As reforms for long-term development kick in, stock picking best way to invest in China

Economy April 01, 2014 00:00

By Bonnie Lam

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China's trade has exceeded expectations, with both imports and exports recording annual growth and inflation generally in line with predictions, driving the Shanghai Composite Index up 5.4 per cent in February and regaining January's losses.

Sessions of the National People’s Congress (NPC) and National Committee of the Chinese People’s Political Consultative Conference (CPPCC) began on March 3, when the market expected details of future policies. If implemented, reform details are likely to bring support to the mainland stock market. 
A blueprint for China’s economic reform was formulated at the Third Plenum last November. The government is expected to turn its attention to how to maintain long-term economic development while reducing the emphasis on short-term growth.
Enhanced sustainable economic growth is expected to lower the borrowing costs for Chinese enterprises. Moreover, with further liberalisation of interest-rate markets and a more diversified financial sector, economic expansion will provide investors with a wider range of investment opportunities. 
In terms of state-owned-enterprise (SOE) reform, these companies are expected to improve operational efficiency and resource allocation, with more being listed on the stock market, resulting in enhanced corporate governance and more economic power being reallocated to the private sector. Furthermore, as the SOE reform will help solve the problem of excess production capacity, the overall market return on equity and dividend rates are expected to rise over time. 
Land reform allows rural landholders to sell or rent their property, which is likely to release assets of about 50 trillion yuan (Bt260 trillion), equivalent to current retail deposits. These reforms may also increase land supply for the real-estate market, which will help rein in property prices. 
In January, shadow banking and credit conditions caused market concerns. However, compared with developed countries such as the United States and Japan, with their debt levels accounting for more than 100 per cent of gross domestic product, China’s debt level is still manageable, with its overall credit-to-GDP ratio being around 53 per cent. If necessary, China’s huge foreign-exchange reserves, at 3 trillion yuan, can be used as a strong backing against credit issues. 
In terms of the trust industry, 70 per cent of Chinese trust financing is borrowed by local governments and the real-estate sector, which, compared with mining, coal and other industries, have a much lower credit risk. We believe the Chinese government should be able to maintain a controlled level of risk. 
That said, these reforms require the support of local governments, businesses, and various government bodies. With further implementation of the reform details, the market may be under pressure in the short term. However, China’s economic development will be more refined and persistent once the obstacles are cleared. 
Macro risk factors may have been reflected in an undervalued Chinese stock market. At the end of January, the price-to-earnings ratio of the Shanghai Composite Index was 10, far lower than its historical 10-year average of 20. If substantial progress has been made in the reforms, the valuations of Chinese stocks should rise or normalise. 
However, the reform-led re-rating may take time, and 2014 will start once again with a strategic focus on stock picking. We believe that environmental stocks carry investment value as China’s leadership hopes to increase energy efficiency through emission reduction and to accomplish the theme of “A Beautiful China”.
In addition, new energy sources such as solar, wind and hydroelectric power and natural gas have gradually become a major investment theme. In terms of consumer-related shares, land reform and urbanisation will help promote a new round of consumer demand. Demand for cars will shift from low-end to high-end products, with strong auto sales expected to continue their momentum in the next few years, which may benefit auto stocks. 
Bonnie Lam is managing director, head of wholesale business, Asia-Pacific, HSBC Global Asset Management.