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Economic Research
November 28, 2014

Special Report

Ten questions about China


Will the government lower its GDP growth target to 7% for 2015?
Will economic rebalancing continue?
Will real estate market adjustment continue? What are the
implications?
Will financial risk in China remain at bay?
Will China face a fiscal cliff?
Is the PBOCs operational framework at a crossroads?
How is China affected by the recent collapse in global oil prices?
Will Chinas current account surplus widen again? What is the
implication for the CNY?
What is the potential impact of Chinas rebalancing on the rest of
the world?
What are the next steps in Chinas ongoing structural reforms?

Chart 1: China real GDP growth

JPMorgan
forecast

% change, both scales


16

%oya

14

14

12

12

%q/q saar

10

10

8
6

16

8
06

07

08

09

10

11

12

13

14

15

Source: NBS, J.P. Morgan forecast

Haibin Zhu
(852) 2800-7039
haibin.zhu@jpmorgan.com

Grace Ng
(852) 2800-7002
grace.h.ng@jpmorgan.com

Lu Jiang
(852) 2800-7053
lu.l.jiang@jpmorgan.com

www.jpmorganmarkets.com

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chinas economic slowing is a major theme in the current global economic developments.
Chinese policymakers will hold the annual Central Economic Working Conference in the
coming weeks, which will set key economic targets for 2015. In this special report, we
elaborate our views on 10 key issues regarding Chinas growth and policy outlook (chart 1),
and the interactions between the Chinese economy and the rest of the world.

1. Will the government lower its GDP growth target to 7% for


2015?
We expect the Chinese economy to grow 7.4% in 2014, in line with our forecast at the
beginning of the year and slightly below the official target of 7.5%. However, the
breakdown deviates somewhat from our initial expectations in Januaryspecifically, the
investment slowdown has been sharper than expected, albeit offset by a stronger-thanforecast contribution from net exports.
The shift in growth drivers is a somewhat mixed bag. From a positive perspective, China
did make concrete progress in economic rebalancing this year, with an emphasis on
addressing overcapacity in some manufacturing sectors and, more importantly, an
adjustment in the real estate market. These efforts have weighed on growth to some extent
in 2014, and in our view, are likely to continue, limiting growth potential in the coming
year.
Data releases point to slower growth than that indicated in the official forecast. To
some extent, this difference may reflect the discrepancy between GDP and high-frequency
economic activity data and business survey results. Implied GDP growth based on
industrial production suggests the economy likely grew at around 5%, 8% and 7% q/q, saar
in the first three quarters of 2014, respectively, and points to full-year GDP growth of
around 7%. This is lower than the official GDP data and PMI-implied growth rate.
Some market observers cite electricity consumption trends as a sign that Chinas
actual 2014 economic growth may only be 5%-6% (or even lower), which we consider
too low. They point to deceleration in electricity consumption growth (from a 7.3%
increase in 2013 to a 3.9% increase in the first three quarters of 2014) to support their
estimates, as electricity consumption and economic activity are closely related in the
manufacturing sector (see Chart 2).
In our view, putting too much emphasis on electricity consumption has its own
shortcomings. This approach tends to emphasize the slowdown in the manufacturing and
real estate sectors, without considering the ongoing changes in Chinas economic structure.
First, the service sector, which accounted for 46% of GDP in 2013 (surpassing the
manufacturing sector for the first time), is an important driver of Chinas economic growth.
Indeed, service sector growth remained relatively stable between 8.3% to 7.9% since 2012
even as electricity consumption growth, at best a noisy indicator for the services sector,
slowed sharply (from 10.2% in 2013 to 5.8% in the first three quarters of 2014; see Chart
3). Second, Chinas growth in 2014 has benefited extensively from an improvement in net
exports and continued softness in imports. We expect the GDP growth contribution from
net exports will rise from -0.3%-pt in 2013 to 0.9%-pt in 2014. Finally, serious efforts to
address pollution may have held back energy consumption in 2014.

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 2: Secondary industry

Chart 3: Tertiary industry

%oya, ytd, both scales


16

30
25

GDP growth

14

20

12

Electricity consumption

15

10

10

6
2010

2011

2012

2013

0
2015

2014

Source: NBS, J.P. Morgan

%oya, ytd, both scales


11

18
16

10

14

Electricity consumption

12

9
8

10
GDP growth

7
2010

8
6

2011

2012

2013

2014

4
2015

Source: NBS, CEIC

Chart 4: Real GDP growth vs. government's growth target


%oya
16
14
12

J.P.Morgan
forecasts

Real GDP growth

Government's growth
target

10
8
6

98

00

02

04

06

08

10

12

14

Source: NBS, J.P. Morgan

We expect the government to lower its growth target to 7% for 2015 from 7.5% in
2014 (see Chart 4). (We think there is a 30% probability that the target could be a range
between 7% and 7.5%, or a specific number within this range.). Meantime, structural
reforms will continue (Question 10). President Xi has highlighted three features of the new
normal for the Chinese economy in the coming years: a transition from high growth to
modestly high growth; economic rebalancing and more inclusive growth (i.e., faster service
sector growth and reduced income inequality); and a transition from input- and investmentdriven growth to innovation-driven growth. Government officials seem cautious on the
2015 outlook, as reflected in growth forecasts from the official sector (State Information
Center: 7.3%; China Academy of Social Science, or CASS: 7%; a senor official from the
National Development and Reform Commission, or NDRC: 7%). By contrast, in late 2013,
the CASS and NDRC forecasts for 2014 growth stood at 7.8% and 8%, respectively.
Despite an apparent willingness to lower the growth target, it is unlikely, in our view, that
the Chinese government would adopt the IMF recommendation (in the Article IV report) to
lower the 2015 growth target to 6.5%-7%.
Our forecast for 2015 full-year GDP is 7.2%, with consumption, investment and net
exports contributing 3.4%-pts, 3.1%-pts and 0.7%-pts, respectively. In our view, the
fundamental growth drivers may not change much in the near term, despite ongoing
economic rebalancing. The positive drivers include relatively stable growth in the service
sector, as well as the constructive outlook for Chinas current account surplus (Question 8).
One major drag on economic growth, in our view, is the continued slowdown in real estate
investment growth (Question 3), along with persistent overcapacity in parts of
3

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Table 1: Real GDP growth


percent change
2014F 2015F
Headline GDP
%oy a
%oy a, y td
%q/q, saar

7.4

7.2

1Q14

2Q14

7.4
7.4
6.3

7.5
7.4
7.9

3Q14 4Q14F 1Q15F 2Q15F 3Q15F 4Q15F


7.3
7.4
7.9

7.3
7.4
7.0

7.3
7.3
6.3

7.1
7.2
7.1

7.1
7.1
8.0

7.2
7.2
7.3

Source: NBS, J.P. Morgan forecasts

manufacturmanufacturing. Regarding the quarterly growth trajectory, we expect GDP


growth to moderate in 4Q14 and 1Q15 to 7.0% q/q, saar and 6.3% respectively, given
lingering weakness in domestic demand, before recovering from 2Q onwards as the impact
of policy easing gradually comes through. The GDP growth trajectories for 2Q15, 3Q and
4Q stand at 7.1%q/q, saar, 8.0% and 7.3% respectively (see Table 1).
We expect 2015 will be a challenging year for Chinas economic policy, as
uncertainties linger. On the fiscal policy side, we expect an increase in the central fiscal
deficit, offset somewhat by tightened rules on local government debt (Question 5).
Uncertainty remains regarding grandfathering policy during the transition period, and
whether social capital participation will pick up to replace curtailed public investment. On
the monetary policy side, the unexpected rate cut in November suggests there is debate
regarding policy implementation and the use of different policy instruments (Question 6),
suggesting policymakers could shift to a mix of traditional and unconventional instruments
in 2015. It will be interesting to watch how financial risks evolve with a shift in monetary
policy stance. Finally, a key challenge is CNY policy, especially as USD strength and the
current account surplus seem to point in opposing directions with regard to currency
movements (Question 8).

2. Will economic rebalancing continue?


Despite the forecast gradual slowing in economic growth, the signs of economic
rebalancing have been encouraging. Notably, the service sectors are making up a larger
share of the economy. In addition, the labor market has remained relatively stable amid the
growth slowdown, and there has been a gradual rebalancing in the distribution of national
income toward the household sector from the corporate and government sectors.
In terms of structure of the economy, it is interesting to note that the pace of growth in
tertiary industry (mainly service sectors) has been relatively stable compared to the
volatility in secondary industry (dominated by manufacturing). The output share of the
tertiary industries has risen steadily from 43.2% in 2010 to 46.1% in 2013 (see Chart 5). In
the first three quarters of this year, tertiary industry activity expanded 7.9%oya,
outperforming the 7.4% growth in the secondary industry.
Rebalancing between the service and manufacturing sectors has notable implications
for the labor market. In particular, as service sectors are generally more labor-intensive,
such structural adjustment in the economy should support employment creation and help
stabilize the labor market, amid gradual slowing of the overall economy. Indeed, while
Chinas 2014 economic growth (at 7.4%oya in our forecast) likely will undershoot the
governments 7.5% target, new job creation in the first nine months, at 10.82 million, has
already overshot the governments full-year target of 10 million.

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 5: GDP by industry

Chart 6: Real GDP vs. real urban and migrant worker wages

% share of total GDP, 4qma

%oya

Secondary
industry

48

Real urban wages

20

46
Tertiary
industry

44

Real migrant worker


wages

15
10

42
40

Real GDP

25

06

08

10

12

14

Source: NBS, J.P. Morgan

2011

2012

2013

2014

Source: NBS, CEIC

Chart 7: Contribution to headline GDP growth


%-pt contribution to headline %oya growth
Total consumption
10
expenditure
8

Gross fixed capital


Net export

6
4
2
0
-2
-4

2008

2009

2010

2011

2012

2013

2014F

2015F

Source: NBS, J.P. Morgan

Another key government macro policy target is for household income to grow in line with,
or preferably outperform, overall economic growth, with a greater share of national income
distributed to the household sector over time. From this perspective, recent trends seem to
be tracking the governments goals (see Chart 6): During the first three quarters of this
year, nationwide household disposable income per capita rose 8.2%oya in real terms (and
10.5% in nominal terms), outperforming real GDP growth at 7.4% (and 8.5% in nominal
terms).
While we expect adjustment in the property sector and overcapacity in several industries
will continue to weigh on the manufacturing sector into 2015, the service sector will likely
continue to expand in a relatively stable manner. Thus, we expect continued, steady
economic restructuring.
With regard to the composition of overall GDP growth, we expect the investment
contribution, which picked up to 4.1%-pts in 2013 after falling for three consecutive years
through 2012, likely will ease to 3.0% in 2014 and remain near that level next year,
marking the lowest level of investment contribution to overall growth since 2000. The final
consumption contribution to GDP likely will slip somewhat to 3.5%-pts in 2014; we look
for it to hold steady close to that level in 2015. Meanwhile, the net exports contribution to
overall GDP growth, after averaging 0.3%-pt annual drag in the three years through 2013,
looks poised to rise to 0.9%-pt in 2014 and remain at a relatively elevated 0.7%-pt in 2015,
given our outlook for a decent upturn in global demand and lingering sluggishness in
Chinese domestic demand (see Chart 7).

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

3. Will real estate market adjustment continue? What are the


implications?
The real estate market slowdown turned out to be the biggest macroeconomic drag in
2014. In the first 10 months, real estate investment, which made up approximately one
quarter of overall fixed asset investment in 2013, slowed to 12.4%oya, ytd, compared to
19.8% in 2013. Housing prices peaked in April at the national level and have since declined
by 3.5% (see Chart 8). Other key market indicators also have been weak, as new floor space
sold fell by 9.5%oya ytd in the first 10 months, home sales (in value term) by 9.9%, and
new home starts by 9.8%.
The property market adjustment is having a significant impact on overall economic
growth. According to our estimates, the real estate investment slowdown from 20%oya in
2013 to a projected 11-12% in 2014 will shave one percentage point from GDP growth,
including its direct and indirect impacts on economic activity (see Chart 9). For instance,
the real estate sector contributes 58% of steel demand (24% from residential property and
34% from commercial property) and 28% of cement demand. As a result, the spillover
effect will touch many segments of the overall economy.
However, the financial impact of the real estate market correction has been far less
severe than expected thus far. In line with our expectations, the housing price decline has
been relatively modest. From the recent peak (in April) to October, prices fell by 3.5%.
Meantime, the asset quality of real estate loans has remained solid: At end-2013, the NPL
ratio for mortgage loans was only 0.26%, and the NPL ratio for loans to real estate
developers was 0.48%, lower than the aggregate NPL ratio of 1.00% (see Chart 10, 11).
Based on anecdotal evidence thus far in 2014, the quality of mortgage loans has remained
high, and the NPL ratio for real estate developers has risen but remained lower than the
aggregate NPL ratio (which has increased from 1.00% at end-2013 to 1.16% in 3Q14).
The government has eased housing policies in recent months, lifting its home purchase
restrictions in most cities and easing mortgage lending restrictions. The objective of the
policy changes is not to drive a rebound in the housing market, in our view, but to mitigate
the negative impact on growth momentum and buy time for economic restructuring. We
believe the policy shift has begun to play a role: housing transactions rebounded in October,
and new home starts also started to recover.
We expect the property market adjustment will continue in 2015, as oversupply
remains in the near term. Housing prices may decline further but should stabilize in
2H15. From peak to bottom, we forecast the price decline will be in the 5%-10% range at
the national level, with tier-2 and tier-3 cities generally facing greater price falls. It is worth
noting that housing affordability, as measured by the price-to-income ratio, should improve
significantly even with modest house price declines, as household income growth in China
is strong and forecast to remain so amid the economic rebalancing.
Real estate investment growth is likely to slow further to 5%-6% in full-year 2015,
from our 11%-12% projection for 2014. Thus, it likely will remain a major drag on
economic growth in the coming year, further weighing on land sale revenues and demand in
related sectors, including steel, cement, and furniture. The real estate sector will experience
further consolidation in 2015, in our view. The golden decade is over, and we look for
industry to enter a stable stage (e.g., with new home supply to remain relatively stable at
around 1 billion square meters every year). Real estate developers will need to be
specialized and improve their service and management in order to be successful. We look

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 8: House price inflation

%oya
25

Chart 9: Real estate investment

%oya, 3mma
80

Tier-1 cities
National (100 cities)

20

Tier-2 cities

15

60

Tier-3 cities

10

Commercial
Residential

Total

40

20

0
-5
2012

2013

2014

0
2010

2015

Source: NBS, Soufun, J.P. Morgan

2011

2012

Chart 10: NPL ratio for commercial banks

Chart 11: NPL ratio by category

10

05

Source: PBOC

07

2013

2014

2015

Source: NBS, J.P. Morgan

09

11

13

0
2008

Manufacturing
Wholesale & retail
Real estate
Overall
Housing mortgage

2009

2010

2011

2012

2013

2014

Source: PBOC

for weak developers to exit the business, but we do not expect trends to put undue stress on
the banking system.

4. Will financial risk in China remain at bay?


Chinas financial risk has been a lingering market concern for several years.
Nonetheless, such risk has not materialized and a near-term financial crisis remains
unlikely, in our view.
Financial sector developments in 2014 were a mixed bag. On the positive side,
regulators strengthened rules and supervision on shadow banking activities, including trust
loans and wealth management products. The new regulations on interbank businesses
announced in May 2014 were a game changer (Katherine Lei: China banks: long-awaited
interbank regulation announced, May 18, 2014); since then, the share of non-bank
financing (trust loans, entrust loans and bank acceptance) in total social financing has
declined significantly (see Chart 12, 13). Separately, the new rules on local government
debt should prove helpful to contain risk associated with local government debt.
On the cautious side, the debt level in the economy continues to increase. We estimate
that total social debt rose to 220% of GDP as of September 2014 (compared to 208% of
GDP at end-2013). It is only since mid-2014, after the introduction of new regulations on
interbank businesses, that the effort to contain non-bank financing has gained traction.

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Chart 13: Breakdown of total social financing

Chart 12: Total social financing

%oya
35

TSF growth (in stock term)


TSF (flow)/ GDP

30
25
20
15
10
2008

2009

2010

Source: PBOC, NBS, J.P. Morgan

2011

Economic Research
Ten questions about China
November 28, 2014

2012

2013

2014

% of TSF

%
70

125

60

100

50

75

40

50

30

25

20

10
2015

-25

Bond, equity
& others

2012

2013

Non-bank
financing

Bank loans

2014

Source: PBOC, NBS, J.P. Morgan

In addition, what appears to be an implicit guarantee phenomenon remains. The


avoidance of defaultsvia protracted restructurings and other quasi bail-outshas created
an implicit guarantee in shadow banking activity and the bond market, fostering lending to
imprudent investors that has driven up perceived risk-free rates and supported excessive
growth in non-bank financing. In March 2014, the Chaori Bond 11 missed an interest
payment and become the first bond default in Chinas onshore market. However, in
October, Chaori announced a restructuring plan in which bond investors receive 100%
repayment of both principal and interest (Katherine Lei: China Financials: a follow-up on
the first bond default: No default is negative for financial reform, October 9, 2014),
effectively avoiding the default. Indeed, there has been no default on trust loans, wealth
management products or local government financing vehicle (LGFV) debt. Although the
central government has stated clearly that breaking the implicit guarantee is important to
restore market discipline, the current environment gives all parties involved no incentive to
allow defaults to occur.
Overall, financial risks have built up in recent years. How serious is the asset quality
problem? The implied NPL ratio based on current trading prices is 4.2%, sharply higher
than the official NPL ratio of 1.16% in 3Q14 and, in addition, loans worth special attention,
which accounted for 2.8% of total loans in the official statistics. Based on the estimate of
our banking analyst Katherine Lei, the NPL ratio could be about 5%-7% if bank exposure
to shadow banking businesses via interbank lending is taken into account (China banks:
Back to fundamentals: rising leverage and declining debt service ability, October 17,
2014).
What is the primary source of risk in the financial sector? We have consistently flagged
corporate debt as the major risk, in terms of both its high level and rapid growth
(Chinas financial sector: concerns about the mounting risks, July 18, 2013). We estimate
that Chinas corporate debt rose from 90% of GDP in 2007 to 129% of GDP in 2013, and
further to 137% of GDP at the end of 3Q14 (see Table 2).
Against the current economic backdrop, deleveraging would be a challenging task.
First, nominal GDP growth has slowed from 17.8% in 2011 to 8.5% in 3Q14, putting
significant pressure on corporate profits. Second, the real interest rate (1-year benchmark
lending rate minus PPI inflation) has stayed above 7% most of the time since 2012,
reaching 8.2% in October 2014, up from a 3.2% average in 2000-2011 (see Chart 14).
Producer prices have fallen since March 2012, the longest deflation period on record, lifting
the real value of the debt. Third, the return on investment has collapsed in recent years. Our
8

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Table 2: China's total social debt


Trillion y uan

1. Total socity financing (v olume)


Of w hich: bank loans
2. Non-financial equity financing
3. Bank acceptance (outstanding)
4. Central gov ernment debt
5. Others
6. Total social debt (1-2-3+4+5)
Breakdow n:
7. Gov ernment debt
Central gov ernment debt
Local gov ernment debt
MoR debt & restructuring loans
8. Consumer loans
Mortgage loans
9. Corporate debt (6-7-8)
Memo
China's GDP
TSF/GDP (%)
TSD/GDP (%)
Gov ernment debt/GDP (%)
Consumer loans/GDP (%)
Corporate debt/GDP (%)

2008

2009

2010

2011

2012

2013

2014Q3

40.40
32.00
1.14
1.03
5.33
1.87
45.43

54.31
42.56
1.47
1.49
6.02
2.50
59.87

68.33
50.92
2.05
3.83
6.75
3.29
72.50

81.16
58.19
2.49
4.85
7.20
4.01
85.03

96.92
67.29
2.74
5.90
7.76
4.45
100.48

114.24
76.63
2.96
6.68
8.67
4.96
118.23

127.07
84.74
3.27
6.80
9.82
5.48
132.31

12.77
5.33
5.57
1.87
3.72
3.35
28.94

17.34
6.02
9.02
2.30
5.54
4.80
36.99

20.36
6.75
10.72
2.89
7.51
6.26
44.62

24.11
7.20
13.50
3.41
8.88
7.24
52.04

27.76
7.76
16.20
3.80
10.44
8.24
62.28

31.83
8.67
19.00
4.16
12.98
10.02
73.42

35.35
9.82
21.00
4.53
14.75
11.35
82.21

31.4
128.6
144.7
40.6
11.9
92.1

34.1
159.3
175.6
50.9
16.2
108.5

40.2
170.2
180.6
50.7
18.7
111.1

47.3
171.5
179.7
51.0
18.8
110.0

51.9
186.8
193.6
53.5
20.1
120.0

56.9
200.8
207.8
56.0
22.8
129.1

60.2
211.2
219.9
58.8
24.5
136.6

Note: 5: others include debt issued by central government on behalf of the local governments, Ministry of Railway debt and carry-over of
the restructuring loans held by the big four AMCs.
Source: NBS, NAO, J.P. Morgan

Chart 14: Real interest rate

%
15

1-year policy lending rate


(adjusted by PPI)

10
5
0
-5

00

02

04

06

08

10

12

14

Source: NBS, NAO, J.P. Morgan

estimates show that the return on capital fell from 17.0% in 2008 to 8.0% in 2013 (Chinas
big fall in productivity, August 22, 2014).
Financial-system risks, while elevated, are unlikely to evolve into a full-scale crisis in
the next couple of years. First, although corporate debt is very high by historical and
international standards, household debt is very low at 25% of GDP, while government debt,
at 59% of GDP including central and local government debt but not SOE debt, remains
manageable. Second, despite the economic slowdown, our projections for above-7% growth
in 2014 and 2015 are still the highest, by far, among the major economies. Third, Chinas
debt is mainly domestically held (external debt is only slightly above 10% of GDP), and the
domestic saving rate is over 50%, the highest in the world. Fourth, despite the rapid growth
in debt noted earlier, total assets also have risen quickly; hence, leverage ratios have
remained stable outside a few sectors, notably real estate and mining. In the government

JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

sector, holdings of state assets and US$4 trillion in FX reserves are strong buffers to protect
against a potential crisis. Finally, China is relatively closed to international capital flows;
hence the risk of a capital flight-driven crisis is fairly low.
Nonetheless, complacency by policymakers and investors would be misplaced. While
the above-discussed sources of resiliency may be able to delay a crisis, they cannot resolve
the financial vulnerabilities. Chinas financial imbalances today bear some resemblance to
the excesses that contributed to Japans stagnation in the 1990s. In particular, we note
certain similarities such as a debt increase and housing boom as well as an aging population
(of course also differences such as the stage of economic developments) in terms of the
challenges China is facing (How similar is China to Japan in the late 1980s? July 19,
2013). In Japans case, the economy failed to deliver on structural reform and the banking
system problem eventually got out of control. Serious banking restructuring occurred in
Japan only after the crisis.
In a downside risk scenario, we estimate China may hit the tipping point in 2018-2019
if structural reforms are not implemented. On the domestic front, debt will continue to
rise if imprudent lending continues. Asset quality will deteriorate if the system continues to
tolerate evergreen loans, allowing loss-making companies to survive by paying only
interest. This could evolve into a zombie system as observed in Japan in the 1990s. From
a global perspective, we expect the US will have completed its tightening cycle by 2018,
and the Euro area and Japan may have started to exit monetary easing, potentially driving
capital outflows from China and other emerging markets. In addition, the aging of Chinas
population likely will result in a decline in the saving rate, and capital account openness
may add to the risk of capital outflows. Last, while the above-mentioned factors could help
China to avoid a crisis in the near term, this may only mean that it will take longer for risks
to materialize than in most other countries. Casual observation suggests that it could take a
decade for the current excess leverage and credit misallocation problem to balloon out of
control, as happened in Japan from late 1980s to the late 1990s and in China from early
1990s to early 2000s. Chinas current credit cycle started to build up in 2008-09 and may
require addressing in 2018-2019 if structural reforms fail to deliver new sources of growth
and the debt problem continues to build up.
The Chinese government seems to be pursing a strategy of growing out of the
problem by putting restrictions on debt for new projects while adopting a lenient attitude
for the rollover of existing debt. A repeat of the successful experience of NPL disposal in
the previous banking crisis in early 2000s would be desirable: at the time, the size of NPLs
(as measured relative to GDP), which looked threatening at the beginning, diminished
quickly when the economy grew rapidly; in addition, many bad assets (especially land)
turned out to be profitable in the subsequent asset market boom.
The current situation is not comparable to the early 2000s. On the comforting side, the
NPL ratio is much lower at this moment: our estimate of a 5%-7% NPL ratio (taking into
account possible losses from shadow banking) is sharply lower than the roughly 30% NPL
ratio in early 2000s. However, the size of total debt (as a % of GDP) is much higher now.
More important, in the next five to 10 years, we consider it unlikely that the Chinese
economy will rebound to double-digit GDP growth as it did in the past decade: we think
Chinas potential growth likely will fall 6.5% in 2016-2020 even with gradual progress in
structural reform (Chinas growth trend to slow below 7%, February 1, 2013).
While growth is necessary to address the debt problem we think other policy measures
are also important to address existing issues now rather than later. These include: (i)
10

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

strengthening supervision and regulation, especially to break implicit debt guarantees; (ii)
lowering the tax and fee burden for the corporate sector and reducing the role of
government (administrative reform) to improve corporate profitability; (iii) taking PPI
deflation risk seriously and accelerating resource pricing reform (oil, gas, electricity, water,
transportation, etc.); (iv) supporting industry upgrades and restoring productivity growth
(via market-oriented reforms such as reducing government intervention, opening
competition and supporting R&D); (v) further developing the capital markets and establish
a multi-channel financial system. This could reduce the concentrated risks in the banking
system and convert some debt into equity financing; (vi) gradually recognizing losses rather
than continuing to postpone them. Banks need to write off bad loans and the government
should use fiscal resources or state-owned assets to cover some debt losses.

5. Will China face a fiscal cliff?


The Chinese government recently announced a series of fiscal reform measures,
with a special focus on local government debt. The key documents include The Plan
to Deepen the Fiscal Reform (the politburo of the Communist Party of China, June 30,
2014), the revision of Budget Law (National Peoples Congress, August 31, 2014), the
State Council proposal on Strengthening Local Government Debt Management (also
know as Document No 43, October 2, 2014), and The Decision on Deepening the
Reform on Budget Management System (State Council, October 8, 2014).
Fiscal reform focuses on three key areas: improving the budget management system;
improving the tax system; and establishing a new system that aligns fiscal spending with
fiscal revenues between central and local governments. The government specified that
most fiscal reforms should be completed by 2016.
Among the various measures that have been announced (China: the first step in fiscal
reform, October 9, 2014), the new rules on local government debt management are
critical, in our view. The general principle is to open the front door for funding local
government spending but close the back door. In particular, the new Budget Law now
allows local governments to issue municipal bonds at their own discretion. Meanwhile,
the central government needs to approve the amount of local government debt issuance,
and more important, in the new regime, local governments can no longer raise funds via
corporate or financing platform entities (e.g., LGFVs).
The new rules should help contain local government debt problems. In the near term,
the shift from LGFV financing to municipal bond financing should mitigate the maturity
mismatch between funding and local government projects and lower the interest rate
burden, thus helping to reduce the default risk. In the long run, it could strengthen market
discipline for local government borrowing, as municipal bonds tend to have stricter
requirements (e.g., external rating requirements, disclosure of fiscal balance sheets, and
monitoring of government spending) than financing by the shadow banking system.
Moreover, the new rules also state that local governments should no longer be involved
in commercial projects, that public projects should welcome the participation of social
capital (from outside the government, e.g. SOE and private investment), and that local
government debt will be included as a major indicator in the performance assessment of
local government officials. Hence, we believe financing demand from local governments
could be limited to a reasonable level.

11

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 15: China's fiscal deficit


% of GDP
5
0

Central government fiscal


deficit
Augmented fiscal deficit
(both central and local governments)

-5
-10
-15

2007

2008

2009

2010

2011

2012

2013

2014f

Source: NAO, NBS, J.P. Morgan forecast

However, strict implementation of these rules, without offsetting policy adjustment,


could cause a fiscal cliff for China in the next couple of years. This concern about a
steep drop-off in government spending arises, for us, from the large discrepancy between
Chinas official and actual fiscal deficits. The official fiscal deficit, which only includes
the central governments balance sheet, was reported at around 2% of GDP in 2012-2014
(see Chart 15). However, local governments off-budget deficit, as measured by the
increase in local government debt, is much greater. According to the statistics released by
the National Auditing Office, local government debt rose from CNY10.7 trillion at the
end of 2010 to CNY17.9 trillion in June 2013. In other words, the increase in aggregate
local government debt was equivalent to about 6%-7% of GDP each year, lifting the
combined central and local government fiscal deficit to 8%-9% of GDP in 2012 and
2013.
The message is clear, in our view: China will face a fiscal cliff if the central
government does not raise the fiscal deficit target, or if social capital does not flow in to
fill the gap between the newly reduced local government funding and current spending
levels. Alternatively, the government could introduce a lenient grandfathering policy;
however, such a policy could compromise efforts to reform the budget management
system.
We expect the central government to raise the budget deficit from 2% of GDP in
2014 to 3% of GDP in 2015, including an increase in the quota for local government
debt issuance from CNY400 billion to around CNY1 trillion. This will be higher than the
maximum central fiscal deficit seen thus far in this century, which peaked at 2.3% of
GDP when large-scale fiscal stimulus was introduced in 2009.
We believe that China should consider an even more aggressive fiscal deficit target,
in the range of 5%-6% of GDP, to offset the expected negative impact from the
tightening of local government spending. This is still relatively low compared to the 8%9% of GDP aggregate fiscal deficit in recent years. From an economic perspective, it is
also sustainable for a high-growth country like China. In a simple calculation, starting
from Chinas current fiscal debt at around 60% of GDP and nominal GDP growth at
10%, the fiscal deficit that will maintain government debt at 60% of GDP is 6% of GDP
(the break-even deficit is 3% of GDP if nominal GDP growth is 5%). Admittedly, such
an adjustment would require a complete reassessment of fiscal policy by the Chinese
authorities, and it may not happen in the near term.

12

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Our posited increase in the fiscal deficit for the central government does not necessarily
result in an increase in government investment. The fiscal deficit could be used to reduce
the corporate tax burden or to increase support (via tax or financing) for R&D investment
by enterprises. Alternatively, it could be used to improve the social safety net and
indirectly encourage household consumption.
Another possible offset for tighter local government funding constraints may come from
the promotion of social capital participation, e.g., in the form of public-private
partnerships or franchise operations. The government has tried this approach to support
public projects in areas such as infrastructure, water supply, and waster disposal. This
year, 80 projects were selected to encourage social capital participation. However, we are
cautious about the near-term policy impact. First, public investment projects frequently
require a long spending cycle and yield a low return; thus attracting social capital can be
challenging. Second, as public-private partnerships are not backed by a government
guarantee, it may not be easy for investors to get external financing at a reasonable cost.
Finally, total debt in the corporate sector has risen to a very high level (see Question 4),
which can add another layer of difficulty in promoting social capital investment in a
deleveraging environment. Our recent field trips suggest that PPP participants are mainly
SOEs at this moment.

6. Is the PBOCs operational framework at a crossroads?


On November 21, the PBOC lowered its policy rates for the first time since July 2012,
cutting the 1-year benchmark deposit rate by 25bp and the 1-year lending rate by 40bp. The
move eliminated uncertainty over the possibility of near-term rate cuts, but it raised a new
question: does this signal a shift in monetary policy stance and in the way the PBOC
conducts monetary policy?
Since July 2012, the PBOC has refrained from traditional monetary easing. In the first
10 months of 2014, despite ups and downs in economic activity, the PBOC kept interest
rates and the RRR unchanged, and credit growth continued to slow. Instead, during this
period, the PBOC adopted a new monetary policy operational framework with three key
features (China: an update of economic policies, September 30, 2014):
First, policy rate cuts were replaced by a target to lower market interest rates, e.g., 7-day
repo and 3-month SHIBOR. The PBOC has used various liquidity measures, including
open market operations and a standard lending facility (SLF), to provide stable liquidity
and guide short-term market interest rates lower. For instance, the 7-day repo fell from
5.25% at the beginning of 2014 to 3.28% at end-October, while the 3-month SHIBOR
concurrently fell from 5.5% to 4.4%. The lower short-term rates have passed through to
lower government bond yields.
Second, the PBOC substituted RRRs by targeted quantitative measures, such as the newly
created medium-term lending facility (MLF) and pledged supplementary lending (PSL),
and targeted RRR cuts. The overall liquidity injection via these three channels totaled CNY
1.37 trillion in 2014 (including a CNY400 billion PSL that we expect will be used in before
year-end, a CNY770 billion MLF and approximately CNY200 billion via targeted RRR
cuts), which is equivalent to a 125bp across-the-board RRR cut. The main benefit of the
targeted quantitative measures is that they allow the PBOC to control the direction of credit,
which helps to limit the risk of credit flowing to low-return investment by over-indebted
traditional sectors (local governments, SOE, real estate developers), as in the past.
13

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Third, credit easing focuses on compositional shifts (from shadow banking to bank loans,
from short-term financing to medium- and long-term loans) to improve the efficiency of
credit to the real sector. In fact, TSF growth (in stock terms) fell to the lowest level on
record in October (14.3%oya), mainly due to a net decline in trust loans and bank
acceptances outstanding (key shadow bank funding channels) in recent months.
The main reason for the change in the operational framework of monetary policy is concern
about distortions in traditional monetary easing. When the central bank eases monetary
policy via rate cuts or credit acceleration, there is generally unequal treatment in the credit
market in that local governments and SOEs (due to their implicit debt guarantee) and
borrowers who are not sensitive to interest rates (and are willing to accept higher interest
rates) crowd out other sectors.
The new operational framework is a compromised near-term solution to address the
above concerns. The targeted approach aims to level the playing field in the credit market
by providing liquidity to support certain sectors, including SMEs, affordable housing, and
the rural sector. However, the new approach has its own shortcomings from the start. It
could generate new distortion as the PBOC may lack the expertise to guide sector lending.
Separately, the transparency of monetary policy operations under the new framework has
been limited, causing unnecessary market uncertainty.
Hence, the announcement of a rate cut on November 21 surprised the market. What
triggered the change? What does it mean for the monetary policy outlook in 2015?
From a macroeconomic perspective, weak growth and low inflation set the stage for rate
cuts. The economy had a weak start in 4Q, with IP edging up 0.5%m/m, sa in October.
Although credit components have shifted encouragingly (from shadow banking funding to
bank lending) since 3Q, the deceleration in aggregate credit is worrisome, in our view.
November data are not available at present, yet weak credit growth may continue, and
economic activity may be soft, in part due to a temporary shutdown of some activities
during the APEC meeting. In our view, the rate cut, in part, was a response to possibly
weaker-than-expected economic activity in 4Q.
Another reason, which may be more important, is that lowering corporate funding costs is
a government priority. The State Council reiterated this objective throughout the year,
most recently two days before the rate cut announcement. Unfortunately, the new monetary
policy operational framework seemed ineffective in achieving this target. Although lower
short-term interbank rates passed through to lower bond yields (see Chart 16), average bank
lending rates and other funding cost indicators like average trust yields and underground
lending rates have not fallen much (see Chart 17). By contrast, cutting policy rates is seen
as a direct and more effective instrument to bring down corporate funding costs, as banks
actual lending rates are often distributed around the benchmark lending rates.
We think the rate announcement indicates a shift toward more aggressive easing. As
such, it is a big setback for the new operational framework, but in our view, it is too early to
say that the PBOC will give up on the new framework. We think it may employ a mixture
of traditional and unconventional easing, as long as it can deliver policy objectives.
Moving into 2015, we expect at least one more interest rate cut, supplemented by
quantitative measures that may include RRR cuts (see Chart 18), targeted quantitative
measures (e.g., PSL, MLF, SLF), and possible adjustment in loan-to-deposit ratio (LDR)
calculations. We have two 50bp RRR cuts in our 2015 baseline scenario, but there could be
14

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Chart 16: Government bond yields

%
5.0

Chart 17: Average lending rates

% both scales
8.00 Average bank lending rate

10-Year CGB

4.5
4.0
3.5
3.0

Economic Research
Ten questions about China
November 28, 2014

2.5
Jan 13 Apr 13 Jul 13 Oct 13 Dec 13 Apr 14 Jul 14 Oct 14 Dec 14
Source: Bloomberg, J.P. Morgan forecast

24

7.50

23

7.00

22

6.50

21

6.00

20

5.50

1-Year CGB

Trust product
consolidated yields

5.00
2012

Wenzhou private lending


composite
2013

2014

19
18
2015

Source: PBOC, J.P. Morgan forecast

Chart 18: Benchmark lending and deposit rates

JP Morgan
forecasts

% per annum
8

1-year lending rate

7
6
5

1-year deposit rate

4
3
2

06

07

08

09

10

Source: PBOC, CEIC, J.P. Morgan forecast

11

12

13

14

15

more. The market appears to expect that a new LDR calculation could include interbank
deposits in the denominator. If that happens, banks may face additional reserve
requirements and the PBOC could implement RRR cuts (perhaps a one-off 100bp cut) to
offset the resulting increase in required reserves.

7. How does the global oil price collapse affect China?


Global oil prices have fallen sharply in recent months. The spot price for Brent has
dipped below $80/bbl, and the J.P. Morgan forecast looks for prices to fall below $70/bbl in
the coming months before rising back to $88/bbl in 4Q15. J.P. Morgans forecast for the
2015 average Brent oil price stands at $82/bbl, approximately 20% lower than in 2014.
In our view, the fall in global oil prices will affect Chinas macro picture mainly
through inflation and external balances.
On the inflation front, the immediate impact of falling global commodity prices has shown
up in the renewed deflationary trend in producer prices. While oya PPI deflation slowed
somewhat between May and July this year, as headline PPI edged up at an average
0.1%m/m, sa pace, deflationary pressure has intensified since August, reflecting the fall in
global commodity prices and lingering softness in domestic industry activity (see Chart 19).
Producer price deflation appears to have fed through to consumer prices: the sequential
growth trend in headline CPI has eased lately, slowing from 3.3%3m/3m, saar in July to
1.0% in October. Historically, a 10% increase in global oil prices has resulted in about a
0.2%-pt rise in Chinas headline CPI inflation rate, but the feed-through seems to have risen
15

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 19: China's PPI vs. global commodity price index

Chart 20: OPEC basket crude price and China's gasoline retail price

%oya, both scales

%3m/3m, both scales


40
Average OPEC
basket crude price
20

J.P.Morgan commodity
price index

60
40

10
China's PPI

20
0

-20
-40
-60

08

Source: NBS, J.P. Morgan

10

12

14

15
10
5

0
-5

-20

-5

-40

-10

-60
2009

China: retail price of No. 93


gasoline - 36 City average
2010

2011

2012

2013

2014

-10
-15
-20
2015

Source: NBS, CEIC, J.P. Morgan

to 0.4% since the global financial crisis, along with further liberalization of domestic fuel
prices.
Overall, considering the expected soft trends in global oil prices going into 2015, we look
for Chinas CPI inflation to ease to about 1.5%oya in 2015, from a projected 2.0% in
2014. There are some concerns about a potential rebound in domestic food prices,
particularly pork prices. However, so far food price inflation has been tame at a 2.4%
3m/3m, saar pace in October, with pork prices rising at a moderate 3.6% 3m/3m, saar rate.
Easing inflationary pressure was an important driver behind the unexpected rate cut in
November 2014, in our view. Separately, subdued global commodity prices provide a good
opportunity for China to push ahead with price reform for a range of resource-based
utilities, such as oil, natural gas and electricity (see Chart 20).
In addition, given Chinas role as a net oil importer (see Chart 21), the decline in global
oil prices is a positive terms-of-trade shock for the country that should help to lift its
merchandise trade and current account surpluses. We estimate that every US$10/bbl decline
in oil prices would boost Chinas current account surplus by about 0.3% of GDP (see
Question 8). Moreover, while falling global oil prices imply lingering deflationary pressure
at the PPI level, it is useful to differentiate the macro implications of PPI deflation arising
from an exogenous, supply-side induced decline in oil prices vs. PPI deflation driven by
sluggish domestic demand. In particular, PPI deflation driven by structural overcapacity
and a cyclical downturn in the industrial sector, as seen in the last two years, exerts
downward pressure on profitability in the industrial sector that, in turn, drags down
manufacturing investment growth. On the other hand, given Chinas role as a significant net
oil importer, PPI deflation arising from an exogenous, supply-side induced decline in global
oil prices would lift corporate profits and real household income, supporting economic
growth.

8. Will Chinas current account surplus widen again? What is


the implication for the CNY?
We expect Chinas current account surplus to widen to 3.1% of GDP in 2014 and
3.5% in 2015, from 2.1% in 2013, reversing the steady downward trend in recent years
(see Chart 22). In US$ terms, the current account surplus in 2014 and 2015 would be the
highest since 2008. As a share of GDP, it would be the highest since 2010.

16

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

The projected widening in Chinas current account surplus largely reflects the latest trend in
merchandise trade, given the combination of gradual improvement in global demand (led
by the US economy), the relatively sluggish domestic economy, and declining global
commodity prices. Chinas merchandise trade surplus has widened notably since July this
year, with the cumulative trade surplus for the first ten months of the year expanding to
US$276.7 billion, compared to US$200.0 billion for the same period last year. This
increase came on the back of steady rise in exports. In the first three quarters, adjusting for
the data discrepancy between Chinas exports to Hong Kong and Hong Kongs reported
imports from China, Chinas export growth accelerated from 3.1%oya in 1Q to 7.8% in 2Q
and 11.7% in 3Q (see Chart 23). Meanwhile, import growth has been persistently weak in
the 1%-2%oya range in each of the three quarters. To some extent the sluggishness of
nominal imports reflects a price effect: overall import prices fell 2.7%oya in the first nine
months of the year, with a more significant decline in commodity prices, while import
volumes of major commodity products, including iron ore, copper and crude oil, have held
up relatively well this year; see more details under Question 9).
For 2015, as J.P. Morgan looks for the global economy to continue accelerating, Chinas
export sector likely will continue to expand solidly; we expect merchandise exports to rise
about 9%oya in 2015. On the other hand, as weakness in Chinas domestic demand persists,
weighed down by further adjustment in the real estate sector, and as the industrial sector
continues to struggle with overcapacity, the growth in major commodities import volumes
likely will ease, while commodity prices remain soft. Both factors will contribute to
continued subdued growth in nominal imports, in our view. In particular, considering the
impact of oil price alone, we estimate that every US$10 decline in oil prices would to
boost Chinas current account surplus by about 0.3% of GDP. Putting these factors
together, Chinas merchandise trade surplus will likely expand further, with the current
account surplus rising toward 3.5% of GDP in 2015.
The widening current account surplus should put additional appreciation pressure on
the CNY. Indeed, the building CA surplus has been an important driver of CNY
appreciation since June 2014, when the PBOC stopped FX intervention amid its effort to
push exchange rate regime reform. The jump in the trade surplus in 3Q was beyond market
expectations, and, in our view, together with the carry trade incentive, drove the reversal of
the CNY trend and the roughly 2% appreciation between June and October (see Chart 24).
Will the CNY continue to appreciate into 2015? We do not think so. We expect the
USD/CNY to trade at 6.15 at the end of 2015, unchanged vs. our forecast of 6.15 at end2014. But we expect also expect more exchange-rate volatility: In 1H15, the CNY is likely
to move back above 6.20 amid weak domestic economic performance and a strong USD
buoyed by expected Fed tightening.
A strong USD should be a major challenge for CNY movements in 2015. Our global
forecast calls for a strong USD against other major currencies, driven by the divergence of
monetary policy between major advanced economies (the Fed likely will start hiking rates
in June 2015, yet we expect the BOJ and ECB to step up quantitative easing policies). By
extension, most emerging market currencies may follow the EUR and JPY, falling against
the USD, and the risk of competitive devaluation cannot be ignored. If the CNY appreciates
against the USD, in REER terms, it would be a drag on exports, which is one of the few
bright spots in the current economic outlook.

17

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 21: Merchandise trade balance, oil and non-oil trade

Chart 22: China's current account surplus

US$ billion, sa, 3mma

% of GDP

Non-oil
balance

Overall trade
balance

60

12
10

40

20

-20
-40

Oil balance
2010

2011

2012

2013

2014

%oya, 3mma
20

Export

05

07

09

11

13

15

CNY/USD

Export (adjusted for fake exports)

15

03

Chart 24: CNY/USD spot exchange rate and fixing

Chart 23: China's trade growth

10

6.40

Mid-point fixing

6.30

6.20

0
-5
-10
2012

J.P. Morgan
forecasts

6.10

Import
2013

2014

Note: The adjusted series correct for the over-invoicing phenomenon.


Source: NBS, J.P. Morgan forecast

2015

6.00

Jan 12

Spot exchange rate


Jul 12

Dec 12

Jul 13

Dec 13

Jun 14

Dec 14

Source: NBS, J.P. Morgan forecast

The more attractive policy, in our view, is to maintain a stable CNY in REER terms,
which implies a modest depreciation against the USD in 2015. However, improvement
in the current account surplus implies that such depreciation would be difficult to achieve
without substantial intervention by the central bank. Given the multiple factors that will
likely coexist in 2015 (trade surplus, carry trade, and RMB internationalization supports a
strong CNY but domestic softness and the incentive to support exports call for a weak
CNY), we think the CNY will trade in a range in 2015, albeit with significant short-term
volatility.

9. What is the potential impact of Chinas rebalancing on the


rest of the world?
Chinas rebalancing is likely to have important implications for the rest of the world. Here
we would like to discuss two areas: commodity demand and Chinas outbound direct
investment (ODI).
1.

Chinas commodity demand

Since the global financial crisis, China has accounted for almost all of the increase in global
commodity consumption, including crude steel, aluminum, copper, nickel, zinc, and iron
ore (see Table 3). Strong economic growth in China, especially rapid growth in fixed asset
investment (FAI), drove robust commodity demand (see Chart 25). However, Chinas
growth has trended downward in recent years, and the economic rebalancing (from
manufacturing to services, from investment to consumption) implies a disproportionate
18

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Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Table 3: China's commodity consumption as a % of global demand


Product
Crude Steel
Aluminum
Copper
Zinc
Nickel
Iron ore

% net increase in

% of global demand
2007
34
32
26
31
25
43

2009
47
39
37
40
34
55

2011
45
43
39
42
41
55

2013E
45
45
41
44
46
59

global demand
2007 - 2013
87
84
121
109
101
79

Source: J.P. Morgan Commodity Research

Table 4: China's m ajor com m odity suppliers (% share of total im ports)


Crude oil

Iron ore

Coal

Copper

Saudi Arabia (19.9%)


Angola (13.6%)
Iran (9.5%)
Russia (8.2%)
Oman (7.2%)

Australia (45.3%)
Brazil (21.5%)
India (7.4%)
Iran (2.4%)
Russia (2.0%)

Indonesia (39.0%)
Australia (19.5%)
Mongolia (9.0%)
Vietnam (8.4%)
Russia (6.5%)

Japan (7.6%)
US (6.5%)
Korea (4.9%)
Australia (4.8%)
India (4.0%)

Source: Customs data

deceleration in FAI relative to the slowing in headline GDP growth. The implications for
the global commodity markets, in our view, are threefold.
First, the global commodity super cycle is over. On a global scale, to the extent that
Chinas role as a driver of global commodity prices gradually diminishes in coming years
(see Chart 26), the related adjustment in the international terms of trade should favor
commodity importers (especially in developed market economies). On the other hand,
commodity exporters will have to adjust their growth strategy (see Table 4), as Chinas
growth gradually slows amid its own economic restructuring.
Looking at the latest trends with some of Chinas major commodity trade partners, growth
in imports from Brazil slowed to 3.3%oya, ytd in the first 10 months of this year and
3.1%oya in 2013, notably slower than the robust annual average growth at 24% for the
three years through 2011. Similarly, growth in Chinas imports from Australia slowed to
4.9%oya, ytd in October, compared to 16.5%oya in 2013, and annual average growth at
31% for the three years through 2011.
Second, Chinas commodity demand should not collapse. Despite the economic
slowdown, Chinas imports of major commodities have held up reasonably well this year;
although industrial production growth slowed to 8.4%oya in the first 10 months of the year,
iron ore imports rose 16.4%oya during the same period, and copper imports rose 8.8%oya
and crude oil imports rose 9.0%oya (see Chart 27).
Economic rebalancing does not mean China will give up investment. The investment/GDP
ratio was 47.8% in 2013, which we consider unsustainable. The rebalancing aims to bring it
down to a more reasonable level, e.g. 35%-40% by 2020. This means investment in China
will decelerate and expand less rapidly than GDP, but should not collapse.

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lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 25: Fixed asset investment and commodity imports

Chart 26: China industrial production and global commodity prices

%oya, 3mma, both scales

%oya, 3mma, both scales

Real fixed investment


(deflated by PPI)

40
35

60

Commodity import
volume

30

40
30
20

25

10

20
15

50

0
2008

2009

2010

2011

2012

2013

2014

-10

Note: Commodity import volume is a weighted aggregate index based on Chinas major commodity
imports. The base year is 2004.
Source: NBS, J.P. Morgan

Chart 27: China's commodity import volume


Index, 2010=100, sa, 3mma

Crude and
refined oil

160

45

China IP

J.P.Morgan aggregate
commodity price
index

30
15
0

10

11

12

14

13

15

-15

Source: NBS, China Customs, J.P. Morgan

Chart 28: China's energy consumption

Coal-equivalent mn ton
4000

Iron ore

Ton per mn yuan, at 2011 price


90
Energy consumption
intensity
85

3500

140

3000

120

80

2500

100

2000

80
60

22
20
18
16
14
12
10
8
6

1500

Copper
10

11

12

13

Note: The adjusted series correct for the over-invoicing phenomenon.


Source: NBS, J.P. Morgan forecast

14

15

1000

75

Energy
consumption
00

02

04

06

08

70
10

12

14

65

Source: NBS, J.P. Morgan forecast

Separately, Chinas energy consumption should continue to increase. In recent years, the
government has reduced energy consumption intensity (energy consumption per unit of
GDP) by about 4% every year, but GDP has grown much faster (see Chart 28). Total
energy consumption increased by 28.7% between 2008 and 2013. We believe rising energy
demand and high investment imply that Chinas commodity demand will remain high.
Third, the structure of Chinas commodity and energy demand likely will change
substantially. For instance, as real estate investment has slowed in 2014 and continues to
decelerate in 2015, steel demand (24% of steel demand is related to housing and 34%
related to commercial property) likely will slow sharply as well, but copper demand may be
less affected due to the projected pickup in infrastructure investment.
Air pollution and environment protection are now a priority. The shift in the
governments environmental priorities could lead to structural changes in Chinas energy
consumption. In November 2014, the State Council announced its Energy Development
Plan (2014-2020). By 2020, the share of coal consumption should be less than 62%, the
share of natural gas should exceed 10% and the share of non-fossil energy should exceed
15% (vs. 66%, 5.8%,and 9.8%, respectively, in 2013). During the APEC meeting, President
Xi and President Obama jointly announced that China will commit to reducing the level of
carbon dioxide emissions by 2030.

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lu.l.jiang@jpmorgan.com
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grace.h.ng@jpmorgan.com

2.

Economic Research
Ten questions about China
November 28, 2014

Chinas outbound direct investment (ODI)

Chinas outbound direct investment (ODI) has grown rapidly in recent years. In 2007,
Chinas ODI was US$26.5 billion, much less than foreign direct investment (FDI) in China
at US$83.5 billion. In 2013, ODI increased to US$108 billion (exceeding US$100 billion
for the first time), slightly less than inbound FDI of US$118 billion (see Chart 29). Chinas
ODI may first exceed inbound foreign direct investment in 2015, we believe.
The faster growth in ODI vs. inbound FDI is a result of Chinas economic growth and
has government policy support. First, the government has eased restrictions on Chinese
companies overseas investment. In October 2014, the government announced that except
for some sensitive regions and sectors, all overseas investment (regardless of investment
amount) would shift to a registration-based system instead of an approval-based (requiring
ad-hoc registration in place of ex-ante approval). Second, China has signed 12 Free Trade
Agreements (FTAs) so far with its trading partners, most recently with Korea and Australia,
and has been actively pushing regional trade agreements (e.g., ASEAN+3, FTAAP). These
agreements should facilitate cross-border investment between China and counterparty
countries. Third, China played a critical role in the recent establishment of the BRICS
Development Bank and Asian Infrastructure Investment Bank (AIIB). It also announced
plans to establish a US$40 billion Silk Road Fund. The objective is to promote
infrastructure development in emerging markets. Despite a lack of details at the
implementation level, we believe China hopes to strengthen its economic ties with the rest
of the world and not only achieve a win-win outcome as infrastructure investment benefits
other countries growth outlooks, but also find potential overseas demand for Chinas
excess capacity.
Chinas overseas M&A activities underwent some changes in 2014. Comparing the top
10 overseas M&A deals by Chinese companies in 1H14 vs. 2013, we note three new
features. First, there is a rising tide of private firm participation. Among the top 10 deals
involving Chinese firms in 2013, nine were undertaken by central SOEs; only one deal was
done by a private company. In 1H14, only four of the top 10 deals were done by central
government administered SOEs (or central SOEs); private companies were involved in
three deals and the other three were taken by SOEs that are supervised and managed by
local governments (i.e., local SOEs). Second, the target sector has moved from
resource/commodity sectors to manufacturing and others. In 2013, seven of the top 10 deals
were in the mining sector. In 1H14, only three were in the mining sector, and the other
seven deals covered the manufacturing (3), banking (1), real estate (1), wholesale & retail
trade (1), and IT (1) sectors. This suggests that the interest of Chinese companies has
broadened from resources to technology, market, and management. Third, the destination of
Chinas overseas investment activity also broadened to include not only resource-rich
developing markets, but also developed markets. The US is now the biggest recipient of
Chinese overseas investment.

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Lu Jiang (852) 2800-7053
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lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

Chart 29: Outward vs. inward FDI


US$ billion
120

Outward direct
investment

Inward direct
investment

100
80
60
40

2008

2009

2010

2011

2012

2013

2014ytd

Source: NBS, J.P. Morgan

10. What are the next steps in Chinas ongoing structural


reforms?
The Communist Party announced its ambitious reform agenda at the 3rd Plenary Session of
the 18th Communist Party of China (CPC) Congress in November 2013. In this section, we
summarize major reform measures announced in each area in the past 12 months and
present our view and expectations on each.
(1) Financial reform
Major reform measures announced in the past 12 months
Major reform measures include: (1) the PBOC announced a widening of the daily trading
band of the USD-CNY exchange rate from 1% to 2% (March 2014); (2) the PBOC
announced an increase in the range of the deposit rate premium from 10% to 20%
(November 2014). As such, banks can now offer as much as 1.2x the benchmark deposit
rate for local currency deposits compared to the previous 1.1x; (3) HK-SH Stock Connect
was launched on November 17, 2014; (4) China (Shanghai) Pilot Free Trade Zone (FTZ)
was established in September 2013. Afterwards, foreign currency deposit rates were fully
liberalized within the FTZ (in March 2014); the PBOC also introduced Free Trade
Accounts (FTA) in May this year, so the companies registered in the FTZ can use the
accounts for cross-border financial transactions without being subject to the capital control
that applies outside of the zone; The Shanghai FTZ is adopting a negative list approach,
which permits all sectors to enter unless they are on the negative list. In July 2014, the list
was shortened to 139 items from 190 items in 2013. (5) the PBOC and regulators jointly
issued a notice (Document no 127) to regulate the interbank business among financial
institutions, effective May 16, 2014. This turned out to be a game changer in containing
excessive growth in shadow banking activities; (6) the China Securities Regulatory
Commission (CSRC) released a proposal to establish a delisting system in the stock market
(October 2014); (7) the China Banking Regulatory Commission (CBRC) approved three
private-owned banks in 2014; (8) RMB internationalization: set up offshore RMB clearing
centers in Frankfurt, London, Paris, Seoul, Kuala Lumpur and Sydney upon the mutual
agreements between China and respective countries, and grant RMB Qualified Foreign
Institutional Investors (RQFII) quotas for UK, Germany, Korea and Australia totaling
CNY290 billion (or about US$47 billion).

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Ten questions about China
November 28, 2014

The reform approach and next steps


In our view, financial reforms announced thus far have taken an opportunistic approach.
That is, we see no apparent sequencing as it relates, for example, to completing financial
reform on the domestic front before liberalizing the capital account. At this stage, we
believe the government will continue to push forward in small steps in all areas. Thus, we
have seen some progress in nearly all areas, but find it difficult to identify break-through
achievements. The gradual reform approach should help to address financial stability
concerns during the process, which we consider a priority given the rapid accumulation of
financial imbalances in recent years.
We expect the government to follow the same approach in 2015. Interest rate liberalization,
exchange rate regime reform, capital account openness, and RMB internalization have long
been focus areas. In addition, developing the domestic capital markets seems to have
become a high priority in the near term, with the objective to establish a multi-channel
financing system for the economy and diversify financial risks. The CSRC proposes to shift
from an approval-based to a registration-based IPO system, strengthen supervision of listed
companies and establish a delisting system. The introduction of HK-SH Stock Connect and
an increase in Qualified Foreign Institutional Investors/RMB Qualified Foreign Institutional
Investors QFII/RQFII quotas should attract institutional investors, which would benefit
Chinas stock market in the long term. Whether A-shares will be included in the MSCI
index in 2015 remains to be seen. Meantime, the bond market has grown very fast in recent
years, with market cap expanding 43.2% to reach 29 trillion yuan by October 2014 from
end-2010. We also will watch whether some defaults will happen in non-bank financing in
2015. The persistence of implicit guarantees in the onshore bond market and shadow
banking activity is by far one of our key failures of the financial reform effort to date and a
significant impediment to further financial market development.
(2) Fiscal reform
Major reform measures announced in the past 12 months
Major reform measures include: (1) on June 30, the CPC Politburo passed The Plan to
Deepen the Fiscal Reform, which outlined the roadmap for fiscal reform in the coming
years. Most tasks should be completed by 2016; (2) on August 31, the National Peoples
Congress approved the revision of the Budget Law (effective January 1, 2015), which
allows provincial governments to issue local government bonds; in 2014, 10 local
governments were allowed to issue municipal bonds (totaling CNY400 billion) in a pilot
program; (3) on October 2, the State Council released a proposal on Strengthening Local
Government Debt Management system (Document No. 43); on October 8, the State
Council released Decision on Deepening the Reform on Budget Management System; (4)
on October 23, the Ministry of Finance released a document to include local government
debt in the budget management system (Document No 351); (5) on April 30, VAT reform
was expanded further to cover the railway transport, postal service, and telecommunication
sectors; (6) on September 29, the State Council announced that starting from December 1,
2014, coal resources will change from being quantity-based to price-based, with tax rates
determined by provincial governments. Before this announcement, the resource tax on coal
was fixed within a range at 0.3-5 yuan/ton, which cannot reflect changes in supply and
demand. Therefore, the change can reinforce the coal industrys adapting to market forces;
(7) The State Council announced a further reduction in the tax and fee burden for SMEs,
e.g., raising the tax threshold level of profits for small and micro companies from

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Economic Research
Ten questions about China
November 28, 2014

CNY60,000 to CNY100,000 (April 2014); and waiving VAT and sales tax for small and
micro enterprises, as well as individual industrial and commercial households, with
monthly sales revenue of less than CNY30,000 (September 2014).
The reform approach and next steps
The progress on fiscal reform in 2014 is encouraging. The three key areas include:
improving the budget management system, of which local government debt is the critical
issue; improving the tax system; and establish a new system that better aligns fiscal
spending with fiscal revenues (Question 5). We expect the first two issues to remain the
focus in 2015.
Regarding the budget management system, we look for progress in 2015 on including local
government debt in the budget management system. We also expect the quota for local
government debt issuance will be increased from CNY400 billion in 2014 to about CYN1
trillion in 2015. That jump implies there will be have to be a transitional arrangement to
avoid a fiscal cliff (Question 5). In our view, even with the issuance increase, local
governments will face stricter rules and funding constraints in financing new projects.
Regarding tax reform, we expect the VAT will be expanded to cover the whole service
sector. In addition, Congress likely will start the legal process to introduce a real estate tax,
although it may still take years before it is implemented at the national level.
(3) Administrative reform
Major reform measures announced in the past 12 months
Major reform measures include: (1) removing administrative approval items covering a
wide range of sectors such as financial, construction, tourism, transportation, etc.: on
August 12, the State Council exempted 45 more items from central government approval,
and most of these items were removed or reassigned to lower levels of government. Since
the new leadership took office in March 2013, the central government has cut or delegated
to lower governments nearly 400 administrative approval items (August 2014); (2)
simplifying the import management and administrative processes (September 2014); (3)
simplifying the pre-approval process for corporate investments, combining the pre-approval
and approval processes for projects and building up information-sharing as well as
regulatory platforms.
Overall, we believe the State Council is on pace to achieve Premier Lis target that about
one-third of existing administrative items should be removed during his term in 2013-2018.
This is an important part of the governments effort to let the market play a bigger role in
governing economic activity and allocating resources. Between March and August, 1.97
million new enterprises were registered, 61% higher compared to the same period last year.
Together with the tax cut measures for small and micro-size enterprises, it will help
generate employment, increase market competition, and support economic growth.
(4) Household registration reform and land reform
Major reform measures announced in the past 12 months
Major reform measures include: (1) on July 30, 2014, the State Council provided more
details on reform of the household registration (or hukou) system. The statement said that
small and mid-sized cities will remove residence restrictions; (2) on September 29, 2014,
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lu.l.jiang@jpmorgan.com
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Economic Research
Ten questions about China
November 28, 2014

the Central Leading Group to Comprehensively Deepen Reforms (Chaired by President Xi)
reviewed and approved The Guide on Rural Land Contract and Management Rights
Transfer and Scale-Management in the Agriculture sector and The Pilot Reform Proposal
to Develop Joint Stock Cooperatives among Farmers and Shareholding Reform of
Entrusted Collective Assets; (3) on November 20, 2014, the State Council released
Opinions to Orderly Transfer of Rural Land Management Rights and to Develop Scale
Management in the Agriculture Sector.
The reform approach and next steps
Hukou reform and land reform are closely connected, as reforms related to land rights
(ownership, contractual rights and management rights) and their transferability are the key
issues for both. Recent proposals seem to lean in the direction of separating the two reforms
at this stage so as to avoid a deadlock.
The hukou reform proposal focuses on removing urban and non-urban household
registration requirements in small and mid-sized cities (i.e., cities with urban population
less than 1 million), and adopting a unified residence system. For non-residents, a residence
permit will be issued. However, it seems that the unified residence system will not
automatically lead to the equal treatment in the social safety net. In other words, we see
residence system reform as an intermediate step that first eliminated the difference in
hukou, but leaves unaddressed the more sensitive issue of equal social services. In large
cities, the hukou restriction will continue to exist in its current form for the foreseeable
future.
The near-term focus of land reform is to clarify land rights, which in our view is necessary
for more meaningful reform. The objective of land reform, in our interpretation, is to clarify
and stabilize land ownership and contractual rights, and allow for the transfer of
management rights. A pilot reform of management rights transfer will be implemented at
local levels in the next one to two years, but nationwide land reform may have to wait
several years before land rights clarification is completed. Land reform is perhaps the most
complicated and difficult task in the overall reform agenda.
(5) State-owned enterprise (SOE) reform
Major reform measures announced in the past 12 months
Major reform measures related to SOEs include: (1) on July 15, 2014, the State-Owned
Assets Supervision and Administration Commission of the State Council (SASAC)
announced that six centrally administered SOEs will pilot reforms in four areas: (i) capital
investment company restructuring, (ii) mixed-ownership economy, (iii) central board of
directors exercising senior management personnel selection, performance appraisal and
compensation management, (iv) supervised by Central Discipline Inspection Group; (2) on
August 27, the Political Bureau of the CPC Central Committee approved plans to reform
the compensation system that determines centrally administered SOE executives salaries
and the size of their expenditure accounts and other privileges; (3) after Shanghai first
announced 20 local level SOE reform measures in December last year, 20 other cities or
provinces (including Guangdong, Chongqing, Guizhou, and Hubei) put forward their
opinions on local SOE reforms, emphasizing mixed ownership.

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Economic Research
Ten questions about China
November 28, 2014

The reform approach and next steps


The local level SOE reforms appear to be more aggressive and flexible in terms of setting
targets on achieving mixed ownership. For instance, Chongqing is targeting to transform
two-thirds of its local-level SOEs into mixed ownership enterprises in the coming three to
five years, with suitable enterprises and assets listed, and the capital of more than 80% of
the SOEs that are in the competitive industrial sectors securitized. On the other hand,
Shanghais reform plan focuses on setting a clear definition on the SOEs based on their
functions, i.e., competitive, functional, and public services, and therefore their targets are
managed differently. Compared to local level SOE reforms, the centrally administered SOE
reform appears to lack clearly defined targets, which can be considered as the pre-condition
for the reforms in the aspects of mixed ownership structure, employee shareholding policy,
board building, and payment structure.
(6) Relaxing one child policy
On January 17, 2014, Zhejiang province became the first to implement a relaxation of the
one-child policy, allowing couples to have two children if one of the parents is an only
child. According to the media (Peoples.com), relaxation of the one-child policy was
implemented nationwide by mid-2014, with a few provinces (i.e., Xinjiang and Tibet)
pledging to implement the policy, but with no specific timetable.

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Economic Research
Ten questions about China
November 28, 2014

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JPMorgan Chase Bank, N.A., Hong Kong


Haibin Zhu (852) 2800-7039
Lu Jiang (852) 2800-7053
haibin.zhu@jpmorgan.com
lu.l.jiang@jpmorgan.com
Grace Ng (852) 2800-7002
grace.h.ng@jpmorgan.com

Economic Research
Ten questions about China
November 28, 2014

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