The Reckoning

The resilience – or otherwise – of China to the current economic slowdown is a favourite conundrum for asset managers. Commodity price inflation, stock market volatility and government restrictions on where managers can and can’t invest don’t make life easy for the investor hoping to capitalise on China’s economic expansion.

Dr Burton Malkiel, Professor of Economics at Princeton University, says that prospective investors should be prepared to look at an investment time horizon of five to 10 years for Chinese equities: “Brazil is usually the poster child for volatility but some of these Chinese markets make Brazil look stable.”

The last 12 months have been particularly troublesome. “In the first half of 2007 investors behaved reasonably, but in the summer, money flooded in through Hong Kong and forced up share prices, which created a bubble,” says Yang Liu, fund adviser to the Atlantis China Fund. “This is a liquidity driven problem. The question is whether China can provide sustainable growth with sound valuations.”

Jonathan Schiessl, manager of the Ashburton Chindia Equity Fund, believes that a lot of the earnings growth in the A-shares market – the one open to domestic investors – was reliant on companies playing the market themselves. The government became alarmed and tried to cool things down, fearing that retail investors would lose everything. “The domestic market is a very political market. All the listed companies are state-owned, and all the participants are state-owned, so it is very prone to sentiment coming from the leadership,” he says.

Volte-face

In the last few weeks, the government has performed a volte-face, deciding that the sell off has gone too far. It is now telling Chinese pension funds that they need to up their China equity weightings. Stamp duty has also been cut. This is tempting investors back into the market.

Liu believes China will be the first market to recover as it was sold off on other people’s mistakes – that is, the credit crunch in Western markets. “Investors will be looking for markets that can generate good returns over three to five years. We saw outflows in Q1 as people needed to cover the losses they were making elsewhere. China has been under-estimated.”

However, she stresses that fund managers need to ensure that companies are delivering good earnings because of all the liquidity sloshing around in the market. She tips Zhaojin Mining, the first 100 percent pure gold player listed in Hong Kong, as an interesting stock. This has a market cap of $2.5 billion, and trades at a P/E of 20x 2008 earnings. “It has been attacked by hedge funds short selling, so the share price fell substantially in March, but the company completed three acquisitions in 2007 which will boost its gold production and reserves,” she says.

William Fong, manager of the new onshore Baring China Growth Fund, also stresses the importance of verifying if the outlook for company earnings is sustainable. “We look at the valuation in comparison with its peers, and the historical trading range, and give more credit to those companies that have shown resilience to a slow down in previous years,” he explains.

Fong is pursuing a consumption growth theme in his new fund, focusing on banks, such as China Construction Bank and Shanghai Pudong Development Bank; real estate companies such as China Overseas Land; and own-brand retailers, which benefit from low-cost manufacturing in China, high profit margins, good growth potential and national distribution.

Difficult dilemma

However, other managers are sceptical about the opportunities in China as inflationary pressures build, social divisions widen, and the profit margins of certain companies come under pressure from regulations that do not allow price increases to offset higher raw material costs. “For example, energy companies like PetroChina and Sinopec haven’t been able to pass on increases in crude oil prices because refined product prices are capped,” points out Jonathan Bell, senior investment manager in the emerging markets group at Pictet.

The Chinese government faces a difficult dilemma – it needs to curb further excessive capacity expansion in overheating industries whilst encouraging the growth of private consumption. Liu suggests that continued rapid urbanisation and industrialisation will lead to further shortages in shops and an increased likelihood of confrontation. She expects to see more pricing interventions in energy and natural resources to protect the economy from commodity price rises and to maintain China’s competitiveness.

The government is already discouraging natural resources exports to keep as much in the country as possible: “The coal producers can’t send coal to Japan, and they are also looking at alternative energy supplies.”

In China’s favour, Schiessl believes that food price inflation will moderate in the coming months, following massive increases in pork and chicken prices in the first quarter. Pork prices rose because the pig population was infected by blue ear disease leading to a shortage of pigs getting to market. As a result, the February CPI figure climbed to 8.7 percent.

The government responded by offering tax breaks to farmers to encourage them to breed more pigs, so now China is awash with piglets, which will hit the market in a couple of months. “Food price inflation should moderate as the supplier response comes through,” says Schiessl. “Also, the winter storms replenished the low water table so the improvement in soil moisture levels should produce a bumper harvest, reducing the price of grains.”

Wild East

But other problems – like poor corporate governance and lack of transparency – remain. “It is difficult getting decent information,” says Schiessl. “The state is the largest investor so you have to look at how they treat foreign and minority interests, and whether they deliver what they say they will. The regulator says that it wants to improve disclosure and accounting standards over time but there is still a long way to go. China’s a bit like the Wild West – capitalism is a fairly new concept and you do still hear stories alarmingly regularly about CEOs disappearing with suitcases full of cash.” However, he stresses that the quality of management is better in the blue chip companies now.

Bell agrees that more attention is now paid to minority interests, whilst Hong Kong-listed companies have to meet a higher standard of transparency and many use international auditors. “But there are still a lot of issues with private sector companies, such as transfer pricing, where the chairman of one company might be using his own private company as a supplier. Or sometimes with asset injections from the state or parent company it is hard to get a clear idea of the timing or pricing of those assets.”

Investing is made more frustrating by the multiplicity of markets, ring-fenced for one investor group or another. It is questionable how long this situation can continue. It seems certain that the B-share market will remain unloved as long as rumours circulate that it will be scrapped and merged with its racier cousin, the A-share market. “B-shares trade at a huge discount to the A-share market, and it is too illiquid and too expensive to deal in, so we avoid it,” says Schiessl.

Malkiel is also frustrated by the A-share market premium to the Hong Kong market – a factor of domestic investors’ inability to invest elsewhere. “Share prices for stocks like China Life can be 40 percent higher in the A-share market compared with the listing in Hong Kong or New York, because you can’t arbitrage between them,” he points out. “But the Chinese want to make Shanghai the major market in Asia and they won’t be able to do that if they insist on keeping foreign investors out.”

The Chinese are worried about loosening up too fast and fret about a run on the yuan, which Malkiel views as unlikely as it is so under-priced. “This government is a very cautious government, so I don’t expect change to happen overnight,” he says.

If you want to read more about how managers are trying to position themselves in China’s rollercoaster markets, please go to:

http://www.thomsonimnews.com/story.asp?storycode=40586