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Market Insights

Market Update - China

Navigation Series 10/2011 Christina Chung, Senior Portfolio Manager of Allianz RCM China & Hong Kong

With recent signs of deteriorating global economy, investors became increasingly concerned over the European debt crisis, a potential recession in the US as well as a hard landing scenario in China. In addition, investor sentiment on China has deteriorated sharply in the past few months due to concerns over weakening domestic demand and financial stress in the small- and medium-sized enterprise (SME) and property sectors. We maintain our view that the risk of a hard landing is not high in China. Of course, it depends on the definition of hard landing which we would consider as real gross domestic product (GDP) growth collapsing to 5-6% in the short term. In China, there are many domestic issues that the central government needs to deal with, and these issues are not the same kind of structural issues facing the US and certain European countries at the moment. Given China is not burdened with external debt, whereas the country has large foreign exchange reserves, high domestic savings, a controlled currency and a largely closed capital account suggest that there will be no forced currency devaluation by hedge funds or capital flight by domestic citizens which typically drives a downward spiral at times of crisis. We believe that real GDP growth will moderate and the slowdown is largely policy engineered, including the tightening of credit and other property market tightening measures. Hence, we believe that if economic growth decelerates sharply, there is room for policy relaxation including expansionary fiscal policies like an increase in government spending on infrastructure, a reduction in required reserves ratio as well as some easing of bank credit particularly to SMEs on the heels of tightening of banks' offbalance sheet lending. However, we do not expect interest rate cuts at this point in time. Our forecast on real GDP growth will be at 8-9% in 2011 and this will slow to 7-8% in 2012. For corporate earnings, we expect there will be some deterioration given the slowdown in Chinas economy and, more importantly, a sharp decline in the global economy. However, the market has discounted ahead this earnings uncertainty as suggested by the sharp price-toearnings ratio de-rating of Chinese stocks. As an alternative, price-to-book (PB) is a better valuation parameter at times of panic selling. In terms of PB, the Morgan Stanley Capital International China index and H-shares are already well below the 2008/2009 crisis level. Hence, we believe the market is oversold and share prices have discounted a lot of potential negatives.

Market Update - China

Valuations are very cheap, and it is now more a question of market confidence. On the other hand, we believe that there is significant hedge fund selling in the current market environment as the short ratio is at historical high. In addition, institutional investors could also be raising cash levels in anticipation of redemption. Regarding the issue of informal lending in China, we believe this kind of private lending has always existed and given that we do not have past statistics relating to underground banking, shadow banking or informal credit, it is difficult to compare and conclude that this is a massive and newly developed phenomenon in China. In sum, we think the problems for SMEs in China has caught too much media attention and hence typically leading to exaggeration. The Wenzhou situation is a case in point. It is well-known that private businessmen in Wenzhou are relatively aggressive and speculative. However, given China is such a big economy, we should not generalize the Wenzhou situation as a typical nationwide phenomenon. Deutsche Securities estimated that per capita informal lending in Wenzhou is 30 times the estimated national average. Even with a much more conservative estimate of the size of informal lending in Wenzhou, its per capita informal lending is still 5-6 times the national average. Of course, these are all very rough estimates as, while we may have data for Wenzhou, it is very difficult if not impossible to gain access to data of informal lending in many parts of China. Overall, we believe that non-performing loans for Chinas banks will rise over time and some SMEs (including smaller property companies) could be under financial stress. However, at this stage, we do not believe that the situation is widespread or the problem has reached an unmanageable situation given the financial strength of the central government. Hence we believe the market is overly bearish on the SME fallout as well as a hard landing in China. Major risks relate to the global economy. In particular, the cost will escalate with further delay in concerted policy actions in Europe to avert deposit flight. In a scenario of global recession, China will be adversely affected. However, we believe time is running out for International Monetary Fund support in the form of deposit insurance to avert deposit flight as well as some form of debt forgiveness, for instance, in the case of Greece. As discussed above, we would also expect the Chinese government to introduce policy support to avert a hard landing scenario in the event of global recession. The EUR will remain weak due to the developing sovereign debt crisis which underlines a pessimistic economic outlook in the euro zone and the growth gap between different euro countries will also be widened. As one of the key driver of China's export growth, Europe is the single largest trading partner of China. Europe is the top importer of Chinese goods and services and the top technological exporter as well. Hence, the worsening European sovereign debt crisis would definitely have an impact on the Sino-European Union economic and trade cooperation, which may result in slower export growth in China. However, economic downturn in Europe could drive an increase in outward investment by European companies to emerging economies including China. In addition, obviously China continues to have strong demand for capital goods to enhance production quality and improve production process in the face of rising labor cost, say, increase automation. Hence, a weak EUR will help to reduce the cost of these capital goods imports, say, from Germany. Furthermore, domestic consumption in China should remain relatively resilient which will help to underpin Chinas economic growth. Nevertheless, Chinas economic growth will inevitably slow down which could also be a blessing in disguise from the perspective of easing inflationary pressure. In fact, with the weak EUR and the rebound of the USD coupled with a slowdown in demand for commodities in the face of a downturn in global
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Market Update - China

economic activity, all these will also help to ease inflationary pressure on China. For the export sector, emerging markets and Asia are increasingly representing a larger share of the global export market. Hence, intra-regional trade could provide support at a time when the US and European export markets slow. We would not be biased towards a particular sector in terms of stock selection in the short term as the market has fallen significantly and generally across the board. However, from a longer term perspective, we would continue to favor sectors that have strong structural growth and recent share price correction will be good opportunities to accumulate positions. For those stocks that we have been holding and we believe in their strong fundamentals, we intend to ride through the current market volatilities similar to the experience in 2008/2009 and expect a recovery in share price performance when investors re-focus on fundamentals.

Information herein is based on sources we believe to be accurate and reliable as at the date it was made. We reserve the right to revise any information herein at any time without notice. No offer or solicitation to buy or sell securities, nor investment advice or recommendation is made herein. In making investment decisions, investors should not rely solely on this material but should seek independent professional advice. Investment involves risks, in particular, risks associated with investment in emerging and less developed markets. Past performance is not indicative of future performance. Investors should read the fund prospectus for further details, including the risk factors, before investing. This material has not been reviewed by the SFC in Hong Kong and the Monetary Authority of Singapore, and is published for information only, and where used in mainland China, only as supporting materials to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. Issued by Allianz Global Investors Hong Kong Limited (Singapore3 office: Allianz Global Investors Singapore Limited (Co. Reg. No. 199907169Z)).