TheChek News Flow

We met with key officials from government ministries, research institutes and regulators, as well as A-share investors, in Beijing and Shanghai last week. We summarize the feedback below.

A-share Investors: Bullish overall, some genuinely but some reluctantly so

- Domestic institutional investors are universally positive on domestic equities. Key fundamental reasons are signs of modestly improving sequential growth (e.g. NBS PMI), ample room for policy easing amid elevated real interest rates, strong asset reallocation demand to equities from other asset classes, and generally optimistic views and resulting themes on reforms and the noticeable progress on economic rebalancing, especially in the 'new China' space.

- Some fund managers suggested that strong fund inflows leave them with no choice but to stay engaged, especially given the intense performance pressures (49% of mutual funds have outperformed CSI300 so far in 2Q). Year-to-date, according to WIND, Rmb895bn has been raised in the mutual fund industry, and we estimate that mutual funds are close to fully invested, with a median cash ratio of 6.7%.

- Some investors expressed their concerns over the hefty A-share market valuations (Forward P/E: aggregate: 24x, average 79x, median: 55x). ChiNext stocks are at the center of the valuation debate. Contrary to most foreign investors' view about the stock market, and prior to the sharp rotation into large caps from small caps on Monday (June 8), most local investors see better return potential in small caps and new economy stocks than large-cap, value stocks for growth and policy reasons. On the latter, they view ChiNext stocks as offering better risk/reward than large caps as they believe a potential further rally in SHCOMP may trigger a market-unfriendly policy response while regulators are less focused on the small/mid cap universe.

- Potential policy responses/tools to cool down the market that were frequently discussed include: 1) raising stamp duty for stock transactions. For reference, the government raised stamp duty in May 2007 which triggered 6.6% and 9.6% 1D and 1M corrections in A shares, respectively; 2) increasing new supply (IPO) to meet demand; 3) levying capital gain tax; and, 4) further tightening of regulatory oversight on personal leverage and financing activities in the stock market.

- Leverage was at the forefront of many discussions. Official margin financing balance through brokers is now at around Rmb2tn, accounting for 12% of free float market cap (for marginable stocks), easily the highest in the history of equity markets globally. However, this hardly gives a 'true' leverage picture in the system: investors can get leverage through other channels, including P2P financing, umbrella trusts, and short-term consumer loans, which have grown 120% yoy ytd (new loans, as of April).

- Other topical issues included the return of ADRs to A-share listing, inclusion of A shares in MSCI/FTSE, investment themes relating to SOE reforms and Jing-Jin-Ji (JJJ), global investors' strategy in A shares, the outperformance of A vs. H, and the government's role in and stance towards the stock market.

Policymakers/regulators: Growth remains a concern, more policy support warranted

- The reported macro numbers so far this year have been softer than many policymakers expected. The three main drivers of growth are facing their own challenges: (1) investment growth has been weak, dragged by the inventory overhang in the property sector and overcapacity in the manufacturing space, and local governments are constrained by funding sources and incentive issues (anti-corruption); (2) exports have only grown 4% ytd as the Rmb has strengthened on a TWI basis alongside a strong USD, China's cost competitiveness is waning, and China's major trading partners have started the year on a weak note; (3) domestic consumption is hurt by anti-corruption (especially in the high-end segment), strong FX which encourages overseas consumption, and traditional retailers are losing market shares to e-commerce players. 1Q GDP grew 7.0% yoy and 4.2% qoq ann. (qoq ann. based on GS estimate) and would have been meaningfully lower without the contributions from the financial industry.

- Accommodative monetary policy is deemed by policymakers as appropriate to buttress growth and to provide a supportive backdrop to facilitate structural reforms. Policymakers also believe that the high real interest rates in China at present are too prohibitive to demand (1Q weighted average financing costs were close to 7% and latest CPI/PPI was at 1.5%/-4.6% in April) in a slowing-growth environment, and the inflation outlook is unlikely to change the loosening bias in the near future.

- Proactive fiscal policy stance was frequently mentioned by policymakers. Jiangsu kicked off the Rmb1.7tn (1tn LGFV debt conversion + 700bn municipal bonds) local government bond issuance program 2 weeks ago. The province was able to sell the bonds at yields just slightly higher than sovereign bond yields, with commercial banks being the main buyers. Commercial banks will be allowed to use the local government bonds as collateral to borrow from the PBoC. Some expect the program to be scaled up to Rmb3tn to cover loan repayment for local governments this year. Lower bond yields could impact banks' profitability but this could be offset by lower NPL ratios and more favorable risk-weight assets composition, which gives banks extra room to fund other businesses. Besides dealing with local government debts, policymakers are also focused on adjusting taxation policies to stimulate growth/consumption, including cutting taxes for consumer goods (including property), and leveraging FTZs/duty free shops to lure overseas consumption back to China.

- Policymakers stressed that reforms are crucial to improve China's growth trajectory and quality going forward. Most regarded the SOE sector and financial markets as the most important areas for reforms given their growth and strategic importance.

- On SOE reforms, reinforced by the statement issued by President Xi last Friday, the objective is to create a framework to regulate, invest, and operate state's assets through establishing state capital investment companies, increasing participation of private capital in select SOEs, and reforming the incentive system of SOE managers. Trial programs have been put in place for 6 central government SOEs, and the progress will be regularly assessed.

- The policy calendar of financial market reform is relatively more active. Shenzhen-HK Connect, QDII2, and (R)QFII enhancements will likely be announced in 2H15. A-share IPO mechanism reform (from approval- to registration-based) is still on the agenda but the more plausible timing could be in 2016 rather than this year.

- Property investment demand is still subdued, growing only 6% yoy ytd. However, property sales have rebounded meaningfully in recent months and the very different supply and demographic dynamics between high-tiered and lower-tiered cities have led to divergent property price trends in China. Prices are rising noticeably in select tier-1 cities (Shenzhen and Shanghai) while those in lower-tiered cities appear remain under pressures.

- Different facets of 'one belt, one road'. Policymakers expect this to be a key conduit of enhancing/diversifying China's foreign reserves, exploiting strong infrastructure and the related supply-chain demand from emerging markets where China's competitiveness remains high, fostering business and financial cooperation with these markets, and enhancing China's political and economic status in the global arena. Revenue opportunities could be significant (US$70bn of annual investment funding gaps in the related economies; Silk Road Fund has an initial capital of US$40bn but could be significantly expanded in the future; in 2016, our China Infrastructure team expects US$106bn of new investment opportunities related to the initiative) but execution and political uncertainty are the key challenges.

- SDR inclusion is an important symbolic move towards the top-down, strategic objective of internationalizing the Rmb. Against this backdrop, most expect more capital market liberalization measures to be rolled out to facilitate a positive SDR-inclusion decision, which will likely have favorable crossover flow impacts to global asset markets, HK in particular. Some believe that the Rmb exchange rate (fixing) will remain stable leading up to the decision by the IMF in October/November this year, broadly in line with our economists' FX forecast on the Rmb. The SDR review normally operates in a 5-year cycle although off-cycle review could be accepted under special conditions.