The case for China

James Chong, investment director, Greater China, Martin Currie Investment Management

“China is like a sleeping giant. And when she awakes, she shall astonish the world.”
(Napoleon Bonaparte, 1803)

Napoleon was right. China is a giant. It is also well and truly awake. Two centuries later China is experiencing a period of sustained growth that is unrivalled in modern history. This presents significant opportunities for pension fund investors, but also a degree of volatility that I believe demands a long-term approach to investing in the region.

The emergence of a global economic powerhouse
Most of us know of China as the most heavily populated country on earth, with some 1.3 billion inhabitants. It is also vast – only Russia, Canada and the US cover a greater geographical area.

Since 1978 China has transformed itself from a state controlled command economy into one of the world’s largest and most vibrant economies. Although still a communist country, it has achieved this by making substantial reforms based on Western economic principles.

From the early 1980s China created a number of special economic zones where investment laws were relaxed, enabling regions such as Shenzhen to attract international capital. As a result, China successfully established itself as a low-cost manufacturing base, benefiting from Western companies that have increasingly outsourced their production to these special economic zones. Today China has become the third largest exporter and importer in the world. Its popularity as a manufacturing base has enabled it to enjoy premium levels of economic growth. While the UK has experienced GDP growth of 2-2.5% for much of the past decade, China has been growing at nearly 10%.

If you look at the driving forces behind China’s economic growth, it all started from leveraging on its low cost structure. The main asset China had was the sheer size of its labour force. Even today labour costs in China are just 3% of those in the UK. This is a massive structural advantage, not only over western manufacturers, but also other Asian economies such as Hong Kong and South Korea.

The benefits of its cheap labour force attracted a tremendous amount of foreign investment to China soon after the economy started to open in the late 1980s. China’s export growth has never slowed, even though the global economy has been up and down in this period.

China’s development is now starting to enter a new phase. Key to this is a new five-year plan, which seeks to rebalance economic growth from foreign investment and exports more towards domestic consumption. The government’s rural reform programme aims to release the purchasing power of the 65% of the population who live in agricultural areas and so benefit domestic consumption. The next decade will see huge infrastructure, healthcare and education expenditures in these regions.

China’s success in creating wealth is reflected in the rapid growth in bank deposits. As China’s middle class becomes more confident about its future, this high savings rate should translate into an increase in asset values. Retail sales have also expanded, with growth running at between 5-6% above China’s nominal GDP growth rate.

Opportunities for investors
Until 2005, the performance of domestic equities in China bore little relation to the stellar economic growth the country was experiencing. The bulk of shares in many enterprises were deemed non-tradable, and the holders had little of the concerns that shareholders normally have, principally wanting to see the share price rise.

This is now changing. In tackling the problem of non-tradable shares, encouraging better standards of corporate governance and permitting equity-based incentives for managements, the authorities have helped to kick-start a recovery in the domestic equity market.

Privatisation in China has been a steady but relentless process. So far, most of the progress has been in the industrial sector, where the number of state-owned enterprises has dropped from 150,000 in 1996, to 25,000 today. A quarter of those were either merged or liquidated, while half ended up in private ownership. Increasingly though, they are coming to the stock market. Industry consolidation is aiming to whittle down inefficient companies, with a view to creating national ‘champions’ in various sectors. This is a key opportunity for investors as highly fragmented industries are pruned until clear leaders emerge in each sector. At Martin Currie, our job is to identify them on behalf of our clients.

China’s 11th five year plan will provide a spur to balanced growth, with a number of sectors becoming strong beneficiaries as indicated in the table below.

Corporate governance in China is improving, which is vital for building the confidence of international investors. Initiatives include separating the government’s ownership interests in State-Owned Enterprises from commercial decision making, and establishing internal incentives and oversight mechanisms to help ensure management act in the best interests of shareholders. And at least one third of company board members will have to be independently appointed, with at least one independent director a professional accountant.

Furthermore, all listed companies must issue quarterly financial reports, which need to be audited by a reputable international accounting firm. Effectively, China is aligning the country’s accounting system with international best practice, which is an important sign of the country’s commitment to continuing its progress.

In summary, I believe China is a multi-year growth story. The re-rating in valuations started just over a year ago. Corporate earnings continue to be strong and analysts are revising their forecasts upwards. We are also seeing significant reform in Chinese companies that is enabling us to identify clear winners on behalf of our clients.

I am often asked what are the biggest risks in China? Clearly there are political considerations, but the country’s leadership is absolutely committed to achieving balanced and stable growth. The threat of an escalation in tensions between Taiwan and China is ongoing, and we can only trust in the leadership to act in a mature and pragmatic way. There is also the possibility of growing social unrest, particularly as the division between rich and poor, and across different regions, are magnified. And finally, given the poor quality of information in China, there are company level risks. These however, we can manage through extensive due diligence on potential investments by our Shanghai-based research team, and through effective portfolio diversification.

When considering investing in China, it is important to understand that it is a volatile market that reacts to news flow in an exaggerated way. The sharpness of the falls in February and the speed of the subsequent recovery demonstrate this. It is very easy to make or lose money in China through short-term speculation. I believe that a five to ten year view offers investors the best chance of capturing China’s premium growth and the beneficial impact of the corporate reforms. As long-term investors, pension funds are in an excellent position to take such a strategic view on the considerable opportunities in China.