201011 China The Next Five Years


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China\'s 12th five-year plan will present many opportunities for the discerning investor.

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201011 China The Next Five Years

  1. 1. CHINA: The Next Five Years An introduction to the 12th five year plan MARTIN GOULET SENIOR ANALYST CALIBURN CAPITAL PARTNERS PTE LTD (SINGAPORE) NOVEMBER 2010Private & ConfidentialCaliburn Capital Partners LLPTime & Life Building 1 Bruton Street London W1J 6TL United Kingdom T: +44 (0) 20 7518 2300 F: +44 (0) 20 7518 2338 www.caliburncapital.comRegistered in England no: OC311183. Registered office as above. Authorised and Regulated by the Financial Services Authority.
  2. 2. A quick introduction to the 12th five-year plan From the 15th to the 18th of October, Chinas 12th five-year plan proposal was discussed and endorsed in the Fifth Plenary Session of the 17th CPC Central Committee. Though the formal five-year plan outline will not be published until it is approved by the National Peoples Congress on March 11th 2011, this proposal is a useful guideline of what to expect in terms of Chinese government policy over the ensuing five years. The National Development and Reform Commission, the country’s effective central economic planning agency, has highlighted a number of key issues which the five-year plan is meant to address. Broadly, these are restraining primary resource use and improving quality of life for the country’s 1.3 billion citizens, particularly those less fortunate. Why will this affect equity investors in the Greater China region? The plan will have far-reaching implications on the Chinese economy and society. But it will also have significant repercussions for listed companies in China’s domestic and offshore equity markets. By design, the plan’s impact on the business community will be uneven. Some companies are and will be better positioned to take advantage of this adjustment in national direction. Others will be burdened by new administrative hurdles or emerging competitive pressures arising from the plan and its policies. Identifying those companies that will thrive in this new business environment will be instrumental to generating superior returns in the Greater China equity market. It follows that an active, selective approach to equity investment in China will outperform a purely passive approach which, in this case, is most often represented by a simple allocation to the MSCI China or Hang Seng China Enterprise (HSCEI) indices and their related futures and exchange-traded funds. What are the plan’s key objectives? In terms of clear, well-defined policies that will be implemented from 2011 to 2015, the proposal has so far provided relatively few examples. The comprehensive list will only be made public in March of next year. Rather, the proposal has focused on issuing broadly defined objectives. Preparations for the plan have been under way since late 2008, however, and there are already a few examples of laws and regulations brought forth by the various arms of government that have been recently put in place or enacted in anticipation of this transition in industrial policy. The four main targets of the proposed plan are: • To increase household income as a share of national income; • To increase private consumption as a driver of China’s GDP; • To expand the social safety net; and • To increase China’s resource-usage efficiency. In order to attain these targets, architects of the proposal have delineated specific areas ripe for reform. The pricing of energy and resources will be made more competitive as subsidies are withdrawn and displaced to support the development of clean energy producers and more efficient users. Industries dominated by large, state-owned enterprises will be rendered more competitive and the companies themselves subject to income redistribution policies. In order to support private consumption, minimum wages will be lifted and the supply of social housing will be increased. In order to accelerate the urbanization of the country’s poorer, inland regions, tax reform, aimed at allowing land-owning farmers to monetize the real value of their land holdings, is also expected.Private & Confidential© Caliburn Capital Partners LLP 2
  3. 3. Further, the proposal lists seven new strategic industries which the government intends to target for accelerated development. These include alternative energy, biotechnology, new-generation information technology, high-end equipment manufacturing, advanced materials, alternative fuel cars and energy- saving technologies. Though no specific policies have yet been communicated, the government is expected to direct banks and venture capital and private equity firms to provide funding for these sectors. Overall, the central theme of the proposed plan is a rebalancing of the Chinese economy, from a focus on rapid industrialization at almost any cost to more equally distributed growth and greater environmental sustainability. In its simplest form, this transition will force through a more equal sharing of the economic pie. In the shake-out, winners and losers will emerge. Wealth will be redistributed from those economic agents that benefitted from earlier industrial policy – the large state owned monopolies, for example – to those that are politically important to or strategically necessary for the China of the future such as the rural peasant or alternative energy producer. We focus on some examples of the different winners and losers in the sections below. 1. The large, monopolistic SOEs The government is expected to limit State-Owned Enterprise (SOE) margins and earnings. This will be far-reaching initiative as there are 6,000 SOEs owned by the central government alone. However, those SOEs likeliest to be targeted (or targeted to a greater degree) will be those enjoying monopolistic rents. In China, state sector earnings are driven by a relative handful of sectors. Chief among these are resources, banks, telecoms and utilities. Some derive a monopolistic or quasi-monopolistic position due to government licensing requirements as is the case in nuclear power generation, power distribution, telecommunication services and banks. Others generate revenues through the use of public resources as is the case in oil fields and hydropower. Indeed, Credit Suisse estimates that among non-financial corporations, central government-owned companies account for approximately 60-70% of total pre-tax profits. Within this, around ten major companies in oil, telecoms, power and resource sectors account for over 60% of central government-owned companies’ earnings. Similarly, policy banks and state-owned commercial banks, which are all owned by the central government, also account for over 60% of the profits from financial corporations. From this overall group of monopolistic and/or large state-owned enterprises, Credit Suisse lists the following as publicly-traded: • China Mobile Group • China Telecom Group • China Unicom Group • CNOOC Group • PetroChina • Sinopec Group • Shenhua Group • Yangtze Power Group • Agricultural Bank of China • Bank of China • China Construction Bank • Industrial & Commercial Bank of ChinaPrivate & Confidential© Caliburn Capital Partners LLP 3
  4. 4. The economic incentives for SOEs will be altered in several ways. First, competition will be introduced. On the 26th of July 2010, the State Council assigned responsibilities of boosting private investment to the relevant ministries which are each expected to create specific policies designed to increase competition in monopolistic industries. Due to social pressure for addressing the inequality in wages earned by those working for the large SOEs and those working in general low-end industries – consider that the average wage at centrally owned SOEs was about 70% higher than the average urban wage rate in 2009 – the government will cap wages, or specifically annual employee wage growth, for certain SOEs. This policy will restrain overall income inequality but will also level the playing field for competitor firms wishing to hire employees at competitive market rates. Lastly, for SOEs that enjoy a monopoly or quasi-monopoly position, policies are expected that will explicitly reduce monopolistic economic rents. This is likely to consist of charging fees for the use of government licenses or taxes on certain resources. Further, SOEs will be forced to increase dividend pay- out ratios to parent companies or directly to governments. As of 2007, some SOEs have been required to pay dividends of 5-10% of earnings to the State-owned Asset Supervision and Administration Commission and the Ministry of Finance. Deutsche Bank expects that during the next 3-4 years, the pay- out ratio to rise to 30-40%. In cases where publicly-traded SOEs already make dividend payments to parent companies, the latter themselves will now be required to increase dividend payments to the government. Inevitably, this will reduce retained earnings at parent company level thereby reducing investment and the likelihood of future asset injections to their listed subsidiaries. Interestingly, these tax, fee and dividend increases will assist in funding the country’s nascent social safety net, itself a major pillar in the government’s plan to support private consumption, particularly among those least well-off. The bottom line is that the outlook for the larger, monopolistic SOEs is clouded at best. At the same time, as indices such as MSCI China and HSCEI are market-capitalization weighted, they have sizable exposure to these same SOEs. Indeed, as of August 31st 2010, both indices had more than a 45% weighting in the equities of the SOEs listed above. Out of the 10 largest-weighted positions in each index, 6 figured in this same list. In this case, therefore, an investor passively exposed to either index has to contend with government-driven headwinds that may persist for some time. 2. The large real-estate developers The proposal has highlighted the need to increase the provision of public housing, especially public rental housing owned by local governments for low-income households. Indeed, Deutsche Bank estimates that the growth rate of public housing investments may continue at 50% for 2011 and 30% p.a. for the following few years. This is expected to be concentrated in Tier-1 cities where elevated real estate prices have caused complaints from the public, particularly those with low incomes. This will reduce incremental demand for commodity housing in tier-1 cities. The government has long considered some form of property tax in order to raise income. At the same time, it has wrestled with speculative investment in the property sector. In April and September 2010, the government announced separate measures to rein in excessive real estate price rises and to curb property speculation. Rumours of some form of additional property tax have weighed on domestic equities for some time. In September 2010, China Business News, a domestic business daily, quoted a source close to the NDRC as saying that the agency had already mooted and later rejected a first draft of a property tax law from the city of Shanghai. Indeed, the Ministry of Finance announced in early November 2010 that a property tax was indeed likely for H1 2011. Given acute social pressures on the issue of poor housing affordability in tier-1 cities (e.g. Shanghai, Beijing, Shenzhen and Guangzhou), a property tax is likeliest to be applied there in order to put a lid on housing price increases driven by speculation. As these same cities are the most urbanized by definition, revenues from land sales to localPrivate & Confidential© Caliburn Capital Partners LLP 4
  5. 5. governments are likely to decline in the future. As result, local governments in these cities are likeliest to favour the introduction of a property tax. In contrast, in tier-2 and -3 cities, larger plots of land are still available given their smaller size and relative under-urbanization. Housing is more affordable and, consequently, there is less social discontent over the issue. Infrastructure build-outs are still funded largely by land sale revenues at the local government level. The lack of both political pressure and incentive therefore lowers the risk of a property tax in these cities. The overall result for listed real estate developers is therefore mixed. Developers with land banks primarily in tier-1 cities, such as Guangzhou R&F Properties and Shui On Land Ltd, risk slower growth. Developers that have successfully expanded into tier-2 and-3 cities, such as Evergrande Real Estate Group, will be less impacted by the advent of a property tax while profiting from the continued development of China’s heartland cities. Consider that over half of the real estate development segment in the CSI 300, China’s domestic A-share index, is exposed to companies which themselves have over a third of their gross assets in tier-1 cities. At the same time, the HSCEI has but a single weighting in a real estate developer; the aforementioned Guangzhou R&F. The MSCI, on the other hand, has limited real estate developer exposure overall with only a 3% weighting—entirely insufficient to take advantage of China’s secular urbanization trend. 3. Consumer-oriented sectors In China, the ratio of aggregate household income to GDP has been decreasing for the last two decades. Currently, the ratio mentioned above is the lowest among the worlds major economies at 46% (2009). Moreover, between individual households, there is significant income disparity. The 2009 UN Human Development Report states that Chinas Gini coefficient, one of the most widely used metrics of income inequality, stood at 41.5, compared to India at 36.8, Russia at 37.5, 24.9 for Japan and Zimbabwe at 50.1. This inequality has led to grievances by the public and even social unrest. At the same time, it is widely noted that private consumption as a share of Chinas economic growth has been remained muted in comparison to government and corporate investment. In its five-year plan, the government has outlined, first and foremost, its intention to reduce income inequality between households as well as between households and corporations. The government intends to redress this imbalance partly through further social infrastructure spending and its continued inland urbanization drive. Government expenditure is expected to shift towards consumer-oriented priorities such as education, healthcare, social security and pensions going forward. While the pension system for urban areas has been in place since the early 1990s, a pilot program for rural areas only started in 2009. By relocating to cities with established pension systems, rural residents can immediately enjoy the social welfare benefits afforded to urban residents, thereby unlocking their consumption potential. Urban residency rights are therefore expected to be granted to all urban residents, including migrant workers. Associated rural land reform will allow farmers to monetize their land-use rights and properly incentivize them to leave their land. In some regions, banks are expected to start a pilot program to allow farmers to access loans collateralized by these same land-use rights. Overall, the central government has officially targeted an urbanization ratio of 60% by 2020 from 47% in 2009 and a target of 5.8 million new housing units. Credit Suisse has, in fact, forecasted that a simple 1 percentage point per annum hike in the urbanization ratio will increase the private consumption-to-GDP ratio by 0.33%. Most importantly, as part of the wage regulation package mentioned previously, the Director of Wages and Labour at the Ministry of Labour and Social Security issued a statement in July 2010 suggesting that the government would target a doubling of minimum wages by 2015. The government will also help support the supply of consumer goods and services in the coming years. Consumer-oriented industries and businesses will be assisted through a host of directives. As but onePrivate & Confidential© Caliburn Capital Partners LLP 5
  6. 6. example, the government is expected to provide low-cost land or existing buildings as well as tax incentives and professional training for the fast-growing elderly care industry. In April 2010, nine ministries and commissions jointly released policy guidance in relation to the countrys "cultural sector", which includes the production of consumer-oriented goods and services, from art to television programming. Among other directives, favourable credit policies will be rolled out to promote growth in the sector. Inevitably, some companies will fare better in this transition. Consumer oriented companies will clearly benefit from their customers earning more. Others, such as those operating in labour-intensive industries, will be pressured to move inland. In September 2010, the State Council issued policy guidance aimed at encouraging specific industries to relocate to Chinas mid and western regions. The net result should be positive for consumption as well as infrastructure and property development in rural areas of the country. The Chinese consumption story is the clearest case of where an active approach to equity investment will offer superior returns to passive investment. Firstly, by construction, both the MSCI China and HSCEI index have relatively limited exposure to consumer-related sectors such as Consumer Staples, Consumer Discretionary, Healthcare and Information Technology (see Table 1 below). Both indices are heavily weighted to large Hong Kong listed banks and insurance companies. Rather, Chinese consumer-oriented companies tend to be both listed onshore as A-shares and much smaller in capitalization. Naturally, the CSI 300 index has relatively more exposure to consumer-oriented companies simply by virtue of its being an onshore-listed index. Nonetheless, its large-capitalization orientation also hinders its ability to access and offer this exposure (see Table 2). Lastly, while some consumer sub-sectors have been singled-out as likely recipients of favourable fiscal, tax and financial policies, others such as labour-intensive, low-end electronic goods and textiles manufacturing, face material wage cost increases over the coming years. There will be an ever larger premium for the ability to pick the right sub-sectors, the right companies and the right stocks. Table 1 Weighting of China stocks by sectors   % of total MSCI  A‐share  H‐share  Brazil India Russia Japan US Europe World China  index index  Consumer discretionary           4.4           9.4           2.6           2.5           4.6 ‐         20.0           9.6           8.2           9.5 Consumer staples           3.9           5.6           0.6           7.2           5.8           0.6           5.5         11.3         12.8         10.1 Energy         17.9         14.8         22.4         26.7         16.7         60.6           1.3         12.5         10.1         10.6 Financials         39.5         27.8         56.2         22.1         25.8         11.5         16.9         14.5         23.5         21.2 Banks         23.7         16.9         18.8         20.1         19.8         11.5           8.7           2.6         13.3         10.2 Insurance           9.4           3.7         16.8           0.2 ‐ ‐           2.4           3.2           4.9           3.9 Real estate           6.2           4.3           0.5 ‐           3.3 ‐           3.2           1.3           0.9           2.3 Healthcare           0.2           4.2           0.9 ‐           3.6           0.7           6.0         12.5         10.4           8.7 Industrials           8.5         17.1           6.5           1.9           9.1 ‐         18.7         10.3         10.2         10.4 Capital goods           5.5         12.3           4.0           0.5           9.1 ‐         13.0           7.7           7.8           7.6 Transportation           3.0           4.4           2.6           1.4 ‐ ‐           4.6           1.9           1.3           2.1 Information technology           5.5           5.2           0.7           2.2 ‐         15.5         13.7         19.2           2.8         11.7 Materials           5.5         12.1           5.7         28.4         10.9         13.6           8.4           3.4           9.2           8.4 Telecommunication services         13.1           0.6           2.5           3.8           1.4           9.5           3.8           3.0           7.2           5.0 Utilities           1.5           3.2           1.9           5.3           6.6           3.4           5.8           3.6           5.7           4.4       100.0       100.0       100.0       100.0       100.0       100.0       100.0       100.0       100.0       100.0 Total; consumer‐related         14.0         24.4           4.8         11.9         14.0         16.8         45.2         52.6         34.2         40.0 Source: Credit Suisse. As at August 31, 2010Private & Confidential© Caliburn Capital Partners LLP 6
  7. 7. Table 2 Weighting of China stocks by market cap   % of total MSCI  A‐share  H‐share  China  index index  Smal l  cap ‐ ‐ ‐ Mi d cap           8.0         32.0           0.5 Large cap          92.0         68.0         99.5 100.0 100.0 100.0 Source: Bloomberg. As at Jun 30 2010 for MSCI China and Aug 31 2010 for A, H-Shares indices 4. Polluters and clean energy providers In November 2009, the State Council announced its objective to reduce the intensity of carbon dioxide emissions per unit of GDP by 2020 to 40-45% from the 2005 level. This was largely a carry-over from the previous five-year plan which had pledged, as a one of its objectives, to increase Chinas energy use efficiency. This objective, brought forward into the 2011-2015 plan, will be accomplished by taxing fossil fuel producers and facilitating investment in alternative energy providers. According to Credit Suisse, Chinas investment in new energy sources from now until 2020 could reach RMB 4.5 trillion with the installed power generation capacity of wind and nuclear increasing by over 500% and 800% respectively. At the same time, on June 1st 2010, Chinas Ministry of Finance introduced a new 5% ad valorem sales tax applied to producers of crude oil and natural gas in the Xinjiang Uygur autonomous region. Xinjiang, however, was a pilot program and a similar tax on oil, gas as well as coal, is expected next year in 12 other western provinces. While the larger, monopolistic resource producers may pass this tax burden onto end users, smaller operators will be less profitable. As the most important source of energy-related carbon emissions, the countrys inefficient coal mining sub-sector, in particular, will be the target of forced consolidations and its aggregate output capped. As part of the plan, other measures to conserve resources and the environment include a change in existing water and power tariffs to disproportionately penalize heavy users. The new five-year plan is expected to have a strong focus on improving environmental stewardship. In this case, outright winners will include alternative energy companies and the more efficient or less significant users of resources. Among the group of fossil fuel based energy providers, relative winners could include natural gas drillers and distributors on account of that resources comparatively low carbon emission profile. In contrast, the coal mining sector faces significant uncertainty. A hallmark of China’s particular industrialization phase, coal supplies the lion’s share of the country’s fuel for electricity production. Nearly one third of the MSCI Chinas underlying energy sector exposure is to coal mining companies. This figure is even higher for the HSCEI and CSI 300 indices with 36% and 69% respectively. Hence, in relation to energy sector exposure, a passive investor in either index will be on the wrong side of Chinese governmental policy. At the same time, Chinese alternative energy companies, such as Haitong, Baoding Tianwei or Xinjiang Goldwind Science & Technology often have smaller market capitalizations and are entirely unrepresented in either the HSCEI or MSCI China index. Within the CSI 300, they face a similar market capitalization hurdle-collectively; these three stocks represent less than 1% of the index. By definition, an active investor in Chinese equity markets benefits from a much wider opportunity set but they can also elect to invest alongside the governments strategic objectives. Given the significant degree of government influence in Chinas economy and capital markets, this would appear to be the most suitable approach.Private & Confidential© Caliburn Capital Partners LLP 7
  8. 8. 5. The banking sector The five-year plan may also produce long term winners but short term losers. We expect this to be the case in the Chinese banking sub-sector. Financials are the single largest sector in Chinese equity markets, both domestic and offshore. The CSI 300 has nearly 28% exposure to the sector and the MSCI China index nearly 40%. The HSCEI index itself has over half its weight in financial companies. In each case, banks represent the largest sub-sector weighting. Though an investor may eventually want to have exposure to Chinese banking equities, policies and initiatives tied to the five-year plan may create shorter term headwinds for some companies in the banking industry. As part of the planned transition towards a slower but more sustainable rate of economic growth, monetary policy is being normalized and loan growth constrained. Deutsche Bank estimates that growth in the broad money aggregate (M2) will be capped at 14% (versus 19% in 2010). All else held equal, banking profit margins will suffer from the loss of volume. According to external research1, the five-year plan’s call for financial sector reform will likely involve initiatives such as deposit rate and RMB liberalization. The former is expected to lead, in the shorter term, to higher deposit rates and lower net interest margins, all other variables being equal. Over the longer term, as China gradually opens its capital account, larger banks with divisions in Hong Kong should profit from the eventual influx of RMB denominated deposits to the exclusion of smaller, ‘onshore-only’ operators. 1 Wall Street Journal, Deutsche Bank, HSBC, Macquarie. Caliburn Capital Partners LLP Caliburn Capital Partners S.A. Caliburn Capital Partners PTE LTD Time & Life Building Rue de Rive 3 (3rd Floor) BEA Building, #10-02 1 Bruton Street 1204 Geneva 60 Robinson Road London Switzerland Singapore 068892 W1J 6TL Tel: +44 20 7518 2300 Tel: +41 22 319 0980 Tel: +65 6304 3230 Fax: +44 20 7518 2338 Fax: +41 22 319 0989 Fax: +65 6221 2532Private & Confidential© Caliburn Capital Partners LLP 8
  9. 9. This document is issued by Caliburn Capital Partners LLP (“Caliburn”), which is authorised and regulated by the Financial Services Authority of the United Kingdom, and is supplied to you solely for your information. The information contained herein is strictly confidential. Nothing contained herein shall constitute a solicitation, offer or recommendation to buy, sell or otherwise dispose of any investment, to engage in any other transaction or to furnish any investment services. This document does not constitute and may not be relied on as constituting investment advice or inducement to invest and any investment decisions in investment funds should be made based on a full reading of the offering memorandum for the relevant fund. Caliburn has not given consideration to the particular investment objectives, financial situation or particular needs of any recipient. Recipients should take independent professional financial advice before deciding to invest in any investment product. The information contained in this document have been compiled in good faith and obtained from sources which Caliburn believes to be reliable. Any expressions of opinion are those of Caliburn only and are subject to change without notice. Caliburn makes no guarantee, representation or warranty and accepts no responsibility or liability as to the accuracy or completeness of the information or opinions contained herein. Caliburn, its partners, officers, employees, representatives and advisors accept no liability whatsoever for any loss, whether directly or indirectly arising from the recipient’s use of this document or its contents. Past performance is not a guarantee of future returns. The value of investments may fall as well as rise. Caliburn, its partners, officers and employees may have or take positions in the investments mentioned in this document. © Caliburn Capital Partners LLP. No part of this document may be reproduced, re-distributed or passed to any other person without the prior written consent of Caliburn.Private & Confidential© Caliburn Capital Partners LLP 9