CHIPS not BRICS

Brian Lou started by pointing out that access restrictions to onshore markets are no longer an impediment for global investors. Recent reforms, like Bond Connect, CIBM Direct and QFII, have opened onshore markets, but only a few overseas institutions - such as UBS AM - have the infrastructure to trade into China's onshore markets.    

Speaking more broadly, Brian said onshore credit ratings standards and low liquidity in onshore bond markets have been limiting factors. However, Brian said that China is bringing overseas competition into the onshore credit ratings system and implementing reforms to address investors' concerns.

Looking ahead, Brian expects onshore ratings reforms, negative yields on fixed income markets around the world, and the inclusion of Chinese bonds in global indices, will likely push overseas investors to raise their allocations to China in the coming years. 

Brian said that Bond Connect is helping global investors get involved in China's onshore market and is a much quicker process in terms of setting up and operations than the QFII programs used before.

Geoffrey Wong said that Stock Connect has made a big difference for international investors.

Firstly, that's because it has made it easier for investors to trade in and out of China's onshore equities markets.

Secondly, set-up processes have been simplified so it takes about the same time to set up a Stock Connect trading account as it does for a standard brokerage account. Finally, Stock Connect has reduced trading costs.

Adolfo Oliete added that the Stock Connect is also a valuable tool for overseas-based hedge fund investors because it allows them to short A-share stocks, thus opening up alpha generation opportunities.

Firstly, China offers scale that other countries do not. For example, if you take two identical companies in terms of quality and expertise, the one based in China will have a much longer growth runway because of the size of the addressable market.

Secondly, China is also experiencing a series of structural changes, like urbanization, ageing population, and the shift from an investment-led to a consumer-driven economy, that are creating winners and losers.

Thirdly, Geoffrey observed a unique mentality on his research trips to China, 'whether companies are big or small, they are driven to be the best in the world – and you don't see this so prominently in other emerging markets.

 The last time I saw that was in the early East Asian Tiger economies, like Japan, Singapore and Taiwan, and that kind of mentality produced companies like Sony and Samsung who ended up being world leaders.' 

Finally, Geoffrey said that as an EM manager there will be a risk limit to how much you want to put into China. But for an end investor convinced about the strategic vision of higher returns available in China, then perhaps a separate allocation will provide the kind of weighting required to meet the investor's return objectives.

Geoffrey said that onshore markets are inefficient and that he estimates the average holding period on China's equity markets is around two days and that more than 80% of turnover is driven by retail investors.

That means on many days, retail investors set the price for stocks trading on the markets, which creates inefficiencies that active, fundamentally-driven investors may exploit.

Geoffrey explained that mutual funds are growing their presence in onshore markets, but that China's equity markets are likely to remain retail-driven for at least the next five years. As such, there's a good opportunity now for professional, active investors to exploit the inefficiencies in China's markets.

From a hedge fund perspective, Adolfo Oliete added that China's onshore equity markets are a quarter of the size of those in the US, but trade almost as much in dollar terms. Additionally, most of the turnover comes from investors with accounts of less than USD 10,000, who create volatility that hedge funds may exploit.

Firstly, that's because over 60% of China's debt is state-owned enterprise and local government debt, which is borrowed from state-owned banks and concentrated within the government.

Secondly, the debt is all locally funded rather than by foreign investors, which is very different to the Latin American crisis of the 1980s or the Asian crisis of the 1990s.

Finally, Geoffrey said that China still has a lot of growth potential. Unlike the Japan situation in 1990, China still has a lot of productivity gains ahead of it.

Geoff cited education statistics, saying that an average of 14% to 15% of the populations in OECD countries have university degrees, but in China around 24% of people under 25 years of age have university degrees.

For Geoffrey, that means China will have a much better educated population entering the workforce in the coming years, compared to their elders and the existing labor force and that may support productivity growth in the future.

Adolfo said it is something to be mindful of, but high debt levels are not necessarily a bad thing for hedge fund strategies because they create volatility and trading opportunities. A bigger risk would be a rollback in the opening of China's onshore financial markets to global investors.