asia special report china rising risks of financial crisis - 15 march 2013

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Nomura NOMURA INTERNATIONAL (HONG KONG) LIMITED Asia Special Report NOMURA GLOBAL ECONOMICS China: Rising risks of financial crisis China is displaying the same three symptoms that Japan, the US and parts of Europe all showed before suffering financial crises: a rapid build-up of leverage, elevated property prices and a decline in potential growth. We delve into the financial risks facing China’s economy and find that the most vulnerable areas are local government financing vehicles, property developers, trust companies and credit guarantee companies. We also show how they are interlinked. 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 financial crisis. But that would come at a short-term cost of slower GDP growth, which we expect to average 7.3% in H2 2013. As history has repeatedly shown, the slower the policy response to financial excesses, the greater the risk of a systemic financial crisis and the more challenging it will be to avoid a hard economic landing. 15 March 2013 Authors Economists, Asia ex-Japan Zhiwei Zhang [email protected] +852 2536 7433 Wendy Chen [email protected] +86 21 6193 7237 See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

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Page 1: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

Nomura

N O M U R A I N T E R N A T I O N A L

( H O N G K O N G ) L I M I T E D

Asia Special Report NOMURA GLOBAL ECONOMICS

China: Rising risks of financial crisis

China is displaying the same three symptoms that Japan, the US

and parts of Europe all showed before suffering financial crises: a rapid build-up of leverage, elevated property prices and a decline in potential growth.

We delve into the financial risks facing China’s economy and find that the most vulnerable areas are local government financing vehicles, property developers, trust companies and credit guarantee companies. We also show how they are interlinked.

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 financial crisis. But that would come at a short-term cost of slower GDP growth, which we expect to average 7.3% in H2 2013.

As history has repeatedly shown, the slower the policy response to financial excesses, the greater the risk of a systemic financial crisis and the more challenging it will be to avoid a hard economic landing.

15 March 2013

Authors

Economists, Asia ex-Japan

Zhiwei Zhang

[email protected]

+852 2536 7433

Wendy Chen

[email protected] +86 21 6193 7237

FX and Rates Strategists, Asia ex-Japan

Craig Chan

[email protected]

+65 6433 6106

Prateek Gupta

[email protected] +65 6433 6197

Vivek Rajpal

[email protected] +91 22 4037 4438

Prateek Gupta

[email protected] +65 6433 6197

Wee Choon Teo

[email protected] +65 6433 6107

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Page 2: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

Nomura | Asia Special Report 15 March 2013

2

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

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Nomura | Asia Special Report 15 March 2013

3

Introduction

The Chinese government has in recent months sent a number of unusually strong signals that it

is concerned about financial risks in the economy. At December‟s Central Economic Working

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

as external sources. Bank of China CEO Xiao Gang, writing in the China Daily (12 October

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

investors. Fears of a hard landing sent the MSCI China index down to 51.63 in the summer of

2012, but the subsequent economic recovery seems to have alleviated such fears with the

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-

alarmed? We believe China faces rising risks of a systemic financial crisis and that the

government needs to take action quickly to contain such risks. We assume it will do so in H1

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

have preceded major financial crises elsewhere: 1) high leverage; 2) the rapid rise of asset

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

Source: Bloomberg and Nomura Global Economics.

Fig. 2: China GDP growth forecast: Nomura vs Consensus

Source: Consensus Economics and Nomura Global Economics.

50

55

60

65

70

Mar-12 Jun-12 Sep-12 Dec-12 Mar-13

Index

7.0

7.5

8.0

8.5

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13

% y-o-y Consensus forecast

Nomura forecast

Actual

The government has sent strong signals that it is concerned about financial risks

The IMF and business leaders have also voiced concerns…

… but since Q4 2012 the market seems to have discounted them as growth recovers

We believe the market is under-estimating the risks in China and that growth will slow in H2 2013

We elaborate our concerns, highlight where the risks lie and discuss how they might play out

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Nomura | Asia Special Report 15 March 2013

4

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

indicator for financial crises in academic research. There is a long list of academic literature on

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

history, bubbles have often been preceded by grand economic miracles, real or illusionary. The

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

hereafter), has reached its highest level since data was made available in 1978. Domestic credit

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

to other economies, arguing that the average level of DCG in OECD economies was 211% in

2011, higher than the current level in China (Figure 4). Moreover, of the large economies that

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

Source: IMF, CEIC and Nomura Global Economics.

Fig. 4: Domestic credit-to-GDP comparison

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

developed economies. First of all, the average DCG ratio for OECD countries should not be

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

95

115

135

155

1997 2000 2003 2006 2009 2012

% of GDP

0

50

100

150

200

250

China (2012)

Thailand (1997)

OECD (2011)

Spain (2011)

Japan (1989)

US (2007)

% of GDP

Academic research shows high leverage causes financial crises

A rise in leverage has preceded many major financial crises in the past

Leverage of China‟s economy has reached an historical high

Some argue leverage is not as high as in developed countries such as Japan, so there is no need to worry

We believe comparing the level of leverage across countries is misleading

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5

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

leverage, but also the change in leverage. A high but stable level of leverage does not

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

quickly from 121% of GDP in 2008 to 155% in 2012 (Figure 5). Looking at China's history over

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

notice an interesting common phenomenon which we call the "5-30 rule" – where financial

crises in large economies are usually preceded by the leverage ratio rising sharply by 30% of

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 based on a five-year rolling window

Note: The gray line shows the change in the DCG ratio in a given year from five years earlier – e.g., the reading in 2012 is 34pp because the leverage ratio rose to 155% of GDP in 2012 from 121% of GDP in 2008. Source: IMF, CEIC and Nomura Global Economics.

Fig. 6: Change in domestic credit to GDP, five-year rolling window

Note: Year t refers to 1989 in Japan, 1999 and 2007 in the US and 2012 in China. The lines show how fast leverage built up – e.g., the line for China shows its DCG level declined by 20pp from 2004 to 2008, then increased by 34pp from 2008 to 2012. Source: IMF, CEIC and Nomura Global Economics.

-30

-20

-10

0

10

20

30

40

80

100

120

140

160

1991 1994 1997 2000 2003 2006 2009 2012

pp% of GDP Domestic credit/GDP

Changes (pp), rhs

-30

-15

0

15

30

45

t-4 t-3 t-2 t-1 t

Changes (pp)

Japan (1985-89) US (2003-07)

China (2008-12) US (1995-99)

The change of leverage is a leading indicator for crises

China‟s leverage rose by 34% of GDP in five years – a worrying sign given its history

Leverage in Japan, the EU and the US rose by around 30% of GDP in the five years before entering a crisis

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Nomura | Asia Special Report 15 March 2013

6

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 rolling window – Japan

Note: Nikkei 225 stock index peaked in 1989 when the asset bubble burst. Source: IMF, CEIC and Nomura Global Economics.

Fig. 8: Domestic credit-to-GDP and its change, five-year rolling window – US

Note: NYSE composite index peaked in 2000 and 2007 respectively when the IT bubble and financial crisis broke out. Source: IMF, CEIC and Nomura Global Economics.

Fig. 9: Domestic credit to GDP and its change, five-year rolling window – EU

Note: The European debt crisis broke out in 2009. Source: IMF, CEIC and Nomura Global Economics.

Fig. 10: Domestic credit to GDP and its change, five-year rolling window – Thailand

Note: Asia crisis broke out in 1997. Source: IMF, CEIC and Nomura Global Economics.

The rise of leverage in China is clearly troublesome, but the problem actually extends beyond

that implied by the DCG ratio. The DCG ratio only captures credit provided by the official

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

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1974 1978 1982 1986 1990 1994

pp% of GDPDomestic credit/GDP

Changes (pp), rhs

-10

0

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250

1993 1996 1999 2002 2005 2008 2011

pp% of GDP Domestic credit/GDP

Changes (pp), rhs

0

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160

1993 1996 1999 2002 2005 2008 2011

pp% of GDP

Domestic credit/GDP

Changes (pp), rhs

-50

-20

10

40

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80

110

140

170

200

1990 1993 1996 1999 2002 2005 2008

pp% of GDP Domestic credit/GDP

Changes (pp), rhs

Actual build-up of credit may be higher than official data suggest

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7

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

to measure overall credit supply to the economy, encompassing not only bank loans but other

credit channels as well. It measures the net flow of credit (i.e., new issuance minus expiring

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)

Source: CEIC and Nomura Global Economics estimates.

(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

loans379 230 423 770 759 1013 1454 1734 1535

Others 61 71 85 108 150 243 308 455 518

Total social financing statistics capture some shadow-banking activities and give a better picture of credit supply

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8

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

account for two other credit channels. One is public financing, which includes bond issuance

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

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

FDI, while for underground lending we estimate the full time series by assuming a constant

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

years, the growth rate of TSF has a better lead-lag relationship with GDP growth than the

growth of bank loans (Figure 13), largely because the government no longer relies on bank

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

Source: IMF, CEIC and Nomura Global Economics.

Fig. 13: Growth of TSF and GDP

Source: CEIC and Nomura Global Economics.

100

130

160

190

220

2004 2006 2008 2010 2012

% of GDP

Total social financing (by the PBoC)

Total social financing (by Nomura)

Domestic credit

5

7

9

11

13

15

10

15

20

25

30

35

Dec-04 Dec-06 Dec-08 Dec-10 Dec-12

% y-o-y% y-o-y Total social financing (stock)

GDP, rhs

But TSF does not include government debt…

… or underground financing

Adding these, the TSF-to-GDP ratio rose sharply to 207% in 2012

TSF measures credit growth better as most has taken place outside the banking system in recent years

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9

2. Rapid asset price inflation

A BIS report in 2009 (Boris and Drehmann) identified that “unusually strong increases in credit

and asset prices have tended to precede banking crises”, and found them “successful in

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

price bubble. Indeed, it is arguable that an equity price bubble has already been experienced –

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,

with prices rising by only a very moderate, cumulative 113% over the period 2004 to 2012 in

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

professors in Tsinghua University and National University of Singapore (Wu, Deng and Liu,

2013), property prices rose by 250% from 2004 to 2009, far outstripping the level of growth in

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

Source: CEIC, WIND and Nomura Global Economics.

Fig. 15: Average land sale price and property sale price

Source: CEIC and Nomura Global Economics.

100

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275

300

Dec-00 Dec-03 Dec-06 Dec-09 Dec-12

China

US: CS housing index

Jan 2000=100

0

100

200

300

400

500

600

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Land price

Property price

2003=100

The equity market does not pose a threat in China at this stage, in our view

An appropriate price index shows China‟s property prices rose more than those in the US housing bubble

Official property price data seriously understate risks in this sector

Rapid asset price inflation usually precedes banking crises

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10

The government obviously recognises the risks in the property sector. It has introduced a series

of progressively tighter policies to contain property prices over the past several years, including

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,

then to rebound, which suggests that the risks have not been mitigated. In early September

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

fundamentals, as inventory on a national level remains high (Figure 16). Another round of

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

Source: CEIC and Nomura Global Economics.

Fig. 17: Property price growth and M2 growth sold

Source: CEIC and Nomura Global Economics.

0

400

800

1,200

1,600

2,000

Feb-01 Feb-04 Feb-07 Feb-10 Feb-13

Floor space started

Floor space sold

Square meter mn (12 month rolling sum basis)

10

13

16

19

22

25

28

31

-3

0

3

6

9

12

15

18

Feb-05 Feb-07 Feb-09 Feb-11 Feb-13

% y-o-y70 city property price, lhs

M2 growth, rhs

% y-o-y

The government has been trying to contain a property bubble

Property prices and investments were weak, but have picked up again recently…

… leading to another round of tightening and downside risks to the property sector

Page 11: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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11

3. Decline of potential growth

Financial crises often follow technology revolutions and/or so-called economic miracles,

because investors and policymakers start to overestimate the potential growth of the economy.

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:

labour, capital and total factor productivity. In many cases, the slowdown in potential growth is

mainly a result of weaker productivity growth. In the US, academic research shows potential

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

labour force and productivity growth. We discuss the productivity issue first. Unfortunately there

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),

the US (2008), Europe (2009) and Thailand (1997).

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

progress has since come to a halt. We do not have the global trade data for full-year 2012 yet,

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.

Decline of potential growth often precedes financial crises

… driven partly by a productivity slowdown, as seen in Japan, Europe and the US before they entered crises

We use export market share as a measure of productivity…

… which fell before crises in Japan, the US, Europe and Thailand

Market share of Chinese exporters rose sharply before 2010, but has since stalled

Page 12: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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12

Fig. 18: Japan’s market share in global export market

Note: Nikkei 225 stock index peaked in 1989 when the asset bubble burst. Source: IMF, CEIC and Nomura Global Economics.

Fig. 19: US market share in global export market

Note: NYSE composite index peaked in 2007 ahead of the global financial crisis. Source: IMF, CEIC and Nomura Global Economics.

Fig. 20: Spain’s market share in global export market

Note: The European debt crisis broke out in 2009. Source: IMF, CEIC and Nomura Global Economics.

Fig. 21: Thailand’s market share in global export market

Note: Asia crisis broke out in 1997. Source: IMF, CEIC and Nomura Global Economics.

Fig. 22: China’s market share in US market

Source: CEIC and Nomura Global Economics. Note: total US imports excluded oil imports.

Fig. 23: China’s market share in US: labour intensive vs capital intensive goods

Note: 12m moving average; for labour-intensive goods we cite footwear; while for capital-intensive goods we cite telecom and sound equipment. Source: CEIC and Nomura Global Economics.

4

6

8

10

12

1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

% of total

7

8

9

10

11

12

13

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

% of total

1.6

1.7

1.8

1.9

2.0

2.1

2.2

1996 1999 2002 2005 2008 2011

% of total

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1983 1987 1991 1995 1999 2003 2007 2011

% of total

5

10

15

20

25

1994 1997 2000 2003 2006 2009 2012

% of total

10

19

28

37

46

55

40

48

56

64

72

80

Nov-00 Nov-03 Nov-06 Nov-09 Nov-12

% %Labour intensive products, lhs

Capital-intensive products, rhs

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13

We believe China's global export market share likely peaked in 2012. The three main sources of

China's competitiveness – demographics, an undervalued currency and reform dividends –

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

relative effective exchange rate (REER) terms between 2005 and 2012. Its appreciation against

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

markets such as Indonesia? We believe it is unlikely. The slowdown in reform momentum since

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

attractive to foreign investors. Indeed, FDI into China used to grow faster than FDI to other

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.

We believe China‟s market share will fall as the labour force starts to contract…

… RMB has appreciated significantly against other currencies…

… and structural reforms have slowed in recent years

China becomes less attractive for FDI as its competitiveness fades

Page 14: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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14

Fig. 24: China labour demand supply ratio and GDP growth

Source: CEIC and Nomura Global Economics.

Fig. 25: China’s working-age population

Source: CEIC and Nomura Global Economics.

Fig. 26: Exchange rate comparison

Source: CEIC and Nomura Global Economics.

Fig. 27: Wage level comparison

Note: For India, the wage is rural wage level. Source: CEIC and Nomura Global Economics.

Fig. 28: FDI growth – China vs developing economies

Source: CEIC and Nomura Global Economics.

Fig. 29: Japan FDI survey

Source: Japan Bank for International Cooperation and Nomura Global Economics.

6

8

10

12

14

16

0.7

0.8

0.9

1.0

1.1

1.2

Dec-03 Dec-06 Dec-09 Dec-12

% y-o-yRatioLabour demand/supply ratio

GDP growth, rhs

7

8

9

10

11

12

13

14

15

-1

0

1

2

3

4

5

1992 1996 2000 2004 2008 2012

% y-o-y% y-o-y

Working-age population growth

GDP growth, rhs

90

100

110

120

130

140

150

160

170

180

Dec-06 Dec-08 Dec-10 Dec-12

IDR/RMB

INR/RMB

MXN/RMB

July 2005=100

RMB appreciation versus other currencies

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2000 2011

USDIndia Indonesia

China Mexico

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

2008 2009 2010 2011 2012

% y-o-y China

Developing economies excluding China

0

10

20

30

40

50

60

70

80

90

100

% share

(FY)

China India

Thailand Vietnam

Indonesia Brazil

Page 15: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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15

Identifying the risks

In this section we delve deeper to evaluate the vulnerability of major economic sectors. The

ideal approach is to get a solid estimate of the balance sheets of the major sectors – the

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

only 15.2% in 2011, while foreign currency-denominated debt only accounted for 0.9% of total

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

consolidated balance sheet for the central and local government. The Chinese Academy of

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

Source: CASS.

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

We identify and evaluate the risks in the major sectors of the economy

… but local governments face tough challenges

The central government is in good financial condition…

Page 16: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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16

Local governments have ramped up their debt…

While the overall public sector does not have a solvency problem, local governments are facing

tough challenges, at least from a liquidity perspective. The CASS study shows local government

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

gone into infrastructure projects, such as the building of subways and highways, which require

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.

Many LGFVs have managed to stay solvent because local governments provided new capital,

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

pressure. Local governments have relied heavily on land sales in the past to generate revenue

(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,

they turned to “urban construction” bonds and infrastructure trust products. Urban construction

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 issuance

Source: WIND, CEIC and Nomura Global Economics.

Fig. 32: Issuance of trust products for infrastructure investment

Source: WIND and Nomura Global Economics.

0

200

400

600

800

1000

1200

1400

0

500

1000

1500

2000

2500

3000

3500

2006 2007 2008 2009 2010 2011 2012

RMB bnRMB bnLand sales revenue, lhs

Urban construction bond, rhs

0

20

40

60

80

100

120

2004 2006 2008 2010 2012

RMB bn

We estimate government debt to be RMB24.9trn, or 48% of GDP in 2012

Most LGFV investments will incur at least short-term losses

LGFVs are solvent because of local government support

But local government land-sale revenues face downside pressure

LGFVs relied on bond issuance in 2012 to raise funds…

Page 17: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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17

… but future funding will be harder to come by

It is not clear to us how the LGFVs will be able to finance their growing investments in 2013 and

beyond. We estimate the current outstanding debt of LGFVs at around RMB11trn. Assuming

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”

measures to finance their investments. A typical example is the so-called “BT” (build-transfer)

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

government finances. On 31 December, 2012, the Ministry of Finance, the PBoC, the National

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

main sources. The first is loan exposure to LGFVs, which reached RMB9.25trn as of September

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

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

these loans sit on banks‟ balance sheets and their NPLs are provided in quarterly reports. At the

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

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

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.

… but it is getting harder to finance a growing appetite for funds and to repay debt

Local governments have resorted to “unconventional” measures to raise funds…

… which the central government is trying to ban

Banks face risks from three dimensions: 1) Loans to LGFVs

2) loans to property developers

3) wealth-management products, which suffer from…

… a maturity mismatch…

… a lack of transparency…

Page 18: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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18

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

(Figure 36). About 36% of WMPs are reportedly related to trusts (Figure 37). As we

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

can judge their investment risk. In reality, however, there may be implicit credit risk for the

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

– is mortgage lending (Figure 38). However, we believe mortgage loans do not constitute a

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

Note: Data is for Q3 2012. Source: CEIC and Nomura Global Economics.

Fig. 34: NPL ratio of major commercial banks

Source: CEIC and Nomura Global Economics estimates.

LGFVs

Mortgages

Property developers

Others

RMB40.5trn

RMB9.3trn

RMB7.9trn

RMB3.8trn

0

2

4

6

8

10

12

14

16

Dec-04 Dec-06 Dec-08 Dec-10 Dec-12

%

Household mortgage loans do not constitute a major problem for banks

… and often have links to risky assets, such as trusts

WMPs may expose banks to heightened credit risks

Page 19: Asia Special Report China Rising Risks of Financial Crisis - 15 March 2013

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19

Fig. 35: WMP issuance by tenor

Note: 2013 data refers to new issuance in January and February. Source: WIND and Nomura Global Economics.

Fig. 36: WMP issuance by asset base

Note: 2013 data refers to new issuance by January and February. Source: WIND and Nomura Global Economics.

Fig. 37: WMP issuance by investment channel

Note: 2013 data refers to new issuance by January and February. Source: WIND and Nomura Global Economics.

Fig. 38: Breakdown of mortgage lending

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

business model has only flourished in recent years as the government has tightened controls on

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

in terms of assets under management (AUM) (Figure 39). In 2008, AUM for the sector was only

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.

0

4000

8000

12000

16000

200001H

05

2H

05

1H

06

2H

06

1H

07

2H

07

1H

08

2H

08

1H

09

2H

09

1H

10

2H

10

1H

11

2H

11

1H

12

2H

12

2013*

Undisclosed above 24m

12-24m 6-12m

3-6m 1-3m

1m

Unit issued

0

4000

8000

12000

16000

20000

1H

05

2H

05

1H

06

2H

06

1H

07

2H

07

1H

08

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2H

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1H

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2H

10

1H

11

2H

11

1H

12

2H

12

2013*

Undisclosed Other

Commodity Credit

FX Rates

Stock Bond

Mix

Unit issued

0

4000

8000

12000

16000

20000

1H

05

2H

05

1H

06

2H

06

1H

07

2H

07

1H

08

2H

08

1H

09

2H

09

1H

10

2H

10

1H

11

2H

11

1H

12

2H

12

2013*

QDII Trust Others

Unit issued Mortgages issued

before 2009

Mortgages issued

before tightening (2009-10)

Mortgages issued after

tightening (2011-12)

15%

55%

30%

Trust and credit guarantee companies face high risks

AUM at the trust companies rose by 5.8x in five years – it is bigger than the insurance sector

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As mentioned before, property and infrastructure projects are the main destinations for funds

raised from trust companies (Figure 40). Official data show that in 2012 around 8% of trust

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

always been utilised as a channel of alternative financing – banks are traditionally heavily

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

was associated with an economic upturn and the bust amplified the deleveraging process and

damaged the economy (see Appendix 1).

Fig. 39: Assets under management at non-bank financial sectors

Source: Media reports, CEIC and Nomura Global Economics.

Fig. 40: Investment channel of trust products

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

boom nearing. The trust companies have received a lot of negative press coverage since mid-

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

and many are reportedly engaged in underground lending. There were several high-profile fraud

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.

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2007 2008 2009 2010 2011 2012

RMB bn

Mutual funds

Insurance

Trust

0

200

400

600

800

1,000

1,200

1,400

Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12

RMB bn Securities Market, Financial Inst & others

Infrastructure

Real Estate

Industrial & Commercial Enterprise

Property and infrastructure projects are popular trust investments

The trust sector is highly cyclical and typical of the shadow banking sector

Five cycles that suggest a trust sector boom usually leads to a bust

The current boom may be close to its end

Some CGCs defaulted when policy was tightened in 2012

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Household sector

China's household sector is in good financial condition, with total household debt at only

RMB10.4trn at end-2012, or 20.1% of GDP. Mortgage loans outstanding were RMB8.1trn, or

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

share index plunged from 5,954 in 2007 to 1,820 in 2008, yet retail sales growth remained solid

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

believe they are manageable. We estimate the total amount of corporate bonds and trust

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

Source: CEIC and Nomura Global Economics.

Fig. 42: Retail sales growth and Shanghai Stock Index

Source: CEIC and Nomura Global Economics.

Corporate sector

Property developers are also leveraging up. There are two sources of data on property

developers' financial conditions: the financial reports of listed companies, which show the debt-

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

cools, developers would be expected to shy away from land sales and the LGFVs would face

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

remains around 58% in recent years. However, it is worth noting that profitability has fallen in

recent years, which shows that they may be becoming more vulnerable to a shock.

4

8

12

16

20

24

2002 2004 2006 2008 2010 2012

Mortgage loans

Total household debt

% of GDP

1,000

2,200

3,400

4,600

5,800

7,000

13

15

17

19

21

23

Dec-06 Jun-07 Dec-07 Jun-08 Dec-08

Retail sales, lhs

SHCOMP Index, rhs

% y-o-y Dec 1990 =100

The household sector is in good financial condition

Low household leverage means consumption has been resilient to equity price shocks

A bond market default is unlikely to affect the household sector significantly

Property developers face risks given their high leverage

Risks of property developers and LGFVs are tied together

Leverage of the whole industrial sector is stable, but profitability has fallen

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Fig. 43: Debt-to-asset ratio of listed property developers

Source: Bloomberg and Nomura Global Economics.

Fig. 44: Property developers’ dependence on non-bank loan funding

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

developers are well linked. The root of the risk is the decline of potential growth and the

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

shadow banking activity to feed the financing needs of local governments and property

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

default in their jurisdiction. For instance, when Saiwei, a major solar panel producer, faced

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.

As many shadow banking products are only open to high net worth retail investors (minimum

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.

0

10

20

30

40

50

60

70

80

2009 2010 2011 2012

% of asset

75

77

79

81

83

85

1997 2000 2003 2006 2009 2012

% of total

Risks of property developers, LGFVs and the financial sector are interlinked

Government support leads to severe moral hazard

The 2012 bailout made investors believe credit risk is limited

The moral hazard issue leads to a transfer of wealth from the general public to the rich

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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

expect the government to gradually bring down growth of M2 money supply and total social

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

actions to contain them. These signals have not yet turned into concrete action – monetary

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

the new Politburo leadership. The consensus view is for a sustained recovery throughout 2013,

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.

First, it underestimates the challenges facing the new leadership. The risks we have identified in

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‟

experiences. We believe they can learn a lot from the lessons of Japan and Germany in the

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

policies to cool the property market in 2010, there was also a widespread view that the

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

much more costly in the future. With the labour market remaining tight in 2012, despite the

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

PBoC to hike interest rates twice by a total of 50bp in H2. Inflation is the ultimate constraint on

how long the government can afford to keep a loose policy bias. Recent data show inflation is

already rising.

We expect the government to contain financial risks via policy tightening

The government has signalled its concerns recently

Consensus believes the new government has to keep policy loose in its first year

We believe the government will tighten because: 1) the risks are high

2) The government may apply lessons learned from other countries‟ failure…

… as it showed in tightening its property sector policies

3) Delayed policy tightening will incur higher costs in the future

4) Inflation will eventually force tighter policy

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We believe that if the government decides to tighten policy quickly, a few cases of default are

likely, but the banks and the government have the capacity to absorb these losses. The

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

risks in exchange for strong growth in the short term. This is clearly a dangerous choice, but we

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

crisis in coming years would rise. We have written before on the risk of an economic hard-

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

Source: IMF, CEIC and Nomura Global Economics.

Fig. 46: Nomura’s China Stress Index (CSI)

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

guarantee companies, the trust companies and the highly leveraged developers without

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

corporate sector. The banks‟ NPL ratios are generally low, partly because the LGFVs had to

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

channel, so in this case, we believe a public bailout would be an inevitable eventuality. A bailout

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.

160

185

210

235

260

95

105

115

125

135

1980 1982 1984 1986 1988 1990 1992

% of GDP% of GDP

Germany

Japan, rhs

99.5

100.0

100.5

101.0

101.5

102.0

Dec-00 Dec-03 Dec-06 Dec-09 Dec-12

Jan 2000 =100

China risks report published

We believe policy tightening in 2013 will not lead to a systemic crisis

The risk scenario is if policy remains loose…

… in which case systemic risks can be expected to rise

CGCs, trust companies and highly leveraged property developers are at most risk

Banks would be affected without government intervention

The government would likely bail out the financial sector, as it has in the past

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Of course, there are many forms that a bailout could take. The conventional “debt restructuring”

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

model, but we do see an increased likelihood of greater privatisation in the years to come. Many

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

kick-start the next growth cycle. In the early 2000s, China‟s economy turned around not

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.

A bailout could take many forms

A bailout may be funded by selling state-owned assets

A crisis may trigger reforms, as has happened in the past

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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.

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Appendix 2: Trust companies have grabbed the headlines

Source: Various media sources; Nomura Global Economics.

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.

Dec 2012Qingdao Kaiyue, a RMB300mn trust loan product originated by Zhong Rong International Trust, had difficulty paying investors. The

collateral (real estate assets) was auctioned at 60% below the original appraised price.

Dec 2012Chaorisolar, a listed solar power company, pledged its equity to eight trust companies. It faces the risk of bankcruptcy and the CEO

has disappeared. Trust loans linked to the company face default risks.

Dec 2012Pingan Trust's RMB3.6bn project "Jiayuan #25" faces heightened default risk as its Fuzhou property project is far from completion, but

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%.

Jan 2013CITIC Trust's RMB710mn real estate project in Qingdao faces a high default risk. The collateral (real estate assets) was auctioned at

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

Feb 2013Tianjin Trust's one trust product was was terminated prematurely in February, less than three months from its issurance, due to inter-

organizational disputes.

Mar 2013An Xin Trust announced a sharp decline in net profit attitributed to shareholders, down by 44.8% from RMB195mn in 2011 to RMB108bn

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%.

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Appendix 3: Forecast summary

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.

% 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

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Recent Asia Special Reports

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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

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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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