Earnings upgrades likely for H-shares

Specialists expect accelerated appreciation of the renminbi to drive up ChinaÆs consensus earnings growth estimates.
Chinese companies listed in Hong Kong deserve an earnings upgrade because the renminbi is on course to appreciate up to 13% in 2008, say analysts who expect the Chinese authorities to use currency appreciation as a key tool this year to manage an escalating inflation threat.

For Chinese companies reporting in Hong Kong dollars, a stronger renminbi will result in a bottom line gain simply as a result of the currency translation -- something which hasn't yet been fully factored into earnings forecasts, some analysts say. And even if analysts have taken renminbi appreciation into account fundamentally, earnings forecast trackers such as the MSCI will not convert the forecasts using an expected exchange rate in the future, which means there will still be some further effect when the actual earnings are translated into the reporting currency. The consensus earnings growth estimate for the MSCI China index is 22% for 2008.

Inflation is on the rise in China, reaching 4.8% in 2007 compared to the average annual inflation of 1.5% from 2001 to 2006. It hit 7.1% in January (although part of this increase is attributed to a supply-side shortfall due to the unexpected cold weather snap that swept through the country).

Goldman Sachs, in a report published on February 22, raised its inflation forecast for China from 4.5% to 6.8% for 2008 based on monetary expansion. The bank believes ôcurrency appreciation remains a viable, and the most optimal, policy tool for China to cure its inflation problemsö, as it doubts the effectiveness of administrative controls and sees ôother policy options become more painfulö.

China raised the benchmark interest rate six times last year and the required reserve ratio 10 times in an effort to cool the economy and combat inflation. Some analysts believe the room for further interest rate hikes in China is limited with the lending rate currently at 7.47% and given that the US is adopting the opposite route of rate cuts. The required reserve ratio now stands at 15%, its highest level since 1984, following a 50bp upward revision in January.

A recent Morgan Stanley research report suggests China will continue to increase the required reserve ratio but will simultaneously allow the renminbi to appreciate to manage liquidity and inflation. Goldman Sachs also agrees currency adjustment will be an important tool to tighten monetary supply.

The renminbi will appreciate 12% against the dollar over the next 12 months versus a previous forecast of 10%, expects Goldman Sachs. And JPMorgan is even more bullish, estimating the renminbi will reach $1 to Rmb6.30 by the end of 2008, representing a 13% appreciation from current levels. The renminbi non-delivery forward curve is pricing in an 8%-10% appreciation over the next 12 months.

Despite embarking on a currency reform programme in 2005, China has been reluctant to allow the renminbi to appreciate significantly as it anticipates an adverse impact on exports. This is what happened to Japan in the 1990s, when the yen appreciated. The result is that despite large surpluses and resultant pressure from the developed world, the renminbi only appreciated 2.6% in 2005 and 3.4% in 2006.

But in 2007 the renminbi appreciated 6.9%, driven by surging international oil prices, domestic inflation and a mounting trade surplus, which hit a record $262.2 billion in 2007.

Renminbi appreciation of 7%-10% will translate to a straight bottom line earnings growth, says Garry Evans, HSBCÆs regional head of equity strategy for Asia-Pacific. He also highlights another factor: ôWeÆll have a corporate tax rate cut in China this year which will boost earnings another 6%-7%. At least a 13% increase in earnings will come from these two factors alone.ö Evans expects actual earnings growth to be over 25%.

HSBC also expects ChinaÆs real GDP growth in 2008 to remain strong at 11%. ôStrong earnings growth will continue,ö says Evans, who believes China represents good value for investors as H-shares trade cheaper than India, Hong Kong and Malaysia.

ôWe see a number of drivers suggesting profits will be stronger than market consensus, including high productivity,ö says Adrian Mowat, chief Asian and emerging markets equity strategist at JPMorgan. Mowat also suggests H-shares will ultimately be driven up by inflows from Chinese investors as mainland China is ôone of the biggest saving surpluses in the worldö.

The JPMorgan strategist expects MSCI China H-shares and red-chips will deliver a 40% return over the next 12 months.

The managed exchange rate policy adopted by China has certainly contributed to over-heating of the economy. If analysts are right that the Chinese authorities will address this by allowing the renminbi to significantly appreciate, H-shares could be one beneficiary.
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