China's short-term pain for long-term gain

by **Cals** Wed 10 Jul 2013, 09:58

China's short-term pain for long-term gain
Business & Markets 2013
Written by Louisa Lo
Wednesday, 10 July 2013 09:33

FOR long-time critics calling for economic rebalancing and the reining in of excessive credit growth in China, they may now be witnessing one of the stronger signs to date that China's new leaders are serious about structural reforms

In the recent liquidity crunch, China's central bank stayed on the sidelines, allowing interbank lending rates to creep above 10% at one point. Its intention to address China's shadow banking industry and runaway credit growth were perhaps broadly expected. It was its initial resolve, though, that took many by surprise.

But this might be a sign of the reform agenda of China's new leaders Xi Jinping and Li Keqiang, as well as an indication that a slower but more sustainable growth rate will be tolerated. All this comes as they seek to steer the world's second largest economy on to its next stage of growth after the significant stimulus and excesses of the past few years — launched in response to the crisis in 2008 and subsequent downturn in external demand.

In our view, this drive to deleverage and address the structural issues confronting China is a step in the right direction. We view China's short to medium-term pain as a necessary trade-off for longer-term gains. China's decision to hike gas prices, announced late last week, was another encouraging sign that this government is seeking to move the economy towards a more market-oriented structure. Despite these initial positive policy moves, though, much more remains to be done for the economy to be on a sustainable, long-term growth trajectory.

What is clear is that more of the old methods of spurring growth (fixed asset investment-driven and credit-driven) no longer work as marginal growth generated from additional credit is slowing. Returns on equity and invested capital have also been declining on the back of poor and inefficient capital allocation.

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Xi and Li have an extensive reform agenda and changes to address, some of which are less sensitive to tackle than others this early on in their tenure. Policy direction in areas ranging from financial and tax reforms, tackling environmental issues, Hukou (household registration), urbanisation and health care, to state-owned enterprise (SOE) reforms must be closely followed when navigating Chinese markets. Pain is inevitable in this period of adjustment as growth slows and further downside to earnings can be expected. That said, the China that emerges from this can be expected to be stronger and better placed to be on a long term trajectory of not only better quality, but also more sustainable growth.

The road to reform is fraught with headwinds, including increasing market concerns of an ensuing financial crisis, but that is not our base case scenario. China's significant foreign reserves, low external debt and current account surplus, we believe, put it in a good position to tackle issues at hand while avoiding a systemic collapse.

However, what does this mean for businesses and investors while the country undergoes this period of slower growth? Remember, we have always stressed that economic growth does not always equate to stock market performance. As China aims to rebalance to a consumption-led economy, long term opportunities will continue to be found in services and consumer-related areas. Health care, Internet and IT as well as media are further areas of opportunity as further urbanisation will drive domestic demand for goods and services. Environment-related industries will also benefit as China seeks to clean up its act. Its people, enjoying all the material goods of rising affluence, are also becoming increasingly aware of their quality of life.

All these themes offer long-term investment opportunities in China. Uncovering and locating these opportunities at the company level bring us up against the market composition in China, where SOEs form a large segment of the market, competing alongside profit-driven private companies. Broadly speaking, we do prefer privately run businesses where stakeholders' and shareholders' interests are often aligned and offer up better return profiles. Banks and cyclical companies are the likely losers in this environment of government policy reform.

We will continue to focus on company fundamentals as a leading criteria in the way we invest, seeking to identify eventual long-term winners in the Chinese markets. Valuations of both the offshore and onshore equity markets are near historical lows, with price-to-book values currently at 1.3 times and circa 10% away from their historical lows. In our view, current levels are already discounting very low expectations and other negatives, hence provide certain downside valuation support given a weakening growth outlook.

Valuations vary across sectors, with consumer staples and banks trading at opposite ends of the spectrum. This reinforces our belief that a strict valuation discipline within the stock selection process continues to be key. Should Chinese equity markets sell down further on heightened fears of a financial crisis, we would deem this as a very attractive buying opportunity for long-term investors to pick up quality businesses. These are in a good position to benefit when China emerges post-restructuring and on the back of reforms that aim to boost its long term growth trajectory. — Schroders

Louisa Lo is fund manager for Greater China Equities at Schroders.

This article first appeared in The Edge Financial Daily, on July 10, 2013.