Ban K n ot es

chineSe tranSition preSentS opportunity

as the WorLDs seconD-LarGest econoMy anD eQuity MarKet, china coMManDs the attention of inVestors eVen thouGh the internationaL Monetary funD (iMf) proJects that its GroWth WiLL sLoW DurinG the next fiVe years. chinas econoMy GreW a staGGerinG 316% in the past DecaDe, coMpareD to aMericas 43% expansion. eVen the GLoBaL econoMic MeLtDoWn Wasnt a De-raiLer. so any DeceLeration of GroWth shouLD Be taKen in context.
IMF predicted last September that Chinas economy will expand at an average rate of 9.4% from 2012 to 2016, which still outpaces any other emerging market. Chinas low government debt 16% of GDP and cheap equity valuations helped secure its top spot among these emerging markets, which is where all the venture capital and investments seem to be flowing at the moment. But is there too much investment in China? Western governments feel it needs to rebalance its economy by investing less and consuming more. Otherwise, diminishing returns on capital will retard future growth; or, worse still, overcapacity will cause a slump in investment and bring the economy to its knees. Deliberate policy to slow growth The figures above certainly seem to point to a burgeoning economy where all units are working well. Recently however, at the opening of the annual session of Chinas Parliament, the National Peoples Congress (NPC), Premier Wen Jiabao announced that the governments target for annual economic growth this year was 7.5% much lower than in previous years. So at a time when the global economy is relying on China to keep it buoyant, does this spell trouble? The premier doesnt think so. He

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pointed out that this figure is more policy than an official projection. The purpose of targeting this lower growth rate is to guide people in all sectors to focus their work on accelerating the transformation of the pattern of economic development and make economic development more sustainable and efficient. So is China tightening its reel now to accommodate future growth patterns in the future? The issue may not be whether it needs more investment, but whether Chinas absorption capacity can continue to accommodate the rapid investment growth of the past decade. Its a case of getting the right balance, and at the moment the Chinese government thinks its tipping unfavourably against them. Eugene Chen, Senior Advisor for Greater China at Russell Investments, a global asset manager, argues that China represents an opportunity for the perceptive investor. Many of the worlds largest banks by capitalisation (including the largest after the global financial crisis) are in China, says Chen. There are many large corporations represented in all sectors there. These firms are typically state-owned enterprises that have only a portion of their shares floated, but they are so large that the shares are still very liquid and easy to research and trade. There are also plenty of small- and mid-cap stocks, as would be expected in a market this

eUgene chen
senior advisor for greater china, russell investments

large and diverse. Chen does see an apparent change in how China is focusing on the future and is taking a more pragmatic approach to its policies. International trade has played a pivotal role in Chinas economic development over the past 30 years. However, the global market is no longer able to absorb Chinas massive exports meaning it may be a victim of its own success. Rising labour costs and a stronger currency

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will undermine the export sector, causing GDP growth to slow this year. This seems to be the reason for the premiers policy of slower but more refined growth. Chinas economy is in the process of shifting from an export and investmentled economy to a more balanced economy where domestic consumption is well represented, he says. However, this shift presents a compelling theme and opportunity to investors. At the end of the day China is an emerging market and as such has many typical emerging-market characteristics, for instance high retail investor participation in the market, high volatility and restricted access for foreign investors. However, China also has the second-largest stock market in the world by capitalisation and therefore has a greater global impact than stock markets in many of the other, smaller emerging markets. Chinas economy and its capital markets in particular are still not as integrated with the rest of the world as other large economies. The renminbis (currency of China) lack of convertibility helps insulate its capital markets from storms in the rest of the world and therefore the market cycles do not move in lock-step with the rest of the world. It is always possible to find time periods where one economy performs very differently from the other, especially when the correlation between China and the rest of the world is relatively low. However, this is also the reason why China is attractive for the global investor it is a very good diversification play from the rest of the world. Investment restrictions Chen mentions that there is restricted access into Chinese markets for foreign investors, but feels any limitations shouldnt be perceived negatively. There are transparency issues in China, as there are in all emerging markets. However we see this as an opportunity rather than a hindrance. The fact that the Chinese market is inefficient means that quality research with local knowledge can pay off handsomely. China is definitely a market ideally suited for active management provided that one has local knowledge and the means to do quality research on the ground. A lot depends on which Chinese stocks

a foreign investor may be interested in there are for instance many Chinese stocks listed in Hong Kong and New York which are open to trade by foreign investors. However, those stocks represent a relatively small subset of all publicly listed Chinese stocks and are skewed toward certain industries. The main Chinese market is inside China in Shanghai and Shenzhen which account for approximately four trillion dollars (QR14.6 trillion) in market capitalisation. Legally a foreign firm can hold 100% of a Chinese-registered firm, but in heavily-regulated industries like finance that firm would not be able to get a licence

chinas econoMy is in the process of shiftinG froM an export anD inVestMent-LeD econoMy to a More BaLanceD econoMy Where DoMestic consuMption is WeLL representeD, anD this shift presents a coMpeLLinG theMe anD opportunity to inVestors

deterring investment. Real estate bubble For the last decade, the most significant category of investment in China has been real-estate development, which accounts for approximately 10% of its GDP and a quarter of total investment. Recent reports from China suggest a major economic downturn may be under way, with idled factories and laid-off workers. Reports of ghost cities are common. There is a real estate bubble in China which has been undergoing a controlled pop for the past 12 months, says Chen. With the massive ongoing urbanisation which is still in its early stages, the demographics in the urban areas would enable the economy to absorb the short-term oversupply much quicker compared to many Western countries where the demographics simply cannot keep up with the oversupply in the short or even medium-term. The yuan has experienced some short-term weaknesses but it is certainly on a long term strengthening trend line. If it becomes convertible, it is certain to become one of the worlds main reserve currencies. Export issues Chinas economy has great growth ahead of it its projected to become the worlds largest economy in 15 years. But to make money from Chinas growth one has to buy and sell investments at the right time. Such is the size of the Chinese economy, its stock market is likely to do well when the Chinese economy is reporting high returns on exports and domestic consumption. However, exports are being hindered by the financial crisis in Europe, Chinas largest export market. The US and Chinese economies are still heavily dependent on one another, says Chen. The political fluctuations in their bilateral relationship cause some white noise in the background which has an effect on the market through shortterm volatility. However, long-term trends remain stable despite this. The EU is a huge market for Chinese goods so any problems in the eurozone will definitely have an impact on China (or any country for that matter). On the other hand, Chinese banks are much less exposed to Europe compared to Western banks.

to do anything. You need the local majority partner, not to own the firm, but rather to get a licence of any sort you need a local partner for market access anyway, even if licensing were wide open to foreigners. Chinas leadership will change in 2012. Theres always that deep-rooted sentiment that the government there may have some role to play in any investment you might make maybe they might engage in a policy of seizing your ownership interests using fabricated tax claims or dubious court cases. There is widespread private ownership of property and corporations in China, explains Chen. For foreign investors I do not see any fundamental property rights issues that would affect us to the point of

May 2012

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