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.

Recently, macro concerns such as the Sino-US trade tensions and the decelerating Chinese economy have been worrying the market. Another significant overhang is the situation surrounding pledged stocks in the A shares market.

Shareholders of listed companies can pledge their stocks to financial institutions such as brokerages, banks, and trusts in return for loans that are worth a percentage of the value of the pledged shares. In the past few years, more private enterprises have been engaging in this practice and the percentage of these pledged shares has been climbing for companies across the board.

The overhang of the market is that, as quite a number of stocks have dropped significantly, the market fears that it would trigger margin calls for those with pledged shares. If investors are not able to fulfill margin requirements, lenders will sell their pledged shares to close out their positions and in the process , it may cause the shares to drop further. Thus, a vicious cycle may form and cause a domino effect. Some major shareholders could end up losing control over their companies.

In recent weeks, new policies were released by regulatory authorities to address this market worry.

On October 22 , China Securities Regulatory Commission (CSRC) announced that 11 securities houses had reached a consensus to start a fund with RMB 21bn initial investment¹. Each house will separately set up their sub-funds to raise money from banks, insurance companies, state-owned enterprises and government platforms etc., forming a fund with total scale of RMB 100bn to help some listed companies tackle liquidity problems¹.

China Banking and Insurance Regulatory Commission (CBIRC) also allowed insurance asset management companies to set up special products to invest in listed companies’ securities. The investable universe includes stocks of listed companies, bonds issued by listed companies and their shareholders, non-public issuances of exchangeable bonds by shareholders of listed companies, and other assets approved by the CBIRC. Institutional investors such as insurance companies and social security funds are usually the main source of fund for special products.The first product was reportedly set up by a large state-owned insurance company on October 29 whose scale was expected to reach RMB 20bn².

Securities houses are required to obtain approvals from the CSRC before they execute forced-selling of the pledged shares. The purpose of this measure is to make sure any collateral-selling will be conducted in an orderly manner. At the same time, we think that the over-seeing of the selling activities might ensure there is minimal conflict of interest between the pledgees and the pledgers.

It is apparent that this risk in the market is well understood by the government and we believe that it has placed a high priority to contain it. Unlike the messy downward spiral that occurred in 2015 after the government cracked down on buying stocks on leverage, the situation concerning pledged stocks is much more transparent in terms of the scale and the parties involved. Hence, our base case is that the government will be able to contain the situation.

[1] Source: Xinhua net, as of Oct 2018

[2] Source: Jiemian, as of Oct 2018

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.