Policy Easing

8/3/2019 Policy Easing

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Asia China

15 December 2011

China Outlook 2012

Policy easing to accelerate in

H1

Deutsche Bank AG/Hong Kong

All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local

exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche

Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firmmay have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single

factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.

MICA(P) 146/04/2011.

Market Update

Research Team

Linan LiuStrategist

(+852) 2203 8709

[email protected]

Jun Ma, Ph.DChief Economist

(+852) 2203 8308

[email protected]

Dennis TanStrategist

(+65) 6 423-5347

[email protected]

FixedIncome

GlobalMarketsResea

rch

Stra

tegy

Economic outlook: We expect annual GDP growth to slow from 9.1% thisyear to 8.3% in 2012, and to recover to 8.6% in 2013. We expect the

economy to be featured by 1) disinflation, 2) initial growth deceleration

followed by a recovery, and 3) policy easing in 1H followed by a more

cautious stance towards the end of the year. On monetary policy, we expect

3-4 RRR cuts in 2012, which should permit average monthly RMB lending to

rebound to RMB800-900bn/month in 1H, and annual lending to reach around

RMB8.4tn in 2012. We expect a modest fiscal easing in 2012. Fiscal priorities

should include public housing, completion of on-going infrastructure projects,

SMEs, services, and consumption.

Main risks: The two most important shocks to the economy in the comingmonths are property FAI deceleration and export slowdown. We expect

property FAI growth to slow from the current 30%yoy to 14%yoy in the first

few months of 2012. We expect export growth to decelerate from the current

15%yoy to 8% in 1Q 2012. For 2012 as a whole, we revised down our export

growth forecast to 8% from the previous 10%.

Local markets strategy: We are constructive on CNY fixed income market inthe first half of 2012. We expect net liquidity inflow to the interbank market to

help bring money market rates 50-100bps lower from where they are now

before the middle of 2012 and we recommend entering Repo IRS/NDIRS or

Shibor IRS/NDIRS 2Y/5Y steepeners about 10bps (target exit 40bps and stop

loss -5bps) and -20bps (target 20bps and stop loss -35bps) respectively. We

recommend overweight CGB bonds.

Currency strategy: We think part of the shift in policy stance by the Chineseauthorities would be to slow down the pace of appreciation of the RMB.

While we still like core short positions in 1Y USD/CNH and/or NDFs (given that

they pricing in more than 1% depreciation of the RMB); we also see value in

buying CNY vols via straddles, given the risk of further squeeze in NDFs in

early 2012 as the economy slows down.

CNH strategy:implementation of RMB FDI and ODI programs; more enterprises will be

allowed to participate in the RMB cross border trade settlement scheme; thelaunch of RMB-QFII program, the RMB cross currency swap arrangement will

likely be expanded with more trading partners, in particular with ASEAN

countries; and the offshore RMB market to expand to more regional trading

centres. The key downside risk to our forecasts is the pace of RMB

appreciation and the possibility of further volatility in the CNH-CNY spot basis.


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15 December 2011 China Outlook 2012

Page 2 Deutsche Bank AG/Hong Kong

Economics

We foresee a deeper qoq GDP trough in

1Q of 2012 than our earlier projection

We cut our 2012 GDP growth forecast to 8.3% as early as

in August 2011, and has since maintained this forecast.

Despite many changes in DBs global economic forecasts

and recent developments in China, we continue to believe

our 8.3% annual forecast remains reasonable.

DBs European economists downgraded their 2012

Eurozone GDP forecast twice in the past four months. The

most recent revision reduced their 2012 Eurozone GDP

forecast from 0.4% to the current -0.5%. As we (DBsChina economics team) took a more bearish view on

Europe as early as in August, the recent European

forecast changes only marginally worsened our annual

outlook for Chinas export growth.

The following table produces our updated yoy and qoq

(saar) GDP growth forecasts for 2012. The slight change

we made is to further cut our qoq GDP growth

forecast for 1Q 2012 to 6.4% from the previous 6.8%,

for two reasons. First, we now expect a sharper

slowdown in real estate FAI growth in the coming months

due to weakness in property sales. Second, the

contraction in European GDP in 1Q is likely to be 1.6% on

qoq saar basis, vs the previous forecast of 0.4%.

China: yoy and qoq GDP growth forecast

yoy % qoq (saar) %2011Q1 9.7% 8.7%

2011Q2 9.5% 9.1%

2011Q3 9.1% 9.5%

2011Q4F 8.5% 7.3%

2012Q1F 7.7% 6.4%

2012Q2F 7.5% 9.0%

2012Q3F 8.7% 10.0%

2012Q4F 8.7% 9.7%

Source: SSB and DB forecast

Three factors are behind our projection of a sequential

growth trough in 1Q 2012. First, we believe that the

European economy is already in recession and its

economic contraction will like to be the worst in 1Q. This

implies that Chinas export growth will suffer the most

from European demand weakness in 1Q. Second, Chinas

real estate sales have slowed sharply since September

2011, and developers will thus likely rein in their

construction activities. Sequential slowdown in

construction should last until Q1 next year, before

property prices and sales may stabilize. Third, Chinas

monetary easing, which began only at the end of

November (as marked by the RRR cut on November 30),

will likely become more visible in 1Q. With a one-quarter

lag, monetary easing should begin to support domestic

demand, especially investment activities, from 2Q.

Note that the qoq GDP growth rates before (and

including) 3Q 2011 are estimates from the National

Bureau of Statistics (NBS). Our estimates differ from

theirs as we use a different seasonal adjustmentmethodology. The NBS uses its own methodology but the

agency does not release its details and original data, and

therefore it is not possible to replicate its estimates. We

believe its estimates are problematic as their yoy and qoq

growth rates appear inconsistent. In particular, the NBS

estimate of a sequential acceleration of GDP growth in 3Q

of 2011 is contradictory to most other indicators which

became visibly weaker in that quarter these include the

PMI, monetary and loan growth rates, commodity prices,

as well as the qoq change in power consumption. In

particular, the PMI fell to around 50 in 3Q and during the

quarter monetary conditions appeared to be the tightest in

two years.

Given this difference in methodologies, we ask readers to

take our qoq GDP estimates as indicative (of our view of

the momentum of the economy), rather than something

that could be verified by NBS data releases in the future.

We expect GDP growth to accelerate to

8.6% in 2013

In this monthly note, we for the first time publish our

forecasts of 2013 economic indicators. We expect GDP

growth to rise to 8.6% in 2013, up from 8.3% in 2012.This is largely reflecting our view that US and Eurozone

GDP growth will be stronger in 2013 than 2012. The

rationales for this forecast include: 1) the worst part of

bank deleveraging, which causes the contraction of the

real economy, would be in 2012; 2) the fiscal contraction

(measured by the reduction in cyclically adjusted fiscal

deficit/GDP ratio) was as much as 1.4ppts in 2012, but

would improve in 2013. In other words, the impact of

fiscal contraction will become less of drag for the

Eurozone economy in 2013.


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Deutsche Bank AG/Hong Kong Page 3

Stronger US and Eurozone growth would enhance

Chinese growth via stronger exports. So, for example,

based on historical correlations, a 1% increase in US&EU

growth would increase Chinese export growth by about

6ppts. We thus forecast acceleration of China export

growth from 8% in 2012 to 14% in 2013. In volume

terms, Chinas export growth will likely accelerate byabout 3-4ppts. This should translate to a 0.5ppt increase in

Chinas GDP growth. However, given that monetary and

fiscal policies will likely become a bit more restrained, we

expect GDP growth in 2013 to accelerate only by 0.3ppts

to 8.6%.

Other changes to the key components of the Chinese

economy should largely offset each other in terms of

impact on GDP. For example, we expect some modest

deceleration in real gross capital formation (as the

corporate profit margin will drop due to the long-term

structural trend of higher wage growth), but real privateconsumption will likely accelerate a bit on better income

growth and higher government spending on social

services and welfare.

On the latter point, the recent unfortunate school bus

accident in Gansu province is illustrative. This accident,

which killed 21 preschool students, provoked a massive

wave of public criticism (in the form of tens of thousands

of Internet and press commentaries) that put pressure for

the government to improve safety standards. A week

later, the State Council decided to allocate additional

budgetary resources for purchasing school buses that

meet safety standards on a nationwide basis. This case

demonstrates the significant rise in the role of public

opinions in influencing policy making in China, and that the

government will likely have no choice but to increasingly

steer its fiscal priority towards social spending.

China: Macroeconomic Forecasts

2010 2011F 2012F 2013FReal GDP (YoY%) 10.3 9.1 8.3 8.6

CPI (YoY%) ann avg 3.3 5.3 2.8 3.5

Broad money (M2) 19.7 13.5 16.0 14.5

Bank credit (YoY%) 19.9 15.0 15.5 14.0

Budget surplus (% of GDP) -1.7 -2.0 -2.2 -1.5

FX rate (eop) CNY/USD 6.59 6.35 6.13 5.86

Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0

Retail sales (nominal) 18.4 16.5 14.0 15.0

Industrial production (real) 15.7 13.0 11.5 12.0

Merch exports (USD nominal) 31.3 20.0 8.0 14.0

Merch imports (USD nominal) 38.7 24.0 9.0 16.0

1-year deposit rate (%) 3.50 3.50 3.50 3.50

Source: CEIC and DB forecasts.

Source: CEIC and DB forecast

We expect property FAI growth to slow

rapidly in the first few months of the

year

It appears that the weakening of property investments by

developers is becoming the most serious challenge to the

economy in the coming few months, even more so than

export deceleration. This is because the average property

price in 35 major cities has declined by about 13% in the

past two months according to Soufun, and sales and floor

space started have both decelerated sharply. In terms of

floor space started a leading indicator of real estate FAI

its growth fell from 30%yoy in Jan-Aug to only 10%yoy

in September and -1% in October. Based on historical

correlation, the deceleration in floor space started will

likely translate into a visible slowdown in real estate FAI

(correlation at 0.5-0.6). We thus expect real estate FAI

growth to decelerate from 30%yoy in the current quarter

to 14%yoy in 1Q next year. On a qoq basis, we expectreal estate FAI to slow to zero in 1Q of 2012.

Real estate FAI growth forecast

yoy qoq (saar)1Q 11 75% 34%

2Q 11 35% 32%

3Q 11 17% 31%

4Q 11F 7% 30%

1Q 12F 0% 14%

2Q 12F 18% 7%

3Q 12F 25% 11%

4Q 12F 20% 19%

Source: CEIC and DB forecast

Estimated composition of FAI by type of real estate

investments, Jan-Oct 2011

Commodity

residential

housing,

60%Office, 4%

Commercial

property,

12%

Public

housing,

14%

Others, 10%

Source: CEIC and DB estimates


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Yoy % change in residential floor space started

-50%

0%

50%

100%

150%

200%

250%

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10

Nov-10

Feb-11

May-11

Aug-11

Source: CEIC

Some readers have wondered why with residential

property sales declining sharply, real estate FAI can still be

growing at positive rates. One thing to clarify here is thatwe are projecting total real estate FAI growth, rather than

commodity housing FAI growth (i.e., investment by

developers for sale at market prices). This is the part of

FAI that will be substantially affected by the slowdown in

property sales. It accounts for about 60% of total real

estate FAI in the first 10 months of this year according to

our estimates. The other components of real estate FAI

include public housing (about 14%), commercial and

office property FAI (16%), and others (including

investments by rural residents and urban work units). The

growth of these components is largely unaffected by the

weakness of property sales in the private market. When

qoq total real estate FAI growth falls to zero in 1Q of

2012, it actually implies that qoq commodity housing FAI

growth declines by 20% (given that the FAI of other real

estate components is growing at 30%yoy).

It is also important to distinguish between yoy and qoq

growth of real estate FAI. The qoq FAI growth can indeed

fall very sharply (e.g., to zero in 1Q next year) due to the

recent decline in property sales, but FAI can remain

positive on a yoy basis as the yoy number reflects the

impact of the cumulative change over past four quarters.

In addition, we expect by Q2 next year property sales and

FAI to pick up on improving affordability and possiblysome government policy support. Therefore, the annual

FAI growth can still be at a positive rate for 2012 as a

whole.

As for impact on GDP, given that real estate sectors

capital formation accounts for about 10% of GDP, we

estimate that a 7ppt deceleration in qoq (saar) real estate

FAI growth could reduce qoq (saar) GDP growth by 0.7ppt

in 1Q next year.

We revised down our 2012 export

forecast to 8% from 10%

Our European economists are projecting the Eurozone

economy will be in recession for the current quarter and

first half of next year. The trough is projected in 1Q of

2012. The driving forces for further deterioration of

sequential growth in Q1 include bank deleveraging, fiscal

contraction, as well as the negative wealth effect arising

from weaker consumer confidence. However, over the

coming months, we expect some progress of the

Eurozone towards fiscal consolidation, which will permit

the ECB to further loosen monetary policy and support the

debt market, and to help lift market and consumer

confidence. The benefits for the real economy are

expected to kick in from Q2 next year.

Given this European growth trajectory and a relatively

steady pace of US economic growth (at around 2.5%annualised rates for most quarters), we expect Chinas

qoq and yoy export growth to look like the following:

China export growth forecast, yoy and qoq %

China export(yoy) China export(qoq saar) EU/US GDP(qoq saar)1Q 11 26% 16.0% 2.0%

2Q 11 22% 7.7% 1.0%

3Q 11 21% 10.2% 1.3%

4Q 11F 15% 6.1% 0.7%

1Q 12F 8% 2.2% 0.3%

2Q 12F 6% 3.0% 0.4%

3Q 12F 6% 12.1% 1.5%

4Q 12F 11% 14.6% 1.9%

Source: DB forecast

According to our estimates, Chinas qoq (saar) export

growth will slow sharply to only 2.2% in 1Q next year,

down from 6.1% in 4Q this year. As a result, yoy export

growth will likely decelerate to 8% in 1Q, stay weak for

2Q and 3Q, before recovering in 4Q 2012. For the year as

a whole, we now forecast export growth at 8% (vs

previous expectation of 10%). We also revised down our

import growth forecast by 2ppts to 9%.

Ceteris paribus, the qoq export deceleration will lead to a

reduction in qoq (saar) GDP growth by about 0.4ppts in

1Q of 2012. We expect only a small part of the GDP

impact from the deceleration of real estate FAI and

exports to be offset by monetary easing in that quarter.


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CPI inflation to drop sharply to 3% in Q2

and 2.8% for 2012 as a whole

We continue to expect CPI inflation to decline sharply to

4.2% in November and 3.8%yoy in December, and to 3%

in 2Q next year. This reflects the significant decline in

wholesale agriculture prices in the past two months (by 7-

8%) and its gradual pass-through to retail food prices.

Based on historical correlation, the food component of

CPI should fall by at least 5% cumulatively between the

peak September and the next trough. Even if the power

tariffs are raised by 5% and refined oil prices are raised by

10%, their boost to CPI is only 0.3ppts, a small fraction of

CPI reduction (by 1.5%) due to a 5% food price drop.

Based on normal seasonality, we assume a 5% rise in

food prices in January and February to reflect the Chinese

New Year effect. Even with this sequential rise in food

prices, yoy CPI inflation will still likely fall to 3% in 2Q andthe full year CPI inflation will likely be at 2.8% for 2012.

Other key assumptions we made in this CPI projection

include a modest decline in PPI in the coming few

months, with a recovery from Q2 next year. For the year

as a whole, we see PPI inflation at about 4%, significantly

lower than the recent peak of about 8%. This projection is

supported by the recent trend of declining input price

index in the PMI report.

Another important contributor to disinflation is the fall in

property prices, which will over time translate to a decline

in the housing component (which includes rents and

imputed rents) of CPI. We estimate that a 10% drop in

physical property prices (Soufun property price index) will

eventually after about 6 months reduce the housing

component of CPI by 1%.

We expect 3-4 RRR cuts to support 15-

16% M2 growth in 2012

We expect M2 growth to accelerate marginally to 15-16%

next year, up from the current 13%. Experience tells us

that M2 growth is typically set at 2-3ppts above nominal

GDP growth. This time, given the consensus forecast of

8.5 for real GDP growth and about 3.5% for CPI inflation,

14% will likely form the bottom for the discussion for next

years M2 growth range. However, arguments for some

additional monetary expansion will likely be made in the

coming months to allow 1-2ppt additional M2 growth in

order to offset the global demand shock and the

weakness in the real estate sector. Thus, the final

outcome will likely be 15%-16% for M2 growth. A M2

growth rate of 15% should be applicable if GDP growth is

running safely above 8%, but 16% is more likely when

yoy GDP growth slips below 8% for two quarters (which

is our forecast).

At this moment, we do not see strong reasons why loan

growth will be much different from M2 growth in 2012.

This implies that new RMB lending will be around

RMB8.4tn next year (i.e., loan growth at around 15.5%),up from this years estimated RMB7.4tn.

We estimate that it may require 4 RRR cuts to generate

enough liquidity (deposit growth) in the banking system to

support 16% loan growth in 2012. Our assumptions in

this calculation include: 1) in 2012 the net purchase of FX

reserves by the PBOC would be USD300bn, about half of

that in 2010; 2) there is no change in outstanding PBOC

bills in 2012; and 3) there are no major changes in reserve

money due to other open market operations. Under these

assumptions, the increase in reserve money due to

PBOCs FX purchase can generate an increase in M2 byRMB7.3tn. Given the fact that each RRR cut by 0.5% can

increase the money multiplier by about 0.07 and boost M2

eventually (after a time lag) by RMB1.4tn, 4 RRR cuts will

be needed to provide additional M2 of about RMB5.8tn.

An increase in M2 by RMB13.1tn (7.3+5.8) is needed to

support 16% loan growth in 2012. Therefore, 3-4 RRR

cuts are likely if loan growth will be in the range of 15-

16%.

As for timing of the RRR cuts, we believe they are likely

be front-loaded for several reasons. First, the capital

outflow due to weak RMB expectation will continue to

restrain domestic liquidity growth due to limited FX

purchase by the central bank in the coming months.

Second, economic growth will likely be weak in 1H (worst

in 1Q on a qoq basis, and worst in 2Q on a yoy basis), and

thus should prompt the government to be relatively more

aggressive in policy easing in 1H, compared with 2H.

Third, the global quantitative easing (by the Fed and ECB)

in the coming months will likely begin to pose upward

pressure on commodity prices in 2H of 2012. Therefore,

towards the end of 2012, Chinas monetary policy stance

may become somewhat more cautious again, due to the

re-emergence of inflationary pressure.

We expect the RMB to resume

appreciation from 2Q next year

The recent depreciation of the RMB vs the USD -- by

about 0.3% in November -- reflected the short-term

change in market expectation of the RMB as well as the

reduced PBOC intervention in our view. We think China

should be pleased to see that the market force is finally

generating some two-way volatility for the RMB. This two-

way volatility has at least two benefits. First, it provides an

argument for China in its debate with the US that China is


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not manipulating its currency. Second, it is an important

warning to short-term speculators that they can lose

money in any period of time by betting on RMB

appreciation, and thus helps deter some speculative

activities and reduce hot money inflows. We have shown

in our previous study that if the RMBs volatility

(annualised daily volatility) rises from 1.5% to 3.5%, it candrastically reduce the Sharpe ratio of investing in the RMB

to 0.22 from 0.57. We believe China is now moving in this

right direction1 of raising the RMB volatility.

We expect the short-term weakness of the RMB to

persist for a few more months, as long as the market

expectation of Chinas growth deceleration and export

contraction remains. However, as soon as sequential GDP

growth begins to show signs of a recovery as indicated

by, for example, a rise in the PMI and a pick up in the

export orders index, the RMB should begin to resume its

appreciation trend. We think this will likely occur from 2Qnext year. On a medium-term basis, we still believe that

Chinas trade balance (including merchandize and services

trade) will remain in surplus for a few more years. Our

projection, based on a CGE model, is that Chinas trade

surplus will decline steadily in the coming few years, and

turn to a deficit in 2016 2 . Given that the RMB

internationalization and capital account liberalization

process may also permit some net capital inflows, this

implies that the despite greater short-term volatility, the

RMB will likely continue its overall trend of appreciation

for the coming four years. For 2012, we expect the RMB

to appreciate by 3.5% against the USD, but it will likely to

be back-loaded (i.e., most of the appreciation taking place

in the last three quarters of next year).

Modest fiscal easing in 2012

We expect some modest fiscal easing in 2012. Despite

the official rhetoric that fiscal policy will remain pro-active,

we think the reality is that there will be only limited fiscal

expansion in 2012 relative to 2011. Our baseline forecast

is that the deficit-GDP-ratio will rise slightly to 2.2% in

2012 (vs 2.0% in 2011). Specifically, we forecast that total

government fiscal deficit will rise to RMB1.1tr (including

RMB300bn for local government deficit/bond financing) in2012, vs RMB900bn in 2011 (including RMB200bn for

local government deficit/bond financing).

Within the fiscal budget for 2012, we expect some

modest tax cuts to support SMEs, exporters,

1See Jun Ma, China should adopt a flexible basket-based RMB exchange

rate mechanism, February 2010 (in Chinese).2See Jun Ma, Mingzhi Xiao, and Yandong Jia, A quantitative analysis of

Chinas trade surplus, published in Jun Ma, The Locus of Money, China

Economic Press, August 2011 (in Chinese).

consumption, and services. These tax cuts may be in the

forms of a reduction in the business tax, more

exemptions/deductions from the VAT, and some increase

in VAT rebate for exporters. Broader-based personal

income tax cuts and VAT cuts are likely to be proposed

but unlikely to get approved in the near future.

On the expenditure side, we expect priorities be given to

support public housing, infrastructure (e.g., resumption of

railway projects, repair of reservoirs and dams), social

services, and consumption. There will likely be some

significant increase in governments funding for public

housing and for railway projects. As a result of the

increased bank, bond, and government funding, we

expect railway FAI to rise 30% in 1H of 2012 from 2H this

year, and public housing investment to rise 20-30% in

2012.

Real estate policy: incentive for firsthome buyers may be needed

The recent sharp decline in property sales is generating

some serious downward pressure on the economy. First,

real estate FAI will likely slow significantly and become a

major drag on the economy. Second, land sales have also

slowed remarkably as a result of weaker property sales

and the funding stress faced by developers. According to

Centaline property agency, land sales in 130 major cities

slumped 30.6%yoy in the first 11 months of 2011. As

local land revenues are a major funding source for local

infrastructure and public housing projects, the decline in

land sales implies local sponsored FAI may be significantly

curtailed at least in the early part of next year even if bank

lending recovers.

We think it is important that property sales recover to a

healthy level from 2Q of 2012 to avoid a hard landing of

the economy. Otherwise, the risk of GDP growth falling

below 7% for two consecutive quarters will become

material (we know it is most likely to be below 7% on qoq

basis in 1Q already), and by then the government will be

concerned about its implication for social stability.

We see two scenarios under which property sales canrebound from 2Q:

First, a 20% drop in property prices will significantly

improve affordability and thus begin to boost demand.

Over the past two months, property prices in 35 major

cities have already declined by 13% according to Soufun,

and another 5-7% drop is quiet easy to achieve within 1Q.

Taking into account the fact that the average wage has

been rising at 13% per year, it means that affordability will

improve by 33% compared with a year ago. This could be

a powerful reason for a meaningful resumption of


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property sales. This is what we call an automatic

stabilizer.

Second, consider the case that the automatic stabilize

does not work, and property prices continue to spiral

downwards after a 20% drop. The resulting further

decline in property sales, property FAI, land sales willbegin to lead to sizeable lay-offs by developers,

construction companies, property agencies, cement and

steel mills, as well as construction machinery companies.

This will force the government to take actions to stabilize

the property market. We do not think the government will

take any major actions in the immediate future, as the

hard landing fear and social pressure are not yet obvious.

But by 2Q, if the property downward spiral is becoming

visible, we think the government will act. To deal with that

situation, our advice to the government is to provide

incentives for first home buyers with a specific expiration

date such as the end of 2012. These incentives caninclude a reduction in the stamp duty, a reduction in the

business tax, a reduction in the down-payment ratio for

mortgage loans, and a discount to mortgage interest

rates, all for first time buyers. The government should

continue to keep the home purchase restrictions in place

to prevent another property bubble driven by speculative

purchases. We think this strategy will work effectively to

boost property sales and to ensure a recovery of the

overall economy.

Jun Ma, Hong Kong, (852) 2203 8308

China: Deutsche Bank forecasts

2010 2011F 2012F 2013F

National Income

Nominal GDP (USD bn) 5879 7031 8141 9516

Population (mn) 1374 1383 1389 1395

GDP per capita (USD) 4279 5084 5860 6819

Real GDP (YoY%)1 10.3 9.1 8.3 8.6

Private consumption 9.0 8.4 8.4 8.8

Government consumption 8.0 9.0 8.5 9.0

Gross capital formation 11.6 10.7 9.0 8.5

Export of goods & services 22.0 12.0 6.4 12.5

Import of goods & services 23.0 14.0 7.8 13.0

Prices, Money and Banking

CPI (YoY%) eop 4.6 3.8 2.8 3.5

CPI (YoY%) ann avg 3.3 5.3 2.8 3.5

Broad money (M2) 19.7 13.5 16.0 14.5

Bank credit (YoY%) 19.9 15.0 15.5 14.0

Fiscal Accounts (% of GDP)

Budget surplus -1.7 -2.0 -2.2 -1.5

Government revenue 21.3 22.7 22.5 22.5

Government expenditure 17.8 24.7 24.7 24.0

Primary surplus -1.2 -1.3 -1.5 -0.8

External Accounts (USD bn)

Merchandise exports 1578.0 1893.6 2045.1 2331.4

Merchandise imports 1395.0 1729.8 1885.5 2187.2

Trade balance 183.0 163.8 159.6 144.2

% of GDP 3.1 2.3 2.0 1.5

Current account balance 306.0 283.8 269.6 244.2

% of GDP 5.2 4.0 3.3 2.6

FDI (net) 124.9 100.0 70.0 50.0

FX reserves (USD bn) 2847.0 3270.0 3600.0 3900.0

FX rate (eop) CNY/USD 6.59 6.35 6.13 5.86

Debt Indicators (% of GDP)

Government debt2 20.3 19.4 19.1 18.3

Domestic 19.7 18.8 18.6 17.8

External 0.6 0.6 0.5 0.5

Total external debt 9.3 10.4 10.2 9.8

in USD bn 549.0 730.0 830.0 930.0

Short-term (% of total) 68.0 70.0 65.0 60.0

General (YoY%)

Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0Retail sales (nominal) 18.4 16.5 14.0 15.0

Industrial production (real) 15.7 13.0 11.5 12.0

Merch exports (USD nominal) 31.3 20.0 8.0 14.0

Merch imports (USD nominal) 38.7 24.0 9.0 16.0

Financial Markets Current 3M 6M 12M

1-year deposit rate 3.50 3.50 3.50 3.50

10-year yield (%) 3.63 3.40 3.30 3.30

CNY/USD 6.35 6.35 6.27 6.13

Source: CEIC, DB Global Markets Research, National Sources

Note: (1) Growth rates of GDP components may not match overall GDP growth rates due to

inconsistency between historical data calculated from expenditure and product method. (2) Including

bank recapitalization and AMC bonds issued


8/21



Strategy

Local Markets Strategy

We are constructive on CNY fixed income market in

the first half of 2012 as disinflation, growth

deceleration and the lack of capital inflow will allow

the central bank to fine-tune its monetary condition

towards easing more proactively. As macro indicators

and policy environment will likely stabilize in H2,

technical factors such as liquidity and bond supply

and demand balances (other than trend factors) will

become more important drivers for rates market

performance.

There are three fundamental factors underpinning our core

constructive outlook on CNY rates market in the H1 of

2012. First, sequential real GDP will decelerate to 7.7%

YoY and 7.5% YoY in Q1 and Q2, before recover to 8.7%

in H2; second, we expect CPI inflation to decline sharply

to 3% YoY in Q2; thirdly, capital inflow is unlikely to be as

strong as in 2011 as export growth will decelerate, and if

coupled with speculative outflow, will likely tighten

domestic liquidity. With our projected balance between

growth/inflation and risk of capital outflows, we believe

monetary policy which has shifted towards easing in

December with a 50bps cut in RRR, likely will accelerate

in the next two-quarters.

We believe PBoC will primarily employ quantitative tools

such as RRR cuts and open market operation to release

liquidity and manage money supply growth. We expect

about 150-200bps RRR cuts, taking the required reserves

for large financial institutions from 21% at present to 19-

19.5% in the first half of next year. Any cut in the policy

interest rates will have to be justified by much faster pace

of disinflation, and for the time being, our base case view

is no change in the policy rates.

Outlook on interbank liquidity: We expect at least a50bps cut in RRR in January (possibly as early as the end

of December 2011) and another one in February. In

addition to reasons such as the risk of capital outflow and

weak growth momentum Q1, there are two more

considerations: (a) PBoC bill redemption in January and

February will be quite low (total CNY 25bn) relative to

other months of the year, and CNY 115bn repo

redemption in January; (b) additional required reserve on

margin deposit for medium and smaller size banks to drain

CNY 320bn in the next nine weeks: the next remaining

three scheduled payment will fall on December 15 th for

Monthly OMO redemption profile in 2012 (CNY bn)

0

20

40

60

80

100

120

140

160

180

200

Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec

PBoC bills Repo

Source: Deutsche Bank, PBoC

RRR vs. the stock of PBoC bills

0

5

10

15

20

25

0

1000

2000

3000

4000

5000

6000

Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

PBoC bill outsta nding CNY bn

RRR

Source: Deutsche Bank, CEIC

1Y PBoC bill yield vs RRR and 1Y policy deposit rate

1

1.5

2

2.5

3

3.5

4

4.5

14

15

16

17

18

19

20

21

22

May-08 Mar-09 Feb-10 Jan-11 Dec-11

RRR (LHS) 1Y PBOC 1Y Depo

Source: Deutsche Bank, Bloomberg Finance LP


9/21



about CNY 80bn, and January 15 th for CNY 120bn and

February 15th for another CNY 120bn. That is to say in

order to keep lending growth and M2 growth at 15-16%,

at the beginning of the year, PBoC has to provide base

money growth of at least RMB 287bn average per month

(assume multiplier of 3.8, was 3.74 by the end of

September), and if we assume FX purchase (capital inflow)grew at USD 25bn per month (as it did in 2011), it is still

insufficient to prevent the system liquidity from net

draining unless PBoC cuts RRR. In the event of capital

inflow at less than USD 25bn per month or capital outflow,

more liquidity injection is necessary to keep the system

liquidity stable. The timing of next 50-100bps cuts in RRR

is more likely in Q2 which will allow PBoC to roll over

OMO redemption from March - May to June- August to

maintain a decent cushion on liquidity operation.

Note in 2011, PBoC reduced the outstanding PBoC bills

by about CNY 2trn, and switched to RRR hikes (six RRRhikes in 2011), which were more effective in reducing

money multiplier which then directly slowed down money

supply growth. In the next few months, we expect PBoC

to use a combination of RRR cuts and increasing bill

issuance to smooth out the impact on domestic liquidity

and to keep money supply growth at a reasonable pace.

However, if liquidity condition becomes more volatile, it is

possible for PBoC to reduce or pause long-dated bill

auctions (1Y or 3Y), and switch to predominantly 3M PBoC

bills to manage liquidity with desired flexibility.

We believe the 1Y PBoC bill yield should not deviate

much (-10-20bps) from the 1Y policy deposit rate

(3.5%) in the first half of 2012, as we do not call for

policy rate cut for now, downward adjustment on the

auction yield of 1Y PBoC bill is only possible when liquidity

becomes more abundant unless PBoC intends to signal

rate cuts.

We expect net liquidity inflow to the interbank market

to help bring money market rates 50-100bps lower

from where they are now (overnight repo at 2.95%

and 7D repo rate at 3.51%)before the middle of 2012.

Currently 1Y Repo swap curve is pricing in 3MMA of 7D

repo rate at 2.63% by the end of 2012, which is in linewith our expectation. However, in the near-term, the

relative stickiness of the 7D repo fixing rate given the

year-end seasonal liquidity demand, and the extent of

liquidity easing being priced in on the Repo IRS curve

argues for the outright level of CNY IRS curves to be

relatively range bound (within 10-15 bps range).

We expect 3M Shibor rate to fall towards 4.75-4.5% in

H1 next year. It will remain stubbornly sticky in the near-

term because of its higher term premium than money

market rates, which means it tends to fluctuate with

changes in policy deposit rates (which we call for no

change in 2012), rather than with short-term liquidity. If

and when Shibor fixing banks get more comfortable with

outlook for liquidity easing, they will price in less term

premium on 3M Shibor fixing.

3M Shibor fixing vs. RRR and 1Y policy deposit rate

(%)

5

7

9

11

13

15

17

19

21

23

1

2

3

4

5

6

7

Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

1Y Depo 3M Shibor RRR (LHS)


CNY rates trade recommendation: We think the risk

reward of outright receiving Repo rates is unfavorable and

costly in carry. We believe Repo swap or Shibor swap

curve steepeners are more suitable for investors sharing

our view. We recommend entering Repo IRS/NDIRS or

Shibor IRS/NDIRS 2Y/5Y steepeners about 10bps (target

exit 40bps and stop loss -5bps) and -20bps (target 20bps

and stop loss -35bps) respectively.

Bullish on cash bonds in H1. We retain our bullish view

on CGB cash bonds and believe 10Y CGB can rally by 20-

30bps over the next one to two quarters if CPI falls

CGB yields and CPI YoY (%)

-4

-2

0

2

4

6

8

10

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

5Y CGB

10Y CGB

CPI Y/Y (RHS)



10/21



sharply towards 3%. Supply risk is low in Q1 which

should provide good technical support. We recommend

overweight CGB bonds.

Net financing to increase by 21% in 2012. We expect

modest fiscal expansion to result in the total government

fiscal deficit to rise to CNY 1100bn, which implies netfinancing for next year will increase by CNY 200bn, 21%

YoY from CNY 900bn (700bn central government financing

and 300bn local government financing) in 2011. 2012

Gross government bond issuance will increase by 23%.

The increase in net financing reflects CNY 300bn local

government deficit financing to partially roll over bank

loans. As we discussed in the November 25 th edition of

Asia Local market weekly, about CNY 1837bn local

government bonds/bank loans will mature and some loans

could be replaced with market placement of local

government bonds.

The term structure of CGBs will be similar to 2011 with an

average duration of roughly 10Y. Duration of local

government debt is likely to be shorter, roughly 5Y on

average.

Local government debt redemption schedule (CNY

bn)

Source: Deutsche Bank, the National Audit Office of China

In 2011, commercial banks net bought CNY 466bn of

CGBs and remained the largest buyers of the bond market.

Assuming CNY deposit and loan growth at 16% in 2012,we estimate commercial banks net allocation for bond

investment in 2012 at approximately CNY 1.8trn, of which

about 35%- 40% can be invested in CGBs. This would be

equivalent to CNY 640bn -730bn net demand for CGBs or

58-66% of our forecast net financing need for 2012.

Insurers, fund houses, security firms will absorb the rest

of the supply, and we expect demand from fund houses

and security firms to be stronger in H1 when equity

market likely will stay volatile than H2.

YTD purchase of CNY bonds by investor type (CNY

bn)

-400

-200

0

200

400

600

800

1,000

1,2001,400

1,600

1,800

Commercial

Bank

Trust

Cooperative

Securities

Company

Insurance

Company

Fund House

CGB Policy bank bonds Corp bonds CPs MTNs


Monthly purchase of CGBs by investor type (CNY bn)

-40

-20

0

20

40

60

80

100

120

140

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-1

Commercial Bank Insurers


Wait for stability in the credit market. We remain

cautious on the onshore credit market in the next few

months and will wait till credit outlook stabilizes before

considering increasing allocation.


11/21



Currency Strategy3

The RMB has been the top performing Asian currency this

year and has risen close to 5% against the USD. However

China has started to ease its policy stance, although a

major reversal is unlikely. We think the policy shift

would likely include a slower pace of RMBappreciation in 2012.

Inflation is falling, and so should the rate of RMB

appreciation

Our view remains that China regards exchange rate as a

monetary policy tool part of a broader policy toolkit that

includes RRR, interest rates, credit guidance and

administrative measures for managing inflation. China

has tended to change the pace of RMB appreciation (with

some lag) in line with inflation trends (see first chart). Our

view of a slowdown in the pace of RMB appreciation is

mostly predicated on the fact that inflation has alreadypeaked for this cycle, and is likely to fall below 3% by Q2

next year. With weaker commodity prices and moderating

tradable goods inflation, the case for a rapidly appreciating

currency has clearly weakened. In y-o-y terms, the pace of

RMB appreciation peaked at around 6% in August, and

has since slowed to about 4.5%. A 3% y-o-y appreciation

at end-June would imply a USD/CNY (fixing) rate of closer

of 6.28 (vs. latest fixing of around 6.33).

Inflation is falling, and so should the rate of RMB

appreciation

Sources: Deutsche Bank, Bloomberg Finance LLP

Downside risks to exports are growing

Chinese exports are slowing but the recent trend of

negative surprises in regional exports suggests more

downside risks for China. For instance Singapores NODX

show that G2 demand for Asian products is weakening

fairly rapidly, particularly for electronics and other capital

3Part of this report was first published in Asia FX Strategy NotesRMB:

Shifting into lower gear on 18 November

goods. Chinese exports have tended to lag regional

exports figures by a few months, and it is likely that more

pronounced weakness shows up in numbers there in the

coming months (second chart).

Regional exports are slowing down, and China

typically lags by a few months

Sources: Deutsche Bank, Bloomberg Finance LLP

BoP pressures are easing

To be sure, BoP pressure is not a major concern at this

stage, as Chinas current account surplus will likely narrow

this year and next. Our third chart shows that China

seems to have in fact allowed more RMB gains this year

than what the current account surplus would have

suggested. Meanwhile, FX reserves show a more

balanced flows picture lately, with ex-valuation reserves

accumulation in the month of September having gone flat.

China appears to have allowed more RMB

appreciation this year than what the current account

would have suggested

Sources: Deutsche Bank, CEIC


12/21



China FX reserves accumulation has slowed

Sources: Deutsche Bank, CEIC

But CNY weakness does not reflect capital flightSome market observers have argued that the recent fall in

FX reserves and weakness in the onshore RMB spot rate

relative to the daily fixings reflects broader capital flight

out of China, and one should start to worry about bigger

declines RMB weakness ahead. We would however point

out that this weakness of the RMB in its trading band

likely reflected arbitrage activities between the onshore

and offshore spot rates when the CNH-CNY spot basis

widened. With the offshore USD/CNH spot rates trading

at higher levels relative to the onshore spot rate, Chinese

corporates have turned to selling dollars in the offshore

market, while most USD buying transactions continue to

take place in the onshore market. The drying up of USD

selling flows in the onshore market has thus been the

reason for onshore spot bumping against the top of its

+/-0.5% FX band.

A buildup in anti-appreciation rhetoric

Growing headwinds for exports has prompted some

government authorities to expressed concerns over

continued RMB appreciation. Not surprising, the Ministry

of Commerce has been most vocal about this. The

MoCom Minister argued at the recent G20 conference

that RMB is now at a more reasonable level, while other

MoCom officials have over the course of this week raisedconcerns over the impact of RMB appreciation on the

Chinese SMEs. We think it is likely that MoCom exerts

more influence over next years FX policy forum.

Onshore spot relative to daily spot fixings, vs. CNH-

CNY spot spreads

Sources: Deutsche Bank, Reuters

Policy easing: Last-in-first-out principle?

As we have previously noted, a typical Chinese hiking

cycle has involved the following sequence: window

guidance first, followed by RRR hikes, then interest rate

hikes and finally faster RMB appreciation. At the same

time, the 2008 experience suggests that China could

possibly adopt a last-in-first-out principle while easing

policy. In mid-2008, PBoC started to slow the pace of

RMB appreciation before cutting rates in October. The

first RRR cut took place later in December, while the

Chinese government ordered a more aggressive credit

easing only in 2009. This year, the easing cycle has

broadly followed a similar sequencing. The pace of RMBappreciation started to slow in November, before PBoC

the cut RRR in early December.

A last-in-first-out principle in policy easing?

0

5

10

15

20

25

02 03 04 05 06 07 08 09 10 11

1y depo rate

cash reserve ratio

3m chg in USD/CNY, annua lized

CPI inflation

%

Deposit ra tecut: Oct 08

RRR cut: Dec 08

Slows pace of

RMB appreciation:

Jun 08

RRR cut: Dec 11

Sources: Deutsche Bank, Bloomberg Finance LP


13/21



External political pressures are unlikely to deter China

To be sure, international pressures on Chinas FX policy

are unlikely to fade any time soon. Obamas comments at

the recent APEC meeting reveal growing impatience in

the US policy circle, and this will likely only get furthered

in the election year. Brazil has escalated the currency

issue to the WTO, and members will soon start to explorepossible punitive measures against currency manipulators.

That said, while it may be politically difficult for China to

put a complete halt to RMB appreciation; domestic

economic concerns have historically been more important

in influencing Chinas FX policy than external political

pressures. Therefore, China is unlikely to be deterred from

slowing RMB gains if policymakers deem this to be critical

in protecting domestic interests. The sharp increase of the

RMB REER recently would add to the argument.

CNY has appreciated sharply in trade-weighted terms

this year

Sources: Deutsche Bank, BIS

Conclusion and trade recommendations

In sum, we retain a structurally bullish view on the RMB

tied to its long term plan for capital account liberalization,

and the need to reduce its undervaluation). Howver, a

more pronounced cyclical slowdown in its appreciation

path, to nearer 3% by H1 2012 can also be expected. We

however see low chances of authorities allowing a sharp

and persistent depreciation in the RMB, as we think that

authorities would in the worst case repeg the RMB to theUSD if China were to experience an economic hardlanding

and/or a severe banking crisis.

Note however that NDFs behave differently from the

onshore spot rate. In fact, we see risks of USD/CNY NDFs

squeezing higher still as the Chinese economy slows in

coming months. The chart below shows how closely

NDFs (3m changes) have been tracking the official

manufacturing PMI series over the past year. Just this

relationship alone would suggest that if the Chinese PMI

were to fall towards 45 over the coming months, it is

possible that we see 12M outrights rally towards 6.60

6.65 (from current levels of around 6.44).

Downside risks to PMI suggest NDFs have room to

rally

Sources: Deutsche Bank, Bloomberg Finance LP

As such, considering the risk of further volatility in the

NDFs, our preferred strategy is to be long vols via

straddles, even though we also think that being short in

the 1Y USD/CNH or NDFs still makes sense given that

the outrights in both markets are pricing in more than

1% depreciation of the RMB. Relative to other regional

currencies, CNY vols have been most well-behaved and

remain near the lower-year of their 12-month ranges (see

chart). The 1Y breakeven ranges for an ATMF straddle is

around 6.63 and 6.13 (3.9%), which stands in contrast to

most other currencies for which straddles are implying a

broader range in 2012 than that in 2011.

Asia FX implied vols (current vs. 12m ranges)

Sources: Deutsche Bank

Linan Liu, Hong Kong, (852) 2203 8709

Dennis Tan, Singapore, (65) 6423 5347


14/21



CNH Strategy

Outlook for 2012

In retrospect, offshore RMB market in 2011 saw

substantial growth in the breath and the depth of the

market thanks to the launch of a series of new

regulations/policies. In the following table, we review a

few key regulations which have been launched or

announced this year.

Review of key regulation milestones announced in

2011

Regulation to support the development of offshore RMB market

Date Regulation

6-Jan-11 RMB ODI (outward bound direct investment)

program launched

23-Jun-11 PBoC and Russia central bank signed bilateral local

currency settlement agreement

18-Aug-11 Vice Premier Li Keqiang announced 10 new

measures including RQFII program

22-Aug-11 RMB cross border trade settlement program

expanded nationwide

12-Oct-11 RMB FDI (foreign direct investment) program

formalized

RMB Cross currency swap agreement

Date Country

18-Apr-11 New Zealand (RMB 25bn)

19-Apr-11 Uzbekistan (RMB 7bn)

6-May-11 Mongolia (RMB 5bn)

13-Jun-11 Kazakhstan (RMB 7bn)

26-Oct-11 Renew and double the cross currency swap

agreement with Bank of Korea (RMB 360bn)

22-Nov-11 Renew and double the cross currency swap

agreement with HKMA (RMB 400 bn)

Opening up CNY interbank bond market to foreign investors

Jan - October 2011 PBoC granted onshore interbank bond market

access to over 37 participating banks, Clearing

Bank and a few foreign central banks

Regulation to support the development of offshore RMB market by

HKMA

Date Regulation

9-May-11 RMB Fiduciary Account Arrangement

27-Jun-11 Spot USD/CNY (HK)Fixing launched by TMA of

HKMA

28-Jul-11 Position squaring with the Clearing Bank and net

open position

1-Oct-11 RMB cross border trade settlement quota doubled

to RMB 8bn in Q4 2011

8-Nov-11 Requirements on position squaring with the RMB

clearing bank

Source: Deutsche Bank, PBoC, HKMA, Ministry of Commerce

The above positive and supportive policy steps provide

fertile ground for the development of the offshore RMB

market in 2011, and the market has achieved several key

development milestones this year.

(a) RMB cross border trade settlement likely to

register a 300% YoY growth from 2010. RMB cross

border trade settlement volume reached RMB 1.5trn in

the first three quarters of this year, and likely for the full

year of 2011, about 9% of Chinas international trade can

be settled in RMB, which is approximately RMB 2trn. It

represents 300% from year 2010 during which cross

border trade settlement was RMB 506bn, approximately5% of Chinas global trade, and back in 2008, only 2% of

Chinas global trade was settled in RMB. Hong Kong

China RMB cross border trade settlement volume

averaged at RMB 149bn/month from Jan-Oct 2011, 157%

growth from an average of RMB57.8bn/month in H2 2010.

RMB cross border trade settlement and deposit

growth

161.50

-3.70

100

200

300

400

500

600

700

-50

0

50

100

150

200

250

Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11

Size of HK-China cross-border settlementMonthly increase in RMB deposit baseRMB Deposit base (rhs)

RMB bnRMB bn


(b). Offshore RMB deposit grew by 185% YoY as of

October. Cross border trade settlement has been the key

driver of offshore RMB liquidity in the past 18 months. By

the end of October, offshore RMB deposit base in Hong

Kong was RMB 618.5bn, vs. RMB 314.9bn by the end of

last year, if we include RMB deposit in Singapore, total

offshore RMB deposit would be close to RMB 670bn as

of October and to RMB 700bn by the end of December

this year. The year-end CNH deposit base would still be

lower than our previous forecast (RMB 750bn initially and

revised up to RMB 1trn around the mid of 2011), and we

think the deterioration in global risk environment and


15/21



volatilities in the USDCNH exchange rate have led to a

sharp deceleration in the offshore deposit base and are

key risk to offshore RMB deposit growth next year.

(c) CNH FX spot and forward trading volume grew by

two to threefold from 2010. CNH FX market has been

fairly active in 2010 with average daily trading volumereached USD 2bn in September this year (according to

HKMA), vs. just USD 500mn at the end of 2010. The

implementation of new rule of RMB position squaring

announced by HKMA in November and global risk

reduction in recent months caused daily FX spot and

forwards trading volume to drop to roughly USD 1.5bn

USD 1.75bn or so.

(d) Two-way volatilities in the CNH-CNY spot basis. In

2011, perhaps the most surprising development in the

CNH FX market was the reversal in the CNH - CNY spot

basis from negative to significantly positive -- CNH tradedas wide at 1200pips above CNY spot during September

October. Contributing factors are risk reduction in the

CNH market, unwinding flows related to RMB Letter of

Credit discounting, and fear of CNH liquidity squeeze due

to unavailability of the RMB cross border trade settlement

quota etc.

CNH CNY spot basis vs. NDF implied yield

-2000

-1500

-1000

-500

0

500

1000

1500

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Sep-10 Feb-11 Jul-11 Dec-11

12M NDF implied appre CNH-CNY spot basis


We see risks that the spot basis remains volatile in early

2012. As we discussed in an earlier CNH Monitor

publication4, there are risks that USD purchases by RMB

LCs discounting banks extend well into Q1 or Q2 next

year based on our estimates of the maturity profile of

RMB LCs, exerting upward pressure on the offshore

USD/CNH spot rate. Unsettling volatilities in the global FX

market and a slowdown in RMB appreciation in H1 would

also limit inflows into the CNH market.

4See Why are RMB spot rates not converging?, 21 October 2011

Maturity profile of RMB LCs suggests that volatility of

spot basis is like extend into early 2012


That said, we note that onshore corporates/MNCs havebecome active in taking advantage of the differences in

the onshore and offshore exchange rates more recently.

Specifically, we believe that Chinese exporters/corporate

with USD receipts have started to shift more of their USD

sales to the offshore CNH market, while dollar purchases

continue to take place mostly in the onshore market. This

has been reflected by the recent weakness in the onshore

RMB exchange rate relative to the daily PBoC fixings.

Notice in the chart below that the onshore USD/CNY spot

rate has tended to trade closer to the upper bound of the

+/-0.5% policy band whenever the spot basis (USD/CNH

less USD/CNY) is positive. This, we think, reflects the

drying up of USD selling flows in the onshore FX market.

Therefore, we think that the increased USD selling flows

by onshore corporate/MNC in the offshore market will

likely dampen volatility in the spot basis and help narrow

the spot basis more quickly whenever LCs-related flows

drive a widening of the basis.


16/21



Weakness in the onshore spot rate (relative to PBoC

fixings) reflect arbitrage activities


(e) Size of CNH fixed income market grew by 267% in

2011. At the time of writing, the YTD gross issuance in the

CNH bond/CD market amounts to RMB 189bn, 330%

growth from 2010. Bond issuances from foreign banks,

Chinese commercial banks, Chinese corporations and

foreign corporations have been among the strongest with

four times to 10 times growth over the past year.

Geographically, issuers from 19 countries have tapped the

CNH bond market, and there has been increasing

diversification among issuers particularly by non-Asia

corporations and banks.

YoY issuance growth

150%

-54%

573%

690%

467%

1040%

-46%

330%

-200%

0%

200%

400%

600%

800%

1000%

1200%


Gross issuance by issuer type (RMB bn)

0

20

40

60

80

100120

140

160

180

200

2007 2008 2009 2010 2011

Foreign Corp Corporat ion

Supranational Foreign Banks

Commercial Banks Policy Banks

Sovereign


Distribution by issuers country of origin

Greater China,

90.32%

Other Asia,

3.53%

Europe, 3.88% America, 1.60%Surpranational,

0.67%


(f) Liquid CNH bonds tracked by DB ORBIT index

delivered a YTD total return of 2.08% to USD-based

investor and -1.28% to CNH based investor (Dec 9 th).

Since July this year, the CNH bond market suffered from a

broad-based risk reduction in the global FX and the credit

market and the average yield of CNH bonds rose from

2.5% in June to peak at 3.95% in mid October, and

retraced slightly to 3.92% in December. Comparing with

other USD-denominated Asia IG and HY credits, which

lost 3.28% and 5.21% YTD (hedged out UST return), CNH

bonds have outperformed so far this year.


17/21



CNH Total Return Index (DB ORBIT)

97

98

99

100

101

102

103

104

105

J an- 11 F eb -11 Ma r- 11 Apr- 11 Ma y- 11 J un- 11 J ul -11 Au g- 11 Se p- 11 O ct- 11 Nov- 11 Dec -11

DB CNH bond index (CNH total return) DB CNH bond index (USD total return)

DBCNH Index for CNH based total return and DBCNHA Index for USD based total return (

Source: Deutsche Bank

While most of the development milestones have been

impressive and showed the vitality of the young offshore

RMB market which came to life only 17 months ago, the

surprisingly high volatilities of CNH FX demonstrated that

the market is still fledging and has yet to strengthen both

its market infrastructure as well as regulatory

infrastructure.

Looking ahead, we believe the offshore RMB market will

continue to thrive in 2012. On the policy front, we are

likely to see solid progress in the following areas:

Implementation of RMB FDI program and ODIprogram. Both programs have been officially

launched, specifically for RMB FDI program which

was formalized in November; so far only a handful ofcases have been approved. We have seen a growing

number of offshore corporations having expressed

interests in the program and we expect regulators to

grant more approval of FDI in 2012. In particular, we

expect about RMB 150-200bn CNH bond issuance for

RMB FDI purpose next year.

More enterprises will be allowed to participate inthe RMB cross border trade settlement scheme.

By the end of 2010, there were 67724 Mainland

Designated Enterprises (MDE) who were eligible to

participate in the RMB cross border trade settlement

scheme. Although the scheme was expanded

nationwide in August of 2011, the list of MDE has yet

to be expanded. In 2012, we expect key regulators to

grant MDE status to a much broader range of

domestic enterprises and in order to make it more

manageable, regulators are likely to draft a list of

exclusion (those who are not permitted in the

scheme) to make the program more manageable.

Launch of the RMB-QFII program. The RMB-QFII(RQFII) program was announced in August 2011

during Vice Premier Li Keqiangs visit to Hong Kong

and the size of the program was set initially at RMB

20bn. It is possible that the program will be officially

launched next year and RQFII quota to be allocated to

CNH fund managers.

Expand RMB cross currency swap arrangementwith more trading partners in particular withASEAN countries. We believe RMB cross currency

swap line is a necessarily arrangement to facilitate

RMB cross border trade settlement. In 2011, PBoC

signed a total of RMB 804bn cross currency swap

agreement with six foreign central banks and

currently PBoC has RMB cross currency swap

agreements with a total of 12 foreign central banks in

the amount of RMB 1.22trn. In November this year,

Premier Wen expressed Chinas interest in

broadening the use of RMB in regional trade

settlement in the ASEAN summit and PBoC has since

then renewed and doubled its RMB cross currency

swap agreements with HKMA and BOK respectively.

In 2012, we are likely to see a continuation of such

efforts with Chinas trade partners.

Outstanding RMB Cross Currency Swap Agreement

(RMB bn)

Malaysia

Belurus

Indonesia

Argentina

Iceland

Singapore

New Zealand

Uzbekistan

Mongolia

Kazakhstan

Korea

HKMA

0

50

100

150

200

250

300

350

400

450

RMB cross currency swap agreement

Source: Deutsche Bank, PBoC

(a) The Offshore RMB market to expand to moreregional trading centres and we do not rule out

the possibility of appointing another offshore

RMB Clearing Bank in Singapore. We are likely to

see more CNH products to be traded in more regional

financial centres such as Singapore, London etc.

Moreover, in order to promote RMB cross border

trade settlement with Chinas trading partners in

ASEAN countries, it is possible PBoC will consider

appointing another offshore RMB Clearing Bank, (in

addition to the Clearing Bank in Hong Kong) in 2012,

most likely in Singapore. To boost RMB as a potential

commodity pricing currency, China has started

settling imports (especially commodities) with Russia

(bilateral local currency trade settlement), next year

RMB is likely to be used for settlement and


18/21



potentially pricing for more commodity imports

(crude oil, iron ore and agriculture products), although

we think it will take at least another 2-3 years for a

broader adoption of RMB in commodity pricing.

On the market development, with the set of policies

currently in place to promote RMB trade settlement andmore channels for RMB repatriation (RMB FDI), we expect

RMB trade settlement volume to increase by 67% next

year to RMB 3.7trn. Besides, the potential appointment of

another offshore Clearing Bank will likely grow the daily

CNH FX trading volume to USD 3.5-4trn. Offshore RMB

loan growth and accumulation of RMB trade surplus will

contribute to the growth of the offshore RMB deposit

base to RMB 1.5trn. A combination of CNH bond supply

from domestic corporations/financial institutions, foreign

corporations, third party issuance of RMB bonds for

funding (cross currency swapped back to local currency),

we expect net issuance of CNH bonds/CDs at RMB 240bn(RMB 280bn gross issuance) in 2012.

We expect CNH bond market performance to remain

choppy in H1 next year and to recover fully in H2, and our

base case assumption is for total return to be primarily

driven by carry and currency gain on the bonds rather than

capital gain. We project the total return of the liquidity

CNH bonds (tracked by DB ORBIT index) at about 3.9%

next year to CNH based investors and 7.4% for UST

based investors based on 3.5% annual appreciation of

RMB against the USD.

2012 forecast of key performance indicators in theoffshore RMB market

RMB appreciation 3.50%

RMB cross border

trade settlement

RMB 3.7trn or 15% of China's global trade volume

Average daily FX

trading volume

USD 3.5-4bn

Offshore deposit base

(HK+Singapore)

RMB 1.5 trn

RMB net bond supply RMB 240bn

CNH Bond Total Return

Forecast

3.9% (CNH) 7.4%(USD)

Source: Deutsche Bank

The key downside risk to our forecast is the pace of RMB

appreciation and the directional risk as well as volatility of

the CNH-CNY spot basis. We believe the risk will be more

acute in the first two quarters of 2012 if we see an

extended period of risk aversion in the global markets and

its negative impact on the global growth. Should it

happen, the bearish case of our forecasts would be a

30% trim in our projected growth of the offshore market.

Linan Liu, Hong Kong, (852) 2203 8709

Dennis Tan, Singapore, (65) 6423 5347


19/21



Appendix 1

Important Disclosures

Additional information available upon requestFor disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see

the most recently published company report or visit our global disclosure look-up page on our website at

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The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the

undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in

this report. Linan Liu/Jun Ma/Dennis Tan
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20/21



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21/21

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