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Two themes in the China market

A presentation at a luncheon in London by Joe Zhang,

Chairman, Cash Equities, Haitong International Securities (665 HK). 9 June 2015.

I see two major themes unfolding in China in the next few years. First, genuine privatisation of the vast state sector, and second, a shakeout in banking.

Between 1978 and 1998, China cut its state sector's share in the economy significantly, only to see the trend completely reversed since then. In 1978, the fiscal revenue as a % of GDP was 25%, and it fell to 11% in 1998. Today, it stands at 23%.

The reversal did not happen by design, but rather, by accident. The following factors are behind the dramatic change.

(1) The change of tax codes (from sales tax to VAT) effectively meant a higher tax rate and a tax harder to evade. The IT revolution and an army of throttling taxmen has also improved tax collection.


(2) Continued inflation has pushed everyone up and higher on the tax scale.

(3) Discrimination in the access to finance, and vastly different interest rates, year in, and year out, has caused hugely different financial results between SOEs and everyone else. Think also in an inflationary context: the SOEs benefit hugely from negative real interest rates of loans.

(4) The magic bailout of the banks via the AMCs in 1999 (Cinda, Huarong, Great Wall and Orient) was a huge dilution of the rest of the economy via the central bank's printing press.

(5) The monetisation of state-owned land.

Let's look at the state sector's dominant shares today. Do not be misled by the fact that many SOEs are listed on the stock market. Beijing does not consult you when they change the top brass at China Mobile or ICBC or China Life. Even at my old lowly shop, Shenzhen Investment!

1. Telecoms, > 90%,
2. IPPs + distribution: >99%,
3. Aviation: 97%,
4. Shipping: 95%,
5. Banking + insurance: 90%,
6. Broker-dealer: 99%,
7. Oil and gas, E&P: 95%,
8. Defense industries: 99%,
9: Tobacco: 100%,
10: Roads, ports, airports and railways: 90%,
11. Real estate Development and investments: >50%
12. Vehicle making, shipyards: >60%
13. Coal mining, gold, other mining sectors: >60%.
14. Hospitals: 99%,
15. Pharma: 60%.

......
The list is endless and depressing.

Even in perfectly competitive sectors such as retail, food, and clothing, SOEs boast significant market shares.

In the next year or two or three, when, as I expect, the domestic stock market crashes, the government will suddenly find that the economy is weak, the real estate market is dead in the water, and selling land is getting harder, while mounting fiscal debts will force the government to embark on genuine privatisation. Luckily, privatization does not sound like such an ugly word after all, now that we have faked it for 36 years. In the state sector, there are numerous businesses that are strategically important, and have moat. I often say, Warren Buffett would have chosen the same businesses had he been given a choice. The only problem with the SOEs is that they are poorly managed. In private hands, however, they will offer sustainable value.

The second theme in the next five years is a shake-out in banking. Interest rates are being liberalised faster than I have thought. The recent introduction of CDs (certificates of deposit) may prove to be a milestone in the right direction. Do not dismiss it as just a baby step. Who knows? Maybe competition amongst banks to grab deposits will lead to a spike in deposit rates in the near term, but the banks will soon come back to their senses: deposit rates will normalize at probably the current levels or slightly higher. In other words, I do not foresee a significant squeeze to the banks' profit margins.

The shadow banks have been busy fighting a noble fight against the banks for the underprivileged customer (the SOEs and consumers). I myself have been in the P2P and microcredit business for the past four years. But I must say that the battle is not being fought on a level-playing field. The banks command substantial advantages over shadow banks: endless flows of cheap deposits, high leverage, safety (or the public perception of safety), and branch networks.

In 2013, I published two articles (at SCMP and The Economist magazine) to say that the Chinese banks are wonderful investments. I say they are "the ultimate contrarian investments". I still hold that view. see the links.

http://www.scmp.com/business/banking-finance/article/1351290/bank-banks

http://www.economist.com/blogs/freeexchange/2013/09/chinas-economy

If, as I expect, a crash takes place in the asset market in China in the next few years, the banks will suffer enormously. But make no mistake: the shadow banks will suffer much more. Most players could be wiped out. Shadow banking as a sector will emerge stronger after the crash similar to phoenix emerging from the ashes. But note that the new shadow banks may not be the same institutions we see today. They may be off-shots of the banks, or new start-ups.

In the past two decades, Chinese companies have not made much money for investors - much less than the headline GDP growth would suggest.

Why?
First of all, they have sold far too many shares, and do not see massive dilution as a problem. Witness their recent flurry of activities.

Second, there have been pervasive frauds. OMG!

Third, general inexperience in managing businesses. Remember many of them are political appointees.

And finally, few economies in the world have been nearly as turbulent as the China's in these 36 years. Turbulence creates dislocation and disruption.

Luckily, a new norm appears to be setting in, and we should look forward to more sustainable gains as investors.

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