China's impressive economic development is providing plenty of investment opportunities for the Western world. Chris Ruffle examines the story of China so far
It is happening every day. Whether the example is Shell going ahead with a $4.3bn petrochemical plant, the Royal Bank of Scotland paying $2.5bn for a 10% stake in Bank of China or the US medical equipment company Stryker setting up a manufacturing base in China, more and more western companies are seeing China as the land of opportunity. They regard China as the place where they can get the premium rates of growth that are now so elusive in the West.
The story so far...
China's 1.3 billion people and its economic dynamism are creating compelling opportunities for investment. Now that China has joined the World Trade Organisation and with development continuing apace, demand for commodities and metals has reached critical mass. China is the third largest consumer of metals (after the US and Europe) and accounts for 15% of global demand. It should displace Europe soon. It already consumes more steel than the US and accounts for well over 50% of the growth of several commodities.
Investment in fixed assets, especially in China's highways, railways, airports and sewage and sanitation systems, is set to continue for other reasons as well. The country is due to host the Olympic Games in 2008 and the World Expo in 2010. So here is another driver of impressive growth and investment, particularly 'foreign direct investment', in China.
Meanwhile the government's commitment to keeping economic growth above 7% was shown by approval of a record budget deficit (2.9% of GDP). There was also further structural reorganisation, with a regulator established to monitor the banking industry, and a commission established to manage state assets.
The listed market is currently unrepresentative of the broader economy. It is weighted around 80% towards the declining state sector, which now represents less than 30% of GDP. But it is the rapidly growing private sector that is the engine of economic growth. This offers us a tremendous structural opportunity to invest in entrepreneurial companies at the expense of state-owned enterprises.
a burgeoning market
As the opportunities grow, so does access to them. Most recently, in May 2003, the domestic Chinese A-share market opened to Qualified Foreign Institutional Investors. With a market capitalisation of over US$500bn, it is the second largest in Asia. Once this market becomes recognised in MSCI indices, it will begin to influence investors' behaviour.
Characteristics of the A-share market, to which in May this year the government has brought significant reforms, include:
• Retail-driven but growing mutual fund industry.
• Political (government control supply of equity).
• Mostly state-owned enterprises (SOEs), but non-SOE element growing rapidly.
• Good liquidity.
Of a number, there are four principal reasons for investing in the A-share market:
• It is cheaper than the H-share market where China companies are also listed.
• The market is at an eight-year low. The market has kept falling as promises of reform and a solution to the issue of non-tradable share failed to materialise. These are now well on the way to being resolved.
• Reform of non-tradeable shares. Of all shares listed in the A-share markets, almost 60% are non-tradable, owned mostly by government agencies. This overhang is the main reason why the A-share market is down. The China Securities Regulatory Commission has announced long-awaited reform on non-tradable shares. The plan is for companies to compensate existing floating shareholders by giving them additional old shares.
Were this system to be rolled out across the whole market it would effectively mean, for existing holders, that the market is at least 30% cheaper than it appears.
• The government is serious about reform of the capital market. It is introducing positive measures.
As well as addressing the non-tradable share issue, other measures include:
• Sponsorship and price bidding for IPOs. To ensure the quality of listed companies, qualified sponsors (both institutions and individuals) are now required for IPOs. Furthermore, IPO prices will be set on the basis of bids from institutional investors.
• Protection of free float shareholders' rights. The approval of the majority of free float shareholders is now mandatory for key decisions regarding listed companies, such as overseas listings, issuance of convertible bonds and new equity, and acquisitions worth more than 20% of a listed company's book value.
• Enhanced responsibility of independent directors. Key issues, such as major related-party transactions and the employment of an accounting firm, must now get approval from a majority of independent directors.
• Permission has been given to banks, insurers and pension funds to invest directly in the A-share markets.
What, though of China's currency, the renminbi (Rmb)? We think the Rmb will be one of the strongest currencies in the world in the next five years - if not the strongest. This will have a compounding effect on market weightings as the currency and then the markets rise. We liken it to what happened in the 1980s in Japan, which was a very similar situation.
On 21 July this year the People's Bank of China announced that the Rmb exchange rate will move from being pegged to the US dollar to being pegged to a basket of currencies. At the same time the Rmb exchange rate against the US$ has been adjusted from 8.28 to 8.11, a 2.1% revaluation. This is a small revaluation, which in itself will have a very limited effect on any Chinese company. Theoretically it is slightly bad news for exporters and commodity producers and good news for importers, and those companies geared in US$. In our Greater China portfolios, which have a bias toward management-owned, small-cap companies, the breakdown between domestic companies and exporters is roughly 70%/30%. Our portfolio companies are, therefore, to a limited extent, net beneficiaries of this revaluation.
This is not a simple re-pegging, but a move to a link to an unspecified basket of currencies. If the US dollar were to resume its rise against the euro and yen, then based upon growing interest rate differentials the Rmb might be expected to depreciate against the US$. We could see Rmb8.28/US$1 again before long. The initial reaction, though, has been positive.
Commentators may interpret this small move, the first in a decade, as just the first of many and predict an inflow of hot money into Rmb-related assets. The initial inflow of capital might not distinguish clearly between beneficiaries and victims of Rmb revaluation. Ahead of Hu Jin- Tao's state visit to the US in September, this move provides the opponents of the Schumer Bill with some ammunition to use against the growing army of protectionists, showing that China is making gradual progress towards a more flexible currency regime.
China's domestic consumption has reached a critical mass and it is now the third largest consumer of metals other than the US and Europe.
The best route to accessing China is through companies in Hong Kong and Taiwan.
The recent revaluation of the currency will have limited impact on the country.
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