Z-Ben Advisors presentsz-ben.com/edm/Public/file/Z-Ben - Strategic Outlook - November 2015.pdf ·...

Z-Ben Advisors presents

A Strategic Outlook

Opportunity

Lower barriers, shifting assets

November 2015

2 Z - B E N A D V I S O R S

Opportunity: Lower barriers, shifting assets Executive Summary

The nearly 20% rebound in mainland markets achieved since China returned from the national week holiday on October 8, has conveniently been paired with a new narrative regarding stronger-than-expected Chinese growth. This follows a summer where slowing economic numbers were seen to move in tandem with falling equity markets in Shanghai and Shenzhen. The reality, however, is rather less symmetrical and markedly more complex.

In one sense, this is yet another reminder that China’s stock market in not an accurate GDP growth barometer, nor do its movements have a material effect on the broader economy. It’s also a reminder that Z-Ben Advisors’ first theme for China in 2016 – volatility – is still a fact of life on the Mainland, and one with both negative and positive effects.

Most troubling about these market-spanning narratives, however, is that they fail to contextualize China’s actual contribution to global growth appropriately, nor establish what that growth means for the broad population of foreign firms itching to enter China’s quickly-developing and newly-opening financial industries. The reality is that opportunity – Z-Ben Advisors’ second theme of 2016 – for foreign financial firms is largely unaffected by recent market (or economic) slowdowns. In fact, it is influenced much more deeply by market maturation, demographic shifts and regulatory liberalization.

• Opportunity will come from reallocation: As China moves away from a bank-dominated financing system, opportunities for managers and service providers are emerging in new markets which are much more accessible to foreigners.

• Demographics: China’s ascending millennial generation and the abolition of the one-child policy highlight the country’s aging population problem, which requires better investment management and portfolio diversification from a growing range of pension providers.

• New markets, new access: Foreign firms are being granted unprecedented market and customer access but face additional hurdles in reaching investors onshore while the infrastructure to service these clients is being built.

China’s growth engine is slowing overall, but it is being redirected towards the services sector, where foreign firms are being granted unprecedented opportunity.


9.2% 11.7% 12.2%

18.7%

15.3% 16.9%

20.5%

66.0%

49.4% 49.8% 11.3%

12.7%

14.2%

9.6% 9.2%

10.6%

9.5%

7.7% 7.7% 7.3%

0%

2%

4%

6%

8%

10%

12%

14%

16%

0%

10%

20%

30%

40%

50%

60%

70%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

China % of global growth China GDP real growth (right)

China’s growth model adapts

China’s recent slower growth represents a greater opportunity for expansion because the nominal size is much larger.

As China shifts from an investment-led economy to one driven by consumption and services provision, its growth has expectedly slowed. The question is not how fast (or slow) China will grow, but instead – for companies with finite resources to allocate globally – how much will China contribute to the new products, services and assets that the world will sell next year. With each year, China’s share of global GDP grows and thus its relative economic importance continues to expand. 2007 was the first year that China contributed a larger amount to overall GDP growth than the US – despite the US economy being four times as large as China’s. Chinese GDP growth has slowed since then but its piece of the overall pie has become larger. Financial markets around the world have woken up to this reality. In 2007, when its growth rate was 14.2%, China produced just 12.2% of global GDP, but since then its GDP has nearly tripled. New products, services and customers are now

coming disproportionately from the Mainland. Apple, for example, now gets 25% of its revenue from China. Within the financial services industry, this shift is even more pronounced. Growth in China’s manufacturing sector has ground to a near halt but GDP growth remains robust because the services industry has picked up the slack. As China’s economy continues to mature, an increasing number of wealth managers and financial firms are becoming able to capitalize on the growth of Chinese consumption, just as Apple and others have already done. The Chinese economy’s growth is likely to continue decelerating, however, Z-Ben Advisors advocates that financial service providers should recognize that headline numbers (and the roars of the bears and bulls) may mean very little to their particular markets of interest.

O P P O R T U N I T Y

Chinese GDP growth rate, contribution to world GDP growth

Growth becomes slower, but more consequential

The services industry has grown rapidly since 2012 and is now China’s largest GDP contributor.

Source: Z-Ben Advisors, World Bank

*

*World GDP growth was negative in 2009


Inbound access

I N B O U N D

I N C R E A S E D Q U O T A A N D G E O G R A P H I C E X P A N S I O N

Chinese regulators continue to issue RQFII and QFII licenses and quota at an increased pace, while the RQFII program expands globally. The Stock Connect program allows foreign investors to buy Shanghai-listed shares directly from Hong Kong and will likely be extended to the small cap focused Shenzhen exchange by mid-2016.

F I X E D I N C O M E L I B E R A L I Z A T I O N

The domestic fixed income market is seeing a wave of new issuances, most notably a new USD400bn municipal bond program. At the same time, foreign investors are gaining access to the interbank bond market. A few domestic managers have already built out their credit teams but, with the RMB’s imminent inclusion into the IMF’s SDR basket, Z-Ben Advisors believes there is already a pressing need for experienced fixed-income managers. Global managers should be vigilant of this pressing need, and the opportunity that it presents.

Total inbound investment (USD bn)

Public fixed income market (USD tr)

0

30

60

90

120

150

180

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015QFII RQFII Connect (Northbound)


0

1

2

3

4

5

2010 2011 2012 2013 2014 2015

IBB Issuance Exchange Issuance Municipal Issuance Total Foreign Investment (right)

0

20

40

60

80

100

120

140

USD

(bn)


O U T B O U N D A N D D O M E S T I C

Chinese investor access points for foreign asset managers

Outbound access

R E G U L A T O R Y C L A R I T Y E M E R G E S

Over the last 12 months, a coordinated regulatory approach has begun to carve out specific segments for investment into global and domestic markets. Regulators are opening up the HNW and institutional space to foreign managers for domestic and global products but are more cautious about extending the same privileges within the mass retail and mass affluent markets.

Global Products Domestic Products

HNWI/Institutional QDII, QDLP, QDIE 100% foreign-owned PFM

Mass Retail/Mass Affluent MRF, QDII JV FMC still needed

QDII (Qualified Domestic Institutional Investor), QDLP (Qualified Domestic Limited Partnership), QDIE (Qualified Domestic Investment Entity), PFM (Private Fund Manager), MRF (Mutual Recognition of Funds), JV FMC (Joint-Venture Fund Management Company)



Investors limited by onshore choices

Chinese investors currently suffer from a lack of diversification options, leading to poorly-designed portfolios which are over-exposed to bank deposits and property. Opportunity for global asset managers hinges on understanding both current exposures and how new asset classes are being constructed for tomorrow’s investments. Insurers, for instance, have long been overexposed to cash deposits with around 25% of their assets sitting in banks. The fastest-growing segment of insurers’ portfolios is alternative investments – which now accounts for 25% of AUM, up from 6% in 2012. These are primarily investments in property and long-maturity trust and insurance AM products. While high allocations to these segments may suggest the relatively primitive nature of Chinese insurers’ investment management, in reality it’s an entirely reasonable attempt to achieve a balanced portfolio given the available onshore investment products. Much of what’s parked in banks is negotiable deposits, a substitute for mid-duration bonds which are themselves very limited in supply on the Mainland.

Individual investors are also finding the product universe inadequate. Like insurers, they hold a high proportion of their assets in bank deposits and property. As China constructs a broader and better-funded social safety net, the need for such high cash allocations will decrease. Many Chinese investors have come to prefer property market investments simply because local stock markets exhibit high volatility and little consistent growth (see last month’s theme - volatility). Over the last two years, however, China’s property market has cooled and investors have begun to shift their assets elsewhere. At the moment, that shift has primarily driven money into wealth management and trust products, which are typically packaged loans. However, as capital markets develop and as public markets begin to offer a greater number and variety of stable long-term investments, the foreign asset management community should become the next inflow recipient. That day, Z-Ben Advisors believes, is already dawning and foreign asset managers are creating onshore products to meet that demand.


China is in the midst of a change in the investor risk-reward profile. Volatility over the last six months is already leading investors – both institutional and individual – to increase their offshore exposure, which currently sits at just over 1%.


Demographic realities necessitate reallocation

The volatility in mainland markets over the last six months has given the central government the political capital to push through long-needed pension reforms.

The recent change to the one-child policy highlighted the structural problems Beijing faces in funding retirement schemes for a labor force whose population has already peaked. Europe and Japan are facing these realities now, while immigration has helped the US stave off some of the aging problems that seem inherent to advanced economic development. A series of such pension reform efforts by the central government are aimed at covering China’s pension shortfall, which Z-Ben Advisors estimates will reach USD1.5tr by 2020. Opportunity here is being created in both public and private retirement schemes. On the public side, aside from raising the retirement age and potential SOE asset transfer, portfolio diversification will create the most opportunities for foreign asset managers. Mainland pension funds are still controlled at the provincial level and subsidies by the central government to cover shortfalls provide little incentive for provincial managers to diversify their holdings (over 90% are in bank deposits). Many provincial funds face deficits and have been borrowing from the government.

Centralization is the next logical step, however (as in any country) significant political hurdles remain. Provinces are hesitant to cede control, while there is no central entity that could immediately replace them. One of the simplest forms of centralization will be realized through investment management: the National Council for Social Security Fund (NCSSF), which receives funding from the Ministry of Finance, SOE IPOs and lottery proceeds, may become the solution. Established in 2000, its assets will slowly be injected into the pension system from 2020 onwards. But, for now, it more closely resembles a sovereign wealth fund than a pension manager. NCSSF is already an important client of many foreign and domestic asset managers. Two provinces, Guangdong and Shandong, have entrusted a portion of their long-term assets to NCSSF to manage. Although entrusted assets from provinces are managed separately and with more provisions, NCSSF’s experience issuing mandates and investing in a diverse range of asset classes – both on- and offshore – gives it a significant edge in experience over provincial managers. Z-Ben Advisors forecasts that NCSSF will appoint the majority of the public pension funds to external managers by the end of 2017.



Reallocation will drive opportunity

China’s financial markets are in the midst of a generational shift away from the state-owned, banking-led model to one that encourages broader professional participation within transparent and risk-priced markets. The central government has outlined a series of policies – most notably for the upcoming 13th Five Year Plan – to encourage this capital reallocation. These plans require diversification by large investors and the construction of developed and liquid non-equity markets. This evolution is a natural part of China’s ongoing economic development. In the previous Strategic Outlook, Z-Ben Advisors outlined parallels between China now, and the US in the 1980s and Europe in the 1990s which both underwent similar financialization. Market forces are now leading the way in China, as investors and capital-seeking companies bypass the state-dominated banking industry. Shadow banking began to rise rapidly in 2011 after the 2009 central government-implemented bank-lending stimulus plan sought to sustain its growth. This form of financing met the

basic economic needs of both companies locked outside the bank-SOE lending system and investors eager to upgrade from artificially-low bank deposit rates. Now, Beijing has begun assembling the institutions and markets needed to replace much of the fast-growing shadow banking sector with a transparent, risk-managed and efficient system. Many of the changes are intended to alleviate concerns that are shared equally between offshore investors and onshore regulators, among them issues such as the inherent risks of lending without appropriate reserves or ambiguity for who is responsible to lenders in the event of a default. These are legitimate worries about the current system. In more developed markets, participants are serviced by a robust public fixed-income market, a PE/VC industry, a liquid commercial paper market and other market makers. However, Z-Ben Advisors believes parallel opportunities in China will often come not from simple market growth but from the new financial infrastructure.


China’s evolving financial system

Shadow banking is a transitional step away from bank financing

Credit and equity financing

Investors Companies

Investors Companies

Investors Companies

Banks Past

Pr

esen

t Fu

ture

Shadow banking

Banks Public

equity and FI market

Banks Public equity and FI Market

Asset-backed securities market

Futures and options market

PE/VC industry Derivatives

market

Source: Z-Ben Advisors


Private retirement schemes have more room to grow

China’s mutual fund AUM sat just north of USD1tr as of 3Q15, which is impressive considering that it rose to that sum without the help of any government-sponsored private pension scheme. China does have a 401k-like program – enterprise annuities (EA) – but it has so far struggled to gain traction outside of eastern urban areas. There are now 20 firms with EA licenses managing roughly

USD136bn as of 2Q15 but no firm has received a new license since 2007.

Offshore investment is not allowed within EA and is likely at

least two years away from receiving regulatory approval.

Ambiguous tax incentives have prevented greater take-up of EA and many small- and medium-sized firms do not offer the plans as employees have yet to demand them.

Still, EA’s AUM has grown at a 25% rate since the program’s inception in 2004. Compared to the country’s pension needs and investor wealth, the program remains marginal (see below). China will create a prominent private pension scheme but will need a much more supportive regulatory environment, which will be fostered by competition: insurers are pushing their own private pension insurance plans. For foreign asset managers, pension opportunities will come in the distant future but widespread, exponential growth of China’s pension assets may not be realized until foreign players are introduced (which may be dependent on their respective expertise). Foreign service providers, in contrast to asset managers, may see better opportunities in the immediate future. EA schemes will soon start paying out to retirees in large numbers and may need high levels of support for portfolio design, back office management and risk control. Few of these are available , let alone well-executed, locally.

Private retirement schemes across different markets

In relation to 2014 country mutual fund AUM and GDP (USD tr)

4.4

15.9

17.4

0 4 8 12 16 20

401k Assets

Mutual Fund

GDP

0.1

0.7

10.4

0 2 4 6 8 10 12

Enterprise Annuities

Mutual Fund

GDP

2.0

1.6

1.5

0 1 2 3

Superannuation

Mutual Fund

GDP

United States Australia China

Source: Z-Ben Advisors, World Bank, ICI, ASFA



Onshore opportunity: The advent of 100% ownership

Foreign firms have long been locked out of the financial space in China even as other industries have seen ownership barriers fall. However, just over the last few months, Hang Seng has received approval to set up the first foreign majority-owned fund management company, while HSBC was recently approved to set up a majority-owned brokerage. Both moves were a direct result of access won through CEPA Supplement X, an economic dialogue between the Mainland and Hong Kong. The larger development – as a previous Strategic Outlook highlighted – is the new possibility of 100% foreign-owned private fund managers, which would allow foreign asset managers to raise money from Chinese HNW and institutional investors to invest in mainland markets. Clear guidelines have not yet been laid out but the regulatory direction is clear. There is already a domestic precedent, with eligible private funds being able to register as full members of the Asset Management Association of China (AMAC). Aberdeen Asset

Management recently became the first foreign-owned firm with “investment management” in its business scope. Z-Ben Advisors believes this is a sign that regulators will soon offer AMAC membership to the enterprise. The Qualified Domestic Limited Partnership (QDLP) program, meanwhile, continues to expand, both geographically and by asset class. Created originally to allow global hedge funds the opportunity to raise funds onshore and invest into their flagship offshore funds, the program has since been extended to other alternative assets and, most recently, traditional asset classes: BlackRock won a license this autumn. All of this access is made possible by – and accept our apologies if we sound like a broken record – the WFOE (Wholly Foreign-Owned Enterprise) platform. With barriers dropping and market opportunity rising, major foreign players, including Fidelity and Schroders amongst others, have set up their own WFOEs. The WFOE is not a strategy, however, but simply a vessel in which to begin executing your long-term China plans.

Officials have started to liberalize ownership requirements for onshore institutions with clear signals as to what’s next.



Distribution remains the worst impediment

For Asia-Pacific executives over the past ten years, following mainland regulatory developments was the most important part of their China strategy. This remains a vital endeavor in China, where financial regulation has an amplifying effect on participant behavior. However, as barriers to entry fall, firms are sensibly focusing less on when they can enter China and more on what they can do now that they are preparing to open their first mainland sales, servicing and manufacturing centers. Distribution on the Mainland remains a key problem. It is fragmented, expensive and consists more of selling than servicing. Banks have a stranglehold on the distribution landscape and are more than willing to exploit this power to their advantage. As an example, the rise of shadow banking can largely be attributed to the popularity of bank wealth management products, many of which were pushed by banks because their short maturity means they get distribution fees every six months (in addition to a slice of the management fee).

It’s hard to put into words the painstaking experience that is buying a financial product in a Chinese bank. The user experience is a mix of a doctor’s office visit and a trip to purgatory as clients wait for their number to be called before a sales representative pushes the product that gives him or her the highest sales commission fee. The domestic fund market has developed around this reality and, as a result, it relies on frequent (and expensive) new product launches to stem the high tide of organic outflows. Even accessing institutional and HNW investors remains difficult and is often still intermediated by the same large state-owned banks, which have longstanding relationships with the largest investors. With the expansion of the QDLP program and the launch of the Mutual Recognition of Funds (MRF) program, foreign managers will have to make the decision whether to pay high fees to the banks, rely on developing alternative channels or build their own sales networks.

Margins at state-backed banks are under pressure as the pseudo-monopoly they have enjoyed begins to be eaten away by smaller, privately-owned banks and technology companies, such as Alibaba.



0

1

2

3

4

5

6

7

8

2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15

AUM

(RM

B tr)

Non-MMF Traditional MMF Other online MMF Yu E Bao

Online distribution is a threat and an opportunity

While China’s financial industry attempts to catch up to developed markets’ product sophistication, Z-Ben Advisors believes that, in many ways, China is leading the world in internet finance and fintech. The immaturity of its markets is precisely the reason why China can leapfrog more advanced economies that must deal with legacy issues; it’s a textbook case of last-mover advantage. Alibaba has completely transformed the makeup of the domestic fund industry through its partnership with asset manager Tianhong and its online money market fund, Yu E Bao. Money market funds had just RMB300bn in industry-wide AUM when Alibaba launched Yu E Bao in 2Q13. At the end of 3Q15, Yu E Bao alone managed more than double that sum (RMB603bn) and money market funds totaled RMB3.7tr (55% of total industry AUM), in no small part thanks to several of Yu E Bao’s rival online MMFs.

In addition to Tencent, Baidu and other tech platforms, brick and mortar wealth managers are setting up standalone online fund marketplaces. Domestic and foreign managers salivate at the potential to raise significant volumes of assets without having to go through the banks but these platforms have not yet shown the ability to provide higher-value services that would allow them to sell more complicated financial products. Meanwhile, China is seeing huge growth in online lending sites, such as Jimu Box and Lufax, which are capitalizing on both millennials’ embrace of online payments and inefficiencies in the state- and bank-backed lending system. Several of them have received mutual fund distribution licenses and all are seeking to become one-stop, online wealth managers. The fear for asset managers is that these lenders might move into product manufacturing or even alternative forms of financing.


Money market fund growth

Comparison of MMF and non-MMF AUM growth, 2Q13-3Q15 (RMB tr)

Source: Z-Ben Advisors


IFAs: Hope on the horizon

While there has long been a market-wide need for professional wealth managers on the Mainland, most IFAs were deemed successful because they attracted interest from product manufacturers, not because they had figured out a way to scale wealth advisory services. From Z-Ben Advisors’ Shanghai headquarters, however, we’ve noticed a revealing development: our walk to lunch has become increasingly populated by the offices of new independent wealth managers, side-by-side with established bank branches. In addition to this anecdotal evidence, the number of IFAs with a mutual fund distribution license has more than doubled in the last two years. Over the past year, we’ve also seen another mainland wealth manager (Jupai) list on the NYSE and the expansion of several established wealth managers into the online space (CreditEase and East Money). The rising investor class is beginning to make demands that require personal, long-term servicing relationships. More encouragingly, this trend is now expanding outside of Tier One

cities. CreditEase boasts a coverage of 232 cities, while leading firm Noah has more than 80,000 clients across 64 cities. The most likely effect of this trend for product manufacturers is that banks may adjust their fees or service structure, worried by online distributors and IFAs breathing down their necks. Yet, some managers, such as large trust companies, have successfully built up their own distribution channels, independent of banks. Z-Ben Advisors believes foreign firms should exercise caution. The industry’s fast growth has led us to wonder which distributors are actually capable of delivering the client base they promise, and most aren’t yet providing any relief on the fee front. Still, as foreign managers move from outside observers to engaged players on the Mainland, they will need to undertake a closer study of the major players, products and services that mainland investors prefer in order to capture the growing opportunities available.



A U T H O R S Chris Powers Manager, Consulting [email protected] Mr. Powers covers the Chinese financial services industry, specializing in domestic asset managers and internet finance. He advises clients on strategy, execution, valuation and due diligence services on the Mainland. He recently completed a market assessment and positioning analysis of the mainland private fund market for a North American hedge fund. He also aided a major European financial institution in establishing its mainland operations. Other projects include due diligence on a Chinese brokerage for a British asset manager and identifying Chinese buyers for a Russian asset manager. Mr. Powers led the firm’s analytical and advisory efforts in the burgeoning internet finance industry, helping clients to develop distribution and product strategies to capitalize on recent growth in online finance. Prior to joining Z-Ben Advisors, he worked at ZPMC, a Chinese state-owned-entity based in Shanghai. He then worked as a consultant for Waypointe, a supply chain consulting company based in Shanghai. Mr. Powers has an A.B. from the University of Chicago with a double concentration in History and Philosophy.

A B O U T Z - B E N A D V I S O R S Z-Ben Advisors is a Shanghai-based consulting firm that helps global financial institutions capitalize on the fast-growing business opportunities presented by the Chinese and Greater China markets. Our business foundation is bottom-up, on the ground research; our services translate that research into actionable intelligence, recommendations and advice. The firm has permanent presences in Hong Kong and New York, with the majority of its staff based on the ground in Shanghai.


Z-BEN ADVISORS Ltd. (Hong Kong) Two Exchange Square, 39/F 8 Connaught Place Central, Hong Kong SAR

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Disclaimer The contents of the Strategic Outlook (the Product hereafter) are for informational purposes only. The data contained herein is based entirely upon the available information provided in public reports by the locally operating fund managers. The contained information has been verified to the best of Z-Ben Advisors and its research affiliate’s ability, but neither can accept responsibility for loss arising from the decisions based upon the product. The Product does not constitute investment advice or solicitation or counsel for investment in any fund or product mentioned thereof. The Product does not constitute or form part of, and should not be construed as, any offer for sale or subscription of any fund or product included herein. Z-Ben Advisors and its research affiliate expressly disclaims any and all responsibility for any consequential loss or damage of any kind whatsoever resulting, directly or indirectly, from (a) the use of the Product, (b) reliance on any information contained herein, (c) any error, inaccuracy or omission in any such information or (d) any action resulting therefrom. Disclosure Z-Ben Advisors and its research affiliate currently provides other products and services to some of the firms whose products are included in the Product. Z-Ben Advisors and its research affiliate may continue to have such dealings and may also have other ongoing business dealings with other firms whose products are included in the Product. Copyright The duplication of all or any part of the Product is strictly prohibited under copyright law. Any and all breaches in that law will be prosecuted. No part of the Product may be reproduced, transmitted in any form, electronic or otherwise, photocopied, stored in a retrieval system or otherwise passed on to any person or firm, in whole or in part, with out the prior written consent from Z-Ben Advisors.

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