Why New Reforms Make Chinese Stocks Attractive - Michelle Gibley, Director of International...

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Why New Reforms Make Chinese Stocks Attractive A white paper by Michelle Gibley, Director of International Research

Schwab Center for Financial Research


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Investors should look past the slower rate of economic

growth in China and focus more on the potential for an

improvement in the quality of growth, which could benefit

Chinese stock prices. In late 2013, the Chinese government

outlined an ambitious reform plan in an attempt to overhaul

its economy. These reform plans could create the next phase

of growth in China and have a positive impact on Chinese

stocks even before they are enacted. Valuations of Chinese

stocks could rise—both because higher-quality growth

typically commands a higher valuation and because investor

sentiment is quite negative on China. In this wide-ranging

conversation, Michelle Gibley shares her views.

Michelle Gibley

CFA, Director of International Research,

Schwab Center for Financial Research

Michelle Gibley conducts stock market

research and analysis, specializing in

international markets. She is co-author of

the Schwab Market Perspective and writes

monthly articles on Schwab.com covering

specific international topics. Gibley is a

member of the Schwab Investment

Strategy Council.


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Executive Summary

• China’s comprehensive reform plan could create higher-quality, more sustainable growth, reducing uncertainty for investors. The main drivers for optimism are the potential impacts on the financial sector and consumer spending.

• Financials could experience improved profits and a reduced risk profile, despite concerns to the contrary. The reforms could open up new business opportunities for banks and shore up the health of local government borrowers, a key client.

• Consumer spending might receive a boost. The reforms to rural land rights and the household registration system could improve incomes as well as propel the next stage of urbanization and productivity gains in China. Additionally, the loosening of the one-child policy could provide a minor lift to consumption.

• Chinese stocks currently trade at a significant valuation discount to both their historical average and the broader emerging market equity universe. Patient investors who can endure volatility can use periods of uncertainty as potential buying opportunities.

• We believe risk-tolerant investors should overweight China’s stock market within their allocation to emerging market stocks. We advise that investors consider mutual funds and exchange traded funds (ETFs) that invest in large-capitalization Chinese stocks, which could benefit over the next year or so because of their discounted valuations.


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What is the idea in a nutshell and how did it come about?

The impetus behind the idea is that China’s comprehensive reform plan,

announced at the Third Plenum government planning session in November

2013, could create the next phase of growth in China. This next phase might be

characterized by slower, yet higher-quality, more sustainable growth, even if

only a portion of the reforms are actually implemented.

As a result, valuations could rise as higher-quality growth typically commands

a higher valuation and because investor sentiment toward emerging markets—

and China—is quite negative. We believe equity investors who have the risk

tolerance to ride out potentially significant volatility should consider investing

in Chinese stocks.

This seems to be a shift away from your advice in early 2013 to avoid investing in China because of the risk of a subprime-like bubble. Are the reforms enough to justify this significant change in your view?

Most investors realize that no investment view lasts forever. After all, when

conditions change, so do the investment implications.

We had a negative view on China until the fall of 2013, when we moved to a

neutral stance because we believed that the country’s growth could accelerate

in the short term—and because Chinese and emerging market stocks were

reflecting a lot of downside risks, which appeared to be lessening. Structural

issues in China’s economy prevented us from moving to a positive stance. As a

result of the Third Plenum in November 2013, reforms to address many of these

structural issues in China came sooner and are more comprehensive than we

expected, leading us now to move to a positive stance toward Chinese stocks.

In addition, Chinese stocks, as represented by the MSCI China Index, have

underperformed the MSCI Emerging Markets Index over the past four years

ending December 2013, and now appear inexpensively valued relative to their

historic relationship to the emerging market universe.

Investor sentiment is

depressed—reforms

could improve the

outlook.


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Our earlier negative view was based on concerns about a credit bubble and that

high levels of debt could hinder future growth. A Lehman-like credit crisis is

still a slight possibility. However, we believe the credit issues are manageable—

bad loans will gradually rise, but not surge. We believe China’s government has

the tools to stem a financial and economic collapse by using a combination of

the following: injecting liquidity into the banking system, devaluing the

currency, and/or stimulating growth if it slows too much by ramping up

infrastructure spending.

What is driving your positive outlook–valuations or the structural reforms in China?

It is a combination of the two–valuations appear inexpensive and have a

catalyst for change. We think the market will begin to anticipate some long-

term improvement in the quality of China’s economic growth due to the reforms.

Additionally, as shown in the chart below, we believe stocks are pricing in a lot

of potential bad news. The price-to-trailing earnings of the Chinese stock

market is at a discounted valuation to the emerging markets universe and well

below its historical average. The valuation of Chinese stocks can improve along

with reform momentum—even before the reforms are fully implemented—as

stock markets typically look ahead and discount the future, not the past.

20062007

20082009

2010 20112012

2013

0.50

1.25

Rel

ativ

e va

luat

ion

2.00

0.75

1.00

1.50

1.75

MSCI China Index P/E relative to MSCI Emerging Markets Index P/E

Chinese stocks valued at a discount to emerging markets

Source: FactSet, Bloomberg and MSCI. Where equal value is at 1.0, a larger/smaller number relative to 1.0 denotes China is more expensive/less expensive relative to emerging markets. As of January 8, 2014.


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17.5

12.111.2 11.0

12.1

14.0

18.7

20.0

22.8

15.5

14.113.6 13.6

11.8

9.4 9.6

11.2

8.8

18.6

17.4

5

10

15

Rat

io

20

25

20072008

20092004

20052006

2010 20112012

2013

MSCI China Index Trailing P/E RatioAverage

Chinese stocks valued below historical average, price in a negative outlook

Source: FactSet, Bloomberg and MSCI. Blue line is 10-year historical price/earnings average of 14.3 times trailing earnings. As of January 3, 2014.

So what are you advising that investors do to act on this idea?

We suggest keeping emerging market equity exposure equal to your long-term

strategic allocation, but overweight China within the emerging market equity

allocation. We believe investors should consider buying mutual funds and ETFs

that invest in large-cap Chinese stocks as they could benefit the most over the

next year or so because they have the most discounted valuations in relation to

smaller-cap funds. This Investing Idea does have significant risk associated

with it, so investors need to be prepared to tolerate the volatility that is likely

while the Idea plays out.

Consumer and small-cap stocks are often cited as good plays to participate in China’s next stage of growth. What are your thoughts on those?

Consumer sector and small-capitalization Chinese stocks are commonly viewed

as the best ways to participate in China’s transition to consumption-led growth

and reform to the large, state-owned companies, respectively. While these

stocks could benefit the most over three to five years, they appear expensively

valued now and we prefer a diversified portfolio of large-cap Chinese stocks at

this point. Additionally, the 2014 opening of the IPO window, allowing companies


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to take their stock public in the mainland Chinese markets where small-cap

stocks typically trade, after being closed since October 2012, could divert

money toward new offerings and away from existing small-cap stocks.

Commodities were seen as a way to participate in China’s growth in the past. Is that still the case?

Commodities and commodity-oriented countries—countries that have high

dependence on commodity exports to China—were typically viewed as tied to

China’s economic growth in the past due to China’s construction-led economic

model. On the extreme end, China constituted over 40% of global demand for many

industrial metals. However, commodity prices and the performance of commodity-

oriented countries came under pressure in 2013 due to China’s economic

slowdown, increased supplies of commodities and rise in the U.S. dollar.

While there could be short periods of catch-up performance by commodities

and commodity-oriented countries, we continue to maintain a neutral view over

the long-term. This is because we believe China’s economy is shifting to a less

commodity-intensive economic model, and many commodities experienced

significant increases in supply in recent years.

Why do you have a positive outlook for China but not emerging markets overall?

Our neutral view on emerging market stocks overall stems from our view that

countries that comprise a large weight of the MSCI Emerging Markets Index

have fundamental economic problems that could hinder intermediate-term

growth. These problems, such as persistently high inflation or reliance on

commodity exports, will not go away or be fixed easily. In addition, there

appears to be little political appetite in these countries to begin difficult

reforms at this time. Also, the U.S. Federal Reserve’s reduced pace of bond

buying (“tapering”) could be a risk to the stocks and economies of countries

with current-account deficits. The currencies of countries dependent on foreign

investment due to current account deficits are vulnerable because rising U.S.

Treasury yields boost the attractiveness of the U.S. dollar on a relative basis. A

falling currency can create inflationary pressures and prompt monetary

tightening, squeezing growth further.

China is ahead of the

emerging market

universe in taking

steps to restructure

its economy.


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Emerging market countries with fundamental concerns

Weight in MSCI EM Index

Commodity-oriented exports

Current account deficit

Brazil 10.9% X X

India 7.2% X

South Africa 7.1% X X

Russia 5.9% X

Indonesia 2.3% X X

Turkey 1.7% X

Chile 1.5% X X

Peru 0.4% X X

Total 36.9%

Source: MSCI, The Economist Intelligence Unit, IMF WEO. As of November 30, 2013.

On the other hand, low stock valuations and depressed investor sentiment are

positive offsets, giving stocks of emerging market countries room to rebound.

Additionally, we believe emerging market equities still deserve a position in

investors’ portfolios. This is due to ties to global growth, which we believe is

improving; diversification benefit in terms of lower stock correlations to moves

of developed market stocks; and growth opportunities as incomes rise and

create a middle class in emerging market countries.

What is the investor sentiment toward China and emerging markets?

The combination of China’s economic slowdown and the prospect that the U.S.

Federal Reserve would taper its asset purchases resulted in investors adopting

an extremely negative stance toward China and emerging markets in 2013.

Additionally, investors generally distrust Chinese banks and believe reforms

and credit risks are negative for both bank profits and Chinese equities.

During the second quarter of 2013, global emerging market funds (stock and

bond ETFs and mutual funds combined) had the biggest quarterly net outflow

of money since the 2009 crisis according to EPFR Global. And global fund

managers polled in August of 2013 indicated a net 19% underweight in global

emerging market equities, the lowest level in nearly two years, according to

Bank of America Merrill Lynch. Meanwhile, the more narrowly-defined asset

class of Chinese stock mutual funds experienced net outflows for every month

from March through November of 2013, and in 29 of the last 36 months through

November 2013.


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Dec. 10Jun. 11

Dec. 11Jun. 12

Dec. 12Jun. 13

Net

mon

thly

mut

ual f

und

flow

s in

mill

ions

of $

–3,000

–1,000

–2,000

0

2,000

3,000

1,000

Investors have shunned Chinese mutual funds

Source: Morningstar. As of November 30, 2013.

What are the main reasons for your optimism on China?

The two main reasons for optimism are the impact of China’s reforms on the

financial sector and consumer spending.

Financials, the largest weight in large-cap indices, could experience improved

profits and reduced risk. While many bears on China focus on the negatives for

banks, there are positive offsets. Fiscal reform could reduce the concerns about

the quality of local government loans at banks, which is a factor in the valuation

discount for Chinese banks stocks. Fitch Ratings indicated the reforms may be

credit positive for local governments. Additionally, China is moving toward a

market-based government yield curve, which could steepen and increase both

investment returns and profit potential for financials. The existing low long-term

government bond yield currently creates a ceiling on profits of banks and

insurers. Lastly, we expect the reforms to open up opportunities in investment

and corporate banking. The financial sector has an outsized impact on China-

related large-cap ETFs due to the large weights in these funds, as seen below.

ETF Name Ticker Assets (in $M)

Financials Weight

iShares China Large-Cap

FXI 5,869 55.8%

SPDR S&P China GXC 870 31.3%

iShares MSCI China MCHI 1,061 38.2%

Source: BlackRock, State Street Global Advisors. As of December 26, 2013. For illustrative purposes only and not a recommendation of any specific investment product or strategy. Holdings are subject to change without notice.


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Consumer spending, meanwhile, could get a boost from the reforms to rural

land rights, the household registration system and China’s one-child policy. The

land reform likely puts more money in the hands of farmers because they would

be able to transfer land-use rights and “monetize” their land or use the land as

collateral to secure bank loans. Reform of the country’s household registration

system would give migrants access to public services in smaller cities, and

could increase mobility of the labor force. As people move from the farm to the

city they typically add to economic growth as they become more productive,

producing higher-value goods and services. In addition, incomes are likely to

rise with the move to cities, which typically generates more spending; while the

loosening of the one-child policy could also provide a minor lift to consumption.

What are the most important reforms in China to watch?

China listed 60 “concrete tasks” in a comprehensive plan to restructure the

country by 2020. While the reforms are intertwined and complicated, we

believe there are six key economic reforms to watch.

• Reforms to rural land rights. We believe these could be historic. The change

will allow farmers to transfer and leverage land as collateral, which could put

money in low-income consumers’ pockets and increase mobility. It also has

the potential to increase food output if land is consolidated into larger farms.

However, local governments’ financial position could deteriorate if the land

rights reform reduces government revenues from land sales.

• Changes to household registration. Migrants don’t have access to public

services such as health care, primary education, low-income housing and

social security unless they have an urban household registration card, also

known as “urban hukou.” Reforms to household registration laws could

extend access to public services to millions of migrants in small and midsize

cities, and increase the mobility of the labor force. When combined with

reforms to rural land rights, this could propel the next stage of urbanization

and productivity gains in China. Although an increased payout by state-

owned enterprises (SOEs) is expected to be used to pay for social services;

giving migrants more rights could be a drain on local government finances,

which are already strained.

Land rights and

household registration

reforms could propel

the next stage of

growth.


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• One-child policy loosening. This change could add to consumer spending and

improve sentiment, but could also increase the burden on social spending

and temporarily reduce the size of the workforce if women go on maternity

leave. We believe the amount of media attention on this reform is outsized

compared to the economic impact, which we believe is likely to be only a minor

boost. Prior exceptions to and ways to circumvent the rule, as well as the high

cost of raising a child are likely to reduce the number of couples wanting to

take advantage of the new policy. Analysts are estimating the potential for an

additional 1 to 2 million births a year, a 6 to 12% increase from the 16.4 million

births recorded by the United Nations in 2011. This potential boost would only

impact a very narrow portion of the Chinese economy.

• Fiscal reform at the local government level. This could be a big positive, as

it is slated to create better transparency and improve the financial health

of local governments. In 2010, local governments were responsible for over

80% of fiscal spending, but collected just 45% of the country’s tax revenues,

according to The Economist. Another potential positive development is the

change in the performance evaluation system for local governments. China

is moving away from “growth at all costs” toward including debt levels and

qualitative factors such as the public well-being and ecological protection in

assessing performance. Fiscal reform could reduce the concerns about asset

quality risk at banks and has the potential to reduce some of the imbalances

that have propelled the property market.

• State-owned enterprises (SOEs) will have to juggle competing goals. In

the past, SOEs benefitted from protectionist policies that likely resulted

in inefficient enterprises. These companies were treated as an arm of the

state, there to maximize employment rather than profits. The government

has declared that SOEs will remain a foundation of the economy. However,

it wants to improve the vitality of SOEs by adapting to a market-based

environment and better management practices that focus on efficiency

and return on investment (ROI). SOEs could see their profits reduced as

input costs rise to market-based prices and the payout ratio to the central

government is raised to 30% by 2020, from a current range of 5% to 20%.

The dividend ratio of the “Big 4” banks is already about 35%, so no change

in large banks’ payout is expected in the near term. We are skeptical about

the degree to which SOE reform will actually occur due to incompatible

goals. In order for pricing power, profits and ROI to improve, some companies

would likely need to shutter to reduce oversupply in some industries. This

could cause job losses and social unrest, something the government is

simultaneously trying to avoid.


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• Financial system reforms. Financial reforms have led the reform agenda

over the past year, and are likely to continue to do so in our opinion. Lending

rates moved toward market-based pricing and a deposit insurance plan is

forthcoming, while moving to market-based deposit rates is expected to

eventually happen. Competition on deposit rates is likely to increase the

cost of funding for banks, but higher loan pricing and the ability to offer new

products will offset some of the pressure. China is also moving toward a

market-based government yield curve, which could steepen and increase

both investment returns and profit potential for financials. The yield curve

has been held down artificially by the closed nature of China’s financial

system, where state-owned banks are the primary owners of long-term

government bonds. State-owned banks are likely to invest more in risk-based

assets in the future to match their increased funding costs. This could result

in rates rising as these investors sell government bonds. Also, as foreigners

are allowed to participate to a greater extent, they may demand a higher yield

than the suppressed yields accepted by state-owned banks. We also expect

the reforms to open up opportunities in investment and corporate banking.

China’s currency, the yuan, is also expected to gradually move toward

market-based pricing. However, moving toward a market-based financial

system has significant risks—please see the risk section below for details.

What are some of the risks associated with this idea?

Overall, this Idea is only for investors that can tolerate potentially significant

volatility. However, we believe times of uncertainty are likely to be buying

opportunities.

Near term risks over the next six months could result in growth or the pace of

reforms disappointing, which is likely to test the patience of less-disciplined

investors while providing patient investors with buying opportunities. China’s

policymakers will be walking a tightrope to balance the reforms with economic

stability.

• The pace of reform momentum could slow or reverse and could cause

renewed skepticism by investors and a sell-off in Chinese stocks.

• Tighter financial conditions and slower growth could increase the possibility

of bankruptcies and bad debts on loans issued by banks, individuals and

companies. In response to government “stealth tightening” to clamp down

on shadow banking and excess credit, both government and corporate bond

yields began to rise in November 2013, and prompted the postponement of


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some bond issues for infrastructure projects. As a result of the rising costs and

tighter access to credit, economic growth will likely continue to slow. However,

we believe the slowdown in economic growth and reduced access to credit will

be moderate, and not cause a hard landing in China’s economy.

10-year benchmark government bond yield–China

20072008

20092010 2011

20122013

2014

Yie

ld (

in p

erce

nt)

2.0

3.0

2.5

3.5

4.5

5.0

4.0

Tighter financial conditions in China are a risk

Source: FactSet, JPMorgan Chase. As of January 3, 2014.

Risks over the next one to two years:

• Profits of banks (the largest weight in Chinese large-cap indices) could be

hurt by increased competition.

• China’s financial system is still vulnerable to the after-effects of a rapid

increase in speculative debt between 2009 and 2013. Local government

debt nearly doubled in two years by June 2013, to 17.9 trillion yuan ($2.95

trillion), with nearly 40% of the debt maturing in 2014 according to an audit

performed by the Chinese government. A negatively reinforcing feedback loop

of credit events could occur if reforms happen too quickly or growth slumps

too far. This could happen if problems build on each other—where multiple

large defaults cause other defaults, such as bank closures or the failure of

suppliers to the bankrupt companies. Sectors of concern include property

developers, local governments and small- and medium-sized businesses.

• Financial system reforms carry risks. China’s central bank has indicated some

small banks may be allowed to fail. The government’s crackdown on shadow

banking has contributed to continued liquidity crunches. Periodic surges in

the Shanghai Interbank Offered Rate (Shibor) could result in a rise in defaults


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by shadow bank borrowers, such as property developers, local governments

and small- and medium-sized businesses, if the government oversteps

or miscalculates. Additionally, cleaning up the banks is likely to result in

“deleveraging,” where distressed assets are written down and/or sold. A revival

of “bad banks” like China Cinda Asset Management Company, which had a

successful 2013 initial public offering (IPO) launch in Hong Kong, can help

banks offload their own distressed assets, as can financial asset exchanges

(FAEs), which help facilitate sales of collateral banks seize from bad loans.

Over the next one to two years, a Lehman-like credit crisis is still a slight

possibility. However, we believe the credit issues are manageable—the amount

of bad loans will gradually rise, but not surge. We believe China’s government

has the tools to stem a financial and economic collapse by using a combination

of the following: injecting liquidity into the banking system, devaluing the

currency, and/or stimulating growth if it slows too much by ramping up

infrastructure spending.

The mix of positive and negative factors, as well as their timing, is somewhat confusing. Can you help clarify?

It’s important to note that we believe there are downside risks to China’s

economy due to past credit excesses and the reforms. But we believe a lot of

concerns are already reflected in the stock market. It is possible that credit

events and lower economic figures don’t end up hurting stocks. To the extent

that stocks do get hit on these concerns, we believe they are likely to be buying

opportunities. Here’s a helpful table representing our perspective on the timing

of positive and negative factors.

Time frame Factor Impact Probability

Near term (less than 1 year)

Disappointment in pace of reform

Tighter financial conditions

Negative

Negative

High

High

Next 1–2 years

Consumption accelerates

Fiscal reform

Steepening yield curve raises bank profits

Deposit rate competition cuts bank profits

Multiple significant credit events

Positive

Positive

Positive

Negative

Negative

Medium

Medium

High

High

Medium

Long term (3–7 years)

Small bank(s) fail

Property prices fall by more than 20%

Negative

Negative

High

Medium


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Some of the reforms have been eyed for a long time–why has the time come for real action on reform?

Overall, the pace of implementation of reforms is uncertain and likely to be

uneven. But we believe that even if just a small portion of the reforms are

enacted, this could result in significant changes and improve the intermediate-

term outlook. Some of the reasons we believe China’s government will tackle

reforms include:

• We believe the old economic model was running out of steam and that China’s

leaders know this. China’s economy has become increasingly reliant on debt to

generate growth; yet each dollar of debt was generating ever smaller returns in

terms of growth. Fitch Ratings estimated that between 2009 and 2012, each

1 yuan in new financing generated only 0.30 yuan in new gross domestic

product (GDP) versus 0.71 yuan before the global financial crisis.

• As income levels rise, people tend to aspire for an improved quality of life

and become less tolerant of corruption, threatening the stability of the

Chinese government. Fiscal and SOE reforms could reduce corruption, while

financial system reforms could address imbalances that are favorable to

government-related entities to the detriment of individuals.

• China’s President Xi and Premier Li have only just begun decade-long terms

that end in early 2023, while the terms of the remaining five members of the

top leadership council, the Standing Committee of the Politburo, may end in

2018 if the prior rule on retirement age is enforced. Now is the time to begin

the long process to transform the economy in time for leaders to cement

their legacies.

• President Xi concentrated his power in 2013, and we believe stronger

leadership is necessary to break the vested interests that could stand in the

way of pushing through difficult reforms. However, concentration of power is

also a risk, as unlimited power can lead to corruption or unilateral decisions.

• Reforms to the financial system occurred at a brisk pace in 2013. The goal of

implementing reforms in the Shanghai Free Trade Zone by March 2014, and

target “replicable” and “expandable” financial system reforms that could be

used on a national basis by the end of 2014, indicate the government has the

disposition to act.

China’s old economic

model was running out

of steam—the time is

ripe for change.


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Is there a risk China’s property bubble bursts?

There are certain locations in China where the property market looks “bubbly,”

but these conditions are due in part to a supply shortage and lack of

investment alternatives. Supply hasn’t kept up with demand due to restrictions

on available land; this encourages developers to hoard land, further restricting

supply and putting upward pressure on prices. Also, China’s effort to improve

the supply of “affordable” homes continues to disappoint. Limited investment

alternatives have resulted in wealthy households using property as a place to

park savings.

As a result, the rate of vacancies is high but the inventory available for sale is low.

While property prices have increased, incomes also have rapidly risen. Lastly, the

low use of debt to purchase property means a U.S.-style property bubble burst is

unlikely in our view. That said, we are concerned about the speculation evident in

smaller, “third-tier” cities. However, the reforms to rural land and migrant rights

could result in a movement from farms to these cities, help absorb some of the

excess supply, and potentially even create additional demand.

It is difficult to pinpoint what would cause a sudden shift of confidence by

property owners. There is the potential that, as part of China’s reforms, a rapid

implementation of a large property tax could result in a rush by property

owners to offload property. This could cause a fall in prices and crisis of

confidence. The creation of a robust property ownership database is a

precondition for the tax, and therefore a broad-based implementation is not

likely in the near term.

China’s government has been trying to crack down on the property market

since early 2010 with a series of measures. But the biggest impact was a price

decline of 2.2% from August 2011 to the low hit in July 2012, after which prices

have been increasing according to a 100-city home price index published by

property consultancy SouFun Holdings Limited. If harsher regulations

transpire, property developers could be unable to pay debts if sales are

sufficiently hurt. The corporate sector could be an unexpected source of

trouble. State-owned enterprises in particular have loaned to property

developers, taking advantage of their access to low-cost bank funding to enter

non-core businesses such as lending.


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We believe China’s property market is likely to continue to be volatile as the

government loosens its influence and implements land supply and fiscal

reforms. However, we believe a large scale burst with reverberations

throughout the economy such as that experienced in the U.S. is unlikely.

Has anything changed in the erosion of China’s competitive advantage against the U.S.?

China’s competitive advantage of lower manufacturing costs has been

threatened in recent years, due to rising costs of labor, real estate and

transportation, as well as a rise in the yuan. The size of China’s workforce has

likely peaked due to the lingering unintended effects of the one-child policy,

which took effect over 30 years ago. As a result, the labor market is fairly tight,

resulting in wages having a tendency to rise. While the reforms to loosen this

policy could help, new births won’t contribute to the size of the workforce for

quite some time. Transportation and real estate costs have risen dramatically

over the past decades. Importantly, China’s government has allowed the yuan

to rise 27% since mid-2005 and 11% since mid-2010, making China’s exports

more expensive and less competitive. In fact, the changing manufacturing cost

equation in China has contributed to a “re-shoring” of production from China

back to the U.S.

China’s competitiveness is unlikely to improve significantly without investment

in productivity-enhancing investments such as technology and automation.

Also required is a focus on addressing skills deficiencies by reforming the

education system to improve critical thinking; creativity and innovation;

collaboration and teamwork; and professionalism. However, this is not a barrier

for this Investing Idea to work. Exports are not the major contributor to growth

that most people believe them to be, and production capacity can be

redirected toward the domestic market, away from exports.


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Investment contribution Consumption contributionNet exports contribution

2009 2010 20112012

2013

YTD

con

trib

utio

n to

Chi

na’s

GD

P g

row

th in

per

cent

–8

0

–4

4

12

16

8

Net exports contribute little to China’s GDP

Source: FactSet, National Bureau of Statistics of China. As of December 27, 2013.

What is the prospect for a wage price spiral in China, leading to sharply higher inflation?

China’s workforce size is peaking and we believe incomes will continue to rise,

both in urban and rural areas. However, we don’t believe China has reached the

“Lewis Turning Point” where demand for labor far outpaces the supply of labor

and results in wages spiraling higher very quickly. This would happen when there

aren’t workers available to move from the farm to manufacturing to improve

productivity and economic growth. A January 2013 paper by the International

Monetary Fund estimates that this turning point will be reached between 2020

and 2025, as China’s labor pool currently has an excess supply of about 150

million people, and that the excess will decline to 30 million by 2020.

One of the reforms is to make SOEs more efficient and use market-based

pricing for inputs. As a result, we believe excess capacity, evidenced by

producer prices being negative for nearly two years through November 2013, is

likely to close. This is likely to result in job losses, ease the tight labor market,

and reduce the pressure to increase wages. Additionally, the household

registration reform could also ease the tight labor market. Migrants could leave

the farm and increase the size of the labor pool, producing higher-valued goods


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(which effectively increases the productivity of labor), and slow the upward

trend in wages. Lastly, we believe Chinese manufacturers are increasingly

looking at ways of adding automation to raise productivity and be less

vulnerable to rising wages.

What might happen that would change your outlook for this idea?

There are various factors that could change our outlook. Some examples would be:

• If China’s economic growth slows too far too fast, and results in multiple

midsize credit events, a negative feedback loop could reverberate through

the economy. This would hurt consumer and business confidence, reduce

spending and hiring, and further hinder growth.

• If monetary policy tightens too quickly, either by raising interest rates or

reducing access to credit, this could result in a hard landing that creates a

negative feedback loop.

• If property prices fall significantly for multiple months due to a rapid increase

in inventory from sellers, this could create a crisis of confidence. It could also

catalyze a string of loan defaults that hurt banks and property developers

as well as high net worth investors and companies that have entered the

property market as ancillary businesses.


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Important DisclosuresInvestors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time

shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

Past performance is no guarantee of future results. Sections of this article contain forward-looking statements which reflect the author’s best judgment based on factors currently known but involve significant risks and uncertainties.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Terms and DefinitionsThe Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips and P chips. With 138 constituents, the index covers about 85% of this China equity universe.

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Why New Reforms Make Chinese Stocks Attractive - Michelle Gibley, Director of International...

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