Janus Henderson: What does reform in China mean for equity investors?

Five years ago Chinese President Xi Jinping laid out a blueprint for reform under a new economic model that would let market forces play a decisive role in the economy. Western analysts cheered and hoped that capitalist economist Adam Smith’s invisible hands would be allowed to drive markets such as energy prices and interest rates.

However, the revaluation and the subsequent slide in the value of the Chinese yuan and the disorderly decline in the mainland stock markets in 2015 prompted strong state intervention. So what has been happening since 2015 when many foreign investors felt disappointed and abandoned looking at China?

Far-reaching political reform  

Since Xi took power in 2012, the political landscape has changed dramatically. Probably Xi Jinping’s most wide-ranging and impactful reform was the anti-corruption crackdown. This clean-up of the Communist Party was applied from the grass roots to the very top and across political, civilian and military society. This policy was an essential and important effort to reform the Party, boosting its legitimacy in the eyes of the populace and also allowed Xi to remove his political opposition and centralise policy decision-making.

In a recent speech at West Point military academy in the US, the former Australian prime minister and China scholar Kevin Rudd said that Xi is the most powerful leader since Chairman Mao “sitting at the apex of the political system but with influence down to every level”. This year has seen the Party remove the two-term limit to the presidency and Mr Rudd suggests Xi might be president for the whole of the 2020s and perhaps into the 2030s. The political environment has evolved, with dissenting voices being crushed, rather than reformed, and there is now significant key man risk around Xi Jinping not dissimilar to Putin in Russia.

At a corporate level, this drive to centralise power has manifested itself in more formal recognition of the roles of Communist Party Secretaries within state-owned enterprises (SOEs). As long time investors in China we see this as formalising the status quo rather than a change for the worse but others interpret these moves less favourably. Foreign investors already place a significant valuation discount on these SOEs, so in fact the biggest risk to some Chinese equities could be if the state demands a significant equity stake in much-loved private sector internet companies such as Baidu, Alibaba and Tencent. 

Business reform with ‘more bite’ 

China’s version of ‘supply side’ industrial reform has seen central government mandated capacity reductions in heavy industries to improve efficiency and environmental standards. China’s environmental bureau now has teeth in enforcing shutdowns of paper mills, steel, aluminium and cement plants if they do not have the requisite environmental licenses. Consequently, industry utilisation levels have risen, helping improve selling prices and boosting the cash flows of industrial China that were already on a cyclical upswing.

Not only has this improving cash flow been used to reduce debt but we are also witnessing a change in management mind set at some SOEs. With fewer permissible avenues for capital expenditure, companies such as coal miner and power generator China Shenhua Energy have paid out large special dividends (approximately US$8bn in 2017) and national oil champions such as Sinopec and CNOOC (China National Offshore Oil Corporation) have lifted dividend payout ratios as free cash flow generation improves. Interestingly, the Hong Kong-listed shares in these SOEs have barely re-rated to reflect this improving return on capital, unlike the valuations in more popular consumer-driven areas of the market. 

Financial reform has some way to go

Financial sector reform has been patchy at best. But now we see increasing state involvement, such as taking over the extended and distressed Anbang Insurance in order to address what have been called ‘tail risks’ in the economy. A broad deleveraging has barely started; instead the focus has been on reducing risks and insulating the economy from liquidity shocks. Xi now seems more determined to force deleveraging as shown by the crackdown on off-balance sheet lending and the creation of an overarching financial super-regulator. 

Social reform very much on the agenda

China has an obvious urban rural divide with notably high income inequality. Recent social reform measures are trying to level the playing field of access to basic social services, such as education and healthcare and we are starting to see more flexibility in land use rights and tradability. These efforts to address income inequality are a key focus for Xi as he seeks to build a better China rather than just a faster-growing China.

China watchers generally agree President Xi is the strongest and most powerful leader since Chairman Mao, therefore China’s evolving reform agenda is most certainly his agenda. Bears and bulls will both find plenty of ammunition for their arguments. But in listed companies we can see opportunity where real change is leading to higher return on capital that has yet to be priced in, even after applying a healthy and justified dose of scepticism.