Managing The Dragon’s China Predictions For 2015

year_of_the_ram_by_sumikitsune-d3d1wdbThe year of the goat may go down as the year of the capital markets in China. In the closing months of 2014, China announced two major reforms that promise to have a far-reaching impact on the deployment of capital flows in and out of the country. As a result, three of my predictions this year relate specifically to China’s capital markets.

On November 17, China announced Shanghai-Hong Kong Stock Connect, a program which enables Chinese mainland investors to buy shares listed in Hong Kong and Hong Kong investors to purchase Shanghai-listed securities. While this program makes available additional international capital to China’s stock market — beyond what was already available through quotas established in 2002 under the Qualified Foreign Institutional Investor (“QFII”) Scheme – It is likely that Shanghai-Hong Kong Connect will be a precursor to further steps to open up China’s stock markets to overseas investors.

On November 30, China announced that, beginning in 2015, all bank deposit accounts up to RMB 500,000 ($80,500) will be insured by the government. China’s central bank estimates that this insurance will cover 99.6 percent of depositors in full. However, the 0.4 percent of accounts that are not fully covered contain more than half of all money on deposit in China, and most of these accounts belong to China’s state-owned enterprises. By its announcement, China has signaled that it is now willing to let banks fail, and that the implicit government guarantee of all investments offered by banks, including investments offered by the country’s massive shadow banking system, can no longer be assumed.

Historically, loans have only been available from China’s banks. In the aftermath of the financial crisis, however, credit became available from a range of sources, such as trusts, leasing companies, credit-guarantee and money-market funds, which are known collectively as shadow banks. By offering returns as high as 10 percent, compared to much lower government-capped deposit rates, the shadow banks have diverted capital from the traditional banks — as well as from the stock market — over the past five years. With an implicit government guaranty by China’s central bank, these higher yielding investments have been considered to be essentially “risk free” and very attractive by investors. Beginning in 2015, such investments will lose much of their appeal.

The Shanghai-Hong Kong Connect and the new deposit insurance programs, combined with soft real estate prices and an unexpected 40 basis point interest rate cut in the one-year benchmark lending rate by the People’s Bank of China on November 21, touched off a 34 percent increase in the Shanghai Stock Exchange (“SSE) Composite Index in the last three months of 2014 as investors turned to the stock market for higher returns. On a longer term basis, these moves are triggering a major shift in household asset allocation, the ripple effects of which are explained in my predictions.

Prediction #1: China’s Gross domestic product (“GDP”) will come in at seven percent or higher for the year.
The annual debate regarding the growth rate of China’s economy centers this year on whether the country’s GDP growth rate will be above or below seven percent.

According to Jim O’Neill, former Chief Economist and Chairman of Goldman Sachs Asset Management, “many international commentators remain bearish about China, expecting real GDP growth to slip significantly below seven percent. The reasons cited usually involve some combination of excessive debt, inefficient lending, weaker export markets and consumers’ ongoing inability to play a bigger role in the economy.” For example, UBS expects China’s GDP growth to slow to 6.8 percent, an opinion that is shared by Nomura.

On the other side of the debate, Stephen Roach, a Yale University professor and former Morgan Stanley Asia Chairman, believes that the government “will be able to comfortably achieve the 7 per cent growth objective that is likely to be clarified” at the National People’s Congress meeting in March. The People’s bank of China is slightly more bullish and predicts a growth rate of 7.1 percent.

While the range of estimates this year is narrower than at any time in memory, I fall in the seven percent or greater camp.

Prediction #2: The SSE Composite Index will pierce the 4,000 level in 2015.
Despite my many failed past attempts to predict the direction of China’s stock market, the performance of the SSE Composite Index over the past six months necessitates that I break my vow never to attempt such predictions again.

For those who have not been following the China market, the SSE Composite Index traded around the 2000 level for the first five months of 2014, the same level it has traded at since 2013. Nothing unusual until the beginning of June when the SSE Composite Index began to break out of this pattern, increasing by 18 percent to 2420, its highest point since February 2012, by October 1. If the Index had stopped there, it would have been the first time since 2009 that China’s stock market had shown an increase for the year, and stock market investors would have been delighted. But the bull market continued. In the remaining three months of the year, the SSE Composite Index rose an additional 34 percent, closing the year at 3234. For the entire year, China’s stock market was up an incredible 59 percent and was one of the best performing bourses in the world.

Due to the fundamental reforms discussed previously, more capital is now flowing into China’s stock market. Shanghai-Hong Kong Connect is bring increasing amounts of international capital, and the shift of household assets away from physical property and shadow banking products to A-shares, is bringing domestic capital. Official data shows that Chinese retail investors, who conduct from 60 to 80 percent of stock trades in China, opened over a million new brokerage accounts in November, up 280 percent year-on-year, after years of stagnation.

Because the effects of these reforms are still in their early stages, the China bull market has a long way to go. “In China, over 61 percent of households have bank deposits, but only 6.5 percent have invested in the stock market,” Julius Baer, a Swiss private banking group with locations in more than 20 countries, has noted. As both households and foreign investors significantly underweight Chinese stocks, the SSE Composite Index will break through 4000, a 24 percent increase, in 2015.

Prediction #3: Over 100 IPOs Will Be Completed on the Shanghai and Shenzhen Stock Exchanges in 2015.
After a 14-month, self-imposed moratorium, China opened the market for Initial Public Offerings (“IPOs”) at the beginning of 2014. As a result, 58 companies were able to take advantage of this source of equity capital and make their debuts on China’s Shanghai and Shenzhen stock markets during the year.

However, there are still 637 IPO candidates on the waiting list for approval, and the success of the IPO market in 2015 will likely open the way for more of these companies to go public as well. Moreover, China will need to step up approvals and increase the supply of securities in order to absorb the flood of new capital coming into the market. Otherwise, valuations, which are already high in many cases, will be pushed up further.

China’s IPO market will continue to be robust with 100 or more companies completing IPOs in 2015.

Prediction #4: Prediction #4: Outbound Chinese M&A Activity Will Reach New Levels in 2015.
While full-year figures are not yet available, 245 overseas transactions with a deal value of just over $51 billion were completed by Chinese companies during the first eight months of 2014. At that rate, the full-year transaction value should reach $75 billion, 10 percent higher than 2013; 50 percent higher than 2010; and more than twice the value of transactions completed in 2007. As noted by Institutional Investor, the pre-eminent magazine for institutional investors, “Chinese Companies Are the New Force In Global M&A.”

Fundamental forces are driving Chinese companies to make overseas acquisitions.

First, the slowdown in China’s economy has increased competition, put downward pressure on pricing and reduced the profitability of many companies. Cross-border acquisitions provide Chinese companies with diversification and access to new international markets.

Second, “Made in China” has come to connote low technology, low quality and low value added products over the past thirty years. Acquisitions of overseas companies with established brands, advanced technology, high value added products and R&D capability will enable Chinese companies to become globally competitive.

Finally, a robust Chinese stock market is providing a new source of funds for acquisitions.

For all of the above reasons, overseas acquisitions by Chinese companies will set a new record in 2015.

Prediction #5: Car Sharing Will Become A Growing Trend In China’s Auto Industry, Spurring Demand For Electric Vehicles
Although China’s increasing wealth will continue to drive the growth of car ownership, severe air pollution and traffic congestion have led a number of large Chinese cities to take actions to limit the growth in the number of private cars. Beijing, Shanghai, Guangzhou, Guiyang ,Tianjin and Hangzhou already limit the number of vehicles registered each year through various means. While Beijing and Guiyang issue plates through a lottery, Shanghai uses a bidding scheme. Guangzhou and Tianjin use both systems.

Aside from government restrictions, and despite increasing per capita incomes, many Chinese consumers still cannot afford the car of their dreams, particularly when the cost of maintenance and parking are taken into account. Many Chinese consumers would prefer access to a car, but do not necessarily need to own a car.

For China’s cities, and for many of Chinese consumers, car sharing programs can help reduce the number of cars on the streets, while at the same time, meet China’s increasing demand for personal mobility. Car sharing programs come in a variety of forms.

Station based car sharing programs offer vehicles at designated car sharing stations within a defined service area. Depending upon availability, cars can be reserved spontaneously or in advance by phone, website or smartphone application. Free floating car sharing programs provide vehicles without designated car sharing stations for spontaneous car access for short trips within a defined area. The cars, which can be located by service hotline, website or smartphone application, are parked in legal parking spots within a defined area. Reservations are not required, and are typically made only for short periods of time — 15 to 30 minutes. Finally, peer-to-peer car-sharing companies provide a platform for members to rent vehicles owned by other members in the network.

Whatever the form, car sharing is growing in China. In 2012 there were only two car-sharing operators, with a total of 39 vehicles in Chinese cities. Today, China’s car-sharing network has grown to a total of 1000 vehicles with five active operators in Beijing, Hangzhou, Wuhan, Shenzhen and Changsha. In its study, “Sharing the future – Perspectives on the Chinese car-sharing market,” Roland Berger Strategy Consultants predict annual growth of about 80 percent in China for the next five years.

The growth in car sharing will also provide new demand for electric vehicles because these programs tend to mitigate the disadvantages of high cost, range and the availability of charging stations normally associated with electric vehicles. An emphasis on low cost and affordability, however, means that the prime beneficiaries of this trend will be the growing number of manufacturers of small and affordable electric vehicles, not necessarily the manufacturers of expensive luxury models.

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