Macro Digest: China flings open the doors
Chief Economist & CIO
Saxo Bank offers access to China’s deepening commitment to open capital markets
China shows a long-term commitment to opening its capital markets to the world as it seeks to attract foreign capital to feed its vision for the future rather than relying on domestic savings. Access to mainland A-shares via the Shanghai-Hong Kong Stock Connect in recent years was one of many steps in China’s opening process. Now, the recent inclusion of A-shares in two MSCI global stock indices will generate a sustained and growing demand for Chinese assets, especially as China’s weight in global indices can only rise from here. And Saxo clients can now also participate in China’s vision for its capital markets with full access to Chinese A-shares in Shanghai and Shenzhen via Stock Connect.
“It does not matter how slowly you go as long as you do not stop” – Confucius
At Saxo we are happy to support our clients by serving as a gateway to the Chinese market, allowing clients to tap into one of the world's most vibrant and exciting economies. Global focus on China’s equity markets has intensified on the MSCI’s recent move to include Chinese A-shares in its Emerging Market Index and MSCI All Country World Index as of June 1, 2018. And as of this week, Saxo Bank will offer access to A-shares listed on the Shanghai and Shenzhen stock exchanges via the Shanghai-Hong Kong Connect link.
China’s has shown its deep commitment to becoming a global economic power with its 2025 vision and One Belt One Road program. But for full realization of its potential and to bring the more of the world on board, China’s leaders also recognise that they will need to vastly deepen China’s capital markets and attract capital flows in addition to mobilising domestic savings. In economic theory a deep capital market is a necessity especially in an economy like China where there are excess savings. These excess savings need a wide variety of assets with different risk profiles to soak up the extra liquidity, otherwise the capital flows overseas.
A McKinsey & Company report – Deepening capital markets in emerging markets – makes the argument clearly that deeper capital markets in emerging Asia could free USD 800 billion in funding annually, mostly for mid- to large-sized corporations and infrastructure, accelerating economic growth and potentially lifting millions from poverty. The building blocks of well-functioning capital markets are understood and documented, but policymakers require both the tools for a detailed diagnostic and a change management approach to carry out the necessary changes.
Make no mistake, China understands this conclusion and it is now aligning itself with the concept of deeper markets .The capital account will continue to open and welcome foreign capital.
In a wider perspective China also wants to gain in the ranks of alternative currencies and erode the US’ near monopoly as the global trade and reserve currency since World War II. The chief strength of the US economy is down to not only its size, but the vast liquidity of its capital markets (equity and debt), and its reserve currency status. These two factors are exactly what China wants a bigger share of and this has been confirmed through its launch earlier this year of the yuan-based oil contract on the Shanghai Commodity Exchange and now by re-listing US ADR listed companies back to China in their CDR scheme. Then there is the massive One Belt, One Road programme of investments across Asia and portions of Africa and Europe, which in size is more ambitious than the post-WWII US Marshall Plan. The plan’s ultimate objective is to create a zone in which trade chiefly takes place in yuan from East Asia to Florence in Italy and down to Cape of Good Hope in South Africa - a competing yuan zone to counterbalance the power of the US dollar and secondarily, the euro.
It is also important to know the milestones and strategy under which the MSCI inclusion of Chinese shares has happened. The driving force front and center remains OBOR and the Made in China 2025 plan.
The idea/concept for the Made in China 2025 plan is borrowed from Germany’s Industry 4.0, so called because it refers to the fourth industrial age. The main driver in the German model is to move the production model from centralised to decentralised and in real time. This is the adoption of the new areas of automation, robotics and the Internet of things (IoT) into the German model. Similarly, China wants to create its own version, although with more centralised principles among other variations in the Chinese model. The plan is to upgrade China’s economy and output to one that focuses on quality more than quantity, and to do it with less pollution, create more innovation through investment and more educated human capital.
One aspect of China’s 2025 vision that has made the rest of world sit up and take notice has been the open goal that by 2020 at least 40% of the core components and materials are made in China, rising to a goal of 70% by 2025. The US, and President Trump in particular, have seen this as a clear warning signal and a lot of the aggressive talk threatening a trade war stems from this plan’s open goal.
The plan has targeted ten key sectors (Source: CSIS.ORG -Made in China 2025)
1. New advanced information technology
2. Automated machine tools and robotics
3. Aerospace and aeronautical equipment
4. Maritime equipment and high-tech shipping
5. Modern rail transport equipment
6. New energy
7. Power equipment
8. Agricultural equipment
9. New materials
10. Biopharmaceutics and advanced medical products
How does the MSCI inclusion fit into this? Looking at the list its clear there will be massive need for investment and capital, China needs to share this investment burden with foreign capital, and it needs in particular to make the overall business environment more competitive domestically. The best way to create higher long-term growth is to increase competition and make the market the allocator of capital, as it will seek the most productive use of that capital. This is hardly a traditional communist principle, but as President XI has defined many times, the Chinese model is one of socialism with Chinese characteristics, a concept born under Deng Xiaoping. In other words, China will retain is central party driven political system but increasingly the market will be open. This is an extension of the programme of an open front-door, closed back-door policy of reforms seen in the financial markets over the past five years.
China’s economy is 15% of the global economy and Shanghai and Shenzhen are the world’s 4th and 7th largest stock markets measured by market cap. So when MSCI includes China many investors will need to benchmark against this, although many of the bigger global players already have broad exposure through both the Qualified Institutional Investor and Stock Connect programmes. But the longer-term impact will come from market structure changes. Today 78% of the turnover in China is retail and foreign participation is 2% versus 40% for the latter in Taiwan and South Korea. The final 5% allocation for China’s A-shares in the MSCI’s EM Index means these shares will make up a paltry 0.8% of the index, but that could rise as high as 16.2% with full inclusion (note that these weights are independent of the weights in these indices from the Chinese giants like Tencent and Baidu that are listed on other international exchanges.)
Peter Garnry, our Head of Equity Strategy, had a look at the new stocks added to our platform and the following five stood the test of his rigid selection. This selection is made with a focus on high ROIC, and low debt leverage.
Focus Media (ticker: 002027:xsec)
• Listed on Shenzhen
• Operates China’s largest out-of-home advertising network
• Revenue $1.83bn and net income of $853mn
• Company has the highest return on invested capital (high quality) of all Chinese shares in our Equity Radar model
• High leverage score (negative net debt) which means that the company has no interest rate sensitivity
Kweichow Moutai (ticker: 600519:xssc)
• Listed on Shanghai
• Produces and sells Maotai liquor and sales of other beverage, food and packaged food
• The world third largest beverage company on market value ($132.7bn)
• Revenue is $8.6bn with net income of $4.4bn
• The company has high return on invested capital and low debt leverage on top of strong price momentum
Hangzhou Hikvision Digital Technology (ticker: 002415:xsec)
• Listed on Shenzhen
• Supplier of video surveillance and products
• Revenue of $6.6bn and net income of $1.5bn
• Company has very strong ROIC and low debt leverage. Price momentum is also high and the stock has recently underperformed global equities.
Yunnan Baiyao (ticker: 000538:xsec)
• Listed on Shenzhen
• Pharmaceutical company that develops and manufactures traditional Chinese medicine
• Revenue of $3.7bn and net income of $473mn
• Above average ROIC (vs global equities) and very low debt leverage. Company has steady organic growth around 10% p.a.
Foshan Haitian Flavouring & Food (ticker: 603288:xssc)
• Listed on Shanghai
• Manufactures sauces and flavourings. The largest manufacturer of soy sauce in the world.
• Revenue is $2.3bn and net income of $547mn
• Very high ROIC and extremely low debt leverage on top of strong price momentum.
• Very strong revenue growth rates around ~15% p.a. over many years
I hope this analysis did not live up to the old Chinese proverb of: “The longer the explanation, the bigger the lie”. The Chinese is clearly in a phase where they are changing their way of producing, their way of financing and finally how they play a global role. This all comes together in the MSCI inclusion, or a one observer, Chin Ping Chia, MSCI Head of Research, Asia Pacific commented: “MSCI – The world comes to China”.
For China this is natural and needed step, for the rest of the world it cements a strong start to deeper capital markets which will make Asia more important both politically and economically, but most importantly as a reservoir for investments and savings.