Beware the Dragon Expert views on risks and opportunities in China TABLE OF CONTENTS

1 Introduction 1 2 Insuretech in China: Revolutionizing the Insurance Industry 2 Cliff Sheng, Partner and Head of China, Oliver Wyman 3 Will Common Ground Between the US and China Strengthen Their Bond? 4 Knowledge@Wharton 4 Beware the Dragon: The Global Impact of a China Hard Landing 7 Jamie Thompson, Head of Macro Scenarios for Oxford Economics 5 China’s Rise: The AIIB and the “One Belt, One Road” 10 David Dollar, Senior Fellow with the Foreign Policy and Global Economy and Development for the Brookings Institution 6 Developing a Blue Economy in China and the United States 13 Michael Conathan et al., Director of Ocean Policy at Center for American Progress 7 Debt, Not Reserves, to Constrain China’s Cross-Border Buying Spree 16 Alicia García Herrero, Senior Fellow for BRUEGEL and Chief Economist for Asia Pacific at Natixis 8 Is it “Deja Vú All Over Again” for China’s Financial Well-Being? 18 Jack Rodman, Senior Advisor for Crosswater Realty Advisors 9 Real and Imagined Risks of China’s Shadow Banking 21 Christian Edelmann et al., Global Head of Corporate and Institutional Banking for Oliver Wyman 10 China’s Aging Population Prepares for Tomorrow 23 Julio Portalatin, President and CEO of Mercer 11 One Belt, One Road: Risks and Countermeasures for Chinese Companies 25 Miao Lu, PhD, Executive Secretary General of the Center for China and Globalisation 12 How Should Business React to China’s Water Crisis 28 Cate Lamb, Head of Water at CDP 13 China’s Aging Population: More than Fifty Shades of Grey 30 Jacques Penhirin et al., Partner at Oliver Wyman, China 14 Behind China’s Attempt to Spread the Risks from its Debt-financed Growth 32 Prasenjit K. Basu, Founder at REAL-Economics.com 15 China Continues to Battle Massive Capital Flight Problem 34 Alicia García-Herrero, Senior Fellow for BRUEGEL and Chief Economist for Asia Pacific at Natixis INTRODUCTION

The articles contained in this publication have been selected for the ways they examine economic, political, and societal issues for China. The compendium collates knowledge and expertise from the world’s leading experts to provide practical and timely insights on the various risks and opportunities associated with China’s unprecedented economic growth over the past decade.

All articles first appeared on BRINK – a digital platform that informs global decision-makers on critical growth and innovation topics. BRINK is made possible by Marsh & McLennan Companies, and managed by Atlantic Media Strategies, the digital consultancy of The Atlantic.

1 oliverwyman.com BRINK Compendium INSURETECH IN CHINA: REVOLUTIONIZING THE INSURANCE INDUSTRY

Cliff Sheng

Partner and Head of China, Oliver Wyman

(defined as insurance further enhanced through technology in a customer-centric way) players. INSURETECH MAKES GAINS

Insuretech is revolutionizing the insurance industry by bringing disruptive products and services to a market that is fast adopting and increasingly moving towards an online ecosystem. The market is also seeing a surge in the number of people who have started to understand and are aware of the benefits of insurance.

China is among the countries at in 2015) compared to developed These gains have been supported the forefront of fintech innovation markets such as the UK (10 percent) by the insurance market regulator and adoption, and the latest and the US (7.3 percent), strong CIRC, which has fostered a technology is now being used government support, coupled supportive regulatory environment there by the insurance industry with a growing middle class, is insuretech. All of this is resulting to better serve its clients. making insurance products more in rapid growth in the Insuretech accessible. In 2015, for example, market, which is expected to grow Capital markets that can support total insurance gross written from 250 billion yuan in 2015 to financial innovation are not yet premiums (GWP) in China more than 1.1 trillion yuan in 2020. mature in China, and existing increased by 20 percent in 2015 to state-owned financial institutions 2.4 trillion yuan ($355 billion). There are broadly three Insuretech are not reforming quickly enough. segments in China (Figure 1), This gap in supply has provided In fact, the Chinese insurance the market sizes for which are opportunities for Chinese market has doubled in size over projected to grow at different rates: fintech players – who are being the past six years. Based on China supported by rapidly growing Insurance Regulatory Commission’s ONLINE DISTRIBUTION OF online ecosystems and a tech-savvy (CIRC) five-year plan and various TRADITIONAL INSURANCE population – in diverse fields other sources, the insurance ranging from investing to payments. market is forecasted to grow at PRODUCTS (E.G. ONLINE 13 percent (compounded annually) AUTO INSURANCE SALES) up to 2020, to 4.5 trillion yuan. A GROWING According to Oliver Wyman INSURANCE MARKET The rapidly growing insurance estimates, GWP for this segment market – albeit from a low base – will grow from about 207 billion While insurance penetration in in China, is also opening up plenty yuan in 2015 to about 747 billion China is currently low (3.6 percent of opportunities for Insuretech yuan in 2020. And within this

2 oliverwyman.com BRINK Compendium segment, non-life insurance to protect themselves against risks stopped by the regulator (which is products will grow at a faster related to these ecosystems. considered a temporary measure pace than life products. to curb increasing risk). In another RISKS AND UNCERTAINTIES case, we observed that the slow TECHNOLOGY ENABLED FACING THE INSURETECH adoption of telematics is caused by UPGRADES OF EXISTING INDUSTRY the tariff set by the regulator even INSURANCE PRODUCTS after the recent pricing reform of auto insurance. In another case (E.G. NEW HEALTH INSURANCE Notwithstanding the tremendous scope and opportunity for certain of regulatory back-and-forth, POLICIES OR PRICES BASED simple products—such as travel smog travel insurance, which ON WEARABLE DEVICES, insurance and shipping return compensates travelers during TELEMATICS) insurance—in the Chinese bad weather caused by smog, has Insuretech market, several products been stopped by the regulator GWP for this segment is expected such auto insurance and universal ȫȫ Technology. Future development to grow from about 28 billion yuan live insurance face uncertainties of technologies such as big data, in 2015 to about 197 billion yuan owing to the following four factors. in 2020. Auto insurance will be the cloud computing, block chain highest contributor to this growth, ȫȫ Macro economy. A fall in Chinese and artificial intelligence are critical to Insuretech. Therefore, followed by health insurance GDP growth to 5 percent or lower technological failures of particular products. would have an adverse impact on per capital disposable income, platforms can pose risks for ECOSYSTEM-ORIENTED which in turn could negatively companies, particularly when they are looking to ramp-up operations INNOVATION OF NEW affect the demand for non- INSURANCE PRODUCTS essentials such as automobiles, ȫȫ Competition. The two kinds of wearable devices and connected (E.G. SHIPPING RETURN players that currently dominate home devices. As a result, GWP in INSURANCE, FLIGHT the industry are traditional these sectors would fall insurers and disruptors. DELAY INSURANCE) Traditional insurers may set ȫȫ Regulation. In general, the up joint ventures with tech Estimates show that GWP in this CIRC has been supportive companies to compete with segment will grow from 12 billion of innovation but there are disruptors, or set up subsidiaries yuan to 202 billion yuan between times when it has been too to attack this market. New players 2015 and 2020. The key contributors conservative. For instance, the could also emerge, increasing to this growth be the e-commerce regulator may put a limit on competition. For example, auto and travel ecosystems because guaranteed return of universal or 3C (computer, communication of their large market size and the life insurance distributed online. and consumer electronics) growing desire among consumers Online universal life was recently manufacturers could set up insurance companies to insure their own products. Similarly, FIGURE 1 CHINA INSURETECH SEGMENTS, KEY PLAYERS AND MARKET SIZE FORECAST BY 2020 peer-to-peer insurers may rise Source: Oliver Wyman analysis to cover online communities and large ecosystems might also self-insure Segment 3: Ecosystem oriented innovation 2020F CNY202 BN Leveraging data analytics to cover needs in embedded Zhongan Insurance ecosystems that are not currently met Tk.cn Insurance Notwithstanding these uncertainties and possible risks, the prospects of Segment 2: Technology enabled upgrade 2020F CNY197 BN the Insuretech industry in China Utilising technology to upgrade existing insurance PingAn Insurance products to become more targeted, customised and ZhongAn Insurance look bright, with the forecasts clearly dynamised PICC Property& Casualty suggesting a growing opportunity Segment 1: Online distribution 2020F CNY747 BN set for businesses in this space. NEW TTECH ENABLED Traditional Selling traditional insurance PingAn Insurance Whether it exceeds, meets or fails products products through online or ZhongAn Insurance mobile channels PICC Property expectations—only time will tell. & Casualty

ONLINE DISTRIBUTED This article first appeared on BRINK on November 7, 2016.

3 oliverwyman.com BRINK Compendium WILL COMMON GROUND BETWEEN With China THE US AND CHINA STRENGTHEN and the US THEIR BOND? positioned to be

Knowledge@Wharton the world’s top growth engines, the world has a stake in their relationship.

China’s transition from an On March 31, President Barack export-led economy to one based Obama met with Chinese President on domestic consumption is a Xi Jinping during a nuclear security leading global economic theme summit for 50 world leaders in today, given the outsized importance Washington. That meeting led to of the country’s economy. But many agreements for more cooperation bumps are expected along the way in the areas of nuclear weapons, in that huge changeover, even if cybersecurity and climate change, things were to go relatively well. according to news reports. On the business side, the two leaders Some areas of contention with also agreed to continue work on trading partners like the US will a bilateral investment treaty. continue to include differences over the valuation of the renminbi It is clear that with China and the and export policies by companies US positioned to be the world’s with state control and funding. top growth engines in the decades One example: new concerns about ahead, the whole world has a stake steel manufacturing overcapacity, in their relationship. If the two which led China’s steel exports to countries can focus more on what surge by 20 percent in 2015 and they have in common, rather than the underpricing of production differences, they could deepen elsewhere. Such a development their bonds, according to Geoffrey caused critics to question just Garrett, Wharton’s dean and also how rapidly China plans to a management professor who abandon what many critics see as spoke at Wharton’s annual E-House beggar-thy-neighbor policies. Real Estate Forum.

Despite such frictions, there A new age is dawning in the are positive developments too. economic relationship between

4 oliverwyman.com BRINK Compendium the United States and China, labour-market growth to drive its people to cities,” said Garrett. one in which the two countries are economy forward. “Urbanisation is how hundreds motivated by shared challenges of millions of Chinese people have and mutual needs, he noted. This Also, China is experiencing the been lifted out of poverty.” The bilateral relationship, a marked transition from family-provided absence of infrastructure in places contrast to the “co-dependent” one care for the elderly to more state- such as India and Indonesia is the that the two countries maintained provided care. This is unfamiliar single biggest impediment to their for many years, has implications territory for the Chinese, and is ability to make similar strides, he that extend far beyond the two thought to be a driving force behind said. In the US, the infrastructure nations’ borders. “The business their high personal savings rates. challenge is about replacing an aging interactions, the people-to-people “People believe that they are saving infrastructure when public debt is interactions between the world’s not only for their retirement but weighing heavily on the country. two most important countries are for their family’s,” noted Garrett. Slowing productivity growth going to be the win/win/win of Public debt tied to the financial has made innovation and the 21st century,” said Garrett. crisis of 2008 is an issue for both entrepreneurship the “number one Although China’s steep growth the US and China. The US – and agenda item” around the world, curve may be flattening – a good other Western countries – spent according to Garrett, because people thing for China, according to Garrett trillions on fiscal stimulus in the believe that new organisations are wake of the financial crisis. “There – China is nevertheless expected better at producing innovation than is a large overhang from these to surpass the US as the world’s mature ones. For its part, China’s policies,” said Garrett, pointing largest economy within the next new five-year plan has supply- out that public debt in the US 10 years. “Together, China and the side structural reform as its key has doubled from its pre-crisis US will be the twin growth engines element – an indication that the levels, arguably at the worst time of the global economy,” noted Chinese government knows that its because of the financial pressures Garrett. The only country that has next stage of economic growth will caused by the aging population. any real chance of catching up is have to be driven by private sector Garrett characterised public debt India, whose status with regard to innovation and entrepreneurship as “a kind of stealth candidate” in rather than by the government. economic transformation he likened the US Presidential election, as it to that of China in the 1980s. sparks concern among candidates In the US, there is plenty of innovation and productivity. The similarities between the and voters of all political stripes. The issue is how they are economies of China and the US are While in the US the public concentrated by geography and far greater than size and influence, debt is a concern at the federal company, and consequently the a fact that is often not recognised. level, China’s heavy post-crisis number of people who benefit. “The fundamental economic spending on infrastructure has “There is a tiny number of people challenges facing the U.S and China left many second- and third-tier who live in the key innovation cities are quite similar, though they play cities saddled with heavy debts. in the US: New York for finance, out differently,” said Garrett, who Though there is no question that Hollywood for entertainment, spoke about how the two countries there were benefits from the San Francisco for information are dealing with aging populations, investment in infrastructure, technology,” Garrett said. Apple public debt, infrastructure, there remains the concern that is considered the most productive productivity and the environment. Beijing may have to bail out company in the world when In the US, the graying of society has provincial and local governments. measured by revenues per employee. profound implications for Social “For shareholders that is great. But Security and Medicare, the two Indeed, infrastructure and public for the country the problem is Apple largest public programs for retirees debt are closely linked in both the doesn’t employ very many people.” and plays into people’s concerns US and China. China’s infrastructure about the programs’ future viability. is new and modern, but building Finally, the environment is a major The consequences of demographics isn’t done. “The challenge for concern in both countries, with in China are different: Having seen China is how does it continue China taking a highly pragmatic a peak in its working-age population, the infrastructure revolution to view that is spurring it to action. China must find sufficient move another 200 or 300 million “They are finding domestic solutions

5 oliverwyman.com BRINK Compendium to domestic problems,” said Garrett. The US automaker went bankrupt is a win-win. The bad news is it “Chinese entrepreneurs have after the financial crisis and was doesn’t work easily politically.” figured out there are a lot of great bailed out by the US government. business opportunities in China But it returned to profitability One solution, noted Garrett, with regard to the environment, thanks to robust demand from would be to have China and the US participate on equal which is good for China and good China. GM now sells more vehicles footing in more trade and for the world.” By contrast, in the in China than it does in the US. economic organisations. Garrett US, the environment is what Garrett “Ten years ago we thought about China as a cheap place to make characterised the Asia-Pacific characterised as “a political football,” cars, but now it’s the biggest growth Economic Cooperation, to which with the result being that the US market for selling them,” said both China and the US belong, as has under-delivered in addressing Garrett. being about “photo opportunities.” climate change because there has Among US-led organisations been no political incentive to do The growth of the Chinese consumer where China is not a member is otherwise. market is critical to many US firms, the Trans Pacific Partnership. even though products designed in the US that are made and sold China’s absence is particularly FROM CO-DEPENDENT overseas don’t show up as exports. notable because other TPP members TO BILATERAL The benefits to employees and trade with China. It has been shareholders of such companies suggested that the US would like These commonalities can deepen are obvious, but explaining to the to see China follow the same path the bond between China and the American public that it is good for to the TPP as it did to the WTO: The US lays down the rules and US Garrett characterised the the US if the Chinese consumer buys China joins once the rules have been relationship between China and American products made in China is politically challenging. established. But “China has grown the US from 1995 to 2005 as a so much that it doesn’t make sense “co-dependent” one: China lent the Garrett pointed out that the US faced now for it to follow that same path,” US money; the US bought Chinese a similar situation some 30 years ago he said. Meanwhile, the RCEP – or goods. “The US became addicted with Japan: The US pushed Japan to Regional Comprehensive Economic to cheap Chinese loans and the increase the value of the yen against Partnership, the proposed free trade Chinese economy was addicted to the dollar, resulting in increased agreement between ASEAN and the US buying. It was co-dependent, Japanese investment in the US other countries – would not include addictive, and profoundly Acceptance of Japanese investment the US. imbalanced,” he said, pointing out in the US was slow. It was helped by that China held some $3 trillion in Japan’s economic downturn, which “A real trade agreement that foreign reserves and that the trade meant Japan was no longer seen as includes China and the US is in deficit is over $300 billion a year. an economic threat, and by Japan’s everyone’s interest,” said Garrett. It was also unsustainable. status as a US security ally. Paraphrasing former US Secretary of State Henry Kissinger, Garrett He said the new economic The US is likely now to see more and said such an agreement between more Chinese investment, too, but relationship began when China the world’s two largest economies acceptance could be slower than it allowed the renminbi to appreciate would create peace and prosperity was for the Japanese. For their part, against the dollar. Over the last in the 21st century – and be a win for Chinese investors have been savvy, China, a win for the US and a win for decade, it has appreciated 30 percent focusing largely on real estate rather the world. in nominal terms, 50 percent in than “big, glamorous” transactions real terms. A defining characteristic involving companies. Eventually, This article first appeared in of this new relationship is the there will be more acquisitions of Knowledge@Wharton, which is the importance of China’s consumer US companies by China. “This is the online research and business analysis market to the US economy, as reality that the US has to accept,” journal of the Wharton School of illustrated through the fall and asserted Garrett. “The good news the University of Pennsylvania and rise of General Motors. about this relationship is that it on BRINK on April 22, 2016.

6 oliverwyman.com BRINK Compendium BEWARE THE DRAGON: THE GLOBAL IMPACT OF A CHINA HARD LANDING

Jamie Thompson Head of Macro Scenarios for Oxford Economics

recently unveiled a potentially radical fiscal consolidation program in its 2016 budget.

Expected gains for some net energy importers have also disappointed. In the United States, the domestic energy sector has dragged heavily on both capital expenditure and payroll growth, in part reflecting the behaviour of shale oil firms. Indeed, as oil prices have plunged, so has capital expenditure in the US oil and gas extraction sector. The drag on the US economy has been material, with the investment fall knocking 0.4 percentage points off annual growth in 2015.

The significance of China for trade is also unquestionable. China has surpassed the US and the EU Risks to the global economy are complex and increasingly as the main export destination are rising, according to the vast powerful. Consider first the impact for its Asian neighbours. And majority of businesses queried of China on global commodity some of the most reliant on in the recent Oxford Economics markets, given the commodity- China are commodity producers, Global Risk Survey. Meanwhile, intensive nature of the country’s leaving them doubly exposed to 25 percent of respondents investment-led growth. Against the a weaker Chinese economy. believe that a global downturn or backdrop of continued strong oil recession is more likely than not. production, increased fears over In addition, severe Chinese Chinese prospects have already weakness would most likely But the most remarkable result from been associated with major falls be accompanied by a shock to the survey – which polled some of in oil and other commodity prices. confidence in the global real the world’s largest companies – economy. That would affect not is the feared trigger for weakness While weaker oil prices have just countries or businesses with in the global economy: Almost traditionally been viewed as a net significant direct exposure to China; all respondents cite the Chinese positive for the global economy – as the global economy slowed, economy among their top concerns. the boost to spending among net investment plans would be scaled energy importers has generally back more generally, accompanied outweighed weakness among net by slackening household spending. CHINA’S GLOBAL LINKS energy exporters – recent history RUN DEEP suggests a more nuanced picture Finally, recent market turbulence at current low oil price levels. has highlighted a number of other The perceived importance of Continued falls in oil prices have key channels. A sharp China China to businesses across the left some producers in a particularly slowdown would undoubtedly globe is perhaps unsurprising. challenging position. In Saudi challenge investor sentiment, Its connections to other countries Arabia, for example, the government sparking major shifts in exchange

7 oliverwyman.com BRINK Compendium rates, interest rates and an array of Not many can cushion the blow. A China other asset prices – with important In a number of advanced economies, implications for not only growth monetary policy rates may already slowdown in different countries, but also the be close to their effective floor, stance of monetary policy across even where that floor is negative. matters. A the globe. In certain emerging market economies, policy is constrained by hard landing concerns over sharp capital outflows, WHAT HAPPENS IN depreciation and inflationary would have a CHINA DOES NOT pressures. Of the 46 countries profound effect STAY IN CHINA we analysed, only half are able to provide a policy rate response. on the global In a qualitative sense, then, The US would be one of the least Chinese developments matter. affected economies in a China hard economy. But, quantitatively, how great landing; however, it is by no means would the fallout be from a immune. On the trade side, China severe China slowdown? accounts for just 7 percent of US In recent research, my colleague merchandise exports. But emerging Alessandro Theiss and I sought to markets, which are more directly answer this question. In particular, exposed to Chinese weakness, are we modelled a “hard landing” responsible for around a third, even involving Chinese growth of just excluding Mexico. That is not to 2.5 percent in 2016. That lies mention other linkages from China far below our central forecast to the US economy, through capital of a limited slowdown and the flows, exchange rates, commodities, probability of such a disappointing confidence and more. growth performance is not high. But, should it materialise, Ahead of the Federal Reserve’s the implications for the global December policy rate hike, economy would be profound. I remarked on the potential for a China hard landing to undermine In the hard landing, global prospects the Federal Reserve’s plans to deteriorate as emerging markets and steadily increase interest rates in commodity producers sink deeper. 2016 and beyond. If such an event But advanced economies are not were to unfold, I argued, the first immune. By 2017, five advanced rate rise in the nascent Fed policy- economies have fallen into recession, tightening cycle would also – for a and relative to our central forecast, while at least – be the last. As events more than 2 percent will be shaved of recent weeks have borne out, from the world’s total GDP. that remains very much the case.

8 oliverwyman.com BRINK Compendium BEWARE THE DRAGON? shock to Chinese activity. In China, the authorities might seek to In short, there is little doubt that counterbalance the slowdown more a China slowdown matters. A hard actively through expansionary fiscal landing would have a profound effect measures and encouraging greater on the global economy. It would bank lending. Elsewhere, additional weigh heavily on emerging markets unconventional measures could be and advanced economies would not countenanced by various central be immune. banks across the world.

But the precise scale of these impacts Moreover, it is important to place is uncertain. Pessimists, for example, this risk in context. While we have might conceive of a more extreme anticipated a China slowdown for China hard landing scenario some time, our central expectation is or a more moderate slowdown that further slowing will be relatively accompanied by a series of other limited. The risks to Chinese growth blows to the global economy. are substantial – but there may be fire in the dragon just yet. Equally, optimists can point to the possibility that a far greater policy This article appeared on BRINK on response would greet a major February 17, 2016.

9 oliverwyman.com BRINK Compendium CHINA’S RISE: THE AIIB AND Changing the THE “ONE BELT, ONE ROAD” incentives of local Chinese officials David Dollar Senior Fellow with the Foreign Policy and Global Economy and Development for the to align with fiscal Brookings Institution rebalancing is a key institutional reform.

China’s six years of breakneck The latter effort has a better chance growth leading up to 2007 were of success than the former. accompanied by a rising trade surplus. But when that surplus fell sharply after the global crisis, SPURRING INVESTMENT Chinese authorities made up for – BUT NOT ENOUGH the shortfall of demand with an increase in investment. Today, It is no coincidence that this period China is using a lot more investment of excess capacity at home is the to fuel slower growth than in the moment at which China launched past: The real-world result of this expensive new initiatives, such as falling capital productivity has the Asian Infrastructure Investment been empty apartment buildings, Bank (AIIB), the BRICS Bank and unused airports and serious the “One Belt, One Road” initiative excess capacity in manufacturing. in order to strengthen infrastructure Meanwhile, consumption is very low, both on the westward land route especially household consumption. from China through Central Asia and on the southerly maritime routes One response China has taken to from China through Southeast Asia. this changing growth dynamic is to try to spur external demand for Developing countries understand Chinese investment, specifically the purpose for the AIIB: Many for major infrastructure projects. have moved away from using the The other response has been existing multilateral infrastructure internal: To initiate reforms investment banks because they are that rebalance its economy from so slow and bureaucratic. The US investment to consumption. made a mild effort to dissuade some

10 oliverwyman.com BRINK Compendium allies from joining the AIIB, fearing One Road” routes, there are some governments worry that they will China would use it for narrow with relatively strong governance lack the resources to fund greater political or economic ends. But a – India, Indonesia and Vietnam, social services for migrant families. diverse group of nearly 60 countries for example – that will be hard has signed up, making it difficult for China to push around. Those China’s Ministry of Finance has for China to use the bank to show countries will not want to accept announced general plans for fiscal favoritism in financing projects. large numbers of Chinese workers reform to support rebalancing. In fact, the AIIB should be viewed or take on large amounts of debt First are measures to bolster local as complementary to – and not relative to their GDP. On the other government revenue, potentially competitive with – America’s own hand, there are weak governance including a nationwide property tax. main economic initiative in the countries – Cambodia and Pakistan, Second is to collect more dividends Asia-Pacific, the Trans-Pacific for instance. It may be more feasible from its state enterprises. If this Partnership trade agreement. for China to send some of its surplus happens at both the local and the production to these countries, but central level, it would reduce some But the AIIB will be too small there is a reasonable prospect that in of the bias towards investment to make a dent in China’s excess the long run, China will not be paid. and help ensure resources for capacity problem. If the AIIB is very government services. Third is to successful, then in five years it might allow municipalities to issue bonds lend $20 billion per year, comparable DOMESTIC ROADS to fund their infrastructure projects, with the World Bank’s International TO REFORM rather than relying on shorter-term Bank for Reconstruction and bank loans. Development. But China would need Domestic reform is a much more The final aspect of fiscal reform $60 billion per year of extra demand promising road to deal with China’s may be the hardest: Local officials to absorb excess capacity in the steel surplus problem, and to rebalance are generally rewarded for their sector alone. its economy away from such a ability to provide investment heavy reliance on investment. and growth. While the system The “One Belt, One Road” initiative The resolution that came out of the has been successful at that, it has is larger than the AIIB. It started Third Plenum in November 2013 been less successful at meeting with the idea that nearby countries sketched out dozens, if not hundreds, other objectives, such as clean in Central Asia could benefit from of reforms. The ones that are likely air, food safety and high-quality more transport infrastructure, to have the greatest effect are the education and health services. some of which China could finance household registration system bilaterally. However, the economies (hukou), intergovernmental fiscal Changing the incentives of local of Central Asia are not that large, reform and financial liberalisation, officials to align with rebalancing and the potential for investment is opening up China’s service sectors is a key institutional reform. limited. For that reason, China added to competition. the idea of a maritime “road.” Under hukou, 62 percent of the LIBERALISING Because “One Belt, One Road” will population is registered as rural CHINA’S FINANCES be implemented bilaterally between residents, and it has been difficult China and different partners, it may for them to change this designation. China’s repressed financial system is seem that there is more potential for Rural migrants to the cities cannot a third area of reform. Real interest China to use this initiative to vent bring their families or truly become rates that are close to zero amount to some of its surplus. But I still doubt citizens of the cities. Reforming both a tax on household savers and a that this will be on a scale to make a the system would help reallocate subsidy to investment by firms and macroeconomic difference for China. labour from low productivity local governments able to borrow (farming) to higher productivity from the banking system. Almost Among the various developing (urban manufacturing and service everywhere in the world has had zero countries along “One Belt, employment) activities. But local real interest rates in recent years,

11 oliverwyman.com BRINK Compendium but in China, they go back more than OPENING a decade. The government has taken SERVICE SECTOR some initial steps to raise deposit and lending rates, as well as to allow TO COMPETITION a shadow banking system to develop with better returns to savers and A final area of reform is to open higher-rate loans to riskier clients. up China’s service sectors to competition from private firms The problem with the current and the international market. arrangement is that most shadow- The modern service sectors are banking wealth products are the domain in which state-owned marketed by commercial banks and enterprises continue to be dominant, treated as low-risk by households. including financial services, Total shadow banking lending has telecom, media and logistics. The grown at an explosive rate in recent rebalancing from investment toward years and, not surprisingly, some of consumption means that, on the the funded investments are starting production side, industry will grow to go bad. The first corporate bond less rapidly than in the past while the default occurred last year, and service sectors expand. China will that result should help ease the need more productivity growth in moral hazard that has built up in the service sectors, which is hard to the system. The announcement of achieve in a protected environment. the formal introduction of deposit insurance this year is another For other developing countries, important step in the separation successful rebalancing in China of a cautious commercial banking will create both challenges and sector from a risky shadow-banking opportunities. While China’s sector. Central Bank Governor appetite for commodities is likely to Zhou Xiaochuan recently announced moderate, rebalancing should lead to that interest rate liberalisation would a rise in its demand for manufactures be completed within one to two years. and services from other developing countries. And China is rapidly Recent moves to liberalise the emerging as a major source of foreign bond and stock markets so that direct investment. A world without private firms can more easily go Chinese rebalancing, by contrast, is to the capital markets are also likely to be more volatile. in the right direction, as are moves to increase the flexibility A more in-depth version of this piece of the exchange rate. The IMF appears on the Brookings site and assesses that China’s exchange was condensed from a paper titled, rate has gone from “substantial “China’s rise as a regional and global undervaluation” to “fairly valued” power: The AIIB and the ‘one belt, in recent years, so it should not one road,’” which was released in be too difficult for the authorities Summer 2015. to reduce their intervention and This article appeared on BRINK on allow a more market-determined April 27, 2016. rate. Finally, opening up the capital account should be the last step in financial liberalisation.

12 oliverwyman.com BRINK Compendium DEVELOPING A BLUE ECONOMY IN CHINA AND THE UNITED STATES

Michael Conathan Director of Ocean Policy at Center for American Progress

Scott Moore International Affairs Fellow at Council on Foreign Relations

are approaching this dilemma by promoting a concept known as the “Blue Economy.”

The Blue Economy represents a relatively new manner of describing ocean economic development that began to emerge first among many island nations, including tiny developing countries such as the Republic of Seychelles, as well as the archipelagic giant Indonesia, the fourth-most-populous country in the world. It’s now gaining recognition in some of the world’s biggest and most powerful nations, including China and the United States, which have increasingly begun to turn to the concept of the Blue Economy to promote development of their ample ocean and coastal resources. As the world population balloons a thickening atmospheric blanket Honing the Blue Economy’s focus toward more than 9 billion people of carbon pollution. They produce could ultimately pay dividends by 2050, nations will need new more than half of the oxygen we by allowing economic growth to resources from a finite amount breathe. In coastal regions, healthy blossom alongside environmental of space to meet soaring demand. coral reefs and other wetlands sustainability. And as more people move to coastal ecosystems safeguard communities regions, their minds will inevitably from storm surges and flooding China has not typically been at be drawn to the sea. After all, more events, sequester massive amounts the top of the list of countries that than two-thirds of our planet is of carbon, and filter out other rely most heavily on their ocean covered with ocean, and the seas pollution produced on land. resources. Its exclusive economic boast tremendous economic zone, or EEZ – the area of ocean development, transportation To sustain a 21st century space over which a nation has sole corridors, sources of oil and gas, population boom, we must balance right to extract resources including and cornucopias of seafood. marine economic development minerals and fish – is the subject of with protection of the ocean’s ongoing debate, with China claiming Oceans also provide less-tangible environmental services that have a vast area of the South China Sea benefits that are often difficult to sustained life on our planet for that neighbouring countries also quantify, including moderating the millions of years. This report claim. But China has sought to planet’s climate by absorbing roughly examines the different ways that two expand the economic contributions 90 percent of the heat trapped by nations, China and the United States, it receives from offshore resources.

13 oliverwyman.com BRINK Compendium The United States, which boasts In January 2014, developing To sustain a the largest EEZ in the world, has nations came together for two also looked beyond its shores days in Abu Dhabi to explore and 21st century to support its economy. Given develop the concept of the Blue both nations’ economic clout, Economy under the auspices of population the United States and China have the UN Sustainable Development tremendous potential to develop Knowledge Platform. Their efforts boom, we must and implement policies that were based on a concept paper promote marine environmental that established the Blue Economy balance marine protection and to prove that these as a “framework for sustainable strategies do not preclude the development.” It explained that economic possibility of economic growth. “at the core of the Blue Economy concept is the de-coupling of development Yet as the Blue Economy emerges as socioeconomic development a means of quantifying the economic from environmental degradation… with protection benefit of ocean industries and founded upon the assessment and of the ocean. resources, its true definition remains incorporation of the real value of opaque. Adding up the contributions the natural (blue) capital into all of all economic activity related to aspects of economic activity.” ocean and coastal ecosystems is a According to international law, relatively simple means of drawing countries have sole economic boundaries. But it fails to account jurisdiction over ocean space that for the reality that industrial extends 200 nautical miles out development frequently comes from their shores. Small-island with an environmental cost. developing states have embraced Offshore fossil-fuel extraction, for the concept of the Blue Economy as example, carries the risk of spills, a means of maximising the benefits which lead to the degradation of that accrue from their greatest asset: their marine resources. natural resources, and will increase The Seychelles, for example, has a emissions of carbon pollution and land area of 455 square kilometres, other greenhouse gases. In other or 175 square miles – roughly three cases, promoting one industry times the size of the District of means preventing another; for Columbia. Yet it has dominion over example, an area designated for an EEZ that encompasses more shipping lanes would be off-limits than 1.3 million square kilometres, to construction of an offshore wind or more than 514,000 square miles farm. As a result, the ocean economy – nearly twice as large as Texas. cannot simply be re-labelled the Blue Economy. The world needs a While island nations clearly have new definition of what constitutes much to gain from improved a Blue Economy both in order to management of their ocean promote the economic benefits resources, so do larger coastal of ocean industries and to ensure nations, including the two economic sustainable development. leviathans: the United States and

14 oliverwyman.com BRINK Compendium China. In both nations, efforts are ȫȫEstablish joint initiatives under underway to better understand, the US Department of State’s define, and promote the Blue EcoPartnerships program, Economy. This report explores the incorporating ocean planning concept’s development, detailing and Blue Technology clusters the similarities and differences, and makes recommendations ȫȫEnhance and expand existing for how the United States and bilateral partnerships and develop China can promote a collaborative new agreements to ensure sharing understanding of how to value the of best practices and consistency ocean’s natural resources around of oceanographic data collection the globe. and dissemination

This report also proposes three Leaders in both China and the key recommendations to help United States understand the need the United States and China to boost economic growth, while account for the true value of curbing environmental degradation robust marine natural resources and reducing carbon pollution and and to boost cooperation as they other emissions that fuel climate increasingly look to their offshore change. Now, it’s time for them to regions for economic growth. turn their attention to their vast areas of ocean space and implement Specifically, the United States and policies that acknowledge the China should: true economic and environmental opportunities that exist offshore. ȫȫJointly develop a methodology to account for the long-term This article first appeared on the economic contributions of healthy Centre for American Progress blog coastal and ocean ecosystems and BRINK on July 20, 2015.

15 oliverwyman.com BRINK Compendium DEBT, NOT RESERVES, Big question: TO CONSTRAIN CHINA’S How are Chinese CROSS-BORDER BUYING SPREE firms financing

Alicia García Herrero their cross- Senior Fellow for BRUEGEL and Chief Economist for Asia Pacific at Natixis border M&A buying sprees?

Despite an $800 billion drain on China’s total M&A activity during China’s foreign reserves over the the first quarter could be close to last 20 months, Chinese firms $100 billion – about the same as have been on a buying spree in 2015 – according to Dealogic, that has only accelerated since one of the largest M&A data the beginning of the year. providers. That figure is bigger than the $60 billion estimated One could argue that the Chinese by the advisory firm, Rhodium government may have to start Group and more than double the rethinking its ”go-out” policy for official $40 billion, published by Chinese companies to preserve China’s Ministry of Commerce. the country’s hard-earned foreign currency assets, accumulated There’s been a lot of speculation after years of an export-led growth about why Chinese firms are strategy; however, the reality is stepping up their purchases. The that the first quarter of 2016 has first and most structural one is that seen an explosion of cross-border the Chinese economy today is much mergers and acquisitions by Chinese larger compared with its presence in companies. In one single operation, the global M&A landscape. In fact, the state-owned ChemChina offered China’s GDP is at least 14 percent up to $43 billion to acquire Syngenta, of the global economy, while its the Swiss agrochemical firm. share in total cross-border M&A lies

16 oliverwyman.com BRINK Compendium between 2 and 6 percent, depending China’s financial woes have radically This is about 5 percent of the total on the source. changed the perception of how many fall in foreign reserves in 2015. reserves China can lose without Even if we were to use the upper Beyond the structural reasons creating a “confidence” problem. estimate on China’s cross border pushing for a bigger part of the The question, then, is whether M&A for 2015 from Dealogic, it pie, more cyclical reasons could be China’s recent boost in cross-border would still only be 13 percent of behind the recent acceleration in M&A could be constrained by the total reserves. China’s cross-border M&A, such as trends in China’s foreign reserves the disenchantment with domestic or, more specifically, whether While large, it seems quite clear that investment opportunities after the M&A activity may decelerate, or cross-border M&A is not driving stock market crash last summer, even stop, if foreign reserves were China’s loss of foreign reserves, so it as well as increasingly low interest to fall again in as rapid a way. is hard to think of reserves as a key rates. Very low rates make the constraint for China’s buying spree domestic financing of such large While such a scenario is appealing on to stop any time soon. M&A operations much less costly; paper, the reality is that the relation Such a constraint might actually that coupled with the widespread between the boost in M&A and the be elsewhere, namely in the expectation of a yuan devaluation fall in reserves is more blurred than increasingly high leverage of Chinese – at least until very recently – may one might think. In fact, only a small firms. In fact, there used to be a have heightened the interest of part of the loss of reserves can really time when Chinese companies were Chinese CFOs for cross-border be explained by such purchases. cash-rich, as credit was limited. purchases. To give a rough sense of dimension, Nowadays, after a long cycle of easy given data limitations, China money since 2008, Chinese firms HOW ARE CHINESE cross-border M&A in 2015 was only have doubled their debt-to-GDP FIRMS FINANCING M&A $40 billion, according to official data, ratios while they have severely as compared to $513 billion foreign reduced their repayment capacity. A key question to ask in order to reserves lost in 2015. Furthermore, A simple measure of such capacity, understand whether this buying part of that amount cannot have EBITDA to interest payments, has worsened dramatically in the last spree can continue and, even more dragged down foreign reserves, as few years and is now half of that importantly, how sustainable it may the M&A operations were either of companies globally. This is due be, is how this cross-border M&A financed offshore or even paid not only to the sharp slowdown activity is being financed. In that in yuan as part of China’s efforts in corporate revenue in China, regard, many observers remain to internationalise the currency. but also to the rapid growth in perplexed by the timing of such a big Regarding the former, according to their interest burden as they surge in M&A, as it coincides with the Ministry of Commerce, as much continue to grow. Large foreign further tightening of controls on as 16 percent ($6.3 billion) of China’s purchases by Chinese companies M&A in 2015 was financed offshore. capital outflows in China in an effort only add more fuel to the fire. to stem the rapid loss of reserves. As for the latter, the People’s Bank of China has estimated that as All in all, it seems that the real One could actually argue that, in much as 16 percent of total Chinese limit for China’s buying spree normal times, reducing the amount outward foreign direct investment abroad may lie on the amount of of low-yielding foreign reserves to was denominated in yuan in 2014. their increasing leverage, rather buy real assets abroad would have Assuming that such a trend did than on the country’s recent fall been considered a great idea and not change much in 2015, only in foreign reserves. is probably one of the key reasons $27 billion (i.e. 68 percent of total for China’s “outward policy.” The cross-border M&A) would have This article appeared on BRINK on problem is that, since last summer, eaten up China’s foreign reserves. April 26, 2016.

17 oliverwyman.com BRINK Compendium IS IT “DEJA VÚ ALL OVER AGAIN” FOR China can’t CHINA’S FINANCIAL WELL-BEING? “kick the can” of its financial Jack Rodman Senior Advisor for Crosswater Realty Advisors problems down the road forever.

Even to long time China watchers, control” residential real estate the start of 2016 has further prices in China’s largest cities. confused and exacerbated an already complex outlook for the Tying this all together is China’s country’s short-term recovery efforts to reform state-owned to the economic slowdown. (zombie) industries that are a drag on the economy and could trigger While there is a lot to be said a collapse of the shadow banking about issues confronting China system and systemic risk to the today, here are four of the financial system, as losses will most complex and pressing: directly impact bank profitability and capital adequacy. Ever-increasing nonperforming loans in China’s financial sector In addition, it will take a generation and how to manage them effectively, to shift from an export-led at the same time re-capitalising economy to a consumption-driven China’s largest banks. economy as China slowly moves away from the one-child policy China’s looming currency crisis, and tries to provide its aging contributing to a massive outflow citizens some form of safety net. of capital (approaching $1 trillion) over the past year. CHINA’S “BACK TO THE Reviving the Chinese residential FUTURE” POLICY MOVES real estate market, suffering from years of reckless building in third Back in 1999, when about to fourth tier cities and “out-of- 45 percent of every loan in China

18 oliverwyman.com BRINK Compendium was considered a nonperforming contributing as much as 20 percent HOW LONG CAN CHINA loan, China recapitalised the of GDP for more than a decade) JUST “KICK THE CAN” OF banking system and created Asset and into investing in WMPs and Management Companies with the trust products offering (annualised) FINANCIAL PROBLEMS sole purpose of removing the bad interest rates of 20-30 percent DOWN THE ROAD? loans from the banking system on very short (less than one year) (enabling the banks to go public maturities. As much as $4 trillion I believe China’s policy makers and raise capital) and resolving was raised in this manner in a might want to read about the global them through debt-to-equity concentrated period of time. Most of financial crisis and the role of swaps, restructuring, collection at the capital went to undercapitalised Lehman Brothers and other large discounted prices and finally, sale real estate developers and small- financial institutions to figure out to foreign investors. While the goal to medium-sized businesses that they cannot “kick the can” down was sound, its implementation was that could not borrow from the the road forever. At some point, a failure. The banks went back to large state-controlled banks. losses in the financial system will making bad loans (many policy- have to be crystallised and marked directed) and stopped “reporting” Today, much of the current and to market, which will once again on bad loans for almost a decade, pending increase in nonperforming require a massive recapitalisation resulting in the bad loan mess they loans is coming from the real of the banking sector. are facing today. estate industry, which was over- extended in third- and fourth-tier As previously mentioned, China The debt-to-equity swaps were markets and inefficient SMEs is struggling to accomplish two totally ineffective as two state- and state-owned businesses that impossible feats previously owned enterprises faced off: the were deemed “uncreditworthy” attempted and failed by banks vs. the borrowers. The by China’s largest banks. many governments. borrowers had no intent of paying back their bad loans, as they took Presently, we have multiple sectors In wake of the Chinese stock the loans as part of the government’s contributing to nonperforming market bubble and a drop in the policy of full employment, and the loans resulting from defaulting Shanghai and Shenzhen indices of banks, which were “bad creditors,” WMPs and trust products that 40 to 60 percent, the government were now asked to be competent were “sold through the banks to attempted to prop up share prices, stewards of “equity shares” of their wealthiest customers,” real which is tantamount to catching a zombie companies they could not estate developers that were forced falling sword. Ask the Bank of Japan control, nor were they willing to lend to borrow at usurious interest how successful it was in trying to them more money. This dilemma, rates to stay alive and thousands of rescue the Nikkei 225. China’s efforts conflicting goals and commitment SMEs and state-owned companies to date are approaching $1 trillion. to financial reforms inadvertently that were kept “solvent” by led to the creation of wealth and China’s export-driven economy The slowing economy and increasing trust management products, sold and infrastructure spending. defaults in WMPs and trust products, through the banks that provided combined with a pending property short-term loans to China’s most China is trying to find a way out bubble, is causing many Chinese cash-strapped borrowers, who were of this by taking a page from the capitalists who profited from two in dire need of liquidity to survive. failed 1999 playbook and planning decades of economic growth to another wave of debt-to-equity begin moving their capital holdings Wealth management products swaps in addition to securitising offshore. These moves were made (WMPs) grew furiously as the bad loans and selling them intra- seeking safety and stability, as well government’s efforts to make bank as securities to the banking as higher rates of return, as China homeownership more affordable system. Its alchemy is brilliant. intentionally devalues its currency forced speculators out of the Yesterday, it was a bad loan; now, to make its export-driven markets housing markets (which has been it is packaged as a “security” that more attractive. Most of the capital a driving force in China’s economy, the banks are forced to buy. flight moves through Hong Kong;

19 oliverwyman.com BRINK Compendium don’t be surprised to read about how profound impact on state and local our citizenship pretty cheap. More much capital was moved to offshore governments that directed the land troubling is the impact that China accounts as more disclosure comes to sales programs, in which bribery is having on both US and Canadian light from the Panama Papers leak. and corruption is endemic. residential markets that are once again grossly out of balance with The massive outflow of capital from China cracked down on money the affordability index of median China saw a brief hiatus in February laundering as well as common home prices to median incomes. after more than $1 trillion had mechanisms to move capital offshore China created its own housing moved offshore. Much of the slight through debit cards in Hong Kong bubble in China and now it appears gain in foreign exchange reserves and life insurance products, which that they are going to export it to was attributed to Chinese holdings accomplished the same objective. the US and Canada. of Japanese Yen and the Euro, both showing renewed strength. In the US real estate market, we see I, for one, can do without another the effect with capital inflows from global financial crisis. The coup de grâce is that a major goal the EB-5 visa program, whereby of President Xi’s policies has been to an investment of $500,000 buys This article appeared on BRINK on root out corruption. This has had a you a green card. I think we sold April 25, 2016.

20 oliverwyman.com BRINK Compendium REAL AND IMAGINED RISKS OF Smart regulation CHINA’S SHADOW BANKING will be key to the future of China’s Christian Edelmann Global Head of Corporate and Institutional Banking for Oliver Wyman shadow banking Andrew Sheng sector. Distinguished Fellow at Fung Global Institute

With China recording its slowest exaggerated in the media. That’s economic growth last year since because traditional approaches to 1990, there is widespread concern measuring the sector are skewed about the country’s financial by counting some of the same system, with a particular focus on exposures twice or even three the fast-growing shadow banking times as credit risk is repackaged. sector as a potential source of Moreover, the sector is smaller, as instability. Shadow banking is a share of the economy, than what not without risks, and targeted the Financial Stability Board found regulation can help mitigate risks in the United States (where it’s throughout the sector. But, with 84 percent of GDP) or the United proper management and safeguards, Kingdom (177 percent of GDP). shadow banks can also play a valuable role by channelling funds to capital-starved sectors. Fears that THREE PRIMARY it could destabilise China’s economy FACTORS HAVE DRIVEN – and economies throughout the world – are overplayed. THE SHADOW BANKING SECTOR’S GROWTH In 2013, China’s shadow banking market amounted to approximately First, China’s economy is over- RMB 31 trillion (US$5 trillion), reliant on bank credit and lacking equivalent to 54 percent of China’s in developed capital markets. GDP. While this essentially doubled With the majority of the funding in relative size since 2009, when circulated within the banking the sector was about 27 percent of system itself, there is a structural GDP, the actual size of the country’s imbalance of equity versus debt shadow banking sector is often in the financial system, which

21 oliverwyman.com BRINK Compendium has led the authorities to impose looking for convenient, transparent, China’s shadow banking sector. strict credit controls such as loan informative investing/trading/ One critical step will be to eliminate quotas and loan-to-deposit ratios. financing platforms. Leading regulatory arbitrage. This can These regulations are major drivers peer-to-peer players are tapping be achieved by redesigning the behind the use of shadow banking into this demand with convenient regulatory framework, with a focus by Chinese banks as a channel for digital solutions and are ahead of on preventing risk mismatching off-balance-sheet credit provision. the formal banking sector in the of assets and liabilities as well as use of “big data” to judge the credit mislabelling, pushing for improved Second, bank lending is significantly worthiness of potential borrowers. transparency and risk management skewed towards state-owned on bank-related shadow banking enterprises and large corporates, But even with more sophisticated products, and establishing a credit whereas small-and-medium credit scoring, the shadow banking “firewall” between commercial enterprises (SME) and retail clients sector is not immune to non- banks and non-bank shadow find it challenging to access bank performing loans. While such banking activities. credit. While 99 percent of Chinese loans are a reality for all lending firms are SMEs, constituting businesses, some analysts have Another important step will be 70 percent of employment, expressed fears that China’s financial closer monitoring and regulation, 60 percent of GDP, and 50 percent system could be adversely affected at the national level, of institutions of tax revenue, they represent less by a large number of shadow providing credit insurance. And than 20 percent of bank lending. banking non-performing assets. the non-bank lending business, So they have turned to the shadow Those fears are overblown. Chinese which can be a healthy complement banking sector for access to banks’ risk/NPL exposures are to the formal banking sector, funding, often at high real rates. still contained, as banks’ direct needs to be brought under proper and indirect exposures to shadow regulatory control while not killing Third, investors in China are banking are still limited in size. the business model in itself. severely restricted in their asset allocation and heavily exposed Financial modelling by While the issues in China’s to bank deposits as their main Oliver Wyman reveals that even in shadow banking sector are still investment avenue. Deposit returns a “disastrous” scenario, NPLs will manageable, it behoves regulators are capped (with initial steps of “only” rise to 24 percent of the total and policymakers to pre-empt any liberalisation only happening value of loans in the shadow banking escalation of shadow banking NPLs, most recently), increasingly sector. Of these NPLs, some 22-44 which could have contagion effects. driving investors to seek out percent entail exposures that may The current juncture represents opportunities to achieve more ultimately be borne by the formal an opportunity for a holistic attractive real returns. These banking system. As a result, under solution to address the structural returns unfortunately carry hidden the worst case scenario, we estimate imbalances in the Chinese economy risks and moral hazard issues. the increase in the NPL ratio for and financial system. This will banks in the formal banking sector ensure the financial system Shadow banking has also grown would be no more than 4.3 percent. meets China’s changing funding in tandem with the emergence of While that is a sizeable increase, requirements as its economy moves new digital-enabled players, such it is still manageable. In absolute towards a middle class, urbanised as peer-to-peer lenders and asset terms, it is still smaller than what the consumption and production transfer platforms. Their growth is Chinese state owned lenders cleared model that will be broadly based, unfolding in an environment where off their balance sheet between technologically driven, mobile- e-commerce sales have surpassed 1999 to 2005, and that process did Internet friendly, inclusive and the total sales of department store not provoke any market turmoil or ecologically sustainable. chains and supermarket chains in financial sector instability. less than a decade. This has created This article was revised and updated a large group of young, increasingly Smart regulation will be key to on April 15, 2015. It appeared on wealthy and educated consumers the future health and stability of BRINK on March 27, 2015.

22 oliverwyman.com BRINK Compendium CHINA’S AGING POPULATION China’s older PREPARES FOR TOMORROW population – those over age 65 Julio Portalatin President and CEO of Mercer – will likely swell to 330 million by 2050.

Ensuring people are prepared to Chinese Academy of Social Sciences thrive in the global workforce of said the fertility rate in China is the future is a top concern of most 1.4 children per woman, close to nations. Technology continues the global warning line of 1.3, the to rapidly shift skilled labour so-called “low fertility trap,” or requirements, but social and the point at which no country has demographic shifts are equally been known to return to population dramatic realities. The aging replacement level. This is an even population raises the critical more concerning number because questions of continued workforce most experts believe Chinese data on participation, retirement sufficiency this issue to be highly conservative. and health care for this growing group. For China – the world’s It’s no surprise then that only most populous nation and second 6 percent of China’s workers expect largest economy – the issue calls to receive income support from their for vision and action, especially children when they retire, as might in the face of the latest data. have been traditionally expected, according to a study on East Asia For example, by the year 2050, retirement by the Global Aging China’s older population – those Institute. Meanwhile, the global shift over age 65 – will likely swell to toward defined contribution pension 330 million, or nearly three times plans further places the problem as many as now. Complementing of retirement income adequacy – this statistical reality is another or, to put it another way, financial one: A recent report from the independence – in the hands of

23 oliverwyman.com BRINK Compendium individuals who are generally professionals owing to the aging use the capital markets to hedge not well-equipped to manage the population phenomenon in most investment and longevity risk. financial challenge just yet. markets around the world. It is regarded as unique in its ability to One capital-market approach is to Indeed, the outcomes of tomorrow examine such indicators as benefit bolster pensions with diversified are absolutely determined by the scheme design, total assets under income streams such as investment actions taken today, although the management, demographics, earnings and bonus payments. For answers are not simple. Nobel government debt and regulation, example, longevity pools (pools Laureate William Sharpe, a while weighing the impact of those of money to which plan members leading economist, in discussing and other factors on the adequacy, contribute payments) can yield retirement research – specifically, sustainability and integrity of each bonus payments to surviving plan “decumulation,” or the conversion pension system. members based on how long they of pension assets accumulated have been contributing to the pool. during an employee’s working life Among the 25 countries examined in (These are features of Mercer’s into pension income to be spent the 2015 Melbourne Mercer index, LifetimePlus product, currently during retirement – declared it China – along with the four other offered in Australia’s pension “the hardest problem I’ve ever Asia-Pacific nations studied: Japan, market.) considered.” In China and other Korea, India, and Indonesia – has a A critical takeaway from the Asian nations, the focus is shifting pension system with some desirable Melbourne Mercer Global Pension from the accumulation of funds to features, but also major weaknesses Index and other analyses is that the drawdown phase. that, if addressed, could better the the pension systems in China situation. China’s system could be But that doesn’t mean there are no and other nations facing similar improved by: answers, and, in our increasingly aging-population challenges can interconnected world, we would do ȫȫOffering more investment only keep delivering if they are well to focus on the opportunities options to members and adjusted for the realities of longevity. and solutions this presents. While thereby permitting a greater Beyond some of the improvements there are few more significant exposure to growth assets recommended for China, that would issues in our lifetime than the aging include appropriate regulation population, I, for one, refuse to look ȫȫImproving the level of as well as more diversified asset at this as a “longevity catastrophe.” communication and classes, minimum funding level The fact that people are living transparency required from requirements and increased longer is a positive thing, with pension plans to members workforce participation among upsides for consumer markets, and older cohorts. opportunities for older workers to ȫȫContinuing to increase the contribute for longer, and in new coverage of workers in the The challenges can seem daunting, and productive ways, to society. pension system but there is the opportunity, as well as the obligation, to meet the In designing solutions, an important ȫȫIntroducing a requirement issues of longevity and retirement place to start is in looking at the that part of the lump-sum adequacy head-on. It requires nations and systems where this issue retirement benefit must be what I call the “triple play” of is being addressed with positive taken as an income stream government, companies and impact to business, society and individuals to do all they can to individuals. For the past several ȫȫIncreasing the state pension encourage and ensure greater – and years, Mercer has published the age (a state proposal to do so earlier – savings for retirement. Melbourne Mercer Global Pension is now being discussed) The strategies are within reach, but Index to provide a framework for there must be commitment on the comparing and rating retirement Clearly, there will be more income part of all stakeholders in China and savings and income systems around drawdown legislation in the coming everywhere, so that our workforces the world. years. It’s going to be interesting can build their tomorrow today. to see if, for example, traditional The index has become influential annuities will prevail, or if there will This article first appeared on BRINK with policymakers and industry be more drawdown products that on April 29, 2016.

24 oliverwyman.com BRINK Compendium ONE BELT, ONE ROAD: RISKS AND Chinese COUNTERMEASURES FOR CHINESE investment COMPANIES in One Belt, One

Miao Lu, PhD Road countries Executive Secretary General of the Centre for China and Globalisation amounted to $92.46 billion in 2014, 15x higher than it was in 2005.

China proposed its “One Belt, transportation infrastructure, One Road” initiative in 2013. railway construction, energy and This ambitious scheme seeks to resources exploitation and shipping connect China more closely with and logistics firms. Small- to Europe, Southeast and Central medium-sized enterprises involved Asia, the Middle East and Africa. in manufacturing light goods and The project is bound up with the technologically advanced products promotion and exercise of China’s are also boosting their investment “soft power,” aimed at devising activity in One Belt, One Road Asian solutions for Asian problems. countries.

One Belt, One Road is strongly According to the Chinese National influencing the flow of Chinese Bureau of Statistics, Chinese outbound investment. The initiative investment in One Belt, One Road is creating significant opportunities countries amounted to $92.46 billion for Chinese state-owned enterprises, in 2014, 15 times higher than it was especially those involved in in 2005.

25 oliverwyman.com BRINK Compendium Like any large-scale and ambitious Uzbekistan’s access to water, a engineering safety and management undertaking, One Belt, One Road scarce resource in Central Asia. issues. At times, firms also have entails not just great opportunities, difficulties obtaining sufficient but considerable risks as well. SECURITY RISKS intelligence and financing to effectively carry out investment Chinese investment in countries projects. When these fail to properly POTENTIAL RISKS along One Belt, One Road may be gather information and conduct due exposed to regional turmoil and diligence, they are more prone to POLITICAL RISKS conflicts, terrorism and religious engage in speculative, bubble-like conflicts. It is worth noting that investment behaviour. Chinese One set of risks stems from the Chinese enterprises investing companies planning to “go global” complicated political situation overseas have yet to devise a by undertaking One Belt, One Road prevailing across large stretches of comprehensive security strategy projects need to up their game when overland and maritime covered by for dealing with such risks. They it comes to corporate governance One Belt, One Road. Myanmar is a currently rely mainly on Chinese and investment decision-making. case in point. Chinese investment in consular and diplomatic protection, the country fell from $407 million which are certainly inadequate in the 2012 fiscal year to just $46 safeguards against major threats COUNTERMEASURES million in the 2013 fiscal year, a drop such as terrorism and ethnic and of nearly 90 percent. This plunge sectarian religious violence. OUTSOURCING EXPERTS TO was caused by rising anti-Chinese CONDUCT RISK ANALYSIS For its part, China has repeatedly sentiment and opposition to key stated that One Belt, One Road is for projects in Myanmar, notably the Chinese enterprises need to be promoting economic and cultural $3.6 billion Myitsone dam in the business-like and realistic in exchange, as opposed to being a northern part of the country. factoring potential risks into the cost Trojan horse for extending Chinese of investment projects. They need Big power rivalry in ASEAN geopolitical influence. But China still to make the best use of top-flight countries, South Asia and Central seems to have problems establishing foreign risk analysis firms, while the credibility of this message. Asia may also threaten Chinese also employing the expertise of investment activities in these areas. ECONOMIC RISK leading Chinese think tanks doing China and Japan are competing to risk analysis, such as the Chinese raise their influence in South Asian Chinese enterprises with Academy of Social Sciences. countries. At the beginning of 2016, investments in One Belt, One Road Japan secured Dhaka’s approval to countries face economic risks. LET THINK TANKS PLAY A BIG begin building an 60-foot–deep port One major risk is the potential ROLE IN RISK MANAGEMENT in Matarbari, on the southeast coast of these countries defaulting on OF ONE BELT, ONE ROAD of Bangladesh. Meanwhile, China foreign lending and investment INITIATIVES and Bangladesh were continuing to projects. Many of the One Belt, negotiate approval for the Sonadia One Road countries, especially Think tanks, particularly those deep water port, which is located those in Central Asia, are among run independently, are in a better about 15 miles away from Matarbari. the poorest economies in the position to evaluate development world and have dysfunctional and risk. Firms investing in One Belt, Potential risks also exist in the corrupt governments. This lack of One Road should involve such One Belt, One Road Central creditworthiness makes them poor organisations in planning for Asian countries. Conflicts exist bets for investment on the part of such projects and attempting between Kyrgyzstan, Tajikistan China’s government and Chinese to balance the interests of the and Uzbekistan. For example, financial institutions and businesses. stakeholders involved in them. Uzbekistan strongly opposes Setting a network of cooperative China’s hydropower project in, Another source of risk lies within the One Belt, One Road zone think as the proposed dam is located the Chinese companies themselves tanks should promote in-depth upstream on the Amu Darya River doing business in One Belt, One and comprehensive discussion of in Tajikistan. This investment Road countries. A great deal the problems and concerns of the could therefore adversely affect remains to be done with respect to relevant parties.

26 oliverwyman.com BRINK Compendium SET UP A SECURITY RECRUITING AND MECHANISM TO ADDRESS NURTURING TALENT WITH SECURITY CONCERNS AN INTERNATIONAL MINDSET

In the short term, Chinese To better understand conditions companies ought to beef up their in diverse and complex foreign internal security by making use of environments, Chinese companies good private security contractors. investing in One Belt, One Road must In the long term, however, they need effectively integrate knowledgeable to establish trust and build durable foreign talent into the management partnerships with local stakeholders of overseas investment operations. in the One Belt, One Road countries targeted for investment. Equally important, two-way educational and cultural exchange ATTACH MORE IMPORTANCE between Chinese and local people TO CORPORATE SOCIAL in One Belt, One Road areas should RESPONSIBILITY be promoted. This can play a crucial role in promoting cross-cultural awareness between China and Chinese companies investing abroad One Belt, One Road countries. should be more concerned about To this end, a One Belt, One Road corporate social responsibility, scholarship fund ought to be which can be a key element in established to enable students from enhancing China’s “soft power” in these countries to study in China, the One Belt, One Road area. Firms and likewise, Chinese to live and should pay especially close attention learn about places like Kazakhstan, to their treatment of local workers which have very different and and the environmental impact of unique cultures and social norms. investment projects (both issues in Myanmar). Effective corporate social This article appeared on BRINK on responsibility can go a long way in April 28, 2016. reducing the internal security risks faced by firms seeking to invest in One Belt, One Road countries.

CAPACITY BUILDING IN NURTURING PARTNERSHIP WITH NGOS AND THE CIVIL SOCIETY

Chinese enterprises with outbound investments need to pay more attention to local nongovernmental organisations and work with civil society actors in One Belt, One Road countries. One road countries where NGOs are very active are becoming important spokesmen for civil society. While doing projects, NGOs should be invited to express their concerns and interests.

27 oliverwyman.com BRINK Compendium HOW SHOULD BUSINESS REACT TO CHINA’S WATER CRISIS

Cate Lamb Head of Water at CDP

targets. The Plan acknowledges the relatively poor quality of China’s water resources and the severe over- extraction of groundwater in some regions, setting the stage for more stringent regulation, enforced with strengthened environmental law.

China’s Hebei province, which surrounds the capital, Beijing, is an important case study for change. Located in the dry north of the country, Hebei is home to much of China’s heavy industry, steel in particular, but is also an important agricultural region. The competition for water among these water- intensive industries is strong – the region’s steel output is expected to be capped at 200 million tons per year, which would still require a Home to a fifth of the world’s decade however, it is clear that the dizzying 12 trillion gallons of water population, but only 7 percent of Chinese government is committed to produce. global freshwater supply, China is to tackling this urgent economic already at a disadvantage when it and environmental issue. All water Now Hebei has become the test bed comes to ensuring it has enough users in the country, businesses in for the country’s first ever tax on water to secure its future growth particular, will have to help deliver water, with a pilot introduced this and prosperity. on these goals. But have companies July. The extraction of surface and truly understood the risks, and just groundwater will now be taxable, Yet the price of water in China is as importantly, opportunities, that with the aim of encouraging industry much lower than the rest of the this new regulatory era will bring? to focus on resource conservation world – less than 50 cents per cubic and ways to drive forward metre compared to over $2 globally. sustainable growth. And demand is only set to grow: THE REGULATORY SHIFT by 2030 it is expected to outstrip The consequences for not falling in supply, resulting in economic losses This year, World Economic Forum line are also getting tougher. of $35 billion a year. experts ranked the water crisis as the top long-term threat facing China’s revised environmental This is not only a worry for China, humanity. However, dealing with protection laws have an increased but for the rest of the world. Given such a complex long-term threat focus on strict compliance our global reliance on Chinese requires swift action now. and imposing punishments on industry, the impacts of China’s environmental violators. water challenge have the ability to Regulators in China have echo through supply chains across understood the need for such This is not to be taken lightly. the world. urgency. China’s 13th Five-Year In January this year China’s top Plan places significant emphasis on court upheld the original ruling of With almost $1.5 trillion in water tackling water issues, second only to an environmental public interest investments set aside over the next achieving the country’s energy case, ordering six companies

28 oliverwyman.com BRINK Compendium to pay more than $26 million in landscape. This is especially the case Companies are starting to view compensation for discharging when compared to multinational effective regulation and sound waste acids into two rivers in 2012, firms with operations in China. water governance as fundamental to the largest environmental penalty enabling vibrant business growth; Just over a third of Chinese imposed to date. 74 percent of the companies in our firms report conducting basic analysis report that water action This year, World Economic Forum measurements of their water offers operational, strategic, or experts ranked the water crisis as usage compared to 82 percent of the top long-term threat facing multinationals. As the adage goes, market opportunities. humanity. you can’t manage what you don’t The Brazilian mining firm, Vale, measure, and adapting to regulation means companies will need to look for example, has implemented a WHERE BUSINESS at the basics of their water use. It number of water efficiency projects COMES IN is a similar story when it comes to throughout its global operations, undertaking water risk assessments, including China, with estimated Is the message getting through to with just 41 percent of Chinese firms financial savings of $76 million. industry? Perhaps. Speaking with undertaking one compared to nearly Examples include the installation a state news agency, Xinhua, one nine in 10 of their multinational of leak monitoring equipment and glass-factory manager in Hebei peers. automated water metres leading to described how environmental a reduction in total water demand. The increasing cost of water means inspections used to be like a slap companies will have to rapidly in the face, but now were more Companies, such as Vale, that are rethink how they factor water into “like having a knife to the neck.” actively pursuing improved water their business strategy. Companies use monitoring and efficiency may are already seeing an impact: The real test of course is not be well-placed to operate in a water- Volkswagen, Sekisui Chemical Co., how sharp business believes the constrained environment under Ltd. and Mars all report higher regulatory impacts will be, but what regional and sectoral water caps. the regulations are doing to improve water prices, resulting in potential water management practices impacts such as higher operating This story ultimately boils down costs or a reduction in revenue. and innovate in the face of such to the winners and the losers. Mars’ operations in China have challenges. China’s new approach to water experienced increasing water indicates that the era of cheap, Each year, companies are asked by costs since 2009, in line with the unregulated water is coming to their supply chain customers and government objective to limit an end. It is now up to business to investors to detail their approach water usage. decide how to succeed by pursuing to managing both water risks and opportunities through CDP, the a path of innovation and growth global environmental disclosure WHERE THERE IS RISK, that respects these environmental platform. THERE IS REWARD boundaries. The business case for building a water-secure future Based on responses from over While changing regulatory has never been stronger. 120 companies in China to CDP landscapes may place restrictions in 2015, it is clear that Chinese on businesses unprepared or unable This article first appeared in Agenda firms appear at risk of being caught to adapt, it is not always viewed blog of the World Economic Forum out by the changing regulatory this way by the private sector. and BRINK on September 11, 2016.

29 oliverwyman.com BRINK Compendium CHINA’S AGING POPULATION: MORE THAN FIFTY SHADES OF GREY

Jacques Penhirin Partner at Oliver Wyman, China

James Yang Engagement Manager at Oliver Wyman

improvement in quality of life. Infant mortality has been on the decline since 1950, and life expectancy has risen to 76 years, its highest level. However, this formerly young and vibrant economy is now aging quickly. China is struggling to keep pace with these changes, which are characterised by:

ȫȫA declining working population, as baby boomers hit retirement age and the historic effects of the “one-child policy” kick in

ȫȫA public social security system under strain as it pays retirement benefits for the elderly

ȫȫA rising population of the “empty- nested elderly” – those living alone The rise of the elderly population in burdens on their family; and their without the support of their child, China has been anticipated for many eagerness to enjoy new experiences who is likely to have moved to a years, but the question of how best to – will stand to benefit. city to seek better employment serve this market’s complex needs is opportunities still being deliberated. One thing is certain: Companies that do not plan FROM GOLD TO GREY well for the surge in demand from NO MORE the old will miss out on a growing China’s rapid economic growth REPLACEMENTS – opportunity. has been driven by a large and productive labour force. The FOR NOW? China’s elderly population will baby boomers of the fifties and almost double to 455 million by sixties began to prosper in 1979, China is now at a critical junction. 2030, and the consumption of under Deng Xiaoping’s “reform The baby boomers are at retirement products and services by the elderly and opening” policy. These age and exiting the workforce, while is predicted to reach $150 billion by demographic groups spent their the one-child policy has stifled 2050. Its aging population is both most productive years working in the country’s ability to replace the a challenge and an opportunity for factories and building businesses. labour required to staff “the factory businesses. The Chinese economy experienced of the world.” an unprecedented 30-year period Companies that are able to respond of GDP growth, which many simply There are currently approximately to three areas of potential growth – describe as the “China Miracle.” 3.4 working adults in China for the desire of the elderly population every elderly person aged 60 and to protect their health and financial The concurrent explosion of above. By 2030, this dependency well-being; their wish to reduce the wealth in China has led to rapid ratio will decrease to 1.5, meaning

30 oliverwyman.com BRINK Compendium that the burden of the elderly on GREY IS GOOD averse to entertainment and new the working population will be experiences. One of the most popular more than double. The “golden Many believe that the rapid pace of smartphones sold online in China, child” family model, where one societal aging could spell doom for for example, is specifically targeted child received the undivided China. However, it could present at the elderly. Similarly, travel tours attention of six adults (parents and companies with opportunities, designed exclusively for seniors two sets of grandparents), is about provided they plan accordingly. – with activities focused on them to undergo a dramatic U-turn. According to the China Research – are also increasingly common. Centre on Aging, the consumption of The government is cognizant of products and services for the elderly I WANT TO STAY AT HOME this and has attempted to rectify the is already worth more than $6 billion In the grey market, homecare situation by ending the one-child in China. A few areas of opportunity services will be among the most policy in October 2015. However, are as follows: promising areas of opportunity for many experts believe its impact business. Homecare is expected on demographics will not be very KEEP ME HEALTHY to remain the dominant eldercare significant in the short term, given As more emphasis is placed on model in China, and this opens an the high costs of raising child in quality of life for the elderly, there is array of opportunities ranging from China today. increasing demand for products and the provision of light services such as services that promise greater well- housekeeping and meal delivery on SOCIAL SECURITY being. Proper long-term elderly care the one hand to high-tech services is in severe short supply in China. such as remote medical treatment on SYSTEM UNDER STRAIN For example, it is estimated that the other. there are just over seven million beds Although efforts have been made available for elderly care in China, in recent years to reform the social enough for only 3 percent of the MORE THAN FIFTY security system, it remains heavily total aging population (and far below SHADES OF GREY underfunded. Total public pension western standards of 5-7 percent). funds accounted for only 5.9 percent The elderly rich in urban China of GDP in 2015 – far lower than in DON’T WORRY ABOUT ME have gone to considerable lengths to many other economies. ensure that the latter stages of their China’s elderly are very keen to lives will be comfortable, but what China’s retirement age is expected generate financial security for works for them is vastly different to to be postponed for the first time themselves and future generations. what the elderly in rural China want since the 1950s. In March 2015, the This ambition is yet to be fulfilled. to prioritise. Therefore, a scattergun Ministry of Human Resources and The lack of financial options for approach is outdated, and business Social Security announced that the these individuals and upcoming strategies need to be sophisticated, retirement age for both urban males retirees has resulted in a portfolio specific and targeted. and females will be gradually pushed largely consisting of real estate Retirees over the next 10 years will back to 65, starting as early as 2017. and cash, which does not cater to their needs. Insurance products also think and act very differently Although no formal announcements for long-term savings and care will from their predecessors. The rapid have been made, it is widely believed become highly sought after as the economic growth in China has produced a broad range of people that health insurance coverage is also elderly seek low-risk investments with very diverse experiences and due for a decrease, covering a lower that complement their pension plans mind-sets, and this needs to be taken percentage of payments and thereby and offer reassurance that medical into account in formulating any relieving the strain on China’s social and additional care costs will be strategy. security system. affordable as they grow older. What remains to be seen is whether While these demographic shifts I WANT TO EXPERIENCE businesses pay heed and acknowledge present significant policy challenges, NEW THINGS that the answers aren’t in black or opportunities exist for businesses to white, but in several shades of grey. exploit the gaps in the provision of If their personal health and services by the public social security financial well-being are taken care This article appeared on BRINK on system. of, the elderly are certainly not September 7, 2016.

31 oliverwyman.com BRINK Compendium BEHIND CHINA’S ATTEMPT TO SPREAD THE RISKS FROM ITS DEBT-FINANCED GROWTH

Prasenjit K. Basu Founder at REAL-Economics.com

to somehow hold the fragile edifice together and prevent industrial prices from collapsing.

China’s trade surplus has burgeoned over the past two years, aggregating $1.15 trillion over that period. But its foreign reserves have declined by $800 billion, implying that services/ income and capital outflows have soared to $1.95 trillion over the last two years. China’s citizens are taking large proportions of the new money being printed in China and investing it in overseas assets.

The bulk of these overseas investments have gone toward the purchase of real-estate, with favoured destinations being London, New York, San Francisco, Sydney, Capital outflows from China are an Given that China’s economy is Melbourne and their suburbs. inevitable feature of the excesses about half the size, its economic Singapore and Hong Kong’s property that have afflicted its economy over imbalances have been greatly markets were early recipients. the past two decades, and while exacerbated by this extraordinary Anecdotal stories abound of busloads nations do potentially benefit surge in money and credit. of Chinese buyers descending on economically from the infusion of a property and offering to pay the China’s capital inflows, recipient full price in cash – overwhelming countries are legitimately wary of SWELLING local buyers, who meticulously the threats to their sovereignty and OVERCAPACITY evaluate a property keeping in mind security from Chinese ownership of their banks’ willingness to grant a key assets. While all that money and credit mortgage loan. has helped to rapidly build out In the eight years since August China’s infrastructure in support For property owners across the 2008 (i.e. just before the start of the of its expanding industrial base, world, the arrival of the cash-rich global financial crisis), China has capacity-expansion far outpaced Chinese buyer is a boon. But, by had the largest monetary expansion any external or domestic demand buoying property prices, they also in human history. Its M2 money for that capacity. China now faces an contribute to income inequality, supply has grown from $6.5 trillion unprecedented mountain of over- placing more properties outside in August 2008 to over $22.3 trillion capacity in most capital-intensive the reach of most locals. The now. The stock of US M2 is industries (steel, petrochemicals, phenomenon of Londoners moving $12.8 trillion, and has increased by other metals, semiconductors) and to the suburbs as the centre of a relatively mild $5.05 trillion in in property. In the past three years, their city becomes unaffordable is the past eight years, compared with China has sought to pump ever more a pattern occurring in more cities China’s $15.8 trillion increase. credit into the economy, in order around the world, with the likes

32 oliverwyman.com BRINK Compendium of Kuala Lumpur, Bangkok and had gone out of its way to court China’s insurance regulator opposed even Iskandar feeling the impact China – snubbing its US alliance the deal, although other security of mainland Chinese buyers. in order to become a founding concerns were just below the surface. member of the China-controlled Asian Infrastructure Investment ONE BELT, ONE ROAD, Bank (AIIB) – Cameron’s successor THE GLOBALISATION MANY OBJECTIVES decided that the security issues OF RISK needed to be thoroughly understood. The most benign form of Chinese The Chinese Communist Party still investment overseas is the has the final say in all state-owned government’s “One Belt, One THE SEARCH enterprises, and it influences Road” initiative to use surplus FOR GROWTH decisions at most nominally-private Chinese capital to invest in Chinese companies. Consequently, infrastructure across Asia, Africa This year has also seen a rash of the recipients of unsolicited bids by and around the world. Indonesia’s hostile takeover attempts by Chinese Chinese companies are naturally high-speed rail project, which groups of choice businesses in the suspicious about Chinese intentions connects Jakarta to the hill town US and Europe. In the first half of – and governments, too, will continue of Bandung, 140 kilometres 2016, there were at least 13 such bids to examine such bids; both from the away, was controversially won totalling $78 billion in value. standpoint of competition policy and by China (despite Japan having internal security. China’s Midea group, a consumer- done the feasibility study for a appliance manufacturer, made a With China’s financial system poised project extending all the way $5 billion bid for Kuka AG, a German on the precipice of a crisis of bad south to Surabaya) after China robotics company, which prompted debt arising from its glut of real offered an interest-free loan. Germany’s economy minister to estate and industrial capacity, the contemplate an alternative German Similarly, China has offered a greatest danger is that China could offer for Kuka, given the company’s massive $40 billion in credit to globalise its internal imbalances crucial role in the country’s Pakistan to build highways and by connecting its financial system automotive sector. other infrastructure across the more symbiotically with the rest of the world. That is a danger that the Himalayas in disputed territory And Anbang Insurance made a occupied by China and Pakistan major central banks and regulatory celebrated offer to acquire Starwood authorities have done well to avert – aimed at connecting Xinjiang (the hotel company that owns the thus far. (formerly East Turkestan) to the Sheraton, Westin, Le Meridien and port of Gwadar in Baluchistan. other brands) for $14 billion, topping The source for all national-level data Separately, a Chinese-led consortium the offer from rival group Marriott. is CEIC, with aggregations done by won the right to build the Hinkley This triggered interest, partly the author from CEIC’s monthly data nuclear power plant in the UK, but because Anbang’s chief executive (which is derived from the national the new government of Theresa was married to the granddaughter of statistics agencies). May immediately ordered a rethink Deng Xiaoping, the father of China’s of the project on security grounds. modern economic success. The offer This article appeared on BRINK on While the Cameron government eventually fell through because September 6, 2016.

33 oliverwyman.com BRINK Compendium CHINA CONTINUES TO BATTLE MASSIVE CAPITAL FLIGHT PROBLEM

Alicia García-Herrero Senior Fellow for BRUEGEL and Chief Economist for Asia Pacific at Natixis

of Chinese companies, as well as the loans of Chinese banks abroad (increasingly in the emerging world).

Looking into the details, currency and deposits were the bulk of the outflows (other investment) in 2015, while repayment of bank loans – as well as Chinese banks’ loans to overseas companies – have become more important during the first quarter of 2016. Portfolio investment has turned negative for both residents and nonresidents. Finally, for the first time since China’s open door policy, the first quarter of 2016, the direct investment of Chinese companies abroad surpassed foreigners’ direct investment in China.

Last summer, China’s stock market Portfolio flows (equity and bond) collapse and unexpected devaluation were also negative, but smaller. A PEEK BEHIND deepened its capital outflow problem The situation has hardly improved and accelerated the fall of reserves, in 2016, based on first quarter data. THE CURTAIN: THE which had started in mid-2014. In fact, all types of capital recorded MAGIC OF FOREIGN Since February, reserves have started outflows, even net foreign direct RESERVES STABILITY to stabilise. While the situation is investment (FDI), which was not clearly better, China continues to the case in 2015. Achieving stability of reserves struggle in terms of stabilising its requires a high degree of precision massive capital outflows. RESIDENTS DRIVING and tools. Beyond lifting the constraints on portfolio inflows – Within that context, foreign reserves THE OUTFLOWS which does not seem to have worked seem to have become a policy target. yet, as net portfolio outflows have Although capital outflows are still It’s important to note that Chinese been larger than ever in the first large, it’s not enough for reserves residents have been driving capital quarter of 2016 – outflows need to be to start falling again. In 2015, the outflows for years. The difference in managed more tightly. largest net outflows stemmed from 2015 is that non-residents stopped the repayment of bank loans (close investing in China and started to Beyond official controls on outflows, to $500 billion in “other investment” move their capital out. Still, the bulk there are at least four ways in outflows), followed by unrecorded of the outflow was made by residents. which capital outflows from China outflows of residents amounting to These are unrecorded outflows and may have been cushioned to avoid nearly $200 billion. also include the investment a loss of foreign reserves beyond

34 oliverwyman.com BRINK Compendium official balance of payment data. FIGURE 2 PRIVATE CAPITAL FLOW IN CHINA (US$BN) First, capital leaving China could be Sources: IIF, Natixis, NB Positive indicates inflow in yuan instead of foreign currencies, which would not affect the level 600 of foreign reserves. In fact, since October 2015, there has been a net 300 outflow of yuan from China. Given that the CNY-CNH interest rate spread is positive, arbitrage reasons 0 cannot explain such outflows. Further, these outflows are actually Total 300 pretty sizable (-$207 billion since Resident October last year). -600 Non-resident Second, it has often been argued that 2007 2008 2009 2010 2011 2012 2013 2014 2015 YEAR China’s capital outflows were mostly Note: Data includes bond, equity and lending. good rather than “bad cholesterol” (i.e. it was Chinese companies and banks repaying debt). While their first quarter of this year and, even surplus continues to cushion a exposure to foreign borrowing now, the net outflow – as recorded potential fall in reserves, but more has been reduced from the peak in seems to be happening for reserves 2015, the scale is not as massive as in the balance of payments – is to be stable. Looking deeper into generally perceived. China’s total moderate. This might sound strange the nature of outflows, one has debt in foreign currency amounted given the large M&A operations to conclude that the situation to $1.705 trillion in the second by Chinese companies announced since the beginning of 2016, but it is remains fragile. It is still residents quarter of 2016, a mere 15 percent driving the outflows and they do decrease since its peak in the not contradictory, as a good part of those deals may have been financed not seem to be a “good cholesterol” same quarter last year. Offshore type (i.e. repayment of debt or outside China (leveraged buyouts issuance of foreign currency bonds purchases of assets abroad). by Chinese companies has been financed in the offshore market). quite steady, while loans from Meanwhile, China hasn’t fully Finally, some of the businesses banks offshore have been reduced. resolved its balance-of-payments closer to the state, China Investment With regard to the offshore bond problem. The reserves are massive, market, Chinese companies have Corporation being the best example, but so are the “bad cholesterol” continued to issue quite massively, seems to have reduced the share of outflows. It is time to go to the doctor but the net issuance has come down foreign assets as opposed to domestic and increase the return on assets thanks to a wave of early redeemed assets, thereby reducing capital for capital to be willing to come bonds, most of which were issued outflows from its purchases. More back. Unfortunately, the Chinese by Chinese real estate developers. generally, M&A engagement is one authorities seem to be heading in the thing, but bringing foreign reserves opposite direction, with increasingly Third, it is generally argued that out of China is another. lower interest rates and a lack of real the spending abroad by Chinese reform for state-owned enterprises. companies is behind a good chunk Any way you do the math, capital of the capital outflows, but it’s not. outflows from China continue to This article appeared on BRINK on FDI net flows were positive until the be massive. A large current account September 23, 2016.

35 oliverwyman.com BRINK Compendium About Oliver Wyman Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 26 countries, Oliver Wyman combines deep industry knowledge with specialised expertise in strategy, operations, risk management, and organisation transformation. The firm’s 3,700 professionals help clients optimise their business, improve their operations and risk profile, and accelerate their organisational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With annual revenue of $13 billion and 57,000 colleagues worldwide, Marsh & McLennan Companies provides analysis, advice, and transactional capabilities to clients in more than 130 countries through: Marsh, a leader in insurance broking and risk management; Guy Carpenter, a leader in reinsurance and intermediary advisory services; and Mercer, a leader in talent, health, retirement, and investment consulting. For more information, visit www.oliverwyman.com. Follow Oliver Wyman on Twitter @OliverWyman or on LinkedIn.

About Asia Pacific Risk Center Marsh & McLennan Companies’ Asia Pacific Risk Center draws on the expertise of Marsh, Mercer, Guy Carpenter, and Oliver Wyman, along with top-tier research partners, to address the major threats facing industries, governments, and societies in the Asia Pacific region. We highlight critical risk issues, bring together leaders from different sectors to stimulate new thinking, and deliver actionable insights that help businesses and governments respond more nimbly to the challenges and opportunities of our time. Our regionally focused digital news hub, BRINK Asia, provides top executives and policy leaders up-to-the-minute insights, analysis, and informed perspectives on developing risk issues relevant to the Asian market.

36 oliverwyman.com BRINK Compendium Copyright © 2016 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.