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Why New Reforms Make Chinese Stocks Attractive

October 24, 2014

China’s growth, which had been the envy of the world for decades, has been sputtering in recent years. China’s debt rose sharply as the government began borrowing money at an alarming rate to finance infrastructure projects and other initiatives to keep its economy humming. For five consecutive years through 2013, China issued net debt that was equivalent to more than 30% of its total economy—helping create an economic environment that reminded some of the subprime credit bubble in the United States.

Investors naturally grew concerned and withdrew money over a period of three years; Chinese stocks, as a group, underperformed the broader emerging market index over the past five years.

But has enough changed to put Chinese equities back on the right track?

We believe it has—enough that investors might want to reconsider China as an attractive investment opportunity. 


Why should investors consider China now?

Our position on China is based on both the discounted valuations of Chinese stocks and the leadership’s response to slowing growth. To their credit, China’s leaders recognized the country’s predicament and understood that its former economic model was running out of steam. They knew the country was overly reliant on debt, with not much in the way of a payoff. In fact, from 2009 through 2012 China was able to generate only 0.30 yuan of economic growth for every yuan in new debt, less than half the 0.71 yuan it had generated previously, according to Fitch Ratings.

In November 2013, Chinese officials unveiled a sweeping plan to overhaul its economy, announcing 60 “concrete tasks” to position the world’s most populated country for its next phase of growth. Even if only a small portion of those reforms produce results, they could set the stage for higher-quality and sustainable future growth. 

That bodes well for stock valuations, as investors typically reward high-quality growth over a long period of time. And Chinese stocks have plenty of room to rebound, as they are currently trading at a significant discount both to their historic valuation and the broader emerging market universe.

Investors should be aware that China's growth might continue to decelerate as China’s economy transitions away from its old economic model and implements reforms to overhaul the economy. 

China secondary chart 1b

The reforms to watch

There are six reforms in particular that bear watching because they could trigger significant changes in China’s economy and position the country for higher growth. Three of those could combine to provide a potent boost to consumer spending and productivity. The other three could help transform China’s financial sector from a major concern to a strong source of growth.

Land rights. The first reform involves China’s rural land rights. This could allow farmers to transfer and leverage land as collateral, which would put money in the pockets of low-income consumers and increase their mobility. This historic reform also might trigger the consolidation of smaller farms into larger ones, which could increase food output.

Household registration. China may broaden the issuance of urban household registration cards, known as urban hukou, to millions of migrants in small and midsize cities. These cards provide access to public services such as healthcare, primary education, low-income housing, and social security. This reform could increase the mobility of the labor force and, coupled with the land reforms, spur the next wave of urbanization and productivity gains in China. 

China secondary chart 2b

One-child policy. China is also loosening its well-known one-child policy. While media attention on this reform is high, we believe the economic impact will be only a marginal boost to consumer spending. The birth policy is still restrictive, and with ways to circumvent the rule, as well as the high cost of raising a child, the number of couples interested in having a second child is likely to be modest.

Local government finances. There’s a renewed emphasis on shoring up the financial health of local governments. Municipal governments have been responsible for 80% of the country’s fiscal spending in recent years but have accounted for a little more than half of its tax revenue, according to The Economist. As a result, local governments have had to lean on the unsupervised, shadow banking system for funding. In addition, they have had to raise money from land sales, contributing to imbalances in the property market. China is also considering a more balanced system for sharing revenues and expenses between the central and local governments, permitting municipalities to access the bond market, and potentially allowing local governments to collect property taxes. Taken together, these steps could reduce both investor concerns about asset quality risk at banks and some of the imbalances that have propelled the property market.

Management of stated-owned enterprises (SOEs). China is also shifting SOE focus to efficiency and return on investment. In the past, SOEs have benefitted from protectionist policies that resulted in inefficient enterprises. These companies, effectively, were arms of the state, there to maximize jobs and full employment rather than profits. The government is now aiming to reposition SOEs to adapt to a market-based environment and install better management practices. Additionally, SOEs are being asked to increase the dividends paid to the government. This reform may have trouble gaining traction, because SOE profits could suffer initially as input costs rise to market-based prices and dividends increase. Nevertheless, the potential economic impact is great if the country’s large domestic companies are more focused on profits and efficiencies, and the dividends can be used to help fund fiscal spending.

Financial system reform. Finally, a series of reforms aimed squarely at the financial sector will likely continue to lead the reform agenda. The government has allowed lending rates to shift to market-based pricing. It also signaled that a deposit insurance plan is forthcoming and that deposit rates will become market-based at some point. China also is moving toward a market-based government yield curve, which could steepen and increase both investment returns and profit potential for financials. Cross-border investing between Shanghai and Hong Kong is also forthcoming. These and other reforms also could open up business opportunities for financial institutions. Of course, moving towards a market-based pricing system has significant risks as well as potential upside.

Overall, the pace of the implementation of such a broad slate of reforms will likely be uncertain and uneven, heightening the odds of increased volatility. But it will only take a handful of the 60 reforms proposed to improve the quality of China’s economic growth, and provide a boost to stocks.


Bumps along the way

Of course, investing in Chinese stocks is not risk-free. It's possible that tighter financial conditions and slower growth could increase bankruptcies and bad debt; a prolonged property market correction could risk a deeper slump in China’s overall economy, or the pace of reform momentum could slow or reverse.

Over the next year or two, a Lehman-like credit crisis or property market crash in China is a small probability. However, in our view the credit issues are manageable. We believe China's government has the tools to resolve financial and economic issues by using a combination of the following: injecting liquidity into the banking system, devaluing the currency, and stimulating growth by increased infrastructure spending. Additionally, a downturn in the property market could be cushioned by new household formation, as children move out and multi-generation living arrangements diminish, as well as replacement of outdated structures and government measures to stimulate demand. 

What should investors do now?

Risk-tolerant investors should consider overweighting their holdings of Chinese stocks within their emerging market stock allocation.

Low valuations and depressed investor sentiment have created a potential opportunity in Chinese equities. The government’s dedicated and sweeping reform efforts could provide the impetus for a new phase of growth, even if there are bumps along the way. We think investors should consider buying diversified mutual funds and exchange-traded funds (ETFs) that invest in large-cap Chinese stocks, which could benefit the most over the next six to twelve months since they have the most discounted valuations.

Important Disclosures

Investors 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.

Some specialized exchange-traded funds can be subject to additional market risks. 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.

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

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 is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. 

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

Charles Schwab Investment Advisory, Inc. ("CSIA") is an affiliate of Charles Schwab & Co., Inc. ("Schwab").

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