Expert eye on China Q MARKET REVIEW: CHINA A-SHARES ON THE RISE. For professional and institutional investors only -

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1 For professional and institutional investors only - Q Expert eye on China MARKET REVIEW: CHINA A-SHARES ON THE RISE MARKET REVIEW QUARTERLY OUTLOOK 1 2 PRIVATISATION IN CHINA WHERE ARE THE OPPORTUNITIES? 3 LOCAL GOVERNMENT DEBT VEHICLES: TOWARD A CLEARER FRAMEWORK? STOCK CONNECT TRAIN: NEXT STOP SHENZHEN EXPANSION OF CHINA MARKET ACCESS TRIGGERS CAPITAL GAINS TAX (CGT) CLARIFICATION In partnership with Despite steady growth in the equity and bond markets, China s economy continued to slow in Q Although the official PMI rose modestly from 49.8 in January to 50.1 in March, major Chinese macro indicators were disappointing. First quarter GDP came at 7.0%, a six-year low. Over the period from January to February, industrial production growth faced downside pressures and dropped from 7.9% to 6.8% YoY. Fixed asset investment growth edged down from 14.6% in December last year to 13.9% in February this year. Retail sales growth slowed from 11.9% in December 2014 to 10.7% in February. In the face of lacklustre GDP growth, the authorities maintained its loose monetary policy in Q to stimulate the real economy. The People s Bank of China (PBoC) cut the RRR* by 50bp in early February and cut its benchmark interest rate by 25bp on the last day of February to bring down real borrowing costs and boost growth. On the fiscal policy front, at the National People s Congress meeting in early March, Premier Li Keqiang said the primary task in 2015 is to stabilise and improve macroeconomic policies and make sure economic growth stays in the reasonable range. It was a more strongly-worded reiteration of the government s bottom-line -focused policy. China s equity market rose strongly after the Chinese New Year. The MSCI China A index gained 18.62% in CNY terms over Q1 2015, driven by good momentum and massive fund inflows in March. New account opened in A shares reached 1.67 million in late March, a seven-year high after the Chinese New Year. The surge in A shares came mainly on the back of the RRR and interest rate cuts, the One Belt One Road project, the new deposit insurance plan and the relaxation of the real estate policies. On the Chinese bond market, the Shanghai Treasury Bond Index and Shanghai Corporate Bond Index rose by 1.57% and 1.85% respectively in CNY terms over the last quarter. Bond yields continued to correct in Q as the yield curve steepened. The PBoC injected more liquidity into the market in Q In terms of FX rate, over the quarter, the Chinese yuan appreciated by 0.09% relative to the US dollar, finishing at /USD. *RRR: Required Reserve Ratio Bloomberg is the source for all data in this article, as end of March 2015.

2 2 - Expert eye on China - BNP Paribas Investment Partners - Q QUARTERLY OUTLOOK: MORE EASING IS COMING After first-quarter GDP growth came in at 7.0%, we expect the Chinese economy to grow at a similar pace in the second quarter. To realise the 7% GDP growth target for the whole of 2015, China needs to take further steps regarding liquidity and fiscal and monetary policy. However, after the significant measures taken in the first quarter (reducing banks reserve requirements and cutting policy interest rates), more specific steps related to direct financing and the public-private partnership may be implemented in the second quarter. However, we believe it may be difficult for CPI, trade and consumption targets to be met, while investment, M2 money supply and the fiscal deficit can be expected to exceed their objectives in During this year s National People s Congress and Chinese People s Political Consultative Conference, Premier Li highlighted topics such as maintaining stable growth, environmental protection, deepening the fiscal reforms and the New Silk Road Project, which aims to improve the infrastructure links between China s economy with the rest of the world. As for the equity market, the success of policies supporting Internet+ and Industry 4.0 should benefit the infrastructure, environmental and new economy sectors. Furthermore, we expect the A share market to develop faster with more funds coming to market, while the introduction of the deposit insurance system also provides a boost. The favourable new property policies the government announced last month should help rectify the lacklustre demand and pessimistic attitude in the real estate sector. Overall, confidence in the economy should improve, underpinning the A share market in the short run. While the economy has relatively weak growth momentum, first-quarter property sales and credit data are showing signs of stabilisation. In the second quarter, there should be an increase in the supply of rate securities. Together with a RMB 1 trillion government debt swap, rate securities may reduce risk in the long run. In addition, we still need to focus on the fluctuations of the renminbi exchange rate and faster interest-rate liberalisation. Credit spreads remain a major issue. With the supply-demand equilibrium being affected by a stock market wealth effect, we expect spreads to widen. For convertible bonds, relatively high valuations are reducing cost effectiveness. In our view, investors should be prudent when investing in such bonds. The narrowing interest-rate spread between the US and China could add to the pressure on the renminbi. Overall, although the recent rate cut will likely weigh on the currency, the pressure is unlikely to be significant since the cut should be conducive to stabilising growth. We expect steady renminbi policies from the PBoC to preserve credibility and enhance the chances of the currency to enter the IMF SDR basket. We will take a closer look at this in June. In the long term, we still expect the renminbi to appreciate against the US dollar. Do you think that the Chinese economy will grow at the same pace in Q2 as it had in Q1 2015? Share your thoughts now. Bloomberg is the source for all data in this article, as end of March 2015.

3 3 - Expert eye on China - BNP Paribas Investment Partners - Q PRIVATISATION IN CHINA WHERE ARE THE OPPORTUNITIES? As Beijing pursues privatisation as part of the reform of state-owned enterprises (SOEs), many investors are looking to buy into China s major industries, such as oil and gas, aviation and telecommunications. However, Beijing is unlikely to sell firms in these strategic industries on any meaningful scale any time soon. The rapid build-up of China s corporate debt is becoming a serious risk to the financial system, because slower economic growth is crimping corporate profits, raising the insolvency risk facing highly leveraged companies. This risk will be aggravated by the gradual and eventual removal of deposit interest rate controls, which will put upward pressure on lending rates. This will hurt the less profitable state firms more by pushing up funding costs when their pricing power is constrained by competition. The return on assets (ROA) of state firms was only half the weighted average bank lending rate of 7.5% in last year s third quarter. 1 Unless their ROA rises along with financial liberalisation, further increases in lending rates will raise the default risk of the state-owned sector. Deleveraging has, thus, become the centrepiece of Beijing s reform strategy, which will include privatisation of state assets. The question is, within China s controlled system, how will privatisation proceed? Beijing appears to be addressing the country s corporate debt risk by partially privatising some SOEs. This process takes the form of mixed ownership and is seen by President Xi Jinping as the lynchpin of SOE reform. Mixed ownership involves selling more shares of SOEs to private investors. Full privatisation is politically implausible in the medium term. The central government launched several experiments involving six centrally-owned SOEs in 2014 as part of this reform initiative, including selling some of their stakes and transferring control of state equity to state-owned holding companies that will focus on capital management and maximisation of shareholder value rather than advancing policy goals. Local governments are also starting to sell infrastructure assets to pare debt. To facilitate this effort, Beijing has launched a publicprivate partnership (PPP) scheme to allow private investors to operate and jointly own local SOEs and infrastructure assets. However, even partial privatisation is a big challenge for the reformers in China. The crown jewels are all concentrated in strategic sectors, such as oil, aviation, rail, gas, electricity, post and telecommunications. The Communist Party will not let go of these in the medium term. Firms in other valuable but nonstrategic sectors, such as property, metals, construction and retail, can be sold more easily, but they may not fetch their book value because of structural and cyclical weaknesses. Local SOEs have also underperformed their central counterparts, as seen in their inferior return on equity (Chart 1). However, this may be a blessing in disguise for investors, because it means there could be plenty of scope for improvement under private ownership. They are also more accessible to private investors, as most are not in the strategic sectors. Chart 1: Return on equity of SOEs ROE (%) Central SOEs Local SOEs Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: CEIC, BNPP IP (Asia), December 2012 Under these circumstances, Beijing will likely focus on mixed ownership reform in non-strategic and consumeroriented sectors. Jinjiang International (Group) Co. Ltd. is a notable example. A local SOE controlled by the Shanghai government, it is one of the world s largest hotel groups, managing properties and travel agencies across China. There are tens of thousands of other state firms like Jinjiang that are in the economic lowlands, with no strategic importance to Beijing. They are running hotels, developing property, managing restaurant chains, operating shopping malls and providing social, business consulting, leasing and entertainment services. These non-strategic sectors present the most viable investment opportunities for investors looking to benefit from China s privatisation. 1. Source: Peterson Institute, January 2015 Do you think the privatisation of non-strategic sectors holds as much appeal to investors as the privatisation of strategic sectors? Share your thoughts now.

4 4 - Expert eye on China - BNP Paribas Investment Partners - Q LOCAL GOVERNMENT DEBT VEHICLES: TOWARD A CLEARER FRAMEWORK? Recent regulations have led toward higher credit differentiation. But, still clearer solutions have to be given to provide a clear answer on the LGFVs status to investors. 1. What are LGFV bonds? Local Government Financing Vehicle (LGFV) bonds are special securities in China s bond market, issued by entities set up by local governments to raise funds for infrastructure and other local development projects. As part of the nationwide programme of economic stimulus, local governments have taken a considerable role in regional investments which give rise to huge financing needs. However, as the formal budget law prohibits local governments from legally raising finance from the public, LGFV became the only method to meet local governments financing needs. The first LGFV bond was issued in 1992 to raise funds for the development of the Shanghai Pudong district, as supported by the Shanghai government. For a long time, LGFV bonds have been regarded as risk-free instruments with quasi-sovereign status within China s economic and political system. However, many LGFVs are making losses and might take years to generate investment returns. With limited profitability, many of them have relied heavily on local government support such as subsidy policies. Although LGFV bonds have been supported by the government, this does not necessarily equate to cast iron government guarantees. The poor financials of LGFV necessarily raise default risk. 2. Change after Guofa [2014] No.43: toward a greater credit differentiation In October 2014, the State Council issued Guofa [2014] No.43, aimed at strengthening management of local government debt. The document included the standard procedures governing borrowing by local government entities and the solutions for repaying maturing debt. Subsequently, the Ministry of Finance issued a document specifying both the debt repayment process and the principles for local government to follow in screening repayable debt. The yield of LGFV bonds fell to historic lows in the secondary market after the issuance of No.43. Since 2014, industrial bonds, particularly private bonds have started to exhibit credit differentiation following a series of credit risk events. In comparison, LGFV bonds remained unaffected. The No.43 document urged local government bodies to screen and clear debts, and the Circular tightened up conditions for financing corporate bond repurchase pledges. Both measures lead to greater credit differentiation within LGFV bonds. With the first peak payments due in 2015 and reinforcement of government screening, the question of whether LGFV bonds should be considered general government debt will be critical. Under the new regulations, the bond market would be closer aligned to a market-based pricing system with better credit differentiation and yield classification. Chart 2: Yield to maturity of AA LFGV bonds (%) Jan-14 LGFV YTM (AA): 7 years LGFV YTM (AA): 5 years LGFV YTM (AA): 3 years 2-Feb-14 2-Mar-14 2-Apr-14 2-May-14 2-Jun-14 2-Jul-14 Guofa [2014] No Aug-14 2-Sep-14 2-Oct-14 2-Nov-14 2-Dec-14 CSDC has released the "Circular" Source: Wind Information, China Central Depository & Clearing Co., April 2015 Chart 3: Credit spreads of AA LGFV bonds and industrial bonds (%) Guofa [2014] No Jan-15 CSDC has released the "Circular" 2-Feb-15 2-Mar-15 2-Apr-15 In December, 2014, China s Securities Depository and Clearing Co., Ltd. (CSDC) released a Circular document stating that new applications for corporate bond repurchase qualifications would not be accepted, and corporate bonds with repurchase qualifications are temporarily prohibited from being warehoused, if they violate the new regulation, with the exception of those corporate bonds with a rating of AAA and those issued by firms with a rating of AA and above. The release of the document by CSDC marked the start of a stark differentiation in yields of LGFV bonds. The credit spread of interbank AA grade LGFV bonds rose above that of industrial bonds with the same maturity for the first time since August Through this yield adjustment, the yields of some LGFV bonds have started to adequately reflect the liquidity risk resulting from their disqualification from their lack of repurchasing qualifications Feb-14 2-Mar-14 2-Apr-14 2-May-14 2-Jun-14 2-Jul-14 2-Aug-14 2-Sep-14 2-Oct-14 2-Nov-14 2-Dec-14 2-Jan-15 2-Feb-15 2-Mar-15 2-Apr-15 Industrial bond YTM (AA): 3 years - CDB YTM: 3 years Industrial bond YTM (AA): 5 years - CDB YTM: 5 years Industrial bond YTM (AA): 7 years - CDB YTM: 7 years LGFV Bonds YTM (AA): 3 years - CDB YTM: 3 years LGFV Bonds YTM (AA): 5 years - CDB YTM: 5 years LGFV Bonds YTM (AA): 7 years - CDB YTM: 7 years Source: Wind Information, China Central Depository & Clearing Co., April 2015

5 5 - Expert eye on China - BNP Paribas Investment Partners - Q Latest developments, but still a long way to go In early March 2015, an officer of the Ministry of Finance stated that, Subject to approval by the State Council, the Ministry of Finance has recently issued 1 trillion yuan1 in local government bonds to replace part of the existing debt, allowing local governments to convert maturing high-cost debt into lower-yielding municipal notes to be repaid at a future date. The replacement bonds are issued by local government to fund repayments of the debt maturing in The total amount of bonds to be issued accounts for 53.8% of the maturing government debts.2 The impact of this solution on the bond market can be viewed in two ways. On one hand, the replacement of debt could reduce the systematic risk associated with repayments of the LGFV bonds, as well as increasing market appetite and risk tolerance. On the other hand, issuing bonds with benchmark interest rates as a replacement for the high yield bonds and extending maturity dates, puts stress on the supply side of interest rate markets. In addition, some regulatory agencies have recently started to relax approval conditions for newlyissued LGFV bonds, without violating No.43. Last, it s likely that the supply of LGFV bonds will recover from the decline following the strict new policy on bond issuance. Yet, worries about the status of LGFV bonds remain apparent among investors, despite the bond replacement solution. This is due to the fact that the process for screening local government debt still has to be determined and which kind of bonds will get the quasi-government status or not is unclear. Do you think the issuance of replacement bonds are largely positive or negative on the bond market? us your thoughts now. 1. Source: Wind, HFT, April Source: HFT, April 2015

6 6 - Expert eye on China - BNP Paribas Investment Partners - Q STOCK CONNECT TRAIN: NEXT STOP SHENZHEN Before 17 November 2014, foreign investors only had exposure to Chinese equities via Chinese listings on the Hong Kong Stock Exchange. Only institutional investors were given access to the Shanghai and Shenzhen stock exchanges via the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programmes. For the average onshore retail investor, there was no option to own investments outside of China except through onshore Qualified Domestic Institutional Investor (QDII) products. These barriers came down when Shanghai-Hong Kong Stock Connect (Stock Connect), known as the through train, went live last November. Stock Connect allows direct mutual market access between the Shanghai and Hong Kong exchanges creating a paradigm shift in China s financial markets. According to Bloomberg, since the launch of Stock Connect, China s A-share market as represented by the CSI300 Index has returned 69.2% (in CNY), and China s H share market as represented by the MSCI China Index has returned 27.3% (in HKD) by 10 April Thus, performance has been stellar when comparing these markets with many regional and global peers. A variety of factors likely contributed to this rally. What is less clear is how much of the rally has been a direct result of Stock Connect. With the Shanghai and Hong Kong pilot link now running smoothly, many would agree that Stock Connect has become the future framework for accessing the Chinese market. Preparations are underway for a Shenzhen-Hong Kong link, expected to go live in 2H15. Shenzhen-Hong Kong Stock Connect will complete the creation of a single China market for international investors, opening up an additional USD 2.6 trillion in market cap value for investment. 1 Shenzhen on its own represents more than a quarter of Chinese-listed equities globally. Chart 1: China s USD 9 trillion market cap distribution Hong Kong 23% US 5% Shenzhen 28% Singapore / Other 0% Shanghai 44% Shanghai Shenzhen Hong Kong US Singapore / Other Source: Wind, Bloomberg, Citi Research, March 2015 The Shenzhen link adds a new and exciting investment universe for foreign investors. The exchange is dominated by private small and mid-sized companies in the information technology, health care, consumer discretionary, and media industries. By contrast, Shanghai is dominated by large state-owned enterprises (SOEs). Shanghai-Hong Kong Stock Connect has made 54% of China s A share market cap available to foreign investors and the Shenzhen link is expected to raise that number to about 75%. 1 Chart 2: Top 3 sectors in Shenzhen 20% 19% 18% 17% 16% 19% 18% 17% Technology Financials Consumer Discretionary Source: Wind, Bloomberg, Citi Research, March 2015 Chart 3: Top 3 sectors in Shanghai-Hong Kong Stock Connect universe 45% 35% 25% 15% 5% -5% 38% 19% 14% Financials Industrials Energy Source: Wind, Bloomberg, Citi Research, March 2015 Stock Connect offers global investors much broader access to China and could speed up the inclusion of A-shares in the MSCI and FTSE benchmarks. Earlier this year, MSCI already proposed 17 US-listed Chinese companies to be added to the MSCI China index in the November 2015 review. In aggregate, these 17 names would boost the market cap of the MSCI China index by more than USD 400 billion and raise China s weighting in the MSCI Asia ex-japan index from 27% to 30%. 2 The China Securities Regulatory Commission recently held discussions with international index providers on the potential for including A-shares in global indices. While a favourable outcome in the next MSCI review in June does not look likely, many would agree that the A-share inclusion in MSCI and FTSE indices will not be far off. Beijing is determined to accelerate the liberalisation of China s financial markets to help fund their economic reform goals. Having China s weighting in global indices raised would be a quick and sure way for China to attract international money. 1. Source: Citi Research, March Source: UBS research, January 2015

7 7 - Expert eye on China - BNP Paribas Investment Partners - Q Currently, many global investors are underweight Chinese equities given China s weight in the MSCI AC World index of a mere 2%. But this 2% weight in the benchmark is significantly under-represented in relative terms to China s economic influence (13% of world GDP) and size of its equity capital market (14% of global market capitalisation). 3 We believe the A share inclusion in the MSCI and FTSE benchmarks will trigger a re-rating of Chinese equities. Chart 4: Global investors are underweight China relative to its economic influence 16% 14% 12% 10% 8% 6% 4% 2% 0% 13% China's GDP as % of world 14% China's market cap as % of world 2% China's weight in MSCI AC World Index Source: Wind, Bloomberg, Citi Research, March 2015 Download our paper on the Stock Connect programme. Do you think the Stock Connect had a strong impact on the Chinese equity markets rally? us your views now. EXPANSION OF CHINA MARKET ACCESS TRIGGERS CAPITAL GAINS TAX (CGT) CLARIFICATION CGT tax clarification on Chinese equities was a prerequisite to the launch of Shanghai-Hong Kong Stock Connect A distinction of CGT applicability in time Taxation applies to equity-related trading only For years, the issue of CGT on gains from the trading of Chinese equities has been up for a topic of discussion. The launch on 17 November 2014 of Shanghai-Hong Kong Stock Connect ( Stock Connect ) mutual market access programme linking the Hong Kong and Shanghai stock markets set in motion a process of (retroactive) CGT clarification for QFIIs and RQFIIs. On the eve of the Stock Connect launch, two circulars Caishui 79 and Caishui 81 were issued jointly by the State Administration of Taxation, the Ministry of Finance and the China Securities Regulatory Commission. These notices, among other measures, introduced a temporary withholding tax exemption on gains from the trading of equities for non-resident QFIIs and RQFIIs from 17 November 2014 onward, marking a first step towards clarification. A Beijing briefing convened by the Asset Management Association of China together with the Beijing Municipal State Tax Bureau three months later was more explicit. Gains realised before 17 November 2009 will not be taxed; however, withholding tax applies to gains from equity traded between 17 November 2009 and 16 November These announcements have driven QFIIs/RQFIIs to have their tax status clarified (including, but not limited to, their tax residency and the possible applicability of a double taxation treaty with all its implications), review their product provisions and put their records in order. The period for reporting by QFIIs/ RQFIIs runs till the end of July 2015, with the deadline for approval two months later. Overall, the recent tax clarifications are a positive development. In particular, managers of longer-running QFII/RQFII products should once taxes due have been settled be able to run their products free from uncertainty around Chinese corporate income taxation and related provisions. As tax-related legacy issues become obsolete, there should be more of a level playing field between QFIIs/RQFIIs and Stock Connect and be a fertile ground for product innovation. Sources: Global Tax Alert, EY, 14 November 2014; China Alert, Z-Ben Advisors, 27 February 2015; consultations with KPMG, February-March Disclaimer: The above approaches the China Corporate Income Tax and CGT issue from a general point of view and relies on different sources. It should not be taken as tax advice and/ or a recommendation. Please consult your tax advisor for more details and/or an evaluation of your personal situation if necessary. 3. Source: CEIC, Haver, Bloomberg, Wind, and Citi Research, March 2015

8 Follow BNP Paribas Investment Partners BNPPIP This material has been prepared by HFT Investment Management (HK) Limited and BNP Paribas Investment Partners Asia Limited* and is issued by BNP Paribas Investment Partners Singapore Limited ( BNPP IPS )** and BNP Paribas Investment Partners Asia Limited, members of BNP Paribas Investment Partners (BNPP IP)***. The content has not been reviewed by the Monetary Authority of Singapore ( MAS ) or the Hong Kong Securities and Futures Commission. This material is produced for information purposes only and does not constitute: 1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever; or 2. any investment advice. Opinions included in this material constitute the judgment of HFT Investment Management (HK) Limited and BNP Paribas Investment Partners Asia Limited or its relevant affiliate(s) at the time specified and may be subject to change without notice. BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited are not obliged to update or alter the information or opinions contained within this material. Such opinions are not to be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient and are not intended to provide the sole basis of evaluation of any strategy or instrument discussed herein. The contents of this material are based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the Financial Instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client s investment portfolio. Investments involve risks. Investments in emerging markets involve above-average risk. Given the economic and market risks, there can be no assurance that the Financial Instrument(s) will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the Financial Instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the Financial Instrument(s) may have a significant effect on the results portrayed in this material. Past performance is not a guide to future performance and the value of the investments in Financial Instrument(s) may go down as well as up. Investors may not get back the amount they originally invested. Any reference to past performance of any market or instrument should not be taken as an indication of future performance. Neither BNP Paribas Investment Partners Singapore Limited, BNP Paribas Investment Partners Asia Limited nor any BNP Paribas Group company accepts any liability whatsoever for any loss arising, whether direct or indirect, from the use of any part of such information. A BNP Paribas Group company may, to the extent permitted by law, have acted upon or used the information contained herein, or where relevant the research or analysis on which it was based, before its publication. This material is for the use of the intended recipients only and may not be delivered or transmitted to any other person without the prior written consent of BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited. Furthermore, any translation, adaptation or total or partial reproduction of this document, by any process whatsoever, in any country whatsoever, is prohibited unless BNP Paribas Investment Partners Singapore Limited and BNP Paribas Investment Partners Asia Limited has given its prior written consent. * BNP Paribas Investment Partners Asia Limited, 30/F Three Exchange Square, 8 Connaught Place, Central, Hong Kong. ** BNP Paribas Investment Partners Singapore Limited, 10 Collyer Quay, #33-01 Ocean Financial Centre, Singapore *** BNP Paribas Investment Partners is the global brand name of the BNP Paribas group s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner. April Design : - P