Taking the Silk Road

“If you do not change direction, you may end up where you are heading” Lao Tzu

The Silk Road, the fabled series of trade routes that brought so much prosperity to China during its early history, is proving an inspiration to C21st Chinese leaders as they look for ways to boost the country’s slowing economy. On a trip to Kazakhstan in 2013, Chinese President Xi Jinping announced his vision of a “Silk Economic Belt,” which has subsequently been backed by massive financial investments from the newly-formed Asian Infrastructure Investment Bank and the Silk Road Fund. This new “Silk Road” was mentioned in the Communist Party’s Third Plenum policy, making it an official national strategy.

Building Chinese regional influence

The key objective of the New Silk Road plan is to “break the connectivity bottleneck” – an ambitious plan to improve communication and trade between China and its neighbours through improved infrastructure, greater cooperation among institutions and the fostering of cultural exchanges.

As the year of the goat gets underway, the concept of the “New Silk Road” will likely be a dominant feature as further details are disclosed on how the newly formed committee will put China’s large forex reserves to work. In all likelihood, China will play the role of the “one-stop-shop”, supplying funding, expertise, and equipment for regional projects. This should help both build Chinese regional influence, and promote Chinese business abroad.

While the companies which will win the biggest orders from the New Silk Road initiative will likely be the large state owned construction/rail businesses, we think there are a number of smaller businesses with the technology, experience and cost competitiveness for which this initiative can provide a far more significant stepping stone into foreign markets. For instance, Hollysys, a business which produces automation and control systems for industrial, rail and power generation clients, has for years been able to enjoy growing market share within China on account of its emphasis on research and development. However, the company, despite gaining the certifications to sell in other regions, has yet to really enjoy progress on selling its product outside greater China. It is companies such as Hollysys, which should stand to gain from China promoting domestic brands abroad.

Time for a new 5-year plan

China’s 5-year plans are a series of social and economic development initiatives; a program started by Mao in the early 1950s to embark on intensive industrialisation and socialisation. Big brush-stroke reforms in China have included the 1980s shift from collective production to a‘household responsibility system’, the 1990’s promotion of privatisation, and the reduction in trade barriers during the 2000’s. The twelfth five year plan (2011-2015) represented a further change in direction, as a greater emphasis was put on re-balancing the economy from investment towards consumption.

Rebalancing the economy

The upcoming 13th 5-year plan is likely to continue to put an emphasis on re-balancing the economy, as well as further reform of China State Owned Organisations (SOE’s), and China’s capital market. In terms of the GDP average annual growth target set within the plan, it is likely to be around 6.5% for the next five years- high enough to support development, but low enough to give policy makers room to reform. While 6.5% sounds a meaningful deceleration from growth of 7.4% in 2014, in itself a 24-year low, China’s economy is multifaceted and can continue, in our view, to present compelling investment opportunities at the stock level.

In terms of investment opportunities arising from a rebalancing of the economy, there are a vast number of businesses seeking to position themselves in a way that they can take advantage of Chinese consumption growth. However, in our view there are only a select group with a proper national brand, pricing power and with the right product positioning to profit from positive structural change. For instance, ecommerce website JD.com, has invested heavily in a national logistics network, is one of the largest online direct sales ecommerce sites and is now using its infrastructure and user volumes to develop a platform for C2C sales. The company in the short and mid-term should be able to benefit from both consumption growth in China, but also the shift into online consumption.

Promoting financial reform

In the past in China, households received a low return on their savings because of caps on bank deposit rates (which were often negative in real terms – i.e. once inflation is taken into account) and a lack of investment alternatives due to restrictions on foreign currency transactions and private ownership of housing was not common until the late 1990s. With the effective subsidy from low household deposit rates, corporate borrowers, most notably state owned organisations, paid interest rates that were often below nominal GDP growth. Financial repression in China has caused deposits to flow into institutions which are not regulated (shadow financing), and has seemingly driven a mis-allocation of capital. Foreign exchange controls have hindered China’s ambitions to promote the use of the renminbi (Rmb) in transactions. Today, however, we see financial reform being promoted as a key area of development.

While financial reform has so far proven to be a relatively gradual process, the pace of change seems to be picking up. For instance, in the last six months alone, China has allowed all foreigners to buy ‘A’ shares in Chinese companies, which up to now had only been available to mainland citizens and a select number of foreign financial institutions; banks have been given greater freedom to set interest rates on deposit accounts while the ceiling has been lifted on the guaranteed rate that can be offered on certain insurance products.

Over the next 12 months, the central bank will likely take advantage of measures to boost the economy and press ahead with further financial liberalisation. The Chinese authorities are also likely to undertake financial reforms that should help shift investment away from overcapacity in heavy industries and towards more dynamic sectors of the economy, including services. In addition, while there are naturally going to be risks of capital outflows from China, there will also likely be greater scope for foreign capital to enter into the Chinese economy. Financial reform is likely to cause a greater range in profitability amongst Chinese banks, and subsequently we consider a decoupling of the tight trading range which they all trade within. For instance, while capital market reform will probably have a negative impact on most banks’ loan business, for Bank of China, currently valued at a discount to peers on account of its exposure to overseas loans, capital market reform and the promotion of the Rmb as an international currency should allow it to re-rate as overseas Rmb lending changes from being a headwind to tailwind.

From an investment prospective, while 2015 will likely provide new challenges to a number of sectors within the economy, we think there are still a high number of very compelling opportunities for businesses standing to benefit from structural, industry and/or company change. In all likelihood, this will cause a greater uncoupling of valuations between those businesses able to embrace and profit from change, relative to those that are challenged by it.