The Shanghai Composite Index plunged 12 percent last week, erasing all bar one point of the rebound from July’s $4 trillion selloff. For CMB International Securities Ltd. and KGI Securities Co., the gap between the growth outlook and China’s stock valuations, which are the highest among the world’s biggest markets, means further declines are inevitable.

While the benchmark stock gauge still traded 57 percent above the levels of a year earlier through Friday, data from industrial output to exports and retail sales depict a deepening slowdown. China’s first major growth indicator for August showed the manufacturing sector is at the weakest since the global financial crisis.

The government is “trying to defy market forces at overvalued levels,” said Daniel So, a strategist at CMB International Securities in Hong Kong. Policy makers should “focus on helping the real economy instead of the stock market,” he said.

 

The Chinese administration picked the 3500 level on the Shanghai Composite as a level they were willing to defend in July. At the time the level coincided with the 200-day MA but other than that was an arbitrary figure which was high relative to the levels the Index had traded at over the preceding six years. The Index fell through 3500 this morning and the big question for tomorrow’s trading will be whether the government will continue to defend that level or pick an easier to achieve target lower down.
 

First, let's address the issue of overstating the GDP. Critics point to the country's weak industrial production, export and investment figures as proof that the country is fudging its number. Lardy, a senior fellow at the Peterson Institute of International Economics, points to a salient fact that many people choose to ignore: the biggest contributor to the country's GDP is now the services industry.

"the skeptics have taken insufficient notice of China's progress in transitioning to its new model of economic growth, one less dependent on expanding industrial output, investment, and exports and more dependent on expanding private consumption expenditure¡±, he says.

Between 2011 and 2014, the size of the service sector as a share of GDP rose by about 4 percentage points to 48 per cent and, at the same time, the share of the industrial sector dropped to 43 per cent of GDP. This is a marked change from a decade ago, when the industrial sector accounted for 47 per cent of the GDP while the service sector only accounted for 41 per cent of the economy.

Considering the size of China's economy -- it's a $US10 trillion behemoth -- the transition is even more impressive. Many services are booming in China, the e-commerce sector grew by 31.4 per cent in 2014. The entertainment sector has been growing at an average of 17 per cent a year between 2010 and 2015. In health care, McKinsey predicts the growth in spending will grow from $US357 billion in 2011 to about $US1 trillion in 2020.

 

Unfortunately the services sector now accounts for more than 50% of GDP because the industrial and construction sectors have declined so much. The services, consumer discretionary, information technology and healthcare sectors are most likely to lead the Chinese economy in a recovery not least because they are receiving a great deal of government support. However this was priced in by the impressive outperformance of the Chinext Index and Shenzhen B shares earlier this year. 

Surely a devaluation of the renmibi should be beneficial to non-Chinese companies that have their manufacturing facilities inside China. If they then export to the rest of the world they will earn other currencies and increase their profits. Which companies correspond to this scenario?

Thank you for raising this point but your question is a difficult one to answer since global companies tend to have manufacturing sites in a number of countries rather than solely in China. Until about five years ago you could have easily answered that garment and small goods manufacturers would fit your criteria but this is no longer the case since lower margin businesses have already migrated at least part of their operations abroad. 
 

The wave of declines is rooted in the problems in Taiwan's economy, Alan Tseng, vice president at Capital Investment Management Corp. in Taipei, said on Wednesday. "The electronics industry is facing the toughest competition in 10 years because of China. The index will fall below 8,000."
     
There is a "looming new bear cycle" in emerging markets, with the weaker yuan adding competitive pressures to Taiwan, Malaysia, Thailand and Vietnam because of their dependence on exports, Lim Say Boon, the Singapore-based chief investment officer at the private banking unit of DBS Group, wrote in a report dated Aug. 17. The MSCI Emerging Markets Index entered a bear market on Aug. 12.

 

China's economy is transitioning away from fixed asset investment. If it is to be weaned away from infrastructure development and housing, the value of other sectors of the economy has to increase. This explains the concerted push to develop the service and high end manufacturing sectors. In this strategy China is following the same path tread by its neighbours in their development. 

More than half of all demand for tin is accounted for by the solder which is used to assemble electronics devices such as smartphones and televisions, according to Fastmarkets, a metal research group.

China’s appetite for tin hasn’t fallen away in the way that it has for other base metals, such as iron ore, and China is tin’s biggest importer. Although this week’s devaluation of the yuan will make the metal more expensive in the Chinese market, electronics manufacturers are likely to be well-hedged and able to absorb price rises, said Ms. Bain.

Analysts see the biggest impact on prices coming from the supply side. Indonesia is the world’s largest tin exporter, with up to 35% of the global trade. New regulation this month bans all but refined products from legal mines leaving the country.

Myanmar, whose exports took off around 2011 after the fall of the ruling military junta led to the lifting of some sanctions, is a recent entrant into the tin market.

Now, though, output from Myanmar’s main tin mine is declining due to falling ore grades, and the challenges posed by the ethnic conflict raging nearby. The recent fall in tin prices also stymied investment in current and prospective tin mines, analysts say.

More than half of all demand for tin is accounted for by the solder which is used to assemble electronics devices such as smartphones and televisions, according to Fastmarkets, a metal research group.

China’s appetite for tin hasn’t fallen away in the way that it has for other base metals, such as iron ore, and China is tin’s biggest importer. Although this week’s devaluation of the yuan will make the metal more expensive in the Chinese market, electronics manufacturers are likely to be well-hedged and able to absorb price rises, said Ms. Bain.

Analysts see the biggest impact on prices coming from the supply side. Indonesia is the world’s largest tin exporter, with up to 35% of the global trade. New regulation this month bans all but refined products from legal mines leaving the country.

Myanmar, whose exports took off around 2011 after the fall of the ruling military junta led to the lifting of some sanctions, is a recent entrant into the tin market.

Now, though, output from Myanmar’s main tin mine is declining due to falling ore grades, and the challenges posed by the ethnic conflict raging nearby. The recent fall in tin prices also stymied investment in current and prospective tin mines, analysts say.

The era of yuan appreciation has come to an end with China’s move to lower the daily reference rate by 1.9 percent, said Yu Yongding, a member of China’s monetary policy committee when the currency was revalued in July 2005.

The yuan exchange rate will enter “a period of stabilization or even depreciation,” said Yu, now a researcher with the Chinese Academy of Social Sciences. The People’s Bank of China’s reduction to the daily fixing was a “symbol” for the change, although signs of yuan depreciation were evident before Tuesday’s move, he said.

The biggest slide of yuan since the peg ended a decade ago is a one-time adjustment, the PBOC said in a statement, adding it will strengthen the market’s role in the fixing and promote the convergence of the onshore and offshore rates. The move comes as sliding exports add to slowdown pressure and may add to concerns more capital will flow out of the nation.
While a weaker yuan may bolster exports in the short term, it’s a dangerous long-term way to increase shipments, Yu said.

“It would be a very wrong and stupid way to boost exports, and I don’t think China’s central bank will opt for that,” he said. “The depreciation is more of a recognition and respect of market forces.”
“The PBOC should reduce its intervention in the yuan,” Yu said. “If the market believes the yuan should be weaker, then just let it weaken.”

Yu said the yuan’s change will “for sure affect other currencies of emerging markets,” although the biggest deciding factor will be the policy stance of the U.S. Federal Reserve.

 

At The Chart Seminar in Singapore in April there was a great deal of interest in how one could hedge exposure to the Euro following its decline but not many people were interested in hedging the Renminbi since it was viewed as such a stalwart. Nevertheless, the time to hedge a currency is before the devaluation rather than after. Today’s move is not very large but it represents a powerful indication that the trend of Yuan appreciation is most definitely over. 

Do you really believe that China's propping up their stock market is any more different from the FED's Plunge Protection team's operations in the US markets?

Thank you for a question of general interest. I agree that China is certainly not the only country to offer assistance to its stock market in times of stress. The Fed has its Plunge Protection Team and Europe banned short positions during its sovereign debt crisis. Countries regularly allow their currencies to take the brunt of selling pressure with a number of commodity producers offering examples at present. Slashing interest rates and boosting money supply achieve many of the same goals. However what sets China apart is the scope of its support. 

The open-to-close strategy on CSI 300 Index contracts has returned 18 percent since July 8, when the mainland market bottomed. That compares with about 6 percent from buy and hold, after accounting for the rollover of contracts in the middle of this month.

“It seems to be an exploitable and workable strategy in the futures market, unless there is some unexpected big news,” said William Fong, an investment director for Asian equities at Baring Asset Management in Hong Kong.

The Shanghai Composite rose 2.4 percent at the close on Thursday, after opening with a 0.1 percent drop.

Like any pattern, its lifespan will diminish as more investors catch on, said Bernard Aw, a Singapore-based strategist at IG Asia Pte Ltd. There’s also the risk that state- backed buyers disappear as the Shanghai Composite approaches 4,500 -- a target Chinese brokerages cited when they unveiled a market support fund on July 4.

 

By loading purchases into the latter half of the day the Chinese authorities are buying a strong close which is what we continue to see in the chart below. On more than a few occasions since the low earlier this month the market has opened lower only to finish higher. This is achieving a rebound in the domestic market but the big question is to what extent the market can function without massive intervention. 

The year 2015 has thus far seen a frenzy of privatization offers to US-listed Chinese companies, some with an intention of subsequent re-listing back home. Questions, however, have arisen about the practicality of this scheme, with virtually no successful precedents yet. In this report, we analyze major hurdles like legal complexities, IPO procedures and timing issues. VIE set-up and unwinding, and the new foreign investment law may further hinder the privatization process. Even with early signs of relaxation of some restrictions, developments are at a premature stage. Nonetheless, we shortlist and assess 'likely go-through bids', those that screen well for a bid and "maybe not's".

Going home is more easily said than done: challenges in privatization and…
Privatization requires a significant amount of immediate funding for the share repurchase, repatriation tax and professional fees. Funding, usually raised through equity capital and debt borrowings from a consortium, largely depends on the target’s ability to generate cash flow, its franchise value and to a lesser extent, its balance sheet strength. Further, the entire process is lengthy (a minimum of 6-12 months) to complete. In addition, the offerors could face litigation from unsatisfied minority shareholders on matters such as abuse of super voting power that might even derail the whole programme.

….challenges in re-listing: complications with the VIE structure 
While some controls have been eased, there is still a long way to go for the Chinese supervisory bodies to continue their relaxation of key restricted areas such as ICP (internet content provider) license, which is a pre-requisite for almost all Chinese internet companies. Those intending to unwind these structures and return home face the risk of being disqualified on other key regulatory pre-requisites, including but not limited to: a) a continued track record of profitability after repatriation tax liabilities, b) unchanged ownership structure, c) consistent historical business operations for the entity intended for listing, d) autonomy of the company over its operations and decision-making power, and e) fairness in related party transactions.

A link to the full report is posted in the Subscribers' Area.

It is possible that the extreme volatility on China’s mainland market will deter executives from taking the decision to delist from the USA and relist in China in the same way that the surge in mainland prices encouraged them to make the decision to relocate in the first place. Generally speaking US listed Chinese companies did not participate in the run-up experienced by their mainland counterparts but have experienced declines though perhaps not as extreme as the mainland. The potential for greater upside potential for the owners is therefore perhaps the most likely motivation for relisting. 

It’s been a tumultuous month with China collapsing then staging an impressive rebound amid some extreme policy measures to stem the decline. This is not a normal situation and China is not a normal market because the state plays such a large role in controlling the trajectory of prices. In an effort to gain a greater insight into how the market is reacting to this situation I clicked through a large number of Chinese shares. 

I first started by looking for shares that might have bottomed early so performed a Bloomberg search for those that had hit 52-week lows between July 1st and 8th. The Shanghai Composite hit its low on the 9th. This gave me a list of 300 shares so I filtered it by those that still have a positive performance month to date. I then took a look at all 300 charts. 

Investors and traders headed for the doors in China related investment vehicles as mainland and Hong Kong shares crashed lower over the last month. Foreign flows reversing through the Stock Connect were a major influence in the speed of the decline and contributed to the panicky environment.  However the government is pulling out the stops and there were more than 100 shares on the Index up their 10% limit today. 

At The Chart Seminar we teach that “Acceleration is an ending of unspecified duration”. There is no doubt that the Chinese markets accelerated lower and that this has the look and feel of climactic action. Today’s strong rebound following yesterday’s steadying suggests shorts are under pressure and bargain hunters are active. 

The International Equity Library’s Performance Filter allows you to scan through the extensive lists of shares in the library and rank constituents by their performance over different time frames. Considering just how quickly Chinese shares have fallen and the impressive rebounds I thought it might be instructive to highlight some of the shares which have had the largest declines and perhaps more importantly those which have been resilient throughout. 

The outstanding balance of margin loans on the Shanghai Stock Exchange dropped for a ninth day on Thursday, sliding to 1.29 trillion yuan in the longest stretch of declines since the city’s bourse began compiling the data. A fivefold surge in borrowing had helped propel the benchmark stock index to a 150 percent advance in the 12 months through June 12.

The authorities are determined to shore up the $6.9 trillion stock market even if it means reversing reforms, according to Partners Capital International Ltd. The Communist Party’s Central Committee pledged in 2013 to make markets “decisive” in allocating resources and to limit the government’s role to maintaining stability.

“They have the whatever-it-takes mentality,” said Ronald Wan, chief executive officer of Partners Capital International in Hong Kong. “Early on Monday, the market may show a knee-jerk reaction to the measures but I am not sure how sustainable it will be. Whether it’s a rally or a decline, it’s policy driven, not market-oriented.”

And

There won’t be any new IPOs in the near future and the number and value of share sales will be significantly reduced once they resume, the CSRC said in a statement on its website Sunday.
The 21 brokers pledged not to reduce any proprietary investments in the equity market as long as the Shanghai Composite Index stays below 4,500, the association said. The measure closed at 3,686.92 on Friday. Listed brokers will actively buy back outstanding shares, while encouraging their parent companies to increase holdings, according to the statement.

The plan by trading firms to boost shares may have only “a fleeting effect” given daily turnover is nearing 2 trillion yuan, said Hao Hong, China equity strategist at Bocom International Holdings Co. in Hong Kong.

“This 120 billion yuan won’t last for an hour in this market,” Hong said by phone from Beijing Saturday. “It might benefit blue-chip stocks, as investors may see them as value, but the bursting of the bubble in small-cap/tech stocks is likely to continue.”

 

China remains a policy driven market but is presented right now with the unwinding of what has been an historically large build up in leverage. This is now declining and measures are underway to remove supply from the market in order to support prices. Allowing the state pension fund to buy shares, cancelling IPOs, funds and brokerages intervening to buy are all aimed at imposing a floor. 

“The margin call, forced sale, margin call vicious cycle can quickly develop a momentum of its own,” Cui, the head of China equity strategy at Bank of America in Singapore, said in an e-mail on Monday.

Doubts about policy makers’ ability to prop up the world’s second-largest stock market are spreading after a weekend interest-rate cut and speculation that regulators will halt IPOs failed to prevent the Shanghai Composite from tumbling into a bear market. The gauge would need to fall a further 13 percent to match its average downturn since 1990.

“Any support the government can provide would be short lived,” Chad Padowitz, the Melbourne-based chief investment officer at Wingate Asset Management Ltd., said by phone. “The only real support they can provide over time is providing a reasonably balanced, growing economy. That’s the best thing they can do. Anything they do short term, decreasing interest rates to support the market or things like that, are somewhat foolish.”

 

Expectations for future upside potential deteriorate within a range not least because they are boring and disappointing relative to the trending phases. We define ranges as explosions waiting to happen.  However, the conditioning process of these congestion areas means that the strength of the breakout is often surprising to people most familiar with the market. Following an impressive breakout from a medium-term range prices will rally for as long as it takes supply to overwhelm demand. The test of whether a new uptrend can persist into the medium-term is in the extent to which the breakout can be sustained in the ensuing period of consolidation. This is what we term the first step above the base. 

The battle will play out entirely online: The banks aren’t planning any warehousing of inventory, leaving that to the merchants. MYbank and Tencent Holdings Ltd.’s online WeBank, which launched in December, plan no physical branches.

WeBank started its consumer lending in May, where borrowers without collateral can get as much as 200,000 yuan at an annualized rate of 18 percent.

MYbank is to begin operating on Thursday as part of Alibaba’s finance arm, Zhejiang Ant Small & Micro Financial Services Group Co. It’s one of a wave of new private banks being licensed by the government to target small loans and aims to use facial-recognition software to let users set up accounts.

Alibaba already has expanded into e-finance, with its Alipay payments system and Yu’E Bao money-market fund.

“The potential of web-based services, be it financial or retail, is huge in China, so it’s not too late to join the game,” said Wang Weidong, an analyst at Internet consultancy iResearch in Beijing.

Established banks have been hamstrung by strict rules on deposit and lending rates that upstarts like Alibaba and more recently Tencent have been able to circumvent. This has allowed a new type of bank to develop online where savers are offered highly attractive rates. So far regulators have not ruled on the legitimacy of their money market funds which has allowed them to proliferate. Since major banks are precluded from this new business line they are trying to hit online merchants’ where it hurts i.e. retail sales. 

We believe part of the motivation for management teams to welcome going private deals is the belief by many investors that the China "A" share stock market may see a sharp correction within the next several months.

The Chinese "A" share stock market contains exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange, where shares of China mainland-based companies are listed. "A" shares are generally only available for purchase by China mainland citizens.~

Thus, ChinaHyrbid management teams and private equity firms may be scurrying to take advantage of the huge valuation gap between ChinaHyrbids and "A" share companies – before the "A" share market corrects – by going private and then eventually re-IPOing in China at much higher valuation multiples.

For example, the Chinex Price Index (SHE: 399006), which is the index that includes small cap growth companies in the China A share market, has an average P/E of 115 as of June 18, 2015. However, the non-binding go private price of QIHU of $77.00 is only 22 times of the analyst estimated EPS in 2015.

 

The Chinese government views the internet as just another organ of the Party’s apparatus like roads or TV stations. The challenge they have is that private sector entrepreneurs who have spearheaded the development of the Chinese technology sector have lower participation rates in the Party than other sectors. An effort has been underway to recruit more people from the technology sector into the administration. Wishing to see more companies take out listings on the mainland rather than decamping to the USA, Singapore or Hong Kong can be seen in these terms. It also helps explain the rationale behind the sweeteners currently on offer for returning companies. 

The rally in A-shares has been impressive, while the H-shares have been lagging behind in a big way. What is your view on this? I also attach a chart showing relative performance. I have lightened my position in the HSCEI but wonder if I should be looking to increase it again.

Thank you for this topical question. The Hong Kong Dollar is pegged to the US Dollar so zero interest rates have propelled property prices on the island to dizzying heights. There is a fear that when interest rates start to rise, Hong Kong will experience some pain. This is at least part of the reason the Hang Seng has underperformed but is less of an issue for the Chinese Enterprises Index (H-Shares). 

The answer is no, not yet, but it could happen before the next MSCI annual market classification review scheduled for June 2016.

On a posting on its website the MSCI noted that it “expects to include China A-shares in its global benchmarks after a few important remaining issues related to market accessibility have been resolved”.

Here’s Remy Briand, MSCI managing director and global head of research, on the decision announced this morning.

“Substantial progress has been made toward the opening of the Chinese equity market to institutional investors. In our 2015 consultation, we learned that major investors around the world are eager for further liberalization of the China A-shares market, especially with regard to the quota allocation process, capital mobility restrictions and beneficial ownership of investments. Because MSCI’s client base is so large and diverse, we have a strong interest in ensuring that remaining issues are addressed in an orderly and transparent way.”

 

The Chinese now have a blueprint for what they need to do to gain access to a massive pool of international liquidity. Considering the fact they have a vested interest in diversifying their domestic risk in sectors that drove the breakneck pace of development, we can expect measures to fulfil MSCI’s requirements over the next year. 

Since the answer was a ‘not yet’ instead of a ‘no’ the mainland stock market has been reasonably steady not least because it has been primarily driven by domestic demand. Nevertheless, the progression of higher reaction lows will need to hold if a deeper and potentially lengthy process of mean reversion is to be avoided. 

While ETFs are a small slice of the junk-bond market, they’re usually a telling gauge of sentiment, and the outflows are significant compared with the $6.7 billion of total deposits into these funds so far in 2015, Bloomberg data show.

Government yields in Europe and the U.S. are rising in the face of improving economic data and signs inflation is picking up (or, in Europe’s case, that there’s any inflation at all.) Yields on 10-year Treasuries have surged past 2.4 percent, reaching the highest level since Oct. 6, from 1.8 percent in April.

And now the $2.2 trillion world junk-bond market is losing steam, at a time of growing questions about how long stocks can keep rallying. The debt tends to be a leading indicator, and its deterioration bodes poorly for stock investors, Tchir said.

While the selloff is short-lived enough that it may just prove a blip in a market propped up by central-bank stimulus, it may also portend broader pain ahead.

 

Corporate bonds of every hue are priced against a government benchmark. This means when Treasury yields rise corporate yields follow. We see this in the yield of BB bonds which are now breaking out of a two-year range.

The spread, however, suggests that the yield on high yield is not rising faster than Treasuries.

The newly-announced Water Pollution Control Plan and the unprecedented government focus on environmental protection reaffirm our positive view on the water industry. Large-cap SOE stocks have been traded strongly, we now see more upside for smaller SOE players. They have a higher growth rate, more potential to surprise and beat market expectations, and a more attractive valuation. We initiate coverage on SIIC Environment (SIIC) and China Everbright Water (CEW) with Buy and designate them as our sector top picks.

Pollution control plan unveiled; over RMB1.9tr investment needed by 2020
The Water Pollution Control Plan released in April will lead to over RMB1.9tr of total investment in the water industry by 2020, as estimated by the Ministry of Environmental Protection. More detailed implementation plans and the 13th five-year plans will be announced by central and local governments in 2H15-
2016, unveiling tightening discharge rules, paving the way for water tariff hikes, and promoting the involvement of specialist operators.

Strong growth upholds premium valuation, leading SOEs to gain market share
New project wins should remain strong over the next few years, supporting premium valuations for the sector. Leading SOEs can gain market share in the currently scattered municipal water industry, leveraging on their better relationship with local governments and access to cheap financing. Management with a commercially-driven mindset, good employee incentive plans, and a wider footprint also help. BEWG, as the role model for the new SOE, has proven to be successful. We believe SIIC and CEW can emulate BEWG’s strong growth and emerge as leading SOE players in the sector.

 

A link to the full report is posted in the Subscriber's Area.

Southern China is a tropical region with abundant rain as well as snowmelt run-off from the Himalayas. Northern China on the other hand is semi-arid and is constantly in need of additional water. Deforestation over the last number of decades has only exacerbated this problem. The breakneck pace of industrialisation has put additional pressure on the country’s water resources and the government is finally taking heed of the dire environmental warnings it has been presented with.

On my return from China in April I created a list of Chinese water companies in the Eoin’s Favourites section of the Chart Library. 

How do you think the H-shares will be affected if MSCI (and later FTSE) add the A-shares to their emerging market indices?

The 2 futures which give easy access to the Chinese market at the moment are the Hang Seng China enterprise index and the FTSE China A-50 index.  Which of these do you think is the better bet?

China has been making efforts to open up its capital market to foreign investment. The Hong Kong Shanghai Connect is the most visible measure and the touted expansion of the system to Shenzhen suggests they are still open to additional expansion of the conduit. However it is open to question whether what has already been achieved is enough to warrant a positive decision by MSCI.  This article from the Wall Street Journal carries additional information. Here is a section:

The looming decision underscores the disconnect between the expanding role China plays in the world economy and the limited weighting China has in global investment portfolios.

In the MSCI All Countries World Index, a global benchmark, China has a weighting of 2.7%, although the country’s economy accounts for 15% of global gross domestic product.

The MSCI emerging-market index has a 25.7% allocation to China, but primarily comprises Chinese companies listed in Hong Kong.

For decades, regulatory restrictions and opaque rules set by Chinese authorities have kept foreigners away. In addition, concerns about the health of China’s economy, corporate governance and the earnings multiples that many Chinese shares trade at have led many managers to hold even fewer Chinese stocks than these benchmarks suggest.

As of 2014, foreign investors held about 3% of the Chinese market, compared with a 12% foreign stake in India, according to Qi Wang, partner at Shanghai MegaTrust Investment, an A-share fund manager based in China.

Why is China’s lurch into deflation on the GDP deflator, but not the CPI measure, so important? We have pointed out before (unfortunately we don’t have space for the chart here) that in Japan during the 1990s the thing to watch to see the havoc that deflation was wreaking on nominal revenues and debt/income loads was not the CPI, but rather the GDP deflator, which fell far faster than the CPI. Economic agents produce far more than just consumer goods and services and the GDP deflator is a much wider basket of goods and services and includes exports and investment goods. Clearly the descent into outright GDP deflation in China explains the more aggressive, even slightly panicky, policy easing measures there.

We also pointed out last week that China’s move into BoP deficit imposes a substantial monetary headwind on the economy. China may wish to keep the renminbi stable at this time while the IMF is currently considering including it in the SDR currency basket. But the economy is simply not in a position to withstand a major yen decline bringing down the currencies of its competitors in the region (and the additional deflationary impulse). I remain convinced that China must start guiding its currency down against the dollar and it can do that easily now it has a BoP deficit by doing absolutely nothing (ie not intervening any longer to hold it up)! China will also take the IMF’s recent declaration that the renminbi is no longer undervalued as justification for these actions - link.

Worrisome deflation is already being imported into the US, especially from Japan (see chart below). China (blue line) has yet to participate, but a further round of Asian devaluations will inevitably see waves of deflation heading westwards – as in 1997/98. Watch this data closely.

A link to the full report is posted in the Subscriber;'s Area. 

The Yen has been a catalyst for competitive currency devaluation across the Asian region since the BoJ initiated its QE program in 2012. As the Yen extends its downtrend there is potential that it will act as an additional incentive for regional competitors to devalue their currencies.

The US Dollar broke out against the Yen last week and a sustained move below ¥122 would be required to begin to question medium-term scope for continued upside. 

China’s most-wanted fugitive, an official accused of embezzling more than $40 million, is in U.S. custody, according to the Communist Party’s anti-graft agency.

Yang Xiuzhu, who fled China in 2003, was detained after entering the U.S. using a fake Dutch passport last year, according to the party’s Central Commission for Discipline Inspection.

In the first confirmation of Yang’s whereabouts in a decade, the commission’s International Cooperation Department said she escaped from detention in the Netherlands in May 2014 - - after being rejected for political asylum and before she could be sent back to China.

Considering the vast sums of money that change hands within state owned organisations my first reaction to this news was “Is that all?” $40 million might sound like a lot of money but is in fact very little when one thinks about the personal and family wealth accrued by the ruling cadres.

Nevertheless this is a PR coup for the Chinese administration. China’s anti-corruption chief and Politburo member Wang Qishan announced in March he will be visiting the USA this summer. Following today’s news we can now put that visit in a wider context. The Party wishes to throw media attention on members who have absconded with millions of Dollars while ensuring that the process of internal reform sustains the status quo. 

The yuan still has some way to go before it can become a major reserve currency, former Federal Reserve Chairman Ben S. Bernanke said Tuesday in Taipei. The IMF requires that a currency is “freely usable” to be included in its SDR basket.

Endorsement by the Washington-based lender would lead to about $1 trillion being switched into Chinese assets over the next five years, according to an estimate this month from Standard Chartered Plc. AXA Investment Managers estimated some 10 percent of the $11.6 trillion of global reserves would flow into yuan assets, though it didn’t give a timeframe.

China should allow greater flexibility in its exchange rate, with intervention limited to avoiding disorderly market conditions or excessive volatility, said the IMF’s China mission, which is led by the lender’s deputy director of Asia and Pacific Markus Rodlauer. The statement said it contains the views of the IMF staff involved and has not yet been endorsed by the institution’s board.

The yuan rose 0.6 percent versus the dollar in the past 12 months, while Brazil’s currency dropped 28 percent and Russia’s slid 32 percent. China’s productivity will probably rise more rapidly than the rest of world so its exchange rate will need to appreciate to take account of that, David Lipton, the IMF’s No.2 official, said at a briefing Tuesday in Beijing.

 

By remaining relatively steady against the Dollar over the last year, the Renminbi has appreciated against a wide basket of other currencies not least the Euro, Yen and Korean Won which account for more of its trade than the US Dollar. The currency has unwound almost the entire 1993 devaluation suggesting that the CNY6 level relative to the US Dollar is probably about as strong as the Chinese want to see the currency. 
 

Entering China would let Netflix, the broadcaster of “House of Cards” and “Orange Is the New Black” take advantage of what’s forecast to be explosive growth in online TV in the nation of 1.4 billion people. The market is estimated to almost triple to 90 billion yuan by 2018, according to Shanghai-based Internet consultant IResearch.

A local partnership would be essential given the Chinese government’s strict controls over licensing for online content. Netflix wants a partner that has licenses for content on all devices -- including mobile phones, computers and set-top boxes, according to the people. China’s State Administration of Press, Publication, Radio, Film and Television has given Internet TV licenses to seven companies, including Wasu.

Wasu didn’t respond to an e-mail seeking comment. Two phone calls to Wasu’s general line weren’t answered.

 

Gaining a foothold China would be a major prize for Netflix but it will have to tread carefully and approach the right partner if it is to succeed in this venture. Additionally there are a number of Chinese competitors it will need to face down regardless of which partner it chooses. 

Alibaba Group Holding Ltd. shares surged the most intraday since September as the company named a new chief executive officer, nine months after a record initial public offering.
China’s biggest e-commerce operator posted a 45 percent increase in revenue.

Daniel Zhang will become CEO on May 10, replacing Jonathan Lu, who will remain on the board as vice chairman, the company said Thursday. The change was announced as Alibaba’s sales rose to 17.4 billion yuan ($2.8 billion) in the three months ended in March, beating analysts’ estimates.
Zhang hopes to build a global platform beyond China, part of a strategy that is “a long journey,” he said in an interview Thursday on Bloomberg Television.

Alibaba’s market value had plunged as much as $90 billion from a November peak amid concern about slowing economic growth and criticism from the Chinese government about its business practices. Billionaire Chairman Jack Ma elevated Zhang after the chief operating officer helped turn the Nov. 11 “Singles’ Day” shopping promotion into the company’s biggest sales day.

“Perhaps Jack is sending a signal to the capital markets and the regulator that he’s willing to make changes,” said Mike Clendenin, managing director of RedTech Advisors.

Alibaba’s honeymoon period is over. Investors are now focusing on the success of its business model in delivering on the promise of international domination. One of the issues it faces with competing internationally is the long shipping times required to move goods from China to the end customer. Solving this challenge requires a great deal of investment in logistics and local warehousing within target markets. As a result progress is slow. 

The opening of the Shanghai-Hong Kong Stock Connect has acted as a catalyst for the revival of interest in the Chinese stock market since November. Since then the mainland administration has followed with market support measures including lower bank reserve requirements, cutting interest rates, removing obstacles to property speculation, opening the market for equity options as well as a politicians talking the market higher. 

The Shanghai A-Share Index began to rally from July and surged higher in October led by brokers, insurance companies, banks and railroads. Following consolidation between January and March it has rallied for the last eight consecutive weeks and is increasingly susceptible to consolidation of those gains. 

While Hong Kong had similar valuations to mainland China it did not rally in line with the mainland. Part of the reason for this is because of the civil unrest that roiled investor sentiment late last year. In fact while the stock connect is a two-way channel between the mainland and Hong Kong and has been open for six months, the mainland to Hong Kong avenue only hit its limit for the first time this month. Hong Kong is now playing catch up with the mainland listed market. 

The stock rally has prompted authorities to roll out measures this year that signal an effort to temper gains and prevent another boom-and-bust cycle after a record number of novice investors entered the market. China’s securities regulator started a campaign on Friday to crack down on stock- market manipulation and insider trading, the latest effort to reduce risks.

The China Securities Regulatory Commission will target trading by brokerage employees using non-public information, and market manipulation, including of futures prices, the CSRC said in a Friday statement on its website.

Chinese officials are trying to find a balance between weeding out speculators and encouraging the stock market to play a bigger role in helping companies raise funds as the government reins in credit expansion. The CSRC and central bank Governor Zhou Xiaochuan have endorsed the flow of funds into equities.

The speed and size of the breakout on China’s stock market creates a quandary for late comers because of the risk that a consolidation of short-term gains could be outsized relative to what one might be used to, but “normal” relative to the size of the breakout. 

As with any breakout from a long-term range there is a great deal of trepidation among those who were previously bearish because they are now either losing money or at least receiving margin calls on short positions. The response is either to switch sides and become a bull (Hugh Hendry for example) or to double down and become even more bearish. 

The increase in short interest may be a signal that long investors are hedging their exposure, the volatility of the move to date is fertile ground for options strategies and/or that bears are increasing their bets. We will continue to be guided by the price. 

Mere sales volume recovery would not improve profitability of developers
While we expect further recovery in the physical property market, given policy relaxations, the recovery could just be a "profit-less" or profitless one for some developers (like those with expensive landbank, high gearing, high financing costs). The strategy of high asset turnover to drive earnings growth has proven ineffective as earnings growth has consistently lagged behind sales growth in the past two years. This prompted some developers to start shifting away from the high asset turnover strategy that they had been adopting in recent years. Meanwhile, we see little scope for profitability to rise significantly in the near term without a marked correction in land prices or a sharp rebound in ASPs. 

Contracted sales growth not directly translate into corresponding profit growth 
Some market participants believe that strong contracted sales growth will lead to corresponding strong earnings growth. However, by comparing contracted sales with earnings, we found that earnings growth has consistently lagged behind contracted sales growth, especially for developers focusing on high asset turnover. Contracted sales for leading developers saw YoY growth of 30% and 17% respectively in 2013 and 2014, but the corresponding core net profit growth was only 21% and -7%, while core EPS growth was lower at 19% and -10% respectively. For developers focusing on high asset turnover, the discrepancy between sales and earnings growths was more severe, reflecting the key industry challenges – land prices rising faster than home prices and rising financing costs from higher debt levels (used to drive higher growth). For example, Country Garden had contracted sales growth of 123% and 22% in 2013 and 2014 but had core EPS growth of only 16% and 10%, while Sunac had sales growth of 61% and 30% in 2013 and 2014 but achieved core EPS growth of only 17% and 4%. Adjusting for some aggressive interest capitalization, core net profits of the key developers were on average 41% and 106% below reported figures, suggesting that actual profitability is even lower

 

A link to the full report is posted in the Subscriber's Area. 

There has been a great deal of commentary on the outlook for the Chinese property market over the last decade as prices soared. Two of the primary reasons for the outperformance were the dearth of other investment opportunities and the availability of credit. From 2009 the government clamped down on overbuilding in an attempt to rein in excesses. This had a major impact on property developer shares which spent much of the last five years ranging. 

The first time I visited China was in 2005 and I didn’t stop coughing until we got back on the plane to leave. The pollution was such that you couldn’t see more than 100 metres in any direction for the entire time we were there and I didn’t think to wear a face mask. It was November. 

Utilities burn large quantities of coal in North China between October and March for heating which results in heavy smog across a wide swathe of the country. From April the weather heats up so heating demand goes down and the air improves. I’ve been to Beijing in the summer and autumn but this was the first time in the spring and the air was cleaner than I’ve ever seen it before. Visibility was up to about a mile and there was a powdery blue sky overhead. 

Mrs. Treacy has often talked about the dust storms that hit Beijing in the spring as well as the willow catkins that fill the air. We experienced both on this occasion. The catkins in particular looked like snow on the freeway and delighted my daughters. 

Last week’s event was another enjoyable visit to Singapore and was an apt time to ruminate on Lee Kwan Yew’s legacy of turning a tropical backwater into a first world private banking and high end manufacturing centre. Delegates came in from Argentina, Australia, Japan and of course Singapore which led to some interesting and varied discussions.

Singapore’s stock market is being led higher by the banking sector and shares a high degree of commonality with Taiwan and South Korea. The Index is somewhat overbought in the short-term and some consolidation of recent gains in looking likely. However a sustained move below the 200-day MA, currently near 3400, would be required to question medium-term scope for additional upside.

As one might imagine the main topic of conversation was on the outlook for the Asian region not least following China’s explosive breakout over the preceding three weeks.  Delegates were also interested in the outlook for the European region and we also looked at the S&P 500. We looked at the oil price and a number of related instruments. We also looked at gold prices and a number of miners, select Singapore shares as well as a wide range of international bank shares. We also had a wide ranging discussion on currencies. 

Australia plans to join the Asian Infrastructure Investment Bank, it said on Sunday, reversing a previous decision to stay out of the China-led institution. But it has placed conditions on its future membership of the bank in an attempt to mollify concerns expressed by its main military ally, the US.

​“The government is today announcing it intends to sign a memorandum of understanding on the Asian Infrastructure Investment Bank, which would allow Australia to participate — as a prospective founding member — in negotiations to set up the bank,” the prime minister’s office stated.

The decision followed moves this month by the UK, France, Germany, Italy and South Korea to join the AIIB. US officials have privately urged allies to stay out of the new bank, at least until Beijing addresses concerns about governance standards. Some in Washington view China’s launch of the AIIB as an effort to undermine the influence of the US-based World Bank.

On Saturday, Russia’s first deputy prime minister, Igor Shuvalov, said his country plans to join the AIIB. Denmark, Brazil and the Netherlands will also participate, China’s finance ministry said at the weekend.

 

Money talks. Additionally, Europe needs investment and the ear of an emerging superpower. It was a miscalculation on the part of the White House to so vocally oppose participating in the Asian Infrastructure Investment Bank (AIIB) not least as it is quickly gaining critical mass without countries insisting on more detail regarding how it will function. 

To date, China’s overseas infrastructure deals, often in return for access to resources, have tended to be one sided, carried high interest rates and there have been issues with accessing funds. It remains to be seen just how the AIIB will function but it is looking increasingly likely that it will be able to do so with the full backing of countries that pride themselves on their high standards of governance.  

The facilities will be replaced by four gas-fired stations with capacity to supply 2.6 times more electricity than the coal plants.

The closures are part of a broader trend in China, which is the world’s biggest carbon emitter. Facing pressure at home and abroad, policy makers are racing to address the environmental damage seen as a byproduct of breakneck economic growth. Beijing plans to cut annual coal consumption by 13 million metric tons by 2017 from the 2012 level in a bid to slash the concentration of pollutants.

And

Nationally, China planned to close more than 2,000 smaller coal mines from 2013 to the end of this year, Song Yuanming, vice chief of the State Administration of Coal Mine Safety, said at a news conference in July.

 

I’ll be stopping off in Beijing on my way to Singapore next week and I’m looking forward to seeing first-hand what measures, if any,  have been taken to tackle the pollution problem. Replacing coal fired power stations with natural gas plants is a hugely positive development which is likely to have some far reaching repercussions. 

We have been positive on Chinese equities for 2015 but caution readers of a weak start to the year (see 2015 China Outlook). After H-shares’ underperformance vs. DM, AsiaPac ex Japan and A-shares YTD, we now see more upside risks than downside ones and turn more positive on the market, in view of the following:

We expect Chinese policy-easing efforts to intensify in 2Q15 (see policy easing cycle may start soon), including monetary, fiscal and property relaxation, given the below-target 1Q15 growth and the “bottom-line”- focused reaction function reiterated by Premier Li during the NPC. We see lower market rates and resumed credit growth ahead, and our economist forecasts GDP to bottom in 1Q15 and edge up to 7.2% in 4Q15. ? We believe the earnings cut cycle will come to an end by April, as the disappointing FY14 results season wraps up and consensus estimates get closer to our top-down forecasts. For FY15, we look for more evidence of cost reduction among mid-stream sectors to reinforce our expectation of a margin-driven non-financial earnings recovery.

We see loosening global liquidity conditions and funds inflow as catalyzing catch-up with A-shares, considering 1) the Fed finally joined forces with other major central banks on the dovish side and suggested “lower for longer” rates over the coming quarters; 2) still deeply discounted H-share valuations suggest light investor positions; and 3) improving cyclical outlook and expediting reform in China.

 

A link to the full report is posted in the Subscriber's Area. 

Liquidity is abundant. Any prospect of the Fed aggressively raising interest rates, however remote, was dismissed at last week’s meeting. If the Bank of England is any guide, the Fed’s balance sheet can remain at its current level for a prolonged period after the end of QE. With the ECB and BoJ engaged in QE and a host of other central banks cutting interest rates it is safe to conclude that there is no shortage of cheap abundant capital for investment. 

There has been a great deal of commentary in financial circles about how elevated cyclically adjusted P/E ratios are, with some concluding that stock markets are fully valued.  On one hand we could consider how likely valuations are to become overvalued, but the other way of looking at it is to ask what is still cheap. 

China’s capital outflows concern may be tempered after the Fed’s comments, and the PBOC will likely become more flexible as worries about a weaker yuan ease, Tommy Xie, a Singapore-based economist at Oversea-Chinese Banking Corp., said in an interview.

China is in talks with the International Monetary Fund to include the yuan in the institution’s basket of reserve currencies, PBOC Deputy Governor Yi Gang said in Beijing on March 12. The currency will decline 0.22 percent the rest of this year to 6.21 a dollar at the end of 2015, according to the median estimate in a Bloomberg survey.

“The fundamentals are still bullish for the yuan with the government’s plan to make it a reserve currency,” said Scotiabank’s Tihanyi. The PBOC fixings also send a “strong signal” that the authorities favor a stable currency, he said.

 

The Renminbi can be viewed from a number of different perspectives. For some it represents how much of an advantage China has gained from devaluing its currency more than twenty years ago. For others it represents the challenges experienced by manufacturers as its value has increased over the last decade. For still others its stability is a totem for the increasingly vital role China plays in the global economy. 

The Chinese authorities have made clear they want to make the Renminbi as international as possible. Opening up the financial markets, encouraging competition, insisting on the currency being used as a medium of international trade and other measures are all designed to achieve this goal. As the largest energy importer, the benefit of sourcing supply denominated in one’s domestic currency is obvious but for that goal to be reached the currency will have to be globally fungible which is not the case just yet. 

The following extracts from an article by Professor James Laurenceson, deputy director of the Australia-China Relations Institute at the University of Technology, Sydney should help subscribers have confidence in China investments.

“With China now having the world’s largest economy in terms of purchasing power, we should be cheering them on.

The World Bank says that between 1980 and 2011, the number of people living in poverty in China fell by 753 million. That’s nearly two and a half times the population of the US, and an outcome unparalleled in history.

The World Trade Organization says that China’s share of world’s goods exports has risen from 1.2 percent in 1983 to 12.1 percent in 2013. It’s now the world’s largest trader.

The Boston Consulting Group found that when utilities and other costs are added to sharply rising wages, manufacturing costs in China are now only four percent less than in the US.

To boost productivity, privatisation isn’t crucial; competition is the way that China’s government is currently muddling through reforming the financial sector.

In 2015, yes, China will muddle through. And it will do so again next year.” 

 

Thank you for this interesting article and the topical excerpts: Muddling through can also be described as being willing to both make mistakes and being committed to learning from them. If learning that competition is to be fostered is an abiding success, then the recent crackdown on corruption might also be viewed in that light. 

Some interpret the recent tightening of controls on the media and freedom of speech as well as selective punishment for moral and financial transgressions to be a retrograde step in terms of standards of governance. Others view it as a necessary process to improve the efficiency of the state owned sector not least versus their privately owned competitors. 

“The market seems to be pricing in that the possibility that the regulator would allow banks to enter the brokerage space,” said Gerry Alfonso, a China equity sales and trading director at Shenwan Hongyuan Group Co. in Shanghai.

Banks also gained after the government said it will allow regional authorities to convert some high-yielding debt into municipal bonds.

 

Liberalisation of the financial sector remains a key policy objective of the Chinese administration. Allowing the major banks to participate as brokers and perhaps more importantly as originators and underwriters is an additional step in that direction. The major banks have the heft in terms of their balance sheets to compete aggressively in financial markets. While it would be tempting to first think about the stock market, this development is much more important for the bond markets. Expanding the number of primary dealers not least for the still underdeveloped municipals sector is a major financial sector innovation. 

"At first, robots replaced workers who had jobs that exposed them to pollution, such as painting, or required that they repeat the same task," the equity manager said. "But gradually, robots have been used for trades requiring skilled workers, such as welders, because they are cost-effective."

Yet some companies have automated their factories simply because they cannot find enough people. A mid-level manager at an electronic manufacturer said that many businesses that are unable to fill positions have had no choice but to install robots.

"Workers quit every day," he said. "Physically challenging jobs under harsh conditions or jobs requiring repetitive processes are much less attractive to young workers than the older generation."

Zhang Fan, who oversees automation at a Midea factory in Wuhu, in the eastern province of Anhui, said the plant installed one robot in 2011 and another in 2012 to rapidly move 70 kilogram air conditioners on an assembly line – a job that was too strenuous for people.

 

China can no longer compete with some of its neighbours as a low cost manufacturing environment. Highly labour intensive, thin margin businesses such as textiles and jewellery manufacture have already migrated to countries like Vietnam, Cambodia, Indonesia and increasingly India and Africa. Some of the larger Chinese families will have operations in all of these countries as they manage their exposure to labour costs. 

The challenges in Taiwan and a Wall Street Journal report about Alibaba merchants paying people to pretend to be customers, called “brushing,” to pad sales figures have created some short-term negative publicity, Ji said.

“We don’t think those views will have a negative financial impact on Alibaba,” she said. “But PR-wise, it may have some negative impact on the stock.”

Alibaba, which connects consumers and businesses across its platforms, has a “credibility crisis” fueled by its failure to crack down on shady merchants, counterfeit goods, bribery and misleading promotions, China’s State Administration for Industry & Commerce said in January.

James Cordwell, an analyst at Atlantic Equities LLP in London, said Alibaba’s fourth-quarter results raised concerns about e-commerce growth and advertising revenue. There may also be a selloff ahead of the first major lockup expiration for insider share sales in mid-March, he said.

“Today’s weakness is no doubt also a result of strong results at key competitor JD.com and also the Taiwan withdrawal news,” Cordwell said.

Jack Ma is an adept stock market player. The first listing of Alibaba in Hong Kong was also met with fanfare but the share languished after the initial spike and was eventually delisted for its IPO price in 2012.

The issues with its platforms being the world leaders in the distribution of counterfeit goods are nontrivial. There have been anecdotal stories for years about the cottage industry in Hangzhou centred on gaining preferential positions on websites through a web of bribery. These are damaging issues and will need to be addressed if the company is serious about preserving the interests of its minority shareholders. 

Debt continues to grow. Since 2007, global debt has grown by $57 trillion, or 17 percentage points of GDP.* Developing economies account for roughly half of the growth, and in many cases this reflects healthy financial deepening. In advanced economies, government debt has soared and private-sector deleveraging has been limited.

Reducing government debt will require a wider range of solutions. Government debt has grown by $25 trillion since 2007, and will continue to rise in many countries, given current economic fundamentals. For the most highly indebted countries, implausibly large increases in real GDP growth or extremely deep reductions in fiscal deficits would be required to start deleveraging. A broader range of solutions for reducing government debt will need to be considered, including larger asset sales, one-time taxes, and more efficient debt restructuring programs.

Shadow banking has retreated, but non-bank credit remains important. One piece of good news: the financial sector has deleveraged, and the most damaging elements of shadow banking in the crisis are declining. However, other forms of non-bank credit, such as corporate bonds and lending by non-bank intermediaries, remain important. For corporations, non-bank sources account for nearly all new credit growth since 2008. These intermediaries can help fill the gap as bank lending remains constrained in the new regulatory environment.

Households borrow more. In the four “core” crisis countries that were hit hard—the United States, the United Kingdom, Spain, and Ireland—households have deleveraged. But in many other countries, household debt-to-income ratios have continued to grow, and in some cases far exceed the peak levels in the crisis countries. To safely manage high levels of household debt, more flexible mortgage contracts, clearer personal bankruptcy rules, and stricter lending standards are needed.

China’s debt is rising rapidly. Fueled by real estate and shadow banking, China’s total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany.* Several factors are worrisome: half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable. 

 

A link to the full report is posted in the Subscriber's Area.

The extent of debt deleveraging tends to be a subject that receives little press attention because it is so difficult to quantify. Some people are worried about the quantity of debt that has continued to climb since 2008. However the detail of who is responsible for this debt is more important. 

Quantitative easing is in many respects a transfer of debt from private institutions to government. This has allowed corporations to reduce their debt servicing costs and to lock in the lowest rates anyone has ever seen; often at lengthy maturities. Consumers have been spending less, refinancing mortgages and today’s news suggests more are getting back to work. The USA’s private sector has deleveraged and its government has become overleveraged. If the data in the above report is considered from a long-term perspective we can see cyclicality where credit contraction follows credit splurges and vice versa. 

The groups, which include the U.S. Chamber of Commerce, called for “urgent discussion and dialogue” about what they said was a “growing trend” toward policies that cite cybersecurity in requiring companies to use only technology products and services that are developed and controlled by Chinese companies.

The letter is the latest salvo in an intensifying tit-for-tat between China and the United States over online security and technology policy. While the United States has accused Chinese military personnel of hacking and stealing from American companies, China has pointed to recent disclosures of United States snooping in foreign countries as a reason to get rid of American technology as quickly as possible.

Although it is unclear to what extent the new rules result from security concerns, and to what extent they are cover for building up the Chinese tech industry, the Chinese regulations go far beyond measures taken by most other countries, lending some credibility to industry claims that they are protectionist. Beijing also has long used the Internet to keep tabs on its citizens and ensure the Communist Party’s hold on power.

Chinese companies must also follow the new regulations, though they will find it easier since for most, their core customers are in China.

 

China has unabashed ambitions of becoming a global economic and military superpower large enough to rival the USA. However if it is to close the technological gap with the USA it will have to invest a great deal of money, time and effort into technological development. Investment in science is already impressive but the commercialisation of ideas takes time. 

Like other emerging countries that have come before it, China has copied what it could not develop itself. Insisting companies that wish to do business in China to sign technology sharing agreements and engaging in corporate espionage are both aimed at achieving the goal of rapidly narrowing technological gaps.

Forcing government agencies and state owned companies to buy from Chinese vendors almost certainly sets the country on course for discourse with the WTO. However by the time a judgement is reached much of the transition will probably have been completed.  The majority of China’s leading technology companies have sought listings in either Hong Kong or the USA which creates a challenge when judging the performance of the sector. 

In new guidelines on online literature made public this month by the State Administration of Press, Publication, Radio, Film and Television, the government called for a system that would require all authors to register their real names with publishing platforms on the Internet.

Under the guidelines, creators of online content will still be allowed to publish under pen names. But unlike before, when some writers registered accounts under fake names, websites will know exactly who is publishing what.

Linking the identities of authors with their writings online, the guidelines say, will encourage them to “take better responsibility” for their works as well as strengthen their “professional moral education and training.” The aim is to promote “healthy” online literature and to root out problems like plagiarism and poor quality, the guidelines state.

“It is very clear that the government is taking these measures with the intention of suppressing online creativity,” the writer known as Murong Xuecun, whose real name is Hao Qun, said in an interview.

 

Anonymity on the internet is a touchy subject. On the one hand anonymous hackers have the ability to disrupt movie releases. Internet trolls might be in the minority but they take pleasure in insulting other people from the comfort of their own homes and totally free from retribution. On the other hand the use of anonymous profiles has allowed the spread of liberal ideals in a number of authoritarian regimes which has challenged the ability of the political apparatus to control news flow. This was particularly the case in a number of the Arab Spring revolts and is something China is now moving to ensure goes no further within its borders. 

Freedom of speech is only possible when backed by a robust legal framework and where the political establishment is subject to the rule of law. The Communist Party’s absolute control of the media was tight before, and this measure represents a considerable escalation of state control. Weibo and Sina blogs are incredibly popular in China. People document almost every aspect of their lives but they are also the modern equivalent of town hall meetings as friends, colleagues, relatives and old school friends actively discuss various topics. It strikes me as no coincidence that the push to implement real name profiles is coming so soon after the unrest in Hong Kong. The Communist Party has no intention of easing its grip on power. 

Cost savers: Mid-stream industrial sectors that could benefit from lower commodity prices and highly leveraged sectors that could benefit from lower financing costs.

Top-line growers: Increasing demand for better quality of life suggests a stronger appetite for healthcare, environmental protection, TMT, and child/senior-related consumption.

Reform beneficiaries: Look for potential beneficiaries from SOE reform, “Go Global”, financial reform and land/Hukou reform, but watch for potential losers from fiscal/tax reform.

MSCI inclusion: Select TMT and consumer discretionary names will benefit at the expense of the largest incumbents including financials, energy and telecom.

 

A link to the full report is posted in the Subscriber's Area.

In many respects the MSCI China Index is similar to the Hang Seng China Enterprises (H-Shares) Index. They certainly have a similar chart pattern and valuations. Mainland listed shares have so far been the primary beneficiaries of the opening up of the Hong Kong Shanghai Stock Connect with overseas investors dominating what has so far been one way traffic. 

Citic Securities Co., China’s biggest brokerage by market value, said it will push ahead with a plan to sell about $4.6 billion of stock even after curbs on margin lending triggered a record plunge in its shares.

The broker’s plan to sell as many as 1.5 billion new H shares remains unchanged, a Hong Kong-based press officer said in an e-mailed response to questions today. Citic Securities said in December it would sell the shares, valued at $4.6 billion based on today’s price, to develop capital-intensive operations including margin financing and securities lending.

Chinese brokerages’ shares plunged today after the securities regulator banned three of the biggest firms from adding new margin-finance accounts for three months. Citic, Haitong Securities Co. and Guotai Junan Securities Co. let customers delay repaying financing for longer than permissible, the China Securities Regulatory Commission said Jan. 16.

The business and operations of Beijing-based Citic Securities remain unchanged, it said in today’s statement. Citic Securities shares fell by the 10 percent daily limit in Shanghai and dropped 16 percent, the most on record, at the close in Hong Kong.

Haitong hasn’t changed its share sale plan, said a person with knowledge of the matter, who asked not to be identified discussing private information. It said in December it plans to raise about $3.9 billion from a sale of 1.92 billion new shares.

 

Today’s announcement clipped the wings of highflying mainland brokers with the three main companies falling the daily limit of 10%. Brokerages have outperformed by a wide margin over last three months with Citic Securities returned to test its 2008 peak. Consolidation of that accelerated move is now underway. 

The good news? We won't see high-yield debt defaults for a few years because everyone has refinanced their debt.

"There are lots of reasons to think rates should rise in five years, but not much in five days or five months."

 

There have been a number of articles over the last week taking the view that the bull market in China has gone too far and that it is time to sell. Unsurprisingly, investors are wary of the Chinese market considering how much bad news they have been fed over the last five years. However the fact that so much high yield debt has already been refinanced is a major tailwind in the short to medium-term. 

“The Swiss National Bank’s decision caught the market a little off footing, and gold gained as a safe-haven buy,” Frank McGhee, the head dealer at Alliance Financial LLC in Chicago, said in a telephone interview. “The Swiss are giving up on the euro at the end of a long and painful run.”

At The Chart Seminar we have long defined ranges as “explosions waiting to happen”. Over the last six months we have been presented with a considerable number of explosive moves, not least oil, copper, mainland China, the US Dollar and now the Swiss Franc. These are not small illiquid instruments but some of the largest most globally significant markets in the world. This kind of volatility is unnerving for investors; unaccustomed to such large swings in their portfolios. Demand for some form of safe haven has increased as a result. 

Some individual investors, of course, try to be more selective than just focusing on the price. Shawn Gao, a 27-year- old bank manager in Chengdu, looks for shares that will benefit from government policy changes while using volume and momentum data to help guide his decisions. Even he admits, though, that he’s sensitive to the absolute price level, staying away from stocks priced above 20 yuan.

What looks cheap to Chinese investors who focus on a stock’s price may actually be expensive. Equities in the CSI 300 index trading below 5 yuan are valued at an average 25 times estimated earnings for the next 12 months, versus 13 times for the overall index, according to data compiled by Bloomberg.

The market impact of individuals who ignore corporate fundamentals is driving away some of the region’s institutional investors, who are concerned speculative price moves will hurt performance, said David Gaud, a Hong Kong-based money manager at Edmond de Rothschild Group, which oversees about $158 billion.

“The market would need more institutionals and less leveraging on the retail side,” Gaud said. “This is not liquidity which is of good quality at the end of the day.”

 

The domestic Chinese investor has been absent from the market since 2008 and is only now returning. If we think about our experience of stock market tops and base formation completion, people are most worried about bubbles following a breakout when they are underweight. Following a multiyear advance when investors have so much confirming evidence of the bullish hypothesis and a vested interest in it continuing, there are fewer people proclaiming the existence of a bubble. 

Macro: Broad-based easing to bottom line ; watch CPI & RMB
We forecast lower-than-consensus GDP in 1H15, while 2H15 may see a minor pick-up thanks to rates and RRR cuts in 1-3Q15. We think the policy regime bottom line, but refrain from suggest closely watching the developments in CPI (esp. pork prices) and RMB depreciation to gauge how far the policy easing could go. 

Earnings: Non-financial earnings to recover at the expense of financials
We see a decent recovery in non-financial earnings growth to 8% in 2015 (vs. 0% in 2014), thanks to profit margin expansion amid softening commodity prices and falling financial costs. However, financials earnings growth may slow to 3% in 2015 (vs. 8.5%), sending overall H-share earnings growth to 5.5% (vs. 4.4%). This trend may extend in 2016 and H-share earnings could grow at a similar 5.4%. We believe cost cutting has its limit for Chinese corporate, top-line is still needed for a more sustainable earnings recovery. 

Liquidity: When G2 diverges the loosening PBoC vs. the tightening Fed
H-share liquidity conditions may weaken due to 1) further global capital outflows alongside the tightening Fed and strengthening US dollar, and 2) the mounting northbound while lukewarm southbound flows in the Shanghai Connect. A-shares may continue to benefit from the loosening PBoC and outperform H-shares, but in the near term, we would watch out for prudential measures given recent rapid leverage build-up, esp. via alternative channels. 

Valuations: 8-11x the fair range; market to enter
Modeling MSCI China with a three-stage DDM, we estimate 8-11x 12-month forward P/E as the fair valuation range. We expect the index to re-rate from the current 9.4x 12-month forward P/E to 10x by end-2015, based on 3.5% RFR and 6.5% risk premium. Also, considering around 5% rollover in 12-month the rising P/E and EPS boosting the index by 12% to 74 by end-2015.

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The Chinese mainland’s stock market remains in robust form despite the short-term overbought condition currently evident. This explosive breakout will roll over into a consolidation of gains at some point but a clear downward dynamic, held for more than a day or two, would be required to check momentum. 

Hong Kong Exchanges & Clearing Ltd. jumped the most in a month after a report that Chinese Premier Li Keqiang said a stock link with Shenzhen should be established.

The new exchange program should follow the Hong Kong- Shanghai connect that began in November, Shenzhen Special Zone Daily reported on its tetimes.com website, citing Li during a visit to the city. Shares of Hong Kong Exchanges rose 2.5 percent to HK$177.30, the biggest advance since Dec. 8. The Shenzhen Composite Index extended gains to 1.5 percent, while the Hang Seng Index slid 0.6 percent.

“A Shenzhen-Hong Kong stock link will have a positive effect on HKEx in terms of turnover and profitability,” said Sam Chi Yung, a strategist at Delta Asia Securities Ltd. in Hong Kong. “We still don’t know the timetable of the program, but at least we know that China intends to launch it.”
Shenzhen Special Zone Daily is the official newspaper of the Communist Party committee in the southern Chinese city.

The existing cross-border trading connect gives foreign money managers greater access to Shanghai-listed equities while allowing mainland investors a route to buy Hong Kong shares. The program usage has been slower than expected, with about 25 percent of the aggregate quota being used for Shanghai-listed shares, and less than 5 percent for Hong Kong stocks traded through the link.

The design of the stock link is scalable and replicable, and can be expanded to cover other markets or asset classes, Lorraine Chan, spokeswoman at Hong Kong Exchanges, said in an e- mail today. The bourse operator has “excellent working relationships with the Shenzhen exchange,” and will inform the market if there are material developments, she said.

 

The above headline is somewhat misleading if one considers the action evident on the chart below. Nonetheless, a sustained move below the 200-day MA would be required to question medium-term upside potential. 

The extension of the Hong Kong Shanghai Connect program to also include the Shenzhen exchange is a positive announcement. This helps to confirm the intention to internationalise the capital markets by attracting additional inward investment and allowing at least some domestically held capital to migrate. 

Chinese stocks traded in Hong Kong rose to their highest close in more than three years amid speculation the government will further ease monetary policy to support a slowing economy.

Mainland developers and financial companies jumped, with China Vanke Co. increasing 11 percent and People’s Insurance Company (Group) of China Ltd. reaching a one-year high. CSR Corp. and China CNR Corp. soared at least 16 percent, extending their Dec. 31 surge after the train builders announced a merger agreement. Kaisa Group Holdings Ltd. remained suspended after the property developer defaulted on a $52 million loan.

The opening up of the stock market connection between Shanghai and Hong Kong in the fourth quarter has acted as a catalyst for investments flows into mainland China. The market was depressed, valuations are still attractive and the promise of additional flows kick started investment demand. The underperformance of the property sector over the same period has acted as an additional catalyst for domestic investors to diversify their exposure. A number of financial sector shares have performed spectacularly. Citic Securities for example rallied from CNY 12 in late October to hit CNY35 last week. 

Facebook Inc. shares rose to a record as the social network caps a year in which mobile advertising increased and marketing initiatives expanded with applications and video.

The shares advanced as much as 2.5 percent to $81.88 in New York trading, the highest price since Facebook’s initial public offering in May 2012. The stock has jumped 49 percent in 2014, a year of rally for the Standard & Poor’s 500 Index, which increased 12 percent.

This year Facebook made further headway in mobile, a business that has flourished from a minor portion of ad revenue at the time of the IPO to a majority. Facebook’s acquisition of Instagram in 2012 for $1 billion has also been paying off: A Citigroup Inc. analyst last week said the photo-sharing app is worth $35 billion.

“While the shares have likely benefited from the recent market rally, we see growing confidence in the monetization prospects of Instagram as an impetus to the recent uptick,”

James Cakmak, an analyst at Monness Crespi Hardt & Co., said in an e-mail. He recommends buying the shares.

Facebook was trading at $81.57 at 11:57 a.m., up 2.1 percent, giving the company a market value of about $228 billion. The stock has more than doubled since the IPO. 

 

Smartphones and social media represent a symbiotic relationship since the roll out of mobile phones and broadband is fuelling the evolution of social media and vice versa.

Facebook has successfully monetised its portal and remains a leader within its sector with global reach. It is open to question whether Mark Zuckerberg’s overtures to China will be successful. Personally, I doubt whether China will allow Facebook access when it has home grown products such as Wechat (Tencent Holdings) or Weibo (Sina.com) over which it has a great deal of control. 

I emailed several weeks ago to ask that you include Prosperity REIT (808:HK) in the Chart Library, but I gave you the wrong ticker, so could you please add this again. And do you think you could review the Hong Kong REIT market at some point as well? It might prove interesting for us all. Thanks so much, and happy holidays.

Thank you for this question which highlights a high yield sector in Hong Kong, which is benefitting from the potential for additional flow of funds from the mainland. We have added the correct ticker for Prosperity REIT to the Chart Library. 

Metal’s flagship has got upside: Copper’s price has come under pressure late in the year, reflecting the energy sector sell-off and a perceived short-term metal surplus. Weaker, but the price remains well above its long-term average, and above the industry’s 90th percentile. Robust support of its value comes mainly from two drivers: China’s overwhelming dependence on imports (70% of supply); and the fickle nature of copper’s complex supply chain (mine supply; concentrates; scrap). Unlike other commodities, copper’s mine supply growth never quite matched demand growth during the Super Cycle, a condition that is unlikely to change over the medium term – underpinning our bullish price outlook.

Why so bearish? Consensus view: copper’s trade will now report persistent surpluses. Yes, current signals point to adequate supply: inventories are rising; key merchant premia are soft; backwardation may just reflect concentrated LME positions. Elsewhere, concentrate flows are adequate (TC/RCs are high); scrap flows are expanding. We acknowledge these bear signals. We’re just not convinced by the mine supply growth story. Low-risk re-rating of Escondida output over the past two years was actually unusual. To expect short-term green/brownfield deployments to proceed without disruptions at a lower price level (assuming unchanged demand growth) ignores the history of this industry.

Projects to watch: Key mine supply growth drivers to watch include Las Bambas, Toromocho, Sentinel, Cerro Verde; track Codelco’s ability to fund growth to >2Mtpa; Indonesia’s exports remain at risk, politically; in 2016, Escondida may de-rate again on lower grades; Rio Tinto has pared Kennecott’s supply outlook. We expect ongoing supply disappointments, simply because it is a feature of the industry.

 

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There are a lot of moving parts to the commodity sector but the biggest change by far to the economics of production has been the falling oil price. We do not yet know at what level prices will eventually stabilise but the fact remains energy costs have fallen almost 50% in six months. Considering how important energy costs are for miners, this move will improve the average cost of production and prolong the ability of marginal producers to increase supply.

However, the currency risk is the issue and we suspect a lot of companies have borrowed USD given low interest rates and on the expectation that the USD would continue to depreciate (Figure 19).

8) This is particularly true for China where BIS data shows borrowing increased an impressive 4.5x over the past five years (Figure 20). While external debt to GDP is manageable from a level perspective, the acceleration is a cause for concern in a world where exchange rates are driven by capital rather than current account flows.

9) Our analysis of Chinese corporate returns reveals that there is overcapacity through much of the listed sector, including the consumer space. Furthermore, returns on equity would have been even lower had leverage not sharply increased. Falling margins, falling asset turnover, falling ROAs, rising leverage, falling ROEs are not great combinations (Figures 34, 39 and 42).

10) We suspect it was weak growth and a strong USD that encouraged the PBoC to surprise the market and cut rates. Left to itself, Chinese policy making credibility is high enough that the work-out can be achieved. The risk is that external pressures, via a stronger USD, attracts capital away and we see downward pressure on the RMB. This keeps us underweight Chinese properties. We would be Neutral China.

 

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At the Chicago venue for The Chart Seminar in September a knowledgeable Peruvian delegate spoke at length on the repercussions for his country of a strong Dollar because there was such a dependency on Dollar funding. It’s easy to think about how this situation could have evolved. 

The Dollar had been weak for a long time. The funny thing about trends is that the longer they persist the greater the incentive to believe they will continue for even longer. If one had a company seeking funding for expansion, and credit in my home country is difficult to come by and/or has high interest rates, the relative attraction of the Dollar, which had been trending lower in nominal and real terms was powerful.  

I am currently long ASHR (yay!!), which is looking mighty parabolic and amazingly extended... 

But, what are the best US-traded ETFs for investing in China with some diversification across sectors, based on your (extensive) knowledge of China?

<change of subject>

I noted that HYG and JNK are moving down, which is a bit of a non-confirmation of the recent S&P performance (though, if I may say so, breadth still sucks). Any thoughts?
Hope you're staying dry. We call this "winter" in CA. :)

 

Thank you for the well wishes. The torrential downpours last week and more due this week certainly make a change from the endless sunshine of the last year. It also made the drive to Arizona last week particularly picturesque as the desert began to bloom.  

The Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (ASHR) is a useful instrument and offers direct exposure to China’s most liquid Index. Today’s downside key day reversal on the Shanghai A-Shares Index has checked the powerful breakout for at least the short term and some consolidation of recent gains is the most likely scenario. Considering how far the Index rallied in the last month, there is ample room for ranging. 

Environmental protection investment. China budgeted CNY3.4trn for environmental protection under the 12FYP, ie 140%/57% above the budgeted/actual for 11FYP respectively. The upcoming Water Pollution Prevention and Treatment Plan will assign CNY2.0trn in 2013-2017 for water projects, 45% above 12FYP’s numbers. This shows China's commitment at least until 2017 on this matter. 

Municipal waste water treatment, higher budget. The NDRC budgeted CNY430bn for municipal waste water treatment in 12FYP. This was 30%/14% above the budgeted/actual numbers under 11FYP. The huge investment was intended to raise the treatment rate for cities/counties/towns to 85%70%/30% in 2015 from 77%60%/20% respectively. Future municipal sewage volume is on an uptrend, backed by the ongoing urbanisation process. Near-term drivers are: i) the “go rural” (county/town) with still low treatment rates, and ii) a discharge standards upgrade.

Industrial waste water treatment, a more centralised treatment. Despite the already high treatment rate of 95% in 2010, industrial sewage still offers enormous opportunities via waste water treatment by third-parties, which have better cost efficiencies than manufacturers that treat sewage by themselves. China’s economy slowdown may drag down industrial sewage volume, but textile industry has better visibility due to the recoveries in the US. We prefer the BOO model for industrial waste water treatment as it charges higher, more flexible tariffs.

Sludge, a new market. Sludge is highly toxic, and its treatment rate was low in 2010 (below 25%). The NDRC plans to raise this rate up to 70% for cities in 2015, and budgeted CNY35.0bn for 12FYP, 7% more than its 11FYP budget. Guangdong has committed the most on sludge treatment and its market is large, accounting for 11% of China’s total new sludge treatment capacity for 12FYP. Sludge BOOs can deliver 20% IRR

 

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The current stock market rally in China is related more to the opening up of two-way investment avenue between the Shanghai and Hong Kong stock exchanges that began last month, than any other single factor. The fact that it has been accompanied by the first cut to short-term interest rates in a number of years has been an additional bonus. This move is being led higher by the banking and broking sectors not least because of their size, liquidity and that they benefit from an increasing number of transactions. 

While the move could limit systemic risks, it may fuel competition for deposits and drive up lenders’ borrowing costs as savers divert money to stronger banks or those that offer higher interest rates, according to Jim Antos, a Hong Kong-based analyst at Mizuho Securities Asia Ltd.

China may offer customers deposit protection as soon as the start of 2015, the official Xinhua News Agency reported, citing unidentified sources. The insurance would help to prepare China’s financial system for bank failures as the economy slows and authorities allow banks to pay higher interest on deposits.

“Competition for large deposits will clearly increase, with pricing and the perceived financial strength of the banks being the key factors for consumers,” Antos wrote in an e-mail.
“We expect to see a shift of large deposits to the megabanks which, being government-owned, are viewed as stronger institutions.”

The government may cap coverage at 500,000 yuan ($81,000) and set different premium levels based on a bank’s regulatory rating under the plan, Economic Information Daily reported today, citing a person close to regulators.

Multiple government departments, including the People’s Bank of China and the China Banking Regulatory Commission, are preparing the program, Xinhua said.

 

One of the challenges with assessing the outlook for the Chinese market is that there has been so much bearish commentary over the last few years that it is difficult to decipher which arguments hold water. What appears clear is there is an impending issue with bad loans coming down the pipe. As the economy slows and state investment priorities evolve it is reasonable to assume that not all loans taken out in the last decade are going to be paid back in full. 

The more important consideration at the present time is that measures are being put in place to deal with this eventuality. The creation of the deposit insurance program is a positive initiative and suggests the Chinese government is not willing to continue to engage in blanket bailouts of troubled institutions. 

Industrial profits in China fell 2.1 percent from a year earlier in October, the biggest decline since August 2012, government data showed today.

The halt to repo sales was “an expected move following the rate cut in the previous week,” said Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group Ltd. “Market interest rates remain sticky in general. This reflects a policy dilemma faced by the Chinese authorities as the rate cut alone cannot manage market expectations.”

And

There will probably be two more rate cuts by mid-2015, each by 25 basis points, and banks’ reserve-requirement ratios are forecast to be lowered by 150 basis points cumulatively next year, HSBC Holdings Plc economists Qu Hongbin and Julia Wang wrote in a Nov. 24 report.

 

In the environment of ultra-low interest rates and extraordinary monetary policy we have been accustomed to it is easy to forget that during this time China has been reloading its central bank’s arsenal of policy tools. 

Interest rate differentials are high relative to other major economies, bank reserve requirements are in the region of 20% versus low single figures elsewhere, the currency remains close to highs not seen in 20 years and aggressive measures are in place to withhold credit from property investments among other tools.

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In his 12 years as People’s Bank of China Governor, Zhou Xiaochuan has never stopped at a single shift to benchmark interest rates once prompted into action.

Zhou, who took office in 2002 when Alan Greenspan was still chairman of the Federal Reserve, has overseen two tightening and two easing cycles for a total of 22 moves to the one-year lending rate and 20 to the one-year deposit rate. Simple math suggests his latest cut is unlikely to be a one-off.

By joining Mario Draghi and Haruhiko Kuroda in the global stimulus camp, Zhou signaled deeper concern over China’s outlook and recognition that targeted measures alone weren’t going to be enough to revive growth. A Bloomberg survey conducted late Nov. 21 through yesterday showed economists forecast further monetary loosening by the middle of next year.

“Expect more interest rate cuts ahead,” said Shane Oliver, who helps oversee about $125 billion as Sydney-based head of investment strategy at AMP Capital Investors Ltd.

“China’s rate cut highlights that global monetary conditions are still easing with monetary easing in Japan, Europe and China taking over from the end of quantitative easing in the U.S.”

The one-year lending rate will be 5.35 percent in the second quarter of 2015 and the one-year deposit rate will be 2.5 percent, according to the median forecast of economists surveyed by Bloomberg. AMP’s Oliver has the lowest forecast, predicting the lending rate will fall to 4.5 percent by the end of next year; by contrast four of 15 economists see no further reduction.

 

China is one of the only countries in Asia where currency market volatility has not impeded capital market appreciation potential for foreign investors over the last year. However as the easing cycle in monetary policy reignites, the prospect of additional strength for the Renminbi is looking increasingly unlikely. 

While it is true that Zhou Xiaochuan has not stopped at one cut when entering an easing cycle, the above chart illustrates that the medium-term peak in lending rates was in 2012 at 6.56% and the recent cut is an extension of that easing policy following a hiatus. The lows near 5.3% have not previously been exceeded and it will be a measure of how much assistance the central bank thinks the economy needs whether they will cut rates below that level. 

Hi David & Eoin, I wanted to get FTM thoughts and opinion on where the best investment returns could be had over the next 12 months and what would be the key things to watch for? Thanks for an excellent service 

Thank you for your kind words and your question. This is a topic we cover almost daily in the written commentary and the audio but it is a good time to summarise our views. 

Let’s ruminate for a moment though on the timing of your question. Generally speaking, the last six weeks of the year is given over to thinking about the possibility of a Santa Claus rally and people don’t generally look at the outlook for the next year until the last week of December or the first week of January. It made headlines during the week that Goldman Sachs had released its prognostication for the coming year, which may have prompted your email. However I believe it is worth considering that the stock market is a discounting mechanism and as a bull market progresses we tend to want to discount cash-flows from increasingly further into the future. It is a measure of how strong the market has been over the last month that investors are already planning for next year. Five consecutive weeks to the upside suggest some consolidation is increasingly likely.

Noodles and drinks can be fashionable if consumers want it that way. Chinese consumers have had most of what they need, so we look into the discretionary side of consumer staples, i.e., what and how they want the beer and tea to be served. We think something new and/or chilled will help companies to put a stop on de-rating in 2015, and to prepare for the recovery ahead.

The myth: staples are no necessities?
YTD in 2014, Hong Kong-listed consumer staples under DB coverage and those we monitor underperformed the MSCI China by 20%. We think the de-rating is partly structural, including the reduction in corporate spending and diminishing channel advantage (as a result of the e-commerce boom); and partly company-specific due to weak product development capabilities and therefore absence of sustainable growth drivers.

Newness to connect with the ‘Post-90s’
We think the anti-extravagance campaign has driven a structural change in consumption, because consumers are now mostly paying out of their own pockets (instead of using pre-paid cards/coupons) for products they desire and from where they deem convenient (instead of whatever is available in designated locations). In addition, the ‘Post-90s’ shoppers have changed from traditional habits of consumption given a more global mindset, and are eager for continuous novelty in product and branding. Therefore we highlight UPC (220 HK; Hold) and Hengan (1044 HK, Buy) due to their proven track record in these areas. They either suffered or are suffering from price wars for different reasons, but we expect them to recover in 2015 with price wars ending/fading.

Putting ourselves into Chinese consumers’ refrigerator
Consumers in some parts of China still drink beer and milk at room temperature. We believe this will change, starting with pasteurised milk, as China’s expensive milk will accelerate consumer sophistication, and we believe the next thing they will ask for is freshness. Then we expect more fridge-pack beer and drinks, and chilled and frozen food. We think potential beneficiaries of this development include Mengniu (2319 HK, Buy), which aims to make chilled products one of its growth engines; and Tsingtao (168 HK, Hold), which has lagged behind in product mix improvement in 2014 – we expect the company to refocus on product upgrade and margin improvement in 2015.

 

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It is open to question whether Chinese consumers will be willing to consume chilled beverages if Mrs. Treacy is any guide. Many Chinese consider air conditioning unhealthy and cold beverages unsettling to one’s internal chemistry. Nevertheless, the penetration of caffeinated, alcoholic, spicy, salty, savoury and sugary food and drinks is unlikely to be curtailed by these cultural factors not least because they have addictive qualities and because they represent the growth in demand for convenient foods. 

Under Shanghai-Hong Kong Stock Connect, The Stock Exchange of Hong Kong Limited (SEHK) and Shanghai Stock Exchange (SSE) will establish mutual order-routing connectivity and related technical infrastructure to enable investors in their respective markets to trade designated equity securities listed in the other’s market. Hong Kong Securities Clearing Company Limited (HKSCC) and China Securities Depository and Clearing Corporation Limited (ChinaClear) will be responsible for clearing, settlement and the provision of depository, nominee and other related services for the trades initiated by the investors in their respective markets. This brochure provides information for investors who want to use Shanghai-Hong Kong Stock Connect to trade equity securities listed on SSE.

The opening up of the Shanghai-Hong Kong Stock Connect is a major undertaking. It represents a further easing of China’s closed capital market, with an additional $50 billion in market liquidity possible, under the terms of the agreement. (Please see this additional note from SocGen highlighting the conditions of the existing QFII, RQFII and new Stock Connect program) 

 

The program allowing a net 23.5 billion yuan ($3.8 billion) of daily cross-border purchases will begin on Nov. 17, regulators said in a joint statement today after weeks of investor speculation on the start date. Benchmark indexes in Shanghai and Hong Kong climbed at least 0.8 percent, while Hong Kong Exchanges & Clearing Ltd. surged 4.6 percent. The yuan strengthened as the central bank raised its reference rate by the most since 2010.

The exchange link is one of China’s biggest steps toward opening up the capital account, increasing use of the yuan and turning Shanghai into an international financial center. It will give foreign investors greater access to Chinese companies tied to the nation’s consumer market, which President Xi Jinping is counting on to reduce the dependence of the world’s second- largest economy on exports and infrastructure spending.

“It’s good to see a date,” Mark Konyn, who helps oversee about $92 billion as the chief executive officer of Cathay Conning Asset Management in Hong Kong. “It’s a great innovation. We understand it’s only the first step.”

Shenzhen Link
A Shenzhen equivalent of the Shanghai-Hong Kong link will probably follow within two years, letting more foreign investors buy shares on China’s smaller exchange, according to Bank of America Corp. and Templeton Emerging Markets Group. Japan would also like be part of a trading link with China, the chief executive officer of Osaka Exchange Inc. said on Nov. 5.

The Shanghai connect will expand access to Chinese shares from a limited number of institutions to anyone with a Hong Kong brokerage account. The $64 billion Qualified Foreign Institutional Investor program has allowed professional money managers to buy local securities since 2002, while a similar system using offshore yuan began in 2011.

Shanghai-listed equities are heading for the best annual gain since 2009, outpacing shares of mainland companies listed overseas amid speculation valuation discounts on domestic securities will narrow as China opens up. The Shanghai Composite Index has climbed 17 percent this year, versus a 1.9 percent drop in the Hang Seng China Enterprises Index of Hong Kong- listed shares

Many Western commentators have decried the upside potential of the Chinese market as ephemeral. The reasons for this pessimism are well known but include the unsustainable pace of fixed asset investment not least in property and infrastructure and the opacity of the financial sector where loans have been made based on national and regional interests rather than capacity to repay. As they say, “there is no smoke without fire” and the downtrend evident on the A-share Index lent credence to these arguments and was debilitating to confidence.  

And Alibaba is making money: Net profit tripled to $3.7 billion in the year ended on March 31. While net income fell 39 percent in the three months ended Sept. 30, in part as a result of the cost of integrating new businesses, revenue jumped 54 percent during the quarter -- beating analysts’ estimates.
     
“The growth potential of Internet companies in China is many multiples greater than in the U.S.,” says Shane Oliver, who helps manage $131 billion at AMP Capital Investors in Sydney. “Businesses which can take advantage of that, such as Alibaba, seem incredibly attractive.” In line with AMP policy, Oliver declined to say whether his firm bought the stock.
    
Ma isn’t the only billionaire tapping China’s Web-savvy consumers. Robin Li, 45, was China’s second-richest man as of Nov. 9, with a fortune of $17.2 billion, after founding search engine Baidu Inc. Ma Huateng, 43, who was worth $15.6 billion on that date, has expanded Tencent Holdings Ltd. into China’s top instant-messaging service.

 

The opening up of the Shanghai – Hong Kong Exchange link is a major event. It is tempting to think of it from the perspective of a Westerner gaining access to a new market but it is even more important for mainland Chinese who will for the first time have access to Hong Kong listed securities and by extension the wider global market. 

Contrary to popular belief, we believe Chinese life insurers should benefit from monetary easing at this point in the cycle. We note that our China economist now expects two interest rate cuts in 2015. We believe a lower rate environment could ease competitive pressure and allow room to lower liability costs, which should more than offset reinvestment pressure. We expect the sector to deliver robust EV and VNB growth in 2014-16, and see the current sector valuation as attractive, especially the major insurers’ A-shares, trading at 0.9-1.1x 2014E P/EV. We initiate coverage of the Chinese insurance A-shares, with Buy ratings on China Life, Ping An and CPIC, and a Hold on NCI.

Why are interest rate cuts positive? 
There are three reasons why we believe potential interest rate cuts are positive for Chinese life insurers. Firstly, we believe insurers’ investment yields could be resilient, despite lower interest rates, thanks to the availability of higher yielding assets. We note that the listed insurers’ net investment yields of 4.8-5.1% in 1H14 are relatively low compared with the 6+% yields offered by new investments, such as preferred shares and other non-standard investments. Secondly, while asset duration is shorter than liability duration, we believe the sector’s liabilities could be re-priced faster than assets, due to the dominance of participating and universal life policies (~77-92% of reserves), which allow insurers flexibility in adjusting liability costs. Furthermore, we believe a lower interest rate environment could ease competitive pressure for the sector, and is positive for growth. Last but not least, an easing monetary situation should ease asset quality deterioration, which has been a key concern for investors.

Expect robust EV and VNB growth in 2014-16 
We forecast robust EV and VNB growth for Chinese life insurers, with average EV growth of 23.7% and VNB growth of 18.3% in 2014, helped by strong investment markets. We forecast EV growth to be sustained at around 14.3%/13.9% in 2015/16, and VNB growth at 15.6%/14.6%, supported by stable market conditions and an increased focus on protection policies. As such, we see current sector valuations – at 0.9-1.1x 2014E P/EV for insurance A-shares, 0.9-1.3x for H-shares – as unjustified and yet to price in any recovery.

 

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China remains a nation of savers. A major contributor to this state of affairs is the underdeveloped insurance sector. If you need to hold large cash balances to provide for accidents, home repairs, healthcare, retirement and death you will need to adopt an inherently cautious attitude to personal finances. Sharing the burden for these eventualities with an insurance company reduces risk and allows for a more productive use of capital. Insurance remains a growth industry in China for these reasons but this is not a new story. The healthcare sector is where the majority of investors currently have their attention trained while the more established insurance companies remain largely rangebound. 

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Russia (P/E 5.66) and the Hong Kong Enterprises (H-Shares) Index (P/E 7.3) have similar valuations but couldn’t be more different. Russia represents the degradation of an economy due to adventurism by the ruling oligarchy. The H-Shares represent a market which has been constrained by tight monetary policy for three years and is only now emerging from it. 

More favorable supply-side dynamics According to NBS, nationwide new home prices have fallen 4-6% since April, and sales have responded positively to such price cuts. On our analysis, overall residential inventory period (including properties under construction but with  presale permits) has already peaked out and fallen to 16.5 months in Sep (down from a high of 21 months early 2014). As developers maintain price cuts and discounts, inventory period should continue to fall. Given significant falls in land sales (-26% YoY) and construction starts (-14% YoY) in 2014 YTD, new supply should fall further in 2H15, by then we see a return of pricing power.

Key concerns: margin pressure, corporate governance events, financing risks
Given more price cuts and slower decline in land prices than property prices, we see more downward margin pressure. And with on-going anti-corruption  campaign of central government and recent corporate governance events for  some Chinese developers, we see higher risk premiums and deeper valuation  discounts to be applied to certain non-state-owned Chinese developers.

Our positive industry views are supported by the current cheap valuations of the China property stocks. Our top picks are those with: 1) favorable landbank vintage (i.e. management has good market expertise in timing market cycles); 2) the ability to obtain cheap financing; 3) good revenue diversification (like a sizeable and growing investment property portfolio); and/or 4) very attractive valuations. 

 

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China is unwinding a property led investment policy and has been squeezing property prices for more than two years. They know as well as anyone else that to keep squeezing when prices are already falling would be a mistake which is why we now see signs of easing. A greater willingness to open up the domestic capital markets is an additional sign that credit expansion will once more be tolerated. 

HKEx is at the “completion stage” of preparation for the link, Li said in a conference call with reporters yesterday, declining to speculate on a timeframe for the start date.

“While the market will always appreciate advance notice, which we will strive to give, I’m not at this point stipulating any particular days,” Li said.

The Hang Seng Index (HSI) slid 0.7 percent at today’s close in Hong Kong. HKEx tumbled 4.7 percent, its biggest loss in six months, while brokerages First Shanghai Investments Ltd. and Shenyin Wanguo HK Ltd. each lost at least 8.8 percent. The Shanghai Composite Index declined 0.5 percent, its lowest closing level in a month.

Authorities said in April they may make further announcements on timing, yet they haven’t given any more details beyond their original statement that the link would start in about six months. Hong Kong’s Securities & Futures Commission declined to comment and the China Securities Regulatory Commission didn’t respond to a faxed request for comment.

Chinese regulators need to address whether foreign investors will pay capital gains taxes on mainland shares before the link can begin, Mark Mobius, who oversees about $40 billion as the executive chairman at Templeton Emerging Markets Group, said in an interview in Hong Kong.
Charles Li, Chief Executive Officer of Hong Kong Exchanges and Clearing Ltd.

“Unless they get all these issues straightened out and clarified, nobody is going to invest,” Mobius said.

 

The opening up of a link between the Shanghai and Hong Kong stock markets would be a very meaningful catalyst for capital flows between China and the international markets and vice versa. However until it is in fact initiated, uncertainty about mainland commitment to the venture will remain, not least because of political uncertainty in Hong Kong. 

A key issue as the Party confronts flaws in the legal system — one that has risked getting lost in the swirl of opinions around the specifics of judicial reform — is the disconnect between local governments and the central government: Local mishandling of problems arising from illegal land expropriations, tolerance of environmental pollution and disregard of product safety problems have led to widespread discontent that undermines the party’s legitimacy. The question underlying the current reform effort is whether the mentality of local officials can be shaped to guide their adherence more closely to centrally promulgated laws and policies.

An article in the progressive journal Caixin recently commented on “bureaucratic lethargy [that] is especially evident in local government departments.” In addition to modifying central-local financial relations, changing the criteria for evaluating local government performance, and simplifying administration, the article identified “setting up a system that is based on the rule of law” as an important remedy.

That’s easier said than done, and many of the legal reforms proposed so far appear to skirt around the issue. What is needed is a more explicit commitment to strengthen the discipline required for the courts to enforce laws consistently and reasonably. More attention needs to be focused on how judges should interpret and follow legal rules, and on how they should exercise their discretion.

 

Much of the debate about the impact of the Communist Party discussing how the law should be interpreted have focused on the difference between “rule by law” versus “rule of law”. However this misses the wider point. The Communist Party is grappling with the challenge of imposing accountability on several hundred thousand officials while also maintaining an iron grip on power and keeping a lid on political dissent. This debate suggests a desire to improve standards of governance. 

“China has a real serious problem in regard to availability of beds,’’ said Benjamin Shobert, managing director of Seattle-based Rubicon Strategy Group, which advises health care companies entering China. The shortage led the Chinese government two years ago to allow outsiders to invest in and provide expertise for the country’s health care system.

Since then, Mass. General, which is the largest hospital in New England, has developed a relationship with China. A Chinese medical tourism firm, Beijing Saint Lucia Consulting, refers patients to the hospital. The firm opened a Boston office last year to provide translators, chauffeurs, and other services for wealthy Chinese coming to Mass. General and other Boston hospitals for cancer treatment, orthopedic procedures, and other medical care.

“There is still a large gap between China and America when it comes to medical technology and service,’’ said Joseph Zhao, the company’s deputy general manager in China. With doctors in high demand there, “physician-patient communication only lasts 5 to 10 minutes,’’ he said.

 

Wealthy Chinese consumers have resources to buy just about any material possession imaginable but domestic healthcare is still developing relative to other countries. World class healthcare is as much an attribute of the upper middle class as luxury brands, property or other services and demand is increasing. Medical tourism continues to expand as demand for services represents growth in Asia while desire for lower cost is fuelling demand elsewhere. 

Asia’s largest economy is forecast to report third-quarter growth of 7.2 percent next week, the least since 2009, after data for September showed overall financing missed estimates and inflation eased to the slowest since 2010. While the central bank lowered the rate on 14-day repurchase agreements this week, a cut in the benchmark is the most direct way to shrink financing costs, the China Securities Journal said in a commentary yesterday. Credit Agricole CIB says there’s a 40 percent likelihood of a reduction.

“The chances are significant because you have a simultaneous growth slowdown and a decline in inflation, which opens the door for policy makers to address slower growth,” said Dariusz Kowalczyk, a strategist at Credit Agricole in Hong Kong. “Most lending is benchmarked off the PBOC’s rate rather than that of the market. It’s precisely because they’ve kept the benchmark lending rate steady that credit growth isn’t that strong.”

 

Many market participants have their attention trained on the Federal Reserve for signs of whether QE3 will be ended and on the ECB for signs that a new LTRO program will begin. However, how the PBOC acts is equally important considering its size and the effect its stimulus had in 2009 and 2010 when the global economy was still weak. 

Surging demand has been fueled in part by the biggest quarterly gain for mainland stocks since 2009. The Shanghai Composite gauge rallied 15 percent in the three months through Sept. 30, even as the MSCI Emerging Markets Index fell 4.3 percent. The Shanghai gauge slid 0.4 percent today while the X-trackers Harvest CSI 300 China A-Shares ETF climbed 0.5 percent to $25.77 at 3:05 p.m. in New York.

To deal with the influx of new money, Frankfurt-based Deutsche Asset & Wealth Management said Sept. 11 that the ETF would accept just one creation unit per day. A unit represents 50,000 shares or about $1.3 million at current valuation. The fund provider is increasing the cap to 10 creation units per day, according to a statement today.

“We wanted to maintain a valve of liquidity, increasing the fund size but doing so in a measured way, in anticipation of getting a higher quota,” Kittsley said.

A Qualified Foreign Institutional Investor license, known as a QFII, or Renminbi Qualified Foreign Institutional Investor license, known as an RQFII, is needed for foreign asset managers to buy A-shares. Once the license is obtained, the investor also needs to submit an application to China’s State Administration of Foreign Exchange for a specific dollar amount of investment quota that they can use to buy mainland stocks.

The opening up of the Shanghai – Hong Kong Connect is a major event. For the first time foreign investors will have relatively open access to the mainland stock market via Hong Kong and mainland investors will have access to companies listed in Hong Kong. This represents the opening up of a conduit for capital flows which will reach hundreds of billions over the coming years and the potential acceptance of mainland Chinese securities into the MSCI Emerging Markets indices sometime next year. 

Vanke, the nation’s biggest listed property developer, gained the most since July 24 while Poly Real Estate’s advance was the biggest since Aug. 4. China Merchants Property Development Co. added 2 percent.

People applying for a loan to buy a second home may get lower down payments and mortgage rates that were previously only available to first-time home buyers so long as they have paid off their initial mortgage, the People’s Bank of China said in a statement on Sept. 30 after the market closed. The central bank also eased a ban on mortgages for people buying a third home.

The action marks a reversal in a four-year tightening campaign, as slowing property investment and industrial production raise risks that 2014 economic growth will drift too far below Premier Li Keqiang’s target of about 7.5 percent.

 

Every morning I click through approximately 200 charts of country indices, bond futures, currencies and commodities to get a feel for how the market is performing. Today I decided to note every country index making a new high. It was a short list. China’s Shanghai A-Shares Index was the only one on it. 

The Chinese engineered a property slowdown in order to avoid a dangerous bubble and now need to stimulate the market if they are to avoid a crash. With property developers offering deep discounts on developments and confidence deteriorating it can only be viewed as good news that the restrictions on the property market are being lifted. The credit squeeze which has affected a good many more sectors than property is easing which is positive for the stock market generally. 

“I’m sure people will thin out because people get worn out,” Next Media Ltd. Chairman Jimmy Lai, publisher of the Hong Kong newspaper that’s most-critical of Chinese rule and an advocate of the protesters, said in an interview. “I’m sure the government in the talks will promise something that will appease people temporarily. But when promises are broken, people will come back.”

Student leaders met with government officials yesterday to map out further talks with the city’s second-highest ranking official, Carrie Lam.

The protests were triggered by China’s decision that candidates for chief executive in the 2017 elections be vetted by a committee. Pro-democracy groups say that will guarantee the candidates’ obedience to China. They are seeking a more open system, as well as the resignation of Chief Executive Leung Chun-ying.

 

It can only be described as good news that the tense situation in Hong Kong is easing. For a city built on commerce, the protests have been bad for business especially during a key annual holiday. As people get back to work and a heavy-handed breakup avoided. investors are likely to begin to refocus on the opening of the Hong Kong - Shanghai stock market connection later this month. 

Lu Yanzeng, a property agent, said he had not sold a single home in two months. Business this year "is very so-so, it's not as good as last year," he said. "Sales of second-hand homes are slow, but new home sales are brisk."

China's property market, where prices surged to all-time highs for five consecutive years, is experiencing its sharpest slowdown in around two years.

Average new home prices fell for a fourth consecutive month in August by 1.1 percent, meaning the market is now close to wiping out gains seen over the last year. Compared to a year ago, sales as measured by floor space were down 12.4 percent.

While the slowdown in a heated market has benefited millions of Chinese, for whom soaring house prices have made home ownership a distant dream, slackening activity has also raised concerns about the health of China's economy.

It is straining already softening domestic demand and pushing overall fixed-asset investment to lows not seen in nearly 14 years on a cumulative basis between January to August.

In an effort to avoid a bubble, the Chinese authorities engineered a property slowdown. They succeeded in that objective and will now need to act in order to avoid a crash. Easing restrictions on property purchases, particularly in tier 1 cities, making more mortgages available and easing credit conditions will all help stoke demand but the question remains as to whether buyers can be encouraged into a declining market. 

Frustrated users have often resorted to “virtual private network,” or V.P.N., services to evade China’s Internet filters. But those services, too, have come under concerted attack from the authorities, who have interrupted service to them with increasing frequency. Many ordinary citizens cannot afford or obtain access to V.P.N.s to begin with.

In the meantime, Google’s business continues to erode. Its share of the Chinese search engine market fell to 10.9 percent in the second quarter of this year, as the stepped-up blocking began to take effect — compared with one-third in 2009, when it still had servers there.

Google’s problems extend far beyond search. Its application store, called Google Play, is only partly accessible in China.

That has led to the rise of a number of locally run application stores, which analysts say will sometimes market pirated copies of software or charge extra to promote a new application. Companies are often forced to create versions of their apps for China that are slightly different from the versions distributed to the rest of the world on Google’s app store.

“Because Google Play has low market share” in the Chinese market, “app publishers who have applications worldwide on Google Play don’t receive the proportionate share of users in China without publishing to local Android stores, even if they have localized Chinese versions,” said Bertrand Schmitt, chief executive of App Annie, a company that tracks global app distribution.

Google also hosts publicly available libraries of coding scripts and fonts on its servers, but China now blocks these libraries. The chief technology officer at the start-up said his company had resorted to creating its own libraries and hosting them on its own servers, wasting costly computing power and space.

Western companies invested heavily in Chinese expansion and accepted knowledge sharing joint ventures for the promise of access to China’s burgeoning consumer sector. The reality of profitability in China has been more disappointing than originally envisaged and companies are understandably chastened at the reception they have received. For a company such as Google with a global franchise that relies on users accessing its search and mobile apps in order to facilitate advertising, the loss of China as a potential market was priced in shortly after its withdrawal from the country. 

At $68 a share, Alibaba’s market capitalization is about $168 billion. It’s hard to find a United States company that’s directly comparable, but Professor Greenwald said eBay comes the closest. Like Alibaba, it has an auction site that benefits from a powerful network effect, it offers a vast e-commerce site and it has a pay system, PayPal. (While Alibaba spun off its payment system, Alipay, Alibaba will get a share of the proceeds from any sale or public offering of Alipay.) EBay’s market capitalization is about $65 billion.

Of course, eBay doesn’t dominate e-commerce in the United States to the degree that Alibaba does in China. But is it reasonable to assume such dominance will persist as the Chinese market matures? No one company dominates e-commerce in the United States or in Europe, and none are as large as old-economy Walmart. China may now be underserved by national brick-and-mortar chains, but that could change. Professor Greenwald said he believed that Alibaba deserved a premium to eBay — perhaps twice eBay’s market capitalization. “But three times? That’s really pushing it,” he said.

The ticker symbol, BABA, means father in Mandarin and this was certainly the mother and father of all IPOs. The share price briefly testing the $100 area today, up from the $68 agreed at the close of the offer stage. Some of the early investors in the company were able to liquidate positions early and others will have had an opportunity to sell today so it is questionable where the additional demand will come from to push prices much above today’s high in the short term.

Meanwhile this additional article from the New York Times highlights the entrepreneurial ecosystem developing in picturesque Hangzhou. The start-ups spawned by former Alibaba employees suggests the number of companies that will be seeking to IPO is likely to increase in the coming years. It remains to be seen if Alibaba’s former employees will have the same effect on Hangzhou as HP’s had on Silicon Valley. 

Both China and India are now in a crucial stage of reform and development. The Chinese people are committed to realising the Chinese dream of great national renewal. We are deepening reform in all sectors. The goal has been set to improve and develop the socialist system with Chinese characteristics and advance the modernisation of national governance system and capability. A total of over 330 major reform measures covering 15 areas have been announced and their implementation is well underway.

Under Prime Minister Narendra Modi’s leadership, the new Indian government has identified ten priority areas including providing a clean and efficient administration and improving infrastructure. It is committed to building a united, strong and modern India — Shreshtha Bharat. The Indian people are endeavouring to achieve their development targets for the new era. China and India are both faced with historic opportunities, and our respective dreams of national renewal are very much aligned with each other. We need to connect our development strategies more closely and jointly pursue our common dream of national strength and prosperity.

As emerging markets, each with its own strengths, we need to become closer development partners who draw upon each other’s strengths and work together for common development. With rich experience in infrastructure building and manufacturing, China is ready to contribute to India’s development in these areas. India is advanced in IT and pharmaceutical industries, and Indian companies are welcome to seek business opportunities in the Chinese market. The combination of the “world’s factory” and the “world’s back office” will produce the most competitive production base and the most attractive consumer market.

As the two engines of the Asian economy, we need to become cooperation partners spearheading growth. I believe that the combination of China’s energy plus India’s wisdom will release massive potential. We need to jointly develop the BCIM Economic Corridor, discuss the initiatives of the Silk Road Economic Belt and the 21st Century Maritime Silk Road, and lead the sustainable growth of the Asian economy.

Ahead of Xi’s visit Chinese troops built a rudimentary road on the contested part of the India/China border and Indian troops destroyed it a day later. India boosted support for Vietnam, agreeing to export arms, the day before his visit. The above text is part of a charm offensive where both countries could benefit from greater bilateral trade, but no one is under any illusion about how much room there still is for relations to improve.   

 

This is an interesting interview where Yang Liu of Aberdeen Asset Management comments on Alibaba’s IPO but perhaps more importantly on the outlook for the Chinese stock market over the next couple of years. It’s an almost 8 minute video where the latter half is more interesting than the first. 

Liao Xinbo, an official with the health commission's Guangdong branch, said this amounts to granting foreign investors the same type of treatment as Chinese nationals when founding hospitals.

There is little doubt that foreign investors can bring advanced technologies and management expertise to the domestic health care industry, but we should not go so far as to celebrate the development as a solution to the problems of expensive drugs and the hardship many have experienced trying to find a good doctor.

In general, foreign-invested hospitals cater to wealthy patients. That means their services often cost a lot. It is unrealistic to hope that more foreign hospitals can make health care more affordable. By diverting wealthy patients away from ordinary hospitals, they might help with easing overcrowding.

But it is too soon to say whether foreign investors will line up for a hospital of their own now that restrictions on their share ownership have been lifted. Other authorities related to the opening of a hospital, such as those overseeing the sales of land and the health insurance and social security systems, must play along as well.

 

Offering the opportunity to foreign groups to build wholly owned hospitals within China probably has more to do with tapping into the global market for medical tourism than any specific aim to improve coverage for Chinese consumers. As the middle classes swell, demand for cosmetic surgery and other elective procedures is rising. Why send wealthy Chinese to Hong Kong, Singapore, the USA, Thailand or India when they could have the procedures at home for a comparable price and to a high standard. 

This report, the third in a series about what Shanghai-Hong Kong Stock Connect means for different asset classes, analyses the implications and dynamics of this move towards market convergence for equities:

Short term: It’s initially about identifying price differences between A-shares and H-shares. Five months after the programme was announced, both markets are up 7-8%, and the Hang Seng China AH Premium Index, which tracks the average price difference for dual-listed companies, remains largely unchanged. However, across sectors there are significant differences between A-share and H-share prices. In general we believe this will lead to an investor preference for blue-chip companies in the A-share market and mid-cap growth companies in the Hong Kong market, which means the price difference should narrow gradually.

Medium term: The scheme should lead to substantially higher market turnover in Hong Kong and greater institutional participation in the A-share market. HSBC analyst York Pun estimates HKEx’s turnover could rise over 80% once all restrictions related to Stock Connect are removed. Similarly, we expect to see institutional investors, who currently own only 15% of the A-share market, become far more active in China. Foreign investors alone could drive up the level of institutional ownership of A-shares by at least 5-8ppts over the next 3-5 years through Stock Connect and existing channels such as the qualified investor schemes (QFII, RQFII).

Long term: We expect to see changes in the style of investment in both markets. The A-share market should move closer to Hong Kong – i.e. favouring value, large-cap and high dividend yield stocks – because of more foreign institutional participation, a lower risk-free rate and increasing dividend pay-outs. If we look at the net capital flow for both markets, defined as dividends paid by listed companies to shareholders minus the sum of equity fund raising plus stamp duty tax and stock trading commission, we find significant differences between Hong Kong and the A-share market. This is mainly driven by large-cap dividend yield stocks – the Hong Kong market recorded average positive cash flows of RMB130bn for the past three years, while the average for the A-share market was negative RMB65bn.

A link to the full report is posted in the Subscriber's Area.

It might seem trite but simply put, weight of capital moves markets. Record low interest rates and declining bond yields are defined in some circles as justifying the high risk premium on equities but it is the weight of capital from underweight pension funds, companies buying back their own shares and retail money more recently that is sustaining high prices.

China’s real-estate slump is spurring local investors to shift more of their money into stocks, according to Chen Xingdong, the chief China economist at BNP Paribas SA in Beijing. Signs of increased risk in wealth management and trust products may also make shares an attractive alternative, said Kathy Xu, a Hong Kong-based money manager at Aberdeen Asset Management Plc.

China’s new-home prices fell in July in almost all cities that the government tracks, according to the National Bureau of Statistics. At least 10 Chinese trusts struggled to meet payments in the three months through August, sparking protests by investors outside banks that distributed the products.

Equities comprised 4 percent of Chinese households’ total assets as of 2013, according to a June report from Credit Suisse. Bank deposits accounted for about 22 percent while property made up 55 percent.

The average annualized investment return on residential properties in China was 3.53 percent in July, down from 4.6 percent in June, according to Zhongjin Standard Data Research Ltd. in Hong Kong. The Shanghai Composite has an earnings yield of about 9 percent.

“You might even start to see retail money re-directed to equities after years of chasing real estate,” said Michael Shaoul, the New York-based chairman of Marketfield Asset Management LLC, which oversees about $18.5 billion.

In 2005, the government announced it would defend a floor on the A-Share market. This acted as a catalyst to spark the impressive rally in Chinese equities until their peak in 2007. The change of sentiment towards the property market, disappointing returns from gold, risible deposit rates and an inability, until the Hong Kong link is opened further, to invest beyond the mainland suggest that the domestic stock market is one of the few asset classes which is both cheap and under-owned where investors can seek a capital gain.

Chinese stocks added to gains on optimism a rebound in services growth will help offset a pullback in manufacturing and a property slump. China’s weakening real-estate market has weighed on related industries, raising concern the government will miss its expansion target of about 7.5 percent this year.

“The economy still faces downside risks to growth in the second half of the year from the property sector slowdown,” Qu Hongbin, HSBC’s chief China economist in Hong Kong, said in a statement. “We think policy makers should use further easing measures to help support the recovery.”

August data point to divergent trends in employment across manufacturing and services, according to a statement from HSBC and Markit.

The intended rebalancing of the Chinese economy continues to proceed with a focus on developing the services sector. The development of the Shanghai financial sector free trade zone and the opening up of the connection between mainland bourses and Hong Kong are indications that the financial market liberalisation that is also part of the broad economic rebalancing continues to proceed. 

“The Chinese consumer space is probably a lot more exciting,” Liang said. “But I’m not saying this is going to be a skyrocketing IPO. The performance depends on the pricing. If it’s priced to perfection there will be little room left for after market appreciation.”

Alibaba may set its IPO value at $154 billion, or 22 percent below analyst valuations, in a move that could avoid repeating Facebook Inc.’s listing flop, according to the average estimate of five analysts surveyed by Bloomberg in July. The poll respondents saw Alibaba’s post-listing valuation at $198 billion. Ma owns 8.8 percent of the company.

 

Alibaba surged following its IPO last time around and anyone still holding the share following its collapse got the price they paid at the initial listing back when it was taken private once more. Let’s ask some fundamental questions about the IPO process:

Does Alibaba need the capital to expand its business? 
With a dominant position in a number of market segments, the answer is probably not. 

Recent developments outlined above suggest that India is not now on the path to replace China in the system. But looking forward, the Modi government’s plan, if implemented, would reload India into the periphery of a Bretton Woods II system. The 2014 election manifesto of the Bharatiya Janata Party announced several economic goals. A country intending to push an export-driven development policy could hardly describe its policies and goals differently. In sum, the manifesto seems aimed at vigorously implementing this strategy. The manifesto espouses: “A strong manufacturing sector will…create millions of jobs and increase incomes for the working class. Above all, it will increase the revenue for the government and lead to import substitution to bring down the import bill. We will make India a hub for cost-competitive labour-intensive mass manufacturing. (p. 29).”

Specifically, the manifesto proposes several policy goals to boost labor-intensive manufacturing. The current account deficit is to be reduced aggressively by focusing on exports and reducing the dependency on imports (italics ours). A program for ports, roads and rail to the interior, and airports is intended to facilitate international merchandise trade by eliminating severe infrastructural barriers. It also intends to eliminate the artificial bureaucratic barriers to commerce. FDI will be allowed in most sectors, except retail, and investment and industrial regions are to be set up as international manufacturing hubs. 

Of course, a political party’s manifesto is a wish list. Full implementation always collides with resource and political constraints. But taking it at face value means that India is readying itself to take up China’s role as the next large periphery in the Revived Bretton Woods system. As we said in Section IV, the key to managing the export-driven strategy at a global macroeconomic scale is the recruitment of FDI. The amount of collateral on hand limits FDI, but a large and persistent current account surplus relaxes the limit. In India, the government is now opening the doors to more FDI; and simultaneously, it intends to reduce the current account deficit. Our caveat is that it cannot expect a China-like attraction of FDI unless it can swing the current account into surplus. The manifesto seems to aim for these conditions, but this is a case of wait-and-see for this next test of the collateral hypothesis.

A link to the full report is posted in the Subscriber's Area.

If you have the time I would recommend reading this report in its entirety not least the portion beginning at the end of page 13 focusing on the role of China’s sanitation of currency inflows on the low interest rates that continue to prevail in the USA and Europe.

When we consider India’s role in the global economy, it has many of the characteristics China is seeking to develop and vice versa. India has a vibrant consumer economy, world class corporations successfully competing internationally, property rights, an independent judiciary and respect for minority shareholder interests. It also runs persistent twin deficits, its manufacturing sector is undeveloped, infrastructure has decayed to the point of obsolescence or does not exist, development planning has been haphazard to say the least, bureaucracy is sclerotic and corruption inhibits growth at every turn. 

1. First of all, we believe energy savings investment will shift from industrial to public facilities, driven by urbanization in China which is the focus of China's smart grid development. As one of the central government's key aims, we expect the Energy Management (EM)'s market size to achieve 22% CAGR in 2012-2015E.

2. In light of this, leading Energy management contract (EMC) companies will enjoy fastest growth as subset of EM industry, at 39% CAGR in 2013-2015E, thanks to supporting government policies for EMC companies such as exemption on corporate tax, subsidies on building retrofit, etc.

3. We also expect the penetration of smart meters to increase rapidly from the current 60% in China to approaching 100%. Besides, we also see replacement demand kick in to drive 4.8% CAGR in 2013-2020E, starting in 2015E.

4. As smart meter penetration is likely to reach full coverage from 2014E onwards, we believe that smart meter suppliers with tailor-made power distribution and energy efficient solutions are able to leverage on the well-established smart meter network to offer value-added service, hence new revenue flow to support its robust earnings growth in the coming five years, we expect the earnings CAGR of Wasion Group (3393 HK) is 20% in 2013-2016E.

5. Ultra High Voltage (UHV) power cables demand CAGR 62% in 2015E-2020E, is much higher than CAGR 18% in 2010-2015E, thanks to National Energy Administration(NEA)’s plan for long distance power grid construction,

6. High entry barrier enable market consolidation. Nationwide UHV grid construction drives demand in EHV power cables construction in regional power distribution, only 12 manufacturers are qualified as suppliers to SGCC. 

 

A link to the full rport is posted in the Subscriber's Area.

China has been aggressive in securing resources overseas in order to provide for increasing energy consumption. Ensuring it makes the most efficient use of that energy is a logical next step not least because there is demand for efficient device management on the international market and China’s lower cost of production may lend it a competitive advantage. 

China’s commitment to reforms continues to deepen, especially in regard to SOE reform. On 15 July, for example, SASAC named six SOEs to undergo pilot programs with respect to mixed-ownership (the greater involvement of private capital), the establishment of state-owned asset investment companies, reform of the board of directors system and disciplinary inspection reform. Various provincial governments (Jiangsu, Shandong, Gansu, Yunnan and Beijing) also recently issued SOE reform plans and over 15 local authorities have now announced reform guidance. At the company level, central SOEs including Chalco, China Everbright and Huarong, together with local SOEs such as Xinjiang Production and Construction Corp and Jiangxi Copper, published reform blueprints in July. In aggregate, all these developments represent a commitment to large-scale corporate restructuring, especially across SOEs.

Base on the principle of ‚differentiated management. revealed in 3rd Plenum Decision, we see various reform paths for SOEs: 1) Central pan-national SOEs in monopolized sectors (e.g. oil & gas, telecom and transportation) may allow private capital investments in minority stakes or in certain business units; 2) local SOEs (e.g. provincial level and below) in competitive sectors including F&B, apparel, electrics and healthcare, may be taken over by private investors in their entirety; 3) proceeds from the sale of competitive SOEs may be managed by the state-owned assets operation companies, which will channel more capital into utilities and strategic sectors; and 4) more SOEs assets may be listed or injected into listcos.

We expect this aggressive focus on SOE reforms to have a material impact on China’s longer-term economic outlook especially as the private sector is still significantly under-represented. Not only will these moves result in a substantial expansion in the private sector but the large-scale inclusion of private capital in current SOE sectors (both monopolies as well as competitive) will further promote the more efficient allocation of capital, result in further productivity gains and underpin longer-term growth.

A link to the full report is posted in the Subscriber's Area.

Considering the dominant position of state owned enterprises (SOEs) in the Shanghai A-Share Index, the effect of positive reforms cannot be underestimated. 

We are often asked what would change our relatively bearish attitude towards the Chinese economy and equity market, to which our first answer is a credible proposal to reorganise the fiscal relationship between central and local government on a similar scale to what happened in 1994, but with the opposite impact, namely of increasing the revenue base of local government.

This is predicated on the belief that much of the sharp drop in China's productivity growth which has taken place in recent years derives from the reliance of local government on manufacturing industries for social/financial support. The resolution of the underlying fiscal issues around local government is also bound up with reforms to the current system of land ownership and the way in which the hukou or residency permits are granted. There have been some fairly strong statements from the finance minister Lou Jiwei since the start of 2014 that the authorities may be on the cusp of announcing a much clearer roadmap for fiscal reform, but so far nothing has emerged. Similarly there has also been a wave of speculation over the past couple of week concerning the possibility of a major liberalisation of the regulations concerning the system of granting hukous, but a clarifying statement has made it clear that any shift can only occur on a city-by-city basis. We will continue to scrutinise policy statements towards both fiscal and land issues very carefully, but so far Beijing appears to be continuing its recent tradition of talking up expectations, which are subsequently not backed by tangible measures. 

The anti-corruption campaign has also become an increasing area of focus for equity investors as it has been steadily increasing in intensity over recent weeks. The sharp rally in the price of Petrochina in particular, has been partly in response to the potential impact of the allegations of corruption made against senior figures at the company, in causing a re-evaluation of the capital expenditure programmes, which have been perceived as value destructive by minority investors. We are sceptical that there will be much in the way of change, since most of the big downstream projects which were undertaken within China and overseas appear to have reflected the strategic priorities of the Chinese state, priorities which are unlikely to change much over the near future.

 

The efforts to give Hong Kong residents greater access to the mainland market and mainlanders access to the Hong Kong market, in addition to veiled stimulus loans to the China Development Bank, have stoked interest in the A-Share Index. If these are additionally associated with long awaited progress in reforming the hukou residence system or the further rollout of a property tax, the recovery potential of the market would be enhanced as it would represent a considerable improvement in governance. 

In yesterday’s message, you showed the big difference between China's A and B shares. Now from the charts, A-shares seem to offer the best opportunities, possible being at the beginning of a bull market. But I understand these are hard to get for foreign investors. Are there funds which are exposed to this market? (personally I own Aberdeen Global Asia Pacific)? Kind regards and thanks for your great daily work,

Thank you for this question which I’m sure will be of interest to other subscribers. David also provided an answer to a similar question on July 23rd. I agree with your conclusion that the A-Share market looks like it is bottoming.

The Aberdeen Global Asia Pacific fund has been performing well not least because of its Indian and South East Asian weightings. However its Chinese positions are Hong Kong rather than mainland listed.

The re-categorisation of the Funds section of the Chart Library makes finding China focused funds easier. Simply choose funds from the main dropdown menu, then Geographic focus,  then select China or Greater China depending on your particular focus.  

“This is another targeted easing measure,” Chang Jian, chief China economist at Barclays Plc, wrote in a July 30 report. While the loan doesn’t represent “broad loosening,” it has “reduced recent market concerns about a shift in the PBOC’s stance away from easing towards neutral or tightening,” she said.

Wang Tao, UBS AG’s chief China economist, says the measure is part of trying to “optimize” the implementation of its existing monetary stance, and doesn’t constitute a shift in policy, according to a July 24 report.

In its Aug. 1 report, the PBOC said targeted measures have become a “new trend of major central banks” since the global financial crisis started and that it will keep using tools such as relending and rediscounting to guide institutions to “optimize their credit structure.”

The CDB loan is the equivalent of an across-the-board cut of 1 percentage point in the ratio of deposits banks must hold as reserves, JPMorgan Chase & Co. estimated, scrapping its forecast for two 50 basis-point cuts from the current 20 percent reserve requirement ratio for large banks.

 

Despite attractive valuations, the Chinese stock market has been in need of a bullish catalyst. Continued largesse on behalf of the central bank in supporting infrastructure projects represents an important tailwind. The size of the loans will be viewed as a positive by the banking and brokerage sectors that will benefit from lending fees and the deals that will go with it. Considering their dominant weighting in the main indices this can be viewed as at least part of the reason for the recent strength in the A-share market.    

We pointed out late last year that the original Asian tigers (Taiwan, Singapore, South Korea and Hong Kong) were moving to positions of outperformance and beginning to break out. Taiwan has outperformed in the meantime and is susceptible to some consolidation. Hong Kong on the other hand is only now breaking out. 

An artificial winter has begun to stretch across the country, through its fields and its ports, its logistics hubs and freeways. China had 250 million cubic feet of refrigerated storage capacity in 2007; by 2017, the country is on track to have 20 times that. At five billion cubic feet, China will surpass even the United States, which has led the world in cold storage ever since artificial refrigeration was invented. And even that translates to only 3.7 cubic feet of cold storage per capita, or roughly a third of what Americans currently have — meaning that the Chinese refrigeration boom is only just beginning.

And

Despite the expansion in frozen foods and refrigerators, the critical growth area is what’s known in the logistics business as the “cold chain” — the seamless network of temperature-controlled space through which perishable food is supposed to travel on its way from farm to refrigerator. In the United States, at least 70 percent of all the food we eat each year passes through a cold chain. By contrast, in China, less than a quarter of the country’s meat supply is slaughtered, transported, stored or sold under refrigeration. The equivalent number for fruit and vegetables is just 5 percent.

The evolution of cold storage capacity tends to move hand in hand with the instant gratification often associated with a developing consumer economy. Having a large refrigerator in one’s home means a large selection of food is available whenever we wish. As the article points out the roll out of a refrigerated food chain doesn’t necessarily reduce food waste over the long term. However it changes food waste from being an inevitable fact to being dependent on people’s purchasing and consumption choices.  While China is on its way to surpassing the USA in terms of refrigeration capacity, India is only now beginning to introduce refrigerated warehouses suggesting there is substantial growth in this sector. 

The central bank in May called on the nation’s biggest lenders to accelerate the granting of mortgages to first-home buyers. Some Chinese cities, including the northern city of Hohhot and the eastern city of Jinan, have started to relax property curbs to stimulate the local market.

Allowing bond sales by property companies is part of government easing measures along with the removal of property curbs and the support of mortgage lending, according to Frank Chen, head of China research at CBRE Group Inc., a commercial real-estate services company based in Los Angeles.

“The revival of property bonds is the right move in the long run,” given real estate’s close ties to many industries including cement, steel and even banking, said Chen in Shanghai. “Property is the single most important sector to the Chinese economy.”

 

Relaxing of some of the strictures that have been imposed on property developers is a positive development from the perspective of the stock market since they represent such a large direct and indirect component of its market cap.

China Vanke is currently rallying from the lower side of a more than 5-year range. This is lending support to the recent positive performance of the Shanghai Property Index 

The seven investors are likely to sign an agreement over the next month, the people said.
China Huarong had about $65.7 billion under management at the end 2013, making it the nation's biggest bad debt manager ahead of China Cinda Asset Management Co Ltd, which raised $2.8 billion in a Hong Kong initial public offering last year.

CICC, Fosun, Goldman Sachs and Warburg Pincus declined to comment. COFCO, CITIC and Khazanah did not immediately respond to calls and emails seeking comments. The sources declined to be identified as the information is not public.

 

China’s bad banks were created 15 years ago to deal with the contagion the economy experienced in the aftermath of the Asian financial crisis. The fact they are now seeking listings suggests that they wish to capitalise on the appreciation in the assets they hold. Another perspective is that they are following a growing trend of Chinese banks seeking listings as they raise capital offshore to help bolster their balance sheets as the housing market cools.  

On 9 July, the Supreme People’s Court issued its fourth five year reform plan for the courts, approved by the Party leadership, which sets out 4 broad areas of reform, relating to 8 general areas. An overview has been released on Wechat and other Chinese social media and can be expected to be published very soon in more traditional media.

The Court described it as taking first steps towards establishing a judicial system with Chinese characteristics and is intended to roll out reforms announced in the 3rd Plenum decision and the judicial reform decision announced earlier this spring and some of its themes were highlighted in press releases published just after Chinese new year.  Many of these issues are ones that have been discussed within the Chinese legal community for many years and draw on international expertise as well. The summary below highlights five of the eight broad areas. 

Morgan Stanley Private Equity Asia (MSPEA) delisted Sihuan from Singapore in late 2009 at a valuation of around $500 million, before relisting it in Hong Kong a year later with a market cap of around $3.7 billion, according to a source with direct knowledge of the matter.

Sihuan's market value has since grown nearly 80 percent to $6.7 billion, not too far off China's biggest listed drugmaker - Shanghi Fosun Pharmaceutical Holdings Group Ltd (600196.SS) which has a market cap of $7.2 billion.

MSPEA has not fully exited its investment but expects to make around eight times its initial investment when it does, said the source, who declined to be identified as details of the investment have not been made public.

Luye's shareholders sold $253 million through the offering while the rest of the proceeds went to the company. For CDH the successful Luye debut is a welcome relief after the IPO of pork giant WH Group Ltd was canceled as mismanaged pricing and other woes led to weak investor demand.

Investors in both Sihuan and Luye are also buying into strong growth prospects for China's drug market, although the sector remains underdeveloped and highly fragmented.
The industry grew at a compounded annual growth rate of 19.3 percent in the five years to 2012 to be worth $69.7 billion and is expected to grow at a similar pace to reach $166 billion by 2017, according to consultancy firm Espicom. 

 

The Chinese domestic healthcare sector represents a significant growth trend as standards of living improve. The pharmaceutical sector has ambitions to compete on the international stages which is at least part of the reason companies are seeking additional capital overseas. However the issues relating to corporate governance raised early in the above article are non- trivial which is at least part of the reason investors tend to favour Hong Kong listings because of the tighter regulations imposed on companies before their IPO. 

I was wondering what your thoughts were on the iShares Chinese A-shares tracker (FTSE/Xinhua China A50 (XIN9I index) on your web site. It looks to me like it might be finishing its lengthy base. Where would be a good point to buy from a technical point of view?

Keep up the great work,

Thank you for this question of general interest. China has some of the lowest valuations of any market amid uncertainty relating to the reorientation of the economy away from infrastructure development and low cost manufacturing.

We would explain the smiley curve pattern in this way:

Innovators: At one end of the smiley curve are innovators, including pharma companies that have accumulated vast knowledge and expertise over long periods. Others are laboratories and CROs (contracted research organisations), which specialise in innovation and benefit from the outsourcing of other companies’ main functions, from diagnosis and biologics manufacturing to R&D.

Health-care service providers: Hospitals, clinics, doctors are the main points-of-sales for the medicine and services sub-sectors. They exert an important influence on sales and have first-hand intelligence on large numbers of patients. These companies should be able to capitalise on strengths to generate returns for investors.

Consumables and distributors: We find these sub-sectors in the value chain less attractive. Despite entry barriers related to scale, knowledge or regulations, their business is too distant from the areas where real innovation is fostered or services are rendered. While they employ the latest technologies to improve efficiency, newer technologies could disrupt their value proposition. For instance, smart medical devices containing diagnostic sensors, such as Dexcom’s continuous glucose monitoring devices, facilitate information flow between patients, physicians and pharma companies; their use diminishes the value of the middle man ¡V distributors.

Will China’s health-care market trend be similar to the US? If so, it would strengthen our case for investing in both ends of China’s smiley curve. Comparing the composition of China’s listed health-care companies with market caps above USD 500mn against the S&P500 Health-care Index, China’s device sub-sector is under-represented (8% in China vs. 15% in the US), suggesting its strong growth potential. In comparison, distribution is over-indexed (14% in China vs. 6% in the US), implying less headroom for growth.

 

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When people move from a subsistence life style to one of plenty they tend to focus on buying consumer goods that make their life easier and on the trappings of wealth in order to display their success. There is no use in accumulating wealth unless one is fit enough to enjoy it, so demand for healthcare goes hand in hand with a higher standard of living. 

This is particularly the case in China where access to healthcare is not universally available beyond the cities. Rolling out services and insurance plans represents a growth trend not least because it helps demonstrate the administration is succeeding in delivering a higher living standard. 

In its most recent 5-Year Plan (2011-15), the Chinese government laid out an aggressive time table for development of its coal-to-olefins (CTO), coal-to syngas (CTG) and methanol-to-olefins (MTO) industries (Appendix 1-3). 

The economics of China coal-to-olefins (ethylene / propylene) is competitive relative to the world’s naphtha-to-olefins industry (Figure 2, Figure 20 & Figure 92-93). The world’s naphtha-to-olefins industry is Asia-based. Ninety percent (90%) of Asia’s olefin (ethylene) capacity uses naphtha as a feedstock (Appendix 6-10). Asia produces 34% of global ethylene. A fast-growing China CTO industry would displace its own naphtha to olefins industry (24% of global ethylene capacity). Somehow, this strategy does not make much sense; although it would produce short-term China GDP growth. 

The economics of China coal-to-olefins however is not competitive relative to a growing North American and Middle Eastern natural gas-to-olefins industry (Figure 2, Figure 20, and Figure 94). From a cost perspective, a fast-growing China CTO industry would displace its own naphtha to olefins industry but then be displaced itself by a lower-cost North American and Middle Eastern natural gas-to-olefins industry. Somehow, this strategy makes even less sense; except for the fact that it creates plenty of China GDP by both building and then dismantling multiple China industry chains. 

China’s coal-to-olefins and / or coal-to-urea do not make economic sense in a world awash in low-cost natural gas. Notwithstanding, China continues to grow its coal-to industries; maybe on the prospect that the world’s growing supplies of cheap natural gas could be short-lived.

The production of olefins from coal requires an abundance of water (Figure 98) and produces an abundance of CO2 emissions (Figure 102). The addition of one 600k tpa CTO facility in Beijing would increase provincial CO2 emissions by 14%. China’s abundant water resource (Figure 95) is located in the South and South West part of the country; its coal resources are located in the North and North West part of the country (Figure 11-12) – bad luck.  

 

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China has a substantial coal sector which, in common with the global sector, has been under pressure from below trend global growth, increasingly stringent environment regulations and competition from lower cost alternatives (at least in some jurisdictions) such as natural gas. The green light for investment in coal to liquids development appears to be an attempt from some portions of the administration to provide the coal sector with an additional business line in order to preserve its viability.

Quite how viable that is when water and environmental concerns have not been addressed and when the country is also investing heavily in developing its own natural gas reserves raises some important questions about whether this will in fact pan out.