ROUNDTABLE: Rules of the game

Our panel of China experts discussed financial technology, policy flip-flops in Beijing and whether MSCI should include A-shares in its Emerging Markets index. Chaired by George Mitton in Hong Kong.

Ashley Dale (chief business development officer and chief marketing officer, Harvest Global Investments)
Peng Fei (chief executive, Winsight Global Asset Management)
Chi Lo (senior economist for Greater China, BNP Paribas Investment Partners)
Richard Tang (chief executive, ICBC Credit Suisse)

Funds Europe: Which sectors of the Chinese stock market are likely to reward investors in the next few years and which would you avoid?

Peng Fei, Winsight Global Asset Management: The sectors in the old economy, with overcapacity, should be avoided. Even though they had a relatively good run this year because of the exceptional stimulus from the Chinese government, it will be a short-term effect. In the long run, those old economy stocks will deteriorate.

I have observed a similar phenomena in global markets. In the US, e-commerce firms such as Amazon and eBay have done extremely well compared with traditional retailers.

I also like exporters. Although they have suffered a lot, in the next few years we see a good opportunity for them, especially starting from next year under the 19th National Congress in China. The fundamental reason is the currency. We believe there will be a significant depreciation of the renminbi in the future and those companies will benefit.

Chi Lo, BNP Paribas Investment Partners: The old economy sectors and stocks may not perform as well as the new economy stocks, but the questions is, what type of new economy stocks should investors get into, and can foreign investors get their hands on them?

With the Shenzhen-Hong Kong Stock Connect up and running soon, that opens up a new scope for investors to get into China’s new economy. Another place to look are emerging industries within the old economy sectors. Some examples are solar batteries, industrial robots, wind power and electric cars, just to name a few. These companies have registered double-digit growth in the past two-and-a-half years while the national economy has come down from double-digit growth to now single-digit growth.

Ashley Dale, Harvest Global Investments: We’ve been talking about the new versus old distinction for years now. The difficulty is finding the new economy stocks, because a lot of them are private companies. Venture capital spend, for example, is greater now in China than it is in the US – China’s got its own Silicon Valley – and yet these opportunities aren’t necessarily available to your run-of-the-mill investor overseas. Hopefully, in time, these firms will begin to list because that’s where long-term returns are going to be found.

As a firm, we also like e-commerce. The penetration of e-commerce is 12% in China, which is higher than that of the US, and $1.9 billion was spent on online shopping last year. The innovation and the pace of change is extraordinary.

We also see opportunities in travel and tourism. About 6% of Chinese people have passports and half of those have only ever been to Hong Kong and Macao. Just imagine what it’s going to be like in five or ten years.

Richard Tang, ICBC Credit Suisse: If you look at them in a traditional way, some of these new companies are not cheap. People look at Ant Financial [the online payments service formerly known as Alipay] and say its valuation is too high. But I would counter that commercial banks will lose their value in the next two decades.

Companies such as Ant Financial are very innovative. For instance, it just acquired some face-recognition technology in China. If a financial company can adapt to artificial intelligence or big data technology, they have a lot of potential. We can argue that in ten or 20 years, Ant Financial can be worth as much as the big four state-owned banks put together.

These new technologies – e-commerce, clean energy, artificial intelligence and big data – will bring dramatic change.

Funds Europe: Do you anticipate more government intervention in the stock market, such as the use of circuit breakers, or have the authorities given up on this kind of interference?

Lo: Interference will never go away in China, because control and intervention are guiding principles of the Communist Party. So long as the Communist Party runs China, this will not change.

Intervention is a rule of the game. And to be fair, we see it in other markets too, by the European Central Bank, the Bank of Japan, everyone. When market conditions become disorderly, the government comes in. This is certainly necessary in the retail-oriented trading environment in China, where volatility is bigger and more frequent than in other markets.

Until we see a more mature Chinese market with more institutional investors and less volatility, this is something we have to live with.

Fei: The government’s intention is good. The tools and the methods they used have been widely adopted in other markets. One of the difficulties they face are highly leveraged investment vehicles used by retail investors, which tend to amplify the situation and make it difficult to control the markets. The current management team of the China Securities Regulatory Commission (CSRC) is doing a good job. As long as they keep doing this, in the future we will see less need for intervention.

Dale: These are young markets that are expected to operate in a mature market fashion because they are so big and so important. The West probably expects too much at this stage of development. However, we’ve got to be careful not to become apologists for poor intervention by the regulators. 

It’s a regulator’s job to intervene but the question is how you do it and how you communicate with the market.

The government, the People’s Bank of China (PBoC) and CSRC have learned some lessons. Arguably, the intervention caused more market mayhem than had they not done it in the first place, so there is a lot of talk as to how they improve that communication, particularly with an international audience.

There’s talk of a super-regulator, much like we have in the UK.

Out of chaos can come great change. What happened in January has made people sit up and think.

Tang: The regulators in China are learning fast. It’s not an easy market to deal with. The majority of investors are not mature or sophisticated.

However, I believe the Western media has a bias about what’s going on in China. When the financial crisis happened, the US government did a lot of interference. It is natural, when something risks your safety, you do something. With experience, the regulators will learn to deal with these problems in a better way. That’s it.

Funds Europe: Are you optimistic about the potential of state-owned enterprise (SOE) reform?

Tang: You’ve got to be optimistic. A majority of the economy is related to SOEs, and they are relatively low efficient units. Reform will help determine the next ten or 20 years of the Chinese story. If the Chinese people and government want to ensure a healthy and continually growing economy, this has to be dealt with.

Dale: There’s clearly a move towards market-led reform. The SOEs are being encouraged to focus more on profitability rather than scale.

But it takes a long time to get to that point, and the last thing you want is disruption, particularly if people lose their jobs. It is going to be a gradual move.

Some firms are experimenting with share options, for instance. Large government-linked shareholders are divesting their stakes and giving them to management and workers. This is gradually moving along the right lines.

Lo: The challenge for Beijing’s state sector reforms is that there’s a conflict of interest. The spirit of reform is to let go of control and allow market forces to run the companies, but the guiding principle of the Communist Party is to run the country with control. These two forces are fighting with each other. You can see in the policies that Beijing has implemented that there are flip-flops. These are a result of this mindset struggle.

In the short term, I’m not optimistic about public sector reform. I don’t think it will happen in the next three to five years even, because there is great uncertainty over the leadership’s ability to do it due to the constraints it is facing.

China is going through a leadership change. Five of the senior members of the standing committee will have to retire in 2017 and we have yet to see who will replace them. If we get five new standing committee members who all support reform as strongly as the premier and the president then, yes, we will get further reform. But we won’t know until after the new standing committee members are put in place, and probably we will have to wait for two years from now to see how their reform policies will play out.

In the long term, I’m optimistic because China has achieved reforms before. From the late 1990s to the early 2000s, the then premier Zhu Rongji shook up the state sector. More than 60,000 state firms were closed down, generating more than 30 million job losses.

It was a painful period of state sector reform, but it worked. Margin returns on investment in the economy shot up.

If China wants to do it, it can do it. Assuming the Chinese leadership has the resolve, we will see meaningful reforms in the longer term. A signpost for entry, as investors, could be when the government allows serious defaults, not those we have seen with Chinese style, to happen.

Fei: Actually, I interpret SOE reform as SOE restructuring or consolidation.

From an investment perspective, I am positive on SOEs. The central government wants to make SOEs stronger and better. These companies have the best access to resources, the largest market share, and restructuring is helping them lower their bad loans. However, when you invest in SOEs, actually you are investing in the Chinese government.

It’s hard to apply stock option plans to SOE companies. Maybe these are just a gesture. I believe the current government will have more control over these companies, not less.

Funds Europe: Is the potential inclusion of A-shares in the MSCI Emerging Markets index important for Chinese equity investors or has its significance been exaggerated?

Dale: China wasn’t included over the summer, but the markets have still done exceptionally well, which gives an answer to that question.

In the long term, inclusion is important, but there are many question marks over it – what’s the weighting going to be, will we have to wait another 12 months from the announcement until the actual inclusion. I don’t think it’s the biggest story out there.

Yes, inclusion would mean international investors would have to take the A-share market seriously, but the importance of that is outweighed by real change that’s happening within the domestic economy.

Tang: I have a strong view on this. First, I don’t think inclusion is that important. MSCI made a lot of noise because they wanted co-operation from the Chinese regulator or government to make their index become more popular. But when you do a trick, you should be very careful. Sometimes it is a double-edged sword. They have played this game three times.

Secondly, the MSCI Emerging Markets index was created many years ago. At that time, China was a small part of the global economy. Of course you could put it together with another 23 emerging markets then, but more than 30 years later, you still want an elephant dancing with a bunch of rabbits? That’s a joke. Let’s remember that China is the second-largest economy and the third-largest equity market in the world.

It has been claimed that the Chinese government did not do enough to open up to foreign investors. Earlier this year, China opened the interbank bond market to international investors. You can easily access 95% of the Chinese bond market right now. For equities, you can go through the Hong Kong-Shanghai Stock Connect, and soon Shenzhen Connect, to access the majority of the market. I wouldn’t be surprised if over 90% of the Chinese equity market is already open to international investors.

For my last point, look at the world’s major economies. Japan and Europe have negative interest rates. The US has 1%. China has around about 2.5%-3%. Take out the currency volatility, if you really want to make money in fixed income, China is the largest market for that.

In terms of GDP, Japan and Europe have zero growth, the US has between 1%-1.5% growth and China has 6.5%. You can argue about the quality of the GDP number, but it’s still far ahead of the others.

Lo: The question asks about the importance of inclusion for Chinese equity investors, but is this for foreign investors in the Chinese equity market, or for local Chinese investors in their own equity market? For foreign investors, it is important, but for the Chinese local investors, I don’t think they care at all.

The system is so big and so deep that unless China completely opens up to allow international market discipline into the system, the impact of foreign investment and foreign investors in the Chinese market will be small.

The importance for China is only in terms of recognition. A-share inclusion in the MSCI index would be a recognition that China’s liberalisation programme has achieved certain milestones and become more acceptable to international investors.

However, would MSCI inclusion itself help institutionalise the market? I used to think so but I changed my mind earlier this year when I saw a shift in thinking from the Chinese authorities concerning the SDR [special drawing rights, a currency basket the renminbi joined on October 1].

There has been a downgrade of reform priority in the policy agenda since SDR inclusion, in exchange for upgrading growth as the first priority. SDR inclusion tells Beijing that OK, they have reformed. The renminbi is recognised by the international community. They have done enough. If that mentality continues, MSCI inclusion of A-shares would not be an external force to push domestic reform as it might have done before.

Fei: I agree with you. The top priority for the Chinese government now is systematic risk control.

Funds Europe: How can investors position themselves to benefit from China’s policy of internationalising its currency?

Lo: As I said, this has become less of a priority since the beginning of this year.

Look at the way that the PBoC intervened in the CNH market [the market for offshore renminbi trading] this year. In previous years, when there was a big shoot-up in the CNH interbank rates, the PBoC asked the Chinese banks to inject liquidity into the market to bring rates down.

This time, interbank CNH rates shot up significantly, but the PBoC didn’t ask the Chinese banks to inject liquidity. Actually, they asked the Chinese banks to take money back.

From a macro perspective, the intervention direction has changed. Because Beijing is not seeing internationalisation of the renminbi as such a high priority as it was before, and because volatility is hurting the Chinese onshore market and bringing unwelcome instability to the domestic system, the authorities are willing to sacrifice the offshore market in exchange for minimising instability for the local system.

Internationalisation is still a goal, but the pace going forward will not be as fast as we saw in the past five years.

Dale: As you say, it’s been amazing progress, considering where the starting point was a number of years ago. You can question the real impact that SDR inclusion will have, but, obviously, that was an aim that they achieved, and to have that recognition is important. The internationalisation of the currency is great for trade and investment.

Tang: This is the reason I came to Hong Kong, because I believe in this trend. Fundamentally, a strong economy will push the renminbi forward. Only if you have a major issue domestically will you destroy the long-term success of the international renminbi.

Ultimately, the Chinese government wants the renminbi to compete in the global financial market. The British government, and the City of London, understand the potential of the Chinese currency, which is why they promoted the renminbi in Europe. The US doesn’t want to accept this. In my view, they are in denial. As sterling was replaced by the US dollar, so the US dollar eventually will be replaced by an emerging currency.

However, there are some challenges. We tried to work on the first real money market fund in Hong Kong, and we encountered a lot of difficulties from the Chinese regulator, the Hong Kong regulator, as well as our service providers such as custodian banks, because the system is only set up to service the US dollar.

Chinese financial institutions should really help the government build the basic products, infrastructure and services to support the renminbi, instead of always looking for short-term profit.

Additionally, the renminbi needs to become a commodity pricing currency – that’s why the Middle East is important.

Over $50 billion of crude oil was acquired by the Chinese government from Saudi Arabia. Why was it priced in US dollars and not renminbi?

Funds Europe: Will China always be a retail-dominated market? What could increase institutional investor participation on the mainland?

Fei: More transparency and consistency of policy are the necessary parts to attract institutional investors. But if the market is growing, and large enough, then large institutions cannot ignore it. As long as China is doing the right things to improve the system and to get growth back, we will see more and more institutions buying into the markets. It’s a natural thing.

Dale: From what I see on the ground, the government are making the right moves to increase domestic institutional participation, via the National Social Security Fund and the insurance companies, for instance. For international institutions, increased accessibility and MSCI inclusion will encourage more participation.

However, part of the problem – it’s not necessarily a problem – is that Hong Kong is here, and open, and most of the good Chinese companies that pass the audit trail and have good governance are listed here. Because H-shares are still trading at a reasonable discount to A-shares, Hong Kong would be the natural place for investors to go, not least because Chinese money, as we’ve seen over the past three months, is pouring into the Hong Kong market.

Lo: The other issue is the liquidity, the access. Foreign investors do not want anything to bar them from exiting the market if they need their money back. These issues are being addressed, however.

For domestic institutions, regulations could help to encourage more investment in equities, for instance.

Tang: It will take time for the market to mature. Even if you have more pension money or institutional money going there, the mindset still has to change. For example, if the market is, say, 70% retail and 30% institutional, in my mind it is more like 90% retail. Why? Because the majority of Chinese mutual fund companies are like representatives of the retail market, and all of their redemptions and creations force them to think like retail investors.

Lo: I’m glad you raised this. I used to run the qualified domestic institutional investor (QDII) fund for one of the largest insurance companies in China. What I found was, for such a big insurance company, they traded like a retail investor. It was all pro-cyclical, chasing on the way up and dumping on the way down. This brings out the point of investor education. China has to do a lot of that, to improve the financial knowledge base – not just the moms and pops, but also the institutions.

Funds Europe: How optimistic are you regarding Chinese equities in the coming 12 months?

Lo: From a macro perspective, considering all the political factors, I’m neutral, for the simple fact that the political transition is uncertain and all the reforms and policies depend on it.

Fei: I’m not very optimistic, but not only for China, for many emerging countries, because we are in the cycle of the US Federal Reserve hiking rates, which will put pressure on emerging countries’ capital markets. China uses a lot of leverage, though the government is trying to counter the leverage now. Hopefully they can reduce it before the hiking cycle starts.

Dale: I take the point about Fed hikes, but that starts from a low base, and any hikes should indicate increased growth in the world’s biggest economy, which should be good for the manufacturing sector in China.

I’m optimistic. However, it is important to pick the right stocks in the right sectors at the right time. Generally, we believe A-shares should perform well, but you’ve got to find the right manager to run them.

Tang: I would say that after almost 18 months of crash, crash and consolidation, downside risks should be limited. However, as the gentlemen have said, there is a lot of uncertainty domestically and internationally. If I had to choose an equity market, I would choose China, however I would rather avoid investment in equities at all at the moment.

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