Nomura Special Report - When China Sneezes

ANCHOR REPORT
GLOBAL MARKETS RESEARCH July 2013
If China sneezes
The global implications of sub-6% growth in China We construct a summary scorecard of indicators to gauge the relative exposure of 26 countries to China, through the export, commodity price and financial markets channels. Our economists estimate the global impact of Chinas GDP growth slipping to 1pp below our baseline forecast of 6.9% in 2014 a scenario to which we attach a non-trivial 10-20% likelihood. The hardest hit economies are in Asia; the impact is also large on Australia and Latam. Germany is one of the more exposed in Europe. The US is among the least exposed. Global equities would unavoidably be set back by a China demand shock, but the biggest risks may not be in AsiaPacific (or even China) stocks, but in resources-rich Latam, EEMEA and (somewhat surprisingly) the UK. Japan stocks would offer comparative safety. We would expect China to hold the USD/CNY fix stable; AUD, CAD, BRL and KRW to suffer among the most; and MXN and PHP to be relative outperformers.
x We would expect the China swap curve to invert and the UST
23 July 2013 Principal Authors Economists Rob Subbaraman rob.subbaraman@nomura.com +852 2536 7435 Zhiwei Zhang Zhiwei.zhang@nomura.com +852 2536 7435 Equity strategist Michael Kurtz - NIHK michael.kurtz@nomura.com +852 2252 2182 Fixed Income strategist Craig Chan craig.chan@nomura.com +65 6433 6106
curve to steepen. We would also expect AUD and EUR frontend rates to benefit and rates in Asia to broadly feel pressured lower.
See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.
document is being provided for the exclusive use of SIVASWAMI ASARY at BANK NEGARA MALAYSIA
Nomura | Anchor Report
23 July 2013
Table of contents
1. Executive summary ................................................................................................. 3 2. China's downside risk scenario ............................................................................. 6 Chinas import elasticity .......................................................................................... 7 Fixed income strategy ............................................................................................ 8 3. Gauging Chinas relative economic impact a scorecard approach ................ 9 Export channel ........................................................................................................... 9 Commodity channel ................................................................................................. 12 Financial channel ..................................................................................................... 13 Nomuras scorecard of Chinas relative economic impact ....................................... 15 4. Global equity strategy ........................................................................................... 17 5. Country views on the downside risk scenario ................................................... 23 Japan ....................................................................................................................... 23 Economics ............................................................................................................ 23 Equity strategy ...................................................................................................... 24 South Korea ............................................................................................................ 25 Economics ............................................................................................................ 25 Equity strategy ...................................................................................................... 25 Fixed income strategy .......................................................................................... 26 Taiwan ..................................................................................................................... 26 Economics ............................................................................................................ 26 Equity strategy ...................................................................................................... 26 Fixed income strategy .......................................................................................... 27 Hong Kong .............................................................................................................. 27 Economics ............................................................................................................ 27 Equity strategy ...................................................................................................... 27 Fixed income strategy .......................................................................................... 30 ASEAN Indonesia, Malaysia, Singapore, Thailand, the Philippines .............. 31 Economics ............................................................................................................ 31 Equity strategy ...................................................................................................... 33 Fixed income strategy .......................................................................................... 33 India ......................................................................................................................... 34 Economics ............................................................................................................ 34 Equity strategy ...................................................................................................... 35 Fixed income strategy .......................................................................................... 35 Australia and Canada ............................................................................................ 36 Economics ............................................................................................................ 36 Equity strategy ...................................................................................................... 37 Fixed income strategy .......................................................................................... 38 Latin America.......................................................................................................... 41 Economics ............................................................................................................ 41 Europe ..................................................................................................................... 42 Economics ............................................................................................................ 42 Equity strategy ...................................................................................................... 50 Fixed income strategy .......................................................................................... 51 US ............................................................................................................................ 52 Economics ............................................................................................................ 52 Fixed income strategy .......................................................................................... 53 6. Recent Asia Special Reports ................................................................................ 55
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1. Executive summary1
We expect Chinas GDP to grow by 6.9% in 2014. Even though our forecast is near the bottom of consensus, we still see the risks skewed to the downside, given the high level of leverage in the economy and its slowing potential growth rate. In this report we outline a China risk scenario to our baseline, involving GDP growth slowing to 5.9% in 2014, and 5% in H1 2014. We believe that the likelihood of China experiencing this risk scenario is 10-20%, i.e. we no longer see it as a small tail risk because the economy faces stress from many dimensions, including financial leverage, pollution and social tensions. Given the size of Chinas economy its nominal GDP at todays market exchange rates is on track to reach USD9trn this year, double the size in 2008 and its growing connectivity to the rest of the world, there is no doubt that the impact of a slowing China economy on the global economy will be much bigger than it was five years ago. To assess the global impact of this China risk scenario, in chapter 3 we first explain the various transmission channels through exports, commodity prices and financial markets and construct a summary scorecard of indicators to gauge the relative economic exposures of 26 countries. Building on this scorecard approach, in chapter 4 our country specialists attempt to quantify the impact on their own economies of Chinas 2014 GDP growth being 1 percentage point (pp) below our baseline forecast, taking into account the second-round effects from slowdowns in other economies, and the initial starting positions of countries in terms of economic strength, the scope for policy responses and idiosyncratic factors. In their analysis, they assume that global metal prices fall by 20-30% in 2014 and oil prices by 15-20%. Economic impact The overall result from this exercise is that a 1pp drop in Chinas GDP growth would lower global growth outside China by 0.3pp, but with a wide variation among economies (Figure 1). The hardest hit economies are in Asia, with growth falling by 1pp or more in Hong Kong, Singapore and Taiwan. The impact is also large on commodity-producing countries, such as Australia, Malaysia and those in Latin America indeed, despite being located much further away from China, the impact on GDP in Latin America (-0.5pp) is as large as that on Asia. In the euro area, the overall impact is -0.3pp. Aside from Ireland, which we believe is a special case, Finland, Austria, Belgium, Germany and the Netherlands are among the most exposed. Interestingly, the worlds largest economy the United States is among the least exposed. Our economists estimate that headline CPI inflation generally falls, because of the doublewhammy of weaker demand and falling prices of commodities, which have a big weight in the CPI baskets of emerging economies. The only exceptions are the large commodity producers in Latin America, for which the inflationary effect from significant currency depreciation dominates. Slowing growth and falling inflation paves the way for 13 of the 19 central banks to cut interest rates in 2014, the exceptions being those that have no scope, either due to the monetary policy framework or because policy rates are already at rock bottom, namely Japan, Hong Kong, Singapore, Canada, the US and the UK. The impact on current accounts varies among countries due to the tug of war between weaker exports and lower commodity prices. For commodity-producing countries, the current account surpluses narrow (or deficits increase), but in much of Asia the terms-of-trade effect dominates, increasing the (mostly) surpluses. Equity strategy Equities as the growth sensitive asset class would likely suffer more than other assets certainly fixed income. Of note, though, these risks appear more fully priced already into China H-share stocks themselves (after a five-year, 70% PBV de-rating) than in much of the rest of Asia-Pacific (or indeed Global) equity space. This extended China de-rating, along with the wellunderway downshift in actual Chinese GDP growth from pre-global financial crisis highs, has already ushered substantial constructive declines in Global and Asian-regional equity correlations vs. China stocks. It is Japan, however, that offers the world's lowest equity correlation vs. H-shares by far, along with key fundamental firebreaks that make it an attractive defensive market in a China slowdown scenario.
This Anchor Report was a global research effort with Nomuras economic, equity and fixed income strategy teams over 40 authors in total contributing particular parts, and they are acknowledged in their respective sections. The principal authors are grateful to Candy Cheung for data assistance and David Vincent for editorial support.
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Looking at Global equity sectors, Materials still exhibit one of the strongest (though also declining) correlations with H-shares. As such, by region, stocks in the (Mining and Energyintensive) UK, Latin America and EEMEA exhibit the MSCI Worlds highest and in this scenario, adverse correlations with China H-shares. Higher, in fact, than any of the other AsiaPacific markets, where more listed-company activity is comprised of downstream value-added manufacturing that benefits from lower commodity costs. Conversely, despite perceptions that Chinese private consumption is more 'structurally' robust than China's investment cycle, relevant Global Consumer Goods stocks may not prove immune or 'defensive' in the China slowdown scenario. Indeed, the Consumer sector globally is now more highly correlated with China shares than are Materials. Fixed income strategy For global FX, a sharp slowdown in Chinas economy would have both direct and indirect negative impacts on commodity producers and countries with relatively large China trade links. Major currencies such as AUD and CAD would suffer from negative terms-of-trade shocks and both remain weaker for longer, with AUD/USD and USD/CAD likely reaching 0.88 and 1.10, respectively, by the end of 2014. In Latin America, BRL would suffer the most (trading to 2.41 vs. USD by end-2014), through direct trade channels with China, lower global commodity prices and weaker US growth. MXN could be a relative outperformer given limited trade ties with China, but there could be some negative spill over from slower US growth. In Asia, a sharp China slowdown would see the USD/CNY fix remain stable, in our view, but spot USD/CNY may trade to the weaker side of the daily trading band (currently 1%). Northeast Asian currencies are likely to be hurt given their strong economic links with China, with KRW (based on our analysis) being one of the more vulnerable. In Southeast Asia, open economies such as Singapore would be at risk from a slowdown in trade and potential capital outflows, while PHP would likely outperform given limited dependence on China, strong domestic-driven growth and favourable local fundamentals. Unlike the rest of Asia, the risk to INR would mainly be from the negative impact of China on global growth prospects given Indias dependence on equity flows to fund its current account deficit. Looking at global rates, a sharp slowdown in Chinas economy would matter not only from a macro perspective but also from a capital-outflows perspective. Initially, we would expect USTs to rally, but if slowdown were to drag on, USTs may be negatively affected given the importance of Chinas buying of US fixed income assets. In Europe, however, we would expect the disinflationary effect of a China slowdown to be more impactful, which may result in the outperformance of the European swap curve, especially in front end. In Australia, we would expect a bull steepening of the curve as a China slowdown would allow the Reserve Bank to lower its cash rate further. In Asia, we would expect a sharp China slowdown to result in a sharp inversion of the China swap curve, reflecting the combination of tight liquidity and low growth. We say this under the assumption that the Peoples Bank of China is expected to maintain a tight monetary policy stance well into 2014. We would expect the Korean curve to bull steepen, the Taiwan curve to bull flatten, and Hong Kong rates to outperform US rates (as would Singapore rates). In Southeast Asia, we would expect the Malaysian rates curve to bull flatten, whereas in Thailand and the Philippines our expected policy response to cut rates should see bull steepening. In India, we would expect rates to move lower, led by the front end of the curve.
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Fig. 1: Real GDP growth in 2014 under Nomuras base case and China risk scenario
China Global, ex- China Asia Australia Hong Kong India Indonesia Japan Malaysia Philippines Singapore S. Korea Taiwan Thailand America US Canada Latin America Brazil Chile Colombia Mexico Euro area Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain UK
Base case 6.9 2.5 4.1 2.1 3.5 5.5 6.0 2.5 4.5 6.2 3.5 4.0 3.5 4.8 2.7 2.6 2.3 3.3 1.8 4.0 4.5 4.7 0.0 0.8 1.1 0.9 0.5 0.7 -1.6 1.3 -1.2 0.2 -0.1 -1.5 1.4
China risk scenario 5.9 2.2 3.6 1.4 2.0 5.2 5.6 2.0 3.7 5.9 2.2 3.5 2.5 4.2 2.4 2.4 2.0 2.8 1.3 3.6 4.0 4.3 -0.3 0.5 0.8 0.5 0.3 0.4 -1.7 0.8 -1.4 -0.1 -0.3 -1.7 1.2
Difference (pp) -1.0 -0.3 -0.5 -0.7 -1.5 -0.3 -0.4 -0.5 -0.8 -0.3 -1.3 -0.5 -1.0 -0.6 -0.3 -0.2 -0.3 -0.5 -0.5 -0.4 -0.5 -0.4 -0.3 -0.3 -0.3 -0.4 -0.2 -0.3 -0.1 -0.5 -0.2 -0.3 -0.2 -0.2 -0.2
Note: Aggregates are calculated using purchasing power parity (PPP) adjusted shares of world GDP. Source: Nomura Global Economics.
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2. China's downside risk scenario

In our baseline scenario, Chinas GDP growth slows to 6.7% in H1 2014 but recovers slightly in H2 such that our full-year forecast is for 6.9% growth in 2014. Both cyclical and structural factors contribute to this slowdown. Structurally, Chinas potential growth is on a downtrend due to a dwindling labour force and a lack of reform. Cyclically, the monetary policy stance has changed from its loose bias in H2 2012 and Q1 2013 to a tightening bias since Q2 2013. The systemic deleveraging process after such a profound period of credit growth is likely to last well into 2014, in our view (see China may enter a prolonged period of policy tightening, 24 June 2013). In our risk scenario, GDP growth slows to 5.9% for full-year 2014 and to 5% in H1 2014. Given the high level of leverage in the economy, policy tightening may lead to a faster deleveraging process, higher interest rates and a credit crunch, all of which would combine to cause a sharp slowdown in economic growth. Investment and consumption would both be affected by deleveraging, but investment would likely be hurt more. A wave of bankruptcies across those industries that face overcapacity problems is not too far-fetched, while property and infrastructure investments would slow due to financing constraints. Some non-bank financial institutions such as trusts would likely fail, while the banks face rising NPLs and require government assistance just to remain solvent. We believe that the likelihood of China experiencing the risk scenario described above or worse is 10-20%. We see this no longer as merely a small tail risk with a 5% probability because the economy faces stress from many dimensions, including financial leverage, pollution and social tensions. Our proprietary China Stress Index rose to a record high of 101.6 in Q1 2013 from 101.5 in Q4 2012 (see Nomuras China Stress Index recorded highest level in Q1, 24 April 2013; Figure 2). We flag, in particular, the speed of the build-up of leverage. The credit-to-GDP ratio has increased by 34pp in the past five years similar to the experience at various times through history in the US, Japan and Europe after which all suffered financial crises (see Asia Special Report: China: Rising risks of financial crisis, 15 March 2013). Moreover, if shadow financing activities are included, the debt buildup has been around 60pp over the same period. The recent liquidity squeeze in June reveals the fragility of the financial system, as the 7-day repo rate rocketing to 28% intraday on 20 June (Figure 3). We do not take the risk scenario as our baseline case, because we think the government can take action to smooth out the deleveraging process and growth slowdown so as to avoid financial sector meltdown. The banking sector is fully under the government control. We do not think government will allow banks to fail. Hence the transmission of corporate default may not be amplified through bank failure. This is the key difference between financial risks in China and market economies.
Fig. 2: Nomuras China Stress Index
Jan 2000=100
Zhiwei Zhang
+852 2536 7433 zhiwei.zhang@nomura.com
Wendy Chen
+86 21 6193 7237 wendy.chen@nomura.com
Fig. 3: 7-day repo rate

% pa
102.0
China Risks report published
30 7-day repo rate 25
101.5 20 101.0 15 100.5 10 100.0
99.5 Mar-03
Mar-05
Mar-07
Mar-09
Mar-11
Mar-13
0 01-May-13
21-May-13
10-Jun-13
30-Jun-13
Source: Nomura Global Economics.
Source: Bloomberg and Nomura Global Economics.
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Chinas import elasticity

When considering the notion of a harder China landing and its effects on other economies, it is misleading to calculate their trade linkage with China by looking at Chinas total imports. First, commodity prices are volatile and can thus distort the value of total imports as China is a voracious importer of commodities. Moreover, China imports a lot of parts for processing and reexporting purposes. We therefore estimate the elasticity for imports excluding commodities and processing trade. We label this as ordinary imports in Figure 4 and believe it is more representative of Chinas imports driven by its domestic demand. We estimate that, if GDP growth drops by 1%, growth of ordinary import drops by 10.9%. For commodity imports, we estimate the elasticity of iron ore, crude oil and copper, separately, in volume terms. The elasticity is 4.2 for iron ore, 5.7 for crude oil and -2.0 for copper (Figures 57). The negative elasticity for copper may be due to the copper-financing business in China when credit tightens, growth slows and some companies manage to borrow from banks by importing copper.
Fig. 4: GDP growth and ordinary import growth

70
Ordinary imports ex commodity (% y-o-y)
Fig. 5: GDP growth and iron ore import growth

70 60
60
Iron ore import volume (% y-o-y)
50 40 30 20 10
y = 10.9x - 81 50 40 30 20 10 0 -10 -20 6 7 8 9 10 11 GDP (% y-o-y) 12 13 y = 4.2x - 24
0
-10 -20 -30
10
11
12
13
GDP (% y-o-y)
Source: CEIC and Nomura Global Economics.
Fig. 6: GDP growth and crude oil import growth
Fig. 7: GDP growth and copper import growth
50
Crude oil import volume (% y-o-y)
120 100
Copper import volume (% y-o-y)
40 30 20 10 0 -10 -20 6 7 8 9 10 11 GDP (% y-o-y) 12 13 y = 5.7x - 40
80
60
40 y = -2.0x + 36 20 0 -20 -40 6 7 8 9 10 11 GDP (% y-o-y) 12 13
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Fixed income strategy

FX: A sharp slowdown in China's economy would likely stall CNY appreciation on a fix basis and raise the risk of some depreciation in RMB spot and forward markets. We currently forecast a stable USD/CNY fix at 6.160 (6.1721 last) in 2014, while spot USD/CNY should rise to around 6.160 (6.1388 last). However, if China downside growth concerns are elevated, there is a risk of spot USD/CNY rising to the extreme weak side of the daily trading band, which would be 6.222 based on a 1% band. If the band is widened to 2%, spot USD/CNY could rise to 6.283. We expect limited deviation in spot USD/CNH from spot USD/CNY, given the increase in traderelated FX arbitrage. The importance of the economic cycle for RMB is reflected in our dummy variable regression 2 analysis with industrial production growth and inflation. Our results show the relationship between economic conditions and changes in USD/CNY, which highlights the risk to RMB appreciation if IP growth and inflation were to slow. During the US financial crisis, China kept USD/CNY virtually fixed. It was only in July 2010, when deflation in China ended and IP growth stabilised, that authorities shifted back to a more basket-orientated FX regime. Although it could be different this time, as this growth slowdown has been led by a significant weakening in domestic demand (rather than a weakening of the external sector), there would likely be a similar FX policy response to a severe China economic slowdown. However, even with an effective peg on the USD/CNY fix, there is a risk of RMB depreciation in spot and FX forward markets from capital outflows. A repeat of the experiences in Q4 2011 and mid-2012 (European debt crisis), when spot USD/CNY tested the extreme weak side of the daily trading band, is possible. China, from March to May 2012 (when the European debt crisis intensified), lost USD55.6bn in FX reserves (adjusted for FX valuation and coupon payment effects). Although China appears to be less vulnerable to capital flow shocks (given the limited amount of foreign ownership/participation in local markets) and ample FX reserves cushion potential outflows (FX reserves to short term debt and imports at 6.2 times and 22.6 times respectively), there are concerns that a sharp economic slowdown could lead to financial/credit defaults and/or social unrest. Rates: As highlighted by our economists, the Peoples Bank of China (PBOC) is expected to maintain a tight monetary policy stance well into 2014 in order to facilitate a systemic deleveraging process. The tightening bias since Q2 2013 has already had an impact on 7-day repo rate fixings. The fixing rose to a high of 10.77% in June, before dropping as the PBOC skipped bills and repo issuances while maturing repos provided a reprieve to the liquidity situation. In our view, tight liquidity conditions into 2014 will continue to exert upward pressure on the front end of the IRS curve. However, growth is likely to slow in H1 2014 (according to our baseline scenario), which would restrict upside in the longer end of the curve. In our view, the interplay between tight liquidity conditions and slowing growth could lead to an inverted IRS curve, as seen in June, and can be expressed through initiating IRS flattener trades at appropriate levels. This position will be further supported in a scenario where Chinas growth slows alarmingly while liquidity conditions remain tight. Vivek Rajpal
+65 6433 6555 vivek.rajpal@nomura.com
Craig Chan
+65 6433 6106 craig.chan@nomura.com
Prashant Pande
+65 6433 6198 prashant.pande@nomura.com
Prashant Pande
A multi-variate linear regression was run for monthly changes in USD/CNY (from Aug 2005 to Jun 2013) against CPI (%y-o-y), IP (%y-o-y), a China event dummy variable and China NEER basket implied spot (%m-o-m). The resultant model has an R-squared of 31%. Regression was conducted in USD/CNY terms, so the inflation coefficient should be negative (i.e., when inflation is relatively high, USD/CNY should be falling relatively rapidly). The coefficients and P-values are (-0.08%, 0%) for CPI, (-0.01, 41%) for IP, (-0.10, 30%) for China event dummy variable and (0.08, 0%) for China NEER basket implied spot.
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3. Gauging Chinas relative economic impact a scorecard approach

Rob Subbaraman Given the size of Chinas economy its nominal GDP at todays market exchange rates is on track to reach USD9trn this year, double the size in 2008 and its growing connectivity to the rest of the world, there is no doubt that the impact of a slowing China economy on the global economy will be much bigger than it was five years ago. The IMF, using a simple global VAR model, estimates that a 1pp fall in Chinas GDP growth would reduce total GDP growth in 3 advanced economies by 0.1pp . But in practice, it is very difficult to quantify precisely the economic impact because of all the indirect and second-round effects that feed into the outcome through commodities, investment flows and financial markets. Moreover, the impact can vary substantially across countries. In this chapter we take a different approach. Instead of estimating the economic impact, we measure the relative economic vulnerability of each country to China. We do this using a scorecard of indicators that are all based on three channels of exposure: either exports to China, commodity prices, or financial effects.
+852 2536 7435 rob.subbaraman@nomura.com
Candy Cheung
+852 2536 7436 candy.cheung@nomura.com
Export channel
In the past decade, exports to China have increased exponentially in most countries. By 2012, China had become the top export market for Australia, Hong Kong, Japan, Korea, Taiwan and Thailand. It was second-largest for Indonesia and Malaysia, and third-largest for India, the Philippines and Singapore. To more accurately assess a countrys economic exposure from its direct exports to China it is important to also take into account the size of a countrys total exports in its GDP. As such, the metric we prefer to use is that of exports to China, as a percentage of each countrys GDP (Figure 8). For example, a hefty 29% of Australias exports were shipped to China last year, but Australia is a relatively closed economy, with its total merchandise exports comprising only 17% of GDP. Therefore, Australias exports to China as a percentage of GDP are 4.9%, which is around the median in Asia, although relatively high on a global comparison. At the other extreme is Malaysia: 13% of its total exports were shipped to China last year, but it is a very open economy, with its merchandise exports comprising 75% of GDP. As such, Malaysias exports to China as a percentage of its GDP are a relatively high 9.4%.
Fig. 8: Merchandise exports to China, 2000 versus 2012
% of GDP
18 16
14
12 10 8 6
2000
2012
4
2 0
Note: Hong Kong data is for domestic exports to China. Source: ABS, CEIC, IMF, Eurostat and Nomura Global Economics.
See Peoples Republic of China: Spillover report for the 2011 article IV, Country report No. 11/193, July 2011.
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However, the numbers in Figure 8 overstate each countrys true direct export exposure to China and hence the importance of Chinese final demand, because they do not take into account the boom in processing/assembly trade in China. Chinas accession to the WTO in December 2001 resulted in a substantial opening of its markets to foreign companies. Many multinationals set up factories in China to utilize the competitive and abundant supply of cheap labour and other resources. The implication is that a large share of exports to China is made up of high valueadded parts and components that are assembled and subsequently re-exported to end-markets in other countries. The distinction between those exports that stay in China, and those that get re-exported, is important. In 2009, the slump in exports to China was largely seen in intermediate exports, reflecting the collapse in final demand in the big advanced economies; indeed, Chinas net exports subtracted 3.5pp from GDP growth that year, whereas Chinese domestic demand added a whopping 12.6pp, reflecting the massive fiscal stimulus. So, back then, China was a support for the rest of the worlds exports. In contrast, the contemporary slowdown in Chinas economy is being internally driven by weakening Chinese domestic demand (notably investment), not net exports. And so for the first time in a long time, China has become a headwind for the rest of the worlds exports. Nomuras Chief China economist, Zhiwei Zhang, utilized a unique firm-level database to separate these intermediate exports to China that are re-exported from those that stay (see Can Demand from China shield East Asian economies from global slowdown?, HKMA Working paper No. 19/2008, December 2008). A drawback of the detailed data is that they are somewhat dated, being for 2006, but the results are revealing. Out of total exports, the share shipped to China, once adjusted for the intermediate exports that are re-exported, drops by 60% for the Philippines, and by roughly 50% for Japan, Korea, Malaysia, Singapore and Thailand, with commensurate increases in share to other markets (Figure 9). The OECD and WTO, drawing on input-output production tables, have also created a special database on global value-added trade for 58 countries, isolating only the value-added content of exports (see on the OECD website, OECD-WTO Trade in Value Added (TiVA) - May 2013).
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Fig. 9: Disentangling the true export exposure to China

Exporter Japan Japan Japan Japan Japan Australia Australia Australia Australia Australia Indonesia Indonesia Indonesia Indonesia Indonesia Korea Korea Korea Korea Korea Malaysia Malaysia Malaysia Malaysia Malaysia Philippines Philippines Philippines Philippines Philippines Singapore Singapore Singapore Singapore Singapore Thailand Thailand Thailand Thailand Thailand Export market U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China World U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China Rest of World U.S. Japan Rest of OECD China Rest of World Direct export exposure 1 22.8 0.0 18.0 20.0 39.2 6.2 19.6 19.1 14.2 40.9 11.5 19.4 15.8 9.2 44.0 13.3 8.1 16.1 27.2 35.3 18.8 8.9 16.3 12.2 43.8 18.3 16.5 20.0 17.7 27.6 10.2 5.5 15.5 19.9 49.0 15.0 12.6 18.6 14.6 39.2 Indirect export exposure 2 1.9 1.1 1.6 -9.2 4.7 0.3 0.3 0.6 -2.7 1.5 0.5 0.3 0.5 -2.8 1.6 2.8 1.5 2.2 -13.5 7.0 1.5 0.6 1.2 -6.2 2.9 2.5 1.0 2.1 -10.7 5.0 2.3 1.0 1.9 -9.9 4.6 1.9 0.8 1.5 -7.7 3.5 Direct and indirect export exposure 24.7 1.1 19.6 10.8 43.9 6.5 19.9 19.7 11.5 42.4 12.0 19.7 16.3 6.4 45.6 16.1 9.6 18.3 13.7 42.3 20.3 9.5 17.5 6.0 46.7 20.8 17.5 22.1 7.0 32.6 12.5 6.5 17.4 10.0 53.6 16.9 13.4 20.1 6.9 42.7
Note: This table measures the direct and indirect bilateral export exposure for East Asian economies to their major trading partners in 2006. The direct exposure is based on the share of economy A's exports to five export markets relative to its total exports, without taking into account its exports to China that were processed and re-exported to other economies. The indirect exposure is A's exports to China that were processed and re-exported to other export markets, as a share of A's total exports. The two measures combined provide an accurate estimate for bilateral export exposure. Source: Hong Kong Monetary Authority.
Drawing on the estimates by Zhiwei Zhang and the OECD-WTO TiVA database, we apply adjustment factors to remove those intermediate exports to China that are re-exported. After these adjustments, we calculate that the economies of Singapore, Taiwan, Malaysia and Korea are among the most exposed to exports to China (Figure 10). Nine of the 12 most exposed are in Asia, along with Chile, South Africa and Germany.
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Fig. 10: Exports to China adjusted for intermediate goods that are re-exported, 2012
% of GDP 12
10
8
6 4 2 0
Note: Hong Kong data are for domestic exports to China. Source: CEIC and Nomura Global Economics.
Commodity channel
The indirect impact of a sharp investment-led China downturn, via a slump in commodity prices, stands to be substantial for some countries. China has become a dominant importer across a range of commodities, most notably hard commodities. In metals, Chinas per capita intensity now rivals that in advanced economies. It accounts for some 30% of the worlds total imports of metals and a full 65% of total iron ore imports globally. In energy, Chinas share of world imports is in the high single digits, while for food it is low single digits, with the substantial exception of soybeans, at over 50%. The IMF (see Country report No. 11/193), using a simple model, has estimated that a 1pp fall in Chinas GDP growth can result in price declines of 6% for oil and base metals. We suspect though that this is a gross underestimate for three reasons: 1) second-round effects, a China downturn slows growth elsewhere, which further weakens demand for commodities; 2) the high degree of financial speculation in global commodity prices, which is likely to exacerbate the price declines; and 3) the limitation of models. The point estimates from models give the historic average result over the data sample period, yet Chinas economic importance has increased substantially in such a short period, the size of its economy doubling in just the past five years. Recursive estimates by the IMF shows that, in general, Chinas effect on global commodity prices has been growing over the last five years (see Chinas impact on world commodity markets, IMF Working Paper No. 12/115, May 2012). For our analysis in the next chapter, we have assumed that if Chinas GDP growth in 2014 is 5.9%, instead of our base case 6.9%, global metal prices would fall by 20-30% and oil prices by 15-20%, while soft commodity prices are less affected. To gauge the relative exposure to this slump in commodity prices, we estimated the share of non-food related commodities in each countrys total merchandise exports. The results show that it is mostly emerging markets that are most exposed to this channel, most notably Russia, Chile, Australia, Indonesia, South Africa, Finland, Brazil and Canada (Figure 11).
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Fig. 11: Percentage share of non-food commodities in total exports, 2000 versus 2012
% of exports 90 80 2000 2012
70
60 50 40 30 20 10 0
Note: Non-food commodities are estimated from the United Nations Comtrade database. At the first-digit SITC classification level, we combine five categories: Inedible crude materials, mineral fuels, lubricants and related materials, animal and vegetable oils, fats and waxes, chemicals and related products and manufactured materials. Source: CEIC, UNCTAD and Nomura Global Economics.
Financial channel
With the opening up of its capital account and the gradual internationalization of the renminbi, Chinas influence on global financial markets is also increasing. A China economic slowdown could have several negative effects on global financial markets, including a decrease in profitability of FDI investments in China; less Chinese investments overseas; a deterioration in the balance sheets of global banks with loan exposures in China; and financial market contagion through sagging equity markets and depreciating currencies. From these transmission mechanisms, the real economies can be affected through financial decelerator effects. These can range from negative wealth and confidence effects, from swooning equity markets to tighter liquidity and credit conditions as a result of net capital outflows, and banks rationing credit. Compared to the export and commodity channels, the financial channel is the most difficult to gauge because of the paucity of data and its indirect effects. We use four proxies. Complete data on investments in and out of China, on a country by country basis, are unavailable, but China does have annual data by country on FDI inflows. Scaled by the size of the investing countrys GDP, the results show that Hong Kong is by far most exposed (Figure 12).
Fig. 12: FDI inflows to China in 2011
% of recipient investing countries' countries'GDP GDP 4.0 29.0 28.0 3.5 27.0 26.0 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Source: CEIC, IMF IFS and Nomura Global Economics.
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Of course, Hong Kong plays the role of being Chinas largest financial conduit to the global economy. A significant proportion of Hong Kongs FDI flows to China are actually from the foreign subsidiaries of other countries that are based in Hong Kong. There is also what is known as round-tripping: part of the FDI flows from China to Hong Kong go back again, but are really other investments disguised as FDI in order to take advantage of Chinese regulations and taxes that favour foreign capital. Overall, we regard FDI inflows to China as a useful proxy for the significant level of financial integration between Hong Kong and mainland China. Similarly, data on Chinas outward foreign investments on a country by country basis are sparse. Chinas overseas portfolio investments are largely conducted by the official sector (i.e. FX reserves), and are concentrated in deep, liquid and high-grade fixed-income markets, notably in the US. What is available, by country, is Chinas outward FDI, which is likely correlated with Chinese bank lending overseas (mostly to Chinese companies). Like inward FDI, these data show that Hong Kong is by far the largest destination of Chinas FDI, followed by Singapore (Figure 13). In support of the FDI data showing the high level of financial integration between Hong Kong and mainland China, data from the Hong Kong Monetary Authority (HKMA) show a surge in Hong Kong bank exposure to companies on the mainland, from 50% of GDP in 2008 to 139% in March 2013 (Figure 13).
Fig. 13: FDI outflows from China in 2011
% of recipient countries' GDP 15.0 3.0 13.0 2.5
11.0 2.0
1.5 1.0
0.5
0.0 -0.5
Source: CEIC, IMF IFS and Nomura Global Economics. Fig. 14: Hong Kong banks non-bank China exposure
% of GDP
160
140
120 100
80
60 40 20 0 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13
Note: Hong Kongs banking sector non-bank China exposure refers to the amount of lending to mainland China by Hong Kongs banking sector as a whole. The figures of Non-bank China Exposures (NBCE) include exposures booked in the retail bank branches and subsidiary banks in mainland China. NBCE can include: International Trust and Investment Corporations and their subsidiaries; H-share companies and their subsidiaries; other state, provincial or municipal government-owned entities and their subsidiaries; other entities incorporated or established in China; companies and individuals outside China where the credit is granted for use in China; and other counterparties where the exposure is considered by the reporting institution to be non-bank China exposure. Source: HKMA and CEIC.
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To measure the potential financial contagion from China we use two proxies. One is the average correlation of the daily returns on the Shanghai composite index to that of other countries benchmark equity market indexes. Here the results show a marked increase in correlation for all countries in 2009-13 compared to 2000-05 (Figure 15). The highest correlation coefficients with Chinas bourse since the financial crisis is with the equity markets in Hong Kong (0.54), and many of the most correlated bourses are those in Asia. The other proxy is the correlation between daily returns on spot local currency per USD against CNY/USD. Here too, there has been a noticeable increase in correlation in 2009-13 compared to 2000-05 when the CNY/USD rate was fixed for most of the period. The highest correlation coefficients with CNY/USD are with the currencies of Singapore, Taiwan, the euro area and Thailand (Figure 16).
Fig. 15: Equity market correlations with China

Equity market correlation with Shanghai composite index
0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1
2000-05 2009-13
Fig. 16: FX correlations with China

Currency correlation with CNY/USD 0.5
0.4 2000-05 2009-13
0.3
0.2
0.1 0.0
-0.1
Source: Bloomberg and Nomura Global Economics.
Nomuras scorecard of Chinas relative economic impact

To summarize the total impact of the three channels, we have created a scorecard (Figure 17). We convert each of the six China vulnerability indicators into indexes and rebase them so that the average level of each for the 26 countries surveyed is 100. We then subjectively weight the indexes, applying 40% to the export channel, 30% to the commodity channel and 30% to the financial channel. The conclusion from this exercise is that the economies of Hong Kong, Singapore and Taiwan are among the most vulnerable to a deeper than expected China growth slowdown. Asia is particularly vulnerable, accounting for eight of the 12 most exposed economies. Chile and Brazil appear to be the most exposed in Latin America, while Russia and South Africa are also quite vulnerable. Finland and Germany are among the most exposed in Europe. At the other extreme, the least exposed are the US, Mexico and the Philippines (Figure 18). The virtue of this scorecard approach is that it is a straightforward and intuitive way to assess relative economic vulnerabilities to China. But it has limitations. The second-round economic effects of a China growth slowdown impacting economy A which in turn affects economy B,
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have been ignored. Also important but neglected, are the initial starting positions of countries in terms of economic strength, the scope for policy responses and idiosyncratic factors. In Chapter 5, our economists take on board these factors as they attempt to quantify the impact on GDP growth, inflation, the current account and policy rates, in a scenario in which Chinas GDP growth in 2014 is a full percentage point below our baseline forecast of 6.9%. Armed with these estimates, our equity and fixed income strategists then consider the market implications for individual countries. However, first we take a look at the Global Equity implications.
Fig. 17: Nomuras scorecard components
Scorecard indicators, indexed so that 100 = sample average Adj. exports Non-food commodity China outward China inward Equity market Currency to China exports FDI FDI % GDP % total exports % recipient % of investing Correlation Correlation countries' GDP countries' GDP coefficient coefficient Weights 0.4 0.3 0.05 0.05 0.1 0.1 Australia 88 170 15 1 101 98 HK 7 105 980 985 154 91 India 16 107 1 0 81 110 Indonesia 49 170 5 0 106 73 Japan 36 62 0 4 89 29 Korea 151 87 0 8 110 104 Malaysia 156 113 2 4 87 112 Philippines 38 40 8 2 58 100 Singapore 227 102 84 79 115 132 Taiwan 223 86 0 16 105 128 Thailand 107 58 5 1 93 124 Brazil 33 130 0 0 56 58 Canada 22 129 2 1 49 90 Chile 90 179 0 0 56 60 Finland 27 139 0 1 54 125 France 15 90 9 1 53 125 Germany 51 75 1 1 49 125 Italy 12 90 1 1 43 125 Mexico 10 66 0 0 53 69 Portugal 10 106 0 0 46 125 Russia 34 205 3 0 80 92 S. Africa 55 153 0 0 83 79 Spain 7 96 1 1 41 125 Turkey 7 95 0 0 41 94 UK 13 101 4 1 61 79 US 14 89 1 1 32 0 Scorecard
1.0 107 157 58 89 45 108 117 43 155 139 82 63 61 101 71 51 60 48 36 53 92 84 48 45 50 35
Note: The export data are for 2012, FDI data for 2011 and correlation coefficients are over 2009-13. Adjusted exports to China are each country's total exports to China less our estimate of intermediate goods shipped to China that are re-exported. For the currency correlation coefficient, we have assigned no correlation between the US and CNY, given the USD is the world's reserve currency. Source: CEIC, Bloomberg, ABS, China Statistical Yearbook, IMF IFS, UNCTAD and Nomura Global Economics. Fig. 18: Nomuras scorecard of overall economic impact
Index 160
140 120 100 80 60 40 20 more vulnerable
Source: CEIC, Bloomberg, ABS, China Statistical Yearbook, IMF IFS, UNCTAD and Nomura Global Economics.
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4. Global equity strategy

Michael Kurtz Given how important Chinese demand has been to global marginal GDP growth in recent years, equities as "the growth sensitive asset class would seem likely to suffer relative to other asset classes certainly fixed income in a deeper-than-expected China slowdown scenario. That said, we note that markets are already attaching a substantial discount to Chinese stocks and in certain key areas outside of China Chinese demand expectations. As Figure 19 demonstrates, Chinese stocks themselves have underperformed the MSCI World Index by no less than 33% since July 2009, and one has to go back to the pre-global financial crisis period (i.e. 2007) to observe an extended period of trend outperformance.
Fig. 19: Chinese market relative performance MSCI China / MSCI AC World (Jan 2001 = 100)
+852 2252 2182 michael.kurtz@nomura.com
Mixo Das
+852 2252 1424 mixo.das@nomura.com
Yiran Zhong
+852 2252 1413 yiran.zhong@nomura.com
300
250
200
150
100
China relative performance

50 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Bloomberg, Nomura Strategy Research.
Moreover, this price underperformance has not been matched by a similarly poor earnings trend, meaning China market multiples have been heavily de-rated to the point, in fact, where the valuation discount now being applied to Chinese equities is the largest since mid-2003.
Fig. 20: Chinese market multiple relative to global market 12m Forward PER: MSCI China / MSCI AC World
1.7 Fwd PER: China / World 1.5
1.3
1.1
0.9
0.7
0.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: IBES, FTSE, Nomura Strategy Research.
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Chinese equities are also trading at historic discounts versus other Emerging Markets (Figure 21).
Fig. 21: Chinese market multiple relative to global EM 12m Forward PER: MSCI China / MSCI EM
2.1 1.9 Fwd PER: China / EM 1.7 1.5 1.3 1.1 0.9 0.7 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: FTSE, Nomura Strategy Research.
As expectations for Chinese growth have already moderated substantially in the past two to three years, correlations between Chinese equities and other global and even Asian-regional equity markets have declined substantially, as Figures 22 and 23 illustrate. Short of hard landing risks, China appears gradually to be losing its power to spoil the party elsewhere.
Fig. 22: China H-share Index correlation vs. MSCI World

100% China Correl with MSCI World - 5w avg of 26-week correl
Fig. 23: China H-share Index correlation vs. MSCI APXJ

100%
80%
90%
60%
80%
40%
70%
20%
60%
0%
50%
China Correl with APXJ 5w avg of 26-week correl
-20%
40%
Source: Bloomberg, Nomura Strategy.
Indeed, a look at recent years statistical correlations between China H-shares and MSCI World key regions and sectors (based on 26-week USD-denominated returns Figure 24) offers insight both into where such China correlations have declined the most but also where the risk of equity market contagion may still be greatest. In most cases, these correlations also comport with our fundamental sense as to how the real and financial effects of a deeper Chinese growth slump would propagate through the global equity space. x Given Chinas predominant role as a driver of global marginal demand for commodities, at the global level the Materials sector (at the GICS-1 level) still exhibits one of the strongest correlations with H-shares, at 0.62.
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Note, however, that due to the larger decline in Materials-sector correlations since the height of the financial crisis, H-share correlation with the Materials sector is now (slightly) lower than those with Consumer Discretionary and Financials both at 0.64. At its March 2012 peak of 0.91, Materials had previously been the most correlated global sector with China stocks. By contrast, lower-beta relationships (i.e. vs. H-share returns) are generally found among the classically defensive sectors (e.g. Utilities, Staples and Healthcare). In other words, positive China-share performance should tend to be associated with outperformance in riskier assets or more cyclical sectors (as seems intuitively logical); but a China-driven rollover could best be sidestepped through exposure in low-beta names.
Fig. 24: China H-share correlation vs. global sectors (26-week USD-denominated returns)
MSCI AC World Sectors Discretionary Energy Financials Healthcare Industrials IT Materials Staples Telecom Utilities
2002-07 Avg. GFC Peak 0.52 0.88 0.40 0.82 0.48 0.85 0.23 0.77 0.49 0.88 0.47 0.85 0.53 0.91 0.31 0.84 0.41 0.89 0.34 0.75
Peak Month/Year Mar-09 Jul-09 Mar-12 May-09 Apr-09 Apr-09 Mar-12 Apr-09 Mar-09 Sep-10
Current 0.64 0.51 0.64 0.41 0.59 0.55 0.62 0.42 0.52 0.39
Change vs. Peak -0.25 -0.31 -0.20 -0.34 -0.29 -0.33 -0.29 -0.42 -0.37 -0.35
By key global region (Figure 25), other than the Asia-Pacific ex-Japan region itself (where China's incumbency forces an unavoidable auto-correlation), it is the UK (somewhat surprisingly) and Latin America, that exhibit the MSCI Worlds highest 26week return correlations with China H-shares. The former, we think, is largely attributable to the fact that UK equities are heavily weighted in Mining and Energy (as indeed are Latin American and EEMEA stocks). Also noteworthy is the fact that ex-China/Hong Kong themselves (again due to autocorrelation), most of the individual Asia-Pacific ex-Japan regional markets exhibit lower correlations with China H-shares than do either the (other) Emerging Market regions (i.e. Latin America and EEMEA) or Europe and the UK. As we have dissected in previous reports (see China slows, Japan goes, Gold knows, 9 May 2013), in large measure we believe Asia's comparatively lower correlation reflects the degree to which much of Asian corporate activity is comprised of downstream value-added manufacturing that benefits from lower input costs. However, more mechanistically, it may simply be due to portfolio allocations within the confines of the Asia-Pacific exJapan benchmarked universe, wherein flows that reallocate from China would be limited for choice only to the other markets of the region (and vice versa). We also note that Japan exhibits the MSCI World's lowest correlation vs. China Hshares by far, at just 0.25 suggesting substantial 'defensive' qualities in a deeperthan-expected China slowdown scenario. Not only do Japanese stocks exhibit the lowest-beta relationship with China H-shares among the major global markets, but Japans domestic consumption-heavy GDP composition and the independence of the Bank of Japans (currently very loose) monetary policy should help insulate it from a Chinese demand slowdown.
x x
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Fig. 25: China H-share correlations vs. Major global region (and by Asia-Pacific country) (26-week USD-denominated returns)
US Europe UK Japan Asia-Pacific ex-Japan Australia Hong Kong India Indonesia Korea Malaysia Philippines Singapore Taiw an Thailand EEMEA LatAm
2002-07 Avg. GFC Peak 0.37 0.84 0.43 0.82 0.39 0.85 0.46 0.83 0.76 0.97 0.51 0.85 0.79 0.95 0.42 0.89 0.33 0.91 0.54 0.87 0.43 0.84 0.28 0.83 0.60 0.92 0.53 0.85 0.40 0.90 0.49 0.92 0.45 0.91
Peak Month/Year Apr-09 Mar-09 Mar-09 Jan-08 Mar-12 Jan-08 Dec-11 Mar-09 Aug-11 Sep-11 Dec-11 Jan-08 Sep-11 Oct-10 Feb-12 Jan-12 Mar-12
Current 0.54 0.62 0.70 0.25 0.83 0.58 0.82 0.58 0.58 0.50 0.47 0.56 0.54 0.61 0.57 0.65 0.69
Change vs. Peak -0.30 -0.20 -0.15 -0.58 -0.14 -0.28 -0.13 -0.31 -0.32 -0.37 -0.37 -0.26 -0.38 -0.31 -0.33 -0.27 -0.22
Despite the decline from global financial crisis peaks in all global equity correlations vs. China, a deeper-than-expected slowdown in the Chinese economy would still have far-reaching consequences for global equities. The Materials and Energy sectors, once regarded as key beneficiaries of structurally strong Chinese demand, remain center-screen in that regard. But as seen in Figure 26, these sectors have been markedly underperforming globally since as early as late 2011 suggesting moderating China growth over the next several quarters has to some degree been discounted.
Fig. 26: Relative performance of Global Energy and Materials sectors MSCI AC World sector indices
300
280
260 240 World Materials relative performance World Energy relative performance
220
200 180
160
140 120
100 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: FTSE, Nomura Strategy Research.
Still, given that the scenario discussed in this report invokes a China slowdown more heavily concentrated within the investment component of GDP, it is the Metals & Mining stocks that may yet have most to lose: The global mining industry invested heavily to expand capacity in the immediate post-crisis years as Chinas demand was artificially boosted by aggressive fiscal stimulus. Assuming demand from China slows further, those investments are far less likely to prove profitable on a relevant timeframe (see Chinese copper demand vs. global copper prices; Figure 27).
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Fig. 27: Chinese copper import volumes and the price of copper
500,000 500
450,000
400,000 350,000 300,000 250,000 200,000 150,000
450 China net imports: Copper (tons)

Copper Price (rhs, US cents/lb) 400 350 300 250 200 150
100,000
50,000 0
100
50 0
Note: Imports of unwrought copper and products. Source: Datastream, Nomura Strategy Research.
With downward pressure on global commodity and energy prices, we would expect top-line revenue slippage in equity markets dominated by upstream-sector (i.e. primary industry) activity, such as Metals & Mining, Oil & Gas Exploration & Production and Agriculture; whereas downstream sectors (e.g. Manufacturing, Refining & Petrochemicals, Power Generation) could at least derive potential flow-through benefits to bottom-line profitability. x As shown in Figure 28, global equity regions with the greatest primary-industry vulnerability as a percent of market capitalization to softer primary goods prices include EEMEA (20.5%) and Latam (18.1%). By comparison, Asia-Pacific ex-Japan suffers half the exposure of its EM cousins, at just over 10%. These measures of vulnerability jibe well with the higher H-share correlations noted earlier particularly for Latam. By contrast, the greatest beneficial downstream industry exposure to lower input prices principally include Japan (45.9%) and the ex-Japan Asia-Pacific region (27.6%), followed by the US (24.9%).
Fig. 28: Asia ex-Japan: upstream vs. downstream sector exposure (% market cap)
US Upstream Exposure Alum inum Steel Diversified Metals & Mining Gold Coal & Consum able Fuels Oil & Gas Exploration & Production Integrated Oil & Gas Agricultural Products Tobacco 0.1 0.1 0.2 0.1 0.1 2.6 3.2 0.2 1.6 8.1
Europe 0.1 0.3 2.6 0.1 0.3 4.4 1.9 9.5
Japan 1.7 0.4 0.4 1.5 3.9
APxJ 0.1 1.2 3.6 0.3 0.7 2.4 0.8 0.6 0.7 10.3
EEMEA 1.1 2.8 1.9 0.3 3.2 11.1 0.1 20.5
LatAm 9.1 2.8 5.4 0.8 18.1
Dow nstream Exposure Industrials Autos Tech Hardw are Sem iconductors Oil & Gas Refining & Marketing Utilities
10.2 1.1 6.0 2.0 2.3 3.3 24.9 16.8 3.1
11.5 3.0 0.9 0.9 4.0 3.9 24.0 14.5 2.5
19.1 15.3 7.1 0.6 0.7 3.1 45.9 42.0 11.7
7.8 3.4 3.2 7.5 2.2 3.4 27.6 17.2 2.7
3.5 0.3 10.2 2.2 16.2 -4.3 0.8
4.7 6.3 4.5 15.5 -2.7 0.9
Net Dow nstream - Upstream Exposure Dow nstream /Upstream Ratio

Source: Datastream, Nomura Strategy Research.
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Finally, we note that despite perceptions that Chinese private consumption may be more 'structurally' robust than China's investment cycle particularly given the multi-year policy agenda to rebalance Chinese growth we would not regard the Global Consumer Goods sector as necessarily immune or 'defensive' in a China slowdown scenario. x As seen in Figure 29, between 2005 and 2012, Global Consumer Goods stocks did rerate relative to their historic valuation norms largely as a result of their exposure to China and other fast growing EM economies. But even this sector has materially underperformed globally over the past year, reflecting, we believe, a growing realism about the sustainable trend-growth even of Chinese private consumption and of Chinese wages and salaries. And (again) as seen above in Figure 24, the Global Consumer Discretionary sector now exhibits the largest correlation with China H-shares exceeding those of Materials and Energy.
Fig. 29: Global Consumer Goods sector 12m forward PE Relative to the market FTSE World sector index
1.8
1.6 Fwd PER: Global consumer goods / World

1.4
1.2
0.8
0.6
Source: IBES, FTSE, Nomura Strategy Research.
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5. Country views on the downside risk scenario

Japan
Fig. 30: Nomura forecasts for our base case and China risk scenario
GDP growth CPI inflation Current account, % of GDP Policy rate Base case 2.5 2.2 1.7 0-0.10 China risk scenario 2.0 1.8 2.2 0-0.10
Source: Ministry of Finance, Japan; Nomura Global Economics.
Economics
China has become increasingly important in recent years to Japan's economy as it is now the biggest export destination in 2012 the share of exports to China (including Hong Kong) as a percentage of total exports reached 23%. In the past, Japanese manufacturers utilized their China subsidiaries primarily as a base to produce export goods to other advanced economies. However, as China's consumer market expanded rapidly, Japanese exports to China for domestic consumption rose. Simultaneously, as China's manufacturing industry grew rapidly and transitioned to more value-added production, China's export of consumer goods to Japan also rose significantly. In 2012, capital goods accounted for a 56.4% of total exports to China from Japan, while the share of intermediate goods and consumption goods were 31.9% and 6.8%, respectively (Figure 31).
Fig. 31: Composition of Japan's exports to China
% 70 60 50 40 30 20 10 0 85 87 89 91 93 95 97 99 01 03 05 07 09 11
Tomo Kinoshita
+81 3 6703 1280 tomo.kinoshita@nomura.com
Minoru Nogimori
+81 3 6703 1287 minoru.nogimori@nomura.com
Kohei Okazaki
+81 3 6703 1291 kohei.okazaki@nomura.com
Shuichi Obata
+81 3 6703 1295 shuichi.obata@nomura.com
Industrial Supplies
Capital Equipment Consumer Goods Others
Source: Ministry of Finance, Japan.
Given increased dependence on China, we estimate that a 1pp decline in China's GDP growth in our risk scenario would lead to a 0.5%pp fall in growth for Japan (Figure 20). Lower exports to China explain a 0.2pp reduction in Japans growth, while a decline in Japan's exports to other economies under this scenario would remove a further 0.1pp. Combining these two channels, the direct impact on Japan's growth through lower exports therefore amounts to a -0.3pp contribution to growth. On the other hand, an export slowdown would generate negative spillover effects on domestic demand in Japan, especially private investment. Combined with a decline in private consumption brought on by lower stock prices, we believe that negative spillover effects would trim another 0.2pp from Japan's growth. As far as the impact of a China slowdown on Japans inflation and current account is concerned, lower commodity prices play an important role in containing the inflation rate and reducing the trade deficit. Our simulation indicates that a 1pp decline in Chinas growth would lower inflation by 0.4% through lower commodity prices and a rising output gap. It would also improve the trade balance by JPY2.3trn, or 0.5pp of GDP.
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Through direct and indirect channels, lower growth in China would especially hurt industries in the electrical machinery, textiles, precision instruments, chemical, plastics and rubber products, and base metal sectors, based on our estimates using an input-output table (Figure 32).
Fig. 32: The impact on Japanese industry value-added when China's growth declines by 1pp
Total impacts Direct Indirect 0.0 0.0 -0.1 -0.3 0.0 -0.3 0.0 -0.7 0.0 -0.1 0.0 -0.3 -0.1 -0.3 -0.2 -0.2 -0.5 -0.7 -0.2 -0.7 -0.3 0.0 0.0 -0.1 0.0 0.0 0.0 0.0 0.0 -0.2 -0.1 -0.2 -0.2 -0.3 -0.3 -0.3 -0.2 -0.4 -0.1 -0.3 -0.2 0.0 -0.1 0.0 -0.2 -0.1 -0.1 -0.1 -0.1 -0.2
Agriculture, Forestry and Fishing Mining Coal, crude oil, natural gas Food products and beverages Textiles Wood and of wooden products Pulp ,paper and paper products Publishing and printing Chemicals Petroleum and coal products Plastics and rubber products Non-metallic mineral products Iron, steel, non-ferrous metals and fabricated metal products Machinery Electrical machinery Transport equipment Precision instruments Other Manufacturing Construction Electricity ,gas and water supply Wholesale and retail trade Finance, insurance and Real estate Transport and communications Service activities Others
0.0 -0.4 -0.3 0.0 -1.0 -0.1 -0.3 -0.2 -0.6 -0.3 -0.6 -0.5 -0.6 -0.6 -1.0 -0.4 -0.7 -0.4 0.0 -0.2 -0.2 -0.1 -0.2 -0.1 -0.2
Note: Indirect impacts are calculated using 2011 input-output tables for Japan. The impacts do not include effects from other economies and financial markets. Source: Nomura, based on Ministry of Economy, Trade & Industry data.
Equity strategy
We estimate that China accounted for 4.9% of Japanese companies' sales and 5.7% of their after-tax profits in FY12 (Figure 33). The regression sensitivity of Japanese companies recurring profit growth to Japan's real GDP growth rate has been 8. If we assume a 1.0pp decline in China's GDP growth would reduce Japans growth by 0.5pp, we calculate it would weigh on Japanese recurring profits by 4% (Actually, the sensitivity of Japan's real GDP growth rate to China's real GDP growth rate is high when utilising a simple regression analysis. If we just observe the data since 2005, it has been 1.4.)
Fig. 33: China business contribution for Japanese companies
% 18 16 14 12 10 8 6 4 Japanese companies' China sales ratio After-tax profit ratio
Hiromichi Tamura
+81 3 6703 1680 hiromichi.tamura@nomura.com
Hisao Matsuura
+81 3 6703 1814 hisao.matsuura@nomura.com
2
0
Source: Nomura.
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Our top-down recurring profit growth estimate for FY13 is about 50%, based on a USD/JPY assumption of 100. Even if a slowdown in the Chinese economy were to affect Japanese companies, we would still expect Japanese corporate profits to grow. In H2 2012, we recommended purchasing risk assets in China, specifically in the materials sectors, but we now think it is inappropriate to take on further China risk.
South Korea
GDP growth CPI inflation Current account, % of GDP Policy rate Base case 4.0 3.0 3.9 2.75 China risk scenario 3.5 2.5 4.5 2.25
Economics
Weaker domestic demand in China would primarily feed through to lower Korean GDP via a reduction in Korean exports. We assume that 60% of Koreas exports to China are for reexports and 40% for domestic consumption and investment. According to the Bank of Korea (BOK), the correlation between each GDP component of China and Koreas exports (19952011) is: China exports: 0.76; China investment: 0.19; China government consumption: -0.04; China private consumption: 0.19. In the past, as China acted as Asias main manufacturing hub Korean exports to China were mostly parts/components (65% of total) used for re-exports. If Chinas GDP growth slows mainly due to domestic demand and exports remain stagnant, the first-round impact on Korean exports would likely be limited, in our opinion, but a second-round impact would be expected: If commodity prices fall sharply and commodity exporting countries in Emerging Markets (the Middle East and Latam, mainly) see growth slow sharply, Korean exports to EM would likely fall. In January-May 2013, Koreas exports to China and South Asia gained by 10% y-o-y and 13%, respectively, but those to Latam and the Middle East fell by 16% y-o-y and 8%, respectively. All in all, we estimate that a 1pp fall in Chinese GDP would lower Korean GDP growth by 0.5pp. In this case, we would expect the Bank of Korea (BOK) to cut its policy rate by 25bp, to 2.25%, to support growth as both growth and inflation would slow (in our current base case, however, we expect the BOK to hike policy rates by 25bp to 2.75% in H2 2014). There would also be room for the government to implement some level of fiscal stimulus. We would expect Koreas current account surplus to increase further, supported by lower commodity prices. Young Sun Kwon
+852 2536 7430 youngsun.kwon@nomura.com
Equity strategy
In the equity space, the impact of a sharper-than-expected China slowdown would be limited, we believe, for the large exporters such as Samsung Electronics and Hyundai Motor in light of their well diversified export markets. Also, as we expect domestic economic growth to pick up and the housing market to recover going forward which could be further supported by a possible BOK rate cut as discussed above domestically oriented Korean sectors (such as Retail and Banking) may prove better insulated from a China slowdown. However, investors should be cautious of more directly China-dependent Korean sectors such as Energy, Petrochemicals, Steel and Machinery. From a broader asset-allocation perspective, however, Korean equities appear unlikely to simply sail above the broader risks. Were investors to turn substantially more cautious on China to the point of further reducing broad EM exposure, Korea would suffer as well potentially from outflows as much as from the discounting process, given that after China, Korea stands among the next-largest markets in the MSCI EM universe. James Kim
+822 (3783) 2341 james.kim@nomura.com
Michael Na
+882 (3783) 2334 michael.na@nomura.com
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FX: KRW appears to bear the most significant FX depreciation risk within the Northeast Asia bloc to a sharp slowdown in China's economy. Despite the expected increase in Koreas current account surplus, partly from lower commodity prices, Korea could still suffer from an overall balance of payments (BoP) deficit. As highlighted in the past six months of BoP data, despite the large average monthly USD4.1bn current account surplus, outflows from the capital and financial account have offset the surplus on four occasions. In addition, in light of weaker growth and low inflation, authorities would likely shift toward a monetary easing bias, which increases the possibility of a preference for a weaker KRW. Overall, based on our financing gap analysis (see Asia's rising risk premium, 28 June 2013), we believe KRW will be one of the more vulnerable currencies in Northeast Asia to a severe growth slowdown in China. Rates: Korea is one of the more vulnerable economies to a China slowdown, leading, in our opinion, to a rate cut by the BOK in order to support growth and inflation. In such a scenario, we would expect the curve to steepen and the impact could be more profound if the government implements a fiscal stimulus. We would also expect volatility in the Korean rates market to pick up, in our China risk scenario. Craig Chan
Prateek Gupta
+65 6433 6197 prateek.gupta@nomura.com
Vivek Rajpal
Prashant Pande
Taiwan
GDP growth CPI inflation Current account, % of GDP Policy rate Base case 3.5 2.3 8.0 2.13 China risk scenario 2.5 1.5 10.0 1.88
Economics
China is Taiwans largest trading partner and most of its exports to China are also for re-export in the technology sector. We believe that the direct impact on Taiwans exports of a domestic demand slump in China may be limited, but the wider effects of a slower economy in general and tighter monetary conditions would have a negative impact given the many business projects between China and Taiwan that would delayed, while weaker global demand would have an indirect impact on Taiwans export-heavy economy. As a result, we estimate a 1pp decline in Chinas growth rate would reduce Taiwans GDP growth by a similar amount. In this scenario, we would expect the Central Bank of China (CBC) to keep policy rates a 1.875%, which is already very low (in our base case we expect the CBC to hike policy rates by 25bp to 2.125% in H2 2014). Instead, the government could implement a fiscal stimulus given that there is room for further fiscal spending in Korea. Taiwans current account surplus would widen on lower global commodity prices. Young Sun Kwon
Equity strategy
Given the degree to which strengthening cross-Strait ties in terms of both trade flows and policy liberalization have underpinned the TAIEX in the past several years, Taiwanese stocks would not be able to sidestep a more abrupt China slowdown. A deeper-than-expected economic slowdown might distract the Chinese leadership from the agenda of deeper cross-Strait economic integration, putting on hold that key sentiment support for Taiwanese stocks. It could also prove a domestic political challenge for Taiwans ruling KMT party, which often capitalizes on China-driven economic prospects to court Taiwans middle-class voters (Taiwans next major elections for city government mayors are preliminarily slated for November 2014]. Taiwans Tech sector could prove relatively more resilient than non-tech stocks, as the former has mostly utilized China primarily as a production base to address global rather than local demand; indeed, a China slowdown could also slow the rise in Chinese production costs, including labour. Any CNY depreciation (in addition to labour-cost relief) could help improve Taiwanese profit margins. On the other hand, Taiwans non-tech companies (e.g. Consumer, Materials) suffer more concentrated exposure to Chinese end-demand. Their likely share price correction(s) would only be deeper in light of the combination of both sharper earnings-estimate Jesse Wang
+886 (2) 2176 9977 jesse.wang@nomura.com
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23 July 2013
consensus downgrades and a higher valuation base of comparison in the first place, in our view. Nevertheless, Taiwanese banks would likely benefit from Chinas policy-tightened liquidity, presumably precipitating the slowdown scenario. This is because many Taiwanese corporates with operations in mainland China would likely turn more to Taiwanese lenders to access working capital credits helping boost loan demand and expand margins at Taiwanese banks, in our view. The ideal proxy would be Taiwans large-corporate-driven banks, which also would likely feature more manageable credit cycles during the more severe downturn in our risk scenario.

FX: TWD would also likely experience depreciation pressures given its high export dependence on China and because its exports compete directly with Korea (particularly in the LCD sector where Taiwan and Korea together account for over 70% of global production). The risk of Taiwans central bank adopting a pro-growth policy stance is high. However, significant TWD depreciation could be limited given the expected recovery in the world economy and/or if China's government responds with stimulus. In addition, unless the cyclical slowdown in China leads to negative credit events, authorities in Northeast Asia generally have ample FX reserves (relative to imports and short-term debt) to support local FX, and can also repeal some of the capital inflow-related macroprudential policies implemented over the years. Rates: Our economists estimate that every percentage point drop in Chinas growth would have a similar impact on Taiwans growth. The expectation of a rate hike (in H2 2014 according to our baseline scenario) with a poorer growth outlook would create an opportunity to enter flattener trades. However, if a sharp slowdown in China (as in the risk scenario) materializes, the expectations of a rate hike would diminish, thus reducing the attractiveness of a flattener trade. In such a scenario, an outright receive position would be a better trade. Craig Chan
Prateek Gupta
+65 6433 6197 prateek.gupta@nomura.com
Vivek Rajpal
Prashant Pande
Hong Kong
GDP growth CPI inflation Current account, % of GDP Policy rate Base case 3.5 4.3 -1.0 0.40 China risk scenario 2.0 3.5 1.0 0.40
Economics
Weaker China demand would have a negative impact on Hong Kong through both real and financial channels. The number of tourists visiting Hong Kong from the mainland could be expected to fall below our base-case assumptions. For example, a slower expansion in China would affect the purchases of luxury items by mainland tourists; luxury brands customer would cut spending while businessmen may not need so many luxury watches to give out as gifts. Tighter credit conditions in China would also have a negative impact on Hong Kongs property market. Its financial service activities, too, would weaken if there was a slump in Chinas capital raising efforts. All in all, we estimate that a decline of 1pp in Chinas growth would reduce Hong Kongs GDP growth by 1.5pp. Meanwhile, Hong Kongs CPI inflation would be lower than in the base case due to lower commodity and food prices. Given its very strong fiscal position, the Hong Kong government could be expected to increase its fiscal spending, or transfer more income to low-income families if job creation shrinks due to weaker China growth. Young Sun Kwon
Equity strategy
Curiously, China slowdown risks may already be more fully priced at present in Hong Konglisted China stocks themselves than in the rest of the Asia-Pacific region and indeed globally. MSCI Chinas consensus aggregate PER, at 8.2x, is Asias second-lowest (after Koreas 8.0x) and by far the deepest historic discount, at -32% (vs. the regional average of just -6.0%) Michael Kurtz
Wendy Liu
+852 2252 6180 wendy.liu@nomura.com
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23 July 2013
representing, we believe, the degree to which exploration of Chinese structural risks has dominated market attention in the past three to four years (Figure 37).
Fig. 37: Asia-Pacific ex-Japan: PER (Absolute & vs historic average) and nominal GDP
% y-o-y 14 Nominal GDP Growth (%) 2012 2013 2014
12
10 8
6
4 2
"x" 20 18 16 14
Fwd P/E (lhs)

40% Premium to L.T. Average (rhs)
30%
20% 10%
0% 12
10 -10%
-20%
-30% -40%
8
6
Moreover, survey-based data suggest that reduction of China relative portfolio weightings vs. benchmark over the past 12 months has been by far the Asia ex-Japan regions most aggressive (followed by Taiwan, Korea and Hong Kong, i.e. a rotation out of North Asia in favour of India and emerging ASEAN Figure 38). This, too, suggests an imminent policydriven deceleration may largely be already embedded in market expectations:
Fig. 38: Net change in consensus country/sector relative weightings (vs. MSCI Asia ex-Japan benchmark)
India Indonesia Philippines Thailand Malaysia Singapore Hong Kong Korea Taiwan China Change vs. Jun-2012 2.7 0.5 0.4 0.2 0.1 -0.1 -0.1 -0.4 -0.7 -2.7 vs. 3-year avg. 2.4 -0.4 0.5 0.2 -0.2 -0.7 -0.9 0.8 -1.5 -0.2 Utilities Staples Materials Industrials Health Care Discretionary Info Tech Energy Financials Telco Change vs. Jun-2012 3.6 1.9 1.1 0.7 0.5 -0.7 -1.2 -1.3 -1.7 -2.9 vs. 3-year avg. 3.2 1.0 0.1 0.0 0.1 -0.1 0.0 -0.4 -1.5 -2.3
Source: EPFR, Nomura Strategy Research.
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23 July 2013
It is instructive to note that equity prices do often move ahead of 1) analyst earnings consensus; 2) the economic consenus; and 3) ratings agencies. Note in Figure 39, for example, that during the China downturn and rebound of 2008-09, A-share equities inflected upward from November 2008 but GDP forecasts and consensus earnings estimates continued to decline through JuneJuly 2009 just weeks before the stock rally peaked.
Fig. 39: CSI-300 Index (2008-09) vs. Consensus 2009 EPS and GDP forecasts
% 12
11 10 9 3,000 Market Bottom Market Peak GDP growth 2009, lhs EPS 2009, lhs CSI 300 Index, rhs 5,000 4,000
7,000
6,000
8
2,000 7 1,000
In assessing what approximate economic growth range China stocks may already be discounting, we note that by regional best-fit standards (Figure 40), MSCI Chinas current 1.3x PBV implies a lower ROE (i.e., roughly 9.5%) than the much stronger trailing ROE (14.8%) that China has actually been generating. x Namely, Chinas PBV is substantially lower than in other Asia-Pacific markets generating similar 15%-16% trailing ROEs such as the Philippines (3.2x), India (2.5x) and Thailand (2.4x) and closer to the PBVs of markets such as Hong Kong and Singapore, generating much lower ROEs. This suggests that Chinas multiple de-rating over the past five years fully -70% from an average of just over 4.0x from mid-2007 through mid-2008 has already embedded expectations of a substantial erosion in return generation (whether from slower GDP growth and thus slower top-line revenues, or from eroding profit margins, but likely both).
Fig. 40: Asia-Pacific ex-Japan: Current PBV vs. 12m trailing ROE
25%
23% 21% 19%
ROE (%)
Indonesia
17% 15% 13% 11% 9% 7% 5% 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 PBV (x) China APxJ Singapore Korea HK Australia Taiwan New Zealand India Thailand Malaysia Philippines
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23 July 2013
Extending from the above implied ROE of 9.5%, we note below that the scatter-chart of actual historical Chinese ROE vs. nominal GDP (Figure 41) equates a roughly 9.5% ROE with nominal GDP growth of roughly 6.0% i.e. the region indicated by the red circle below. Chinas implied GDP deflator in Q2 13 was 0.5%, which if unchanged in 2014 would translate nominal GDP growth of 6.0% to real growth of roughly 5.5%.
Fig. 41: China: Historical quarterly ROE vs. nominal GDP

20 18 16
Trailing 12-month ROE
14 12 10 8 6 4 2 0 y = 47.397x + 6.648 R = 0.3795
0%
5%
10%
15%
20%
25% 30% Nominal GDP Growth
Source: Datastream, CEIC, Nomura Strategy Research.
The above can only be regarded as very approximate given, for example, that 1) the sector composition of Chinese equity markets has changed substantially since the previous historic period in which single-digit ROEs were observed (i.e. the late 1990s), and 2) ROE declines, as noted, can be a function of both aggregate demand (i.e. GDP) slowdown and/or margin erosion. In the end, we assume both have contributed to Chinas post-2008 PBV de-rating. However, this in our view does not negate the implication that a substantial demand deceleration has already been discounted into China stocks.

FX: A sharp slowdown in Chinas economy could reverse appreciation pressures on HKD because of likely asset price declines and an expected fall in headline inflation. Indeed, if the China slowdown is severe, capital outflow risk could prompt HKD to move toward the weak side of the USD/HKD convertibility undertaking rate. On the peg regime, we do not expect the HKD peg to undergo any significant changes, as it may ultimately just fade away as the use of RMB becomes increasingly widespread in Hong Kong. This is because of the uncertain benefits and market volatilities associated with an unnecessary regime change such as this. Furthermore, societal pressure for change in the regime to address inflationary pressures could abate on a China led downturn. Rates: Hong Kong, according to our analysis, is the most vulnerable economy to a China slowdown in the region. The low level of rates in Hong Kong creates an opportunity to enter a receive position in the belly of the curve as diminishing growth prospects exert more downward pressure on rates. However, we remain prudent to the high correlation of Hong Kong rates with US rates and would recommend a beta-adjusted receive Hong Kong/pay USD spread trade. Craig Chan
Wee Choon Teo

+65 6433 6107 weechoon.teo@nomura.com
Vivek Rajpal
Prashant Pande
30
23 July 2013
ASEAN Indonesia, Malaysia, Singapore, Thailand, the Philippines

Fig. 42: Nomuras forecasts for ASEAN under the base case and risk scenario
Base case 6.0 4.3 -2.7 6.5 Indonesia China risk scenario 5.6 3.9 -3.0 6.0 Base case 6.2 4.0 1.8 4.5 Philippines China risk scenario 5.9 3.4 2.1 4.0
GDP growth CPI inflation Current account, % of GDP Policy rate
Base case 4.5 2.5 3.2 4.0
Malaysia China risk scenario 3.7 2.0 1.8 3.5
Singapore Base China risk case scenario 3.5 2.2 3.6 3.1 14.9 7.4 0.5 0.5
Base case 4.8 2.7 -0.6 2.8
Thailand China risk scenario 4.2 1.8 0.6 2.0
Economics
Growth: The ASEAN umbrella covers economies that would be both among the worst-hit (Singapore) and the least vulnerable (the Philippines) to a sharp slowdown in China. Singapore, on our estimates, would see 1.3pp shaved off from our 2014 baseline forecast in our China slowdown scenario. By contrast, the Philippines would see growth cut by a relatively modest 0.3pp. Our estimates are based on an econometric model which should capture the underlying dynamics, but complemented with our judgment on the impact of the various channels described in the first chapter. For Singapore, the trade channel will clearly be key given the openness of the economy (exports to China account for 16% of Singapores GDP). The financial channel will also be important because of the potentially large negative wealth effects due to financial market volatility, given the size of financial asset holdings in household balance sheets. While lower commodity prices would provide some reprieve, any policy easing would partly be constrained by the economic restructuring, which is keeping labour policies tight and the fiscal impulse neutral. By contrast, not only is the Philippines less exposed to weaker export demand from China, but domestic demand is being boosted by the structural reforms that are allowing higher quality fiscal spending particularly infrastructure implementation and are crowding in private investment. The climb in the business confidence index to a record high in Q2 2013 despite earlier concerns over Europe and the US fiscal situation implies onshore investment spending should be relatively immune to additional external risks from China, provided reform momentum continues. Lower commodity prices would push inflation significantly lower (see below) and create even more space for accommodative policy. Of the two commodity exporters in ASEAN, we would expect Malaysia to be hit much harder than Indonesia, seeing growth lowered by 0.8pp twice our estimate of the impact on Indonesia. The difference is that the Malaysian economy is much more open and has seen a much more rapid increase in exports to China than Indonesia. In addition, Indonesias net oil importer status suggests a drop in oil prices would improve the fiscal and current account deficits, and provide more space for stimulus which, in contrast, is already very narrow in Malaysia. Central government debt in Indonesia had fallen to 24.0% of GDP in 2012 from 35.2% in 2007, but over the same period increased to 53.3% from 40.1% in Malaysia. For Thailand, another highly open economy, the main channel of impact will be weaker exports given that China became its largest trade partner in 2012. The slowdown in Thailand a sizeable 0.6pp reduction in growth by our estimates would be further exacerbated by the fact that domestic demand, after recovering strongly from the 2011 floods, is now on a much weaker footing. There is room for monetary policy easing but this would be hampered by central bank concerns of financial stability risks from rapidly rising household debt. Political pressures are also mounting to increase transparency in short-term fiscal stimulus measures (hence making implementation of additional measures more difficult), but also risks delays in much-needed infrastructure projects. Euben Paracuelles
+65 6433 6956 euben.pracuelles@nomura.com
Lavanya Venkateswaran
+91 22 305 33053 lavanya.venkateswarana@nomura.com
31
23 July 2013
Inflation: Given the large weight of commodities in Asean countries CPI inflation baskets, a sharp slowdown in China and its subsequent impact on global commodity prices would result in headline inflation easing across the board. The disinflationary effect from weaker global commodity prices would have the largest impact in Thailand and the Philippines, where the weighting of food and energy in the CPI basket is 56.1% and 50.8%, respectively. We estimate that a 20% drop in commodity prices versus our base case would lead to headline CPI dropping 4 by around 0.8-1pp in these countries . In Indonesia, Malaysia and Singapore, we would expect headline inflation to ease by 0.6-0.7pp from our base case, corresponding to the weight of commodities in the CPI basket. Current account balances: The extent of the impact of lower commodity prices on Asean current accounts depends on whether the country is a net commodity exporter or importer. The two net commodity exporters, Malaysia and Indonesia, would see their trade balances affected negatively from falling global commodity prices (price effects) and lower external demand 5 (volume effects) given the knock-on impact globally of slower Chinese growth . Although import growth would also likely slow in this scenario, Indonesias imports (led by fuel imports) would likely see a larger drop than Malaysias imports given that domestic investments under the Economic Transformation Programme will remain in place, bolstering demand for capital goods. As such, we would expect a small widening in Indonesias current account deficit to 3.0% of GDP (from our base case of 2.7% of GDP), while Malaysias surplus would likely narrow considerably to 1.8% of GDP (from our base case of 3.2%). Singapore would also likely suffer from by a sharp slowdown in China, with resultant weak growth in other major trade partners as well. We would expect Singapores current account surplus to narrow sharply to 7.4% of GDP, from our base case of 14.9% in 2014. In Thailand and the Philippines, both net commodity importers, we would expect the current account balance to benefit from lower global commodity prices. The import bill would fall as lower prices more than offset weaker exports (from both lower volume and price effects). In addition, we would expect the Philippines current account balance to remain resilient given still substantial remittances from overseas workers. We estimate Thailands current account balance would swing back from a deficit of 0.6% of GDP to a surplus of 0.6%, while the current account surplus in the Philippines would widen slightly from 1.8% to 2.1% of GDP. Policy response: Should our China risk scenario play out, we would forecast further rate cuts of 50bp in Indonesia, Malaysia and the Philippines, taking the respective policy rates to 6.0%, 3.5% and 4.0%. In Thailand, we would expect a 75bp reduction in the policy rate, to 2.0%. In Singapore, which operates monetary policy by adjusting the slope and pace of S$NEER appreciation or depreciation against a basket of undisclosed currencies, we would expect looser FX policy to support growth. In terms of fiscal policy, as mentioned, Malaysia has the least scope to provide stimulus measures. In contrast, Indonesia and the Philippines have ample fiscal space: Indonesias public debt ratios are relatively low and fuel subsidies were recently cut; in the Philippines, fiscal reforms that we expect to continue have supported higher spending in social and economic services. In Singapore and Thailand, where the GDP growth slowdown would be the sharpest, there may be scope for some temporary fiscal stimulus, but we would expect that to be limited. The Singapore government has shown resolve in implementing its economic restructuring agenda aimed at increasing productivity and has resisted the temptation to provide countercyclical fiscal policy. In Thailand, many of the short-term fiscal measures have expired and those that remain face heavy scrutiny from political opposition. Infrastructure spending also looks likely to be delayed by a court ruling which will be difficult to reverse.
4 By means of a simple regression, we estimate the impact on headline inflation of changes in the countrys exchange rate to USD, domestic demand and global oil prices. In all five Asean countries the impact of global commodity prices is of the correct sign and significant. 5 To disaggregate the volume and price effects from exports (imports) we regressed the impact of trade partner demand (domestic demand) on export (import) volumes and global commodity prices on export (import) prices, respectively.
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23 July 2013
Equity strategy
Under the China slowdown scenario, the impact on ASEAN equity markets overall will likely be smaller than in the rest of the Asia-Pacific ex-Japan region. We note three primary channels of impact: 1) direct effect on earnings; 2) impact on valuations through sentiment and flows; and 3) second-round effects from change in overall economic performance. In terms of the direct impact on earnings, overall we would expect this to be limited to the Materials, Energy and Tourism sector (and selective impact on Banks and/or Property names with specific exposure). By our estimates, over 90% of revenues for listed companies in Thailand, the Philippines and Indonesia are derived domestically, and we would expect the direct earnings impacts in these three markets to be limited. Still, the first channel would be expected to have more adverse effects on specific sectors and stocks (whereas effects from the second and third channels would likely be broader and more general). x For the Philippines, having low exposure to Chinese growth and being a net commodity importer means that the earnings impact is likely to be limited to the Tourism sector (i.e. Resorts and Gaming). In Malaysia, the Chemicals and Energy sector, alongside Gaming, could be affected. In Singapore, Tourism and Property could be impacted; in particular, property sentiment could be hit by waning demand from Chinese buyers (who have made up about 6% of total buyers over the past year). Local bank DBS (which has direct exposure to Hong Kong/China) might be more affected, as could Developers with direct exposure to China, including Capitaland and Keppel Land. We also note that the integrated agribusiness firm Wilmar derives 50% of its earnings from China. For Thailand, the economic deceleration would come at arguably the worst time for macro risk management i.e. just as Thailand begins a substantial program of infrastructure project spending (the country needs around 5% GDP growth to keep its public debt-to-GDP at around 60%). Within the SET, the Energy/Chemical complex comprises around 20% of market capitalization, but the Thai company with the largest direct exposure to China is CP Group (via Ping Ans acquisition). In Indonesia, the most direct impact on earnings would be on the Energy and Materials sectors, but a China-triggered generalized increase in risk aversion could be especially destabilizing for sentiment via volatility in the rupiah. Jitsoon Lim
+65 6433 6969 jitsoon.lim@nomura.com
Mixo Das
x x
In terms of the impact on valuations, risk aversion associated with a sharp slowdown in China could be relatively less severe for ASEAN markets given their more defensive nature. This would not be the case if such a risk event causes a more generalized unwind of cross-border capital flows from EM; rather, ASEAN markets given higher foreign ownership levels and foreign participation in trading volume are more sensitive to foreign capital withdrawal and would likely underperform in that scenario. But to the degree that key global interest rates and core bond yields might be biased incrementally lower in the slower China scenario, it could in fact reduce such pressures. In any case, we note that Malaysia and Singapore are likely to be more insulated from valuation impacts. Including all the channels of impact then, we judge the Malaysian and Philippine equity markets to be most insulated, followed by Singapore and then Thailand and Indonesia.

FX: In Southeast Asia, we believe FX performance would vary greatly from a rapid slowdown in China's economy. Open economies such as Singapore are most at risk from a slowdown in trade and potential capital outflows. If the overall global growth momentum slows because of China, the combination of a low-inflation backdrop (in part led by lower commodity prices) could prompt the MAS to shift away from its current FX appreciation stance (estimated 2% annualised S$NEER appreciation). Depreciation risks also exist in MYR, not just from the high level of foreign bond positioning and the risk of outflows, but also from a likely smaller current account surplus. The surplus would likely narrow given the fall in both the volume and value of commodity exports. THB underperformance (vs. USD) is unlikely to be as severe as SGD or MYR, but its vulnerability has grown given its increased dependence on China through trade channels. In addition, Thailands economic growth momentum has already slowed, the current account is expected to remain in a deficit this year (Jan-May deficit of USD3.1bn) and policy and Craig Chan
Wee Choon Teo

+65 6433 6107 weechoon.teo@nomura.com
33
23 July 2013
political developments have progressively worsened. In particular, Thailands government was pressuring the central bank to loosen monetary policy, the Thai court has ordered that the water management project (worth around THB350bn) be put on hold until greater transparency has been achieved, while Prime Minister Yingluck has been pushing consistently for constitutional change. Indonesia and the Philippines should prove to be more resilient to a significant China slowdown scenario. The risk to IDR remains the heavy foreign positioning in the local bond market (31.7% of outstanding), but given the recent larger-than-expected fuel price hike and Bank Indonesias (BI) relatively aggressive stance to stem inflation expectations, we see space for some relative FX outperformance. Although BI's tightening stance is encouraging and should help to stabilise local markets, it will need to be sustained until inflation is perceived by the market to be under control. We do, however see risks, as Bank Indonesia recently moved away from its previous stance of holding the 10,000 level, and allowed onshore spot USD/IDR to move above 10,000. The Philippines should be the relative outperformer in the region given the strength of its economy (7.8% y-o-y in Q1, the highest growth in Asia) driven primarily by domestic demand, a favourable political backdrop, a structurally strong current account surplus (remittances and BPO sector), and limited dependence on foreign capital inflows. Rates: Although Southeast Asian economies are very differentiated in their dependence on China, a reduction of interest rates would be a common response across the region to a slowdown of Chinas economy. Malaysia is one country that is highly vulnerable to a China slowdown, as it would create a significant drag on Malaysias growth, inflation and current account (and thus prompt a couple of rate cuts). A broad-based suppression of rates would allow us to have a received bias on the Malaysia IRS curve. A similar impact would be felt in Singapore, and given the higher influence of the US on Singaporean rates, we would recommend a beta-adjusted receive SGD/pay USD trade as China slows down. The impact on Thailands growth would be sizeable, but with the central bank having more space to ease policy and stimulate growth, we would recommend a receive bias in the short end of the (ND) IRS curve. The Philippines would likely benefit from lower commodity prices, which would provide BSP with space to cut rates, while the macro backdrop would remain relatively unaffected; this could lead to a bull steepening of the yield curve. Vivek Rajpal
Prashant Pande
India
Fig. 43: Nomuras forecasts under the base case and risk scenario
GDP growth WPI inflation Current account, % of GDP Policy rate Base case 5.5 5.4 -3.1 6.50 China risk scenario 5.2 3.8 -2.3 6.25
Economics
The spillover effects of the China slowdown will be negative for Indias growth prospects due to the effect of reduced demand from other trading partners. A slowdown from emerging markets could lead to a weaker currency as financing the current account deficit remains difficult. However, a slowdown in China will also have positive spillover effects. Roughly 70% of Indias domestic oil requirement is imported and partly subsidized by the government. As such, with an economic slowdown reducing Chinas commodity demand, lower crude oil and commodity prices should help narrow Indias current account deficit, reduce the fiscal subsidy burden and lower WPI inflation. In turn this would create more space for rate cuts. Overall, therefore, while growth would be hit, we would also expect Indias macro imbalances to simultaneously correct. Our baseline scenario assumes real GDP growth of 5.5% y-o-y in 2014, which could fall to 5.2% on weak external demand. Crude prices softening would result in the current account deficit improving to 2.3% of GDP, on our estimates, from our baseline scenario of 3.1%, while WPI inflation would likely come off to 3.8% y-o-y from our current estimate of 5.4%. In response to the improving twin deficits, falling inflation and a negative output gap, we believe the Reserve Bank of India would likely lower its repo rate to 6.25% versus our base case of 6. 50%. Sonal Varma
+91 22 4037 4087 sonal.varma@nomura.com
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23 July 2013
Equity strategy
For Indian stocks, we believe the range of potential outcomes is wider than for most of the rest of the Asia-Pacific region. As our economists discuss, the direct impact on Indias (domestically dominated) growth is comparatively limited, and indeed there could be positive pass-through from lower commodity/energy prices both of which suggest India could be the most naturally uncorrelated Asia-Pacific market fundamentally in a China slowdown scenario, making it a potential outperformer. But much will depend on whether the presumed decline in global commodity prices (helping narrow the current account deficit and opening room for possible growth-supportive RBI interest rate cuts) will be offset by increased difficulty of financing Indias current account deficit due to generally heightened short-term capital risk aversion. We do not assume the better case scenario, however a view which seems recently to be borne out in actual equity and FX flows recently. We already see downside risk to our March 2014 Sensex target of 21,700 as the RBIs loss of maneuvering room on interest rates (indeed the increased risk of rate hikes to defend the fragile rupee) implies compression of market multiples. Even modestly weaker GDP implies further downside risks to consensus earnings forecasts in FY14 and even at present we assume no better than 10% growth in FY14 Sensex earnings, compared to consensus at around 16%. Sector-wise, the change in RBIs monetary policy stance suggests further outperformance of defensive sectors, while Industrials and domestic cyclical sectors (particularly Autos and Property, and other interest rate-sensitive cyclicals) would likely continue to underperform, in our view. For now, we recommend caution and prefer to ride out potential market volatility by sticking to defensive growth, low-beta names and exporters. Separately, upcoming general elections in India will be the key domestic trigger in the next six to nine months. Historical evidence suggests that market volatility typically declines going into elections, but picks up afterwards. Prabhat Awasthi
+91 22 4037 4181 prabhat.awasthi@nomura.com
Nipun Prem
+91 22 4037 5030 nipun.prem@nomura.com

FX: Unlike the rest of Asia, the risk to INR from a significant slowdown in China's economy is likely to be more a response to adjusting global growth prospects than a direct impact from trade links. Indias struggle to finance its current account deficit is likely to worsen with additional concerns from projected short-term external debt maturities. We estimate that there are around USD21bn of ECBs maturing in FY2014. That said, there are still short-term measures that the government can take to limit INR depreciation, such as a large NRI dollar bond issuance. In addition, a significant fall in global commodity prices will help to narrow the current account deficit and lower inflation, which would allow the RBI to loosen monetary policy. This could eventually lead to some stabilisation of INR, but is unlikely until after the parliamentary elections in May 2014. Rates: As noted in our scorecard analysis, we believe India would be one of the least-impacted economies from a China slowdown. As highlighted above, a slowdown in China could help contain inflation and the twin deficits in India and thus create room for the RBI to cut policy rates. The rates (especially front end and bond yields) have risen sharply due to the tight monetary stance maintained by the RBI, especially after the measures announced on 15 July (see India rates strategy: Liquidity squeeze in the making, 16 July 2013). We expect the RBI to continue preferring tight liquidity conditions in order to support INR and thus provide good entry point for long bond positions and receive positions in OIS. Our FX strategy team and economists expect a stabilisation of INR and a rate cut, respectively, in the event of China slowdown; this would help loosen liquidity conditions, which would be beneficial for these positions. Craig Chan
Prashant Pande
Vivek Rajpal
Prashant Pande
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23 July 2013
Australia and Canada

Base case 2.1 2.3 -3.9 2.75 Australia China risk scenario 1.4 1.8 -4.5 2.00 Base case 2.3 2.0 -3.1 1.50 Canada China risk scenario 2.0 1.7 -3.4 1.25
Charles St. Arnaud

+1 212 667 1986 charles.starnaud@nomura.com
Economics
The Australian economy would only be moderately affected by weaker growth in China, in our view. There are two main channels through which the impact would be felt: 1) the direct trade link between the two countries, and 2) the indirect impact coming from the terms-of-trade shock that would result from lower commodity prices. The trade link between Australia and China is very important, with China absorbing about onethird of all Australian exports; of which, it also accounts for about 75% of all iron ore exports and about 23% of total coal exports. Moreover, the spillover from weaker Chinese growth on other Asian countries would also affect Australia as about 75% of all exports are destined within the region. We estimate that the direct impact of a growth slowdown in China as described in this scenario would reduce Australian GDP growth by about 0.3 pp. On top of that, we believe that weaker growth in the rest of Asia would reduce Australian growth by another 0.1pp, for a total impact of an estimated 0.4pp. With regard to the second channel, the terms of trade, the impact is less direct, more complex and would take longer to play out. A decline in the terms of trade would lead to lower gross domestic income growth, which would be reflected in lower corporate profits, wages and ultimately government revenues, which would all contribute to weaker domestic demand. Moreover, lower commodity prices would also have a knock-on effect, likely delaying or cancelling investment projects in the resource sector. The second half of 2012 already experienced a wave of project cancellations due to lower commodity prices so the adjustment could be smaller than at that time but nevertheless, this would mean weaker employment and lower imports since most of the capital goods needed are imported. A lower terms of trade would also cause a depreciation of AUD, which we estimate could see AUD/USD remain weaker for longer, reaching 0.88 by end of 2014. This depreciation would improve the competitiveness of the non-resource sector but it may take time for foreign demand to adjust, while the weaker currency would lead to a decline in the purchasing power of consumer and businesses, reducing demand. Overall, we believe that the impact from weaker commodity prices and the associated terms-oftrade shock would reduce Australian growth by about 0.3pp. Combined with the 0.4pp trade impact, we therefore estimate that a weaker China in this scenario would have the effect of shaving about 0.7pp off Australian growth. Based on our base case of growth in 2014 of 2.1%, this means that a meaningful Chinese slowdown could lower this to 1.4% the weakest level since the onset of the financial crisis. The impact on Canada of a China slowdown as described would be more muted given the weaker trade links between the two countries. Only about 4% of Canadian exports go to China. However, despite this small share, exports to China have been growing quickly, and are responsible for almost one-fifth of Canadian export growth over the past year. Nevertheless, we estimate the trade impact on Canadian growth is likely to be modest, at around 0.1pp. Most of the impact, we believe, would be felt through a terms-of-trade shock, similar the one described above for Australia. However, since energy prices are expected to be less affected by weaker Chinese growth, the terms-of-trade impact on Canada should be smaller than in the Australia. Moreover, with a bigger manufacturing sector, the Canadian economy could benefit more quickly from a weaker currency. We estimate that the decline in the terms of trade could see USD/CAD experience a bout of weakness for longer, at around 1.10 by end-2014. Overall,
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we believe that weaker growth in China would shave about 0.3pp from Canadian growth, taking our 2014 forecast of 2.3% to 2.0%.
Equity strategy
It has always been somewhat of an oversimplification to treat Australia merely as a derivative play on Chinese resources demand, despite the obvious linkages. Indeed, as a starting point it is useful to note that by market capitalization, Australia is only 17% Materials and 6% Energy with the bulk of the balance (more than three-quarters) being domestic (Figure 45).
Fig. 45: Australia ASX 200: Composition by sector
Utilities, 1.8% Discretionary, 4.2% Health Care, 4.7% Telecom, 5.3% IT, 0.7%
Michael Kurtz
Mixo Das
Energy, 6.3% Financials, 44.9%
Industrials, 6.3%
Staples, 8.6%
Materials, 17.2%
That said, the broader question remains what the key rationale now is for Australian equity exposure. Australias economic cycle does seem destined for higher volatility as the China peak steel'-related decline in resource investment (which in recent years had been more robust and largely stable/predictable) is replaced by resource exports (cyclical and geared to global demand). This volatility (including in corporate earnings) would certainly be substantially magnified in our risk scenario which we believe will by extension require the impounding of a longer-term discount from Australian asset prices. A further commodity downdraft would be tough on primary-goods producers everywhere arguably raising the spectre of a 1997-98 style downturn in which the rollover in commodity prices leads a blow-out in both sovereign- and micro-level financial risks. Among MSCI World equity index constituents that demonstrate higher primary sector (i.e. extractive industry) shares of GDP, this includes Chile, Peru, Colombia, Emerging ASEAN, India, Morocco, Russia; and in developed markets, Australia, Canada and Austria. Of some reassurance, however, is that Australia has seen the third-smallest widening of its CDS spread among these countries since 31 January, 2013 (i.e. the date of the CRB Commodity Indexs highest level this year) a negligible 6bp widening (Figure 46).
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Fig. 46: Change in CDS spreads for primary industry-intense economies

250
Morocco
200
CDS spreads as of Jan 31, 2013
150
Russia Mexico Philippines Thailand Peru Colombia Malaysia Chile
Indonesia Turkey Brazil
100
China
50
Austria
Australia
0 -20 -10 0 10 20 30 40 50 60 70 Change in CDS since Jan 31, 2013
Looking beyond the Resources sector, and Australias region-high aggregate dividend yield of 4.5% has meant that its market raison detre for much of the past two years has been as a source of yield rather than China growth primarily through local Banks, Telcos and Consumer Staples names. But since the start of 2013 the generally upward pressures on global fixedincome yields has also undermined this particular attraction for Australian equities as well. Moreover, our economists believe that the neutral rate in Australia has likely declined by between 200bp and 300bp since the global financial crisis due to slower potential growth, higher funding costs for banks, tighter financial regulations, higher savings, financial inflows, and the above-noted weakening of investment. In other words, the RBA would still have to reduce policy rates substantially simply to avoid tightening, let alone to actually loosen. Thus, there is a case for Australian equities should a deeper China slowdown either: 1) refocus global equity investors back on yield plays by flattening the US Treasury yield curve; or 2) motivate the RBA to consider a more radical interest rate cutting cycle than the shallow one it has implemented in recent quarters or both. In that regard, our US rates strategy team discusses below that by weakening global growth, a deeper Chinese economic slowdown would keep US Treasuries in favour at least over the short to medium term. And as noted above, the RBA does at least have the potential to cut rates significantly.

The most obvious observation to the scenario being painted is that the Reserve Bank of Australia (RBA), already at its lowest ever official cash rate of 2.75%, has the potential to cut rates significantly if needed. A significant drop in growth in China would have the effect of lowering domestic growth and inflation, in our opinion, which would allow the cash rate to follow what we have seen in other G10 economies in the last few years. From a strategy perspective, we believe a fall in Chinese GDP would have significant effects on the Australian markets. A weaker growth outlook for China would likely be played out in an immediate fall in the AUD exchange rate, as well as a rally in the front end of the rates curve. As we noted in the Rates Weekly: 2Q13 Review and 3Q13 Outlook (pg 29-30) the Australian market has bifurcated into two different curves. The front end of the Australian rates curve has a higher correlation than the back end to domestic data and the macro outlook. Given the difficulty the economy has had in transitioning from a resource boom to the interest rate/FX sensitive sectors of the economy, the market continues to factor in further rate cuts. Indeed, our view for some time has been that this transition will be a difficult one and ultimately take policy rates lower. Our Special Report, Australia: The terminal cash rate (20 May, 2013), suggested that the policy rate will fall to at least 2.25% based on a lower neutral rate and the sluggish economy. Based on the economic scenarios outlined, we could expect a further 25bp of cuts to take the Martin Whetton
+61 (2) 8062 8611 martin.whetton@nomura.com
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policy rate to 2%. To the extent that the RBA signals its forward rate guidance, we would expect a dovish tone, or use of the words more scope to ease, to remain in place. In terms of the rates market, we would see the greatest impact from a downgrade to Chinese growth being played out with a steeper Australian yield curve. The curve (as measured by the 3s10s futures) has recently moved to multi-year highs (Figure 47). It is likely to steepen further in the near term and perhaps approach the old highs in the mid-100s. However, the curve also has a tendency to flatten or invert ahead of recessions or major slowdowns, so while the curve is currently sitting at high levels, a flattener would only be in play if the economy was moving into recession.
Fig. 47: 3s10s curve against RBA cash rate
20 18 16 14 12 10 8 6 4 2
RBA cash rate,lhs
Aust 3/10 curve, rhs
2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5
Source: Nomura Rates Strategy.
The front end of the OIS/IRS curve would quickly move to price in a lower terminal rate than the current levels, as we have seen many times over the last few years. Typically markets overshoot and we would expect to see the terminal rate lowered from ~2.3% to as low as 2% (Figure 48). This would likely flatten the OIS curve, with the cuts from around the 3m to 9m sector outperforming, pulling the leveraged forward trades like 1yr forward 1yr and 2yr forward 1yr lower, and on to the 3yr part of the curve. We have mentioned these trades recently in our weeklies as being attractive, but with recent market volatility have not formally recommended them. In the event of a significant writedown in Chinese GDP, we would enter these positions and look for 30-40bp of directional moves, augmented with the significant carry and roll that the trades offer.
Fig. 48: 1yr OIS rates and China GDP
bp 250 150 50 -50 -150 -250
1yr OIS rate moves priced in, lhs
China GDP, rhs
% y-o-y 13 12 11 10 9 8 7 6
While the rates market should pull yields lower overall, we would have some medium-term concerns over the long end of the ACGB market. These derive from the likely drop in government revenues as activity falls, increasing the risk to further ACGB issuance. At this stage, given both sides of the political spectrum are committed to a budget surplus, a fiscal stimulus would not be an immediate risk. This scenario would be seen first in the steepening of the curve, but could eventually see long-end bonds underperform on an ASW basis. The
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short-dated bonds are likely to move back through the cash rate past the 4yr sector of the curve (with that part of the cure yielding around 2.75%). Further out the curve, the 10yr ACGB is trading around 100bp over cash. For much of the cutting cycle (and while central banks were accumulating bonds), this spread was negative. Current levels are at a two- year high (Figure 49).
Fig. 49: Australian 10yr cash spread against RBA cash rate
300 200 100 0 -100 -200
In spread product, the semi-government sector is enjoying some tailwinds for the moment, with reduced issuance (see Rates Insights: Australian Semi-government supply, 4 July, 2013), but a weaker Chinese growth scenario would hurt the resource states (particularly Western Australia and Queensland) more than others. We are already negative on WA, but we hold a positive view on QTC given the drop in issuance. We would thus be more cautious on QTC, but note that each 1c drop in AUD is worth AUD33m in improved bottom line for Queensland (according to the state Treasurer). Given the recent fall in AUD and the fall we would expect in this scenario, we would expect to see a drop in Australian bank funding in offshore markets. ANZ Bank noted recently that the fall in AUD has released around AUD7bn to its balance sheet from swap collateral on crosscurrency borrowing, effectively nullifying the need to borrow further in the year to 30 September, 2013. Extrapolating this across the banking system, a smaller offshore borrowing requirement would put downward pressure on the AUD/USD basis, pulling the term structure lower and helping the sorts of positive carry cross-currency basis trades we noted in Rates Insights: Australia: The next 25bp (3 May 2013).
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Latin America
Base case 1.8 5.2 -3.0 9.25 Brazil China risk scenario 1.3 5.5 -4.0 9.25 Base case 4.0 3.0 -4.0 4.50 Chile China risk scenario 3.6 3.4 -5.0 4.00 Colombia Base China risk case scenario 4.5 4.0 2.8 2.9 -3.3 -3.8 4.00 3.50 Base case 4.7 3.8 -1.5 4.50 Mexico China risk scenario 4.3 3.5 -1.5 4.25
Economics
A sharper-than-expected slowdown in China growth will likely impact Brazil most significantly in Latin America, through various channels. Lower demand for commodities would directly hit Brazilian exports, of which 70% are raw or semi-processed materials. In the China downside risk scenario, our Chief China Economist Zhiwei Zhang believes that Chinese investment would get hit the hardest, and so in terms of global commodity prices we assume that base metal prices would fall the most; by 20-30% in 2014 from 2013 average levels. This negative terms-oftrade shock would have major repercussions on investment, national wealth and future growth. Our analysis shows that a 1pp fall in Chinese growth could directly reduce Brazilian growth by 0.45pp. Second-round effects, especially through lower US growth, could shave off another 0.1pp. If the 30% fall in commodity prices materializes, we would expect BRL/USD to fall to 2.28 by end-2013 and to 2.41 by end-2014 (spot: 2.26). In this case, we estimate the FX passthrough to push inflation up by 0.5pp, primarily via tradable prices. Nonetheless, economic deceleration and, consequently, higher unemployment, would likely lower non-tradable prices and keep the overall inflationary impact in check over the medium term. Lower export prices could lead to a trade deficit in 2014 and Brazils current account deficit, already at 3.2% of GDP, could top 4% a level last seen in the early 2000s. For Chile, the key transmission channel is copper, which accounts for 15% of its GDP and over half of its exports. The copper price has been struggling above $3/lb, not only a critical level for breakeven of many mining projects, but also the long-term assumption used for the structural fiscal balance. Should copper prices fall below $3/lb and continue to drop, we would expect to see another 10% fall in the currency by end-2014, pushing CPI inflation up by 0.6pp, although lower growth and a less intense labour market may partly cushion this impact. As long as inflation stays below target, the central bank will keep cutting its policy rate (currently at 5.0%) to offset external shocks. The current account deficit (now 4% of GDP) would be expected to further deteriorate, possibly climbing to above 5% a level last seen in 1998 when copper prices were at their low. In Colombias case, trade links with China are not very strong; China represents only 6% of Colombias exports, compared with 35% for the US. However, a China slowdown may have significant implications for the local economy through its impact on commodities prices, particularly oil. Colombias economic cycles are highly dependent on its terms of trade, which at the same time are highly correlated to oil prices. Overall, we estimate that a decrease of 1pp in Chinese growth reduces Colombian growth by 0.47pp (taking into consideration second-round effects of the Chinese slowdown on the US economy). The reaction of the currency would depend on the final impact of Chinas deceleration on oil prices. Our estimates suggest that a 1% reduction in Brent prices depreciates COP by 0.20%. Under such scenario, a decrease in Brent prices to $100/barrel would push COP to the $1,940 level, keeping everything else constant. For Mexico despite the recent visit of President Xi Jinping trade ties with China remain very limited too. For example, in 2012 Mexico exported less than US$6bn to China (0.5% GDP) while importing 10 times that amount over the same period. Therefore, the direct impact of a Chinese slowdown on Mexico through trade and investment channels would be close to nil. However, to the extent that Chinas deceleration meaningfully impacts US GDP growth, Mexicos main trade partner (our US economist expects growth lower by 0.25pp), there could be some spillover effect on to the Mexican economy (a 1pp fall in US growth reduces Mexican growth by 1.5pp). Tony Volpon
+1 212 667 2182 tony.volpon@nomura.com
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Europe
Base case 0.0 1.4 0.50 Euro area China risk scenario -0.3 1.1 0.25 Base case 1.4 2.5 0.50 UK China risk scenario 1.2 2.2 0.50
GDP growth CPI inflation Policy rate
Economics
Jacques Cailloux Export growth to Asia has been a key offset to weak European demand Since the recovery in external trade in 2009, euro area total exports (including intra-regional trade) have grown by a cumulative 35% in nominal terms. However, as Figure 52 shows, a significant 65% of this recovery has been led by demand from outside the region, which has grown by 45%. Since 2010, the importance of non-euro area demand has grown even further, with 70% of euro area total export growth since then explained by demand from outside the region a strong signal of the dependence of the euro area business cycle on foreign demand. A breakdown of euro area exports to the rest of the world shows that since 2009, Asia has made the second-largest contribution to export growth (of 12pp out of 45%) after Greater Europe (including UK, Sweden, Switzerland, Turkey), which accounted for 20pp of the 45% total increase. The importance of Asia in contributing strongly to European exports is nothing new and has been noticeable since 2001. Indeed, between 2001 and 2012, export growth to Asia contributed around one-third of euro area export growth outside of the monetary union more than five times the US. Within Asia, China accounted for 10pp of extra euro area export growth over that period, more than twice the contribution from the US. Since 2009 however, the relative contribution of Asia has been declining somewhat, accounting for only twice that of the US (Figure 53).
+44 20 7102 2734 jacques.cailloux@nomura.com
Silvio Peruzzo
+44 20 7102 3205 silvio.peruzzo@nomura.com
Stella Wang
+44 20 7102 0599 stella.wang@nomura.com
Fig. 52: Intra and extra euro area exports

bn 4,000 Extra EA Intra EA
Fig. 53: Breakdown of extra euro area exports

bn 2,000 Other Latam US Europe non-EA Asia Extra EA
3,500
3,000
Total
1,800
1,600
1,400
1,200 1,000 800 600
2,500
2,000 1,500 1,000 500
400
200
1999 2001 2003 2005 2007 2009 2011
1999
2001
2003
2005
2007
2009
2011
Source: Eurostat and Nomura Global Economics.
Direct exposure to China As can be seen from Figure 54, Germany (by far), Finland, France, the UK and Italy have the largest export share to China among European countries.
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Fig. 54: Exports to China as % of total exports

% of total exports 7 6.1 6 4.6 5 4 3
2 1 3.4 3.3
2.3
2.2
2.1
1.7
1.7
1.7
1.6
1.6
1.4
1.0
Ireland
Finland
France
Poland
Spain
Netherlands
Portugal
Second-round impact via exports to Asia-5 Our Asian economists have identified six Asian countries that are particularly exposed to a China slowdown. Below, we provide a ranking of European countries trade shares to five of these six Asian economies (Taiwan is excluded due to a lack of data). The same five countries have the most exposure as in the case of China, although the order is different with the UK and France displaying the largest export shares.
Fig. 55: Exports to Asia-5 as % of total exports

% of total exports 8 6.7 7 6 5
Germany
Hungary
Belgium
Greece
Austria
Italy
UK
4.9
3.7
4
3 2
3.7
3.6
3.4
2.6 2.5 2.4 2.3
2.2 1.3
1.2
1
0
0.8
Portugal
Ireland
Finland
Poland
France
Spain
Netherlands
Germany
Hungary
Belgium
Greece
Austria
Italy
Note: Asia-5 is Australia, South Korea, Hong Kong, Malaysia, Singapore. Source: Eurostat and Nomura Global Economics.
Combining total exposure to China and the Asia-5 leads to the rankings shown in Figure 56. The UK comes most exposed to a slowdown in China and Asia-5, followed closely by Germany. France and Finland are equally exposed (more than 8% of their total exports).
UK
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Fig. 56: Top 5 countries with the most exposure to Asia

% of total exports 12 9.9 10
8 6.1
9.7
8.4
8.3
6
4
2
0
Germany
Finland
France
Italy
Note: Asia represented by China and Asia-5. Hereafter is the same. Source: Eurostat and Nomura Global Economics.
Shares of exports as a percentage of GDP Another metric to assess the potential impact from a China/Asia slowdown is to look at the share of exports to GDP. Figures 57 and 58 show the share of exports-to-GDP for exports to China and the Asia-5, respectively. While Germany remains the most exposed to China, Belgium and Hungary now rank second and third. The Netherlands also makes it into the top 5, while the UK drops significantly to ninth from fourth in the export share ranking. In terms of exposures to the Asia-5, the Netherlands and Belgium rank highest, followed by Germany, Ireland and the UK.
Fig. 57: Exports to China as % of GDP

% of GDP 2.5
UK
Fig. 58: Exports to Asia-5 as % of GDP

% of GDP 2.5 2.1
2.5
2.0 2.0 1.5 1.0 0.5
2.0 1.5 1.5
2.0
1.4 1.4 1.3
1.0 0.9 0.7
1.5
0.6 0.6 0.5
1.3
1.1 1.1 1.0 1.0
1.0
0.4 0.4
Poland Spain
0.9 0.5 0.5 0.4
0.2
Greece
0.5
0.0
0.2
Netherlands Portugal Germany Hungary Belgium Ireland Greece Finland Austria Poland France Spain Italy UK
0.0
Netherlands
Portugal
Again, if we combine exposures to China and the Asia-5, we find that under this measure, Germany and Belgium have the greatest exposure from their exports to that region accounting for around 4% of their respective GDP. The Netherlands, Hungary and Finland are the three other European economies with significant exposure (Figure 59).
Germany
Hungary
Belgium
Ireland
Finland
Austria
France
Italy
UK
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Fig. 59: Exports to China + Asia-5 as % of GDP

% of GDP 5
4.1
4 3
4.0
3.5 2.5 2.4
2
1 0
Netherlands
Germany
Hungary
Changes in the composition of goods exports to China Figure 60 shows the changes in the composition of export to China over the past 10 years for select countries. Looking across the six countries shows that the bulk of exports to China are in the capital goods and/or transportation sectors. Indeed, the two sectors account for more than 50% of total exports to China from Germany, France, Italy and the UK. Germany tops the ranking with almost 80% of total exports to China falling in those two sectors in 2012. Capital goods and transportation equipment accounted for around 30% of Dutch and Spanish exports last year, as almost half their exports were accounted for by intermediate goods outside the transportation sector. The share of consumer goods exports (including food and beverage) from European countries to China has been rising, even if it still remains quite low compared to other sectors. In 2012, France, Italy and Spain were the countries with the highest share of consumer goods exports to China (around 20% of total exports, twice as much as 10 years ago). A breakdown of exports shows that while no European country would be immune to an investment-led slowdown in China, Germany, the Netherlands and the UK stand to be most affected. Should consumer spending abruptly slow in China, then France, Italy and Spain would be hit hardest.
Belgium
Finland
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Fig. 60: Export composition to China over the past 10 years

share of total
100%
Consumer goods nes
Transport equipment and parts and accessories
Capital goods excl transport
Other
Industrial supplies nes
Food and beverage
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2000 2005 2009 2012 Germany
2000 2005 2009 2012 France
2000 2005 2009 2012 Italy
2000 2005 2009 2012 Spain
2000 2005 2009 2012 Netherlands
2000 2005 2009 2012 UK
The domestic value-added content of exports: a new methodology to assess transmission channels Up until recently, headline bilateral trade data were the only data available to assess transmission mechanisms between trading partners. But headline bilateral trade numbers are unlikely to provide the right metric to assess precisely the impact on GDP given the increasingly globalised nature of production processes. Indeed, the increasing import content of exports might actually lead to an overestimation of trade linkages. We thus make use of the recently published OECD-WTO database TiVA to measure the more direct impact on European countries GDP by focusing on the value-added content of exports. These data also have the benefit of including statistics on international trade in services, which is not included in the analysis above. The caveat is that the latest data available for is 2009. Figures 61 and 62 show the domestic value-added content of select European countries exports to China and Asia-5 as a share of the exporters GDP. It is important to note that country differences might reflect either differences in the level of import content of exports, or a higher level of exports of intermediate goods to third countries that would enter the production process of final exports to China. In 2009, the latest year for which data are available, the value-added content of exports to China was the highest in Hungary and Finland and the lowest in Greece and Spain. Ireland, Germany and Belgium were the three others in the top 5 most exposed. We believe that this ranking provides a truer picture of the actual degree of exposure to China. The high ranking of Hungary reflects the significant share of Hungarian intermediate exports to third countries which are ultimately used for exports to China.
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Fig. 61: Domestic value-added content of exports to China

% of GDP 2 1.5 1.5 1.3
1.2
1.2
1.2 0.7 0.7 0.6
0.6
0.6
0.6
0.5
0.4
Ireland
Finland
Poland
France
Spain
Netherlands
Portugal
Germany
Note: Note: How to read the figures: in the case of Spain for example, the domestic value added content of Spanish exports to China include not only the part of value added in Spanish exports from Spain to China but also the Spanish value added content of any other exports to China via the exports of intermediary goods made in Spain which are then turned into inputs of exports to China from a third country. Source: OECD and Nomura Global Economics.
Figure 62 provides the same statistics for exposure to Asia-5. The ranking also appears quite different from the one derived from export shares as a ratio to GDP. Ireland and Hungary top the ranking this time, with the total value-added content of Irish exports to China (either directly or indirectly via the exports of intermediate goods and services) accounting for 3% of Irish GDP in 2009.
Fig. 62: Domestic value-added content of exports to Asia 5

% of GDP
3.0
Hungary
Belgium
Greece
Austria
Italy
UK
2.6 2.5 2.2 2.1 2.0
1.5 1.4
1.3 1.2 1.2 1.1 1.1
0.8
Source: OECD and Nomura Global Economics.
The high ranking of Ireland should be taken with caution for several reasons. First, the specialisation of Ireland is less cyclical (eg. pharmaceutical) than in other countries, making the elasticity of Irish exports to an Asia slowdown less than that of other countries. Second, Irish export performance in the 2008 downturn displayed a huge resilience compared to all other European countries, which saw exports to Asia collapse, a phenomenon likely to be repeated in an Asian slowdown scenario. Third, and finally, the very sizeable exposure of Ireland to the US (see below for more) would also provide a sizeable cushion. Total impact assessment Below we provide a total impact assessment on euro area countries. A number of important assumptions are required for these estimates, and they should be used as a rough guide. The table shows that the impact of a China/Asia slowdown would shave around 0.3pp of euro area GDP growth. The impact is composed of the second-round impact from the Chinese slowdown,
Ireland
Finland
Poland
France
Spain
Netherlands
Portugal
Germany
Hungary
Belgium
Greece
Austria
Italy
UK
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the Asia-6 slowdown and the indirect impact of other countries slowing also. We include some indirect impact from financial transmission channels, which we assume to be minimal in the context of reduced European equity market correlations (see Equity section), low FDI stock exposures and relatively low banking asset exposure as a percent of bank assets (Figure 63).
Fig. 63: Total impact assessment of China slowdown across the euro area
Trade channels Total Direct impact Euro area Germany France Italy Spain Netherlands Finland Belgium Austria Ireland Portugal 0.3 0.3 0.2 0.2 0.2 0.3 0.4 0.3 0.3 0.5 0.2 0.11 0.15 0.09 0.09 0.07 0.10 0.18 0.15 0.15 0.16 0.09 Indirect impact from Asia-5 0.07 0.09 0.06 0.06 0.04 0.07 0.11 0.10 0.08 0.17 0.06 Indirect impact from other countries 0.03 0.04 0.03 0.03 0.02 0.04 0.04 0.05 0.04 0.10 0.02 Other channels
0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
Fig. 64: Total bank exposure for select European countries, as of December 2012
% of total MFI assets Germany France Italy Spain Netherlands UK
China 0.2 0.6 0.0 0.2 0.4 0.8
Australia 0.2 0.4 0.0 0.0 2.4 0.4
HK 0.1 0.4 0.0 0.1 0.3 1.6
Korea 0.1 0.4 0.0 0.0 0.2 0.5
Malaysia Singapore 0.0 0.1 0.0 0.0 0.0 0.3 0.1 0.4 0.0 0.0 0.5 0.5
Asia6 0.8 2.3 0.1 0.3 3.8 4.0
Source: BIS and Nomura Global Economics.
Exposure to the US remains on average higher than to Asia An important mitigating factor to an Asia slowdown would be US demand for European goods. Indeed, using the same dataset on the value-added content of European exports (Figure 65) we find that all European countries have either a higher or equal value-added content in exports to the US than to Asia. In the case of the UK and Ireland, the value-added content of exports to the US is more than twice greater than that to Asia an indication of a greater sensitivity of those economies to the US business cycle.
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Fig. 65: Domestic value-added content of exports to Asia and the US

% of GDP 9 8 7 6 5 4 3 2 1 0
Asia-6 incl. China US
Portugal
Germany
Hungary
Belgium
Source: OECD and Nomura Global Economics.
Impact on inflation We find the impact on euro area inflation from lower commodity prices to be very significant. Indeed, based on the assumption of a 15% decline in oil prices, a 20% decline in non-oil nonfood commodities and a 5% decline in food commodities (assuming a stable EUR), euro area inflation in 2014 would be around 0.3pp lower than in our base case. A decomposition of the impact (Figure 66) shows that most of the impact would come from lower energy prices.
Fig. 66: Impact of lower commodity prices on euro area inflation
Simulated impact of: 15% in oil price 5% in food commodity
Core goods (NMR 20% in non-oil / non-food commodities measure) Estimated impact on total inflation
Conclusion The globalisation of production processes as well as the huge increase in the contribution to global trade from China since joining the WTO has contributed to increasing the interdependence of Europe and Asia. Our analysis has shown that focusing solely on the headline trade linkages between the two regions might be somewhat misleading. To address the issue of the rising share of the import content of exports and the increasing share of intermediate goods exports via third countries, we have made use of the recently published OECD-WTO database TiVA which provides a more refined framework to assess the transmission channels via trade linkages. While recognising that this framework has its own limitations, we find that a significant slowdown in China characterised by a 1pp decline in GDP growth and a 10% decline in ordinary imports growth would shave about 0.3pp of euro area GDP (Figure 16). Aside from Ireland, which is a special case, we find that Finland, Belgium, Germany and Austria would be most exposed among euro area member countries.
Ireland
Finland
Greece
Austria
Poland
France
Spain
Italy
UK
Netherlands
Estimated CPI component directly CPI weight elasticities impacted (i) (ii) Energy Food 0.11 0.14 0.13 0.06
impact on headline (i)*(ii)*expected change 0.21 0.04
0.11
0.01
0.02 0.28
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We also find that the nominal impact could be more significant than the real impact with a sizeable decline in euro area inflation through the assumption of significantly lower commodity prices. All in all, a deeper China slowdown could result in a significantly lower nominal growth environment in Europe at a stage where nominal growth is already low. Such a development would likely lead markets to discount additional easing measures by the ECB, including full blown QE.
Equity strategy
We do not believe that the slowdown in China GDP growth will pose a sufficiently strong headwind to alter our positive view on European equities. In our recent Global Strategy report (Beijing brakes, Tokyo gas, 9 May 2013) we noted the falling correlation between the Chinese and global stock indices (Figure 67). We have also stressed the disconnect between the European equity risk premium and other exogenous measures of risk, such as policy uncertainty, credit spreads or implied volatility. The narrowing gap between the two should be supportive for European equity valuations, in our opinion. Lastly, European companies have significant sales exposure to US and Japan where our economists are optimistic about the growth prospects in H2 this year and beyond. Robertas Stancikas
+ 44 20 710 23127 r.stancikas@nomura.com
Inigo Fraser-Jenkins
+44 20 710 24658 inigo.fraser-jenkins@nomura.com
Fig. 67: Chinese and global equity correlation
Source: Bloomberg, MSCI, Nomura Strategy Research.
However, some European sectors are much more vulnerable to the slowdown in China than others. As Figure 68 shows, earnings in the basic industries sector have the strongest link to China GDP growth. Within the sector we would highlight the mining sub-sector in particular as we believe that it is likely to be the most affected as a result of falling commodity prices. In our European Recommended portfolio, we started to reduce our mining exposure at the beginning of February and in late April explicitly turned Underweight in favour of exposure to the capital goods sector (see European strategy report, Further rotation from China to the US, 24 April 2013). While other cyclical sectors are likely to be affected as well, we believe that at least some of the earnings decline can be offset by improving growth prospects in other regions.
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Fig. 68: Correlation of relative European sector earnings and China GDP growth
0.5 0.4
0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 -0.5
Media
Consumer Cyclicals
Financials
Basic Materials (incl mining)
Utilities
Mining
Banks
Energy
Healthcare
Insurance
Note: Figure shows the correlation between relative year-on-year change in European sector earnings and year-on-year China GDP growth since 1994. Source: FTSE, Nomura Strategy Research.

Rates battle: Term premium vs inflation premium In the period following the financial crisis, central bank asset purchase programmes had the effect of removing term premium from the curve. The recent Fed discussion in terms of tapering its asset purchase programme leading to decreasing liquidity additions into the economy is likely to reintroduce this term premium over time. As such, in order for the fundamentals such as disinflationary pressures to have more impact than merely a beta adjustment across the euro and sterling curves from the USD curves, we believe the ECB and BoEs forward guidance would need to be more robust to cause a significant decoupling. As has been discussed above, the disinflationary effect of a China slowdown is likely to be more impactful on Europe than the US. Even without a decoupling of the curves this should be most beneficial for short-dated euro forwards and the belly of core European bond curves. As such, we would favour positions such as being long euro swaps against USD equivalents around the 2yr point, which is just beyond the Feds current forward rate guidance point. To materially affect maturities beyond the 5-7yr points of the European curves, a more robust anchoring of curves would be required, in our view. Disinflation could benefit Europe, forcing the ECB into a QE programme Adding an additional deflationary element from a China slowdown to the impact of the competitiveness rebalancing process across the euro area raises the potential for further ECB action to combat the disinflationary environment. If this took the form of an asset purchase programme, likely weighted on the ECB capital key, we would expect term premiums (and credit premiums) across the European sovereign curves to reduce, in a similar fashion as under the Feds QE. In Europe, the reduction in premiums could bring a second-order effect in terms of strengthening bank balance sheets, particularly in Italy and Spain where banks own 421.8bn and 302.9bn in government debt, respectively. Without central bank action, we would expect a slowing growth environment to have negative consequences for the stock of nominal debt, particularly in those countries that still have positive debt trajectories. As wages/inflation fall, real rates rise, increasing the real value of the existing stock of debt. This could create a greater propensity to deleverage, decreasing domestic demand and further affecting growth. Guy Mandy
+44 20 710 35886 guy.mandy@nomura.com
Consumer Staples
Telecoms
Capital Goods
Technology
David Mendez-Vives
+44 20 710 31202 David.Mendez-Vives@nomura.com
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In aggregate, we believe maintaining exposure to 5-7yr Germany captures upside on a number of potential European rates paths. Rates risk could be hedged via paying EUR 5y5y. European inflation markets already pricing in a lot of disinflation The impact of a slowdown in China on European/UK inflation-linked markets would come from a further downgrade of inflation expectations, beyond what the market is already pricing in. Inflation markets have been under pressure since April due precisely to the negative outlook on China and its impact on commodity prices, with base metals and agricultural products prices showing strong falls on a yearly basis not to mention gold. In our view, the downside for inflation markets from a further downgrade of Chinas growth is limited. In effect, Eurozone breakevens have already come to price medium-term inflation well below the 2% ECB inflation target. The 5yr inflation swap is now barely above the 1.5% area, and bond breakevens are substantially below OATei18 at 1.27%, or OBLei18 at 1.00%. This is driven by the strongly deflationary environment in the peripheral Eurozone countries, engaged by necessity in a competitive disinflation process. Except for administered prices and consumption taxes there is very little inflation pressure in the short term, as reflected by very low wage-growth prospects. Longer-term, inflation expectations appear to normalise, as measured by the 5y5y inflation swap forward at 2.25%, or the 10y inflation swap at 1.91%. The dynamics in the UK are slightly different, as inflation has been well over target (2.0% CPI) for a very long time, the Bank of England has engaged in a large programme of quantitative easing and the currency has depreciated strongly over the last couple of years. The inflation market is pricing in a certain tolerance for inflation by the monetary authorities, with RPI inflation swaps well above 3% along the whole curve (e.g. 3.22% for 5y). A slowdown in inflation due to China may bring down the front end of the breakeven curve, but the underlying inflationary forces would remain for instance, the explicit forward guidance by the new BoE Governor Carney. All in all, lower-than-expected GDP growth in China may bring down the front end of the euro/UK breakeven curves somewhat, but the surprise element would need to be sizable, beyond what is priced in.
US
Fig. 69: US economy response to a China slowdown
GDP growth CPI inflation Current account, % of GDP Policy rate Base case 2.6 1.6 -2.4 0-0.25 China risk scenario 2.4 1.1 -2.7 0-0.25
Lewis Alexander
+1 212 667 9665 lewis.alexander@nomura.com
Joseph Song
+212 667 2415 joseph.song@nomura.com
Economics
Growth: The 1pp slowdown in Chinas growth as described in our scenario would likely slow growth in the United States by about 0.2pp. This estimate primarily reflects the direct effects of the associated slowdown in US exports to China, and to other countries. US exports to China have grown rapidly in recent years. Between 2000 and 2012, the share of US exports that China accounted for increased from 2.1% to 7.1%. Currently, China is the thirdlargest export market for US businesses, after NAFTA partners Canada and Mexico. But the US remains a relatively closed economy: total goods exports accounted for only 9.8% of GDP last year; in 2012, US exports to China were equivalent to about 0.8% of US GDP; and over the last three years, the growth of US exports to China accounted for, on average, a mere 0.06pp of US GDP growth per year. We estimate that the projected 11% slowdown in the growth of Chinas imports, as well as declines in US exports to the other countries noted in Figure 1, would slow the growth of US
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exports by a little less than 2pp in 2014.6 We used a mid-sized macroeconomic model of the 7 US economy to estimate the impact of such an export slowdown on US GDP growth. Note that the model assumes that short-term interest rates are fixed at the lower bound in the near-term, but the slowdown in growth delays future interest rate increases. As a result, long-term interest rates fall about 5bp (for 2014) in response to the shock, offsetting to some degree the direct effect of the decline in exports. Of course a slowdown in China could affect the US economy in a number of other ways. The US is a net importer of commodities, primarily energy products. The projected decline in commodity prices would tend to boost US aggregate demand, at the margin, but US domestic production of energy has been rising rapidly in recent years, and this should, over time, diminish the net impact of swings in commodity prices on US aggregate output (as domestic production increases, gains and losses of domestic producers increasingly offset the impact on consumers). Consequently, we did not assume any offset from lower commodity prices on US aggregate demand. US foreign direct investment to China has been rising sharply in recent years, but it remains less than 2% of all US outward FDI. Similarly, claims of US banks on China have been growing rapidly, but are still small relative to US banks total balance sheets and cross-border exposures (about 2%). If the Chinese economy simply slows more than expected, without significant financial disruptions, the spillover to the US economy through FDI and financial linkages would be modest, in our view. Inflation: Lower commodity prices should have a negative effect on energy and food prices. As food and energy prices make up approximately a quarter of the CPI inflation basket, we expect a commodity price shock to cause the headline index to drop by 0.5pp from 1.6% to 1.1%. Core prices should be well shielded from the price shock and remain relatively stable. Current account balance: The impact on the US current account would be driven by a tug of war between the slowdown in US exports and the impact of lower commodity prices. On the one hand, given that the US is a net commodity importer, the estimated drop in commodity prices helps to narrow the trade deficit. We estimate a decline in nominal imports of 0.8% relative to the baseline scenario. However, the estimated decline in global demand for US exports is larger, the net impact being a decline in the US current account balance from -2.4% of GDP to -2.6% of GDP. Policy rate: Given the muted response to GDP growth, we would expect the policy rate to remain unchanged at 0-0.25%.

As far as the impact on US interest rates is concerned, we believe Chinas economic slowdown will matter more to the macro backdrop resulting in less global growth and thus keeping USTs in favour in the short to medium term. However, if the slowdown were to drag on, that could lead to capital outflows and less USD reserve accumulation in the quarters ahead, resulting in less UST purchases on balance. Our studies have found that cumulative China flows into US fixedincome assets has resulted in 10-year UST yields being lower by about 40-50bp, all else remaining equal. The effects of these total UST purchases by China work from both a flow and stock effect, so a reduction in buying, or worse if China actually started selling US bonds on a consistent basis, the rise in the natural equilibrium level of rates could be more severe. It is evident that in recent quarters, and really over the last few years, that Chinas buying of US fixed income has been steady, but not at the same pace of growth as through the 2000s. This could be due to the well-publicized initiative to try to diversify some of their reserves away from USTs. That said, China has not pulled away from the worlds largest and deepest rates market in any way, as its holdings of UST continue to rise, just at generally slower pace. What China has been doing a bit differently, in our view, is slowly going out the curve as most investors have been, in the low rate environment for yield pickup. Liquidity is one key consideration, but total return is also paramount for Chinas investment, which is why in our view George Goncalves
+1 212 298 4216 george.goncalves@nomura.com
Stanley Sun
+212 667 1236 stanley.sun@nomura.com
The contribution of Chinese domestic demand to US value-added, as estimated by the OECD (see discussion in the section for Europe) is marginally lower than the direct ratio of US exports (as reported by the US Census Bureau) to US GDP. 7 We implement a modified version of the Fair Model a medium-sized macroeconomic model. For more information, see Ray Fair, Estimating how the Macroeconomy Works, (Harvard University Press, 2004).
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there has been very little Chinese T-bill holdings since the global financial crisis. Hence, if China does slow its Treasury purchases, or even start to sell US bonds to put its FX reserves to domestic use, we expect the US curve to have a steepening bias. We have seen China recently as the investor with the ability to deploy its reserve warchest at a time when others may have already executed their buying in a sell-off. A good example of this was in May 2013, when China boosted its UST holdings (according to US TIC data) while other investors, such as hedge funds, began to sell US rates products. As such, China flows into US bonds remain an important feature of yields remaining low, but if China proactively scales back its UST buying as a result of its slower economic growth (and not just because of diversification) and if the Fed is determined to taper back QE then the next rise in US rates (especially if domestic investors retreat from bonds) may be more extreme than what we experienced in the latest selloff.
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6. Recent Asia Special Reports

Date 19-Jul-13 28-Jun-13 17-Jun-13 19-Apr-13 15-Mar-13 6-Mar-13 28-Nov-12 14-Nov-12 25-Oct-12 11-Oct-12 24-Sep-12 14-Sep-12 5-Sep-12 3-Sep-12 7-Aug-12 2-Aug-12 31-Jul-12 9-Jul-12 31-May-12 29-May-12 2-May-12 23-Apr-12 16-Apr-12 11-Apr-12 27-Mar-12 9-Mar-12 1-Mar-12 23-Feb-12 16-Jan-12 20-Dec-11 18-Nov-11 3-Nov-11 31-Oct-11 19-Oct-11 21-Sep-11 8-Aug-11 7-Jun-11 10-Mar-11 3-Mar-11 14-Jan-11 1-Nov-10 Report Title India: Turbulent times ahead Asia's rising risk premium South Korea's deflation fears are overdone Lower commodity prices a boon for Asia China: Rising risks of financial crisis Southeast Asia: Different strokes 2013 Outlook: Asia's overheating risks South Korea: An Economic Democracy India reforms (Part I): A long way to go Introducing NESII The Nomura Economic Surprise Index for India Thailand: New growth engines China primed to surprise on the upside Better hedges for a China hard landing India's chronic balance of payments Asia's inflation wildcard Indonesia: Policy swings India: A poor monsoon and its impact (Q&A) South Korea: Prolonged low growth, inflation and rates through 2013 Pan-Asia: Inventory cycle threatens a slow recovery China's peaking FX reserves India: Make or break The China compass Korea: Uncomfortable trade-off India: Four cyclical tailwinds to watch Capital account liberalisation in China India budget preview: Fiscal cheer Asia: What if oil prices keep rising? Philippines Fiscal space to maneuver Decoding Indias stubbornly high inflation Implications from North Korea A cold winter in China Thailand: Dealing with another disaster China Risks Korea: Falling, converging bond yields China: The case for structurally higher inflation Global market turbulence: Implications for Asia Indonesia: Building momentum Vietnam: Prioritizing macro stability South Koreas demographic sweet spot India's 2011 outlook: Rising symptoms of a supply-constrained economy The case for capital controls in Asia
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Disclosure Appendix A-1
ANALYST CERTIFICATIONS
Each research analyst identified herein certifies that all of the views expressed in this report by such analyst accurately reflect his or her personal views about the subject securities and issuers. In addition, each research analyst identified on the cover page hereof hereby certifies that no part of his or her compensation was, is, or will be, directly or indirectly related to the specific recommendations or views that he or she has expressed in this research report, nor is it tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.
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Nomura research is available on www.nomuranow.com/research, Bloomberg, Capital IQ, Factset, MarkitHub, Reuters and ThomsonOne. Important disclosures may be read at http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx or requested from Nomura Securities International, Inc., on 1-877-865-5752. If you have any difficulties with the website, please email grpsupport@nomura.com for help. The analysts responsible for preparing this report have received compensation based upon various factors including the firm's total revenues, a portion of which is generated by Investment Banking activities. Unless otherwise noted, the non-US analysts listed at the front of this report are not registered/qualified as research analysts under FINRA/NYSE rules, may not be associated persons of NSI, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account. Nomura Global Financial Products Inc. (NGFP) Nomura Derivative Products Inc. (NDPI) and Nomura International plc. (NIplc) are registered with the Commodities Futures Trading Commission and the National Futures Association (NFA) as swap dealers. NGFP, NDPI, and NIplc are generally engaged in the trading of swaps and other derivative products, any of which may be the subject of this report. ADDITIONAL DISCLOSURES REQUIRED IN THE U.S. Principal Trading: Nomura Securities International, Inc. and its affiliates will usually trade as principal in the fixed income securities (or in related derivatives) that are the subject of this research report. Analyst Interactions with other Nomura Securities International, Inc. Personnel: The fixed income research analysts of Nomura Securities International, Inc. and its affiliates regularly interact with sales and trading desk personnel in connection with obtaining liquidity and pricing information for their respective coverage universe. Any authors named in this report are research analysts unless otherwise indicated. Industry Specialists identified in some Nomura International plc research reports are employees within the Firm who are responsible for the sales and trading effort in the sector for which they have coverage. Industry Specialists do not contribute in any manner to the content of research reports in which their names appear. Marketing Analysts identified in some Nomura research reports are research analysts employed by Nomura International plc who are primarily responsible for marketing Nomuras Equity Research product in the sector for which they have coverage. Marketing An alysts may also contribute to research reports in which their names appear and publish research on their sector.
Valuation methodology Fixed Income

Nomuras Fixed Income Strategists express views on the price of securities and financial markets by provi ding trade recommendations. These can be relative value recommendations, directional trade recommendations, asset allocation recommendations, or a mixture of all three. The analysis which is embedded in a trade recommendation would include, but not be limited to: x Fundamental analysis regarding whether a securitys price deviates from its underlying macro - or micro-economic fundamentals. x Quantitative analysis of price variations. x Technical factors such as regulatory changes, changes to risk appetite in the market, unexpected rating actions, primary market activity and supply/ demand considerations. The timeframe for a trade recommendation is variable. Tactical ideas have a short timeframe, typically less than three months. Strategic trade ideas have a longer timeframe of typically more than three months.
Distribution of ratings (Global) Equity

The distribution of all ratings published by Nomura Global Equity Research is as follows: 43% have been assigned a Buy rating which, for purposes of mandatory disclosures, are classified as a Buy rating; 37% of companies with this rating are investment banking clients of the Nomura Group*. 45% have been assigned a Neutral rating which, for purposes of mandatory disclosures, is classified as a Hold rating; 49% of companies with this rating are investment banking clients of the Nomura Group*. 12% have been assigned a Reduce rating which, for purposes of mandatory disclosures, are classified as a Sell rating; 18% of companies with this rating are investment banking clients of the Nomura Group*. As at 30 June 2013. *The Nomura Group as defined in the Disclaimer section at the end of this report.
Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America
The rating system is a relative system indicating expected performance against a specific benchmark identified for each individual stock. Analysts may also indicate absolute upside to target price defined as (fair value - current price)/current price, subject to limited management discretion. In most cases, the fair value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as discounted cash flow or multiple analysis, etc. STOCKS A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of ' Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. A rating of ' Reduce', indicates that the analyst expects the stock to underperform the Benchmark over the next 12 months. A rating of ' Suspended', indicates that the rating, target price and estimates have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including, but not limited to, when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the company. Benchmarks are as
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follows: United States/Europe: please see valuation methodologies for explanations of relevant benchmarks for stocks, which can be accessed at: http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia, unless otherwise stated in the valuation methodology. SECTORS A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next 12 months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next 12 months. A ' Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next 12 months. Benchmarks are as follows: United States: S&P 500; Europe: Dow Jones STOXX 600; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia.
Explanation of Nomura's equity research rating system in Japan and Asia ex-Japan
STOCKS Stock recommendations are based on absolute valuation upside (downside), which is defined as (Target Price - Current Price) / Current Price, subject to limited management discretion. In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A ' Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. SECTORS A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation.
Target Price
A Target Price, if discussed, reflects in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates.
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58

Nomura Special Report - When China Sneezes

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Nomura Special Report - When China Sneezes

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ANCHOR REPORT

GLOBAL MARKETS RESEARCH July 2013

Nomura | Anchor Report

Nomura | Anchor Report

Nomura | Anchor Report

Nomura | Anchor Report

Nomura | Anchor Report

2. China's downside risk scenario

Fig. 3: 7-day repo rate

China Risks report published

30 7-day repo rate 25

101.5 20 101.0 15 100.5 10 100.0

Source: Nomura Global Economics.

Source: Bloomberg and Nomura Global Economics.

Nomura | Anchor Report

Chinas import elasticity

Fig. 4: GDP growth and ordinary import growth

Fig. 5: GDP growth and iron ore import growth

y = 10.9x - 81 50 40 30 20 10 0 -10 -20 6 7 8 9 10 11 GDP (% y-o-y) 12 13 y = 4.2x - 24

Source: CEIC and Nomura Global Economics.

Source: CEIC and Nomura Global Economics.

Fig. 6: GDP growth and crude oil import growth

Fig. 7: GDP growth and copper import growth

40 30 20 10 0 -10 -20 6 7 8 9 10 11 GDP (% y-o-y) 12 13 y = 5.7x - 40

Source: CEIC and Nomura Global Economics.

Source: CEIC and Nomura Global Economics.

Nomura | Anchor Report

Fixed income strategy

Nomura | Anchor Report

3. Gauging Chinas relative economic impact a scorecard approach

Nomura | Anchor Report

Nomura | Anchor Report

Fig. 9: Disentangling the true export exposure to China

Nomura | Anchor Report

Nomura | Anchor Report

Source: CEIC, IMF IFS and Nomura Global Economics.

Nomura | Anchor Report

Nomura | Anchor Report

Fig. 15: Equity market correlations with China

0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1

Source: CEIC and Nomura Global Economics.

Fig. 16: FX correlations with China

Source: Bloomberg and Nomura Global Economics.

Nomuras scorecard of Chinas relative economic impact

Nomura | Anchor Report

1.0 107 157 58 89 45 108 117 43 155 139 82 63 61 101 71 51 60 48 36 53 92 84 48 45 50 35

Nomura | Anchor Report

4. Global equity strategy

China relative performance

Source: Bloomberg, Nomura Strategy Research.

Source: IBES, FTSE, Nomura Strategy Research.

Nomura | Anchor Report

Source: FTSE, Nomura Strategy Research.

Fig. 22: China H-share Index correlation vs. MSCI World

Fig. 23: China H-share Index correlation vs. MSCI APXJ

China Correl with APXJ 5w avg of 26-week correl

Source: Bloomberg, Nomura Strategy.

Source: Bloomberg, Nomura Strategy.

Nomura | Anchor Report

Source: Bloomberg, Nomura Strategy.

Nomura | Anchor Report

Source: FTSE, Nomura Strategy Research.

Nomura | Anchor Report

450 China net imports: Copper (tons)