The Communist Party of China concluded its once every five year policy setting meeting this month, culminating in a 60-point policy document. This was a far lengthier and comprehensive document than ones from prior meetings, and has led analysts to talk up potential impact from reforms.
Despite the document being punctuated with customary nostalgic slogans such as ‘raise high the flag of socialism’ and the ideals of Mao and Deng (Xiaoping), included to appease the old cadres. It is clear that the direction of recent Chinese reforms has been to encourage market-driven mechanisms. These include, growth of the middle class, developing the private sector and protection of property rights, with any ideological inconsistency legitimised under the qualification of ‘Chinese characteristics’. Investors should read this as a sign of pragmatism from Beijing. This has arguably been the slant since Deng’s “Reform and Open Up’ meeting in 1978. While it remains work in progress, we think China’s institutional framework is being strengthened at the margin and this can only be positive long term.
Some of the key points of the reforms are highlighted below. Our view is based on ease of implementation and potential medium term impact:
Gradually allow migrant workers to earn household registration, starting with smaller cities.
– This is potentially the big win for those exposed to the Chinese consumption story. The idea is that, with an urban registration, more citizens will have a basic level of health care and social security which can free up savings for incremental spending.
Boosting the private sector by easing administrative hurdles (30% of requirements to be removed by 2015) leading to a more level playing field and protection of property rights
– The share of industrial profits by private firms now exceeds profits at State-owned Enterprises (SOE). The private sector carries out two-thirds of China’s investments. Unfortunately, ‘red tape’ is not the only factor holding back growth of small and medium-sized enterprises. Chinese SOE banks have had a strong bias in lending to other SOEs, giving a disproportionate share of credit to poorer capital allocators.
Relaxation of one-child policy
– Implementable but the impact will be limited and will be felt over time. Long term, China’s fertility rate will continue to decline partly due to socio-economic factors common to all developed countries. Some forecasters expect c.1-2m extra new births compared to a base figure of 16m annual expected babies.
Support for market forces in resource allocation, price setting and competition. Reduce excessive government intervention.
– Implementable but will result in higher utility and natural resource pricing (with explicit mention of gas, water, electricity, telecom), potentially dampening industrial profits. Net impact will depend on if resource tax is adjusted.
Currency convertibility and marketization of interest rates
– Bank lending margins have been helped by regulated, below-market deposit rates. Market driven deposit rates will likely be higher and could hurt profitability in a sector dominated by large listed SOEs. Currency convertibility, or the opening of capital account, is a long term objective but it may also lead to capital outflows and a less stable financial system. We think progress will be slow due to unknown potential knock-on effects.
Importantly, we do not think all reforms will be positive for Chinese stocks in the near term, especially considering that the H-share Chinese listings in Hong Kong are dominated by large SOEs.
For ‘New Zealand Inc.’ the supply of goods out of China could potentially become more expensive on account of higher input cost and an indirect burden from funding social welfare. Although a potentially weaker currency may offset some of this if the Renminbi starts trading within a wider band and weakens. Fundamentally, China is already running out of workers, as suggested by double-digit wage growth, and the modification to the one-child policy will not change that. On the other hand, if these reforms are successful the long term growth potential of China will rise by virtue of productivity, which will be positive for our exports.
That said, reforms rarely show instant results (although the Global Fund did benefit from the recent jump in Chinese share prices). Assessment is only fair over years if not decades. Short term, the likelihood is that investors overestimate the impact of reforms in hope of a silver bullet to China’s known problems, such as slowing growth, credit excesses and over reliance on investments. Long term, we think this is a significant turning point for the country and the market will underestimate the gains from efficiency and innovation through market forces.
Felix Fok
Portfolio Manager, Milford Global Fund