(Abstract) - China

Q4 2015

(Abstract)

For Professional Clients and Institutional Investors

Asia ex Japan’s external fundamentals are in better shape than in the 1990s Summary  Concerns about China’s economic slowdown, FX policy uncertainty and a correction in A-shares, as well as worries over the impact of a Fed lift-off and further weakness in global commodity prices, have jolted Asian financial markets in July and August  Recent economic data has showed continued weakness in the region with uncertainties remaining over the growth outlook. Asia faces headwinds such as sluggish global trade, excess capacity, weak productivity of capital, high leverage, and demographic challenges  Fed policy tightening will present a challenging transition for Asia. However, the adjustment since the Taper Tantrum has now placed the region in a better position to withstand the cycle of rising US interest rates and manage external/market volatility  China’s transition to slower trend growth will affect the rest of the region via trade and financial linkages and could mean weaker commodity prices and disinflationary pressures. However, amid policy buffers we do not forecast a sharp slowdown in China  Comparing Asia today vs. the Asian financial crisis shows that external fundamentals are in much better shape; most Asian countries have a flexible FX policy; Asia is now collectively better prepared, with improved financial backstops; and many countries still have the policy space and flexibility to implement countercyclical measures  The trajectory of US interest rates, the outlook for Chinese and global growth and Asian/EM currency volatility remain key near-term risks to Asian financial markets. Market volatility is also likely to remain high in the near term  However, we remain constructive on Asian equities and credit in the medium to long term, given the region’s overall solid macro/corporate fundamentals, positive reform and long-term growth prospects, as well as the potential structural support from a growing local investor base

Heightened financial market volatility Concerns about China’s economic slowdown, FX policy uncertainty and a correction in A-shares, as well as worries over the impact of the coming Fed interest rate rise and further

weakness in global commodity prices, jolted Asian financial markets in July and August in a global risk-off environment. In particular, China’s surprise move to a more market-based CNY-fixing mechanism on 11 August and a one-off CNY devaluation had ripple effects across the region and injected significant volatility into Asian financial markets, affecting equities, currencies, and bonds. The MSCI Asia ex. Japan index posted a negative total return in Q3. Asian markets did receive some respite from the Fed’s decision to hold off from raising interest rates at its 16-17 September meeting, though the Fed’s stance reflecting concerns over global growth also hit risk appetite. Chinese policymakers continue to remain supportive. The People’s Bank of China (PBoC) cut policy rates by 25bp and the reserve requirement ratio (RRR) by 50bp on 25 August, in order to help stabilise both growth and financial markets. Emerging Asian currencies weakened across the board against the USD, euro and yen and on a trade-weighted basis in July and August, particularly following the CNY devaluation. This signalled more general risk aversion toward EM assets and, in some cases, concerns about domestic policy credibility (China and Indonesia), political stability (Malaysia) and/or reform prospects (India). Nevertheless, most currencies pared some of their losses in September on the back of a retreat in the USD heading into the Fed policy meeting and the subsequent decision not to hike rates. Asian local-currency sovereign bond markets were likewise hit in August, particularly Singapore, Indonesia and Malaysia. Lower commodity and oil prices also hurt Indonesian and Malaysian rates, while Malaysia faced increased political risk. On the other hand, government bond yields in China and Korea fell and in India held relatively stable. Bond yields in most countries (ex. Indonesia) retreated in September as the FX selloff and risk aversion (toward EM) eased. In the USD credit space, Asian spreads widened against a range-bound trading of US Treasuries (10-year Treasury yields ended the month roughly flat) in August. High-beta Indonesian credits were bottom performers. Sovereign credit default swaps (CDS) jumped in countries such as Indonesia, Malaysia and Thailand. However, the impact was modest relative to other asset classes. The Fed rate decision and modestly dovish comments provided some lift to the credit market. The JACI Composite index had a negative total return of -0.5% in Q3 but still posted a positive 1.6% return year-to-date (30 September).

Macro challenges ahead for Asia…

Cyclical and structural downshifts in growth

Recent economic data from the region overall has shown continued weakness, particularly in foreign trade and industrial activity. Weak manufacturing PMIs reflect contracting trade flows, sluggish domestic demand, inventory adjustment, and low capacity utilisation rates (Figure 1).

Asia’s generally slower economic growth rates post the 200809 global financial crisis (GFC) reflect not only cyclical headwinds but also a structural downshift in growth rates. This is compounded by the large overhang of private-sector leverage as the region’s response to a sharp slowdown in external demand during the GFC was a sharp increase in debtfuelled domestic investment and production capacity (Figure 2).

Figure 1: Manufacturing PMIs indicated weakness in industrial activity (ex. India)

Sources: Bloomberg, HSBC Global Asset Management, as of 7 September 2015

Trade contraction and sluggish domestic demand Sluggish Asian trade reflects both cyclical weakness in global demand and a structural downshift in the trade intensity of global growth. Falling prices, largely driven by lower commodity prices, and currency movements also weighed on trade growth in USD terms. The structural decline in the elasticity of trade to GDP (or economic growth being less import-intensive), notably in the US and China, suggests Asia is unlikely to get the same cyclical boost from the global/US growth recovery as in the past. The rebalancing of China’s economy towards consumption and the services sector means less import demand for commodities and capital goods, affecting countries such as Indonesia, Malaysia and Taiwan. The decline in commodity prices has also reduced demand from commodity-producing EM countries for Asian exports. Meanwhile, China is increasing its production capacity domestically and moving up the value chain, thus increasingly competing with the regional higher-value-added producers, such as Taiwan and Korea, in the global market. China is also exporting goods in which it has excess capacity, such as steel, posing challenges to countries producing these goods.

This caused excessive investment and misallocation of capital and credit in many countries, keeping unprofitable projects and inefficient companies afloat, creating excess capacity and resulting in PPI deflation. The trend in the productivity of capital, measured by the Incremental Capital Output Ratio (ICOR), which measures the additional capital required to increase one unit of output, has deteriorated in many countries. Lower ICOR has contributed to slowing total factor productivity growth (Figure 3). Furthermore, there is an unfavourable demographic shift in Northeast Asian economies, Singapore and Thailand, in the form of ageing populations and declining fertility rates. The UN forecasts that the size of the working-age population will shrink over the next five years in China, Hong Kong, Korea, Taiwan and Thailand. Whether Asia can continue growing strongly will crucially depend on reforms to clear structural bottlenecks and boost productivity growth. Figure 2: Rapid build-up in Asian private sector debt

Source: BIS, CEIC, HSBC Global Asset Management, September 2015

Figure 3: Slower total factor productivity growth post GFC

Stronger currencies on a real effective exchange rate (REER) basis over the past few years have been a headwind for many countries’ exports and a policy concern for some central banks in the region. . Despite lower energy prices boosting real incomes, domestic demand has been lacklustre in most countries. Policymakers in the region have also eased monetary policy, increased fiscal stimulus, accelerated infrastructure investment, and relaxed macro-prudential measures (e.g. China, Korea, Indonesia, and Taiwan have relaxed property sector measures) but so far have had little impact and more measures could be announced.

Source: Conference Board Total Economy database, HSBC Global Asset Management, September 2015

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… compounded by Fed policy tightening and a slowdown in Chinese growth Going forward, Asian economies and financial markets also face the key twin headwinds of Fed policy tightening and China’s growth slowdown. However, while these headwinds could increase uncertainty over the region’s growth outlook and volatility in financial markets, we believe the risks are manageable and unlikely to lead to a significant slowdown in Asia’s economic growth. Fed policy tightening Fed policy tightening will present a challenging hurdle for Asia and could affect the region via financial linkages, i.e. risks of capital outflows, higher costs of capital (reflecting higher risk premiums), a tightening of financial conditions, increased financial market volatility, and a correction of asset prices. Consequently, there could be a spill-over impact on the real economy via downward currency effects alongside upward pressure on (real) interest rates and tighter liquidity conditions. Also, significant currency volatility could constrain the ability to ease policy in the face of tighter financial market conditions. Vulnerability to this trend will be more significant for countries with current account deficits, a high reliance on foreign capital or sizeable foreign debt, and/or high domestic leverage. However, the current situation differs from the 2013 Taper Tantrum. Taper talk was a surprise whilst a rate hike will not be. Asian central banks and financial institutions have been proactive in keeping leverage in check. Post GFC, Asian policymakers introduced pre-emptive macro-prudential measures to address the build-up of financial imbalances from rapid credit growth, high private sector leverage, asset price inflation (property prices in particular) and volatile capital flows. Efforts have also been directed towards strengthening macroeconomic fundamentals, with a greater focus on current account and fiscal balances. The region's current account balance in aggregate today is in a much better position than prior to the 2013 Taper Tantrum. Furthermore, currency mismatch risk looks manageable at the sovereign level. In fact, much of Asian corporate USD debt is in sectors with natural hedges, i.e. USD revenues and overseas business, and in many countries the rise in external debt has come with an increase in foreign assets held by residents. High domestic savings and liquid domestic capital markets are also helping to finance the debt. Furthermore, against a backdrop of divergent business cycles, shifts in FX rates could be a constructive force that could promote rebalancing over time, if the pace of adjustment is moderate and gradual. In fact, currency depreciation in some countries is a deliberate policy choice and should on balance be supportive of Asian growth via export competitiveness.

Chinese growth slowdown While we expect fiscal and monetary policy support to help stabilise the Chinese economy, to roughly meet the official target of “about 7%” for this year, downside risks to the growth outlook remain. Moreover, short-term stimulus measures will not help address structural headwinds. We think the government needs to push forward with structural reforms and accept lower growth in the short term to secure longer-term, sustainable, balanced and stable growth. However, financial market volatility complicates policy-making and risks weakening reform momentum in the near term. The target of doubling percapita GDP and overall GDP by 2020 from its 2010 level implies that China needs to reach an annual GDP growth rate of 6.5% during 2016-20. China’s growth slowdown could also impact the region via cross-border banking linkages or via FDI. Hong Kong, Korea and Taiwan are relatively more exposed to China in this respect. Meanwhile, uncertainty over China’s FX policy and the potential spill-over effects could pose challenges for other countries in the region in managing their exchange rates. Asian markets are sensitive to CNY moves through trade, tourism, and financial linkages. Countries that compete more directly with China on global markets (e.g. Taiwan, Korea, Philippines and Thailand) or rely on exports for Chinese domestic demand (ASEAN) would be the most affected. Tourists from China also account a relatively large share of total arrivals in Hong Kong, Korea, Taiwan and Thailand. Countries with relatively weaker external positions or companies with significant USD debt exposure would also be vulnerable from a competitive depreciation of regional currencies. China’s growth slowdown, FX policy uncertainty and the structural change in its trade could therefore adversely impact almost all countries across the region, given that China is their largest or second largest export market. Within Asia, India and Philippines are relatively more insulated, especially India given its small exposure to China’s final demand (Figure 4). On the CNY front, we believe capital outflow pressures could gradually slow. The government has tightened its scrutiny of cross-border capital flows, using tools such Figure 4: Direct export exposure by destinations (share of total exports)

Source: CEIC, HSBC Global Asset Management, September 2015

Additionally, due to the data-dependent nature of the Fed’s monetary policy, we believe US rate increases would occur alongside an improving US economy, which would be positive for Asian and global growth.

as the new derivative rule to discourage speculative and arbitrage flows on CNY depreciation. There are some fundamental supports for the CNY (e.g. solid external balances) and the PBoC will maintain control in the near-term. Sharp or substantial CNY depreciation looks unlikely amid

Overall, we expect orderly Fed tightening to have little disruptive impact on Asian economies or financial markets, but there will likely be increased volatility in the near term. 3

economic/political concerns. In the medium-term, we believe the FX reform objective remains intact, given the importance of a market-driven, flexible FX policy to address economic imbalances, help the economy better cope with external shocks, and maintain monetary policy autonomy as China opens up its capital account.

Figure 7: FX reserves buffers vs short-term external debt are more sufficient now vs. AFC in most countries

Asia is robust on macro risk metrics; longterm growth prospects are solid Recent financial market turbulence, coupled with generally disappointing macro data coming out of the region, has raised concerns about the risk of another Asian financial crisis in the making. Moreover, there are some similarities between the current macro trends in the region and the pre-1997-98 Asian financial crisis (AFC) environment. These include: (1) a period of low (real) interest rates, aided by easy monetary policy in the US; (2) misallocation of resources and capital into unproductive areas; (3) the rapid build-up of corporate and household debt; (4) a stronger USD and (5) falling commodity prices. Nevertheless, there are also major differences between the two periods. External fundamentals are in much better shape Most countries in the region are now running current account surpluses, have large FX reserves and lower external debt-toGDP ratios (Figures 5, 6, 7). In the run-up to the AFC, many countries undertook unsustainable short-term FX borrowing to finance large current account deficits. In contrast, a large part of the debt build-up in this period has been in domestic rather than external debt, and Asia is now less reliant on short-term external funding. Figure 5: Most countries now run current account surpluses vs mostly in deficits in AFC

Source: CEIC, HSBC Global Asset Management, September

Most Asian countries now have flexible FX policies Asian FX regimes prior to the AFC were pegged to the USD or heavily managed, encouraging significant FX borrowing. As the USD began to appreciate with the Fed starting its tightening cycle in 1994, many Asian currencies appreciated sharply on an effective exchange-rate basis, just as current account deficits widened, resulting in significantly overvalued exchange rates in the run-up to the AFC. Massive capital outflows and insufficient FX reserves to defend the currencies eventually led to a collapse of Asian currency pegs and a substantial depreciation of many Asian currencies. With the notable exception of Hong Kong, FX policies today are much more flexible, even in the case of China since it ended the CNY’s peg to the USD in 2005, gradually widened the daily trading band and adjusted the daily fixing mechanism. Although the REER has appreciated in many currencies over the past few years, in most countries we do not observe overvaluations, especially against current-account positions. Based on our estimate, some currencies look attractively valued or even undervalued, particularly following the recent depreciation. Asia is now collectively better prepared with improved financial backstops


Figure 6: External debt-to-GDP ratio is lower now than in AFC in most countries

Asian policymakers are much better prepared and coordinated to pre-emptively address risks to regional economic and financial stability, especially in the areas of cross-border surveillance and crisis management. In addition to the traditional IMF credit lines, Asia has central bank bilateral swap lines and regional financial safety nets (e.g. the USD240bn Chang Mai Initiative for Multilateralisation) to provide short-term liquidity at times of liquidity crisis. ASEAN+3 (China, Japan and Korea) policymakers have worked to develop stronger bond markets regionally through the Asia Bond Markets Initiative. Moreover, Asia’s financial institutions and central banks are better equipped and capitalised to deal with the challenges ahead. Sources of financing are also more diversified following efforts to develop and deepen the domestic capital markets, with many having established liquid bond markets. Many countries still have the policy space and flexibility to implement countercyclical measures The 1997-98 AFC was made worse by policy interest rate hikes to defend overvalued currency pegs and to keep high inflation in check. The sharp rise in (real) interest rates led to a rise in non-performing loans (NPLs), a banking system crisis with a


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significant tightening of financial conditions, and eventually an economic recession. Today, despite the turbulence in financial markets, there are no signs of unusual stress in short-term funding markets or of a credit crunch in any major Asian economy. We expect central banks in the region to maintain an accommodative monetary policy. In some cases they may even ease. CPI inflation is still running below central bank targets in most countries and this is likely to continue, while PPI deflation is observed across the region (ex. Indonesia). Asian governments today are far less dependent on FX borrowing and the development of a liquid domestic bond market provides another source of financing. Therefore, there is space for most countries to expand fiscal policy, given the highly manageable levels of public debt, although the fiscal space varies across the region. Fed policy tightening is likely to be more gradual this time around The Fed surprised the markets by beginning to tighten monetary policy aggressively in 1994. This time around, a Fed lift-off should not be too much of a surprise and the pace of increases in (real) interest rates is likely to be more gradual than in the 1990s with the magnitude of rate hikes smaller.

Investment implications Equities The US interest rate trajectory, Chinese and global economic outlook, global equity market and currency volatility remain key near-term risks to Asian equities, while weak commodity prices could affect related sectors. However, the backdrop of a gradual Fed tightening cycle should be supportive of equities, as long as US growth also improves. Also, overall supportive macro policies and the lagged growth impulse from lower energy costs should help underpin a moderate recovery in domestic demand and earnings prospects. We believe policymakers in most countries in the region remain committed to structural reforms, which could prompt re-rating potential while China’s accelerated capital-market liberalisation and further financial integration in the region could be medium-term market catalysts. Valuations metrics are also attractive. MSCI Asia ex-Japan (MXASJ) had fallen by more than 20% from the recent highs in late April (as of 18 September) vs. 25% and 21% correction in the 1994 and 2004 tightening cycle, respectively. For the MSCI Asia ex. Japan index, the current trailing price-to-book ratio (P/B) of 1.3x is very close to the 2008-09 lows (GFC) and troughs seen in the SARS episode and 2001 global recession. The P/B is especially low when set against the potential for ROE pickup in the medium term on reforms. We think current valuations have priced in a lot of fear factors and Asia ex. Japan equities offer attractive risk-adjusted rewards based on our long-term expected returns model.

sentiment and be negative for Asian currencies. Investors are also likely to continue watching developments in China. The near-term inflation outlook remains benign with weakness in commodity prices while uncertainty over the growth outlook remains high for a large part of the region, leaving room for some countries to ease monetary policy further. Higher US/DM bond yields could affect the countries which depend more on external funding or where foreign holdings of local debt are relatively high (e.g. Indonesia and Malaysia). Markets with still accommodative monetary policy or room for further easing, less sensitivity to currency weakness, positive reform prospects and more attractive valuations could do relatively well. Domestic political risks (e.g. in Malaysia) could also affect local-currency bonds while supply is another technical factor to consider. USD Credit The key driver/risk of Asian USD credit will be fund flows amid concerns over Fed policy tightening and China. A delayed Fed rate hike and slightly dovish comments could be short-term positive for Asian credit. However, beyond some short-term adjustments, uncertainty over the Fed policy outlook remains. HY credit tends to be more sensitive to shifts in market sentiment, while IG credit remains susceptible to US Treasury volatility. Fed policy tightening could put pressure on credit markets. The risk of significant spread-widening could result from increased redemption pressure and/or negative credit events (e.g. rating downgrades or defaults). The credit fundamentals of some companies could deteriorate due to currency volatility (those that have large unhedged USD/FX exposure or face currency mismatch risks), weaker top-line growth and continued commodity-price weakness. However, generally we do not expect a significant rise in default rates, particularly given the limited bond refinancing requirements over next 6-12 months. Chinese corporates now also have cheaper onshore funding alternatives. Near-term support for Asian corporate credit should also come from relatively solid credit fundamentals (vs. other EMs), still good carry in the HY space, a combination of tepid global and domestic growth and low inflation, accommodative monetary policy in most countries, and largely supportive demand-supply dynamics. We have also seen increasing demand from onshore investors for USD credits, especially those names that have strong connections to the onshore market, in a bid to diversify their currency risk. We think the recent market volatility has led to some market dislocation and that in some spaces a much more bearish macro/ fundamental scenario has been priced in, although we need to be selective given the near-term challenging macro environment and currency risks. In the medium to long term, we remain constructive on Asian credit.

Asia Local currency bonds Higher US interest rates and currency risks will likely remain headwinds to Asian local-currency bonds in the near term, while overall risk sentiment toward EMs is another key driver. The Fed’s delayed lift-off and slightly dovish tone reflects concerns about global growth, which could weigh on risk

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