China's next five year plan - what it means for equities Oct. 2010

8/7/2019 China's next five year plan - what it means for equities Oct. 2010

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ababcGlobal Research

Private capital and equity markets will

play a crucial role

This represents a sea change from the

bank-led, SOE-centric financing model

We analyse the sectors that could

benefit, including services and seven

emerging strategic industriesChina will officially unveil its 12

thFive-Year Plan in March

2011. We think if the government is to achieve its target of

more balanced and sustainable growth it will have to take a

new approach. This will involve real reform of income

distribution, industrial regulations and the fiscal system

(pages 4-9). Key points to look for include:

Growth targets could be lowered to stress quality over

quantity. But dont panic China always under-

promises and over-delivers when it comes to GDP.

Personal income could double through a more balanced

distribution of GDP among the government, corporate,

household and financial sectors.

Private capital, rather than state investment, will play a

much bigger role in developing service and emerging

strategic industries.

Property prices must be controlled to ensure the

continuation of the important urbanization process.

Experience from the US, South Korea and Taiwan shows the

stock market helps to drive economic transformation and

upgrade industry. This will be even more important in China

as bank lending is likely to be constrained by risk aversion

and the need to repair balance sheets (pages 17-20).

Service sectors such as IT, consumer financing, education,

healthcare and retail are significantly underdeveloped, so the

potential for growth is huge for both existing companies and

new issuers. We identify 15 listed IT outsourcing companies

worth watching (pages 21-25).

A-share stocks in seven new priority industries are fully

valued at 50-80x trailing PE. We also provide a list of 60

relevant stocks in the Hong Kong market (pages 26-31).

China Macro

Economics & Equity Strategy

Chinas next 5-yearplanWhat it means for equity markets

6 October 2010

Steven Sun ()*Head of China Equity Strategy

The Hongkong and Shanghai Banking Corporation Limited

+852 2822 4298 [email protected]

Hongbin Qu

Co-Head of Asian Economics Research

The Hongkong and Shanghai Banking Corporation Limited+852 2822 2025 [email protected]

Garry Evans*

Global Head of Equity Strategy

The Hongkong and Shanghai Banking Corporation Limited

+852 2996 6916 [email protected]

View HSBC Global Research at: http://www.research.hsbc.com*Employed by a non-US affiliate of HSBC Securities (USA) Inc,and is not registered/qualified pursuant to FINRA regulations

Issuer of report: The Hongkong and Shanghai BankingCorporation Limited

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it
http://www.research.hsbc.com/http://www.research.hsbc.com/http://www.research.hsbc.com/


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Economics: from quantity toquality of growth 4A new game plan 4

Key economic themes 5Unleashing consumer power 5

Optimising investment 6

Reform, reform, reform 7

Takeaways from provincial drafts 8

Equity: how stock market

helps and benefits? 10

Roadmap for state strategy 10

Changing economic growth model 10

Income distribution reform 13

Urbanization 15

Enter private capital 16

Stock markets crucial for economic transformation 17

US, Taiwan and Korea 17

China is no exception 19

Promoting service sectors 21

The US experience and comparison 21

From made in to serviced in China 23

Screening:15 IT outsourcing stocks 25

Emerging strategic industries 26

Does industry policy work: the old vs. new Magic 7? 26

Growth priced in and valuation rich 28

Screening: 60 relevant stocks in 7 emerging strategic

industries 30

Disclosure appendix 33

Disclaimer 35

Contents


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The consultative draft of the 12th Five-Year Plan

will be discussed at the Fifth Plenary Session of the

17th Central Committee of the Communist Party of

China, on 15-18 October 2010. Based on these

discussions, the final draft plan will be completed by

the start of 2011 and then submitted to the annual

session of the National People's Congress in March

2011 for deliberation and ratification.

A new game plan

The market is now focusing on the risk of a

double-dip in China in the coming quarters. Our

view remains unchanged: Chinas overheated

economy will continue to slow as Beijing curbs

credit but the likelihood of a double-dip is remote.

And the economy can still rely on continued

investment in ongoing infrastructure projects and

resilient consumption to grow by around 9% in

2H10 and 2011.

A more important question, we believe, is what

China can and will do over the next few years tosustain growth. President Hu Jintao mentioned

inclusive growth () in his speech at

an APEC meeting on 16 Sept, emphasising that

making all the people benefit from economic

growth is the ultimate goal of inclusive growth.

Lets take a look at some initial indications for the

key agenda in the forthcoming five-year plan.

Although China will likely overtake Japan as the

worlds second-largest economy this year, it is

still a poor country, with per-capita GDP of less

than USD4,000 per year. So the next five-year

period (2011-15) will be critical for China to

achieve its announced long-term overall goal ofquadrupling per-capita GDP by 2020 (from the

2000 level).

Policymakers are likely to make steady and

sustainable growth the most important objective,

with structural adjustments and reforms as the

policy tools. However, against the backdrop of the

sluggish recovery of the developed world, we

believe they have a challenging task ahead,

especially given the decades of double-digit

growth and the prolonged sluggish recovery in

developed economies.

Economics: from quantityto quality of growth

Achieving more balanced and sustainable growth will be the key

policy objective of Chinas 12th five year plan

This requires real reforms of income distribution, industrial

regulations and fiscal system

Further steps towards financial reforms are also necessary to

unleash the power of consumers and inland regions

Hongbin Qu

Co-Head of Asian EconomicsResearchThe Hongkong and ShanghaiBanking Corporation Limited+852 2822 [email protected]

Jun Wei SunChina Economist


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Key economic themes

What can we expect from Beijing for the next

five-year period? As weve said earlier, we

believe structural adjustments and reforms to

achieve more sustainable and balanced growth are

likely to be the key policy focus. In other words,

the quality and sustainability rather than the speed

of growth will matter most.

Unleashing consumer power

One key theme is likely to be making the

economy more domestically demand-driven, with

a larger contribution from private consumption.

Indeed, the share of private consumption to GDP

fell to 36% in 2009 from nearly 50% 20 years ago

(see Chart 2). In recent years, despite Beijings

intensified pro-consumption measures (including

improving the social security network and

subsidies on durable goods), even faster growth in

investment pushed the ratio of investment to GDP

higher. This imbalance became even more

pronounced last year due to the investment-centric

stimulus package.

There will likely be more efforts to boost Chinese

consumer power. Increasing household income

and lifting the propensity to consume are

important. To achieve the former, reforms are

needed in the income distribution system and the

income gap needs to be narrowed. The latter

Table 1. Five-year plans: a snapshot

Five year plans Period GDP (USDbn,current price,

period end)

Actualgrowth

Targetedgrowth

Key agenda

12th 2011-2015 n.a. n.a. n.a. Making growth more balanced and sustainable will likely be the mainobjective. Key items on the agenda will include reforming incomedistribution, boosting the social security system, promoting investmentin less developed regions, encouraging private investment, reformingthe resources pricing system, and further reforms of financial markets.

11th 2006-2010* 5,695 11.4 7.5% Growth driver shifting from investment and exports to coordinatedgrowth between investment and consumption, domestic demand andexternal demand; industrial structural change from secondaryindustry-led to balanced driver by three industries and structuralupgrading; save energy, protect the environment and promoteresource efficiency; continuous reform to allow market to play a majorrole in resource allocation

10th 2001-2005 2,260 9.76 7% Structural adjustment to achieve profitable growth; strengthenagricultural sector, speed up industrial restructuring and structuraloptimisation, promote service sectors, strengthen infrastructureconstruction; expand employment, increase household income, adjustincome distribution, improve social security

9th 1996-2000 1198 8.62 8% Quadruple GDP by 2000 from 1980 level; eliminate poverty, achievexiaokang life; accelerate the building-up of modern enterprises (SOEsreform), establish socialist market economic institutions

8th 1991-1995 728 12.28 6% Deepen reform to facilitate economic growth, reduce the imbalancebetween agricultural and secondary industries and the imbalancebetween basic industries/infrastructure and manufacturing sectors;technology upgrading for key enterprises; opening-up to expandexport income and invite foreign capital, technology and humanresources

* based on HSBC estimatesSource: HSBC

Chart 2. Investment rising faster than consumption (%)

20

25

30

35

40

45

50

55

1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Private consumption Capital formation

Source: CEIC, HSBC


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implies the need to continue reforming the social

security system, and expanding the coverage of

social security to the rural population.

Reforming income distribution

The long-awaited income distribution reform is

likely to mainly target primary distribution, with

secondary distribution as a supplement. Overall

labour compensation has been falling sharply as a

percentage of GDP, while government tax income

and enterprises profit have both increased (Chart3). Hence, as wage income accounts for the lions

share of household income, private consumption

has fallen as a proportion of GDP (see Chart 4).

If successful, the reform is likely to increase the

share of labour compensation and consequently the

share of private consumption to GDP. To achieve

this, policy makers need to increase incomes (wages)

and reduce the tax burden of Chinese households.

Minimum wage and collective wage consultation

systems are likely to be more widely implemented.

Raising the threshold of personal income tax and

levying family-based income tax are also possible

solutions.

Income distribution reform also requires

corresponding reform of enterprise taxation it

will take a slice from companies profits, and so

will likely meet with resistance. Therefore it will

be a challenge for Beijing to design a

comprehensive reform package, including wider

tax reform, and strictly reinforcing employers

contributions to social security.

Boosting the social security system

To increase the propensity to consume, it is

critical to improve social security provisions and

build more public housing for low-income groups.

As the social security system has been in better

shape in urban areas than in rural ones, the focus

will be on the latter.

Meanwhile, reforming the residents registration

(a.k.a. hukou) system will likely be another

important tool to accelerate urbanisation. This

should provide a long-term growth driver as new

urban residents start buying modern home

appliances, eating out more frequently and going

on holiday more often.

Optimising investment

Does lifting private consumption mean depressinginvestment? Not really. Investment will continue

to be a key growth driver in the next five years,

but the structure and efficiency of investment

need to change.

Promoting investment in less developed

regions

Investment is likely to focus on the less-developed

inland regions to improve infrastructure and

Chart 3. The falling share of labour compensation in GDP Chart 4. Private consumption moves in line with labourcompensation

53

14 1320

40

15 14

31

0

10

20

30

40

50

60

Labourcompensation

Depreciation Tax Profit

(As % of GDP)

1997 2007

30

40

50

60

1997 1998 1999 2000 2001 2003 2005 2006 2007

(As % of GDP)

Labour compensation Private consumption

Source: CEIC, HSBC Source: NBS, HSBC


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industry. This will allow inland provinces to catch

up and promote more balanced growth across the

nation. Such initiatives are reflected in a slew of

regional plans, such as the Western

development initiative. More are in the pipeline.

Property investment will likely be supported by

both public and private investment. The rules

curbing speculative demand are likely to stay in

place in the medium term. This is critical to

ensuring that property prices rise gradually ratherthan rapidly. This, coupled with the likelihood of

introducing property taxes and other regulations

for developers, should help achieve the well-

regulated development of the property market and

rational property investment. The initiative of

building more public housing should continue

over the next five-year period, lending support to

property investment.

Industrial investment is likely to be skewed

towards energy efficiency and strategically new

industries. The focus will likely lie in equipment

and technology upgrades to adopt advanced

capacity or investment in new industries. This is

likely be facilitated by preferential tax policies.

For example, government subsidies on electric

cars and subsidies on interest payments to new

energy enterprises should encourage investment in

these areas. This is essential for China to achieve

its target of reducing energy intensity by 40-50%

by 2020 (from the 2005 level), which Premier

Wen committed to at the Copenhagen Climate

Change Summit.

Encouraging private investment

We also expect the further deregulation and

opening up of investment policy to encourage

more private investors. The State Councils

circular in May to lift private investment should

be effective in the coming years.

Last but not least, China should continue to

reform the resources pricing mechanism and

interest rate formation scheme to properly reflect

the cost of investment.

Reform, reform, reform

The importance of reforms has just been stressed

by Premier Wen during his recent visit to

Shenzhen, while Vice Premier Li Keqiang

Wens likely successor also underlined reforms

to promote the transition of economic

development patterns.

Reforms should be comprehensive: from changing

the hukou system to accelerating the pace of

urbanisation the long-term growth driver to

fiscal reforms, and from further openness and

more direct financing in the capital markets to

promoting the use of the renminbi in international

trade and investment.

Urbanisation to speed up

In the 11th five-year plan, Beijing set the target of

urbanisation rate at 47% by the end of 2010. Thiswas reached in 2009. In the 12th five-year plan, a

new target of 55% by the end of 2015 is expected,

which suggests nearly 150m people will move to

urban areas in the next five years.

Liberalizing the Hukou system will effectively help

Chinas 120m migrant workers better integrate into

cities. Household registration constraints in

metropolises such as Beijing and Shanghai are not

likely to be loosened to migrant workers in the

foreseeable future. However, there may be more

flexibility in medium and small sized cities that are

more attractive to migrant workers in that they offer

better education, medical facilities and relatively

affordable housing.

This will certainly boost investment demand for

city infrastructure. In the meantime, as income

rises, these new urban citizens are most likely to

consume as much as established city residents.

This incremental demand will be a strong driving

force that could sustain Chinas economic growth

at a relatively rapid pace for the next 5-10 years.


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Now for the hard part of fiscal system reform

Chinas central government pockets more than

half of the national fiscal revenues, but

expenditure accounts for only 20%, delivering

much of the surplus to local governments in the

form of transfer payments (expected to total

RMB3trn in 2010, or 65% of total central

government expenditure). Local governments

undertake most public expenditure such as

medical care, education and social security but

they have limited financial resources and tools.

This is the key factor behind the underdevelopment

in Chinas social security system. Top leaders need

to sort out ways to streamline responsibilities and

financial resources between central and local

governments. This is crucial for the implementation

of Beijings plan of strengthening public expenditure,

especially in rural and western areas, so that both

urban and rural residents can enjoy equal basic

public services.

Developing bond market

Chinas bond market, especially the inter-bank

bond market, sustained rapid growth in the past

few years, with overall market cap reaching

RMB18trn. But the bond market is still in its

infancy relative to indirect bank financing. The

RMB4trn stimulus package has aggravated the

situation as local governments borrowed heavily

from banks via financing vehicles for

infrastructure projects to support economic

growth. By allowing local governments to issue

municipal bonds, China can not only facilitate the

development of bond market, but also address the

needs of local governments infrastructure

investment. At the same time, it might allow

Chinas banks to avoid contingent system risk

(local government related credit totalled

RMB7.7trn according to the CBRC).

The development of the bond market is closelyconnected with liberalization of interest rates.

After years of effort, Chinas Treasury bondrates,

inter-bank corporate bond rates and policy

financial bond rates have all been liberalized. The

next step is to free traditional bank lending and

deposit rates, which is crucial to Chinas banking

sector reform.

Growth shifts to inland regions

Economic growth in Chinas western region has

accelerated in the past few years, recording

double-digit GDP growth for eight consecutive

years. This is thanks to Beijings preferentialpolicies and industrial outsourcing from coastal

areas. Western regions GDP grew by 13.5% y-o-

y in 2009, outpacing coastal provinces for the

third year running, with the latter suffering from

the external shock of the global financial crisis.

Top leaders reiterated policy support to the

western region on July 6 this year, launching a

new round of development plans. Planned

investment totalled RMB682bn in 2010, mostly

infrastructure projects, such as power grids,

railways, roads, and water conservancy. Since

infrastructure in inland provinces lags behind

coastal regions, this will certainly boost

investment in the western region.

To balance development between coastal and

inland regions, better co-ordination is needed.

This involves building appropriate transportation

and communications infrastructure in inland

regions and providing tax preference policies.Beijing can also help coastal regions to upgrade

their industrial base so that they can move up the

value chain.

Takeaways from provincialdrafts

Lets get some quick takeaways from the drafts of

provincial plans:

Coastal Guangdong province the largest

province in terms of economic scale,

representing 11% of the countrys GDP is


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setting a target of 8% GDP growth and 7%

per-capita GDP growth in the 12th

FYP. It

will introduce structural adjustments to make

the economy more balanced, driven by

consumption, investment and exports. It also

aims to lift foreign investment and curb

investment in backward capacity and projects,

and to boost service industries to make the

economy less dependent on manufacturing.

In inland southwest Chongqing, the largestmunicipal city and home to nearly 30m

people, the government targets RMB1,400bn

GDP in 2015, nearly double the expected

GDP in 2010. The strategy is to build up the

manufacturing base and services centre in the

southwest, with a RMB4trn investment plan

(doubling that in the 11th

FYP) and the non-

agriculture sectors making up 95% of GDP

(vs 90.7% in 2009).

In the middle of country, Henan province, the

second-most populous province with 95m

people, the government aims to double per-

capita GDP from USD3,000 to USD6,000 by

2015. While urbanisation and industrialisation

should be the dual growth engines, it also

emphasises adjusting primary income

distribution to lift the incomes of low and

mid-income groups.

It is inevitable that the central government and

provincial leaders will put a different emphasis on

certain issues. It is interesting to note that

provincial plans traditionally have a higher

growth target than the national one and local plans

normally get earlier approval.

Local governments tend to strive for big goals and

can sometimes be short sighted. As a result the

quality of growth gives way to quantity of growth

at the local level, leading to persistent imbalancesand significant cost in terms of the environment

and resources. To avoid this, Beijing also needs

political reform to change evaluation standards for

local officials, with less weighting given to

quantity of growth and more to quality.


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Roadmap for state strategy

Changing economic growth model

HSBC China economists expect the strategic

focus to shift from quantity to quality of growthfor the next five-year plan. Its easier said than

done. In 2001-2010f, the average share of

consumption expenditure to GDP growth has

actually dropped by 14ppts to 43%, while that of

capital formation has gone up by 18ppts to 54%

and an astonishing 95% in 2009 (chart 5), thanks

to the RMB4trn stimulus package.

At the risk of simplification, the top two strategic

goals on the economic front are higher growth

contribution from domestic demand, particularly

private consumption, and lower carbon intensity

40-45% reduction by 2020 from the 2005 level.

Its interesting to note that for the past 30 years

(1980-2009) there are 15 years with above 10%

real GDP growth. It appears growth has been

more balanced in years of relatively lower growth

on average a 4ppt higher contribution from

consumption and 18ppt lower from investment

(chart 6). Hence its possible that China may

target slightly lower GDP growth for the 12th

Five-Year Plan (chart 7).

But dont panic China always under-promises

and over-delivers on economic growth targets. As

a reference, HSBC China economists forecast

8.9% and 8.6% GDP growth for 2011 and 2012,

respectively.

Apart from the US, which over-consumes, and

China, which under-consumes (consumption is

only 36% of the economy), all other G7 and BRIC

countries have similar levels of consumption-to-

GDP ratio, averaging 58%. Moreover, the higher

the share of consumption, the lower the carbon

intensity (chart 8), so they are really two sides of

the same coin.

China announced at the Copenhagen climate

summit in November 2009 that by 2020 it will

reduce its carbon intensity, the CO2 emitted per

unit GDP, by 40-45% from 2005 levels. This

target will measure only the emissions from

energy consumption and industrial activity. The

target implies a 3.3-3.9% compounded annual

reduction for China, which is largely inline with

what China has achieved in 1980-2005 (chart 9).

But its worth pointing out the ratio rebounded by

14% in 2002-05, according to the World

Resources Institute.

Equity: how stock markethelps and benefits?

Equity markets will play a crucial role to drive the transformation,

moving away from the bank-led and SOE-centric financing model

Service highlights: IT outsourcing, education, healthcare and retail

Emerging strategic industries: Will the policy work? Is it priced in?

Steven Sun ()*Head of China EquityStrategyThe Hongkong and ShanghaiBanking Corporation Limited+852 2822 [email protected]

Devendra Joshi*Strategy Associate

*Employed by a non-US affiliateof HSBC Securities (USA) Inc,and is not registered/qualifiedpursuant to FINRA regulations


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Chart 5. Quality of growth has deteriorated in the past decade (2001-2010) compared to 1991-2000

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1981 (6th FYP) 1986 (7th FYP) 1991 (8th FYP) 1996 (9th FYP) 2001 (10th FYP) 2006 (11th FYP) 2011f

Share to GDP Growth: Final Consumption Expenditure Gross Capital Formation Net Exports

Consumption: 57% in 1991-2000 to 43% in 2001-2010f; 14ppts

Inves tments: 36% in 1991-2000 to 54% in 2001-2010f;18ppts

Source: CEIC, HSBC Economic Research

Chart 6. GDP growth: quantity vs. quality in 1980-2009 Chart 7. 12th FYP likely to target lower economic growth

0%

10%

20%

30%

40%50%

60%

70%

Consumption to

GDP Grow th

Gross C apital

Formation

Net ex ports

Contribution

Below 10% GDP Growth Above 10%

12.3%

8.6%

9.8%11.4%

0%2%4%6%8%

10%

12%14%16%

8th FYP

(1991-

1995)

9th FYP

(1996-

2000)

10th FYP

(2001-

2005)

11th FYP

(2006-

2010)

12th FYP

(2011-

2015)

Targeted Acutal GDP CAGR

?

Source: CEIC (15 years real GDP growth below 10%; 15 years higher than 10%) Source: HSBC Economic Research

Chart 8: Higher consumption lower carbon intensity Chart 9. A tall order to cut carbon intensity by 40-45%

USAUK

Japan

China

IndiaBrazilRussia

20%

30%

40%

50%

60%

70%

80%

90%

100 300 500 700 900 1100

2005 CO2 intensity

2009 consumption/GDP

Continental Europe

Canada

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

Brazil

Ind

ia

Ita

ly

Japa

n

Kore

a

Canad

a

Russ

ia

U

S

U

K

Franc

e

German

y

Chin

a

Taiwa

n

CO2 Intensity C AGR (1980-2005)

Implied by China's 2005-2020

goal or 3.3-3.9% per year

Source: CEIC, WRI (unit: metric tons of CO2 emission per mn PPP intl 2005 dollars) Source: WRI


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In our view there are three major tasks involved in

rebalancing domestic and external demand, which

is imperative given the sluggish recovery outlook

in the developed countries and the emerging

labour movement in China (please refer to China

Investment Atlas Issue 27, Workers united!,

July 2010):

Income distribution reform the State

Council has already indicated its intention to

double disposable personal income during the12th Five-Year Plan period, inferring a 15%

CAGR in 2011-15.

Accelerating urbanization in western

regions Assuming Chinas urbanization rate

will reach 65% by 2030e, the size of the

urban population could grow by 200-300m in

the next two decades, averaging 10-15m per

year and providing stimulus for both

consumption and investment.

Encouraging private investment Further

deregulate and open up the state monopolized

industries to encourage private capital to

supplement public investment. The private

sector is more efficient and generates more

jobs, boosting consumption.

To strive for lower carbon intensity and a greener

economy, China will upgrade existing industries

and cultivate emerging strategic industries:

Industry upgrading Deepen pricing reformof energy and natural resources products to

normalize subsidized prices. Speed up

industry consolidation to digest overcapacity

and cut back on high pollution and high

energy-consuming sectors. Accelerating

growth of producer services sectors.

Emerging strategic industries Energy-

saving and environmental protection; next

generation information technology; bio-

technology; high-end manufacturing; new

energy; new materials; clean-energy vehicles.

Chart 10. A road-map for the 12th Five-Year Plan (2011-15)

Industry upgradingEmerging strategic

industries

Accelerating transformation of Chinas economic growthmodel to focus more on quality & sustainability of growth

(Likely to target lower GDP growth in 2011-2015)

Higher domestic demand(esp. consumption)

Lower carbon intensity(40-45% reduction by 2020)

Urbanization(esp. western regions)

1. Raise the share of laborcompensation in G DP byhigher w age and lower tax

2. Better implementation ofminimum wage & collective

wage consultation systems3. More fiscal spending toimprove peoples livelihood

1. Pricing reform of energy& natural resources product

2. Speed up consolidation to

digest industry overcapacity;cut back on high pollution &

energy-consuming sectors3. Accelerating growth ofproducer services sectors

1. The Magic 7 Energy-saving and environmentalprotection; next generationinformation technology; bio-technology; high-end

manufacturing; new energy;new materials and clean-energy vehicles

1. Opinions on Encouragingand Guiding HealthyDevelopment of PrivateInvestment, New 36 clauses

2. Private sectors tend to

have higher efficiency andgenerate more jobs hencealso helping consumptions

1. Urbanization rate couldtop 65% by 2030e from46.6% in 2009 (only 38% inwestern regions in 2008)

2. 24 r egional development

plans unveiled since 20083. Further reforms on Hukousystem and land transfer

Encouraging privateinvestment

Income distributionreform

Industry upgradingEmerging strategic

industries

Accelerating transformation of Chinas economic growthmodel to focus more on quality & sustainability of growth

(Likely to target lower GDP growth in 2011-2015)

Higher domestic demand(esp. consumption)

Lower carbon intensity(40-45% reduction by 2020)

Urbanization(esp. western regions)

1. Raise the share of laborcompensation in G DP byhigher w age and lower tax

2. Better implementation ofminimum wage & collective

wage consultation systems3. More fiscal spending toimprove peoples livelihood

1. Pricing reform of energy& natural resources product

2. Speed up consolidation to

digest industry overcapacity;cut back on high pollution &

energy-consuming sectors3. Accelerating growth ofproducer services sectors

1. The Magic 7 Energy-saving and environmentalprotection; next generationinformation technology; bio-technology; high-end

manufacturing; new energy;new materials and clean-energy vehicles

1. Opinions on Encouragingand Guiding HealthyDevelopment of PrivateInvestment, New 36 clauses

2. Private sectors tend to

have higher efficiency andgenerate more jobs hencealso helping consumptions

1. Urbanization rate couldtop 65% by 2030e from46.6% in 2009 (only 38% inwestern regions in 2008)

2. 24 r egional development

plans unveiled since 20083. Further reforms on Hukousystem and land transfer

Encouraging privateinvestment

Income distributionreform

Source: HSBC Equity Strategy Research


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Income distribution reformThe 12th Five-Year plans to double disposable

personal income (DPI) through various channels

and approaches (Charts 11-12). This suggests

15% CAGR of DPI in 2011-15 and a more

balanced distribution of GDP by the government,

corporate, household and financial sectors:

Labour compensation (83% share in

disposable income) We have seen minimum

wage requirements increase 10-30% acrossChina this year, though consensus appears to

be this should be largely determined by the

market. That said, collective wage

consultation is expected in 2011 to better

protect workers interests.

Property income (4%) Interest rate

liberalization and mandatory dividend payout

for listed companies are the best way to

increase property income, e.g., a 1ppt higher

depository rate equals RMB200bn income

transfer to households.

Operational income (12.5%) Promote

family services through efforts in five areas.

Transfer income (10%) Increase share of

fiscal spending on social security and

employment, medical and health care, public

housing and education.

Individual income tax (-2%) Further tax

reforms such as raising the threshold, linking

threshold to inflation, more special deduction

items or simplifying cumulative tax rates.

Social securities contribution (-7.5%) Lower

both employer and employee contributions by

beefing up the National Social Security Fund

(NSSF). Examples include the 2009 regulation

on share transfer to the NSSF from domestic

listed SOEs and dividend transfer from SOEs at

parent group level.

Break up the SOE monopoly by increasing

market competition from the private sector.

Chart 11. Analyzing income distribution reform

Secondary distribution government drivenPrimary distribution largely market driven

+ (83% share)Labor remuneration

+ (4%)Property income

+ (12.5%)Operational income

+ (10%)Transfer income

1. Regulations on minimumwage, in 2004 by Ministryof Labor and SocialSecurities minimumwage shall be adjusted atleast once every two yearsand shall make referenceto 40-60% of local averagewage level;

2. The new labor contractlaw in 2008 strengthenedprotection of laborsinterests;

3. To establish andimplement collective wageconsultation systems,

expected in 2011

1. Income from smallbusiness operation or self-employment

2. State Council issuednew regulation inSeptember 2010 topromote family servicesthrough efforts in fiveareas. Family services

business employ some15mn people and generatearound RMB160bnrevenue each year

3. Various preferential taxand credit policies tofacilitate self-employment

of laid-off workers andfresh college graduates

1. Increase fiscal spendingon social security andemployment, medical andhealth care, public housingand education

2. Health care reformlaunched in 2009 toprovide a wider coverageof basic medical insurance

system (RMB850bncommitted in 3 years)

3. The new rural pensioninsurance system initiatedin 2009 covered 10% of allcounties, with the goal toextend to all farmers by

2020

1. Interest income ofsaving deposits isexempted from income tax.But the real issue is whenChina will push for interestrate liberalization;

2. CSRC publishedregulation in 2008 toenforce higher dividend

payment for listedcompanies that plan to dosecondary offering. Butactual payout ratio is stillvery low;

3. 2010 new regulationraises land acquisition

compensation standard by20-30%

1. Individual income tax(IIT) threshold was raisedto RMB1,600 yuan permonth from RMB800 yuanin 2005

2. IIT threshold was raisedagain to RMB2,000 yuanfrom RMB1,600 yuanin2008

3. Further reforms on IITtax code such as raisingthreshold further, linkingthreshold to inflation, morespecial deduction items orsimplifying cumulative taxrates (say from nine tax

categories to five)

1. Lower the burden -currently employercontributes 33%+ of basicsalary as pension (20%),medical (10%), on-jobinjury, unemployment andmaternity insurance; whileemployee contributes over10% of basic salary

2. How? more funding forthe National SocialSecurity Fund (NSSF)such as the 2009regulation on sharetransfer to NSSF ofdomestic listed SOEs and

dividend transfer fromSOEs at parent group level

- (2%)Individual income tax

- (7.5%)Social securitycontribution

Income distribution reform to double disposable personal income in 2011-2015

Secondary distribution government drivenPrimary distribution largely market driven

+ (83% share)Labor remuneration

+ (4%)Property income

+ (12.5%)Operational income

+ (10%)Transfer income

1. Regulations on minimumwage, in 2004 by Ministryof Labor and SocialSecurities minimumwage shall be adjusted atleast once every two yearsand shall make referenceto 40-60% of local averagewage level;

2. The new labor contractlaw in 2008 strengthenedprotection of laborsinterests;

3. To establish andimplement collective wageconsultation systems,

expected in 2011

1. Income from smallbusiness operation or self-employment

2. State Council issuednew regulation inSeptember 2010 topromote family servicesthrough efforts in fiveareas. Family services

business employ some15mn people and generatearound RMB160bnrevenue each year

3. Various preferential taxand credit policies tofacilitate self-employment

of laid-off workers andfresh college graduates

1. Increase fiscal spendingon social security andemployment, medical andhealth care, public housingand education

2. Health care reformlaunched in 2009 toprovide a wider coverageof basic medical insurance

system (RMB850bncommitted in 3 years)

3. The new rural pensioninsurance system initiatedin 2009 covered 10% of allcounties, with the goal toextend to all farmers by

2020

1. Interest income ofsaving deposits isexempted from income tax.But the real issue is whenChina will push for interestrate liberalization;

2. CSRC publishedregulation in 2008 toenforce higher dividend

payment for listedcompanies that plan to dosecondary offering. Butactual payout ratio is stillvery low;

3. 2010 new regulationraises land acquisition

compensation standard by20-30%

1. Individual income tax(IIT) threshold was raisedto RMB1,600 yuan permonth from RMB800 yuanin 2005

2. IIT threshold was raisedagain to RMB2,000 yuanfrom RMB1,600 yuanin2008

3. Further reforms on IITtax code such as raisingthreshold further, linkingthreshold to inflation, morespecial deduction items orsimplifying cumulative taxrates (say from nine tax

categories to five)

1. Lower the burden -currently employercontributes 33%+ of basicsalary as pension (20%),medical (10%), on-jobinjury, unemployment andmaternity insurance; whileemployee contributes over10% of basic salary

2. How? more funding forthe National SocialSecurity Fund (NSSF)such as the 2009regulation on sharetransfer to NSSF ofdomestic listed SOEs and

dividend transfer fromSOEs at parent group level

- (2%)Individual income tax

- (7.5%)Social securitycontribution

Income distribution reform to double disposable personal income in 2011-2015

Source: HSBC Equity Strategy Research (disposable income breakdown calculated on 2007 statistics)


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We have conducted an attribution analysis on the

declining share of DPI to GDP, by 12ppts to 57%

in 1992-2007 (chart 42), which helps to reveal the

various causes of the problem. The shaded

columns on the left show how the GDP is divided

after the primary and secondary distributions

among the government (mainly tax revenues),

non-financial corporate (mainly profits) and

households (mainly labour compensation), with

the balance going to financial institutions:

For the 15-year period 1992-2007, the

government sector, corporate and financialsectors represented some 30%, 55% and 15%

of the declining share of DPI, respectively.

In 1992-97, the share of DPI remained largely

flat at two-thirds of GDP, while corporate

profits had gained share mainly at the expense

of government tax revenues.

In 1997-2002, the share of DPI dropped

7.3ppts, with some 40% attributable to the

higher share of the governments disposable

income in GDP and the other 60%

attributable to the corporate sector.

In 2002-07, the share of DPI had dropped

4.2ppts, which mainly benefited the

government sector.

The columns on the right show five categories of

the DPI labour compensation, fiscal transfer

from the government, personal income tax and

social security contributions, income from

property and operational income:

Declining share of labour compensation,

which accounts for 83% of DPI, contributed

7.5ppts to the 11.9ppts share loss of DPI.

Share of fiscal transfer in GDP increased less

than 1ppt but share of personal income tax

and social securities contributions went up by

nearly 3ppts, resulting in a net decline of

2.2ppts of DPI, or some 20% of total loss.

Share of income from property in GDP,

mainly interest income and dividends,

declined 2.1ppts and explained another 20%

loss of DPIs share in GDP.

It suggests corporate, government and financial

institutions should all contribute in order to

reverse the trend.

Chart 12. Attribution analysis on the declining share of disposable personal income (DPI) to GDP, or 12ppts in 1992-2007

GDP(RMB

bn)

Gov't % ofGDP

Corp.profit

% ofGDP

DPI % ofGDP

LabourComp.

LC-to-GDP

FiscalTransfer

FT-to-GDP

Fiscalcontri.

FC-to-GDP

Incomefrom

Propert.

IP-to-GDP

Operat.income

OI-to-GDP

1992 2,692 539 20.0% 285 10.6% 1,845 68.5% 1,470 54.6% 132 4.9% -66 -2.5% 119 4.4% 191 1993 3,533 694 19.7% 503 14.2% 2,283 64.6% 1,817 51.4% 171 4.8% -95 -2.7% 179 5.1% 211 1994 4,820 893 18.5% 642 13.3% 3,229 67.0% 2,521 52.3% 214 4.4% -119 -2.5% 275 5.7% 338 1995 6,079 992 16.3% 884 14.5% 4,029 66.3% 3,209 52.8% 273 4.5% -147 -2.4% 295 4.9% 398 1996 7,118 1,257 17.7% 867 12.2% 4,813 67.6% 3,709 52.1% 333 4.7% -184 -2.6% 367 5.1% 588 8.31997 7,897 1,436 18.2% 966 12.2% 5,384 68.2% 4,187 53.0% 458 5.8% -228 -2.9% 335 4.2% 632 8.01998 8,440 1,512 17.9% 1,077 12.8% 5,704 67.6% 4,432 52.5% 469 5.6% -250 -3.0% 358 4.2% 695 8.2%1999 8,968 1,609 17.9% 1,223 13.6% 5,973 66.6% 4,713 52.6% 472 5.3% -254 -2.8% 302 3.4% 740 8.2%2000 9,921 1,892 19.1% 1,582 15.9% 6,325 63.8% 5,002 50.4% 452 4.6% -339 -3.4% 309 3.1% 902 9.1%2001 10,966 2,230 20.3% 1,850 16.9% 6,744 61.5% 5,437 49.6% 530 4.8% -412 -3.8% 327 3.0% 861 7.9%2002 12,033 2,524 21.0% 2,018 16.8% 7,330 60.9% 6,065 50.4% 665 5.5% -544 -4.5% 339 2.8% 806 6.7%2003 13,582 3,006 22.1% 2,220 16.3% 8,171 60.2% 6,683 49.2% 765 5.6% -665 -4.9% 327 2.4% 1,059 7.8%2004 15,988 3,052 19.1% 3,608 22.6% 9,339 58.4% 7,525 47.1% 896 5.6% -762 -4.8% 254 1.6% 1,425 8.9%2005 18,494 3,825 20.7% 3,602 19.5% 11,061 59.8% 9,280 50.2% 1,014 5.5% -923 -5.0% 347 1.9% 1,343 7.3%2006 21,631 4,902 22.7% 3,790 17.5% 12,653 58.5% 10,537 48.7% 1,199 5.5% -1,125 -5.2% 511 2.4% 1,532 7.1%2007 26,581 6,308 23.7% 4,551 17.1% 15,082 56.7% 12,517 47.1% 1,493 5.6% -1,426 -5.4% 615 2.3% 1,883 7.1%97/92 -1.8% 1.7% -0.4% -1.6% 0.9% -0.4% -0.2% 0.9%

02/97 2.8% 4.5% -7.3% -2.6% -0.3% -1.6% -1.4% -1.3%

07/02 2.8% 0.4% -4.2% -3.3% 0.1% -0.8% -0.5% 0.4%

07/92 3.7% 6.5% -11.8% -7.5% 0.7% -2.9% -2.1% 0.0%Source: CEIC, HSBC Equity Strategy Research


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UrbanizationUrbanization has been identified as the single

most important factor for domestic demand

growth. The government is pinning its hopes on

accelerating urbanization in western regions as a

policy platform to gradually solve the long-term

economic challenges such as imbalanced regional

development levels, the urban-rural divergence

and industry upgrading. Property prices must be

controlled to ensure the pace of urbanization

process wont become stalled.

Estimates from various academic sources, as well

as comments from government officials, suggest

Chinas urbanisation rate could go up from 47%

to 65% by the end of 2030 and eventually reach

70-80% by 2050 (chart 13). Even if the 150-170m

migrant workers are counted as urban residents,

the potential upside could still be 10-20ppts.

From an investment perspective, urbanization

boosts both the property sector and publicinfrastructure investments. For instance, 10-15m

new urban residents every year could translate

into 100-150m sqm of potential housing demand,

assuming 10 sqm per person (the national average

living standard for the low-income group in urban

areas). Regression for the past two decades also

suggests that around 20% of the potential demand,

or 20-30m sqm, could be realized as residential

floor space sold in a year, representing 3-5% of

incremental demand.

Urbanization could also propel consumption

growth through the growing pool of urban

consumers. Urban per capita consumption in 2009

stood at RMB12,265 (USD1,800), or 3.5 times

that of rural areas. For the top 36 cities in China,

average consumption expenditure was

RMB15,604 (USD2,200), or 4.5 times.

Further liberalization of the urban household

registration system, or Hukou, and reforms to land

ownership transfer will be regulatory changesdriving the urbanization process. Various regional

development plans and the emerging trend of

industrial manufacturing base migrating to inland

and western provinces are economic drivers.

Moreover, the public housing scheme will also

greatly facilitate the urbanization process.

The Ministry of Finance stated in August that

over 88% of the fiscal budget for public housing

in 2010, or RMB63bn, had been deployed in the

first seven months of the year. Its possible that

the central government may eventually raise the

budget to RMB90-100bn, or 12-15% of what is

needed to complete the task, i.e., building 5.8m

public housing units plus revamping 1.2m units in

rural areas over the next 18 months also (chart

14). The Peoples Daily also reported that by end

August, RMB470bn had been spent on public

housing, or 60% of the full-year target.

Chart 13. Urbanization set to power ahead for years to come Chart 14. Public housing scheme to facilitate urbanization

29%

46.6%

65%

300

400

500

600

700

800

900

1000

1100

1950

1960

1970

1980

1990

2000

2009

2020f

2030f

2040f

2050f

5%

15%

25%

35%

45%

55%

65%

75%

85%Working population (mn)Urbanization rate

Slum

2.8

Public-

Rental,

housing

0.4

Low-rental

Housing,

1.8

Rural

reconstruction

1.2

Economic,

housing

0.8

reconstruction

Slum

2.8

Public-

Rental,

housing

0.4

Low-rental

Housing,

1.8

Rural

reconstruction

1.2

Economic,

housing

0.8

reconstruction

Source: UN, CEIC, HSBC (working population refers to age group in 15-54) Source: State Council


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Enter private capitalIn May, the State Council issued the Opinions on

Encouraging and Guiding the Healthy Development

of Private Investment. It proposed opening more

sectors, most of them currently monopolized by the

SOEs, to domestic private investors and encouraging

private capital to invest in areas and industries where

existing regulations do not explicitly prohibit

domestic private investments.

The new policy, or the so-called new 36clauses, is a follow-up to the Cabinets policy

released five years ago, known as 36 clauses for

the non-state-owned economy. While the

original provided general principles for the private

sector, the new one is geared towards investment-

related issues and should provide better guidance

to domestic private investors.

Statistics from the Xinhua news agency show that

state-owned capital is permitted to enter 72 of the

80 industries in China, foreign capital is allowed

in 62, and domestic private capital has access to

only 41. The new policies will encourage much

broader private investment, including the basic

industries (e.g. transport, power generation, oil

and gas exploration and telecom services), as well

as infrastructure, utilities, public housing,

financial services, trade-related business

management and logistics, and even national

defence science and technology.

The new policies will also establish a financing

guarantee system, which should improve venture

capital investment mechanisms, promote the

development of private equity investment funds

and encourage private companies to obtain

financing from the stock and bond markets.

The importance of private sector investment, both

domestic and foreign, is self explanatory but often

underappreciated:

It employs 44% of the workforce, up from

less than 2% in 1992. For the past 18 years, it

has created 3m jobs per annum on average,

vs. 2.3m lay-offs by the SOEs and 1.7m job

reductions by the collective-owned

enterprises (chart 15).

The percentage of fixed asset investment by

SOEs has dropped to 41% from 61% in 2004,

while that of domestic private capital has

gone up to 21% from 10% (chart 16).

The 12th

Five-Year Plan will rely more on private

capital to create jobs and boost investment.

Private capital, in particular equity (public and

private), will play a more significant funding

role in developing cutting-edge and service

industries, signalling a sea change away from

the bank-led and SOE-centric financing model

of the last two decades.

Chart 15. Private sector creates 3m jobs per year Chart 16. Domestic private sector a future investment driver

0

20

40

60

80

100

120

92 94 96 98 00 02 04 06 08 10

SOEs Collectiv e ow ned Priv ate ow ned

# of employees: mn

2%

44%

0%

10%

20%

30%

40%

50%

60%

70%

2004 2005 2006 2007 2008 2009 2010

FAIs: % by SOEs Domestic private enterprises

Source: CEIC Source: CEIC


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Stock markets crucial foreconomic transformation

The role of capital markets, particularly stock

markets, could become a strong catalyst of

Chinas economic transformation, particularly at a

time when the banking sector needs to repair its

balance sheet. High equity valuations, sometimes

on the bubbly side, can provide an incentive to

mobilize private capital as well as create

investment opportunities.

Both stock markets and banks provide sources of

external financing for firms. For the purpose of

resource allocation, they both create information

to guide the process. They differ only in the way

the information is transmitted. Information in

stock markets is contained in equity prices, while

loan managers perform this function for banks.

While banks finance only well-established, safe

borrowers, stock markets can finance risky,productive and innovative investment projects.

This fits with Chinas state strategy for the next

five years upgrading existing industries through

consolidation and value-chain repositioning and

cultivating the so-called emerging strategic

industries (energy-saving and environmental

protection, next generation information

technology, bio-technology, high-end

manufacturing, new energy, new materials and

clean-energy vehicles). Thats why stock marketsare crucial for Chinas economic transformation.

US, Taiwan and Korea

Our approach is to analyze how the sector

composition of stock indices has migrated

along with economic transformation in the past

two decades. An increasing sector weighting

indicates either outperformance of existing index

members from the sector or addition of new index

members, which is generally a reflection of thegrowing share or importance of the underlying

sector in the economy.

The S&P 500 provides a good case in point

(chart 17). For instance, the IT sector

accounted for less than 6% of the index in

1990, the smallest sector. But by 2000, its

share soared to 20%+ thanks to the internet

bubble, or the largest sector by weighting.

Ten years after the bubble burst, IT is still the

top sector with 17% share. The number of IT

companies in the S&P 500 went up to 70 in

2000 from 27 in 1990 and dropped slightly to

61 in 2010, i.e., most of the IT companies

have survived the bubble and prospered (e.g.

Apple, Microsoft and Intel). The financial

sector has also gained 9ppts index weighting

over the past two decades; the losers are

telecom (down 6ppts), consumers (e.g., auto,

5ppts) and materials (3ppts).

Taiwan is an extreme case (chart 18). In the

1990s, the IT sector was almost non-existent

but by 2000 it was nearly 44% of the MSCITaiwan index. The IT sector has continued to

grow, taking share from other sectors and

now accounts for 58% of the index. The

number of IT companies also tripled to 60

over 2000-10, or over half of all index

members. By contrast, financials plummeted

from 50%+ of the index in 1990s to 21% in

2000 and 16% by 2010. Industrials and

materials accounted some 40% of the index in

the 90s but shrunk to a combined share of22% in 2000 and 16% by 2010.

Korea is a more balanced case (chart 19). In

the past decade, the IT sector has taken

another 4ppt share in the MSCI Korea index

to 28%, consumer sectors a combined 3ppts

to 18% and healthcare from zero to 0.5ppt.

Financials have given away 3ppts to 16% of

the index, telecom another 2ppts to 3%,

utilities 1ppt to 2% and industrials 1ppt to

15%. Notably, the IT sector has gained at the

cost of telecom services due to regulation.


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Chart 17. S&P500 sector composition: migration in 1990-2000-2010

S&P Weights 1990 2000 2010 # of companies 1990 2000 2010

IT 5.9% 20.2% 17.2% 11.3% IT 27 70 61 34

Financials 7.2% 17.4% 16.5% 9.3% Financials 59 76 83 24

Healthcare 11.3% 14.3% 11.3% 0.1% Healthcare 30 40 46 16

Cons Disc 19.7% 15.6% 17.5% -2.1% Cons Disc 129 113 107 -22

Industrials 13.0% 10.1% 10.8% -2.2% Industrials 94 64 65 -29

Energy 13.2% 7.0% 10.9% -2.4% Energy 26 28 35 9

Utilities 6.2% 3.4% 3.9% -2.4% Utilities 36 36 36 0

Cons Staples 7.5% 3.9% 4.9% -2.6% Cons Staples 24 18 23 -1

Materials 7.0% 2.5% 3.7% -3.4% Materials 63 43 34 -29

Telcos 8.9% 5.5% 3.4% -5.6% Telcos 12 12 10 -2 Source: Datastream (Change = 2010 1990)

Chart 18. MSCI Taiwan sector composition: migration in 2000-2010

MSCI TW Weights Dec-00 Aug-10 # of companies Dec-00 Aug-10

IT 43.7% 58.0% 14.3% IT 21 60 39

Energy - 0.8% 0.8% Energy - 1 1

Telcos 4.4% 4.6% 0.2% Telcos 1 3 2

Cons Staples 1.9% 1.8% -0.1% Cons Staples 2 2 0

Industrials 4.7% 3.5% -1.1% Industrials 9 11 2

Cons Disc 6.8% 3.0% -3.8% Cons Disc 9 9 0

Materials 17.6% 12.7% -4.9% Materials 8 11 3

Financials 20.9% 15.6% -5.3% Financials 14 21 7

Total (AxJ weighting) 13.3% 15.1% 1.8% 64 118 54

Source: Datastream (Change = 2010 2000)

Chart 19. MSCI Korea sector composition: migration in 2000-2010

MSCI Korea Weights Dec-00 Aug-10 # of companies Dec-00 Aug-10

IT 23.9% 27.7% 3.7% IT 6 11 5

Cons Disc 11.4% 13.4% 2.0% Cons Disc 7 12 5

Cons Staples 3.9% 4.9% 1.1% Cons Staples 4 7 3

Healthcare - 0.5% 0.5% Healthcare - 2 2

Energy 2.3% 2.5% 0.2% Energy 2 3 1

Materials 14.9% 15.0% 0.1% Materials 9 11 2

Industrials 16.1% 15.1% -1.0% Industrials 14 27 13

Utilities 2.8% 1.7% -1.1% Utilities 2 2 0

Telcos 5.0% 2.8% -2.1% Telcos 4 4 0

Financials 19.6% 16.3% -3.4% Financials 12 20 8

Total (AxJ weighting) 15.8% 19.0% 3.2% 60 99 39

Source: Datastream (Change = 2010 2000)


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China is no exceptionThe evolution of sector composition for MSCI

China during the past decade is also a classic

example how the stock market reflects (and has

helped to drive) the transformation of the Chinese

economy over the past decade (chart 20):

Within the MSCI Asia-ex-Japan universe,

Chinas index weighting has almost tripled to

26%, largely inline with its GDP growth.

Index weighting for the financials sector has

more than quadrupled to 38% and the number

of index members has gone up to 31 from 7.

Back in 2000, none of the eight H-share

Chinese banks and five insurance companies

was listed. Moreover, 14 out of the 17

property companies were listed after 2005,

reflecting a decade-long property boom;

The broader consumer-related sectors

(discretionary, staples, IT and healthcare)have gained 14ppts to 18% of the index,

while the number of index members has

exploded to 33 from just six thanks to new

listings. Notably, the healthcare sector was

non-existent in index before 2006.

Furthermore, we benchmark MSCI China sector

composition against the S&P 500 (chart 21) and

MSCI Korea (chart 22). The findings are

revealing in that the MSCI China index is highly

imbalanced, which also reflects the status of

the Chinese economy, in our view:

Sector weighting for financials in China

(38%) is more than twice that of both the US

and Korea (16%), which is contrary to the

general perception that the financial sector in

China is underdeveloped compared to Korea,

not to mention the US.

Together, the top three sectors in China financials, energy and telecom account for two

thirds of the index, or 37ppts and 46ppts higher

than the US and Korea, respectively. Not

surprisingly, the top three sectors in China are

dominated by state-owned companies that have

enjoyed monopolies for decades.

IT is the least developed sector in China,

representing a 5% vs. 17% in the US and 28%

for Korea, a reflection of Chinas low-end

positioning in the manufacturing value chain

and a lack of innovative capacity.

While the share of consumer staples in China

is slightly higher that the US and Korea (6%

vs. 5%), consumer discretionary companies

are underrepresented in MSCI China index at

6%, or 8-12ppts lower than Korea and the US,

indicating huge long-term growth potential.

The share of industrials in China at 8% is

3ppts lower than the US and 7ppts below

Korea, indicating good long-term prospects as

China moves up the value chain intoadvanced manufacturing.

Last but not least, healthcare in both China

and Korea is underdeveloped, or less than 1%

of the market index vs. 11% in the US.

The stock market can provide the price signal

and incentive to facilitate and drive economic

transformation. IPOs in the A-share market

doubled in 2009 to top RMB200bn and are set to

double again in 2010 (chart 23). Its encouraging tosee that IPO value in the SME board and ChiNext,

both suited for smaller and private companies, for

the first time exceeded the main board, designed for

the big-cap SOEs, in 2010. Average IPO PE is 34x

for the main board, 53x for SME board and 66x for

ChiNext, sending a clear signal to encourage

innovation and growth. The exploding number of

deals in the SME board and ChiNext is a good

indication of where Chinas growth will come from

in the future (chart 24).


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Chart 20. MSCI China sector composition: migration in 2000-2005-2010

MSCI China Weights 2000 2005 2010 # of companies 2000 2005 2010

Financials 8.5% 30.0% 37.9% 29.3% Financials 7 9 31 24

Cons Disc 0.4% 3.9% 6.2% 5.9% Cons Disc 3 5 13 10

IT 1.2% 1.7% 5.0% 3.9% IT 1 3 6 5

Cons Staples 1.8% 3.9% 5.5% 3.7% Cons Staples 2 3 11 9

Materials 3.1% 4.4% 5.3% 2.2% Materials 5 7 18 13

Healthcare - - 0.9% 0.9% Healthcare - - 3 3

Utilities 2.5% 2.3% 2.0% -0.5% Utilities 5 4 6 1

Energy 20.6% 24.7% 16.4% -4.2% Energy 3 6 9 6

Industrials 13.2% 9.3% 7.7% -5.5% Industrials 13 16 23 10

Telecos 48.8% 21.9% 13.1% -35.7% Telecos 2 3 4 2Subtotal (broader consumer) 3.3% 9.5% 17.6% 14.3% 6 11 33 27

Total (AxJ Weighting) 8.9% 15.5% 26.2% 17.3% 41 56 124 83

Source: Datastream (Change = 2010 2000; Broader consumer = C ons Dis + Cons Staples + IT + Healthcare)

Chart 21. 2010 sector composition China vs. U.S. Chart 22. 2010 sector composition China vs. Korea

Sector Weights S&P500 MSCI China Diff.

Financials 16.5% 37.9% 21.4%

Telcos 3.4% 13.1% 9.8%Energy 10.9% 16.4% 5.5%

Materials 3.7% 5.3% 1.6%

Cons Staples 4.9% 6.2% 1.3%

Utilities 3.9% 2.0% -1.9%

Industrials 10.8% 7.7% -3.1%

Healthcare 11.3% 0.9% -10.5%

Cons Disc 17.5% 5.5% -12.0%

IT 17.2% 5.0% -12.1%

Sector Weights MSCI Korea China Diff.

Financials 16.3% 37.9% 21.6%

Energy 2.5% 16.4% 13.9%Telcos 2.8% 13.1% 10.3%

Cons Staples 4.9% 6.2% 1.3%

Healthcare 0.5% 0.9% 0.4%

Utilities 1.7% 2.0% 0.3%

Industrials 15.1% 7.7% -7.4%

Cons Disc 13.4% 5.5% -7.9%

Materials 15.0% 5.3% -9.8%

IT 27.7% 5.0% -22.7%

Source: Datastream Source: Datastream

Chart 23. IPO value in SME board and ChiNext for the firsttime exceeded that of main board in the first 9M of 2010

Chart 24. The exploding # of deals in both SME and ChiNextis a good indicator of where growth will come from in future

0

50

100

150

200

250

300

350

400

2008 2009 F9M10

Main Board SME Board ChiNext

IPO (Rmb bn)

15150

86

5 12 1672 67

0

50

100

150

200

250

300

2008 2009 F9M10

Main Board SME Board ChiNext

IPO (# of deals)

Source: Wind Source: Wind


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ababc

Promoting service sectorsTo achieve the 40-45% carbon intensity reduction

goal by 2020 not only does China need to

normalize the price of energy and natural

resources through continuing pricing mechanism

reforms, but also:

Speed up consolidation to digest existing

industry overcapacity (see China Investment

Atlas, Issue 19, From Mr. Big to Mr. Strong

in March 2009; and Issue 22, M&A A

long-term share price driver in July 2009);

Cut back on high pollution and energy-

consuming sectors, mainly in the heavy

industries such as metals and mining.

Accelerate the movement of producer

services sectors up the value chain and

improve economic structures (this section).

Cultivating the so-called seven emergingstrategic industries to sustain the new phase

of growth (next section).

The US experience and comparison

In 1935, the American economist Irving Fisher

was the first to define tertiary industry. But it was

not until 1957 that British economist Colin Clark

named tertiary industry as service industry and

proposed the following categorization: i) producer

services (financial, insurance, engineering, law

and business services); ii) social services (health,

education, welfare and government); iii) personal

services (domestic trade, lodging, repair and

entertainment).

While there is no consensus yet on the impact of

service industry on employment and economic

growth, various academic reports have found that

service industry growth usually takes off once per

capita income surpasses USD3,000-5,000, which

is precisely the level China is experiencing.

Despite Chinas manufacturing prowess, its

services sectors have remained severely under-

developed, accounting for 43% of the GDP, vs.

54% for India and 74% for the US (chart 25). Its

even lower than the US in the 1950s and roughly

the same level as India around the 1990s.

The external trade balance further reveals Chinas

weak spot in the service sectors. Since 2007,

Indias quarterly trade surplus in services sectorshas averaged over USD10bn, vs. a deficit of over

USD4bn for China (chart 26).

Its also worth noting that the US service trade

surplus really started to take off after Chinas

entry into the WTO at the end of 2001, soaring

from USD10bn a quarter to nearly USD40bn.

This was helped by Chinas trade-related

insurance payments and manufacturing-related

fees for patents and royalties.

Chart 25. Chinas service sector is underdeveloped Chart 26. China a net importer of services

20%

30%

40%

50%

60%

70%

80%

1950 1960 1970 1980 1990 2000

India (service-to-GDP) U.S. China

-10

0

10

20

30

40

50

1998 2000 2002 2004 2006 2008 2010

India: BoP-Serv ices U .S. C hina

US$bn: quarterly

After China re

entry to WTO



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22

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ababc

In the US, the share of consumer (personal)

services and government (social) services has

remained largely stable since the end of the World

War II. They have averaged 17% and 13% for the

past six decades, respectively, while that of

producer services nearly doubled to 48% at the

cost of manufacturing, which saw its share drop

by 15ppts to 11.5% by 2008 (chart 27).

Within the producer services sectors, education

and healthcare have grown the most a 9.3% 60-

year CAGR to over 8% of US GDP followed by

professional and business services at 9% CAGR

to 12.7% of GDP and financial sectors at 7.9%

CAGR to 20% of GDP. Transport and

warehousing has seen its share in GDP decline to

below 3% from 6%, while the share of IT has

remained largely stable since 90s (chart 28).

In Chinas case, its remarkable that the share of

wholesale and retail trade in GDP increased by

1ppts to 8.5% over 2005-09 and that of banking

and insurance by 2ppts to 5.4% in 2004-08 (chart

29). Real estate has also doubled its share of GDP

to 4% over the past three decades.

By comparing service industry developments in

the US and China and assuming that Chinas

industry structures are evolving closer to that of

the US, there could be huge room for growth in

China for professional and business services (for

both domestic and overseas outsourcing markets),

financials (consumer financing), education and

healthcare, wholesale and retail trade, IT services,

and hotel and catering, with transportation,

storage and post services being the only exception

(chart 30).

Chart 29. Historical GDP share of Chinas service sectors Chart 30. Services sectors GDP share: U.S. vs. China

0%

2%

4%

6%

8%

10%

1978 1983 1988 1993 1998 2003 2008

China services

sectors: % GDPWholesales & Retail

Trans., storage & post

Hotel & Catering

Banking & Insurance

Real estate

% of 2008 GDP China U.S. Diff.

Wholesale & Retail 8.3% 11.9% 3.6%

Hotel and Catering 2.1% 3.8% 1.7%

Transportat ion, S torage & Post 5.2% 2.9% -2.3%

Financials 9.4% 20.0% 10.6%

IT* 2.3% 4.4% 2.1%

Education & Healthcare* 4.3% 8.1% 3.8%

Professional & Business Services* 2.6% 12.7% 10.1%

Government Services n.a. 12.9% n.a.

Total 39.3% 63.7% 24.4%

Source: CEIC Source: CEIC (* Calculated based on 2007 statistics)

Chart 27. Historical GDP share of U.S. service sectors Chart 28. HistoricalGDP share U.S. producer service sectors

0%

10%

20%

30%

40%

50%

60%

1947 1957 1967 1977 1987 1997 2007

US: MFG-to-GDP Producer serv ices

Consumer serv ices Gov' t serv ices

0%

5%

10%

15%

20%

25%

1947 1957 1967 1977 1987 1997 2007

Financials

Prof. & business serv ices

Edu & Healthcare

ITTrans. & Warehouse

US producer service

sectors: % of GDP



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From made in to serviced in China

With more producer services appearing in

manufacturing activities (chart 31), they are

gradually becoming value-adding parts of the

manufacturing value chain, particularly in

developed economies. Due to the rapid

development of IT and the accelerated division of

labour and specialisation across the globe,

producer services help manufacturers gain

competitive advantages through cost advantages

and product differentiation.

This explains why producer services now

represent almost half of the US economy and is a

rising force in Indias IT outsourcing (ITO)

industry, which has a 27.5% CAGR for the past

10 years and now contributes 4% of Indias

economy (chart 32).

Although Chinas ITO sector is still small and

estimated to be an eighth of Indias, its catching

up rapidly and has the potential to challenge

Indias dominant position (chart 33). During the

11th

Five-Year Plan (2005-10), China for the first

time made producer services industry a priority

and this is set to continue into the 12th

Five-Year

Plan. ITO, business process outsourcing (BPO)and knowledge process outsourcing (KPO),

targeting both domestic and overseas outsourcing

markets, are a key element of the state strategy.

Gartner forecasts that the worldwide IT services

market, the largest segment within the outsourcing

industry, is expected to reach USD1.1trn in 2012,

up from USD748bn in 2007. Other niche areas

according to the KPMGs 2009 report, A New

Dawn: Chinas Emerging Role in Global

Chart 31. Value chain of producer services

1. Advertisement

2. Logistics & Storage

3. Sales & Marketing

4. After -sale services

1. Feasibility study

2. R&D (e.g., productconcept design)

3. Market research

4. Venture capital

1. Financial services

2. Accounting

3. IT Services

4. Quality control

5. Legal services

6. Human resources

Upstream Midstream Downstream

1. Advertisement






3. Market research

4. Venture capital


2. Accounting

3. IT Services

4. Quality control

5. Legal services

6. Human resources


1. Advertisement






3. Market research

4. Venture capital


2. Accounting

3. IT Services

4. Quality control

5. Legal services

6. Human resources


1. Advertisement






3. Market research

4. Venture capital


2. Accounting

3. IT Services

4. Quality control

5. Legal services

6. Human resources


Source: HSBC Equity Strategy Research

Chart 32. Indias IT outsourcing: top of the world Chart 33. China ITO 1/8th of India but catching up

0

3

6

9

12

15

00 01 02 03 04 05 06 07 08 09 10

0%

1%

2%

3%

4%

5%IT outsourcing (US$bn) % India GDP

10Y CAGR

27.5%

-

1

2

3

4

1H01

2H01

1H02

2H02

1H03

2H03

1H04

2H04

1H05

2H05

1H06

2H06

1H07

2H07

1H08

2H08

1H09

2H09

China BoP credit: IT serv ices (US$bn)

Source: CEIC (quarterly) Source: CEIC (half-year)


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Outsourcing, are animation and gaming, E-

learning and online-tutoring, offshore

engineering, pharmaceutical R&D, and legal

process outsourcing.

Top-notch infrastructure, large talent pool and

diverse language skills aside, one of the major

advantages China enjoys over India in the global

outsourcing market is its huge domestic market,

as well as nearby overseas markets such as Japan

and Korea that share parts of Chinese culture.According to the IDC data, IT services only

account for 13.8% of Chinas IT market vs. 30.3%

for Asia Pacific, indicating huge potential.

This potential particularly applies to Chinas

banking and telecom services industries, as both

sectors are under pressure to improve cost

efficiency as earnings growth decelerates. This

could even be encouraged by the central

government to help cultivate Chinas nascent

outsourcing market.

During the 11th

Five-Year Plan period, for

instance, the central government rolled out the so-

called 1,000-100-10 project in 2006, i.e., to

develop 10 base cities of service outsourcing with

international competitiveness, promote 100 well-

known multinational corporations to transfer their

service outsourcing businesses to China and

cultivate 1,000 large and medium-sized service

outsourcing enterprises with internationalqualifications.

Furthermore, the State Council has designated 21

Service Outsourcing Model Cities since early

2009: Beijing, Changsha, Chengdu, Chongqing,

Dalian, Daqing, Guangzhou, Hangzhou, Harbin,

Hefei, Jinan, Nanchang, Nanjing, Shanghai,

Shenzhen, Tianjin, Wuhan, Wuxi, Xiamen (added

in early 2010) and Xian. For the model cities, the

government has introduced the ATSE (Advanced

Technology Service Enterprise) certification

programme, under which a certified ATSE

receives a reduced income tax rate of 15% as well

as a business tax exemption on service income

from offshore clients, valid from 2009 to 2012.

In April 2010, the State Council expanded the

scope of the business tax exemption and relaxed

the ATSE certification criteria. Outsourcing

services provided to offshore customers by all

enterprises located in the 21 model cities will be

exempted from business tax.

All these efforts are starting to pay off:

According to forecasts by IDC, three Chinese

cities Dalian, Shanghai and Beijing made

the top 10 list as most attractive for

outsourcing. By 2011, Shanghai could be

challenging Bangalore for the leading spot

and Dalian and Beijing could move up into

top five spots;

The number of outsourcing enterprises in

China has exploded to more than 3,000

according to the Ministry of Information and

Industries, with numerous service providers

that have surpassed the scale of USD50m

revenue per year.

Private equity investors are increasing their

activity in this space. China Everbright

Holding invested in iSoftStone in January,

Carlyle Group invested in the ATMU

Corporation in June and Global Data Solutionalso expects new funding in 2010.

The importance of intellectual property rights

(IPR) protection can vary across outsourcing

efforts. It becomes increasingly important for

more advanced outsourcing activities and its still

a common perception among foreign outsourcing

contractors that China still has to make

improvements on IPR protection, representing a

potential bottleneck for development in this

industry in the long term.


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Screening:15 IT outsourcing stocksThe following list of top 30 outsourcing

companies in China provides a good snapshot of

the competitive landscape (table 34).

We have indentified 15 listed entities from the

nascent outsourcing industry. Four are listed in

the US, including VanceInfo, with a total market

cap of USD5bn, eight are listed on the domestic

A-share market, such as NeuSoft, with a total

market cap of USD7bn, and three are listed inHong Kong, including ChinaSoft, with a total

market cap of USD0.7bn. The combined revenue

for all the listed Chinese companies is only

USD3.3bn. In comparison, the top three Indian

outsourcing companies have a combined market

cap of USD107bn, or seven times larger.

On aggregate basis, India companies are

traded at 6.5x revenue (USD16.5bn) vs. 3.8x

for Chinese companies, a 70%+ premium.

PE wise, India companies averaged 26.4x

2009 PE vs. 44x for Chinese companies

(excluding the outliners).

Performance wide, India companies averaged

20% y-t-d and 14% in the last month vs. 21%

y-t-d and 3% for Chinese companies.

Table 34. Snapshot of Chinas top 30 outsourcing companies

Rank Name Name in Chinese Listed entity 2009Revenue(USDm)

2009 PE(x)

Mkt. cap(USDm)

Lastmonth

perf (%)

y-t-dperf. (%)

Website

Tata Consultancy Services TCS IN 6,199 26.8 42,053 14.4 27.8 http://www.tcs.comInfosys INFO IN 4,695 28.0 39,412 11.0 18.1 http: //www.infosys.comWipro WPRO IN 5,618 24.4 25,594 16.0 14.2 http: //www.wipro.com

1 Neusoft Corporation 600718 CH 602 33.5 3,216 4.0 0.8 http://www.neusoft.com

2 INSIGMA TECHNOLOGY 600797 CH 707 169.5 824 -9.1 -1.7 http://www.insigma.com.cn3 VanceInfo Technologies VIT US 148 34.3 1185.0 8.4 68.0 http://www.vanceinfo.com

4 WuXi AppTec WX US 270 21.8 1,173 0.7 12.4 http://www.wuxiapptec.com.cn

5 hiSoft Technology Intl HSFT US 91 96.7 602.2 22.1 148.1 http://www.hisoft.com

6 Longtop LFT US 169 33.4 1995.6 5.8 4.2 http://www.longtop.com

7 Dalian Hi-Think n.a. http://www.dhc.com.cn

8 iSoftStone n.a. http://www.isoftstone.com9 China Data Group (Suzhou) n.a. http://www.chinadatagroup.com

10 SHANDONG LANGCHAO 600756 CH 55 87.4 388 -5.1 -1.5 http://www.inspur.com

Inspur Group 000977 CH 150 783.9 438 10.1 33.5INSPUR INTERNATIONAL 596 HK 278 8.7 311 -3.0 -42.3

11 Sodexo ADR SDXAY US 14,681 16.6 9,436 7.0 14.2 http://cn.sodexo.com

12 ChinaSoft International 354 HK 143 -16.4 285 11.4 126.4 http://www.chinasofti.com

13 Achievo Corporation n.a. http://www.achievo.cn

14 Dextrys n.a. http://www.dextrys.com/cn15 SinoCom Software Group 299 HK 82 10.3 138 -4.0 1.1 http://www.sinocom.cn

16 Sunyard System Engineering 600571 CH 86 89.1 337 -4.2 17.8 http://www.sunyard.com

17 Beijing Lanxum Technology 300010 CH 53 49.6 436 -1.1 -43.6 http://www.lanxum.com

18 M&Y Data Solutions n.a. http://www.huatuodata.com.cn

19 SYNNEX IT SNX US 7,719 9.7 977 11.5 -10.5 http://www.synnex-china.com

20 Compupacific International n.a. http://www.compupacific.com

21 Beijing Teamsun Technology 600410 CH 486 40.8 1,149 10.7 -1.8 http://www.teamsun.com.cn

22 Shanghai Hyron Software 002195 CH 28 78.1 235 -0.5 0.5 http://www.hyron.com

23 BroadenGate Software n.a. http://www.bgsws.com

24 SYKES (Shanghai) SYKE US 846 12.8 641 4.7 -46.9 http://www.sykes.com.cn

25 Shanghai Seio Software n.a. http://www.seiosoft.com

26 ATMU Corporation n.a. http://www.atmu.cn27 Global Data Solutions n.a. http://www.gds-china.com28 Diyixian.com n.a. http://www.anlai.com

29 JIANGSU OCEANSOF n.a. http://www.oceansoft.com.cn

30 Liandi (Nanjing) Info.Systems

n.a.

http://www.liandisys.com.cn

Source: Bloomberg, Devott (India companies included for comparison; highlighted companies are those got private equity funding in 2010)


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