China\'s 12th five-year plan will present many opportunities for the discerning investor.

1. CHINA: The Next Five Years
An introduction to the 12th five year plan
MARTIN GOULET
SENIOR ANALYST
CALIBURN CAPITAL PARTNERS PTE LTD (SINGAPORE)
NOVEMBER 2010
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2. A quick introduction to the 12th five-year plan
From the 15th to the 18th of October, China's 12th five-year plan proposal was discussed and endorsed in
the Fifth Plenary Session of the 17th CPC Central Committee. Though the formal five-year plan outline
will not be published until it is approved by the National People's Congress on March 11th 2011, this
proposal is a useful guideline of what to expect in terms of Chinese government policy over the ensuing
five years.
The National Development and Reform Commission, the country’s effective central economic planning
agency, has highlighted a number of key issues which the five-year plan is meant to address. Broadly,
these are restraining primary resource use and improving quality of life for the country’s 1.3 billion
citizens, particularly those less fortunate.
Why will this affect equity investors in the Greater China region?
The plan will have far-reaching implications on the Chinese economy and society. But it will also have
significant repercussions for listed companies in China’s domestic and offshore equity markets. By
design, the plan’s impact on the business community will be uneven. Some companies are and will be
better positioned to take advantage of this adjustment in national direction. Others will be burdened by
new administrative hurdles or emerging competitive pressures arising from the plan and its policies.
Identifying those companies that will thrive in this new business environment will be instrumental to
generating superior returns in the Greater China equity market. It follows that an active, selective
approach to equity investment in China will outperform a purely passive approach which, in this case, is
most often represented by a simple allocation to the MSCI China or Hang Seng China Enterprise (HSCEI)
indices and their related futures and exchange-traded funds.
What are the plan’s key objectives?
In terms of clear, well-defined policies that will be implemented from 2011 to 2015, the proposal has so
far provided relatively few examples. The comprehensive list will only be made public in March of next
year. Rather, the proposal has focused on issuing broadly defined objectives. Preparations for the plan
have been under way since late 2008, however, and there are already a few examples of laws and
regulations brought forth by the various arms of government that have been recently put in place or
enacted in anticipation of this transition in industrial policy.
The four main targets of the proposed plan are:
• To increase household income as a share of national income;
• To increase private consumption as a driver of China’s GDP;
• To expand the social safety net; and
• To increase China’s resource-usage efficiency.
In order to attain these targets, architects of the proposal have delineated specific areas ripe for reform.
The pricing of energy and resources will be made more competitive as subsidies are withdrawn and
displaced to support the development of clean energy producers and more efficient users. Industries
dominated by large, state-owned enterprises will be rendered more competitive and the companies
themselves subject to income redistribution policies. In order to support private consumption, minimum
wages will be lifted and the supply of social housing will be increased. In order to accelerate the
urbanization of the country’s poorer, inland regions, tax reform, aimed at allowing land-owning farmers to
monetize the real value of their land holdings, is also expected.
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3. Further, the proposal lists seven new strategic industries which the government intends to target for
accelerated development. These include alternative energy, biotechnology, new-generation information
technology, high-end equipment manufacturing, advanced materials, alternative fuel cars and energy-
saving technologies. Though no specific policies have yet been communicated, the government is
expected to direct banks and venture capital and private equity firms to provide funding for these sectors.
Overall, the central theme of the proposed plan is a rebalancing of the Chinese economy, from a focus on
rapid industrialization at almost any cost to more equally distributed growth and greater environmental
sustainability. In its simplest form, this transition will force through a more equal sharing of the economic
pie. In the shake-out, winners and losers will emerge. Wealth will be redistributed from those economic
agents that benefitted from earlier industrial policy – the large state owned monopolies, for example – to
those that are politically important to or strategically necessary for the China of the future such as the
rural peasant or alternative energy producer. We focus on some examples of the different winners and
losers in the sections below.
1. The large, monopolistic SOEs
The government is expected to limit State-Owned Enterprise (SOE) margins and earnings. This will be
far-reaching initiative as there are 6,000 SOEs owned by the central government alone. However, those
SOEs likeliest to be targeted (or targeted to a greater degree) will be those enjoying monopolistic rents.
In China, state sector earnings are driven by a relative handful of sectors. Chief among these are
resources, banks, telecoms and utilities. Some derive a monopolistic or quasi-monopolistic position due
to government licensing requirements as is the case in nuclear power generation, power distribution,
telecommunication services and banks. Others generate revenues through the use of public resources as
is the case in oil fields and hydropower. Indeed, Credit Suisse estimates that among non-financial
corporations, central government-owned companies account for approximately 60-70% of total pre-tax
profits. Within this, around ten major companies in oil, telecoms, power and resource sectors account for
over 60% of central government-owned companies’ earnings. Similarly, policy banks and state-owned
commercial banks, which are all owned by the central government, also account for over 60% of the
profits from financial corporations. From this overall group of monopolistic and/or large state-owned
enterprises, Credit Suisse lists the following as publicly-traded:
• China Mobile Group
• China Telecom Group
• China Unicom Group
• CNOOC Group
• PetroChina
• Sinopec Group
• Shenhua Group
• Yangtze Power Group
• Agricultural Bank of China
• Bank of China
• China Construction Bank
• Industrial & Commercial Bank of China
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4. The economic incentives for SOEs will be altered in several ways. First, competition will be introduced.
On the 26th of July 2010, the State Council assigned responsibilities of boosting private investment to the
relevant ministries which are each expected to create specific policies designed to increase competition in
monopolistic industries.
Due to social pressure for addressing the inequality in wages earned by those working for the large SOEs
and those working in general low-end industries – consider that the average wage at centrally owned
SOEs was about 70% higher than the average urban wage rate in 2009 – the government will cap wages,
or specifically annual employee wage growth, for certain SOEs. This policy will restrain overall income
inequality but will also level the playing field for competitor firms wishing to hire employees at competitive
market rates.
Lastly, for SOEs that enjoy a monopoly or quasi-monopoly position, policies are expected that will
explicitly reduce monopolistic economic rents. This is likely to consist of charging fees for the use of
government licenses or taxes on certain resources. Further, SOEs will be forced to increase dividend pay-
out ratios to parent companies or directly to governments. As of 2007, some SOEs have been required to
pay dividends of 5-10% of earnings to the State-owned Asset Supervision and Administration
Commission and the Ministry of Finance. Deutsche Bank expects that during the next 3-4 years, the pay-
out ratio to rise to 30-40%. In cases where publicly-traded SOEs already make dividend payments to
parent companies, the latter themselves will now be required to increase dividend payments to the
government. Inevitably, this will reduce retained earnings at parent company level thereby reducing
investment and the likelihood of future asset injections to their listed subsidiaries. Interestingly, these tax,
fee and dividend increases will assist in funding the country’s nascent social safety net, itself a major
pillar in the government’s plan to support private consumption, particularly among those least well-off.
The bottom line is that the outlook for the larger, monopolistic SOEs is clouded at best. At the same time,
as indices such as MSCI China and HSCEI are market-capitalization weighted, they have sizable
exposure to these same SOEs. Indeed, as of August 31st 2010, both indices had more than a 45%
weighting in the equities of the SOEs listed above. Out of the 10 largest-weighted positions in each index,
6 figured in this same list. In this case, therefore, an investor passively exposed to either index has to
contend with government-driven headwinds that may persist for some time.
2. The large real-estate developers
The proposal has highlighted the need to increase the provision of public housing, especially public rental
housing owned by local governments for low-income households. Indeed, Deutsche Bank estimates that
the growth rate of public housing investments may continue at 50% for 2011 and 30% p.a. for the
following few years. This is expected to be concentrated in Tier-1 cities where elevated real estate prices
have caused complaints from the public, particularly those with low incomes. This will reduce incremental
demand for commodity housing in tier-1 cities.
The government has long considered some form of property tax in order to raise income. At the same
time, it has wrestled with speculative investment in the property sector. In April and September 2010, the
government announced separate measures to rein in excessive real estate price rises and to curb
property speculation. Rumours of some form of additional property tax have weighed on domestic
equities for some time. In September 2010, China Business News, a domestic business daily, quoted a
source close to the NDRC as saying that the agency had already mooted and later rejected a first draft of
a property tax law from the city of Shanghai. Indeed, the Ministry of Finance announced in early
November 2010 that a property tax was indeed likely for H1 2011. Given acute social pressures on the
issue of poor housing affordability in tier-1 cities (e.g. Shanghai, Beijing, Shenzhen and Guangzhou), a
property tax is likeliest to be applied there in order to put a lid on housing price increases driven by
speculation. As these same cities are the most urbanized by definition, revenues from land sales to local
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5. governments are likely to decline in the future. As result, local governments in these cities are likeliest to
favour the introduction of a property tax.
In contrast, in tier-2 and -3 cities, larger plots of land are still available given their smaller size and relative
under-urbanization. Housing is more affordable and, consequently, there is less social discontent over the
issue. Infrastructure build-outs are still funded largely by land sale revenues at the local government level.
The lack of both political pressure and incentive therefore lowers the risk of a property tax in these cities.
The overall result for listed real estate developers is therefore mixed. Developers with land banks
primarily in tier-1 cities, such as Guangzhou R&F Properties and Shui On Land Ltd, risk slower growth.
Developers that have successfully expanded into tier-2 and-3 cities, such as Evergrande Real Estate
Group, will be less impacted by the advent of a property tax while profiting from the continued
development of China’s heartland cities. Consider that over half of the real estate development segment
in the CSI 300, China’s domestic A-share index, is exposed to companies which themselves have over a
third of their gross assets in tier-1 cities. At the same time, the HSCEI has but a single weighting in a real
estate developer; the aforementioned Guangzhou R&F. The MSCI, on the other hand, has limited real
estate developer exposure overall with only a 3% weighting—entirely insufficient to take advantage of
China’s secular urbanization trend.
3. Consumer-oriented sectors
In China, the ratio of aggregate household income to GDP has been decreasing for the last two decades.
Currently, the ratio mentioned above is the lowest among the world's major economies at 46% (2009).
Moreover, between individual households, there is significant income disparity. The 2009 UN Human
Development Report states that China's Gini coefficient, one of the most widely used metrics of income
inequality, stood at 41.5, compared to India at 36.8, Russia at 37.5, 24.9 for Japan and Zimbabwe at
50.1. This inequality has led to grievances by the public and even social unrest. At the same time, it is
widely noted that private consumption as a share of China's economic growth has been remained muted
in comparison to government and corporate investment. In its five-year plan, the government has
outlined, first and foremost, its intention to reduce income inequality between households as well as
between households and corporations.
The government intends to redress this imbalance partly through further social infrastructure spending
and its continued inland urbanization drive. Government expenditure is expected to shift towards
consumer-oriented priorities such as education, healthcare, social security and pensions going forward.
While the pension system for urban areas has been in place since the early 1990s, a pilot program for
rural areas only started in 2009. By relocating to cities with established pension systems, rural residents
can immediately enjoy the social welfare benefits afforded to urban residents, thereby unlocking their
consumption potential. Urban residency rights are therefore expected to be granted to all urban residents,
including migrant workers. Associated rural land reform will allow farmers to monetize their land-use rights
and properly incentivize them to leave their land. In some regions, banks are expected to start a pilot
program to allow farmers to access loans collateralized by these same land-use rights. Overall, the
central government has officially targeted an urbanization ratio of 60% by 2020 from 47% in 2009 and a
target of 5.8 million new housing units. Credit Suisse has, in fact, forecasted that a simple 1 percentage
point per annum hike in the urbanization ratio will increase the private consumption-to-GDP ratio by
0.33%.
Most importantly, as part of the wage regulation package mentioned previously, the Director of Wages
and Labour at the Ministry of Labour and Social Security issued a statement in July 2010 suggesting that
the government would target a doubling of minimum wages by 2015.
The government will also help support the supply of consumer goods and services in the coming years.
Consumer-oriented industries and businesses will be assisted through a host of directives. As but one
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6. example, the government is expected to provide low-cost land or existing buildings as well as tax
incentives and professional training for the fast-growing elderly care industry. In April 2010, nine
ministries and commissions jointly released policy guidance in relation to the country's "cultural sector",
which includes the production of consumer-oriented goods and services, from art to television
programming. Among other directives, favourable credit policies will be rolled out to promote growth in the
sector.
Inevitably, some companies will fare better in this transition. Consumer oriented companies will clearly
benefit from their customers earning more. Others, such as those operating in labour-intensive industries,
will be pressured to move inland. In September 2010, the State Council issued policy guidance aimed at
encouraging specific industries to relocate to China's mid and western regions. The net result should be
positive for consumption as well as infrastructure and property development in rural areas of the country.
The Chinese consumption story is the clearest case of where an active approach to equity investment will
offer superior returns to passive investment. Firstly, by construction, both the MSCI China and HSCEI
index have relatively limited exposure to consumer-related sectors such as Consumer Staples, Consumer
Discretionary, Healthcare and Information Technology (see Table 1 below). Both indices are heavily
weighted to large Hong Kong listed banks and insurance companies. Rather, Chinese consumer-oriented
companies tend to be both listed onshore as A-shares and much smaller in capitalization. Naturally, the
CSI 300 index has relatively more exposure to consumer-oriented companies simply by virtue of its being
an onshore-listed index. Nonetheless, its large-capitalization orientation also hinders its ability to access
and offer this exposure (see Table 2). Lastly, while some consumer sub-sectors have been singled-out as
likely recipients of favourable fiscal, tax and financial policies, others such as labour-intensive, low-end
electronic goods and textiles manufacturing, face material wage cost increases over the coming years.
There will be an ever larger premium for the ability to pick the right sub-sectors, the right companies and
the right stocks.
Table 1
Weighting of China stocks by sectors
% of total MSCI A‐share H‐share Brazil India Russia Japan US Europe World
China index index
Consumer discretionary 4.4 9.4 2.6 2.5 4.6 ‐ 20.0 9.6 8.2 9.5
Consumer staples 3.9 5.6 0.6 7.2 5.8 0.6 5.5 11.3 12.8 10.1
Energy 17.9 14.8 22.4 26.7 16.7 60.6 1.3 12.5 10.1 10.6
Financials 39.5 27.8 56.2 22.1 25.8 11.5 16.9 14.5 23.5 21.2
Banks 23.7 16.9 18.8 20.1 19.8 11.5 8.7 2.6 13.3 10.2
Insurance 9.4 3.7 16.8 0.2 ‐ ‐ 2.4 3.2 4.9 3.9
Real estate 6.2 4.3 0.5 ‐ 3.3 ‐ 3.2 1.3 0.9 2.3
Healthcare 0.2 4.2 0.9 ‐ 3.6 0.7 6.0 12.5 10.4 8.7
Industrials 8.5 17.1 6.5 1.9 9.1 ‐ 18.7 10.3 10.2 10.4
Capital goods 5.5 12.3 4.0 0.5 9.1 ‐ 13.0 7.7 7.8 7.6
Transportation 3.0 4.4 2.6 1.4 ‐ ‐ 4.6 1.9 1.3 2.1
Information technology 5.5 5.2 0.7 2.2 ‐ 15.5 13.7 19.2 2.8 11.7
Materials 5.5 12.1 5.7 28.4 10.9 13.6 8.4 3.4 9.2 8.4
Telecommunication services 13.1 0.6 2.5 3.8 1.4 9.5 3.8 3.0 7.2 5.0
Utilities 1.5 3.2 1.9 5.3 6.6 3.4 5.8 3.6 5.7 4.4
100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Total; consumer‐related 14.0 24.4 4.8 11.9 14.0 16.8 45.2 52.6 34.2 40.0
Source: Credit Suisse. As at August 31, 2010
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7. Table 2
Weighting of China stocks by market cap
% of total MSCI A‐share H‐share
China index index
Smal l cap ‐ ‐ ‐
Mi d cap 8.0 32.0 0.5
Large cap
92.0 68.0 99.5
100.0 100.0 100.0
Source: Bloomberg. As at Jun 30 2010 for MSCI China and Aug 31 2010 for A, H-Shares indices
4. Polluters and clean energy providers
In November 2009, the State Council announced its objective to reduce the intensity of carbon dioxide
emissions per unit of GDP by 2020 to 40-45% from the 2005 level. This was largely a carry-over from the
previous five-year plan which had pledged, as a one of its objectives, to increase China's energy use
efficiency. This objective, brought forward into the 2011-2015 plan, will be accomplished by taxing fossil
fuel producers and facilitating investment in alternative energy providers.
According to Credit Suisse, China's investment in new energy sources from now until 2020 could reach
RMB 4.5 trillion with the installed power generation capacity of wind and nuclear increasing by over 500%
and 800% respectively. At the same time, on June 1st 2010, China's Ministry of Finance introduced a new
5% ad valorem sales tax applied to producers of crude oil and natural gas in the Xinjiang Uygur
autonomous region. Xinjiang, however, was a pilot program and a similar tax on oil, gas as well as coal, is
expected next year in 12 other western provinces. While the larger, monopolistic resource producers may
pass this tax burden onto end users, smaller operators will be less profitable. As the most important
source of energy-related carbon emissions, the country's inefficient coal mining sub-sector, in particular,
will be the target of forced consolidations and its aggregate output capped. As part of the plan, other
measures to conserve resources and the environment include a change in existing water and power
tariffs to disproportionately penalize heavy users.
The new five-year plan is expected to have a strong focus on improving environmental stewardship. In
this case, outright winners will include alternative energy companies and the more efficient or less
significant users of resources. Among the group of fossil fuel based energy providers, relative winners
could include natural gas drillers and distributors on account of that resource's comparatively low carbon
emission profile. In contrast, the coal mining sector faces significant uncertainty. A hallmark of China’s
particular industrialization phase, coal supplies the lion’s share of the country’s fuel for electricity
production. Nearly one third of the MSCI China's underlying energy sector exposure is to coal mining
companies. This figure is even higher for the HSCEI and CSI 300 indices with 36% and 69% respectively.
Hence, in relation to energy sector exposure, a passive investor in either index will be on the wrong side
of Chinese governmental policy. At the same time, Chinese alternative energy companies, such as
Haitong, Baoding Tianwei or Xinjiang Goldwind Science & Technology often have smaller market
capitalizations and are entirely unrepresented in either the HSCEI or MSCI China index. Within the CSI
300, they face a similar market capitalization hurdle-collectively; these three stocks represent less than
1% of the index. By definition, an active investor in Chinese equity markets benefits from a much wider
opportunity set but they can also elect to invest 'alongside' the government's strategic objectives. Given
the significant degree of government influence in China's economy and capital markets, this would appear
to be the most suitable approach.
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8. 5. The banking sector
The five-year plan may also produce long term winners but short term losers. We expect this to be the
case in the Chinese banking sub-sector. Financials are the single largest sector in Chinese equity
markets, both domestic and offshore. The CSI 300 has nearly 28% exposure to the sector and the MSCI
China index nearly 40%. The HSCEI index itself has over half its weight in financial companies. In each
case, banks represent the largest sub-sector weighting.
Though an investor may eventually want to have exposure to Chinese banking equities, policies and
initiatives tied to the five-year plan may create shorter term headwinds for some companies in the
banking industry. As part of the planned transition towards a slower but more sustainable rate of
economic growth, monetary policy is being normalized and loan growth constrained. Deutsche Bank
estimates that growth in the broad money aggregate (M2) will be capped at 14% (versus 19% in 2010).
All else held equal, banking profit margins will suffer from the loss of volume.
According to external research1, the five-year plan’s call for financial sector reform will likely involve
initiatives such as deposit rate and RMB liberalization. The former is expected to lead, in the shorter term,
to higher deposit rates and lower net interest margins, all other variables being equal. Over the longer
term, as China gradually opens its capital account, larger banks with divisions in Hong Kong should profit
from the eventual influx of RMB denominated deposits to the exclusion of smaller, ‘onshore-only’
operators.
1
Wall Street Journal, Deutsche Bank, HSBC, Macquarie.
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