by Mark Mobius, Vice-chairman, Franklin Templeton Investments
Chinese officials are concerned about future developments in their country. As a result of some labor shortages and rising wages in the low-end labor intensive manufacturing sector, some managers are moving parts of their production out of China to lower-cost countries such as Vietnam. This of course raises the question of unemployment in the export-oriented area which, combined with inflation, could result in social turmoil and labor unrest, if it’s not well-managed. One positive aspect is that the Chinese government recognizes the issues and addresses many of them in their new Five-Year Plan.
China’s 12th Five-Year Plan adopted in March of 2011 includes a program to shift away from its reliance on cheap exports towards greater domestic consumption. This will hopefully help to correct the trade imbalances that have developed, which are a concern to the global community, although China now dominates in so many consumer goods areas and increasingly in technical products that a stronger renminbi could result in even greater trade imbalances, at least in the short-term, since buyers have no other source of supply. The Plan calls for improvement in 12 areas: (1) growing its services such as insurance, banking, retail trade, etc.; (2) improving its industries with emphasis on added value; (3) encouraging local innovation; (4) relying less on global demand and policies; (5) reducing trade friction by increasing imports; (6) reducing the portion of investment devoted to government fixed asset investment; (7) addressing the environment to prevent further environmental degradation; (8) improving energy efficiency and thereby limiting energy demand; (9) ensuring better distribution of wealth from future economic growth; (10) preventing labor unrest by addressing workers’ rights and better union representation; (11) ensuring that citizen complaints about housing, health care, education and other areas are addressed; and (12) reducing regional disparities.
Rather than focusing purely on growth, it seems that this new plan will stress better development with an emphasis on a “harmonious society”. In order for China to make this transition, many economists realize that the government will need to rely more on private capital and market forces. This eventually amounts to a relaxation of government controls over the massive state enterprises so that they can expand internationally. In other words, the government needs to rely less on resource allocation and instead allow consumers to determine those allocations. This means that the government must focus on infrastructure, development of human capital with better educational facilities, social services and health care.
The Chinese government has been moving in that direction since Deng Xiaoping re-opened China to the world and introduced a series of economic reforms. The state-owned sector has fallen from 78% of the overall industrial output in 1978 to an estimated 30% in 2009.[1] Nevertheless, the government still exerts a high degree of control over things such as grain and energy prices, as well as wage-setting in state and many listed government-controlled companies. The new Plan calls for more market-oriented pricing, a liberalization of interest rates and a further reduction of state-owned enterprises.
Signs of an increasingly consumerist society are readily evident. China has become the world’s largest automotive market with annual sales of 18 million compared to 13 million for the U.S. [2]
We have seen an increasing use of credit cards, the rise of local minimum wages in most provinces and increasing dividend payouts to shareholders of state-owned companies. The government wants to put more money in the hands of consumers by raising bank interest rates so that they get better returns from their savings, cutting income taxes and expanding consumer credit. In addition, the government is also building more affordable housing and raising social spending so that consumers need not save as much for education, healthcare and retirement. When we consider that the current number of Chinese in the middle income class is 157 million[3], about half the size of the U.S. population, there is substantial room for expansion within the consumer-related sector.
I have heard queries from baffled investors about past underperformance of the Chinese stock market despite the long-term positive outlook for China. One key factor that I would like to stress is that, as equity investors, we look at individual stocks rather than the market as a whole. There is quite a difference between what’s happening in the domestic Chinese A share market and the H share market in Hong Kong, which is where we are buying and hold stocks. The A share market is generally closed to foreign investors, the renminbi is not convertible in this market and the capital cost structure and a systematic shortage of equity supplies; all contribute to higher volatility. In addition, the underperformance of the broader Chinese A share market last year was a result of the influx of initial public offerings, which made a strong comeback on the mainland, soaking up a significant amount of liquidity from listed stocks to higher-valued new companies. We continue to focus on the H shares and the so-called “red-chips” listed in Hong Kong, which is where we finding the most interesting opportunities. Most importantly, markets go through cycles, and investments, and the Chinese market are no exception. This underscores the importance of patience and our view that any serious investor should have at least a five year investment horizon.
[1] Source: ©2009 OECD, State Owned Enterprises in China: Reviewing The Evidence. As of January 2009.
[2] Source: China Association of Automobile Manufacturers (CAAM), as of January 21, 2011.
[3] Source: ©2010 OECD, The Emerging Middle Class in Developing Countries. As of January 2010.
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