China Macro

Economics & Equity Strategy

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Global Research

China’s next 5-year  Private capital and equity markets will

play a crucial role
plan  This represents a sea change from the
What it means for equity markets bank-led, SOE-centric financing model

 We analyse the sectors that could

benefit, including services and seven
emerging strategic industries

China will officially unveil its 12th Five-Year Plan in March

2011. We think if the government is to achieve its target of
more balanced and sustainable growth it will have to take a
new approach. This will involve real reform of income
distribution, industrial regulations and the fiscal system
(pages 4-9). Key points to look for include:

 Growth targets could be lowered to stress quality over

quantity. But don’t panic – China always under-
promises and over-delivers when it comes to GDP.

 Personal income could double through a more balanced

distribution of GDP among the government, corporate,
household and financial sectors.

 Private capital, rather than state investment, will play a

much bigger role in developing service and emerging
6 October 2010
strategic industries.
Steven Sun (孙 瑜)*
Head of China Equity Strategy  Property prices must be controlled to ensure the
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4298 stevensun@hsbc.com.hk
continuation of the important urbanization process.

Hongbin Qu Experience from the US, South Korea and Taiwan shows the
Co-Head of Asian Economics Research stock market helps to drive economic transformation and
The Hongkong and Shanghai Banking Corporation Limited upgrade industry. This will be even more important in China
+852 2822 2025 hongbinqu@hsbc.com.hk
as bank lending is likely to be constrained by risk aversion
Garry Evans* and the need to repair balance sheets (pages 17-20).
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited Service sectors such as IT, consumer financing, education,
+852 2996 6916 garryevans@hsbc.com.hk
healthcare and retail are significantly underdeveloped, so the
potential for growth is huge for both existing companies and
View HSBC Global Research at: http://www.research.hsbc.com
new issuers. We identify 15 listed IT outsourcing companies
*Employed by a non-US affiliate of HSBC Securities (USA) Inc,
and is not registered/qualified pursuant to FINRA regulations worth watching (pages 21-25).
Issuer of report: The Hongkong and Shanghai Banking
Corporation Limited A-share stocks in seven new priority industries are fully
valued at 50-80x trailing PE. We also provide a list of 60
Disclaimer & Disclosures
relevant stocks in the Hong Kong market (pages 26-31).
This report must be read with the
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it
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China Macro
Economics & Equity Strategy
6 October 2010

A road-map to navigate the 12th Five-Year Plan in 2011-15

Accelerating transformation of China’s economic growth

model to focus more on quality & sustainability of growth
(Likely to target lower GDP growth in 2011-2015)

Higher domestic demand Lower carbon intensity

(esp. consumption) (40-45% reduction by 2020)

Income distribution Urbanization Encouraging private Emerging strategic

Industry upgrading
reform (esp. western regions) investment industries

1. Raise the share of labor
compensation in GDP by
higher wage and lower tax
2. Better implementation of
minimum wage & collective
wage consultation systems
3. More fiscal spending to
improve people’s livelihood
1. Urbanization rate could
top 65% by 2030e from
46.6% in 2009 (only 38% in
western regions in 2008)
2. 24 regional development
plans unveiled since 2008
3. Further reforms on Hukou
system and land transfer
1. Opinions on Encouraging
and Guiding Healthy
Development of Private
Investment, New 36 clauses
2. Private sectors tend to
have higher efficiency and
generate more jobs – hence
also helping consumptions
1. Pricing reform of energy
& natural resources product
2. Speed up consolidation to
digest industry overcapacity;
cut back on high pollution &
energy-consuming sectors
3. Accelerating growth of
producer services sectors
1. The Magic 7 – Energy-
saving and environmental
protection; next generation
information technology; bio-
technology; high-end
manufacturing; new energy;
new materials and clean-
energy vehicles

Source: HSBC Equity Strategy Research

A framework to analyse income distribution reform

Income distribution reform to double disposable personal income in 2011-2015

Primary distribution – largely market driven Secondary distribution – government driven

- (2%) - (7.5%)
+ (83% share) + (4%) + (12.5%) + (10%)
Individual income tax Social security
Labor remuneration Property income Operational income Transfer income
contribution

1. Regulations on minimum
wage, in 2004 by Ministry
of Labor and Social
Securities – minimum
wage shall be adjusted at
least once every two years
and shall make reference
to 40-60% of local average
wage level;
2. The new labor contract
law in 2008 strengthened
protection of labor’s
interests;
3. To establish and
implement collective wage
consultation systems,
expected in 2011
1. Interest income of
saving deposits is
exempted from income tax.
But the real issue is when
China will push for interest
rate liberalization;
2. CSRC published
regulation in 2008 to
enforce higher dividend
payment for listed
companies that plan to do
secondary offering. But
actual payout ratio is still
very low;
3. 2010 new regulation
raises land acquisition
compensation standard by
20-30%
1. Income from small
business operation or self-
employment
2. State Council issued
new regulation in
September 2010 to
promote family services
through efforts in five
areas. Family services
business employ some
15mn people and generate
around RMB160bn
revenue each year
3. Various preferential tax
and credit policies to
facilitate self-employment
of laid-off workers and
fresh college graduates
1. Increase fiscal spending
on social security and
employment, medical and
health care, public housing
and education
2. Health care reform
launched in 2009 to
provide a wider coverage
of basic medical insurance
system (RMB850bn
committed in 3 years)
3. The new rural pension
insurance system initiated
in 2009 covered 10% of all
counties, with the goal to
extend to all farmers by
2020
1. Individual income tax
(IIT) threshold was raised
to RMB1,600 yuan per
month from RMB800 yuan
in 2005
2. IIT threshold was raised
again to RMB2,000 yuan
from RMB1,600 yuan in
2008
3. Further reforms on IIT
tax code such as raising
threshold further, linking
threshold to inflation, more
special deduction items or
simplifying cumulative tax
rates (say from nine tax
categories to five)
1. Lower the burden -
currently employer
contributes 33%+ of basic
salary as pension (20%),
medical (10%), on-job
injury, unemployment and
maternity insurance; while
employee contributes over
10% of basic salary
2. How? more funding for
the National Social
Security Fund (NSSF)
such as the 2009
regulation on share
transfer to NSSF of
domestic listed SOEs and
dividend transfer from
SOEs at parent group level

Source: HSBC Equity Strategy Research (disposable income breakdown calculated on 2007 statistics)

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China Macro
Economics & Equity Strategy
6 October 2010

Contents
Economics: from quantity to Stock markets crucial for economic transformation 17
quality of growth 4 US, Taiwan and Korea 17
A new game plan 4
China is no exception 19
Key economic themes 5
Promoting service sectors 21
Unleashing consumer power 5
The US experience and comparison 21
Optimising investment 6
From “made in” to “serviced in” China 23
Reform, reform, reform… 7
Screening:15 IT outsourcing stocks 25
Takeaways from provincial drafts 8
Emerging strategic industries 26

Does industry policy work: the old vs. new Magic 7? 26

Equity: how stock market
helps and benefits? 10 Growth priced in and valuation rich 28
Roadmap for state strategy 10 Screening: 60 relevant stocks in 7 emerging strategic
Changing economic growth model 10 industries 30

Income distribution reform 13

Disclosure appendix 33
Urbanization 15

Enter private capital 16 Disclaimer 35

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China Macro
Economics & Equity Strategy
6 October 2010

Economics: from quantity

to quality of growth
 Achieving more balanced and sustainable growth will be the key
policy objective of China’s 12th five year plan
 This requires real reforms of income distribution, industrial
regulations and fiscal system
 Further steps towards financial reforms are also necessary to
unleash the power of consumers and inland regions

The consultative draft of the 12th Five-Year Plan
will be discussed at the Fifth Plenary Session of the
17th Central Committee of the Communist Party of
China, on 15-18 October 2010. Based on these
discussions, the final draft plan will be completed by
the start of 2011 and then submitted to the annual
session of the National People's Congress in March
2011 for deliberation and ratification.
A new game plan
The market is now focusing on the risk of a
double-dip in China in the coming quarters. Our
view remains unchanged: China’s overheated
economy will continue to slow as Beijing curbs
credit but the likelihood of a double-dip is remote.
And the economy can still rely on continued
investment in ongoing infrastructure projects and
resilient consumption to grow by around 9% in
2H10 and 2011.
A more important question, we believe, is what
China can and will do over the next few years to
sustain growth. President Hu Jintao mentioned
“inclusive growth (包容性增長)” in his speech at
an APEC meeting on 16 Sept, emphasising that Hongbin Qu
Co-Head of Asian Economics
making all the people benefit from economic Research
growth is the ultimate goal of inclusive growth. The Hongkong and Shanghai
Banking Corporation Limited
Let’s take a look at some initial indications for the +852 2822 2025
hongbinqu@hsbc.com.hk
key agenda in the forthcoming five-year plan.
Jun Wei Sun
China Economist
Although China will likely overtake Japan as the
world’s second-largest economy this year, it is
still a poor country, with per-capita GDP of less
than USD4,000 per year. So the next five-year
period (2011-15) will be critical for China to
achieve its announced long-term overall goal of
quadrupling per-capita GDP by 2020 (from the
2000 level).
Policymakers are likely to make steady and
sustainable growth the most important objective,
with structural adjustments and reforms as the
policy tools. However, against the backdrop of the
sluggish recovery of the developed world, we
believe they have a challenging task ahead,
especially given the decades of double-digit
growth and the prolonged sluggish recovery in
developed economies.

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China Macro
Economics & Equity Strategy
6 October 2010

Table 1. Five-year plans: a snapshot

Five year plans Period GDP (USDbn, Actual Targeted Key agenda
current price, growth growth
period end)
12th 2011-2015 n.a. n.a. n.a. Making growth more balanced and sustainable will likely be the main
objective. Key items on the agenda will include reforming income
distribution, boosting the social security system, promoting investment
in less developed regions, encouraging private investment, reforming
the resources pricing system, and further reforms of financial markets.
11th 2006-2010* 5,695 11.4 7.5% Growth driver shifting from investment and exports to coordinated
growth between investment and consumption, domestic demand and
external demand; industrial structural change from secondary
industry-led to balanced driver by three industries and structural
upgrading; save energy, protect the environment and promote
resource efficiency; continuous reform to allow market to play a major
role in resource allocation
10th 2001-2005 2,260 9.76 7% Structural adjustment to achieve profitable growth; strengthen
agricultural sector, speed up industrial restructuring and structural
optimisation, promote service sectors, strengthen infrastructure
construction; expand employment, increase household income, adjust
income distribution, improve social security
9th 1996-2000 1198 8.62 8% Quadruple GDP by 2000 from 1980 level; eliminate poverty, achieve
xiaokang life; accelerate the building-up of modern enterprises (SOEs
reform), establish socialist market economic institutions
8th 1991-1995 728 12.28 6% Deepen reform to facilitate economic growth, reduce the imbalance
between agricultural and secondary industries and the imbalance
between basic industries/infrastructure and manufacturing sectors;
technology upgrading for key enterprises; opening-up to expand
export income and invite foreign capital, technology and human
resources
* based on HSBC estimates
Source: HSBC

Key economic themes pronounced last year due to the investment-centric

What can we expect from Beijing for the next
five-year period? As we’ve said earlier, we
believe structural adjustments and reforms to
achieve more sustainable and balanced growth are
likely to be the key policy focus. In other words,
the quality and sustainability rather than the speed
of growth will matter most.
stimulus package.
There will likely be more efforts to boost Chinese
consumer power. Increasing household income
and lifting the propensity to consume are
important. To achieve the former, reforms are
needed in the income distribution system and the
income gap needs to be narrowed. The latter

Unleashing consumer power

Chart 2. Investment rising faster than consumption (%)
One key theme is likely to be making the
economy more domestically demand-driven, with 55
50
a larger contribution from private consumption.
45
Indeed, the share of private consumption to GDP
40
fell to 36% in 2009 from nearly 50% 20 years ago 35
(see Chart 2). In recent years, despite Beijing’s 30
intensified pro-consumption measures (including 25
20
improving the social security network and
1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
subsidies on durable goods), even faster growth in
Priv ate consumption Capital formation
investment pushed the ratio of investment to GDP
higher. This imbalance became even more Source: CEIC, HSBC

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China Macro
Economics & Equity Strategy
6 October 2010
implies the need to continue reforming the social
security system, and expanding the coverage of
social security to the rural population.
Reforming income distribution
The long-awaited income distribution reform is
likely to mainly target primary distribution, with
secondary distribution as a supplement. Overall
labour compensation has been falling sharply as a
percentage of GDP, while government tax income
and enterprises’ profit have both increased (Chart
3). Hence, as wage income accounts for the lion’s
share of household income, private consumption
has fallen as a proportion of GDP (see Chart 4).
If successful, the reform is likely to increase the
share of labour compensation and consequently the
share of private consumption to GDP. To achieve
this, policy makers need to increase incomes (wages)
and reduce the tax burden of Chinese households.
Minimum wage and collective wage consultation
systems are likely to be more widely implemented.
Raising the threshold of personal income tax and
levying family-based income tax are also possible
solutions.
Income distribution reform also requires
corresponding reform of enterprise taxation – it
will take a slice from companies’ profits, and so
will likely meet with resistance. Therefore it will
be a challenge for Beijing to design a
Chart 3. The falling share of labour compensation in GDP
(As % of GDP)
53
60
50 40
40
30
20 14 15 13 14
10
0 30
Labour Depreciation Tax
compensation
1997
Source: CEIC, HSBC
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comprehensive reform package, including wider
tax reform, and strictly reinforcing employers’
contributions to social security.
Boosting the social security system
To increase the propensity to consume, it is
critical to improve social security provisions and
build more public housing for low-income groups.
As the social security system has been in better
shape in urban areas than in rural ones, the focus
will be on the latter.
Meanwhile, reforming the residents’ registration
(a.k.a. hukou) system will likely be another
important tool to accelerate urbanisation. This
should provide a long-term growth driver as new
urban residents start buying modern home
appliances, eating out more frequently and going
on holiday more often.
Optimising investment
Does lifting private consumption mean depressing
investment? Not really. Investment will continue
to be a key growth driver in the next five years,
but the structure and efficiency of investment
need to change.
Promoting investment in less developed
regions
Investment is likely to focus on the less-developed
inland regions to improve infrastructure and
Chart 4. Private consumption moves in line with labour
compensation
(As % of GDP)
60
31 50
20
40
Profit 1997 1998 1999 2000 2001 2003 2005 2006 2007
2007 Labour compensation Priv ate consumption
Source: NBS, HSBC

China Macro
Economics & Equity Strategy
6 October 2010
industry. This will allow inland provinces to catch
up and promote more balanced growth across the
nation. Such initiatives are reflected in a slew of
regional plans, such as the “Western
development” initiative. More are in the pipeline.
Property investment will likely be supported by
both public and private investment. The rules
curbing speculative demand are likely to stay in
place in the medium term. This is critical to
ensuring that property prices rise gradually rather
than rapidly. This, coupled with the likelihood of
introducing property taxes and other regulations
for developers, should help achieve the well-
regulated development of the property market and
rational property investment. The initiative of
building more public housing should continue
over the next five-year period, lending support to
property investment.
Industrial investment is likely to be skewed
towards energy efficiency and strategically new
industries. The focus will likely lie in equipment
and technology upgrades to adopt advanced
capacity or investment in new industries. This is
likely be facilitated by preferential tax policies.
For example, government subsidies on electric
cars and subsidies on interest payments to new
energy enterprises should encourage investment in
these areas. This is essential for China to achieve
its target of reducing energy intensity by 40-50%
by 2020 (from the 2005 level), which Premier
Wen committed to at the Copenhagen Climate
Change Summit.
Encouraging private investment
We also expect the further deregulation and
opening up of investment policy to encourage
more private investors. The State Council’s
circular in May to lift private investment should
be effective in the coming years.
Last but not least, China should continue to
reform the resources pricing mechanism and
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interest rate formation scheme to properly reflect
the cost of investment.
Reform, reform, reform…
The importance of reforms has just been stressed
by Premier Wen during his recent visit to
Shenzhen, while Vice Premier Li Keqiang –
Wen’s likely successor – also underlined reforms
to promote the transition of economic
development patterns.
Reforms should be comprehensive: from changing
the hukou system to accelerating the pace of
urbanisation – the long-term growth driver – to
fiscal reforms, and from further openness and
more direct financing in the capital markets to
promoting the use of the renminbi in international
trade and investment.
Urbanisation to speed up
In the 11th five-year plan, Beijing set the target of
urbanisation rate at 47% by the end of 2010. This
was reached in 2009. In the 12th five-year plan, a
new target of 55% by the end of 2015 is expected,
which suggests nearly 150m people will move to
urban areas in the next five years.
Liberalizing the Hukou system will effectively help
China’s 120m migrant workers better integrate into
cities. Household registration constraints in
metropolises such as Beijing and Shanghai are not
likely to be loosened to migrant workers in the
foreseeable future. However, there may be more
flexibility in medium and small sized cities that are
more attractive to migrant workers in that they offer
better education, medical facilities and relatively
affordable housing.
This will certainly boost investment demand for
city infrastructure. In the meantime, as income
rises, these new urban citizens are most likely to
consume as much as established city residents.
This incremental demand will be a strong driving
force that could sustain China’s economic growth
at a relatively rapid pace for the next 5-10 years.
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China Macro
Economics & Equity Strategy
6 October 2010

Now for the hard part of fiscal system reform
China’s central government pockets more than
half of the national fiscal revenues, but
expenditure accounts for only 20%, delivering
much of the surplus to local governments in the
form of transfer payments (expected to total
RMB3trn in 2010, or 65% of total central
government expenditure). Local governments
undertake most public expenditure such as
medical care, education and social security but
they have limited financial resources and tools.
This is the key factor behind the underdevelopment
in China’s social security system. Top leaders need
to sort out ways to streamline responsibilities and
financial resources between central and local
governments. This is crucial for the implementation
of Beijing’s plan of strengthening public expenditure,
especially in rural and western areas, so that both
urban and rural residents can enjoy equal basic
public services.
Developing bond market
China’s bond market, especially the inter-bank
bond market, sustained rapid growth in the past
few years, with overall market cap reaching
RMB18trn. But the bond market is still in its
infancy relative to indirect bank financing. The
RMB4trn stimulus package has aggravated the
situation as local governments borrowed heavily
from banks via financing vehicles for
infrastructure projects to support economic
growth. By allowing local governments to issue
municipal bonds, China can not only facilitate the
development of bond market, but also address the
needs of local governments’ infrastructure
investment. At the same time, it might allow
China’s banks to avoid contingent system risk
(local government related credit totalled
RMB7.7trn according to the CBRC).
The development of the bond market is closely
connected with liberalization of interest rates.
After years of effort, China’s Treasury bond rates,
inter-bank corporate bond rates and policy
financial bond rates have all been liberalized. The
next step is to free traditional bank lending and
deposit rates, which is crucial to China’s banking
sector reform.
Growth shifts to inland regions
Economic growth in China’s western region has
accelerated in the past few years, recording
double-digit GDP growth for eight consecutive
years. This is thanks to Beijing’s preferential
policies and industrial outsourcing from coastal
areas. Western region’s GDP grew by 13.5% y-o-
y in 2009, outpacing coastal provinces for the
third year running, with the latter suffering from
the external shock of the global financial crisis.
Top leaders reiterated policy support to the
western region on July 6 this year, launching a
new round of development plans. Planned
investment totalled RMB682bn in 2010, mostly
infrastructure projects, such as power grids,
railways, roads, and water conservancy. Since
infrastructure in inland provinces lags behind
coastal regions, this will certainly boost
investment in the western region.
To balance development between coastal and
inland regions, better co-ordination is needed.
This involves building appropriate transportation
and communications infrastructure in inland
regions and providing tax preference policies.
Beijing can also help coastal regions to upgrade
their industrial base so that they can move up the
value chain.
Takeaways from provincial
drafts
Let’s get some quick takeaways from the drafts of
provincial plans:
 Coastal Guangdong province – the largest
province in terms of economic scale,
representing 11% of the country’s GDP – is

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China Macro
Economics & Equity Strategy
6 October 2010

setting a target of 8% GDP growth and 7%
per-capita GDP growth in the 12th FYP. It
will introduce structural adjustments to make
the economy more balanced, driven by
consumption, investment and exports. It also
aims to lift foreign investment and curb
investment in backward capacity and projects,
and to boost service industries to make the
economy less dependent on manufacturing.
 In inland southwest Chongqing, the largest
municipal city and home to nearly 30m
people, the government targets RMB1,400bn
GDP in 2015, nearly double the expected
GDP in 2010. The strategy is to build up the
manufacturing base and services centre in the
southwest, with a RMB4trn investment plan
(doubling that in the 11th FYP) and the non-
agriculture sectors making up 95% of GDP
(vs 90.7% in 2009).
It is inevitable that the central government and
provincial leaders will put a different emphasis on
certain issues. It is interesting to note that
provincial plans traditionally have a higher
growth target than the national one and local plans
normally get earlier approval.
Local governments tend to strive for big goals and
can sometimes be short sighted. As a result the
quality of growth gives way to quantity of growth
at the local level, leading to persistent imbalances
and significant cost in terms of the environment
and resources. To avoid this, Beijing also needs
political reform to change evaluation standards for
local officials, with less weighting given to
quantity of growth and more to quality.

 In the middle of country, Henan province, the

second-most populous province with 95m
people, the government aims to double per-
capita GDP from USD3,000 to USD6,000 by
2015. While urbanisation and industrialisation
should be the dual growth engines, it also
emphasises adjusting primary income
distribution to lift the incomes of low and
mid-income groups.

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China Macro
Economics & Equity Strategy
6 October 2010

Equity: how stock market

helps and benefits?
 Equity markets will play a crucial role to drive the transformation,
moving away from the bank-led and SOE-centric financing model
 Service highlights: IT outsourcing, education, healthcare and retail
 Emerging strategic industries: Will the policy work? Is it priced in?

Roadmap for state strategy But don’t panic – China always under-promises Steven Sun (孙 瑜)*
and over-delivers on economic growth targets. As Head of China Equity
Changing economic growth model Strategy
a reference, HSBC China economists forecast The Hongkong and Shanghai
HSBC China economists expect the strategic Banking Corporation Limited
8.9% and 8.6% GDP growth for 2011 and 2012, +852 2822 4298
focus to shift from quantity to quality of growth stevensun@hsbc.com.hk
respectively.
for the next five-year plan. It’s easier said than Devendra Joshi*
done. In 2001-2010f, the average share of Apart from the US, which over-consumes, and Strategy Associate

consumption expenditure to GDP growth has China, which under-consumes (consumption is *Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
actually dropped by 14ppts to 43%, while that of only 36% of the economy), all other G7 and BRIC and is not registered/qualified
capital formation has gone up by 18ppts to 54% countries have similar levels of consumption-to- pursuant to FINRA regulations

and an astonishing 95% in 2009 (chart 5), thanks GDP ratio, averaging 58%. Moreover, the higher
to the RMB4trn stimulus package. the share of consumption, the lower the carbon
intensity (chart 8), so they are really two sides of
At the risk of simplification, the top two strategic
the same coin.
goals on the economic front are higher growth
contribution from domestic demand, particularly China announced at the Copenhagen climate
private consumption, and lower carbon intensity – summit in November 2009 that by 2020 it will
40-45% reduction by 2020 from the 2005 level. reduce its carbon intensity, the CO2 emitted per
unit GDP, by 40-45% from 2005 levels. This
It’s interesting to note that for the past 30 years
target will measure only the emissions from
(1980-2009) there are 15 years with above 10%
energy consumption and industrial activity. The
real GDP growth. It appears growth has been
target implies a 3.3-3.9% compounded annual
more balanced in years of relatively lower growth
reduction for China, which is largely inline with
– on average a 4ppt higher contribution from
what China has achieved in 1980-2005 (chart 9).
consumption and 18ppt lower from investment
But it’s worth pointing out the ratio rebounded by
(chart 6). Hence it’s possible that China may
14% in 2002-05, according to the World
target slightly lower GDP growth for the 12th
Resources Institute.
Five-Year Plan (chart 7).

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China Macro
Economics & Equity Strategy
6 October 2010

Chart 5. Quality of growth has deteriorated in the past decade (2001-2010) compared to 1991-2000

Share to GDP Grow th: Final Consumption Ex penditure Gross Capital Formation Net Ex ports
100%
80%
60%
40%
20%
0%
-20%
-40%
Consumption: 57% in 1991-2000 to 43% in 2001-2010f; ↓14ppts
-60%
Inv estments: 36% in 1991-2000 to 54% in 2001-2010f; ↑18ppts
-80%
1981 (6th FYP) 1986 (7th FYP) 1991 (8th FYP) 1996 (9th FYP) 2001 (10th FYP) 2006 (11th FYP) 2011f

Source: CEIC, HSBC Economic Research

Chart 6. GDP growth: quantity vs. quality in 1980-2009 Chart 7. 12th FYP likely to target lower economic growth

70% Below 10% GDP Grow th Abov e 10% 16% Targeted Acutal GDP CAGR
14% 12.3%
60% 11.4%
12% 9.8%
50% 8.6%
10%
40% 8% ?
30% 6%
4%
20% 2%
10% 0%
0% 8th FYP 9th FYP 10th FYP 11th FYP 12th FYP
Consumption to Gross Capital Net ex ports (1991- (1996- (2001- (2006- (2011-
GDP Grow th Formation Contribution 1995) 2000) 2005) 2010) 2015)

Source: CEIC (15 years real GDP growth below 10%; 15 years higher than 10%) Source: HSBC Economic Research

Chart 8: Higher consumption ←→ lower carbon intensity Chart 9. A tall order to cut carbon intensity by 40-45%

90% 2009 consumption/GDP 1% CO2 Intensity CAGR (1980-2005)

80% 0%
USA -1%
70% UK -2%
Brazil Japan India
60% Russia -3%
50% Canada -4%
-5% Implied by China's 2005-2020
40% China
-6% goal or 3.3-3.9% per y ear
Continental Europe
30% -7%
2005 CO2 intensity
India
Italy

US
UK
Japan
Korea
Canada
Russia

France

China
Brazil

Taiwan
Germany

20%
100 300 500 700 900 1100

Source: CEIC, WRI (unit: metric tons of CO2 emission per mn PPP int’l 2005 dollars) Source: WRI

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China Macro
Economics & Equity Strategy
6 October 2010

In our view there are three major tasks involved in
rebalancing domestic and external demand, which
is imperative given the sluggish recovery outlook
in the developed countries and the emerging
labour movement in China (please refer to China
Investment Atlas Issue 27, “Workers united!”,
July 2010):
 Income distribution reform – the State
Council has already indicated its intention to
double disposable personal income during the
12th Five-Year Plan period, inferring a 15%
CAGR in 2011-15.
 Accelerating urbanization in western
regions – Assuming China’s urbanization rate
will reach 65% by 2030e, the size of the
urban population could grow by 200-300m in
the next two decades, averaging 10-15m per
year and providing stimulus for both
consumption and investment.
 Encouraging private investment – Further
deregulate and open up the state monopolized
industries to encourage private capital to
supplement public investment. The private
sector is more efficient and generates more
jobs, boosting consumption.
To strive for lower carbon intensity and a greener
economy, China will upgrade existing industries
and cultivate emerging strategic industries:
 Industry upgrading – Deepen pricing reform
of energy and natural resources products to
normalize subsidized prices. Speed up
industry consolidation to digest overcapacity
and cut back on high pollution and high
energy-consuming sectors. Accelerating
growth of producer services sectors.
 Emerging strategic industries – Energy-
saving and environmental protection; next
generation information technology; bio-
technology; high-end manufacturing; new
energy; new materials; clean-energy vehicles.

Chart 10. A road-map for the 12th Five-Year Plan (2011-15)

Accelerating transformation of China’s economic growth

model to focus more on quality & sustainability of growth
(Likely to target lower GDP growth in 2011-2015)

Higher domestic demand Lower carbon intensity

(esp. consumption) (40-45% reduction by 2020)

Income distribution Urbanization Encouraging private Emerging strategic

Industry upgrading
reform (esp. western regions) investment industries

1. Raise the share of labor
compensation in GDP by
higher wage and lower tax
2. Better implementation of
minimum wage & collective
wage consultation systems
3. More fiscal spending to
improve people’s livelihood
1. Urbanization rate could
top 65% by 2030e from
46.6% in 2009 (only 38% in
western regions in 2008)
2. 24 regional development
plans unveiled since 2008
3. Further reforms on Hukou
system and land transfer
1. Opinions on Encouraging 1. Pricing reform of energy 1. The Magic 7 – Energy-
and Guiding Healthy & natural resources product saving and environmental
Development of Private 2. Speed up consolidation to protection; next generation
Investment, New 36 clauses digest industry overcapacity; information technology; bio-
2. Private sectors tend to cut back on high pollution & technology; high-end
have higher efficiency and energy-consuming sectors manufacturing; new energy;
generate more jobs – hence 3. Accelerating growth of new materials and clean-
also helping consumptions producer services sectors energy vehicles

Source: HSBC Equity Strategy Research

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China Macro
Economics & Equity Strategy
6 October 2010

Income distribution reform  Operational income (12.5%) – Promote

th
The 12 Five-Year plans to double disposable family services through efforts in five areas.
personal income (DPI) through various channels  Transfer income (10%) – Increase share of
and approaches (Charts 11-12). This suggests fiscal spending on social security and
15% CAGR of DPI in 2011-15 and a more employment, medical and health care, public
balanced distribution of GDP by the government, housing and education.
corporate, household and financial sectors:
 Individual income tax (-2%) – Further tax
 Labour compensation (83% share in reforms such as raising the threshold, linking
disposable income) – We have seen minimum threshold to inflation, more special deduction
wage requirements increase 10-30% across items or simplifying cumulative tax rates.
China this year, though consensus appears to
be this should be largely determined by the  Social securities contribution (-7.5%) – Lower
market. That said, collective wage both employer and employee contributions by
consultation is expected in 2011 to better beefing up the National Social Security Fund
protect workers’ interests. (NSSF). Examples include the 2009 regulation
on share transfer to the NSSF from domestic
 Property income (4%) – Interest rate listed SOEs and dividend transfer from SOEs at
liberalization and mandatory dividend payout parent group level.
for listed companies are the best way to
increase property income, e.g., a 1ppt higher  Break up the SOE monopoly by increasing
depository rate equals RMB200bn income market competition from the private sector.
transfer to households.

Chart 11. Analyzing income distribution reform

Income distribution reform to double disposable personal income in 2011-2015

Primary distribution – largely market driven Secondary distribution – government driven

- (2%) - (7.5%)
+ (83% share) + (4%) + (12.5%) + (10%)
Individual income tax Social security
Labor remuneration Property income Operational income Transfer income
contribution

1. Regulations on minimum
wage, in 2004 by Ministry
of Labor and Social
Securities – minimum
wage shall be adjusted at
least once every two years
and shall make reference
to 40-60% of local average
wage level;
2. The new labor contract
law in 2008 strengthened
protection of labor’s
interests;
3. To establish and
implement collective wage
consultation systems,
expected in 2011
1. Interest income of
saving deposits is
exempted from income tax.
But the real issue is when
China will push for interest
rate liberalization;
2. CSRC published
regulation in 2008 to
enforce higher dividend
payment for listed
companies that plan to do
secondary offering. But
actual payout ratio is still
very low;
3. 2010 new regulation
raises land acquisition
compensation standard by
20-30%
1. Income from small
business operation or self-
employment
2. State Council issued
new regulation in
September 2010 to
promote family services
through efforts in five
areas. Family services
business employ some
15mn people and generate
around RMB160bn
revenue each year
3. Various preferential tax
and credit policies to
facilitate self-employment
of laid-off workers and
fresh college graduates
1. Increase fiscal spending
on social security and
employment, medical and
health care, public housing
and education
2. Health care reform
launched in 2009 to
provide a wider coverage
of basic medical insurance
system (RMB850bn
committed in 3 years)
3. The new rural pension
insurance system initiated
in 2009 covered 10% of all
counties, with the goal to
extend to all farmers by
2020
1. Individual income tax
(IIT) threshold was raised
to RMB1,600 yuan per
month from RMB800 yuan
in 2005
2. IIT threshold was raised
again to RMB2,000 yuan
from RMB1,600 yuan in
2008
3. Further reforms on IIT
tax code such as raising
threshold further, linking
threshold to inflation, more
special deduction items or
simplifying cumulative tax
rates (say from nine tax
categories to five)
1. Lower the burden -
currently employer
contributes 33%+ of basic
salary as pension (20%),
medical (10%), on-job
injury, unemployment and
maternity insurance; while
employee contributes over
10% of basic salary
2. How? more funding for
the National Social
Security Fund (NSSF)
such as the 2009
regulation on share
transfer to NSSF of
domestic listed SOEs and
dividend transfer from
SOEs at parent group level

Source: HSBC Equity Strategy Research (disposable income breakdown calculated on 2007 statistics)

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China Macro
Economics & Equity Strategy
6 October 2010

Chart 12. Attribution analysis on the declining share of disposable personal income (DPI) to GDP, or 12ppts in 1992-2007
GDP Gov't % of Corp. % of DPI % of Labour LC-to- Fiscal FT-to- Fiscal FC-to- Income IP-to- Operat. OI-to-
(RMB GDP profit GDP GDP Comp. GDP Transfer GDP contri. GDP from GDP income GDP
bn) Propert.
1992 2,692 539 20.0% 285 10.6% 1,845 68.5% 1,470 54.6% 132 4.9% -66 -2.5% 119 4.4% 191 7.1%
1993 3,533 694 19.7% 503 14.2% 2,283 64.6% 1,817 51.4% 171 4.8% -95 -2.7% 179 5.1% 211 6.0%
1994 4,820 893 18.5% 642 13.3% 3,229 67.0% 2,521 52.3% 214 4.4% -119 -2.5% 275 5.7% 338 7.0%
1995 6,079 992 16.3% 884 14.5% 4,029 66.3% 3,209 52.8% 273 4.5% -147 -2.4% 295 4.9% 398 6.6%
1996 7,118 1,257 17.7% 867 12.2% 4,813 67.6% 3,709 52.1% 333 4.7% -184 -2.6% 367 5.1% 588 8.3%
1997 7,897 1,436 18.2% 966 12.2% 5,384 68.2% 4,187 53.0% 458 5.8% -228 -2.9% 335 4.2% 632 8.0%
1998 8,440 1,512 17.9% 1,077 12.8% 5,704 67.6% 4,432 52.5% 469 5.6% -250 -3.0% 358 4.2% 695 8.2%
1999 8,968 1,609 17.9% 1,223 13.6% 5,973 66.6% 4,713 52.6% 472 5.3% -254 -2.8% 302 3.4% 740 8.2%
2000 9,921 1,892 19.1% 1,582 15.9% 6,325 63.8% 5,002 50.4% 452 4.6% -339 -3.4% 309 3.1% 902 9.1%
2001 10,966 2,230 20.3% 1,850 16.9% 6,744 61.5% 5,437 49.6% 530 4.8% -412 -3.8% 327 3.0% 861 7.9%
2002 12,033 2,524 21.0% 2,018 16.8% 7,330 60.9% 6,065 50.4% 665 5.5% -544 -4.5% 339 2.8% 806 6.7%
2003 13,582 3,006 22.1% 2,220 16.3% 8,171 60.2% 6,683 49.2% 765 5.6% -665 -4.9% 327 2.4% 1,059 7.8%
2004 15,988 3,052 19.1% 3,608 22.6% 9,339 58.4% 7,525 47.1% 896 5.6% -762 -4.8% 254 1.6% 1,425 8.9%
2005 18,494 3,825 20.7% 3,602 19.5% 11,061 59.8% 9,280 50.2% 1,014 5.5% -923 -5.0% 347 1.9% 1,343 7.3%
2006 21,631 4,902 22.7% 3,790 17.5% 12,653 58.5% 10,537 48.7% 1,199 5.5% -1,125 -5.2% 511 2.4% 1,532 7.1%
2007 26,581 6,308 23.7% 4,551 17.1% 15,082 56.7% 12,517 47.1% 1,493 5.6% -1,426 -5.4% 615 2.3% 1,883 7.1%
97/92 -1.8% 1.7% -0.4% -1.6% 0.9% -0.4% -0.2% 0.9%
02/97 2.8% 4.5% -7.3% -2.6% -0.3% -1.6% -1.4% -1.3%
07/02 2.8% 0.4% -4.2% -3.3% 0.1% -0.8% -0.5% 0.4%
07/92 Δ 3.7% 6.5% -11.8% -7.5% 0.7% -2.9% -2.1% 0.0%
Source: CEIC, HSBC Equity Strategy Research

We have conducted an attribution analysis on the
declining share of DPI to GDP, by 12ppts to 57%
in 1992-2007 (chart 42), which helps to reveal the
various causes of the problem. The shaded
columns on the left show how the GDP is divided
after the primary and secondary distributions
among the government (mainly tax revenues),
non-financial corporate (mainly profits) and
households (mainly labour compensation), with
the balance going to financial institutions:
 For the 15-year period 1992-2007, the
government sector, corporate and financial
sectors represented some 30%, 55% and 15%
of the declining share of DPI, respectively.
 In 1992-97, the share of DPI remained largely
flat at two-thirds of GDP, while corporate
profits had gained share mainly at the expense
of government tax revenues.
 In 1997-2002, the share of DPI dropped
7.3ppts, with some 40% attributable to the
higher share of the government’s disposable
income in GDP and the other 60%
attributable to the corporate sector.
 In 2002-07, the share of DPI had dropped
4.2ppts, which mainly benefited the
government sector.
The columns on the right show five categories of
the DPI – labour compensation, fiscal transfer
from the government, personal income tax and
social security contributions, income from
property and operational income:
 Declining share of labour compensation,
which accounts for 83% of DPI, contributed
7.5ppts to the 11.9ppts share loss of DPI.
 Share of fiscal transfer in GDP increased less
than 1ppt but share of personal income tax
and social securities contributions went up by
nearly 3ppts, resulting in a net decline of
2.2ppts of DPI, or some 20% of total loss.
 Share of income from property in GDP,
mainly interest income and dividends,
declined 2.1ppts and explained another 20%
loss of DPI’s share in GDP.
It suggests corporate, government and financial
institutions should all contribute in order to
reverse the trend.

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China Macro
Economics & Equity Strategy
6 October 2010

Urbanization Urbanization could also propel consumption

Urbanization has been identified as the single growth through the growing pool of urban
most important factor for domestic demand consumers. Urban per capita consumption in 2009
growth. The government is pinning its hopes on stood at RMB12,265 (USD1,800), or 3.5 times
accelerating urbanization in western regions as a that of rural areas. For the top 36 cities in China,
policy platform to gradually solve the long-term average consumption expenditure was
economic challenges such as imbalanced regional RMB15,604 (USD2,200), or 4.5 times.
development levels, the urban-rural divergence
Further liberalization of the urban household
and industry upgrading. Property prices must be
registration system, or Hukou, and reforms to land
controlled to ensure the pace of urbanization
ownership transfer will be regulatory changes
process won’t become stalled.
driving the urbanization process. Various regional
Estimates from various academic sources, as well development plans and the emerging trend of
as comments from government officials, suggest industrial manufacturing base migrating to inland
China’s urbanisation rate could go up from 47% and western provinces are economic drivers.
to 65% by the end of 2030 and eventually reach Moreover, the public housing scheme will also
70-80% by 2050 (chart 13). Even if the 150-170m greatly facilitate the urbanization process.
migrant workers are counted as urban residents,
the potential upside could still be 10-20ppts. The Ministry of Finance stated in August that
over 88% of the fiscal budget for public housing
From an investment perspective, urbanization
in 2010, or RMB63bn, had been deployed in the
boosts both the property sector and public
first seven months of the year. It’s possible that
infrastructure investments. For instance, 10-15m
the central government may eventually raise the
new urban residents every year could translate
budget to RMB90-100bn, or 12-15% of what is
into 100-150m sqm of potential housing demand,
needed to complete the task, i.e., building 5.8m
assuming 10 sqm per person (the national average
public housing units plus revamping 1.2m units in
living standard for the low-income group in urban
rural areas over the next 18 months also (chart
areas). Regression for the past two decades also
suggests that around 20% of the potential demand, 14). The People’s Daily also reported that by end
or 20-30m sqm, could be realized as residential August, RMB470bn had been spent on public
floor space sold in a year, representing 3-5% of housing, or 60% of the full-year target.
incremental demand.

Chart 13. Urbanization set to power ahead for years to come Chart 14. Public housing scheme to facilitate urbanization

1100 Working population (mn) 85% Economic,

Urbanization rate 65% Rural
1000 75% housing
reconstruction
0.8
900 65% 1.2
800 46.6% 55% Low-rental
45% Housing,
700
1.8
600 35%
500 25% Public-
29% Slum
Rental,
400 15% reconstruction
housing
300 5% 2.8
0.4
2020f
2030f
2040f
2050f
1950
1960
1970
1980
1990
2000
2009

Source: UN, CEIC, HSBC (working population refers to age group in 15-54) Source: State Council

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China Macro
Economics & Equity Strategy
6 October 2010
Enter private capital
In May, the State Council issued the “Opinions on
Encouraging and Guiding the Healthy Development
of Private Investment”. It proposed opening more
sectors, most of them currently monopolized by the
SOEs, to domestic private investors and encouraging
private capital to invest in areas and industries where
existing regulations do not explicitly prohibit
domestic private investments.
The new policy, or the so-called “new 36
clauses”, is a follow-up to the Cabinet’s policy
released five years ago, known as “36 clauses for
the non-state-owned economy.” While the
original provided general principles for the private
sector, the new one is geared towards investment-
related issues and should provide better guidance
to domestic private investors.
Statistics from the Xinhua news agency show that
state-owned capital is permitted to enter 72 of the
80 industries in China, foreign capital is allowed
in 62, and domestic private capital has access to
only 41. The new policies will encourage much
broader private investment, including the basic
industries (e.g. transport, power generation, oil
and gas exploration and telecom services), as well
as infrastructure, utilities, public housing,
financial services, trade-related business
management and logistics, and even national
defence science and technology.
Chart 15. Private sector creates 3m jobs per year
120 # of employees: mn
100
80
60
40
20 2%
0 10%
92 94 96 98 00 02 04
SOEs Collectiv e ow ned
Source: CEIC
16
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The new policies will also establish a financing
guarantee system, which should improve venture
capital investment mechanisms, promote the
development of private equity investment funds
and encourage private companies to obtain
financing from the stock and bond markets.
The importance of private sector investment, both
domestic and foreign, is self explanatory but often
underappreciated:
 It employs 44% of the workforce, up from
less than 2% in 1992. For the past 18 years, it
has created 3m jobs per annum on average,
vs. 2.3m lay-offs by the SOEs and 1.7m job
reductions by the collective-owned
enterprises (chart 15).
 The percentage of fixed asset investment by
SOEs has dropped to 41% from 61% in 2004,
while that of domestic private capital has
gone up to 21% from 10% (chart 16).
The 12th Five-Year Plan will rely more on private
capital to create jobs and boost investment.
Private capital, in particular equity (public and
private), will play a more significant funding
role in developing cutting-edge and service
industries, signalling a sea change away from
the bank-led and SOE-centric financing model
of the last two decades.
Chart 16. Domestic private sector a future investment driver
FAIs: % by SOEs Domestic priv ate enterprises
70%
60%
50%
40%
44% 30%
20%
0%
06 08 10
Priv ate ow ned 2004 2005 2006 2007 2008 2009 2010
Source: CEIC

China Macro
Economics & Equity Strategy
6 October 2010
Stock markets crucial for
economic transformation
The role of capital markets, particularly stock
markets, could become a strong catalyst of
China’s economic transformation, particularly at a
time when the banking sector needs to repair its
balance sheet. High equity valuations, sometimes
on the bubbly side, can provide an incentive to
mobilize private capital as well as create
investment opportunities.
Both stock markets and banks provide sources of
external financing for firms. For the purpose of
resource allocation, they both create information
to guide the process. They differ only in the way
the information is transmitted. Information in
stock markets is contained in equity prices, while
loan managers perform this function for banks.
While banks finance only well-established, safe
borrowers, stock markets can finance risky,
productive and innovative investment projects.
This fits with China’s state strategy for the next
five years – upgrading existing industries through
consolidation and value-chain repositioning and
cultivating the so-called emerging strategic
industries (energy-saving and environmental
protection, next generation information
technology, bio-technology, high-end
manufacturing, new energy, new materials and
clean-energy vehicles). That’s why stock markets
are crucial for China’s economic transformation.
US, Taiwan and Korea
Our approach is to analyze how the sector
composition of stock indices has migrated
along with economic transformation in the past
two decades. An increasing sector weighting
indicates either outperformance of existing index
members from the sector or addition of new index
members, which is generally a reflection of the
growing share or importance of the underlying
sector in the economy.
ababc
 The S&P 500 provides a good case in point
(chart 17). For instance, the IT sector
accounted for less than 6% of the index in
1990, the smallest sector. But by 2000, its
share soared to 20%+ thanks to the internet
bubble, or the largest sector by weighting.
Ten years after the bubble burst, IT is still the
top sector with 17% share. The number of IT
companies in the S&P 500 went up to 70 in
2000 from 27 in 1990 and dropped slightly to
61 in 2010, i.e., most of the IT companies
have survived the bubble and prospered (e.g.
Apple, Microsoft and Intel). The financial
sector has also gained 9ppts index weighting
over the past two decades; the losers are
telecom (down 6ppts), consumers (e.g., auto,
5ppts) and materials (3ppts).
 Taiwan is an extreme case (chart 18). In the
1990s, the IT sector was almost non-existent
but by 2000 it was nearly 44% of the MSCI
Taiwan index. The IT sector has continued to
grow, taking share from other sectors and
now accounts for 58% of the index. The
number of IT companies also tripled to 60
over 2000-10, or over half of all index
members. By contrast, financials plummeted
from 50%+ of the index in 1990s to 21% in
2000 and 16% by 2010. Industrials and
materials accounted some 40% of the index in
the 90s but shrunk to a combined share of
22% in 2000 and 16% by 2010.
 Korea is a more balanced case (chart 19). In
the past decade, the IT sector has taken
another 4ppt share in the MSCI Korea index
to 28%, consumer sectors a combined 3ppts
to 18% and healthcare from zero to 0.5ppt.
Financials have given away 3ppts to 16% of
the index, telecom another 2ppts to 3%,
utilities 1ppt to 2% and industrials 1ppt to
15%. Notably, the IT sector has gained at the
cost of telecom services due to regulation.
17
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China Macro
Economics & Equity Strategy
6 October 2010

Chart 17. S&P500 sector composition: migration in 1990-2000-2010

S&P Weights 1990 2000 2010 Δ # of companies 1990 2000 2010 Δ

IT 5.9% 20.2% 17.2% 11.3% IT 27 70 61 34

Financials 7.2% 17.4% 16.5% 9.3% Financials 59 76 83 24
Healthcare 11.3% 14.3% 11.3% 0.1% Healthcare 30 40 46 16
Cons Disc 19.7% 15.6% 17.5% -2.1% Cons Disc 129 113 107 -22
Industrials 13.0% 10.1% 10.8% -2.2% Industrials 94 64 65 -29
Energy 13.2% 7.0% 10.9% -2.4% Energy 26 28 35 9
Utilities 6.2% 3.4% 3.9% -2.4% Utilities 36 36 36 0
Cons Staples 7.5% 3.9% 4.9% -2.6% Cons Staples 24 18 23 -1
Materials 7.0% 2.5% 3.7% -3.4% Materials 63 43 34 -29
Telcos 8.9% 5.5% 3.4% -5.6% Telcos 12 12 10 -2

Source: Datastream (Change = 2010 – 1990)

Chart 18. MSCI Taiwan sector composition: migration in 2000-2010

MSCI TW Weights Dec-00 Aug-10 Δ # of companies Dec-00 Aug-10 Δ

IT 43.7% 58.0% 14.3% IT 21 60 39

Energy - 0.8% 0.8% Energy - 1 1
Telcos 4.4% 4.6% 0.2% Telcos 1 3 2
Cons Staples 1.9% 1.8% -0.1% Cons Staples 2 2 0
Industrials 4.7% 3.5% -1.1% Industrials 9 11 2
Cons Disc 6.8% 3.0% -3.8% Cons Disc 9 9 0
Materials 17.6% 12.7% -4.9% Materials 8 11 3
Financials 20.9% 15.6% -5.3% Financials 14 21 7
Total (AxJ weighting) 13.3% 15.1% 1.8% 64 118 54

Source: Datastream (Change = 2010 – 2000)

Chart 19. MSCI Korea sector composition: migration in 2000-2010

MSCI Korea Weights Dec-00 Aug-10 Δ # of companies Dec-00 Aug-10 Δ

IT 23.9% 27.7% 3.7% IT 6 11 5

Cons Disc 11.4% 13.4% 2.0% Cons Disc 7 12 5
Cons Staples 3.9% 4.9% 1.1% Cons Staples 4 7 3
Healthcare - 0.5% 0.5% Healthcare - 2 2
Energy 2.3% 2.5% 0.2% Energy 2 3 1
Materials 14.9% 15.0% 0.1% Materials 9 11 2
Industrials 16.1% 15.1% -1.0% Industrials 14 27 13
Utilities 2.8% 1.7% -1.1% Utilities 2 2 0
Telcos 5.0% 2.8% -2.1% Telcos 4 4 0
Financials 19.6% 16.3% -3.4% Financials 12 20 8
Total (AxJ weighting) 15.8% 19.0% 3.2% 60 99 39
Source: Datastream (Change = 2010 – 2000)

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China Macro
Economics & Equity Strategy
6 October 2010
China is no exception
The evolution of sector composition for MSCI
China during the past decade is also a classic
example how the stock market reflects (and has
helped to drive) the transformation of the Chinese
economy over the past decade (chart 20):
 Within the MSCI Asia-ex-Japan universe,
China’s index weighting has almost tripled to
26%, largely inline with its GDP growth.
 Index weighting for the financials sector has
more than quadrupled to 38% and the number
of index members has gone up to 31 from 7.
Back in 2000, none of the eight H-share
Chinese banks and five insurance companies
was listed. Moreover, 14 out of the 17
property companies were listed after 2005,
reflecting a decade-long property boom;
 The broader consumer-related sectors
(discretionary, staples, IT and healthcare)
have gained 14ppts to 18% of the index,
while the number of index members has
exploded to 33 from just six thanks to new
listings. Notably, the healthcare sector was
non-existent in index before 2006.
Furthermore, we benchmark MSCI China sector
composition against the S&P 500 (chart 21) and
MSCI Korea (chart 22). The findings are
revealing in that the MSCI China index is highly
imbalanced, which also reflects the status of
the Chinese economy, in our view:
 Sector weighting for financials in China
(38%) is more than twice that of both the US
and Korea (16%), which is contrary to the
general perception that the financial sector in
China is underdeveloped compared to Korea,
not to mention the US.
 Together, the top three sectors in China –
financials, energy and telecom – account for two
thirds of the index, or 37ppts and 46ppts higher
ababc
than the US and Korea, respectively. Not
surprisingly, the top three sectors in China are
dominated by state-owned companies that have
enjoyed monopolies for decades.
 IT is the least developed sector in China,
representing a 5% vs. 17% in the US and 28%
for Korea, a reflection of China’s low-end
positioning in the manufacturing value chain
and a lack of innovative capacity.
 While the share of consumer staples in China
is slightly higher that the US and Korea (6%
vs. 5%), consumer discretionary companies
are underrepresented in MSCI China index at
6%, or 8-12ppts lower than Korea and the US,
indicating huge long-term growth potential.
 The share of industrials in China at 8% is
3ppts lower than the US and 7ppts below
Korea, indicating good long-term prospects as
China moves up the value chain into
advanced manufacturing.
 Last but not least, healthcare in both China
and Korea is underdeveloped, or less than 1%
of the market index vs. 11% in the US.
The stock market can provide the price signal
and incentive to facilitate and drive economic
transformation. IPOs in the A-share market
doubled in 2009 to top RMB200bn and are set to
double again in 2010 (chart 23). It’s encouraging to
see that IPO value in the SME board and ChiNext,
both suited for smaller and private companies, for
the first time exceeded the main board, designed for
the big-cap SOEs, in 2010. Average IPO PE is 34x
for the main board, 53x for SME board and 66x for
ChiNext, sending a clear signal to encourage
innovation and growth. The exploding number of
deals in the SME board and ChiNext is a good
indication of where China’s growth will come from
in the future (chart 24).
19
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China Macro
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6 October 2010

Chart 20. MSCI China sector composition: migration in 2000-2005-2010

MSCI China Weights 2000 2005 2010 Δ # of companies 2000 2005 2010 Δ

Financials 8.5% 30.0% 37.9% 29.3% Financials 7 9 31 24

Cons Disc 0.4% 3.9% 6.2% 5.9% Cons Disc 3 5 13 10
IT 1.2% 1.7% 5.0% 3.9% IT 1 3 6 5
Cons Staples 1.8% 3.9% 5.5% 3.7% Cons Staples 2 3 11 9
Materials 3.1% 4.4% 5.3% 2.2% Materials 5 7 18 13
Healthcare - - 0.9% 0.9% Healthcare - - 3 3
Utilities 2.5% 2.3% 2.0% -0.5% Utilities 5 4 6 1
Energy 20.6% 24.7% 16.4% -4.2% Energy 3 6 9 6
Industrials 13.2% 9.3% 7.7% -5.5% Industrials 13 16 23 10
Telecos 48.8% 21.9% 13.1% -35.7% Telecos 2 3 4 2
Subtotal (broader consumer) 3.3% 9.5% 17.6% 14.3% 6 11 33 27
Total (AxJ Weighting) 8.9% 15.5% 26.2% 17.3% 41 56 124 83

Source: Datastream (Change = 2010 – 2000; Broader consumer = Cons Dis + Cons Staples + IT + Healthcare)

Chart 21. 2010 sector composition – China vs. U.S. Chart 22. 2010 sector composition – China vs. Korea

Sector Weights S&P500 MSCI China Diff. Sector Weights MSCI Korea China Diff.

Financials 16.5% 37.9% 21.4% Financials 16.3% 37.9% 21.6%

Telcos 3.4% 13.1% 9.8% Energy 2.5% 16.4% 13.9%
Energy 10.9% 16.4% 5.5% Telcos 2.8% 13.1% 10.3%
Materials 3.7% 5.3% 1.6% Cons Staples 4.9% 6.2% 1.3%
Cons Staples 4.9% 6.2% 1.3% Healthcare 0.5% 0.9% 0.4%
Utilities 3.9% 2.0% -1.9% Utilities 1.7% 2.0% 0.3%
Industrials 10.8% 7.7% -3.1% Industrials 15.1% 7.7% -7.4%
Healthcare 11.3% 0.9% -10.5% Cons Disc 13.4% 5.5% -7.9%
Cons Disc 17.5% 5.5% -12.0% Materials 15.0% 5.3% -9.8%
IT 17.2% 5.0% -12.1% IT 27.7% 5.0% -22.7%
Source: Datastream Source: Datastream

Chart 23. IPO value in SME board and ChiNext for the first Chart 24. The exploding # of deals in both SME and ChiNext
time exceeded that of main board in the first 9M of 2010 is a good indicator of where growth will come from in future

400 Main Board SME Board ChiNex t 300 Main Board SME Board ChiNex t
350 IPO (Rmb bn) 250 IPO (# of deals)
300
200 86
250
200 150
150 50
100 151
100
50 72 67
50 16
5 12
0 0
2008 2009 F9M10 2008 2009 F9M10

Source: Wind Source: Wind

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China Macro
Economics & Equity Strategy
6 October 2010
Promoting service sectors
To achieve the 40-45% carbon intensity reduction
goal by 2020 not only does China need to
normalize the price of energy and natural
resources through continuing pricing mechanism
reforms, but also:
 Speed up consolidation to digest existing
industry overcapacity (see China Investment
Atlas, Issue 19, From Mr. Big to Mr. Strong
in March 2009; and Issue 22, “M&A – A
long-term share price driver” in July 2009);
 Cut back on high pollution and energy-
consuming sectors, mainly in the heavy
industries such as metals and mining.
 Accelerate the movement of producer
services sectors up the value chain and
improve economic structures (this section).
 Cultivating the so-called seven emerging
strategic industries to sustain the new phase
of growth (next section).
The US experience and comparison
In 1935, the American economist Irving Fisher
was the first to define tertiary industry. But it was
not until 1957 that British economist Colin Clark
named tertiary industry as service industry and
proposed the following categorization: i) producer
services (financial, insurance, engineering, law
Chart 25. China’s service sector is underdeveloped
80% India (serv ice-to-GDP) U.S.
70%
60%
50%
40%
30%
20%
1950 1960 1970 1980 1990 2000
Source: CEIC
ababc
and business services); ii) social services (health,
education, welfare and government); iii) personal
services (domestic trade, lodging, repair and
entertainment).
While there is no consensus yet on the impact of
service industry on employment and economic
growth, various academic reports have found that
service industry growth usually takes off once per
capita income surpasses USD3,000-5,000, which
is precisely the level China is experiencing.
Despite China’s manufacturing prowess, its
services sectors have remained severely under-
developed, accounting for 43% of the GDP, vs.
54% for India and 74% for the US (chart 25). It’s
even lower than the US in the 1950s and roughly
the same level as India around the 1990s.
The external trade balance further reveals China’s
weak spot in the service sectors. Since 2007,
India’s quarterly trade surplus in services sectors
has averaged over USD10bn, vs. a deficit of over
USD4bn for China (chart 26).
It’s also worth noting that the US service trade
surplus really started to take off after China’s
entry into the WTO at the end of 2001, soaring
from USD10bn a quarter to nearly USD40bn.
This was helped by China’s trade-related
insurance payments and manufacturing-related
fees for patents and royalties.
Chart 26. China a net importer of services
China 50 India: BoP-Serv ices U.S. China
US$bn: quarterly
40
30 After China re
entry to WTO
20
10
0
-10
1998 2000 2002 2004 2006 2008 2010
Source: CEIC
21
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China Macro
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6 October 2010

Chart 27. Historical GDP share of U.S. service sectors Chart 28. Historical GDP share U.S. producer service sectors

60% US: MFG-to-GDP Producer serv ices 25% US producer service

Consumer serv ices Gov 't serv ices sectors: % of GDP Financials
50% 20%
40%
15%
30% Prof. & business serv ices
10%
20% Trans. & Warehouse Edu & Healthcare
5% IT
10%

0% 0%
1947 1957 1967 1977 1987 1997 2007 1947 1957 1967 1977 1987 1997 2007

Source: CEIC Source: CEIC

In the US, the share of consumer (personal)
services and government (social) services has
remained largely stable since the end of the World
War II. They have averaged 17% and 13% for the
past six decades, respectively, while that of
producer services nearly doubled to 48% at the
cost of manufacturing, which saw its share drop
by 15ppts to 11.5% by 2008 (chart 27).
Within the producer services sectors, education
and healthcare have grown the most – a 9.3% 60-
year CAGR to over 8% of US GDP – followed by
professional and business services at 9% CAGR
to 12.7% of GDP and financial sectors at 7.9%
CAGR to 20% of GDP. Transport and
warehousing has seen its share in GDP decline to
below 3% from 6%, while the share of IT has
remained largely stable since 90s (chart 28).
In China’s case, it’s remarkable that the share of
wholesale and retail trade in GDP increased by
1ppts to 8.5% over 2005-09 and that of banking
and insurance by 2ppts to 5.4% in 2004-08 (chart
29). Real estate has also doubled its share of GDP
to 4% over the past three decades.
By comparing service industry developments in
the US and China and assuming that China’s
industry structures are evolving closer to that of
the US, there could be huge room for growth in
China for professional and business services (for
both domestic and overseas outsourcing markets),
financials (consumer financing), education and
healthcare, wholesale and retail trade, IT services,
and hotel and catering, with transportation,
storage and post services being the only exception
(chart 30).

Chart 29. Historical GDP share of China’s service sectors Chart 30. Services sectors GDP share: U.S. vs. China

10% % of 2008 GDP China U.S. Diff.

China services
Wholesales & Retail
sectors: % GDP Wholesale & Retail 8.3% 11.9% 3.6%
8%
Trans., storage & post Hotel and Catering 2.1% 3.8% 1.7%
6% Transportation, Storage & Post 5.2% 2.9% -2.3%
Real estate
Financials 9.4% 20.0% 10.6%
4%
Banking & Insurance IT* 2.3% 4.4% 2.1%
2% Education & Healthcare* 4.3% 8.1% 3.8%
Hotel & Catering
Professional & Business Services* 2.6% 12.7% 10.1%
0%
Government Services n.a. 12.9% n.a.
1978 1983 1988 1993 1998 2003 2008
Total 39.3% 63.7% 24.4%

Source: CEIC Source: CEIC (* Calculated based on 2007 statistics)

22
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China Macro
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6 October 2010

Chart 31. Value chain of producer services

Upstream
Upstream Midstream
Midstream Downstream
Downstream

1. Feasibility study 1. Financial services

1. Advertisement
2. Accounting
2. R&D (e.g., product
3. IT Services 2. Logistics & Storage
concept design)
4. Quality control 3. Sales & Marketing
3. Market research
5. Legal services 4. After - sale services
4. Venture capital 6. Human resources

Source: HSBC Equity Strategy Research

From “made in” to “serviced in” China
With more producer services appearing in
manufacturing activities (chart 31), they are
gradually becoming value-adding parts of the
manufacturing value chain, particularly in
developed economies. Due to the rapid
development of IT and the accelerated division of
labour and specialisation across the globe,
producer services help manufacturers gain
competitive advantages through cost advantages
and product differentiation.
Although China’s ITO sector is still small and
estimated to be an eighth of India’s, it’s catching
up rapidly and has the potential to challenge
India’s dominant position (chart 33). During the
11th Five-Year Plan (2005-10), China for the first
time made producer services industry a priority
and this is set to continue into the 12th Five-Year
Plan. ITO, business process outsourcing (BPO)
and knowledge process outsourcing (KPO),
targeting both domestic and overseas outsourcing
markets, are a key element of the state strategy.

This explains why producer services now
represent almost half of the US economy and is a
rising force in India’s IT outsourcing (ITO)
industry, which has a 27.5% CAGR for the past
10 years and now contributes 4% of India’s
economy (chart 32).
Gartner forecasts that the worldwide IT services
market, the largest segment within the outsourcing
industry, is expected to reach USD1.1trn in 2012,
up from USD748bn in 2007. Other niche areas
according to the KPMG’s 2009 report, A New
Dawn: China’s Emerging Role in Global

Chart 32. India’s IT outsourcing: top of the world Chart 33. China ITO – 1/8th of India but catching up

15 IT outsourcing (US$bn) % India GDP 5% 4 China BoP credit: IT serv ices (US$bn)

12 10Y CAGR 4%
3
27.5%
9 3%
2
6 2%
1
3 1%

0 0% -
1H01
2H01
1H02
2H02
1H03
2H03
1H04
2H04
1H05
2H05
1H06
2H06
1H07
2H07
1H08
2H08
1H09
2H09

00 01 02 03 04 05 06 07 08 09 10

Source: CEIC (quarterly) Source: CEIC (half-year)

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China Macro
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6 October 2010
Outsourcing, are animation and gaming, E-
learning and online-tutoring, offshore
engineering, pharmaceutical R&D, and legal
process outsourcing.
Top-notch infrastructure, large talent pool and
diverse language skills aside, one of the major
advantages China enjoys over India in the global
outsourcing market is its huge domestic market,
as well as nearby overseas markets such as Japan
and Korea that share parts of Chinese culture.
According to the IDC data, IT services only
account for 13.8% of China’s IT market vs. 30.3%
for Asia Pacific, indicating huge potential.
This potential particularly applies to China’s
banking and telecom services industries, as both
sectors are under pressure to improve cost
efficiency as earnings growth decelerates. This
could even be encouraged by the central
government to help cultivate China’s nascent
outsourcing market.
During the 11th Five-Year Plan period, for
instance, the central government rolled out the so-
called “1,000-100-10” project in 2006, i.e., to
develop 10 base cities of service outsourcing with
international competitiveness, promote 100 well-
known multinational corporations to transfer their
service outsourcing businesses to China and
cultivate 1,000 large and medium-sized service
outsourcing enterprises with international
qualifications.
Furthermore, the State Council has designated 21
“Service Outsourcing Model Cities” since early
2009: Beijing, Changsha, Chengdu, Chongqing,
Dalian, Daqing, Guangzhou, Hangzhou, Harbin,
Hefei, Jinan, Nanchang, Nanjing, Shanghai,
Shenzhen, Tianjin, Wuhan, Wuxi, Xiamen (added
in early 2010) and Xi’an. For the model cities, the
government has introduced the ATSE (Advanced
Technology Service Enterprise) certification
programme, under which a certified ATSE
24
ababc
receives a reduced income tax rate of 15% as well
as a business tax exemption on service income
from offshore clients, valid from 2009 to 2012.
In April 2010, the State Council expanded the
scope of the business tax exemption and relaxed
the ATSE certification criteria. Outsourcing
services provided to offshore customers by all
enterprises located in the 21 model cities will be
exempted from business tax.
All these efforts are starting to pay off:
 According to forecasts by IDC, three Chinese
cities – Dalian, Shanghai and Beijing – made
the top 10 list as most attractive for
outsourcing. By 2011, Shanghai could be
challenging Bangalore for the leading spot
and Dalian and Beijing could move up into
top five spots;
 The number of outsourcing enterprises in
China has exploded to more than 3,000
according to the Ministry of Information and
Industries, with numerous service providers
that have surpassed the scale of USD50m
revenue per year.
 Private equity investors are increasing their
activity in this space. China Everbright
Holding invested in iSoftStone in January,
Carlyle Group invested in the ATMU
Corporation in June and Global Data Solution
also expects new funding in 2010.
The importance of intellectual property rights
(IPR) protection can vary across outsourcing
efforts. It becomes increasingly important for
more advanced outsourcing activities and it’s still
a common perception among foreign outsourcing
contractors that China still has to make
improvements on IPR protection, representing a
potential bottleneck for development in this
industry in the long term.
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China Macro
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6 October 2010

Screening:15 IT outsourcing stocks USD3.3bn. In comparison, the top three Indian

The following list of top 30 outsourcing outsourcing companies have a combined market
companies in China provides a good snapshot of cap of USD107bn, or seven times larger.
the competitive landscape (table 34).  On aggregate basis, India companies are
We have indentified 15 listed entities from the traded at 6.5x revenue (USD16.5bn) vs. 3.8x
nascent outsourcing industry. Four are listed in for Chinese companies, a 70%+ premium.
the US, including VanceInfo, with a total market  PE wise, India companies averaged 26.4x
cap of USD5bn, eight are listed on the domestic 2009 PE vs. 44x for Chinese companies
A-share market, such as NeuSoft, with a total (excluding the outliners).
market cap of USD7bn, and three are listed in
Hong Kong, including ChinaSoft, with a total  Performance wide, India companies averaged
market cap of USD0.7bn. The combined revenue 20% y-t-d and 14% in the last month vs. 21%
for all the listed Chinese companies is only y-t-d and 3% for Chinese companies.

Table 34. Snapshot of China’s top 30 outsourcing companies

Rank Name Name in Chinese Listed entity 2009 2009 PE Mkt. cap Last y-t-d Website
Revenue (x) (USDm) month perf. (%)
(USDm) perf (%)
Tata Consultancy Services TCS IN 6,199 26.8 42,053 14.4 27.8 http://www.tcs.com
Infosys INFO IN 4,695 28.0 39,412 11.0 18.1 http://www.infosys.com
Wipro WPRO IN 5,618 24.4 25,594 16.0 14.2 http://www.wipro.com
1 Neusoft Corporation 东软集团 600718 CH 602 33.5 3,216 4.0 0.8 http://www.neusoft.com
2 INSIGMA TECHNOLOGY 浙大网新科技 600797 CH 707 169.5 824 -9.1 -1.7 http://www.insigma.com.cn
3 VanceInfo Technologies 文思信息技术 VIT US 148 34.3 1185.0 8.4 68.0 http://www.vanceinfo.com
4 WuXi AppTec 药明康德 WX US 270 21.8 1,173 0.7 12.4 http://www.wuxiapptec.com.cn
5 hiSoft Technology Int’l 海辉软件 HSFT US 91 96.7 602.2 22.1 148.1 http://www.hisoft.com
6 Longtop 东南融通 LFT US 169 33.4 1995.6 5.8 4.2 http://www.longtop.com
7 Dalian Hi-Think 大连华信计算机技术 n.a. http://www.dhc.com.cn
8 iSoftStone 软通动力信息技术 n.a. http://www.isoftstone.com
9 China Data Group (Suzhou) 华道数据处理苏州 n.a. http://www.chinadatagroup.com
10 SHANDONG LANGCHAO 浪潮集团 600756 CH 55 87.4 388 -5.1 -1.5 http://www.inspur.com
Inspur Group 000977 CH 150 783.9 438 10.1 33.5
INSPUR INTERNATIONAL 596 HK 278 8.7 311 -3.0 -42.3
11 Sodexo ADR 索迪斯 SDXAY US 14,681 16.6 9,436 7.0 14.2 http://cn.sodexo.com
12 ChinaSoft International 中软国际 354 HK 143 -16.4 285 11.4 126.4 http://www.chinasofti.com
13 Achievo Corporation 大展集团 n.a. http://www.achievo.cn
14 Dextrys 新宇软件苏州工业园 n.a. http://www.dextrys.com/cn
15 SinoCom Software Group 中讯软件集团 299 HK 82 10.3 138 -4.0 1.1 http://www.sinocom.cn
16 Sunyard System Engineering 信雅达系统工程 600571 CH 86 89.1 337 -4.2 17.8 http://www.sunyard.com
17 Beijing Lanxum Technology 北京立思辰科技 300010 CH 53 49.6 436 -1.1 -43.6 http://www.lanxum.com
18 M&Y Data Solutions 大庆市华拓数码科技 n.a. http://www.huatuodata.com.cn
19 SYNNEX IT 北京新聚思信息技术 SNX US 7,719 9.7 977 11.5 -10.5 http://www.synnex-china.com
20 Compupacific International 西安炎兴科技软件 n.a. http://www.compupacific.com
21 Beijing Teamsun Technology 北京华胜天成科技 600410 CH 486 40.8 1,149 10.7 -1.8 http://www.teamsun.com.cn
22 Shanghai Hyron Software 上海海隆软件 002195 CH 28 78.1 235 -0.5 0.5 http://www.hyron.com
23 BroadenGate Software 深圳市易思博软件 n.a. http://www.bgsws.com
24 SYKES (Shanghai) 赛科斯信息技术 SYKE US 846 12.8 641 4.7 -46.9 http://www.sykes.com.cn
25 Shanghai Seio Software 上海晟欧软件技术 n.a. http://www.seiosoft.com
26 ATMU Corporation 通邮集团 n.a. http://www.atmu.cn
27 Global Data Solutions 万国数据服务 n.a. http://www.gds-china.com
28 Diyixian.com 第一线安莱 n.a. http://www.anlai.com
29 JIANGSU OCEANSOF 江苏欧索软件 n.a. http://www.oceansoft.com.cn
30 Liandi (Nanjing) Info. 联迪恒星南京信息 n.a. http://www.liandisys.com.cn
Systems
Source: Bloomberg, Devott (India companies included for comparison; highlighted companies are those got private equity funding in 2010)

25
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China Macro
Economics & Equity Strategy
6 October 2010

Emerging strategic industries 2010 version of “Guidance Catalogue for

After the RMB4trn stimulus package at the end of
2008 and the release of revitalisation policies for
the 10 major industries in early 2009, the
emerging strategic industries and producer
services sectors will be the two driving forces in
the attempt to lower carbon intensity in the 12th
Five-Year Plan.
On 8 September 2010, the State Council adopted
“Decision on speeding up the cultivation and
development of emerging strategic industries (國
務院關於加快培育戰略性新興產業的決定).
The new Magic 7 are energy-saving and
environmental protection; next generation
information technology; bio-technology; high-
end manufacturing; new energy; new materials
and clean-energy vehicles (table 35).
This suggests that the government could give
private capital wider access to these industries.
This could be done through capital markets
ranging from venture capital to private equity
investment to stock markets, as well as
conventional fiscal, tax and credit policy support.
The state will also establish dedicated industrial
funds and stable fiscal budgets to aid the seven
emerging industries.
Investors should monitor the next two policy
documents from the National Development and
Reform Commission for more details, i.e.,
“Development Planning of Emerging Strategic
Industries (戰略性新興產業發展規劃) and the
Adjustment of Industrial Structure (產業結構調
整和指導目錄：2010 年本).
Does industry policy work: the old vs.
new Magic 7?
Since the inception of economic reform in the late
1970s, China has pursued industrial policies that
have boosted its growth as a manufacturing
powerhouse. The Chinese government has
designated a number of pillar industries and
pursued a strategy of picking and nurturing
winners. These policies have been successful in
certain ways but unsatisfactory in others.
For instance, the State-owned Assets Supervision
and Administration Commission (SASAC) has a
three-tier national industry strategy. The state
makes it clear that it intends to dominate in certain
industries that are strategically crucial for the
national security and public interests; 70-80% of
centrally-controlled SOE assets and profits are
concentrated in the seven strategic industries – the
old Magic 7 – namely national defence,
telecom, electricity, oil, coal, airlines and
marine shipping.
Enterprises in the state-monopolised and state-led
pillar industries are supported through a range of
national industrial policies, which include: tariffs;
limitations on foreign access to domestic
marketing channels; requirements for technology
transfer by foreign investors; government
selection of partners for major international joint

Table 35. The new Magic 7

Emerging strategic industries Main content
Energy-saving and environmental Energy efficiency, advanced environmental protection, recycling
protection
Next generation information Next-generation communications networks, Internet of things, network convergence, new flat panel display,
technology high-performance integrated circuits and high-end software
Bio-technology Bio-medicine, bio-agriculture, bio-manufacturing
High-end manufacturing Aeronautics & astronautics, marine engineering equipment, high-speed rail, high-end smart equipment
New energy Nuclear, solar, wind, biomass
New materials Special function and high-performance composite materials
Clean-energy vehicles Plug-in hybrid vehicles and pure electric cars
Source: State Council (http://www.gov.cn/ldhd/2010-09/08/content_1698604.htm)

26

China Macro
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6 October 2010
ventures; preferential loans from state-controlled
banks; privileged access to listings on domestic
and international stock markets; tax relief;
privileged access to land; and direct support for
R&D from the government budget.
These policies have helped the so-called SOE’s
national team to quickly build up scale and enjoy
artificially-protected profit margins, a necessity to
compete on the global stage from the central
government’s perspective. Unfortunately, one side
effect is that a vibrant private sector with globally
competitive firms is largely absent. Moreover,
China’s industry policies have lagged in terms of
fostering innovation and building brand equity.
While monopolies (the old Magic 7) are a natural
fit with top-down decision-making inherited in
governmental hierarchies, innovation (the new
Magic 7) is pretty much a firm-dominated bottom-
up approach. The earlier the government
recognises that the less involvement it has in the
capital allocation process, the better the outcome
is likely to be.
For instance, Silicon Valley has never been a
success of governmental planning, but severe
overcapacity faced by most of the heavy
industries in China could trace its roots in policies
previously enacted by the government.
Chart 36. Stock valuation a good signal in allocating capital
80 Avg. A-share IPO PE (X)
70
60
50
40
30
20
2008 2009 F9M10
Main Board SME Board ChiNex t
Source: Wind
ababc
As we argued in the previous section (page 12-
15), the role of capital markets, particularly stock
markets, could help propel China’s economic
transformation, particularly at a time when the
banking sector needs to repair its balance sheets.
High equity valuations, sometimes reaching the
bubbly stage, could provide the incentive to
mobilise private capital. For instance, the average
IPO PE is 34x for the main board (i.e. big caps),
53x for SME board and 66x for ChiNext (i.e.
high-growth small-caps), sending a clear signal to
encourage innovation and growth (chart 36).
Moreover, venture capital and private equity
funds have invested a total of USD64bn in some
4,000 companies in China since 2001 (chart 37).
According to Zeor2IPO, USD1.5bn was invested
by venture capital and private equity funds in 202
companies in the seven emerging strategic
industries during the first half of 2010, or 39% by
deal value and 55% by number of deals.
By comparison, these types of funds invested
USD1.9bn in 307 companies in the seven
emerging strategic industries in 2009, or 17% by
deal value and 52% by number of deal. This
happened at a time when these funds are turning
more cautious in investment.
Chart 37: VC/PE funds more cautious…but not for ESIs
20 China: VC inv estment (US$bn) PE
16
12
8
4
-
1H10
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: Zero2IPO (ESIs = emerging strategic industries)
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China Macro
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6 October 2010
Growth priced in and valuation rich
The Wind database has compiled a series of
indices for the emerging strategic industries (ESI),
as well as other theme-based investment universes
for the A-share market. This provides a good
foundation for us to conduct our analysis.
We have selected eight ESI indices – new energy,
new materials, clean-energy vehicles, bio-
agriculture, triple play (network convergence),
environmental protection, “Internet of Things”,
and smart grid.
On an aggregate basis, the total floatable market
cap of the eight indices amounts to RMB2.6trn, or
roughly 20% of the total A-share floatable market
cap. New energy, new materials, clean-energy
vehicles and triple play account for 29%, 22%,
14% and 12%, respectively, of the ESI plays.
It’s interesting to note that the monthly turnover
rate in 2010 is roughly 50% on average for the
eight ESI indices, 30% for the mid-cap Shenzhen
Stock Exchange 100 index (SZSE 100) and a
mere 5% for the big-cap Shanghai A50 index.
Clearly the ESIs are where the flows and
investors’ interests are.
Not surprisingly, the average performance of the
eight ESI indices, up 1% y-t-d and 168% from the
2008 bottom, has far outperformed that of the
SZSE 100, down 21% y-t-d and up 96% from the
2008 bottom, and the Shanghai A50, down 26%
y-t-d and up a mere 1% from the new bottom in
2010 (chart 38).
Despite the 30% correction from their recent
peaks, the A-share ESI plays are still traded at 50-
80x, or averaging over 70x on a trailing 12-month
PE basis, twice the valuation of the mid-cap index
in Shenzhen and over three times the big-cap
index in Shanghai (chart 39).
28
ababc
At 71x trailing 12 month PE, the ESI plays are
even more richly priced than the ChiNext, which
is traded at 64x PE and by design is the listing
destination for innovative and high growth private
companies in China.
As a reference, the A-share market in Shanghai
peaked at 71x trailing PE in Oct. 2007 and A-
shares in Shenzhen peaked at 78x trailing PE in
Jan. 2008. Hence, the current valuation for ESI
plays appears quite rich.
On a growth adjusted basis, EPSG for the next
two years in 2011 and 2012 ranges between 20%
and 40%, averaging 33%. All eight ESI indices,
with the exception of smart grid, are overvalued
relative to all three A-share market indices, the
ChiNext, SZSE 100 and Shanghai A50 (chart 40).
Moreover, the ROE for triple play, new materials
and the bio-agriculture indices is 6%, 8% and
10%, respectively, all lower than our cost of
equity assumption for the A-share market, 11%.
But they are still traded at hefty 3x, 5x and 9x
2009 PB (chart 41).
The lacklustre performance of big caps in China,
particularly the A-share banks, might have fuelled
the bubbly valuation of the ESI sectors, as
investors choose to go in search of absolute return
or relative performance.
Price and valuation movement in the A-share
market is highly sensitive to and largely driven by
policy announcements (or even speculation about
policy), while the delivery of actual economic
outcome and corporate earnings are lagging.
When expectations run ahead of reality, a
correction is inevitable. If reality starts to match
expectations then a new rally can emerge. That’s
why we think the ESI sectors could still provide
good investment opportunities down the road.
 ababc
China Macro
Economics & Equity Strategy
6 October 2010

Chart 38. A-share market emerging strategic industry (ESI) plays have far outperformed both big-cap and mid-cap indices

Clean- Enviorn-
ChiNext SZSE 100 SH A-50 Avg. New New Bio- Internet of Smart
Perf. enegy Triple Play mental
(small-cap) (mid-cap) (big-cap) (ESIs) Energy Materials agriculture Things Grid
Vehicles Protection

Since 2008 -52% -73% -19% -45% -34% -14% 45% -46% -36% -26% 0%

Since 2009 67% -14% 106% 60% 155% 173% 144% 45% 82% 89% 102%

YTD -28% -21% -26% 1% -11% 1% -15% 41% -12% 1% -7% 11%

L3M -7% 12% -3% 16% 13% 20% 27% 36% 3% 10% 4% 14%

L1M -8% 1% -5% 6% 6% 8% 7% 9% 0% 4% 6% 7%

Since bottom 8% 96% 1% 168% 105% 206% 239% 222% 70% 118% 173% 215%

Since peak -40% -54% -74% -29% -45% -37% -19% -3% -48% -37% -30% -14%

Source: Wind (ChiNext index started from June 2010 and the performance might not be representative)

Chart 39. A-share ESI plays are traded at 50-80x on TTM PE, or twice as much as mid-cap valuation and three times to big-cap

Trailing Clean- Enviorn-

ChiNext SZSE 100 SH A-50 Avg. New New Bio- Internet of Smart
12M PE enegy Triple Play mental
(small-cap) (mid-cap) (big-cap) (ESIs) Energy Materials agriculture Things Grid
(X) Vehicles Protection

2008 avg. - 37.0 28.2 61.5 63.8 61.1 42.8 76.4 75.8 57.9 61.8 52.7

2009 avg. 84.9 56.1 38.5 74.4 88.2 83.1 62.5 85.0 72.4 55.7 72.9 75.8

YTD avg. 69.5 41.4 24.9 74.8 75.8 83.7 53.1 66.5 86.9 73.2 83.0 76.2

L3M avg. 65.4 36.3 23.2 67.7 66.3 69.6 49.6 67.9 77.6 62.4 74.0 74.6

Bottom 58.4 18.0 16.7 29.2 32.1 28.8 18.8 33.2 42.5 26.5 29.5 22.3

Peak 94.6 69.3 52.4 106.3 104.1 108.2 91.0 128.4 119.3 92.1 107.3 99.7

Now 63.9 36.5 23.6 71.2 72.6 73.4 54.9 77.4 78.5 64.5 75.5 72.4

vs. bottom 10% 103% 41% 144% 126% 155% 193% 133% 85% 143% 156% 224%

vs. peak -32% -47% -55% -33% -30% -32% -40% -40% -34% -30% -30% -27%

Source: Wind (ChiNext valuation available from Oct. 2009; TTM = 2H2009 + 1H2010)

Chart 40. TTM PE vs. EPSG (2010-2012) Chart 41. PB vs. ROE (2009)

95 TTM PE (x) Bio- New 12 PB (x)

Bio- ChiNext
85 Internet of agriculture Materials
10 agriculture
75 New Things
65 Clean- Triple Play Smart Grid 8
New
Energy Internet of Smart Grid
55 enegy Env iorn- ChiNext 6 Materials Things Clean-
45 Vehicles mental enegy
4 Env iorn-
35 Protection New SZSE 100 Vehicles
SZSE 100 2 Triple Play mental
25 Energy
SH A-50 EPSG 2010-12 Protection SH A-50 ROE
15 0
15% 20% 25% 30% 35% 40% 45% 3% 6% 9% 12% 15% 18% 21% 24%

Source: Wind Source: Wind

29
30

Screening: 60 relevant stocks in 7 emerging strategic industries

6 October 2010
Economics & Equity Strategy
China Macro
Table 42. Screening: 60 relevant stocks in 7 emerging strategic industries
BBG Ticker Company Free Float Market Avg T/O 3M YTD Perf (%) 2009 PE 2010 PE 2010 EPSg 2009PB ROE (Fwd) % DY (Fwd) %
Cap (USD Mn) (USD Mn) (%)

2302 HK equity CNNC INTL LTD New Energy 105 0.3 -26.5 -58.7 10.8 644.6 3.0 25.4
2188 HK equity CHINA TITANS ENE New Energy 23 0.4 11.4 2.4
750 HK equity CHINA SINGYES SO New Energy 148 1.3 10.8 12.6 2.5 1.9
712 HK equity COMTEC SOLAR New Energy 94 1.8 -12.4 76.7 19.0 303.7 2.4 4.6
3800 HK equity GCL ENERGY HLDGS New Energy 3,196 17.0 0.9 -131.5 14.2 1027.0 3.1 18.0 0.5
757 HK equity SOLARGIGA ENERGY New Energy 174 0.8 -5.9 -33.0 24.4 235.7 2.5 9.4 1.0
STP US equity SUNTECH POWE-ADR New Energy 1,116 29.8 -47.1 17.6 40.3 -56.4 1.0 12.7 0.0
YGE US equity YINGLI GREEN-ADR New Energy 1,231 37.6 -18.7 -23.0 45.9 150.0 2.0 13.8 0.0
TSL US equity TRINA SOLAR-ADR New Energy 2,202 81.3 3.5 15.6 33.0 -52.8 2.9 28.1 0.0
182 HK equity CHINA WINDPOWER New Energy 388 2.1 1.1 44.3 36.0 23.2 2.3 0.0
658 HK equity CHINA HIGH-SPEED New Energy 2,558 26.4 -10.0 21.9 24.4 -10.3 4.8 2.0
916 HK equity CHINA LONGYUAN-H New Energy 5,500 11.5 -20.5 45.9 33.3 37.9 2.7 8.0 0.5
1211 HK equity BYD CO LTD-H Clean-energy vehicles 11,939 49.7 -8.0 35.6 70.8 -49.7 17.2 0.6
489 HK equity DONGFENG MOTOR-H Clean-energy vehicles 18,079 39.5 45.6 22.4 29.4 -23.8 5.1 1.0
2238 HK equity GUANGZHOU AUTO-H Clean-energy vehicles 10,539 24.6 15.7 56.8 26.6 2.2
1043 HK equity COSLIGHT TECH Clean-energy vehicles 80 1.2 -50.4 10.6 23.3 -54.4 1.5 7.1 0.8
1399 HK equity SCUD GROUP LTD Clean-energy vehicles 36 0.2 -4.4 18.9 0.8
729 HK equity THUNDER SKY BATT Clean-energy vehicles 326 6.9 190.2 -30.2 31.0
819 HK equity TIANNENG POWER Clean-energy vehicles 240 2.3 -13.6 11.5 28.2 -59.3 2.0 2.2
1066 HK equity SHANDONG WEIG-H Bio-technology 4,874 3.9 67.2 73.4 191.6 -61.7 15.9 0.5
3933 HK equity THE UNITED LABOR Bio-technology 789 9.4 271.8 34.0 38.3 -11.3 5.8 1.8
2005 HK equity LIJUN INTL PHARM Bio-technology 298 6.1 141.6 32.3 51.2 -36.8 4.5 1.5
8120 HK equity CHINA MEDICAL Bio-technology 3 0.0 -0.7 -0.4
8231 HK equity SHANGHAI FUDAN-H Bio-technology 40 0.0 77.9 -148.5 8.0
2348 HK equity DAWNRAYS PHARMAC Bio-technology 164 1.1 216.0 26.1 17.2 52.0 4.4 20.4 2.4
1666 HK equity TONG REN TANG-H Bio-technology 568 0.7 59.9 25.4 21.6 17.6 3.0 2.5
809 HK equity GLOBAL BIO-CHEM Bio-technology 302 2.5 -25.2 -236.5 20.5 1253.8 0.4 0.7

ababc
818 HK equity HI SUN TECHNOLOG Energy efficient/Environment-friendly 570 1.8 -30.6 86.9 60.8 42.9 4.6 0.0
3393 HK equity WASION GROUP HOL Energy efficient/Environment-friendly 324 2.0 -25.2 19.6 28.9 -32.3 2.6 2.1
1129 HK equity CHINA WATER INDU Energy efficient/Environment-friendly 40 0.6 -46.6 -0.8 0.3
Source: HSBC Equity Strategy Research, Bloomberg
 Table 42. Screening: 60 relevant stocks in 7 emerging strategic industries (cont’d)

6 October 2010
Economics & Equity Strategy
China Macro
BBG Ticker Company Free Float Avg T/O 3M YTD Perf (%) 2009 PE 2010 PE 2010 EPSg 2009 PB ROE (Fwd) % DY (Fwd) %
Market Cap (USD Mn) (%)
(USD Mn)

735 HK equity CHINA POWER NEW Energy efficient/Environment-friendly 328 2.8 44.6 37.3 21.3 75.1 1.2 5.4 0.0
1065 HK equity TIANJIN CAP-H Energy efficient/Environment-friendly 1,053 0.4 -2.5 15.9 16.3 -2.4 1.2 6.8 2.5
556 HK equity PAN ASIA ENVIRON Energy efficient/Environment-friendly 38 0.1 23.3 13.4 14.8 -9.2 1.0 2.7
257 HK equity CHINA EVERBR INT Energy efficient/Environment-friendly 883 2.4 1.0 35.5 53.2 -33.3 3.2 0.6
3989 HK equity NEW ENVIRONMENTA Energy efficient/Environment-friendly 39 0.7 -78.9 -0.2 3.2 106.8 0.7 21.0 2.1
2222 HK equity NVC LIGHTING HOL Energy efficient/Environment-friendly 994 8.8 0.7
449 HK equity CHIGO HOLDINGS Energy efficient/Environment-friendly 235 1.9 10.0 8.8 7.0 25.9 1.7 19.9 3.9
552 HK equity CHINA COMM SER-H New information technology 3,422 5.1 20.4 16.6 27.1 -38.6 2.0 3.1
763 HK equity ZTE CORP-H New information technology 10,234 21.0 -5.3 32.5 4.9 0.9
2342 HK equity COMBA TELECOM SY New information technology 702 8.3 15.9 19.4 22.2 -12.8 4.4 1.9
877 HK equity O-NET COMMUNICAT New information technology 179 2.2 38.5 0.0
500 HK equity DVN HOLDINGS LTD New information technology 47 0.1 13.7 52.9 0.6
521 HK equity SHOUGANG TECH New information technology 10 0.1 -19.3 6.7 0.8
903 HK equity TPV TECHNOLOGY New information technology 634 1.2 3.8 74.1 381.5 -80.6 7.0 2.8
981 HK equity SEMICONDUCTOR MA New information technology 1,622 7.8 10.0 -13.8 100.0 6.8 -0.6 0.0
3355 HK equity ADVANCED SEMIC-H New information technology 32 0.1 27.9 -5.8 0.9
8102 HK equity SHANGHAI FUDAN-H New information technology 225 0.3 76.9 32.9 4.9
597 HK equity CHINA RES MICRO High end equipment manufacturing 128 0.6 34.0 -14.3 12.0 219.1 0.9
232 HK equity AVIC INTL HLDGS High end equipment manufacturing 162 0.6 14.3 88.0 2.2
696 HK equity TRAVELSKY TECH High end equipment manufacturing 2,016 1.3 2.8 20.1 26.8 -25.0 2.6 2.5
2727 HK equity SHANGHAI ELECT-H High end equipment manufacturing 13,140 7.3 20.3 22.0 20.4 8.1 2.4 10.7 1.8
1133 HK equity HARBIN POWER-H High end equipment manufacturing 1,719 5.9 39.9 22.1 1.5 1.0
1072 HK equity DONGFANG ELECT-H High end equipment manufacturing 8,440 8.5 76.9 38.5 28.6 34.5 8.5 22.9 0.8
1766 HK equity CSR CORP LTD-H High end equipment manufacturing 9,330 7.0 26.8 50.9 4.9 0.9
631 HK equity SANY HEAVY EQUIP High end equipment manufacturing 984 3.2 35.4 41.5 35.8 15.9 6.5 17.1 0.7

ababc
2228 HK equity COSTIN NEW MATER New Material 367 2.6 15.4 16.0 -4.0
769 HK equity CHINA RARE EARTH New Material 395 8.5 103.2 55.8 18.9 195.7 1.8 8.7 1.2
2168 HK equity YINGDE GASES GRP New Material 940 1.7 -6.9 21.9 17.4 25.6 3.6 17.0 0.6
3993 HK equity CHINA MOLYBDENUM New Material 3,154 4.3 -11.5 55.2 21.6 155.0 2.5 10.2 2.1
189 HK equity DONGYUE GROUP New Material 278 3.0 81.0 33.3 13.3 150.0 2.8 1.4
Source: HSBC Equity Strategy Research, Bloomberg
31
 China Macro
Economics & Equity Strategy abc
6 October 2010

Notes

32
 China Macro
Economics & Equity Strategy abc
6 October 2010

Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Steven Sun, Hongbin Qu and Garry Evans

Important disclosures
Stock ratings and basis for financial analysis
HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which
depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations.
Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities
based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon;
and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative,
technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating.
HSBC has assigned ratings for its long-term investment opportunities as described below.

This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when
HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at
www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this
website.

HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's
existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating
systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research
report. In addition, because research reports contain more complete information concerning the analysts' views, investors
should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not
be used or relied on in isolation as investment advice.

Rating definitions for long-term investment opportunities

Stock ratings
HSBC assigns ratings to its stocks in this sector on the following basis:

For each stock we set a required rate of return calculated from the risk free rate for that stock's domestic, or as appropriate,
regional market and the relevant equity risk premium established by our strategy team. The price target for a stock represents
the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a
stock to be classified as Overweight, the implied return must exceed the required return by at least 5 percentage points over the
next 12 months (or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the
stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10
percentage points for a stock classified as Volatile*). Stocks between these bands are classified as Neutral.

Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility
status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review,
expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily
triggering a rating change.

*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12
months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However,

33
 China Macro
Economics & Equity Strategy abc
6 October 2010

stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past
month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating,
however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.

Rating distribution for long-term investment opportunities

As of 05 October 2010, the distribution of all ratings published is as follows:
Overweight (Buy) 50% (21% of these provided with Investment Banking Services)
Neutral (Hold) 36% (18% of these provided with Investment Banking Services)
Underweight (Sell) 14% (19% of these provided with Investment Banking Services)

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment
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For disclosures in respect of any company mentioned in this report, please see the most recently published report on that
company available at www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures
1 This report is dated as at 06 October 2010.
2 All market data included in this report are dated as at close 04 October 2010, unless otherwise indicated in the report.
3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research
operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier
procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or
price sensitive information is handled in an appropriate manner.

34
 China Macro
Economics & Equity Strategy abc
6 October 2010

Disclaimer
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35
 abc

Global Equity Strategy Research Team

Global Asia
Garry Evans Garry Evans
Global Head of Equity Strategy +852 2996 6916 garryevans@hsbc.com.hk
+852 2996 6916 garryevans@hsbc.com.hk
Steven Sun
Europe +852 2822 4298 stevensun@hsbc.com.hk

Robert Parkes Jacqueline Tse

+44 20 7991 6716 robert.parkes@hsbcib.com +852 2996 6602 jacquelinetse@hsbc.com.hk

CEEMEA Vivek Misra

+91 80 3001 3699 vivekmisra@hsbc.co.in
John Lomax
+44 20 7992 3712 john.lomax@hsbcib.com
Wietse Nijenhuis
+44 20 7992 3680 wietse.nijenhuis@hsbcib.com