China Report: Mind the gap� as China rebalances growth
Comment of the Day

June 08 2010

Commentary by David Fuller

China Report: Mind the gap� as China rebalances growth

My thanks to a subscriber for this interesting report from J.P. Morgan. Here are two opening bullet points
We stay cautious on MSCI China in the coming months, despite possible technical rebound because: (1) We see downside earnings risk to MSCI China due to the economic deceleration on the back of the combined ripple effect of the crack-down on property sector and slowdown in banks' lending to local government-funded investment projects. (2) Policy risks, such as the resource tax, which may hurt the earnings of and de-rate the multiples of the energy and upstream resources companies. (3) Tight liquidity situation in China, as reflected in the recent rise in short-term interest rate in the repo market as well as inter-bank market. (4) Possible additional tightening measures in the property and FAI areas, such as raising share capital funds requirement for investment projects, and property tax on tier one cities on a pilot basis, etc. We recommend investors to wait for a better entry point until the above-listed concerns are addressed before buying China's secular growth sectors.

We firmly believe in China's bright medium-term growth prospects: (1) China boasts of a strong balance sheet at the country, household, and consumer level. Total government debt is still below 50% of GDP, which is well below the ratios of many developed countries, whose government debt to GDP ratios typically hover above 60%. China's household debt burden is also well below that of developed economies-household debt/GDP ratio by end-09 was 24.4% in China versus 88.2% in US and 64.9% in Japan. (2) Favorable demographics-China's dependency ratio, a measure showing the degree of dependents (aged 0-14 and over the age of 65) to the total working population (aged 15-64), has declined from around 50% in early 1990s to below 40% towards late 2000s, and is not expected to rise until at least 2015 by our estimates. (3) We can still find some sectors with low penetration rates and solid secular growth. (4) A powerful central government with strong execution capability to carry on the necessary economic reforms.

David Fuller's view These points make sense to me. Consequently I am cautious in the short-term but becoming more interested as valuations improve. The immediate concern of China's central government is inflation, which it is sensibly reducing. China faces few of the deflationary pressures experienced in the west. Meanwhile, many western companies continue to manufacture goods in China and export them to their home markets.

Few countries will match China's continued economic growth. This will result in strong corporate profits growth over the longer term and therefore a competitive stock market performance. However stock markets in countries which supply what China needs to import may continue to see even stronger stock market performances when equity markets stabilise once again following the current correction. One reason for this is that they have fewer IPOs. (See also Eoin's comments on China below.)

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