nn theme 121027 the investment case for china

7/31/2019 NN THEME 121027 the Investment Case for China

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Date: 27 October 2012

nonameInvestment

Research

Robin HU

[email protected]

The Investment Case for China

Executive SummaryChinas growth in the last 30 years is simply astounding and

unprecedented. Never before has the world seen an economy of

this size grew so fast. Between 1980 and 2010, China GDP grew a

massive 90x or a huge 16% every year for the last 30 years. In only

three decades, China went from a non-event to the second largest

economy in the world. In 1980, the US was 37x larger than China

but in 2010, the US was only 2x larger than China.

Today, China is the worlds largest creditor nation and possesses

the largest forex reserve, accounting for one third of world total.

China is also the worlds largest exporter and FDI recipient. China isnow the largest single source of demand in many markets,

accounting for half the global consumption in coal, steel, cement

and soybean amongst other things.

In line with China rapid economic growth, GDP per capita grew 65x

or 15% p.a. over the last 30 years. A rapidly growing income and

sheer population size have turned China into the fastest growing

and often the single largest market segment for many

multinationals. China is Apple second largest market after US with

revenue growing 450% in 2011. Similarly, KFC profits in China

doubled in just three years and China is now Yum Brands largest

profit division.

Collectively, Chinas stock exchanges are the largest in Asia. Two of

China three stock exchanges are amongst the top 10 largest stock

exchanges in the world. Shanghai Stock Exchange at USD2.4tn and

Hong Kong Exchanges at USD2.3tn are ranked 6th

and 7th

globally.

Three out of the worlds ten largest companies are listed on the

Chinese stock exchanges. In total, there are close to a hundred

companies that are listed on the Chinese stock exchanges that

have a market cap of USD10bn and above.

Yet, despite all these, the Chinese stock markets are still accorded

very low valuation. On a P/E basis, HKEX and SSE are being priced

9.7x and 11.2x earnings respectively. This is despite the fact that

the average corporate earnings growth was 15% p.a. between

2006 and 2010. The dividend yields also paint a similar story. HKEX

dividend yield of 3.3% is higher than the 10yr yields of UK, Canada,

US, German and Japan.

In our view, there is a disjoint between current Chinese equity

valuations and China underlying fundamentals. At P/E close to 10x,

dividend yield of 3%, strong balance sheet, low payout ratio and

high earnings growth, Chinese equities certainly deserves more

attention. China is an thin but ex ensive.

Thematic Report


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nonameresearch.com | 27 October 2012

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Table of Contents

Overview - The Rise of China ...................................................................................... 4

30 years of staggering growth in GDP .................................................................... 4

Deadly size, deadly speed ....................................................................................... 4

Reforms - The Why and When of Chinas Rise ........................................................... 6

What went wrong Central planning under Mao ................................................. 6

Correcting the wrong Market reforms under Deng ............................................ 6

GDP Manufacturing for the World .......................................................................... 8

From agriculture to manufacturing ........................................................................ 8

Is China over-investing? .......................................................................................... 9

Trade At the Center of World Trade ...................................................................... 13

China place in world trade .................................................................................... 13

A closer look at Chinas exports ........................................................................... 13

A closer look at Chinas imports ........................................................................... 15

Chinas balance of payment ................................................................................. 17

Fiscal No Worries Here .......................................................................................... 19

Market economy and tax reforms ........................................................................ 19

A closer look at government revenue .................................................................. 20

A closer look at government expenditure ............................................................ 21

Strong fiscal position overall ................................................................................ 22

Monetary No Laissez Faire Here ............................................................................ 24

Still at a nascent stage .......................................................................................... 24

Central bank and administrative policies ............................................................. 24

China managed exchange rate system ................................................................. 25

A looming Chinese banking problem? .................................................................. 26

Equity Market China Three Exchanges .................................................................. 29

China stock markets bigger than you think .......................................................... 29

Market valuation not excessive ............................................................................ 30

The ongoing liberalisation of Chinese stock markets ........................................... 32

The A-S of Chinese shares .................................................................................... 32

In Detail: Hong Kong Stock Exchange ....................................................................... 34

Size and growth .................................................................................................... 34

Market valuation .................................................................................................. 36

Hang Seng Index composition and performance ................................................. 36

H-shares subsegment ........................................................................................... 38


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HSCEI composition and performancce ................................................................. 39

In Detail: Shanghai Stock Exchange .......................................................................... 41

Size and growth .................................................................................................... 41


SSE Composite Index composition and performance .......................................... 44

In Detail: Shenzhen Stock Exchange ......................................................................... 46

Size and growth .................................................................................................... 46


Shenzhen Stock Exchange Composite Index composition and performance ...... 48

The Investment Case for China................................................................................. 50

Rise of the Chinese consumers ............................................................................. 50

More than reasonable valuation .......................................................................... 52

Conclusion ................................................................................................................ 55


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Overview - The Rise of China

30 years of staggering growth in GDP

GDP grew 90x over 30 years. Chinas growth in the last 30 years is simply

astounding and unprecedented. Never before has the world seen an economy of

this size grew so fast.

Between 1980 and 2010, China GDP grew a massive 90x from justRMB455bn in 1980 to RMB40,120bn in 2010

1

This is equivalent to a nominal GDP growth of 16% p.a. for the last 30years!

As a result of Chinas growth, an estimated 120m people, equivalent to the entire

population of Japan, have been lifted out of poverty. China growth has indirectly

created the worlds largest poverty alleviation program. Before China embarked on

her growth trajectory, around 60% of the population earned less than USD1 per

day. Today, that number is less than 10%.

Figure 1:China nominal GDP 1980 to 2010

Source: World Bank

Deadly size, deadly speed

Deadly combination of size and growth. China explosive growth in GDP and per

capita income combine with her size, rapidly turned China into an important playerin the world economy.

In 1980, China GDP was USD76bn. US GDP was USD2,788bn or 37x larger But over the 30 year period from 1980 to 2010, China grew at 16% p.a. vs

US at 5.6% p.a.

Consequently, in 2010, China GDP has grown to USD6,687bn. US GDP ofUSD14,552bn is now only 2x larger

Hence, in only three decades, China went from a non-event to the second largest

economy in the world. Not only that, and in contrast to US, China is still a rapidly

1RMB47tn in 2011


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growing economy whereas the US economy has all but stalled. It wont be long

before China overtakes US to be the worlds largest economy.

Also, the size of Chinas economy is understated since generally such comparisons

are made in USD. As the RMB appreciates, the gap between these two economies

will quickly close.

Comparison between US and China GDP growth over the past 30 yearsTable 1:

Nominal GDP (USD bn) 1980 2010 CAGR Rank 2010

US 2,788 14,552 5.6% 1st

China 76 6,687 16.0% 2nd

US / China 37x 2x

Assumed USD1 = RMB6

Size does matter. With 1.3bn people, China has the largest population in the world

and at 16% p.a. nominal GDP growth, China is also one of the worlds fastest

growing economy. It would be remiss to label China a developing giant. China is

already a giant.

In trade, China is the worlds:

Number 1 exporter Number 2 importer (after US) Busiest port (Shanghai is ahead of Rotterdam and Singapore)

In financial market, China is the worlds:

Largest creditor nation (owns 20% of US treasury) Number 1 in FDI Number 1 forex reserve (a third of world total)

In consumption, China is the worlds:

Largest car market (and growing 30% a year) Largest consumer of energy (20% of world total) Largest consumer of coal (48% of world total) Largest consumer of steel (47% of world total) Largest consumer of cement (54% of world total) Largest consumer of soybean (60% of world total)

As can be seen, China is already making her presence felt in various markets

ranging from financial to resources. It would be hard to talk about these markets

without mentioning China in the same breath. Consider this. Since China consumes

almost half the output in raw materials such as coal, steel, cement and soybean,

changes in Chinese demand will materially impact these markets.


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Reforms - The Why and When of Chinas Rise

What went wrong Central planning under Mao

People forget that 500 years ago, China was the world's sole superpower.

When many Europeans were living in mud huts and scratching the soil with

sticks, China was the greatest economic and military power on earth.

A hundred years before Europe began its mastery of Asia and America, China

had the biggest and best navy in the world. But for an accident of history,

Europe would be speaking Chinese today.

Given this economic, military and technical head start, what happened?

Europe, not China, became the world's colonizer and mapmaker. Why did China

do so badly in the modern era?

TIME magazine

Failed experiment with central planning. The Chinese Communist Party (CCP)

under Mao took control of China in 1949 and by 1956, nationalised all private

enterprises and introduced central planning.

Mao version of central planning involved organising households into communes. A

commune is an economic unit where land is collectively owned by its members.

90% of China rural households were organised into such communes and by 1979,

there were 53,300 communes divided into 699,000 brigades and 5m production

teams with each production team consisting of 150 persons.

Needless to say, Mao communes failed as central planning could never be a viable

economic system since the most important coordinator of production, the price

mechanism, has been removed. Furthermore, as resources were jointly owned and

outputs jointly shared, there were no incentives to work harder or work smarter.

Not surprisingly, during China period of central planning, there was no increase in

food availability per capita. In fact, the average grain consumption in 1970s was

lower than during 1950s. China also experienced a famine in 1959-61 that cost

30m lives.

Correcting the wrong Market reforms under Deng

To get rich is glorious. By late 1970s, the CCP itself recognised the deficiencies in

central planning. However, real reforms could only be carried out after Maos

death in 1976. After Maos death, Deng Xiaoping came into power and thus began

Chinas path towards market reforms. In Dengs words, to get rich is glorious.

Deng started small in early 1980s but quickly introduced a succession of bold

market reforms. So successful were Deng reforms that by 1987, the CCP officially

used the term socialist market economy to describe Chinas economy. By this

stage, the communists have fully embraced capitalism.

In order to provide a sense of how different things could be under a centrally

planned economy, below are selected reforms introduced under Deng (and his

successors) in order to remedy the deficient central planning system:


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Moved agriculture back to household farming, undoing Maos communes Increased emphasis on enterprise profits. Enterprises are now allowed to

retain profits. Previously, excess profit was surrendered to the government

Allowed enterprise flexibility in hiring workers. Previously, workers wereallocated to enterprises by the State Labour Bureau

Allowed enterprise to borrow from banks to finance investment plans.Previously, opex and capex funds were allocated by central government

Allowed managers to change organisational structures. Previously,organisation structures were dictated from central planners

Introduced modern banking system by breaking up the People Bank ofChina into a central bank and four large commercial banks

Created two stock exchanges to facilitate privatisation of state ownedenterprises (SOE). The Shenzhen Stock Exchange and the Shanghai Stock

Exchange were created in 1990 and 1991 respectively

China before and after reformsTable 2:

Before After

Central planning Market economy

All services provided by state Mixture of state and private sector

Rural society Urban society

Agriculture Manufacturing and services

Closed economy Hub of world trade

And off we go. Once China unleashed capitalism under Deng in 1980, the economy

never looked back. For the next three decades from 1980 to 2010, China would

continue to register explosive GDP growth. The average five years growth in China

clearly jumped form 1985 onwards (see Figure 2).

Figure 2:China average five years growth 1960 to 2010

Source: World Bank


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GDP Manufacturing for the World

From agriculture to manufacturing

Abundant labour and expansion from the Eastern Coastal Region. Chinas switch

away from central planning released abundant labour into her economy. This

allows China to move up the value chain from what was then a predominantlyagricultural economy.

Geographically, economic growth started in Chinas Eastern Coastal Region before

gradually spreading inwards into the second and third tier cities. As a result, many

of the rich cities such as Shanghai and Guangdong are concentrated in the Eastern

Coastal Region while resource rich regions are located inland. There are a number

of reasons why growth began in the Eastern Coastal Region.

Firstly, the Eastern Coastal Region is where key river basins and port citiesare located and this facilitated imports/exports

Secondly, these coastal towns are also in close proximity to Hong Kong andTaiwan, where there already exist an established Chinese entrepreneurialclass. Most of the early capital coming into China were from these

overseas Chinese entrepreneurs who decided to move their manufacturing

to China in order to take advantage of the low labour cost

Initially, in the 1990s, China was reliant on light manufacturing such clothing, toys

and footwear. Such manufacturing accounted for 40% of Chinas exports. Today,

while China still manufactures these items, manufacturing has shifted more

towards electronics such as computers, phones, office equipments and other

electrical machineries. Today, these constitute 40% of Chinas exports.

Shift away from primary industry. Reflective of this development, primary

industry share of GDP declined from 30% in 1980 to 10% in 2010 while tertiaryindustry share of GDP increased from 22% in 1980 to 43% in 2010. Secondary

industry share of GDP remained constant at circa 50%.

Figure 3:China GDP by industry 1980 (L) and 2010 (R)

Source: China Statistical Agency

But strong growth all around. While primary industry is now a smaller portion of

GDP, all three segments actually grew rapidly in the 30 years from 1980 to 2010.

Primary grew 12% p.a., secondary industry grew 16% p.a. and tertiary industry


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grew 19% p.a. These are actually remarkably rapid growth sustained over an

extended period of time. China is simply producing more of everything.

Figure 4:China GDP growth 1980 to 2010


Is China over-investing?

Capital investment driver of GDP growth. From Table 3 below, it can be seen that

from 1980 to 2000:

Household consumption contribution to GDP declined from 51% in 1980 to33% in 2010

Gross fixed capital formation contribution (GFCF) to GDP increased from29% in 1980 to 45% in 2010

Government consumption contribution to GDP was stable at circa 13% Net export increased from 0% in 1980 to 4% in 2010

At 45% of GDP, China GFCF is large by any standard. On an absolute basis, it grew

from RMB132bn in 1980 to RMB19tn in 2010, a massive 138x increase. To put

things into perspective, US spent USD2tn in capital investment in 2010. China

RMB19tn (USD3.2tn) capital investment was 1.6x that of US.

This gives rise to concerns on whether the Chinese economy is rigged.

Considering that the private side of the economy (household contribution) is

declining, while the government side of the economy (government consumption

and GFCF) is increasing rapidly, it is understandable why there are concerns about

whether the government is overspending fiscally to generate GDP growth?

To answer this question, we would need to look closer at the breakdown for GFCF.

Unfortunately, Chinese statistics is very opaque. Such details are not available so

we have to look at another related statistics instead; fixed asset investment (FAI)2.

2Gross fixed capital investment is not the same as fixed asset investment. Generally GFCF will be smaller than FAI

as it less out fixed asset disposed


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China nominal GDP 1980 to 2010Table 3:

RMB bn 1980 1990 2000 2010 CAGR

Household consumption 233 945 4,585 13,329 14%

Government consumption 68 264 1,566 5,361 16%

Final consumption 301 1,209 6,152 18,691 15%

Gross fixed capital formation 132 483 3,384 18,234 18%

Changes in inventory 28 192 100 935 12%

Net export/(import) (2) 56 239 1,571 N/A

Stats disc (5) (73) 47 689 N/A

Nominal GDP 455 1,867 9,921 40,120 16%

Breakdown

Household consumption 51% 51% 46% 33%

Government consumption 15% 14% 16% 13%

Final consumption 66% 65% 62% 47%

Gross fixed capital formation 29% 26% 34% 45%

Changes in inventory 6% 10% 1% 2%

Net export/(import) 0% 3% 2% 4%

Stats disc -1% -4% 0% 2%

Nominal GDP 100% 100% 100% 100%

Source: World Bank

FAI growing rapidly, faster than GDP. Between 2000 and 2010, overall FAI grew by

24% p.a., almost 1.5x faster than GDP. As such, FAI is now RMB28tn or 69% of

nominal GDP of RMB40tn. This means out of RMB40tn worth of goods and servicesthat was produced by China in 2010:

Almost 69% of it was roads, bridges, equipment, factories, plants,properties, etc.

Only 31% of it was consumables (e.g. food, clothes) and services (e.g.haircuts, education, entertainment)

Out of the RMB28tn FAI, 62% was directed towards construction and 22% was

directed towards equipment purchase. Note that construction of properties is also

grouped under FAI and in 2010 this amounted to RMB4.8tn or 17% of FAI and 12%

of GDP.

Fixed asset investment by type, 2000 to 2010Table 4:

RMB bn 2000 2005 2010CAGR

00-10

Construction 2,054 5,338 17,135 24%

Equipment purchase 779 2,142 6,168 23%

Others 460 1,397 4,509 26%

Total FAI 3,292 8,877 27,812 24%

Real estate investment 498 1,591 4,826 25%



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But private sector driving FAI growth. Turning to the source of FAI, note that

State source of fund is growing relatively slower at only 18% CAGR Similarly for foreign source of fund (21% CAGR) and HK, Taiwan, Macau

funds (20% CAGR)

But, individuals source of fund has been growing rapidly at 31% CAGR Likewise, shareholding source of fund has also been rapidly at 36% CAGR

In short, the growth in FAI has been driven largely by the private sector (namely

individuals and shareholding) instead of the traditional state source of fund3. Not

only that, it seems that Chinas investment growth is now more domestically

generated as investment from foreign funds have lagged domestic spending.

Fixed asset investment by source 2000 to 2010Table 5:

RMB bn 2000 2005 2010 CAGR

State owned 1,650 2,967 8,332 18%

Collective owned 480 1,197 1,004 8%Individuals 471 1,389 7,008 31%

Jointly owned 9 23 83 24%

Shareholding 406 2,354 8,897 36%

Foreign funded 131 466 891 21%

HK, Taiwan, Macau funded 129 377 830 20%

Others 14 106 768 49%

Total FAI 3,292 8,877 27,812 24%


No reason to be too worried about large capital investment. Which brings us back

to our earlier question, is China disproportionately large capital investment a

problem?

The critics argued that the Chinese government has been artificially boosting China

GDP growth through profligate spending in infrastructure. Such coordination

would not be hard to do considering that the CCP has both political power and

control of China financial system. Despite being publicly listed, all the big four

banks in China is still controlled by the Chinese government so financing would not

be hard to come by. Under this scenario, once this artificial stimulus is

withdrawn, then China GDP will decline as capital investment contributes half of

GDP. Conceivably, this decline in activity will affect other sectors (e.g. buildingmaterials) and bad infrastructure projects will translate into bad loans resulting in

a spike in NPL for the state directed Chinese banks.

In our view, Chinas large capital spending is not as big a problem as it may appear

to be.

Firstly, the role of capital spending is overstated in Chinas GDP due to theinclusion of housing (which has been growing rapidly and which may lead

to oversupply but thats another topic). On our estimate, reversing out

3

We suspect that the growth in individuals source of fund is due to higher purchase of properties while growthfrom shareholding source of fund can be ambiguous as the government may still be a substantial shareholders in

such enterprises.


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housing will decrease GFCF contribution to GDP from 45% to circa 35%.

Now GFCF does not look as big as before

Secondly, most of the increase in capital spending is coming from theprivate sector and not state directed

Thirdly, China is not overbuilt. Chinas base metal intensity (e.g. steeldensity per capita, copper density per capita) is still only half that of

developed countries

Fourthly, the Chinese government is actively trying to slow down theeconomy not speed it up

Hence, for the above reasons, we do not find Chinas large capital spending to be

an issue.


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Trade At the Center of World Trade

China place in world trade

No 1 in imports, no 2 in exports. In 30 years, China has gone from being a closed

economy to being the worlds no 1 exporter and worlds no 2 importer.

China exported USD1,578bn worth of goods in 2010 or 10.4% of totalworld exports

China imported USD1,395bn worth of goods in 2010 or 9.1% of total worldimports

Leading exporters and importers 2010Table 6:

Rank Exporters USD bn % Importers USD bn %

1 China 1,578 10.4% US 1,968 12.8%

2 US 1,278 8.4% China 1,395 9.1%

3 Germany 1,269 8.3% Germany 1,067 6.9%

4 Japan 770 5.1% Japan 693 4.5%

5 Netherlands 572 3.8% France 606 3.9%

6 France 521 3.4% UK 558 3.6%

7 Korea 466 3.1% Netherlands 517 3.4%

8 Italy 448 2.9% Italy 484 3.1%

9 Belgium 411 2.7% Hong Kong 442 2.9%

10 UK 405 2.7% Korea 425 2.8%

Top 10 7,718 51% Top 10 8,155 53%

Others 7,520 49% Others 7,221 47%

World 15,238 100% World 15,376 100%

Source: WTO

A closer look at Chinas exports

Exporting heavy machines and textiles. In 2010, the size of China export was

USD1,578bn or RMB9.4tn (24% of China GDP of RMB40tn).

China exports grew 16% p.a. in the 30 year period between 1980 to 2010 95% of Chinas exports is in the form of manufactured goods. Primary

goods contribute the remaining 5%

Manufactured goods exports (19% growth p.a.) have grown much fasterthan primary goods exports (8% growth p.a.)

Machinery and transport equipment is the single biggest category ofexports (50% of total)

It is also interesting to look at what China is not exporting. Natural resources is one

item China is clearly not exporting as China is herself hungry for such resources.


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China exports 1980 to 2010Table 7:

USD bn 1980 1990 2000 2010 CAGR

Food 3 7 12 41 9%

Beverages and tobacco 0 0 1 2 11%

Non food raw mat 2 4 4 12 7%

Mineral fuels, lubricants and others 4 5 8 27 6%

Animal and vegetable oils, fats, waxes 0 0 0 0 6%

Primary export 9 16 25 82 8%

Chemicals and allied products 1 4 12 88 16%

Light, textile, rubber, minerals, iron 4 13 43 249 15%

Machinery and transport equip 1 6 83 780 26%

Misc products 3 13 86 378 18%

Not classified 0 12 0 1 7%

Manufactured export 9 46 224 1,496 19%

Total export 18 62 249 1,578 16%

Source: IMF

Half of China exports stay in Asia. About half of China exports stay in Asia and

about 40% of China exports go to Europe and US. In the past, exports to Asia

occupied an even bigger proportion but this has gradually declined as exports to

developed regions such as Europe and America grew faster.

China export by region 1990 to 2010Table 8:

USD bn 1990 2000 2010 CAGR

Asia 45 132 732 15%

Africa 1 5 60 21%

Europe 9 45 355 20%

Latam 1 7 92 27%

North America 6 55 306 22%

Oceania and pacific 1 4 33 22%

Total export 62 249 1,578 18%

BreakdownAsia 72% 53% 46%

Africa 2% 2% 4%

Europe 15% 18% 23%

Latam 1% 3% 6%

North America 9% 22% 19%

Oceania and pacific 1% 2% 2%

Total export 100% 100% 100%

Source: IMF


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A closer look at the top 10 exports destinations reveal that after US, the next top

three export destinations are Hong Kong, Japan and South Korea respectively. This

indicates that the bulk of China exports are meant for further processing at other

Asian countries before being shipped to final consumers.

China top 10 exports destinations 2010Table 9:

Rank Destination USD bn

1 US 283

2 Hong Kong 218

3 Japan 121

4 South Korea 69

5 Germany 68

6 Netherlands 50

7 UK 39

8 Singapore 32

9 Italy 3110 Taiwan 30


US is Chinas biggest export partner. In 2010, almost a fifth of China exports went

to US. Interestingly, in 2004, Walmart spent USD18bn on merchandise trade with

China on products such as toys, footwear, sporting equipments, etc. If Walmart

was a country, it would be Chinas sixth largest trading partner.

A closer look at Chinas imports

Importing intermediate capital goods and raw materials. In 2010, the size of

China import was USD1,395bn or RMB8.4tn (20% of China GDP of RMB40tn).

China imports grew 15% p.a. in the 30 year period between 1980 to 2010 In contrast to exports, China imports is not biased towards manufactured

goods but include primary goods as well

About 1/3 of China imports consist of primary goods. Raw materials andenergy are major components

Machinery and transport equipment is again the single biggest category ofimports (40% of total) and this underscores Chinas role as an assembler

4

4

For example, US largest exports and imports to China are both machinery and equipment. This is because UScompanies take advantage of China cheap labour by sending components to China for assembly. Subsequently,

these are sent back to US as imports


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China imports 1980 to 2010Table 10:

USD bn 1980 1990 2000 2010 CAGR

Food 3 3 5 22 7%

Beverages and tobacco 0 0 0 2 15%

Non food raw mat 4 4 20 211 15%

Mineral fuels, lubricants and others 0 1 21 189 26%

Animal and vegetable oils, fats, waxes 0 1 1 9 13%

Primary import 7 10 47 433 15%

Chemicals and allied products 3 7 30 150 14%

Light, textile, rubber, minerals, iron 4 9 42 131 12%

Machinery and transport equip 5 17 92 550 17%

Misc products 1 2 13 114 20%

Not classified 0 9 2 18 14%

Manufactured import 13 43 178 962 15%

Total import 20 53 225 1,395 15%

Source: IMF

2/3 of imports from Asia. In contrast to exports where about 40% goes to Europe

and Asia, China imports is essentially one-sided with almost 2/3 of imports coming

from its Asian neighbours. Hence, just as Europe and US are important export

partners for China, China is in turn, an important export partner for Asia.

China import by region 1990 to 2010Table 11:

USD bn 1990 2000 2010 CAGR

Asia 29 141 835 18%

Africa 0 6 67 30%

Europe 13 41 218 15%

Latam 2 5 91 23%

North America 8 26 117 14%

Oceania and pacific 1 6 66 21%

Total import 53 225 1,393 18%

Breakdown

Asia 54% 63% 60%

Africa 1% 2% 5%

Europe 24% 18% 16%

Latam 3% 2% 7%

North America 15% 12% 8%

Oceania and pacific 3% 3% 5%

Total import 100% 100% 100%

Source: IMF

Chinas top three sources of imports are Japan, South Korea and Taiwan. About 1/3

of China imports is sourced these three neighbours.


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China top 10 source of imports 2010Table 12:

Rank Source USD bn

1 Japan 177

2 South Korea 138

3 Taiwan 116

4 USA 102

5 Germany 74

6 Australia 61

7 Malaysia 50

8 Thailand 33

9 Russia 26

10 Singapore 25


Chinas balance of payment

Large trade surplus and net investment inflow. As China exports has been growing

faster than imports, China has been accumulating trade surplus on goods.

In 2010, this amounted to USD254bn and is the main contributor to Chinaoverall current account surplus of USD305bn

Increasing net investment inflow has also resulted in a positive financialaccount surplus to the tune of USD221bn in 2010

Sustained surplus in both the current and financial account result in Chinacontinuing to accumulate forex reserve. In 2010, a sizeable USD472bn was

added China forex reserve

China balance of payment 1990 to 2010Table 13:

USD bn 1990 2000 2010

Goods 9 34 254

Services 2 (6) (22)

Income 1 (15) 30

Transfers 0 6 43

Current account 12 21 305

Direct investment 3 37 125

Portfolio investment (0) (4) 24

Other investment 0 (32) 72

Financial account 3 2 221

Capital account - (0) 5

Statistical discrepancy (3) (12) (60)

Change in reserve 12 11 472

Source: IMF


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US has the largest trade deficit with China. From a country perspective, Hong

Kong ran the largest trade deficit with China (USD206bn in 2010). If we ignore

Hong Kong on the basis that most goods to Hong Kong are meant for re-exports

then US ran the largest trade deficit with China. In 2010, US trade deficit with

China was USD181bn, dwarfing Netherlands (the next in line) by 4x.

China surplus/(deficit) with main trading partners 1990 to 2010Table 14:

USD bn 1990 2000 2010

HK 12 35 206

USA (1) 30 181

Netherlands 1 5 43

UK (1) 3 27

Italy (0) 1 17

France (1) (0) 11

Singapore 1 1 8

Canada (1) (1) 7

Russia 0 (4) 4

Indonesia (0) (1) 1

Germany (1) (1) (6)

Thailand 0 (2) (13)

Malaysia (0) (3) (27)

Australia (1) (2) (34)

Japan 1 0 (56)

South Korea 1 (12) (70)

Taiwan (2) (20) (86)

Source: IMF


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Fiscal No Worries Here

Market economy and tax reforms

Transition to market economy reduced tax revenue. Prior to 1980s, China was a

centrally planned economy and the government budgetary processes reflected

this. Under this system, all outputs were first centrally collected and then re-allocated.

Upon embarking on market reforms, the government introduced tax reforms to

replace the old budgeting mechanisms. State enterprises now pay income tax

instead of contributing profits. The reforms resulted in a decline in government

revenue due to inefficient tax collection, widespread tax evasion and low tax base.

Government revenue to GDP ratio declined from 25.7% in 1980 to a low of 10.7%

in 1995.

Figure 5:Total government revenue to GDP


1994 tax reforms introduced to reverse revenue decline. To arrest the decline in

revenue, another round of tax reforms were introduced in 1994.

The central government role in revenue collection was strengthened The tax base was broadened. For example, when VAT was first introduced

in 1984, it applied only to a small based of products. From 1994 onwards,

the VAT was imposed on all production, wholesale, retail and import of

goods

New taxes were introduced. Consumption tax was also introduced in 1994on items such as alcohol, tobacco, cosmetics, fireworks, jewelry and

gasoline

The 1994 tax reforms were successful and the revenue to GDP recovered from

1994 onwards. The new taxes introduced now form the backbone of Chinas

government revenue.


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A closer look at government revenue

VAT key contributor to revenue. Subsequent to the 1994 tax reforms, the two

largest components of revenue are now VAT and business tax. Collectively, these

contributed 40% of revenue in 2010.

VAT is the largest contributor to revenue at 25%. VAT is a tax levied onprovision of goods and services, The VAT rate is generally at 17% butexporters may be eligible for refunds

Business tax is the second largest5 contributor to revenue at 13%. Businesstax is a tax on certain business transactions such as sale of property,

intangible assets and provision of certain services that are currently not

subjected to VAT. The business tax rate ranges from 3% to 20%

Another key tax is consumption tax (circa 7%) which is levied at non-essential or luxury items such as alcohol, cosmetics, jewelry etc

China does not have capital gains tax but does have a land appreciation tax Also, personal income tax (circa 7%) is yet to be a major contributor as is

the case in developed countries6

Figure 6:VAT, business and consumption tax contribution to govt revenue, 2010


Key taxes controlled by central govt. Taxation can be broadly divided into central

government taxes, local government taxes and shared taxes.

The most important tax, VAT, is collected by the central government. 75%of VAT collected goes to the central government and 25% goes to localgovernments

Central government also collects consumption tax which are excises ongoods such as tobacco and luxury goods

5Company tax is actually tied with business tax for second place as they are almost the same in size. However, as

the statistics for company tax is no longer consistently reported, it has been grouped under other tax. Otherwise,

collectively business tax and company tax contributes another 25% to government revenue or 50% if VAT is

included6

On a related topic, social security contribution is comparatively high in China. Employers are expected to

contribute 20% of basic pay while employees contribute 8%


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Central government collects 60% of company income tax and 60% ofpersonal income tax and local governments collect the remainder

Local governments collects 100% of business tax A prominent area of taxation reserved for the local governments is land tax

which is now a lucrative source of revenue. It is estimated that a quarter of

local government revenue now comes from land tax7

The central government also plays a redistributive role. A third of local

governments revenue came from redistribution from the central government

Division of revenue between central and localTable 15:

Central Shared Local

Tariffs

Consumption tax

Vehicle purchase tax

Cargo tax

Value added tax

Personal income tax

Company income tax

Stamp duty

Business tax

Maintenance and

development tax

Contracts tax

Resource tax

Land tax

A closer look at government expenditure

From hardware to software. The four main categories of government

expenditure are economic construction, social, defense and administrative. Overtime, total allocation to these four categories has gradually declined. In 1980s,

these four categories collectively accounted for 96% of government expenditure

but in 2006, they have declined to 80%.

Allocation to economic construction halved from 58% of governmentexpenditure in 1980 to 27% in 2006

Similarly, allocation to defense declined from 16% in 1980 to 7% in 2006 But, social expenditure increased from 16% in 1980 to 27% in 2006 And administrative expenditure tripled from 6% in 1980 to 19% in 2006 The most rapid growth is seen in the other exp category which increased

4x from 5% in 1980 to 21% in 20068

Therefore, since 1980s, China has gradually shift focus from expenditure on the

hardware side of the economy such as infrastructure and defense to the

software side of the economy such as social and educational expenditure.

7Some have flagged this as a potential issue as in recent years, the growing property market in China has resulted

in extra revenue for local governments from land sale8

Unclear what is captured here as statistics not further broken down


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Figure 7:Key government expenditure, 1980 to 2006


An increase across the board. China total government expenditure increased from

RM1.6tn in 2000 to RMB4tn in 2006, a 2.5x increase. Not only that, expenditure in

every single category was higher in 2006 compared to 2000.

Government expenditure 2000 vs 2006Table 16:

RMB bn 2000 2006

Economic construction 575 1,073

Social, cultural and educational 439 1,085

National defense 121 298

Administration exp 277 757

Other exp 178 829

Total government expenditure 1,589 4,042


Strong fiscal position overall

Revenue and expenditure growing 20% a year. Chinas government collected

RMB8.3tn in revenue or 21% of GDP in 2010. China spent slightly more than it

collected with expenditure at RMB9tn or 22% of GDP in 2010. Both government

revenue and expenditure have been growing very rapidly at around 20% p.a. forthe last ten years.


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Figure 8:Fiscal revenue and expenditure


But small fiscal deficit. Because revenue and expenditure has been growing in

lockstep, China fiscal deficit continues to be negligible.

In 2010, China collected 21% of GDP in revenue and spent 22% of GDP inexpenditure resulting in a net fiscal deficit of 1% which was easily covered

by borrowings

Typically, deficits are less than 1.5% of GDP The worst year on record was a 2.8% deficit during the 2009 global

recession as revenue collection slowed

Figure 9:Fiscal surplus/(deficit) to GDP

Overall, China looks healthy fiscally. China combination of (1) small budget deficits

(2) fast growing economy (3) low government debt and (4) large forex reserve put

China in a strong fiscal position (especially when compared to her western

neighbours).


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Monetary No Laissez Faire Here

Still at a nascent stage

Barely 30 years old. As per other facets of Chinas economy, the monetary system

only began to take form in the 1980s.

Prior to 1980s, China had neither a central bank nor commercial banks.The economy had only one bank, the Peoples Bank of China(PBC). Even

then, the PBC was technically not a bank but more of an extension of the

government

After 1980, China monobank system was abandoned and the PBC wasredesignated as China central bank

Despite taking the form of a modern banking system, most lending was stilldirected (an issue which continues today). The indiscriminate lending led

to skyrocketing NPLs9

in the late 1990s that required a bank bailout

Key milestones in China monetary systemTable 17:

Central bank and administrative policies

Lacking independence. The PBC was established in 1948 shortly after

establishment of the Peoples Republic of China and for almost 30 years until 1978,

PBC was the only bank in China and it was not until 1983 that the PBC was formally

established as Chinas central bank. Around this time as well, the PBCs commercial

banking function was divided amongst four newly created state-owned banks.

Unlike central banks in developed countries, PBC do not have legal and functional

independence. PBC serves only in an advisory capacity and is subordinate to the

State Council.

9Estimated to be 50%

Year Event

2010 Agricultural Bank of China, the last of big four was listed

2006 PBOC began using RRR to sterilise FX inflow

2005 PBOC ended 10 year RMB peg against USD

2003 Separate banking regulatory commission established

2003 Second round of bank recapitalisation

1998 PBOC abolished directed lending

1998 First bank bailout. Bank recapitalisation took place (about 18% of GDP)

1996 PBOC began open market operations using treasury bonds

1995 PBC legally institutionalised as central bank

1994 Agricultural Bank, China Construction Bank turned into commercial

banks

1983 First commercial bank, ICBC, established PBC designated central bank

Pre-1980 China under monobank system. The PBC was simply an extension of

fiscal authority. Funds allocated based on production plans


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Not your standard monetary tools. While the PBC has the same arsenal of

monetary tools as other central banks in developed countries (e.g discount rate,

open market operations, reserve requirements), there are key administrative

differences that sets PBC apart.

Unlike central banks in developed countries, China had strict credit control up until

the late 1990s which controls the size and direction of credit expansion.

Credit quota imposes limit on the total annual credit that banks canextend. While such practices have been formally abolished today, PBC still

maintain significant persuasive power over credit practices

Consequently, commercial banks could not always direct funds as they seefit but may be forced to direct funds into less credit worthy sectors

This renders some of the other standard monetary tools less useful. Forexample, with an annual credit quota in place, the discount rate has little

effect on lending since lending is restricted by quotas

Other distortive administrative measures include setting the ceiling on deposit

rates, the floor on lending rates and coupon rates on corporate bonds.

China managed exchange rate system

PBC and exchange controls. For most of 1980s, China operated a fixed exchange

rate system with frequent devaluations of the RMB.

Between 1988 and 1993, China operated a dual system consisting of anofficial exchange rate and a market rate determined in swap centers

This system broke down in 1994 when the official rate became increasinglyovervalued. The official rate was discarded and replaced by the market

rate at the swap centers

After 2005, the RMB was moved to a crawling peg against an undisclosedbasket of currencies but it was still essentially tied to the USD

In order to maintain control over monetary policy, China relies on two elements (1)

PBC intervention (2) a closed capital account.

The PBC intervenes by standing ready to buy or sell forex from the banks.For example, when a Chinese exporter is paid USD, the exporter will

exchange the USD for RMB at the bank. The bank will then sell the USD to

PBC in exchange for RMB at the official exchange rate

Generally, forex transactions are made to facilitate a transaction ingoods/services. However, a larger and more volatile flow takes place in the

capital account. In order to preserve PBC capacity to act as a buyer/seller

of last resort and prevent sudden changes in the money supply, China

closed the capital account. Capital injections, trade settlement in foreign

exchange, overseas financing and profit repatriations are under State

Administration of Foreign Exchange (SAFE) regulations

Sterilisation by the PBC. Since PBC stands ready to exchange forex for RMB at a

pre-defined rate, as China trade surplus increases, more and more forex is being

converted into RMB. This has two effects. Firstly, China forex reserves continue torise and secondly more RMB is added into the local monetary system.


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The additional RMB introduced into the system constitute monetary expansion. To

avoid the unwanted monetary expansion, China can either (1) let the RMB

appreciates (2) sterilize. Thus far, China has pursued the second option through

issuance of short term debt to the local banks and increase in the reserve

requirement of banks.

A looming Chinese banking problem?

Chinese banks now very profitable. The Chinese banks currently operate in a

protected environment. With a closed capital account and an underdeveloped

capital market (both equity and bond), the Chinese banks dominates both savings

and financing. This allows the banks to grow very rapidly. Credit to GDP has tripled

from 50% in 1980 to 150% in 2010.

Figure 10:Credit as a percentage of GDP, 1980 to 2010

Source: World Bank

Furthermore, due to the savings rate ceiling and loan rate floor imposed by the

central bank, the banks are guaranteed a positive spread. Consequently, the banks

enjoy both a growing asset base and a positive spread resulting in growing profits.

Total banking system PAT increased rapidly from just RMB32bn in 2003 to

RMB899bn in 2010.

Figure 11:Chinese banking system PAT 2003 to 2010

Source: CBRC


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But a history of NPL problems. However, because historically Chinese banks were

no more than an extension of the government, most of the Chinese banks

operations, procedures and organisational structures were still geared towards the

distributing credit rather than market based assessment.

This leads to high NPLs which came to light in the mid-1990s when China

experienced a recession. The significantly affected the banks and they buckled

under NPLs estimated to be has high as 50%. The Chinese government respondedwith a banking bailout in 1998:

RMB270bn (3% of GDP) was injected into the four commercial banks Since then, the banks have written off about 40% of their loan portfolio Four asset management companies (AMC) were created to purchase

RMB1.4tn (14% of GDP) of NPLs from the banks. These NPLs were

purchased at face value (not written down)

Will China face another NPL problem soon? This brings us to our main concern

about China.

Despite market reforms, China banking system is still the sector least subjected tomarket forces. The government still controls the banks through both direct

ownership and indirect influence. The central bank also imposes various

administrative measures and intervenes in the forex market. As highlighted above,

all these distortions led to huge NPLs and a subsequent banking bailout in 1998.

Since such distortive lending practices and administrative measures are still in

place today, is China due for another NPL problem?

Officially, that does not seem to be the case. The formal NPL statistics seem to

indicate that the NPL of Chinese banks have declined from a high of 30% in 2001 to

a very low 1% in 2010.

Figure 12:NPL of banks, 2000 to 2010

Source: CBRC

However, we would exercise caution here.

Firstly, the NPL appears too low. A 1% is an overly low NPL on all accountand implies that the Chinese banks are very good at assessing and

managing risk. This is hard to believe considering that just a decade ago,

the NPLs were 30% to 50%. Furthermore, the banking sector continues to

be influenced more by government directive than market signals. All themore reasons for higher not lower NPLs


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Secondly, the problems with the NPLs in the late 90s are still unresolved.While the government created AMCs to take the NPLs off the banks

balance sheet, the problem still exists at the AMC level. The AMCs still

need to recover these NPLs. Anecdotally, the NPL recovery rate is only 30%

implying that the banks assets need to be written down as well

Hence, despite the growing profitability of Chinese banks, all is not as well as it

seems. We would not be surprised if NPL problems resurface again.

Too early to worry. We believe that the banking sector could be Chinas Achilles

heel.

Firstly, in a country as large and diverse in China, any serious problem inthe economy would probably be financial in nature

Secondly, the continued lack of market discipline and transparency inChina financial system add to the agony. In particular, the still unresolved

NPL problems from a decade ago could lit the fuse to Chinas next big

problem just as it did in the late 1990s

Yet, despite all the above, we are just mildly negative on a potential financialproblem in China for now. This is an issue with many fast moving parts. But

considering China strong economy and financial position, we prefer to err on the

side of optimism for now. Recall that China had to deal with failing SOEs, a political

uprising and 50% NPL in the late 1990s. China did that successfully and a few years

after that, the Chinese stock market had its most successful run before being

halted by the global recession in 2008. We would argue that China is in a stronger

position today compared to a decade ago and has enough bullets to deal with any

potential problems.


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Equity Market China Three Exchanges

China stock markets bigger than you think

Largest in Asia with market cap of USD5.7tn. Collectively, Chinas stock exchanges

are the largest in Asia.

Two of China three stock exchanges are amongst the top 10 largest stockexchanges in the world. Shanghai Stock Exchange (SSE) at USD2.4tn and

Hong Kong Exchanges (HKEx) at USD2.3tn are ranked 6th

and 7th

globally

Shenzhen Stock Exchange (SZSE) is ranked 13th with USD1tn in marketcapitalisation. This puts SZSE ahead of the Korea Stock Exchange, the

Taiwan Stock Exchange and the Indian exchanges

China three stock exchanges have USD5.7tn in market capitalisation.Collectively, the Chinese exchanges are larger than even the USD3.5tn

combined size of Tokyo Stock Exchange and Osaka Stock Exchange

Figure 13:Top 10 stock exchanges worldwide (end 2011)

Source: WFE

Big China, big companies. Considering how China is synonymous with size, it

should be no surprise to find very large listed companies on the Chinese

exchanges. Three out of the worlds ten largest companies are listed on the

Chinese stock exchanges.

Petrochina is ranked 3rd

behind Exxon-Mobil and Apple

ICBC is ranked 5th behind Royal Dutch Shell at 4th China Mobile is ranked 10th behind Walmart at 9th

Furthermore,

There are a total of 810 companies whose market cap is USD100bn andabove namely China Mobile, Petrochina, ICBC, Agricultural Bank of China,

Bank of China, China Construction Bank, China Petroleum, China Shenhua

10After adjusting for companies listed in both HK and China to avoid double counting


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There are 6 companies whose market cap is between USD50bn andUSD100bn, namely CNOOC, Tencent, China Life, Ping An Insurance, China

Merchants Bank, Shanghai Pudong Development Bank

There are 83 companies (not adjusted for dual listing) whose market cap isbetween USD10bn-USD50bn

In total, there are close to a hundred companies that are listed on the Chinese

stock exchanges that have a market cap of USD10bn and above.

Companies listed in China exchanges 2011 (not adjusted for dual listing)Table 18:

Size HKEx SSE SZSE

USD100bn and above 8 7 0

USD50bn up to USD100bn 5 4 0

USD10bn up to USD50bn 46 37 9

Less than USD10bn 1,437 883 1,402

Total 1,496 931 1,411

Source: Bloomberg

Market valuation not excessive

One in HK, two in mainland. In terms of size, HKEx and SSE are similar in size at

circa RMB15tn in market capitalisation11

while SZSE is approximately half the size

at RMB6.6tn.

However, HKEx is a more mature exchange compared to SSE and SZSE witha turnover of 69% compared to 135% for SSE and 272%

HKEx also has a higher dividend yield of 3.3% compared to 2.2% for SSEand 1% for SZSE

With high turnover and low yield, the two mainland exchanges have amore speculative flavour

Overview of HKEx, SSE and SZSETable 19:

Exchange Companies Market cap Turnover Div yield P/E

HKEx 1,496 HKD17.5tn 69% 3.3% 9.7x

SSE 931 RMB14.8tn 135% 2.2% 11.2x

SZSE 1,411 RMB6.6tn 272% 1.0% 19.3x

11HKD1 = RMB0.8, USD1 = HKD7.8, USD1 = RMB6


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Very high velocity in mainland exchanges. From the perspective of turnover

velocity, the mainland exchanges exhibit very high velocity. SZSE and SSE are

ranked 2nd

and 5th

respectively in terms of velocity globally. SZSE and SSE velocity

of 269% and 155% implies that 2.7x and 1.5x of their market capitalisation are

traded annually. In contrast, HKEx has a more moderate velocity of 69%.

Figure 14:Top 10 exchanges by turnover velocity 2011

Source: WFE

Relatively attractive yield. Generally, companies listed in fast-growing economies

command high P/E in line with high growth expectations. The converse of high P/E

is low dividend yield. However, despite Chinas breakneck growth, the Chinese

markets are not excessively priced with yields higher than most government bond

yields (see Figure 15).

Figure 15:Selected dividend yields and bond yields, March 2012

Source: Bloomberg


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The ongoing liberalisation of Chinese stock markets

From retail to institutional. Due to Chinas restriction on capital movement, a

disproportionately large 60% of Chinas tradable12

shares is actually held by retail

investors. This is in contrast more developed market where institutional investors

are the major player. However, this is gradually changing as China relaxes capital

control.

Continued expansion of QFII. China introduced the Qualified Foreign Institutional

Investor (QFII) system in 2002 to allow foreign investors to invest in China equity

and debt markets. Previously, foreign investors only had access through the B-

share market.

China is now accelerating the expansion of QFII. As at end of 2011, China had 129

institutions under QFII status with investment quota of USD30bn. In March 2012,

China expanded the program to more institutions and significantly expanded the

investment quota to USD80bn. There are currently 158 institutions from 23

countries under QFII with the following breakdown.

Figure 16:Breakdown of QFII institutions (L) and investment (R), March 2012

Source: CSRC

The total asset held by QFII institutions as at March 2012, is RMB267bn (about half

of the USD80bn quota) with 74% of it allocated to equities.

The A-S of Chinese shares

The alphabet soup. China recognises that it is to its benefit to list state-ownedenterprises (SOE) as listing will subject the SOEs to the scrutiny of professional

investors thereby improving performance and accountability. At the same time,

China also wish to retain control of these SOEs. Consequently, China came up with

a complicated share segmentation scheme for these listed SOEs.

Both A-shares and B-shares are traded on SSE and SZSE. The other shares are

traded in overseas markets.

A-shares. A-shares are shares of Chinese enterprises incorporated inChina. Chinese nationals are free to trade the shares but in order to

12The emphasis here is on tradable shares. Non-tradable shares, which constitute a large block of Chinese

companies market capitalization is still exclusively held by the government


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control foreign participation, only foreign institutions under the QFII are

allowed to trade (by quota). A-shares are quoted in RMB. The market

consists overwhelmingly of A-shares.

B-shares. B-share were originally created to cater to foreign investors andare denominated in HKD/USD. Initially, only foreign institutions were

allowed to purchase B-shares but now Chinese nationals are also allowed

to participate.

C-shares. C-shares are big control blocks in SOEs that are deemed nottradeable in order to preserve China control over SOEs. As such, they are

not listed on both exchanges and any transfer requires the approval of

CSRC.

H-shares. H-shares are formally stocks grouped under Hang Seng ChinaEnterprises Index and are shares of Chinese company incorporated on the

mainland but traded on HKEx. H-shares represent the largest market for

Chinese stocks outside China. Its capitalisation was HKD4tn in 2011.

N-shares. N-shares are similar to H-shares but traded on NYSE. L-shares. L-shares are similar to H-shares but traded on LSE. S-shares. S-shares are similar to H-shares but traded on SGX.

Overview of A-share, B-share and H-shareTable 20:

Registr

ationListing Currency Investor

Listed

companies

Market

cap

A-share PRC PRC RMB PRC, foreigners

via QFII

2,342 RMB21tn

B-share PRC PRC HKD/USD PRC, foreigners

H-share PRC HK HKD Foreigners, PRC

via QDII

139 HKD4tn/

RMB3tn


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In Detail: Hong Kong Stock Exchange

Size and growth

On an uptrend due to China H-shares listing. HKEx market capitalisation was little

changed between 1999 and 2003. There onwards, HKEx market capitalisation

began to increase rapidly from HKD6.7tn in 2004 to a high HKD20.7tn in 2007before declining by half to HKD10.3tn in 2008. HKEx market capitalisation stands at

HKD17.5tn as at end of 2011.

The rapid rise in HKEx market capitalisation from 2004 onwards can be attributed

to two factors. Firstly, the rise coincided with the general bull market in 2006-2008

period that was subsequently ended by the Lehman crisis. Secondly, this period

also witnessed a number of large H-shares IPO listed on HKEx. In fact, H-shares

now constitute a quarter of HKEx capitalisation.

Figure 17:HKEx market capitalisation 1999 to 2011

Source: HKEx

Slow and steady. The number of companies listed in HKEx showed a burst of

activity pre 2003 but the growth has been more subdued since then despite the

increase in H-shares listing. As at 2011, there were 1,496 companies listed on the

HKEx.

Figure 18:HKEx no of listed companies 1999 to 2011

Source: HKEx


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Financials dominate capitalisation. Not surprisingly, the financial sector

constitutes 30% of HKEx capitalisation considering the exchange is home to three

out of China Big 4 banks. Other noteworthy sector includes telecommunication

which is effectively driven by just one company, China Mobile. At a market

capitalisation of HKD1.7tn, the mammoth China Mobile constitutes 10% of HKEx

capitalisation on its own.

Figure 19:HKEx market cap by sector and country of incorporation, end 2011

Source: HKEx

Slight increase in velocity in recent years. There appears to be an increase in

velocity post Lehman crisis. Excluding the bull market years of 2007 and 2008

where velocity was at 81% and 123%, the velocity pre-2007 mostly clustered

around 50%. However, post 2008, velocity appeared to have increased slightly to

around the 60%-70% mark.

Figure 20:HKEx turnover velocity 1999 to 2011

Source: HKEx


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Market valuation

Dividend yield declining. Post the tech crash of 2001, HKEx dividend yield have

declined from 3.4% in 2002 to 2.3% in 2010. Here, we have excluded the abnormal

year of 2008 where dividend yield spiked to 5.4%. Also note that dividend yield

appear to have spiked again 2011 to 3.3%. Generally, one would expect HKEx

dividend yield to follow the path of US interest rates as HKD is fixed to USD.

Figure 21:HKEx dividend yield 1999 to 2011

Source: HKEx

P/E surprisingly low lately. Again excluding the abnormal years of 2007 and 2008,

P/E has generally been around the 16x-18x range. However, 2011 appear to be

peculiar as P/E declined to 9.7x which appears to be a very low multiple for a

market tied to fast growing China.

Figure 22:HKEx average P/E and P/B 1999 to 2011

Source: HKEx

Hang Seng Index composition and performance

Large well developed companies. The Hang Seng Index is a free-float capitalisation

weighted index of companies listed on the Hong Kong Exchange. There are 48

members in total. The index is fairly concentrated with the four stocks constituting

almost 40% of the index weight. These are HSBC and three China companies; ChinaMobile, China Construction Bank and ICBC.


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Top 20 companies in HIS by weight (as at Mar 2012)Table 21:

CompanyWeight

in HSI

Market cap

(HKD bn)

1 HSBC Holdings PLC 15.82 1,250

2 China Mobile Ltd 8.11 1,690

3 China Construction Bank Corp 8.06 1,5004 Industrial & Commercial Bank of China 5.14 1,820

5 CNOOC Ltd 4.55 712

6 Tencent Holdings Ltd 3.85 401

7 AIA Group Ltd 3.80 340

8 PetroChina Co Ltd 3.63 2,170

9 Bank of China Ltd 3.52 966

10 Hutchison Whampoa Ltd 2.72 341

11 Sun Hung Kai Properties Ltd 2.57 291

12 China Life Insurance Co Ltd 2.38 571

13 Cheung Kong Holdings Ltd 2.30 24214 China Petroleum & Chemical Corp 2.28 761

15 Hong Kong Exchanges and Clearing Ltd 2.17 143

16 CLP Holdings Ltd 1.94 161

17 Ping An Insurance Group Co 1.91 400

18 China Shenhua Energy Co Ltd 1.77 629

19 Li & Fung Ltd 1.66 149

20 Hong Kong & China Gas Co Ltd 1.53 160

Source: Bloomberg

Not particularly exciting return of 4.9%. Contrary to the perception that HK should

benefit from its proximity to China, HSI return is actually rather mediocre. Post the

1997 Asian Financial Crisis, HSI declined from 9,321 at end of 2002 before starting

a sustained upward movement over the next years culminating in a high of 27,813

in 2007 and crashing 48% to 14,387 in 2008. The HIS is currently at 18,464 as at

end of 2011. Taken from the low in 2002 to end 2011, the annual return is only

7.9% while taken from the decade ending 2011, the annual return is only 4.9%.

Figure 23:HSI Index 2000 to 2012

Source: Bloomberg


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HSI best years were in 2003, 2006 and 2007 where it returned 35%, 34% and 39%

respectively. 2003 can be seen as a recovery from a secular downtrend that began

with the Asian Financial Crisis while 2006 and 2007 were due to the general global

stock market exuberance seen during that period. We have excluded the 52%

return in 2009 as it was really just a partial recovery of the 48% correction seen in

2008. To date, the HSI has yet to surpass its 2007 high.

Figure 24:HSI annual return (year-end), 2000 to 2011

Source: Bloomberg

H-shares subsegment

Important but still 20% down from 2007. At HKD4tn, H-shares now constitute 25%

of HKEx market capitalisation. The number of Chinese companies listed in HKEx

continues to grow nominally. As at 2011, there were 139 H-shares listed on HKEx.

Figure 25:Number of H-shares 2005 to 2011

Source: HKEx

However, from a market capitalisation perspective, despite the increased in the

number of H-shares listed on HKEx, their overall size has not changed materially

from HKD5tn market capitalisation reached in 2007. In fact, as at 2011, the overall

market capitalisation of H-shares is 20% down from its size in 2007.


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Figure 26:Market cap of H-shares 2005 to 2011

Source: HKEx

HSCEI composition and performancce

The H-shares index. The Hang Seng China Enterprises Index (HSCEI) is free float

adjusted index of companies incorporated in China but listed on HKSE. The index

consists of 40 members and a 10% capping is applied to avoid single stock

domination. It is informally referred to as H-Shares index.

Top 20 companies in HSCEI by weight (as at Mar 2012)Table 22:

CompanyWeight in

HSCEI %

Market cap

(HKD bn)

1 PetroChina Co 10.11 2,1702 China Construction Bank 10.05 1,499

3 Bank of China 9.75 985

4 Industrial & Commercial Bank of China 9.66 1,825

5 China Life Insurance 6.64 582

6 China Petroleum & Chemical 6.13 760

7 Ping An Insurance 5.33 411

8 China Shenhua Energy 4.92 638

9 Agricultural Bank of China 3.34 1,061

10 China Merchants Bank 2.71 319

11 China Telecom 2.53 33912 China Pacific Insurance Group 2.12 209

13 Bank of Communications 1.82 355

14 China Minsheng Banking 1.79 217

15 Dongfeng Motor Group 1.65 121

16 China Citic Bank 1.64 237

17 China Coal Energy 1.50 139

18 China Communications Construction 1.49 117

19 Yanzhou Coal Mining 1.46 116

20 Anhui Conch Cement 1.40 117

Source: Bloomberg


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Surprisingly good return of 18.9% per year over a decade. Similar to other Chinese

indices, the index reached a high of 16,125 in 2007 before dropping 50% to 7,982

in 2008. It stands at 9,936 as at end 2011, 40% lower than the high reached in

2007.

Figure 27:HSCEI Index 2000 to 2012

Source: Bloomberg

However, over the decade ending 2011, HSCEI return a much superior 18.9% per

year compared to the large HSI and SHCOMP at 4.9% and 2.9% respectively. The

source of this superior performance is the outsized gain of 152% and 94% in 2003

and 2006 respectively.

Since HSCEI is really just a subset of HSI and SHCOMP, such outperformance is

rather unexpected. However, as the facts would have it, the selection criteria of (1)

large Chinese companies and (2) listed in HKEx did contribute to the

outperformance.

Figure 28:HSCEI annual return (year-end) 2000 to 2011

Source: Bloomberg


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In Detail: Shanghai Stock Exchange

Size and growth

Volatile growth. The SSE was relatively dormant in the seven years between 1999

and 2005. During this period, SSE market capitalisation grew only 8% p.a.. Then in

2006 and 2007, SSE came alive and dramatically increased its market capitalisationby 3.1x in 2006 and 3.8x in 2007. Two large companies were also listed during with

ICBC RMB47bn IPO in 2006 and Petrochina RMB67bn IPO in 2007.

Subsequently, after reaching a year end high of RMB27tn in 2007, SSE market

capitalisation declined by a large 64% to RMB9.7tn in 2008 (following Lehman

crisis) before doubling to RMB18tn in 2009. As at end of 2011, SSE market

capitalisation stands at RMB14.8tn, 45% down from its year end high in 2007.

Figure 29:SSE market cap 1999 to 2011

Source: SSE

Slow growth in no. of companies. Between 1999 and 2004, in line with the

Chinese government privatisation of state-owned enterprises, the number of

companies listed on SSE increased from 484 companies in 1999 to 837 companies

in 2004. From 2005 onwards, new listings became more subdued and the total

number of listed companies hovered around the 900 mark.

Figure 30:SSE no of listed companies 1999 to 2011

Source: SSE


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Financials dominate market capitalisation. Banks and insurance are the dominant

sectors, constituting 32% of SSE market capitalisation. The next two large sectors

are manufacturing (at 24%) and mining (at 22%) in line with the Chinese economy

focus on manufacturing and resource extraction. Collectively, these three sectors

constitute a significant 78% of total SSE market capitalisation.

Figure 31:SSE market cap by sector 2011

Source: SSE

Very high turnover velocity. SSE has very high turnover velocity. Excluding the post

2001 tech bubble years where velocity declined below 80%, SSE velocity generally

exceeds 100%. This means the whole market capitalisation of SSE is traded every

year. Velocity increased significantly during periods of increasing market

capitalisation of 2006, 2007 and 2009. In fact, in 2007 and 2009, velocity exceeded

200% implying twice the size of SSE market capitalisation was traded in each of

those years.

Figure 32:SSE turnover velocity 1999 to 2000

Source: SSE


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Market valuation

Dividend yield a bit on the low side. While SHCOMP dividend yield has been

gradually increasing from sub 0.50% in 1999 to between 1.5% and 2.0% from 2003

onwards, it is still relatively low. For comparison, China one year fixed deposit rate

is already 3.5%. SHCOMP yield of 2.21% is 130bps below that of its one year FD

rate. In contrast, Hong Kong has a dividend yield of 3.3% is 315bps above its one

year fixed deposit rate of 0.15%.

Interestingly, the bubble years of 2006 and 2007 are fairly evident in retrospect.

The dividend yield during those two years declined below trend at 1% and 0.35%

respectively.

Figure 33:SHCOMP dividend yield 1999 to 2011

Source: Bloomberg

P/E, P/B declining. Both P/E and P/B have been on a declining trend. P/E declined

from 49.2x in 1999 to 11.2x in 2011 while P/B declined from 4.7x in 1999 to 1.8x in2011. The bubble years of 2006 and 2007 were clearly marked by large spikes in

both P/E and P/B. P/E spiked to 28.0x and 39.9x while P/B spiked to 2.9x and 6.9x

in those years in contrast to the general declining trend. At current P/E of 11.2x

and P/B of 1.8x, SHCOMP appears to be relatively undervalued.

Figure 34:SHCOMP P/E and P/B 1999 to 2011

Source: Bloomberg


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SSE Composite Index composition and performance

Home to Chinas heavy hitters. The SSE Composite Index is capitalisation weighted

index of both A-shares and B-shares listed on Shanghai Stock Exchange. It is a very

broad index with 972 members (essentially all the listed companies). However, it is

a top heavy index with the top 10 stocks constituting 40% of the index. In fact,

Petrochina and and the three banks ICBC, ABC and BOC already constituted a

quarter of the index.

Top 20 largest companies in SHCOMP (as at Mar 2012)Table 23:

CompanyWeight in

SHCOMP %

Market cap

(RMB bn)

1 PetroChina Co Ltd 10.41 1,770

2 Industrial & Commercial Bank of China 7.43 1,480

3 Agricultural Bank of China Ltd 5.14 865

4 Bank of China Ltd 3.78 785

5 China Petroleum & Chemical Corp 3.31 618

6 China Shenhua Energy Co Ltd 2.77 511

7 China Life Insurance Co Ltd 2.24 464

8 China Merchants Bank Co Ltd 1.39 324

9 Kweichow Moutai Co Ltd 1.38 292

10 Ping An Insurance Group Co 1.16 258

11 Shanghai Pudong Development Bank 1.10 211

12 Bank of Communications Co Ltd 1.01 193

13 Industrial Bank Co Ltd 0.94 167

14 China Minsheng Banking Corp Ltd 0.92 167

15 China Citic Bank Corp Ltd 0.90 162

16 SAIC Motor Corp Ltd 0.87 158

17 China Pacific Insurance Group Co Ltd 0.79 143

18 China Everbright Bank Co Ltd 0.76 127

19 CITIC Securities Co Ltd 0.75 115

20 Daqin Railway Co Ltd 0.72 110

Source: Bloomberg

Subpar return of 2.9% over a decade. The SSE lost half its value in the five years

between 2001 and 2005. It began 2001 at 2,073 and ended 2005 at 1,161. This

completely turned around in 2006 and 2007 as the index surged a huge 130% and97% in those two years before declining 65% in 2008. The index was at 2,199 at the

end of 2011, 58% off the 5,262 high reached in 2007. Taken over a decade ending

2011, the SHCOMP return has been dissappointig with only an annualised return of

2.9% p.a..


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Figure 35:SHCOMP index 2000 to 2012

Source: Bloomberg

The SHCOMP returns is not for the faint hearted as it varies between long years of

losses and short years of sudden oversized gain. It can be observed that in the

years 2006-2009, the return were either large gain of 130%, 97% and 80% or largeloss of 65%. This is probably a reflection of the immaturity of SSE.

Figure 36:SHCOMP annual return (year-end), 2000-2011

Source: Bloomberg


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In Detail: Shenzhen Stock Exchange

Size and growth

China little casino. Similar to SSE, and perhaps even more so, SZSE market

capitalisation exhibits wild swings. Swings in market capitalisation can be

attributed to two things (1) changes in valuation of listed companies (2) newlistings. Judging by the severity of the decline and the fact that there are not many

large listings on SZSE, it seems like the market capitalisation was affected very

much by just wildly changing valuation.

Figure 37:SZSE market capitalisation 1999 to 2011

Source: SZSE

The number of companies listed in SZSE witnessed a significant 40% increase in

2010 and 20% increase in 2011 but most of these are small listings. The increase in

2010 was due to the opening of Chinext market which caters for IPO of small

companies.

Figure 38:SZSE listed companies 1999 to 2011

Source: SZSE

Excessive turnover velocity. SZSE also has the distinction of being the stock

exchange with the highest turnover velocity. At 272% in 2011, SZSE is the stock

exchange with the highest velocity in Asia and no 2 globally. The velocity was even

worse in 2008 at 412%.


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Figure 39:SZSE turnover velocity 1999 to 2011

Source: SZSE

With wildly swinging valuation and high turnover velocity, SZSE appears more like

China little casino than a proper stock exchange.

Market valuation

Very low yield. Consistent with SZSE current status as a punters market, the

dividend yield is very low at circa 1%. For comparison, China one year fixed deposit

rate is already 3.5%. SZSE yield is 250bps below that of its one year FD rate. In

contrast, Hong Kong has a dividend yield of 3.3% is 315bps above its one year fixed

deposit rate of 0.15%.

Figure 40:SZCOMP dividend yield 2001 to 2011

Source: Bloomberg

High P/E and high P/B. Again, as would be consistent with SZSE speculative nature,

the market P/E and P/B are high at 19.3x and 2.5x respectively. These numbers

have actually trended downwards compared to past years where P/E was close to

30x and P/B was hovering around 4x.


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Figure 41:SZCOMP P/E and P/B, 2001 to 2011

Source: Bloomberg

Shenzhen Stock Exchange Composite Index composition and

performance

Comparatively small companies. The Shenzhen Stock Exchange Composite Index

(SZCOMP) is a market cap weighted index with no adjustment to free float. Like

SHCOMP, SZCOMP is also a broad index with all 1,478 members.

Top 20 companies in SZCOMP 2011Table 24:

CompanyWeight in

SZCOMP %

Market cap

(RMB bn)

1 Jiangsu Yanghe Brewery 1.91 132

2 Wuliangye Yibin 1.79 125

3 Shenzhen Development Bank 1.16 80

4 GF Securities 1.16 80

5 China Vanke 1.15 90

6 Suning Appliance 0.98 68

7 Gree Electric Appliances 0.88 61

8 Luzhou Laojiao 0.78 54

9 Zoomlion Heavy Industry Science and Tech 0.78 66

10 Qinghai Salt Lake Industry 0.73 51

11 Shanxi Xishan Coal & Electricity Power 0.67 46

12 ZTE Corp 0.66 57

13 GD Midea Holding 0.64 44

14 Byd 0.64 58

15 Hangzhou Hikvision Digital Technology 0.61 43

16 Henan Shuanghui Investment & Dev 0.60 42

17 Jizhong Energy Resources 0.57 40

18 Shenzhen Overseas Chinese Town 0.56 39

19 Pangang Group Steel Vanadium & Titanium 0.55 38

20 Weichai Power 0.55 50

Source: Bloomberg


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Return of 6.2% actually better that HSI and SHCOMP. In contrast to HSI or

SHCOMP, SZCOMP actually managed to perform better over the decade ending

2011. While HSI and SHCOMP only managed 4.9% and 2.9% p.a., SZCOMP returned

6.2% p.a. in this period. As at end 2011, SZCOMP index was at 867, 40% down from

the 1,447 high reached in 2007.

Figure 42:SZCOMP index 2001 to 2011

Source: Bloomberg

Wild swings in annual return. While SZCOMP has managed to perform better than

HSI or SHCOMP on an annualised basis, volatility in returns was high. SZCOMP

returns is highly erratic with a 163% return in 2007 and 62% loss in 2008.

Figure 43:SZCOMP year end return 2000 to 2011

Source: Bloomberg


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The Investment Case for China

Rise of the Chinese consumers

Rapid rise in income creates new class of consumers. Over a period of 30 years,

GDP growth could be buoyed upwards simply through population growth and

therefore it is important to look at per capita growth as well. On this metric, Chinagrowth is equally astounding.

Per capita GDP grew from RMB463 per person in 1980 to circa RMB30,000per person in 2010

This amounts to a GDP per capita growth of 65x or 15% p.a. over the last30 years

Figure 44:China GDP per capita 1980 to 2010


Rising purchasing power and size is a deadly combination. Despite growing by

15% p.a. for the last 30 years, China per capita income of RMB26,855 p.a. is still far

off from US per capita income of RMB288,528 (see Table 25).

However, a few distinctions need to be made.

Firstly, while China per capita is still a fraction of that of US, it is growing ata much rapid rate. In the 15 years from 1995 to 2010, China per capita

income grew at 11% p.a. compared to US 4% p.a.

Secondly, compared to other countries, China is already fast catching up.For example, China per capita income is already half that of Malaysia at

nn theme 121027 the investment case for china

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