A confluence of headwinds face Asia’s economic powerhouse, including slowing growth, a debt build-up and less effective monetary policy. However in his latest investment note, Kunjal Gala, Senior Investment Analyst on the Hermes Global Emerging Markets Fund, identifies several key reforms set to create long-term opportunities for investors in China.
Fears are escalating over a ‘Japanification’ of China, as deflationary pressures rise and reforms are considered too gradual. The failure to implement decisive reform has exacerbated problems in the debt-laden engines of China’s economy, infrastructure and real estate. China needs to move away from deploying mass stimulus projects and embrace painful, but necessary, supply-side changes to remove overcapacity issues.
The slow pace of reform has been a perennial failing of Chinese policymakers. It appears that some in the administration are not entirely convinced of the need for supply-side reforms and are opposed to radical measures. However, we think President Xi Jinping is firmly in the camp believing supply-side reforms are critical and excessive credit growth could plunge China into a financial crisis. The key question therefore is, how will the reforms be implemented?
From our visits on the ground, we are seeing some encouraging signs. China is beginning to move up the value chain and is also starting to gradually address the build-up of leverage in the system. China’s great transition will take time, but we are seeing exciting long-term investment opportunities.
The rise of smart cities
What makes a city ‘smart’ is the ability to track the movement of people in real-time and swiftly allocating resources according to demand. A part of the RMB 4.7 trillion transport programme is a focus on much-needed urban transit systems, which includes the creation of cutting-edge data networks. Urbanisation is an essential component in addressing the significant layoffs likely with aggressive supply side reform, hence investments in urban infrastructure are essential.
Indirect tax boosting the services sector
After years of debate on indirect taxation, the tax overhaul is now complete, with the majority of sectors shifting from business tax to VAT. This will result in RMB 500 billion savings in the corporate sector. Beijing will compensate provinces for any tax revenues lost as a result. The overhaul is also positive for the service sector and will help the economic rebalancing process.
Growing innovation hubs
Several cities outside of Beijing, Shanghai and Shenzhen are growing faster than the national average. Strong leadership is turning these growing cities into hubs of innovation and talent. Xi’an has a high tech industry zone, where Samsung has established a large presence. The city recently signed 23 new projects in the field of emerging technologies – new energy vehicles, IT and advanced manufacturing. Such targeted fiscal measures are likely to result in sustainable economic growth.
New economy industries
China has identified several essential industries in its transition to a value-added economy – including semiconductors, the internet, high-end manufacturing, alternative energy, environment protection and healthcare. The government is actively supporting a number of these industries and some of these have the potential to become meaningful in several years. It is crucial for China to accelerate development of new economy, to relieve over-employment and overcapacity in the old economy.
Reforming the old economy
China also needs to reform its old economy. For example, reforms in the oil and gas industry are encouraging private refining, and leading to the overhaul of the management of state run companies. The restructuring of China National Petroleum Corporation will eventually result in its spin-off into three or four service companies. In addition, the government intends to reduce overcapacity and address supply-side concerns in the coal and steel industry.
State-owned enterprise (SOE) reform
The government is continuing on its programme of reforms at SOEs. The 345 zombie SOEs displaying a lack of profitability, high debt, mismanagement or overcapacity have been identified and a clean-up effort has been initiated. This may include mergers of SOEs, though this will be less likely to happen if it creates a monopoly. Other efforts include overhauls through innovation, restructuring and personnel management reform. SOE reform is likely to be complex and a long term process, and central government SOEs are likely to lead the efforts over the next several years.
The PBOC recently issued regulation, Document 82, which will have far reaching implications for the bloated banking sector. The reform aims to close the shadow banking loophole by regulating off balance sheet exposures. Implementation of the reform is key and is expected to be carried out over the next several quarters.
Notwithstanding the recent spike in economic activity, driven by the property and commodity sectors, we remain cautious about the overall prospects for China. Reforms are critical and we will be looking for signs of a change in political decision making. It is increasingly obvious that strong leadership does not always translate into actions on the ground, due to differences in opinion and likely conflicts of interest.
Reaching a GDP of US$10 trillion and per-capita income of US$10,000 are important milestones, emblematic of a vast and largely successful economy. Despite the macro risks, there are sustainable opportunities to be found in China. Many of these can be found in companies exposed to urbanisation, the strong middle class with high savings and disposable incomes and emerging new industries. These promising areas have the potential to cushion the economy against a potential ‘hard landing’.
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