NN THEME 121027 The Investment Case For China

noname
Investment Research
Thematic Report
The Investment Case for China

Date: 27 October 2012
Executive Summary
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 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 is now 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 anything but expensive.
Robin HU
robin@nonameresearch.com
nonameresearch.com | 27 October 2012
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
HSCEI composition and performancce ................................................................. 39 In Detail: Shanghai Stock Exchange .......................................................................... 41 Size and growth .................................................................................................... 41 Market valuation .................................................................................................. 43 SSE Composite Index composition and performance .......................................... 44 In Detail: Shenzhen Stock Exchange ......................................................................... 46 Size and growth .................................................................................................... 46 Market valuation .................................................................................................. 47 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
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 just RMB455bn in 1980 to RMB40,120bn in 20101 This is equivalent to a nominal GDP growth of 16% p.a. for the last 30 years!
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 player in 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 of USD14,552bn 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
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RMB47tn in 2011
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.
Table 1: Comparison between US and China GDP growth over the past 30 years Nominal GDP (USD bn) US China US / China
Assumed USD1 = RMB6
1980 2,788 76 37x
2010 14,552 6,687 2x
CAGR 5.6% 16.0%
Rank 2010 1st 2nd
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.
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:
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 were allocated 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 of China into a central bank and four large commercial banks Created two stock exchanges to facilitate privatisation of state owned enterprises (SOE). The Shenzhen Stock Exchange and the Shanghai Stock Exchange were created in 1990 and 1991 respectively
Table 2: China before and after reforms Before Central planning All services provided by state Rural society Agriculture Closed economy After Market economy Mixture of state and private sector Urban society Manufacturing and services 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
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 predominantly agricultural 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 cities are located and this facilitated imports/exports Secondly, these coastal towns are also in close proximity to Hong Kong and Taiwan, where there already exist an established Chinese entrepreneurial class. 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 tertiary industry 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
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 to 33% in 2010 Gross fixed capital formation contribution (GFCF) to GDP increased from 29% 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.
Gross 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
Table 3: China nominal GDP 1980 to 2010 RMB bn Household consumption Government consumption Final consumption Gross fixed capital formation Changes in inventory Net export/(import) Stats disc Nominal GDP Breakdown Household consumption Government consumption Final consumption Gross fixed capital formation Changes in inventory Net export/(import) Stats disc Nominal GDP
Source: World Bank
1980 233 68 301 132 28 (2) (5) 455
1990 945 264 1,209 483 192 56 (73) 1,867
2000 4,585 1,566 6,152 3,384 100 239 47 9,921
2010 13,329 5,361 18,691 18,234 935 1,571 689 40,120
CAGR 14% 16% 15% 18% 12% N/A N/A 16%
51% 15% 66% 29% 6% 0% -1% 100%
51% 14% 65% 26% 10% 3% -4% 100%
46% 16% 62% 34% 1% 2% 0% 100%
33% 13% 47% 45% 2% 4% 2% 100%
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 services that 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.
Table 4: Fixed asset investment by type, 2000 to 2010 RMB bn Construction Equipment purchase Others Total FAI Real estate investment
2000 2,054 779 460 3,292 498
2005 5,338 2,142 1,397 8,877 1,591
2010 17,135 6,168 4,509 27,812 4,826
CAGR 00-10 24% 23% 26% 24% 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.
Table 5: Fixed asset investment by source 2000 to 2010 RMB bn State owned Collective owned Individuals Jointly owned Shareholding Foreign funded HK, Taiwan, Macau funded Others Total FAI
2000 1,650 480 471 9 406 131 129 14 3,292
2005 2,967 1,197 1,389 23 2,354 466 377 106 8,877
2010 8,332 1,004 7,008 83 8,897 891 830 768 27,812
CAGR 18% 8% 31% 24% 36% 21% 20% 49% 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. building materials) 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 the inclusion of housing (which has been growing rapidly and which may lead to oversupply but thats another topic). On our estimate, reversing out
We suspect that the growth in individuals source of fund is due to higher purchase of properties while growth from 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 the private sector and not state directed Thirdly, China is not overbuilt. Chinas base metal intensity (e.g. steel density per capita, copper density per capita) is still only half that of developed countries Fourthly, the Chinese government is actively trying to slow down the economy 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 total world exports China imported USD1,395bn worth of goods in 2010 or 9.1% of total world imports
Table 6: Leading exporters and importers 2010 Rank Exporters 1 2 3 4 5 6 7 8 9 10 China US Germany Japan Netherlands France Korea Italy Belgium UK Top 10 Others World USD bn 1,578 1,278 1,269 770 572 521 466 448 411 405 7,718 7,520 15,238 % 10.4% 8.4% 8.3% 5.1% 3.8% 3.4% 3.1% 2.9% 2.7% 2.7% 51% 49% 100% Importers US China Germany Japan France UK Netherlands Italy Hong Kong Korea Top 10 Others World USD bn 1,968 1,395 1,067 693 606 558 517 484 442 425 8,155 7,221 15,376 % 12.8% 9.1% 6.9% 4.5% 3.9% 3.6% 3.4% 3.1% 2.9% 2.8% 53% 47% 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 faster than primary goods exports (8% growth p.a.) Machinery and transport equipment is the single biggest category of exports (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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Table 7: China exports 1980 to 2010 USD bn Food Beverages and tobacco Non food raw mat Mineral fuels, lubricants and others Animal and vegetable oils, fats, waxes Primary export Chemicals and allied products Light, textile, rubber, minerals, iron Machinery and transport equip Misc products Not classified Manufactured export Total export
Source: IMF
1980 3 0 2 4 0 9 1 4 1 3 0 9 18
1990 7 0 4 5 0 16 4 13 6 13 12 46 62
2000 12 1 4 8 0 25 12 43 83 86 0 224 249
2010 41 2 12 27 0 82 88 249 780 378 1 1,496 1,578
CAGR 9% 11% 7% 6% 6% 8% 16% 15% 26% 18% 7% 19% 16%
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.
Table 8: China export by region 1990 to 2010 USD bn Asia Africa Europe Latam North America Oceania and pacific Total export Breakdown Asia Africa Europe Latam North America Oceania and pacific Total export
Source: IMF
1990 45 1 9 1 6 1 62
2000 132 5 45 7 55 4 249
2010 732 60 355 92 306 33 1,578
CAGR 15% 21% 20% 27% 22% 22% 18%
72% 2% 15% 1% 9% 1% 100%
53% 2% 18% 3% 22% 2% 100%
46% 4% 23% 6% 19% 2% 100%
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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.
Table 9: China top 10 exports destinations 2010 Rank 1 2 3 4 5 6 7 8 9 10 Destination US Hong Kong Japan South Korea Germany Netherlands UK Singapore Italy Taiwan USD bn 283 218 121 69 68 50 39 32 31 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 and energy are major components Machinery and transport equipment is again the single biggest category of imports (40% of total) and this underscores Chinas role as an assembler4
For example, US largest exports and imports to China are both machinery and equipment. This is because US companies 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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Table 10: China imports 1980 to 2010 USD bn Food Beverages and tobacco Non food raw mat Mineral fuels, lubricants and others Animal and vegetable oils, fats, waxes Primary import Chemicals and allied products Light, textile, rubber, minerals, iron Machinery and transport equip Misc products Not classified Manufactured import Total import
Source: IMF
1980 3 0 4 0 0 7 3 4 5 1 0 13 20
1990 3 0 4 1 1 10 7 9 17 2 9 43 53
2000 5 0 20 21 1 47 30 42 92 13 2 178 225
2010 22 2 211 189 9 433 150 131 550 114 18 962 1,395
CAGR 7% 15% 15% 26% 13% 15% 14% 12% 17% 20% 14% 15% 15%
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.
Table 11: China import by region 1990 to 2010 USD bn Asia Africa Europe Latam North America Oceania and pacific Total import Breakdown Asia Africa Europe Latam North America Oceania and pacific Total import
Source: IMF
1990 29 0 13 2 8 1 53
2000 141 6 41 5 26 6 225
2010 835 67 218 91 117 66 1,393
CAGR 18% 30% 15% 23% 14% 21% 18%
54% 1% 24% 3% 15% 3% 100%
63% 2% 18% 2% 12% 3% 100%
60% 5% 16% 7% 8% 5% 100%
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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Table 12: China top 10 source of imports 2010 Rank 1 2 3 4 5 6 7 8 9 10 Source Japan South Korea Taiwan USA Germany Australia Malaysia Thailand Russia Singapore USD bn 177 138 116 102 74 61 50 33 26 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 China overall current account surplus of USD305bn Increasing net investment inflow has also resulted in a positive financial account surplus to the tune of USD221bn in 2010 Sustained surplus in both the current and financial account result in China continuing to accumulate forex reserve. In 2010, a sizeable USD472bn was added China forex reserve
Table 13: China balance of payment 1990 to 2010 USD bn Goods Services Income Transfers Current account Direct investment Portfolio investment Other investment Financial account Capital account Statistical discrepancy Change in reserve
Source: IMF
1990 9 2 1 0 12 3 (0) 0 3 (3) 12
2000 34 (6) (15) 6 21 37 (4) (32) 2 (0) (12) 11
2010 254 (22) 30 43 305 125 24 72 221 5 (60) 472
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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.
Table 14: China surplus/(deficit) with main trading partners 1990 to 2010 USD bn HK USA Netherlands UK Italy France Singapore Canada Russia Indonesia Germany Thailand Malaysia Australia Japan South Korea Taiwan
Source: IMF
1990 12 (1) 1 (1) (0) (1) 1 (1) 0 (0) (1) 0 (0) (1) 1 1 (2)
2000 35 30 5 3 1 (0) 1 (1) (4) (1) (1) (2) (3) (2) 0 (12) (20)
2010 206 181 43 27 17 11 8 7 4 1 (6) (13) (27) (34) (56) (70) (86)
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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 reallocated. 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 1994 on 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 on provision of goods and services, The VAT rate is generally at 17% but exporters may be eligible for refunds Business tax is the second largest5 contributor to revenue at 13%. Business tax 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 nonessential 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 local governments Central government also collects consumption tax which are excises on goods such as tobacco and luxury goods
Company 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 included
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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% of personal 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
Table 15: Division of revenue between central and local Central Tariffs Consumption tax Vehicle purchase tax Cargo tax Shared Value added tax Personal income tax Company income tax Stamp duty Local 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. Over time, 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 government expenditure 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.
Some 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 sale
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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.
Table 16: Government expenditure 2000 vs 2006 RMB bn Economic construction Social, cultural and educational National defense Administration exp Other exp Total government expenditure
2000 575 439 121 277 178 1,589
2006 1,073 1,085 298 757 829 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. for the 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 in expenditure 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 was redesignated as China central bank Despite taking the form of a modern banking system, most lending was still directed (an issue which continues today). The indiscriminate lending led to skyrocketing NPLs9 in the late 1990s that required a bank bailout
Table 17: Key milestones in China monetary system Year 2010 2006 2005 2003 2003 1998 1998 1996 1995 1994 Event
Agricultural Bank of China, the last of big four was listed PBOC began using RRR to sterilise FX inflow PBOC ended 10 year RMB peg against USD Separate banking regulatory commission established Second round of bank recapitalisation PBOC abolished directed lending First bank bailout. Bank recapitalisation took place (about 18% of GDP) PBOC began open market operations using treasury bonds PBC legally institutionalised as central bank 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
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.
Estimated to be 50%
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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 can extend. 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 see fit but may be forced to direct funds into less credit worthy sectors This renders some of the other standard monetary tools less useful. For example, 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 an official exchange rate and a market rate determined in swap centers This system broke down in 1994 when the official rate became increasingly overvalued. 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 undisclosed basket 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 in goods/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 to rise 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 responded with 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 to market 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 account and 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 the more 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 in the economy would probably be financial in nature Secondly, the continued lack of market discipline and transparency in China 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 financial problem 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 stock exchanges 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 market capitalisation. 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 There are a total of 810 companies whose market cap is USD100bn and above namely China Mobile, Petrochina, ICBC, Agricultural Bank of China, Bank of China, China Construction Bank, China Petroleum, China Shenhua
Furthermore,
10
After 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 and USD100bn, 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 is between 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.
Table 18: Companies listed in China exchanges 2011 (not adjusted for dual listing) Size USD100bn and above USD50bn up to USD100bn USD10bn up to USD50bn Less than USD10bn Total
Source: Bloomberg
HKEx 8 5 46 1,437 1,496
SSE 7 4 37 883 931
SZSE 0 0 9 1,402 1,411
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 with a 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 SSE and 1% for SZSE With high turnover and low yield, the two mainland exchanges have a more speculative flavour
Table 19: Overview of HKEx, SSE and SZSE Exchange HKEx SSE SZSE Companies 1,496 931 1,411 Market cap HKD17.5tn RMB14.8tn RMB6.6tn Turnover 69% 135% 272% Div yield 3.3% 2.2% 1.0% P/E 9.7x 11.2x 19.3x
11
HKD1 = 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 Bshare 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-owned enterprises (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 in China. Chinese nationals are free to trade the shares but in order to
12
The 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 and are 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 not tradeable 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 China Enterprises 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.
Table 20: Overview of A-share, B-share and H-share Registr ation PRC PRC PRC Listing PRC PRC HK Currency RMB HKD/USD HKD Investor Listed companies PRC, foreigners 2,342 via QFII PRC, foreigners 139 Market cap RMB21tn
A-share B-share H-share
Foreigners, PRC via QDII
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 2007 before 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; China Mobile, China Construction Bank and ICBC.
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Table 21: Top 20 companies in HIS by weight (as at Mar 2012) Company 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 HSBC Holdings PLC China Mobile Ltd China Construction Bank Corp Industrial & Commercial Bank of China CNOOC Ltd Tencent Holdings Ltd AIA Group Ltd PetroChina Co Ltd Bank of China Ltd Hutchison Whampoa Ltd Sun Hung Kai Properties Ltd China Life Insurance Co Ltd Cheung Kong Holdings Ltd China Petroleum & Chemical Corp Hong Kong Exchanges and Clearing Ltd CLP Holdings Ltd Ping An Insurance Group Co China Shenhua Energy Co Ltd Li & Fung Ltd Hong Kong & China Gas Co Ltd Weight in HSI 15.82 8.11 8.06 5.14 4.55 3.85 3.80 3.63 3.52 2.72 2.57 2.38 2.30 2.28 2.17 1.94 1.91 1.77 1.66 1.53 Market cap (HKD bn) 1,250 1,690 1,500 1,820 712 401 340 2,170 966 341 291 571 242 761 143 161 400 629 149 160
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.
Table 22: Top 20 companies in HSCEI by weight (as at Mar 2012) Company 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 PetroChina Co China Construction Bank Bank of China Industrial & Commercial Bank of China China Life Insurance China Petroleum & Chemical Ping An Insurance China Shenhua Energy Agricultural Bank of China China Merchants Bank China Telecom China Pacific Insurance Group Bank of Communications China Minsheng Banking Dongfeng Motor Group China Citic Bank China Coal Energy China Communications Construction Yanzhou Coal Mining Anhui Conch Cement Weight in HSCEI % 10.11 10.05 9.75 9.66 6.64 6.13 5.33 4.92 3.34 2.71 2.53 2.12 1.82 1.79 1.65 1.64 1.50 1.49 1.46 1.40 Market cap (HKD bn) 2,170 1,499 985 1,825 582 760 411 638 1,061 319 339 209 355 217 121 237 139 117 116 117
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 capitalisation by 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 in 2011. 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.
Table 23: Top 20 largest companies in SHCOMP (as at Mar 2012) Company 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 PetroChina Co Ltd Industrial & Commercial Bank of China Agricultural Bank of China Ltd Bank of China Ltd China Petroleum & Chemical Corp China Shenhua Energy Co Ltd China Life Insurance Co Ltd China Merchants Bank Co Ltd Kweichow Moutai Co Ltd Ping An Insurance Group Co Shanghai Pudong Development Bank Bank of Communications Co Ltd Industrial Bank Co Ltd China Minsheng Banking Corp Ltd China Citic Bank Corp Ltd SAIC Motor Corp Ltd China Pacific Insurance Group Co Ltd China Everbright Bank Co Ltd CITIC Securities Co Ltd Daqin Railway Co Ltd Weight in SHCOMP % 10.41 7.43 5.14 3.78 3.31 2.77 2.24 1.39 1.38 1.16 1.10 1.01 0.94 0.92 0.90 0.87 0.79 0.76 0.75 0.72 Market cap (RMB bn) 1,770 1,480 865 785 618 511 464 324 292 258 211 193 167 167 162 158 143 127 115 110
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% and 97% 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 large loss 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) new listings. 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.
Table 24: Top 20 companies in SZCOMP 2011 Company 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Jiangsu Yanghe Brewery Wuliangye Yibin Shenzhen Development Bank GF Securities China Vanke Suning Appliance Gree Electric Appliances Luzhou Laojiao Zoomlion Heavy Industry Science and Tech Qinghai Salt Lake Industry Shanxi Xishan Coal & Electricity Power ZTE Corp GD Midea Holding Byd Hangzhou Hikvision Digital Technology Henan Shuanghui Investment & Dev Jizhong Energy Resources Shenzhen Overseas Chinese Town Pangang Group Steel Vanadium & Titanium Weichai Power Weight in SZCOMP % 1.91 1.79 1.16 1.16 1.15 0.98 0.88 0.78 0.78 0.73 0.67 0.66 0.64 0.64 0.61 0.60 0.57 0.56 0.55 0.55 Market cap (RMB bn) 132 125 80 80 90 68 61 54 66 51 46 57 44 58 43 42 40 39 38 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, China growth is equally astounding. Per capita GDP grew from RMB463 per person in 1980 to circa RMB30,000 per person in 2010 This amounts to a GDP per capita growth of 65x or 15% p.a. over the last 30 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 at a 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 RMB56,178 but it is still growing 60% faster Thirdly, due to Chinas large land mass, per capita income can differ markedly from city to city. Generally, highest per capita income can be found in the coastal industrial cities. For example, Guangzhou has a per capita income of RMB36,296 p.a. in 2010. Other similar cities include Shanghai, Shenzhen, Beijing, Ningbo, Xiamen, Hangzhou and Nanjing Finally, size makes all the difference. For example, the eight coastal cities mentioned above collectively contain a population of 100m or almost three times that of Malaysia. With 20m inhabitants each, Shanghai and Beijing are already almost the size of Malaysia individually. This implies that on an absolute basis, China will actually have more people with higher
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per capita income/purchasing power than Malaysia despite the overall lower per capita income statistically
Table 25: Per capita income of Top 10 Chinese cities RMB p.a. Guangzhou Shanghai Shenzhen Beijing Ningbo Xiamen Hangzhou Nanjing Jinan Qingdao China US 1995 9,118 7,196 12,728 6,238 7,292 7,135 6,313 4,996 4,723 5,618 5,440 169,698 2000 13,812 11,802 21,769 10,416 10,983 10,931 9,709 8,261 8,538 8,071 8,449 215,502 2005 21,301 20,602 31,305 19,533 19,681 18,094 18,757 16,470 14,920 13,867 14,301 262,140 2010 36,296 35,739 35,524 35,256 34,324 33,866 33,810 31,314 27,724 27,283 26,855 288,528 CAGR 95-10 10% 11% 7% 12% 11% 11% 12% 13% 13% 11% 11% 4%
Source: China Statistical Agency, World Bank (US:RMB = 1:6)
Chinas potent combination of size and rapidly rising per capita is already impacting businesses globally. These impacts extend throughout the supply chain affecting demand from raw materials (steel, coal, rare earth, etc) to finished goods (luxury goods, champagne, BMW, KFC, iPhone, movies, etc).
Figure 45: China income growth (1995-2000) (L) and per capita income (2010) (R)
Chinese consumers already central to multinationals business today. The first to be affected by Chinas rise are the multinationals with footprints in China. Across, the board, with industries ranging raw materials to iPhones, China is fast becoming the multinationals number one business segment and key profit drivers. For example, Asia Pacific contribution to Apple revenue has grown from just 7% in 2009 to 21% in 2011 (see Figure 46). This has been driven by growth in China. China is Apple second largest market after US. Revenue growth was 360%
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in 2010 and 450% in 2011. For 2012, Greater China alone is expected to contribute USD24bn or 15% total Apple revenue, up 78% yoy KFC profits in China grew 17% in 2008, 24% in 2009 and 26% in 2010. Profits doubled in 3 years and China is now Yum Brands largest profit division. KFC has 3,200 restaurants in 700 cities and added another 400 in 2010. Yum also has 500 Pizza Huts in 130 cities 60% of Rio Tinto sales now comes from China 12% of BMW sales comes from China and sales grew 85% in 2010. Half of all BMW sold in Asia is in China China is Volkswagen 2nd largest market and grew 37% in 2010. In contrast, the largest market Western Europe showed no growth. China will be Volkswagen largest market in 2-3 years Starbucks opened 500th stores in China in 2011 and will open 150 new stores in 2012
Figure 46: Asia Pacific contribution to Apple total revenue
Source: Apple annual report
These are just a preview of Chinas potential as a consumer market. While the previous 30 years were about low cost labour in China, in our view, the next 30 years would probably about the billion consumers in China.
More than reasonable valuation

Corporate earnings continue to grow strongly. In the five years from 2006 to 2010, earnings for the companies under MSCI China grew at an average rate of 15% p.a. As expected, the earnings growth was interrupted by the 2008 global recession. In that year, aggregate MSCI China earnings declined by 15%. The decline then was broad based and the only sectors to register positive growth were Telecom and surprisingly, Banks The next year, 2009, saw a strong rebound across all sectors with aggregate MSCI China earnings rebounding 14% Across the five years, the fastest growing sectors were Banks and Insurance which grew at a CAGR of 22% and 35% respectively
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In short, while China was not spared during the 2008 global recession, the average earnings growth was hardly shabby at 15% p.a when taken over the five years from 2006 to 2010. Considering nominal GDP which was growing at roughly 16%, a 15% earnings growth sounds reasonable.
Table 26: MSCI China EPS growth 2006 to 2010 2006 Banks Capital goods Consumer discretionary Consumer staples Energy Healthcare IT Insurance Materials Real estate Telecom Transportation Utilities Total MSCI China
Source: IBES
2007 36% 22% 44% 9% 0% N/A -5% 104% 4% 43% 36% 178% 13% 31%
2008 35% -88% -31% -12% 2% N/A -72% -58% -69% -16% 19% -52% -91% -15%
2009
2010
Cum 265% 147% 188% 219% 177% N/A 162% 446% 134% 163% 202% 174% 89% 197%
CAGR 22% 8% 13% 17% 12% N/A 10% 35% 6% 10% 15% 12% -2% 15%
-11% 26% 22% 35% 20% N/A 0% 115% 54% -16% 23% -27% 8% 13%
21% 34% 538% 24% 25% 24% 52% 12% -4% 51% N/A 58% 121% 173% 99% 21% 52% 79% 14% 42% -4% 6% -93% 2510% 735% -7% 14% 37%
Yet market still cheaply priced. However, despite Chinas earnings resilience and growth, the Chinese stock markets are still accorded very low valuation. On a P/E basis, HKEX and SSE markets as a whole are being priced 9.7x and 11.2x earnings respectively. SZSE is being priced at 19.3x earnings but as we alluded to earlier, SZSE is a little volatile and behaves more like Chinas little casino so the higher P/E is not unexpected. But considering that Chinas largest companies are listed on both the HKEX and SSE, surely a 9.7x and 11.2x P/E are a bit too low.
Table 27: Chinese stock exchanges key statistics Exchange HKEX SSE SZSE Companies 1,496 931 1,411 Market cap HKD17.5tn RMB14.8tn RMB6.6tn Turnover 69% 135% 272% Div yield 3.3% 2.2% 1.0% P/E 9.7x 11.2x 19.3x
As at 2Q2012
The dividend yields also paint a similar story. Again, ignoring SZSE, both HKEX and SSE are already yielding 3.3% and 2.2% respectively. In fact as at 1Q12, HKEX dividend yield of 3.3% is: Only 40bps away from Australia 10yr yield of 3.7% Higher than the 10yr yields of UK, Canada, US, German and Japan A whole 300bps higher than UST 2yr yield of 0.3%
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Since SSE dividend yield is lower than that of HKEX, the comparison is not as strong but still SSE yield is still either comparable to or higher than most bond yields.
Figure 47: Selected dividend yields and bond yields, March 2012
Source: Bloomberg
Cheap however you look at it. It appears that both P/E and dividend yield indicate that the Chinese stock markets are not expensive. And if they are not expensive, then they must be either fairly priced or cheap. We think the latter is more likely and here is why: Relatively high dividend yield. Equity market yields are generally supposed to be lower than bond yields as the majority of equity market returns are expected to come from capital gains. Now, when the overall HKEX yield is 3.3% while the UST 10yr yield is 2.0%, HKEX equity investors are getting paid a full 130bps above UST 10 yr13 and a chance to participate in capital appreciation. If HKEX were to decline further, then the dividend yield gap widens further Low P/E. A P/E of around 10x would already be considered inexpensive just for a nominally growing market. Considering that Chinese companies earnings are actually growing 15% per year, a P/E of 10x is really lowballing the valuation Strong balance sheet. We have not mentioned the balance sheet but most Chinese companies are actually cash rich Low payout ratio. While we do not have the statistics here, we suspect that the payout ratio is still relatively low. If this is true, then the Chinese companies are giving 3% plus dividend yield on relatively low payout ratio implying there is further room for higher dividend. From a bottoms up perspective, we can point to a number of very large Chinese companies on both HKEX and SSE that are already yielding 3% plus at a 50% to 75% payout ratio
In summary, it is a bit of a stretch to call the Chinese stock market expensive. Chinese stock market valuations are cheap however you look at it.
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This is especially interesting for USD investor because HKD is fixed against the USD, eliminating forex risk
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Conclusion
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 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 is now 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 anything but expensive.
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nonameresearch.com | 27 October 2012 Rating structure The rating structure consists of two main elements; fair value and conviction rating. The fair value reflects the security intrinsic value and is derived based on fundamental analysis. The conviction rating reflects uncertainty associated with the security fair value and is derived based on broad factors such as underlying business risks, contingent events and other variables. Both the fair value and conviction rating are then used to form a view of the security potential total return. A Buy call implies a potential total return of 10% or more, a Sell call implies a potential total loss of 10% or more while all other circumstances result in a Neutral call.
Disclaimer This report is for information purposes only and is prepared from data and sources believed to be correct and reliable at the time of issue. The data and sources have not been independently verified and as such, no representation, express or implied, is made with respect to the accuracy, completeness or reliability of the information or opinions in this report. The information and opinions in this report are not and should not be construed as an offer, recommendation or solicitation to buy or sell any securities referred to herein. Investors are advised to make their own independent evaluation of the information contained in this research report, consider their own individual investment objectives, financial situation and particular needs and consult their own professional and financial advisers as to the legal, business, financial, tax and other aspects before participating in any transaction.
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NN THEME 121027 The Investment Case For China

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The Investment Case for China

nonameresearch.com | 27 October 2012

nonameresearch.com | 27 October 2012

nonameresearch.com | 27 October 2012

Overview - The Rise of China

Source: World Bank

Deadly size, deadly speed

nonameresearch.com | 27 October 2012

1980 2,788 76 37x

2010 14,552 6,687 2x

CAGR 5.6% 16.0%

Rank 2010 1st 2nd

nonameresearch.com | 27 October 2012

Reforms - The Why and When of Chinas Rise

Correcting the wrong Market reforms under Deng

nonameresearch.com | 27 October 2012

Source: World Bank

nonameresearch.com | 27 October 2012

GDP Manufacturing for the World

Source: China Statistical Agency

nonameresearch.com | 27 October 2012

Source: China Statistical Agency

nonameresearch.com | 27 October 2012

1980 233 68 301 132 28 (2) (5) 455

1990 945 264 1,209 483 192 56 (73) 1,867

2000 4,585 1,566 6,152 3,384 100 239 47 9,921

2010 13,329 5,361 18,691 18,234 935 1,571 689 40,120

CAGR 14% 16% 15% 18% 12% N/A N/A 16%

51% 15% 66% 29% 6% 0% -1% 100%

51% 14% 65% 26% 10% 3% -4% 100%

46% 16% 62% 34% 1% 2% 0% 100%

33% 13% 47% 45% 2% 4% 2% 100%

2000 2,054 779 460 3,292 498

2005 5,338 2,142 1,397 8,877 1,591

2010 17,135 6,168 4,509 27,812 4,826

CAGR 00-10 24% 23% 26% 24% 25%

nonameresearch.com | 27 October 2012

2000 1,650 480 471 9 406 131 129 14 3,292

2005 2,967 1,197 1,389 23 2,354 466 377 106 8,877

2010 8,332 1,004 7,008 83 8,897 891 830 768 27,812

CAGR 18% 8% 31% 24% 36% 21% 20% 49% 24%

nonameresearch.com | 27 October 2012

nonameresearch.com | 27 October 2012

Trade At the Center of World Trade

A closer look at Chinas exports

nonameresearch.com | 27 October 2012

2000 12 1 4 8 0 25 12 43 83 86 0 224 249

2010 41 2 12 27 0 82 88 249 780 378 1 1,496 1,578

CAGR 9% 11% 7% 6% 6% 8% 16% 15% 26% 18% 7% 19% 16%

2000 132 5 45 7 55 4 249

2010 732 60 355 92 306 33 1,578

CAGR 15% 21% 20% 27% 22% 22% 18%

72% 2% 15% 1% 9% 1% 100%

53% 2% 18% 3% 22% 2% 100%

46% 4% 23% 6% 19% 2% 100%

nonameresearch.com | 27 October 2012

Source: China Statistical Agency

A closer look at Chinas imports

nonameresearch.com | 27 October 2012

2000 5 0 20 21 1 47 30 42 92 13 2 178 225

2000 141 6 41 5 26 6 225

2010 835 67 218 91 117 66 1,393

CAGR 18% 30% 15% 23% 14% 21% 18%

54% 1% 24% 3% 15% 3% 100%