"Nomura -China Rising risks of financial crisis"
Asia Special Report NOMURA GLOBAL ECONOMICS NOMURA INTERNATIONAL (HONG KONG) LIMITED China: Rising risks of financial crisis China is displaying the same three symptoms that Japan, the US 15 March 2013 and parts of Europe all showed before suffering financial crises: Authors a rapid build-up of leverage, elevated property prices and a decline in potential growth. Economists, Asia ex-Japan We delve into the financial risks facing China’s economy and find Zhiwei Zhang email@example.com that the most vulnerable areas are local government financing +852 2536 7433 vehicles, property developers, trust companies and credit Wendy Chen guarantee companies. We also show how they are interlinked. firstname.lastname@example.org +86 21 6193 7237 If the government acts this year with tighter policies – and our base case is that it will – we believe it can still avoid a systemic FX and Rates Strategists, Asia ex-Japan financial crisis. But that would come at a short-term cost of Craig Chan slower GDP growth, which we expect to average 7.3% in H2 2013. email@example.com See Appendix A-1 +65 6433 6106 for analyst As history has repeatedly shown, the slower the policy response certification, important Prateek Gupta to financial excesses, the greater the risk of a systemic financial disclosures and the firstname.lastname@example.org status of crisis and the more challenging it will be to avoid a hard economic +65 6433 6197 non-US analysts. landing. Vivek Rajpal email@example.com +91 22 4037 4438 Prateek Gupta firstname.lastname@example.org +65 6433 6197 Wee Choon Teo email@example.com +65 6433 6107 Nomura Nomura | Asia Special Report 15 March 2013 Contents Introduction 3 Symptoms of financial risks 4 1. Rapid build-up of leverage 4 2. Rapid asset price inflation 9 3. Decline of potential growth 11 Identifying the risks 15 Government finances 15 Financial sector conditions 17 Household sector 21 Corporate sector 21 The linkage of risks and moral hazard 22 Endgame: Base case and risk scenario 23 Base case 23 Risk scenario 24 Appendices 26 Appendix 1: Five rounds of trust company regulation 26 Appendix 2: Trust companies have grabbed the headlines 27 Appendix 3: Forecast summary 28 References 29 Recent Asia Special Reports 30 2 Nomura | Asia Special Report 15 March 2013 Introduction The Chinese government has in recent months sent a number of unusually strong signals that it The government has sent is concerned about financial risks in the economy. At December‟s Central Economic Working strong signals that it is concerned about financial risks Conference, the new generation of leaders stated the need “to defend the bottom line of preventing [a] systemic financial crisis”. At its Q4 2012 monetary policy committee meeting, the People‟s Bank of China (PBoC) decided to make “controlling risks” a top policy objective. Then on 31 December, the Ministry of Finance, the National Development and Reform Commission (NDRC), the PBoC and the China Banking Regulatory Commission (CBRC) issued a joint statement on one of the most pressing issues facing China‟s authorities – the need to crack down on improper fundraising activities by local governments. The government lowered the M2 growth target to 13% in 2013 from 14% in 2012 at the National People‟s Congress in March. Government concerns have been echoed by warnings from within the financial industry as well The IMF and business leaders as external sources. Bank of China CEO Xiao Gang, writing in the China Daily (12 October have also voiced concerns… 2012, “Regulating shadow banking”), openly criticised the common bank practice of relying on a non-transparent “capital pool” to manage wealth-management products and accused them of “running a Ponzi game”. In its October 2012 Global Financial Stability Report (GFSR) the IMF highlighted China‟s rising financial risks. As we illustrate in this report, there has been a substantial amount of negative news related to new financial products – especially trust products – and the intensity of such coverage has picked up since late 2012. Nonetheless, we believe the true extent of financial risks in China is not fully appreciated by … but since Q4 2012 the investors. Fears of a hard landing sent the MSCI China index down to 51.63 in the summer of market seems to have discounted them as growth 2012, but the subsequent economic recovery seems to have alleviated such fears with the recovers index up some 20% since then (Figure 1). The consensus forecast expects a sustainable recovery of GDP growth from 7.8% in 2012 to 8.1% in 2013 and 8.0% in 2014. The market has turned from being very bearish on China‟s outlook six months ago to being quite optimistic. So is the market underestimating the financial risks in China or is the government over- We believe the market is under- alarmed? We believe China faces rising risks of a systemic financial crisis and that the estimating the risks in China and that growth will slow in H2 government needs to take action quickly to contain such risks. We assume it will do so in H1 2013 2013 and consequently we expect GDP growth to slow to 7.3% y-o-y in H2 from 8.1% in H1 (Consensus is for growth of around 8% through 2013; Figure 2). If a loose policy stance is maintained and these risks are not brought under control, strong growth of above 8% in 2013 is possible, but that would heighten the risks of high inflation and a financial crisis in 2014. We elaborate our concerns in this report and illustrate them via three common symptoms that We elaborate our concerns, have preceded major financial crises elsewhere: 1) high leverage; 2) the rapid rise of asset highlight where the risks lie and discuss how they might play out prices; and 3) a decline of potential growth. China‟s economy already exhibits these symptoms. We discuss financial conditions in the public, financial, corporate and household sectors, and identify the risks that are building for local government financing vehicles, property developers, trust companies and credit guarantee companies. We conclude by laying out our views on the potential triggers that could turn these risks into real threats to the economy. Fig. 1: MSCI China index Fig. 2: China GDP growth forecast: Nomura vs Consensus Index % y-o-y Consensus forecast 70 8.5 Nomura forecast Actual 65 8.0 60 7.5 55 50 7.0 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 Source: Bloomberg and Nomura Global Economics. Source: Consensus Economics and Nomura Global Economics. 3 Nomura | Asia Special Report 15 March 2013 Symptoms of financial risks 1. Rapid build-up of leverage Empirically, the build-up of leverage has been identified as a simple but tried and tested leading Academic research shows high indicator for financial crises in academic research. There is a long list of academic literature on leverage causes financial crises this, growing quickly due to the higher frequency of crises in recent years that drives a need for useful early warning indicators (see Zhang, 2001, for research on the Asian financial crisis; Frankel and Saravelos, 2011, for an extensive reference list on the global financial crisis). Intuitively, it makes sense why leverage works as a leading indicator of financial crises. Through A rise in leverage has preceded history, bubbles have often been preceded by grand economic miracles, real or illusionary. The many major financial crises in the past 1840s saw the birth of British railway mania after the world‟s first inter-city railway, connecting Liverpool and Manchester, opened in 1830 and proved highly successful. A hundred and fifty years later, Japan‟s bubble was preceded by 30 years of rapid economic growth. The dotcom bubble in the late 1990s claimed the backing of technological revolution; while before the global crisis of 2008, the US housing bubble was described as the “great moderation” due to central bankers who had won the battle against inflation and put an end to business cycles. In such cases investors and firms leveraged up to maximise returns, assuming past performance would continue in the future. Leverage in China‟s economy, as measured by the domestic credit-to-GDP ratio (DCG Leverage of China‟s economy hereafter), has reached its highest level since data was made available in 1978. Domestic credit has reached an historical high is defined as claims by deposit taking institutions, mostly loans and government and corporate bonds held by banks and credit unions. The DCG ratio was 120.8% before the global financial crisis but has risen sharply since as the government implemented proactive fiscal and monetary policies to support growth and relied on bank loans to finance the fiscal expansion (Figure 3). Some analysts and government officials believe that China's leverage is unalarming compared Some argue leverage is not as to other economies, arguing that the average level of DCG in OECD economies was 211% in high as in developed countries such as Japan, so there is no 2011, higher than the current level in China (Figure 4). Moreover, of the large economies that need to worry have experienced major financial crises, they experienced much higher levels of leverage than China today – Japan‟s DCG ratio was 237% in 1989; it was 224% in 2008 in the US; and it was 158% in Europe in 2009. If we take Japan's DCG in 1989 as a benchmark of sorts, then China still has a very long way to leverage up before reaching the "crisis zone". Fig. 3: China’s domestic credit-to-GDP ratio Fig. 4: Domestic credit-to-GDP comparison % of GDP % of GDP 250 155 200 135 150 100 115 50 0 95 China Thailand OECD Spain Japan US 1997 2000 2003 2006 2009 2012 (2012) (1997) (2011) (2011) (1989) (2007) Source: IMF, CEIC and Nomura Global Economics. Source: IMF, World Bank and Nomura Global Economics. However, we believe it is misleading to compare the level of leverage in China to that of We believe comparing the level developed economies. First of all, the average DCG ratio for OECD countries should not be of leverage across countries is misleading taken as a healthy benchmark as many developed economies are in debt crises – it makes little sense to argue that a person standing close to a cliff‟s edge is safe because he‟s standing so much higher than those who have already fallen off it. Neither does it make sense to compare 4 Nomura | Asia Special Report 15 March 2013 the level of leverage in China today with that in Japan 25 years ago as it fails to take into account the country-specific conditions of the different eras, such as, for example, the development of financial markets and the level of financial assets in the economy. A better approach to compare different countries' experience is to assess not only the level of The change of leverage is a leverage, but also the change in leverage. A high but stable level of leverage does not leading indicator for crises necessarily suggest high risks, but a rapid build-up of leverage (i.e., where credit growth outpaces GDP growth) should make both investors and regulators vigilant. In that sense we need to worry about China. Its leverage, measured by the DCG ratio, rose China‟s leverage rose by 34% quickly from 121% of GDP in 2008 to 155% in 2012 (Figure 5). Looking at China's history over of GDP in five years – a worrying sign given its history the last 30 years, there was a similar build-up of leverage in the 1990s which made the whole banking sector insolvent. After Deng Xiaoping‟s famous Southern tour in 1992, China began an investment boom which ultimately led to economic overheating and high inflation. Leverage rose quickly, as the DCG ratio climbed 24 percentage points (pp) from 1994 to 1998. Policy had to tighten to contain inflation, and then the Asian financial crisis amplified the cycle as the government pushed expansionary policies to offset a decline in exports. Consequently, China went through a long and painful deleveraging process from 1998 to 2004. According to the World Bank, the non-performing loan (NPL) ratio in China's banking sector rose to a high of 29.8% in 2001 and the government had to restructure the major banks by injecting public funds and removing bad loans to asset management companies. The 5-30 rule International comparison also suggests the build-up of leverage since 2008 is dangerous. We Leverage in Japan, the EU and notice an interesting common phenomenon which we call the "5-30 rule" – where financial the US rose by around 30% of GDP in the five years before crises in large economies are usually preceded by the leverage ratio rising sharply by 30% of entering a crisis GDP in the five years before the crisis is triggered (Figure 6). In Japan, the DCG ratio rose from 205.9% in 1985 to 237.4% in 1989. The stock market peaked in December 1989 and the economy entered its “lost decade” – the average GDP growth rate fell to 2.0% from 1989 to 1998 from 4.4% from 1979 to 1988 (Figure 7). In the US, the 5-30 rule can be applied to two crises in the past 15 years (Figure 8). During the tech bubble, the DCG ratio rose by 36% of GDP, from 173% in 1995 to 209% in 1999. The bubble burst in 2001, dragging GDP growth down by 3pp from 2000 to 2001. The Federal Reserve lowered interest rates, which saw the formation of the housing bubble that burst in 2008. The DCG ratio rose by 30% of GDP to 244% in 2007 from 214% in 2003. Fig. 5: China’s domestic credit to GDP ratio and its change Fig. 6: Change in domestic credit to GDP, five-year rolling based on a five-year rolling window window % of GDP Domestic credit/GDP pp Changes Japan (1985-89) US (2003-07) 160 Changes (pp), rhs 40 (pp) China (2008-12) US (1995-99) 45 30 140 30 20 10 15 120 0 0 -10 100 -15 -20 80 -30 -30 1991 1994 1997 2000 2003 2006 2009 2012 t-4 t-3 t-2 t-1 t Note: The gray line shows the change in the DCG ratio in a Note: Year t refers to 1989 in Japan, 1999 and 2007 in the US given year from five years earlier – e.g., the reading in 2012 is and 2012 in China. The lines show how fast leverage built up – 34pp because the leverage ratio rose to 155% of GDP in 2012 e.g., the line for China shows its DCG level declined by 20pp from 121% of GDP in 2008. Source: IMF, CEIC and Nomura from 2004 to 2008, then increased by 34pp from 2008 to 2012. Global Economics. Source: IMF, CEIC and Nomura Global Economics. 5 Nomura | Asia Special Report 15 March 2013 In the European Union, the DCG ratio rose by 26% of GDP over the period 2006-10, from 134% to 160% (Figure 9). While the 5-30 rule may provide a useful handle as a financial crisis indicator, of course there is room for the DCG ratio to grow by more than 30% of GDP over the timeframe – in Thailand, for example, the DCG ratio rose 46% of GDP from 131% in 1994 to 177% in 1998 (Figure 9). Still, given the size of the economy, we believe it more appropriate to compare China to Europe, Japan and the US. Moreover, China's own experience in the 1990s suggests that the DCG rising by 34% of GDP in five years is a dangerous extension of credit – the infamous GITIC (Guangdong International Trust and Investment Corporation) default happened in 1998, when the DCG ratio rose to 110% from 86% in 1994. Fig. 7: Domestic credit-to-GDP and its change, five-year Fig. 8: Domestic credit-to-GDP and its change, five-year rolling window – Japan rolling window – US % of GDP pp % of GDP Domestic credit/GDP pp Domestic credit/GDP 250 35 250 Changes (pp), rhs 40 Changes (pp), rhs 230 30 30 210 25 220 20 190 20 10 170 15 190 150 10 0 130 5 160 -10 1974 1978 1982 1986 1990 1994 1993 1996 1999 2002 2005 2008 2011 Note: Nikkei 225 stock index peaked in 1989 when the asset Note: NYSE composite index peaked in 2000 and 2007 bubble burst. Source: IMF, CEIC and Nomura Global respectively when the IT bubble and financial crisis broke out. Economics. Source: IMF, CEIC and Nomura Global Economics. Fig. 9: Domestic credit to GDP and its change, five-year Fig. 10: Domestic credit to GDP and its change, five-year rolling window – EU rolling window – Thailand % of GDP pp % of GDP Domestic credit/GDP pp 160 30 200 Changes (pp), rhs 70 Domestic credit/GDP Changes (pp), rhs 170 40 140 20 140 10 120 10 110 -20 100 0 80 -50 1993 1996 1999 2002 2005 2008 2011 1990 1993 1996 1999 2002 2005 2008 Note: The European debt crisis broke out in 2009. Source: IMF, Note: Asia crisis broke out in 1997. Source: IMF, CEIC and CEIC and Nomura Global Economics. Nomura Global Economics. The rise of leverage in China is clearly troublesome, but the problem actually extends beyond Actual build-up of credit may be that implied by the DCG ratio. The DCG ratio only captures credit provided by the official higher than official data suggest banking system and does not include credit supplied through the bond and equity markets, or the shadow banking system (i.e., lending activity that does not show up on bank balance sheets is less transparent and less subject to supervision, regulation and capital requirements). Credit extension outside the banking system has become increasingly important since 2008 as the 6 Nomura | Asia Special Report 15 March 2013 government tightened regulations on bank lending. The 20% reserve ratio requirement on bank deposits, earning a very low rate of interest, smacks of financial repression and has most likely encouraged the disintermediation. Total social financing data offers a more comprehensive picture… In April 2011, the PBoC began to publish a “total social financing” (TSF) statistic which attempts Total social financing statistics to measure overall credit supply to the economy, encompassing not only bank loans but other capture some shadow-banking activities and give a better credit channels as well. It measures the net flow of credit (i.e., new issuance minus expiring picture of credit supply credit). Figure 11 shows a breakdown of TSF. The main components are: Bank loans. Standard loans made by banks, which fall into the loan quota set by regulators. This has been the most dominant force in credit supply, but its share in TSF has tumbled from 95.5% in 2002 to 57.9% in 2012. The sharp rise of bank loans since 2008 has been largely driven by lending to local government financing vehicles (LGFVs). According to official news agency Xinhua, Mr. Shang Fulin, the head of the CBRC, said last November that the amount of total outstanding bank loans to LGFVs was around RMB9.25trn at September 2012, or 14.1% of total bank loans. Trust loans. This refers to loans arranged by trust companies, which are non-bank financial institutions. They raise funds from retail and institutional investors before channeling them into specific projects. They are not constrained by bank loan quotas set by the regulators. The amount of new trust loans soared to RMB1.289trn in 2012 from just RMB203bn in 2011 as regulators tightened controls on bank loans to property developers and LGFVs, but left the trust loan channel open for these borrowers – hence a 534.3% rise of new trust loans issued in 2012. Entrusted loans. These refer to lending from one company to another through the banks. Direct lending from one corporate to another is illegal in China, so cross-firm lending goes through the banking system. Corporate bonds. The amount of issuance has risen sharply in recent years to RMB2.25trn in 2012 from just RMB552bn in 2008. This is partly driven by deregulation of the bond market as regulators intentionally loosened control to foster the market‟s development to diversify risks from the banking sector, and partly due to the same reason trust loans soared – tight control on bank lending squeezed demand from LGFVs into the bond market. Fig. 11: Total social financing and its main components (flow) (RMB bn) 2004 2005 2006 2007 2008 2009 2010 2011 2012 TSF estimated by Nomura 3328 3438 4701 7993 7510 15388 15494 14050 17068 Government bonds 326 292 240 1793 234 867 986 755 778 Underground lending 140 145 191 233 296 610 489 466 529 TSF released by the PBC 2863 3001 4270 5966 6980 13911 14019 12829 15761 New loans 2406 2496 3298 4019 5099 10521 8430 8043 9120 Trust loans 0 0 83 170 315 436 386 203 1289 Corporate bonds 47 201 231 229 552 1237 1106 1366 2250 Short-term bill -29 2 150 670 107 461 2335 1027 1050 NF equity financing & entrusted 379 230 423 770 759 1013 1454 1734 1535 loans Others 61 71 85 108 150 243 308 455 518 Source: CEIC and Nomura Global Economics estimates. 7 Nomura | Asia Special Report 15 March 2013 Banker acceptance bills. These are a promised future payment issued by firms that are accepted and guaranteed by commercial banks. After acceptance, the bill becomes an unconditional liability of the bank, but the holder can sell (exchange) it for cash at a discount to a buyer who is willing to wait until the maturity date. Banker acceptances are frequently used in money market funds. Equity financing. Equity market IPOs have slowed in recent years due to bearish market conditions. … but still has its limitations While providing a better picture than the domestic credit-to-GDP ratio, TSF data still fails to But TSF does not include account for two other credit channels. One is public financing, which includes bond issuance government debt… from both the central and local governments. In 2012, central government bond issuance was RMB1.356trn, while local government bond issuance was RMB250bn. The two combined suggest public bond issuance rose by 0.4% in 2012 from 2011. Note that this is a rather narrow definition of “public financing” – bond and trust issuance and bank lending by LGFVs are also liabilities on the government‟s balance sheet. We discuss the public versus private composition of outstanding credit later. The other channel is underground lending, which is reportedly active in some regions such as … or underground financing Wenzhou and Erdos. There is little reliable data on the aggregate size of underground lending, but the 21 Century Business Herald reports that the PBoC conducted a survey in mid-2011 and concluded that the stock was RMB3.38trn, equivalent to 5.8% of total bank loans in 2011. We can add these channels to the TSF number, using official data for public bond issuance and Adding these, the TSF-to-GDP FDI, while for underground lending we estimate the full time series by assuming a constant ratio rose sharply to 207% in 2012 share (i.e., 5.8%) of total outstanding bank loans. Figure 11 tabulates our estimate of its flow. Our estimate shows the stock of total TSF has risen by 62% of GDP to 207% in 2012 from 145% in 2008. The build-up of leverage is faster than that suggested by the official TSF-to- GDP ratio which shows a 58%-of-GDP increase from 129% to 187%, much faster than the domestic credit-to-GDP ratio, which rose 32% of GDP to 153% from 121% over the same period (Figure 12). We believe that total TSF is the best leading indicator of government policy in China. In recent TSF measures credit growth years, the growth rate of TSF has a better lead-lag relationship with GDP growth than the better as most has taken place outside the banking system in growth of bank loans (Figure 13), largely because the government no longer relies on bank recent years loans as the primary source for policy guidance as it recognises that many banks are already in difficult positions. After the global financial crisis hit Chinese exporters in 2008, the government introduced its RMB4trn fiscal stimulus and banks were ordered to lend to LGFVs. Total bank loans to LGFVs stood at RMB9.25trn in September 2012, which accounted for 14.1% of total bank loans. The government decided to allow the bond market and trust loans to take the bulk of policy easing in 2012; indeed, bank loan growth grew only 12% y-o-y in H2 2012, while non- bank credit growth soared by 164% y-o-y. Fig. 12: TSF (total stock) to GDP ratio Fig. 13: Growth of TSF and GDP % of GDP % y-o-y Total social financing (stock) % y-o-y 220 Total social financing (by the PBoC) GDP, rhs 35 15 Total social financing (by Nomura) Domestic credit 30 13 190 25 11 160 20 9 130 15 7 100 10 5 2004 2006 2008 2010 2012 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Source: IMF, CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics. 8 Nomura | Asia Special Report 15 March 2013 2. Rapid asset price inflation A BIS report in 2009 (Boris and Drehmann) identified that “unusually strong increases in credit Rapid asset price inflation and asset prices have tended to precede banking crises”, and found them “successful in usually precedes banking crises providing a signal for several banking systems currently in distress, including that of the United States”. In our view, China faces a much higher risk of a property price bubble bursting than an equity The equity market does not price bubble. Indeed, it is arguable that an equity price bubble has already been experienced – pose a threat in China at this stage, in our view the Shanghai Stock Composite Index rose 461% between May 2005 and October 2007 – from 1,060 to 5,954 – before collapsing in October 2008 to 1729 and is now around the 2,300 level. The collapse of the stock market did not have much of a damaging effect on the economy as the market was dominated by retail investors who were not heavily leveraged, therefore the negative price effect did not spillover into the banking sector. If we look at the official housing price data, then property sector conditions seem rather benign, Official property price data with prices rising by only a very moderate, cumulative 113% over the period 2004 to 2012 in seriously understate risks in this sector major Chinese cities (Figure 14). However, the quality of the official housing price index is highly questionable and it contradicts our observations on the ground and recent academic research on the topic. The problem may be due to the fact that China‟s property market went through a rapid phase of development since 2004 and the quality of new properties is very different from the old ones. An accurate property price index needs to control for changes in quality to provide a fair like-for-like comparison over time – what in technical terms is called an “hedonic” price index. A recent academic paper provided a hedonic index for 25 major cities. According to three An appropriate price index professors in Tsinghua University and National University of Singapore (Wu, Deng and Liu, shows China‟s property prices rose more than those in the US 2013), property prices rose by 250% from 2004 to 2009, far outstripping the level of growth in housing bubble the official index. By comparison, it also rose faster than the Case-Shiller US housing price index, which climbed by 84% from 2001 to its peak in 2006. Furthermore, land prices rose even more sharply than property prices (Figure 15). According to official statistics, the average price per square metre of land at sale was just RMB573 in 2003 (USD69.2 on the 2003 exchange rate), rising to RMB3,393 in 2012 (USD537) – a 492% rise over 10 years. Another academic paper (Wu, Gyourko and Deng, 2012) found land prices in Beijing rose 800% from Q1 2003 to Q1 2010 after adjusting for quality difference. The average sale price for properties per square metre rose from RMB2,378 in 2003 to RMB5,791 in 2012, a 143% appreciation over 10 years. It is not surprising that many state-owned companies made aggressive moves in the land auctions and that hoarding of land is a common problem – as of 2012 there was 402mn square meters of land already purchased by developers but not yet developed, equivalent to 10.3% of total land sales in the past 10 years. Fig. 14: Housing price indexes – China and US Fig. 15: Average land sale price and property sale price Jan 2000=100 2003=100 300 600 China Land price 275 US: CS housing index 500 Property price 250 400 225 200 300 175 200 150 100 125 100 0 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: CEIC, WIND and Nomura Global Economics. Source: CEIC and Nomura Global Economics. 9 Nomura | Asia Special Report 15 March 2013 The government obviously recognises the risks in the property sector. It has introduced a series The government has been of progressively tighter policies to contain property prices over the past several years, including trying to contain a property bubble raising the down-payment ratio for second-home purchases, limiting home purchases by non- local families, applying stricter criteria when levying land value-added tax from real-estate developers, prohibiting mortgages for a third home (or higher) purchases, and limiting bank lending to real estate developers. The pattern has been for house prices to initially dip after tightening policies are introduced, Property prices and investments then to rebound, which suggests that the risks have not been mitigated. In early September were weak, but have picked up again recently… 2012, land auctions suddenly turned hot again as large developers – many of them state-owned enterprises – pushed up bidding. The Shanghai Stock Exchange Property Index rebounded sharply by 29% from August 2012 to January 2013. Fixed asset investment growth in the housing sector also picked up. The recovery in the housing market is not, in our view, a reflection of improved underlying … leading to another round of fundamentals, as inventory on a national level remains high (Figure 16). Another round of tightening and downside risks to the property sector measures, including the 20% capital gains tax, was implemented on 1 March and M2 growth will likely fall from 15.2% in February as the government has set its target at 13% for 2013, which should pose downside risks to both property prices and investment (Figure 17). Fig. 16: Floor space started and sold Fig. 17: Property price growth and M2 growth sold Square meter mn (12 month rolling sum basis) % y-o-y % y-o-y 70 city property price, lhs 2,000 18 31 M2 growth, rhs Floor space started 15 28 1,600 Floor space sold 12 25 1,200 9 22 6 19 800 3 16 400 0 13 0 -3 10 Feb-01 Feb-04 Feb-07 Feb-10 Feb-13 Feb-05 Feb-07 Feb-09 Feb-11 Feb-13 Source: CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics. 10 Nomura | Asia Special Report 15 March 2013 3. Decline of potential growth Financial crises often follow technology revolutions and/or so-called economic miracles, Decline of potential growth often because investors and policymakers start to overestimate the potential growth of the economy. precedes financial crises Policymakers may misinterpret a structural slowdown in potential growth as cyclical and utilise expansionary policies to boost growth, which leads to a further deviation of actual GDP growth from its potential level, planting the seeds for overheating and an eventual painful correction. The decline of potential growth is a useful leading indicator of financial crises. Classic economic theory says that potential growth is driven by the growth of three factors: … driven partly by a productivity labour, capital and total factor productivity. In many cases, the slowdown in potential growth is slowdown, as seen in Japan, Europe and the US before they mainly a result of weaker productivity growth. In the US, academic research shows potential entered crises growth dropped to 2.0% for the period of Q2 2007 to Q2 2008 from the 10-year average of 2.8% (Robert Gordon, 2008), while an OECD study shows labour productivity declined significantly prior to the crisis, particularly in the construction sector (Brackfield and Martins, 2009). A report from Banco de Espana shows Spain‟s potential growth fell to 2.6% in 2006 and 2.2% in 2007 from an average of 3.2% over 2000-05 (Hernández de Cos, Izquierdo and Urtasun, 2011). Another study, this from the Brookings Institute, shows that Spain‟s productivity growth had been on a slide since 1995 but the pace of decline picked up after 2004, according to data from European Central Bank (Baily, 2008). In Japan, productivity growth slowed in 1980 compared to the 1970s, according to data from the Research Institute of Economy, Trade and Industry. In China, there are also signs of a slowdown in potential growth, driven by a decline of both the We use export market share as labour force and productivity growth. We discuss the productivity issue first. Unfortunately there a measure of productivity… are no up-to-date and reliable productivity data available in China. In an effort to find an alternative way to evaluate countries' productivity, we examine global export market shares, which we prefer over export growth as it provides a reflection of exporters‟ competitiveness and is not influenced by changing global demand conditions. Global export market share works well as a leading indicator of financial crises in Japan (1989), … which fell before crises in the US (2008), Europe (2009) and Thailand (1997). Japan, the US, Europe and Thailand Japanese exporters‟ share of global exports peaked in 1986 after the Plaza Accord as they gradually lost market share to low-cost competitors such as South Korea (Figure 18). US exporters‟ share of global exports was around 12% in the 1990s, but declined steadily to 8.1% in 2008 (Figure 19). Spanish exporters‟ share of global exports dropped to 1.6% in 2010 from 2.1% in 2003 (Figure 20). Thailand‟s market share was on an uptrend throughout the 1980s but peaked in 1995 (Figure 21), partly because China‟s export competitiveness picked up and crowded out some Thai exporters (Federal Reserve Bank of Atlanta, 1999). Some may wonder why global export market share worked well in predicting financial crises given the fact that not all of the above economies are export-dependent; the US, for example, is much more driven by domestic than external demand. We believe the reason is because changes in export market share are a good indicator for changes in competitiveness and productivity of the overall manufacturing industry. The latest economic research in academia shows that, in a given economy, more productive firms move across borders to compete in global markets (Melitz and Redding, 2012; Manova and Zhang, 2012). Therefore, if there is a broad-based productivity slowdown, exporters' market share in the global market would shrink even if exports are not a pillar of growth in that economy. The market-share analysis shows that China gained competitiveness rapidly before 2010, but Market share of Chinese progress has since come to a halt. We do not have the global trade data for full-year 2012 yet, exporters rose sharply before 2010, but has since stalled but taking China‟s market share in the US as a proxy it appears to have peaked in 2010 (Figure 22). This suggests that the rapid productivity growth after WTO accession has likely ended. For labour intensive industries such as footwear and apparel, Chinese exporters‟ market share has fallen (Figure 23), which has offset the rising share of capital intensive goods. 11 Nomura | Asia Special Report 15 March 2013 Fig. 18: Japan’s market share in global export market Fig. 19: US market share in global export market % of total % of total 12 13 12 10 11 8 10 9 6 8 4 7 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Note: Nikkei 225 stock index peaked in 1989 when the asset Note: NYSE composite index peaked in 2007 ahead of the bubble burst. Source: IMF, CEIC and Nomura Global global financial crisis. Source: IMF, CEIC and Nomura Global Economics. Economics. Fig. 20: Spain’s market share in global export market Fig. 21: Thailand’s market share in global export market % of total % of total 2.2 1.4 2.1 1.2 2.0 1.0 1.9 0.8 1.8 0.6 1.7 0.4 1.6 0.2 1996 1999 2002 2005 2008 2011 1983 1987 1991 1995 1999 2003 2007 2011 Note: The European debt crisis broke out in 2009. Source: IMF, Note: Asia crisis broke out in 1997. Source: IMF, CEIC and CEIC and Nomura Global Economics. Nomura Global Economics. Fig. 22: China’s market share in US market Fig. 23: China’s market share in US: labour intensive vs capital intensive goods % % % of total Labour intensive products, lhs 25 80 55 Capital-intensive products, rhs 72 46 20 64 37 15 56 28 10 48 19 5 40 10 1994 1997 2000 2003 2006 2009 2012 Nov-00 Nov-03 Nov-06 Nov-09 Nov-12 Source: CEIC and Nomura Global Economics. Note: total US Note: 12m moving average; for labour-intensive goods we cite imports excluded oil imports. footwear; while for capital-intensive goods we cite telecom and sound equipment. Source: CEIC and Nomura Global Economics. 12 Nomura | Asia Special Report 15 March 2013 We believe China's global export market share likely peaked in 2012. The three main sources of We believe China‟s market China's competitiveness – demographics, an undervalued currency and reform dividends – share will fall as the labour force starts to contract… have all weakened since 2008. On the demographics side, trends that were working in China‟s favour before 2008 have now turned against it. The demand supply ratio in the urban labour market is arguably the best indicator of wider labour market conditions in China. The ratio was persistently below 1 before 2009, suggesting the labour market was over-supplied, mostly due to the large influx of migrant workers from inland rural areas. But in 2009 the trend reversed. The ratio climbed above 1 in Q4 2009 and remained there for 12 consecutive quarters. Even when GDP growth slowed to 7.4% in Q3 2012, the ratio remained above 1 (Figure 24), which suggests to us that the potential growth rate has likely slowed to 7.0-7.5%. Working-age population. The United Nations projected that China‟s working-age population would peak in 2015. This projection has been widely cited in China and taken as a working assumption for many policymakers and researchers, but the data show that China‟s working-age population began to decline in 2012 (Figure 25), having grown for at least the past 20 years. On the currency side, RMB has appreciated by 22.9% against the US dollar and 25.7% in … RMB has appreciated relative effective exchange rate (REER) terms between 2005 and 2012. Its appreciation against significantly against other currencies… some emerging market currencies has been particularly significant – for example, one RMB could be exchanged for IDR1,191 in 2005, but had strengthened 25.4% to IDR1493 in 2012 (Figure 26). During the same period, RMB appreciated by 57.4% and 56.8%, respectively, against the Indian rupee and the Mexican peso. The real economic effects of the labour market tightening and currency strength caused the wage differential between Chinese workers and Indonesian workers to widen significantly over the same period. The average wage in China was about twice that in Indonesia in 2000, but by 2011 this had risen to 3.5 times (Figure 27). Over the period of 2000 and 2011, cumulative wage growth in China was 473.7%, much higher than 238.6% in Indonesia, 137.2% in India and 46.3% in Mexico. Can productivity growth in China offset the rising wage differential between China and emerging … and structural reforms have markets such as Indonesia? We believe it is unlikely. The slowdown in reform momentum since slowed in recent years WTO accession in 2001 is hurting China's productivity growth today. There is widespread complaint in China's policy circles and the media over the slow progress of major reforms. The government has relied heavily on Keynesian-style infrastructure investments to boost growth and avoided difficult structural reforms such as moving to a fully market-based monetary policy framework and opening up the service sector that is monopolised by the SOEs. As the three main sources of China‟s competitiveness run out of steam, China is no longer as China becomes less attractive attractive to foreign investors. Indeed, FDI into China used to grow faster than FDI to other for FDI as its competitiveness fades developing countries, but this trend is changing (Figure 28). A recent survey by Japan Bank for International Cooperation shows China's popularity among Japanese companies declined sharply in 2012 while Indonesia's popularity rose (Figure 29). This suggests FDI growth in China may face downward pressure in the years ahead as well. FDI is also a leading indicator for exports; as China increasingly relies on public investment over private and foreign investment, its productivity faces downside risks. 13 Nomura | Asia Special Report 15 March 2013 Fig. 24: China labour demand supply ratio and GDP growth Fig. 25: China’s working-age population Ratio % y-o-y % y-o-y % y-o-y Labour demand/supply ratio Working-age population growth 1.2 16 5 15 GDP growth, rhs GDP growth, rhs 14 4 1.1 14 13 3 1.0 12 12 2 11 0.9 10 10 1 9 0.8 8 0 8 0.7 6 -1 7 Dec-03 Dec-06 Dec-09 Dec-12 1992 1996 2000 2004 2008 2012 Source: CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics. Fig. 26: Exchange rate comparison Fig. 27: Wage level comparison July 2005=100 USD India Indonesia 180 IDR/RMB RMB appreciation versus 8,000 INR/RMB other currencies China Mexico 170 MXN/RMB 7,000 160 6,000 150 5,000 140 4,000 130 3,000 120 2,000 110 100 1,000 90 0 Dec-06 Dec-08 Dec-10 Dec-12 2000 2011 Source: CEIC and Nomura Global Economics. Note: For India, the wage is rural wage level. Source: CEIC and Nomura Global Economics. Fig. 28: FDI growth – China vs developing economies Fig. 29: Japan FDI survey % y-o-y % share China India China 30 100 Developing economies excluding China Thailand Vietnam 25 90 Indonesia Brazil 20 80 15 70 10 60 5 50 0 40 -5 30 -10 20 -15 10 -20 0 -25 2008 2009 2010 2011 2012 (FY) Source: CEIC and Nomura Global Economics. Source: Japan Bank for International Cooperation and Nomura Global Economics. 14 Nomura | Asia Special Report 15 March 2013 Identifying the risks In this section we delve deeper to evaluate the vulnerability of major economic sectors. The We identify and evaluate the ideal approach is to get a solid estimate of the balance sheets of the major sectors – the risks in the major sectors of the economy government, banks/financial institutions, households and corporates. This "balance sheet approach" has proved useful in analysing past financial crises (Koo, 2012). For instance, the financial condition of the government sector remains a key driving factor in the European crisis, while the deterioration of bank balance sheets was a major reason behind the Japanese financial crisis. That said, we cannot fully follow the balance sheet approach in China due to data constraints. Consolidated balance sheets are not available for the household or corporate sector. For the financial sector, we have information on listed banks which constitute most of the banking sector, but as we discuss later, the more serious risks are more heavily skewed towards the non-bank financial institutions such as trust and guarantee companies. On the government sector there are some estimates from think-tanks, but these are largely outdated. Nonetheless, it turns out that with the available information we can conclude that the main risks lie mostly in three areas: local governments, property developers and non-bank financial institutions. Government finances The central government is clearly in good financial condition. The public debt-to-GDP ratio was The central government is in only 15.2% in 2011, while foreign currency-denominated debt only accounted for 0.9% of total good financial condition… central government debt. The fiscal balance has registered a deficit in recent years, but the deficit has been limited to below 3% of GDP. Moreover, on the asset side, the government holds USD3.3trn of FX reserves, while the value of SOE assets reached RMB85.37trn in December 2011. Financial conditions in the general public sector are not nearly as favourable. There is no official … but local governments face consolidated balance sheet for the central and local government. The Chinese Academy of tough challenges Social Science (CASS), an official government think-tank, published its estimate of China's consolidated public balance sheet for 2010, including the central and local governments, as well as the SOEs (Li and Zhang, 2012). The CASS study claims that the public sector in China should be considered solvent because of potential revenue from selling natural resources such as land, and privatisation of SOEs (Figure 30). CASS estimates total public sector assets of RMB142.3trn in 2010 against total liabilities of just RMB72.7trn. On the asset side, however, the two major items that could be sold to pay down debt are natural resources (RMB44.3trn) and SOEs (financial and non-financial, combined, at RMB67.3trn). Local governments have relied heavily on land sales as a major source of debt financing in recent years. Privatisation of the SOEs has not yet been utilised as a major source of funds, but we expect it will likely take the spotlight in coming years. Fig. 30: China’s public sector balance sheet, 2010 Total Assets RMB trn Total Liabilities RMB trn Government deposit in the PBoC 2.4 Central government's domestic debt 6.7 Reserve asset 19.7 Sovereign debt 2.3 Natual resources including land 44.3 Local government debt (excluding LGFV) 5.8 SOA in administrative public entities 7.8 Debt of LGFV 9.0 SOA in non-financial enterprises 59.1 Debt of non-financial SOEs (excluding LGFV) 35.6 SOA in financial institutions 8.2 Debt of policy banks 5.2 SOA in national social security fund 0.8 NPL of banks 0.4 Potential debt from solving NPL 4.2 Implicit debt from pension fund 3.5 Total assets 142.3 Total liabilities 72.7 Public sector net assets 69.6 Source: CASS. 15 Nomura | Asia Special Report 15 March 2013 Local governments have ramped up their debt… While the overall public sector does not have a solvency problem, local governments are facing We estimate government debt tough challenges, at least from a liquidity perspective. The CASS study shows local government to be RMB24.9trn, or 48% of GDP in 2012 debt amounting to RMB14.8trn by 2010, which includes RMB5.8trn of explicit government debt and RMB9trn on LGFV balance sheets. Furthermore, we believe the situation since has only worsened for local governments. While we do not have detailed information to update the full set of government balance sheets for 2012, we can offer an update on central and local government debt levels, which we estimate at a combined RMB24.9trn, or 47.7% of GDP in 2012. This was mostly due to a further increase of local government liabilities through trust loans of RMB154bn and bonds of RMB2.1trn (urban construction bonds and local government bonds). Most local government investment is not yet profitable, because of the large share that has Most LGFV investments will gone into infrastructure projects, such as the building of subways and highways, which require incur at least short-term losses substantial investment upfront but take many years to break even. Indeed, financial statements disclosed by most LGFVs who sought capital from the bond market show negative cash flows. Tianjing Urban Construction Company, the largest LGFV in the country, reported that its cash flow in 2011 fell to -RMB31bn from -RMB7bn in 2010. It has not yet released its 2012 financial statements. LGFVs are solvent because of Many LGFVs have managed to stay solvent because local governments provided new capital, local government support subsidies and guarantees to allow them to issue new debt. New capital is often in the form of land, the value of which is subject to substantial market risks. The guarantees by local governments are critical to LGFVs if they are going to continue to tap the bond market. However, we believe local government support of their LGFVs will come under increasing But local government land-sale pressure. Local governments have relied heavily on land sales in the past to generate revenue revenues face downside pressure (Figure 31), but land-sale revenues were broadly flat in 2011 and 2012 due to policy tightening. Land sales in January/February (combined) were down 12% y-o-y and we believe the round of policy tightening announced on 1 March makes it unlikely that they will experience rapid growth in 2013. When land sales failed to provide the required incremental growth in funding for LGFVs in 2012, LGFVs relied on bond issuance they turned to “urban construction” bonds and infrastructure trust products. Urban construction in 2012 to raise funds… bonds are issued by the LGFVs themselves and new issuance soared to RMB1.2trn in 2012 from barely RMB29.4bn in 2006 (Figure 31). Infrastructure trust products are essentially private placements of loans arranged by trust companies, that channel funding from retail, corporate and institutional investors to the LGFVs. Issuance of infrastructure trust products rose to RMB112bn in 2012 from RMB39.3bn in 2011 (Figure 32). Fig. 31: Land sales revenue and urban construction bond Fig. 32: Issuance of trust products for infrastructure issuance investment RMB bn RMB bn RMB bn 3500 Land sales revenue, lhs 1400 120 Urban construction bond, rhs 3000 1200 100 2500 1000 80 2000 800 60 1500 600 40 1000 400 500 200 20 0 0 0 2006 2007 2008 2009 2010 2011 2012 2004 2006 2008 2010 2012 Source: WIND, CEIC and Nomura Global Economics. Source: WIND and Nomura Global Economics. 16 Nomura | Asia Special Report 15 March 2013 … but future funding will be harder to come by … but it is getting harder to It is not clear to us how the LGFVs will be able to finance their growing investments in 2013 and finance a growing appetite for beyond. We estimate the current outstanding debt of LGFVs at around RMB11trn. Assuming funds and to repay debt 10% of the principle becomes due in 2012 and an interest rate of 6%, the LGFVs would need RMB1.76trn just to repay existing debt – more than the total amount of urban construction bonds issued in 2012. Moreover, the central government‟s plan to cut M2 growth to 13% in 2013 from 14% in 2012 means overall credit supply will be tightened in 2013. It will be difficult for LGFVs to continue their investment spree as they run out of new funding sources. This mounting pressure has already pushed some local governments to take “unconventional” Local governments have measures to finance their investments. A typical example is the so-called “BT” (build-transfer) resorted to “unconventional” measures to raise funds… model, whereby the local government asks a private company or a state-owned enterprise to handle an investment project and agrees to buy it at a set price when it is completed. One example is Lanzhou city, where the government – despite total revenues of only RMB8.6bn in 2011 – promised to pay the Pacific Group RMB80bn for the construction of a new city next to the existing urban area. In terms of accounting or judging balance-sheet strength, the BT model leads to liabilities in the future, but does not show up in official government debt statistics. Perhaps rather unsurprisingly, it is not known exactly how much of this sort of debt is outstanding, although it is generally understood that the practice is pervasive among local governments. Of course, it is no secret that the central government is concerned about the state of local … which the central government finances. On 31 December, 2012, the Ministry of Finance, the PBoC, the National government is trying to ban Development and Reform Commission and the CBRC issued a joint statement banning the BT financing model alongside other innovations at the local government level, to avoid a rise in contingent liabilities. There is a long list of what local governments cannot do, but there is no clear solution as to what they can do to meet their spending obligations. Financial sector conditions Banks We believe the banks are also worse off now than in 2008. Bank weakness comes from three Banks face risks from three main sources. The first is loan exposure to LGFVs, which reached RMB9.25trn as of September dimensions: 1) Loans to LGFVs 2012, which accounted for 14.1% of total outstanding bank loans (Figure 33). The CBRC has put tight controls on the banks to not extend new credit to LGFVs, but the outstanding amount has not fallen in recent years despite the short maturity of these loans, which suggests expired loans have been rolled over. The second source is exposure to property developers. The size of loans made to property 2) loans to property developers developers has been constrained by regulators, but at end-2012 stood at RMB3.9trn, or 6.2% of total loans outstanding. The risks from exposure to LGFVs and the property sector are relatively more transparent as 3) wealth-management these loans sit on banks‟ balance sheets and their NPLs are provided in quarterly reports. At the products, which suffer from… moment, the NPL ratio for the five major banks is only 1.2% (Figure 34), and with huge net profits of RMB1.24trn in 2012, there is a buffer through which they can absorb losses even if the NPL ratio was to rise to 1.8%. Tight regulations on bank new loans to LGFVs and property developers should help mitigate these risks. A far more problematic and less transparent risk stems from so-called wealth-management products (WMPs) that banks sell to retail investors. According to the CBRC, the amount of WMPs outstanding soared to RMB7.1trn by end-2012, equivalent to 7.4% of bank deposits. There are several reasons to be concerned in this area. Maturity mismatch. WMPs are predominantly short-term instruments, with an average … a maturity mismatch… maturity of less than 1yr (Figure 35). Yet some of the funds raised have been utilised in long-term projects, such as infrastructure and property projects. To keep the maturity mismatch problem at bay, banks have to constantly issue new WMPs to fill the gap left by expiring ones. A lack of transparency. A common practice at commercial banks in operating WMPs is … a lack of transparency… through the “fund pools” mechanism, where a bank issues a series of WMPs and puts the funds into a pool to finance a large number of projects. The projects and the WMPs are not matched bilaterally, and so it is impossible to clearly identify the risk of any given WMP. 17 Nomura | Asia Special Report 15 March 2013 The CBRC has asked banks to clean up the fund pools and match WMPs with specific projects. Links to risky assets. Many WMPs are linked to stocks, bonds and exchange rates … and often have links to risky (Figure 36). About 36% of WMPs are reportedly related to trusts (Figure 37). As we assets, such as trusts discuss below, trust products may well be the weakest link in the financial leverage chain. The boom of WMPs has only happened in the past several years and has not been tested by a downturn in the credit cycle – so far there have only been a limited number of default cases in the trust sector, but we believe the likelihood is high that there will be more in the years ahead. In theory, WMPs do not add credit risk to the banks, as information is disclosed so that investors WMPs may expose banks to can judge their investment risk. In reality, however, there may be implicit credit risk for the heightened credit risks banks. A very recent example involving Huaxia Bank demonstrates this after an employee sold a WMP which subsequently defaulted. It was discovered that the salesman was not authorized by the bank to sell it and many investors then claimed that this was fraud and demanded Huaxia Bank pay for their losses. The losses were eventually paid, though the source of the funds was not clear. Nonetheless, this example illustrates that it is not 100% clear whether the banks can walk away from credit risk related to WMPs. In the case of default, there is every chance that investors will become embroiled in lengthy disputes with the bank that sold them the product. Another significant loan category – amounting to RMB8.2trn, or 13.1% of total loans outstanding Household mortgage loans do – is mortgage lending (Figure 38). However, we believe mortgage loans do not constitute a not constitute a major problem for banks major risk to banks because: 1) down-payment requirements are high – 30% for first-time homebuyers, 60% for a second house, while mortgages are not an option for third houses or more; 2) 30% of mortgage loans were made before 2009, when housing prices were 33% lower than current levels. Therefore, even if housing prices were to fall sharply, by say 30%, the net impact on bank mortgage loans would not be too significant. Fig. 33: Breakdown of bank loans Fig. 34: NPL ratio of major commercial banks % LGFVs 16 14 RMB9.3trn Mortgages Others 12 10 RMB40.5trn RMB7.9trn 8 RMB3.8trn 6 4 2 Property developers 0 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Note: Data is for Q3 2012. Source: CEIC and Nomura Global Source: CEIC and Nomura Global Economics estimates. Economics. 18 Nomura | Asia Special Report 15 March 2013 Fig. 35: WMP issuance by tenor Fig. 36: WMP issuance by asset base Unit issued Unit issued 20000 20000 Undisclosed above 24m Undisclosed Other 16000 16000 Commodity Credit 12-24m 6-12m FX Rates 3-6m 1-3m 12000 Stock Bond 12000 1m Mix 8000 8000 4000 4000 0 0 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12 2H11 2013* 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12 2H11 2013* Note: 2013 data refers to new issuance in January and Note: 2013 data refers to new issuance by January and February. Source: WIND and Nomura Global Economics. February. Source: WIND and Nomura Global Economics. Fig. 37: WMP issuance by investment channel Fig. 38: Breakdown of mortgage lending Unit issued Mortgages 20000 issued before 2009 Mortgages issued after 16000 tightening (2011-12) QDII Trust Others 12000 30% 8000 55% 4000 15% Mortgages issued before 0 tightening 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 1H12 2H12 2H11 2013* (2009-10) Note: 2013 data refers to new issuance by January and Source: WIND and Nomura Global Economics. February. Source: WIND and Nomura Global Economics. Trust companies and credit guarantee companies Trust companies and credit guarantee companies face, and also pose, high risks. Their Trust and credit guarantee business model has only flourished in recent years as the government has tightened controls on companies face high risks bank lending, restricting their exposure to LGFVs and property developers. However, with access to bank loans curbed, LGFVs and developers simply turned to the bond market and trust companies for financing. Tapping the bond market requires a credit rating and more detailed disclosure, such that borrowers with lower credit quality were more likely to look to the trust companies for financing, while having credit guarantee companies (CGCs) helps lower their borrowing costs. The trust companies quickly became the second-largest group of non-bank financial institutions AUM at the trust companies in terms of assets under management (AUM) (Figure 39). In 2008, AUM for the sector was only rose by 5.8x in five years – it is bigger than the insurance sector RMB1.2trn, smaller than the insurance sector (RMB3.3trn) and mutual funds (RMB2.6trn). By 2012, this AUM had rocketed to RMB7trn, exceeding both the insurance (RMB6.9trn) and mutual fund (RMB2.9trn) sectors. 19 Nomura | Asia Special Report 15 March 2013 As mentioned before, property and infrastructure projects are the main destinations for funds Property and infrastructure raised from trust companies (Figure 40). Official data show that in 2012 around 8% of trust projects are popular trust investments funds went to property investment, 28% to infrastructure and 35% to industrial and commercial companies. Information is not provided on where the remaining funds are invested. We think a large part of it may have gone to property-related projects as well. The business of trust companies in China is highly cyclical. Indeed, trust companies have The trust sector is highly always been utilised as a channel of alternative financing – banks are traditionally heavily cyclical and typical of the shadow banking sector regulated, yet trust companies could work through loopholes in the system to offer credit supply to money-hungry firms that do not have access to banks. In that sense, trust companies in China work exactly as shadow banks. History suggests we need to be very cautious about the boom in the trust sector There have been five boom-and-bust cycles in the trust sector since 1980. Each time the boom Five cycles that suggest a trust was associated with an economic upturn and the bust amplified the deleveraging process and sector boom usually leads to a bust damaged the economy (see Appendix 1). Fig. 39: Assets under management at non-bank financial Fig. 40: Investment channel of trust products sectors RMB bn RMB bn Securities Market, Financial Inst & others 7,000 Infrastructure 1,400 Real Estate Mutual funds Industrial & Commercial Enterprise 6,000 Insurance 1,200 Trust 5,000 1,000 4,000 800 3,000 600 2,000 400 1,000 200 0 0 2007 2008 2009 2010 2011 2012 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Source: Media reports, CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics. We believe China‟s trust sector is going through its sixth boom-bust cycle – with the end of the The current boom may be close boom nearing. The trust companies have received a lot of negative press coverage since mid- to its end 2012 (see Appendix 2), with reports that many trust products were close to default – yet they have managed to somehow survive. When monetary policy and regulations on trust companies tighten, the risks in this sector will eventually emerge and may be difficult for local governments to contain. CGCs also face high risks if the economic cycle turns down. These are also not well regulated Some CGCs defaulted when and many are reportedly engaged in underground lending. There were several high-profile fraud policy was tightened in 2012 cases reported in 2011 and 2012 in this sector, including the case of Zhong Dan, which was one of the top private CGCs in China. In May 2012, it went into bankruptcy as its owner disappeared with his clients' money after reportedly running a heavily leveraged business empire that ran into trouble once monetary policy was tightened early in the year. The total loss to clients was RMB1.3bn. The CGCs are not transparent and there is very limited information about the current state of this sector, but the Zhong Dan case suggests they may be subject to high credit risks in the next round of policy tightening. 20 Nomura | Asia Special Report 15 March 2013 Household sector China's household sector is in good financial condition, with total household debt at only The household sector is in good RMB10.4trn at end-2012, or 20.1% of GDP. Mortgage loans outstanding were RMB8.1trn, or financial condition 15.6% of GDP (Figure 41). The low leverage of the household sector is in large part because of stringent requirements on down-payments and a relatively low mortgage rate, as well as policy tightening in the property sector in recent years. A household borrowing culture has only recently started to take hold. The household saving rate remains high, and home ownership is high as well. The household sector has so far proven rather resilient to equity price shocks. The Shanghai A Low household leverage means share index plunged from 5,954 in 2007 to 1,820 in 2008, yet retail sales growth remained solid consumption has been resilient to equity price shocks at 21.6% in 2008 from 16.8 in 2007 (Figure 42). Low leverage in the household sector must in large part be recognised as a significant factor in the muted reaction. Financial market liberalisation has led to some new risks to household balance sheets, but we A bond market default is believe they are manageable. We estimate the total amount of corporate bonds and trust unlikely to affect the household sector significantly products outstanding by the end of 2012 was RMB8.5trn, with most held by financial institutions rather than household. Moreover, total household deposits are RMB41.1trn. Combined with limited leverage, we therefore believe the impact of a potential default on household balance sheets would be manageable. Fig. 41: Household debt Fig. 42: Retail sales growth and Shanghai Stock Index % of GDP % y-o-y Retail sales, lhs Dec 1990 =100 24 23 7,000 SHCOMP Index, rhs Mortgage loans 20 21 5,800 Total household debt 16 19 4,600 12 17 3,400 8 15 2,200 4 13 1,000 2002 2004 2006 2008 2010 2012 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Source: CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics. Corporate sector Property developers are also leveraging up. There are two sources of data on property Property developers face risks developers' financial conditions: the financial reports of listed companies, which show the debt- given their high leverage to-asset ratio had risen to 71% by 2012, from 40% in 2009 (Figure 43). The other is data from the National Bureau of Statistics (NBS) data on the source of funds for property investment by all property developers, which shows that they rely increasingly heavily on funding from outside the banks (Figure 44). We believe the risks to property developers and LGFVs are tied together. If the property market Risks of property developers cools, developers would be expected to shy away from land sales and the LGFVs would face and LGFVs are tied together severe financing problems. Actually, some LGFVs are property developers themselves. For instance, in Changzhou, the Wujin Urban Construction Company owns a property developer which contributes most of the funding to its infrastructure projects. Leverage conditions in the overall industrial sector seem stable, as the debt-to-asset ratio Leverage of the whole industrial remains around 58% in recent years. However, it is worth noting that profitability has fallen in sector is stable, but profitability has fallen recent years, which shows that they may be becoming more vulnerable to a shock. 21 Nomura | Asia Special Report 15 March 2013 Fig. 43: Debt-to-asset ratio of listed property developers Fig. 44: Property developers’ dependence on non-bank loan funding % of asset % of total 80 85 70 83 60 50 81 40 30 79 20 77 10 0 75 2009 2010 2011 2012 1997 2000 2003 2006 2009 2012 Source: Bloomberg and Nomura Global Economics. Source: CEIC and Nomura Global Economics. The linkage of risks and moral hazard From a macro perspective, risks to the financial sector, local governments and property Risks of property developers, developers are well linked. The root of the risk is the decline of potential growth and the LGFVs and the financial sector are interlinked government‟s efforts to maintain high growth amid the global financial crisis and political transition. This has lead to a heavy reliance on infrastructure investment and loose monetary and fiscal policies since 2008. A large part of the financing burden of infrastructure investments has fallen on local governments who had no choice but to resort to land sales and LGFV bond issuance. Loose monetary policy has led to a rapid rise in land and property prices, which helped local governments finance their investments in the short term. In the longer term, though, the current model is unsustainable, as local government financing needs to grow faster than revenue. Regulators tried to contain the risks in the banking sector, but they tolerated the boom of Government support leads to shadow banking activity to feed the financing needs of local governments and property severe moral hazard developers. It is important to note that the implicit government support of shadow banking activity was critical to the rapid growth in this sector. Trust products to LGFVs often sell out quickly, although the promised returns sound too good to be true, largely because investors assumed there is little credit risk given the borrowers‟ ties to government. This perceived government guarantee introduces a significant moral hazard problem in the financial market. Indeed, local governments have even been known to bail out private companies to avoid a The 2012 bailout made default in their jurisdiction. For instance, when Saiwei, a major solar panel producer, faced investors believe credit risk is limited trouble paying its bonds, the city government of Xinyu in Jiangxi Province (where Saiwei is located), used public funds to pay the bonds and avoid default. The story was widely reported in the Chinese-language financial press and made investors believe corporate bonds in general faced little credit risk. The moral hazard problem is not helped by the rating agencies. The IMF reported that 97% of corporate bonds in China were rated AA or higher (IMF, GFSR, October 2012). The moral hazard problem not only leads to financial risks, but also worsens income inequality. The moral hazard issue leads to As many shadow banking products are only open to high net worth retail investors (minimum a transfer of wealth from the general public to the rich subscription for trust products is usually RMB1m- 3m), only the rich can take advantage of the implicit government guarantee, while the government will likely have to pick up losses, at least from LGFV-related investments using funds that ultimately come from the general public. The boom in shadow banking and the severe moral hazard problem essentially lead to wealth transfer from the poor to the rich. 22 Nomura | Asia Special Report 15 March 2013 Endgame: Base case and risk scenario Base case Our base case is that the government will tighten policies to contain financial risks in 2013. We We expect the government to expect the government to gradually bring down growth of M2 money supply and total social contain financial risks via policy tightening financing as early as from Q2 2013, to tighten controls on shadow-banking activities and LGFV financing, and to hike interest rates twice in H2 2013. The cost of the tightening is that we estimate economic growth to slow to 7.3% y-o-y in H2 from 8.1% in H1. The benefit is that China should be able to reduce the risks of a systemic financial crisis and avoid a much harder economic landing beyond 2013. The government has started to signal that it is concerned with financial risks and plans to take The government has signalled actions to contain them. These signals have not yet turned into concrete action – monetary its concerns recently policy remains loose as TSF hit an all-time high in January and remained strong in February on a working-day adjusted basis. M2 growth stood at 15.2% y-o-y in February compared to 13.8% in December. Still, we continue to believe that policy will eventually be tightened, as the government announced on 5 March to target M2 growth at 13% in 2013, from 14% in 2012. Investors may wonder why we believe proactive policy tightening is possible in the first year of Consensus believes the new the new Politburo leadership. The consensus view is for a sustained recovery throughout 2013, government has to keep policy loose in its first year exactly because of the political argument – new leaders always have an incentive to push up growth when they take over, hence policy will maintain its easing bias for 2013 and even 2014, with GDP growth staying above 8% for both years. We believe the consensus view is wrong for four reasons. We believe the government will tighten because: 1) the risks are First, it underestimates the challenges facing the new leadership. The risks we have identified in high this report have been well-flagged by international organisations as well as domestic leaders and researchers. We believe the new leadership understands that it is in the best interests of the nation – and their own best interests – to handle the risks early in their 10-year tenure. They have the capacity to keep the investment boom in the property and infrastructure sectors going for a year or two by keeping policies loose, but eventually the problem will become bigger and harder to resolve. Second, the leadership has the advantage of hindsight and can learn from other countries‟ 2) The government may apply experiences. We believe they can learn a lot from the lessons of Japan and Germany in the lessons learned from other countries‟ failure… 1980s, when both countries experienced rapid economic growth, but Japan experienced an asset price bubble that burst and led to its lost decade, while Germany maintained strong growth without a major crisis. One key difference is that the German central bank adopted a prudent monetary policy such that the leverage ratio of the economy did not rise sharply, as it did in Japan (Figure 45). This is a clear lesson for China that it should control its leverage to help avoid systemic financial risks. Recent experience does show that lessons have been learned. When the government rolled out … as it showed in tightening its policies to cool the property market in 2010, there was also a widespread view that the property sector policies measures would only be temporary, but actions over the past three years demonstrate the government‟s clear awareness of how dangerous a property bubble can be, and how determined it is to handle the risk. We believe the government is far-sighted and will react decisively to risks that challenge sustainable growth, even if reacting comes at a cost to short- term growth. Third, we believe the government understands that a failure to tighten policy now will become 3) Delayed policy tightening will much more costly in the future. With the labour market remaining tight in 2012, despite the incur higher costs in the future economy slowing to 7.8% growth, there was no widespread social complaint over slower growth. We believe the Chinese leaders recognise that the key problem now facing China is no longer maintaining high growth at around 8%, as unemployment is no longer a big issue. The main risks are now financial stability, inflation and a property bubble. Slower growth will help to address these problems, and as such, can be tolerated. Lastly, we expect inflation to rise above the government target of 3.5% by mid-2013, forcing the 4) Inflation will eventually force PBoC to hike interest rates twice by a total of 50bp in H2. Inflation is the ultimate constraint on tighter policy how long the government can afford to keep a loose policy bias. Recent data show inflation is already rising. 23 Nomura | Asia Special Report 15 March 2013 We believe that if the government decides to tighten policy quickly, a few cases of default are We believe policy tightening in likely, but the banks and the government have the capacity to absorb these losses. The 2013 will not lead to a systemic crisis question becomes one of burden sharing among the government, the financial sector and investors, but we see little risk of a systemic financial crisis. Risk scenario The risk scenario is that the government decides to keep policy loose and tolerate the financial The risk scenario is if policy risks in exchange for strong growth in the short term. This is clearly a dangerous choice, but we remains loose… cannot rule it out given political pressures to maintain strong growth. We acknowledge the fact that this is the first year for the new leaders in office, and that at the recent National People‟s Congress it was decided to keep a growth target of 7.5% rather than cutting it to 7% (the target for the 2011-15 five-year plan). When growth slows to 7.5% or below, we can expect a lot of pressure to loosen policy and deliver another round of fiscal stimulus. If the government does decide to loosen policy further this year, then the risks of a systemic … in which case systemic risks crisis in coming years would rise. We have written before on the risk of an economic hard- can be expected to rise landing (see China risks, November 2011), while our proprietary China Stress Index suggests elevated macro risks in the economy (see Nomura's China Stress Index (CSI) - high but stable in Q4, 31 January 2013; Figure 46). Further policy easing could push the leverage ratio and inflation even higher, which would make the eventual deleveraging process more disruptive. Fig. 45: Domestic credit-to-GDP ratio, Germany and Japan Fig. 46: Nomura’s China Stress Index (CSI) % of GDP % of GDP Jan 2000 =100 Germany 102.0 China risks 135 260 report Japan, rhs published 101.5 125 235 101.0 115 210 100.5 105 185 100.0 95 160 99.5 1980 1982 1984 1986 1988 1990 1992 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Source: IMF, CEIC and Nomura Global Economics. Source: IMF, CEIC, WIND and Nomura Global Economics. In a systemic crisis scenario, we believe the first link in the system to break would be the credit CGCs, trust companies and guarantee companies, the trust companies and the highly leveraged developers without highly leveraged property developers are at most risk government ties. CGCs and trust companies are highly leveraged, as they have only a limited amount of capital. Once a default occurs in the bond and/or trust market, credit spreads could widen to price in the actual risk premium and we can expect the volume of transactions to shrink quickly. Contagion could quickly spread because many of the risks have become interlinked. It would be difficult for firms to issue new debt without an explicit government guarantee. Without government intervention, the risks would inevitably spread to the banks and the Banks would be affected corporate sector. The banks‟ NPL ratios are generally low, partly because the LGFVs had to without government intervention borrow from the bond and trust markets to repay bank loans. If LGFVs can no longer issue new debt, then NPLs at the banks would likely rise. The same argument applies to the corporate sector as well, particularly the property developers. That said, we doubt the government would allow the shock to be amplified through the above The government would likely channel, so in this case, we believe a public bailout would be an inevitable eventuality. A bailout bail out the financial sector, as it has in the past on such a scale is not unprecedented in China. In the early 2000s, the government set up four asset management companies (AMCs) and transferred the bad loans from bank balance sheets to them. The operation was financed through the Ministry of Finance. The AMCs still exist and could play an important role in this risk scenario. 24 Nomura | Asia Special Report 15 March 2013 Of course, there are many forms that a bailout could take. The conventional “debt restructuring” A bailout could take many forms or debt writedown of bank NPLs, in which investors (including the government as major shareholder) would have to bear the loss. The injection of public funds to recapitalise the banks and transfer NPLs to the AMCs at a discounted price, similar to events in the early 2000s, is also an option. Third, is a potential transfer of central government funds to local governments as a source to allow them to repay their debt, or, fourth, the sale and privatisation of local government assets to repay the debt. We do not have a particularly strong view on which particular option would be the primary A bailout may be funded by model, but we do see an increased likelihood of greater privatisation in the years to come. Many selling state-owned assets local governments own assets in areas such as public utilities, highways and housing, many of which are the result of fiscal largesse in recent years. It is not hard to imagine local governments being forced to sell such assets at discounted prices as pressure builds. While a bailout could help avoid a complete financial sector meltdown, it would not be enough to A crisis may trigger reforms, as kick-start the next growth cycle. In the early 2000s, China‟s economy turned around not has happened in the past because of the bailout, but because of a series of aggressive reforms alongside WTO accession; the high potential for productivity growth given favourable demographic trends; and a huge labour force that migrated to the coastal regions to work. The key to China‟s future is reform, which usually only happens when the pressure to act has built to intense levels. Privatisation at both the state and local level may also help improve productivity. The government may even be forced into other tough reform decisions, such as de facto land privatisation. The economic outlook will depend on how these reforms are conducted, and the end-game will plant the seeds of the next phase of economic development. 25 Nomura | Asia Special Report 15 March 2013 Appendices Appendix 1: Five rounds of trust company regulation Round 1: 1985. In 1977 Deng Xiaoping took over the political leadership and began his famous market-oriented reforms. The establishment of China International Trust and Investment Corporation (CITIC) in October 1979 marked the re-emergence of the trust industry in China. Over 1981-82, many new trust companies were established by banks, local governments and government ministries, but their main business was to take deposits or enable interbank lending, either for lending or direct investment in development projects. However, the practice quickly led to an overheating in fixed asset investment and rising inflation. The State Council tightened regulations on the trust industry in September 1985, banning new trust loans and cleaned up existing trust loans. Round 2: 1988. The economic cycle picked up in 1986 and ended in 1988 when the economy overheated. Fixed asset investment growth reached 25.4% and hyper-inflation surged to 20% from 7.8% in 1987. By early 1988, the number of trust companies had increased to around 1,000, of which 745 had received formal approval from the Peoples‟ Bank of China. In August the government controls reduced the number of trust companies to 360. Round 3: June 1993. The economy overheated once more following Deng Xiaoping‟s famous “south tour” in 1992. One important regulation was the separation of trust and banking businesses. Trust companies were banned from deposit-taking or conducting settlement business and were also excluded from the securities brokerage and underwriting businesses. Round 4: 1998. The financial crisis in East Asia led to a growth slowdown in China and some high profile bankruptcy cases such as Guangdong International Trust Company (GITIC). By 2001, the number of trust companies had fallen to just 59. Round 5: 2007. Amid another period of economic overheating, these were partly triggered by several bankruptcy cases in the trust sector between 2004 and 2006, such as D‟Long Company and Hainan Huitong Trust and Investment Corporation. In March 2007, the regulators announced that they would apply ratings-based regulations on the trust industry. Source: Nomura Global Economics. 26 Nomura | Asia Special Report 15 March 2013 Appendix 2: Trust companies have grabbed the headlines Media reports Risk event Feb 2012 SDIC Trust arranged a trust loan of RMB200mn to a company with no income or tax record, and with poor collateral. Mar 2012 Jilin Province Trust suffered a loss from a fraud related to one of its trusts worth RMB150mn. May 2012 Local government in Shandong reportedly asked trust companies to issue trust products for government financing. June 2012 China Credit Trust's RMB3.0bn mineral energy trust product reportedly faced a high default risk. Sep 2012 Zhong Rong International Trust's RMB1.164bn of products related to real estate projects in Ordos faced a high default risk. Nov 2012 China Fortune International Trust failed to pay interest on its RMB547mn of trust products. Nov 2012 A trust product sold by Huaxia Bank defaulted, which was widely reported in both Chinese and international media. Dec 2012 CITIC Trust's RMB1.3bn San Xia Quan Tong Project faced high default risks and failed to make interest payments on time. Qingdao Kaiyue, a RMB300mn trust loan product originated by Zhong Rong International Trust, had difficulty paying investors. The Dec 2012 collateral (real estate assets) was auctioned at 60% below the original appraised price. Chaorisolar, a listed solar power company, pledged its equity to eight trust companies. It faces the risk of bankcruptcy and the CEO Dec 2012 has disappeared. Trust loans linked to the company face default risks. Pingan Trust's RMB3.6bn project "Jiayuan #25" faces heightened default risk as its Fuzhou property project is far from completion, but Dec 2012 the trust repayment date is close. Dec 2012 The RMB400mn "golden bull" trust product issued by CCB Trust reportedly suffered a book loss of over 50%. CITIC Trust's RMB710mn real estate project in Qingdao faces a high default risk. The collateral (real estate assets) was auctioned at Jan 2013 40% below the original appraised price Jan 2013 Xinhua Trust announced one of its trust loans faces default risks, as the guarantor, Gaoyuan Real Estates, is stuck in a debt crisis. Jan 2013 CITIC Trust's RMB1.3bn San Xia Quan Tong Project failed to pay interest on time Tianjin Trust's one trust product was was terminated prematurely in February, less than three months from its issurance, due to inter- Feb 2013 organizational disputes. An Xin Trust announced a sharp decline in net profit attitributed to shareholders, down by 44.8% from RMB195mn in 2011 to RMB108bn Mar 2013 in 2012. Mar 2013 The trust product named Chuang FU, issued by Ping'an Trust, was reported to have suffered a loss close to 30%. Source: Various media sources; Nomura Global Economics. 27 Nomura | Asia Special Report 15 March 2013 Appendix 3: Forecast summary % y-o-y growth unless otherwise stated 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 2012 2013 2014 Real GDP 8.1 7.6 7.4 7.9 8.2 8.0 7.4 7.2 7.8 7.7 7.5 Consumer prices 3.8 2.9 1.9 2.1 2.7 3.4 3.6 4.5 2.6 3.5 4.0 Core CPI 1.5 1.3 1.5 1.5 2.0 2.1 2.4 2.1 1.5 2.2 2.0 Retail sales (nominal) 14.9 13.9 13.5 14.9 16.2 15.9 15.5 15.6 14.2 15.8 16.0 Fixed-asset investment (nominal, ytd) 20.9 20.4 20.5 20.6 21.0 21.2 21.3 22.0 20.6 22.0 20.0 Industrial production (real) 11.6 9.5 9.1 10.0 10.8 10.5 9.6 9.6 10.1 10.1 9.7 Exports (value) 7.6 10.4 4.4 9.5 3.0 4.0 6.0 6.0 7.9 4.9 6.0 Imports (value) 6.9 6.4 1.4 2.8 7.0 8.0 9.0 9.0 4.4 8.3 10.0 Trade surplus (US$bn) 0.2 68.4 79.2 83.4 -16.9 52.9 70.1 74.3 231.2 180.3 122.0 Current account (% of GDP) 2.6 1.0 -0.4 Fiscal balance (% of GDP) -1.6 -1.5 -1.6 New increased RMB loans (CNY trn) 8.2 9.0 9.0 1-yr bank lending rate (%) 6.56 6.31 6.00 6.00 6.00 6.00 6.25 6.50 6.00 6.50 6.50 1-yr bank deposit rate (%) 3.50 3.25 3.00 3.00 3.00 3.00 3.25 3.50 3.00 3.50 3.50 Reserve requirement ratio (%) 20.5 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0 19.0 Exchange rate (CNY/USD) 6.31 6.32 6.34 6.29 6.22 6.18 6.16 6.15 6.29 6.15 6.14 Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table reflects data available as of 15 March 2013. Source: CEIC and Nomura Global Economics. 28 Nomura | Asia Special Report 15 March 2013 References Martin Neil Baily, “Productivity and potential growth in the US and Europe”, January 2008, presentation at the European Central Bank. Claudio Borio and Mathias Drehmann (March 2009), “Assessing the risk of banking crises – revisited”, BIS Quarterly Review, p. 25-46. David Brackfield and Joaquim Oliveira Martins, “Productivity and the crisis: Revisiting the fundamentals”, 11 July 2009. Yongheng Deng, Jing Wu and Hongyu Liu (2013, forthcoming), “House Price Index Construction in the Nascent housing market: The Case of China”, Journal of Real Estate Finance and Economics. Yongheng Deng, Joseph Gyourko and Jing Wu (September 2012), “Land and House Price Measurement in China”, NBER Working Paper No. 18403. Federal Reserve Bank of Atlanta, “The role of external shocks in the Asian financial crisis”, Economic Review, Q2 1999. Jeffrey Frankel and George Saravelos (2011), “Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis”, Regulatory Policy Program Working Paper RPP-2011-02. Robert J. Gordon, “The Slowest Potential Output Growth in U. S. History: Measurement and Interpretation”, presented at the Center for the Study of Innovation and Productivity at the Federal Reserve Bank of San Francisco, 2008. Pablo Hernández de Cos, Mario Izquierdo and Alberto Urtasun, “An estimate of the potential growth of the Spanish Economy”, Banco de Espana Documentos Ocasionales, Nº 1104, 2011. Richard C. Koo (14 October 2012), Balance Sheet Recession as the Other-Half of Macroeconomics, Nomura Research Institute. Yang Li, Zhang Xiaojing et al. (June 2012), “China‟s Sovereign Balance Sheet and Its Risk Assessment”, Economic Research Journal, p. 4-19. Kalina Manova and Zhiwei Zhang (2012), “Export Prices across Firms and Destinations”, Quarterly Journal of Economics 127 (2012), p.379-436. Xiao Gang (12 October 2012), “Regulating shadow banking”, China Daily. Zhiwei Zhang (November 2001), “Speculative Attaches in the Asia Crisis”, IMF Working Paper Series, WP/01/189. 29 Nomura | Asia Special Report 15 March 2013 Recent Asia Special Reports Date Report Title 6-Mar-13 Southeast Asia: Different strokes 28-Nov-12 2013 Outlook: Asia's overheating risks 14-Nov-12 South Korea: An Economic Democracy 25-Oct-12 India reforms (Part I): A long way to go 11-Oct-12 Introducing NESII – The Nomura Economic Surprise Index for India 24-Sep-12 Thailand: New growth engines 14-Sep-12 China primed to surprise on the upside 5-Sep-12 Better hedges for a China hard landing 3-Sep-12 India's chronic balance of payments 7-Aug-12 Asia's inflation wildcard 2-Aug-12 Indonesia: Policy swings 31-Jul-12 India: A poor monsoon and its impact (Q&A) 9-Jul-12 South Korea: Prolonged low growth, inflation and rates through 2013 31-May-12 Pan-Asia: Inventory cycle threatens a slow recovery 29-May-12 China's peaking FX reserves 2-May-12 India: Make or break 23-Apr-12 The China compass 16-Apr-12 Korea: Uncomfortable trade-off 11-Apr-12 India: Four cyclical tailwinds to watch 27-Mar-12 Capital account liberalisation in China 9-Mar-12 India budget preview: Fiscal cheer 1-Mar-12 Asia: What if oil prices keep rising? 23-Feb-12 Philippines – Fiscal space to maneuver 16-Jan-12 Decoding India‟s stubbornly high inflation 20-Dec-11 Implications from North Korea 18-Nov-11 A cold winter in China 3-Nov-11 Thailand: Dealing with another disaster 31-Oct-11 China Risks 19-Oct-11 Korea: Falling, converging bond yields 21-Sep-11 China: The case for structurally higher inflation 8-Aug-11 Global market turbulence: Implications for Asia 7-Jun-11 Indonesia: Building momentum 10-Mar-11 Vietnam: Prioritizing macro stability 3-Mar-11 South Korea‟s demographic sweet spot 14-Jan-11 India's 2011 outlook: Rising symptoms of a supply-constrained economy 1-Nov-10 The case for capital controls in Asia 11-Sep-10 The coming surge in food prices 6-Aug-10 Another step towards becoming an offshore RMB centre 28-May-10 The heat is on 26-May-10 Brinkmanship returns to the Korean peninsula 9-Nov-09 China: Not just an investment boom 30 Nomura | Asia Special Report 15 March 2013 Disclosure Appendix A-1 ANALYST CERTIFICATIONS We, Zhiwei Zhang and Wendy Chen, hereby certify (1) that the views expressed in this Research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company. 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