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China: An Update on the Market and
Government Policy
May 2011
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After disappointing performance in 2010 and the first
quarter of 2011, Chinese equities have only recently
started to outperform regional markets.
In this paper, we aim to investigate the reasons for the poor performance in 2010
and to analyze the implications of recent government policy announcements on the
stock market. We believe that after the recent focus on developed markets, the
investment case for Chinese equities looks appealing once again.
Explaining the Poor Performance of Chinese Equities
Chinese equity markets ended 2010 as the worst performing market in a regional
context, rising by only 2.3% in U.S. dollar terms. This pales in comparison to the MSCI
Asia ex Japan’s 17% rise, and the 20% rise in other markets such as Korea, India, Hong
Kong, Taiwan and Singapore. The poor performance continued into 2011, with the
Chinese market only starting to register outperformance in March 2011 (Exhibit 1).
The reasons for China’s poor performance in 2010 were relatively straightforward.
Despite strong 9.8% year-on-year growth in 2010, foreign investors largely avoided
Chinese equities given rising inflation, monetary tightening, policy headwinds and
earnings downgrades.
Exhibit 1: Index—Absolute performance in U.S. dollar (%) and valuations
May 2, 2011 U.S. dollar price index
MSCI Australia
MSCI China
MSCI Hong Kong
Author
Sherene Ban
Executive Director
Client Portfolio Manager—Far East Equities
[email protected]
1 month
5.7
3-month
10.4
YTD 12-month
9.9
18.1
2011 PE (x)
14.0
-0.1
3.2
4.2
9.0
11.8
1.8
-2.1
1.5
22.5
15.3
15.0
MSCI India
-2.2
7.2
-7.3
3.8
MSCI Indonesia
5.3
20.1
11.2
25.1
15.0
MSCI Japan
4.6
-6.4
-3.9
1.7
14.6
MSCI Korea
7.8
13.1
16.2
34.1
11.2
MSCI Malaysia
0.8
3.0
5.3
23.8
15.1
MSCI Philippines
3.9
11.2
1.6
22.1
15.3
MSCI Singapore
4.5
2.7
4.1
19.0
14.3
MSCI Taiwan
5.8
-1.1
2.1
22.5
13.8
MSCI Thailand
3.6
16.9
9.2
52.3
12.8
MSCI AC Asia Pacific
4.1
1.3
2.3
11.9
13.6
MSCI AC Asia ex Japan
3.1
5.0
5.0
19.4
13.1
MSCI AC Asia Pacific ex Japan
3.8
6.4
6.3
18.9
13.4
Source: MSCI, Factset, Thomson Financial Datastream, Credit Suisse
China: An Update on the Market and Government Policy
Since reaching a trough in July 2009, inflation, as measured by
the Consumer Price Index (CPI), has risen steadily and has
hovered at around 5% for the past quarter, a level above the
government’s official 4% target. Food, which makes up a third
of China’s CPI basket, has seen inflation in the 10% range due
to the effect of colder-than-expected weather on vegetable
prices. Given that it has mainly been a supply-side disruption
that has caused the spike in food inflation, we believe that the
CPI will moderate from June 2011 onwards as the supply shock
reverses and food prices fall.
Nevertheless, since the beginning of 2010, China’s Required
Reserve Ratio (RRR) for large banks was increased nine times
by 4.5% to 20%. China’s central bank has also hiked rates four
times since October 2010, taking the benchmark one-year
lending and deposit rates to 6.31% and 3.25% respectively.
Furthermore, authorities have introduced a raft of measures
to cool the property market, such as tightening the lending
conditions of mortgage loans and raising the minimum downpayment on a first house to 30%. Earnings in sectors that
have been unable to pass on input price increases, such as the
consumer staples sector, have also been downgraded, leading
to falls in share prices.
increase interest rates and the RRR throughout 2011 in response
to CPI over 4%, and to use necessary administrative policies to
maintain stable prices, such as price caps on government-controlled products (e.g., energy, utilities). However, we believe that
these measures have been well flagged by the government and
are already priced into market expectations.
In terms of the composition of GDP and growth rates, the government has set a modest 2% budget deficit target to support
private consumer expenditure growth in order to restructure
the economy towards being increasingly domestic driven.
The government has announced plans to increase spending on
social welfare, education, healthcare, pension and, importantly,
on social housing, to be funded by reducing spending on fixed
asset investment.
As a result, rising inflation, the monetary and administrative
response to inflation, and the impact of inflation on corporate
earnings, have provided an element of uncertainty to the
Chinese equity market and have led China to de-rate to a
price-to-earnings multiple of 12x in the first quarter of 2011—a
discount to the rest of the region (Exhibit 1).
Social housing, the provision of low-cost housing, is one of the
key tenets of government policy that has been in focus over the
past year and the NPC meeting provided more details on how
the government aims to achieve its plan to make social housing
available to 20% of urban households by 2015. Essentially, the
central government is targeting the construction of ten million
units of social housing in 2011 and 2012, and five to six million
units per year in 2013, 2014 and 2015. To put the numbers in
perspective, ten million units of social housing could account for
a third of residential housing starts in 2011. Our Greater China
team believe that the introduction of social housing will offset
the expected slowdown in private residential construction and
be a significant boost to companies involved in the construction
sector (e.g., building materials, cement).
An Update on China’s Government Policy
The 12th Five-Year Plan (FYP)
In early March, China held a National People’s Congress (NPC)
meeting where Premier Wen Jiaobao delivered the government’s annual work plan along with details of the twelfth FiveYear Plan. The message from the NPC was consistent with
prior government announcements.
Given that 2011 is the first year of a new FYP, the NPC also
provided more detail on the government’s twelfth FYP.
In general, the main targets of the new plan include:
The key takeaways from the government’s economic targets
for 2011 include an inflation target of 4% (versus 4.9% as of
the end of February 2011, and versus the prior target of 3%)
and a real GDP growth rate of 8%, with a focus on improving
the quality of growth and on economic structuring.
• A focus on economic restructuring, including support for the
service sector and for strategic new industries (e.g.,
alternative energy, biomedical, environment protection).
Stabilizing prices was identified as the top priority of macroeconomic policy in 2011, with a target of 16% broad money (M2)
supply growth in 2011. We continue to expect the government to
2 | China: An Update on the Market and Government Policy
• Real GDP growth averaging 7%, with a focus on enhancing
the quality and efficiency of growth.
• A shift of the growth driver towards domestic demand, by
aiming for real income growth over GDP growth, and a target
of 45 million jobs being created in the urban area.
• An increased emphasis on improving the welfare of citizens
via “inclusive growth,” which includes expansion of tax
• An increase in the share of non-fossil fuel energy from 8% to
11% via the construction of alternative energy capacity (e.g.,
wind, solar, nuclear, hydroelectric).
Exhibit 2 provides some numerical data on targets of the
previous FYP, the realized numbers and the targets for the
new FYP.
Exhibit 2: Comparisons of the 11th and 12th FYPs
Real GDP growth (%)
GDP (RMB trillion)
Urban income per capita
(RMB ‘000)
11th FYP
target
7.5
26.0
11th FYP 12th FYP
actual
target
10.5
7.0
40.0
N/A
13.4
19.1 7% CAGR
Rural income per capita (RMB ‘000)
4.2
5.9 7% CAGR
Population (bn)
1.4
1.3
<1.39
47.0
46.7
51.5
35.1
34.9*
N/A
43.3
5.0
43.0
4.1
47.3
<5
20.0
19.1
16.0
60.0
66.0
N/A
R&D as % of GDP (%)
2.0
1.7
2.2
Social housing coverage (%)
N/A
<8
20.0
Urbanization ratio (%)
People employed in services
sectors (%)
The service industry as % of
value added (%)
Urban employment (%)
Energy consumption reduction
per unit of GDP (%)
Comprehensive utilization rate of
industrial solid wastes (%)
Chinese Equities Look Attractive
After underperforming in 2010 and early in the first quarter of
2011, the MSCI China ended the first quarter as the second
cheapest market in the region with a 2011 price-to-earnings
ratio of 12x, versus the MSCI Asia Ex Japan average of 13x and
versus India’s 15.4x (Exhibit 1).
After seeing earnings downgrades throughout 2010, the
earnings of Chinese equities started to be upgraded in
February and in March 2011 (Exhibits 3 and 4). This was led
firstly by the benchmark heavy energy sector given rising oil
prices. More importantly, late in the first quarter of 2011,
Chinese banks released their 2010 earnings and guided to
strong earnings in 2011, both of which surpassed consensus
analyst expectations. In particular, given the rising interest
rate environment, Chinese banks’ net-interest-margins started
to expand, highlighting the pricing power of banks in a credit
constrained environment. In 2010, the banking sector faced
Exhibit 3: China earnings per share (EPS), 2011
105
6 consecutive months of
upgrades with March +2.1%
100
95
Percent
reform, pension coverage, an increase in minimum wages by
over 13% annually and the construction of social housing.
90
85
80
Source: CLSA Asia-Pacific Markets, Lianghui discussions, 12th Five-Year
Plan draft.
75
Dec-09
Apr-10
Aug-10
Dec-10
Source: Credit Suisse
Political Change
Exhibit 4: Chinese banks EPS, 2011
102
101
+1.4% in March,
first upgrade
in nine months
100
Percent
In October 2010, Xi Jinping was appointed vice chairman of the
Central Military Commission, a move that means he will almost
certainly succeed the incumbent Hu Jintao as party secretary
in late 2012 and as president in 2013. Howard Wang, head of
J.P. Morgan Asset Management’s Greater China team, does
not believe that there will be any shift in government policy
given the new leadership. He believes that the new generation
of leaders have been carefully chosen to ensure a continuation
of past policy and there is little in the political record of Xi
Jinping to suggest that he intends to steer China in a different
direction. In our view, the main tenets of the incumbent
regime’s economic views—strong growth, social harmony and
inflation control, will be continued.
99
98
97
96
95
Dec-09
Apr-10
Aug-10
Dec-10
Source: Credit Suisse
J.P. Morgan Asset Management | 3
China: An Update on the Market and Government Policy
earnings downgrades given concerns over asset quality and
non-performing loans, and was weighed down further by large
capital raising across the sector. In hindsight, we believe that
the regulators were prudent by proactively ensuring that the
sector had high levels of capital adequacy and that banks’
provisioning levels would be sufficient to absorb any potential
bad loans.
Higher oil prices due to the events of the Middle-East may cause
inflation to remain above the government’s official target in
2011. Nevertheless, we expect inflation to peak by the end of
the second quarter, given the low base effect (the recent trough
in inflation was in June 2010) and moderating food price
pressure. Our Greater China team believe that monetary
conditions are already very tight and unlikely to be significantly
more restrictive going forward. Past experience has seen the
Chinese equity markets trough several months before inflation
actually peaks, and we believe that this cycle will be no
different. In our opinion, inflation and the risk of further
monetary tightening have been increasingly priced into the
equity markets, as evidenced by the outperformance year-todate of Chinese A-shares, the market most reflective of changes
in investor sentiment. Furthermore, we believe that we have
seen the peak in tightening policies and thus any corrections
would present a good buying opportunity for Chinese equities
given the attractive valuations relative to growth.
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