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Andrew Leung International Consultants Ltd

China’s leadership transition and US presidential election

Whys, wherefores, risks and opportunities for Asia

A presentation at the Jeffries Conference for corporate investors

(Key points in pictures)

Andrew K P Leung, SBS, FRSA

Island Shangri-La Hotel, Hong Kong 17 October, 2012 1 How does the CPC work?

2 How are the leaders selected?

3 Rivalry for collective leadership

习李近克平强

Straight and narrow Economics and Tocqueville

李王张汪刘源岐高洋延潮山丽东

Kennedy School 2nd Zhu Rongji SZ, SD, TJ star Wukang model Party balancer

张俞刘德正云声江山

*Already 2 terms in Politburo *ZJ v HSR disaster *Jiang Qing 江青 *Propaganda czar 4 Princelings v Tuanpi

• Career affiliations

• Leadership track record

• Lack of scandals

• Intra-Party respectability and popularity (Central Committee 350, Politburo 25)

• Personal ties 5 Socio-political dynamics

Central Political and Legislative Affairs Committee

Central Guidance Commission for Building Spiritual Civilization 6 Health warnings and bottlenecks

Unbalanced, Unstable, Uncoordinated, Unsustainable Catching-up on innovation Worker’s rights

Aging population Middle-income trap Energy security Great wall of protectionism ? 7 Lewis Curve turning point

The Lewis Turning Point in China and its Impacts on the World Economy, Tsinghua University , Feb 2012

• Better employment rates

• Lower government expenditure as % of GDP

• Higher income per capita

• Little impact on low inflation

• Strengthening real exchange rates

• Build-up of exchange reserves 8 Beyond the clouds

“China 2030: Building a Modern, Harmonious, and Creative High-Income Society“ •Local government • SOEs •Hukou •Healthcare, education, housing •Civil society •Finance •RMB •Green economy 9 New urbanised China taking shape

McKinsey Global Institute –

• 350 m more urbanites > whole of US, by • 54% of urban GDP in 900 smaller cities 2025 by 2025, to house70% population • 1 b in cities by 2030 • 221 new cities @1 m v 35 in Europe • China’s GDP will have multiplied 5 times • 170 mass transit systems will be built • 50,000 skyscrapers = 10 NY Cites 10 China’s eco-city drive

The Economist dated 22 February, 2012 - as of 2009, China had 40 eco-cities in development, including "4 smart-grid pilot cities, 21 LED-street-light cities, and 13 electric-vehicle cities". 11

. The holy grail of China’s middle class

• Middle-class from 23% (~300 m) to grow • One million US$ millionaires (Hurun Wealth to 50% of population (~700 m) by 2025. Report , April, 2011). World Luxury Association (The Chinese Dream, Bestseller Press, 2010-2011 report - China to become the world’s 2010), “mass affluent” RMB100,001 to largest luxury market from 2012. 200,000 - from 9.8% in 2005 to 36.4% by 2025. (x2.5 to adjust to PPP ). • Consumption 36% of GDP (v 71% in US). While 150 m live < a dollar a day or less, Credit • 80 % under 45 years of age, v 30 % in the Suisse expects China to displace US in global US and 19 % in Japan. consumption growth by 2014 (China Development Research Foundation, 2012). 12

China’s surging ODI

•In 2010, China's ODI surged 36.3 % to $59 b v FDI growing only 17.4 % to $105.7 b. ODI to US increased by 297 % + to EU by 81.4 %. China ODI to overtake FDI in coming decade.

• Most Chinese ODI is in service industry e.g. commercial services, finance, retail and wholesale.

13 High-speed connectivity

• World’s largest rail expansion since 19th C. 86,000 • Dec 2011 – 513 m internet users km in 2009 to 110,000 km. 2012 (second to US 260,000 km). World’s fastest (average 350 km/hr) and • May 2012 – one b mobile phone subscribers longest high-speed rail network . Beijing to most provincial capitals < 8 hrs. • 400 m mobile Web users

• China inc HK - 6 of world’s top 8 container ports: • 38% of web users are mobile-only SH, Singapore, HK, SZ, Busan, Ningbo, GZ, Qingdao, Dubai, Rotterdam • > US as world’s top smart-phone market 14 21st century Silk Road

Alreay half-completed “Modern Silk Road” or Asia –Europe Continental Land Bridge, or Euro-Asia Land Bridge, 10,900-km rail-link traversing 40 countries linking Shanghai’s Lianyunggang - through Gansu (Lanzhou), Xinjiang, to Rotterdam (freight) and London (passenger). Interest of transit countries, including Turkey, being canvassed. China to provide capital subject to payments in resource -contracts 15 RMB internationalization

Three Ways out of the USD Trap (Nomura, 5 March 2010) - (1) Incremental diversification (2) Reducing current account surplus (gradual RMB appreciation, more imports + consumption, + ODI (3) RMB internationalization - currency swaps – RMB-denominated bonds and other instruments 16 RMB-linked investments through the private sector

• M & A of China enterprises • Joint M & A with Chinese ODI • Investment in suppliers /exporters to China • Investment in home/foreign brands/technologies/ financial institutions/ resource enterprises/retailers (what China needs) and selling stake to ODI • FDIs in Five Year Plan 2011-15 priority-areas 17

Game changer for global energy markets

Three main trends - CIGS (Canon Institute for Global Studies) Xinjiang (China SignPost, 20.09.2012)

Xinjiang to become world’s 5th largest coal (1) Oil to natural gas producers by volume. Xinjiang could produce more than 250,000 bpd of (2) Battery revolution to store solar, wind and irregular liquid fuels from coal and potentially1 m bpd forms of energy scalable through smart grid technologies. Low-cost thermal coal and coal-by-wire electricity from Xinjiang competitive threat to shale gas (3) Sustainable nuclear energy. development in Central and South-western China. 18 China 2012 – Hard or soft landing?

• Soft-landing more likely as China has plenty of financial and administrative fire power to ward off any serious economic shock..

• Song Guoqing, PBOC advisor and MPC member, growth to slow further to 7.3-7.4% in Q3 and 7-7.5% in H1, 2013. CASS - growth to slow below 7% in Q3, 2013.

• September bank loans $111 b, up 30% since July. Infrastructural projects totalling $150 b. Export tax rebates, reduced administrative fees and better export credits possible. Consumption still strong in lower-tier cities.

• Continuing robust infrastructural investments – history’s largest and fastest urbanization

• Monetary conditions remain cautious for fear of high inflation and over-investment,.

• Dramatic change in consumer landscape - Carrefour . Wal-Mart, Home Depot either closing stores or leaving China. Traditional stores clustered by type now preferred. Wal-Mart takes 51% stake of online retailer Yihaodian. Rising wage and rent costs, excessive supply and fluctuating demand taking toll. 19

Brighter days ahead ? Brighter days ahead for China's economy" - China's Economy and Policy, Gateway International, reported in SCMP 19.09.2012

• (a) > U.S. by 2018 to 2021, even if growth drops to 5%; • (b) RMB one of world's leading reserve currencies by 2020 • (c) Hong Kong > New York within 20 years; • (d) Fortune 500 from 11 a decade ago to 73 companies. Possibly up to half within two decades. • (e) Patent applications > Japan and US in 2011. Science and technology think tank Battelle - China to increase share of 15% of global research and development spending > US within a decade. • (f) To narrow gap with US in aerospace industry < 2 decades.

• "Eclipse: Living in the Shadow of China’s Economic Dominance” by Arvind Subramanian, Senior Fellow, Peterson Institute for International Economics, Washington DC “China's looming economic dominance "possibly only years away“

• CPC becoming a “normal” ruling party 20 Changing American public opinion on foreign policy

Foreign Policy in the New Millennium – Chicago Council on Global Affairs, 09.2012 (notwithstanding election rhetoric)

• Less hooked on global activism and less antagonistic re China than portrayed.

• Shifting foreign policy focus towards Asia and rising China, more for economic dynamism than potential threat. First asked in 1994, majority of Americans (52%) see Asia as more important to United States than Europe (47%)

• Millennials”—aged 18 and 29—more pronounced shift. See the world less threatening, and less concerned than other age groups about international terrorism, Islamic fundamentalism, and China as a world power.

• Also favour a less activist approach to foreign policy, slight majority (52%) saying the US should “stay out” of world affairs, compared to just 35% among older groups. Parties differ in degree, general consensus among majorities.

• Majorities oppose UN authorizing a strike on Iran (51% ), oppose a unilateral U.S. strike on Iran (70% ), and do not want to get involved in a potential Iran-Israel war (59%). 21 Impact of US presidential election

* Jobs, Tax, Government, Trade. Middle America deciding factor. * Romney - less government, less regulation, and less national debt (more fiscal discipline)”. Debt of $16T now 70% of GDP, to reach 200% by 2037. Romney promises a balanced budget by 2020. Romney’s proposed corporate tax cut from 35% to 25% (near OECD average) would make America a more tax-efficient home for corporations. 2 to 1 American favours taxing the rich more (income above $250,000). * Immediate concern is jobs. (51% > debt reduction). Romney promises 12 m jobs and Obama a modest (and perhaps more realistic) 1 m. But neither has a sure-fire answer as to how. Lowest unemployment rate in 4 years will help Obama. * Trickle-down economics (Romney) v trickle-down government (Obama) * Republican camp said to favour removal of Bernache as Fed Chairman and to have sponsored a study of the gold standard. Romney win to mean cutting government and welfare spending but more military spending (+$2.1 T = 4% GDP), a stronger dollar and a weaker RMB. * On foreign policy, Romney likely to favour American “exceptionalism”, and more China-bashing e.g. RMB and trade. But every former US President started with saying something about China but ended up carrying on with more or less the same strategy (barring major breakthroughs as Nixon with Maoist China). • An Obama or a Romney win is unlikely to change US Pivot. By 2020, 60% of US military assets will be located in the region (up from 55%). Romney win is likely to favour more aggressive foreign policy, e.g. v Russia and Iran, but see changing American public opinion in slide above. 22 IImpact on Japan

(Asian-Pacific Journal – Japan Focus)

• By 2011 government debt above 200% GDP, compared to 130% in Greece and Italy.

• By the end of 2011 Moody’s rating down to Aa3, S&P’s long-term rating down to AA-

• 93% government debt financed internally, most deposits held by banks.

• Household saving rate fallen sharply over four decades to only 6% (5% in USA)

• Continuing outsourced manufacturing mostly in the region retaining innovation at home

• Long established trade surplus now turned to deficit

• Hollowing out of manufacturing jobs - rising number of young NEETs (not in employment, education or training)

• High yen policy (aging population) .

• China now Japan’s largest trading partner where Japan has outsourced most of its manufacturing.

• Relation with US unlikely to change. Right –wing politics risk clashes with China.

Impact on India

• Quarter ending June 2012, GDP growth 5.5 % v 8% growth in 2011 . •Slowing economic growth, corruption scandals, ethnic strife and political gridlock.

•United Progressive Alliance (UPA) government signals lower stake in state- owned enterprises (petroleum, aluminium, copper, and other minerals).

•Individual states discretion to reject FDI— limiting FDI to cities with population of 1 m or more, and retailers to source at least 30% of products from within India.

•Complex coalition politics. Reforms feeble

•A new US administration will continue to view India as a US major ally in support of America Pivot to Asia . •New Chinese leadership also likely to continue expanding China-Indian ties.

24 Time to re-think a new Asian order?

• Discord in Asia, SCMP Op-ed article, 6 •Confrontations cover China’s flexible power September, 2012. projection (Toshi Yoshihara, Chair of Asia-Pacific

• ASEAN-China Free Trade Area, the “ASEAN Studies, U.S. Naval War College) way” based on consensus and equality •“The China Choice”, Prof Hugh White. “Concert of • Not in China’s best interest to dislodge U.S. Asia”, accommodating China’s core regional interests, along with those of India and Japan • U.S.-China security dilemma •Brzezinski - “Larger West” + “Complex East”, U.S. • “Great Sino-American Divorce” (Mark to act as “regional balancer” as Britain before early Leonard) v “chimerica” (Niall Ferguson) th 20 C.“U.S.-Japan-China Cooperative Triangle 25

*Main takeaways Multiple crises (Lehmann)

Breed a collective leadership of proven talents In a changed world

Amidst opportunities and challenges of epic scale

Possible investment picks – retail in inner cities; healthcare, education, technology; RMB, M & A,

ODI; copper, gold and silver

26 Andrew Leung International Consultants Ltd

Thank you

Andrew K P Leung, SBS, FRSA www.andrewleunginternationalconsultants.com

International and independent China Specialist with over 40 years professional experience covering Hong Kong and Mainland China. Chairman of Andrew Leung International Consultants, founded in London now relocated to Hong Kong. Provides strategic advice on China-related finance, investment, politics and economics globally, including both business and governments. China Futures Fellow selected worldwide by Berkshire Publishing Group, Massachusetts. On the Brain Trust of Evian Group, a Lausanne-based think-tank. Founding Chairman of China Group of Institute of Directors City Branch, London. Advisory Board Member of China Policy Institute, Nottingham University, 2005-10. Governing Council, King’s College London, 2004-10. Visiting Professor with Metropolitan University Business School. Helped set up Standard Chartered Bank’s first merchant-banking subsidiary in Hong Kong (1983); oversaw the trans-migration of industries into China as Deputy Director-General of Industry; US-government sponsored month-long visit to brief Fortune 50 CEOs on China beyond Tiananmen Square (1990); Editor-at-Large of a London-based international consultancy on China’s energies (2007). Sponsored Speaker on China at international conferences, including Forum Istanbul, Turkey, Annual African Banking and Financial Institutions Conference in Accra, Ghana, and Low Carbon Earth Summit in Dalian, China. Regular interviewee on live television with CNBC, Aljazeera English, Times Now of India, BBC and other international channels. Awarded Hong Kong’s Silver Bauhinia Star (SBS) and included in UK's Who's Who since 2002. 27 Andrew Leung International Consultants Ltd

China’s leadership transition and US presidential election

Whys, wherefores, risks and opportunities for Asia

A presentation at the Jeffries Conference for corporate investors

(Full version)

Andrew K P Leung, SBS, FRSA

Island Shangri-La Hotel, Hong Kong 17 October, 2012 28 *Transition dynamics • How does the Party select its leaders? • “Team of Rivals”” (Cheng Li, Brookings) – influence, competition, trust, long- term strategic needs • Why is the Bo Xilai affair an existential clarion call? • Why are the Wukan and Shifang sagas political harbingers? • Is there anything to be read into the promotion of “pro-democracy” lieutenant general Liu Yazhou刘亚洲 (son-in-law of Li Xiannian) • Why reducing Politburo Standing Committee size from 9 to 7 so critical? • Is there anything political about Xi’s recent disappearance? • Is it coincidence that Fifth Generation leaders tend to have non-engineering and higher degrees? - doctoral Xi (law), Li Kq (economics), LiYc (economics). Other education background includes Wang Qs (history and macroeconomics) and WangY (management) • Contenders (*Princelings ^ Communist Youth League #Already served max 2 terms in Politburo) - Over-simplified, powerful connections in US, Singapore? *Xi Jinping 习近平 (son of Xi Zhongxun 习仲勋) (“Straight and narrow family”) ^Li Keqiang 李克强 (favourite book, Alexis de Tocqueville’s “Ancien Regime & The French Revolution”, cf – “Why Nations Fail”, Daron Acemoglu and James Robinson) ^*Li Yuanchao 李源潮 (trained at Harvard Kennedy School, close to Hu, Xi and Li Kq) *Wang Qishan王岐山 (son-in-law of Yao Yilin 姚依林, Zhu Rongji’s predecessor) (Historian, “economic czar”, Olympics mastermind, Time 100, Tocqueville pointer ) *Zhang Gaoli 张高丽 Jiang Zemin’s protégé, impressive – Shenzhen, Shandong, Tianjin) ^Madam Liu Yandong 刘延东 (education, culture, arts – a great balancer) ^Wang Yang 汪洋 (bold promoter of Wukan model) *#Zhang Dejiang 张德江 (Close to Xi and Jiang Zemin’s long-time protégé ) *#Liu Yunshan 刘云山 (unpopular Minister of Propaganda) *#Yu Zhengsheng 俞正声 (princeling core, son of Jiang Qing 江青’s ex-husband) 29

Health warnings and systemic threats

• “Unstable, Unbalanced, Uncoordinated, and Unsustainable”” Premier Wen , 2007 • Critical domestic and external challenges, - leadership transition. corruption, inequalities, social discontent, ecological degradation, water, energy and other resource constraints, unbalanced reliance on infrastructural investments, low-margin exports, weakened external markets, problematic foreign relations, a rapidly--aging demographic profile and rising aspirations of an educated, liberal and internet-savvy middle-class *How sustainable is the Party? (Collective leadership system at crossroads) • Suspicious of a rising China as an outlier to world-accepted norms and values • Superpower U.S. to limit rise of ideologically-different challenger (part rational for Pivot to Asia) • “No water, No Power” - HSBC Global Research, Sept 2012."China to add > total installed power capacity of US, UK and Australia by 2030. Nearly 1/2 China’s GDP earned in water-scarce provinces (inc Beijing, Shanghai and Tianjin). Increasing focus on water and energy efficiency in the power, industry and mining sectors. *AmCham 2012 China Business Climate Survey Report - • 76% forecast 2012 revenue > 2011 • Top worries - Management-level and other human resources constraints, inconsistent and unclear regulatory interpretation, difficulty obtaining licenses and corruption • 78% rank China as top 3 destinations for global investment • 89% think China losing competitive edge due to rising costs (82% suffer labour costs, inc benefits) • Only 22 % think equal treatment in granting licenses between Chinese and foreign companies (68% experience negative impact of slow licence approvals on expansion and investments) • 66% think China’s IPR enforcement about the same or deteriorated, despite special campaign (79% think IPR enforcement ineffective, a 9% decline) • 2/3 think cyber security in China worse than other countries; 74% report unstable 30 internet access; 40% find negative impact of China’s internet censorship

A likely new chapter in governance

*Professionalization of ruling elite – “Elite recruitment and Chinese party state”, Chien-wen Kou, In Search of China’s Development Model – Beyond the Beijing Consensus, S Philip Hsu et al (ed.), Routledge Contemporary China Series, 2011) Of 270 Gov + VG - 77.8% postgraduates; 21.5% doctorate 60% Party Secretaries/deputies – postgraduates 90% of officials at provincial/ministry levels – received overseas training * 468-page World Bank joint report with Development Research Centre of State Council - "China 2030: Building a Modern, Harmonious, and Creative High-Income Society“ - to escape the $8,000 per capita "Middle Income Trap“, over a m millionaires v 170 m under $1.25 a day. University graduates to swell by 200 m over next two decades, bigger than entire American workforce. By 2030, China to become two-thirds urbanized, compared with 50% at present. Owing to demographics, China is likely to "grow old before it gets rich”. • Focuses on efficiency, equity, and sustainability – (a) redefining central and local authorities to avoid land appropriation as main source of revenue; (b) unlocking inefficient capital accumulated by SOEs and promoting private sector; (c) implementing State Council decision 2011 of guaranteeing heath-care, education and housing by 2020; (d) unblocking "hukou" (household registration) system marginalizing migrant workers ) (e) using rising middle class as a catalyst for improved governance, services, and empowerment of civil society; (f) liberalizing the financial system to achieve higher total factor productivity; (g) RMB internationalization and capital-account convertibility as international reserve currency; (h) delivering a comprehensive economic, social and environmental agenda to achieve a green economy and society by 2030 (e.g. by capitalizing on a voluntary "cap-and-trade" scheme and introducing green standards in the massive government procurement program); and (i) playing a more proactive role as a responsible stakeholder in helping to shape the global order commensurate with the growing size and influence of China's economy. • No reference to independent judiciary and abolition of One Child Policy 31

China’s battle for talent

*"Beyond Factory Floor: China’s Plan to Nurture Talent" - YaleGlobal, 10 September 2012 • To build a Nation of Innovation, 10th FYP (2005-2010). China reforms education, invests in talent incubators. • 7 million college graduates p.a. and a R&D staff >1.5 million. Reforming higher-education system, hiring practices and immigration regulations; encouraging cooperation with industry; new science specialties alternative energies and new-materials engineering; and generous packaged privileges for specialized returnees. • 1200 ‘talent incubators’ for technicians in major cities by 2020. • Funding initiatives to develop leaders in philosophy, social science, publishing, culture, the arts and heritage protection. • The goal is to transform Chinese firms into multinationals ranking among the world’s top companies and to develop China’s global soft-power edge. • Chinese professionals now see more immediate and long- term career development opportunities in China (Harvard Business Review, March 2011)

32 A new urban China in the making

* MGI Report “Preparing for China’s Urban Billion”, 01.03.09

• 350 m more urbanites > whole of US • 1 b to live in China’s cities by 2030 • 221 cities =>@1 m v 35 in Europe today • 5 b sq metres of roads will be paved • 170 mass transit systems will be built • 40 b sq metres of floor space in 5 m buildings • 50,000 skyscrapers = building 10 New York Cites • China’s GDP will have multiplied 5 times

• 6 more for a total of 8 mega-cities (> 10 m population); 9 more for a total of 15 big cities (population 5 – 10 m) ; 55 more for a total of 115 medium-sized cities (population over 1.5 - 5 m); 163 more for a total of 280 small cities (population 0.5 – 1.5 m ); and 72 more for a total of 521 big towns (population up to 0.5 m).

• 35 second-tier cities in 17 provinces collectively account for 16 % of China’s population but represent 36% total GDP (China Britain Business Council Report , August 2008).

* 54% of urban GDP to be generated by 900 smaller cities by 2025, where 70% of China’s population is expected to live.

• Past 10 years, nearly 50% GDP growth from urban fixed investment to realize aim of quadrupling Y2000 GDP@ by 2020 = 20% of global GDP growth during this period. 33

China’s eco-city drive

• In 2000, State Council issued directives to promote "eco-provinces, eco-cities, eco-counties and eco- townships.” In 2002 ,The Cleaner Production Promotion Law and the Environment Impact Assessment Law were passed. In 2008, an amendment to China’s Energy Conservation Law held local government officials accountable for managing environmental standards.

* The Economist dated 22 February, 2012 - as of 2009, China had 40 eco-cities in development, including "4 smart-grid pilot cities, 21 LED-street- light cities, and 13 electric-vehicle cities".

• Near Shanghai, Dongtan eco-city designed by Arup was proclaimed as China's first, originally thought to be ready for the Beijing Olympics. It has since stalled. Another, the planned Sino-Singapore Tianjin Eco-City in collaboration with the World Bank, appears more promising. After some delay, now expected to be completed by 2020.

34 The holy grail of China’s middle class • National Bureau of Statistics – RMB60,000 – 500,000. (*x2.5 to adjust to PPP ). *From 23% (~300 m) to grow to 50% of population (~700 m) by 2025. (The Chinese Dream, Bestseller Press, 2010)

• 2010 - lower middle-class RMB 25,001 to 40,000 > class below. *“mass affluent” RMB100,001 to 200,000 - from 9.8% of total in 2005 to 36.4% by 2025. 2020, upper m-class RMB 40,001 to 100,000 > lower middle class.

• “Global affluent’ with annual household income over RMB 200,000 from 1.6 m in 2008 to > 4.4 million by 2015, < only US, Japan, and UK. Despite slowdown, wealthy households likely to grow 16 % p.a. for the next 5-7 years. (McKinsey Quarterly, 2006 Special Edition)

* 80 % under 45 years of age, v 30 % in the US and 19 % in Japan.

• 120 million of 350 m internet users shop online. (The Chinese Dream)

• Yum! Brands opened 500 new restaurants in China in 2010 including one new KFC every day.

• China > India as largest gold market , World Gold Council, Jan 2012

• 13.6 million cars sold in China, 2009, surpassing the US first time

• One million US$ millionaires (Hurun Wealth Report , April, 2011). World Luxury Association’s 2010-2011 annual report - China becoming the world’s largest market for luxury brands from 2012 (current slowdown regardless).

* Consumption 36% of GDP (v 71% in US); 150 m live at a dollar a day or less. (China Development Research Foundation, 2012). But Credit Suisse expects China to displace US in global consumption growth by 2014. 35

China’s surging ODI

(Is there a China model of overseas direct investment?, Bijun Wang and Yiping Huang, ANU and Peking University, April 12th, 2011)

•ODI increased from $2.85 b in 2003 to $56.53 b in 2009, + 55 % p.a., expanding global share from 0.45 to 5.1 %.

• In 2009, China largest developing country investor + 5th largest investor after US, France, Japan, Germany, up from 12th in 2008.

*In 2010, China's ODI surged 36.3 % to $59 b v FDI growing only 17.4 % to $105.7 b. ODI to US increased by 297 % + to EU by 81.4 %. China ODI poised to overtake FDI in coming decade.

*Most Chinese ODI is in service industry, including commercial services, finance, retail and wholesale.

•Desirous for advanced technology, brands, management skills and stable supply of resources. 2006-8 ODI in primary sector = 18.7 % v 7.84% (developed countries) and 8.83% (developing countries)

•Manufacturing ODI = 4.7% v 24.1% (developed) and 15% (developing) but rising wages and economic upgrading will see China moving more labour and energy –intensive manufacturing to other lower-cost countries, especially Africa

• In 2011, ODI in 680 enterprises first 2 months + 13.1 % to $5.27 b (Yao Jian, Ministry of Commerce spokesman, 23 March, 2011)

36 China’s high-speed connectivity • In 2011, 85,000 km intercity freeway system exceeds the US interstate highway system by 10,000 km. * World’s largest rail expansion since 19th C. From 86,000 km in 2009 to 110,000 km. 2012 (second to US 260,000 km). World’s fastest (average 350 km/hr) and longest high-speed rail network . Beijing to most provincial capitals < 8 hrs. • 1,956 km, state-of-the-art Qinghai-Tibet Railway - 4,000 m high. • 97 new airports by 2020 (82% population <90 min to airport). • World’s largest deep-water Yangshan port linked by longest 32-km sea-bridge to Shanghai; Qingdao to build largest iron-ore handling terminal by 2030 *China inc HK - 6 of world’s top 8 container ports: SH, Singapore, HK, SZ, Busan, Ningbo, GZ, Qingdao, Dubai, Rotterdam * Already half-completed “Modern Silk Road” or Asia –Europe Continental Land Bridge, or Euro-Asia Land Bridge, 10,900-km rail- link traversing 40 countries linking Shanghai’s Lianyunggang - through Gansu (Lanzhou), Xinjiang, to Rotterdam (freight) and London (passenger). Interest of transit countries, including Turkey, being canvassed. China to provide capital subject to payments in resource -contracts * Dec 2011 – 513 m internet users; May 2012 – one billion mobile phone subscribers 400 m mobile Web users and > US as world’s top 37 smart-phone market

RMB internationalization

• The USD Trap (Paul Krugman, Nobel Prize laureate)

• Zhou Xiaochuan, Governor, PBOC hinted at unofficial USD peg being ‘temporary’ (FT 6.03.2010)

* Three Ways out of the USD Trap (Nomura, 5 March 2010)

(1) Incremental Diversification out of US Treasuries (Chinese holding rose 0.1 percent to $1.1455 trillion in June 2012, a decrease from $1.1699 trillion reported on May 15.)

(2) Reducing current account surplus (gradual though irregular RMB appreciation, more imports, more consumption, outward FDI

(3) RMB internationalization to become a global reserve currency

 Currency swaps – 2010 HSBC report estimated half of China’s trade with emerging market countries by 2015 would be swaps, (nearly USD 2 trillion worth of trade flows) making RMB one of the top three global trading currencies.

 Issuing RMB-denominated bonds and other financial instruments and products (initially in HK) 38

Ideas for RMB-linked investments through the private sector

(Central banks may consider using investment vehicles similarly to SAFE using CIC as a Sovereign Wealth Fund) • Purchase of ‘dim sum bonds’ denominated in RMB issued in Hong Kong • Purchase of shares listed overseas by Chinese champions, including H Shares • QFII -for investing in selected “A Shares” in China • Purchase RMB through China Foreign Exchange Trade System (CFETS) • Currency swaps * M & A of China enterprises in China * Joint M & A with Chinese ODI (under pilot RMB international settlements) • Investment in suppliers /exporters to China * Investment in home/foreign brands/technologies/ financial institutions/ resource enterprises/retailers (what China needs) and selling stake to ODI • Forming partnership (joint investment vehicles) with CIC under “Going Out” strategy, using reimbursement/fee receipt route to receive RMB for settlements • Helping issue RMB-denominated bonds overseas (e.g. London and New York) * FDIs in Five Year Plan 2011-15 priority-areas • Joint investments with China in Africa e.g. resources, infrastructure projects, agriculture and food processing, labour-intensive production and distribution, mobile banking, telecommunications, China’s African SEZs • Joint investments with China in home/overseas infrastructure including regional high-speed rail, port facilities, utilities, smart grids, etc. • Special “Swap Fund” with China for joint bilateral investments in each other’s country and overseas 39

Age of energy, water and food security

* Three Billion New Capitalists, Clyde Prestowitz • China 8% of world crude oil demand to generate 20 m extra jobs p.a. v US 25%; each only 3% of world oil reserve • GCC now exports more oil to China> US. Trade with China to reach $350-500 b by 2020, v $6 b in 2000s. • China – 9% world’s arable land to support 20% of world population • Wheat, rice and corn 37% less by 2h of 21st C – food shortage 5- 10% within 20 yrs (China’s joint deptal report, March 2007) • Energy-rich but food-scare countries quest for overseas food supply – MENA e.g. Libya, Ukraine; Saudi Arabia to invest in agriculture and livestock overseas; Chinese Ministry of Agriculture - land in Brazil for soybean production, investment in agriculture in Africa, the world’s largest Food Basket • Security of supply and transportation routes – diplomacy, choke points and territorial disputes • Geo-economics and geopolitics - Russia, Iran, Venezuela, petrodollars, Scramble for Africa • Arctic (Trausti Valsson, U of Iceland) – Davis + Denmark Straits, GIUK, Bering Strait, Kamchatka, Sea of Okhotsk, Aleutian Islands, safe Canadian Nortern Passage + cornucopia of resources * Bullish outlook 2013 for yellow and silver metals (copper, zinc,

gold (not platinum), silver ) + foodstuffs 40

Game changer for global energy markets

* Three main trends changing the global energy situation - CIGS (Canon Institute for Global Studies) (1) Transition from oil to natural gas. Commercialization of natural gas extracted from deep shale strata previously non-feasible. Price of natural gas to remain low in the mid- to long-term. (2) Battery revolution to store solar, wind and irregular forms of energy scalable through smart grid technologies. “Who control batteries will control the world.” Japan advantage but competition with U.S., China, and Korea to intensify. (3) Sustainable nuclear energy. Fukushima - oldest second-generation plants (developed late 1960s). Safer “third-generation plus” reactors under construction in the U.S. and China. China building 40 “AP1000” reactors – automatic gravity and natural cooling in case of power outage. 4th generation reactors being developed for use around 2030, moving forward in the U.S., China, India, and Russia. On March 23, 2010, NIKKEI newspaper - Toshiba' cooperation with TerraPower LLC backed by Bill Gates in joint development of nuclear reactor with potential to run for 100 years without refuelling * Xinjiang (China SignPost, 20.09.2012) • In 2011, Xinjiang produced 120 m tonnes of coal. Xinjiang will produce ~240 m tonnes per year of coal in 2015 to expand to 750 tonnes per year in 2020. Xinjiang to become the world’s 5 largest coal producers by volume. • By 2020, Xinjiang to export 200 m tonnes per year of coal to other parts of China by rail, 200 m tonnes per year as electricity, and potentially 100+ m tonnes per year of chemicals and liquid fuel. • Xinjiang coal could be delivered in physical form to Central China at a cost of around US$3.30 per million BTU, whereas shale gas in the region is likely to cost US$5 per million BTU or more to produce. Low-cost thermal coal and coal-by-wire electricity from Xinjiang competitive threat to shale gas development in Central and South-western China. • Xinjiang could produce more than 250,000 bpd of liquid fuels from coal and potentially as much as 1 m barrels per day, subject to producers’ increased water-use efficiency and National Development & Reform (NDRC) approval. 41

China 2012 – Hard or soft landing?

*Economy feeble and at inflexion point towards slower-growth model but hard-landing not foregone conclusion. • HSBC Sept 2012 PMI - industrial output shrank 11 consecutive months. FDI down 9 /10 months. Industrial profits fell by 5.4% July. Reuters data show weakest full year growth at 7.7% since 1999, down from 7.4% Q3 and 7.6% Q2, 2012. • Economy expanded 7.8% H1, against Premier Wen’s 2012 target of 7.5%. China's exports to Europe were up only 3.2 % in May 2012, while exports to U.S. up 23 %. HSBC PMI 47.9 in September up from 9-month low of 47.6 in August. Total exports up 2.7% September 2012. * (Bloomberg) Song Guoqing, PBOC advisor and MPC member, growth to slow further to 7.3- 7.4% in Q3 and 7-7.5% in H1, 2013. CASS - growth to slow below 7% in Q3, 2013. * Dramatic change in consumer landscape - Carrefour to sell off stores in China, after pullout from Singapore and other Asian countries, Italy, and Greece. Wal-Mart to reduce, and possibly halve, new store openings. Tesco after layoffs and failed partnerships, to reduce sales points. Home Depot closing 100 stores and leaving China. Consumers attracted by quality and prices but complex outlets spread across multiple floors difficult to find exactly wanted. Traditional stores clustered by type now preferred. Wal-Mart invested in e-commerce via the acquisition of 51% of Chinese online retailer Yihaodian. Also, rising wage and rent costs, excessive supply and fluctuating demand taking toll. • Interest rate cuts in June and July. September 2012, bank loans increased to $111 b, up some 30% since July. Infrastructural projects totalling $150 b approved. Further moderate money supply and bank credit increases expected. Export tax rebates, reduced administrative fees and better export credits possible. Consumption robust in lower-tier cities. • FYP (2011-15) priorities on track - e.g. energy saving, environmental protection, new informatics, bio-tech, high-tech manufacturing • BBVA July 2012 research – EAGLEs corporate revenue = 22% of global total v only 7% in 2005. China (14%) dwarfs the rest (~ up to 2% each for Korea, Brazil, and Russia) • Continuing robust infrastructural investments – history’s largest and fastest urbanisation *(28.09.12) RMB highest since 1993 on speculations of stimulus against 7-Q slowdown. 42 Monetary conditions remain cautious for fear of high inflation and over-investment,.

Brighter days ahead ?

Brighter days ahead for China's economy" - China's Economy and Policy, Gateway International, reported in SCMP 19.09.2012 • (a) China's economy set to overtake U.S. by 2018 to 2021, even if China's growth rate drops to 5% p.a.; * (b) Already rapidly internationalized, RMB to become one of world's leading reserve currencies, if not the leading one, after becoming fully convertible on capital account by 2020, economy becomes world's largest. • (c) Deepening economic integration with Mainland, Hong Kong to overtake New York as leading financial centre within 20 years; • (d) Albeit scale x global brand leadership, China's enterprises made Fortune 500 from 11 a decade ago to 73 companies (79 if Taiwanese included). Possibly up to half of the league table within two decades. * (e) China's State Intellectual Property Office, patent applications > Japan and US in 2011. Science and technology think tank Battelle - China to increase share of 15% of global research and development spending > US within a decade. International ranking of Chinese universities to rise: HKU to rank among top 10, while Peking and Tsinghua to rise among top 20. • (f) To narrow gap with US in aerospace industry within 2 decades. * "Eclipse: Living in the Shadow of China’s Economic Dominance by Arvind Subramanian, Senior Fellow at the Peterson Institute for International Economics, Washington DC “China's looming economic dominance "possibly only years away“ * CPC becoming a “normal” ruling party sustaining legitimacy by delivering what most people want, building China's long-term competitiveness, and re- inventing itself in keeping with the changing times. 43 Changing American public opinion and foreign policy

Foreign Policy in the New Millennium – Chicago Council on Global Affairs, Survey of American public opinion and U.S. foreign policy, September 2012 * Less hooked on global activism and less antagonistic re China than portrayed. • Fewer Americans concerned about international terrorism as a “critical” threat to the United States than any time since September 11, 2001. * While Americans consider ME as greatest threats, gradually shifting foreign policy focus towards Asia and a rising China, more for economic dynamism than potential threat. Since first asked in 1994, a majority of Americans (52%) see Asia as more important to United States than Europe (47%) * “Millennials”—aged 18 and 29—more pronounced shift. See the world less threatening, and less concerned than other age groups about international terrorism, Islamic fundamentalism, and China as a world power. * Millennials also favour a less activist approach to foreign policy, slight majority (52%) saying the US should “stay out” of world affairs, compared to just 35% among older groups. While Parties differ in degree, general consensus among the majorities. Independents less likely than both to support an active U.S. role in global affairs and less likely to view U.S. leadership as “very” desirable". • Just over half (54%) support attack by U.S. ground troops against terrorist training camps and facilities, down from 82 % in 2002. * Majorities oppose the UN authorizing a strike on Iran (51% opposed), oppose a unilateral U.S. strike on Iran (70% opposed), and do not want to get involved in a potential Iran-Israel war (59% opposed). • To deal with the crisis in Syria, majorities of Americans support diplomatic and economic sanctions (63%) as well as a no-fly zone(58%). 44

Impact of US presidential election

* Jobs, Tax, Government, Trade. Middle America deciding factor. * Romney - less government, less regulation, and less national debt (more fiscal discipline)”. Debt of $16T now 70% of GDP, to reach 200% by 2037. Romney promises a balanced budget by 2020. Romney’s proposed corporate tax cut from 35% to 25% (near OECD average) would make America a more tax-efficient home for corporations. 2 to 1 American favours taxing the rich more (income above $250,000). * Immediate concern is jobs. (51% > debt reduction). Romney promises 12 m jobs and Obama a modest (and perhaps more realistic) 1 m. But neither has a sure-fire answer as to how. Lowest unemployment rate in 4 years will help Obama. * Trickle-down economics (Romney) v trickle-down government (Obama) * Republican camp said to favour removal of Bernache as Fed Chairman and to have sponsored a study of the gold standard. So a Romney win could mean cutting government and welfare spending but more military spending (+$2.1 T = 4% GDP), a stronger dollar and a weaker RMB. * On foreign policy, Romney likely to favour American “exceptionalism”, greater tendency towards China-bashing e.g. RMB and trade. As in the past, every new US President started with saying something about China but ended up carrying on with more or less the same strategy (barring major breakthroughs as in the case of Nixon with Maoist China). • An Obama or a Romney win is unlikely to change US Pivot. By 2020, 60% of US military assets will be located in the region (up from 55%). Romney win is likely to favour more aggressive foreign policy, e.g. v Russia and Iran, but see changing American public opinion in slide above. 45 IImpact on Japan

(Asian-Pacific Journal – Japan Focus) • Japan’s lost decades + March 2011 earthquake and tsunami + Fukushima nuclear catastrophe • Chronic deflation + aging population + dysfunctional politics (7 PMs since 2005) • NIKKEI index 39,900 in Dec 1989 to below 9,000 in May 2012 but average per capita GDP in 2010 was 21% higher than in 1990. • Late 1980s average income of top 10% 7x poorest 10%; by 2010 gap was more than 10x, Gini coefficient (0.329) still lower than UK (0.342) and US (0.378) but higher than Canada (0.324), Germany (0.295) and France (0.293). • By 2011 government debt above 200% GDP, compared to 130% in Greece and Italy. • By the end of 2011 Moody’s rating was down to Aa3, S&P’s long-term rating was down to AA-, and in February 2012, further downgrades possible * However, 93% government debt financed internally, most deposits held by banks. * Japan’s household saving rate fallen sharply over four decades to only 6% (5% in USA) • Japan’s strategy is continuing ODI for outsourced manufacturing mostly in the region retaining innovation at home (= high yen policy (aging population) . • Sony’s TV division has been a large money-loser for eighth straight years. Declines in market value by April 2012 are almost 92% for Sony and about 79% for Panasonic. Auto industries also losing edge. But high-tech components industries continue to thrive • Long established trade surplus now turned to deficit . • By 2010 30% of all retirees and nearly half of all retirees living alone (mostly widows) were living below the poverty line • Hollowing out of manufacturing jobs - rising number of young NEETs, people not in employment, education or training . Results of recent global studies how that Japanese are not satisfied with their lot. * Japan’s largest trading partner is now China where Japan has outsourced most of its manufacturing. Worsening Japan-China relations are not good news for Japanese economy. 46 • US Election, Japan’s relation with the US is unlikely to change either way.

Impact on India

* Quarter ending June 2012, GDP growth of 5.5 %, a slight increase from 5.3% previous quarter, but very different from 8% growth in 2011. • Slowing economic growth, corruption scandals, ethnic strife and political gridlock. The Congress-led United Progressive Alliance (UPA) government announced bold new economic reforms to get economy back on track. * Government signalled intention to reduce stake in state-owned enterprises (petroleum, aluminium, copper, and other minerals). * On retail , individual states discretion to reject FDI—setting the stage for experimentation among the states in federal system. Also places constraints on new investment, such as limiting FDI to cities with a population of 1 m or more, and requires retailers to source at least 30% of products from within India. * Complex coalition politics. Reforms modest direct effect on growth but could restore business confidence, reassuring skittish foreign investors increasingly despairing about the future of Indian economy, and bolstering credibility of the ruling government. But grass-root politics remain a wild card. • US Election either way is unlikely to change Indian economy. A new US administration will continue to view India as a US major ally in support of America Pivot to Asia. * In an increasingly multi-polar world, the new Chinese leadership is also likely to continue expanding China-Indian ties. 47

Time to re-think a new Asian order?

• ‘China’s re-emergence v traditional regional US dominance. How to accommodate the other? - Discord in Asia, SCMP Op-ed article, 6 September, 2012. • China views South China Sea as critical sea lanes for economic survival * China building harmonious relations all around. First non-ASEAN nation to sign Treaty of Amity and Cooperation in Southeast Asia in 2003. With ASEAN-China Free Trade Area, the “ASEAN way” based on consensus and equality gaining traction. This mutually-beneficial harmony now under strain. • U.S.-China security dilemma. "A2/AD (anti-access/area-denial)" - mobile "aircraft- carrier killer" missiles,“C5ISR” (Command, Control, Communications, Computers, Combat Systems, Intelligence, Surveillance, and Reconnaissance). * Looming “Great Sino-American Divorce” v “chimerica” (Niall Ferguson in 2006). (Mark Leonard, Co-Founder and Director of the European Council on Foreign Relations, 23 August 2012) • China benefitting from stable regional order underwritten by U.S. While a rising China can no longer unreservedly accept America’s dominance, but not in China’s best interest to dislodge U.S. • Recent territorial confrontations provide cover for China’s flexible power projection, combining military strength including onshore mobile anti-ship missile capabilities with non-military China Maritime Surveillance deployments, while blue-water navy being built (Toshi Yoshihara, Chair of Asia-Pacific Studies at the U.S. Naval War College) * “The China Choice”, Professor Hugh White. “Concert of Asia”, accommodating or balancing China’s core regional interests, along with those of India and Japan * Brzezinski has advanced a global American grand strategy, comprising a “Larger West” and a ““Complex East”, where the U.S. would act as “regional balancer”, similar to the role played by Britain in intra-European politics before early 20th century. Underpinning this is a “U.S.-Japan-China Cooperative Triangle” to be nurtured through reconciliation between China and Japan,. 48 *Main takeaways • Fifth Generation leaders collective leadership under Xi,. Strong body of non-science degree-holding reformers with good track record, 18th Party Congress on 8 November. • Bo Xilai affair has woken up Party at an inflexion point. Major reforms afoot for SOEs, financial and currency liberalization, hukou system, and civil society. • China to upgrade industries, balance economy and society, and to build a more sustainable and innovative economy, defined by urbanization, consumption, rapid connectivity, and outward globalization. • FYP 2011-15 - urbanization, domestic consumption (especially lower-tier cities), retail chains, famous Chinese brands, tourism and hospitality, new technologies, high-end manufacturing, life sciences, bio-technology, nanotechnology, aircraft production, deep-water drilling technologies, R & D, creative industries, green energies, new materials, conservation, eco-business, green cars, financial services, shipping and transportation, agriculture, healthcare, and education. • RMB to assume growing importance as an international currency. • China poised to overtake the US economy in a decade or so. • US public opinion less interventionist; China more as opportunity rather than threat. • A new Asian Order in the making with China playing a more influential role in ASEAN-China Free Trade Area, largest by population. • China-Japan relations - Regional geo-economic realities, combined with a balancing Pivot, could eventually lead to a “US-China-Japan cooperative triangle”. • US election unlikely to change Asian picture, including India and Japan. However, Romney win likely to lead to (a) a stronger greenback, and (b) more China- batching e.g. on RMB and trade, at least initially. • Possible investment picks – retail in inner cities; healthcare, education,

technology; RMB, M & A, ODI; copper, gold and silver

49 Andrew Leung International Consultants Ltd

Thank you

Andrew K P Leung, SBS, FRSA www.andrewleunginternationalconsultants.com