25 August 2014

Page | 1 MCI (P) 034/11/2013 Ref. No.: SG2014_0145

China Paving way to realizing the “Chinese Dream”

MACRO | ECONOMY | EQUITY MARKET

Rating: Overweight Upgrade to OW from NW

Key takeaways

Patchy economic recovery – concerns on hard-landing, slower growth as well as credit risk stemming from the mammoth local government debt receded; “fine-tuning” policy (also dubbed as “mini-stimulus” measures) and reforms would lend support to the underlying trend of economic fundamentals; however, the backpedalling property market remains a drag

Turning point for China – economic and cultural structural reforms are crucial for China, benefitting the nation as a whole, domestically as well as to foreign investors; authorities would need to balance between reforms and sustaining the economic recovery

Chinese stocks are still cheap – Chinese equities rallied 9.13% year-to-date on the back of encouraging reforms, in particular the Shanghai-Hong Kong Stock Connect. SHCOMP is trading at 10.89x P/E, slightly higher than its 52-weeks Trailing P/E (10.33x), but substantially lower than its long term mean (29.51x). For the year 2014, the consensus forecast earnings growth for SHCOMP is 24.15% y-y which translates to a forward 8.85x P/E.

Mutual Funds that proxy China

Fidelity Greater China

First State Regional China

Schroder Greater China

ETFs that proxy China

db x-trackers MSCI China TRN Index 1C (LG9.SGX) USD

db x-trackers CSI300 Index ETF 1D (KT4.SGX) USD

ChinaAMC CSI 300 ETF (3188.HK/83188.HK) HKD/RMB

iShares FTSE A50 China (2823.HK) HKD

CSOP FTSE China A50 ETF (2822.HK/82822.HK) HKD/RMB

Shanghai Composite Index

Bond Yields (10 Yr Yield and 2 Yr Yield)

Gross Domestic Product

Foreign Exchange

Inflation and Policy Rate

Analyst Soh Lin Sin sohls@phillip.com.sg +65 6531 1516

China – Macro 25 August 2014

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Table of Contents

Executive Summary ..................................................................................................................................................................... 3

Beijing's Broad-Sweeping Support Measures Kicking In ......................................................................................................... 3

Tailwind from Steady Global Recovery ................................................................................................................................... 3

Immediate Risk Remains as the Cooling Housing Market ....................................................................................................... 4

Private Investments Set to Multiply ........................................................................................................................................ 4

Scope for More Targeted Easing/ Further Monetary Easing on Benign Inflation ................................................................... 5

However, on the Budget Front… ............................................................................................................................................. 5

Conclusion ............................................................................................................................................................................... 6

Appendix ..................................................................................................................................................................................... 7

Reforms and Development ..................................................................................................................................................... 7

Challenges and risks .............................................................................................................................................................. 10

“Policy tweaking”/ “Mini-stimulus” package ........................................................................................................................ 10

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Executive Summary Beijing's Broad-Sweeping Support Measures Kicking In Taking its title from the American Dream, the “Chinese Dream”, put forth by Chinese President Xi Jinping, is to build a moderately prosperous society and realize national rejuvenation. The aspirations stir hope and set expectations within the Chinese, but also stoke investors’ concerns. With exploring attitudes, the world’s second largest economy embarks on reform measures which may tip the balance, sending ripple effects to the well interconnected world. Pro-growth mini stimulus announced by the Chinese officials in April was set to support the slowing economy (please refer to the April China macro report) and the recent stream of positive data showed that the series of stimulus measures has been filtering through the economy. Buoyed by improving exports and targeted domestic spending on public housing, transport and energy, economic growth edged up to 7.5% on-year in the 2Q 2014, picking up from the 7.4% expansion in the first quarter, matching Beijing's annual growth target. Economy expanded 2% from the previous quarter on a seasonally-adjusted basis, while first-half growth in 2014 was 7.4% from a year earlier, showing good momentum of stable and moderate growth in the first half. In addition, economic structure continued to be optimized as growth of the tertiary sector outperformed the primary and secondary industries during this period. Official data showed that the added value of the tertiary industry accounted for 46.6% of GDP, 1.3 percentage points higher than the same period last year, reflecting that China’s rebalancing act from investment to consumption at work. (Note: Primary industry refers to agriculture, secondary industry refers to industry, while tertiary industry comprises all other industries not included in primary or secondary industry.) The robust Purchasing Managers' Indices (PMIs) and cyclical indicator readings further evidence that the economy is holding up.

Manufacturing sector growth accelerated last month, based on both private and official surveys.

While the non-manufacturing sector was stagnant under the HSBC/ Markit China Services PMI, but showed expansion in July, albeit slower than the preceding month, in the official data. Nonetheless, both services readings are at least above the neutral 50-point mark.

Industrial production rose 9.0% on-year while retail sales increased 12.2% in July, albeit both shaving 0.2 percentage point off June’s record.

Fixed-asset investment, a measure of government spending on infrastructure, rose 17.0% on-year in the first seven months, easing slightly from the 17.3% reading for the first six months of the year in June.

Overall, sentiment remains upbeat despite contrasting data. Tailwind from Steady Global Recovery China posted a record monthly trade surplus at $47.3 billion in July as compared to June’s $31.6 billion, as trade exports gain momentum and imports slowed. The country's previous monthly trade surplus record was $40.09 billion in November 2008. Exports expanded 14.5% on-year in July, doubling June’s 7.2% gain. Meanwhile, imports fell 1.6% on-year in July, following a 5.5% increase in the previous month. Strong exports was fuelled by double-digit growth to the U.S., the EU, Southeast Asia and Hong Kong as well as have been bolstered by a yuan that has depreciated 1.7% against the U.S. dollar this year. The large surplus could intensify calls by U.S. export groups to let the Chinese currency appreciate as China’s controlled currency gives the country's exporters an unfair trade advantage. On the other hand, weak imports reflected slower domestic growth, tepid investment and a troubled real-

Fig 1: Gross Domestic Product

Fig 2: Purchasing Managers’ Index

Fig 3: Industrial Production

Fig 4: Retail Sales

Fig 5: Fixed-asset Investment

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estate market, which has reduced imports of building materials and commodities. A recent crackdown on commodity-financing irregularities may also contribute to the drag. As economic momentum slipped early in the year, Beijing took steps to support exporters. In May, China's cabinet announced measures to speed up export-tax rebates and expand credit to importers and exporters. A month later, the central bank encouraged banks to innovate and lend more to exporters to boost shipments. China has had to sacrifice some of it long term goal of domestic driven growth by aiding the external sector. Nonetheless, with global economic activity continue to strengthen broadly, the strong export numbers should bolster Chinese economic growth. Immediate Risk Remains as the Cooling Housing Market The raft of mini-stimulants Beijing adopted to re-energize China's economy in June, including pumping more money into the system and pressing banks to extend more loans, underscores the role of debt in supporting expansion. The loosening has somewhat boosted exports, but failed to support home sales, as mortgage restrictions from the central government remain in place. Chinese banks made 385.2 billion yuan worth of new yuan loans in July, slowing sharply from June’s 1.08 trillion yuan, as demands for loans slipped amid slackening economic growth and a backpedalling property sector. M2, a broad measure of money supply that covers cash in circulation and all deposits, rose 13.5% on-year or 1.2 percentage points lower than June’s pace. Meanwhile, China's total social financing aggregate, a broad measure of liquidity in the economy, stood at 273.1 billion yuan in July, about one seventh of the 1.97 trillion yuan the month before. However, China's property sector continues to show signs of cooling down in July, as prices fell for a third straight month and price softness spread to more major cities, adding to concerns about the health of the economy. New home prices fell in 64 of the 70 cities in July, up from the 55 cities that posted declines in June, underlining a worsening property downturn despite many local governments (in around 30 cities) loosening property restrictions to lure buyers back into the market, while state-controlled banks have also revved up lending to the sector. Developers’ sales remained weak due to poor prospects given the weak demand. On one side, developers are reluctant to sell units at lower prices, worsening home glut, which would extend a slide in construction that is already a laggard in the economy. While on the other end, potential home buyers adopt a wait and see strategy as the uncertainties on the outlook of the property market may prompt local authorities to intensify efforts to shore up the sector. Private Investments Set to Multiply Shanghai received 9.2 billion U.S. dollars of foreign investment in the first half of 2014, up 10.9% from a year earlier, with about half of new foreign-invested projects went to the Shanghai Free Trade Zone, according to the officials. The recent rally in China's stock market as a "rebound" due to improving performance in the economy, more liquidity, and market reforms, including the planned Shanghai-Hong Kong stock market connector pilot programme.

Fig 6: Exports & Imports

Fig 7: Trade Balance

Fig 8: Exchange Rate against USD

Fig 9: New Home Price Index

Fig 10: New Loan Growth

Fig 11: Money Supply, M2

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China’s antitrust crackdown, combined with signs the government is shunning some US technology companies for security reasons, signals a new era of regulatory scrutiny in the country. However, the vague rules in a paradigm shifting economy that’s no longer as reliant on foreign investment as in past decades, creates an uncertain business climate, and thus holding back foreign investors, and even led to some global companies retreating from China. With corruption so deep and endemic in China, the controversial anti-graft campaign which some perceived as President Xi Jinping’s move to power consolidation, are deemed favorable to investors. Corruption is no longer viewed as a lubricant for economic development but a basic threat to the stability of Chinese state. Economic growth boosted by the traditional engine of large, and often wasteful, state-supported investments is no longer viewed as sustainable. The stepped-up anti-corruption drive would be bullish for stocks over the long term. Scope for More Targeted Easing/ Further Monetary Easing on Benign Inflation China’s consumer price index (CPI) grew at a steady rate of 2.3% on-year in July, the same pace as a month earlier. The growth rate was also the same as that of the first half of this year, showing stable pricing in the world’s second-largest economy, but well below the Chinese government’s target inflation at around 3.5% this year amid property downturn. Meanwhile, the producer price index (PPI) dropped for 29 months in a row, to a rate of 0.9% on-year in July. Nonetheless, the pace of decline has narrowed for four consecutive months, pointing to slight improvement in market demand for industrial products. Downward pressure increases scope for the government to embark more targeted pro-growth measures. However, on the Budget Front… Fiscal revenues continued to slow sharply in July and may see difficulties in growing in the coming months, as more tax cuts under a program is to replace business tax with value-added tax (VAT) and a higher comparison base last year. The weak fiscal revenue growth could create pressure for China's policymakers to stabilize the economy. Fiscal revenue rose 6.9% on-year to 1.27 trillion yuan in July, slowing from the 8.8% rise seen in June. The pace of fiscal spending also slowed in July, retreating from a 26.1% surge to single digit growth of 9.6% in June. The Chinese government has called for front-loading of delayed fiscal spending from the existing budget to guard against downside risks to the economy (rather than broad stimulus or to increase fiscal spending). However, regional governments are experiencing challenges as they are left with too many spending obligations without receiving adequate funding from the central authorities under the present fiscal system. The limited aid from central authorities stems from the current local government debt that swelled to about $3 trillion as of June 2013 as a result of reckless spending in the past few years. Nevertheless, China has vowed to revamp its tax collection and fiscal budget systems and redefine the financial obligations of its central and regional governments by 2016 its fiscal and tax system as part of its efforts to jumpstart a new round of across-the-board reforms in the country. The government is aiming for a fiscal deficit equivalent to 2.1% of GDP this year. Last year’s fiscal deficit was 1.86% of GDP.

Fig 12: Foreign Direct Investment (FDI)

Fig 13: Inflation vs Policy Rate

Fig 14: Producer Price Index (PPI)

Fig 15: Government Surplus/Deficit

Fig 16: Govt. Debt Outstanding

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Conclusion As the world’s second-largest economy gathers pace, grappling to meet this year’s target of “about” 7.5% growth, woes on slower growth receded somewhat. Slower growth is now the “New Normal” for Asia’s growth engine, amid a cooling property sector which continues to be a drag on its economy. The slowing real estate market is sending ripple effects to the construction sector and other housing-dependent industries, magnifying the slackening imports, decelerating retail sales (negative wealth effects), as well as dampening investment and bank lending. However, we maintain our view that we do not expect a hard landing. While we see some downside surprises in July, despite a burst of government stimulus measures, the patchy economic recovery suggests more policy support may be needed to keep growth on track as a property downturn worsens. It would be a challenge to the authorities to balance between the reforms and sustaining the recovery. On balance, we upgrade to OW from NW on optimistic prospect on China’s deepening reforms and signs of economic recovery. But we remain cautious on the risk of reforms being delayed and how reforms interact amid a depressed growth and elevated credit risk.

Fig 17: Shanghai Composite Index (PE ratio)

Fig 18: Shanghai Composite Index (PB ratio)

Fig 19: Shanghai Composite Index (EPS growth)

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Appendix Reforms and Development

Reforms Objective Progress

SOE Reforms

Capacity shutdowns leveraged corporate sectors/ privatization

Reducing excess production capacity and improve the efficiency of the economy

More private or foreign capital might be channeled in to support growth by opening up some monopoly sectors; may help alleviate some domestic credit pressure, thus cutting general debt levels

Greater role for the market – factor price liberalization in SOE dominated sectors such as energy, water, telecoms

Improve corporate governance

Rein in informal credit/ Bank NPL recognition and charge offs thus opening up of banking sector to new competition

The Ministry of Finance has released financial statements for the country's 155 state-owned enterprises. The 2013 report is the first document to publicly detail the financial accounts of the country's SOEs.

Reduce excess capacity:-

Addressing overproduction through measures such as closing small factories and limiting investment into these industries, in particular in sectors like steel, electrolytic aluminium, cement, plate glass producers, as well as shipbuilders.

China's central energy authority unveiled its photovoltaic (PV) development targets for 2014, vowing to install 13 gigawatts of new PV power capacity this year. To boost the sagging solar power industry, China has turned to distributed PV power generation and rolled out a string of preferential policies, including subsidies and tax reduction. Government also encouraged local governments to further facilitate the development of distributed solar power generation.

SOE mixed-ownership reform:-

The State-owned Assets Supervision and Administration Commission has rolled out a series of measures to step up the process.

Six companies were singled out for state asset investment reform trials, including State Development & Investment Corp (SDIC); China National Cereals, Oils and Foodstuffs Corp (COFCO); China National Building Materials Group; China Energy Conservation and Environmental Protection Group (CECEP); Xinxing Cathay International Group; and China National Pharmaceutical Group. The six big SOEs will pilot reforms in ownership, management and supervision, including selectively setting up investment companies and a "board of directors" system. Sinopharm and China National Building Materials (CNBM) are next in line.

Bank of Communications to deepen mixed ownership.

Chinese SOE giants like China National Petroleum Co. and China Telecom have carried out their own plans to diversify corporate ownership and attract social funds to cooperate on some business.

The China Securities Regulatory Commission (CSRC) issued a “Guiding Opinions” on employee stock ownership plans (ESOP), where companies listed on a Chinese stock exchange will soon be able to offer ESOP as a type of employee benefit.

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Reforms Objective Progress

Details of how the system will work and its implications for foreign-invested enterprises remain limited.

SOEs are required to pay 0-25% of profits to fiscus this year under a new dividend payout scheme. China would raise the SOE dividend payout ratio up to 30% by 2020.

Financial institutions reform:-

China's central bank to deepen reforms to the nation's large commercial banks as well as other large financial institutions. Specifically, reforms will be accelerated in the Export-Import Bank of China and the Agricultural Development Bank of China, which are both wholly state-owned, with an aim to standardize their accounting. The China Development Bank, another state-owned policy bank, will prioritize lending to shantytown renovation projects. The central bank will seek to build a sustainable model through which commercial banks may improve their financial services for agriculture and farmers. The central bank will also improve standards and regulations regarding Internet finance in a bid to create fair competition and enhance risk control.

36 privately owned banks have received approval by the State Administration for Industry and Commerce as part of the country’s trial plan to encourage private capital to launch banks.

Land Reforms/ Urbanization

Hukou reform/ Shantytown renovation/ One child policy reform

Accelerates rural/ urban migration and household formation

Land reform should benefit rural consumer – social security system expanded; consumer leverage/GDP ratio improves

New central government guidelines on reform of China’s household registration system have been unveiled. The guidelines said basic public services, including education, healthcare, social insurance, employment, aged care and housing, will be expanded to migrants’ children – thus inducing large government spending. China also intends to subsidize vocational training for all rural migrants by 2020. However, expansion of the country’s megacities including Beijing and Shanghai will be limited.

Allow farmers to lease or sell their land when they leave villages, thus more efficient resource allocation.

Step up financial support – government will support state-owned companies to raise funds for shantytown renovation through issuing bonds. Private companies will enjoy the same preferential policies as their state peers when they participate in renovation projects. The new housing finance division in the China Development Bank should prioritize lending to shantytown renovation projects, and commercial banks should improve lending services to them. The government has set the goal of subsidizing the rebuilding of 4.7 million housing units across the country this year.

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Reforms Objective Progress

Fiscal/ Political/ Cultural Structural Reforms

Anti-graft campaign; Crackdown in antitrust; Crackdown in commodity-financing (also part of shadow banking crackdown)

Promote better governance and healthier growth. Corruptions among the officials strained the legitimacy of the ruling party as well as the creditworthiness of the system – deterring private investment, misallocates resources and generates social grievances

Encourage local entrepreneurs and producers, promote local product, boost competitiveness

Brought down numerous high-profile targets in its sweeping anti-corruption campaign – also involved cracking down industries such as luxury goods, real estate, high-end hotels, and automobiles

Anti-graft movement which involved investigations into major multinational companies, such as Microsoft, GlaxoSmithKline and Audi

Actively support domestic companies in anti-dumping and anti-subsidy trade suits

Introduce property taxation/ improve local government financing

To regulate the property market A legislation plan to establish a property sector taxation will be submitted to the Standing Committee of the National People’s Congress, China’s top legislature, later this year. Target to complete the legislation process by the end of 2016, and related taxes to be implemented in 2017. This will involve a basket of tax reforms, including a real estate tax levied on homeowners and a land tax on property developers.

Regular review on government debt

More transparency on government’s balance sheet

According to the State Council revised version of “Regulations for the Implementation of the Audit Law of the People’s Republic China”, audit of government debt into regular auditing cycles will be included going forward.

Reorient investment spending in social infrastructure and environmental improvements

Strong commitment in the area of pollution control

New energy cars exempted from vehicle purchase taxation

Three types of new energy vehicles will be exempted of vehicle purchase tax (8.5%) between 1 Sep 2014 to 31 Dec 2017.

State Council announced guideline of 25 measures in 6 areas to promote electronic vehicles. Measures include power charge station, tax benefit and subsidy etc.

NDRC launched favourable electricity price for electric vehicles, including waiving basic power charge for centralized charging facilities through 2020.

Economic Reforms

Shifting growth engine toward services sector

A new growth model driven by private demand such as consumer spending rather than by the traditional engine of large, and often wasteful, state-supported investment

Amid economic downward pressure both at home and abroad, China has made efforts to facilitate business registration. A new business registration rule took effect on March 1, with lower capital requirement for new companies and simplified registration procedures.

Redefining KPI for local government

Reduce overcapacity

Encourage better quality of life, in particular via environmental protection and reducing poverty

More than 70 Chinese smaller cities and counties have dropped gross domestic product as performance metric for government officials. Evaluation will instead be based on raising living standards for poor residents and reducing the number of people living in poverty. Unclear whether the change will be taken up by larger and richer cities.

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Reforms Objective Progress

Capital Market Liberalization

Accelerate capital markets development Guide to real exchange rate & Promoting RMB internationalization

RMB interest rate liberalization to be realized in two years.

HK/Shanghai Mutual Market Access/ (also dubbed as “Through Train” program) target to launch in October this year.

Currency hedges for cross-border trade, and export credit insurance.

RDFII program, which so far has covered HK, London, Singapore, France, Korea and Germany with total investment quota of RMB640 bn.

China (Shanghai) Pilot Free Trade Zone

Ningxia Pilot Economic Zone

Challenges and risks

Vested interest might fight back, thus increasing execution risk.

Breaking up state monopolies could result in state asset losses or would de-stabilize the socialist system.

May cause short term dislocation and hurt the economy, however a better governance is surely better for China.

Growth may slow but it is a healthier form of growth. Growth boosted by corruptions and commodity-financing are artificial.

“Policy tweaking”/ “Mini-stimulus” package

Steps to shore up the economy in the form of tax breaks for small enterprises, targeted infrastructure outlays and lending

incentives in rural areas and for small companies.

Targeting Policy/ Measure

Cooling housing market (hurt by a housing supply glut and tightened credit)

Chinese cities relaxing property curbs – to “encourage financial institutions to support

households’ basic housing demand and to boost the healthy development of the province’s

construction and property sectors

Around 30 local governments, including Chengdu, Hohhot, Hangzhou and Ningbo, have eased restrictions on home purchases in recent weeks to juice tepid housing sales. Central government officials have said that local governments have been given more authority to adjust their housing policies according to the local conditions.

Waning trade New export tax measures – including plans to improve the country’s export tax rebate system

and simplify the application process for claiming rebates

A pilot scheme allowing financial leasing enterprises to claim export tax refunds on goods leased to foreign parties will also be expanded. Export VAT refunds extended to foreign trade comprehensive service providers—defined as foreign trade enterprises who provide export-related services for domestic SMEs in the manufacturing industry. Both measures show the Chinese government’s concern with maintaining strong growth in foreign trade (especially as a means to maintain the employment rate).

Domestic companies received new incentives to import advanced technology and engage in outward investment for business development purposes

Weakening economic growth Cut required reserve ratio (RRR) for some lenders – freeing up more cash for loans

The reduction will apply to banks whose new loans to the farm sector last year exceeded

50% of total new lending for 2014. It is also a requirement that outstanding loans to the

farming sector exceeds 30% of total outstanding loans. Current liquidity in China's banking

system was ample, and that the direction of the country's monetary policy had not changed.

Banks' reserve requirements are neither uniform nor transparent in China. Smaller banks

tend to have lower RRRs than major banks, which had an RRR of 20% in 2012.

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INDONESIA PT Phillip Securities Indonesia

ANZ Tower Level 23B, Jl Jend Sudirman Kav 33A Jakarta 10220 – Indonesia

Tel +62-21 5790 0800 Fax +62-21 5790 0809

Website: www.phillip.co.id

CHINA Phillip Financial Advisory (Shanghai) Co Ltd

No 550 Yan An East Road, Ocean Tower Unit 2318,

Postal code 200001 Tel +86-21 5169 9200 Fax +86-21 6351 2940

Website: www.phillip.com.cn

THAILAND Phillip Securities (Thailand) Public Co. Ltd

15th Floor, Vorawat Building, 849 Silom Road, Silom, Bangrak,

Bangkok 10500 Thailand Tel +66-2 6351700 / 22680999

Fax +66-2 22680921 Website www.phillip.co.th

FRANCE King & Shaxson Capital Limited

3rd Floor, 35 Rue de la Bienfaisance 75008 Paris France

Tel +33-1 45633100 Fax +33-1 45636017

Website: www.kingandshaxson.com

UNITED KINGDOM King & Shaxson Capital Limited

6th Floor, Candlewick House, 120 Cannon Street, London, EC4N 6AS

Tel +44-20 7426 5950 Fax +44-20 7626 1757

Website: www.kingandshaxson.com

UNITED STATES Phillip Futures Inc

141 W Jackson Blvd Ste 3050 The Chicago Board of Trade Building

Chicago, IL 60604 USA Tel +1-312 356 9000 Fax +1-312 356 9005

AUSTRALIA PhillipCapital

Level 12, 15 William Street, Melbourne, Victoria 3000, Australia

Tel +61-03 9629 8288 Fax +61-03 9629 8882

Website: www.phillipcapital.com.au

SRI LANKA Asha Phillip Securities Limited

2nd Floor,Lakshmans Building, No.321, Galle Road, Colombo 03, Sri Lanka

Tel: (94) 11 2429 100 Fax: (94) 2429 199 Website: www.ashaphillip.net

INDIA

PhillipCapital (India) Private Limited No. 1, C‐Block, 2nd Floor, Modern Center , Jacob

Circle, K. K. Marg, Mahalaxmi Mumbai 400011 Tel: (9122) 2300 2999 Fax: (9122) 6667 9955

Website: www.phillipcapital.in