Having made clear in Part 1 the various policy leanings, uncertainty, and potential reform headlines, we delve a little deeper into the specifics of what the systemic and idiosyncratic implications might be. In two simple tables, Goldman lays out the top-down asset-class perspectives as 'new' China addresses its systemic issues and then looks at how China's equities (and by implication global equity indices) can meaningfully re-rate with a background of economic sustainability concerns as reforms impact various sectors more or less. As Goldman concludes: "Cyclical adjustments can help to restore confidence, but investors will likely be unwilling to meaningfully re-rate the market until more concrete progress is made on the reform front…but reforms may not be good for all sectors."
Via Goldman Sachs:
The leadership elections/transitions in both the United States and China have again drawn attention to the long-established practice of Chinese currency management through the setting of a daily “fix” of the $/CNY by the People’s Bank of China (PBOC), around which the $/CNY is allowed to fluctuate within a predetermined band. However, despite the continuation of this practice, several small steps have been taken to increase the flexibility of the CNY. Under the new leadership, it is more important to watch for further CNY reform progress than to focus on the daily CNY fix.
This more market-determined push has lead to an increase in volatility...
Much of this increased volatility can be attributed to swings in “hot money” flows, or how much money has flowed into or out of the Yuan, reflecting the desire to hold CNY versus foreign currency assets. Since late 2011, hot money outflows dominated, owing to a general easing of CNY interbank interest rates that reduced the attractiveness of holding money in Yuan and, more importantly, rising concerns about China’s hard landing risk and Europe’s sovereign debt crisis. These outflows were likely a key driver in reducing appreciation pressure from an otherwise solid external balance over the past year, pushing onshore CNY to the weak side of its trading band.
More recently, major monetary easing initiatives by global central banks and better-than-expected activity data for China has helped lift market sentiment, particularly towards Chinese growth. As a result, net hot money outflows have appeared to stabilize in September and might even have reversed thereafter, consistent with onshore spot trading persistently at the strong side of its daily band. Looking ahead, while the “fix” is likely to remain largely determined by policy factors and China’s overall external balance with the rest of the world, money flows driven by market sentiment are expected to continue to influence how onshore CNY trades within its daily trading band.
Less appreciation pressure and increased two-way expectations for $/CNY bring fundamentals more closely aligned with increasing freedom of flows in and out of China. The steps taken in the last few years are likely to be broadened, both in size and coverage.
Investors have long been concerned about the rapid credit expansion in China since the 2008 global financial crisis, and the efficiency of the Chinese banking system in allocating credits, especially to the private sector and to small and medium-sized enterprises (SMEs). The new leadership will have to address these concerns, potentially sooner than later, in order to quell the growing discontent from the private sector, which will be key to China’s economic future.
[As we pointed out here, things look extremely bubble-like in our view]
Reforms - the key to growth sustainability
In spite of a long period of strong growth, China’s economic model is facing intense skepticism. Investors are increasingly worried about critical issues such as:
(1) economic rebalancing away from exports and investment;
(2) deregulation and moving towards market-oriented systems;
(3) wealth disparity reduction; and
(4) limiting State-Owned-Enterprise (SOE) dominance.
Many investors feel that the past few years have seen not only no forward reform progress on these fronts, but actually some setbacks.
Seven top priorities pave the way to a better future
Fortunately, hopes for reform are improving as the once in a decade leadership transition in 4Q12-1Q13 approaches. There are likely seven main areas of reform that will be most urgent and most directly relevant to key industries and markets according to the 12th five year plan and yearly State Council reform agendas. Reform progress may be easier for some of those reforms than others (which involve reallocations of existing interests, such as deregulation or restructuring).
- Pricing deregulation: moving away from price control towards market driven pricing; impacting areas like oil, commodities, IPPs, as well as services such as airlines.
- Tax reforms: tax reduction for SMEs/private companies, shift from indirect to direct taxes such as resource tax, and property taxes.
- Energy savings: stricter emission standards, lower energy consumption, subsidies for green products, etc.
- Social safety net and healthcare: enhancement of safety nets for the masses including efforts such as pension reform, social housing, hukou (household registration) reform, education reform, and healthcare reform.
- Financial sector deregulation: interest rate deregulation, liberalization of insurance investment areas, etc.
- Financial sector innovation: deepening markets such as the corporate and municipal bond markets, new products.
- Railway restructuring: breaking up the Ministry of Railways into several parts to separate regulation and operation and pave the way towards more market driven, sustainable organizations.
While structural reform in China is mainly domestic facing, there will be large knock-on effects for global equities and assets classes; though expectations are low...
Source: Goldman Sachs