China’s equity markets have been having a hard time finding their footing lately. The benchmark Shanghai Stock Exchange composite index, which skyrocketed 80 percent in 2009, tumbled more than 20 percent in the first five months of this year. Economic policies designed to cool off China’s booming housing market, including an increase in mortgage rates and down-payment requirements and tighter government restrictions on bank lending have thrown the markets off-kilter.
Even June’s revelation that Beijing would allow a revaluation of the yuan — a move widely seen as China’s bowing to U.S. pressure — was greeted with only brief enthusiasm. Markets in China and around the world rallied immediately after the announcement was made, only to give back most of their gains by the end of that trading session as investors realized that the revaluation would happen slowly.
[Click here to see the complete results of the All-China Research Team, including analysts ranked in the second, third and runner-up positions.]
The downturn in China’s equity markets stands in stark contrast to the nation’s economic expansion. Year-over-year gross domestic product growth surged nearly 12 percent in the first quarter, prompting the Asian Development Bank to raise its forecast for China’s 2010 growth from 8.9 percent to 9.6 percent.
With China offering such enviable economic performance but so much uncertainty over the impact of present and future policy changes on the nation’s equity markets, it’s not surprising that investors are clamoring for research and insight into what has become arguably the world’s most important economy. Portfolio managers say the firm that does the best job of publishing the type of research they find most valuable is Nomura, which leads Institutional Investor’s inaugural All-China Research Team ranking. The Japanese bank claims 14 total team positions, five more than the two firms that tie for second place: Citi and Goldman Sachs (Asia). In fourth place, with eight positions, is BofA Merrill Lynch Global Research, followed by Deutsche Bank, with six positions. Results are based on responses from 1,300 investment professionals at more than 560 institutions managing an estimated $704 billion in Chinese equities.
Many economists and market observers attribute China’s equity markets’ bleak performance in the face of its strong economic growth to the government’s decision to phase out its stimulus initiatives, which included a loosening of credit controls and an easing of property investment and ownership policies.
“The Chinese government was among the most aggressive in implementing stimulus measures amid the global financial crisis but was also among the first to exit some of them,” explains David Cui, head of China equity strategy at BofA Merrill Lynch in Shanghai and the No. 2 analyst in Portfolio Strategy. “The Chinese government started to tighten credit as early as August 2009, and the severity of its crackdown on the property market in mid-April this year caught most players by surprise,” he adds. As a result, “the Chinese stock markets, particularly the domestic A-share market, have largely underperformed the global equity market and other emerging markets over the last 12 months,” Cui says.
The CSI300 index, which maps the performance of 300 of the most highly liquid A shares on the Shanghai and the Shenzhen stock exchanges, tumbled 22.4 percent year to date through May. “The A-share market has corrected more, partly because it outperformed the other markets during 2009 and valuations were higher than the Hong Kong stocks’ and H shares’,” says Beijing-based Kelvin Koh, director of equity research for Greater China at Goldman Sachs.
Minggao Shen, Citi’s Hong Kong–based head of China research, believes that the government may have overreacted. “The latest property-tightening initiative has erased all stimulus policies in the property sector,” says Shen. He cites a Beijing municipal government mandate restricting families from buying more than one new home in the city. “These policies will effectively pull down not only leverage but also demand.”
But other market observers praise Beijing for acting quickly to deflate a housing bubble before it became unmanageable and wrought havoc in the wider economy. “The pace of the property-price increase has been too fast, relative to the growth of household income,” insists Hong Kong–based Hua He, who in May was named Nomura’s head of equities for China.
Foreign investors whose portfolios were decimated by the collapse of housing markets in Europe and the U.S. may appreciate the Beijing government’s efforts. However, their ability to invest in China remains severely limited, owing to restrictions set forth in the qualified foreign institutional investor program overseen by the China Securities Regulatory Commission. But that may be about to change. The QFII program was designed to open China’s stock markets to foreign expertise, but without allowing unlimited amounts of capital to flow into and out of the country. As of May the CSRC had approved 96 QFIIs since the program began in 2003, with $17.1 billion in assets. That represents only a fraction of the A-share market capitalization.
“Right now we estimate that QFII investors account for approximately 1 percent of the A-share market’s total cap and 3 to 4 percent of its free float — too small to make a difference,” says Cui. “But over time their status should grow as China grants more QFII quotas and ultimately allows capital to flow freely.”
China has ambitions of turning the city of Shanghai into a global financial center by 2020, he adds, “so we expect noticeable loosening of foreign investment restrictions over the next few years.”
According to Nomura’s He, foreign investors could increase their ownership of China’s A-share market to 20 percent over the next five to ten years.
In the meantime, investors are wondering whether China can maintain its fast-paced economic growth. He believes the growth is sustainable, driven mainly by urbanization as farmers continue to move into the cities. He also credits a number of government-backed stimulus measures aimed at improving infrastructure in the central and western parts of China.
“Improving infrastructure helps move capital from the coastal cities into inland areas, as goods produced there can be shipped elsewhere,” He says. “As people’s mobility improves, consumption will be stimulated.”
An increase in domestic consumption would be good news for China, whose growth has historically been fueled by exports. Demand for exports was down 16 percent year over year in 2009 but has since shot back up in 2010. “In May exports in China went up almost 50 percent year over year, due to easy base and strong external demand, but we expect the growth to slow down in the second half of the year,” notes Citi’s Shen.
If domestic demand rises to offset an expected decline in exports, China’s growth will likely continue. “If the transition can succeed over the course of the next few years, we expect GDP growth can be sustained at 6 to 8 percent within the next decade and beyond,” Shen adds.
Cui, of BofA, agrees that a greater emphasis on consumption is key to China’s future success. “China has relied on saving more, investing in capital goods, employing more people, making more things destined for the overseas market for a significant portion of its growth,” he explains. “The global financial crisis has laid bare the risks associated with this model — exports can and did collapse 20 to 30 percent, with little warning.”
Deutsche Bank’s Jun Ma, who is ranked No. 1 in Economics, is convinced that such a transition is already under way. He believes that with yuan appreciation, acceleration of wage inflation and a range of reforms to improve income distribution, domestic consumption will increase in importance. “Over time consumption will replace exports and investment as a new engine for growth in China and should support an annual average GDP growth rate of 8 percent for the next five years,” he says.
That would be a positive development for China’s equity markets, especially if foreign investors have greater access to them. Many firms are already anticipating such a change and are building teams to serve investors.
Nomura’s success in the region can be attributed at least in part to its 2008 acquisition of the Asian operations of Lehman Brothers Holdings, including its highly regarded research department. Last fall the firm appointed Mingchun Sun to head its China equity research operations; Sun, who is ranked second in Economics, also serves as Nomura’s chief China economist (the same position he held at Lehman). He oversees a Hong Kong–based team of 18 analysts who follow 164 Chinese companies.
Shen directs Citi’s squad of 27 analysts based in Beijing; they track roughly 140 companies across 20 sectors. Goldman’s China research effort is guided by Koh, who has 28 analysts in Beijing, Hong Kong, Shanghai and Taipei covering 293 stocks (including domestic and offshore listings). David Clark is in charge of Deutsche’s research operations in China; his team consists of 40 analysts in Hong Kong and Shanghai who track 185 companies.
Many research directors remain optimistic about China’s growth prospects despite this year’s market downturn. Nomura’s He forecasts China’s GDP will grow by 10.5 percent this year and 9.8 percent next year. Koh is even more sanguine, anticipating growth of 11.4 percent in 2010 and 10 percent in 2011.
Shen is more cautious. “China does not need above 8 percent growth for another decade — what it does need is to achieve a slower but sustainable growth,” he says.
