Hbcs China National Sept 20

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ab cGlobal Research

A practical guide for investors on howChinas Communist Party operates

We look at the growth challenges andreform agenda facing the new leaders

as well as the implications for Chinasequity and credit markets

The 18 th National Congress of the Communist Party of China

(CPC) will be held in Beijing in the coming weeks. This report

aims to help investors understand how the CPC works and also

looks at the implications for economic policy and markets.

Power: The National Party Congress meets every five years.

No date has been announced for this year, but we expect it tobe held in mid-October (like the previous meeting). This

congress is particularly significant. A once-in-a-decade

leadership transition will take place and around two-thirds of

important party and government positions will change hands.

This presents challenges as well as an opportunity for change.

Policy: The most pressing issue for the new leaders is to

sustain growth and create jobs. Reforming the financial

system, including the liberalisation of interest rates and the

convertibility of the RMB, should be top of the policy

agenda. Other reform priorities are fairer income distribution,

industrial consolidation and bolstering the service industry.

Stock implications: 1) A cyclical rebound is possible as

growth stabilises and the transition of power goes smoothly;

2) a bull market will require further major reforms, and the

3rd plenum later next year could be a catalyst; 3) state-owned

enterprises in large-cap sectors are likely to continue tounderperform the private sector; 4) the themes that will

capture the next phase of growth include smarter exports,

new spending habits and health/old-age. We list 24 stocks

with strong structural growth stories.

Credit implication s: Ensuring both the supply and efficient

distribution of credit to fund growth remains the challenge.

The local corporate credit market is expected to become theengine for funding, but genuine credit risk needs to be

established. Risks loom for banks, which have stretched loan

books and large corporate bond holdings.

Multi-assetChina Research

Chinas NationalParty CongressWhat it means for macro and markets

20 September 2012Steven Sun* ( )Head of China Equity Strategy The Hongkong and Shanghai Banking Corporation Limited+852 2822 4298 [email protected]

Hongbin Qu ( ) Co-Head of Asian Economic ResearchChief China EconomistThe Hongkong and Shanghai Banking Corporation Limited+852 2822 2025 [email protected]

Zhiming Zhang ( ) Head of China Research The Hongkong and Shanghai Banking Corporation Limited+852 2822 4523 [email protected]

View HSBC Global Research at: http://www.research.hsbc.com

*Employed by a non-US affiliate of HSBC Securities (USA) Inc,and is not registered/qualified pursuant to FINRA regulations

Issuer of report: The Hongkong and Shanghai BankingCorporation Limited

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it
http://www.research.hsbc.com/http://www.research.hsbc.com/http://www.research.hsbc.com/


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Multi-assetChina Research20 September 2012

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Political cycle, the economy and stock market performanceThe political cycle has a clear impact on the investment and credit growth cycles FAI a focus next year

0

10

20

30

40

50

60

1997 1998 1999 2000 2001 2002 2 003 20 04 2005 2006 2007 2008 2009 2010 2011 2012 2013

M1 y /y , %FAI ytd y /yRMB loan y/y

15th NPC and pow ertransition from De ngXiaoping to Jiang Zemin

16th NPC and powertransition from JiangZemin to Hu Jintao

18th N PC and powertransition from from HuJintao to Xi Jinping

Source: CEIC, HSBC Equity Strategy Research

Political cycle and stock market performance 3rd plenum late next year could be a re-rating catalyst

-20%

-10%

0%

10%

20%

30%

40%

50%

N a

t i o n a

l

P a r

t y

C o n g r e s s

1 s t -

2 n d

P l e n u m

2 n d -

3 n d

P l e n u m

3 r d -

4 t h

P l e n u m

4 t h -

5 t h

P l e n u m

5 t h -

6 t h

P l e n u m

6 t h -

7 t h

P l e n u m

Shanghai Comp. perf. H-s hare perf. R ed-c hip perf. Hang Seng perf.

Avg. perf. (15th, 16th and 17th NPC)

Source: CEIC, HSBC Equity Strategy Research (average performance for the period of 6th-7th plenum, excludes t he 16th National Party Congress as 2007 was a market bubble.)

12th Five-Year Plan (FYP) aims to ensure policy continuity under the new leadership (key theme: economic restructuring)

Target Policy initiatives Policy measures

Consumption Job creation Create 45m new jobs, plus 40m migrant worker jobs; unemployment rate 7% p.a.Rural cash income to rise >7% p.a.; minimum wage to increase at >13% p.a.

Promoting service sector Service sector as % of GDP to reach 47% in 2015 from the current 43%Consolidation and upgradingindustries Develop a better business environment for service sector development

Remove price discrimination in electricity, water, gas and heat supplyStrategic emerging industry Set up a special industrial fund for SEI development and investment

Channel social funds into enterprises doing innovative business in their early stageUse risk compensation and other financial incentives to encourage financial

institutions to offer credit support to SEIsInfrastructure investment Clean energy development, including nuclear power, large hydropower plantsLength of highway network to reach 83,000km; high-speed railway 45,000km,a new airport in Beijing by the end of 2015

Source: 12th FYP, HSBC estimates


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How does the CommunistParty operate? 4 Power, hierarchy and central organisations 4

A smooth transition would ensure policy continuity 6

Economic challenges and thereform agenda 9 Supporting growth and creating jobs 9

New leaderships reform agenda 10

Implications for Chinas equitymarket 15 The political cycle and stock market performance 15

Enter private capital 17

Investment themes for the new phase of growth 19

Implications for credit 27 Credit challenge for the new leadership 27

Too much of a good thing? 28

Rising corporate bond exposure 29

What LDK Solar tells us 29

Disclosure appendix 32

Disclaimer 35

Contents


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Power, hierarchy and centralorganisationsFormed in July 1921 in Shanghai, the Chinese

Communist Party (CPC) is the founding political

party of the Peoples Republic of China (PRC). Itis also the worlds largest party, claiming over

82.6m members at the end of 2011. This

represents over 6% of the population, more people

than live in Germany.

The CPC assumed power in 1949. The party has

since been in power for almost 63 years and its

legal power is guaranteed by Chinas national

constitution. Its longevity is set to rival the 69years of the Communist Party of the Soviet Union

(1922-91).

Throughout its history, the CPC has fluctuated

between periods of reform and political

conservatism. Its current ideology was defined in

the late 1970s under Deng Xiaoping to

incorporate principles of market economics and

the subsequent reforms have enabled China to

enjoy three decades of rapid economic growth.

Since the 8 th National Party Congress in 1956, thepower structure of the CPC can be likened, in

simple terms, to a pyramid (Chart 1):

At the top, the most senior decision-makingbody is the Politburo Standing Committee

(PSC) of the Central Committee of the CPC,

which currently has nine members. At

different times the PSC has had five, six,

seven, nine and 11 members and a smallerPSC means a relatively higher concentration

of decision-making power. Members of the

PSC form a collective leadership in which

each member has a rank and is responsible for

a specific portfolio. The collective leadership

is designed to guard against a repeat of events

such as the Cultural Revolution or the

emergence of a dominant leader. Due to termand age limit restrictions, seven of the nine

How does the CommunistParty operate?

The National Party Congress is held every five years; its followedby seven Central Committee plenums over the next five years The National Party Congress and each plenum have a distinctivetheme, from ideology and personnel to economic reforms and planning The 18 th National Party Congress will convene in the comingweeks and we expect a smooth handover of power; the leadershipreshuffle presents both challenges and opportunities for change


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PSC members will be retiring at the 18 th National Party Congress.

The second level is the Political Bureau(Politburo), which currently has 24 members,

including the nine PSC members. Its power is

underpinned by the fact that its members

simultaneously hold important state positions

in the military, key provinces or

municipalities, and the National Party

Congress. At least 14 out of the 24 Politburo

members have reached the retiring age limit

of 68 and will be replaced, a turnover rate of around 60%.

The third layer is the Central Committee,which includes some 200 full members and

150-170 alternative members (who have no

voting rights). Full and alternate members are

elected by delegates once every five years atthe National Party Congress. The Central

Committee contains leading figures from the

party, state and military. Membershipturnover is rapid, averaging 62% at the last

six party congresses over the past 30 years.

At the fourth level come the 2,270 partycongress delegates elected from 40

constituencies, of which 31 represent different

provinces, autonomous regions and

municipalities.

The base of this pyramid rests on 82.6mmembers and 4m grass-root organisations. In2011, nearly 22m people applied for party

membership, but only 3.2m were admitted, an

admission rate of less than 15%.

Having explained the pyramid, Chart 2 illustrates

the power structure of the CPC and how the party

functions. The Central Committee of the CPC is

elected by the National Party Congress for a term

of five years. When the National Party Congress

is not in session, the Central Committee is in

charge of party matters. It also decides when to

Chart 1. Chinas national-level Communist Party hierarchy

PolitburoStanding

Committee9 members

Politburo24 members

Central Committee203 members;

167 alternate members

Party Congress2,270 delegates (18 th NPC)

Party Members82.6m members, 4m grass-root organizations (at end-2011)

PolitburoStanding

Committee9 members

Politburo24 members

Central Committee203 members;

167 alternate members

Party Congress2,270 delegates (18 th NPC)

Party Members82.6m members, 4m grass-root organizations (at end-2011)

Source: Communist Party of China (note: number of members for the top three layers refers to the current term of the 17th National Party Congress convened in 2007.)


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convene the National Party Congress and thecommittees plenary sessions, or plenums, which

are usually held seven times over the five-year

term (see Table 3).

Each plenum has a particular theme. We

highlight the importance of the third plenum,

normally held about a year after the National

Party Congress. It is then that the new leadership

traditionally focuses on economic reforms. Thats

why we emphasise that it will be probably at leasta few quarters before the changes needed to help

create a bull market emerge.

When the plenum of the Central Committee is not

in session, the Political Bureau and its Standing

Committee exercise the functions and powers of

the Central Committee. The Secretariat of the

Central Committee is the administrative body of

the Political Bureau and its Standing Committee,with members nominated by the

Standing Committee.

How the Political Bureau works internally isunclear; however, it appears that the full Political

Bureau meets once a month and the Standing

Committee meets usually weekly or bi-weekly,

according to article published in the Xinhua News

Agencys Outlook Weekly .

The General Secretary of the Central Committee isresponsible for calling sessions of both the

Political Bureau and its Standing Committee, and

is in charge of the work of the Secretariat of theCentral Committee.

A smooth transition wouldensure policy continuityIn an effort to ensure a smooth transition of power, the CPC is attempting to institutionalise

the way leaders are selected. Although

negotiations and compromise are still an

important part of the process, candidates for

senior positions are now also judged on theiradministrative experience. And thanks to Deng

Chart 2. The central organisations of the CPC

(National PartyCongress)

(Central Committeeof the CPC)

(Central Commission forDiscipline Inspection)

(General Secretary)

(Standing Committee of the

Political Bureau)

(PoliticalBureau)

(Secretariat ofthe CentralCommittee)

(Central MilitaryCommission of the CPC )

(National PartyCongress)

(Central Committeeof the CPC)

(Central Commission forDiscipline Inspection)

(General Secretary)

(Standing Committee of the

Political Bureau)

(PoliticalBureau)

(Secretariat ofthe CentralCommittee)

(Central MilitaryCommission of the CPC )

Source: Communist Party of China


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Xiaopings reforms, Politburo members mustretire at age 68 and cant serve more than two

five-year terms.

While power remains highly concentrated at the

top, consensus building is crucial to the decision-

making process. This emphasis on consensus

means that the important personnel changes aresorted out well in advance of the National Party

Congress and new faces have often been involved

in policymaking for 2-3 years. Given the risingchallenges of running the worlds second largest

economy, power-sharing and teamwork are

expected to be recurring themes for future

leadership transitions.

The importance of this years National Party

Congress cant be overstated. Around two-thirds

of the members of the Politburo, its Standing

Committee, the State Council, major stateministries and the Central Military Commission

will be replaced, mainly due to term and age

limits. These organisations represent three centres

of power the party, the government and

the military.

The leadership reshuffle at the party and the

military level at the National Party Congress,

which will be followed by changes in governmentpositions in the spring of 2013.

Five-year plan ensures policycontinuityBeijing released its 12 th Five-Year Plan (2011-15)

in March 2011, setting a framework for economic

policy for the next few years. This is another

mechanism to ensure policy continuity during the

leadership changes.

Previous five-year plans provided strict policy

guidance for ministries and local governments.

While this has been relaxed slightly since the 11th

Five-Year Plan, the document is still seen as an

important roadmap for economic and social

development and reform agenda.


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Table 1. Snapshots of the past three National Party Congresses (the last two major political transitions occurred in 1997 and 2002)

Timeline 15th Party Congress (1997-2002) 16th Party Congress (2002-07) 17th Party Congress (2007-12) 18th Party Congress (2012-17)

National Party Congress 12-18 Sep. 1997 8-14 Nov. 2002 15-21 Oct. 2007 October 2012? 1st Plenary session 19 Sep. 1997 15 Nov. 2002 22 Oct. 2007 Day after Party Congress 2nd Plenary session 25-26 Feb. 1998 24-26 Feb. 2003 25-27 Feb. 2008 2013, before Peoples Congress3rd Plenary session 12-14 Oct. 1998 11-14 Oct. 2003 9-12 Oct. 2008 Late 20134th Plenary session 19-22 Sep. 1999 16-19 Sep. 2004 15-18 Sep. 2009 Late 20145th Plenary session 9-11 Oct. 2000 8-11 Oct. 2005 15-18 Oct. 2010 Late 20156th Plenary session 24-26 Sep. 2001 8-11 Oct. 2006 15-18 Oct. 2011 Late 20167th Plenary session 3-5 Nov. 2002 9-12 Oct. 2007 Days before 18 th Party Congress Late 2017

Headcount 15 th Party Congress (1997-2002) 16th Party Congress (2002-07) 17th Party Congress (2007-12) 18th Party Congress (2012-17)

Party Congress delegates 2,048 2,114 2,213 2,270Central Committee members 193 198 204 ?Alternate Central Committee members 151 158 167 ? Politburo members 22 24 25 ?Alternate Politburo members 2 1 - - Politburo Standing Committee members 7 9 9 ? Central Military Commission members 8 8 11 ?

Agenda/theme 15th Party Congress (1997-2002) 16th Party Congress (2002-07) 17th Party Congress (2007-12) 18th Party Congress (2012-17)

National Party Congress (Year 1) Constitution amended to stipulatethe theory of Deng Xiaoping

(emphasising economicconstruction and stability) as thenations guiding thought; election

of the Central Committee andalternate members, and Central

Disciplinary Committee

Constitution amended to stipulatethe Three Representatives

theory ( ) (what theparty stands for in terms of

advanced productive forces,culture and representing the

majority of the people) as thepartys mission statement

Further implementation ofthe theory of ScientificDevelopment Concept

( ) sustainabledevelopment and the creation of a

harmonious society

Ideological unity andpolitical mobilisation

(potential amendment to theconstitution to stipulate the

Scientific Development Conceptas the partys mission statement)

1st Plenary session (Year 1) Elect and/or appoint party

leadership teams (Politburomembers and its StandingCommittee, party General

Secretary, members of theSecretariat and Central Military

Committee)

Elect and/or appoint party



Committee)

Elect and/or appoint party



Committee)

Party leadership reshuffle

(possible change in size of thePolitburo standing committee)

2nd Plenary session (Year 2) Recommended state(government) leadership team for

confirmation at the NationalPeoples Congress; approvedReform Plan of State Council

Organisations

Recommended state(government) leadership team for

confirmation at the NationalPeoples Congress; approved

Opinions on Further Reformingthe Government Administration

System and Organisations

Recommended state(government) leadership team for

confirmation at the NationalPeoples Congress; approved

Opinions on Further Reformingthe Government Administration

System

Government reshuffle andadministration reform

(potential super ministry reform)

3rd Plenary session (Year 2) Decisions on Several MajorIssues of Agriculture and Rural

Work

Decisions on Several Issuesconcerning the Improvement ofthe Socialist Market Economy

Decisions on Several MajorIssues on Promoting the Reform

and Development of Rural Areas

Economic reform

4th

Plenary session (Year 3) Decisions on Several MajorIssues concerning Reform andDevelopment of the State-owned

Enterprises

Decisions on the Construction ofthe Governing Ability of the Partyand approval of Jiang Zemins

resignation from the CentralMilitary Commission

Decisions on Several MajorIssues on Strengthening andImproving the Governing Ability of

the Party under New Situation

Governing ability

5th Plenary session (Year 4) Suggestions concerningFormulating National Economy &Social Development Plan for the

10th Five-Year Period

Suggestions concerningFormulating National Economy &Social Development Plan for the

11th Five-Year Period

Suggestions concerningFormulating National Economy &Social Development Plan for the

12th Five-Year-Period

Economic planning

6th Plenary session (Year 5) Decisions on Several MajorIssues on Strengthening and

Improving the Work Style of theParty

Decisions on Several MajorIssues on Building a Harmonious

Socialist Society

Decisions on Several MajorIssues on Deepening Reform ofCultural System and Promoting

the Great Development andFlourishing of Socialist Culture

Ideology

7th Plenary session (Year 1, justbefore the next National PartyCongress)

Announced date for the next PartyCongress, approved the Central

Committees report to the nextParty Congress and proposed an

amendment to the PartyConstitution







Preparatory meeting

Source: Communist Party of China


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Supporting growth andcreating jobsChinas economic growth expanded 7.6% in the

second quarter of this year, the slowest pace in

three years due to falling overseas demand and

weakening domestic investment.

The numbers in July and August were also

disappointing. July export growth dropped sharply

and industrial production and bank lending were

both lower than expected. Augusts reading for

the HSBC China Manufacturing Purchasing

Managers Index (PMI) deteriorated to a post-2009 low. The austerity measures designed to

cool the property market have put a significant

dent in domestic investment.

All this bad news is feeding through into corporateperformance. Falling profits and rising inventory

levels have forced corporations to cut jobs.

Chart 1. A deteriorating employment situation

(3mma)

40

45

50

55

60

05 06 07 08 09 10 11 12

HSBC China Manufacturing PMI-Employment

HSBC C hina Serv ices PMI-Employment

Source: CEIC, HSBC

Profits of industrial enterprises (annual revenues RMB20m) shrank 2.7% y-o-y YTD in July, whileSOE profits were down 12.2% y-o-y. Inventories

are also on the rise, with the finished goods sub-

index of the HSBC Manufacturing PMI rising to a

record high.

More worryingly, Augusts employment index

contracted for the sixth consecutive month

(Chart 1). Anecdotal evidence suggests that an

increasing number of coastal enterprises arelaying off workers or closing down factories. A

slow policy response to the rapidly deteriorating

Economic challenges andthe reform agenda

The most pressing issue is to support growth and create jobs Financial reforms will be the top policy agenda; support forinterest rate liberalisation and RMB reform could gain momentum Other items on the agenda include promoting income distribution,driving industrial consolidation and bolstering the service industry


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employment situation could hurt the economybadly in terms of consumer consumption and may

raise concerns about social stability.

Pressure to keep easingIn our view, there is still plenty of ammunition

left to stimulate the economy and reverse theslowdown. Despite two cuts so far this year, the

banks reserve requirement ratio (RRR) is still

high at 19.5%. Therefore, aside from reverse repo

and other open market operation tools, we expectanother 200bp cuts in RRR for the rest of the year.

Although demand for credit from the

manufacturing sector could remain weak on

sluggish external demand, the recent approval of

more infrastructure investment projects should

boost domestic demand.

Meanwhile, the government recorded a fiscalsurplus of RMB990bn in 1H12, or about 2% of

annualised 1H12 GDP. While this is unlikely to

be repeated in the second half of the year for

seasonal reasons, resulting in a small deficit, we

can still expect more tax reductions for small- and

medium-sized enterprises (SMEs) in the coming

months. More importantly, there is room for

increasing government spending on public works

such as public housing, water treatment plants and

other infrastructure projects.

Inflation will likely stay low despite rising global

food prices. Chinas Producer Price Index (PPI)has fallen into negative territory and the

Consumer Price Index (CPI) dropped to 1.8%,

less than half of the 4% full-year target. Rising

global grain prices may lift the cost of pork in

China in the coming months, but the rebound in

the overall CPI will likely be small, given fallingPPI and the modest pace of the recovery in

domestic demand.

With CPI likely staying below 3%, we believeBeijings policymakers should not have to worry

about inflation. We still expect another 25bpinterest rate cut in the coming months.

Once all the above easing measures filter through,

growth is expected to recover to above 8% and

stay there in 2013 and beyond (for more on

Chinas potential growth rate please refer to

China Inside Out , 28 August 2012).

New leaderships reformagendaReforms are likely to focus on economic

restructuring, the social welfare system, energy

efficiency and scientific development. With

steady and rapid economic development in the

long run remaining one of the key targets, moreemphasis is being put on promoting social

harmony.

Beijings policymakers want to rebalance Chinas

economic growth by expanding domestic demand

and moving away from the current export-led

model. The new leaders will also make improving

the balance of income distribution and developing

the social welfare system policy priorities.

We expect the following key reforms in thecoming years:

1. Reforming the financial system toimprove capital allocationBeijing has made it clear that reforming the

financial system will provide an important boost

to the rebalancing of Chinas economic growth

model. The PBoC has been leading the joint-

efforts of all financial regulators and published a

lengthy report in mid-September on 12 th Five-

Year Plan on Development and Reforms of theFinancial Industry. In a nutshell, its a

deliberation on the industry blueprint agreed upon

the Fourth National Financial Working

Conference in January 2012.
https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=BsiRbEL4yk&n=340766.PDFhttps://www.research.hsbc.com/midas/Res/RDV?ao=20&key=BsiRbEL4yk&n=340766.PDFhttps://www.research.hsbc.com/midas/Res/RDV?ao=20&key=BsiRbEL4yk&n=340766.PDF


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Two major goals to be achieved in the next threeyears are worthy highlighting:

Financial industry value-added to reach 5% of the GDP, up from 4.4-4.5% for the past two

decades, inferring faster growth for the

industry than economic growth. Assuming

10% nominal GDP growth in 2013-2015f,financial sector has to grow at 14-15% per

annum to reach the goal. In comparison, the

ratio stood at 6.5% in Japan and 8% in the USon average for the past decade; and

The share of direct financing to total socialfinancing to reach 15% by 2015, up from

11% at the end 2010.

There are three key areas to watch the reform of

stated-owned banks, liberalising interest rates andRMB convertibility.

Banks: improving the supply of credit

Like its Asian neighbours, bank loans have played

a dominant role in financing Chinas economic

growth. As a result, Chinas banking assets have

ballooned along with the countrys economic

growth rate. At the end of 2011, bank assets

topped RMB113.3trn, three times the total in 2005.

In contrast to the boom in bank credit, direct

financing through the bond and equity markets

has declined in the past few years. In 2011, totalRMB bond issuance (including treasury bonds

and financial bonds issued by policy banks)

accounted for 46% of total financing bank loans,

bonds and the stock market down from 57% in

2008 (Chart 2).

Chart 2. Fund raising in China

02,0004,0006,0008,000

10,00012,000

2006 2007 2008 2009 2010 2011

(RMB bn)

0

20

40

60

80

Equity (Lhs)Bond (Lhs)Loan (Lhs)Bond as % of total financing (Rhs)

Source: CEIC, HSBC

Beijing wants to significantly lift the share of

direct financing by actively promoting the

development of the bond market, and reformingthe IPO and delisting system, standardising the

main board of the stock market and developing an

SME board for the stock market. According to

the 12 th Five-Year Plan, there are also plans to

establish an international board.

Interest rate liberalisation

Under the current system the central bank, the

Peoples Bank of China (PBoC), sets a ceiling forbank deposit rates and a floor for lending rates,

creating a high spread that generates a large share

of banks profits. It also means that savers earn

negative returns on their deposits when headline

inflation is high.

The downside is that this policy has slowed thedevelopment of financial services and reduced the

efficiency of allocating funds to businesses. In

simple terms, credit doesnt always go to where it

is needed most. For example, its easy for big

SOEs to get credit while many SMEs are starvedof funds.

The aim of interest rate liberalisation is to

establish a market-oriented structure, with money

market rates acting as the benchmark based on the

supply and demand for funds. The central bank

would be able to influence the system by


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adjusting money market rates instead of changinglending quotas and the reserve requirement ratio.

Reform has stalled for seven years, but the PBoC

is now accelerating the process of interest rate

liberalisation. It asymmetrically cut the

benchmark one-year lending rate by 31bp to 6%

and the one-year deposit rate by 25bp to 3%,effective 6 July.

The central bank then allowed banks to be more

flexible about the interest rates they can charge onbank loans (preferred customers can now borrow

at 70% of the benchmark lending rate, down from

80%). This will increase competition between

banks; however, this change does not apply to

mortgage rates as the central bank reiterated that

the property tightening measures would stay in

place. We expect the full liberalisation of interest

rates to be completed within three years.

RMB full capital account convertibilityIn April, China expanded the RMBs trading band

to 1% from 0.5%, the first change since 2007.

This signals a move towards a more flexible and

market-driven currency regime, as flagged in the

12 th Five-Year Plan.

The RMB exchange rate is also much closer to its

market equilibrium level, after appreciating 30%

against a basket of currencies since it was de-pegged from the USD in 2005. Markets now have

two-way expectations for the RMB exchange rate;

even expecting depreciation from time to time.

This is in sharp contrast with the previous

situation when investors saw the currency as a

one-way appreciation play against the USD.

Making the RMB a convertible currency is the

ultimate goal of Chinas exchange rate reform.While the currency has been convertible under the

current account for 15 years, policymakers now

see a window of opportunity to further speed upthe process, although debate over the pace of

reform continues.

2. Transforming the economicdevelopment modelChinas economy expanded at an average of

11.2% during the 11 th Five-Year Plan (2006-10),

significantly exceeding GDP targets. In contrast,

the 12 th Five-Year Plan calls for economic

restructuring and a preference for quality growth

over large-scale expansion. Beijing is also aimingto raise incomes at a faster rate. It wants the

disposable income of urban residents and the net

income of the rural population to grow at the same

rate as GDP. This is all part of rebalancing

economic and social development so ordinary

people can enjoy the benefits of economic growth.

Move away from investment- and export-led

growth towards consumption

Beijing aims to increase consumptions share of

GDP from 35% in 2010. This involves expanding

domestic consumption demand, steadily

accelerating urbanisation, enhancing employment,deepening income distribution reform and

improving the social security system.

Chart 3. Higher income target to boost consumption

-10-50

51015202530

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

(%yr)

Retail sales Total wage

Source: CEIC, HSBC

The 12 th Five-Year Plan (2011-15) aims to create

45m jobs in urban areas and lower the

unemployment rate to below 5% (urban registered

unemployment rate), as well as increase spending

on education, healthcare and pension systems.


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Promoting the service industryIn 2010, the value-added of the service sector

accounted for 43% of Chinas GDP (vs. 70-80%

in developed countries and 50% in India) and only

34% of national employment. Chinas economic

growth relies heavily on secondary industries such

as its manufacturing sector, but tax reform could

help increase competition in the service sector.

We believe this years pilot value-added schemein Shanghai is a good start.

However, speeding up the development of the

service industry will be done in parallel with

upgrading manufacturing, which continues to gain

government support in the form of new strategic

industries.

Chart 4. Service sector as % of GDP, 2011

0

20

40

60

80

US Japan China Brazil India Korea

%

Source: IMF, HSBC

Industrial consolidation and seven strategic

emerging industriesSeven strategic emerging industries (SEIs) clean

energy technology, next-generation IT,

biotechnology, high-end equipment

manufacturing, alternative energy, new materials

and clean energy vehicles have been selected asthe drivers that will help China move away from

low-end manufacturing to higher value-added

industries and sustainable growth.

These SEIs will receive special funding and tax

breaks. Beijing wants to grow their share of GDP

from 5% in 2010 to 8% in 2015 and 15% in 2020.

Chart 5. Beijing has a clear goal to grow SEIs

0

5

10

15

20

2010 2015e 2020e

%

SEIs v alue added as % of GDP


3. Promoting income equalityBy accelerating urbanisation and giving more

policy support to western and central regions of

China, Beijing is trying to close the gap between

urban and rural development. For example,

farmers have benefitted from a series of measuresto lift their incomes.

Fairer income distribution

China has a large wealth gap and the problem has

gotten worse in recent years. Beijing wants to

improve the situation by giving households a

greater share of national income and 23 of the 31

provincial governments have promised to ensure

that residential incomes increase in line with GDPgrowth. Six governments, including Shandong,

Zhejiang and the municipality of Chongqing,

pledged that income growth will outpace GDP.

Wages represent 80% of household income, so

Beijing wants to gradually raise the minimum

wage to help narrow the wage gap between

different industries. This will involve reformingthe SOE payroll system.

Improving the tax system

The government intends to reform the tax system.

This includes increasing tax rates for the rich and

cutting them for the poor, improving the property

tax system and social security payments.


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4. Going greenStretched natural resources and growing

environmental problems have forced Beijing to

set mandatory energy efficiency targets and

launch a series of green initiatives.

Of the seven SEIs, three (alternative energy, clean

energy vehicles and clean energy technology) are

in line with sustainable development targets,

while the other are consistent with the

governments goal of moving up the value chain.

Table 1. 12th FYP to ensure policy continuity under the new leadership (key theme: economic restructuring)

Target Policy initiatives Policy measures

Consumption Job creation Create 45m new jobs plus 40m migrant worker jobs; urban unemployment rate 7% p.a.Rural cash income to rise >7% p.a.; minimum wage to increase at >13% p.a.

Promoting service sector Service sector as % of GDP to reach 47% in 2015 from currently 43%Consolidation and upgradingof industries Develop a better business environment to develop service sector

Remove price discriminations of electricity, water, gas and heat supplySEIs development Set up special industrial fund for SEIs development and investment

Channel social fund into enterprises doing innovative business in their early stageUse risk compensation and other financial incentives to encourage financialinstitutions to offer credit support to SEIs

Infrastructure investment Clean energy development, including nuclear power, large-scale hydropower plantsLength of highway network to reach 83,000km; high-speed railway 45,000km,a new airport in Beijing by the end of 2015



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The political cycle and stockmarket performanceWe first wrote about the political cycle and its

impact on earnings in May 2010 ( China

Unplugged Earnings warning system for 2012

reshuffle ). With the 18 th National Party Congress

set to convene in a matter of weeks, its time to

refresh those thoughts. Key observations include:

The generational power transition has onlyhappened three times in the history of the

PRC, with the last one (at the 16 th National

Party Congress in 2002), particularly

remarkable due to its orderly, peaceful and

institutionalised nature. The upcoming

leadership transition could set another good

precedent, thus alleviating a key short-termmarket concern.

A cyclical market rebound is possible ashistory suggests that leadership reshuffles

have an impact (usually positive) oninvestment activities and the credit cycle,

especially when growth stabilisation and job

creation are near-term priorities.

A bull market will likely take longer. Asustainable valuation re-rating hinges on

further economic reforms that are needed to

generate new growth momentum. We believethis is unlikely to happen until the third

plenum of the Central Committee of the CPC

in about a year, or a specially convened party

convention to discuss major economic issues.

Hopes are high that the new leadership willsucceed in pushing through these reforms.

Some 60-70% of the most important positions

(party, government and military) will change

hands.

With China aiming for more balanced growth,it will affect different types of companies in

different ways. We see this having a

significant impact on the composition of a

number of sectors within various marketindices in the next few years.

Implications for Chinasequity market

Cyclical rebound possible on growth stabilisation and smoothtransition; 3 rd plenum later next year could be a re-rating catalyst SOE-dominant big-cap sectors likely to continue to underperformprivate sectors like IT, consumer and healthcare in the long term Three themes for the next phase of growth: smarter exports, newspending, health/old-age security
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=1ha5x9yqvz&n=268849.PDF


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Previous examplesLets look at what happened after previous

leadership transitions. In early 1998, money

supply (M1) growth bottomed out and fixed-asset

investment (FAI) growth took off as efforts were

made to smooth the turbulent aftermath of the

Asian financial crisis. This was a year after the

15 th National Party Congress at which a newleadership team was installed after the death of

Deng Xiaoping. It was a similar story five years

later after the 16 th National Party Congress when

Hu Jintao took over the leadership from Jiang

Zemin (Chart 1).

This time around we believe there will be both

similarities and differences. Chinas economic

growth continues to decelerate in 3Q12 to perhaps7-8% and job creation will likely be a near-term

priority for the new leadership. Yet, initial signs that

inflation might be picking up and the fact that

property prices are rebounding following the surgein transaction volumes are likely to make the PBoC

reluctant to ease aggressively. This means that

expansionary fiscal policy will probably be the main

tool used to spur growth, led by tax cuts and

spending on infrastructure and public housing.

This is evidenced by the NDRCs project approval

spree in early September, which has exceeded the

size of RMB1trn, including 25 urban rail transitprojects, 13 highway projects with total length of

more than 2000km and constructions of rubbish

burning power plant, sewage treatment plants,

ports, warehouses, etc. HSBC infrastructure

analyst Anderson Chow estimates that around

RMB700bn is incremental new spending.

Looking further ahead, economic reform has animportant part to play in the next phase of growth.The high-volume, low-cost and low value-addedexport model is outdated, so the next generationof leaders will have to balance the long-term goalof rebalancing the economy with the short-termgoal of stabilising growth through stimulus.

We believe that 7-9% GDP growth is here to stayand that companies and investors should adapt tothe new normal. Data for 1978-2011 suggest thatthe economy was more balanced in years of moderate growth, i.e., when consumptions

contribution to GDP was higher and that of investment was lower.

A bull market and sustainable re-rating still hinges

on further reforms, and hence is unlikely until the

3rd plenum Central Committee of the CPC (a year

later), or a dedicated party convention for

decision-making on major economic issues, as

shown in previous political cycles (Chart 2).

Chart 1. The political cycle has a clear impact on investment and credit growth cycle FAI a focus next year

0

10

20

30

40

50

60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

M1 y/ y, %FAI y td y/yRMB loan y/y

15th NPC and powertransition from Deng

Xiaoping to Jiang Zemin

16th N PC and pow ertransition from Jiang

Z emin to Hu Jintao

18th NPC and powertransition from from Hu

Jintao to Xi Jinping

Source: CEIC, HSBC Equity Strategy Research


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Enter private capitalSince the RMB4trn stimulus programme in 2009there has been a debate about whether Chinaseconomy is going through a process of nationalisation ( , the state enters and the

people withdraw) or one of privatisation (, the state withdraws and the people enter).

Privatisation ( ) was a term introduced inthe late 1990s to describe a policy promoted byformer Prime Minister Zhu Rongji.Nationalisation ( ) is an expression usedsince 2009 to describe the apparent reversal of economic reforms as the state increased its stakein a number of important industries.

However, a closer look at the representation of state-owned enterprises (SOEs) and privatelyowned enterprises (POEs) in the MSCI ChinaIndex suggests otherwise (Chart 3-4). This mayalso be because Hong Kong is a preferred listingplace for POEs:

The index weighting of POEs has more thantripled to 22% during the past decade (2002-

12), and it has doubled over the past five

years in 2007-12.

Ten years ago POEs were only represented inthree sectors (IT, consumer discretionary and

healthcare); they are in four other sectors

(staples, real estate, industrials and materials).

Chart 2. Political cycle and stock market performance 3rd plenum late next year could be a re-rating catalyst

-20%

-10%

0%

10%

20%

30%

40%

50%

N a t i o n a l

P a r t y

C o n g r e s s

1 s t -

2 n d

P l e n u m

2 n d -

3 n d

P l e n u m

3 r d -

4 t h

P l e n u m

4 t h -

5 t h

P l e n u m

5 t h -

6 t h

P l e n u m

6 t h -

7 t h

P l e n u m

Shanghai Comp. perf. H-share per f. Red-chip perf. Hang Seng per f.

Avg. perf. (15th, 16th and 17th NPC)

Source: CEIC, HSBC Equity Strategy Research (average performance for the period of 6th -7th plenum excluded the 16th National Party Congress as 2007 was a year of market bubble.)

Chart 3. Index weighting for POEs are on the rise Chart 4. Shifting sector composition of POEs

6.6 10.821.9

93.4 89.278.1

0%

20%

40%

60%

80%

100%

02 07 12Q2

SOEPOE

0%

20%

40%

60%

80%

100%

02 07 12Q2

CD CS FN HC IN IT MT

Source: Thomson Reuters Datastream, HSBC Equity Strategy Research; MSCI ChinaIndex is primarily comprised of Chinese companies listed on the HK Exchange)

Source: Thomson Reuters Datastream(CD: consumer discretionary; CS: consumer staples; FN: mainly real estates; HC:health care; IN: industrials; IT: information technology: MT: materials)


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Across different sectors (Chart 5), IT, consumer

discretionary and staples have the highest

representation of POEs (70-100%). Examplesinclude companies like Tencent, Lenovo, Belle,

Great Wall Motor, Hengan and Want Want.

Interestingly, for the past five years (2007-12),

POE-heavy sectors like IT, staples and healthcare

have had positive returns of 20-70%,

outperforming the index (down 20%) and the

SOE-dominant sectors like energy, telecom

services and financials. The only exception isconsumer discretionary, which has been suffering

from overcapacity and high inventory since 2008,

similar to SOE-dominant sectors like materials,

industrials and utilities. By and large,

overcapacity is much less of an issue for sectors

where major players are POEs, due to bettersupply discipline.

The private sector is more efficient and generates

more jobs, boosting consumption. For instance,

according to the National Bureau of Statistics

SMEs, private companies account for roughly

60% of Chinas GDP, 50% of tax revenue, three-

quarters of job creation and over 80% of new

product development.

Statistics from the Xinhua News Agency showthat state-owned capital is permitted to enter 72 of

the 80 industries in China, foreign capital is

allowed in 62, and domestic private capital has

access to only 41. However, the slew of new

policies rolled out this year by almost all majorcentral government agencies will encourage much

broader private investments, including basic

industries (e.g., railway transportation, power

generation, oil and gas exploration, and telecom

services), as well as infrastructure, utilities, publichousing, financial services (banks and

insurances), healthcare, trade-related business

management and logistics, and even national

defence science and technology.

Private capital, in particular equity (public and

private), will also play a more significant funding

role in developing cutting-edge emerging strategic

industries and service sectors, signalling a landmark

change away from the bank-led and SOE-centricfinancing model of the past two decades.

In the long run, fostering growth in private sectors

is the way forward as China restructures its

economy and narrows income inequality. It is

clear to us that future leaders will likely rely more

on private capital to create jobs and boost

investment. In our view, should the

transformation proceed smoothly, it could help

Chinas equity market to re-rate along the way.

Chart 5. Sector representation of private-owned enterprises Chart 6. Sector performance in 2007-12

0%

20%

40%

60%

80%

100%

IT CD CS HC MT FN IN EN TS UT

POE (% MSCI China sector w eighting) SOE (%)

-80%-60%-40%-20%

0%

20%40%60%80%

I T C S

H C

E N

T S

M X C N

F N

U T

C D I N

M T

MSCI China Sector Index Perf, L5Y

Source: Thomson Reuters Datastream, HSBC Equity Strategy Research Source: Bloomberg


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Investment themes for thenew phase of growthHSBCs Head of Equity Strategy Research, Asia-

Pacific, Herald van der Linde, published a

thematic report in early September titled Asias

growth story: The next phase How to spot

structural growth stocks . Please see below for an

excerpt thats relevant to China:

1. Export smarter goodsChinas growth is slowing. For years, low wages

have been a way of life for many Chinese

companies, particularly exporters. However,

labour costs are rising and firms now need to use

workers more productively, as well as export

more sophisticated products and adapt to newdemand trends. Productivity, innovation and

adaptability, rather than cheap labour, are now

seen as the keys to success.

In 2002, most Chinese exports were not verysophisticated, in line with products exported by

low-income countries (Chart 7). By 2011, China

was exporting products that fitted the profile of

mid- to high-income countries. Chart 8 shows thesame data on an accumulated percentage basis,

highlighting a clear shift in quality.

The need to offset rising cost pressures hasincreased the need to change the product mix and

upgrade machinery, particularly automation.Demand for automated machinery is driven bytwo trends in manufacturing: the phasing out of manual labour for repetitive processes withautomation and the growing adoption of computer-controlled systems.

For example, according to Chinas 12 th Five-YearPlan for the machine tool industry, the 2015 targetis to enable domestic numerical control machinetools to take up 70% of the domestic market(versus 32% in 2011) and to increase the marketshare of domestic medium- to high-end numericalcontrol systems in the domestic market to 50%(from less than 10% in2012). In addition, thegovernment is trying to promote the machinerycomponent industry. It wants to increase thedomestic share of medium- to high-end functionalparts to 20% (from less than 5% in 2012).

Moreover, the State Council approved in late May a

plan outlining the development of seven strategicemerging industries (SEIs) as the primary growthdriver in the future ( China Strategy: New priorityindustries: aiming high for quality growth , 6 June2012). We estimate that the seven SEIs would needto grow by RMB4trn to RMB6trn (or 8% of GDP)in 2015 and by another RMB10trn to RMB16trn (or15% of GDP) in 2020 to reach the target set by theplan, an ambitious goal.

Chart 7. Chinas exports: A shift in sophistication Chart 8. Chinas exports: Moving up the value chain (%)

010

2030

405060

40k

2011 2002

product sophistication

share in exports

0

20

40

60

80

100

40k

2011 2002

Source: HSBC, US Census (for both charts; currency: USD) Source: HSBC

Note: On the X-axis we show the percentage of products that are typically sold bycountries with that respective income level. Hence, about 60% of Chinese exports areproducts that are typically exported by countries with GDP/capita of below US10,000.
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=6xYu1f3mmi&n=332108.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=6xYu1f3mmi&n=332108.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=6xYu1f3mmi&n=332108.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=6xYu1f3mmi&n=332108.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=6xYu1f3mmi&n=332108.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=60ELqGkIVJ&n=341548.PDF


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2. Emerging middle class: newspending and social habitsConsumer dynamics are changing in China as

the emerging middle class has developed new

habits in terms of what, where and how to buy

What: It is well-documented that the penetration

levels of products such as cars, motorcycles and

luxury goods remain low in China. For instance,there is still room to grow and demand for cars

should remain high in the coming years (Chart 9).

There are plenty of other products and services

that show similar S-curves, such as consumer

credit availability and gaming.

Chart 9. Car sales grow exponentially as income grows

USA

Ger

JP

SGCHIN

ID

KRMY

PHBD

SL

UK

0100200300

400500600700800900

1000 10000 100000GNI per Capita (PPP)- Log Scale

M o t o r V e h i c

l e p e r 1 0 0 0 p p l -

2 0 0 9

Source: World Bank, HSBC

Some of the changes that are taking place are less

obvious. As consumers become more

sophisticated about buying luxury products, theycreate what HSBCs luxury goods research team

led by Erwan Rambourg, calls first-mover

disadvantage, with consumers moving away

from the big, established brands like Louis

Vuitton in favour of Coach or Prada.

Boutique stores are becoming more important, as

are temporary collections that increase the

exclusivity of a product.

Companies such as LOccitane are spendingmoney on regular store refurbishing to create a

sense that product ranges change regularly.

Likewise, footwear companies roll out regularnew collections.

Where and how: This is the age of the shopping

mall in China. Footwear player Belle and fashion

company China Lilang say consumers

increasingly prefer large, integrated shopping

malls rather than department stores.

Consumers want a better shopping experience andmore brands to choose from. These shopping

malls, which are larger than department stores, areoften located outside city centres and cater for the

whole family, with playgrounds and F&B outlets.

Chinese retailers such as Intime and Golden Eagle

(an Asia Super Ten portfolio stock) have been

busy adjusting to this new terrain. At times, this

has involved having to acquire land or retailers inareas where they previously had little exposure.

Another trend in China is that department stores

are increasingly active in managing the products

they sell. In some cases, they have even acquired

suppliers. For example, Golden Eagle acquired a

food import distributor to ensure that this range of

products was available in its stores.

Product upgrades can also be done in a different

way. For example, Adidas and Nike have recentlystarted to produce more volume per new product

launch, but have fewer product launches in a year.

This less is more approach creates a morefocused product offering. This allows them to

create production efficiencies that offset

(partially) the rise in wages.

This works differently for other consumer

companies, e.g., shoe companies have opted to

have more seasonal product adjustments. This

draws more consumers into stores, but also means

more rush orders and the need for better just-in-time inventory management. These are known as

flash collections and offerings are sometime on

display for only about a month or so.


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Social media is the new platform for brands togenerate awareness, engage with customers,

support customers and build brand loyalty

HSBCs telecom and internet analysts Tucker

Grinnan and Chi Tsang think growth of social

media has become one of the most important

developments for Chinas Internet sector and

China as a whole. There are over 250m users on

social networks in China, with Internetpenetration levels above 40%. The user base has

increased by over 10 times in the past two years.The typical social media user has three social

media profiles, one professional and 1-2 social

profiles and total accounts number 1.2bn.

We see significant advertising potential from

social media in China, because of attractive

demographics and levels of engagement: 1) 95%of Internet users living in tier 1-3 cities are

registered on a social media site; 2) the typical

consumer spends 47 minutes per day on socialnetworking sites; and 3) in China, word of mouth

is more trusted by consumers that advertising.

Social media advertising is hence an increasingly

important part of display advertising, which was

RMB28bn in 2011 and is estimated be

RMB431bn by 2020, a CAGR of 35%.

From a cultural perspective, social media has

filled an important void. Unlike Facebook in theUS, the growth of social media in China has

grown mostly from Twitter-like micro-blogging

services. Users tweet, retweet, comment on new

stories (and sometimes, rumours and speculation),

and share photos, often anonymously using

pseudonyms.

The best example of the power of Weibo occurred

last July when a high-speed train crashed inWenzhou, killing 40 people. Within minutes the

Weibo platform lit up and 26m messages were

sent in five days. This watershed event haschanged Weibo from a social media to a socio-

political phenomenon.

Branded companies are already paying for socialmedia advertising in China now. Kotex is

currently running a campaign on Sina Weibo

featuring videos using a fictional character named

An Xiaoqi who lives in Shanghai to discuss

feminine hygiene issues. In a series of videos

entitled, Stuff Girls Dont Say, Kotex uses

humour and real life situations to raise awareness.

An Xiaoqi has 150,000 followers.

The secret to social media advertising is data.Social media platforms map connections between

people (social graph) and between people and

things they like (interest graph). Marketers can

identify what I like (interest graph) and leverage

that with who I know (social graph). This is all

valuable data that marketers can exploit for

targeted advertising.

We think Sina is best positioned in China tocapitalise on the advertising opportunity from its

social media users. We believe the company has

the most attractive Weibo users in terms of

demographics (tier 1, educated and high income).

Further, it is considered to have the best relations

with branded companies as the leading online

advertising portal in China. Finally, Sina is among

the first to monetise its Weibo platform, selling

ads and working with enterprises to strengthen

their social presence.

Gaming a niche growth storyGaming is a booming and distinct sub-sector and

Macau leads the market following substantial

investments in casinos. The industry advantage is

its high concentration, with few large-scale

dominant players. Given the limited availability of

licences in Macau, which is unlikely to change

soon, and demand on the rise, HSBCs gaminganalyst Sean Monaghan believes this is positive

for profitability. A product mix change is also

expected to take place, with mass gaming torepresent an estimated 50% of market revenue by

2020, up from 30% in 2011. Stocks that dominate


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are Sands China, Galaxy Entertainment and MGMin Macau.

3. Health and old-age securityA more capable labour force will demand better

healthcare and better pension plans. Across the

region, most Asian countries, including China, arein the process of establishing pension and health

care systems, although this may take years to

complete.

The desire for improved work conditions goes

hand in hand with changes in lifestyles in urban

China. As incomes rise, so does spending on a

healthy lifestyle. In turn, healthcare and financial

security in old-age become ever larger priorities.

Pension changes local demand for equities

Currently, most of the wealth held by Asian

households is non-financial, i.e. real estate and

land. These assets tend to be largely illiquid.

However, there is evidence that a rapid increase indemand for financial instruments to diversify

these household assets is already taking place.

The development of pension systems can act as a

catalyst to increase Asias appetite for liquid

financial investments, such as equities.

In China, the pool of pension assets is the largest

in the region. Chinas pension system is set togrow from RMB7.4trn at the end of 2012 to

RMB28trn by 2020, according to one local

estimate (source: Z-Ben, July 2012). Chinesebanks and insurers also hold large pools of

deposits, so there is potential to create strong

demand for local equities.

One clear consequence of these pension system

changes is that, as institutional assets under

management grow, the market capitalisation of the stock market also tends to grow as a

percentage of GDP (Chart 10).

Securities brokerages, as well as banks andinsurers that sell mutual funds or savings products

can reap the benefits, in our view. In a theme

related to household asset diversification, we

believe BOC HK should benefit from the

internationalisation of RMB.

Healthy lifestyles

When it comes to lifestyle choices, health is key.

In North Asia, where societies are aging more

rapidly, demand for health products and insuranceagainst sickness is on the rise. Healthcare

spending typically increases exponentially as

income grows (Chart 11).

This benefits companies that provide medical

services, medical equipment (Chinas Shandong

Weigao and Mindray) or pharmaceutical products

ranging from low-end generic drugs to the

development of cutting-edge biosimilars.

Chart 10. Total pension AUM/GDP vs. per capita GDP (USD) Chart 11. Healthcare expenditure grows exponentially

Taiw anHK

China

Korea

India

Singapore

Thailand

Malaysia

Indonesia0%

50%

100%

150%

200%

0 5 10 15 20 25 30 35 40 45 50 55

in '000

TH

PHMY

KRIDINCH

SG

JP

Ger

USA

0

2000

4000

6000

8000

10000

1000 10000 100000GNI per Capita (PPP)- Log Scale

H e a l t h E x p p e r C a p i t a ( U S D ) -

2 0 1 0

Source: HSBC Source: World Bank, HSBC


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Table 1: Stocks that 1) play to our structural growth themes and 2) are OW rated by HSBC analysts

Company Name BBGCode

CurrentPrice

Target Price Rating Market Sector Valuation Methodology Risks

Baidu BIDU US 112.0 (USD) 157.0 (USD) OW(V) CHINA Internet Based on PEG, with athree-year expectedearnings growth rate.

Macro outlook dampening sentiments, execution risk onregional expansion and wireless, stronger competition andlower than expected investment, Government enforcementof foreign ownership rules

Biostime 1112 HK 21.7 (HKD) 23.3 (HKD) OW(V) CHINA Food &StaplesRetailing

Based on average of PEand DCF valuationmethodology

Importing all of Biostimes products creates supply and FXrisks, steeper-than-expected raw material price increasesand new regulatory requirements.

China Lilang 1234 HK 4.9 (HKD) 9.5 (HKD) OW(V) CHINA Textiles,Apparel &LuxuryGoods

Based on target PE multipleof 11.5x

Excessive inventory build-ups by its distributors, which inturn hinder the groups revenue and earnings growth; andan inability to contain marketing and headquarter expensesat a 14-15% level.

China LongyuanPower

916 HK 5.1 (HKD) 6.1 (HKD) OW(V) CHINA ElectricUtilities

Based on equally weightedblend of DCF and ROE-implied PB

Change in government policies, slowdown in wind farmapproval, grid connectivity issues, financing and CDM risks.

Daphne 210 HK 7.9 (HKD) 11.8 (HKD) OW(V) CHINA Textiles,Apparel &LuxuryGoods

Based on target PE multipleof 19x 2012e

Inability to sustain its SSS growth and new store openingsand; difficulties in further enhancing production efficienciesat its manufacturing facilities.

Digital China 861 HK 11.7 (HKD) 16.0 (HKD) OW(V) CHINA ElectronicEquipment

Based on DCF valuationmethodology

A substantial slowdown in the Chinese economy, which couldadversely impact consumer IT demand and corporate ITspending; significant changes in the governments technologypolicy; slower-than-expected growth of IT services could lead toweaker-than-expected margin expansion; increasing R&Dinvestments for the Sm@rt City projects could put a dent inDigital Chinas near-term margin expansion trajectory.

Golden Eagle 3308 HK 15.7 (HKD) 19.0 (HKD) OW(V) CHINA MultilineRetail

Based on average one-yearforward PE of 24x

Worse than expected sales in its Nanjing flagship stores; aproperty injection of new stores from the sister propertycompany, such as properties for the new Maanshan,Jiangning and Hexi stores

Hengan 1044 HK 76.6 (HKD) 95.0 (HKD) OW CHINA PersonalProducts

Based on target PE multipleof 27x

Higher-than-expected wood pulp price, the weakening ofthe USD, which may drive up raw material prices. Upsiderisk could be higher-than-anticipated demand for tissueand napkins in China, lower pulp prices, positive if Hengandiversify into FMCG

Hengdeli 3389 HK 2.3 (HKD) 3.2 (HKD) OW(V) CHINA Distributors Based on DCF valuationmethodology

Execution risk in managing store expansion plans, higher-than-expected rent and staff cost inflation, and any macrothreat in China affecting watch sales or making investorsbelieve that watch sales are at risk.

Intime 1833 HK 8.0 (HKD) 10.4 (HKD) OW(V) CHINA MultilineRetail

Based on average one-yearforward PE of 21x

Continuous worsening of macro economy in Zhejiang.

KunLun Energy 135 HK 13.5 (HKD) 16.6 (HKD) OW CHINA Oil & Gas Based on sum-of-the-part(SOTP) methodology

Margin contraction in the natural gas sales and processingbusinesses; cost overruns in rolling out natural gas salesand processing businesses; slower-than-expected LNGterminal utilisation ramp-up, causing margin pressure onthe company; and lower oil prices, eroding the gasbusinesss compelling economics.

Lenovo 992 HK 6.4 (HKD) 7.6 (HKD) OW CHINA Computers &Peripherals

Based on target PE multipleof 16.1x FY13e

A potential further deceleration in Chinas PC demand, whichmight be more negatively affected than we expect by theslowdown in the regions economic growth.

Mindray MR US 34.6 (USD) 35.0 (USD) OW CHINA Health CareEquipment


Healthcare budget review in developed markets, fasterthan expected ASP erosion on policy change, near-termmargin impact from higher expenses incurred on saleschannel expansion, intensifying competition from JVsbetween foreign players and local players in the lower andmid segments

Sun Art 6808 HK 9.8 (HKD) 11.0 (HKD) OW CHINA MultilineRetail

Based on target PE multipleof 28x 1-year forward

Potential share placement by cornerstone investors; lessthan expected expansion in GPM with execution in newsupplier contracts in 2H

United Labo 3933 HK 3.7 (HKD) 6.2 (HKD) OW(V) CHINA Pharmaceuticals

Based on sum-of-the-part(SOTP) methodology

The most immediate risk is probably substantial earningsdowngrades by the market. Our forecasts are belowconsensus by a wide margin already. Other risks includeworse-than-expected revenue and earnings this yearand/or delay in an earnings recovery


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Table 1: Stocks that 1) play to our structural growth themes and 2) are OW rated by HSBC analysts

Company Name BBGCode

CurrentPrice

Target Price Rating Market Sector Valuation Methodology Risks

BOC HK 2388 HK 24.3 (HKD) 29.0 (HKD) OW HONGKONG

CommercialBanks

Based on target PB multipleof 2x 2013e

Unfavourable changes to the macro condition and creditquality are the key downside risks. Offshore RMB businessmargin can also be negatively affected by the easingmonetary policies in China.Offshore RMB business is a key driver in our forecast butthat would be affected by the policymakers plan. BOCHKis well capitalized and depends on it uses its capital, thatcould affect our forecast.

Ch Metal Recycl 773 HK 6.3 (HKD) 12.3 (HKD) OW(V) HONGKONG

Metals &Mining

Based on blend of PE andDCF valuation

There is a risk that the sector consolidates more slowlythan we anticipate and that margins are lower than weforecast. The companys earnings are sensitive to salesvolumes and margins and this could result in lower-than-

expected earnings and a lower valuation.CTF 1929 HK 10.9 (HKD) 11.0 (HKD) OW(V) HONG

KONGSpecialtyRetail

Based on variant of GordonGrowth Model

Downside risks include deterioration in macro conditions inChina, which would likely hurt jewellery sales; and worse-than-expected gem-set gross profit margin.

Galaxy 27 HK 25.8 (HKD) 35.9 (HKD) OW(V) HONGKONG

HotelsRestaurants& Leisure

Based on weighted averageof SOTP and DCFvaluations

Generic risks for Macau casino concessionaires includeunexpected changes in government gaming policy, oreconomic changes in China that can impair customervisitation and expenditure. Business concentration risk alsoexists given all of the companys operations are largelycentred in Macau SAR.

L'Occitane 973 HK 20.1 (HKD) 25.0 (HKD) OW(V) HONGKONG

PersonalProducts

Based on DCF valuationmethodology

Key risks include currency (USD depreciating against EURon the downside), consumer sentiment in key markets(e.g., Japan, the US and China) and how long theturnaround of Melvita will take.

Mandarin MAND SP 1.4 (USD) 1.9 (USD) OW HONGKONG

HotelsRestaurants

& Leisure

Based on average of fivevaluation methods: DCF,

one-year forwardEV/EBITDA, PB tradingrange, peer comparison,and market value ofleasehold land.

Further weakening of the European economy, a majorslowdown in the Hong Kong economy and a delay in the

launch of MOHs managed hotels.

Melco 6883 HK 34.7 (HKD) 53.5 (HKD) OW(V) HONGKONG

HotelsRestaurants& Leisure

Based on weighted averageof our SOTP and DCFvaluations

Risks to our rating and estimates Generic risks for Macaucasino concessionaires include unexpected changes ingovernment gaming policy, or economic changes in Chinathat could impair customer visitation and expenditure.

Sh Weigao 1066 HK 9.8 (HKD) 10.5 (HKD) OW(V) HONGKONG

Health CareEquipment


Potential government policy changes in terms of licenceapprovals for dialysis centres that may lead to greatercompetition and adversely impact Weigaos dialysis centreexpansion plans; government policy risk on price cuts orrestrictions on higher-end consumables that maynegatively impact the companys consumable sales; highcapex required by operating dialysis centres that may takea while before meaningful financial contributions can beachieved; intensifying competition in the stent market;higher labour and raw material costs, delays in hospitalpayments and potentially higher accounts receivable; andlower-than-expected income from associates.

Sina SINA US 66.3 (USD) 62.0 (USD) OW(V) CHINA Internet PEG methodology, using2007-09 mean PEG, prior toWeibo enthusiasm

Weaker-than-expected economic growth may further weighon Sinas performance; government regulation createsuncertainty regarding VIE structure and usage of blogging;Sina is also facing competition from rivals such asTencent.

Source: HSBC estimates; prices as of 19 Septe mber 2012

Under our research model, for stocks with (without) a volatility indicator, the Neutral band is 10 (5)ppts

above and below the hurdle rate for China stocks of 10%. At the time we set our target prices, it implied

potential returns that were above the Neutral band; therefore, we rate the stocks Overweight

(Overweight (V)). Potential return equals the percentage difference between the current share price and

the target price, including the forecast dividend yield when indicated.


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Table 2: Coverage and analyst contact details

Company name BBG code Rating Name Telephone Email

Baidu.com Inc. BIDU US Overweight (V) Chi Tsang* +852 2822 2590 [email protected] International 1112 HK Overweight (V) Catherine Chao* +852 2996 6570 [email protected] Lilang Limited 1234 HK Overweight (V) Chris Zee* +852 2822 2912 [email protected] Longyuan Power 916 HK Overweight (V) Jenny Cosgrove* +852 2996 6619 [email protected] 210 HK Overweight (V) Chris Zee* +852 2822 2912 [email protected] China 861 HK Overweight (V) Carrie Liu* +8862 6631 2864 [email protected] Eagle Retail Group 3308 HK Overweight (V) Lina Yan* +852 2822 4344 [email protected] 1044 HK Overweight Walden Shing* +852 2996 6751 [email protected] Holdings Ltd 3389 HK Overweight (V) Erwan Rambourg* +852 2996 6572 [email protected] Department Store 1833 HK Overweight (V) Lina Yan* +852 2822 4344 [email protected] Energy 135 HK Overweight Kevin Lian* +852 2822 4337 [email protected] Group Ltd 992 HK Overweight Jenny Lai* +8862 6631 2860 [email protected] Medical Internati MR US Overweight Carolyn Poon* +852 2996 6586 [email protected] Art Retail Group 6808 HK Overweight Lina Yan* +852 2822 4344 [email protected] Laboratories Int 3933 HK Overweight (V) Nam Park* +852 2996 6591 [email protected] HK Holdings 2388 HK Overweight Todd Dunivant* +852 2996 6599 [email protected] Metal Recycling 773 HK Overweight (V) Simon Francis* +852 2996 6620 [email protected] Tai Fook Jewellery G 1929 HK Overweight (V) Lina Yan* +852 2822 4344 [email protected] Entertainment Grou 27 HK Overweight (V) Sean Monaghan* +65 66580610 [email protected]''Occitane International 973 HK Overweight (V) Erwan Rambourg* +852 2996 6572 [email protected] Oriental Intl MAND SP Overweight Stephen Wan* +852 2996 6566 [email protected] Crown Entertainment 6883 HK Overweight (V) Sean Monaghan* +65 66580610 [email protected] Weigao Group Med 1066 HK Overweight (V) Carolyn Poon* +852 2996 6586 [email protected] SINA US Overweight (V) Chi Tsang* +852 2822 2590 [email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to F INRA regulations

Source: HSBC estimates


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Credit challenge for the newleadershipWe believe one of the big challenges facing

Chinas new leadership after the 18th

PartyCongress is improving the flow of credit. The

challenge lies in making sure there is enough to

maintain healthy annual GDP growth above 8%

without reviving a new round of inflation and

inflationary expectations. The other part of the

equation is to ensure that enough money gets tocompanies that need funding such as SMEs, while

at the same time stopping excessive amounts of

credit flowing into the property sector and other

areas of speculation.

Increasing dependence of fundingOver the last decade or so Chinas growth has

become increasingly dependent on funding. Thatmeans for every increase in GDP growth, more

new credit is needed to fund the corresponding

rise in production (Fig. 1).

This is taking place at a time when banks capital

is stretched thanks to substantial loan growth

since Beijings large stimulus programme in 2009.

Unfortunately, it has coincided with a period of

underperformance by Chinas stock market. With

banks finding it difficult to raise equity capital in

onshore and offshore stock markets, the nations

local corporate credit market needs to develop

rapidly to offset the deceleration in loan growth.

Growth engine for creditBanks loans have dominated corporate credit for

years, but this is starting to change. Since 2009other forms of financing have increased at the

expense of bank loans. The domestic corporate

credit market is a relatively healthy and, more

importantly, transparent means of credit

expansion. As such, policymakers and regulators

in Beijing who oversee the nations domestic

Implications for credit The big challenge is to ensure the supply and efficient distributionof credit to fund growth The local corporate credit market will likely become the growthengine for funding, but genuine credit risk needs to be restored Risks loom for banks, which have stretched loan books and largecorporate bond holdings

Fig. 1 Growth dependency on credit expansion

0

5

10

15

12/2002 12/2004 12/2006 12/2008 12/2010 06/2012

RMB (trn)

0%

20%

40%

60%

80%

100%

TSF New RMB loanTSF/GDP (RHS) New loan/TSF (RHS)

Source: CEIC, HSBC


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bond markets are all keen to expedite the growthof this form of credit.

The pace of expansion of the domestic corporate

credit market has accelerated. For example,

issuance of corporate credit by the end of August

approached the total for the whole of 2011, which

was a record year (Fig. 2).

This is certainly a welcome sign. However, forsustainable growth long-term, we believe a

genuine credit culture has to be restored to avoid apotential credit bubble down the road.

Fig. 2 Corporate bond YTD issuance hit 94% of the FY11 number

0

2

4

6

8

FY 2011 Jan-Aug 2012

RMB (trn)

0%

10%

20%

30%

40%

50%

Corporate bondAll bondcorporate bond/all bond (RHS)

Source: Wind, HSBC

Too much of a good thing?Chinas domestic credit market is booming

spreads are tight and theres been a surge in bond

issues but we are not sure it is happening for allthe right reasons.

Earlier this year, we wrote about how a small

fibre maker, Shandong Helon, unnerved domestic

credit markets in late 2011 when it almost became

the first Chinese company to default on a

corporate bond (see Default dynamics , 7 March

2012). A government-backed bailout was

arranged in the last minute. Now something

similar is happening, but the potential problem is

much larger.

Now, LDK Solar, a US-listed Chinese green

energy company with bonds maturing in October

2012, is in trouble; however, this time the creditmarket has hardly blinked. Why? We believe

investors are ignoring credit fundamentals

because they are expecting another bailout.

This is not surprising as Beijing has instructed

local governments and banks not to allow bonds

to default. The implicit guarantee has resulted intighter spreads and a slew of new bond issues as

companies use this window of opportunity to

refinance their maturing debt and extend theirmaturity profile.

Fig. 3 Yield spreadsChina 5-year CP& MTN spreads over Treasury

0

100

200

300

400

500

600

700

07/09 10/09 01/10 04/10 07/10 10/10 01/11 04/11 07/11 10/11 01/12 04/12 07/12

bps

AAA AAA- AA+ AAAA- A+ A

Shandong Helon's near default sent domestic

credit spreads to record highs

The marketremained calm when

LDK Solar's problems emerged

Source: HSBC

To explain why this is happening we have to look

at the big picture. As Beijing tries to push up

flagging GDP growth, policymakers want the

corporate bond market, rather than the stretched

banking system, to become the main source of

financing, getting credit to where it is needed

most. Defaults would not be good for sentiment.

Our concern is that while this may help companies

raise funds and support growth in the short term, it

is just storing up trouble for the future. This, in turn,means looming risks to banks, which have stretched

loan books and large corporate bond holdings. All

this is reflected in Chinas underperforming equity

market, particularly valuation multiples in the

financial sector.
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=RjBiTaukAk&n=323467.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=RjBiTaukAk&n=323467.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=RjBiTaukAk&n=323467.PDF


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Rising corporate bondexposureChinas banks have made a large amount of loans

to the countrys corporate sector. Besides the risk

of a rise in non-performing loans (NPLs), banksare also exposed to default risks as a result of the

increasing amount of corporate bonds they hold.

At the end of June 2012, commercial banks we

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