Regional Focus

China: approaching the last mile

Published: Feb 2016
Side view of jogger's legs on fire

In recent years, China has taken great strides to reform its economy and liberalise the market and we are now arguably entering the final stages on this journey. In this article, a number of experts give their opinions on what they expect the future to hold for China both on a macro-level and also in terms of corporate treasury operations.

It was Chinese philosopher Laozi who said “a journey of a thousand miles begins with a single step,” alluding to the fact that even the longest and most difficult ventures have to begin somewhere. For the Chinese economy this proverb has rung true in respect of its transition from a planned to a market orientated economy.

China took its first steps towards financial reform in the late 1970s through incremental economic reform that helped generate high growth, improve living standards and also eliminate supply shortages. Such was the success of these reforms that in 1993 China decided to abolish its planned economy altogether and fully chart a course towards a market driven economy.

The rest is history: China has become the world’s second largest economy, a manufacturing hub, a mega trader, and overall a country with substantial economic and political might. However, we are now arguably beginning to enter the last mile of China’s journey, and if the first step was tough, the last, if recent events are anything to go by, may be the toughest yet. And as China moves closer to the ‘new normal’, corporates, perhaps more than ever, need to keep a close eye on what is happening.

Boom or bust?

At the forefront of many business leaders’ minds may be the economic health of the country. Much has been made of the slowing GDP growth, volatility in the stock markets, the debt-to-GDP ratio, as well as a host of other performance metrics that seek to provide insight into the well-being of the Chinese economy. Yet, as Gordon Orr, Senior Advisor at McKinsey states in a recent article: “In debates about whether growth is a percentage point up or down, we often lose sight of the absolute scale of China’s economy.” And as Orr goes on to point out: “China’s economy is today made up of multiple sub-economies, each more than a trillion dollars in size. Some are booming, some declining. Some are globally competitive, others fit for the scrap heap. How you feel about China depends more than ever on the parts of the economy where you compete.”

That being said, overall GDP growth remains a key focus in discussions around China, perhaps because even half a percentage point shift accounts for such a huge number in real terms and creates ripples that extend beyond its borders. The news therefore that in Q415 China’s economy grew at its slowest pace in 25 years, at a rate of 6.8%, again brought up questions around if it is heading towards a hard landing.

For Kelvin Lau, Senior Economist at Standard Chartered, there is little need to worry about such an event primarily because, just as Orr alluded to, of the diversity of the economy. “Whilst we have seen a slowing in the GDP numbers, if you look at the month-by-month numbers we are beginning to see signs of it bottoming out,” explains Lau. “If you take this one step further and begin to look at the individual parts of the economy, then of course there are some aspects that are struggling, but on the other hand there are many that are starting to bottom-out, like services and retail.”

For Lau, this is to be expected and highlights the success that China is having in rebalancing the economy to one less reliant on areas such as investment, real-estate and manufacturing, to one driven by consumption and services. But China cannot be complacent, and to continue to strive towards its goals Lau argues that further policy easing is required. “This should be monetary easing in terms of reserve requirement ratio (RRR) cuts and on the fiscal side the government should look at tax cuts and fast tracking key infrastructure projects.” Overall his message is positive. “Over the next five years we expect to see China deliver 6.5% growth – enough to meet the ambitions to double the size of the economy outlined in 2010 – this is a long way away from a hard landing.”

That being said, this isn’t a view shared by all. For some the risk of a hard landing is still very real. “The risk has not diminished and is, in our view, increasing,” says Chris Leung, Executive Director Group Research at DBS. “The reason being that many structural problems, such as overcapacity and resource allocation, remain unresolved and are deepening.”

Despite this view, there is hope that this can be avoided. “There is an increasing popularity of supply side economics within the Chinese government,” explains Leung. “This shuns short-term demand-side stimulus. Rather, it emphasises tax reduction, deregulation, and innovation to sustain long-term economic growth. Although these steps are positive there is still plenty of work to be done. For instance, allowing non-performing loans to surface to enable the banking sector to function normally, allowing the exchange rate to shoulder some of the pressure, moving ahead with state owned enterprise (SOE) reforms and quicken service sector deregulation.”

Although many have accepted numerous aspects of China’s ‘new normal’ there may be less understanding that policy responses from the Chinese government are also changing. This change in thinking was encapsulated by the remarks made by Chinese Premier Li Keqiang, who in January stated that market forces will play a role in solving many of the structural issues in China, including leaving those businesses which are unable to compete to die out – a marked policy change from previous years where the government would typically intervene.

Overall, whether China is heading for a hard landing or not comes down to a matter of perspective, but what might be more important for corporates in the short term is adjusting to China’s change in macro management philosophy. “Those who don’t will be caught off guard,” stresses Leung.

The road to reserve

On 11th August last year, many market participants were caught by surprise by China’s sudden devaluation of the RMB – the biggest in two decades. The 1.9% downward move by the central bank sent shockwaves through financial markets and shone a spotlight on the Chinese economy, which some market commentators argued was perhaps weaker than the numbers let on.

Yet, despite recent bumps in the road, China’s strategy around its currency, and in particular its ambition of making the RMB globally recognised, can largely be seen as a success. Significant work has been done by the Chinese government to promote the currency and make it easier to use on and offshore. This includes the creation of RMB hubs in various countries around the world, improvements in infrastructure through the creation of CIPS, and regulatory relaxation, in particular the ability to pool and sweep the currency cross-border. The result according to Lum Yin Fong, Managing Director Global Transaction Services at DBS is a greater usage of RMB by corporates. “We have definitely seen an increase in the use of RMB as a payment currency and in trade,” she says. “In fact, recent SWIFT data shows that the RMB has surpassed the Japanes yen to be the fourth most used payment currency, it is also the second most used currency for trade transactions. Now with the recent announcement that RMB is being added to the SDR basket of currencies we expect an increase in RMB usage, not just in trade, but in other areas as well.”

It is not only China that has been on a journey in regards to the RMB. Corporates with operations in, and even outside the country, have also been closely tracking the currency’s rise. “When China first began to liberalise its economy the concept of using RMB as a functional currency sounded interesting to many of our clients, but for the most part few of these had any need to use the currency outside of China,” says Sridhar Kanthadai, Regional Head, Transaction Banking, Greater China & North Asia at Standard Chartered. “Yet in recent years, more and more corporates have been asking us about the RMB and how it can be used and managed both on and offshore.”

Indeed, many of these conversations have been with Chinese corporates, for which the RMB is their natural currency. But, Kanthadai has also been having many conversations with multinationals around adopting the RMB as a treasury currency. “Many Asian companies that don’t have a bias towards the US dollar are looking at the RMB as an alternative option, as are some European companies,” he says. “US companies, as you may expect, are a little slower but the pace is beginning to build.”

A bright future?

Moving forward, it would be hard to argue that the RMB will not continue to gain in popularity amongst corporates around the world. “If you look at the proliferation of offshore clearing centres, the access to liquidity, the deepening of the financial markets – FX, hedging products, investment products, dim-sum bonds – I think the market has developed to a point that it can be considered a broadly usable currency not just in China but also in trade with China,” adds Kanthadai.

That being said, China hasn’t yet reached the finish line and there remains lots of work to be done. As Miguel Otero-Iglesias of the Elcano Royal Institute highlighted in an op-ed for the Financial Times, the currency only represents around 1% global reserve assets and is eighth in terms of international bond issuance and ninth in global currency trading. And whilst the numbers on the trade side look impressive, 80% of RMB trade is conducted with Hong Kong and as he states: “Perhaps more importantly, in most international trade contracts the RMB is the medium of exchange and not the unit of account. In other words, the Chinese currency is the means of payment, while the dollar remains the invoice currency, which is much more important because that is where the exchange rate risk lies.”

Otero-Iglesias goes on to say that perhaps the main reason for these less than impressive figures is down to confidence and the fact that China still highly regulates the capital account and conversion of its currency. A nod is also made to the lack of transparency around its political and legal frameworks.

If confidence was already limited then the recent bouts of currency volatility, beginning on 11th August 2015, may have spooked people further. But, for Kanthadai, it should be seen as an opportunity to begin looking at the RMB as a market based currency that will continue to face two-way volatility. “China can, and will continue to, promote the currency through infrastructure developments and policy changes, but for confidence to really be installed in the RMB it needs to be seen in a different light, akin to other major currencies.”

Spreading its wings

A potential key driver in both the RMB’s continued assent and the overall fortunes of the Chinese economy is the government’s belt and road initiative. The strategy looks to reawaken the historical routes used by silk traders between China and neighbouring countries on three continents, and export China Inc. to the rest of the world on a massive scale.

It is a complex, multi-faceted and highly ambitious project and as yet hasn’t been fully outlined by the Chinese rule makers. It is therefore unsurprising that some commentators are cautious about its overall ambitions, with some going as far to say that we are entering a period of Chinese hegemony. Some argue on the contrary. As Xu Sitao, Chief Economist at Deloitte China points out: “Contrary to conventional wisdom, China’s belt and road initiative is neither a scheme to export China’s excess capacity south and west, nor a grand scheme to exert geopolitical control over the regions concerned. Quite simply, it is an effort to boost regional connectivity in ways that would help China manage certain domestic economic challenges. If China can do this while exporting its growth model to partner countries, the initiative could be considered a success.”

Although the overall ambitions seem opaque, one area that does seem clear and that corporates certainly will be paying attention to is the role that the belt and road initiative can have in boosting the use of the RMB. For DBS’s Leung, it may have particular significance: “To finance infrastructure spending, Beijing is encouraging Chinese banks to extend credit to project participants – most likely in the Chinese currency.” Moreover, the strategy also looks to boost China’s overseas direct investment. “Recipient countries would use RMB to purchase capital goods, construction materials and services from the mainland. The circular nature of these flows will further raise RMB settlement for China’s exports. Closer trade and business ties with China would increase regional demand for the RMB.”

Whilst in its nascent stages of development, the belt and road initiative seems to be having some impact already. Recent research from merchant bank Grison’s Peak highlights that outbound policy loans, equity investments and M&A activity has reached its highest levels in seven years. Yet, the path ahead may be a difficult one, especially for those companies that have had little experience operating outside of their home markets.

A much improved treasury environment

As many Western corporates will testify to, moving out of your home market and into unfamiliar waters creates many challenges, especially around achieving standardised processes. This challenge is amplified in the treasury department, which has to adhere to the differing regulatory regimes as the business moves from country to country.

For nearly two decades it was China that caused a headache for international treasurers, with its tight regulatory regime and opaque internal mechanisms. Yet steps taken by the government in recent years have certainly improved things, with treasurers afforded more freedom to manage their cash and liquidity, both onshore and cross-border. Achieving standardisation, best practice and integrating China into global treasury operations is starting to become a reality.

“The relaxation of many rules and regulations has enabled our corporate clients to strive towards centralising and standardising their processes,” says Yigen Pei, China Country Head, Treasury and Trade Solutions at Citi. “As a result corporates are frequently coming to us and asking what they can do and how they can look to implement solutions such as shared service centres, cross-border pooling structures, payment on behalf of (POBO) and receivables on behalf of (ROBO).”

Things look set to further improve given the recent moves by the Chinese regulators to free up interest rates. For corporates, investing in China has therefore become more like investing in other parts of the world. This should also enable corporates access to cheaper and more flexible funding options. Moreover, in levelling the banking playing field DBS’s Lum believes that corporates will be afforded even greater access to best-in-class products and services. “Corporates will gain from having more options, banks will need to innovative in order to stay competitive and support their customers.”

Although treasurers in China are now operating in a greatly improved environment, there remains a need to pay attention to the changing regulatory environment. “Whenever you operate in a foreign market you have to adapt to the local context,” says Pei. “In China, the regulations are changing so quickly that it is important to stay close to them in order to know what you can and cannot do. This also gives you a chance to be part of new regulation formation as they are being developed.” Many companies have successfully demonstrated the benefits of this approach including Adam Smith Award Winners Intertek and BASF.

Yet, despite all these improvements, the last mile is often the hardest. Treasurers across the board will hope that recent issues such as restrictions on liquidity management, imposed limits on FX transactions and government induced volatility are unintended consequences or necessary evils of China’s rapid development and not the beginning of a new set of challenges to contend with. One thing is for sure, the world, and in particular the world of corporate treasury, will be watching China’s next steps with a keen eye.

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