China Research

8/2/2019 China Research

1/30

CHINA

Nomura Asia

A journey of tenthousand miles......starts with a great leap into the

WTO

11 December 2001

EconomicInsight

PU Yonghao (852) 2536-1843

Nomura Asian Equity Research is available electronically on NOMURA.COM, MULTEX, RESEARCHDIRECT#, BLOOMBERG* and FIRSTCALL. Contact your Nomura representative for information.#US clients only, *Non-US clients only.

The phrase Chinas imminent accession to the WTO was startingto wear a little thin. At last, China is a WTO member. We see WTOmembership adding 0.5 percentage points (pp) to GDP growththrough 2006, and look for export growth to average 16% perannum in 2002-06. But while we see membership of the tradebody as a positive, we dont see it leading to a workers utopia.We expect unemployment, especially in rural areas, will risesignificantly given the uncompetitiveness of the agricultural sector.There will be pain elsewhere: the big state banks must purge theirbalance sheets before competition arrives and state-ownedenterprises (SOEs) will have to accelerate restructuring if they are

to compete a significant number of smaller SOEs will likely fail.Doubling of foreign trade, FDI. As a result of trade liberalisation, weexpect Chinas foreign trade will double to more than US$1tn by 2006.Its share of global exports should increase to 5.9% in the same timeframe.On our projections, utilised foreign direct investment (FDI) will grow16% per annum in 2002-06, with FDI seen to total US$100bn by 2006.

Faster GDP growth. Our expectation of a WTO-driven 0.5pp boost toannual GDP growth should take GDP to RMB15.5tn in 2006, from RMB8.9tnin 2000. We see this growth being underpinned by greater productivity,improved efficiency and a rise in value-added output.

No rush to be rid of exchange controls. Despite WTO membership,we dont believe the countrys capital account will be liberalised before2006 at the earliest; nor do we expect the renminbi to become freelyconvertible any time soon.

Pink slips aplenty. On our projections, 12m urban workers will losetheir jobs as a result of accession, mostly owing to SOE restructuring.This argues for urban unemployment of 15% in 2004, from 11.5% thisyear. We expect even more job losses in agriculture: 13m by 2006.

Agriculture in trouble; financial sector racing against time. Weexpect agriculture will be worst hit, owing to its high cost structure andsurplus production. Chinese banks, meanwhile, will have to off-loadbad loans and develop risk management systems if they are to competewith foreign players. Securities companies and fund management firmswill face increasing pressure to merge, given the need for synergies andweak equity-market conditions.


2/30

11 December 2001

2

Economic Insight

Contents

l Executive summary ....................................................................................................... 3

l The road to WTO membership ...................................................................................... 4

l Chinas obligations ........................................................................................................ 5

l Institutional changes and reform ................................................................................. 7

l Macroeconomic impact ................................................................................................ 9

l A boost for GDP growth...............................................................................................12

l Rising unemployment ..................................................................................................13

l Renminbi convertibility and the capital account .........................................................14

l Sector impact ...............................................................................................................17

l Banking facing tough competition .........................................................................19

l Capital markets a gradual opening .........................................................................24

l Securities industry slow consolidation.....................................................................26

ASIAN RATINGS

Outperform - stock expected to outperform the local benchmark index by more than 10% over the next six months.Neutral - stock expected to perform in-line with the local benchmark index over the next six months.Underperform - stock expected to underperform the local benchmark index by more than 10% over the next six months.

US RATINGS

Strong Buy - stock expected to outperform the S&P 500 by more than 15% over the next six months.Buy - stock expected to outperform the S&P 500 by 5% or more but less than 15% over the next six months.Hold - stock expected to either outperform or underperform the S&P 500 by less than 5% over the next six months.Reduce - stock expected to underperform the S&P 500 by 5% or more but less than 15% over the next six months.Sell - stock expected to underperform the S&P 500 by 15% or more over the next six months.

EUROPEAN RATINGS

Strong Buy - stock expected to outperform the relevant sector index by more than 15% over the next six months.Buy - stock expected to outperform the relevant sector index by more than 5% over the next three months.Hold - stock expected to either outperform or underperform the relevant sector index by less than 5% over the next six months.Sell - stock expected to underperform the relevant sector index by more than 5% over the next six months.Strong Sell - stock expected to underperform the relevant sector index by more than 15% over the next six months.

All share prices as at 4 December, 2001


3/30

11 December 2001

3

Economic Insight

We look at the impactof WTO accession froma macroeconomic

perspective

Executive summary

Few doubt that WTO membership will have a profound impact on the Chinese economy,changing dynamics in every industry, both directly and indirectly. An analysis of theconsequences for every industry is beyond the scope of this report, and we confine

our discussion to the macroeconomic impact of WTO accession and focus on sectorsthat have seen and will continue to see the most radical reforms: agriculture, bankingand capital markets. We expect reforms in these sectors will be accelerated over thenext few years. The reforms are mostly aimed at making domestic participants inthese industries more competitive prior to the entry of foreign players and atsafeguarding domestic capital. The timetable for opening these markets suggeststhat the implementation of reform measures will be accelerated to prevent exogenousshocks to the economy when foreign participation becomes a reality.

No freedom for the currency just yet. In addition to microeconomic reform measures,macroeconomic reforms will play a central role, though they are not tied specificallyto WTO-agreed rules. In this regard, the convertibility of the currency and the openingof the capital account are of particular concern. Given the weakness of the domesticfinancial system and the consequences of painful corporate restructuring, now is notthe time to be opening the capital account or making the renminbi fully convertible.These goals are most likely reserved for the long term. We expect the government willimplement interim measures step-by-step, so as to render capital more mobile and toliberalise renminbi exchange-rate movements.

Quality growth first. Taken together, we believe the governments micro- andmacroeconomic policies are aimed not so much at increasing the headline rate ofgrowth, but rather at improving the quality of growth and ensuring its sustainability.On the micro side, mergers and acquisitions, higher value-added output, cost cuttingand changes in relative pricing will be the key driving forces for corporate earningsgrowth. From a macroeconomic perspective, a surge in foreign trade, FDI and increased

technology-intensive capital inputs will likely augment each component of GDP.

Agricultural sector hit hardest. The cost of grain in China is around 40% higher thanthe international norm. Given Chinas agreement to cut tariffs to 15% from 21%, weforesee job losses in the sector of around 13m by 2006. Still, the pain could be mitigatedby a cap on imports at 5% of domestic production. Moreover, gains in other non-grain subsectors could add 1m jobs. The governments land reform programme,meanwhile, will allow farmers to lease out land, somewhat making up for lost income.

Banking sector. Since the bank system is one of the greatest structural weaknesses inthe system, the government is setting up a timetable for state banks to reduce NPLsand for expanded foreign participation in the sector. We note, however, that progress

by asset management companies (AMCs) in resolving NPLs has been limited and weanticipate only a 15% recovery ratio on overall NPL disposal. We expect that statebanks will eventually list on the domestic stock market and offer equity stakes toforeign investors. Once foreign participation starts, we think corporate banking willsee more competition between domestic and foreign banks than retail banking.

Capital markets. In a bid to open the domestic capital markets gradually, the authoritieshave introduced mechanisms that will allow foreign investors to invest in A shareswhile allowing local investors to gain exposure to securities listed outside China. In arelated move, the government is preparing for the launch of Chinese DepositaryReceipts to allow foreign firms access to Chinese capital. Meanwhile, weak equity-market conditions have left domestic securities companies vulnerable and we foreseefurther consolidation in the industry and, perhaps, the formation of co-operativeventures with foreign companies.

Amid a weak bankingsystem and painfulcorporate restructuring,

we expect opening ofthe capital account willbe deferred until atleast 2006

We believe thegovernments micro andmacro policies areaimed at inducingquality growth

We expect 13m joblosses in the agriculturalsector by 2006

The immediate goal forstate banks is to purgetheir balance sheets

Domestic investors willbe allowed to investoverseas while foreigninvestors will bewelcomed in the A-share market


4/30

11 December 2001

4

Economic Insight

The road to WTO membership

Historical overview

A little known fact is that China was one of the 23 founding members of the General

Agreement on Trade and Tariffs (GATT) in 1948. However, following the CommunistPartys takeover of the mainland, the Kuomintang then still recognised as thelegitimate government of all China announced that China would abrogate itsGATT membership. Although the Communist government never recognised thiswithdrawal, it took almost 40 years for China to inform the GATT in 1986 of its wishto resume its status as a GATT contracting party. This marked the start of negotiationsfor Chinas WTO accession.

Chinas accession to the WTO has been managed by a working group which comprisedrepresentatives from all interested WTO member governments that sought negotiationswith China. The working group on Chinas accession was set up under GATT in 1987and was mandated only to deliberate matters relating to Chinas trade regime forgoods. In 1995, it was converted into the WTO Working Group on Accession and itsscope broadened to include trade in services, new rules on non-tariff measures andrules relating to intellectual property rights.

A substantial part of the process involved bilateral negotiations between China andWTO members. The working group had two tasks: to compile a report based on itsdeliberations and to complete a Protocol of Accession, with a number of annexesattached, serving as a timetable for bringing the applicants trade regime into linewith the WTOs rules and obligations.

In September 2001, the working group concluded that China and its major tradingpartners had finally reached formal agreement on all required legal documents relatingto Chinas WTO entry. Later China also concluded an agreement with Mexico. No

voting procedure was required and China secured its relevant ministers consensus onits membership the voting was virtually a formality on the first day of a five-daymeeting that took place from 9-13 November.

To speed up Chinas accession, the Standing Committee of the National PeoplesCongress convened a special session on the same day as the ministerial meeting inQatar (11 November) to ratify the terms of membership. Under WTO regulations, theratified terms would be lodged with the WTO secretariat for 30 days before membershipbecame official.

China was a founding

member of the GATT,but abandonedmembership in 1948

Chinas WTO accessionhas been managed by aworking group

The accession processinvolved bilateralnegotiations betweenChina and WTOmembers

China ratified the WTOagreement on 11November, 2001


5/30

11 December 2001

5

Economic Insight

Chinas obligations

The successful completion of negotiations on terms for Chinas membership of theWTO paved the way for the ratification of 900 pages of legal text of the agreementfor formal acceptance by the 142 members of the WTO Ministerial Conference in

Doha in November. China has agreed to undertake a series of steps to open andliberalise its economy to foreign competition and offer a more predictable environmentfor trade and foreign investment in accordance with WTO rules. The WTO agreement(see WTO press release/243, 17 September, 2001) stipulates that China will assume thefollowing commitments:

l It will provide non-discriminatory treatment to all WTO members. All foreign partieswill be treated on equal terms with domestic enterprises with respect to the rightto trade.

l All dual pricing practices will be abolished and differential treatment accorded togoods produced for sale in China and those produced for export will come to anend.

l China will not exercise price controls for the purpose of protecting domestic firms.

l China will implement the WTO agreement in an effective and uniform manner byrevising its existing domestic laws and enacting new legislation in compliance withthe WTO agreement.

l All enterprises in China will have the right to import and export all goods andtrade them throughout the customs territory within three years of accession.

l China will not maintain or introduce any export subsidies on agricultural products.

While China will reserve some rights of exclusive state trading on products such astobacco, fuel and minerals and maintain some restrictions on transportation anddistribution of goods inside the country, many restrictions that foreign companiesnow face will be eliminated or considerably eased after a three-year phase-out period.In other areas, such as the protection of intellectual property rights, China willimplement the Trade-related Aspects of Intellectual Property Rights Agreement (TRIPS)in full from the date of accession.

The agreement makes provision for the establishment of a special Transitional SafeguardMechanism that will function for a period of 12 years, starting from accession. Thecommittee will deal with cases where the import of products of Chinese origin causesmarket disruptions to other WTO members. At the same time, prohibitions, quantitative

restrictions or other measures maintained against imports from China that areinconsistent with the WTO agreement will be phased out or otherwise dealt withunder mutually agreed terms and timetables specified in an annex to the Protocol ofAccession.

Goods

Chinas average bound tariff level will decrease to 15% for agricultural products. Forindustrial goods the average bound tariff level will recede to 8.9% within a range of0-47%, with the highest rates applied to photographic film, cars and related products.By 2004, tariffs will have been mostly reduced or abolished, but in some cases thedeadline extends to 2010, at the latest.

Textiles. Upon accession, China will commit to the Agreement on Textiles and Clothingand become subject to its rights and obligations. Quotas on textiles for all WTO memberswill end on 31 December, 2004.

900 pages of legaldocuments on theterms of the accession

will be published soon

China has vowed thatthe opening will beorderly and gradual

A safeguard mechanismwill be implemented fora period of 12 years

Average Chinese importtariffs will be reducedto 15% formanufactured goods


6/30

11 December 2001

6

Economic Insight

Agriculture. China has agreed to limit its subsidies for agricultural production to 8.5%of the value of farm output.

Services

Telecoms. Following accession, foreign firms will be allowed to take up to a 25%

stake in wireless services in Beijing, Shanghai and Guangzhou, a limit that will beincreased to 35% in these cities and 14 more one year after accession. Three yearsafter accession the cap on foreign ownership will be increased to 49% with nogeographic restrictions. Similar timetables will apply to fixed-line service and Internetservice providers (ISP) with variations in the limits on foreign ownership.

Banking. Foreign financial institutions will be permitted to conduct foreign currencybusiness in specified areas of the country upon accession and conduct local currencybusiness within two years of accession. Within five years of accession, foreign financialinstitutions will be permitted to provide services to all Chinese clients.

Insurance. Foreign non-life insurers will be permitted to establish as a branch or ajoint venture (JV) with a maximum ownership of 51%. Within two years of accession,foreign non-life insurers will be permitted to establish wholly owned subsidiaries.

In the services sector,

foreign shareholding willbe gradually increased


7/30

11 December 2001

7

Economic Insight

Institutional changes and reform

The commitment of Chinas leadership to further open domestic markets to foreignentry suggests that competition will become more intense. This provides addedincentive for restructuring of the domestic economy. We believe the WTO commitments

will force the state to manage the economy according to market principles andreorganise industries to prepare for competition. Even under a gradual phase-in ofmarket-access concessions, WTO membership implies increased structural reform the dismantling of monopolies, the removal of regional barriers to trade, more M&Aactivity, layoffs and debt write-offs.

We believe the governments immediate goal is not so much to increase the headlinerate of growth, but rather to improve the quality of growth and ensure itssustainability. On the micro side, mergers and acquisitions, higher value-added output,cost cutting and changes in relative pricing will be the key driving forces for corporateearnings growth. Ownership restructuring will likely remain one of the key principlesof reforming the state-owned enterprises (SOE) after accession. From a macroeconomicperspective, a surge in foreign trade and FDI, and increased technology-intensivecapital inputs will likely induce quality enhancement and provide a stimulus foreconomic growth.

Broader and deeper industrial reform

The manufacturing sector is the backbone of Chinas economy, contributing 40% ofGDP, 50% of fiscal revenue and 90% of exports. In June, the government published adetailed Tenth Five-Year Plan for 13 major industries. As a follow-up, the governmentpublished its "Tenth Five-Year Plan of Industrial Structure Adjustment", which addressesthe structural adjustment required by the WTO. The plan aims to lift competitivenessand to maintain a 7% sustainable annual GDP growth from 2001-05. The main tenetsof the plan include improvement to the state funds allocation system to achieve a

higher return, encouraging large companies and enterprise groups to improvecompetitiveness, expanding the Western China regional development strategy tonarrow the income gap between regions, devoting more resources to energy savingand upgrading information technology.

In addition to restructuring guidelines, the government has announced a strategy ofcreating of 50 super league (similar to Fortune 500 companies) manufacturingcompanies through M&A, IPOs and restructuring as a first step in its industryreorganisation programme. Domestic companies, including big ones, lag multinationalsin terms of sales value, market share, R&D and management. We believe the centralproblem is that these firms lack economies of scale. In the machinery sector, forinstance, there are an estimated 115,000 machinery companies at and above the

township level together employing 18m people, not including village enterprises. Tocreate competitive companies in this sector will require a good deal of M&A,technological innovation, foreign investment, the formation of business alliances andstock market listings.

The government envisions the super-league companies becoming leaders in each sector,with their own brand names, focused business, advanced technology and strongR&D capabilities. Measures required to create such companies will be implemented intwo phases. First, to streamline production, non-core business activities and assetswill be decreased. Second, core businesses will be expanded so economies of scalecan be attained. We believe the governments policy focus on big firms has undergonea metamorphosis, moving away from encouraging the formation of diverse, chaebol-type companies to core competency-focused companies.

Structural changes suchas the break-up ofmonopolies and the

removal of barriers totrade will beimplemented

The goal is not toincrease growth, but toenhance quality of thegrowth boostingefficiency and increasinghigher value-added

output

The governmentrecently releasedreform guidelines forthe manufacturingindustry...

...and it wants to seethe emergence ofsuper-leaguecompanies

Enhancing productivityand streamliningproduction are key


8/30

11 December 2001

8

Economic Insight

Small and medium enterprises (SMEs) face a much less accommodating governmentpolicy environment only the fittest will survive. Last year, about 19,000 loss-makingSOEs, all SMEs, were closed down, sold off or declared bankrupt. As a result, netassets of the state sector declined by RMB30bn. The government seems to have ruledout the possibility of assistance for smaller SOEs.

We understand the State Economic and Trade Commission is nearing completion oflegislation intended to create a fairer operating climate for the countrys 8m SMEs,which account for about 60% of total industrial turnover and exports. Key aspects ofthe draft legislation define special terms in the state budget for SMEs and establishdedicated funds to support their growth. The government will also provide assistancein SMEs efforts to upgrade technology, gain market access and to improve informationand human resources. It seems the proposed legislation will not discriminate betweenSOEs and private SMEs.

Over the past three years, the major domestic industries have made efforts to gain anunderstanding of the WTO rules and drawn up plans for dealing with foreigncompetition. Major corporations have adopted various measures aimed at improvingmanagerial skills, including studying and adopting models of foreign enterprises. Still,we think the majority of SMEs have done little to prepare for WTO accession and weexpect they will face significant competitive challenges. At the same time, we emphasisethat SMEs by their very nature are flexible and can adapt to a new business environmentwithin a relatively short period of time.

Local protectionism to be contained

This year has seen the government launch a campaign aimed at rectifying and restoringmarket order (if indeed it ever existed in an appreciable sense). This drive entailscracking down on counterfeit goods, tax fraud, and suchlike. In May, the State Councilunveiled regulations designed to prevent local protectionist measures. Included onthe target list are regulations barring non-local companies from entering local markets,

discriminatory rules preventing investment by non-local enterprises, and relatedinfringements of legal rights. Clearly, this push wont be a panacea for the perils ofregional protectionism. But we see it as a step in the right direction and envisageWTO accession adding further momentum to this effort. With some of the barriersdismantled, the result could be an increase in cross-regional M&A activity, investmentand trade.

The WTO itself could gradually push local governments to stop protecting firms byexcluding goods made overseas or other regions. The reality is that many local andprovincial governments have attempted to block or restrict the entry of outside goodsto ensure the local population buys from companies the local government owns andtaxes. This practice, although illegal, has been a custom for many years and is unlikely

to come to an immediate end. We expect the implications of the WTO deal will havethe greatest impact on provinces where the state sector the major provider ofjobs, tax revenue, housing and medical benefits dominates.

We expect the central government will encourage more inter-provincial exchanges asa start. These exchanges will probably involve exploiting comparative advantagesbetween provinces and a boost to investment by one province in another. Accordingthe official government news service, Xinhua News Service, some cross-provincialprojects, such as the transfer of electricity and natural gas, have already been launched.Jiangxi, a major agricultural base in eastern China, has enjoyed rising trade with otherprovinces. Interprovincial labour mobility has also increased significantly. For example,some 100,000 surplus labourers in Nanchang (Jiangxi province) have been offered

jobs in Wuxi (Jiangsu province). Of course, these are examples of government initiatives,

but market forces will likely provide the biggest incentive for inter-regional exchanges,resulting in the realisation of economies of scale and greater efficiency.

SMEs have been left to fend for themselves...

...but a fairerenvironment will beprovided

SMEs have made littlepreparation for post-WTO entry competition

Bringing an end to localprotection will be alengthy but crucialbattle

The central governmentis starting to promoteinterprovincialco-operation


9/30

11 December 2001

9

Economic Insight

Macroeconomic impact

Foreign trade seen to double by 2006

China is the sixth-largest trading nation in the world, but has more scope to develop

its external sector, in our view. Various restrictions have prevented the country fromfully exploiting its competitive advantages and inhibited greater expansion of externaltrade and capital inflow. As a result of the trade liberalisation required by accessionterms reducing tariffs and abolishing quotas and the likely increase of export-oriented FDI, we believe Chinas foreign trade (combination of exports and imports)could rise to more than US$1tn by 2006 from an estimated US$500bn in 2001.

We believe imports will initially surge on the heels of tariff cuts and the removal ofnon-tariff barriers. Tariffs on industrial goods will be reduced to an average of about8.9% from 15%. We estimate that the expected tariff reduction, the dismantling ofnon-tariff barriers and a rise in FDI-induced imports (equipment and machinery) willgenerate an additional US$30bn in imports per year over 2002-06. On an aggregatebasis, imports will likely rise to about US$500bn a year by 2006.

Meanwhile, we expect exports will grow 16% per year over 2002-06, compared witha projected 9% under the assumption that China had no WTO membership. From1996-2001, we estimate actual export growth was 10% per year. In total, exports willlikely rise to about US$530bn in 2006, equivalent to 28% of GDP, up from 23% in 2000.Assuming world export growth of 6.9% annually in 2002-06, we project Chinas shareof world exports will increase to 5.9% by 2006, compared with 4.4% in a no-WTOmembership scenario.

Our projection of an initial rapid rise in imports suggests that Chinas trade surpluswill shrink, exerting a negative influence on the economy. However, export growthwill likely exceed import growth two to three years after accession, as export-oriented

FDI becomes productive. Growth in industrial production (IP), which accounts forabout 50% of GDP, is likely to accelerate on the heels of strong exports (accountingfor about 16% of IP in 2001). We expect rising manufacturing production will augmentpersonal income and consumption and have a spill-over effect in other sectors. Hence,foreign trade should boost GDP growth by 0.085pp per annum during 2002-06, whiletrade- and production-led improvements in personal income and consumption shouldadd 0.2pp annually to GDP growth over the same period.

In sectors where China enjoys competitive advantages, WTO membership couldsignificantly boost exports. Hence, we see a considerable rise in the export of productssuch as textiles, footwear, toys, consumer electronics and some information,communications and technology (ICT) products. Last year, Chinas exports of clothing

and footwear grew 40% y-y to US$43bn. The corresponding figure for the first ninemonths of this year was 12.1% y-y, outperforming overall exports by 7.2%. Includingrelated products such as yarn and fabrics, Chinas overall textile exports last yearreached US$62.1bn (25% of total exports). The rise in exports has also benefitedhigher value-added products; in the first nine months of this year, ICT-related exportsrose to US$42.2bn (20.5% of total exports), up 22.5% y-y.

The timing of Chinas accession to the WTO is perhaps not perfect; a weakeningglobal economy will likely have a negative short-term impact on the Chinese economy(in Market Insight, Optimism deferred, published 22 October, we provide a detaileddiscussion of the short-term impact of the US economic slowing following the 11September events on Chinas economy). Yet, even before the terrorist attacks on theUS, the external sector was plagued by declining demand; the value of exports grew

7.2% y-y in the January-September period, down sharply from the 28% increaserecorded in 2000. In October, exports rose only 0.2% y-y, on the heels of a furtherslump in demand, particularly from the US, which accounts for about 20% of Chinas

Liberalisation and rising

FDI should spur a rapidincrease in trade

Initially imports shouldrise significantly...

...followed by a surge inexports...

...leading, ultimately, toan improvement inconsumption

WTO accession shouldbenefit exports oftextiles and ICTproducts

Given the weakening global economy, weexpect an exportcontraction in 4Q01


10/30

11 December 2001

10

Economic Insight

total exports. Should one take into account indirect exports (such as those transshippedthrough Hong Kong), the US accounts for about 33% of Chinas exports. We foreseean export contraction of 5.3% y-y in 4Q01 and 3.1% in 1H01, returning to positiveterritory by 2H01. All told, annual growth in exports will likely slow to around 4.2%this year and 3.3% next year.

FDI seen to double by 2006China is the second-largest recipient country of FDI after the US. In the first tenmonths of this year, utilised FDI rose 18.6% y-y, against a 1% y-y increase in 2000. FDIapprovals, meanwhile, grew 27% y-y. However, FDI flows to emerging markets havenot been spared the effects of a slowing world economy and the terrorist attacks inthe US and will likely decline in the short term. The Institute of International Finance(IIF), a subsidiary of the World Bank, predicts that net private capital flows to emergingmarkets will drop to US$106bn this year from US$167bn last year, before reboundingto US$127bn next year. On the heels of this reduction in flows to emerging markets,FDI to China will likely decline in the near term, particularly from the US where manycompanies have suspended overseas expansion in the aftermath of 11 September.

We think that despite a short-term decline in FDI flows to China, the country willremain a favoured destination for FDI over the medium to long term. In addition tothe usual considerations such as the potential size of the domestic market and labourcosts, we think Chinas WTO accession will add additional momentum to FDI inflows,based on three factors:

lThe promise of greater exports and the opening of the domestic market serve asa powerful driver for increased FDI flows. For the first nine months of this year,contracted FDI rose 32.4% in the textile sector, 47.1% in chemicals, 37.5% inpharmaceuticals, 72.9% in machinery, 184.1% in utilities, and 98.8% in construction.

lFalling global demand and weakening Asian economies have prompted a shift ofproduction to China as a low-cost outsourcing destination. This business has flowed

from the likes of Taiwan and Japan, a trend enhanced by the fact that economicconditions in these countries are less favourable than in China. In year-on-yearterms, contracted FDI rose 66.9% from Japan, 76.8% from Taiwan, 54.8% fromSouth Korea, but dropped 14.1% from the US in the first nine months of 2001.

lIntra-company trade flows induce FDI, owing to specialisation of the productionchain.

On our projections, Chinas annual utilised FDI growth rate will come in at 16% in2002-06, bringing the total to about US$100bn by 2006. In the absence of WTOmembership, we estimate Chinas utilised FDI annual growth rate would be 6% (theutilised FDI average annual growth rate was 4.7% during 1996-2001) during the sameperiod.

To meet WTO obligations, China needs to abolish most forms of FDI restrictions and mosteconomic sectors are required to open to foreign competition, including agriculture,telecoms, retail and distribution, and financial services. Meanwhile, other sectors haveseen tentative opening. The most prominent of these is the media sector, where limitedJV formation has been approved.

Chinas utilised FDI

Amount (US$m) Growth (% y-y) Share of total (%)By origin 2000 9M01 2000 9M01 2000 9M01

Hong Kong 15,500.0 11,166.3 (5.3) 3.8 38.1 34.6US 4,383.9 3,443.9 4.0 37.1 10.8 10.7Japan 2,915.9 3,064.7 (1.9) 53.8 7.2 9.5

Taiwan 2,296.3 1,969.1 (11.6) 37.9 5.6 6.1Korea 1,489.6 1,403.3 16.9 63.1 3.7 4.3Singapore 2,172.2 1,337.7 (17.8) (7.6) 5.3 4.1Germany 1,041.5 878.7 (24.2) 18.2 2.6 2.7Source: CEIC, Nomura International (Hong Kong) Limited

Chinas FDI will likelydecelerate in the shortterm...

...but in the long term,China will remain a favoured FDIdestination

WTO membershipcould lead to utilisedFDI growth of 16%through 2006

Opening up moresectors to induce moreFDI


11/30

11 December 2001

11

Economic Insight

Chinas utilised FDI by sector

FDI (US$m) Growth (% y-y) Share of total (%)Sector 2000 9M01 2000 9M01 2000 9M01

Electronics 4,594.1 4,694.1 46.0 48.8 11.3 14.5

Real Estate 4,657.5 3,298.4 (16.7) 2.1 11.4 10.2Textiles 1,367.5 1,229.4 (0.2) 34.9 3.4 3.8Chemicals 1,795.0 1,359.0 (6.5) 46.4 4.4 4.2Utilities 2,242.1 1,461.4 (39.4) (6.2) 5.5 4.5Machinery 1,043.5 838.4 6.8 52.6 2.6 2.6Construction 905.4 556.3 (1.2) 3.1 2.2 1.7

Transportation 1,011.9 621.2 (34.8) (22.9) 2.5 1.9Trade 857.8 1,130.7 (11.1) 65.1 2.1 3.5

Source: CEIC, Nomura International (Hong Kong) Limited

On the whole, we believe Chinas WTO accession will result in both external andinternal liberalisation, a boost to FDI flows and a rise in private investment. We expectfixed capital formation will grow over 11.1% annually over 2002-06. The investmentboost from WTO accession slated for this period should be a major source of economicgrowth, contributing an additional 0.34pp per annum over the period.

Multinationals expansion plans in China

Company Code Price Rating Investments

Motorola MOT US US$17.05 Hold Invested US$3.4bn, another US$6.6bn to follow in 2002-06

Erricsson ERIC IM 27.14 Not covered Invested US$2.4bn, another US$5.1bn to follow by 2005General Motors GM US US$49.80 Not covered Invested US$1.4bn, another US$700m planned

Volkswagen VOW GR 49.10 Not covered Plans to invest RMB12bn in 2002-06

BP-Amoco BP/ LN Not covered Plans to invest US$5bn in 2002-06

Bayer BAY GR 35.62 Not covered Plans to invest another US$3.1bn and double sales by 2005 from1.1bnat present

Dell Computer DELL US US$28.08 Hold Plans to shift some production to China (US$0.15bn)

Carrefour CA FP 59.0 Not covered Already has 18 branches, plans to establish five global purchasing centresin China

Wal-Mart WMT US US$55.17 Not covered Already 18 branches, plans to open another fiveCoca-Cola KO US US$46.55 Not covered Already has 28 factories, plans to open six more factoriesMcDonalds MCD US US$26.87 Not covered 300 outlets in China, plans to expand through franchising

Source: Bloomberg, Hong Kong Economic Daily(13 November, 2001)

FDI contributes moreGDP growth


12/30

11 December 2001

12

Economic Insight

A boost for GDP growth

Chinas real GDP growth is likely to moderate to 7.3% this year and 7.0% next year,from 8.0% in 2000. The government has made contingency plans should externaldemand collapse and the economy descends into a slump. We believe it will issue

RMB80bn in special bonds early next year, in addition to the issuance of RMB150bn inlong-term bonds slated for next year. State fixed asset investment (FAI) grew 17.4% y-y in January-October. The increase in FAI in 1H01 was fuelled by funds left over(RMB50bn) from a bond issuance last year; the proceeds of this years issue have justbeen deployed.

We forecast that Chinas entry to the WTO will boost GDP growth by 0.5pp in 2002-06to an average 7.7% per year, assuming that the US economy will recover no later than2003. Our projected growth trajectory for China suggests total GDP will rise toRMB15.5tn in 2006 from RMB8.9tn in 2000, an increase of 74% over six years in nominalterms, assuming a 2.1% per annum inflation rate. Assuming an appreciation of 1% inthe renminbi relative to the US dollar, GDP could increase to US$1.9tn in 2006 from

just over US$1tn in 2000. We expect the Chinese economy will record the fastestgrowth in Asia during this period.

We believe the added economic growth will primarily be induced by efficiency gainsand a rise in higher value-added output. Such efficiency gains will more than offset theconsequences of shrinking employment on economic growth and will flow primarilyfrom sector consolidation, economies of scale, the exploitation of comparative advantagesin both the internal and external markets, improved technology and rising FDI.

We foresee economic growth losses of 0.1-0.2pp per annum in the first two yearsafter accession, owing to rising unemployment and a surge in imports, including asharp increase in FDI-related capital equipment. Rising imports will likely result in ashrinking current account surplus, compromising GDP growth. Likewise, rising

unemployment will likely depress consumption. Still, in a no-WTO membership scenario,fiscal spending would likely be higher, thereby offsetting the negative impact thatWTO membership will have initially.

China GDP growth rates after WTO accession

(%) 2000 2001F 2002F 2003F 2004F 2005F 2006F

GDPNo-WTO membership 8.0 7.3 7.2 7.8 7.5 7.2 7.0WTO membership 8.0 7.3 7.0 7.7 8.1 8.2 7.9

Private consumptionAs a percentage of GDP 48.2 48.3 48.5 48.2 47.5 46.8 46.6Change (y-y) 9.1 7.7 7.5 7.2 7.0 7.5 8.0

Government consumptionAs a percentage of GDP 13.1 13.1 13.2 13.2 13.0 12.7 12.5

Change (y-y) 14.0 7.3 7.5 7.5 6.7 5.8 5.5InvestmentAs a percentage of GDP 36.6 37.9 39.2 39.9 40.2 40.2 40.1Change (y-y) 10.9 11.2 10.6 11.1 11.5 11.0 11.1

Net exports (G&S)As a percentage of GDP 2.5 1.6 0.8 0.7 1.0 1.4 2.1Change (y-y) (0.2) (34.4) (45.9) 0.6 45.7 57.4 59.3

Source: CEIC, Nomura International (Hong Kong) Limited

Impact of WTO accession on GDP components

GDP growth (2002-06F) No WTO: 7.2% WTO: 7.7% WTO impact on GDP

Growth (pp)Private consumption 7.0 7.4 +0.205Government 7.0 6.6 -0.052

Investment 10.2 11.1 +0.343Net exports -35.2 -28.2 +0.085Other adjustments -0.082Net adjustments +0.500

Note: Other adjustments capture the net impact of changes in weights, the deflator and inventory.Source: Nomura International (Hong Kong) Limited

Fiscal policy will likelybe pro-active

We believe Chinaseconomy will record thehighest growth in Asia

Economic growth shouldgain a boost fromimproved quality ratherthan a rise in output

In the first two yearsafter accession, weexpect a loss to GDPgrowth of

0.1-0.2pp

Chinas WTO accessionshould contribute anaverage 0.5pp to GDP

growth in 2002-06


13/30

11 December 2001

13

Economic Insight

Rising unemployment

Officials have publicly admitted that the actual unemployment rate in China is around7-8%, instead of the recorded rate of 3.3%, which does not include workers inre-employment training centres. On our estimates, average unemployment in 2001

will be 11.5%. While the civil service and the state-owned sector axed nearly 26%(28m) of staff in 1996-2001, we estimate collectively owned enterprises reducedemployee numbers by more than 50% (15m). In contrast, only 15m jobs were createdby foreign and privately owned enterprises during the period. In the immediate periodafter WTO accession, we estimate unemployment will surge, mainly in the state sector.As a result, urban unemployment could rise from 11.5% this year to around 15% in2004 before declining to 13.5% by 2006. This implies about 12m more redundancies inurban areas, mainly from SOEs, than under a non-WTO membership scenario.

Still, other sectors, such as textiles, garments, construction, trade and services couldserve as net job creators. This could take place on the heels of further policy measuresto spur employment, encompassing the purchase, rent or lease of SOE assets. Thestate can provide a number of incentives such as tax breaks, more realistic criteria formarket entry and easier access to banking services. Some local governments are alreadypursuing preferential policies to encourage non-state firms to take over state assets.For example, the Yunnan provincial government has pledged three-year tax cuts andtax exemptions for non-state firms that merge with or acquire state SMEs. We see thismove as a reflection of the states desire to withdraw from most industries, with thespecific goal of creating a fair and open market that encourages expansion of thenon-state sector. In urban areas, we expect employment in the state sector will declinefrom 67% to around 55% by 2006.

Unemployment willlikely rise; we see theloss of 12m jobs,

primarily in the statesector...

...but employmentcould rise in somesectors such as textiles


14/30

11 December 2001

14

Economic Insight

Renminbi convertibility and the capitalaccount

The WTO agreement contains no explicit or implicit requirements to liberalise the

capital account or to make the renminbi fully convertible. The capital account regimeis a matter for the IMF, which has, of late, encouraged China to gradually open thecapital account and opt for a more flexible regime. But even as a member of the IMF,China is not obliged to make its currency fully convertible on capital accounttransactions. In our view, authorities are not yet ready to commit to a completeliberalisation of the capital account.

The impact of WTO membership on the mobility of capital and the exchange rateregime has been a vigorously debated issue in recent years and many observers haveadvocated the opening of the capital account and convertibility of the currency inthe near term. In our view, Chinas controlled capital account system, while saddledwith shortcomings, has served the country well so far (for a detailed discussion ofCHinas capital controls see article by Pu Yonghao "Chinas New Economic Agenda:

Policy Implications for Liberalising the Capital Account", Cato Journal, Vol 21, Spring/Summer 2001. We believe this policy has helped to: 1) prevent an outflow of capital;2) implement a highly effective monetary policy; 3) preserve public confidence in thedomestic financial system; and 4) protect the country from the contagion of theAsian financial crisis.

We believe that given the importance attached to WTO accession, liberalisation of themonetary regime has been shifted to the back burner. We do not foresee opening ofthe capital account and convertibility of the currency at least until 2006. Before theauthorities turn their attention to liberalisation of the monetary regime, we think thefollowing issues will feature as policy priorities:

Converting domestic savings into productive investment. In recent years, China hassuffered from what appears to be oversaving, despite the fact that interest rates ondeposit accounts have dropped to historical lows (for a detailed discussion on excessivesaving in China, see article by Pu Yonghao, Squaring the cycle in Financial Times, 10August, 1999). This year, household savings growth started to accelerate again, amidweakening of the domestic equity market. Oversaving is a pernicious trend consideringthat many regions and projects are starved of capital and unemployment rates on thewhole have risen to around 11.5%. We think the absence of proper investment channelsand a legal framework that would encourage private investment have contributed inlarge part to this phenomenon. In our view, under-utilisation of domestic savings is aproblem that must be addressed as a matter of urgency.

Reform of the financial sector. When a financial system is weak, managed liberalisationof the capital account becomes a hazardous exercise. In China, domestic financialinstitutions have a limited ability to assess and manage risks associated with largecapital inflows, while regulatory authorities have limited experience and capabilitiesto exercise proper supervisory authority. From a macroeconomic management pointof view, China needs to develop a healthy financial system that features well-functioningand regulated financial institutions, capital markets and financial products before thecapital account can be opened. As these systems are put in place, less sophisticatedpolicy measures that could restrict capital flows are probably a necessary evil to preservemacroeconomic integrity.

Refining interest-rate policy. To balance domestic supply and demand in a closedeconomic regime, interest-rate policy is an instrument that has proved highly effective.

When capital controls are lifted other factors enter the equation, making interest-rate policy less effective. Authorities then have to contend with the internationaleconomic environment in addition to domestic economic conditions since interest-rate differentials between countries become a major driving force for cross-border

WTO membership does

not require China toopen the capitalaccount or to free thecurrency

In the past, a closedcapital account andfixed exchange rateserved China well

We believe the capitalaccount will remainclosed until at least2006 since...

...the capital allocationsystem is not efficient...

...the financial sector isfragile...

...interest rates areconstrained...


15/30

11 December 2001

15

Economic Insight

capital movements. For now, domestic interest rates are relatively fixed and the systemis designed to respond to domestic conditions only. A policy mechanism to deal withcapital account liberalisation will have to be established prior to the actual openingof the capital account.

Establishing a more flexible exchange-rate regime. Since 1994, domestic firms have

been obliged to sell any hard-currency earnings to designated state-owned commercialbanks. Chinas central bank, the Peoples Bank of China (PBoC), imposes a quota oneach commercial banks hard currency balance. When this balance is below or abovethe quota, the bank in question is required to take action to restore its foreigncurrency holdings to the quota either through inter-bank operations or swaps. Fromtime to time, the PBoC has to intervene in the forex market to maintain the stability ofthe exchange rate. In recent years, China has maintained a positive balance of paymentson the heels of a trade surplus and strong FDI inflows. Without the PBoCs intervention,the renminbi would likely have appreciated significantly. Appreciation pressure couldmount on the currency, given the divergence in Chinas economic performance relativeto Asia and the world. The trading band of the renminbi will likely be expanded toallow for more exchange-rate flexibility.

There are indications that China has begun its transition to a managed float regime.We believe that after Chinas WTO entry, the country will adopt a more flexibleexchange-rate regime to respond to increasing capital mobility. Measures will likelyinclude widening the exchange-rate band. By allowing SOEs to be taken over byforeign companies, opening up previously closed sectors, such as telecoms and thefinancial sector, and permitting offshore funds to enter the domestic capital marketunder a Qualified Foreign Institutional Investor (QFII) system (perhaps allowing themto invest in A shares) will likely attract a significantly increased inflow of capital. Undersuch circumstances, a more flexible exchange-rate regime would be required to avoidreal exchange-rate appreciation or depreciation and to achieve domestic monetaryobjectives.

Setting capital free involves significant benefits, but comes at a cost. Once free capitalmobility is achieved, economic power and influence of the government becomes afunction of external factors as well, disturbing the congruency that exists betweeneconomic and political power in a closed economy. As a result, the political environmentwill invariably become less predictable. We believe that liberalising capital mobility willhave to be achieved in intermediate steps, to avoid a policy void and market volatility.

Following WTO accession, we foresee a rapid rise in imports in the short term on theheels of lower tariffs and market opening. This will likely result in a decline in thecurrent account surplus, a trend that will probably continue until improved marketaccess for Chinese export products improves and export-oriented additional FDI becomesproductive. Still, Chinas balance of payment (BoP) position should remain stable

throughout, given the offsetting effect of higher FDI inflows immediately after WTOaccession.

Appreciation pressure has mounted on the renminbi as the capital account surplusaccumulated over the past few years and China gained the status of safe havenduring and after the Asian financial crisis. We note that the renminbi exchange rateto the US dollar on the black market is at around a 1% premium to the officialRMB8.28:US$1 rate. We expect the projected weakening of the US dollar to the eurowill relieve some of the pressure on the Chinese currency. We look for the renminbi toremain stable this year while firming moderately in the next five years on the heels ofrobust capital inflows and a positive current account.

Since membership of the WTO entails the adoption of internationally accepted policystandards and adherence to international rules, we think China will evolve to embracea more open and transparent policy regime, leading to greater consistency,transparency and predictability in policy making.

...and the exchange

rate is not flexible yet

Liberalising capital couldrender the politicalenvironment lesspredictable

WTO accession pointsto a surge in importsand a shrinking currentaccount surplus

We expect therenminbi will remainstable in the post-WTOaccession era

WTO accession willlikely enhance policy-making transparency

The exchange band forthe renminbi could begradually widened


16/30

11 December 2001

16

Economic Insight

Two recent events point to the improvement in this regard. First, at the beginning ofNovember, the government announced outstanding foreign debt at end-June wasUS$170.4bn, up sharply from the official US$145.7bn at end-2000. The significant risewas the result of a change in the compilation of the data. The new figures includeoverseas borrowings of foreign financial institutions operating in China, offshoredeposits at Chinese banks and some trade-related loans the standard measurement

recommended by the IMF. Second, Chinas state banks have adopted the internationallyaccepted five-category loan classification system to disclose non-performing loan (NPL)ratios. Applying this measurement, the banks announced an NPL ratio of 40% beforethe transfer of some NPLs to asset management companies (representing around10% of NPLs). This is in stark contrast to the NPL figure of 10% announced at thebeginning of 2000, based on the Chinese four-category classification system.Implementing standard reporting measures, enforcing timely disclosure and settingtransparent regulatory supervision will likely reduce the degree of risk in investing inChina debt securities, brought on by regulatory uncertainty. Hence, sovereign andcorporate debt ratings will likely improve.

The government haschanged themeasurement ofoutstanding foreign debtto arrive at morerealistic figures


17/30

11 December 2001

17

Economic Insight

Sector impact

Agriculture more pain

The agricultural sector will likely suffer the greatest negative impact from WTO accession,

mainly owing to dated production methods and high costs. The cost of grain (wheatand cotton), we believe, is about 40% higher than international market prices. Thegovernment has traditionally kept the grain purchasing price below production cost tosubsidise industrial and urban development. Implementation of this policy over an extendedperiod of time has resulted in economic backwardness for farmers. Growth in farmersincome in 2000 was a mere 2% y-y, compared with around 8.5% for urban dwellers. Infirst three quarters of this year, per capita income in cities rose 7.4% y-y versus 5.2% inrural areas. The current income of urban residents (per capita disposal income wasRMB6,280 in 2000) is 2.5x that of farmers. We believe there are about 300m surpluslabourers in rural areas, resulting in low productivity and high unit costs.

After WTO entry, tariffs on agricultural produce will be reduced to 15% from 21%. Nosubsidising of agricultural exports will be allowed a somewhat insignificant provisosince the government terminated subsidies in 1994. More crucially, import quotas onmajor grain (wheat, corn, cotton) will be lifted from 3% of total domestic productionto 5% in five years following accession, implying grain imports will rise from 12m tonnesto 20m tonnes by 2006 and about 30m tonnes by 2011. As a consequence, we estimate

job losses will amount to 2.5m in corn production, 5.5m in wheat production and 5m incotton production. In aggregate terms, we see total job losses in the sector reaching13m by 2006, representing 3% of the total numbers of workers employed in agriculture.

Still, it is not all doom and gloom for agriculture. We believe the opening of domesticand overseas markets will help create jobs in non-grain production sub-sectors, suchas animal husbandry, fishery and vegetable, fruit, flower, greenfood, and medicineplant cultivation. We expect 1m jobs to be created in animal husbandry and another

1m in other non-grain production.

Policies to ease the pain in rural areasChina has recorded bumper grain harvests over the past few years, resulting in depressedprices. As mentioned, we estimate the number of surplus farm labourers at 300m.This poses the threat of social instability, compounded by the imposition of moretaxes and levies by local authorities a move that has led to a number of protestsand clashes between farmers and local authorities. Moreover, there is almost no socialsafety net in rural areas, except for more affluent regions such as Shanghai.

Keenly aware of the danger that unemployment in rural areas poses, the centralgovernment has implemented a number of reform measures such as relaxing residential

permit controls and accelerating urbanisation. We foresee a net increase in the numberof farmers migrating to urban areas from 6m per year at present to about 15m by2006 and we expect the rate of urbanisation to reach 40% by 2006 from 36% atpresent. In addition, the government has increased assistance to privately ownedtownship and village enterprises (such as the extension of bank credit) to help withthe creation of jobs.

One of the most significant land measures enacted as part of Chinas open doorpolicy in the late 1970s was the de-collectivisation of farms. Now another wave ofsignificant land reform is in process. This involves the encouragement of switchingfrom household production to large-scale agricultural production, which implies ashift toward corporatisation of farms. The government has embarked on a process ofland reform under which farmers will be entitled to lease land on a long-term basis.

This policy, in our view, forms the basis for consolidation and corporatisation in thesector. Equally import, it empowers farmers to lease out land on a sublease, a significantcompensation for the lack of a social safety net since it will provide a supplementaryincome stream.

Grain prices in China

compare unfavourablywith international prices

Job losses could reach13m by 2006...

...but some sub-sectorsmay benefit

Social problems in ruralareas are compoundedby the lack of a socialsafety net

The central governmenthas implemented some

reforms to benefit therural population

Allowing farmers tolease land in the longterm will allow forconsolidation andcorporatisation ofagriculture


18/30

11 December 2001

18

Economic Insight

In our view, the development of agriculture will depend on shifting the policy focusfrom increasing grain production to diversification of crops, specifically the cultivationof profitable agricultural produce (eg, fruit, flowers, biomedical produce). Meanwhile,a government proposal to increase investment in agriculture will help too. We expectthe government will issue RMB50-80bn in special bonds to upgrade infrastructureand the education system in rural areas. Other measures include a reduction in the

tax burden, the cutting of various fees and levies and the provision of policy andfinancial support measures to farmers to adopt new technologies and shift to highvalue-added production. The competitiveness of the agricultural sector will likelyimprove only if these policy measures are implemented successfully not an easy taskin Chinas countryside.

Rural areas need moreinvestment and policysupport


19/30

11 December 2001

19

Economic Insight

Banking facing tough competition

Probably one of the greatest structural weakness in the Chinese economy is the highlevel of NPLs in the banking system. The government seems to be aware of the pressingneed to address banking sector problems and has set a timetable to allow the health

of the banking sector to improve before the liberalisation of financial instruments.

The PBoC recently published a timetable of banking sector reforms in accordancewith WTO accession terms. These reforms include allowing foreign banks to conductrenminbi business without any geographic restrictions within five years of accession.At present only about two dozen foreign bank branches are allowed to conductlimited renminbi business in Shanghai and Shenzhen.

By end-September, China had extended approval to 190 foreign-bank branches andoffices (including 158 branches and six sub-branches) to conduct banking business inthe country. However, the bulk of the banks are only allowed to engage in foreigncurrency business with foreign clients and with certain restrictions in place. The nextstep in the opening process is to allow foreign banks to conduct renminbi transactionswith foreign-funded companies in China. Within two years of accession, this businesswill be extended to Chinese companies in general. Five years after accession, foreignbanks will be allowed to conduct renminbi business with clients of their choice,including individuals.

Renminbi business timetable

Time horizon Lifting of geographic restrictions in:

Present Shanghai, and ShenzhenImmediately after accession Dalian, Tianjin

One year after accession Guangzhou, Qingdao, Nanjing, and WuhanTwo years after accession Jinan, Fuzhou, Chengdu and ChongqingThree years after accession Kunming, Zhuhai, Beijing and Xiamen

Four years after accession Shantou, Ningbo, Shenyang and XianFive years after accession All geographic restrictions lifted

Source: Xinhua News Service

On 9 December, the PBoC announced new market opening measures that will comeinto effect when China becomes a full member of the WTO. These include:

l Client restrictions on foreign banks foreign currency business will be abolished,allowing such banks to deal with both corporate and individual clients in foreigncurrency business.

l The Shanghai and Shenzhen branches of foreign banks will be allowed tocommence renminbi business, while foreign bank branches in Tianjin and Dalianwill be allowed to apply for renminbi business operations.

l Non-bank, foreign financial institutions will be allowed to apply to engage inmotor vehicle financing, either through a JV or a wholly owned subsidiary.

l Foreign companies will be allowed to establish financial leasing companies eitherthrough JVs or wholly owned subsidiaries.

Dai Xianglong, governor of the PBoC, acknowledged that NPLs at the "big four" state-owned commercial banks Industrial and Commercial Bank of China (ICBC), AgricultureBank of China (ABC), China Construction Bank (CCB), and Bank of China (BOC) accounted for 29% of their total loan portfolios at end-2000. This was even after thetransfer of some RMB1.4tn in bad loans to four asset management companies, implyingthat the initial figure was around 39% at banks, which account for 80% of domesticbanking assets. We believe NPLs in the domestic banking system prior to the transfer

of NPLs to the asset management firms stood at around 45%. At this level, manydomestic banks would be considered insolvent by international ratings agencies. Againstthis background, we believe the banking sector is the most vulnerable to foreign

Timetables have beenset for the reduction ofNPLs

Opening the bankingsector will be gradual...

...in both business andgeographic terms

NPLs remain at analarming level, but willlikely be reducedconsistently


20/30

11 December 2001

20

Economic Insight

competition after WTO accession. While a number of reform measures have been put inplace to improve the health of the system, we think a lot remains to be done. This all butobliterates the possibility of an early opening of the capital account.

Banking reform progress

The first step in the banking reform process was to establish four AMCs to take overNPLs from banks. In 1998, the government issued RMB270bn in bonds to recapitalisethe banks and enhance their capital adequacy ratios. It also acted as an implicitguarantor for RMB1,400bn in bonds issued by the four AMCs. By 2000, the four AMCsassumed about RMB1.4tn in NPLs from the big four banks, resulting in a 10pp drop inthe NPL ratio. We think the big four will issue corporate bonds in future to enhancetheir capital base and bring capital ratios to the required 8%.

Chinas AMC asset transfers (1999-2000)

NPLs transferred Share of bank loans

Company Assigned bank (RMBbn) outstanding (% end-1998)Orient BOC 267.4 20.4Great Wall ABC 345.8 24.6

Cinda CCB 375.6 21.9Huarong ICBC 407.7 17.9

Total 1,396.5 20.8

Source: Nomura International (Hong Kong) Limited

Meanwhile, the banks have also made efforts to reduce NPLs. In July, the PBoCannounced growth in NPLs slowed in 4Q00 and became negative at the beginning ofthis year. In 1H01, the big four banks NPLs dropped another 2.1pp through thewrite-off of NPLs against operating profit. Banks have established loan managementsystems, which involve the separation of loan application assessment from approvaland auditing processes and the introduction of a risk management system. Weunderstand the government has set a target for an NPL reduction of 2-3pp per yearfor commercial and policy banks.

According to the China Trade News (May 2001), Bank of China (BOC) had an NPL ratio of28% at the end of 2000. The chairman of BOC indicated that the bank cut NPLs byRMB18.5bn in 2000 and plans further cuts of RMB20bn in 2001 and RMB25bn in 2002.Meanwhile, the chairman of CCB pledged in September that the banks NPL ratio wouldbe below 10% in three years. We understand the big four banks aim to bring the NPLratio to an average 15% by 2005. Meanwhile, the other two banks have taken similarmeasures to reduce NPLs and Chinas only private national bank, China Minsheng BankingCorp (600016 CH, RMB14.8, not covered), announced its net profit rose almost 90% y-y in1H01 (we note, though, that the bank uses Chinese accounting standards) while NPLsfell to 4.1% from 6.5% in 2000, and lending increased 35.3% y-y.

The NPL problem that has plagued the big four banks is attributable to past lendingpractices. Lending has traditionally been a function of policy considerations orrelationships while banks have lacked a centralised approval process, a proper creditrating system and a risk management system. Now, the era of easy credit for well-connected borrowers seems to be coming to an end. This year, major state banksunveiled a credit rating system, designed to assess borrowers repayment ability, andintroduced other indicators for comprehensive loan appraisal. In addition, branchmanagers will be expected to monitor credit standing through follow-up supervision.According to Xinhua News Service, both ICBC and CCB have activated such systems.

Efforts to improve lending practices have not been limited to hardware and the bigfour banks have launched investigations into irregularities at branches to bring errant

employees to book. Disciplinary action has been taken against 1,240 staff members(out of a workforce of 1.5m). This was in response to investigations of 6.15m bad-loan cases at 316 bank branches in 1H01.

Banks haveimplemented reformmeasures of their ownto constrain NPLs

NPLs at the big fourcould drop to 15% by2005

Policy considerationsand personalrelationships will makeway for commercialconsiderations

Banks have started tocrack down on lending

malpractices


21/30

11 December 2001

21

Economic Insight

In our view, AMCs are making slow progress in resolving NPLs. According to XinhuaNews Service, a total of RMB73.2bn of assets had been disposed of by the four AMCslast year, of which 32.2% had been recovered. By September this year, a total ofRMB95.8bn of assets, or 6.86% of the total, had been disposed of by the four AMCs.Some 42% of this sum was recovered in cash. For example, Huarong, one of thebiggest AMCs, has recovered more than 30% of the assets it has taken from ICBC. It

has assumed around NPLs of RMB407.7bn (US$49.2bn) from the bank since 1999. Weunderstand Cinda, another big AMC, also managed to recover 30-35% of disposedassets. AMCs are allowed to sell shares and debts to overseas investors once NPLs aresecuritised.

AMCs NPL recovery (at September 2001)

AMC NPLs transferred Gross NPLs Total NPL Cash recovered(RMBbn) disposal asset recovery (RMBbn)

(RMBbn) (RMBbn)

Orient 267.4 15.4 6.6 3.2Great Wall 345.8 25.7 6.7 2.8Cinda 375.6 36.2 18.1 11.7Huarong 407.7 18.2 8.9 5.6

Total 1,396.5 95.8 40.3 23.3

Source: Nomura International (Hong Kong) Limited

Huarong has sold most of the current tranche of RMB16.6bn (at December) in NPLs to aUS-Sino consortium in Chinas first such auction. The Morgan Stanley Dean Witter-led(MWD US, US$52.72, Strong buy) consortium has agreed to buy a RMB10.8bn portfolioof NPLs from Huarong. A total of RMB16.6bn in loans, packaged into five pools, were upfor auction. The consortium agreed to buy four of the five pools; about 45% of the totalis collateralised by property. The deal reflects the governments determination to tackleNPLs. We note international investors are generally interested in the assets but arearguably taking a realistic view of their quality. Huarong expects to recover about 21%of this tranches assets (post consortium/advisory fees), with about 10% in cash. The

relative low pricing of this tranche may reflect the sellers intention to open up overseasmarkets. Overall, we expect the recovery ratio to be around 15%.

Other AMCs seem to have adopted similar strategies. Cinda has tied up with US-basedmortgage bank Lonestar Capital (unlisted), Deutsche Bank (DBK GY, 77.32, Hold) andGoldman Sachs (GS US, US$93.9, not covered) to sell bad assets to overseas investors.Great Wall, an AMC managing NPLs for the Agricultural Bank of China, is teaming upother foreign banks, such as Deutsche Bank, to auction about RMB15bn of NPLs inthe international market. Meanwhile, Orient, an AMC for BOC, plans to auction 15-20% of its RMB267bn in NPLs. In future, China will likely sell NPLs to overseas investorsvia securitisation. We believe a JV model will be adopted to manage these assets, withAMCs contributing assets and overseas buyers contributing funds and assumingmanagement control.

While the terms of WTO accession allow for a grace period before foreign competitionis permitted, we believe banks will have to address problems as a matter of urgency.In our view, they must use the transition period to restructure, recapitalise and controlNPLs. The governments policy approach to banking appears multi-pronged. While itwill force state banks to become more competitive and function like commercial banksrather than government agencies, non-state banks will be allowed to compete withstate banks and foreign banks will be allowed to make a gradual entry into themarket.

The PBoC has indicated that Chinas state banks will be allowed to sell shares toforeign investors, thereby raising funds to offset the write-offs and enhance

competitiveness after WTO accession. We understand investment negotiations betweenforeign banks and several small Chinese banks have already started. For example,Bloomberg reports (21 November, 2001) that the International Finance Corp, the WorldBanks investment arm, will buy 15% of Nanjing Commercial Bank for RMB219m. Bank

AMCs have been sellingassets to foreigninstitutions

AMCs are seekingalliances with foreignpartners to manageassets

State banks will have touse the interim periodto restructure,recapitalise and addressNPLs

AMCs are makinglimited progress indisposing and recoveringimpaired assets

Some foreign banks arenegotiating with smaller

Chinese banks toassume an equity stake


22/30

11 December 2001

22

Economic Insight

of Communications, Chinas fifth-largest bank, said in August it had obtainedgovernment approval to sell a 15% stake to foreign investors while Hong Kong-basedBank of East Asia (23 HK, HK$16.35, OUTPERFORM) is believed to be in talks withChina Minsheng Banking Corp to acquire a stake.

Further down the line, the government will seek to diversify the ownership of state

banks. This will involve partial stock market listings and foreign investment. We believeBOCs decision to merge all its Hong Kong subsidiaries bringing total assets toHK$820bn and its application for listing in Hong Kong next year are in line with thisstrategy. We believe CCB will announce similar moves in the near future.

Competition in the banking sector

Much has been made of the impact of WTO accession on Chinas banks. More oftenthan not the conclusions are dire: Chinese banks will lose professional staff, depositsand clients to foreign banks. Such conclusions, while realistic, are perhaps anoversimplification and ignore the impact of accession on sub-sectors and the dynamicrole of government in monitoring and regulating the industry. Of more use is aninvestigation into the probable impact on the constituent parts of the industry (seealso an article by Pu Yonghao, "Chinas banking industry: The winners and losers afterWTO entry", in The Banker, May 2000).

Retail bankingWe do not expect foreign banks will mount a significant competitive challenge in theretail banking segment. Much more likely is that competition between domestic bankswill intensify. In countries where the banking system is more open, foreign bankshave taken a back seat. One example is the UK, arguably one of the most openbanking systems anywhere. Yet, the four dominant banks control 68% of personalcurrent accounts and 86% of SME current accounts, according to the Cruickshankreport to HM Treasury on banking competitiveness in the UK. This state of affairsseems even more peculiar when one considers that charges at these banks are not

competitive compared with other, smaller banks. It appears then that the perceivedopportunity cost of changing banks may be higher than meets the eye. We expectChinese banks will remain dominant in the retail sector, but less so in foreign currencybusiness.

Bank branch distribution in major Chinese cities

Shanghai Beijing Tianjin Guangzhou Shenzhen

592 734 453 116China Agricultural Bank 421 400 595 396 146Bank of China 137 199 234 116China Construction Bank 253 144 113Foreign banks 60 19 14 15 28

Source: PBoC, China Financial Yearbook 2000

One aspect worth noting is the development of on-line banking. In theory, foreignbanks could use this low-cost vehicle to overcome the weakness of limited branchesin China. However, there is still a long way to go before the necessary infrastructureis in place and the major domestic banks are already developing on-line bankingnetworks.

Corporate bankingWe reckon corporate banking will become a more intensely fought-over domain. The80/20 rule applies also to banking in China: 80% of Chinas bank profits come from20% of clients, which are mainly corporates. Multinationals represent a particularlyattractive client base and many foreign banks with a presence in China have courted

such clients. The transactions these multinationals conduct money transfers andcollections, letters of credit and overseas trade-related settlements generate heftyprofits for banks. At present, about 35% of all international settlement business inChina is conducted by foreign banks. We expect this figure to rise to around 55% by

Chinese banks mayprove to be resilient inretail banking

Foreign banks couldpose a biggercompetitive threat incorporate banking


23/30

11 December 2001

23

Economic Insight

2006. According to the Nanfang Dushi Daily(14 November), overseas banks assetsaccount for only 2% of total assets in the financial sector, but these banks extend 20%of all foreign currency loans in the country.

Current restrictions on foreign banks mean that they necessarily focus on foreigncurrency business, and foreign funded companies (FFC), mainly in the manufacturing

sector, for their business. Moreover, foreign banks can only extend renminbi loansequivalent to less than 35% of their foreign currency liabilities and take renminbideposits of no more than 40% of their total registered assets.

We expect Chinese banks will make a concerted effort to raise their profile in corporatebanking. For one, they will have to protect their Chinese corporate client base andcourt foreign-funded companies. The advantage Chinese banks have is their largepool of savings and the freedom to engage in both local currency and foreign currencybusiness. We expect domestic banks relationships with corporates to become evenstronger as they take ownership in the wake of debt-equity swaps and restructuring.More importantly, the government is unlikely to allow foreign banks to cherry pickand leave loss-making firms to domestic banks. Instead, it will likely ensure a levelplaying field so that all banks have equal access to potential clients.

Domestic banks haveadvantages too, such as freedom to lendrenminbi and foreigncurrency and a largepool of savings


24/30

11 December 2001

24

Economic Insight

Capital markets a gradual opening

Capital market opening is a reality that China will have to prepare for. The authoritieshave made a number of proposals to usher in greater liberalisation of the capitalmarkets. In addition to measures such as allowing QFIIs to invest domestically and the

introduction of CDRs (for a detailed discussion of these, refer to our Economic Insight:Capital markets Darwinism with Chinese characteristics", published 11 April, 2001),the authorities have proposed a Qualified Domestic Institutional Investors (QDII) scheme.Another significant move is to allow (locally incorporated) FFCs to be listed on Chineseexchanges.

QDII scheme seen to be launched in 2H03

The QDII scheme has been proposed to the China Securities Regulatory Commission(CSRC) and has been referred for study for a period of one year. Under the QDIIscheme, qualified domestic institutions can invest in overseas-listed mainland shares,subject to approved quotas on the amount of foreign currency to be invested. Chinahad a pool of foreign currency savings of US$135.7bn (US$80.5bn from individuals,and US$46.7bn from corporates) at end-October. We understand Hong Kong-basedfinancial institutions have been lobbying for approval of mainland investment in HongKongs security markets. In theory, once the QDII scheme is launched, authorisedcandidates should be able to construct globally diversified portfolios to minimise riskand enhance returns for mainland investors.

Chinese investors can only invest in Chinese A or B shares at present. These marketshave performed poorly of late and have been dealt a telling blow since the authoritieslaunched a crackdown on malpractice, fraud and stock manipulation in the securitiesindustry. Yet, even after this setback, PERs of A and B shares remain high by internationalstandards. There are concerns that these are tell-tale signs of a stock market bubble.Managing a deflation of the bubble calls for skilful regulatory management of the

market, in our view, since a sudden opening of the securities market could lead to amarket crash. The QDII scheme is intended to help in preventing a sudden marketcollapse by providing alternative investment channels for local investors, thereby easingbuying pressure in the domestic market.

The last thing the central government wants to see is a drain of foreign currencyreserves through the QDII system. Hence, we believe the QDII scheme will be limitedto a few open-end funds and possibly social security funds, pension funds, governmentinvestment vehicles and corporate funds. There are only 13 asset managementcompanies in China with two open-end funds Huaan Fund Management Co andNanfang Fund Management Co were launched this year and Huaxia Fund ManagementCo has been authorised to launch a third while the rest comprise 47 closed-end

funds.

We expect that the maximum investable amount under the QDII system will be limitedto US$1bn and hence the impact on the A- and B-share markets will likely be limited.Moreover, we think the QDII system will be implemented alongside the QFII system tobalance capital flows in and out of the country. A number of technical obstacles willalso have to be addressed, including clearing and settlement and easing forexrestrictions. Hence, we foresee implementation toward the middle of 2002 at theearliest.

A number of transitionalsteps have been takento open the capital

markets

The QDII system willallow domestic investorsto invest overseas

QDII is intended torelieve buying pressurein the domestic market

Initially the number ofQDII candidates willlikely be limited and...

...the impact on thedomestic equity marketshould be muted


25/30

11 December 2001

25

Economic Insight

Allowing FFCs to tap Chinese capital

The CSRC has announced detailed guidelines for the listing of FFCs on the domestic A-and B-share markets. The requirements include:

l FFCs must meet the criteria set by the state on industry eligibility;

lFFCs must retain at least 10% of shares after listing (lowered from the 25% requiredpreviously);

l a Chinese partner must maintain a portion of shares after listing; andl candidates must meet listing requirements for domestic companies.

We believe a number of FFCs in operation have restructured with the intent to listdomestically. We understand there are another 14 FFCs in Shanghai which havecompleted restructuring to meet listing requirements pertaining to the shareholdingsystem, including Kodak (China), Unilever (China), Bright Dairy and Food Industry,Novel Color Tube, Shanghai Midaway Infrastructure and Cimic Ceramic. Moreover,we understand a number of Hong Kong firms are considering listing on mainlandexchanges. We believe the CSRC approval process will not be a short one and hencewe do not expect any FFCs to be formally listed on the A-share market soon.

We believe the listing of FFCs will bring a number of benefits, such as an improvementin the quality of domestically listed companies, new investment opportunities fordomestic investors, more efficient allocation of domestic capital, an improvement incorporate governance practices and facilitation of more overseas investment, especiallyfrom technology companies. Since the China operations of most overseas companiesare small, we think the new rules will have little effect on the overseas parents. FFCswill be allowed to repatriate funds, but we expect the effect will be limited since theportion of shares that must be held by FCCs cannot be traded.

Implementation of the QFII system

As part of the gradual opening of its capital markets, China will allow foreign investorsto purchase A shares. To this end the government will institute the QFII system. Themain regulations pertaining to the system are:

Candidate prerequisites:l Banks will be ranked on the basis of their universal banking activities (such as

securities, asset management, insurance).l Asset management firms or institutions (including pension funds, mutual funds,

and government investment vehicles) will have to meet a minimum requirementwith regard to assets under management (most likely US$1bn) and have an operatingtrack record of three years.

l Securities brokers will have to meet minimum requirements with regard to net

assets (most likely US$1bn) and have three years of global investment experience.

Operational procedures:l Candidates will have to register with the regulator, most likely the CSRC. We expect

the initial number of approvals will be between 10 and 20.l All capital flows will be monitored by the State Administration for Foreign Exchange

(SAFE). A special subaccount will be created in the BoP to record the flow offunds.

l Candidates will be required to open a special local-currency account with a minimumdeposit of currency-converted capital.

l Shares will be held by appointed custodians so shareholdings/transactions can bechecked at any time.

l

Funds will have to remain in the country for a specified period of time (likely oneyear) before they can be repatriated with the approval of the regulator. Uponrepatriation, the funds will be subject to taxation.

FFCs will be allowed toapply for a listing on aChinese exchange

FFCs will be allowed torepatriate funds, butwe expect the effectwill be limited

The QFII system givesforeign investors accessto A shares


26/30

11 December 2001

26

Economic Insight

Size of quota:l Foreign investment in securities will likely be limited to a 10% equivalent of total

domestic market capitalisation (currently RMB4tn) over a period of five years.Moreover, we expect the quota for each year will be around RMB80bn.

l All funds will face individual quotas on their total investment; we expect thequotas will be RMB4-8bn.

l We think a 10% limit on foreign investment in strategic sector stocks, such aspower and telecoms, will be imposed.


27/30

11 December 2001

27

Economic Insight

Securities industry slow consolidation

Following accession, Chinas securities industry will be opened to foreign participation.We understand foreign investors will initially be allowed to take a stake of up to 33%in JV securities firms. Within three years of accession, the ceiling on foreign ownership

will be increased to 49%, with the proviso that a local partner remains the majorshareholder. JV firms will be entitled to underwrite and trade domestically listedsecurities. In September, Credit Lyonnais (CL FP, 37.15, not covered) and XiangcaiSecurities applied for the establishment of the first investment banking JV between aChinese and a European partner. We understand the companies applied for thecompetency to offer a full range of investment banking services, including investmentadvisory and underwriting. Meanwhile, Taiwanese securities are believed to be planningJVs while other foreign companies are establishing representative offices andnegotiating with potential partners.

Separately, we understand two mainland-funded overseas securities firms Bank ofChina International and China International Capital (a China Construction Bank/MorganStanley JV) have approached the regulator for A-share underwriting licences. Webelieve underwriting licences will be extended to overseas-registered Chinese securitiesfirms first before JVs are allowed to enter the market.

Following Chinas entry to the WTO, minority foreign-owned joint ventures will bepermitted to engage in fund management on the same terms as domestic firms.Foreign asset management companies will be allowed to assume up to a 33% stake in

jointly managed funds and a 49% stake within three years of WTO membership, againwith the proviso that a local partner remains the major shareholder. We understanda number of high-profile foreign fund management companies have entered technicalagreements with domestic players in areas such as portfolio management, productdevelopment, marketing, customer service, investor relations and training. Accordingto Xinhua News Service, a special preparatory work team has been established by

Huaan Fund Management and JPMorgan Chase (JPM US, US$37.22, Hold) to preparefor the establishment of a JV fund once authorities issue the relevant laws andregulations. We understand Penghua Fund Management and a foreign partner haveplans for a similar venture.

On government figures, China had 101 securities companies with total assets

China Research

Documents

Transcript of China Research