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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
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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
leadership teams (Politburomembers and its StandingCommittee, party General
Secretary, members of theSecretariat and Central Military
Committee)
Elect and/or appoint party
leadership teams (Politburomembers and its StandingCommittee, party General
Secretary, members of theSecretariat and Central Military
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
Announced date for the next PartyCongress, approved the Central
Committees report to the nextParty Congress and proposed an
amendment to the PartyConstitution
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.
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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
Source: 12th FYP, HSBC estimates
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
Source: 12th FYP, HSBC estimates
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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
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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.PDF7/31/2019 Hbcs China National Sept 20
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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
Based on average of PEand DCF valuationmethodology
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
Based on average of PEand DCF valuationmethodology
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.PDF7/31/2019 Hbcs China National Sept 20
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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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