China's Great Leap

China’s government just announced it would take a big step back … and let its economy take a giant leap forward. Don’t underestimate the power of free-market forces as they get unleashed in the world’s second-largest economy, or what these changes could mean for China equities.

A few highlights of the economic reforms announced by China’s government this month included the relaxing of the country’s one-child policy, welfare reform aimed at urbanization, financial reforms for the banking system and new rules for state-owned enterprises (SOEs).

We believe such reforms will accomplish two broad goals that should transform the Chinese economy. First, proposed reforms lessen the government’s hand in operating the economy. As more free-market policies take hold, we believe it will lead to a more efficient allocation of resources throughout the economy and promote a more productive and competitive business environment. Second, the economic reforms will help transition China to a consumption-driven economy, which is needed for the country to avoid a hard landing.

Consider how some of the new reforms accomplish these two goals, and what it means for China. Some of the most important reforms deal with China’s SOEs. The government announced it will allow private companies to enter into some of the industries where SOEs have a monopoly and also will allow the private sector to invest in projects with SOEs. Further, the new reforms hint that the government no longer will financially backstop troubled SOEs.

Historically, SOEs have been a tool used by the government to stimulate the economy. Local and state governments subsidize large SOEs running at a loss to keep the economy afloat, with little concern for the profitability of these enterprises. If SOEs have to compete with private companies, or answer to shareholders, profitability becomes a chief concern. All of a sudden, return on capital becomes important. And without the backing of the government, the SOE will have to learn to operate profitably or cede its market share to competitors. As the government walks away from some of the SOEs that are not profitable, it will likely shutter capacity in large industries such as the steel and cement industries, where reckless borrowing and expansion led to far too much capacity over the last decade.

Reforms to the banking system also play a role in creating a more efficient, market-driven economy. The government has said it will be less involved in bank lending. In other words, banks won’t be asked to give loans to unprofitable SOEs. As part of the reforms, banks will also be given more freedom in pricing the loans. Such reforms strengthen bank balance sheets, but they also encourage lending to only the most profitable companies or projects, dramatically improving the allocation of financial resources within the economy.

The second important aspect of China’s sweeping reforms is that many of the new policies will help transform the Chinese economy from one driven by government investment to one driven by consumption. Relaxing China’s one-child policy is one of the key reforms that will drive the transition — and quickly. Chinese families spend generously on their children, with a lot of parents spending more on their single child than on themselves. Spending on a second child would quickly lead to greater spending on a number of items.

Welfare reforms will also encourage greater consumer spending. Key welfare reforms include Hukou system reform. Hukou is a household registration system that identifies a person as a resident of a specific state. Currently, Chinese citizens can access public health care or attend public schools only in the state where they are registered, and it is even prohibited to buy a home in major cities such as Beijing without Hukou. The limitations to Hukou have led to an estimated population of 230 million rural migrant workers, who take temporary or seasonal jobs in urban areas for part of the year, then return home. These workers consume little as they send money back home and save what they can due to the short-term nature of any job prospects.

Another key welfare reform is Land Reform. The Chinese government is seeking to establish an integrated urban and rural construction land market by allowing rural collectively-owned construction land to be treated similar to urban land. This reform will standardize the rural land acquisition procedure to protect farmers’ rights. The reforms should substantially increase the value of rural construction land and increase farmers’ wealth.

Reforms to the Hukou system will allow the migrant population to permanently move to urban areas where jobs are. As these families settle down, they can get more formal training to land jobs they will keep for the long term. Greater consumption will follow. Hukou reform will have an added benefit in that as these workers take on more permanent jobs, companies can give them better training and improve productivity for their businesses.

Implications for Investors

The economic reforms are transformational for China’s economy, but they also broadly benefit Chinese equities. Fears of a hard landing in China and fears about rising corporate and local government debt have led to a substantial de-rating of Chinese equities, with the MSCI China 12-month forward price/earnings ratio declining from above 15 times forward earnings in 2009 to roughly 9 times earnings today.

In our view, there is opportunity for investors. We believe that economic reforms should allay investors’ main concerns about Chinese markets. The transition to a consumption-driven economy should help China’s economy avoid a hard landing. Meanwhile, as the government steps back to let private industry — rather than government investment — drive the economy, we think debt levels in the country should improve. Corporate debt levels will naturally improve both as troubled and indebted SOEs fail and as banks have more freedom to discourage funding for riskier business investments by not approving such loans. We also expect municipal debt levels to improve as private industry begins to fund projects, instead of municipalities racking up debt by funding projects through local government funded vehicles (LGFVs).

While the moves are good for Chinese equity markets as a whole, we also believe there are a number of specific investment opportunities that will arise. For example, we believe China’s insurance industry is poised to benefit from the relaxing of the one-child policy. With only one child, families felt secure that they had plenty of assets for their child’s future because that single child would inherit assets from his parents and both sets of grandparents. With more children in the family, we believe parents will seek out life insurance to protect their children’s future.

As Chinese consumers grow wealth and increase consumption, we believe it should benefit a number of companies across different industries. Some of the attractive investment opportunities as China transitions to a consumption driven economy include e-commerce companies, automakers and auto dealers, jewelry distributors and large retailers.

Finally, as China’s reforms create a more productive and competitive landscape for businesses, we think investors can benefit by choosing the strongest or lowest-cost competitors in any industry. For example, China’s steel industry is often cited as a troubled industry because of all the overcapacity that was built out when the government encouraged banks to loan to the industry to prop up the economy. But well-run steel companies exist. For example, the best-managed steel company in China operates at 100% capacity utilization with good profitability and cash flow generation, which has allowed the company to pay a dividend to its shareholders over the last 10 years. We believe companies such as this will be well positioned to gain market share when less-efficient steel companies lose government support. We see a similar benefit for the strongest auto manufacturers.

As China carries out its reforms to create an economy driven by free-market forces, it could reshape the country’s economic fortunes. It could also provide a powerful opportunity for investors.

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The views expressed are those of Janus research analysts as of December 2013. They do not necessarily reflect the views of Janus portfolio managers or other persons in Janus’ organization. These views are subject to change at any time based on market and other conditions, and Janus disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any Janus fund.

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