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Feb. 15, 2016

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PBOC Governor Zhou Speaks, Questions RemainTOM ORLIK AND FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMISTS Zhou Xiaochuan is back. After several months out of the public eye, China’s central bank governor has given a lengthy interview to Caixin magazine. The absence of public comment from Zhou during months of market turmoil was itself a source of uncertainty.

Zhou stuck to the script, saying China’s strong economic fundamentals provide no basis for yuan depreciation in real effective terms and speculators can’t be allowed to define the mood in the markets. He appeared to push back the timetable for liberalization; the central bank is patient and wants to make progress over the course of the 13th Five Year Plan, he said. That reinforces Bloomberg Intelligence Economics’ view that the immediate outlook is for yuan stability.

Zhou’s remarks leave the central bank with room for discretion. The market must be respected, he says, though, the central bank should push back against speculators and herd mentality when necessary to maintain basic stability. The central bank has already moved away from a peg to the U.S. dollar, but conditions are not yet ripe for management against a basket of currencies. BI Economics’ view is that leaving the central bank with room for discretion has its advantages in a time of transition. But leaving the markets guessing also comes at a cost in heightened volatility.

The interview may preview China’s line of argument at the upcoming meeting of Group of 20 finance ministers and central bank governors. Zhou said quantitative easing in the U.S. supplied the funds that have empowered the speculators who are currently destabilizing global financial markets. BI Economics’ view is the chances of a grand bargain between central banks when they meet on Feb. 26-27 is remote.

The yuan’s internationalization is a “wavy process,” according to Zhou. He hinted that the process could slow if speculation dominates in the foreign exchange market. That suggests yuan internationalization is not the central bank’s first priority and may not be a main constraint to China’s foreign exchange policy.

Tightening control over the capital account would be neither effective nor helpful for China, said Zhou. The government will continue to facilitate cross-border trade and investment, while increasing efforts to tackle illegal capital flows. That may ease investors’ concerns about China implementing stricter capital account rules.    

Current Account Key to Argument Against Depreciation

INSIDEBIG PICTURE. A at set-look forwardpiece occasions in the next few weeks, when leaders may advance the policy agenda.

PBOC. The yuan surged by the most since 2005 as the voiced support PBOCfor the exchange rate and raised its fixing.

TRADE DATA. slid in January, Exportseclipsed by an even bigger tumble in imports, leaving a record trade surplus.

FX RESERVES. There’s little sign of the cascading that would call the capital flightsustainability of China's’s exchange rate regime into question.

GREEN BONDS. China’s effort to build a market may reap 1.5 trillion green bond

yuan for renewable energy and environment projects within five years.

EMERGING MARKETS. A look back at emerging-market shows China is crisesfar fromone itself.

INDUSTRY INSIGHTS. Capital outflows may be squeezing the availability of domestic .bank deposits

OPINION. The true impact of a falling yuan is likely to be both nuanced and limited in nature: Christopher Balding.

QUOTE OF THE WEEK

"This shows that if China wants to deliver a 6.5 to 7 percent growth target this year they have to rely on domestic demand."

— Larry Hu, Macquarie Securities, on the

country's overseas shipments declining by 11.2

percent in January.

BIG PICTURE TOM ORLIK AND FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMISTS

Among the topics China’s central bank governor touched upon were the yuan’s exchange rate and internationalization, and China’s capital account opening.

Feb. 15, 2016 Bloomberg Brief China Brief 2

BIG PICTURE TOM ORLIK AND FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMISTS

What to Expect After the New Year Holiday    China’s holiday week has not brought any calm to troubled markets. Global equities extended their losses. Hong Kong’s Hang Seng Index was only open for two days and managed to fall 5 percent. Federal Reserve Chair Janet Yellen pointed the finger at China as the source of global turmoil. If ever there was a moment for clear communication of a credible strategy, it’s now. However, it’s a moment China’s leaders may be ill-equipped to seize.

An interest-rate cut would be the most

At a minimum, People’s Bank of China Governor Zhou Xiaochuan will have a

public stage to clarify China’s exchange-rate policy.

On March 5, China’s National People’s Congress will include Premier Li Keqiang’s work plan for 2016. Plans for a larger fiscal deficit and expansion of the 3.2 trillion yuan bail out for local governments would underpin confidence in the 2016 growth outlook.

The NPC will also see publication of the

complete 13th Five-Year Plan. Given the timing of the drafting (spread over the course of 2015) and the need to achieve consensus on the language, it’s unlikely the Five-Year Plan will be a time-lined, objective-defined blueprint the markets want to see. To judge the government’s commitment to reform we’ll have to watch what they do, not to listen to what they say. In the year ahead, that means keeping a close eye on progress with state-owned enterprise reform.    

potent tool to bolster growth and confidence in the short term. Concerns about downward pressure on the yuan may have taken it off the table.

The need to withdraw some of the about 2 trillion yuan ($304 billion) in liquidity injected ahead of the holiday will complicate the operation and messaging on monetary policy, with the potential for ripples in money markets. China’s leaders very likely do not share the sense of impending crisis that some in the markets feel. China has a reputation for authoritarian effectiveness. Policy making happens on a fixed timetable and doesn’t turn on a dime.

Though China has major problems still to solve, in some important respects policy is already moving in the right direction. The yuan has been repegged to the dollar. That’s a step back on exchange-rate reform but should at least put a cork in capital outflows. Multiple rate cuts and expanded fiscal stimulus are underpinning growth. A 3.2 trillion yuan bail out for local governments has reduced once of the main sources of financial risk. Lower down-payment requirements are boosting home sales.

Looking further forward, there are several set-piece occasions in the next few weeks which China’s leaders could use to clarify their position and move the policy agenda forward:

On Feb. 26-27, Group of 20 finance ministers and central bank governors will

meet in Shanghai. Speculation on a grandbargain on exchange rates is likely idle.

PBOC

Yuan, U.S.-China Rate Differential 

Yuan-Dollar Spot Rate, Real Effective Exchange Rate 

Feb. 15, 2016 Bloomberg Brief China Brief 3

PBOC

BLOOMBERG NEWS

Yuan Rises Most Since 2005 as Raises Fixing

The yuan surged by the most in more than a decade, catching up with dollar declines during a week-long holiday, after the central bank chief voiced support for the currency and set its fixing at a one-month high.

The currency advanced 0.89 percent, the most since the nation scrapped a peg to the dollar in July 2005, to 6.5174 a dollar as of 9:46 a.m. in Shanghai, according to data compiled by Bloomberg. The offshore yuan traded in Hong Kong fell 0.18 percent to 6.5201.

The People’s Bank of China earlier raised the daily fixing against the dollar, which restricts onshore moves to a maximum 2 percent on either side, by 0.3 percent to 6.5118, the strongest since Jan. 4. A gauge of dollar strength declined 0.8 percent last week, when onshore Chinese markets were shut for the Lunar New Year Holiday.

TOM ORLIK, BLOOMBERG INTELLIGENCE ECONOMIST  

Central Bank Transparency — or Lack Thereof

Former U.S. Federal Reserve Chairman Ben S. Bernanke said that monetary policy is 98 percent talk and 2 percent action. For the 98 percent that is talk, the approach from the People’s Bank of China differs widely from practices developed by Bernanke at the Fed.

Lack of communication from the PBOC results from a combination of inexperience, key policy decisions taken elsewhere and deliberate attempts to take the market by surprise. Inexperience will fade. Institutional constraints and a push-and-pull approach to the market will not.

As Fed chairman, Bernanke saw communication as a critical part of policy. The Fed instituted inflation targeting, published the forecasts of Federal Open Market Committee members, used speaking events to signal policy intentions, held press conferences after FOMC meetings and provided briefings to journalists. Those practices have been maintained by Janet Yellen.

In China, there’s an inflation target, but it’s not the only objective of policy.

Forecasts of Monetary Policy Committee members aren’t published. Even if they were, they would be irrelevant as the MPC is only an advisory body. Major decisions on the direction and timing of policy are taken by the State Council. PBOC Governor Zhou Xiaochuan holds one press conference a year. Speaking events are few and far between. Policy documents use boiler plate language and offer scant details. Journalists have virtually no access to top policy makers.

Two recent incidents illustrate the problems that can cause. First, a 1.8 percent shift in the yuan’s central parity in August was interpreted as the beginning of a competitive devaluation. After days of intense selling pressure on the yuan, the PBOC convened a press conference to clarify their intention was to bring their daily fixing into line with the market price, not devalue to boost exports. In the weeks that followed, the PBOC was forced into active intervention in the markets to stem the yuan’s slide. That’s the opposite of what policy makers,

aiming for a more market-set exchange rate, wanted. More recently, the spike in the offshore yuan interest rate to 65 percent, a deliberate move to squeeze offshore yuan shorts and close the gap between China’s onshore and offshore currency, was conducted as a covert operation by the PBOC.

The PBOC’s miscommunication reflects a learning curve for a central bank not used to dealing with international markets in real time. That is starting to improve. The central bank has shifted to publishing detailed explanations of its policy moves in Q&A format on its website. Ma Jun, a senior economist, communicates with journalists on the thinking behind policy changes. In part, the PBOC’s communication problems reflect institutional issues and deliberate strategy that are not going to change any time soon. As long as the PBOC is attempting to resist market pressure for yuan depreciation, while keeping a lid on FX reserve sales, surprise moves to punish speculators will remain part of its arsenal.

TRADE DATA  FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMIST

Feb. 15, 2016 Bloomberg Brief China Brief 4

TRADE DATA  FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMIST

Export Slump Suggests Policy Support ImminentAn unexpected fall in China’s January exports underscores the fragility of global demand. That dents hopes that strengthening overseas sales in 2016 would support the world’s second-largest economy. Imports and other early indicators also point to weak domestic demand. To keep growth momentum from falling below the government’s comfort zone, policy makers may need to accelerate fiscal and monetary easing.

Exports measured in yuan terms dropped 6.6 percent year on year in January, down from a 2.3 percent rise in December and well below expectations of a 3.6 percent increase. That marked the lowest reading since July 2015. The drop suggests the fleeting pickup in exports in December may have been due to seasonal effects. January’s export data may have also been distorted by the Lunar New Year holiday, so it may be necessary to watch additional data points for further signs on the state of exports.

Exports dropped across China’s main trading partners. Overseas sales to Hong Kong fell 2.8 percent after a 10.6 percent rise in December. That suggests the likely over-invoicing of trade between China and Hong Kong eased in January.

Imports shrank 14.4 percent, down from December’s 4 percent fall and below expectations of 1.8 percent rise. Trade growth rates in the month were also flattered by a weaker yuan, which fell 5 percent at the end of January from a year earlier. The trade balance rose to record 406.2 billion yuan ($62 billion), up from 382 billion yuan.

January’s data are consistent with other early indicators — which point to fragile global demand. Fading competitiveness is a problem, but the fact that Chinese exporters continue to gain global market share suggests weak global demand is the main issue.

It is worth noting that headline import numbers might understate domestic demand, as low prices reduce China’s import bill. Looking at the data in volume terms, China’s purchases of major commodities remain on trend. Commodities markets might be

 

concerned about China’s growth outlook, but based on current purchases there’s little cause for alarm.

Weak exports pose a further downside risk to the weak economy, suggesting the government may need to step in more quickly with policy support to shore up domestic demand. In particular, policy makers may want to amp up fiscal

stimulus as soon as possible in order to bolster investment and consumption. Bloomberg Intelligence Economics also expects the People’s Bank of China will cut interest rates two times in the first half of the year. On the currency front, the disappointing data may also increase the depreciation pressure on the yuan.

FX   TOM ORLIK AND FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMISTS

Exports, Imports and Trade Balance

China Exports and Global Imports

Feb. 15, 2016 Bloomberg Brief China Brief 5

FX   TOM ORLIK AND FIELDING CHEN, BLOOMBERG INTELLIGENCE ECONOMISTS

China FX Reserve Drop Shows Stress, Not PanicChina’s foreign exchange reserves registered another significant drop in January. So far, though, there’s little sign of the cascading capital flight that would call the sustainability of the country’s exchange rate regime into question.

Bloomberg Intelligence Economics’ base case remains that the central bank will keep a close hold of the yuan through this period of selling pressure.

China’s foreign reserves fell to $3.23 trillion in January from $3.33 trillion in December. A drop of $99 billion was less than December’s $108 billion fall and below expectations of a $120 billion drop. Capital outflows remain substantial, and the central bank continues to intervene to prevent those from tipping over into yuan depreciation.

It’s possible the cost of defending the yuan was even larger than the headline drop in reserves suggests. That could be the case if the intervention in the Hong Kong market, which pushed the offshore yuan borrowing rate to 65 percent in January, was channeled through commercial banks rather than the People’s Bank of China.

The central bank may also be taking positions in the forward market, which are not immediately reflected in the FX reserve data.

Even so, January’s drop was less than forecast. That suggests the worst fears of cascading capital flight have not come to pass. Households are not maxing out their $50,000 annual quota for FX purchases. That might reflect what appears to be a re-peg of the yuan against the dollar since mid-January, which reduces the incentive for households to shift funds out of China’s currency.

A smaller-than-expected drop in reserves strengthens BI Economics’ view that the PBOC will be able to resist pressure for a disorderly depreciation. That reflects a number of factors:

Read this analysis with additional, live charts on the Bloomberg terminal . here

The stock of reserves remains ample, enough to cover outflows at the current rate for more than two and a half years.

A portion of outflows so far has come from loan repayment by corporates and overseas loans by banks — the headline drop overstates the degree of capital flight.

The costs of a disorderly depreciation would be substantial, and the government has other tools at its disposal to support growth.

BI Economics’ base case is that the PBOC’s management of the exchange rate in the months ahead will go through three stages. First, the yuan will be closely managed against the dollar — as it has been since mid-January. Then, as the dollar strengthens and a greater degree of calm returns to the markets, the PBOC will return to a peg to a basket of currencies. Finally, the central bank will step back from day-to-day intervention in the exchange rate and manage a float against a basket of currencies.

Close management of the exchange rate has implications for China’s other policy choices. Further interest rate cuts would place more downward pressure on the currency. In the short term, that means the PBOC is more likely to rely on less high-profile tools, including its alphabet soup of lending programs, to guide down rates. Fiscal policy will also play an expanded role.

January’s drop in FX reserves comes despite continued inflows on the trade account. The consensus forecast is for a trade surplus of some $60 billion in January. The mismatch between an expanding trade surplus and shrinking reserves suggests China’s exporters are choosing to keep their earnings in dollars rather than converting them into yuan — another register of bearish sentiment on the currency.

In past months, valuation effects have likely had a significant impact on the shift in headline reserves. With little movement in the euro against the dollar in January, valuation effects were likely muted.

MARKET CALLS BLOOMBERG NEWS

January's $99 Billion Drop Was Below Expectations

Feb. 15, 2016 Bloomberg Brief China Brief 6

MARKET CALLS BLOOMBERG NEWS

China’s strategy to weaken the currency periodically is unsustainable because such a depreciation leads to market selloffs and accelerated capital outflows, which in turn tighten financial conditions in the country contrary to broader policy goals, Goldman Sachs

strategists led by Group Robin Brooks wrote in a note. That suggests China may prefer a stable yuan to a “large, one-off” devaluation going forward, the strategists wrote. “Given that regulatory measures to stem outflows may ultimately prove insufficient, the best way to slow capital flight is to signal stability” in their daily reference rate “at least for the foreseeable future,” they said. The yuan may trade between 6.6 per dollar and about 7 per dollar by year-end, according to Goldman Sachs.

China’s benchmark stock index has plunged 24 percent this year on concern that the economic slowdown and weakening yuan will exacerbate capital outflows. Margin traders have also been unwinding bullish bets on stocks amid speculation valuations are still too high. Chinese investors “looked to global markets last week which were highly volatile,” said , chief Ronald Wanexecutive officer at Partners Capital

in Hong Kong. “If you look Internationalat the 2 percent drop, it’s not too drastic. The Shanghai index may have some support around 2,500.”

A slide in China’s exports in January was eclipsed by an even bigger tumble in imports, leaving a record trade surplus for the world’s biggest trading nation. A fuller reading on how China’s economy has started 2016 won’t be available until next month, when fresh readings on retail sales, investment and industrial output are due. "This shows that if China wants to deliver a 6.5 to 7 percent growth target this year they have to rely on domestic demand," said , head of China Larry HuEconomics at in Macquarie SecuritiesHong Kong. "Exports are likely to grow zero percent this year and property investment by zero to 5 percent. They need to come out with a bigger infrastructure package to invest."

FINANCIAL SYSTEM KATIA PORZECANSKI

Bank Losses May Top 400% of Subprime Crisis: Bass

Hedge fund manager Kyle Bass said China’s banking system may see losses of more than four times those suffered by U.S. banks during the last crisis. Should the banking system lose 10 percent of its assets because of nonperforming loans, the nation’s banks will see about $3.5 trillion in equity vanish, Bass, the founder of Hayman Capital Management, wrote in a letter to investors. China's economy may end up having to print more than $10 trillion of yuan to recapitalize banks, pressuring the currency to devalue in excess of 30 percent against the dollar, according to Bass.

“What we are witnessing is the resetting of the largest macro imbalance the world has ever seen,” he wrote. “Credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world.”

Bass said his hedge fund has sold most of its riskier assets since the middle of last year to position itself for 18 months of “various events that are likely to transpire along this long road to a Chinese credit and currency reset.” He said about 85 percent of his portfolio is invested in China-related trades.

“The problems China faces have no precedent,” Bass wrote in the letter. “They are so large that it will take every ounce of commitment by the Chinese government to rectify the imbalances.”

The banking system, which he estimates swelled 10-fold in assets over the last decade to more than $34.5 trillion, is fraught with risky products used by financial companies to skirt regulations, wrote Bass. The nation’s expanding shadow banking system — which he says has grown almost 600 percent in the last three years, citing UBS Group data — “is where the first credit problems are emerging.”

Wealth-management products, which have been used by Chinese banks for off-balance sheet lending and to lure buyers with perceived guarantees and yields that trump the deposit rate, are being brought back onto the balance sheets as they begin to fail, according to Bass. He also said the use of trust-beneficiary rights are “ticking time bombs” because they’re used by banks to hide loan losses.

“We believe the epicenter of the problem is the Chinese banking system and its coming losses,” he wrote. “Until China experiences a significant devaluation, it will not be able to cope with the build-up of credit that has helped fuel its rise, but may, in the short-term, be its undoing.”

ENVIRONMENT   FEIFEI SHEN, BLOOMBERG NEWS

Feb. 15, 2016 Bloomberg Brief China Brief 7

ENVIRONMENT   FEIFEI SHEN, BLOOMBERG NEWS

China's $230 Billion Green Bond Thirst to Supercharge MarketChina’s effort to build a green bond market may reap 1.5 trillion yuan ($230 billion) for renewable energy and environment projects within five years, potentially charging growth in a market that barely existed a few years ago.

The nation authorized the first sales of the securities in December, prompting two Chinese banks to raise a total of 30 billion yuan last month. The market may rake in 300 billion yuan a year from now to 2020 in China alone, according to Xu Nan, a senior policy analyst at the Research Center for Climate and Energy Finance under the Central University of Finance and Economics.

Sales of that magnitude would add weight to the $46 billion in green bonds sold worldwide in 2015, according to Bloomberg New Energy Finance, which estimates that the value of deals has doubled in the past two years. China’s government is encouraging green bonds as a way to finance its drive to build clean-power generators and the companies that promote them.

“China will be the main battlefield for future energy saving and emission reduction,” with rising demand for green financing, Lu Zhengwei, chief economist at the Industrial Bank, said at a briefing in Beijing on Feb. 2. It also “means that China’s efforts to protect the environment and cut emissions are put under the international supervision” of investors who will buy the bonds.

Bonds labeled as green use proceeds on projects that save energy, curb pollution and recycle resources as well as clean transportation and renewable energy. Clean energy investment alone in China increased by almost 10-fold in the past decade to a record $110.5 billion in 2015, Bloomberg New Energy Finance data show. The market was worth less than $5 billion a year until 2010.

The two Chinese banks that sold green bonds to date were Shanghai PudongDevelopment Bank, which raised 20 billion yuan in China’s first domestic green bond on Jan. 27, and Industrial Bank, with a 10 billion-yuan issue.Shanghai Pudong had offers to buy twice the value of securities it sold.

“China could become a major green

bond issuer in the world,” Ma Jun, the chief economist at the People’s Bank of China’s research bureau, said at a briefing in Beijing on Feb. 2.

The niche product used to fund projects tackling climate change has been gathering pace worldwide in recent years. The value of outstanding green bonds may almost double this year to as much as $158 billion from a year earlier as they start to become mainstream, according to HSBC Holdings.

Green bond sales are needed to fund China’s political policies on reducing pollution and building alternatives to fossil fuels, said Li Haitao, head of fixed income trading at Hua Fu Securities.

“Major buyers are currently banks as they are more driven by policies than the market,” Li said.

Chinese companies were starting to tap the green bond market abroad last year. In July, Xinjiang Goldwind Science & Technology issued $300 million of three-year bonds, marking China’s first sale of green bonds denominated in dollars. In October, Agricultural Bank of China’s sale of 600 million yuan of two-year green bonds was eight times oversubscribed.

Even the green bond sales forecast may not be enough to fund all the projects China envisions. The nation needs 2.9

investment annually in thetrillion yuan of

next five years to support its green energy ambitions, the Financial Research Institute of the State Council’s Development Research Center forecasts.

Until now, bank lending has been the main funding source for environmentally friendly initiatives. Green-project lending from 21 major Chinese banks exceeded 6 trillion yuan as of the end of 2014, according to the China Banking Association. That made up almost 10 percent of the lending activity on the part of the group.

Green bonds may become a cheaper source of finance than traditional bank loans. Shanghai Pudong and Industrial Bank will both pay 2.95 percent interest annually on their three-year green bonds. This compared with a rate of 3.18 percent for traditional financial bonds from commercial banks with similar terms and the central bank’s benchmark rate of 4.75 percent for borrowings of up to five years.

China could issue policies such as helping energy saving projects cover some of a bond’s interest to attract investors, said Hao Yijun, a senior trader at China Guangfa Bank Co. in Shanghai.“As more policies come out, the group of green investors will become bigger,” said Ivan Tong, a partner on climate change & sustainability services in Ernst & Young Hua Ming.

EM CRISIS   FIELDING CHEN AND TOM ORLIK, BLOOMBERG INTELLIGENCE ECONOMISTS

Green Bond Issuance Totaled $46 Billion Last Year

Feb. 15, 2016 Bloomberg Brief China Brief 8

EM CRISIS   FIELDING CHEN AND TOM ORLIK, BLOOMBERG INTELLIGENCE ECONOMISTS

Crisis Contained? Emerging Market Lessons for ChinaIs China on the cusp of an old-fashioned emerging market crisis? A review of meltdowns over the last 25 years shows these events are triggered by a combination of four factors: high foreign debt, inadequate reserve buffers, limited policy space to support growth and political instability. On those axes, China scores significantly better than its peers, suggesting the country is well-resourced to stave off the worst outcomes.

In 1996, on the eve of the Asian financial crisis, Indonesia had foreign debt at 57 percent of GDP and FX reserves at just 8 percent of GDP. Other pre-crash emerging markets exhibited similar combinations. At the end of 2015, China's foreign debt was just 15 percentof GDP and the People's Bank of China boasted FX reserves of 32 percent of GDP.

China also scores well on the fundamentals of growth and inflation. While its economy might not be growing as fast as it was, 6.9 percent expansion in 2015 means China is still generating a lot of resources that can be put to use in times of crisis. Inflation at 1.4 percent and low central government debt means there’s scope for policy to support growth.

Political stability is also an advantage. With stability at the top and respected veterans in charge at the central bank and Ministry of Finance, China does not face those problems.

High leverage is a significant problem and already a drag on growth, but on a one- to two-year time horizon will not tip the economy into crisis. The vast majority of debt is domestic. Much of the lending and borrowing is between different arms of the government. That means the government has time and tools to manage the problem.

The lesson of recent history is that the consequences if a currency crisis would be severe and far reaching. On average, the seven emerging markets in our sample saw currencies fall 64 percent against the dollar from pre-crisis to trough. GDP contracted 7 percent in the first year and unemployment rose 2 percentage points. Countries that did not face instability ahead of the crisis did so afterward, with Indonesia among those

seeing a change of government.  Would China’s low foreign debt provide

a cushion, even if the yuan fell sharply? Maybe. But the impact of capital flight on the financial system could still be

damaging. Recovering from the blow to confidence as events spiral out of the control would also take time. The risk of a crisis is low. The impact if it does occur will be high.    

INDUSTRY INSIGHTS  FRANCIS CHAN, BLOOMBERG INTELLIGENCE ANALYST

One Cause For Concern: Economy-Wide Leverage

China's M2, at 206 percent of GDP in 2015, is significantly higher than in other emerging markets. Massive domestic money supply means significant scope for capital outflows, which could overrun even the PBOC’s $3.3 trillion in FX reserves. Banks and corporates are overstretched, reducing their capacity to deal with a capital exodus.    

Currency Performance Three Years After Crises

Feb. 15, 2016 Bloomberg Brief China Brief 9

INDUSTRY INSIGHTS  FRANCIS CHAN, BLOOMBERG INTELLIGENCE ANALYST

China’s Capital Outflow May Weigh on Bank Margins, DepositsChina's onging capital flight, hastened by projections for a weaker yuan, may be squeezing the availability of domestic bank deposits. Growth in deposit balances has decelerated, rising just 1.1 percent from August through December last year. That compares with a gain of 15.9 percent in the first half of 2015 and 9.6 percent in 2014. If businesses and Chinese citizens continue to move capital offshore, this may increase deposit- and funding costs at China's banks.

Slower growth in bank deposits may also crimp lenders' margins, which have already been squeezed by the People's Bank of China's rate cuts through 2015. The average net interest margin of six of China's largest banks — CCB, BOC, Bocom, CMB, Minsheng and Citic — was 2.4 percent in the first nine months of 2015, narrowing by 11 basis points from the same period in the previous year.

Capital outflows that evade the banking system are also another concern for lenders. The exodus of capital from mainland China may flow through channels outside the nation's banks, making it difficult for the government to track. Outbound tourist transactions and bulk cash smuggling are among the more common avenues residents may consider for capital flight. Chinese tourists will spend $200 billion to $500 billion abroad annually, according to estimates by the Shanghai-based asset manager Canaan Capital.

Bank fees from foreign-exchange remittance and related transactions may fall as a result. ICBC, China Construction and Bank of China are among China's biggest banks providing foreign-currency remittance and exchange services worldwide. Global banks such as HSBC, Standard Chartered and Citibank are also competing in this business.        

OIL HEESU LEE, DEBJIT CHAKRABORTY AND WINNIE ZHU, BLOOMBERG NEWS

Domestic Bank Deposit Growth Slowing Down

Tourist Transactions Common Avenue for Capital Flight

Feb. 15, 2016 Bloomberg Brief China Brief 10

OIL HEESU LEE, DEBJIT CHAKRABORTY AND WINNIE ZHU, BLOOMBERG NEWS

China Turns a Glut of Oil Into a Flood of Diesel Swamping Asia    Fuel producers from India to South Korea are finding that rising refined products from China are cutting the profit margins they’ve enjoyed from cheap oil to the lowest in more than a year. Worse may be coming.

China’s total net exports of oil products will rise 31 percent this year to 25 million metric tons, China National Petroleum Corp. said in its annual research report. That comes after diesel exports jumped almost 75 percent last year.

“If China dumps more fuel into the market, international prices will crash,” said B.K. Namdeo, director of refineries at India’s Hindustan Petroleum. “It will be similar to what happened to crude prices due to the oversupply. If international prices of oil products come down, then it will hurt margins of all refiners.”

A common measure of refining profitability in Asia — the margin from turning Middle East benchmark Dubai grade into fuels including diesel and gasoline in the regional trading hub of Singapore — slid this week to the lowest level since October 2014, adding to mounting evidence that China’s exports are weighing on Asian processors.

Singapore Dubai cracking margins have averaged $1.92 a barrel so far this year, down from $3.96 during the last quarter of 2015, research firm Energy Aspects said in a report. Profits are expected to average $3 a barrel during the first quarter of 2016, down 32 percent from the same period last year, it said.

CNPC predicts the country’s refineries will increase output this year after the government started giving licenses to independent refiners — those known as teapots — to ship their products abroad. South Korea’s biggest processor says the

flood will probably weaken margins and Taiwan’s Formosa Petrochemical sees it as a “risk factor.”

China shipped a record amount of diesel, kerosene and gasoline abroad last year and for the first time exported more products than it imported amid the slowest economic expansion in 25 years. Its crude purchases increased to a record in 2015 as the world’s second-biggest oil consumer sought to fill its strategic oil reserve and the government allowed those teapots to buy foreign supplies. Refineries will increase oil processing by 5.3 percent, while net crude imports rise 7.3 percent to 357 million tons, according to CNPC.

The teapot refiners, clustered around the eastern province of Shandong, will account for the bulk of the increase in oil

processing this year as the country’s bigger state-owned processors decrease output, CNPC said in its report.

The country’s commerce ministry has issued more than 1.8 million barrels a day of export quotas for the first quarter, more than double in the same period last year, analysts at Barclays including Miswin Mahesh said in a report Feb. 5. The bulk of the increase is coming from diesel, which is up almost sixfold from the first three months of 2015, they said.

“Chinese domestic incentives to export refined fuel, if they run out of product inventory storage, could lead to discounted products and would be competitive with refined product exports from India and South Korea,” said Mahesh.

PRECIOUS METALS KENNETH HOFFMAN, BLOOMBERG INTELLIGENCE ANALYST

Refining Margins Dropped to Lowest Since Oct. 2014

Feb. 15, 2016 Bloomberg Brief China Brief 11

PRECIOUS METALS KENNETH HOFFMAN, BLOOMBERG INTELLIGENCE ANALYST

Gold Consumption Rebounded Amid Yuan Uncertainty

The People's Bank of China, is increasingly transparent about its gold reserve holdings after years of being opaque. China announced six increases in its holdings in 2015. The latest increase, in December, added almost 19 metric tons and pushed the country's reserves to 56.66 million troy ounces, still well behind the U.S., which holds 261.5 million ounces. Until 2015, the People's Bank of China had gone six years without making an announcement on a change in holdings.

China badly trails the U.S. in gold holdings, even after years of buying, newly released figures show. The Federal Reserve has 261.5 million ounces of gold stored, compared with Chinese holdings of 56.7 million ounces. Gold stored by central banks can project strong physical backing for a currency. China, which is seeking to establish the yuan as a reserve currency, boosted its holdings by 3.3 million ounces in the second half of 2015. At the current pace, it will take China 30 years to overtake the U.S.    

Strain on the yuan is draining China's reserves, with foreign exchange plunging to $3.23 trillion from $3.33 trillion in December. This could help gold but hurt copper prices. A weaker yuan may convince Chinese buyers to buy more gold as a way to store their dwindling assets in a safe-haven investment. As for copper, the attractiveness of the carry trade, may be lessened if the yuan falls. Traders may pressure the People's Bank of China to devalue the yuan.

China's gold consumption rebounded in December as buyers returned to gold as a safe haven amid concerns of further yuan deterioration. Shipments to China surged to 59,000 kilograms, more than triple November's 16,500 kg. Swiss gold exports jumped 15.6 percent sequentially to 218,181 kilograms, the highest level since April 2013. Outflows to Asia, 70 percent of total shipments, varied. Shipments to Hong Kong rose 33.7 percent.

BLOOMBERG ECONOMIC STATISTICS {ECST <GO>}

Gold Reserves Now Updated Frequently Gold Dominance Dream May Be Years Away

FX Reserve Drop Aids Gold, May Hurt Copper Swiss Gold Exports at 32-Month High

Feb. 15, 2016 Bloomberg Brief China Brief 12

BLOOMBERG ECONOMIC STATISTICS {ECST <GO>}

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Equity Market

Feb. 15, 2016 Bloomberg Brief China Brief 13

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BLOOMBERG ECONOMIC STATISTICS…

The People’s Bank of China earlier this month cut down payment requirements for first-time home buyers to 20 percent from 25 percent, the latest in a series of moves aimed at reviving a flagging housing market. Down payment requirements for second-home buyers will be cut to 30 percent from 40 percent.

The lower down payment requirement significantly reduces the threshold to buy a home. For an average 1.3 million yuan ($198,000) apartment, first-time buyers now have to stump up 260,000 yuan, down from 325,000 yuan previously. Average urban disposable incomes stood at 31,000 yuan in 2015.

A year of property easing has succeeded in driving a revival in sales and a firming of prices, especially in top-tier cities. The latest move, which is targeted at cities outside the top tier, should help spread those benefits a little more widely around the country.

There’s little sign that rebounding sales are passing through to construction. That reflects developers’ concerns about high inventory and massive quantities of empty apartments owned by speculators.

In 2015, China built 10 million apartments, compared with fundamental demand of 8 million units, Bloomberg Intelligence Economics’ calculations show. In the next few years, supply will contract to come into line with demand. Measures like the down payment cut will smooth that transition; they won’t change the overall trajectory of the sector.

—  Tom Orlik and Fielding Chen, Bloomberg

Intelligence economists

Property Move Will Boost Sales, Not Construction  

Bloomberg Brief: ChinaBloomberg Brief Managing Editor

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Michael McDonough

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Chief Asia Economist

Tom Orlik

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Asia Economist

Fielding Chen

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Asia Economist

Tamara Henderson

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THE BOTTOM LINE   BLOOMBERG NEWS

Feb. 15, 2016 Bloomberg Brief China Brief 14

THE BOTTOM LINE   BLOOMBERG NEWS

The Bottom Line collects a week's worth of

corporate anecdotes in China from Bloomberg

News stories.  

Kaidi to Build $1.1 Billion Biorefinery

Sunshine Kaidi New Energy Group will invest about 1 billion euros ($1.1 billion) in a new biodiesel plant in Finland, betting liquid fuels will play a key role in the transport sector over the coming years. Kaidi Finland expects to produce 200,000 tonnes of second-generation biofuel each year, once the plant in Kemi, northern Finland, comes online in 2019. “We believe liquid fuels will play a significant role in traffic use in the future,” said Pekka Koponen, chief executive officer of Kaidi Finland. “Cars and distribution infrastructure exists already, and biofuels fit in the picture without any additional investment.”

— Raine Tiessalo and Jessica Shankleman

China Said to Pitch Hong Kong Listing, Funds for Aramco IPO    

Chinese officials pitched a dual listing for that would put Saudi Arabian Oil Co.the government-owned oil giant’s shares on both the Hong Kong and Saudi exchanges in return for anchor investments from Chinese funds, according to people familiar with the matter. One option Aramco is considering is an IPO for part of its downstream and refining businesses, which could be valued at more than $90 billion and raise $5 billion to $10 billion, the people said. Aramco is a strategically important asset for China. Saudi Arabia was the source of 16 percent of China’s foreign oil, its largest supplier in 2014, according to the U.S. Energy Information Administration.

— Ruth David and Dinesh Nair

Behind China's $720 Million Bet on U.K. Tech Startups    

It’s not every day that a new venture capital fund rocks up in London with 500

Biodiesel

Oil

Startups

million pounds ($720 million) in its purse and an ambitious plan to help British startups. is Cocoon Networks Venturesone of the first Chinese venture funds to open for business in the U.K. — and one of the largest of any kind aimed at early stage investment in the country. Cocoon is targeting the U.K. in part because startup valuations were more attractive than in China, where there is too much money chasing every good idea, or Silicon Valley, which has already seen an influx of Chinese investment. He said valuations in the U.K. were about a third of that in China. "The Chinese economy is going through a transition and it realizes it needs innovation," said Koen Vandecaveye, a senior business manager at London & Partners. He said Cocoon Networks realized that it could help startup companies based in London go back to Asia and build a global presence.

— Jeremy Kahn

Opera to Be Sold to Chinese Tech Companies for $1.2 Billion  

Opera Software agreed to sell itself to a group of Chinese technology companies for about 10.5 billion kroner ($1.2 billion) in a deal that will give the Norwegian maker of Web browsers additional financing and access to new customers in China. The buyers include Golden Brick Capital Management, Beijing Kunlun Tech, Qihoo 360 Technology and Yonglian Investment. The sale will give Opera access to the Web-user base of Kunlun and Qihoo in China as well as additional financing, the company said.  “If you look at the industrial partners, it’s an ecosystem idea,” Chairman Sverre Munck said. “Ecosystem is a key word because we compete with the big ones, Facebook, Google, Apple. To compete alone against an ecosystem is rather demanding. Now we become part of an ecosystem that suits us well.”

Adam Ewing—

Foxconn's Gou Takes Step Toward Victory in Battle For Sharp   

Foxconn Technology Group

Software  

Electronics

Chairman Terry Gou took a step forward in the hotly contested battle for control of Japan’s Sharp Corp., saying he’s become the preferred negotiating partner for a bailout of the struggling consumer electronics maker. Gou spoke outside Sharp headquarters in Osaka after a meeting that stretched to nine hours, long past its planned completion. He held up a paper with his signature and that of Sharp CEO Kozo Takahashi, and said he expects to have a final agreement by the end of February.

— Takashi Amano and Pavel Alpeyev

Chinese Shoppers Boost Japanese Premium-Mall Sales to Record

Chinese tourists buying million-yen watches and luxury brands helped boost sales at Japanese premium outlet malls owned by Mitsubishi Estate to a record last year, as a weaker currency led to a

The surge in bargain-hunting visitors. tourism boom is helping Japan’s largest developer by market value navigate slowing consumption as the nation’s population drops. Overseas tourists visiting the company’s nine high-end outlets rose more than 80 percent to 1.17 million in the first nine months of 2015, said Yutaka Tajima, a senior executive officer at Mitsubishi Estate.

— Chris Cooper and Katsuyo Kuwako

Cognac Maker Forecasts China's Market Declining 5% to 10%

Pernod Ricard fell the most in almost six months after the world’s second-largest distiller said it expects the Chinese market for spirits to decline by 5-to-10 percent in its fiscal year, the company said. Pernod CFO Gilles Bogaert said the company can’t raise prices in China at the moment. “Pernod is the least bullish of the three majors” on China, said Eamonn Ferry, an analyst at Exane BNP Paribas. Pernod’s first-half sales in China fell 8 percent after adjusting for the earlier arrival of Lunar New Year, the spirits maker said, worse than the 7 percent expected by analysts including Mirabaud’s Jonathan Fyfe.

— Thomas Buckley

Luxury

Spirits

OPINION: CHINA  CHRISTOPHER BALDING, BLOOMBERG VIEW CONTRIBUTOR

Feb. 15, 2016 Bloomberg Brief China Brief 15

OPINION: CHINA  CHRISTOPHER BALDING, BLOOMBERG VIEW CONTRIBUTOR

Why Should the World Fear a Falling Yuan?Everyone from buttoned-down Japanese central bankers to ex-slugger Jose Canseco seems to be worried about the sliding value of China's currency, the yuan. The fear is that a cheaper yuan will spur other export-dependent countries to devalue as well in order to remain competitive, sparking a global currency war. Meanwhile, ordinary Chinese will presumably race to move their money out of the country and Chinese companies will struggle to pay back loans taken out in dollars. A truly uncontrolled dive threatens to cause havoc throughout China's opaque financial system.

Such fears are overblown. The true impact of a falling yuan is likely to be both more nuanced and more limited in nature.

At the most basic level, a falling currency raises the prices of imported goods and lowers the prices of exported goods. Demand for and consumption of imports should decline as they become more expensive, while exports receive a boost. That's the model China used for decades to power its economic boom. Most other countries, including the U.S., have traditionally favored a strong currency that raises the domestic standard of living vis-a-vis the rest of the world.

China, too, says it now favors a stable yuan and has been spending billions each month to buy up the currency to bolster its value. There would appear to be two dangers: first, that the effort fails in the face of concerted downward pressure from the markets; or second, that China itself decides to devalue in order to revive its export-focused manufacturing sector.

Yet how bad would that really be? Chinese companies are moving quickly to pay off or restructure their dollar loans. As for consumers, it's important to remember that large countries such as China trade less than small countries in relative terms. Thus they're better insulated against a rise in the price of imports. (Imports comprise only about a fifth of Chinese GDP.)

Additionally, not all the products countries import are equally price-sensitive. Machinery, metals, minerals and chemicals make up about 60 percent of Chinese imports. Add in precision equipment such as watches and medical devices, precious metals, transport and rubber products and the proportion rises to nearly 90 percent. Price affects but doesn't finally determine demand for most of these goods. Chinese commodity imports are likely to continue declining, but more because of the overcapacity created by a surge in investment after the 2008 global financial crisis, rather than anything to do with the yuan.

The true impact of a falling yuan is likely to

be both more nuanced and more

limited in nature.

The sheer volume of Chinese exports means the country does have an outsized impact on world markets. Yet Chinese exports remain dominated by electronics and garments. Base metal processing and miscellaneous manufacturing bring the proportion up to almost 70 percent of total exports. These are, despite talk of moving up the value chain, still low-wage and low-skill sectors.

The countries that will feel the most pain — low-wage nations such as Bangladesh, Vietnam and Indonesia — represent a relatively limited subset of the global economy. While China's recently raised its share of global clothing exports at their expense, the world's biggest economies have much less to fear.

The latter no longer make the kind of basic manufactured goods that dominate

Chinese exports, at least not in large quantities. To take one example, China received $459 per ton of exported steel in December but paid $1,023 per imported ton. Why the difference? China is exporting low-quality steel but importing more valuable, specialty products. Japan, the U.S. and South Korea hold dominant positions in the latter fields.

Nor would a falling yuan necessarily generate a wave of global deflation. Core price deflation in areas such as energy, commodities, and food has more to do with increased productivity and overinvestment outside of China than it does with yuan policy. If declines in the dollar after the 2008 crisis and the yen more recently didn't spur worldwide deflation, there's no reason to think a fall in the yuan would now.

Before worrying about what China does or doesn't do with its currency, other countries should set their own houses in order. After 2008, the world economy revived on the back of a Chinese construction boom that drove up commodity prices and investment. Now that China's slowdown has been evident for at least a year, companies would be well advised to start planning for a "new normal" of slower growth and investment, as well as a moderately weaker yuan.

If the rest of the world wants China to join the global economy, they have to be willing to treat the country the same as any other. It's a bit rich for nations such as Japan, which has allowed the yen to plummet against the dollar, to suggest that China should impose hard capital controls to prevent the yuan from sliding. If the market thinks the Chinese currency is overvalued, it should be allowed to find its fair level. It won't be the end of the world.

Christopher Balding is an associate professor of

business and economics at the HSBC Business

School in Shenzhen. This column does not

necessarily reflect the opinion of the editorial

board or Bloomberg LP and its owners.