2016/17 china macroeconomic outlook & market opportunities

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CHINA ASSET MANAGEMENT

2016/17 China Macroeconomic Outlook & Market Opportunities

House View

October 2016

Confidential

This document is for professional clients and qualified/institutional investors only

It is not to be distributed to or relied upon by retail clients

China Asset Management House View, October 2016

2 This document is for professional clients and qualified/institutional investors only. It is not to be distributed to or relied upon by retail investors.

CONTENTS

1. Review of China Macroeconomic Environment in 2016

1.1 Over-leverage: High Leverage Levels Compel Deleveraging 3

1.2 Financial Reform Deepens, More Efforts Down the Road 7

1.3 Chinese Credit Issue: More Frequent Defaults, Systemic Risk Unlikely 9

1.4 Supply Side Reform: Capacity Reduction May Intensify in 2016H2 10

1.5 Property Markets: Impending Risks after Rampant Growth 13

2. China Macroeconomics in 2017

2.1 Support and Potential Issues of the Chinese Economy 18

2.2 Potential Effects of the Fed’s Rate Hike on the Chinese Economy 22

3. Investment Strategies in 2017

3.1 Equity Market Opportunities 25

3.1.1 Recap of Chinese Equity Markets in 2016 25

3.1.2 Equity Investment Opportunities in 2017 27

3.2 Fixed Income Opportunities 29

3.2.1 RMB’s Inclusion into the SDR Basket 29

3.2.2 Fixed Income Investment Opportunities in 2017 32


This document is for professional clients and qualified/institutional investors only. It is not to be distributed to or relied upon by retail investors. 3

1. Review of China Macroeconomic Environment in 2016

1.1 Over-leverage: High Leverage Levels Compel Deleveraging

Bank of International Settlements (“BIS”) estimated that non-financial institutions (government,

corporations, and households) in China had a total leverage ratio of 248.6% as of September 2015. This

exceeds that of developing countries such as Brazil, India, and Russia, and is among the highly levered

developed economies. The Chinese leverage ratio is only lower than Japan (387.1%), France (291.3%),

and United Kingdom (262.6%).

Exhibit 1. Non Financial Corporate Leverage Ratio across Major Economies (%)

Source: BIS, value of debt calculated at market value

Leverage levels of Chinese non-financial institutions were estimated by BIS, while the total leverage

was estimated by China Academy of Social Sciences (“CASS”). Although exact figures differ, the overall

trend is consistent. After a short halt in 2010 and 2011, the Debt/GDP ratio of various Chinese economic

components had steadily risen since 2008.

Exhibit 2. China Leverage Ratio Hit New Highs since 2008 (%)

Source: Wind

0

50

100

150

200

250

300

350

400

Japan France UK China US Germaney Brazil India Russia

Household Debt/GDP Non Financial Corp Debt/GDP Govn't Debt/GDP

0

20

40

60

80

100

120

140

1997

1998

1999

1999

2000

2000

2001

2002

2002

2003

2003

2004

2004

2005

2006

2006

2007

2007

2008

2009

2009

2010

2010

2011

2011

2012

2013

2013

2014

2014

2015

Household Debt/GDP Govn't Debt (Central+Local)/GDP

Financial Institution Debt (Bonds)/GDP Non Finaical Corp Debt (incld SOEs)/GDP

Record leverage

levels throughout the

economy

Chinese economy

among other highly

levered economies



S

We estimate the Chinese economic leverage ratio to be approximately 248.5% at the end of 2015,

among which 127.8% was attributed to the corporate sector. Bank loans, non-standardized loans and

bond financing are the main sources of corporate liabilities.

Exhibit 3. Leverage Composition of the Corporate Sector

Source: Wind

As the main source of corporate liabilities, the bank loan ratio has been traditionally stable at around

80% for the past three years. Since 2013, credit growth dropped to below 10% in 2015. By August 2016,

corporate credit growth had dropped to 8.6%, approaching the levels of nominal GDP growth.

Alternatively, non-standardized loans and bond financing both rebounded in 2016H1, with

year-over-year growth at around 20%. Hence corporate sector leverage, defined as the combination of

these sources had no meaningful decline.

Exhibit 4. Bank Loan Growth vs. Non-Standardized + Bond Financing (%)

Source: Wind

Microeconomic data indicates that the aggregated debt ratio of the industrial sector has trended

downward, yet the debt ratio of State-Owned-Enterprises (“SOE”) picked up despite its previously high

levels. Prioritizing expansion over profitability, SOEs have been the pillar in growth stabilization and

credit expansion.

70

75

80

85

90

95

100

105

-40

-20

0

20

40

60

80

100

120

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Bank Loan/GDP (Non-Standardized+Bonds)/GDP

Infrastructure Finance/GDP (Debit) Bank Loan % (Right)

0

20

40

60

80

100

120

140

0

5

10

15

20

25

30

35

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Bank Loan Growth

Non-Standardized+Bond Growth (Right)

Industrials levered

down, Chinese SOE

levered up

Credit growth

subsides, bond

financing bottomed

Leverage in corporate

sector remains high



Exhibit 5. Monthly Total Borrowing by Trust Loans, Entrusted Loans and Corporate Bonds

Source: Wind

Exhibit 6. Leverage Ratio: Industrial Sector Down, SOEs Up

Source: Wind

By the end of 2015, China Government Bonds (“CGB”) outstanding totaled to 10.7 trillion RMB. This

represents approximately 80% of the central government’s total obligations and implies approximately

13 trillion RMB in total debt owed by the central government. In the same period, total debt obligation

borne by the local government totaled 16 trillion RMB, plus an estimated contingent obligation of 10

trillion RMB. These figures imply a total public sector leverage of 57.2%, up 2% from 2014, with central

government and local governments account for 19% and 38% respectively.

Exhibit 7. Leverage Ratios of Central and Local Governments

Source: Wind

0

200

400

600

800

1,000

1,200

01 02 03 04 05 06 07 08 09 10 11 12

2013 2014 2015 2016

63.0

63.5

64.0

64.5

65.0

65.5

66.0

66.5

67.0

56.0

56.5

57.0

57.5

58.0

58.5

59.0

59.5

60.0

12-2 12-8 13-2 13-8 14-2 14-8 15-2 15-8 16-2

Industrial Corp Debt% SOE Debt% (RHS)

0%

10%

20%

30%

40%

50%

60%

09 10 11 12 13 14 15

Central Government Leverage Local Government Leverage

Public sector

leverage: central

government lever up,

local governments

deleverage



Exhibit 8. Major Government Debt as % of GDP

Source: Bloomberg

The current leverage level of the Chinese central government is well below the red line of 60%. While its

global counterparts such as the US, Japan and EU are all well above 50% (but their local government

debt levels are lower than China), which leads to the conclusion that the Chinese central government

debt level may be well managed. Yet, high local government debt remains a potential concern. The

Chinese government introduced No.43 legislation, which focuses on quota rationing of the local

government debt and local government debt swaps.

Local government debt is mainly comprised of local government bonds, external sovereign debts,

financing platform loans, trust loans and local-government funding vehicle (“LGFV”) bonds. After the

2015 local debt swap, financing platform loans account for 44% of total local government debt, LGFV

bonds and trust loans accounted for another 35%, local government bonds (general + swap) account for

the remaining 20% and is expected to grow.

In order to counter deleveraging in the corporate sector and as the accompanying effects of a sliding

economy, the government remains the key driving force in adding leverage. In China, the most likely

path is for the central government to lever up and the local government to deleverage. Central

government still has ability and flexibility to add debt, expand government deficit and increase CGB

issuance to finance fiscal spending. At the local level, swaps of the existing debt remains a priority. New

debt issuance will be tightly scrutinized by budget controls to prevent risks.

Exhibit 9. Fiscal Income

Source: Wind

0%

50%

100%

150%

200%

250%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Japan Germany U.S U.K. Eurozone

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

2,500

3,000

13-7 13-10 14-1 14-4 14-7 14-10 15-1 15-4 15-7 15-10 16-1 16-4 16-7

Net fiscal income Fiscal revenue Fiscal expenditure

With the public sector

levering up, and the

fiscal spending

outpacing fiscal

income, deficit ratio

could surpass 3%



The household indebtedness has been climbing since 2008, and has reached 40% by the end of 2015.

Globally, such debt level not only falls behind developed economies such as U.S., Japan and the EU,

but also lags those of Brazil, India and Russia. From a structural point of view, medium to long term

consumer loans account for the largest portion of household debt, rising from its low of 52.0% in 2013 to

54.9% in 2015.

The medium to long term loan growth has exceeded 30% in 2016, and 20% for the household loan

growth. Based on these growth figures, household leverage could reach 45% in 2016. If we take the

provident loans into account, the de-facto household leverage could be as high as 50%. Owing to the

heterogeneity in GDP composition, Chinese household disposable income as a percentage of GDP is

significantly lower than that of developed nations. Hence, Chinese household leverage could be in

reality, comparable to those of U.S. and Japan. Global experience suggests that, as dependency ratio

bottoms, household leverage typically peaks. The Chinese dependency ratio bottomed in 2011, implying

limited room for further leverage stretching by the household sector.

Exhibit 10. Growth of Household Leverage

Source: Wind

Exhibit 11. Household Leverage of Major Economies Moderated after Reaching Peaks

Source: Wind

1.2 Financial Reform Deepens, More Efforts Down the Road

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0

5

10

15

20

25

30

35

04 05 06 07 08 09 10 11 12 13 14 15 16E

Trillion RMB Long-term business loans Long-term consumer loans

Short-term business loans Short-term consumer loans

Household debt ratio (see right)

0%

10%

20%

30%

40%

50%

60%

70%

80%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

70 75 80 85 90 95 00 05 10 15

UK US

Japan (right) Germany (right)

Household leverage

growth accelerated

Household sector

leverage: low

baseline, rapid growth



In the Government Working Report issued in March 2016, detailed working plans were announced to

materialize further financial system reforms. Key focus areas include refining financial regulation and

oversight, deepening interest rate and RMB exchange rate market reform, and accelerate of capital

market reform and legislation. Specifically, the following milestones have been achieve within the 2016:

The Value-Added Tax reform, which was kick-started in Jan 1, 2012, is now at full speed. Since May 1st,

2016, last four industries: Construction, Real Estate, Financials, and Services will be admitted into the

pilot scope to further reduce corporate tax burden and promote professional specialization.

The People’s Bank of China (“PBOC”) has dedicated a special column in its May 6, 2015 issue of

“2016Q1 monetary policy enforcement report”, detailing the market-driven CNY/USD fixing formation

mechanism. It has concluded that the “Closing rate + exchange rate change of a basket of currencies”

CNY/USD fixing formation mechanism has been established.

On May 11, 2016, China Insurance Regulatory Commission (CIRC) and the Ministry of Finance jointly

announced the “Implementation Plan for Establishing the Catastrophe Insurance System for Urban and

Rural Residential Housing in Earthquakes”. This marked a milestone of the Chinese catastrophe

insurance system.

The centerpiece of the reform is a reform and innovation framework featuring bilateral free trade

accounts, RMB cross-border transactions, interest liberalization and foreign exchange reform which

aims to promote Shanghai as a global financial hub. The opinion issued by the Shanghai government

also outlines risk prevention guidelines associated with the internationalization of the RMB.

It is expected to go online after a four month trial run. At the same time, the aggregated quota has been

abolished for both SH and SZ connects, which marks another milestone in improving market

accessibility. As a result, 70% of the market capitalization, both northbound and southbound becomes

directly accessible.

Table 1. Other Financial Reforms

Financial Oversight Financial regulators will continue to push for reform to maintain market order

and risk oversight. Details pending

Other Financial

Reforms

Mentioned in the

Government

Working Report of

2016

Deepening interest market reform

Extend state-owned commercial banking and government financial

institutional reform, develop private-owned banking sector. Begin trials for

alternative lending and investment programs.

Further equity and debt market reform and the development of the

legislative landscape. Improve proportion of direct investments.

Standardize and develop online banking and finance platforms. Promote

financial inclusiveness and green finance. Crack down on financial crimes

including illegal collection of funds. Aim to prevent systemic crisis.

HK-SZ Connect

officially announced

in August

Reform accelerated in

Shanghai Free Trade

Zone

Catastrophe

insurance system

underway

CNY fixing formation

mechanism in place

VAT pilot program at

full speed



1.3 Chinese Credit Issue: More Frequent Defaults, Systemic Risk Unlikely

Since 2016, there have been 24 defaults across major bond types (commercial papers, super

short-term commercial papers, medium-term notes, enterprise bonds, corporate bonds, and private

placement notes), doubled that of 2015. Default entities include private companies, SOEs, and

companies owned by regional governments. Only Local Government Funding Vehicles (“LGFV”) debt

remains intact.

Defaulting issuers in 2016 concentrated into three categories: over-capacity SOEs in heavy industries

such as steel, coal, and cement; renewable energy industries such as solar and wind power; and

private-owned light manufacturing firms and consumer firms. Corporate governance issues were

common among the default entities.

Among the 18 companies that defaulted on their obligations, no bond types were immune from the

credit risk outbreak, including Short Term Commercial Papers (SCPs). Rating wise, AA issuers

accounted for 65% of the defaults, and AA+ and AA- account for 18%. None of the AAA rated issuers

report defaults. There is no precedent of an AAA issuer defaulting.

Exhibit 12. Number of Bond Defaults by Sector

Source: Wind

Catalysts to Credit Risks

1) Internally, against the backdrop of macro economy slide and overcapacity issues, corporate

earnings deterioration and operating cash flow decline pushed up demand for external financing.

Burdened by more indebtedness, the repayment ability further weakens.

2) Externally, the de-capacity effort made refinancing and rolling over of borrowing more challenging.

Bond investor taking refuge in safety has led to widening credit spread and even cases of

unsuccessful credit bond issuance.

3) Creditor protection scheme to be further improved and instruments for credit risks hedging are

currently absent.

0

1

2

3

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Ligh

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Cem

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Non

-fer

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met

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Foo

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Che

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Mac

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Com

mer

ce

More credit defaults,

LGFVs remain intact



Defaults unlikely to trigger systemic risks

1) Total value of defaults is still minimal, merely 0.2% of total credit bond value outstanding, and

0.02% of total social financing outstanding.

2) The less risky bond classes, such as LGFV bonds, utilities, account for roughly 46%, overcapacity

industries account for 15%. Among over capacity issues, 78% are AAA rated bonds and less than

10% are rated AA or below.

Exhibit 13. Term Bonds Market by Issuer Type

Source: Wind

Exhibit 14. Credit Rating of Outstanding Bonds in Overcapacity Industries

Source: Wind

1.4 Supply Side Reform: Capacity Reduction May Intensify in 2016H2

With output rising instead of falling, the steel industry still faces weak supply-demand dynamics and

headwinds are expected with the capacity reduction progress. By July 2016, only 47% of the annual

target was met. The de-capacity progress varied by region. Regional shares of production capacities

have shifted. The steel industry has decelerated its capacity growth but has yet to reduce actual

capacity.

Urban Construction, Infrastructure & Utilities

46%

Coal, Steel & Non-ferrous metals 15%

Real Estate 6%

Others 33%

AAA 78%

AA+ 13%

AA 7%

AA- and lower 2%

Steel industry faces

headwinds

Defaults unlikely to

trigger systemic risks



Exhibit 15. Weekly Steel Inventory YoY Growth (%)

Source: Wind

By July 2016, the coal industry has reduced its production capacity by approximately 95 million tons, or

38% the annual target of 250 million tons. 2016 progress varied by province. Some provinces have

already reached their targets, while others, such as Inner Mongolia, Fujian, Ningxia, Guangxi, and

Xinjiang have just initiated their de-capacity program. August saw significant acceleration progress. By

the end of August, national-wide capacity has reduced by 150 million tons, or 60% of the annual target.

Current supply-demand structure favors coal over steel. Since June 2016, coal demand has recovered

due to higher consumption growth in power generation. Inventory levels at key power plants and ports

have declined declines. Between January and July 2016, output capacity has been cut by 10%, and

capacity reduction is expected to continue.

Exhibit 16. Coal Consumption YoY Growth by Major Power Companies

Source: Wind

-20%

-10%

0%

10%

20%

30%

40%

50%

W1 W6 W11 W16 W21 W26 W31 W36 W41 W46 W51

2011 2012 2013 2014 2015 2016

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

13-8 14-2 14-8 15-2 15-8 16-2 16-8

Coal Consumption by Six Major Power Companies Daily Average YoY Growth

Coal Consumption by Six Major Power Companies Monthly Average YoY Growth

Sound supply-demand

dynamics in coal

industry while

de-capacity continues



Exhibit 17. Coal Inventory Levels in Key Power Plants

Source: Wind

Growth rate of the nationwide property for sale by square footage trended downwards since 2015.

Growth of residential square footage for sale decelerated from 30% in 2014 to nearly 0% in 2016.

Exhibit 18. Square Footage of Residential Properties for Sale YoY Growth

Source: Wind

Cost component as a percent of revenue has consistently decreased over the past two years. Between

March and July 2016, profit margin in the industrials sector reached new highs over the same period

since 2012.

Exhibit 19. Profit Margin of the Industrial Sector

Source: Wind

10.00

15.00

20.00

25.00

30.00

35.00

40

60

80

100

14-8 15-2 15-8 16-2 16-8

Spot Inventory (Million Tons) Turnover days

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

01-7 02-7 03-7 04-7 05-7 06-7 07-7 08-7 09-7 10-7 11-7 12-7 13-7 14-7 15-7

Square Footage of Properties for Sale YoY Growth

Square Footage of Residential Properties for Sale YoY Growth

4.5%

5.0%

5.5%

6.0%

6.5%

1-2 3 4 5 6 7 8 9 10 11 12

2011 2012 2013 2014 2015 2016

Cost reduction

initiatives shown early

results in the

industrials sector

Accelerated inventory

reduction in the

property market



1.5 Property Markets: Impending Risks after Rampant Growth

By August 2016, residential property square footage sold grew by 25.8%, sales soared by 40.1%.

Property prices in first tier cities boomed and spill-over effects were observed in second tier cities.

According to the National Bureau of Statistics, resold property price in Shenzhen, Beijing and Shanghai

rallied by 66%, 48% and 39%, respectively.

Exhibit 20. Residential Property Sales vs. Real Estate Investment YoY (%)

Source: Wind

Exhibit 21. Housing Price Changes among 70 Cities YoY (%)

Source: Wind

Property purchases are backed by mortgages. Data suggests that from 2015 to 2016H1, deposit growth

has been relatively stable. However, loan growth has risen significantly in 2015. The discrepancy was a

result from lower interest rates and the revision in deposit calculation guidelines by PBOC in early 2015.

This recategorized 10 trillion RMB in financial institution deposits to general deposits. Loan-to-deposit

ratio in banks was lowered and fueled a round of rampant credit growth as a result. After June 2015,

PBOC further abolished the loan-to-deposit ratio as a statutory measure, with the intention to support

the real economy with credit.

Exhibit 22. Savings and Lending Growth (%)

Source: Wind

-30

-20

-10

0

10

20

30

40

50

60

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Residential property sales, cumulative growth Real estate development investment amount completed growth

-10

0

10

20

30

13-8 14-2 14-8 15-2 15-8 16-2 16-8

Tier one cities Tier two cities Tier three cities

0%

5%

10%

15%

20%

25%

12-12 13-6 13-12 14-6 14-12 15-6 15-12 16-6

Lending Growth Savings Growth

Property market surge

largely a credit

phenomenon

Chinese property

market surged in price

and volume



Exhibit 23. New Deposits by Year (Billion RMB)

Source: Wind

Households and non-bank financial institutions saw dropping deposit balances. Prior to 2015, the

household deposit decrease was mainly caused by re-allocation to investment products such as the

wealth management products and equities. The tide swiftly turned after the 2015 market correction.

Non-bank financial institution deposits began seeing net outflows after peaking in July 2015. This

indicates that allocation to wealth management products and equities are decelerating.

Households are withdrawing from deposits and allocating to the property market. Household loans grew

by over 20% YoY through July 2016. Medium to long term consumer loans are the key contributor with

over 30% growth and represents approximately 50% of the total loan market. Over 80% of the loans in

this category are mortgages. Growth in other types of loans we suppressed, falling to 7% YoY, even

lagging deposit growth. The mortgage driven household loan rally has funnel deposits and loans to the

corporate sector through the properties market.

Exhibit 24. Household Deposits Growth

Source: Wind

Exhibit 25. Household Leverage Growth Concentrated in Mid-to-Long Term Consumer Loans

Source: Wind

0

5,000

10,000

15,000

20,000

25,000

2011 2012 2013 2014 2015 2016

-10%

0%

10%

20%

30%

40%

2010 2011 2012 2013 2014 2015 2016

Deposits Balance YoY Growth Current Deposits Balance YoY Growth

Other Deposits Balance YoY Growth

0%

10%

20%

30%

40%

2011 2012 2013 2014 2015 2016

Growth in Loans Outstanding Growth in Mid-to-Long Term Consumer Loans Growth in Other Loans

Households taking

more loans, investing

in properties

Property boom

causing changes in

capital flows



The corporate sector saw higher deposits while new loans decelerated. In 2016H1the non-financial

sectors and syndicated credit growth dipped below 10% for the first time. The industrial sector credit

growth fell under 3% indicating weak credit demand by corporations.

Conversely, the deposit balance surged. Deposits of non-financial companies grew by 16%. Capital has

accumulated in corporate accounts but unutilized. Household property buying and government debt

swap are major sources of these funds.

Exhibit 26. Non-Financial Corporate Deposits YoY Growth

Source: Wind

Exhibit 27. Non-Financials Corporate Credit Balance YoY Growth

Source: Wind

Implied risks present in the property market may exceed previous cycles. The Chinese population has

reached an inflection point. Current fundamentals fail to explain the property bull market. Rapid growth

of household leverage is the true driving force.

If mortgage balance (commercial mortgage and provident mortgage) as a percentage of household

disposable income is used to gauge household leverage, the metric grew from low levels before 2012 to

57% in 2015. We expect this metric to reach approximately 70% in 2016, a level similar to that of the

U.S. and Japan. If this pace continues, mortgage balance may surpass the historical high in the U.S.

and reach 100% of household disposable income.

-20%

-10%

0%

10%

20%

30%

40%

14-1 14-5 14-9 15-1 15-5 15-9 16-1 16-5

Non-financial Deposits YoY Growth Non-financial Current Deposits YoY Growth

0%

2%

4%

6%

8%

10%

12%

14%

16%

14-1 14-5 14-9 15-1 15-5 15-9 16-1 16-5

Non-Financial Credit Balance YoY Growth Industrial Credit Outstanding YoY Growth

Property bull market

driven by leverage,

risks looming

Corporate sector

accumulates capital



Exhibit 28. Mortgage Balance/Household Disposable Income and Projection in U.S., Japan, and

China

Source: Wind

We try to estimate the marginal leverage change of household property purchases using new

mortgage/sales ratio (incremental mortgage/ incremental property sales value). We observed that prior

to 2012, the reading was as low as 25% and it had elevated to 39% in 2015. It is estimated to reach

50% in 2016, which is close to the 52% of U.S.’s peak prior to the financial crisis.

Exhibit 29. U.S Residential Mortgage Increase/Property Sales, Pre-Crisis

Source: Wind

Exhibit 30. U.S. Residential Mortgage Increase/Property Sales, After-Crisis

Source: Wind

0%

20%

40%

60%

80%

100%

120%

140%

160%

1980 1985 1990 1995 2000 2005 2010 2015 2020E

U.S. Japan China Scenario 1: mortgage growth of 25% China Scenario 2: mortgage growth of 30%

0%

10%

20%

30%

40%

50%

60%

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

1999 2000 2001 2002 2003 2004 2005 2006 2007

US residential mortgage increase, million USD

US residential property sales, million USD

US residential mortgage increase/property sales (see right)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

2010 2011 2012 2013 2014 2015 2016E

Residential mortgage increase(commercial loan+housing provident loan), billion CNY

Residential property sales(new+second hand), billion CNY

Residential mortgage increase/property sales (right)

Household marginal

leverage surged



Even Japan, in the peak of its bubble economy in 1989 never saw its incremental mortgage/GDP ratio

exceeding 3%. While in the U.S., prior to the outbreak of the financial crisis, this ratio peaked in 2005

after reaching 8%. In China, the incremental mortgages (commercial + provident)/GDP ratio was merely

4.9% in 2015, has jumped to 7.7% in 2016H1. This alerting figure is comparable to the U.S. peak,

implying looming risks in the property market.

Exhibit 31. U.S. and Japan Residential Mortgage Increase/GDP

Source: Wind

Exhibit 32. Chinese Residential Mortgage Growth/GDP

Source: Wind

In essence, the 2016 property bull market in China is a leverage driven one, coupled with vast capital

flow moving between sectors. Deceleration of household deposit growth and surging leverage ratio

would soon reach U.S. historical highs. This may indicate significant risks in the property markets.

Further growth in property prices may come at the cost of lower volume.

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

US mortgage increase/GDP Japan mortgage increase/GDP

0%

1%

2%

3%

4%

5%

6%

7%

8%

2010 2011 2012 2013 2014 2015 2016E

China mortgage increase(commercial loan)/GDP

China mortgage increase(commercial loan+housing provident fund loan)/GDP

New mortgages as

larger part of GDP



2. China Macroeconomics in 2017

2.1 Support and Potential Issues of the Chinese Economy

Short-term economic rebound in 2016 was primarily supported by real-estate and infrastructure

construction. The industrials value-added grew 6.3% YoY, higher than the expected 6.2% while reaching

a five-month high. This was confirmed by the rebound of Manufacturing PMI and total electricity

generated in August. Growing demand and profitability brought short-term improvements to industrials

and manufacturing. Capital investments in August grew 8.1% YoY compared to 3.9% YoY growth in

July. Growth rates of the major investment categories were mixed. Manufacture-related investments

were largely flat; real-estate received moderate growth while infrastructure investments grew

significantly due to positive fiscal stimulus.

Exhibit 33. Investments in Three Major Industries, YoY Growth (%)

Source: Wind

Significant growth in infrastructure investments were due to relaxed fiscal policies. Significant

infrastructure investments in 2016H1 were a result of relaxed fiscal policies. In 2016H1, growth of fiscal

expenditures reached 15.1%, while the ratio of fiscal expenditure/fiscal income in the first six months in

has reached 104.3%.

Exhibit 34. Fiscal Expenditure/Income Ratio Continues to Grow Since 2008

Source: Wind

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

14-3 14-6 14-9 14-12 15-4 15-7 15-10 16-1 16-5 16-8

Manufacturing Infrastructure Real estate

-2%

0%

2%

4%

6%

8%

10% 0%

20%

40%

60%

80%

100%

120%

2008 2009 2010 2011 2012 2013 2014 2015 2016

Fiscal expenditure/Income in the first half year

Net fiscal income/GDP (Right, inverted)

Short-term economic

rebound mainly

supported by

real-estate and

infrastructure

Short-term economic

rebound mainly

supported by

real-estate and

infrastructure



Exhibit 35. Infrastructure Investment and Fiscal Expenditure, Same Month YoY Growth

Source: Wind

However, there may be limited room for economic support through fiscal expenditures in 2016H2. Fiscal

expenditures ratio in the first eight months has reached 105%, while the Ministry of Finance has stated

that downward economic pressures will persist over the next few months. In 2016, Real GDP is

expected to grow by 6.6%, while nominal GDP is expected to grow by 8.5%. Given the projected annual

fiscal income/expenditures in 2016, there may be pressures to reduce fiscal spending in the remainder

of 2016.

Growth in the real-estate sector will likely moderate. The real-estate sector was a significant contributor

to steady economic growth in 2016. Real-estate sales by square footage in the first eight months of

2016 grew by nearly 30% YoY. However, real-estate sales may be reaching historic highs and is

expected to moderate in the future.

Exhibit 36. Residential Properties Sold by Square Footage

Source: Wind

Exhibit 37. Real Estate Investment Growth (%)

Source: Wind

-10%

0%

10%

20%

30%

40%

13-8 14-3 14-9 15-4 15-10 16-5

Infrastructure investment YoY growth

Fiscal expenditure YoY growth

-20

-10

0

10

20

30

40

50

13-9 14-3 14-10 15-4 15-11 16-5

Residential Properties Sold by Square Footage YoY

Residential Properties Sold by Square Footage MoM

-10

-5

0

5

10

15

20

25

13-9 14-3 14-10 15-4 15-11 16-5

Cumulated YoY growth

YoY growth

Fiscal spending

limited in 2016H2



The age group between 25 and 44 is expected to decrease after reaching its peak of 449 million in

2015. This age group is the demographic driving domestic consumptions. Among which they are major

consumers of durable goods including housing, automobiles and furniture, as well as fast-moving

consumer goods including alcohol and beverages, clothing, and entertainment.

Exhibit 38. Projected Change in Population Demographics between 1990 and 2030 (Thousands)

Source: Wind

Developed economies generally observe weakening demand for housing and automobiles upon

reaching population peaks. Historical figures in Japan and Korea showed that new housing construction

figures rise and fell in tandem with the 25 to 45 age group.

New housing construction in China peaked in 2013 and property sales may peak in 2016. New housing

construction experienced significant growth since the Chinese housing reform in 1998. The figure grew

from less than 2 million units in 1998 to 14 million units in 2013. New housing constructions per

thousand have reached 18.5, surpassing that of the U.S. and approaching historical highs of Japan and

Korea. Similarly, property sales may reach a peak of approximately 14 million units in 2016.

Exhibit 39. New Housing Starts per Thousand People

Source: Wind

Exhibit 40. Number of Housing Starts and Sales Volume

Source: Wind

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

<25 25-44 45-64 >65

1990 1995 2000 2005 2010 2015 2020 2025 2030

0

5

10

15

20

25

U.S. Japan S. Korea China

New Housing Starts Per Thousand (Urban) New Housing Starts Per Thousand (Total)

0

5

10

15

07 08 09 10 11 12 13 14 15 16

New Housing Starts Property Sales

Property sales may

peak in 2016

Population inflection

point observed



The current growth cycle in housing price began in 2015. The growth was primarily led by first-tier cities

such as Beijing, Shanghai, Shenzhen and surrounding areas. However, this cycle was highly correlated

with growth in household savings rather than GDP growth. In 2015, the government relaxed regulations

on financial institution deposits, allowing financial institutions to lend out capital locally. This resulted in

explosive savings growth in regional financial centers. The same year savings growth rate in Shenzhen

reached 70%, while savings in Beijing and Shanghai grew by nearly 50%. However, savings growth has

approached 0% since then, and therefore future liquidity may be limited.

Exhibit 41. Changes in Macroeconomic Metrics in Tier One Cities

Source: Wind

Exhibit 42. RMB Savings Growth in Tier One Cities

Source: PBOC, Wind

Fiscal support has led to growth in infrastructure spending. However, due to budgetary constraints, the

same level of expenditure is unlikely. Current progress on reducing overcapacity may imply further

accelerated efforts in the future, imposing additional pressure on industrial growth. We expect 2016

GDP growth to be approximately 6.6%, and 2017 GDP growth to be approximately 6.3%.

Exhibit 43. GDP Growth and Forecast

Source: Wind

0%

5%

10%

15%

20%

Shanghai Beijing Shenzhen

Nominal GDP Growth Housing Price Growth Deposits Growth

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

14-1 14-7 15-1 15-7 16-1 16-7

Beijing Shanghai Shenzhen

6.0%

6.2%

6.4%

6.6%

6.8%

7.0%

15-3 15-9 16-3 16-9 17-3 17-9

Downward pressure

on the economy

remains in 2017,

further slowdown

expected

Liquidity inflection

point observed



We believe the current stagflation environment is a short-term phenomenon, and we are currently at the

mid-to-late inflation cycle. As price increases, value of commodities in asset allocation gradually

reduces. We expect inflation to peak in 2016Q4, and deflationary pressure will appear in 2017.

Exhibit 44. CPI Changes and Predictions (%)

Source: Wind

We are cautious that the zero-interest rate environment may be a long-term trend. As the population

aging continues, the real-estate cycle is peaking. Return on assets will gradually decrease and

gradually approach zero. As housing sales decrease in 2017, we expect the 10-year CGB yield to

approach 2%.

Exhibit 45. 10 Year China Government Bond Yield (%)

Source: Wind

2.2 Potential Effects of the Fed’s Rate Hike on the Chinese Economy

In September, the U.S. Federal Reserve Open Market Committee (“FOMC”) postponed the interest rate

hike with a 7 to 3 vote. The FOMC believes that the U.S. economy has shown consistent recovery in

2016H1, and the labor market remains sound. Although the unemployment rate held steady over the

past few months, employment was relatively stable and household spending has gradually increased.

The FOMC expects the positive trend to continue. However, current sub-2% inflation remains a

concern. In addition, commercial investments remain weak. The FOMC’s decision is consistent with the

market’s general expectations.

2.5

3.0

3.5

4.0

4.5

5.0

10-11 11-5 11-11 12-5 12-11 13-5 13-11 14-5 14-11 15-5 15-11 16-5

10Yr China Government Bond Yield

Interest rate reduction

cycle reinitiates

Inflation over the short

term, deflation in the

long term

PPP Changes (see right) CPI Changes



Exhibit 46. Federal Funds Target Rates Movements (%)

Source: Federal Reserve

The probability for the Federal Reserve to raise interest rates once in 2016 remains high. It is expected

that a December hike may be appropriate due to strong employment and inflationary environment. The

Federal Reserve previously expected two rate hikes in 2016. Not raising the rates in 2016 may damage

the Federal Reserve’s credibility. Data from the futures market indicates a 14.5% probability of a

November hike, and a 59.3% probability of a December hike.

Exhibit 47. Rate Rise is Highly Likely as Priced in the Futures Market

Source: Fedwatch

We expect the rising interest rate cycle to continue into 2017. This will be the weakest rising interest rate

cycle in the Federal Reserve’s history. In September, the FOMC expected the benchmark rate to be

0.6% by the end of 2016, lower than the 0.9% expected in June 2016. This reduces the number of rate

hikes from two to one. Furthermore, the FOMC also revises this figure from 1.6% to 1.1% by the end of

2017, and from 2.4% to 1.9% by the end of 2018. These revisions indicate a slower pace than

previously expected. If one rate-hike is materialized in December 2016, there will be a maximum of two

rate-hikes in 2017.

Considering the dominant position of the U.S. Dollar in the international currency systems, the U.S.

interest rate-hikes exert significant effects on the Chinese economy. The primary means of influence will

be the following.

Due to USD being one of the major reference currencies for the RMB, an interest rate-hike by the

Federal Reserve will cause PBOC to balance between foreign reserves, interest rates, and exchange

rates. This will reduce PBOC’s ability dictate monetary policy. The Chinese government has sufficient

foreign reserves to maintain steady short-term exchange rates when under pressure from a stronger

U.S. Dollar. However, the RMB has yet to become an international currency, and a certain level of

foreign reserves must be maintained. Under the current expectation for the RMB to depreciate, PBOC

must balance between the exchange rate and foreign reserves in the event of a U.S. rate hike.

0

1

2

3

4

5

6

7

91-9 96-9 01-9 06-9 11-9 16-9

Federal Funds Target Rates

0

20

40

60

80

100

16-9 16-10 16-11 16-12 17-1 17-2 17-3 17-4 17-5 17-6 17-7 17-8 17-9

Pre-FOMC Meeting Post-FOMC Meeting

PBOC needs to

balance exchange rate

and foreign reserves

Fed’s December rate

hike likely



a

Furthermore, PBOC must balance between the exchange rate and the interest rate as the spread

between U.S. and China government yield narrows. This would further result in RMB capital outflow and

depreciation. Further interest rate reduction in this environment may result in additional capital controls

in exchange for independence in Chinese monetary policies.

The anticipated U.S. rate hikes would result in global liquidity crunch and indirectly weaken the easing

programs of various countries. Such impact was observed in the first rate hike in 2015. Equity markets

in China, Brazil, Hong Kong, and Russia had all experienced sharp declines. We expect elevated

volatility in risky assets in 2017 as the U.S. rate hike cycle continues.

Global market cycles have been historically associated with the global central banks and their interest

rate policies. Housing bubbles often originate from easy monetary policies. Tightening monetary policies

as a result of foreign exchange pressures are usually the primary catalyst to bursting the housing

bubble. Once the U.S. raises rates, and the RMB faces foreign exchange pressure, then the housing

market may face significant headwinds.

Exhibit 48. Major Stock Market Changes

Source: Wind

-30%

-20%

-10%

0%

10%

20%

30%

40%

Dec 2015-Jan 2016 Jan 2016-Aug 2016

China Brazil Hong Kong Argentina Russia US Japan Germany

France Phillipines India South Korea Mexico UK Indonesia

Headwinds on the

Chinese housing

market

Fed’s rate hike may

cause liquidity crunch



3. Investment Strategies in 2017

3.1 Equity Market Opportunities

3.1.1 Recap of Chinese Equity Markets in 2016

The market has experienced significant volatility in early 2016. The failure of the circuit breaker system,

supply side policy expectations, and global implications of Brexit has resulted in a series of market

downturns. The Shanghai Composite Index began the year at 3,539, and bottomed at 2,737 in January.

The market was under downward pressures from RMB depreciation and the fear of major shareholders

disposing of their equity positions. Throughout majority of 2016, the equity market has been primarily

driven by government policies. Stability of the financial markets has been an important priority for the

current political regime. The two new members of the China Securities Regulatory Commission

(“CSRC”) boast extensive experience in the Chinese financial system. Their progressive track record

represents the government’s commitment to further financial market reforms. The Shanghai Composite

Index has since recovered to 3,085 as of August 31, 2016. In the remainder of 2016, the market will

primarily focus on the next U.S. rate hike as well as its influence on capital flows and the currency. This

remains to be an outstanding factor for investors to maintain a risk-adverse perspective.

Exhibit 49. Shanghai Composite Index and 10-Year Treasury Yield

Source: Wind

Exhibit 50. Major Stock Market Indices since Jan 27, 2016 (%)

Source: Wind

2.6%

2.8%

3.0%

3.2%

3.4%

3.6%

3.8%

2,500

3,000

3,500

4,000

4,500

5,000

5,500

15-01 15-03 15-05 15-07 15-09 15-11 16-01 16-03 16-05 16-07 16-09

Shanghai Composite Index closing price (see left) 10-year treasury yield (see right)

11.28% 11.02%

9.88%

8.66%

7.30% 6.34%

0%

2%

4%

6%

8%

10%

12%

SSE Dividend SSE 50 CSI 300 SSE Composite GEI Composite SME Composite

Market experienced

significant volatility in

early 2016



In the current market, company performance is the key factor to determining stock prices. Sector

allocation and thematic investments mainly revolve around profitability. Among others, SOE reforms and

public-private-partnerships (“PPP”) were major types of thematic investments. Since January 27, 2016,

large-cap indices such as the Shanghai Dividend Index and Shanghai 50 Composite Index delivered

12.2% and 12.1%, outperforming the CSI 300 index. Investment strategies focused on medium

price-earnings ratio, profitability, and large-caps delivered 16%, 19%, and 14% respectively. High

performance sectors in 2016 were alcoholic beverages, stock farming, electric vehicles, and consumer

electronics. Stocks reaching their new highs have an average annualized return on equity (“ROE”) of

14%, higher than 9% of the entire A-share market. This statistic is consistent with the overall sector

allocation and investment themes of 2016.

Exhibit 51. Style Index Changes since Jan 27, 2016

Source: Wind, as of Sep 22, 2016

Exhibit 52. Stocks Reaching New Highs Outperformed A-Shares in 2016H1

Source: Wind

Exhibit 53. 10 Best Performing Investment Themes since Jan 27, 2016

Source: Wind

1.77%

15.79% 14.36%

12.79%

16.54% 18.55%

10.01% 12.23%

14.00%

0%

4%

8%

12%

16%

20%

Hig

h P

/E

Med

ium

P/E

Low

P/E

Non

-pe

rfor

min

g st

ocks

Mic

ro-p

rofit

st

ocks

Blu

e ch

ip

stoc

ks

Sm

all c

ap

Mid

cap

Larg

e ca

p

-10%

0%

10%

20%

30%

40%

50%

60%

Growth of profit attributive to parent companies

Annualized ROE EPS

Stocks making new highs (off-the-run stocks excluded)

A-share overall

169%

51% 51% 43% 43% 41% 40% 39% 38% 37%

0%

50%

100%

150%

200%

Sub

-New

Sto

cks

OLE

D

Lith

ium

Bat

tery

Dec

orat

ions

&

Gar

deni

ng

Con

stru

ctio

n &

Ene

rgy

Effi

cien

cy

Wat

er &

Hyd

ropo

wer

Rar

e E

arth

s &

M

agne

ts

New

Mat

eria

ls

Gra

phen

e

Sm

art G

rid

Fundamentals dictate

equity prices



Exhibit 54. 10 Worst Performing Investment Themes since Jan 27, 2016

Source: Wind

Exhibit 55. Sector Valuations and Price Changes

Source: Wind

3.1.2 Equity Investment Opportunities in 2017

Investors should take a long-term view on the China A-shares market. The Shanghai Composite Index

grew 29 fold since its inception on December 19, 1990 at a compound annualized growth rate (“CAGR”)

of 14.0%. The free-float-weighted A-shares market grew 74 times at CAGR of 18.2% during this period.

If a portfolio of RMB-weighted A-shares equities was reinvested at the beginning of each year and

additional RMB-weighted investments were added to new issues in the prior year, the portfolio would

have grown by 576 times at CAGR of 28.0%. Over the same period, a share-weighted approach would

-4%

-1% -1%

1% 2%

3%

6% 6% 7% 7%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Onl

ine

Tra

vel

IP tr

affic

Mon

etiz

atio

n

E-S

port

s

Onl

ine

Cel

ebrit

y E

cono

mic

s

Ani

me

Maj

or S

OE

s re

stru

ctur

e

Airc

raft

Car

rier

Cro

ss-b

orde

r E

-Com

mer

ce

Inte

rnet

Lot

tery

Gen

etic

Tes

ts

Appliances

Food & Beverage

Electronic Components

Construction Materials

88.14

Chemicals

Automobile

Telecom

Comprehensives

Pharmaceuticals

Light Manufacturing

Non-Banking Finance

Agriculture & Farming

Construction

Power Equipment

Banking

Textiles

Oil & Gas

Real Estate

Machinery

Power & Utilities

Coal

Commerce & Retail

Steel

National Defense & Military

Catering & Tourism

Computers

Transportation

Media

x

10x

20x

30x

40x

50x

60x

70x

80x

90x

100x

-5% 0% 5% 10% 15% 20% 25% 30%

P/E

Mu

ltip

le (

TT

M)

Sector Price Change (%)

Bullish over the long

term, expect volatility

in the short term



grow the portfolio by 256 times at CAGR of 24.0%. Major asset classes also yielded phenomenal

returns. Between 2000 and 2015, residential properties in China grew by CAGR of 5.1% while the same

figure grew at CAGR of 24.0% in tier-one cities. Over the same period, 10-year Chinese treasury bonds

provided 3.5% yield to maturity. In the worst case scenario, assuming equal quantities of stocks were

purchased at the Shanghai Composite peaks (2,245 in 2001, 6,124 in 2007, 3,478 in 2009, and 5,178

points in 2015) and held to August 2015, the holding period return would be 168%, 105%, 128% and

-22% respectively. The market was dominated by a series of fluctuations within a narrow band.

Between April and August 2016, the market’s monthly range was 5.7% while weekly range was 3.0%.

There were two similar occurrences over the past 12 years. January to May of 2013 saw monthly and

weekly ranges of 6.2% and 3.4% respectively, while October 2013 to June 2014 saw 6.3% and 2.9%

respectively. These two narrow-range-bound markets were during periods of stable macro

fundamentals and liquidity. External catalysts were required to break the bounds. The market will likely

to be range-bound until domestic and international regulators offer additional clarity on further actions.

90% of the price fluctuations in both bullish and bearish markets can be attributed to company

valuations. In a volatile market where valuations decline, company profitability help to anchor and

support share prices. We expect that the market will continue to fluctuate over the medium term, and

company performance will be the primary factor for stock selection. Emerging industries and industries

with reasonable valuations and performances may offer attractive opportunities. We believe sectors

where companies report annual earnings growth of 15% or more and PEG ratio of 1.2 times or lower are

reasonable targets. These are mostly consumer-focused sectors including household appliances, food,

agriculture, real-estate, and computers. Emerging industries such as education, fitness, high-end

equipment, and automated manufacturing may also deliver strong performance. For over a decade, the

accelerated industrialization featured a population with average age between 30 and 40 years old. The

1970’s generation was the primary buyers of consumer discretionary goods, including durable goods

such as housing and automobiles. The millennials born between 1985 and 2000 are entering their

primes where they have larger appetite for consumer discretionary services such as education, fitness,

and entertainment. We expect the real-estate market to moderate after square-footage sales peaked in

2013, and consumption of emerging products and services should pick up. Since 2010, the global

automobile industry is undergoing a new era of revolution through innovation. This is driven by

extensive integration and implementation of improved mobility, artificial intelligence, and sharing.

Automobile manufacturers and technology conglomerates have invested unprecedented amounts of

capital and resources to transform their offering. This is expected to facilitate the development of related

industries in China, such as high-end manufacturing and smart-cars.

Exhibit 56. Shanghai Composite Index Underestimates Investment Returns in A-Shares

Source: Wind

14.0%

18.2%

24.0%

28.0%

0%

5%

10%

15%

20%

25%

30%

SSE Composite Free-float-weighted Share-weighted RMB-weighted

CAGR since SSE establishment

Company profitability

dictates stock prices

during market

turbulence



Exhibit 57. Even Invested at Market Peaks, A-Shares Equities Paid Off in the Long Term

Source: Wind

3.2 Fixed Income Opportunities

3.2.1 RMB’s Inclusion into the SDR Basket

On November 30, 2015, the International Monetary Fund (“IMF”) announced the decision to include

RMB into the Special Drawing Rights (“SDR”) basket. The change had taken effect on October 1, 2016:

the SDR basket currently have a RMB weight of 10.92%, with dollar, euro, yen and pound weighting

41.73%, 30.93%, 8.33% and 8.09%, respectively.

Exhibit 58. Composition of SDR Before and After RMB Inclusion

Source: Wind

In the longer term, there can be hundreds of billions of dollars flowing into the Chinese capital markets

as a result. The inclusion into the SDR is effectively labeling the RMB as a “hard currency”. As a result

central banks and sovereign wealth funds will increase their allocation of RMB assets. In the current

global government reserves, the shares of dollar, euro, pound and yen are approximately 63.8%,

22.5%, 4.7% and 3.8% respectively, while RMB’s share is only 1.1%. Once RMB is included in the SDR,

global central banks’ demand for RMB-denominated assets can grow substantially. The growth will be

$210 billion if the share of RMB in the international reserves matches the yen or $290 billion if it does

the pound. Meanwhile other overseas institutions will also increase their demands for

RMB-denominated assets, which is even more significant.

168%

105%

128%

-22%

176%

58%

98%

-35% -50%

0%

50%

100%

150%

200%

Since 2,245 in 2001 Since 6,124 in 2007 Since 3,478 in 2009 Since 5,178 in 2015

RMB-weighted investment Share-weighted investment

41.9%

37.4%

0.0%

9.4% 11.3%

41.7%

30.9%

10.9% 8.3% 8.1%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

USD Euro RMB JPY GBP

Before SDR Inclusion After SDR Inclusion

RMB’s SDR inclusion

will further drive

foreign capital to

China



Exhibit 59. Shares of Major Currencies in Total Official Foreign Reserves

Source: COFER

Exhibit 60. Global Official Foreign Reserves Held in Yen-Denominated Assets

Source: COFER

Since the financial crisis of 2008, quantitative easing policies adopted by developed economies such as

U.S., Europe and Japan quickly led to zero or even negative yields in the short term. High-yielding

assets will be rare to find. Although China has also loosened its monetary policy, the magnitude is far

from the quantitative easing programs in Europe and U.S. and the current interest rates are still at a

high level. Current U.S. 10-year government bond yield is at 2.22%, Eurozone at 0.58%, and Japan at

0.32%, while China is at 3.04%.

Exhibit 61. 10-Year Government Bond Yield-To-Maturity of China, U.S., Europe, and Japan

Source: Wind

Hence China’s bond market is more attractive to long-term institutional investors including central

63.6%

20.4%

4.8% 4.1% 2.0% 1.9% 0.3% 3.0%

0%

10%

20%

30%

40%

50%

60%

70%

USD EUR GBP JPY CAD AUD CHF Others

0%

1%

2%

3%

4%

5%

6%

7%

8%

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

1995 2000 2005 2010 2015

Claims in JPY (Billions) % of Total Reserves (Right)

-1%

0%

1%

2%

3%

4%

5%

6%

07-1 07-7 08-1 08-7 09-1 09-7 10-1 10-7 11-1 11-7 12-1 12-7 13-1 13-7 14-1 14-7 15-1 15-7 16-1 16-7

U.S. EU Japan China

Chinese debt market

attractive to

international investors

with its higher interest

rates



banks, offshore RMB clearing banks, pensions and insurance companies. As of August 2016, overseas

institutions registered with ChinaBond have invested 633.8 billion RMB in the Chinese interbank bond

market, only 2.15% of the total market. In comparison, foreign institutions held 23% of Korea’s

government bond, and in Japan’s case this is 8% and in U.S., nearly 48%. As more and more foreign

investors enter China’s bond market, we shall see the bond market growing in both size and activity.

Exhibit 62. Size and Percentage of Bond Held by Overseas Institutions

Source: ChinaBond Custody

Fixed income products with high ratings and low risks may be the primary investment target, and the

long-end yields are again moving downward. Specifically, foreign capital will still favor treasury bonds

and financial bonds featuring high transparency, liquidity, and low risk. As of the August 2016, overseas

institutions held 54% of their total debt investments in Treasury bonds, and 39% in financial bonds, yet

only less than 10% in the more risky credit bonds.

In addition, the nascent onshore SDR bond is another important instrument for investors. For instance,

the debut SDR bond in China, dubbed a “Mulan bond”, was issued on August 31 and has sold 500

million SDR, equivalent of $700 million. The 3-year bond was subscribed 2.47 times and the 0.49%

yield was set at the lower bound of its range (0.4%-0.7%).

Exhibit 63. Composition of Chinese Debt Held by Overseas Institutions

Source: ChinaBond

1.5%

1.6%

1.7%

1.8%

1.9%

2.0%

2.1%

2.2%

2.3%

0

100

200

300

400

500

600

700

14-6 14-9 14-12 15-3 15-6 15-9 15-12 16-3 16-6

Overseas Institutional Holding (RMB Billions) Composition (%)

CGB 54%

CDB 19%

Corporate 3%

Others 1%

MTN 3%

EXIM 9%

ADBC 11%

Fixed income

products with high

rating and low risks

are attractive targets



3.2.2 Fixed Income Investment Opportunities in 2017

The government bond yields of major developed countries have continued to decline since 1980. The

U.S. 10-year Treasury yield dropped from over 10% to the current 1.6%-1.7%, and Japan’s 10-year

yield declined from 5% at the end of 1980s to the current -0.1%. The world has entered an era of low or

even negative interest rates.

Exhibit 64. Interest Rates in Major Developed Countries Sliding to New Lows (%)

Source: Wind

The drivers behind the global low interest rates mainly include: 1) disappearing demographic dividend

slowing down the economy. As a countermeasure, central banks scrambled to adopt monetary easing

policies and have thrown interest rates onto a long-term downtrend. 2) Declining return of the real

economy is driving capital out of the real economy and into financial assets. Treasury yields are thus

“bought down” by the newly allocated capital. 3) With the lingering deflation expectation and limited

sources for long-term growth, the marginal effect of quantitative easing has weakened, resulting in low

interest’s self-fulfilling cycle.

Exhibit 65. Dependency Ratio in China

Source: Wind

-2

0

2

4

6

8

10

12

14

16

80 83 86 89 92 95 98 01 04 07 10 13 16

S. Korea Japan Germany U.S.

0

20

40

60

80

100

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

Youth as % of Population Seniors as % of Population Total Dependency Ratio

Zero interest rate will

be the long-term trend



China’s interest rates will remain low for a long time regardless of perspective, demographic and real

estate, return on capital, or government leveraging. Firstly, with the aging population, the dependency

ratio of population bottomed at 36% in 2010, and the property boom has passed its peak and will be

followed by declining demand. Secondly, with the future excess capital and labor shortage, the balance

will shift to the labor force causing return on capital to decline. Lastly, the government is leveraging up

and replacing local government debt in order to prevent extensive economic slowdown. A low-rate

environment will be necessary for the government to succeed.

Since the onset of the monetary easing cycle in 2014, the Chinese bond market has seen a bull market

of more than two years. In August 2016, the 10-year treasury yield had broken the support of 2.7%

toward 2.6%, and the 10-year CDB has also moved to its new low of 3%. This bond bonanza will likely

continue over a long period.

Exhibit 66. 10-Year Government Bond Yields (%)

Source: Wind

Interest rates are expected to hit new lows in 2017. The pressure of economic slowdown will be

relatively high in 2017. Chinese corporations are pressured by low profitability. Total profits from the

industrials grew negatively in 2015. With the shrinking investment in manufacturing, the economy had to

be supported by real estate and infrastructure. In real estate, the growth of investment during 2016H1

has picked up together with the sales growth. Home buyers took out large amount of mortgage loans,

accounting for about half of the monthly average of 1 trillion RMB lending so far this year. However, the

leverage growth from the household source has reached its capacity so the rapid growth of property

sales is not going to last. In infrastructure, the investment is constrained by the financing. The

infrastructure investment’s supporting function would be mitigated should the financing lag behind.

Moreover, PPP’s support to the infrastructure will unlikely meet market expectations given that PPP

projects’ execution rate is still low.

In our view, although the economic slowdown will continue in Q3 and Q4 of 2016, current production

activity is relatively stable and better than the market’s earlier gloomy forecast. There is a risk that

inflation may rebound in the fourth quarter and peak around that time due to the base effect. And then in

2017 deflation pressure will come back, taking the long rate back to the downtrend.

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

02-9 04-9 06-9 08-9 10-9 12-9 14-9 16-9

10-Yr CGB Yield to Maturity 10-Yr Policy Bonds Yield to Maturity

Inflation in the short

term and deflation

pressure may

resurface in 2017

2017 bond market

outlook is optimistic



Exhibit 67. Investment Growth

Source: Wind

Exhibit 68. Historical CPI and PPI and Forecasts

Source: Wind

Monetary policy is stable in the short term, but still has possibility of easing over the longer horizon. The

reasons for the current stable monetary policy include: 1) The short-term economic fundamentals have

stabilized and inflation has risk of rebounding. 2) The exchange rate needs to remain stable given the

possibility of another Fed rate hike. 3) To prevent asset bubbles. 4) To control leverage in the bond

market. However, economic fundamentals are the key to monetary policy. If in 2017 the economy faces

further pressure of slowdown and real return rate slides, the monetary easing will come rather late than

not.

Asset allocation needs will support interest rates. Many non-standard assets and negotiable convertible

debentures will mature this year. The maturing fund from wealth management products and insurance

will continue to turn to the bond market opportunities due to the impact of financial deleveraging on

non-standard products and the shortage of high-yield assets. In the meantime, corporate loans on bank

balance sheets continued to drop while mortgage is the only thriving lending business. In addition, the

funds led by the rural and municipal commercial banks are also rushing into the bond market in search

for yield.

Optimistic about the opportunities in 2017, interest rates are expected to hit record lows. We believe that

the down movement of short-term interest rate is limited and the bond market will be dominated by

fluctuations. However, faced by the high base in 2016, property sales in 2017 are expected to peak

followed by pullback. Next year China's economy will likely remain under the slowdown pressure and

monetary easing will be inevitable. Coupled with the asset allocation needs, record low interest rates

can be expected. It will be a great opportunity to add positions for next year If treasury yield in Q4

-5

0

5

10

15

20

25

30

35

11-7 12-1 12-7 13-1 13-7 14-1 14-7 15-1 15-7 16-1 16-7

Capital Investment YoY Growth Infrastructure Investment YoY Growth

Real-Estate Investment YoY Growth Manufacturing Investment YoY Growth

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

15-1 15-4 15-7 15-10 16-1 16-4 16-7 16-10 17-1 17-4 17-7 17-10

CPI & Forecast PPI & Forecast

Interest rates are

expected to hit record

lows

Monetary policy stable

in the short term



adjusts to the upper bound of its band or even higher.

From the fundamentals, China's real estate demand can hardly be said to have improved and is getting

closer to the turning point; Governments' revenue and expenditure balance has stretched and

infrastructure investment is not optimistic either. The economic downward pressure will remain high,

therefore we will be long-term bullish on the bond market. This year the 10-year Treasury yield has

already broken the 2008 low of 2.7% and is likely to break the 2002 low of 2.3% in 2017.

Interest rates may be able to touch the long-term bottom. In 2002, 2006 and 2008, the deterioration of

the economic fundamentals and deflationary pressure were the leading factors that drove the Treasury

yields to low levels. In the medium term, China's manufacturing investment will be constrained by

overcapacity, and the decline of real estate investment will be unavoidable once the demographic

dividend disappears. But the infrastructure investment can only support the bottom, so investment will

be under pressure. Combined with limited income growth and real estate's crowding out effect on,

China's future economic growth may be lower than in 2008, causing interest rates to bottom.

Table 2. Comparison of Market Fundamentals during Low Yield Markets

Time GDP

Growth CPI Growth

10-Yr CGB

Min. Yield Economic Environment

2002 8%-10% -1%-1% 2.30% Urbanization initiated

post-Asian Financial Crisis

2006 >12% 1%-2% 2.80%

Economic expansion

Low inflation environment

Rising rate cycle

2008 6%-7% -1%-2% 2.70%

Population dividend remains

Real-estate boom

4 trillion RMB stimulus

package

2016 and

after 6.5%-7%

Short-Term

1.3%-2%;

Deflationary Risk

Impending

New Lows

Expected

Demographic dividend

disappearing

Property market at inflection

point

Excess capacity in industrials

Infrastructure remains strong

Source: Wind, ChinaAMC Estimates

Lending cost angle: loan rate should match bond's yield. The yield on 10-year Treasury bonds should

be commensurate with the rate of return on loans after the costs of capital and taxes. The current

lending rate is about 5.25%, corresponding to the 10-year Treasury yield of around 2.75% and 10-year

China Development Bank (“CDB”)’s 3.1%. For bond yields to move lower, it will need the lending rates

to move down further, which in turn will depend on more monetary easing policy.

Asset allocation of wealth management products (“WMP”): Bond yield on the asset side of WMP needs

to cover the cost on the liability side. Using a leverage ratio of 2 and interest rate of 2.2% -2.3%, we

estimate the bond yield in WMP can be covered. Current yield of WMP remains at 3.9%, corresponding

to 10-year CDB yield of 3.1% and 10-year Treasury yield of 2.7% -2.75%. Future trend will depend on



how far interest rates and the cost of WMP will go down.

In our view, interest rates may be pushed down if one or more of the following conditions emerge:

downward adjustments of the repo-rates rates, further monetary easing, declining property sales and

peaking inflation.

Table 3. Short-Term Yield (2016Q4) Target Range on Rate Bonds

Metric Evaluation CGB Yield

Target

CDB Bond

Yield Target

Fundamentals Comparing fundamentals in ’02, ’06,

and ’08 2.5%-2.7% 2.9%-3.1%

Term Spread R007 remains low, term spread of 60bps,

relatively reasonable 2.5%-2.8% 2.9%-3.2%

Allocation by

WMPs

Wealth planning costs covered by

government bonds under 2x leverage 2.5%-2.7% 2.8%-3.1%

Lending Cost

Loan rate should be comparable to

government bonds after cost of capital and

taxes

2.55%-2.7% 2.9%-3.1%

Source: ChinaAMC



Contact Information

China Asset Management Co. Ltd.

Address: Level 8, Tower 7, One Yuetan Street South, Xicheng District, Beijing, China, 100045

Website: www.chinaamc.com

Email: [email protected]

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the actual returns that may be achieved.

The information in this report reflects prevailing market conditions and our judgment as of this date, which

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2016/17 china macroeconomic outlook & market opportunities

Economy & Finance