BlackRock Investment InstItute

clImBInG cHIna’s GReat Wall of WoRRy INVESTMENT RISKS AND OPPORTUNITIES

JUNE 2015

[ 2 ] c l I m B I n G c H I n a’ s G R e at W a l l o f W o R R y

SummaryChina’s economic growth model is looking out of date, debt is piling up and capital outflows are rising. Policymakers are walking a tightrope, trying to balance short-term stimulus with tough reforms to ready the economy for the future. We climbed this Great Wall of Worry in discussions with Chinese policymakers, entrepreneurs and academics in Beijing in early May. Our main conclusions:

} We recognize China’s economy is slowing, likely by more than official statistics indicate. Yet we do not expect an economic hard landing or financial market crash in the short term. This is reflected in our overweighting pro-cyclical investments—an implicit belief that China’s economic miracle will last a bit longer.

} The four trends that most influence our investment strategies and thinking are: China’s reining in runaway credit growth; the shift toward a services economy and manufacturing’s move up the value chain; the risk of a property market downturn; and the government’s ability to stimulate the economy in the near term.

} Many of us believe China can meet these challenges in the short term, with some hiccups along the way. Policymakers appear aware of the risks, and have credible long-term plans (an ambitious reform agenda) and short-term tools (room for monetary and fiscal stimulus) to address them.

} China has contributed more than a third of global economic growth since 2008-2009, and its current slowdown is reverberating around the world. We take a peek at Australia, examining China’s effect on the country’s currency and interest rates.

} Officials are keenly aware of the dangers of continuous debt rollovers by state enterprises and local governments. They appear confident they can avoid a major credit crunch, in part by converting short-term, high-interest local government loans into municipal bonds with longer maturities and lower coupons.

} We think the People’s Bank of China (PBoC) will further cut interest rates and historically high bank reserve ratios in an attempt to reignite growth. The government also appears ready to prop up real estate prices and support the construction industry by investing in infrastructure at home and abroad.

} China has committed to opening its capital account by year-end, but it is unclear what exactly “open” means. The risk of capital flight will likely make the country tread carefully, and we do not expect a truly free-floating yuan currency any time soon. Policymakers’ focus on currency stability should anchor the yuan for now.

} Investors should think of China as a continent, not as a country. Economic trends, development and policy implementation vary greatly by region. The economy is slowing in the Northeast (heavy industries) and West (mining) but is still going strong in the densely populated and prosperous coastal areas.

} It is tempting to simply dismiss buying Chinese assets: too much debt, too little growth and too policy-driven. This is a mistake, in our view. One can worry about the economy and rising risks in the long run but be bullish on markets in the short to medium term.

} China’s domestic equity markets look frothy after more than doubling in 12 months. We prefer less expensive Hong Kong-listed Chinese equities, especially small- and medium-sized stocks, because they have suffered a liquidity discount that is set to dissipate. We like selected corporate bonds in offshore markets because of their relatively high yields and limited duration risk.

What Is Inside

Slowing Growth ........................3–4

Leverage Risk ............................5–6

Long-Term Reform ........................7

Short-Term Stimulus ...................8

Currency ..............................................9

Equities..............................................10

Fixed Income ................................. 11

Helen Zhu (BOT TOM RIGHT)

Head of China Equities, BlackRock Alpha Strategies

Andrew Swan (BOT TOM LEF T)

Head of Asia Equities, BlackRock Alpha Strategies

Jean Boivin (TOP LEF T)

Deputy Chief Investment Strategist, BlackRock Investment Institute

Neeraj Seth (TOP RIGHT)

Head of Asia Credit, BlackRock Alpha Strategies

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 3 ]

“ Think about China’s innovation and tech savvy. This is a place where things are happening with incredible velocity. ”

— Jeff Shen Head of BlackRock Emerging Markets

and Co-Head of Scientific Active Equity

Slowing GrowthIt is tough to get a handle on China’s economic growth. Ask officials: “Why do you think growth is going to be 7%?” The answer often is: “Why do you even ask this question? We told you it’s going to be 7%.”

Here is what we do know: China’s official gross domestic product (GDP) growth is slowing. The productivity gains of shifting workers from agriculture into industry have largely been harvested. China’s population is set to peak at nearly 1.4 billion within a decade—and then start a rapid decline.

The growth formula that worked so well in the past (an export-led economy supported by massive investment, cheap wages and an explosion of credit) is at the end of its shelf life. What is needed? A shift toward a consumption economy and a move up the manufacturing value chain.

The challenge is to pull this off without triggering an economic hard landing, a credit crisis or both. This is no easy task; the arithmetic of rebalancing is challenging— and conveniently overlooked by many China bulls.

DeceleRatInG DRaGon BoatChina Fixed Asset Investment Growth, 2004–2015

Sources: BlackRock Investment Institute and National Bureau of Statistics of China, May 2015. Note: The average in the bar chart is calculated from May 2004 to April 2015.

AN

NU

AL

CH

AN

GE

35%

25

15

10

2004 2015

20

30

2006 2008 2010 2012

Information Technology

Health

Research and Prospecting

Transport & Telecom

Retail

Utilities

Education

Conservation

Residential & Other Services

Manufacturing

Real Estate

Banking

Mining

ANNUAL CHANGE

Construction

-10 0 10 20 30 40%

CurrentAverage

Consumption as a share of GDP has actually edged down to 34%, well below the global average of 65%. Suppose China wanted to raise the share to 50% of GDP over a decade. Consumption would have to outpace real GDP growth by four percentage points a year, Michael Pettis of Peking University estimates. This means if China is to hit its 7% annual growth target, consumption would have to rise an average of 11% a year —something that has not happened before. Conclusion: GDP growth of 3%–4% is a more likely outcome, China bears argue.

Our view is somewhere in between. We see China as a continent, not a country. GDP growth between provinces varied as much as nine percentage points in the first quarter. See our interactive graphic for details. We also think the economy will likely remain heavily dependent on investment-led growth in the next decade. And that is just fine: China’s per-capita income and capital stock are still at low levels.

Growth in fixed asset investment in China has already slowed in recent years. The slowdown has been led by mining, real estate and manufacturing. Investment in health care, IT, transport and conservation—the industries of the future—has stayed strong. See the charts below.

[ 4 ] c l I m B I n G c H I n a’ s G R e at W a l l o f W o R R y

“ There are secular headwinds for Australia: The Chinese economy is transitioning growth away from commodity-intensive sectors. ”

— Steve Miller Head of Australian Dollar Bond Portfolios,

BlackRock Alpha Strategies

GLO

BA

L G

DP

GR

OW

TH

6%

4

2

-2

China

0

OtherJapanEurozoneU.S.

20092007 2008 2010 2011 2012 2013 2014 2015

WoRlD’s locomotIveBreakdown of Global Real GDP Growth, 2007–2015

Sources: BlackRock Investment Institute and IMF, May 2015.Notes: Contributions to global real GDP growth are in percentage points and based on purchasing power parity GDP weights. 2015 is based on IMF forecasts.

China now needs to increase the quality of its investment and target productive areas of the economy: technology and the services industry. It needs to move from imitation to innovation. How to manage a growth slowdown without triggering a crisis? We expect a grinding, multi-year economic slowdown but think policymakers will be able to prevent a collapse—at least in the short to medium term.

Yet China’s “slow” growth is coming off an increasingly large base. The country is expected to contribute 1.1 percentage points to global GDP growth this year, or one-third of the total. See the chart above. Suppose China’s economic growth slows to 6% a year. This has the same effect on the global economy as Canada’s GDP expanding by 69% annually.

China also has an outsized influence on commodities. The country accounts for roughly half the global demand for nickel (13% in 2004), aluminum and copper (both up from 20%), according to the World Bureau of Metal Statistics and the International Copper Study Group. China makes up 11.3% of global oil demand, up from 3.3% three decades ago, according to the International Energy Agency.

China’s slowdown has hit commodity-exporting countries by depressing prices. This has dampened inflation both at home and abroad. China once again is exporting disinflation.

Germany

South Africa

U.S.

Russia

Indonesia

Brazil

Saudi Arabia

Japan

South Korea

Australia 31.9%

26.6%

18.5%

13.9%

11.6%

11%

9.2%

9%

8.1%

6%

Emerging Market

Developed Market

cHIna DePenDentsShare of Exports Going to China by Country, Q4 2014

Sources: BlackRock Investment Institute and IMF, May 2015. Notes: The bars show each country’s gross exports to China as a share of its total exports. Gross exports may overstate China exposure for exporters of intermediate goods.

AuStrAliAN CrAwlCommodity exporter Australia is taking an outsized hit as China’s economy slows. China makes up 31.9% of Australia’s exports—the highest share in the G20. See the chart below.

The price of Australia’s biggest export, iron ore, has plunged, and the country’s terms of trade have tumbled. This is playing havoc with Australia’s budget (deficit forecasts are widening)—and has led to a big fall in mining investment. Other sectors of the economy are not picking up the slack.

The Reserve Bank of Australia (RBA) hopes to engineer a recovery by cutting interest rates and pushing the currency lower. The trade-weighted Australian dollar has fallen 18% below a 2013 peak. What happens next? We see an extended period of rising unemployment and subtrend growth. We believe the RBA will cut its benchmark rate further this year, from a record-low 2%, and expect more declines in the currency. The front end of the yield curve is partly pricing in this scenario, whereas long-maturity bonds and credit spreads tend to follow global bond market trends.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 5 ]

DE

BT

TO G

DP

2000 2007 2014

121%8%

83%

7%23%

20%

72%

24%

42%

158%

282%

38%

125%

65%

55%

Households

Non-Financial Corporate

Financial Institutions

Government

Total

tHe lonG DeBt maRcHChina Debt as a Share of GDP, 2000–2014

Sources: BlackRock Investment Institute and McKinsey Global Institute, February 2015.Note: 2014 data are as of the second quarter.

Leverage RiskChina has been taking on increasing amounts of debt to maintain growth. Yet it has been getting less bang for its yuan as growth has edged down. Credit growth is not just losing its potency; it is turning into a poison. Debt is growing faster than borrowers’ ability to service it.

The resulting debt mountain stood at $28.2 trillion at the end of 2014, according to a McKinsey report. The debt cannot be rolled over indefinitely. China’s debt-to-GDP ratio has reached almost 300%. Government debt makes up a relatively small share of the total, with the bulk in the corporate sector. See the chart below.

Debt accumulation has happened as things happen in China—with lightning speed. China has added $21 trillion in debt since 2007, representing more than one-third of the total global increase over that period, according to McKinsey. Outstanding Chinese corporate debt overtook the U.S. in 2013 and is set to make up 30% of the global corporate debt stock by 2018, according to Standard & Poor’s research.

Will China’s credit boom end with a bust? History is not on China’s side. There have only been four credit booms of a similar magnitude to China’s over the past 50 years, an International Monetary Fund study shows. All four suffered a banking crisis within three years. The good news? The fallout could be limited in China’s case due to the government’s effective ownership and control of the banks.

AN

NU

AL

CH

AN

GE

20

10

2004 2010 201520122006 2008

30

40%

tHe GReat cReDIt fall?China Credit Growth, 2004–2015

Sources: BlackRock Investment Institute, People’s Bank of China and Bloomberg, May 2015. Note: The line shows the annual change in the stock of total social financing.

QuAlitY OVEr QuANtitYThere are signs credit growth is finally starting to slow. Steps to rein in China’s “shadow banking” sector (non-bank financing) have put the brakes on lending growth. See the chart above. The key is increasing the quality of credit. This means funneling more money to the private sector—and less to China’s two biggest credit junkies, local governments and state-owned enterprises (SOEs).

Many local governments and SOEs can no longer service their debts, let alone pay them back. A quick way to deal with the issue would be to nationalize local debts. The government has resisted this step so far (it would reward profligate spenders). Beijing instead is trying to bring bank loans racked up by murky local government financing vehicles (LGFVs) into the open and eventually convert them into bonds. The goal is to swap short-term, high-interest bank debt into long-maturity, low-interest bonds. This would provide debt relief and support the growth of a municipal debt market. The devil is in the details: The plan would just shuffle debt from one pocket to the other if (state-backed) banks were to buy all the bonds, in our view.

The province of Jiangsu was the guinea pig. It sold around $8.4 billion of yuan-denominated bonds in May after calling off an earlier sale in April due to lack of investor interest. The bonds ranged from three to 10 years in maturity and carried interest rates of up to 3.4%, replacing costlier debt set to mature in 2015. This is welcome yield compression: The province said the deal would cut its interest burden in half. Caveat: This is just an opening salvo. The timetable for more debt conversions is unclear; it could take years to implement.

[ 6 ] c l I m B I n G c H I n a’ s G R e at W a l l o f W o R R y

“ The Chinese government is increasingly supporting the economy at a time revenue growth is slowing. It also underwrites the financial system. So expect plenty of issuance of sovereign and other debt ahead. ”

— Ewen Cameron watt Global Chief Investment Strategist,

BlackRock Investment Institute

accumulatInG claIms Bank Lending to China, 2006–2014

Sources: DSG Asia and Bank for International Settlements (BIS), April 2015. Notes: The chart shows claims of BIS-reporting banks and Hong Kong banks on China. The Hong Kong data are based on Hong Kong Monetary Authority statistics.

BIL

LIO

NS

$1,200

0

2010 201420122006 2008

600

Hong Kong Banks

BIS-Reporting Banks

rEAl EStAtE riSkReal estate has powered China’s rapid economic growth—and has an outsized impact on the country’s economy. Housing investment rose to 10.5% of GDP in 2014, according to the International Monetary Fund, some four times the 1997 level. (By comparison, U.S. housing investment peaked at 6.5% of GDP in 2005.) Roughly $9 trillion of China’s debt, or almost one-third of the total, is tied to real estate, McKinsey estimates. Real estate, therefore, is likely to feature in any economic scenario, we think.

The sector also is highly political. Example: It is supposed to achieve social policy goals of decent housing for all residents. Yet the industry has built for the “haves” (white-collar city workers). The mass market is less profitable and requires cheap land. The problem: Local governments finance about a quarter of their budgets through land sales, according to Moody’s. So they have an incentive to boost land prices. As a result, a central government-led push to serve the mass market could bring about a chain reaction of local governments no longer being able to service their debts.

A prolonged period of negative real deposit rates, a lack of alternative financial assets and capital account restrictions made real estate a go-to investment for many Chinese. This has made the market prone to overbuilding and inflated values. Oversupply is especially pronounced in smaller cities and in China’s Northeast. The adjustment is likely to take years.

The government lifted most restrictions on buyers last year to resuscitate the moribund real estate market. It is worrying to hear government officials predicting real estate gains this year—and seeing TV commercials talking up second home ownership. Building houses for investment, rather than for living, is a prerequisite for any bubble. Beijing’s tactics are working—for now. Prices appear to be bottoming, also helped by a contraction in supply growth after years of rapid expansion. In addition, the government is creating more runway for the industry by pushing big infrastructure works in China and abroad (see page 8). This will absorb capacity and create new markets.

leaky lanteRn China Hot Money Flows as a Share of GDP, 1999–2015

Sources: BlackRock Investment Institute, China State Administration of Foreign Exchange and BNP Paribas. May 2015. Note: The bars show the four-quarter rolling sum of China’s non-foreign direct investment net flows as a share of GDP.

SH

AR

E O

F G

DP

3%

-6

1999 2005 201520072001 2003

0

-3

2009 2011 2013

The good news for investors? China poses little systemic risk to the global financial system. It is still a relatively closed economy. Foreign banks’ claims on China have been rising fast (a red flag) but are just a fraction of domestic banks’ lending. See the chart above. Yet capital is leaking out of the country—a sign not all is well. See the chart below.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 7 ]

“ The belief in policymakers is touching and sweet. We have an enormous amount of confidence in people we cannot name and hardly know.”

— Sam Vecht Head of Emerging Markets Specialist Team,

BlackRock Alpha Strategies

Sources: BlackRock Investment Institute and Citigroup, May 2015.

RefoRm PaIns anD GaInsPlot of China Planned Reforms and Policy Measures

Relax One-Child Policy

National Safety Net

Services Sector Deregulation

Urbanization

Free Trade Zones

Capital Markets Reform

Fiscal Reform

Environment Initiatives

SOE Reform

Intellectual Property Protection

LO

NG

-TE

RM

GA

IN

Interest Rate Liberalization

Property Tax

Bankruptcy of Insolvent

Institutions

Financial Product Defaults

Price Reform

Land Reform

FX Reform

Anti-Corruption Campaign

Debt Nationalization

Reduce Excess Capacity

Stimulus/Releveraging

Monetary Policy Easing

PBOC Relending

Debt Restructuring

Securitization

Municipal Bonds

LO

NG

-TE

RM

PA

IN

SHOR T-T ERM G A INSHORT-TERM PAIN

Long-Term ReformMany of China’s most ambitious reforms promise long-term gains—but involve pain in the short run. See the top left quadrant in the chart below. The anti-corruption campaign is a prime example. It should boost the rule of law, strengthen government institutions and bolster economic growth over time. Yet the campaign has led to a slowdown in decision making and created uncertainty for businesses. Some decision makers have been carted off to prison. Those holding on to their jobs are afraid of signing anything that may open them up to corruption charges.

The campaign also has killed luxury goods sales and bankrupted many fancy restaurants. (Most of the bad news is by now baked in to the shares of European luxury goods makers, we believe.)

Almost half of China’s middle class is either on the government’s payroll or depends on it, Goldman Sachs estimates. This explains why changes in government policies can have an outsized impact on consumer spending.

Other reforms—SOE, urbanization and fiscal—offer both short- and long-term benefits (the chart’s top right quadrant). Many zombie SOEs enjoy subsidies such as artificially cheap funding, land and energy. Reforms are meant to chip away at these advantages by consolidating industries with overcapacity, cutting bloated payrolls and policing risky sidelines such as lending.

What are the risks? We are placing a lot of trust in people we know little about. Many of us will struggle to name two Chinese officials. Yet China’s policymakers have a lot of credibility—because they deserve it. Whenever things have started to look bad, policymakers have come to the rescue.

[ 8 ] c l I m B I n G c H I n a’ s G R e at W a l l o f W o R R y

RR

R R

ATE

25%

10

5

2001 2007 20152009 201320112003 2005

FX Reserves

Reserve Requirement Ratio (RRR)

TRILLIO

NS

OF F

X RE

SE

RVE

S

15

20

$5

0

2.5

JoIneD at tHe HIPChina Reserve Requirement Ratio and FX Reserves, 2001–2015

Sources: BlackRock Investment Institute and People’s Bank of China, May 2015.

Short-Term StimulusChina is in stimulus mode. Fiscal policy is loosening and the PBoC is trying to ease financial conditions without further inflating the credit bubble. The central bank has plenty of room—and appetite—to cut interest rates. Consumer inflation is about 1% and producer price inflation (PPI) has been falling for years.

Here is how one policymaker put it to us in early May: Nominal lending rates for corporates are 6.3%, versus 6.8% a year ago. However, PPI hit -4.6% in April. This means real lending rates are more like 10%-plus a year. This is too high; lending rates should equal the GDP growth rate, the policymaker said.

The PBoC cut its benchmark one-year lending rate by 0.25% to 5.1% in May—the third cut in six months. The problem: Many borrowers are using easy money to roll over existing loans or buy into the red-hot domestic stock market. China now is at risk of developing a case of financial constipation.

rEDuCiNG rrrThe PBoC also is likely to further cut its reserve requirement ratio (RRR)—the amount of liquid assets or reserves commercial banks must keep at hand. Why does an RRR cut matter? The PBoC does not have a fixed target for interbank rates (like most other central banks). It instead uses the RRR to adjust the reserves in the banking system—and control the overall pace of lending. All things being equal, a lower RRR should encourage banks to lend more and stimulate the economy.

The argument for cutting the rate is that the PBoC no longer needs to worry about foreign exchange (FX) inflows. The central bank increased the RRR to offset the liquidity gusher created by converting FX inflows into yuan. These flows have since reversed. Yet the RRR still stands at a historically high level, having fluctuated between 7.5% and 21.5% in the last decade. See the chart above right. Plus, most other countries require lower bank reserves.

We see the PBoC cutting the rate to as low as 12%, from 18.5%. Every 1% cut releases about 1.5 trillion yuan of liquidity, Merrill Lynch estimates, or about 2.4% of current GDP. We think these cuts will likely only partly offset the liquidity-draining effects of capital outflows. (These lead to buying of foreign currency and thereby take yuan out of the system.) Capital outflows accelerated to an annualized pace of almost 6% of GDP in 2015, the highest level since the Asian financial crisis.

lONG MArCH AHEADYet China has more arrows in its quiver. The government is likely to funnel money to policy banks such as China Development Bank to support infrastructure works both in China and abroad. Beijing wants to improve transport connections to its neighbors and trading partners in South Asia, Europe and Africa. China has bunched (and relabeled) these plans into an ambitious “One Belt, One Road” project. Potential long-term benefits for China include lowering trade costs through better roads, railways, ports and airports, developing new export markets, putting the domestic infrastructure industry’s excess capacity to work, and promoting internationalization of the yuan.

The strategy—which faces plenty of political hurdles—dovetails with China’s growing global financial ambitions. The latest example is the Asian Infrastructure Investment Bank (AIIB). This development institution has signed up 57 countries, with the U.S., Japan, Mexico and Canada notable absentees for now. The initiatives could have similarly positive effects as China’s ascension to the World Trade Organization in 2001, which was underappreciated at the time. They could also boost countries supplying infrastructure-related goods, such as Australia, Indonesia, Japan and South Korea, HSBC argued in a recent report.

How about other fiscal stimulus? The government appears to want to keep the deficit below 3% of GDP (it is 2.7% now), yet this may be wishful thinking. Spending growth must slow in line with the economy, or tax revenues must grow faster. This is tough amid tepid growth, slowing government land sales and signs of disinflation.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 9 ]

loosenInG tHe leasHChinese Yuan to U.S. Dollar, 2011–2015

Sources: BlackRock Investment Institute and Thomson Reuters, May 2015.

YUA

N P

ER

U.S

. DO

LLA

R (S

CA

LE R

EVE

RS

ED

)

6

6.4

6.6

6.8

2011 2012 20152013 2014

6.2Spot Rate

PBoC FixingTrading Band

Band WidenedFrom 1% to 2%

Band WidenedFrom 0.5% to 1%

YuanStrengthening

YuanWeakening

CurrencyThe yuan recently broke into the top-five currencies for global payments, overtaking the Canadian and Australian dollars, according to interbank association SWIFT. The yuan is now only behind the U.S. dollar, euro, British pound and Japanese yen with a 2.2% share—although it has some catching up to do to match the U.S. dollar’s dominant 44.6% share.

Illustrating the yuan’s internationalization, the International Monetary Fund’s board this year could pave the way for the yuan to be included in its special drawing rights (SDRs). The argument is that the yuan is freely usable—if not fully convertible yet. Approval is mostly a status symbol cherished by China.

The yuan’s internationalization also means the exchange rate is partly driven by portfolio flows aiming to take advantage of interest rate differentials. This is business as usual in most emerging markets, but marks a sea change for a country that has tightly controlled its currency.

Case in point: Chinese companies have been borrowing U.S. dollars offshore and investing the proceeds in higher-yielding domestic assets. A Chinese company arranges a cheap offshore U.S. dollar loan from a big domestic bank. The mainland bank issues a $100 letter of credit and the borrower obtains a $100 U.S. dollar loan offshore with a borrowing cost of 1.5%. The company exchanges this loan into yuan and parks the funds in a wealth management product yielding 6% or more. It pockets the interest differential and the currency gain. Rinse and repeat. Much of China’s capital influx in recent years likely came through this route.

These popular trades boosted the yuan’s value in early 2014—until the PBoC widened the trading band and made clear these trades were not a one-way bet. See the chart above right. Chinese companies also have become wary of borrowing abroad as the prospect of U.S. Federal Reserve rate hikes threatens to further boost the dollar. Many need U.S. dollars to repay their loans. This raises the specter of a credit crunch.

For now, the problem is reflected in increasing capital outflows—with ramifications beyond China. The country has been absent from U.S. Treasury auctions, for example. China has sold $50 billion of Treasuries in the past year, U.S. Treasury data show. (Japan has picked up some of the slack and is now once again the largest creditor of the U.S.) Caveat: Many purchases of U.S. Treasuries are routed through offshore financial centers. The Caribbean and Belgium are the third- and fourth-biggest holders, respectively, the data show.

CurrENCY CrOSSwiNDSWhere is China’s currency headed? There is a fundamental argument for a weaker yuan. The rebalancing toward a consumer economy should reduce the current account surplus over time. Export growth is deteriorating due to an appreciation in China’s real effective exchange rate. And increasing capital outflows indicate the currency is too expensive. The counter argument: China’s current account surplus has come down but still amounts to a sizable 3.5% of GDP. The country also has a high savings rate. This should translate into a stronger currency over time.

Our view: The level of China’s currency depends more on policy choices than on fundamentals. So the real question is: Where is China’s currency policy headed?

The “impossible trinity” of international finance says a country cannot at the same time have an independent monetary policy, free capital flows and a fixed exchange rate. Policymakers realistically can pursue only two of the three. China wants an independent monetary policy and has committed to opening the capital account by year-end. China’s accelerating push abroad also heralds further yuan liberalization. Yet the government appears to understand the danger of going all the way. Rapid currency movements or capital flight could torpedo the PBoC’s monetary policy goals—or the government’s plan to rebalance the economy.

So what gives? We believe currency stability is an important goal of policymakers. Implication: Capital account liberalization will happen only partially in the near term—and at a gradual pace. This should anchor the yuan for some time.

[ 1 0 ] c l I m B I n G c H I n a’ s G R e at W a l l o f W o R R y

“ You have to get two things right: policy and sentiment. The A-share market is all about sentiment.”

— rui Zhao Portfolio Manager of Asia Pacific and EM Equity,

BlackRock Scientific Active Equity

IND

EX

200

100

80

2015

A-Shares at Premium

20082006 2010

150

2012

H-Shares at Premium

PayInG a PRemIumChina Equities A- to H-Share Premium, 2006–2015

Sources: BlackRock Investment Institute and Hang Seng, May 2015.Note: The Hang Seng China AH Premium Index measures the absolute price premium (or discount) of A-shares over H-shares for the largest and most liquid mainland Chinese companies with both A-share and H-share listings.

EquitiesFears of an economic slowdown and skepticism about corporate bookkeeping led to deeply discounted Chinese stock prices until the middle of 2014. Then shares took off on a mix of excitement over share trading liberalization, anticipation of short-term government stimulus to boost the economy, and expectations that China’s reforms set the country and its capital markets on a course toward sustainable growth.

Chinese equities are split over two main markets:

1 The A-share market in mainland China. Foreign investors have until recently had only limited access through programs such as the Qualified Foreign Institutional Investor (QFII) Scheme.

2 The H-share market deals in companies incorporated in mainland China but listed in Hong Kong or on other international stock markets. Capital account controls restrict participation of domestic Chinese funds in this market.

The Shanghai-Hong Kong Stock Connect program is a step toward merging the markets. This initiative—known as Mutual Market Access (MMA)—lets Hong Kong and overseas investors trade a capped amount of stocks listed on the Shanghai exchange. Funds in mainland China for the first time can buy and sell selected Hong Kong-listed equities.

A Or H? The A-share market has doubled over the past 12 months, while H-shares touched seven-year highs in April. Rising valuations mean it is important to be choosy. A-shares have traditionally traded at a premium to H-shares. Capital controls prevented arbitrageurs from chipping away at the differential. The premium has widened, making H-shares better value today, in our view. See the chart above right.

We see value in H-shares of selected banks, property developers, utilities and new energy. We also like small- and medium-sized companies in the H-share market. These trade at only a small premium to large caps, compared with the segment’s 150% higher P/E ratios in the A-share market. The reason is poor liquidity—a factor we think will dissipate over time as the integration between the exchanges deepens.

The value of turnover in China’s domestic equity markets has more than doubled in 2015, and now often exceeds that of U.S. markets. There are warning signs the A-share market has become overheated. Margin debt recently reached a record 8% of the market’s free float, according to Macquarie research. Brokers opened four million new accounts in a single week in April. New stock offerings abound. Old Asia hands know this pattern often ends in tears.

This is not a buy-and-hold market. It is about rapid sector and stock rotation. Our systematic equity portfolio managers are pursuing several strategies to crack the code. One parses articles in the official government newspaper, People’s Daily. The resulting “What’s on Xi’s mind?” indicator shows policy increasingly is targeting the environment and agricultural modernization. Another uses machine-learning analytics to gauge retail investor sentiment from social media websites. Sentiment rules, while valuation is an afterthought.

Does China’s slowdown spell doom for its equity market? High GDP growth often does not translate into high asset prices, as detailed in Risk and Resilience of September 2013. And consumption is likely to grow faster than GDP as China rebalances. Conclusion: Companies benefiting from domestic demand and reforms can still be winners.

B l a c k R o c k I n v e s t m e n t I n s t I t u t e [ 1 1 ]

BonD BReakDoWn China Bond Market Segments, 2003–2015

Sources: BlackRock Investment Institute and BNP Paribas, May 2015.

100%

02009 201520132003 2007

50

40

0

20

20112005

Corporate Bonds

Financial Bonds

Policy Bank Bonds

PBoC Bills

Government Bonds

YUA

N TR

ILLION

S

Total Debt Outstanding

Fixed IncomeRapid growth in Chinese debt levels has turned the country from a fledgling to a giant in global fixed income markets. China now has the world’s third-largest bond market (after the U.S. and Japan), with almost $6 trillion of tradable debt. See the chart on the right. Domestic investors dominate, supporting the funding of China’s pension and welfare system in the long run. The market is undergoing a big transition. Corporate issuance has been on the rise— while the weight of government bonds has fallen.

Risk assessment and access to information are problems. Local governments and private companies are stingy with any financial information. Investors are lucky to get any income statements, let alone reliable balance sheet information. Bankruptcy laws are still evolving—as is investor protection. And a government bailout is not a given. Some of us remember the 1999 failure of Guangdong province’s investment arm that left debts of some $4.3 billion to mostly foreign lenders.

Yet the corporate bond market today represents a huge opportunity, for both fixed income and equity investors:

1 It dramatically reduces funding costs for private enterprises that now rely on banks or SOEs for funding (if they are lucky or well connected).

2 It reduces systemic risk. SOEs are using their access to cheap bank funding to lend to private enterprises at higher rates—without caring too much about their borrowers’ creditworthiness. Any default has the potential to ripple through this interlinked system.

3 It gives yield-hungry domestic investors a wider range of investment options beyond SOE bonds or increasingly risky financial products. Opening the market to foreign investors should have a similar effect and could rectify an imbalance between GDP growth and investable debt: Chinese local bonds are not yet part of emerging market or global bond market indexes.

Access to China’s onshore bond market is still limited. Ownership is mostly restricted to institutions through the Renminbi Qualified Foreign Institutional Investor (RQFII) program—a modified version of QFII.

BOND BANQuEtThe RQFII program’s quota of around 800 billion yuan amounts to just 2.5% of the market’s size. RQFII has already hit its quota in Hong Kong, prompting some asset managers to grow their yuan businesses in other regional centers such as Singapore, where quotas are not yet full.

A small but fast-growing alternative is the offshore market. These “dim sum” bonds make for a tasty dish. The bonds—denominated in yuan but issued outside of mainland China—on average carry 5% coupons. Yet their duration risk is less than three years, versus more than seven years for comparable U.S. credit, data from HSBC and JP Morgan show. They should be more resilient in an environment of rising U.S. interest rates, we think. The correlation of offshore yuan bond yields to U.S. Treasuries has actually been negative for most of the past year, our research shows.

We are also keeping an eye on China’s fledgling municipal bond market. The conversion of Chinese local government debt into bonds will lead to the creation of a deep and liquid market along the lines of U.S. municipals over time, we believe. These bonds will be eligible for refinancing by the PBoC and should carry higher coupons than Chinese government bonds. Watch this space.

“ Many SOEs borrow a lot … to lend to smaller players. The development of the corporate bond market reduces the systemic risk this brings along.”

— Suanjin tan Portfolio Manager,

BlackRock Asia Credit

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