Beyond the Olympics

Originally published in the November 2007 issue

China’s infrastructure explosion has been dramatic. Today, China has 45,000 km of expressways, up from less than 7,000 a decade ago. Under the current five-year plan, Beijing has committed US$197 billion to new and upgraded rail infrastructure. In 2006 alone, China added to its national grid the equivalent of the entire power output of the United Kingdom, and the government has committed US$184 billion to upgrade the power grid by the end of the decade.

The re-industrialisation of China over the last two decades has been one of the most remarkable transformations of any economy in recent years, and the way companies have successfully started to move up the value chain from low value-added assembly work to skilled precision engineering and construction has been nothing short of remarkable. We expect China to continue to deliver growth in the region of 10% each year, not just in the run-up to the Beijing Olympics in 2008 but beyond, well into the long term.

And for investors, the pace of change doesn’t show any signs of slowing down. At the 17th National Congress of the Chinese Communist Party last month, President Hu said that economic growth must remain the party’s “central task”. His policies, designed to benefit poorer, rural areas, and clean energy initiatives should continue to drive change, spearheaded by some of the newer generation of politicians who are considered to be more market friendly.

Attractive prospects

With more financial, banking and market liberalisation likely to follow in China, we believe the long term investment perspective continues to get more attractive. Strong liquidity and an appreciating currency combined with upwards earnings momentum and reasonable valuations should help the China market to re-rate further, particularly the China stocks listed in Hong Kong.

Valuation levels aren’t an issue yet either, if you take history as your guide. In October, the Hang Seng H-share index was trading at 17x 08 earnings on 23% growth. Although most Chinese stocks are trading at even higher valuations, the market still has some way to go before reaching the dizzy heights of 50x to 70x that the Japanese and Taiwanese markets reached during their major re-ratings in previous decades.

We expect the Hong Kong and China markets to trend up further as we approach the end of 2007, but this may be followed in the short term by a period of consolidation. Investors in these markets know that government policy has always been the major risk factor to watch out for. It will be interesting to see how the new initiatives emerging from the National Congress are digested by market participants, but we do not expect them to derail growth, although they may cause some market turbulence in the short term.

More growth to come

Macroeconomically, China remains healthy. The pace of economic growth is firm and strong, driven by the twin engines of domestic consumption and investment. We are expecting real economic growth of around 10% to 12% in the near term, and a more moderate annual expansion of around 8% over the long term. The process of urbanisation and the rise of the middle class in China have formed a strong basis for robust consumer spending growth in China.

At the same time, the Chinese government is spearheading the development of inland provinces and investing to solve the infrastructure problems which have emerged following the remarkable growth and population moves in China in recent years. Inter-city high speed rail network and metro-lines are being constructed, and fixed asset investment will not slow down as much as people anticipate, although construction projects directly related to the Olympics are due to complete in the second quarter of next year.

Liquidity conditions remain as favourable as ever. We expect the Renminbi will continue to rise on a widening interest rate spread against the US Dollar, as rates have gradually been moving higher in China while the US has started to ease back. It would be no surprise to see another 50bp to 100bp move in China, bringing more pressure to the Renminbi in terms of appreciation and continuing to attract foreign inflows.

We believe the shift in the macroeconomic environment in China will continue to foster asset price inflation in China, and there is a possibility that China will go for a faster pace of appreciation to curb the level of domestic inflation. Although the trade surplus may be affected by an economic slow-down in the US going into the first half of next year, China is in the process of reforming its capital market, with the aim of promoting more efficient usage of its US$5 trillion bank deposit. We expect this to be sufficient to offset any potential setbacks on the export front and the impact from any monetary tightening.

Sting in the tail?

On a more cautionary note, the creation of a stock and property market bubble is of real concern to the Chinese government. New policies to curb the property market boom have already been introduced, with strict measures to tighten housing credit. For example, individuals speculating on the property market are now being punished with a fixed increase in the tariff for a second mortgage, and further tightening measures could follow.

Some retail investors are relying on the greater fool theory, in which valuations cease to matter in the hope that someone will always pay a higher price. However, history has taught us that it is important not to lose sight of valuations. Does anyone really think a paper company in China is worth 10x sales or 124x cash flow? Can a U$100 billion insurance company ever be worth 14x book value?

The atmosphere might be heady but it pays to keep a cool head when investing. Our experience tells us that, fundamentally, A shares look expensive at current levels, and our positioning in the China hedge fund is for a low, net long exposure to domestic names.

Our strategy in this environment has been to build up long positions in domestically focused sectors such as real estate and retailing, which are benefiting from strong underlying demand and improving purchasing power under the inflationary environment in China. We also favour cyclicals such as hard and soft commodities, where we believe the cycle will be sustainable.

Infrastructure stocks such as shipbuilding and alternative energy will continue to be our core long positions, where we see strong upward earnings potential. Against these, we expect to maintain short positions in exporters, which we believe are likely to suffer on slower US growth and an appreciating currency. Companies which are losing pricing power due to rising input prices are also short candidates.

Finally, although Taiwan has become one of the cheapest markets in Asia after a long period of underperformance, concerns about the economically sensitive nature of corporate earnings there in the context of slowing growth in the US have meant that it has failed to shine.

Banks are still struggling to recover from the cash credit card bubble, and with domestic politics still disruptive, attempts to stimulate the domestic economy have faltered. We are necessarily being selective about investing in Taiwan at present, although opportunities on the long and the short side do emerge from time to time.

Khiem Do is Investment manager, Baring China Absolute Return Fund, Baring Asset Management, Hong Kong