Some of the hype would suggest that we are witnessing the death of banking, but we believe banks will be much more resilient and actually benefit from development of the industry both in terms of cost efficiency gains and revenue generating capabilities. A less well publicised statistic is that financial services IT spending in 2015 hit USD 455 bn with USD 114 bn on mobility, cloud and big data analytics (IDC Financial Insights).

In this article, we review a couple of major developments globally and what impact these could have on banks and financial companies across Asia, namely the pressure on peer-to-peer lenders (P2P) and the emergence of blockchain. We compare attitudes of governments and regulators around the region toward digital financial innovation as we believe this will be key in assessing the balance between disruption and benefits to banks. We are also starting to see new potential revenue streams for banks as a result of digital innovation.

Why is the fintech revolution happening now?

A combination of all-time low interest rates and intense regulatory pressure resulting in considerable cost and capital burdens has led to significant development in competing business models and financial technology. A change in consumer preferences is also playing a part as millennials become a greater share of the working-age population while data processing power and internet data acquisition are finally allowing new entrants to compete with incumbents. These developments have attracted a wave of venture capital funding and significant resources are now focused on addressing these issues.

Rates

Persistently low and even negative interest rates are forcing investors to take on excessive duration risk and move up the risk curve by investing in new alternative investments, and P2P lending is one such alternative investment. Institutional investors, particularly those with guaranteed liabilities and investment return targets, are under pressure from increasingly low returns in traditional asset markets and this has resulted in a boom in alternative investments such as P2P lenders, P2P trusts and wealth management products.

While households are also sensitive to the low and even negative real rate environment, we would note that historically, it has been inflationary shocks that greatly drive asset rotation amongst consumers and with the ongoing threat of deflation, we see greater likelihood that they will stick to cash and deposit investments going forward.

Costs

Since the GFC, banks have been subject to one of the largest regulatory overhauls in perhaps a century, resulting in significant new requirements on capital, compliance and risk management. Estimates for the amount of additional costs range from anywhere between 1-3 percentage points off return on equity at major global banks.

Tighter requirements on capital positions have also restricted banks from originating riskier loans in many countries. This has led to a proliferation of fintech business models that seek to take advantage of regulatory arbitrage. It has also forced banks to look more aggressively at potential cost savings from fintech innovation – one of them being the blockchain.

Millennials and changing consumer preferences

Fintech is also responding to consumer trends – millennials are becoming a larger proportion of the work force and they are much more likely to use mobile and online applications. Internet companies carry strong brand names amongst this demographic and technology has allowed more open platforms for financial products than ever before.

Data processing capabilities, internet data availability and usage

Significant advances in data processing capabilities have allowed fintechs to compete in the electronic payments space, which has significantly improved efficiencies but at the expense of much lower fees. Banks have little advantage over new entrants in this space. Data processing, internet availability and internet data are also some of the key resources being exploited in the unsecured consumer and small-to-mid sized enterprise (SME) lending space, called the P2P/Marketplace.

P2P/ Marketplace lender business models being tested

Through much lower operating costs and commoditised credit risk analysis, it is possible for P2P lenders to offer investors direct access to borrowers at a rate that is lower than competing banks. Target segments are unsecured consumer and SME – and unlike banks, no maturity transformation takes place between lender and borrower, as they are all matched.

Recently, one of the most famous P2P/marketplace lending platforms in the US has suffered from very weak equity sentiment despite consistently increasing loan issuance. A combination of rising defaults, internal compliance lapses, fickle funding sources and conflicts of interest among management led to selling pressure amongst shareholders. Indeed, confidence is waning in the entire sector in the US.

In China, the world’s largest P2P market, where USD 149 bn loans were originated by P2P companies in 2015, authorities uncovered a huge (USD 7.6 bn) ‘ponzi scheme’ at P2P lender Ezubao in January this year, which impacted almost one million investors. This was part of an ongoing clean-up in a sector which has seen over 200 of its previously registered 2,600 P2P platforms shut down since 2015. This clean-up has benefited some market leaders that are seen to be more legitimate longer term operators.

These issues highlight some of the vulnerabilities in the space, namely funding sources, untested credit risk management and transparency. The current dependence on fast-money funding (hedge funds, investment banks and other institutional investors) makes these businesses very cyclical. Securing ‘sticky’ retail deposits is something very few P2P companies have managed to achieve so far and is one of the main reasons we see them remaining as niche financial market players. While these businesses bear no credit risk directly, their ability to manage it will directly influence the availability of funding.

Blockchain emerges as a potential saviour

While blockchain technology is not new (its first major use being the software behind Bitcoin), it has shot to prominence over the last year following several major announcements by leading financial companies and regulators exploring its potential uses within their respective financial systems.

Blockchain is an encrypted, distributed ledger software that can be used by multiple participants at any one time on either an open (such as with Bitcoin) or permissioned/closed system. The term blockchain describes computers transferring blocks of records in a chronological chain through a shared software infrastructure. Data entries are captured at each individual node and recorded on the ledger, which is immediately available to all parties on the blockchain. This can theoretically avoid a lot of duplication at each participant, speed up the flow of information and create greater transparency. There are multiple user cases being discussed with trade finance, settlement and clearing and know your customer (KYC) requirements amongst those garnering most attention currently.

It is not difficult to see why governments and regulators would want to push this, as it can aid regulatory oversight, clean up tax collections and potentially reduce risk within a banking system. For banks, this technology can help reduce duplication and costs while potentially unlocking new revenue streams.

In theory, the broader the application and the more financial entities that use it, the greater the potential cost savings can be. The technology may be used between teams operating in one office, across different geographic regions, or even as a global solution – so the cost savings could rise exponentially.

Issues with adopting blockchain solutions more broadly centre around co-ordination, co-operation and trust between institutions. Regulators also need to balance innovation with risk and stability, and must play an active role in development. It is for these reasons that we think a nationwide application is still some way off.

It is much easier and more likely that financial companies will focus on blockchain applications internally before committing to multi-participant/nationwide applications. In January, the Australia Stock Exchange (ASX) announced it had taken a 5% (since increased to 8.5%) stake in Digital Asset Holdings, a developer of distributed, encrypted straight-through processing tools. It also entered into a commercial agreement with the company to investigate the potential for using blockchain application to replace its current Clearing House Electronic Sub-register System.

Meanwhile, the Singapore Exchange is exploring several proof-of-concept solutions in areas of syndicated loans and fixed income trading. In a recent global survey of 210 banks, UBS found that 8% have already adopted some internal blockchain solution while 19% are at a testing and pilot stage and this is led by banks in developed markets (33%).

For any nationwide solutions to succeed, we believe it is essential to have both government and regulatory support. We believe regulators and central banks will play a key role in the development of such solutions. In Singapore, we are encouraged by the Monetary Authority of Singapore’s (MAS) willingness to explore blockchain solutions. Given Singapore’s desire to bolster its position as a financial hub and with a central bank that is actively co-ordinating efforts, we would not be surprised if the country becomes one of the first to implement a nationwide blockchain solution, particularly in the area of trade finance, giving it first-mover advantage over competing centres

It is difficult at this stage to estimate the potential cost savings available to banks as a direct result of blockchain. Given the network effect and potential solutions being discussed, we think the potential is immense– for the first time in a long time people have begun to really question the infrastructure of financial intermediaries and the potential for huge cost savings in a sharing economy.

The overwhelming cost burden for a bank remains labour costs and this technology could start carving out or re-allocating large portions of the non-revenue generating workforce. Some of the more optimistic heads of technology that we have spoken to at banks in Asia thought it could be possible to run their banks with one-10th of the current workforce in the next 10-15 years.

Regulatory environment key to fintech success

Whether fintech proves to be more a disruptor or saviour will depend heavily on the regulatory environment in each jurisdiction and we are starting to see contrasting attitudes towards fintech innovation both at a government and regulatory level. Central bankers and regulators need to weigh the potential benefits of digitalisation with the oversight to mitigate risks and maintain financial stability.

Chinese authorities have been one of the strongest backers of fintech development globally and as a result, China is a leader in the space with several large financial conglomerates and internet companies at the forefront of innovation. Premier Li Keqiang officially marked the launch of China’s first private online-only bank, Tencent’s Webank at a ceremony in January 2015. Since then, we have seen numerous fund raisings by major players, making them the highest valued non-listed fintech companies globally.

Regulators in China allow a certain amount of development and open competition before imposing regulations, which greatly concerns many western commentators. We have recently witnessed a clampdown in the P2P market in China, while regulators have also stepped into the internet banking and payments space by introducing KYC requirements as well as daily and annual payment caps. It is also questionable just what scope internet and private banks will be allowed to achieve within China’s centrally managed credit system.

Singapore, like the UK and Canada has adopted a ‘sandbox’ approach to fintech development within existing banks. This keeps innovation under the direct purview of banks and allows them to benefit from successful innovation. In the MAS, Singapore also has a central bank that is actively assessing fintech for applications that can benefit the financial system as a whole.

Banks in India have greater potential to prosper from fintech innovation and digital roll-out given the lack of large internet company competition (unlike China where internet companies were first movers in payments and have sizeable e-commerce networks and user base). Regulators have also been more reluctant to allow internet companies/fintechs to compete in the financial services space in India. Instead, the pattern has been for JVs between banks and tech companies.

Korea, despite being a very technologically advanced economy, has been slow to embrace fintech applications or internet banks. There are two current consortiums still waiting for an official launch date with the scope of activities still undecided. We also see inflexible labour laws and powerful banking unions as obstacles to development here.

In other countries in Asia, we are encouraged by individual banks taking a lead on internal technology development. In Thailand, we have seen efforts to move parts of core banking systems onto the cloud, the evaluation of using machine learning tools and the establishment of internal innovation labs. We believe there is room for individual banks to become digital leaders within their own respective systems.

Revenue-generating initiatives

Banks have amongst the largest customer bases within their domestic markets, second only to telecommunications and internet companies in many countries, and with mobile banking have the opportunity to grow their customer bases further. Banks are also in the extremely advantageous position of being able to see both the asset and liability side of a customer’s balance sheet. Banks need to find better ways of monetising this before data-hungry digital finance firms find ways to gather their own data. We see some evidence of this happening but again this is still early stage.

In 2013, Danske Bank of Denmark rolled out MobilePay, a person-to-person payments app linked to an individual’s credit card which now has over 3 million users. Danske Bank had around 1 million customers on its traditional banking platform before the launch of this app in 2013. While the service is currently free, the bank hopes to roll it out to SMEs and start adding a fee to payments.

DBS of Singapore recently launched a mobile-only ’digibank’ in an effort to expand its operations in India and if successful, will replicate this strategy in Indonesia. ICBC of China now offers an e-commerce platform of its own, similar to that of JD.com. With RMB 900 bn of transactions last year, up from RMB 80 bn in 2014, the platform is growing fast.

Exchanges are looking at using blockchain technology as a means of making several more illiquid/over-the-counter (OTC) asset classes tradeable, be it syndicated loans, corporate bonds and many others.

Conclusions

Although there are arguments favouring fintech as a major disruptor of incumbent banks, we believe it is far too early to write banks off. Fintech is one of the unintended consequences of post-GFC regulation and monetary policy. It is symptomatic of a well-functioning capitalist economy responding to inefficiencies and new demand drivers brought about by the upheaval in regulatory conditions and operating environments. Banks have always found ways to adapt and on-board new technology, be it telephone banking, credit cards, capital markets and now internet and smartphone banking and we don’t see why this shouldn’t be the case with fintech as well. Blockchain and other technological advances have the potential to deliver huge cost savings to banks over the next five to 10 years.

Different regions have very different objectives when it comes to fintech development. In the West, we believe there will be relatively greater emphasis on cost efficiencies and providing investment returns, while in Asia we see more development in customer acquisition and financial inclusion. Improving customer experience and generating new revenue streams should be a priority for all.

It is important to monitor the direction regulators take when assessing the potential for fintech disruption versus its benefits. We believe those banking systems with greater regulatory support for banks, flexible labour laws and high potential digital penetration are best placed. We continue to believe that fintech has more disruptive potential in markets faced with all-time low interest rates and less regulatory oversight or regimes that provide less protection for banks. In Asia, we see Singapore, India and Thailand as countries where banks stand to benefit, while in China there is greater room for disruption.

It will also become increasingly important to evaluate individual bank’s digital strategies, core IT systems and personnel capabilities to assess who will be future digital leaders. We believe that digital banking leaders will start commanding premiums over those lagging behind. Although pure spending on IT is not a gauge of future success, proof will be in customer acquisition, cost efficiency and new revenue growth.

By Peter Monson, Senior Equity Analyst, Nikko AM Asian Equity team

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References:
1. Santander – The Fintech 2.0 Paper: rebooting financial services
2. KPMG/H2 Ventures – Fintech 100 – http://www.fintechinnovators.com/
3. Brett King – Author Bank 3.0, Founder Moven – http://www.moven.com/
4. Citibank – Digital Disruption – How Fintech is Forcing Banking to a Tipping Point
4. Nikko Asset Management – Fintech Broad Strategy Study
5. Morgan Stanley – Global Insight: Blockchain in Banking: Disruptive Threat of Tool
6. Nomura – China Fintech
7. UBS – Global Bank: Is Fintech a threat or an opportunity
8. MAS – Consultation Paper on Fintech Regulatory Sandbox
9. RBI – payments in India vision 2012-2015. Payments and Settlements Systems
10. World Economic Forum (2015) – “The future of financial services”
11. Jean Dermine INSEAD – Digital Banking and market disruption: a sense of déjà vu?

Important Information: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Local governments, in a rush to tap policy stimulus, used local government financing vehicles (LGFVs) to raise bank loans to invest in infrastructure development, thus promoting urbanization and growth. This led to excess investment and as the Chinese government clamped down on its booming property market, it cut a prime funding source for local governments, exposing creditors to default risk.

On 8 March 2015, China’s Ministry of Finance (MoF) issued a 1 trillion RMB quota for local governments to convert LGFV debts into lower-yielding municipal notes. By migrating to more formal financing channels, the debt swaps should give rise to more market discipline and more effective risk pricing, as well as improving financial markets’ perception of risk within the banking system.

In our view, the introduction of the debt swap program is significant, representing one of the first steps in addressing more fundamental issues within China’s fiscal framework. In this paper, we examine how LGFV debt grew to its current levels, the effect that the debt swap program will have on local governments and banks, how this is already affecting Chinese stocks and what further structural reforms we should expect.

2009 policy stimulus led to sharp increase in LGFV debt

LGFVs are not a recent phenomenon in China – they have been in existence since the 1980s when the first was set up in Shanghai to facilitate local infrastructure development. Many more were set up following the Asian Financial Crisis as China limited local government bond issuance and bank lending, and then again in 2009 in reaction to the government’s stimulus package.

Following the central government’s rapid centralization of revenue sources in 1994, the only major remaining source for local governments was land sales, supplemented with some revenues from utilities, tolls and infrastructure projects. Indeed, they have little discretion over tax rates and policy, while central government transfers are mainly to cover current spending, leaving little for infrastructure investment without off-balance sheet financing. The central government intended that this would instil greater discipline on local government spending.

In 2009, as a policy response to the global financial crisis, China launched an unprecedented stimulus program to boost growth through infrastructure investment and urbanisation. But you will not find evidence of this in headline fiscal statistics because the majority was conducted through an expansion in bank credit. With limited capacity for local governments to borrow on-balance sheet and forbidden from taking on bank loans directly, LGFVs were used to access this stimulus program. The perception of an implicit central government guarantee made LGFVs attractive credits for banks and led to a surge in bank loans in 2009. As the economy recovered, these stimulus measures were unwound. With slowing growth, they were resumed in 2012, except that banks were now more reluctant to lend directly to LGFVs and this gave rise to Trust loans (see Chart 2) and more direct bond issuance by LGFVs.

These waves of liquidity undoubtedly led to some reckless lending and ambitious projects as local governments competed for growth. Estimates of the total amount of local government debt outstanding vary, but the last official estimate by China’s National Audit Office (NAO) put the figure at around RMB 17.9 trillion by mid-2013. Based on the MoF’s disclosures, independent research house BCA estimates this figure will have risen to around 20 trillion by end 2014[1], with Goldman Sachs estimating it slightly higher at 21 trillion[2].

In September 2014, the State Council issued Article No. 43 to resolve local government financing issues. One key recommendation of this article was that from 2016 onwards all government-funded projects would need to be financed by municipal bonds issued by provincial governments and would be included in fiscal budgetary planning. It also stipulates that for public projects with commercial viability, governments should finance via project-based bonds or PPPs and LGFVs should be shut down, consolidated or transformed from 2016.

On 8 March, China’s MoF issued a 1 trillion RMB quota for local governments to convert some LGFV debts into lower-yielding municipal notes, together with 600 billion of new approved municipal bond issuance (up from 400 billion in 2014). This swap arrangement represents around 56% of LGFV debt expected to mature in 2015, according to NAO’s survey.

Debt swap program could save local governments up to 5% in interest payments

This development has many implications, chief among them being lower borrowing costs for local governments, greater transparency in China’s debt markets and ultimately a lower equity risk premium for Chinese stocks, particularly banks. For debt markets, we are likely to see a swathe of new issuance in the municipal and corporate space, with the crowding out impact likely moving from loan markets to debt markets.

The MoF estimates that the 1 trillion debt swap program would save local governments 40-50 billion RMB in borrowing costs this year, an effective decrease of 4-5% in borrowing rates. Extrapolating this to the entire RMB 20-22 trillion outstanding would result in savings of around 1 trillion or 1.5% of current GDP, although this is a best case scenario.

It is important to note that this exercise does not lower leverage within the system; it is merely a transfer of off-balance sheet debt into more formal fiscal liabilities. By migrating to more formal financing channels, it should also give rise to more market discipline and more effective risk pricing compared with the previous system. Municipal debt should be formally included on broader government debt-to-GDP ratios giving market participants greater transparency on China’s true debt profile. The focus will likely shift away from LGFVs to other problem areas like overleveraged and inefficient state-owned enterprises (SOEs), which still make up the majority of corporate debt in China (see Chart 3).

Bank stocks should benefit from lower equity risk premium

Greater clarity on local government debts and reduced borrowing rates should improve financial markets’ perception of risk within the banking system. LGFV defaults were one of the main segments stress-tested by analysts when trying to gauge potential non-performing loan formation in the banking sector. Lower systemic risk should help reduce the equity risk premium of Chinese stocks and, in particular, bank stocks. For this to happen, the market needs to assume that the debt swap facility will be implemented on an annual basis covering those debts due that particular year, something that is difficult to do without further disclosures on the outstanding debt and the quality of underlying assets.

Shares in China Construction Bank, one of China’s largest banks by assets, de-rated considerably as asset quality concerns intensified following the 2009 stimulus, despite its return on equity remaining largely unchanged over the period (see Chart 4). We note here that its A-share listing has started to re-rate reflecting renewed optimism amongst mainland investors that the worst may be behind us.

The direct impact on banks is to free up capital and loan quotas whilst eroding net interest margins. LGFV loans account for approximately 5% of total loans and have a 100% risk weighting vs. municipal debts at 20%. Hence, this swap will lead to a reduction in risk-weighted assets (RWA) and an uplift in capital. Similarly, when LGFV loans are reclassified into municipal debt, they drop out of the loan-to-deposit ratio calculation, freeing up more capital to redistribute lending into under-served areas (private corporates and retail) of the financial system. It may also result in some release of provisions otherwise set aside for bad debts in this segment. This whole exercise should help to reduce the crowding out impact that local governments have had on private sector borrowers in bank loan channels.

We do not expect that this move will lead to a dramatic uptick in new credit formation and would be concerned if this were to occur. This is less about the quantum of credit and more about the move toward more efficient allocation within the credit system. The migration from off-balance sheet to more formal channels is also well underway in other segments of China’s credit system. ‘Shadow banking’ finance channels have slowed significantly since mid-2013, while growth in corporate debt issuance, equity raising and conventional bank loans has picked up (see chart 5).

One unanswered question is: ‘Who is the end buyer?’ The answer will determine whether this measure is akin to fiscal stimulus and/or a liquidity injection by the government or People’s Bank of China (PBoC). We will watch this closely, but our base case is that banks will be the initial buyers in a straight swap of loans for debt and will then sell them in secondary markets to insurers, institutions and retail investors (likely via wealth management products and money market products like Alibaba’s Yu E’Bao). We think the Chinese government would want to avoid placing more funds in the hands of local governments following their recent track record, but it is an option if growth started to materially disappoint. Whilst writing this article, the state council moved to allow the Social Security Fund to invest, for the first time, up to 300 billion RMB into local government debt, adding another sizable investor to the list.

Confident investors have driven Shanghai Composite up 13% since March announcement

Despite the western world’s conclusions that China was headed for a shadow banking/LGFV-induced financial crisis, it has demonstrated that it still has plenty of tools at its disposal to avoid such a scenario. A key reason why China has been able to avoid a crisis has been the central command function of the state, together with its closed financial system. In such a system, so long as confidence is maintained, it is unlikely that widespread bankruptcies or bank runs can occur without intention.

We believe LGFV debt swaps are a game changer, but must be complemented with strategic reform in terms of how local governments allocate capital, raise revenues and finance infrastructure projects. In isolation this debt swap event should help to reduce the equity risk premium priced into China’s equity markets, in particular the banking sector. We note here that mainland investors have reacted a lot more positively than overseas investors, with the Shanghai Composite Index up 13% since the announcement and MSCI China up only 4% (through 31 March; see Chart 6).

The Shanghai Composite Index now trades at a price to earnings multiple of 19.4x, while MSCI China trades at only 11.4x. While A-share markets have, to some extent, been driven by strong retail buying and margin finance, it is premised on confidence in China’s leadership and their ability to structurally correct system vulnerabilities and drive its next economic chapter. We expect international investors will gradually reach similar conclusions.

While there are over-leveraged segments in the Chinese economy, there are two significant components of the system’s balance sheet that remain largely under-utilised: the central government and the consumer (and arguably large parts of the private sector (excluding property) which have been crowded out by local governments and SOEs). While the debt swap program should alleviate some of this crowding out effect, deposit insurance (announced 31 March) and better social security systems are two prerequisites for ‘unleashing’ the Chinese consumer. These are necessary if China is to achieve its goal of transitioning its economic growth model more towards consumption from investment. We note that the Chinese consumer still holds 73% of their financial assets in cash deposits, far more than their developed market peers (see Chart 7). The central government remains under-leveraged by international standards and still has a very strong asset side of the balance sheet which provides further room to manoeuvre (see Chart 8).

Authorities likely to implement much-needed strategic reforms

The debt swap program buys time for authorities to address more fundamental issues within China’s fiscal framework. The country needs to develop a more streamlined mechanism between central and local governments for capital allocation and budgetary decisions to ensure a repeat of this debt build-up cannot occur. The most pressing issue for buyers of municipal debts is that of the chronic mismatch between local government revenue sources and expenditures.

As discussed previously, local governments have been overwhelmingly reliant on land sales as a source of revenues ever since the central government centralised revenue sources in 1994. Their reliance on land sales for financing resulted in an over-supply of real estate that, in turn, makes the property market highly susceptible to a cyclical downturn.

VAT implementation and distribution, direct property taxes (currently being piloted in Shanghai and Chongqing), SOE restructuring and asset sales are some of the key measures required to improve revenue sources on a sustainable basis. China’s public sector asset base is still huge and there is plenty of potential for restructuring inefficient SOEs and selling assets. It is difficult to get accurate and timely data on the asset side of the government’s balance sheet, but as we see from the International Monetary Fund’s (IMF’s) estimates in Chart 9, there are still significant quantities of capital in natural resources and for-profit non-financial SOEs.

As LGFV repayment issues subside, the focus shifts to restructuring and possible selling underperforming and inefficient SOEs. From a capital allocation perspective, we would also like to see policies to gradually remove implicit state guarantees, improve profitability and eventually allow weaker institutions to fail. This is a pre-requisite for more efficient and market-orientated capital allocation by banks and credit markets. We note from recent bank management briefings that they have started to discuss the possibility of SOE defaults, something that was unheard of before the era of Xi Jinping and the new leadership’s unprecedented anti-graft campaign.

Another important change would be to develop more sustainable metrics, other than pure GDP growth, to assess provincial government performance. This would lead to more productive investment decisions helping to alleviate the threat of new bad debts arising. In October 2014, the State Council announced it would establish assessment accountability mechanisms where local government debt levels would be used as one of the hard measures for evaluating performance and this is a step in the right direction. We would also note that Shanghai has decided not to set a GDP growth target at all this year, the first province to do so.

Conclusion: Debt swaps demonstrate government’s intention to implement strategic reforms

The importance of President Xi Jinping’s strong leadership cannot be stressed enough. Under him, China is undergoing dramatic changes. While the most thorough cleansing of state corruption is ongoing, elements of China’s grand strategy are becoming more evident. Domestically, we are seeing efforts to correct financial system vulnerabilities, promote market based risk-pricing and open up capital markets. On foreign policy, key examples include China’s ‘One Belt, One Road’ initiative and its setting up of the Asia Infrastructure Investment Bank (AIIB).

We remain optimistic that China is emerging from a tough period in its economic development cycle and the LGFV debt swap program is one of the first steps in addressing system vulnerabilities. However, the debt swaps must be complemented with strategic reform in terms of how local governments allocate capital, raise revenues and finance infrastructure projects. These reforms are essential if China wants to ensure a similar debt build-up will not occur in the future.

While the debt swap program does not alter the trend for slower GDP growth, it should provide greater confidence in the country’s ability to deal with other well-documented issues. Mainland investors have grasped this concept and we believe it will not be long before western investors start to reach similar conclusions.

Peter Monson, Senior Equity Analyst, Nikko Asset Management Asia

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[1] ‘China Investment Strategy – Weekly Report’, BCA, 18 March 2015

[2] ‘Untangling China’s credit conundrum‘, Goldman Sachs, 26 January 2015

For Sophisticated Investors Only

Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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