWL0FhODNhR2M90

http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=550316&appname=Email&cid=dFVqK2hod3hFSmc90


http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=550361&appname=GRP&cid=L0dSdVI1ODA4c1U90


16

Fig. 23: Investments announced by authorities and local governments

Note: * Adjusted second half of 2012 assuming a uniform expenditure (i.e. no front loading). If investment horizon is not specified it is assumed to be 5 years. Source: NDRC and local government websites, Nomura Global economics.

Fig. 24: Regression analysis – impact of growth, inflation and major events on USD/CNY

Note: A multi-variate linear regression was run for monthly changes in USD/CNY (from Aug 2005 to Jul 2012) against the above-mentioned variables. The resultant model has an R2of 35%. Estimates are conducted in USD/CNY terms, so the inflation coefficient should be negative, i.e. when inflation is relatively high, USD/CNY should be falling relatively rapidly. Source: CEIC, Bloomberg, Nomura.

Fig. 25: China inflation and USD/CNY

Source: CEIC, Nomura

Fig. 26: China’s capital outflows persisted in July

Source: CEIC, Bloomberg, Nomura

Date RegionAmount

(RMB bn)Period

Est for

2012*Policy measure

16-May-12 National 32.5 NA 33 Subsidies for energy-efficient home appliances (RMB26.5bn) and energy saving vehicles (RMB6bn).

21-May-12 National The NDRC approved about 100 projects in a single day, most of which were in clean energy sectors.

25-May-12 National 100 NA 100 The NDRC approved several large steel mill expansion projects valued at about RMB100bn.

28-May-12 National Measures to subsidize manufacturers of energy-saving air conditioners and LCD TVs

29-May-12 National 1.5 NA 2 Plan to spend RMB1-2bn per year to support R&D in energy-saving vehicles.

13-Jun-12 National Renewal of an existing vehicle replacement subsidy program which had expired in March 2012.

15-Jun-12 Railways Construction for six new railway lines and the resumption of suspended railway projects.

28-Jun-12 Seven provinces 47.8 NA 48 Plan to issue RMB47.8bn worth of bonds in July on behalf of Qinghai, Shanxi, Beijing, Fujian, Ningxia,

Heilongjiang and Jiangsu.25-Jul-12

Hunan,

Changsha829 5 83

Stimulus package of RMB829bn.Investment in 195 large and155 medium-sized projects. On the same day the

State Council approved a "strategic plan to promote the central region's economy".

30-Jul-12 Railways 64 NA 64 The plan for total railway investment in 2012 was revised up to RMB580bn from RMB516bn.

July Guangdong 235 NA 235Speed up major projects and focus on reversing the downtrend in investment, prioritizing the stabilization of

growth.

23-Jul-12 Guizhou 3000 NA 300 Since May 2012, there have been 2,382 projects screened, amounting to a total investment RMB3.2479trn.

7-Aug-12 Guangzhou 200 NA 200In H2, Guangzhou will focus on 101 major projects totalling yearly investment of RMB71.4bn and 120

construction projects totalling more than RMB127bn.

14-Aug-12 Changchun 2 NA 2RMB2bn worth of special funds for the science and technology and services sectors, industry and infrastructure

finances.

20-Aug-12 Chongqing 1500 3 250 Invest a total of RMB1.5trn in industry. Chongqing aims for its industrial output to exceed RMB3trn.

20-Aug-12 Shanxi 2000 1 1742 In H1 Shanxi attracted a total of RMB258bn afor investment purposes.

21-Aug-12 Tianjin 1500 4 188 Tianjin will invest RMB1.5trn over the next four years in major industrial production chains.

22-Aug-12 Guangdong 1000 5 100 Announced RMB1trn of investment in 177 marine projects and intends to increase this to RMB1.4trn by 2014.

22-Aug-12 Zhejiang 1200 3.5 171 Planning 490 major projects, totalling RMB1.2trn of investment.

5-Sep-12 National 700 4.4 80

The NDRC announced that it has approved 25 subway projects across more than 20 cities and 13 highway

projects since April 2012. The average construction time is 4.4 years. Note that some of these projects may

also be a part of stimulus packages announced by local governments.

6-Sep-12 National 59 NA 12

The NDRC announced approval of 13 highway projects (total length: 1,976km) in Jun-Aug, with an estimated

investment of RMB59bn. A list of projects approved (including subways, highways and others) was released

indicating approvals of a total of RMB848bn. Adding projects for which actual investment amounts have not been

announced, we estimate total investment of about RMB1trn.

Measured as Regression Coefficients T-stat P-value

CPI Change (y-o-y, %) -0.08 -4.92 0%

Basket Change (m-o-m, %) 0.07 3.01 0%

Event Dummy variable -0.12 -0.88 38%

IP Change (y-o-y, %) -0.02 -1.15 25%

Intercept 0.35 0.98 33%

6.0

6.5

7.0

7.5

8.0

8.5-4

-2

0

2

4

6

8

10

Jul-05 Oct-06 Jan-08 Apr-09 Jul-10 Oct-11 Jan-13

China Inflation (%, y-o-y)

China Inflation forecast

USD/CNY (inverted, RHS)

USD/CNY forecast (inverted,RHS)

-90

-60

-30

0

30

60

Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12

USD bn

Banks' net FX purchases ex trade balance and FDI

Change in FX deposits in China (inverted)

Change in FX Loans

Capital flows


17

Signs of stabilising capital flows

Our near-term CNY appreciation view is also supported by further signs of stabilising capital

flows. Capital flows, which we measure by the monthly change in adjusted10

FX reserves less

the trade balance and net FDI, fell by an average USD18.9bn over the past three quarters (to

June 2012). In addition, July FX purchase data from the central bank shows intense net capital

outflows in July (according to our measure11

) at USD27.2bn from USD25.0bn in June (Figure

26).

However, our optimism that capital flows have somewhat stabilised rests on the back of the

global policy backstops initiated by the ECB and the Fed. The FOMC‟s QE3 and the ECB‟s

outright monetary transactions (OMT) announcement have helped reduce the global risk

premium. The narrowing of the spread between spot USD/CNY and the USD/CNY fix since mid-

July from a peak of 623 pips (20 July 2012) to -91 pips (12 September 2012; see Figure 27) is

another positive signal of reduced capital outflows. Aside from the anticipation of global stimulus

and a reduction of economic tail risks, the fall in USD/CNY spot could also have been caused

by the People‟s Bank of China (PBOC) selling USD to offset capital outflows. We are actually

encouraged by such action as it demonstrates to market participants the authorities‟ willingness

to lean against depreciation pressures. China has ample ammunition to continue such a stance

with USD3.24trn of FX reserves in Q3 2012. That said, there may also have been some

technical factors for the fall in spot as offshore banks may have been informed that their

quarterly conversion quota has been exhausted12

.

Some uncertainty in the political landscape

The near-term political focus will be on China‟s leadership transition with the 18th Communist

Party Congress likely in mid-October. Barring any surprise nominations, it is likely that this will

be a relatively smooth transition, with the market aware that the new leadership will consist

namely of Vice President Xi Jinping (replacing President Hu Jintao) and Vice Premier Li

Keqiang (replacing Premier Wen Jiabao). Indeed, it is positive that Xi Jinping is an advocate of

faster economic liberalisation as well as a relaxation of political controls13

.

Fig. 27: USD/CNY spot-fix spread


Fig. 28: CNY valuations

Source: BIS, IMF, CEIC, Bloomberg, Nomura. Note: 1) Latest data as of Aug-12. 2) REER and PPP valuations are based on 5y rolling window. 3) PPP annual estimates are taken from IMF WEO database. For latest value, we adjusted end 2011 PPP rate for USD/CNY change and our estimates of relative prices

The largest source of political risk, however, is the 6 November US presidential election, which

for now remains a fairly close call between President Obama and Republican frontrunner Mitt

Romney. An Obama re-election would be the more favourable scenario for CNY appreciation as

the Obama administration and the new Chinese leadership could accelerate the liberalisation of

the FX policy regime. However, a Romney win could pose a risk to Sino-US relations and to the

CNY FX liberalisation/reform process given his strong stance against the value of CNY – he told

10

) We adjust headline FX reserves for FX valuation and coupon effects. 11

) We adjust local banks‟ FX purchasing data for the trade balance, FDI inflows and changes in FX deposits and loans to arrive at a rough estimate for capital outflows (see July's capital outflows probably intensified but likely eased in August, 16 August 2012). 12

) See Asia FX Insights: USD/CNY: Spot meets fix, 5 September 2012. 13

) Reuters, Exclusive: China president-in-waiting signals quicker reform – sources, 7 September 2012.

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-600

-400

-200

0

200

400

600

Jul-11 Aug-11Nov-11 Jan-12 Mar-12 May-12 Jul-12

Spot-Fix Spread (pips, LHS)

3M NDF implied appreciation (annualised, RHS)

FEER REER PPP Average

Latest -7.0% 8.1% -6.6% -1.8%

2011 -7.6% 10.3% -7.5% -1.6%

2010 -8.9% 7.5% -6.2% -2.5%

2009 -11.7% 6.4% -3.8% -3.0%

2008 -13.2% 16.3% -7.2% -1.4%

2007 -12.1% 4.5% -5.2% -4.3%

2006 -9.6% -1.4% -2.9% -4.7%

2005 -7.6% -2.8% -3.5% -4.6%

2004 -6.3% -10.8% -3.1% -6.7%

CNY Valuation


http://go.nomuranow.com/research/globalresearchportal/getpub.aspx?pid=548265&appname=Email&cid=K3FWL0FhODNhR2M90

http://www.reuters.com/article/2012/09/07/us-china-politics-xi-idUSBRE8860BI20120907


18

the Wall Street Journal on 16 February that “on Day One of my presidency I will designate

[China] a currency manipulator and take appropriate counteraction.” 14

Limited CNY appreciation over the medium term

As we highlight in our Asia Special Report (see China‟s peaking FX reserves, 29 May 2012), we

see limited CNY appreciation (vs. USD) over the coming years and even the risk of depreciation

into 2015. The main factor is the narrowing of China‟s current account surplus, which Nomura

Economics forecasts to swing from a surplus of 1.7% of GDP in 2012 to deficits of 0.4% in 2014

and 0.9% in 2015. This is likely to be driven by the increased policy focus on domestic demand

over exports in the wake of the global financial crisis, while imports of natural resources should

remain high as China struggles to be self-sufficient. In terms of the overall balance of payments

(BoP), another risk is slowing net FDI inflows due not only to mounting outbound investment,

but also higher labour costs, which will erode China‟s competitiveness. As such, we believe the

risk is that the overall BoP surplus will fall and move to balance by 2015.

From a medium-term FX valuation perspective, CNY is also less attractive being only 1.8%

undervalued (as of August) based on an average of our PPP, FEER and REER models (Figure

6). This compares with a 6.7% undervaluation at end-2004 ahead of the July 2005 revaluation.

This assessment of CNY undervaluation should, we believe, be close to the IMF‟s July 201215

view that CNY is now only “moderately undervalued against a broad basket of currencies” (from

its previous view that it was “substantially undervalued”).

A shift towards further FX liberalisation and a basket regime also poses many risks for CNY, as

seen in China‟s allowance of the USD/CNY fix to be increasingly determined by moves in the

currencies of its major trade partners. The average 10-day sensitivity of the USD/CNY fix to our

CNY basket has almost doubled to 32% in 2012 from 17% in 2011. The risk is that if there is

broad USD strength and USD/CNY rises because of moves in the basket, CNY depreciation

fears could lead to acceleration in capital outflows and more CNY depreciation pressure. Indeed,

a more porous capital account in future will only imply greater influence of the global economy

on China‟s economic and financial system.

14

) See WSJ article, How I'll Respond to China's Rising Power, 16 February 2012. 15

) See IMF, People’s Republic of China, 2012 Article IV consultation, July 2012.


http://online.wsj.com/article/SB10001424052970204880404577225340763595570.html

http://www.imf.org/external/pubs/ft/scr/2012/cr12195.pdf


19

Equity strategy: Overweight China ahead of data

improvements

Perhaps our greatest frustration in the equity space this past summer has been China stocks‟

seeming unwillingness to "give the benefit of the doubt" on the (eventual) effectiveness of

China‟s gathering monetary and fiscal stimulus. Recent months‟ soggy Manufacturing PMI and

Industrial Production releases no doubt undermined investor confidence at the same time that

the coming political leadership change fuelled investor concerns about effective policy

implementation. Yet we think it would be exceedingly premature for equity markets to conclude

that China‟s stimulus has been “ineffective” or that China‟s economy and corporate earnings will

fail to rebound in the months ahead – indeed China remains a key „Overweight‟ market for us in

Asia-Pacific ex-Japan.

As detailed in the macro section of this note, leading indicators of an investment-led demand

recovery have already begun to manifest in the August data cycle. Given the centrality of

China‟s monetary loosening both as a direct instrument of stimulus in its own right and an

enabler of fiscal stimulus, August bank credit and total social financing data were further

confirmations of strengthened policy support.

On top of this, the recent completion of Hong Kong‟s semi-annual results season effectively

clears an overhang of negative earnings surprises and EPS forecast downgrades; and we note

with tentative encouragement in Figure 29 below that MSCI China stocks‟ earnings revision

breadth (i.e., the ratio of individual upgrades to downgrades), while still well below 1.0, has at

least stabilised and begun to improve since the completion of H-shares semi-annual results.

More importantly, as China‟s August-September data begin showing more unambiguous

evidence of policy stimulus supporting aggregate demand – changing the likely demand

trajectory in H2 – the 1H12 H-share results season is likely to be regarded as particularly

backward-looking in any case. And at the same time stimulus traction begins to resuscitate top-

line Sales expectations, we may begin to see more flow-through to bottom-line earnings as well:

At -5.2% y-y in August, raw materials PPI has declined by substantially more than the

consumer price index (CPI) – i.e. corporate input costs are falling faster (or rising more

slowly) than final asking prices. Indeed initially, rising CPI trends would likely be well-

received by stocks as evidence of recovering pricing power.

Other factors equal, this all bodes well for margins and profits, in our view. Figure 30

reveals a strong and (again) leading correlation between China‟s CPI-PPI differential

and the y-y MSCI China profit cycle – with recent trends pointing to improving

profitability rather than a 2008-like earnings slump:

Fig. 29: MSCI China consensus earnings revision breadth

Source: Datastream, Nomura Strategy Research.

Fig. 30: CPI-PPI differential vs. MSCI China consensus forward earnings growth Six-month lead/lag

Source: Bloomberg, Nomura Strategy Research.

Our sense is that the ruling Chinese Communist Party (CCP) leadership transition to be ratified

at next month‟s CCP Congress has also caused a degree of equity nervousness, but is

generally moving ahead within broad expectations – and will cease to be as considerable an

overhang by this time next month. The ouster of Chongqing Party boss Bo Xilai earlier this year

has, if anything, slightly tilted the balance of power toward pro-market and pro-reform figures in

0.0

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1.0

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1.6

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24

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MSCI China:12m fwd EPS growth, six months lag, % (LHS)

China: Non-food CPI y-y% - Raw Materials PPI y-y% (RHS)

Michael Kurtz, NIHK

[email protected]

+852 2252 2182

Wendy Liu, NIHK

[email protected]

+852 2252 6180

Mixo Das, NIHK

[email protected]

+65 6433 1424

Yiran Zhong, NIHK

[email protected]

+65 6433 1413


20

our view – and we see numerous pieces of incremental Financial and Capital Account reform

already implemented this year as evidence that the CCP is aware of the need to keep the

restructuring agenda on track.

With all this, we note that China stocks are selling at a particularly unchallenging 8.5x forward

PER – Asia‟s cheapest in absolute terms (along with Korea) and deepest discount to historic

average in both percentage (-31%) and standard deviation (-1.3) terms. And those low multiples

are on already-low EPS consensus of 2.6%, considering China‟s nominal GDP growth outlook

of roughly 11% – Asia‟s second-strongest after India‟s 13.3% (which is higher only because

India faces a stubborn inflation problem that China for the moment does not):

Fig. 31: APxJ: PER and discount vs. long-term mean

Source: Datastream, Nomura Strategy Research.

Fig. 32: APxJ: nominal GDP growth

Source: Nomura Global Economics.

From a technical perspective, we also note that short-selling in Hong Kong as a percentage of

total daily turnover recently remains near historic highs of 10-11%, implying scope for

substantial short squeezes in H2 as policy support takes effect. In the post-GFC period, such

short-covering rallies in Hong Kong have averaged roughly 10 weeks in length and roughly 20%

in magnitude:

Fig. 33: Hong Kong: Short selling (% daily turnover) vs. HSCEI

Source: Bloomberg, Nomura Strategy Research.

Among key listed China sectors, we favour Railways, Cement (through our sector analyst‟s top

pick of CNBM as an investment-cycle proxy given its geographical location and high

gearing/high beta) and Construction Machinery as primary beneficiaries of the recent

acceleration in new project approvals by the NDRC. Additionally, Health care (through

Mindray) and Consumption names (through top picks Daphne and Tingyi in Discretionary

and Staples, respectively) may receive policy support as the new CCP begins to effect

economic rebalancing post-October potentially by broadening social benefit coverage, raising

the level of coverage, and raising funding for social security. In China‟s Tech space, the default

beneficiary due to improving investor appetite is likely to be Search, and we are keeping Baidu

in both our „tactical call‟ list and as a core holding. Additionally, accelerated Telco capex

spending should particularly benefit wireless systems hardware-maker Comba.

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

6

7

8

9

10

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Fwd P/E (lhs) Premium to L.T. Average (rhs)

0.0

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gapore

Ind

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Ch

ina

Kore

a

2011 2012 2013

Nominal GDP Growth (%)

6,000

7,000

8,000

9,000

10,000

11,000

12,000

13,000

14,000

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

Jan

-09

Mar-

09

May-0

9

Jul-

09

Sep

-09

No

v-0

9

Jan

-10

Mar-

10

May-1

0

Jul-

10

Sep

-10

No

v-1

0

Jan

-11

Mar-

11

May-1

1

Jul-

11

Sep

-11

No

v-1

1

Jan

-12

Mar-

12

May-1

2

Jul-

12

Sep

-12

HK short selling as % total turnover (10-day mov-avg., LHS) HSCEI Index (RHS)


21

Recent Asia special reports

Date Report Title

5-Sep-12 Better hedges for a China hard landing

3-Sep-12 India's chronic balance of payments

7-Aug-12 Asia's inflation wildcard

2-Aug-12 Indonesia: Policy swings

31-Jul-12 India: A poor monsoon and its impact (Q&A)

9-Jul-12 South Korea: Prolonged low growth, inflation and rates through 2013

31-May-12 Pan-Asia: Inventory cycle threatens a slow recovery

29-May-12 China's peaking FX reserves

2-May-12 India: Make or break

23-Apr-12 The China compass

16-Apr-12 Korea: Uncomfortable trade-off

11-Apr-12 India: Four cyclical tailwinds to watch

27-Mar-12 Capital account liberalisation in China

9-Mar-12 India budget preview: Fiscal cheer

1-Mar-12 Asia: What if oil prices keep rising?

23-Feb-12 Philippines – Fiscal space to maneuver

16-Jan-12 Decoding India‟s stubbornly high inflation

20-Dec-11 Implications from North Korea

18-Nov-11 A cold winter in China

3-Nov-11 Thailand: Dealing with another disaster

31-Oct-11 China Risks

19-Oct-11 Korea: Falling, converging bond yields

21-Sep-11 China: The case for structurally higher inflation

8-Aug-11 Global market turbulence: Implications for Asia

7-Jun-11 Indonesia: Building momentum

10-Mar-11 Vietnam: Prioritizing macro stability

3-Mar-11 South Korea‟s demographic sweet spot

14-Jan-11 India's 2011 outlook: Rising symptoms of a supply-constrained economy

1-Nov-10 The case for capital controls in Asia

11-Sep-10 The coming surge in food prices

6-Aug-10 Another step towards becoming an offshore RMB centre

28-May-10 The heat is on

26-May-10 Brinkmanship returns to the Korean peninsula

9-Nov-09 China: Not just an investment boom

19-Oct-09 What Japan‟s 1980s experience means for China

8-Sep-09 South Korea: Household debt: Myths and reality

23-Jul-09 China & Hong Kong: RMB trade settlement: New opportunities, new risks

http://intranet.nomuranow.com/portal/site/employees/asia/home/


22

Disclosure Appendix A-1

ANALYST CERTIFICATIONS

We, Zhiwei Zhang, Wendy Chen, Kewei Yang, Craig Chan, Prashant Pande, Prateek Gupta, Wee Choon Teo, Shubhankar Das, Michael Kurtz, Wendy Liu and Yiran Zhong hereby certify (1) that the views expressed in this Research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Important Disclosures Online availability of research and conflict-of-interest disclosures Nomura research is available on www.nomuranow.com/research, Bloomberg, Capital IQ, Factset, MarkitHub, Reuters and ThomsonOne. Important disclosures may be read at http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx or requested from Nomura Securities International, Inc., on 1-877-865-5752. If you have any difficulties with the website, please email [email protected] for help. The analysts responsible for preparing this report have received compensation based upon various factors including the firm's total revenues, a portion of which is generated by Investment Banking activities. Unless otherwise noted, the non-US analysts listed at the front of this report are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of NSI, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account. Any authors named in this report are research analysts unless otherwise indicated. Industry Specialists identified in some Nomura International plc research reports are employees within the Firm who are responsible for the sales and trading effort in the sector for which they have coverage. Industry Specialists do not contribute in any manner to the content of research reports in which their names appear. Marketing Analysts identified in some Nomura research reports are research analysts employed by Nomura International plc who are primarily responsible for marketing Nomura‟s Equity Research product in the sector for which they have coverage. Marketing Analysts may also contribute to research reports in which their names appear and publish research on their sector.

Distribution of ratings (US) The distribution of all ratings published by Nomura US Equity Research is as follows: 43% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 21% of companies with this rating are investment banking clients of the Nomura Group*. 51% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 9% of companies with this rating are investment banking clients of the Nomura Group*. 6% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 0% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2012. *The Nomura Group as defined in the Disclaimer section at the end of this report.

Distribution of ratings (Global) The distribution of all ratings published by Nomura Global Equity Research is as follows: 46% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 40% of companies with this rating are investment banking clients of the Nomura Group*. 43% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 46% of companies with this rating are investment banking clients of the Nomura Group*. 11% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 21% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2012. *The Nomura Group as defined in the Disclaimer section at the end of this report.

Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America The rating system is a relative system indicating expected performance against a specific benchmark identified for each individual stock. Analysts may also indicate absolute upside to target price defined as (fair value - current price)/current price, subject to limited management discretion. In most cases, the fair value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as discounted cash flow or multiple analysis, etc. STOCKS A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of 'Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. A rating of 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark over the next 12 months. A rating of 'Suspended', indicates that the rating, target price and estimates have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including, but not limited to, when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the company. Benchmarks are as follows: United States/Europe: please see valuation methodologies for explanations of relevant benchmarks for stocks, which can be accessed at: http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia, unless otherwise stated in the valuation methodology. SECTORS A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next 12 months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next 12 months. A 'Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next 12 months.

http://www.nomuranow.com/research

http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx

[email protected]

[email protected]



23

Benchmarks are as follows: United States: S&P 500; Europe: Dow Jones STOXX 600; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia.

Explanation of Nomura's equity research rating system in Japan and Asia ex-Japan STOCKS Stock recommendations are based on absolute valuation upside (downside), which is defined as (Target Price - Current Price) / Current Price, subject to limited management discretion. In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A 'Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. SECTORS A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation.

Target Price A Target Price, if discussed, reflect in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates.

ADDITIONAL DISCLOSURES REQUIRED IN THE U.S. Principal Trading: Nomura Securities International, Inc and its affiliates will usually trade as principal in the fixed income securities (or in related derivatives) that are the subject of this research report. Analyst Interactions with other Nomura Securities International, Inc. Personnel: The fixed income research analysts of Nomura Securities International, Inc and its affiliates regularly interact with sales and trading desk personnel in connection with obtaining liquidity and pricing information for their respective coverage universe. Valuation Methodology - Global Strategy A “Relative Value” based recommendation is the principal approach used by Nomura‟s Fixed Income Strategists / Analysts when they make “Buy” (Long) “Hold” and “Sell”(Short) recommendations to clients. These recommendations use a valuation methodology that identifies relative value based on: a) Opportunistic spread differences between the appropriate benchmark and the security or the financial instrument, b) Divergence between a country‟s underlying macro or micro-economic fundamentals and its currency‟s value and c) Technical factors such as supply and demand flows in the market that may temporarily distort valuations when compared to an equilibrium priced solely on fundamental factors. In addition, a “Buy” (Long) or “Sell” (Short) recommendation on an individual security or financial instrument is intended to convey Nomura‟s belief that the price/spread on the security in question is expected to outperform (underperform) similarly structured securities over a three to twelve-month time period. This outperformance (underperformance) can be the result of several factors, including but not limited to: credit fundamentals, macro/micro economic factors, unexpected trading activity or an unexpected upgrade (downgrade) by a major rating agency. Disclaimers This document contains material that has been prepared by the Nomura entity identified at the top or bottom of page 1 herein, if any, and/or, with the sole or joint contributions of one or more Nomura entities whose employees and their respective affiliations are specified on page 1 herein or identified elsewhere in the document. Affiliates and subsidiaries of Nomura Holdings, Inc. (collectively, the 'Nomura Group'), include: Nomura Securities Co., Ltd. ('NSC') Tokyo, Japan; Nomura International plc ('NIplc'), UK; Nomura Securities International, Inc. ('NSI'), New York, US; Nomura International (Hong Kong) Ltd. („NIHK‟), Hong Kong; Nomura Financial Investment (Korea) Co., Ltd. („NFIK‟), Korea (Information on Nomura analysts registered with the Korea Financial Investment Association ('KOFIA') can be found on the KOFIA Intranet at http://dis.kofia.or.kr); Nomura Singapore Ltd. („NSL‟), Singapore (Registration number 197201440E, regulated by the Monetary Authority of Singapore); Capital Nomura Securities Public Company Limited („CNS‟), Thailand; Nomura Australia Ltd. („NAL‟), Australia (ABN 48 003 032 513), regulated by the Australian Securities and Investment Commission ('ASIC') and holder of an Australian financial services licence number 246412; P.T. Nomura Indonesia („PTNI‟), Indonesia; Nomura Securities Malaysia Sdn. Bhd. („NSM‟), Malaysia; Nomura International (Hong Kong) Ltd., Taipei Branch („NITB‟), Taiwan; Nomura Financial Advisory and Securities (India) Private Limited („NFASL‟), Mumbai, India (Registered Address: Ceejay House, Level 11, Plot F, Shivsagar Estate, Dr. Annie Besant Road, Worli, Mumbai- 400 018, India; Tel: +91 22 4037 4037, Fax: +91 22 4037 4111; SEBI Registration No: BSE INB011299030, NSE INB231299034, INF231299034, INE 231299034, MCX: INE261299034); NIplc, Dubai Branch („NIplc, Dubai‟); NIplc, Madrid Branch („NIplc, Madrid‟) and NIplc, Italian Branch („NIplc, Italy‟). „CNS Thailand‟ next to an analyst‟s name on the front page of a research report indicates that the analyst is employed by Capital Nomura Securities Public Company Limited („CNS‟) to provide research assistance services to NSL under a Research Assistance Agreement. CNS is not a Nomura entity. THIS MATERIAL IS: (I) FOR YOUR PRIVATE INFORMATION, AND WE ARE NOT SOLICITING ANY ACTION BASED UPON IT; (II) NOT TO BE CONSTRUED AS AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY ANY SECURITY IN ANY JURISDICTION WHERE SUCH OFFER OR SOLICITATION WOULD BE ILLEGAL; AND (III) BASED UPON INFORMATION FROM SOURCES THAT WE CONSIDER RELIABLE, BUT HAS NOT BEEN INDEPENDENTLY VERIFIED BY NOMURA GROUP. Nomura Group does not warrant or represent that the document is accurate, complete, reliable, fit for any particular purpose or merchantable and does not accept liability for any act (or decision not to act) resulting from use of this document and related data. To the maximum extent permissible all warranties and other assurances by Nomura group are hereby excluded and Nomura Group shall have no liability for the use, misuse, or distribution of this information. Opinions or estimates expressed are current opinions as of the original publication date appearing on this material and the information, including the opinions and estimates contained herein, are subject to change without notice. Nomura Group is under no duty to update this document. Any comments or statements made herein are those of the author(s) and may differ from views held by other parties within Nomura Group. Clients should consider whether any advice or recommendation in this report is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. Nomura Group does not provide tax advice.

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24

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Asia Special Report - jrj.com.cnpg.jrj.com.cn/acc/Res/CN_RES/INVEST/2012/9/14/... · 9/14/2012 ·...

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Transcript of Asia Special Report - jrj.com.cnpg.jrj.com.cn/acc/Res/CN_RES/INVEST/2012/9/14/... · 9/14/2012 ·...