The Deloitte Research Monthly Outlook and Perspectives

Economy

A rising RMB – future trend or flash in the pan?

The sharp appreciation of the RMB against the greenback in 2017 has once again raised the fundamental question of whether the RMB's ascent is simply a repeat of what happened between 2005 and 2015 (a prolonged bull-run of the RMB) or an aberration. Answering the question correctly becomes more urgent as the speed of appreciation picked up after the PBOC's introduction of a countercyclical factor in late May. The intention of such an act presumably is to adjust the calculation of the RMB's daily reference rate against the dollar. But in practical terms, what this has done is to give the PBOC more discretion in terms of intervention. The PBOC's preferences were clear - to reduce people's expectation of the RMB's depreciation and hence to stop capital outflows. As a result, from late August 2017, the RMB staged a ten consecutive day rally against the dollar, posting a 16-month high of 6.47 against the dollar on Sept 10 (until the PBOC's announcement of eliminating the reserve requirement rate on foreign exchange risk on Sept 11). The latter was in all probability a hint that the PBOC was going to halt further increase of the RMB. As expected, the dollar has recovered some lost ground because this reserve requirement had made dollar buying more expensive with 20% of non-interest-bearing deposits.

If the RMB's dramatic turnaround is sustainable, should China relax capital controls too? If not, what would be the optimal way of engineering future RMB revaluations without perturbing the market as in the summer of 2015? In order to answer this question, it is important to first examine the factors that have contributed to the weakness of the dollar this year and at the same time to evaluate the prospects of China's balance of payments and policy bias.        

To start with, the trend of the weak dollar is not likely to come to an end yet. The reality is that the much reduced likelihood of campaign promises by President Trump on tax cuts and infrastructure spending being met means that the Fed's accommodative policy might last longer than previously expected, which means that the dollar will probably remain bearish in the short run. The bigger issue is that the synchronized economic recovery of developed countries (both the Eurozone and Japan have done far better than most have expected) and absence of black swan events in Europe (elections specifically) have resulted in a stable Yen and a surging euro. Rebounding commodity prices, largely due to the stable Chinese economy, have bolstered the Australian dollar, the Canadian dollar and other “so-called” commodity currencies. In a nutshell, robust global economic recovery, a relatively benign inflationary outlook for major economies and a weak dollar together make for an environment that is more than conducive for risk-taking. However, forex market tends to look a long way ahead and so, it is probably safe to assume that further strengthening of most major currencies (except the British pound) against the greenback is unlikely. For example, a stronger euro could jeopardize the fragile recovery of certain key euro zone economies (e.g., Italy). The Japanese Yen is expected to strengthen on Bank of Japan’s likely move of shrinking its balance sheet. The weakness of the dollar could allow some central banks (e.g., European Central Bank and Reserve Bank of Australia) to not increase interest rates at least in the initial phase of the Fed's tightening cycle by allowing their currencies to fall. In fact, policymakers in most of these developed countries (against, except the UK) would love to see their currencies weaken.  So interest rate differentials are likely to favor the dollar in 2018.

In China, the ongoing debate on when to cut the reserve requirement rate means that the PBOC will prefer to maintain a relatively loose hold on monetary policy. Meanwhile, the overarching objective of reducing leverage is making any hike of short term interest rates less feasible in the foreseeable future. So, unlike the period of 2005 to 2015 when interest rate differentials between China and the US were widening in favor of the former and at the same time, RMB denominated assets were cheap, today fundamentals (current account surplus aside) no longer justify a stronger RMB.

Moreover, geopolitical flash-points may significantly enhance the dollar's status as a safe-haven currency. Take, for example, North Korea. Even though so far financial markets have taken the almost cynical view that Pyongyang's nuclear provocations will eventually force major powers (the US, China, and Russia) to accept it as another quasi-nuclear country (e.g., Pakistan), what if North Korea crosses the red line drawn by the US? Will further sanctions provoke more rash acts? Will China exert more pressure on North Korea after Trump's visit to Beijing in November? What if Pyongyang continues to exploit differences among major powers? Any permutation of the above scenarios will prompt investors to flock to buy dollar-denominated assets.                 

Trump's upcoming visit to China will very likely bring the issue of bilateral trade deficit reduction, the goal which was set during the Xi-Trump meeting at Mar-a-Lago in April of 2017, to the forefront. As we have repeatedly argued in this column, the RMB exchange rate is a minor issue compared to the much thornier one of market access as China's vast domestic market is something that companies across the globe want to access. But this time the US is likely to push China not to devalue the RMB regardless of the outcome of negotiations on market access. The fact remains that for the 2nd largest economy in the world with a current account surplus (we forecast about $20 billion of current account surplus a month in 2018) and aspirations of becoming a global leader, it is difficult to justify a RMB devaluation. However, it helps to bear in mind that in the past, countries which run current account surpluses have undergone sharp devaluations, Japan, the 2nd largest economy during much of the post-war era, being a case in point. Of course, under a relatively flexible exchange rate regime, countries who are running current account surplus are supposed to run capital account deficits. So the crux of the issue for China is to what extent a capital account deficit would offset a current account surplus in the medium term.

Over the past 3 quarters, the PBOC has come up with several measures which are aimed at curtailing capital outflows. First, firms are under much closer scrutiny of their invoicing as in international trade, over-invoicing imports and under-invoicing exports is an old trick that firms have used to hoard hard currency. Second, the Government has prohibited firms from investing in foreign hotels, sports clubs, and cinema operations, the logic of such a measure being to prevent firms from drastically increasing their leverage and thus destabilize the domestic financial system. Third, on purchases of foreign currencies by residents, approvals will be limited to purposes such as travel and education (overseas securities and real estate are not allowed).

Chart: Japan – a perennial c/a surplus country devalues the Yen from time to time

Let's assume that the RMB exchange rate will stabilize around the current level of 6.5 with minimum intervention. It would then be sensible for policymakers to remove some of the restrictions on capital outflows. More specifically, firms could be given more leeway in retaining their foreign exchange proceeds outside the country. Procedures for residents' foreign exchange purchases could be streamlined on the ground that some restrictions were only meant to be temporary anyway. What is needed is to avoid a one-way appreciation trap. If the RMB exchange rate holds up, China could even ease capital restrictions by allowing residents to buy foreign securities and properties. If foreign reserves start to fall as they did in 2016, China could slow the pace of capital account liberalization.

In conclusion, 2018 and beyond is fundamentally different from the period of 2005-2015 in the sense that interest rate differentials, Chinese residents' need to diversify their assets, geopolitical risks and possible backlashes against globalization all favor a stronger dollar in the medium term. In the short run, the policy bias towards stability calls for a stable or even stronger RMB. As confidence returns however, reason should replace emotion in the forex market. Going forward, in our view, the countercyclical factor could be used by the PBOC to guide the RMB to appreciate less vis-a-vis the basket when the dollar is appreciating and depreciate more when the dollar is depreciating. Yet, let us not forget that for a large creditor country who faces challenges of deleveraging, a minor depreciation serves the economy well.

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Retail

Three keys to transform ailing supermarkets

By late August, thirteen listed supermarket corporations had filed their mid-year earnings reports. With the exception of two, all reported profits when compared with the same period last year. Of these, Zhongbai Holdings Group, Beijing Hualian Hypermarket and C.P. Lotus Corporation turned losses into profits.

Source: Wind, Deloitte Research

Although most corporations are now operating in the black, this does not mean that the tough times are over. There are three reasons why:

• Profit growth at some corporations did not come from their core businesses. This phenomenon is especially obvious among those corporations which turned losses into profit. Zhongbai Holdings Group had a large gain from asset securitization while Beijing Hualian Hypermarket sold its subsidiary, which is what contributed to the substantial improvement in its profit. As for Sun Art Retail Group Limited which has the largest revenue among the 13 corporations, much of it came from unused prepaid cards (RMB 345 million after tax). Thus, in reality, the increase in profit was much less as overall, net profit increased RMB437 million only).
• Financial performance of these companies is polarizing. Four supermarkets experienced negative profit growth, among which Lianhua Supermarket Holdings and Renrenle Commercial Group turned profit into losses. What's more, Renrenle Commercial Group projected that its net losses would expand in the third quarter.
• Sluggish revenue growth. Supermarket corporations are still under assault from online retailers as is evidenced by their sluggish revenue growth. Six corporations experienced revenue decline, among which Sanjiang Shopping Club, Renrenle Commercial Group experienced double-digit revenue decline. Only Yonghui Superstores and Chengdu Hongqi Chain achieved double-digit revenue growth while at the same time online retail sales ratcheted up more than 20% growth. Slow growth indicates that the industry is still undergoing a difficult transition and competition from online retailers makes revenue growth slow. 

On the other hand, every cloud has a silver lining. Mid-year reports show that corporations like Yonghui Superstores continue to expand rapidly. Better Life Commercial Chain Share and Beijing Jingkelong Company also achieved both revenue and profit growth through a series of initiatives. In the face of the aforementioned challenges, these companies' actions present valuable lessons for other supermarket corporations to follow in their endeavour to transform their businesses. Three key measures are as follows. 

• Integration of supply chain resources. Capacity to integrate the supply chain determines the ability to control the source and cost of goods. Yonghui Superstores is focusing on the development of its global supply chain system which will enable them to secure more high quality goods globally and hence move upstream to become the supplier of and platform for fresh food. Diversified development will no doubt enhance Yonghui's growth potential.
• Digital transformation. Digitalization lays the foundation for consumer relationship management, operation efficiency and resource integration. The continuous improvement of digitalization enabled Yonghui to expand its global supply chain network and helped Beijing Jingkelong to optimize its operation process in delivery, pricing, positioning.
• Innovative formats and optimized categories. Store optimization and format innovation are useful tools which are widely employed to generate returns and boost consumer satisfaction. Yonghui now has 5 different major formats which include red label stores, green label stores, Yonghui Select, membership stores and Super Species. In the first half of 2017, Yonghui opened 64 new stores while upgrading some red label stores to green label. Among the 64 new stores, 29 are innovative format stores like Yonghui Select, Super Species and Membership based stores. Category optimization is another source of profit growth. Beijing Jingkelong improved its gross profit margin by centralizing its purchasing, exclusive right of sales and customized commodity development.

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Technology & Media

The power of the "Anime Economy"

On June 22, 2017, the State Administration of Press Publication, Radio, Film and Television of China temporarily shut down video streaming services at major websites such as "Weibo", "AcFun" and "iFeng" as part of its `further standardization of online video programs’- or in other words, tightening control over and supervision of video streaming channels. The move was widely discussed across the Internet and propelled AcFun, a niche site of anime videos, into the mainstream for the first time. AcFun is regarded as the cradle of the Chinese "Anime Culture". Anime culture is perhaps best understood by its acronym ACGN, which collectively stands for Animation, Comic, Game and Novel. Like in many parts of the world, ACGN is an essential part of Chinese youth culture today.

In the US and Japan, "Anime" is far from being a niche. Marvel Comics has already become a signature product of American culture, the source of producing best-selling movies and TV series. In Japan, often regarded as the "Anime Kingdom", literally everything has links with "Anime". For example, KUMANON, the anime representative of KUMANON Town in Kyushu Island, enjoys great global popularity and supports the town’s tourism industry. In China too, an "Anime Economy" is finally emerging: 《Arena of Valor》, an online battle mobile game produced by Tencent, has become the most profitable mobile game in the world. In the first season of 2017, some 50 million daily active users generated RMB 6 billion in revenue for Tencent. The "Anime Economy" is not limited to the domain of mobile games as it in fact has emerged as a new element in the entertainment and consumer markets. 《Monkey King: Hero Is Back》and 《Big Fish & Begonia》, the two blockbuster domestic animation films, both play important roles in the entire "Anime Economy" system.

Transformation of consumers in entertainment market

Three factors gave rise to the rapid adoption of the "Anime Culture". First, in the era of explosive information, consumers can easily access anime content as communication between users and content creators is becoming ever more convenient and transparent. There are more "Anime users" in China's east coast thanks to a higher Internet penetration rate in such provinces as Guangdong, Jiangsu and Zhejiang.  Second, the post-1995 segment of the population has gradually become the main force in content consumption many of whom enjoy the thrill fantasy and virtual reality provide. The number of both core and casual "Anime users" who have higher user stickiness and willingness to consume is estimated at 350 million. Moreover, the Chinese government in its bid to increase soft power have launched a series of policies in support of domestic comics. As a result, the number of domestic anime has increased significantly.

Capital investment provides a necessary boost

Preliminary statistics show that 34 anime-related financing and investment transactions took place in the first half of 2017, hitting the RMB 1 billion mark. "Anime" has become one of the hottest industries for venture capital. Furthermore, recognizing the explosive potential of this industry, BAT (Baidu, Alibaba, Tencent) are tripping over one another to get involved in incubating boutique comics intellectual property (IP). Tencent has the biggest advantage as its user base is already highly interlaced with "Anime Users". This makes it very easy for Tencent to extend its core business to reach a much wider spectrum of the entertainment market. Baidu’s anime business plan, on the other hand, relies on its 'Tieba' message board and mainstream video website IQIYI. Baidu 'Tieba' has a whopping 300 million monthly active users, 70% of whom were born after the 1990. Through its investment in AcFun and Bilibili, Alibaba indirectly develops original animations via its subsidiary of Youku Tudou, which aimed at transferring original IPs into animation products that can be accepted widely by users.

Advertisers join the fray

Because "Anime" captures the attention of the younger generation advertisers are beginning to pay close attention. For instance, almost 100,000 people attended a B World+BML (offline live concert of Bilibili, a niche anime video site) while 340,000 visited the 4-day long China Joy Game Show. These events attracted the attention of many brands and advertisers as they have come to realize that traditional media is no longer the best approach to attract young consumers. On the other hand, cultural experience and content are the keys to connect with them. In the future, among these 300 million plus "Anime Users" are the potential customers for motor vehicles, bank/credit cards and commercial loans. Hence, how to incorporate "anime culture" into branding with subdivision streaming has become a major concern for traditional brands.

Commercialization of "Anime" is the biggest challenge

The core attraction of "Anime Culture" lies in developing animations and comics IP (Intellectual Property) into mainstream entertainment channels, thus harnessing the power of the entire industry and extending the ecosystem to include games, films, televisions series, novels and other derivatives. To develop a successful "Anime Economy", attention should focus not only on original animation IPs, but also on the commercialization of animation content. For now, merchandising and games are the easiest ways for the Chinese "Anime Industry" to monetize. The real issue is how to connect what is a niche market phenomenon to the global industry ecosystem, or, in other words, how to commercialize animation content. For this, there are basically two things to consider:

1. Improve content quality and product functions, while developing IP derivatives. Irrespective of IP derivatives production or theme shops and comics shows, high quality content is always the driving force in business development for downstream companies and the foundation of IP commercialization. Excellent content production by upstream companies will capture the attention of online platforms, which will further increase IP market value during the commercialization phase.
2. Downstream companies should get involved from the start, bringing to the table their knowledge of user preferences. This will help in the monetization of IP. Downstream companies which are intimately familiar with commercialization channels and user preferences should get involved in upstream activities right from the animation creation phase, which enables IPs created with commercial elements. Take Japan for example, advertising companies, music companies, television stations and toy manufacturers can all be members of the content production committee for the simple reason that they can turn user preference into IP content and users are willing to pay for the content if it is close to what they desire. 

In the foreseeable future, it is expected that "Anime Culture" will become an important part of economic development. Domestic animation IP derivatives and licensing is set to become the major business model for this industry. As consumers become more aware of and willing to pay for copyrighted domestic "Anime", this industry could generate as much as RMB100 billion in value. As the younger generation grows, Anime content will gradually become an indispensable element of contemporary cultural life. 

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