Why China and India remain in favour

In an investor dialogue organized by The Asset Events in association with Deutsche Bank in London, a panel of experts share their views

Date

3 May 2018

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Reform and market opening will drive a steady flow of funds from Europe into the capital markets of China and India in 2018. These are not the easiest emerging markets to access but given the stock and bond selection opportunities and the macro growth outlook, China and India are two markets hard to ignore.

Already, the inclusion of China’s A shares in the MSCI emerging markets index in June this year is spurring offshore funds to set up onshore to participate in China’s stock markets. Among those granted licenses to sell onshore funds include Aberdeen Standard Investment, Blackrock, Fidelity International, Schroders and UBS Asset Management.

More recently, Bloomberg Barclays Global Aggregate Indices also announced its plan to include renminbi-denominated government securities and policy bank bonds in the index starting April 2019. When fully accounted for, these Chinese bonds will be the fourth largest currency component following the US dollar, euro and the Japanese yen.

India’s strong economic fundamentals, favourable demographics, attractive yield pick-up, and intention to further increase and simplify the quota and system for foreign portfolio investors (FPI) are among the reasons behind the increased activity among offshore investors in a country predicted to be the world’s third largest economy by 2030.

“China and India are perceived by investors as large but also complex markets,” explains Anand Rengarajan, head of securities services, Asia-Pacific at Deutsche Bank. “Being large, they are attractive from an investor’s standpoint so investors are still enduring some of the difficulties in getting access, notwithstanding recent efforts by India and China to make it easier.”

Leverage in China
An indebted China with 270% of debt to GDP according to one estimate represents a risk for investing in China at this stage. Inevitably, this could lead to bad debt problems for the banks. But speakers at The Asset Investor Dialogue in London seem less perturbed.

“I would not let that put me off as a stock picker,” says Ross Teverson, head of strategy, emerging markets, Jupiter Asset Management, which has US$71.5 billion in assets under management. “There are some fantastic stock-picking opportunities in China. In our emerging market funds we currently have about 16% exposure to China. That is a lot less than the 30% that China represents of the MSCI emerging market index. Nonetheless, it tells you that we are finding a number of opportunities we really liked.”

Arnab Das, head of emerging markets and EMEA macro research, fixed income, at Invesco, which has US$934.2 billion of assets under management, observes that everybody tends to be focused on the large amount of debt in China, and rightly so. “What people tend to emphasize less is the high rate of savings,” he points out.

“China currently saves about 50% of GDP or about US$6.5 trillion to US$7 trillion of annual flow,” he explains. “That’s more than all the other large economies put together.” If a financial crisis happens, Das believes that there are deep pockets in China, which are much deeper than many other places, to help fix that problem.

The flipside of that benign view is, Das continues, “that if you save that much and most of those savings are trapped through capital controls, home bias, and some direct measures by the state to keep savings in various places and to direct savings to companies and sectors, you are pretty likely to get some bad debt”.

It was a problem that threatened to spill over to the rest of the world in 2015 and 2016, especially after the August 2015 devaluation of the renminbi. “The Chinese authorities were able to contain that problem by clamping down on capital outflows,” he explains. “Because they clamped down on all sides of the balance sheet, that is one of the main reasons why we are not having this potential financial crisis which we have been talking about for many years. It was [also] because the state either controls or owns a lot of the banks and corporates or has imposed greater authority over them.”

India challenge and return
In the case of India, Rengarajan shares that the FPI regulation was launched a few years ago and basically opened up India’s market for much simpler access. “But if you look at the experience overall, four years after the FPI has come into existence, people still find some aspects of it fairly challenging.”

He relates that the regulators are looking at forming a small team of people to look into what can be done to further refine it. “We are part of that. There is the opportunity to get much better,” he maintains. “In the current form, while we can say it is way better than what it was a few years ago, in certain aspects, it is still fairly complicated. Documentation and eligibility requirements are still onerous in certain parts and there is significant room for improvement in terms of documentation and process efficiency.”

While hurdles remain, Indian regulators have introduced changes that have been positive. “As a bond investor, the reform I cared most about was the shift towards inflation targeting, which started even before the [Modi] government got on board,” says Kieran Curtis, senior investment manager for emerging markets at Aberdeen Standard Investments, one of the largest active managers in the UK with US$820 billion of assets under management. “And the reason why is that for the first time you can actually make real return on an Indian government bond, which for most of my career has not been possible.”

Inflation in India will likely be centred around the target at 4%. “We are expecting 4.5% this year,” he conveys. “With bond yields at around 7% and with a little bit of a steep yield curve, you get some roll down if you buy a longer-dated bond and you hold it for a couple of years and get a bit of a revaluation effect as well. This steep yield curve was also fairly alien in the Indian bond market throughout most of my career.”

This has come at the same time that it has become much easier to buy bonds. The recent announced change in the quota for the Indian government bond market will make it possible for foreigners to be able to buy 6% of the notional by fiscal year 2019-2020. Curtis notes there have also been micro reforms on the transaction side, which have made it easier to buy and complete purchases of Indian government bonds. “That is a big difference from ten years ago when you would probably have about a 60% hit rate of actually completing trades you create especially when you are based in London with very short cut-off times in confirming trades. We still have issues with cut-off times, but the process has become much cleaner and the authorities have made a real effort to improve the process by lowering the risk of transacting in the Indian bond market now.”

ESG in China and India
As pensions and real-money investors embrace environmental, social and governance (ESG) principles, applying them into emerging markets presents unique challenges for managers. “It is a complex topic when it comes to sovereigns,” describes Salman Ahmed, chief investment strategist, Lombard Odier Investment Managers, which manages US$47.8 billion of assets on behalf of the Swiss-based Lombard Odier group. He adds that the yardstick used to assess sovereigns is quite different from corporates. ESG is also a developing field. Methodologies are being constructed and tested. In some areas, such as in the case of corporates, it is quite rich. “When it comes to sovereigns, we have done quite a bit work internally. We are focused on the E part of ESG or environmental.”

As you start assessing these emerging markets based on criteria shaped by investment values, Ahmed points out, then you lock yourself out of 95% of the emerging-market countries. “The environment side is quite interesting and relevant because tangible signs of climate change are happening and have links to macro outcomes. Most of these emerging markets are exposed to climate change, especially the more populous ones in Asia. There is a lot verifiable data available – carbon intensity, sustainable development goals (SDG) and other World Bank indicators.”

But there is still complexity in how to apply that to portfolios because there are still a lot of hidden variables, he says. “If you rank these countries, say in fixed income using GBI (JPMorgan Government Bond Index) and if you include India and China as well, you might as well rank those countries on a per-capita income basis – countries that are poorer will have lower SDG scores; you might as well not use any ESG criteria and reward/punish these countries on the basis of per-capita income.”

Ahmed says that his firm therefore has to apply “sophisticated investment machinery to take those pseudo effects out and to see what the rankings of these countries actually are, based on the various variables”. He adds that the key is the E part of ESG that has some kind of impact on future performance rather than the S or the G when it comes to the larger emerging markets.

On the equity side, Teverson says that people care a lot about ESG because clients care about it. “I have always been asked about governance because there is this understanding among clients that governance is an important part of long-term investing in emerging markets. Ideally, you have a good alignment of interest between management and minority shareholders.”

There is increasing awareness on E and S, he says, because there is a great push from clients to make sure that they can report to their end-customers that they take these things into account. Teverson is of the view that governance in the emerging markets has improved a lot over the past two decades. One of the easiest ways to prove that is to look at the proportion of companies paying a dividend. “When I started investing in emerging markets in the late 1990s, at the time 40% of companies paid some sort of dividend. Now, that is closer to 90%. Cash coming back to us is the single best measure or evidence that there is some alignment between management and us as minority shareholders.”

In China, Teverson agrees that when the topic of governance is discussed, the question is can the numbers be trusted? “There have been some case studies in the past that have made investors understandably quite wary that companies in China audited by some of the big accounting firms have been lying about their cash balances. As an investor, you always have to be slightly cautious, do your due diligence to make sure that you are avoiding those types of cases of poor governance.”

He argues that those have become less common. It has been a while since we have had an accounting scandal like that in China. Overall, governance is improving even in state-owned enterprises. “China Unicom, which is the second largest mobile operator in China, has recently introduced a management share-based incentive scheme that sets very clear targets for net income growth over the next three years. You have a state-owned enterprise, which previously could just have been a tool of state policy. Now you have a management team that are very clearly incentivized to grow profits and increase value for shareholders.”

Focusing on governance is very important and a good thing to do when it comes to emerging markets, argues Das. Taking a step back, he says the difference between ESG in emerging markets – in China and India in particular – compared with the developed markets is that when poor governance issues emerge in countries with strong institutions and the rule of law, something changes. “Somebody goes to jail; a price is paid; rules are tightened, and things hopefully change, and we don’t have a repeat of the same sort of crisis,” he points out. “In countries with weaker institutions, where the state is involved in large swathes of the economy and very close to many large corporations, it may be quite difficult to make those kinds of changes.”

That is the core reason, he thinks, why you would have a stronger misalignment of minority shareholders’ interest with the majority shareholder. “If you are running a company for a state, presumably you are running it in the public interest. But if the state itself is an authoritarian entity, or the institutions of the state are not necessarily geared towards what you might generally describe as the wider public interest but a much narrower public interest, which is in the case of many emerging-market countries, it may be quite difficult to get that alignment right. You may be able to persuade people that you are doing that by paying them a dividend and it may even be true. But there will be some doubt about that, and therefore there will be a discount for that governance issue.”

Trade war
The other issue that is having an impact on the emerging markets such as China and India is the geo-strategic uncertainty including the possibility of a trade war between the US and China. In an extreme scenario, including actions such as a sharp depreciation of the Chinese currency and using its US Treasuries holding as a weapon, Ahmed believes that in a pure macro analysis of it, it will be China that will be hit the most. “China has a stronger export economy and a depreciation of the currency can destabilize their own financial system. Using US Treasuries might tighten financial conditions in the US but can boomerang back on China. But the pattern, which is appearing from [President] Trump, is very strong bark but very flexible bite.”

Das somewhat differs. “The tail risk of further tension and escalation is quite high. What worries me about this is it is not obvious how either side climbs down. I think it will cause more volatility and disruption than what we have already seen. I tend to agree that it will not lead to a trade war in the end because that is in nobody’s interest.” However, he reckons there will be more rivalries and more difficulties in negotiating and in “taking care of things in a calm way, pointing to more volatility but not a collapse in globalization”. There is good reason to be genuinely concerned, Curtis concurs, partly because some of the grievances the US administration has about how China operates are pretty legitimate. “It is difficult to say, ‘oh yes, everyone will back down on this’, which is possible. The hope is that things don’t escalate into a trade war, but it is not something one can turn a completely blind eye to. Predicting what’s going to happen is very difficult if not impossible.”

An important point on the trade war and how both sides can back down from this to some extent without losing too much face, explains Teverson, is the speech by Chinese vice minister [Liu He] at Davos in January who was volunteering the idea that China would open up a bit more to US goods and services. He was also volunteering the idea that there should be stronger intellectual property protection in China. “If China offers some kind of concession to the US on that front then there is no loss of face at all, as that is what China is already saying it would do.”

One area to watch might be financial services, Curtis proposes. “This is one place China is actually opening up in both directions. This year we had changes to the way that foreign asset management companies can operate in China; as an asset manager you don’t need a local partner. This is a very new thing and we don’t know how it is going to work. We as a business certainly hope to be able to sell global asset management products to Chinese savers in the coming years and to not have to do that through a local partner. At the same time, the opening up of the capital market is designed to offset that flow: so as local savers are able to invest offshore, more channels can be opened up for foreign savings to come into China. The truth is there is pent-up demand on both sides of that balance sheet.” “It is not in anyone’s interest to escalate the trade war further,” agrees Elina Ribakova, chief economist for EEMEA, Deutsche Bank. “China does have higher tariffs than the US on certain products and it has already offered better access to local services as part of the more reconciliatory tone. There is room for small adjustments, which save face to both parties to back away from it.”

Positive outlook
Overall, China and India are improving stories but there are vulnerabilities in the case of China on leverage and India on fiscal issues, says Ribakova. There are structural changes in both cases not to be overlooked.

Chinese consumption, the rise of the middle class and urbanization have been acknowledged for the past ten years. “Export growth is no longer the major driver for Chinese growth for a number of years already. The rebalancing has happened to a large degree. It is consumption that is driving growth more than in the past.”

At the same time, she says, there is also the strong support for the so-called new economy. “In terms of the online or high-tech services to the consumers, China is up there with the US, although it is not yet a big share of GDP. But this could be China’s next plan, including to develop robotics and other IT offerings.”

India’s potential from the middle class, urbanization and transformation has been less publicized. “Until recently, a lot of government policy in India is about lifting from poverty,” Ribakova explains. “But there has been a switch towards improving the quality of life for the middle class and drawing more people into the middle class. There is a story developing and that’s driving expectation for higher GDP growth in the coming years.”

Date

3 May 2018

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