Asian Equity: Markets of choice

The Oasis of Strength that is China

The continuing double digit expansion of the Middle Kingdom is truly breathtaking, especially versus Western developed economies. The rapid industrialization and urbanization of China will continue to power its economy. And this turbo-paced growth has helped drive up the global prices of many a commodity - oil and non-oil alike (China has now overtaken Japan as the second-largest user of oil; that is to say, only the United States is a bigger petroleum-consuming nation).

Another logical corollary of China's growth has been increased employment and higher wages, which will support higher domestic consumption. According to official statistics as much as $200 billion of foreign direct investment has found its way into businesses that serve the Chinese domestic market – over the past five years. One would do well to note that China's population is zeroing in at 1.4 billion and that there is a plethora of pent-up demand. As telecommunications have been improving by leaps and bounds, mainlanders' aspirations and desires have been boosted by increased knowledge of the world outside China. Moreover, the majority of China's consumers are first-time buyers. According to General Motors, China will be the world's second-biggest auto market within the next two years.

Throughout the 1990s and right up to 2002, China's industries were concentrated on producing low-cost, low-technology and low-value-added products like garments, shoes, and consumer electronics. In recent years, however, it has been moving up the ladder even as it has retained an overwhelming, commanding lead in the lower strata of the production pyramid. The lure of its huge domestic market also allows China to drive a hard bargain in terms of technology transfer.

Notwithstanding the fact that China's $1.4 trillion economy is only a third of the size of Japan's, in recent years it has been instrumental in nurturing the stagnant Land of the Rising Sun back to a semblance of growth. China is also proving a significant catalyst to growth not only in the rest of Asia but the world over, including even the deficit-obsessed US. To all intents and purposes, China's rise is no longer a prediction; it is fait accompli. Witness that the Middle Kingdom is already the world's fastest-growing large economy, and the second-largest holder of foreign exchange reserves. Like it or not, China has become an economic behemoth by most standards.

Soft Landing, Hard Landing, No Landing?

As China's economy flies high to some dark clouds may well be gathering. Questions have arisen - and have yet to be answered - as regards the sustainability of the country's economic boom. Will there be a soft landing, hard landing or no landing? The industrialized West continues to constitute the largest export markets for emerging Asia, but International Monetary Fund figures suggest that exports between and among the economies in the region have increased steadily from about 20% of total exports in the late 1970s to 40% in 2002. Over that period, China absorbed 14% of the exports of other economies in emerging Asia; about half of these imports are for processing and re-export. Thus, the rise in intra-regional trade has been a major factor contributing to the relatively strong export performance in the Asia since 1990s. And, as mentioned above, China is a pivotal factor in this connection.

But with real gross domestic product growing at nearly 10% per annum, there are bound to be signs and omens of economic overheating here and there; real estate, cement and steel come immediately to mind. Gratifyingly, no one is more acutely aware of the hazards and challenges that lie ahead than Zhongnanhai and, where the employment imperative is not unduly jeopardised, the powers that be have been sparing little effort in trying to rein things in and cool down the domestic economy. And even more gratifyingly still, crude administrative measures are increasingly giving way to market-oriented economic policies (for example, fiscal consolidation and interest-rate hikes). In April, consumer-price inflation chalked in at a considerably lower-than-expected and non-threatening rate of 1.8%, measured year-on-year. We judge the prospects for a soft landing of the economy (i.e., real GDP growth of 8%-plus) to be the most likely scenario for China over the next year or two.

A Rising Chinese Tide Will Help Float the Boats of Japan and Rest of Asia

It will be beneficial to Japan if it chooses to work with China on both economic and geopolitical issues. In that way, Japan will be able to increasingly piggyback on China's growth rather than feeling threatened by it as to be thrust into an urge to contain the rise of Zongguo. Japan's economic expansion in recent years, has been led primarily by exports and secondarily by business outlays. At a time when the US economy is poised to slow down from 2004's stellar real gain of 4.5%, the significance of China's continued growth and absorption of Japanese exports really cannot be exaggerated.

Meanwhile, Japan's banks have made consistent and meaningful strides in balance-sheet repair. Both their ability and their willingness to lend have been substantially strengthened. Consumers have been reducing their savings ratios and continued to spend notwithstanding anaemic wages and bonuses. There are also nascent signs of life in the property markets in the major metropolises, with vacancy rates on their way down. The country's index of leading economic indicators was above 50% for the first time in five months in January. Currently at 21 times, the valuation level of the Tokyo bourse is well below historical average and strikes us as distinctly attractive. Furthermore, we are persuaded that the corporate profit recovery in Japan will be sustainable - and sustained - going forward.

The spread effect from the economic dragon that is China should also augur well for the "Tigers", in particularly North Asian markets like Hong Kong, Taiwan and South Korea. Not only have they outgrown the leading industrialised countries in the West in recent years but since the 1997-98 Asian financial crises, companies in these countries have been going through intensive and extensive restructuring to augment their balance sheets as well as improve corporate management and governance. Now, more than ever before, they have the precious opportunity of integrating more closely with China's superb and promising economic development.

Despite its enviable track record since 1979, when economic reforms first began in earnest, China's capital markets leave a lot to be desired, blighted as they are by government meddling, state ownership, ineffective regulation, poor disclosure, and lack of investor protection. This is probably befitting an emerging economy-cum-market. For equity investments, Hong Kong offers the best way to participate in the growth of China. Its corporate governance is exemplary and its regulation of capital markets has improved by leaps and bounds in recent years. Apart from the local blue chip companies, investors also have a choice of China related shares like H-shares and Red Chips as a proxy for investing in China itself.

For our favoured Asian equity markets:

  • Japan remains our preferred market, because structural reforms are in the right direction. Moving forward, the Japanese market recovery will no doubt continue to benefit from the growth shown by China and the other Asian economies
  • Hong Kong – even though it is vulnerable to higher interest rates from the US, valuation remains attractive with price-to-earnings ratio of less than 15x, not to mention the Hang Seng Index offers a dividend yield of 3%. Most importantly, Hong Kong as the gateway to China, will benefit from China's dynamic long term growth.
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