I N V E S T M E N T S T R A T E G Y G R O U P
The Long-Term Investment
Outlook for China
W W W. J A N N E Y. C O M2
Investors have taken a pessimistic view of China’s
economic fundamentals and long-term structural
outlook. This has been driven by concerns over
the banking system, overall debt levels in the
economy, and slower economic growth rates.
Meanwhile, Chinese stocks are now trading at a deep
discount to global benchmarks, despite faster growth
in the economy and corporate profits. The new lead-
ership, under Premier Li Keqiang and President Xi
Jinping, has also recently announced significant positive
reform measures to emphasize free-market principles
and reduce the government’s role in the economy.
In this paper, we examine major issues that China faces
in continuing its extraordinarily rapid development,
and we discuss potential investment opportunities that
may result from economic reform.
of China’s Rapid Development
The growth of China is historically unprecedented and
is happening at about 10 times the speed at which the
United Kingdom improved average incomes during the
Industrial Revolution—and on a much greater scale.
China’s GDP growth has averaged about 10% since the
1990s, per capita income has jumped 13-fold in the
last three decades, and over 500 million people have
been lifted out of poverty. Even with this extraordinary
growth, China still needs to grow at an 8% per annum
rate through 2030 in order to reach the per-capita GDP
of South Korea, another emerging market country.
Keys to China’s Rapid
1) Rapid industrialization, aided by globalization, and
structural movement of workers from low-productivity
agricultural jobs to high-productivity urban manu-
facturing and services jobs has led to a self-feeding,
positive development cycle.
2) Massive domestic savings have enabled large-scale
investment, without reliance on external funds, while
incorporating foreign investors has brought in ad-
vanced technology. Both of these factors have enhanced
productivity. Resulting low-cost, efficient infrastructure
and productivity gains created significant competitive
advantages, facilitating rapid industrialization and rising
3) Chinese policymakers, while far from perfect, have
been flexible and responsive in meeting challenges.
The country’s economic reforms over the years have
eliminated rigidities, improved efficiencies, and
unleashed creativity—while avoiding major policy
blunders, as we discuss further.
China’s Importance to the Global
Economy has Grown Enormously
The Chinese economy expanded by about 8% in
2013, which represents a marked slowdown from the
double-digit pace commonly seen before the Global
Financial Crisis. Even so, five years after the Great
Recession, China’s GDP is currently 40% larger than
in 2008, accounting for 12% of the global total—up
from 7% in 2008 at the onset of the crisis. China
has contributed to almost half of the net increase in
global output over the past five years.
Currently, China accounts for 19% of emerging
market exports, compared with 14% five years ago.
Similarly, China accounts for 16% of exports of some
commodity-producing countries, more than double
2008 levels. China has emerged as the largest crude oil
importer in the world.
The global impact of the Chinese economy has grown
enormously, and its marginal impact will likely contin-
ue to grow. As such, getting China right has become all the
more important in understanding the global macro picture.
Chart A: Chinese GDP as a
Share of Global Total
(Source: Janney ISG, BCA Research)
Chart B: Chinese Contribution
to Global GDP Growth
2007 2013 2007 2013
3W W W. J A N N E Y. C O M
While there is little doubt that China will play a
leading role on the world stage in the 21st century,
there is more uncertainty about how investors
should seek to profit from this trend. Histori-
cally, the most straightforward and lucrative way
to “play” China has been through the commodity
markets and commodity related countries and
stocks. We think this has changed.
China is at a
Critical Turning Point
China’s double-digit growth rates over the last
decade were significantly aided by the massive
consumption boom in the developed world (China
was the high-volume manufacturer of low-margin
products for the world), which most likely ended
with the Great Recession. Contribution to growth
by net exports has recently turned negative, and
slower global demand will be a formidable head-
wind going forward.
Existing growth model flaws are also evidenced
by excess capacity that has built up in nearly all
sectors that the government had subsidized and
interfered in, in the rising cost structure, declining
global competitiveness, and shrinking corporate
profitability of many Chinese companies and in
the unprecedented environmental degradation.
With its export markets increasingly saturated, the
country has no choice but to shift its growth model
from investment and exports to domestic con-
sumption. This transition will offer investors many
opportunities, while also posing risks.
We View the Odds of a Debt-Driven
Chinese “Hard Landing” as Remote
A potential China “hard landing” is considered a
top risk facing the global economy. This concern
is driven by the amount of debt in the Chinese
economy, which is causing the Chinese authorities
to take precautionary measures. These measures
include cooling off the housing sector, restricting
local government borrowing, and tightening scru-
tiny on “shadow” banking (shadow banking, which
exists in every major economy, occurs when non-
bank financial institutions provide services similar
to traditional banks—but outside the system of
regulated depository banking).
Regulators have mandated banks to dramatically
increase the provision coverage ratio of non-
performing loans. The provision coverage ratio
of banks has increased from a mere 40% in 2007
prior to the financial crisis to about 300% current-
ly, a massive buffer to protect banks’ capital base.
The overall leverage ratio in the Chinese economy
is not exceptionally high compared with other
countries. The total indebtedness of the economy,
including the government, the corporate and
household sectors, is about 150% of GDP, substan-
tially lower than most other major countries in the
world (the U.S. stands at 300% of GDP). Even tak-
ing into consideration the shadow banking activity,
China’s overall leverage ratio, at 205% of GDP,
does not stand out in a global comparison.
Shadow Banking Analysis: The rapid expansion of
shadow banking activity in the past few years is a
risk factor that has weighed heavily on investors’
sentiment and on Chinese stocks.
Despite growing rapidly, the shadow banking activity
has not yet reached systemic significance (Charts
C and D). While there are certainly some trust and
wealth management products that have promised
unrealistic returns for investors, the overall situation
is less alarming than the individual cases that have
grabbed the headlines.
The average yield on wealth management products
is currently 5.5%, higher than Treasury yields but
lower than corporate bonds. Trust products on av-
erage have higher yields, but historically have been
more volatile and have not been too far off from
the average lending rate of new bank loans.
Finally, an overwhelming majority of Chinese financial
institutions are state-owned or state-controlled, and all
trust and wealth management products are issued in
local currency terms. Barring major policy mistakes, the
Chinese authorities have unlimited resources to back-
stop any potential crisis scenario.
We expect the shadow banking issue to remain un-
resolved for an extended period. While we believe
the risk of a credit event or financial crisis remains
low, the risk of default on trust and wealth man-
agement products will likely continue to surface,
creating headline risk and uncertainty for investors.
W W W. J A N N E Y. C O M4
Importance of Urbanization
Second, China’s urbanization rate will likely reach
53% as of 2013, compared with 20% at the begin-
ning of the country’s economic reforms in the
late 1970s. Nonetheless, China’s urbanization
rate is still substantially lower than that of other
countries at comparable income levels, let alone
the developed world.
Currently, China’s average urban income is three
times that of the rural sector, which generates
strong incentive for rural workers to move to cities
for more productive and better-paying jobs. If the
experience of some newly industrialized countries
offers a useful guide for China’s future roadmap, it
will take at least two more decades before China’s
urbanization rate reaches 80%—still a relatively
modest level compared with other major world
economies. Urbanization also generates the need
for infrastructure investment, especially in trans-
portation, housing, power, water, sanitation, and
social services—providing sources of demand as
well as economic growth.
Finally, the vast gap between China’s relatively
developed coastal region and the poorer inland
provinces provides the potential for less devel-
oped areas to catch up. The government has
been pouring capital into the inland provinces
to improve transportation infrastructure, and
private sectors have also been moving in to take
advantage of cheaper costs. As a result, the inland
provinces have been growing at a notably faster
pace than the coastal region in recent years. The
inland region can benefit from the experiences,
expertise, and capital of the more developed parts
Drivers of Future Growth
A key driver to China’s future growth potential
is the gap between China and other advanced
economies. Using the U.S. as a benchmark for
the advanced frontier, China’s current per capita
GDP is slightly over 30% of the U.S. level, com-
parable to Japan in the 1960s and Korea in the
mid-1970s. This comparison highlights that despite
the tremendous progress China has made in the
past several decades, it still significantly lags other
advanced economies. This “catching-up” enables
China to achieve much faster productivity gains by
learning from technology know-how, institutional
infrastructure, and business best practices in the
developed world. This should not change funda-
mentally for at least the next 10 years.
Chart E: Per Capita GDP
(Source: Janney ISG, World Bank)
China Mexico Korea Japan U.S.
$51,749Chart C: Trust Assets as a % of Total Bank Assets
(Source: Janney ISG, BCA Research)
2010 2011 2012
(thru Q3 2013)
Chart D: Wealth Management Products as a % of Total Bank Deposits
(Source: Janney ISG, BCA Research)
2010 2011 2012
(thru Q3 2013)
Shadow Banking is not yet Systemically Significant
5W W W. J A N N E Y. C O M
of the country. Infrastructure density and social
development levels in the inland regions are still
far inferior compared with the national average,
which suggests that the catch-up process has much
further to run.
Importance of Growing Middle Class
As China shifts its economy from an investment
and export-centric model to a consumer-centric
one, this will generate tremendous opportunities
for companies that are able to tap into the rising
incomes of China’s expanding middle class.
Defining the middle class as those who earn be-
tween $6,000 and $30,000 (this range is roughly
between the average income of Brazil and Italy),
China now has about 335 million people whose
incomes fall in that range—the current size of the
entire U.S. population. By 2020, over 75% of Chi-
nese income-earners will belong to this middle class,
up from 25% today. To put this in some perspective,
approximately 740 million Chinese people will join
the middle class club over the next decade, which is
more than Europe’s entire current population.
McKinsey research suggests that the upper middle
class is poised to become the principal engine of
consumer spending over the next decade. China
is already the world’s largest auto market and the
second largest luxury goods market. McKinsey
research also indicates that by 2015, more than
one-third of the money spent around the world
on high-end bags, shoes, watches, jewelry, and
ready-to-wear clothing will come from Chinese
consumers. There is also strong secular demand
for healthcare and insurance products.
Importance of Recent
In November of 2013, the Chinese government
released its reform blueprint, following the third
Plenum (a major Communist Party policy meet-
ing), which will guide the country’s development
in the coming decade. This policy meeting and
associated reform blueprint are notable because
they coincide with the early-days of the Xi Jinping-
Li Keqiang leadership decade, and because of the
historical record of prior third Plenums: the 1978
third Plenum launched what was to become the
economic reforms that transformed China from
a moribund, self-sufficient economy into a global
powerhouse, and the 1993 third Plenum estab-
lished the market reform agenda that was later
to be essential to the modernization of China’s
economy under Premier Zhu Rongji—both major
thresholds of policy change that were fundamental
to catalyzing China’s development progress.
The proposed reform measures seek to rearrange
the relationship between market forces and the
government in regulating economic affairs. The
Chinese leadership stated that market forces will be
granted the “determining” role, which infers that
the government will recede to a supportive position.
Role of the Market
The top leadership believes there are some ma-
jor problems in the economy where the role of
markets is insufficient, and the latest reform push
implies major changes in the pricing mechanism
in three areas where the government still main-
tains strong administrative controls:
1. Allowing free-market pricing of money—the
backbone of China’s financial reform. The
proposed reforms involve freer cross-border
capital flows, and ultimately the movement to
a market-driven floating exchange-rate system.
Furthermore, interest rates are to be liberal-
ized, allowing market participants to price
capital based on demand and supply, as well
as risk assessment. Liberalization measures
also include allowing private banks, setting up
deposit insurance programs, and changing
initial public offering (IPOs) procedures in the
equity market—all of which are designed to
encourage more efficient allocation of capital.
2. Allowing market forces and competition to
take control of resources—including utility
prices of water, petroleum, natural gas, electric-
ity, transportation, and telecom.
3. Allowing free-market pricing of land, particu-
larly in rural areas. This has the potential to
enable the rural population to monetize the
rising value of rural residential land, further
7W W W. J A N N E Y. C O M
Table 2: Multinational Companies With Significant Chinese Opportunities
Company Name Ticker
Improving internal consumption is at the center of China’s long-term economic plans. Upper middle class is growing rapidly and demanding luxury brands.
BAYERISCHE MOTOREN WERKE AG BMW GR 10.11 4.15 - A+ German car brands are in big demand in China. S&P
LAS VEGAS SANDS CORP LVS 19.64 16.50 1.87 BBB-
Major casino operator in Macau, the adult
playground of China.
WYNN RESORTS LTD WYNN 25.80 11.00 3.33 BB+
Major casino operator in Macau, the adult
playground of China.
SWATCH GROUP AG/THE-BR UHR VX 16.95 11.26 - -
Watches, jewelry, and accessories are coveted by
LVMH MOET HENNESSY LOUIS VUI MC FP 16.57 11.22 2.38 A+
Portfolio of luxury brands in high demand for
NIKE INC -CL B NKE 23.63 12.76 1.23 AA- Nike Swoosh is a strong brand in China. S&P/CS/J
YUM! BRANDS INC YUM 20.04 11.61 2.48 BBB
More revenue and profit comes from China than
These companies are providing the Chinese economy with new “must have” staple items.
COLGATE-PALMOLIVE CO CL 19.65 9.50 2.20 AA- Leading market share in China for Oral Care. S&P/CS
Procter & Gamble PG 17.86 9.18 3.10 AA-
Growing middle class provides opportunity for PG’s
China is now the largest oil importer in the world and big oil will benefit from this demand.
EXXON MOBIL CORP XOM 11.80 16.91 2.72 AAA
World’s largest publicly-owned integrated oil
company. Low risk energy play.
SCHLUMBERGER LTD SLB 15.16 15.20 1.45 AA-
Bellweather oil service firm benefits from Chinese
China needs lots of industrial and machinery equipment for its urbanization and infrastructure build.Air travel is also growing rapidly.
BOEING CO/THE BA 16.69 10.83 1.60 A Large demand for aircraft as China develops. S&P/CS
CATERPILLAR INC CAT 15.80 9.00 2.52 A
World’s largest producer of earthmoving equipment.
A credit rating.
GENERAL ELECTRIC CO GE 14.49 9.00 3.21 AA+
Leader in Power & Water, Oil & Gas,Aviation,
Transportation and Energy Management.
AMETEK AME 20.53 15.00 0.50 BBB
Well positioned in China for many advanced
A growing middle class and aging population demand more and better health care.
JOHNSON & JOHNSON JNJ 14.90 6.93 2.98 AAA
AAA rated blue chip selling Pharmaceuticals and
Medical Devices in China.
MEDTRONIC INC MDT 14.21 7.94 1.99 AA-
Very diverse product line, strong cash flow,
valuation and dividend support.
Technology and communication play key roles in modernizing an economy.
APPLE INC AAPL 11.77 18.37 2.34 AA+
Products are in big demand with growing middle
BAIDU INC - SPON ADR BIDU 29.78 25.25 - -
The Google of China has tremendous opportunity as
Internet becomes Ubiquitous.
INTEL CORP INTC 12.54 7.68 3.78 A+
World’s largest microprocessor manufacturer has
majority of sales to Asia and Pacific.
QUALCOMM INC QCOM 14.26 14.45 1.78 NR
QCOM technology in high demand for China’s
wireless telecommunications needs.
Infrastructure requires lots of materials. Diversified metals and mining firms are finding, mining and processing the metals and minerals needed to create China’s infrastructure.
RIO TINTO PLC-SPON ADR RIO 10.13 7.00 - A-
One of world’s largest miners of iron ore, industrial
minerals, aluminum and copper.
ISHARES MSCI GLOBAL METALS & PICK - - - -
ETF provides broad exposure to global metal &
Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters.
Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company’s next full business cycle (typically 3-5 years).
Dividend Yield - Trailing 12 month dividend per share divided by share price
Credit Rating - Rating assigned by Standard & Poor’s to the long term obligations of the issuer if repaid in the local currency of the issuer.