China Fund (NYSE:CHN)

China Fund Manager Still Bullish:

In May the managers visited the Shanghai Expo. Some gluttons for punishment visited it more than once. The main feature is very large crowds of bemused visitors, uncertain why they are there and forming long queues to see they know not what. Chinese markets seem similarly clueless. Are we really still panicking about South European sovereign debt? (A beneficial side-effect is that a whole generation of Chinese investors can now point to Greece on the map.) Or is the mad Dear Leader finally about to push the button? (The managers visited the North Korean pavilion, which is positioned in a kind of rogue’s alley alongside Iran and Lebanon; one of the Expo planners clearly had a sense of humour.) Certainly, the main topic of conversation among the chattering classes of Shanghai is the government’s attitude to the property market. But after the initial announcement of administrative measures against property speculation in Beijing, things have gone rather quiet, with local governments announcing watered-down measures. And, after all, interest rates have not been raised, and the real return on a Chinese bank deposit is still negative. At the end of the month there were already signs of a change in the government’s tone, as shown in news releases about the seven million welfare houses to be built at a cost of Rmb430 billion by the year-end (subtext: ‘so don’t worry about construction demand’) and insurance companies being allowed to hold an increased amount of equity (20% excluding funds).

Inflation has so far this year been led by food prices (CPI in April +2.8%, food +5.9%). The retreat in food and commodity prices indicates that inflationary pressures may have peaked. This would remove the main reason a Chinese leader would have for allowing the currency to appreciate against the US dollar, especially given what has happened to the euro. In April, import growth (+49.7% year on year) once more outpaced export growth (+30.5%), leading to an 87% fall in the trade surplus. Perhaps by this autumn the talk will be about renminbi depreciation? Not that we expect them to do this either, but that does not stop people talking (or companies with large US dollar debt positions shuffling nervously…).

There were some interesting noises on the tax front. The Ministry of Finance indicated that it would be increasing the tax that state-owned companies pay to the government (currently 10% for monopolies and just 5% for other state-owned enterprises). A resources tax was also announced, though details remain unclear (a pilot scheme of 5% of revenue is being started in Xinjiang). Yet at the same time, the 3.3% business tax on airlines’ international flights was abolished as a further bailout to this sector. Given that the government wishes to list the horrible Agricultural Bank in July, I would not bet against a similar, auspiciously timed reduction in bank business tax.

China Fund Management Remains Confident:

Excerpt from monthly insight report from China Fund Inc.

During the short month of February (only 15 trading days in Shanghai), we circled the globe talking to investors. In each location there were questions about the ‘China Bubble’, with experts in the media predicting its imminent demise. Like Cassandra, they will be right eventually, but I see no evidence on the ground of a bubble about to burst. Some of the stimulus cash will have gone astray, and non-performing loans are doubtless forming in the banking system as I write. But the loan-to-deposit ratio in the banking system was just 66.9% at the end of 2009, and the general lack of leverage at any level of the economy – personal, corporate or governmental – does not speak to me of bubbles. The main distortion, caused by the currency peg, will dissipate as currency appreciation returns and the policy initiatives to boost consumption cause the trade surplus to disappear. In January exports rose 21% year on year, but imports 85%. Retail sales during the Chinese New Year holiday were up by 17.2% year on year.

Once the misleading low-base effect fades and inflation is seen to stabilize at an unthreatening 3–4%, we expect markets to rally. The ending of the National People’s Congress (last day 13 March) will also allay fears of aggressive government counter-measures. For the first time, we have initiated a 5% long position in renminbi non-deliverable futures, in anticipation of a resumption in the yuan’s appreciation.

More evidence that supports our point of view that China is not dead.

Excerpt from monthly insight report from China Fund Inc.

During January, the Fund’s managers organized a conference on Chinese healthcare in Lijiang, Yunnan province. Regular readers of this report will know that healthcare is a sector about which we have been – and remain – bullish. Between sessions, we ascended to 4,500 metres on the highest local peak, Jade Dragon Snow Mountain. Towards the top there was much stopping to admire the view (not that we were tired or out of breath, you understand). Chinese stockmarkets also paused for breath in January as the government reacted to a revival of inflation (CPI in December reached +1.9%). The actual measures taken were mild – a 50-basis-point rise in the reserve-requirement ratio, a few money-market operations and a lot of hot air – but the markets took the moves as an inflection point and decided to book profits ahead of the Chinese New Year holiday. Continued heavy equity supply and unhelpful background noise from US politics contributed to the turn in sentiment.

The low base effect, which is boosting all kinds of statistics, including exports, production and inflation, should last through March. Thereafter, when it is clear that inflation is not going to race away and that the government is not about to stamp on the brakes, we expect the markets to rally. Many doom-laden comments about the ‘China bubble’ and its imminent demise, have caught media attention recently. We believe this is wide off the mark in a society which lacks leverage, at the individual, corporate, banking and national levels. China faces many challenges, but we believe the domestic-consumption growth story remains intact.

In certain respects, the public-spending stimulus is already being withdrawn; there has been recent news about funding difficulties for railway and electricity grid projects, and the tax break for buying small cars ended on 1 January. But the government continues to give benefits to certain areas, such as the rural economy (a new initiative helps farmers to rebuild their homes) and the service sector. There is also clear evidence of a pick-up in private investment, which should help mask the winding down of the public stimulus. Chinese exports rebounded strongly in December (+17.7% year on year), though this was largely due to the low base effect. The situation remains tough, especially as wages are again on the rise. The sharp jump in imports (+56% year on year) is, perhaps, an indicator of the future as the emphasis on domestic consumption gradually erodes the trade surplus (not great news for US bonds...).