GLOBAL EMERGING MARKETS AUGUST 2015

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1 GLOBAL EMERGING MARKETS AUGUST 2015 FOR PROFESSIONAL CLIENTS ONLY WHAT NEXT FOR THE CHINESE DREAM? Volatile share prices and continuing geopolitical pressures have meant China has never been far from the headlines this year. However, for investors engaged in emerging markets, the country remains a key focus. Kim Catechis, Head of Global Emerging Markets, looks at the ambitious growth and reform plans of China s great rejuvenation and what the realisation of the so-called Chinese Dream will mean for investors in the country. In addition, Andrew Ness Portfolio Manager, Global Emerging Markets, provides his insight from a recent research trip to Beijing and David Sheasby, Head of Governance and Sustainability, focuses on environmental, social and governance (ESG) issues in China. Kim Catechis Head of Global Emerging Markets

2 active VIEWPOINT: GLOBAL EMERGING MARKETS The Chinese Dream China is changing rapidly. The country is attempting radical economic transformation aimed at evolving from Old China (an economy which consumes high energy, produces significant pollution and demands mass resources) to New China (structured around technology and innovation). The changes are multifaceted and widespread, from anti-corruption measures through to market liberalisation and environmental reform. Rooted in the sweeping initiatives laid out in the Fourth Plenum and popularised in President Xi Jinping s adoption of the Chinese Dream slogan, the path of such significant change undoubtedly has farreaching consequences. Government intervention and currency devaluation China has found itself at the end of a long economic growth cycle, powered by capital investment, which is 46% of GDP. * This has resulted in some highly developed infrastructure (China has more high-speed rail track than any other country), but also excess domestic capacity in the old economy of industrial and capital goods sectors. The measure of this government s long-term success will be the extent of China s economic transformation, but political and social stability also remain a top priority. Naturally, these objectives will at times be conflicting. It is through this desire to achieve economic growth without incurring large-scale social discord that the Chinese government viewed the recent sell-off in the Shanghai stock exchange with some serious concern. In mid- June the Shanghai SE Composite index peaked at 5,166, but by late August, this had fallen 43% to 2,965. For Beijing, government intervention was deemed essential: domestic investors losing their savings in a stock-exchange collapse could trigger social unrest and embolden opponents of Xi s plans for reform and tackling corruption. On 11 August this year, the People s Bank of China (PBoC) also surprised the markets by announcing an effective devaluation of the currency fixing it by 1.9%. This is the first such event since 1994; it represents a significant move in terms of the size of the devaluation and marks a departure from recent policy. By the end of the week in which the announcement happened, the currency was down around 3% against the US dollar, prompting investors to consider the impact of the devaluation. The move was driven again by the desire to have positive intervention, this time with regard to deflation, debt and economic growth, whilst selectively liberalising markets. The next government moves will probably involve cutting the reserve requirement for the banks. However, it is questionable whether weakening the currency will be enough to boost exports and reactivate the economy. In the meantime, the currencies and stockmarkets of neighbouring Asian economies are likely to be negatively impacted in the short term. Looking further afield, the PBoC s actions will almost certainly factor into the US Federal Reserve s (Fed) expected rate rise, potentially delaying the decision further into next year. International prestige and challenging US dominance At the same time as suffering economic pressures internally, China faces significant geopolitical tensions. Many countries are wary of its reinvestment in military hardware and a series of construction projects on disputed islets in the South China Sea. Beijing has insisted that these moves are not offensive in nature, rather a modernisation of its self-defence capabilities, but there appears to have been a price paid: China has not been invited to join the Trans- Pacific Partnership, a 12-member group of countries whose trade agreement unusually includes a significant liberalisation agenda, aimed at cementing links to the US. Against this backdrop, China is pushing for the renminbi (RMB) to be included in the basket of currencies that comprise the International Monetary Fund s (IMF) international reserves, known as Special Drawing Rights (SDR). Currently, the SDR is composed of four currencies, the US dollar, euro, sterling and yen. In a previous application in 2010, China was rejected as the RMB was not deemed freely useable. China s recent devaluation of its currency was partly motivated by its bid to join the SDR, which requires more market-driven exchange rates. China wants inclusion not just for prestige, but because it has serious complaints about the status quo, arguing that the Fed has a disproportionate weight in influencing global monetary conditions. In Beijing s view, the US dollar s position as global reserve currency endangers monetary stability worldwide as evidenced by the impact of the Fed s quantitative easing (QE) programme and is pushing for the SDR to take on the role instead. However, in order for the RMB to qualify for inclusion, China must liberalise its banking system and allow market forces to set interest rates. There is significant domestic opposition to these steps, therefore we expect progress to be gradual. However, a successful application would weaken opposition to further reforms. Even so, if the RMB is included, it will probably be at a relatively low allocation of perhaps 5% and will not be displacing the US dollar. * Source: The World Bank. Gross fixed capital formation (% of GDP) The World Bank Group authorises the use of this material subject to the terms and conditions on its website, Source: Bloomberg. Shanghai SE Composite index between 12 June and 25 August Source: Bloomberg.

3 PAGE 3 Launch of new financial institutions The clearest sign yet of the Xi administration s ambition for China to assume a stronger leadership role in world affairs is the China-led initiative to launch two international financing institutions this year: the Asian Infrastructure Investment Bank (AIIB) and the New Development Bank (NDB). Beijing s motivations for supporting these new banks are a result of frustration with the slow pace of reform by international financial institutions in giving emerging economies more voting power, and that infrastructure has not been a top priority for the World Bank. The AIIB will have the larger focus for Beijing as it is likely to be a more credible multilateral financial institution and therefore have a larger global impact. Not only will it have more legitimacy than the NDB (because of its larger membership) it is also likely to be more successful. Given the international scrutiny and scepticism, particularly from the US, a failed AIIB would be a big loss of face for China. The AIIB will have the larger focus for Beijing as it is likely to be a more credible multilateral financial institution and therefore have a larger global impact. The Asian Infrastructure Investment Bank and New Development Bank The AIIB has attracted not only Russia and other Asian neighbours, but also traditional US allies such as Germany, the UK and Australia. A total of 50 countries signed articles in June, determining each member s share and the bank s initial capital. Registered capital is initially US$50 billion, which will eventually rise to US$100 billion. n T he NDB has been set up by the BRICS nations (Brazil, Russia, India, China and South Africa) as an alternative to the US-dominated World Bank and IMF. It has reserves of US$50 billion, but these are likely to double in the coming years. n AIIB Headquarters (Beijing) NDB Headquarters (Shanghai) Source: Martin Currie. AIIB signatories at 29 June 2015 NDB members

4 active VIEWPOINT: GLOBAL EMERGING MARKETS Reviving the Silk Road These new international banks will be needed in order to finance one of the most high-profile aspects of China s plans on the global stage the One Belt, One Road (OBOR) initiative. This is Xi s plan to connect China to Europe via the construction of continuous transport and communication links, reviving the historic Silk Road and further developing trade links across Asia and the Middle East to Europe. The plan is a projection of soft power by China and an effective use of spare capacity in the country s steel, cement and aluminium industries, but also ensures trade and economic growth for China and other countries along the route. A Silk Road Infrastructure Fund with US$40 billion will invest in OBOR, capitalised by China s foreign-exchange reserves and managed in the same way as the country s sovereign wealth fund, the China Investment Corporation (CIC). One Belt, One Road The basic blueprint for the OBOR initiative can be seen in Africa, where Chinese companies have been building power plants, transmission lines, rail, ports, oil & gas pipelines, airports, roads and telecommunications installations. While ports and airports are relatively quick and easy to build, the key attraction for the Central Asian countries, in particular, is the promise of roads and high-speed rail. A high-speed Beijingto-Moscow rail line is currently under construction, and a Chinese-built high-speed route in Turkey started operating last year. China already benefits from three gas pipelines from Turkmenistan, in Central Asia. The administration has learned valuable lessons from the challenges of direct investment in Africa, such as the social, political and environmental problems encountered by infrastructure companies. Eventually though, China wants to transform this ambitious enterprise into a huge freetrade zone. There are 65 countries on or connected to the new Silk Road and China aims to negotiate free-trade agreements with each one. So far 12 agreements have been concluded and eight are in progress. The challenge for us as equity portfolio investors is to find attractive opportunities for our clients in projects on this scale. At this point, it is probably too early to tell where the possibilities will be found. However, we can be sure that in the key civil engineering and construction phases, the first wave of beneficiaries will be state-owned enterprises (SOEs) unfortunately these companies are typically price-takers, likely to get cost-plus calculated margins, which are not compelling for equity investors. The early stages will no doubt be of interest to directinfrastructure investors. Our opportunities will emerge later as private sector companies benefit from the resulting trade.

5 PAGE 5 State-owned enterprises Among the many plans for economic reform and market liberalisation is the revival of an ambitious restructuring of SOEs. The aims are simple: to eliminate corrupt practices in SOEdominated industries and introduce greater competition and efficiency (since the global financial crisis, despite significantly lower levels of profitability, SOEs have been squeezing out the private sector in some industries, while remaining protected from competition). The latest wave of reforms is expected to be formally announced soon. In order to enable the transformation, some SOEs will be combined, with reports the total number will be cut back from 112 to 40. They will be obliged to pay dividends of 30% of earnings and opened up to strategic private investment, without loss of overall state control. Such an undertaking requires a healthy stockmarket to facilitate the changes. Ultimately, the intention is to open up previously protected industries, such as telecommunications and energy, to competition. These aims are laudable, however, in practice, limits to corporate governance which prioritise party control over that of outside investors will put a check on any efficiency gains. The implications of these changes are significant, but progress is likely to be slow The Stock Connect and reform of the Chinese market The gradual reform and liberalisation of financial markets over many years has led to an unusual stockmarket structure. Typically, international investors access Chinese mainland companies through Hong Kong listings, known as H-shares. These constitute the China portion of the MSCI Asia Pacific, China, and Emerging Market indices our investment universes. Until late last year, mainland Chinese residents could only buy companies listed in China, known as A-shares on the Shanghai and Shenzhen exchanges. After November 2014, the introduction of the Shanghai-Hong Kong Stock Connect programme allowed limited two-way flow of investment in each of these markets for account holders based in China and Hong Kong. The Shenzhen-Hong Kong Connect is due to be launched in the second half of this year. Including A-shares in global benchmarks Another significant change for China will be MSCI s plans to include A-shares in its global benchmarks. The index provider announced in its classification review in June that it expects to include them once outstanding issues relating to market accessibility have been resolved and it will form a working group with the China Securities Regulatory Commission. By including A-shares and overseas-listed Chinese companies, the number of constituents of the simulated MSCI China index would go from 139 stocks to 522. MSCI aims to start with a 5% inclusion factor, which would mean China s weighting in the Emerging Markets index would rise from 25.3% to 30%. If this were to happen and all A-shares are included, the full weighting in the index would be 43.6%. In terms of market capitalisation, China would go from US$1.02 trillion to US$1.17 trillion once overseas-listed Chinese companies are included and US$2.33 trillion with full inclusion. The implications of these changes are significant, but progress is likely to be slow the potential inclusion date is in the May 2017 Semi-Annual Index Review and also depends on both further market liberalisation and public consultation with market participants. * MSCI appears to have taken reasonable steps to consult with market practitioners. At Martin Currie, we have significant in-house experience in running China mandates and we have an excellent understanding of the top-tier companies. In reality, most of these newly included companies would currently be unlikely to pass the stringent criteria for inclusion in our approved research list; but, in the future, company management teams should be able to demonstrate longer and better track records of cash-flow delivery. We continue to monitor these developments. The main issues which MSCI requires to be resolved before A-shares can be included in its global benchmarks are: Quota-allocation process This needs to be more streamlined, transparent and predictable. Larger investors require a size that is commensurate with the size of their assets under management. Capital-mobility restrictions Market liquidity needs to be daily and complete regardless of the investor type. Beneficial ownership Asset owners must have the confidence that their title to ownership is clearly recognised. * * Source: MSCI. Consultation on China A-shares Index Inclusive Road Map. June Data as of 29 May 2015.

6 active VIEWPOINT: GLOBAL EMERGING MARKETS ESG in China Historically, many significant environmental, social and governance (ESG) issues have been ignored in China at a government level as well as by companies, to the point that they threaten long-term sustainable growth. However, what is clear now is that growth will no longer be pursued without regard to environmental impact, social cost or responsible governance. A number of reforms are now underway in the country and gaining momentum across a number of areas. Financial David Sheasby Head of Governance and Sustainability China is bidding for the RMB to be included in the IMF s Special Drawing Rights basket of currencies. If it is to meet the criteria which includes ensuring it is freely usable or convertible financial reform will be key. This will also encourage institutions to be more innovative in designing financial products to meet demand from the markets and encourage more flexibility in pricing them. Environment With improving both the country s air and water quality a top priority, Premier Li Keqiang s war on pollution will accelerate this year. New legislation came into force in January, meaning environmental agencies can enforce stricter penalties on illegal polluters. In addition, a drive to compensate for poor management of the environment in the past has increased pressure on local authorities to comply. The country s power sector is experiencing huge changes as the country reduces its dependency on fossil fuels. State-owned enterprises The new round of reforms to SOEs is a key focus for the Leading Small Group for Comprehensively Deepening Reforms a new policy panel established by the government last year. It is targeting structural corporate governance weakness and aims to bring China more in line with other countries. What does this new focus on reform mean for stockpickers? 2015 is the year of reform in China and we will see policies with the purpose of enhancing company profitability through market consolidation, management incentive schemes and private capital entering state-owned businesses. These transformational changes are aimed at helping the evolution of a New China which will provide wide-ranging investment opportunities, particularly in technology and innovation. The single biggest challenge is the scale of the problem. It is estimated that more than 25 years of consistent execution is required to bring tangible improvements to air and water quality. An aggressive approach is necessary for the Chinese authorities to tackle both environmental regulations and a culture of non-compliance. We engage with the management of companies, adopting a case-by-case approach. We also participate in collaborative engagement with industry bodies where appropriate. We are active, rather than activist investors, and our aim is to identify companies which are well placed to benefit from the evolving focus on ESG reforms. Conclusions At the beginning of the year our Global Emerging Markets strategy was underweight in China. The economy was slowing and we had concerns this would impact businesses in the industrial and capital goods sectors, as well as doubts over the overall health of the financial sector. As always, our focus is on bottom-up stockpicking. Overall, despite the huge volatility, the impact of China s moves on the portfolio has been limited. Throughout the first half of the year, we added to our holdings in China and as the market sold off, we used the opportunity to add to existing holdings where we had high conviction. We are now less underweight China than at the start of the year. We continue to monitor developments in all countries in our investment universe, both economic and political. These tend to determine policy outcomes, which ultimately impact on the evolution of the bottom-up investment cases that we analyse and stresstest on a daily basis. China is particularly important to emerging market investors, especially given the country s 25% weighting in the MSCI benchmark index and, as the MSCI and other index suppliers begin to take account of the A-share markets, the likelihood is it will continue to grow in the future. For us, however, there is no question of these prospective changes to the benchmark indices driving our portfolio construction. We will monitor them and continuously challenge our research agenda, making sure we are investing in the most attractive companies that we can find in our wide and heterogeneous asset class. While China s markets have a number of different characteristics to other areas in which we invest, we treat them as we do any other in our investable universe we make no special case. For us, however, there is no question of these prospective changes to the benchmark indices driving our portfolio construction.

7 PAGE 7 TALES FROM THE ROAD BEIJING Against a backdrop of extreme volatility in the Chinese stockmarket, Andrew Ness went to Beijing to gain a greater insight into a growing disconnect between the equity market, economic data and corporate earnings. My recent research trip to Beijing was an interesting time to visit China. The domestic A-share market was on fire fuelled by monetary policy easing, a surge in new broker account openings and the rapid growth in margin financing. Market sentiment was further boosted by local investor expectations of both MSCI A-share inclusion and foreign investor inflows via the newly launched Shanghai-Hong Kong Stock Connect programme. This was in sharp contrast to more recent economic data highlighting a still slowing economy and widespread evidence of persistent deflationary pressure. After meeting company management teams including leading players in banking, insurance and internet sectors as well as policy makers, regulators and multinationals with direct investments in China, my conclusions support many aspects of our existing investment theses: n Banking earnings are under pressure, but policy changes are addressing balance-sheet tail risks which should support higher sector multiples. n Insurance regulatory and demand trends in the sector remain supportive of valuations. China s insurance market remains deeply underpenetrated and offers attractive long-term growth opportunities. n Internet e-commerce is proving to be irrevocably disruptive and digital advertising is surging. There seems to be an insatiable appetite for mobile data in the country. Andrew Ness Portfolio Manager, Global Emerging Markets Market sentiment was further boosted by local investor expectations of both MSCI A-share inclusion and foreign investor inflows via the newly launched Shanghai-Hong Kong Stock Connect programme.

8 active VIEWPOINT: GLOBAL EMERGING MARKETS Banking Margins, credit demand and asset quality remain under pressure due to the slowing economy. Rate cuts to date have only eased interbank funding costs as the real economy struggles with high real interest rates. Further rate cuts are therefore expected. Deposit pricing, meanwhile, has been more rational than previously thought, demonstrating that banks are keen to preserve profitability and not pursue growth at any price. They continue to claim credit costs are manageable while regulatory pressures on fee income are easing. Policymakers and banks alike were keen to point out that recent government measures have helped to reduce sector balance-sheet tail risks. Plans to allow local governments to convert maturing bonds to municipal bonds with lower rates and permitting local authorities to issue debt directly will mitigate the immediate risks related to heavy debt burdens. Rating agency Fitch expects the debt swap to reduce the financing costs for local governments and extend their debt maturities, thus significantly reducing their liquidity risks. * Also discussed was the growing use of securitisation transforming an illiquid asset through financial engineering into a security as a measure to further support bank balance sheets, which is presently being trialed by the authorities. Banks are also preparing themselves for a new environment with their assets considered too large relative to the economy and getting ready for the eventual disintermediation by capital markets. In addition, they see rising competition from newly licensed internet banks and a shift of their own business to the online world which may generate substantial cost savings and enable growth in fee-generating capabilities. Finally, we discussed the potential impact of the government s One Belt, One Road initiative. For some banks, these programmes will have a tangible impact, driving loan growth higher as they co-invest along with the country s sovereign wealth fund and the state development banks. The challenge for investors will be to assess the cash flow and return opportunity of these mega investment projects. It won t be easy. Insurance The rest of 2015 is set to be an exciting time for the industry due to a number of policy initiatives. Key measures include the long-awaited launch of taxadvantaged retirement savings products. The absence of any tax incentive to save has often been given as a reason why the Chinese life insurance penetration rate lags many of its emerging market peers, including India where the industry is supported by generous tax breaks. In addition to this, the industry regulator (the China Insurance Regulatory Commission) is set to clarify the rules for its new solvency framework due to launch in This is a positive for the sector as it should improve risk management and promote underwriting discipline, while also encouraging insurers to address assetliability mismatches. The threat posed by new online insurance providers was also discussed. The risks to market share were played down the mere fact we were talking about them highlights the fast-changing disruptive world of the Chinese internet space. Banks are also preparing themselves for a new environment with their assets considered too large relative to the economy and getting ready for the eventual disintermediation by capital markets. * Source: Fitch Ratings 22 July 2015.

9 PAGE 9 Internet The Chinese consumer has well and truly embraced the internet. We can see this through high growth rates in mobile phone data usage, soaring e-commerce activity and the rapid growth in online advertising. The advertising industry expects the market in China to grow over 10% in 2015 to more than US$80 billion, with online advertising expected to grow over 30%. * At this pace, online spending will account for almost 40% of the total market compared with 19% in the US. Market data shows that Chinese internet users spent an average 4.3 hours on the internet (excluding working hours) each day in 2014 compared with 3.8 hours in the US and 3.5 in Japan. * This helps to explain why advertisers have shifted their budget to digital media more aggressively in China than elsewhere. China is also seeing rapid growth in mobile phone data usage. My meeting with one of the country s leading mobile operators highlighted that, in terms of time spent on the internet, mobile use (including tablets) has jumped from 25% to 61% in the past two years, while PC usage accounted for only 39% of the total time spent online. * The company expects to see continued strong data usage growth for years to come and is investing heavily in its broadband and 4G network capabilities. Conclusions While signs of a slowdown continue in many parts of the economy, particularly in sectors tied to the fixed-asset investment cycle and manufacturing, there are also plenty of signs of a robust consumer economy. Advertising and e-commerce activities remain solid, while the demand for financial services (loans, savings and insurance) remains unsatisfied. It is difficult to predict where the overall market will be in the coming months given the speculative nature of many local participants. Our strategy, however, is not dependent on a particular market outcome. Instead, we prefer to focus on individual company opportunities where we think the market is incorrectly valuing long-term cash flows and capital returns. This adherence to our long-tested, proven investment approach stands us in good stead during the current volatile period in Chinese equity markets. While signs of a slowdown continue in many parts of the economy, particularly in sectors tied to the fixed-asset investment cycle and manufacturing, there are also plenty of signs of a robust consumer economy. * Source: Martin Currie from company sources, May 2015.

10 active VIEWPOINT: GLOBAL EMERGING MARKETS ontact: Find out more For further information on Martin Currie or our strategies please visit our website You can find your local contact at Or please call our global offices, press office or global consultant team on the numbers below: Edinburgh (headquarters) 44 (0) Singapore (65) Media 44 (0) London 44 (0) New York (1) Melbourne (61) Global consultants 44 (0) Important information This information is issued and approved by Martin Currie Investment Management Limited ( MCIM ). It does not constitute investment advice or represent an inducement to invest. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested. Past performance is not a guide to future returns. The information contained has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The document may not be distributed to third parties and is intended only for the recipient. The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Investors should also be aware of the following risk factors which may be applicable to the strategies shown in this document. Investing in foreign markets introduces a risk where adverse movements in currency exchange rates could result in a decrease in the value of your investment. Emerging markets or less developed countries may face more political, economic or structural challenges than developed countries. Accordingly, investment in emerging markets is generally characterised by higher levels of risk than investment in fully developed markets. This strategy hold a limited number of investments. If one of these investments falls in value this can have a greater impact on the portfolio s value than if it held a larger number of investments Smaller companies may be riskier and their shares may be less liquid than larger companies, meaning that their share price may be more volatile. The strategy may invest in derivatives to obtain, increase or reduce exposure to underlying assets. The use of derivatives may restrict potential gains and may result in greater fluctuations of returns for the portfolio. Certain types of derivatives may become difficult to purchase or sell in such market conditions. Distribution of this material in Singapore is by Martin Currie Asia Pte. Limited ( MCAP ) whose registered office is 3 Anson Road, #23-02 Springleaf Tower, Singapore Tel: (65) Fax: (65) This material has been approved by MCAP for distribution in Singapore to accredited and institutional investors. It must not be relied upon by retail investors. Please note that calls may be recorded. Martin Currie Investment Management Limited, registered in Scotland (no SC066107) Martin Currie Inc, incorporated in New York and having a UK branch registered in Scotland (no SF000300), Saltire Court, 20 Castle Terrace, Edinburgh EH1 2ES Tel: (44) Fax: (44) Both companies are authorised and regulated by the Financial Conduct Authority. Martin Currie Inc, 1350 Avenue of the Americas, Suite 3010, New York, NY is also registered with the Securities Exchange Commission. Please note that calls to the above numbers may be recorded.