The off-shore China markets as represented by MSCI China and Hang Seng China Enterprises Index showed a technical bounce in November as investors expected some positive developments from the Xi-Trump meeting in early December.  It’s interesting to note that in contrast, the Shanghai Composite Index edged down slightly, highlighting that domestic investors’ sentiments were still being dragged by the weak economy and the continued tight liquidity, especially for private enterprises, in China.  From recent policy developments, we can see that the Government is expanding financial support for the real economy and shoring up confidence in the private sector.

More credit supply for the real economy

There is a rather disturbing phenomenon on the corporate financing front – despite of loosening liquidity, credit impulses are still weak.  The liquidity in the system has not been translated into credit for the real economy, especially for private and small/medium sized enterprises.  One of the major reasons is that, as part of the financial sector reform efforts, the Government imposed a rather stringent rule on credit officers of the state-owned banks called the “life-long responsibility” system.  This means that a credit officer would be held life-long responsible for any bad loans he has made during his tenure.  This was a rather drastic move by the Government who was trying desperately to rectify the lack of credit process in the banking system, if not corruptive practices, within a short period of time.  The immediate backfire was credit officers effectively going on a lending strike.  However, the latest development we have learnt is that the Government has subtly changed this policy of “life-long responsibility” to “exempted responsibility after due credit process”. This means that so long as the credit process is strictly adhered to, the credit officer would not be held responsible even if the loans go wrong afterwards.  We think that this approach is a lot more sensible.  Obviously, this change still needs some time to filter through the system; nevertheless, this is a positive change at the margin despite generally weak credit demand which may continue until more trade-war clarity is established.

More tax cuts on the way

On December 18, China Daily reported that more tax cuts are on the way to boost domestic consumption and revitalize  private enterprises. According to a senior official from the State Administration of Taxation, personal income tax reduction will be the Government’s top priority next year, coupling with tax exemptions for SMEs and high-tech companies. Based on the plan promoted by the Ministry of Finance, the market predicts that next year’s tax cuts may reach 1.5 trillion yuan ($217.5 billion), 200 billion yuan more than 2018¹. The state news site also reported that a researcher with the Chinese Academy of Social Sciences, Zhang Ming, said it is likely the government will further cut the VAT by 2% in 2019¹. The tax cuts which we and some market participants have been expecting seem to be quite imminent and will in time provide an important relief to the economy and investor sentiment.

Less restrictions on real estate developers to issue bonds

Most recently, the National Development and Reform Commission has relaxed the restriction on big real estate developers (with annual sales exceeding Rmb30bn) to issue bonds².  We think that this is a very positive policy signal as the Government has effectively given up on their one-size-fits-all crackdown policies in the property sector.  We have taken the view for a long time that underlying demand of residential properties is still healthy, but in certain cities, prices might have been rising too fast therefore soliciting Government interventions. Nevertheless, we don’t think this warrants an across-the-board crackdown as we have emphasized that China’s real estate isn’t a one single market but consists of hundreds.  What we have learnt from the local governments is that they are now subtly given more flexibility in determining their own fine-tuned policies on residential properties.  As such, we think that one more downside risk to the economy is contained.

Looking ahead, we are closely watching the effect of global central banks shrinking their balance sheets at the same time in 2019.  Also, we realize that it takes time for measures like tax cuts to filter through to the economy, as such, the Chinese economy and individual companies may still release relatively weak figures, resulting in some volatility in early 2019.  That said, we have definitely turned less bearish and believe that the backdrop for our stock picking efforts has notably improved.

[1] Source: China Daily, as of Dec 2018

[2] Source: NDRC, as of Dec 2018

Disclaimer:

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Looking at the demand side of growth, China has long relied on infrastructure investments to support its economy. Investments accounted for 48.0% of China’s nominal GDP in 2011, reaching an all-time high, and still contributed to 44.4% of that in 2017¹.

Chinese state-owned enterprises (SOE) used to over-invest to keep production up and keep unemployment rate down, as managements tend not to be return conscientious. The capacity and scale obsession leads to overcapacity, poor profitability and pathetic returns. China launched its “going global” strategy 18 years ago to encourage domestic enterprises to invest overseas². China’s outbound investment hit a record high of US$183bn in 2016 and the country became the second largest overseas investor in the world³. While there are successful stories of Belt and Road projects to export excess industrial capacity and increase local employment, we see many overseas deals fail due to Chinese enterprises’ lack of understanding about outbound investment risks or weak corporate governance.

Is China resuming its old habit?

Bank loan is one of the main sources of corporate funding for investments, especially for SOEs. If these investment projects fail, the loans may turn into bad debts, which has a negative impact on banks’ asset quality. Hence, the growth-oriented domestic investments and “irrational” overseas investments may increase risks in the entire financial system.

Faced with the increasing risk of demand uncertainty, China has been introducing a series of stimulus measures, including infrastructure investments, to provide a cushion for growth. China’s fixed asset investment (FAI) growth slowed to a historic low (5.3%) in the first eight months of the year⁴. October NBS data show FAI increased by 5.7% in January to October of 2018,  which marked a growth rebound for the second consecutive months and Industrial Production was up by 5.9% YoY, an increase of 0.1% from last month⁴. Some worry that China is resuming its old habit, which may hinder the country’s progress in deleveraging and make the debt problem worse. Nevertheless, China’s FAI growth averaged 20.05% from 1996 to 2018 and Industrial Production growth averaged 12.12% from 1990 to 2018⁴. Current growth rate is way below the historical average level.

Why is this time different?

From our point of view, besides improved economic fundamentals, as compared to 10 years ago when China embarked on infrastructure sprees, one key factor that will make the difference this time is sound risk management. The government, banks and corporates are becoming more aware of risks and operational discipline in recent years.

The  government has been pushing through structural reforms to address the economy’s structural deficiency and implementing policy tools to regulate investments, which in turn help enterprises strengthen governance and build the risk management capabilities. There are numerous examples and we would highlight a likely development in the foreseeable future which shows that when appropriate measures are taken, there are good scopes for China to fix its inherited issues.  This is about the government’s latest efforts to reform the social security system. China’s pension fund is faced with a shortfall of 600 billion yuan this year and the deficit keeps widening as population ages⁵. In late 2017, the government published the implementation plan for transferring 10% of the shares of large and medium-sized central and local SOEs and financial institutions to the Social Security Fund (SSF)⁵. The dividends paid annually become a stable funding source to help fill the pension gap. If the transfer speeds up, the SOEs being put under the SSF would have to pay better dividends and make less investments for the latter to meet its pension liabilities. Since November 2016, China has been increasing its scrutiny of outbound direct investment made by domestic companies. Further guidelines came into effect from August 2017, standardizing the financial management of SOEs throughout the investment process and  requiring SOEs to specify rules on feasibility and financial due diligence. We expect such measures to help SOEs make better investment decisions and improve corporate governance in the medium to long term.

De-risking has been a top priority for Chinese banks given the country’s deleveraging campaign. People’s Bank of China announced  four reserve requirement ratio(RRR) cuts this year⁶,  keeping liquidity ample and reasonable under its prudent monetary policy. But the slumping SHIBOR rate indicates the unwillingness of banks to make new loans to the real economy despite sufficient liquidity. These banks are adopting more stringent lending criteria – loans for projects that feature high energy-consumption, high pollution or low profitability are difficult to get approved.  According to 3Q18 results, most of the state-owned banks reported lower bad-debt ratios. In addition, the expansion of “shadow banks” that used to help the local government funding vehicles (LGFVs) issue LGFV bonds has been substantially curbed since the new regulations governing the asset management business kicked in. Local government funding vehicles are companies established by Chinese local governments and agencies to raise funds  for municipal projects. Local governments used such vehicles to get bank loans as well as issue the urban construction investment bonds (known as Chengtouzhai in Mandarin), which usually have weaker credit profile and less transparency. The local infrastructure projects funded by LGFVs often take long time to generate returns and some of which are even potentially loss-making, increasing the risk of default. Local governments now are issuing bonds directly instead of LGFV bonds to finance infrastructure projects with reasonable cash flow forecast, which reduces unknown risks. With tax reduction measures and other accommodative policies implemented, we expect economic activities to be stimulated progressively; hence business confidence is likely to pick up and demand for loans to recover amid a relatively rosy outlook. When the liquidity released is used to support better quality investment projects, the whole value chain will see a steady and healthy growth.

Meanwhile, Chinese enterprises have been enhancing their risk management capabilities and focusing more on the quality of their investments rather than on the pace if its expansion. According to EY’s survey on risk management for overseas investment,  “perform thorough due diligence”, “establish highly effective and reasonable organizational structures and management processes adopted by international markets” and “establish risk prevention and control systems with cooperation from government and third parties” were chosen to be the three most effective actions to prevent and  address risks in outbound investment ⁷. From recent on-the-ground research, we’re encouraged to see Chinese companies pursuing positive changes in operation and risk management. For example, some highly-leveraged real estate companies are re-evaluating their business models, optimizing cash flow and paying more attention to workplace safety issues. Although the market has barely noticed this incremental change, we believe such change is beneficial to improving business’ financial position, and in the medium and long term, it will be conducive to creating a healthier economic system in China.

[1] Source: CEIC, as of Dec 2017

[2] Source: Overseas Chinese Affairs Office of The State Council, as of 2011

[3] Source: Xinhua net, as of June 2017

[4] Source: Trading Economics, as of Nov 2018

[5] Source: SCMP, as of Feb 2018

[6] Source: Reuters, as of Oct 2018

[7] Source: Ernst & Young, as of April 2017

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. You may lose part or all of your investment. You should not make an investment decision solely based on this information. If you have any queries, please contact your financial advisor and seek professional advice. This document is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.