SH-HK Connect: New Regime, Unprecedented Opportunity

September 11, 2014 China Strategy SH-HK Connect: New regime, unprecedented opportunity

Portfolio Strategy Research The ‘new’ investment case for China for global/A-share investors

SH-HK Stock Connect: Redefining the Chinese equity market Kinger Lau, CFA +852-2978-1224 [email protected] The Connect scheme brings China A to the global arena and potentially Goldman Sachs (Asia) L.L.C. unleashes significant portfolio flows from China to HK. We provide a framework for the new market landscape for global and A-share investors. Timothy Moe, CFA +852-2978-1328 [email protected] Goldman Sachs (Asia) L.L.C. Global investors: China A is too important to ignore nd rd Ben Bei 1. The scheme creates a single ‘China’ market which ranks as the 2 /3 +852-2978-1220 [email protected] largest globally by cap/turnover, and adds 855 US$1bn companies to the Goldman Sachs (Asia) L.L.C. investable universe. 2. China A will likely be included in global benchmarks Chenjie Liu, Ph.D soon, based on Korea’s and Taiwan’s experience. 3. Global investors may +86(10)6627-3324 [email protected] be able to trade China growth more efficiently in China A. Key micro Beijing Gao Hua Securities Company Limited overlays for stock picking may revolve around scarcity value, GDP proxy, , and . high/stable yields, QFII ownership proper management incentive

A-share investors: Diversification, undervalued growth in HK

The scheme allows Chinese households to diversify their inefficient asset allocation: 72% in property, 6% in equities. Their investment behavior and demand for diversification suggest they may focus on: (1) mid-cap growth stocks, including select dual-listed H on possible re-rating; (2) HK blue chips with global footprint; and (3) household brands not available in A.

Think ahead and get prepared a) Future roadmap of the scheme; b) A-H valuation convergence; c) market impact of liberalization; d) end game for B shares; e) competition between SH and HK ; and f) business challenges for investors

This report is a modified version of SH-HK Connect: New regime, unprecedented opportunity, originally published on Sep 1, 2014.

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S.

The Goldman Sachs Group, Inc. Global Investment Research September 11, 2014 China

Executive summary

A paradigm shift presents new opportunities The SH-HK Stock Connect Scheme will likely commence in October this year, based on guidance from the exchanges when the scheme was first announced in April 2014. In this report, we aim to look beyond the short-term flow and investment implications, and focus on the structural opportunities and the new investment case for Chinese equities that this policy breakthrough may offer global and A-share investors. For our analytical purpose, we assume full liberalization of the scheme throughout this report unless otherwise stated. Our analysis and conclusions are structured as follows:

Part 1: Global investors—China A will become too big to ignore  The scheme essentially integrates China A and HK, creates the 2nd/3rd largest equity market globally by market cap/turnover, and opens up the largely internally-driven China A shares to global investors. Close to US$4tn of incremental market cap and 855 companies (ex dual-listed) with above US$1bn of market cap will become accessible to investors through HK (568 companies with US$2.4tn on current configuration).

 We believe China A will soon be included in global equity benchmarks, expedited by the scheme, and supported by the experiences from Korea and Taiwan during their respective market opening process.

 Global investors may be able to monetize China’s still promising growth in a more efficient and less restrictive manner in A than has previously been the case.

 Other appeals: (1) High and stable dividend yields, and (2) Positive portfolio effects.

Part 2: A-share investors—Diversification, underpriced growth in HK  Chinese household asset allocation is far from efficient: 72% in real estate, 6% in equities—They are incentivized to diversify but channels are rather limited.

 HK-listed stocks provide three themes of diversification: (1) Geographic (non-China revenues); (2) Sector (scarcity value); and (3) Business (Chinese household brands).

 A-share investors are biased towards growth and small caps—HK-listed stocks with similar profile and relatively low valuations than in A could re-rate.

Part 3: Think ahead and get prepared  Future roadmap of the scheme: We see upside risk to both the scale and scope.

 A-H P/E convergence: Potential re-rating on select H shares.

 Market impact of liberalization: Potential near-term excitement, but not long-lasting.

 End game for B shares: Likely more B-H conversion to take place.

 Shanghai vs. HK: Not a zero-sum game as two-way flows could be significant.

 Challenges: Revenue opportunities for investors will come with higher cost base.

Goldman Sachs Global Investment Research 2 September 11, 2014 China

Exhibit 1: What is the Shanghai-Hong Kong Stock Connect Scheme?

Connectivity Model Northbound New Stock Connect Quota – RMB 300bn (~US$48bn, 33% of total) Existing (R)QFII Quotas – ~RMB 601bn (~US$96.848bn)

RMB 13bn (~US$2.1bn) daily quota (19% of SSE securities’ ADVT) RMB 300bn aggregated quota (~5% of SSE securities’ estimated float) Southbound New Stock Connect Quota – RMB 250bn (~US$40bn, 33% of total) Existing QDII Quota – ~RMB 499bn (US$80.493bn) RMB 10.5bn daily quota (~US$1.7bn) 33% of SEHK securities’ ADVT) RMB 250bn aggregated quota (~3% of SEHK securities’ estimated float) Market Comparison Northbound (to SSE) Southbound (to HKEx) Institutional investors (no restrictions on account balance); Eligible Investors No restrictions (local / foreign, retail / institutional accepted) Retail investors with account balance > RMB 500,000 568 Eligible Names 266 Eligible Names Investible World . SSE 180 Index / 380 Index . Hang Seng Composite LargeCap & MidCap Indices . Dual-listed A & H shares listed SSE . Dual-listed A & H shares listed SSE . Opening Call Auction (09:15 – 09:25) . Pre-opening Session (09:00 – 09:30) Market Hours . Morning Continuous Auction (09:30 – 11:30) . Morning Session (09:30 – 12:00) . Afternoon Continuous Auction (13:00 – 15:00) . Afternoon Session (13:00 – 16:00) . At Auction (Pre-opening) Order Types Limit only (no amends, must cancel & re-enter) . Enhanced Limit (Continuous Trading) . No amends, must cancel & re-enter Trading Currency RMB for trading & settlement HKD to trade, RMB to settle Pre-trade Checks Broker level checks on Sells (based on T-1 holdings) Individual level checks on Buys (money) and Sells (stock) Intra-day Trading X √ Margin Trading TBC (offshore) X Securities Lending TBC (offshore) X Short Selling TBC (no naked shorts) X Block / Manual Trades X (block not allowed / manual not supported) X (block not supported / manual not allowed) Odd Lots Sells only TBC Sells only (HKEx) / Both Buys and Sells (SSE) Settlement Cycle . T-day (stock), T+1 (money) . T+2 (DVP) . Handling Fee (SSE) 0.696 bps . Trading Fee (HKEx) 0.500 bps Confirmed Fees & Taxes . Securities Mgmt. Fee (CSRC) 0.200 bps . Transaction Levy (HKSFC) 0.300 bps (New CCASS fee, Mainland . Seller Stamp Duty (SAT) 10.000 bps . Buy/ Sell Stamp Duty (HKIRD) 10.000 bps Dividend & Capital Gains taxes . Clearing: Transfer Fee (ChinaClear)—Note par 6 bps on . Clearing: Settlement Fee (CCASS) HKD$2 - $100 TBD) value RMB1 per share ex 601899 & 603993 par/face value

Source: HKEx, SSE, SAFE, CSRC, Goldman Sachs Securities Division, Goldman Sachs Global Investment Research.

Exhibit 2: Big picture: It is a part of the broader financial/capital market reform and liberalization process

1. Settlement and Providing Clearing agreeement Settlement and Clearing agreement on RMB RQFII expanded to RMB 80bn and Started Personal RMB on RMB business business between PBOC and HKMA financial institutions RMB 80bn RQFII Business in HK between China and registered and quota to Korea Korea Expand RMB Trade RMB settlement expanded with major operations and Germany 2. PBOC abolished Expand HK personal Settlement Pilot to whole China in HK. respectively pricing restrictions on RMB Business Scheme Personal RMB banks; FX First RMB- transactions with Non-tradable business expanded denominated corporates and share reform RMB Trade Settlement to non-locals CNH HIBOR REIT listed households launched pilot scheme fixing launched

Nov 02 Feb 04 Apr 04 Dec 05 Jun 07 Jul 09 Jul 10 Aug 11 Jul 12 Nov 12 Jan 13 Mar 13 13 JunJun 13 13Nov 13 AprApr 14 14 Jul 14

RMB bond issuance Qianhai SHFTZ was QFII Announced pilot RQFII announced in HK cross- set up scheme for RMB expanded to border yuan settlement of QDII US$50bn loan RMB liberalization program Overnight RMB funds Allow foreign RQFII announced Issued launched on T+0 basis and one- institutions to invest Equity market with initial quota at guidance day funds on T+1 basis SH-HK Stock in interbank bond RQFII to be expanded provided for Authorized US$20bn on RMB FDI Connect Other liberalization market with RMB to US$200bn Institutions

Source: HKMA, PBOC, CSRC, SFC, SSE, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 3 September 11, 2014 China

Why the scheme is important to global investors

Exhibit 3: The combined A and HK market would be the 2nd largest equity market in the world and the 3rd largest by cash turnover—simply too big to ignore ADVT Annualized Turnover Velocity (RHS) Total listed market cap (USD tn) US bn 2014 YTD 25 70 3.5 19.2 20 60 3.0 Note: Class market cap is used for 50 2.5 A share and H share 15 40 2.0 10 30 1.5 6.7 6.7 4.6 20 1.0 5 3.9 10 0.5 0 - - LSE LSE NYSE NYSE Euronext NASDAQ Shanghai Shenzhen Taiwan SE Euronext NASDAQ China + HK + China Shanghai Shenzhen Australia SE Taiwan SE China + HK + China SHSE + SZSE Singapore SE Australia SE Hong Kong SE Deutsche Börse SHSE + SZSE SHSE + Singapore SE Singapore Korea Exchange Japan Exchange Hong Kong Kong SE Hong Deutsche Börse Deutsche Korea Exchange Korea Japan Exchange Japan

Source: World Federation of Exchanges, Bloomberg, Goldman Sachs Global Investment Research

Exhibit 4: China A is under-represented in the global equity universe but global investors may find more ‘GDP proxies’ in the market (than in HK)... Macro Average correlation of SPSg & EPSg to GDPg, past 10 years 15% Market 0.8 0.6 0.4 0.2 0.0 0.2 0.4 0.6 0.8 Autos 12.3% Banks 12% Beverage 10.5% Cap Goods Cons Dur. Cons Serv. Market Market 9% Diver. Fins 0.55 0.41 Energy Health. Equip China-A China-H Insurance 6% Materials Media Pro forma weight Pharm Biotech Real Estate 3% Retailing 2.2% 1.8% Semi Software 0.6% Stap Retailing 0.1% Tech H/W 0% Telecom GDP Total cap as % MXCN % in AC China A-shr wgt in A-shr wgt in Transport. of the world World Underweight MXEM (IF=5%) AC World Utilities in global MFs (IF=5%) 0.8 0.6 0.4 0.2 0.0 0.2 0.4 0.6 0.8

Source: FactSet, MSCI, I/B/E/S, WFE, Wind, Goldman Sachs Global Investment Research.

Exhibit 5: ...especially when valuations are low and dividend yields are relatively high CAGR (%) MSCI China-A f-P/E (X) US$bnCumulative free float cap, All China-A US$bn 18% Valuation chg f-12m EPS chg Price return 38 1,000 1,000 165 companies, f-12m P/E (X) [RHS] 34 900 900 12% Total free float cap = $244bn 800 800 30 High-yield opportunities to 6% 700 global Investors 700 26 600 600 22 0% 500 500 18 400 400 -6% 14 300 300

-12% 10 200 200 100 AC World: 100 -18% 6 2.5% 0 87654321 0 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% Past (X)- years 2014 Dividend Yield (%)

Source: FactSet, MSCI, I/B/E/S, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 4 September 11, 2014 China

Why the scheme is important to A-share investors

Exhibit 6: Chinese household balance sheets seem very skewed to real estate and cash equivalents Housing assets as % of total household balance sheets Composition of household financial balance sheets 90 100% Currency Korea (2006) 15% 80 China 90% 22% (2010) 28% Japan (1990) 70 80% 42% 9% Others 45% 0% Spain 54% 60 70% 3% New Zealand USA 72% Other 50 60% 31% Securities Indonesia France Germany Singapore 7% Australia 50% 5% 40 Japan 59% 6% Insurance & Canada Netherlands 3% Pension 40% 56% 30 India Italy 11 % 29% 22% 30% Mutual Fund 20 Taiwan 27% 7% 20% 2% 10 3% 11 % 33% Equity 10% 5% 2% 21% 0 2% 17% 17% 7% 9% 10% 0 10,000 20,000 30,000 40,000 50,000 60,000 0% Per capita income (USD) CN JP UK KR AU TW US Note: OECD countries as of 2010; others as of 2000 except stated otherwise Note: China and Taiwan as of 2012; Others as of 2013

Source: OECD, CEIC, Davies et al. (2009), Central banks of respective countries, Goldman Sachs Global Investment Research.

Exhibit 7: A-share investors are incentivized to diversify, and select HK stocks could help achieve that purpose Efficient frontier (China), past 10 years Exposure to 18% 2013 revenue exposure to China/HK(%) After adding international non- China/HK 100% 5% 16% equities to the portfolio 11% 6% 12% Properties Before 14% 80% 37% 44% 12% Equities (China-A) Optimal 10% 60% By mkt cap combination Equities (AC World) 95% 8% 89% 94% 88% 40% By revenue 6% Corporate bonds Optimal combination 63% Before After 56% Govt. Bond -68% -50% Annualized total return (%) 4% Government bonds 20% Corp. Bond 141% 119% 2% Properties 18% 16% Deposit A-Shares 8% 4% World Equities NA 11% 0% 0% 0% 5% 10% 15% 20% 25% 30% MSCI China A MSCI China H MSCI Hong Kong Annualized risk (%) + HSBC, SCB

Source: FactSet, Bloomberg, MSCI, CEIC, Wind, Goldman Sachs Global Investment Research.

Exhibit 8: A-share retail investors prefer growth over value, small caps over large, and select underappreciated growth opportunities in HK may appeal to them 100 PEG (X) *PEG= trailing PE/ forward12m EPSg 90 2.5 Retail Ownership in the bottom 25%ile 80 Retail Ownership between 25%ile and 50%ile Retail Ownership between 50%ile and 75%ile Chinext 70 2.0 Retail Ownership in the top 25%ile 60

50 1.5

40 15E EPSg (%)

30 1.0

20 "New China" GSNEWCHN 10 0.5

0 Jul-11 Jul-12 Jul-13 Jul-14 Oct-11 Oct-12 Oct-13 Jan-11 Apr-11 Jan-12 Apr-12 Jan-13 Apr-13 0 5 10 15 20 25 30 35 40 45 Jan-14 Apr-14 Market Cap (USD bn)

Source: Bloomberg, FactSet, I/B/E/S, Worldscope, Wind, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 5 September 11, 2014 China

Part 1: The case for Chinese (A-share) equities for global investors

Value proposition #1: Too big to ignore  The Stock Connect scheme essentially integrates China A and the HK market, creates the world’s 2nd largest equity market by market cap (US$6.7tn) and the 3rd largest in terms of cash trading (US$35.7bn/day). Turnover velocity of the combined market would rank 2nd highest globally, just behind Nasdaq.

 The scheme may add close to US$4tn of incremental market cap, and 855 companies with over US$1bn of listed market cap to the investable universe assuming full liberalization (i.e. global investors can buy all A shares listed in both Shanghai and Shenzhen).

 The new investable universe represents 6.4% and 28.9% of the current MXAPJ market cap on partial (only 568 stocks listed on SHSE) and full liberalization based on free-float market cap. We only count A shares that are not listed in HK and A shares that are priced at a discount to their H-share counterparts in the partial universe.

Exhibit 9: The combined A and HK market could be the Exhibit 10: ...and 3rd largest in terms of cash turnover 2nd largest equity market in the world (by exchange)... ADVT Annualized Turnover Velocity (RHS) Total listed market cap (USD tn) US bn 2014 YTD 25 70 3.5 19.2 20 60 3.0 Note: Class market cap is used for 50 2.5 A share and H share 15 40 2.0 10 30 1.5 6.7 6.7 4.6 20 1.0 5 3.9 10 0.5 0 - - LSE LSE NYSE NYSE Euronext NASDAQ Shanghai Shenzhen Taiwan SE Euronext NASDAQ China + HK + China Shanghai Shenzhen Australia SE Taiwan SE China + HK + China SHSE + SZSE Singapore SE Australia SE Hong Kong SE Deutsche Börse SHSE + SZSE SHSE + Singapore SE Singapore Korea Exchange Japan Exchange Hong Kong Kong SE Hong Deutsche Börse Deutsche Korea Exchange Korea Japan Exchange Japan

Source: World Federation of Exchanges, Bloomberg, Goldman Sachs Global Investment Research

Exhibit 11: The scheme may add close to US$4tn of Exhibit 12: ...and 1,253 (1,171 ex dual-listed) companies incremental market cap to the investable universe with over US$1bn of listed market cap assuming full liberalization

Market cap (USD bn) # of companies # of companies (Mkt cap >US$1bn) A shares with H shares 7,000 4,500 A shares listing, premium to H shares with H 6,000 4,000 shares HK shares with A- listing, 5,000 3,500 share listing with discount to value premium to 4,000 3,681 3,000 H-shares A shares 3,000 2,500 New HK shares 2,000 universe to New 1,253 2,000 A shares with H-share global universe to 1,000 with no HK listing, investors A-share 1,500 listing discount to A (Total: 2416) investors - shares 1,000 (Total:

HK shares 1733) LSE 500 with no A- NYSE

share listing Euronext Tokyo SE

- Taiwan SE

Hong Kong SZ SH + HK + SHSE SZSE + Australian SE

China Singapore SE Hong Kong SEHong Kong ShanghaiA SE NASDAQ OMX Shenzhen SE A Deutsche Börse Korea Exchange

Source: CEIC, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 6 September 11, 2014 China

Value proposition #2: China A will be added to global indexes soon  MSCI announced in June 2014 that China A will not be included in the MSCI EM index for its upcoming index rebalancing largely due to the investability constraints linked to the QFII/ RQFII quota systems. However, China A will remain on the review list as part of the 2015 review process, results of which are to be revealed in June 2015.

 FTSE announced in June 2014 the launch of the FTSE Global R/QFII Index Series to prepare market participants for the inclusion of China A in FTSE’s standard indices as a separate index. The next review is due in September 2014.

 While China A isn’t in major global benchmarks yet, we believe the conditions for it to be included are already in place because:

. China has further liberalized the A-share market by raising the size of QFII and RQFII, and broadening the scope of these programs geographically.

. Although the Stock Connect is still subject to quota restrictions, it significantly improves the accessibility of China A to foreign investors, with the total Northbound quota representing close to 5%/20% of the existing free-float market cap/daily turnover of the Shanghai Stock Exchange.

. Based on the past experiences from Korea and Taiwan during their capital market opening processes, it seems China A is not far from being included in terms of the progress made on financial market liberalization, in our view.

 We think the potential inclusion of China A in global equity benchmarks may catalyze a catchup of allocations to China by global investors as it is currently under-represented in the global equity market universe relative to its economic influence: China is 12.3% of global GDP, 11.3% of global trade, 23.1% of global FAI, and 7.9% of global consumption but China’s weight in MSCI AC World is only 2.2%. Furthermore, investors are generally underweight Chinese equities, as suggested by our positioning analysis (in the offshore market) and the low QFII ownership of 3.0% in the A-share market. If China A were to be included in MSCI global benchmark in the next review, we estimate it could result in US$5.3bn/US$21bn of passive fund buying in 2016 assuming a 5%/20% inclusion factor (IF).

Exhibit 13: Korea’s and Taiwan’s experience suggests the conditions for A-share inclusion to global indexes are in place

First time inclusion Event timeline FI can invest in local stocks in MSCI EM (50%) Full inclusion in MSCI EM MSCI EM inclusion through ADR and trusts listed in NYSE FI can buy Financial market liberalization Open convertible Allow Expand future and financial QFII QFII quota (1) (2) (3) investment in quota for 3m market to securities limitation launched 3m money money foreign Allow free capital cancelled market market investors (1) Before first-time QFII/ equity market opening outward remittance instrument instrument (2) After QFII, but before MSCI EM inclusion (3) After first-time inclusion in MSCI EM Taiwan

Partial opening of Issued guidance on the domestic stock Allow FI to issue fixed FI limits on private/ RMB FDI market to FI income securities state-run enterprises QDII quota raised to 55%/30%; expansion Qianhai cross- RQFII border yuan loan Allow foreign A number of Started personal FI could invest via launched program started foreign custodian bank enterprises restrictions on FI RMB business in RMB bond listing in KSE activities were lifted. HK issuance in HK Personal SH-HK RMB Korea QFII QDII Allow FI to participate business Stock launched launched in interbank bond expanded Connect market with RMB to non- locals First time MSCI EM Full inclusion in MSCI EM inclusion in MSCI inclusion to 50% EM (20%) China

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: MSCI, Local stock exchanges, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 7 September 11, 2014 China

Exhibit 14: Chinese equities are under-presented in the equity space and the current foreign ownership is low

Macro Market 15% Pro forma weight 12.3% 12% 11.3% 10.5% 10.2%

9% 7. 9 %

6% 3.0% 3% 2.2% 1.8% 1.3% 0.6% 0.1% 0% GDP Total trade Consumption Total cap as MXCN % in China A-shr wgt in A-shr wgt in A-shr wgt in A-shr wgt in QFII (granted) China as % of the world % of the AC World Underweight MXEM MXEM AC World AC World as % of float world in global MFs (IF=100%) (IF=5%) (IF=100%) (IF=5%) cap in A

Source: Bloomberg, MSCI, Exchanges, CEIC, Goldman Sachs Global Investment Research.

Value proposition #3: More opportunities to monetize China growth  Chinese equities haven’t been an efficient vehicle for investors to trade China’s strong GDP growth in the past decade: HSCEI and CSI300 have generated 15% and 10% total return CAGR since 2003, trailing the nominal GDP (US$) CAGR of 18% and underperforming global peers in terms of converting economic growth into equity returns.

 The slippages between delivered equity returns and economic growth have been mainly driven by the volatility of valuation changes while corporate revenue and earnings have tracked macro growth reasonably well in A shares (Exhibits 16 and 17)

 Looking ahead, we think the efficiency of equity tracking economic growth may improve because:

. Valuations are already at historically and cyclically low levels, measured by both P/E and P/B, thereby reducing valuation volatility, at least to the downside, in our view.

. The opening up of the A-share market may allow investors to capture China growth in a more efficient manner as the fundamentals (sales and earnings growth) of many A-share sectors seem more sensitive to economic growth than China stocks listed in HK, and these sectors tend to have better depth (market cap, liquidity) and breadth (number of companies) relative to the HK market.

. Investors have the opportunity to invest in ‘scarce’ sectors which are only available in the onshore market. Importantly, these sectors usually operate in niche markets where the sensitivity to policy swings and cyclical volatility tends to be lower than the traditional cyclical, FAI-related sectors, which make up a significant portion of the offshore equity universe.

Goldman Sachs Global Investment Research 8 September 11, 2014 China

Exhibit 15: Equity returns have trailed economic growth in China in the past decade

25% 10-year CAGR (2003 - 2013)

ex-CN, RU 20% PH ID R² = 0.71

R² = 0.35 15% SA MY KR SG AU CN-H HK TH DE IN CN-A 10%

MSCI Total Return (US$) TR RU FR TW UK US 5% 0% 5% 10% 15% 20% Nominal GDP Growth (US$)

Source: FactSet, MSCI, CEIC, Goldman Sachs Global Investment Research.

Exhibit 16: Earnings growth has been tracking GDP Exhibit 17: High base and valuation volatility has been a growth quite well but not for stock returns key culprit for the lackluster headline index returns

Rolling 5-year correlation MSCI China-A CAGR (%) MSCI China-A f-P/E (X) 1.00 18% Valuation chg f-12m EPS chg Price return 38 f-12m P/E (X) [RHS] 34 0.75 12% 30 0.50 6% 26 0.25 0% 22 0.00 18 -6% -0.25 EPS growth vs. Real GDP growth 14 -12% 10 -0.50 Total return vs. Real GDP growth 6 -0.75 -18% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 87654321 Past (X)- years

Source: FactSet, MSCI, CEIC, Goldman Sachs Global Investment Research. Source: FactSet, MSCI, Goldman Sachs Global Investment Research.

Exhibit 18: Valuations (ex- and cum- banks) are at historically and cyclically low levels, suggesting lower downside valuation risks than in the past

Forward 12m P/E (X) CSI300 Trailing 12m P/B (X) CSI300 11 45 CSI300 (ex-bank) CSI300 (ex-bank) 10 40 Average Average 9 35 8 30 7 25 +1 Stdev: 21.7X 6 +1 Stdev: 5.0X 20 11.7X 5 Average: 15.1X 1.9X Z Score: -0.79 4 Average: 3.1X 15 Z Score: -0.78 3 10 2 -1 Stdev: 8.5X 5 8.6X 1 Z Score: -0.99 -1 Stdev: 1.2X 1.7X, Z Score: -0.72 - - 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: FactSet, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 9 September 11, 2014 China

Exhibit 19: Global investors may find more opportunities to monetize China growth in select A-share sectors

Average correlation/T-stats of SPSg & EPSg to GDPg, past 10 years Avg correlation [Top] Avg T-stats (simple reg.) [Bottom] 0.8 0.6 0.4 0.2 0.0 0.2 0.4 0.6 0.8 Autos Banks Beverage Cap Goods Cons Dur. Cons Serv. Market Market Diver. Fins 0.55 0.41 Energy Health. Equip China-A China-H Insurance Materials Media Pharm Biotech Real Estate Retailing Semi Software Stap Retailing Tech H/W Telecom Transport. Utilities

3.0 2.0 1.0 0.0 1.0 2.0 3.0

Source: FactSet, MSCI, I/B/E/S, Goldman Sachs Global Investment Research.

Exhibit 20: Investors can find specific niche market exposures that are only available in A shares

Total Average Total Average Industry freefloat Freefloat # of industry company availability market market companies ADVT ADVT cap cap (US$ mn) (US$ mn) GICS Sub-industry AHK (US$ mn) (US$ mn) Cable & Satellite √ X 7 3,288 548 109 18 Commercial Printing √ X 7 2,599 371 116 17 Distillers & Vintners √ X 20 21,787 1,147 345 17 Drug Retail √ X 4 1,291 430 67 17 Electric Utilities √ X 14 4,669 334 80 6 Forest Products √ X 11 3,351 335 124 12 General Merchandise Stores √ X 10 3,487 349 79 8 Housewares & Specialties √ X 9 3,405 486 43 6 Motorcycle Manufacturers √ X 4 1,065 266 42 10 Multi-Utilities √ X 3 1,250 417 29 10 Office Services & Supplies √ X 3 1,233 411 16 5 Precious Metals & Minerals √ X 3 1,160 387 38 13 Publishing √ X 13 7,140 649 237 22 Research & Consulting Services √ X 5 5,089 1,018 66 13 Systems Software √ X 12 5,263 658 211 19 Trucking √ X 11 3,897 354 118 11

Source: Wind, FactSet, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 10 September 11, 2014 China

Value proposition #4: Relatively high yields – compelling with global mandate  Our economists expect global rates (DM in particular) to stay at low absolute levels in the foreseeable future although the Fed may begin to normalize its zero-interest-rate policy starting 3Q15.

 Markets with high dividend yields, and stable dividend growth and payout profile will continue to be in demand in a low rates environment, in our view. China A is currently yielding in a range of 2.9% to 4.2% depending on benchmarks, meaningfully higher than the global aggregate of 2.5%.

 Dividends of China A have also been growing very steadily with low volatility, partly supported by the solid fundamental growth, and partly buttressed by the government’s policy of encouraging dividends in the SOE sector.

 Importantly, the high-yield opportunities seem concentrated in the large-cap, liquid space which may attract interest from global investors with high-yield/income mandates. We estimate the AUM of this subset is about US$1.3tn, of which 30% is eligible to invest in A shares given their geographic focus.

Exhibit 21: China A is offering high dividend yields Exhibit 22: ...with a relatively stable dividend profile compared with global alternatives... 220 D/Y (%)2014E D/Y (%) PayoutRatio (%) Payout Ratio (%) Rebased trailing DPS integer, China-A 5 80 200 180 China Rest of the world 70 160 4 60 140 120 50 3 AC World, 100 2.5% 40 80

2 30 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 20 30% Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 DPSg volatility, past 10 years 25% 1 10 20% SA UK 15% USA India Brazil Korea Japan HSCEI France 10% Taiwan Mexico CSI 300 CSI Canada China-H China-A Thailand Australia SHCOMP Germany

Indonesia 5% Singapore Hong Kong Hong TW KR TH MX SA BR ID DE JP FR CA SG US AU CH UK HK IN

Source: FactSet, MSCI, Goldman Sachs Global Investment Research. Source: FactSet, MSCI, Goldman Sachs Global Investment Research.

Exhibit 23: Over US$200bn free-float market cap of high- Exhibit 24: We estimate at least US$40bn of global and yield opportunities Asia high yield/income funds will be looking to buy high yield stocks in A shares US$bnCumulative free float cap, All China-A US$bn Global equity funds breakdown by style (incl. ETF) 1,000 1,000 165 companies, Geographical Focus 900 900 Total free float cap = $244bn Growth APxJ 800 800 20% High-yield opportunities to Global Europe 4% 700 global Investors 700 26% 20% Japan 600 600 1% Blend Yield/Income 500 500 53% 10% LATAM 400 400 0% 300 300 EEMEA US 0% 49% 200 200 Value 100 AC World: 100 16% 2.5% Others 0 0 1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% Total AUM size = US$13.1tn, based on the Bloomberg fund universe 2014 Dividend Yield (%)

Source: FactSet, I/B/E/S, Goldman Sachs Global Investment Research. Source: Bloomberg, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 11 September 11, 2014 China

Value proposition #5: Positive portfolio effects  It is well documented that China A’s return correlation with global equities has been low as foreign investors’ access has been strictly regulated (by the QFII and RQFII programs) and the market (trading activity) is largely dominated by onshore individual investors who tend to embrace different investment objectives and styles than institutional investors globally.

 This unique characteristic of China A means adding it to a typical global, EM, or Asia- focused portfolio, in most cases would likely generate positive portfolio effects, and improve the theoretical efficient frontier in different phases of the business cycle. See Appendix for details.

 However, we reckon that as foreign participation and ownership increase, the benefits of diversification may recede over time as foreign liquidity flows and positioning become more important to market returns. See Part 3 for more analysis on this topic.

Exhibit 25: A shares have exhibited low return correlations with major global markets, given the low foreign investor participation and ownership

Weekly MSCI market return (USD) correlation, past 10 years CN-A CN-H APJ AeJ JP US EU EM WD Avg CN-A 25% 34% 36% 20% 10% 15% 30% 17% 23% CN-H 25% 92% 82% 64% 75% 85% 86% 88% 74% APJ 34% 92% 98% 66% 73% 82% 96% 87% 78% AeJ 36% 82% 98% 63% 67% 76% 95% 81% 75% JP 20% 64% 66% 63% 54% 60% 61% 66% 57% US 10% 75% 73% 67% 54% 85% 76% 95% 67% EU 15% 85% 82% 76% 60% 85% 85% 96% 73% EM 30% 86% 96% 95% 61% 76% 85% 89% 77%

WD 17% 88% 87% 81% 66% 95% 96% 89% 77%

Source: FactSet, MSCI, Goldman Sachs Global Investment Research.

Exhibit 26: Adding China A to an EM portfolio could Exhibit 27: ...similar to adding to a global equity portfolio provide positive portfolio effects... Efficient frontier, MSCI China vs. MSCI ACWI, past 10 years Efficient frontier, MSCI China A vs. MSCI EM, past 10 years

14.0% CML 16%

14% CML 13.5% 12% China-A China-A Optimal 13.0% Optimal 10%

8% 12.5% MSCI EM 6% MSCI ACWI Annualized total return(USD) Annualized total return(USD) 12.0% 4% 20% 25% 30% 35% 10% 15% 20% 25% 30% 35% Annualized return volatility Annualized return volatility

Source: FactSet, MSCI, Goldman Sachs Global Investment Research. Source: FactSet, MSCI, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 12 September 11, 2014 China

Part 2: The case for HK-listed equities for A-share investors

Current state: A-share investors need to diversify  Chinese households’ balance sheets are heavily skewed towards real assets and cash equivalents, with properties accounting for 72% of their total assets (financial assets + real assets) and cash equivalents representing 72% of their financial balance sheets. Equities, including both direct investment and indirect exposures through mutual funds and retirement money, only take up less than 20% of their financial holdings (6% of their total assets), significantly lower than the average of around 60% in more developed economies.

 As such, this creates a situation where the theoretical investment frontier for onshore investors is far from optimal. We believe a combination of factors is responsible for this, including:

. Limited investment channels (capital account regulations);

. Specific local investment preference (property-heavy); and,

. Inefficient interest rate setting mechanism (non-market-based, implicit guarantee of SOE debts).

In the current setup, we estimate the optimal allocation for A-share investors is to heavily overweigh corporate bonds (mainly due to moral hazard inefficiency), funded by government bonds (unattractive risk/reward relative to corporate bonds), with properties and onshore equities combining to around a quarter of the portfolio (Exhibit 29).

 Assuming no drastic changes to the capital account and interest rate profile in the near future, our model suggests adding global equities to the portfolio would enhance the portfolio’s risk/reward tradeoff, with global equities taking shares from all domestic asset classes.

 Indeed, we note that the demand for diversification (or ‘going out’) from Chinese investors (and consumers) has been strong, as evidenced by the rapid rise of outbound FDI, overseas real asset (property) investment, and outbound consumption, although outward equity portfolio flows have been subdued, constrained mainly by the lack of investment channels.

Exhibit 28: Chinese household balance sheets seem very skewed to real assets and cash equivalents Housing assets as % of total household balance sheets Composition of household financial balance sheets 90 100% Currency Korea (2006) 15% 80 China 90% 22% (2010) 28% Japan (1990) 70 80% 42% 9% Others 45% 0% Spain 54% 60 70% 3% New Zealand USA 72% Other 50 60% 31% Securities Indonesia France Germany Singapore 7% Australia 50% 5% 40 Japan 59% 6% Insurance & Canada Netherlands 3% Pension 40% 56% 11 % 30 India Italy 29% 22% 30% Mutual Fund 20 Taiwan 27% 7% 20% 2% 10 3% 11 % 33% Equity 10% 5% 2% 21% 0 2% 17% 17% 7% 9% 10% 0 10,000 20,000 30,000 40,000 50,000 60,000 0% Per capita income (USD) CN JP UK KR AU TW US Note: OECD countries as of 2010; others as of 2000 except stated otherwise Note: China and Taiwan as of 2012; Others as of 2013

Source: OECD, CEIC, Davies et al. (2009), Central banks of respective countries, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 13 September 11, 2014 China

Exhibit 29: Adding international equities to a typical onshore investor’s portfolio could improve the risk/reward tradeoff

Efficient frontier (China), past 10 years 18% After adding international 16% equities to the portfolio Properties 14% Before

12% Equities (China-A) Optimal 10% combination Equities 8% (AC World)

6% Corporate bonds Optimal combination Before After Govt. Bond -68% -50% Annualized total (%) total return Annualized 4% Government bonds Corp. Bond 141% 119% 2% Properties 18% 16% Deposit A-Shares 8% 4% World Equities NA 11% 0% 0% 5% 10% 15% 20% 25% 30% Annualized risk (%)

Note (1): We use 1-year time deposit rate, S&P China Govt. Bond Index, S&P China Corp. Bond Index, and average building selling price (+ rental yield) to proxy returns for deposit, government bonds, corporate bonds, and properties respectively. Note (2): Annualized total return is the 10-year CAGR (Loc) for different asset classes; Risk is the annualized standard deviation of monthly returns. Note (3): The mean-variance efficient frontier (MVEF) is constructed based on the assumption that investors’ goal is to maximize the expected return on their portfolio for a given level of risk taken (i.e. maximizing the mean for a given variance). For every level of expected return, there is a set of portfolio weights that minimizes the return volatility, and thus MVEF is constructed by different sets of optimal portfolio. Note (4): Optimal combination is calculated based on a hypothetical multi-asset-class portfolio that maximizes the Sharp ratio with risk-free rate being assumed to be the 1-year time deposit rate. Investors with different risk appetites are expected to hold different optimal portfolios lying on the MVEF that offers the best possible expected return at a given risk level.

Source: FactSet, Bloomberg, Wind, CEIC, Goldman Sachs Global Investment Research.

Exhibit 30: Demand for ‘going out’ is strong... Exhibit 31: ...but portfolio flows (both in and out) are constrained by the capital account regulations

US $bn as % of Direct Investment Portfolio Investment: equity US $bn country GDP 140 +27% 2012 12 +45% Portfolio Investment: debt Financial derivatives Other investment Reserves 120 2013 10 200% 100 +193% 8 80 150% 6 60 -46% 100% 4 40 21% 38% 20 2 50% 39% 35% 3% 0 0 11 % 16% 2% Outbound FDI Total Chinese Portfolio Real estate 0% spending outflows investment OutwardInwardOutwardInwardOutwardInwardOutwardInward overseas overseas China (YE13) US (YE13) EU (YE12) Japan (YE12) Note: Outbound FDI is from Bloomberg, Total Chinese spending overseas is from World Tourism Organization, Real Estate investment overseas is from Jones Lang Lasalle.

Source: Bloomberg, World Tourism Organization, Jones Lang Lasalle, Goldman Source: Bloomberg, CEIC, Goldman Sachs Global Investment Research Sachs Global Investment Research

Goldman Sachs Global Investment Research 14 September 11, 2014 China

Value proposition #1: Three themes of diversification in HK We see HK’s diversification appeal for A-share investors coming from 3 different angles:

 Revenue diversification: A-share companies’ revenues, and to a large extent H-share companies, are China-centric, with China A and H generating less than 10% of their total revenues from non HK/China regions.

In HK, using the MSCI HK index as a proxy, HK companies generated over 30% of their sales overseas, with a number of the largest listed companies in HK (excluding A-H dual-listings) boasting significant business footprints in non HK/China regions.

Looking ahead, the well-developed capital market infrastructure, efficient market access, and enhanced integration with China (HK’s hinterland) should continue to help attract multinational and emerging companies to list their shares in HK, further reinforcing HK’s status as the financial gateway of liquidity flows in and out of China.

 Sector diversification: Similar to the argument for global investors who look to broaden their investment frontier in the A-share market, we believe A-share investors would embrace a similar mentality when they position in the HK market. Upstream oil/gas producers, Macau gaming, and property/casualty insurance are the three major sectors that are available only in HK and not in China A, based on GICS sub-industry classification (level 4).

 Business diversification: A-share investors (and press) often bemoan the fact that some of the Chinese household brand names are not listed domestically and hence they are unable to monetize the growth opportunities that these companies may offer. Based on Interbrand’s ranking, we note that 12 out of the top-50 Chinese brands are only listed in HK, with a combined brand value of over US$300bn by Interbrand’s valuation methodology.

Exhibit 32: Select HK stocks offer geographic exposure Exhibit 33: Top-10 largest stocks in HK (ex H shares) diversification to A-share investors generated a large portion of their revenues overseas Exposure to 2013 revenue exposure (%) Others US Europe China/HK 2013 revenue exposure to China/HK(%) non- China/HK 100% 100% 100% 5% 11% 6% 12% 80% 80% 37% 44% 60% 60% By mkt cap

95% 40% 89% 94% 88% 40% By revenue 63% 56% 20% 20% 0% 0% AIA SCB CKH SHK HSBC MSCI China A MSCI China H MSCI Hong Kong Hutch Sands CMHK CNOOC + HSBC, SCB Tencent

Source: Bloomberg, FactSet, MSCI, Goldman Sachs Global Investment Research.

Exhibit 34: Upstream oil/gas companies, Macau gaming, and P&C insurance are not available in the A-share market

Total Average Total Average Industry freefloat Freefloat # of industry company availability market market companies ADVT ADVT cap cap (US$ mn) (US$ mn) (US$ mn) (US$ mn) GICS Sub-industry HK A Oil & Gas Exploration & Production √ X 6 41,973 6,996 119 20 Casinos & Gaming √ X 8 58,718 7,340 320 40 Property & Casualty Insurance √ X 2 7,867 3,934 23 12

Source: FactSet, Wind, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 15 September 11, 2014 China

Value proposition #2: Underappreciated growth opportunities  A strong preference towards growth and small caps. Given onshore individual investors are likely to be the key participants in the scheme (institutional investors can invest overseas through QDII), we feel it is important to understand their investment behavior.

Exhibits 36 and 37 compare the retail ownership of stocks based on their perceived proposition to investors and their liquidity profile in terms of market cap and turnover velocity. It seems clear that A-share retail investors have shown a strong preference towards growth over value, and with noticeable small-mid-cap bias. Sectorally, they seem to favor tech (both Semi and Hardware), ‘New China’ such as Internet and Media, and select consumer sectors including retailing and staples, partly reflecting the abovementioned style and liquidity partiality.

 Growth stocks are in demand in China A. Onshore retail investors’ investment preference, coupled with the fact that they represent 82% of the aggregate A-share market turnover, has led to a phenomenon where high-growth, mid-cap stocks in China A are trading at meaningfully higher valuations relative to their offshore- listed comparables (including ADRs). From a PEG (price-to-earnings-growth) standpoint, growth stocks in China A are priced at close to a 100% premium vs. their offshore counterparts (Exhibits 39 and 40).

 Potential re-rating of select growth stocks in HK. We think it is reasonable to expect the A-H valuation gaps to gradually narrow, facilitated by the improving liquidity porosity between China A and H on the back of the scheme. That said, considering the investment style of both A and HK investors and the potential costs of engaging in that trade, we believe the re-rating opportunities will likely manifest in:

. Small/mid cap universe;

. High-growth stocks;

. Select sectors, mostly from non-traditional spaces that offer strong growth but are priced at discounts to A.

. Select dual-listed names that trade at H-share discounts to A.

Exhibit 35: A-share investors have shown a strong Exhibit 36: ...which leads to high turnover velocity of preference to invest in high-growth, small-mid caps... those stocks

100 10

90 9 Retail Ownership in the bottom 25%ile Retail Ownership in the bottom 25%ile 80 Retail Ownership between 25%ile and 50%ile 8 Retail Ownership between 25%ile and 50%ile Retail Ownership between 50%ile and 75%ile 70 7 Retail Ownership in the top 25%ile Retail Ownership between 50%ile and 75%ile 60 6 Retail Ownership in the top 25%ile

50 5

40 4 15E EPSg (%)

30 3

20 Annualized turnover velocity 2

10 1

0 0 0 5 10 15 20 25 30 35 40 45 0 5 10 15 20 25 30 35 40 45 Market Cap (USD bn) Market Cap (USD mn)

Source: Bloomberg, FactSet, I/B/E/S, Worldscope, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 16 September 11, 2014 China

Exhibit 37: Retail investors are arguably the marginal Exhibit 38: A-share investors seem to favor ‘New China’ price setter in China A given their lion’s share of turnover sectors and tech companies

as % of average daily trading millions Energy volume in A shares in last 5 yrs Insurance 230 Number of individual Transport trading accounts Banks 210 Health Care Equip. Beverage & Tobacco A-share market 190 Utilities retail ownership 18% Div. Fin 82% :54% 170 Food & Staples Consumer Services 150 Auto Properties 130 Pharma Professional Serv 110 Household Products Telecom 90 Durables Capital Goods 70 Retailing Retail investors IT Hardware 50 Materials Institutional investors Semiconductors Media 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Software 30% 40% 50% 60% 70%

Source: CEIC, Goldman Sachs Global Investment Research

Exhibit 39: ‘New China’ and high-growth stocks are Exhibit 40: ...also with lower PEG ratios generally priced more attractively in HK than in China A... Trailing 12m P/E (X) PEG (X) 70 *PEG= trailing PE/ forward12m EPSg 2.5

60 Chinext 2.0 Chinext 50

40 1.5

30 1.0 "New China" 20 GSNEWCHN "New China" 10 GSNEWCHN 0.5 Jul-11 Jul-12 Jul-13 Jul-14 Jul-11 Jul-12 Jul-13 Jul-14 Oct-11 Oct-12 Oct-13 Jan-11 Apr-11 Jan-12 Apr-12 Jan-13 Apr-13 Jan-14 Apr-14 Oct-11 Oct-12 Oct-13 Jan-11 Apr-11 Jan-12 Apr-12 Jan-13 Apr-13 Jan-14 Apr-14

Source: Wind, Goldman Sachs Global Investment Research Source: Wind, Goldman Sachs Global Investment Research

Exhibit 41: Select sectors in HK offer high growth but at discounts to their A-share peers China Offshore (HK-listed) vs. China A 150% Healthcare equip Industry Personal Prod. Market 100% Software Te ch H/W 50% Storage Household Prod. HSCI vs. CSI300 Transport. Infra. Specialty Retail Pharm 0%

GSNEWCHN -50% vs. Chinext (HK-listed offshore -A) China 2014 EPS growth differentials growth EPS 2014 HSMI vs. Chinext

-100% -100% -75% -50% -25% 0% 25% 50% 2014 PE premium/discount (%), HK-listed offshore vs. China A

Source: Bloomberg, FactSet, I/B/E/S, Wind, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 17 September 11, 2014 China

Part 3: Think ahead and be prepared

#1: Future roadmap While the Stock-Connect scheme is undoubtedly a major policy breakthrough in the context of the Chinese capital market, we see this as one of the key steps and milestones in the overall market liberalization regime, because:

. It is an important piece of the broader reform puzzles in China, linking financial market reforms (Rmb internationalization, market efficiency) and SOE reforms (foreign capital participation and SOE restructuring), which we view as the top priority in the policy agenda. Hence it is backed by strong political commitments, implying upside risk to both the scale and scope.

. Experiences of previously announced market liberalization measures, including QFII, QDII, and RQFII, suggest the scheme could gradually expand, especially when the relevant regulatory bodies gain confidence about the executional issues as it develops. In numbers, we forecast the accumulative outward (from China) and inward equity investment portfolio flows attributable to the scheme to exceed US$1tn and US$2tn by 2020, translating into significant revenue opportunities for market intermediaries including exchange operators and brokers.

Exhibit 42: The scheme is one of the major pieces in the broader reform agenda in China Key areas of reform

Financial market Land/rural/ Fiscal reforms SOE reforms reforms hukou reforms

. Division of responsibility and . Increasing the role of market . Raising competitions between . Encouraging urbanization, spending rights between the forces, improving transparency SOE and private companies, circulation of agricultural central and local govts, more and efficiency of financial enhancing SOEs' profitability land, developing intensive transparency and markets, reinforcing the by introducing private farming, and bringing rural accountability on spending mutual beneficial relationship capital/expertise and instilling commercial collective land responsibilities, and a more between the real economy and cost awareness, and into the market to sustain sustainable fiscal revenue the financial market. encouraging M&As to solve and rebalance growth. 3, OBJECTIVES model. over-capacity.

VAT reform extended to Expanded CNYUSD trading CITIC Pacific acquired CITIC Detailed urbanization plan Telecom industry band Group's entire asset with concrete action plans

Suggested budget Preferred share issuance pilot Opened up 80 state popjects Announced Hukou and public management and tax program for private investment service transition procedure collection system modifcation SH-HK Stock Connect scheme PetroChina injected its Eastern Included agricultural Further discussion of China's asset into a subsidiary buildings into real estate introducing property tax(by Nine new capital market reform and allowed private registration system State Council) measures investment

Allowing local govt to issue Lowering ChiNext IPO access Selected 6 SOEs as SOE debt on a trial basis indicator ownership reform pilots

Banks not allowed to use Bank of Communications backdoor transaction that applied for mixed ownership involves disguising corporate pilot loan POLICIES/DEVELOPMENTS State Council approved China Bank's L/D ratio adjustment Everbright to be transformed to shareholding company Si SHFTZ Source: Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 18 September 11, 2014 China

Exhibit 43: Big picture: The scheme is an important part of the broader financial/capital market reform

Nov 02 Feb 04 Apr 04 Dec 05 Jun 07 Jul 09 Jul 10 Aug 11 Jul 12 Nov 12 Jan 13 Mar 13 13 JunJun 13 13Nov 13 AprApr 14 14 Jul 14

RMB bond issuance Qianhai SHFTZ was QFII Announced pilot RQFII announced in HK cross- set up scheme for RMB expanded to border yuan settlement of QDII US$50bn loan RMB liberalization program Overnight RMB funds Allow foreign RQFII announced Issued launched on T+0 basis and one- institutions to invest day funds on T+1 basis Equity market with initial quota at guidance SH-HK Stock in interbank bond RQFII to be expanded provided for Authorized US$20bn on RMB FDI to US$200bn Connect Other liberalization market with RMB Institutions

Source: HKMA, PBOC, CSRC, SFC, SSE, Goldman Sachs Global Investment Research

Exhibit 44: The scale of previously announced market liberalization measures has increased gradually over time

USD bn USD bn Number of QFII accounts 120 800 729 60 100 20000 CSI300 Future 20D Number of QFIIs 100 90 ADVT (RHS) 50 QDII granted 80 600 15000 80 quota (RHS) 40 70 60 60 400 10000 30 50 268 QFII granted 40 40 20 quota 5000 30 200 CSI300 Future 20 10 20 Open Interest 10 0 0 RQFII granted quota 0 - - 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Oct-10 Oct-11 Oct-12 Oct-13 Apr-11 Apr-12 Apr-13 Apr-14 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 May-10

Source: Wind, NBS, CEIC, Goldman Sachs Global Investment Research

Exhibit 45: Further expansion in terms of scale, scope, and geographic linkages of the Scheme is likely, in our view

HK-Shanghai Stock Connect scheme - allows cash equity 2014 trading link-up between HK and SSE (Shanghai Stock Exchange)

Commodity trading link with HK Expansion of quotas ETF inclusion 2015

Geographical expansion (to IPO inclusion FIC trading link with HK include Shenzhen SE) 2016 Further geographical expansion (to include Singapore, Taiwan, London) Connect scheme Shanghai-HK Stock Stock Shanghai-HK Successive steps in stepsSuccessive Further product expansion (to include equity derivatives, structured products ex ETFs) 2017 FIC and commodity link-ups with other exchanges

Source: Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 19 September 11, 2014 China

#2: A-H valuation convergence While the aggregate A-share premium has compressed significantly over time, the upcoming Stock Connect has prompted investor questions on (and desire to trade) the price equalization between dual-listed A and H shares, with the former currently trading at a 24% premium on average but 8% discount to H weighted by total market cap.

Given the scope of this report, we focus on the practical aspects without going into the theoretical arguments behind this phenomenon. Again, we feel it is important to understand the following characteristics between the two markets:

 Style difference: As shown in Exhibits 35 and 36, A-share investors generally prefer growth over value, and small caps over large caps, while offshore investors in HK tend to focus more on valuations, relatively speaking.

 Marginal price setter: A-share retail investors are arguably the price setter in the onshore market as they account for around 80% of the turnover, while HK is driven more by institutional flows, which have an estimated 61% market share (in 2013) based on the survey compiled by HKEx.

Cross-sectional analysis reveals that large-cap stocks with relatively low turnover velocity usually trade at A-share discounts (H premiums) and vice versa, primarily reflecting the difference of investment style and philosophy of the two investor pools, in our view. This is the case for Financials but also applicable to Energy and Utilities.

The enhancing flows connectivity between the two exchanges should help improve the price discovery efficiency and narrow the gaps between A and H. However, investors should be mindful of the following caveats:

 The two markets are still largely dominated by separate investor pools with different investment philosophies.

 Full legal fungibility (the ability to deliver either A or H shares to settle trades), which would almost certainly make the shares trade within a narrower band (not always at parity), is still absent.

 It is difficult to predict in which direction the gaps may converge (i.e. whether A falls or H rises, or a combination of both). Specifically, there are 4 possible ‘arbitrage’ scenarios:

1. Offshore investors sell the overvalued H and buy the undervalued A (large-cap sectors like Financials and Energy). They may be incentivized to switch (assuming they already have positions on H) but it depends on how high the switching costs (transaction cost and market impact) might be. We think select well-held offshore names could be disproportionately impacted by these arbitrage flows.

2. Offshore investors buy small-cap H shares (most are not well covered with thin liquidity) and go short their expensive A-share counterparts, which practically speaking is difficult to execute.

3. A-share investors go short the expensive large caps in HK and buy the undervalued A shares in China, which doesn’t conform to their investment style.

4. A-share investors buy undervalued small-cap H, funded by their A shares, which appears the most plausible scenario to us among the four.

Goldman Sachs Global Investment Research 20 September 11, 2014 China

Exhibit 46: A-H premium, while it still exists, has Exhibit 47: Small caps, which are favored (and frequently compressed meaningfully over time traded) by A-share investors, tend to trade at valuation premiums over their H-share counterparts A/H Premium Average Total-cap weighted 6 220% A-Premium H-Premium 5 180% 4 Bubble size = A/H premium 140% 3 100% 2 60% 24% 1 20% -8% velocity turnover Annualized 0 -20% (1) 0 1 5 25 125 625 Total listed cap (US$bn), log scale Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14

Source: Wind, Bloomberg, Goldman Sachs Global Investment Research. Source: Wind, Bloomberg, Goldman Sachs Global Investment Research.

Exhibit 48: Cross-sectional regression model also Exhibit 49: Price differentials exist even for fully-fungible suggests market cap and turnover ratios are reasonable dual listings explanatory factors for A-H premium T-stats Price (HKD) HSBC HKEx-listed vs. LSE-listed shares Cross-sectional Latest 1Y Avg 105 Premium/Discount, UK vs. HK listed shares [Right] 5% regression premium premium HSBC (HK-listed) 4% Total listed cap (Log scaled) -7.32 -5.94 95 3%

Annualized turnover velocity 2.15 1.40 2%

Market A/H share ratio 1.41 1.08 85 1% Consumer Discretionary 1.02 1.44 0% Consumer Staples -0.65 -0.51 Energy 0.13 0.04 75 -1% Financials -1.23 -1.06 -2% Health Care -0.03 -0.17 65 -3%

Sector Industrials 0.40 -0.17 -4% Information Technology 0.50 0.49 55 -5% Materials 0.64 0.24 Utilities -0.76 -0.31 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 R Squared 0.63 0.53 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Adjusted R Squared 0.56 0.44

Source: Goldman Sachs Global Investment Research. Source: FactSet.

Goldman Sachs Global Investment Research 21 September 11, 2014 China

#3: Market impact of liberalization We believe the Stock Connect scheme will create a platform whereby A-share and global investors can exchange investment philosophies, allowing the two investor pools to assimilate and reshape the future development of the Chinese capital market. In the short run, however, the collision of the two groups may usher in new dynamics to the market. We examine two important events—allowance of direct foreign participation in local equity market (e.g. QFII), and MSCI EM inclusion—in Korea’s and Taiwan’s respective market liberalization processes, which may shed light on what may take place in China in the next few years.

 Market returns: Korea and Taiwan allowed foreign investors to directly purchase domestic equities in 1992 and 1991 respectively subject to specific regulations. In the same year, Korea was admitted to the MSCI EM universe and Taiwan was added in 1996. These two events appeared to have limited return impact on Korea while Taiwan enjoyed a strong rally (and outperformance) on these catalysts.

 Valuations: Taiwan’s rally was primarily fuelled by multiple expansion, and we note there was similar re-rating in Korea, although it was short-lived and lasted for only 1-2 months.

 Turnover velocity: We note there were meaningful increases in turnover velocity in all the three episodes but the rise in trading activity only sustained for 2-3 months, possibly reflecting investors’ initial excitement about the market liberalization developments.

 Volatility: Volatility rose significantly before the QFII implementation in Taiwan but subsequently normalized. In the other two cases, volatility remained largely stable around the events.

 Return correlation: Contrary to common perception, the opening up of these two markets didn’t introduce higher return correlation with global equities (we use MXAPJ as a proxy). We think this reflects the positioning shifts of domestic investors in anticipation of the liberalization measures, and the lagged effects between the opening up and actual implementation by foreign investors when they enter into a new market.

 Foreigners drive market returns? Possibly longer term, but unlikely in China A in the near future. While the relationships are far from stable, foreign investors’ influence on stock prices has been generally high in Asian markets in recent years, much more so for Korea and Taiwan, mainly attributable to the relatively high foreign ownerships in these two markets.

Given the QFII (based on granted quota) and the Northbound Stock Connect quotas in aggregate represent 5.5% of free float A-share market cap, with much lower turnover velocity than individual A-share investors, we believe the latter would remain a dominant marginal price setter in the onshore market until foreign ownership reaches more meaningful levels.

Goldman Sachs Global Investment Research 22 September 11, 2014 China

Exhibit 50: Taiwan rallied on its market liberalization Exhibit 51: ...and the returns were mainly driven by events... valuation expansion Rebased price index (LOC) (event dates = 100) f-12m P/E (X) 300 80 70 MXTW 250 TWSE (First time QFII) (First time QFII) TWSE 60 (First time EM inclusion) 200 50 MXTW (First time EM inclusion) 40 150 30 20 100 KOSPI 10 MXKR (First time EM inclusion) (First time EM inclusion) 50 0 -24-21-18-15-12-9-6-30 3 6 9 1215182124 -24-21-18-15-12-9-6-303691215182124 Months before/after market liberalization events Months before/after market liberalization events

Source: FactSet, Goldman Sachs Global Investment Research. Source: DataStream, I/B/E/S, MSCI, Goldman Sachs Global Investment Research.

Exhibit 52: Turnover velocity rose immediately post these Exhibit 53: Volatility decreased after Taiwan market events but normalized thereafter implemented the QFII system

Annualized turnover velocity, 3M moving average Annualized volatility, rolling 260D 6 70% TWSE TWSE (First time QFII) (First time EM 5 inclusion) 60% TWSE 4 50% (First time QFII)

3 40% KOSPI (First time EM inclusion) 2 30%

1 20% KOSPI TWSE (First time EM inclusion) (First time EM inclusion) 0 10% -24-21-18-15-12-9-6-30 3 6 9 1215182124 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 Months before/after market liberalization events Months before/after market liberalization events

Source: TWSE, KSE, WFE, CEIC, Goldman Sachs Global Investment Research. Source: FactSet, Goldman Sachs Global Investment Research.

Exhibit 54: Empirically, market return correlations with Exhibit 55: Foreign investors generally have high market global equities didn’t rise post the events impact on most Asian bourses

Monthly price (US$) correlation vs. MXAPJ, rolling 2 years Rolling 5Y monthly correl. (net foregin inflows vs. market returns) 0.8 1.0 Korea Taiwan India ASEAN Japan TWSE 0.6 (First time EM inclusion) 0.8

0.4 0.6 0.2 TWSE 0.4 (First time QFII) 0.0 KOSPI 0.2 Current foreign ownership (%) -0.2 (First time EM inclusion) KR TW IN TH PH JP CN 34% 37% 21% 19% 23% 31% 3% 0.0 -0.4 -24-21-18-15-12-9-6-30 3 6 9 1215182124 Months before/after market liberalization events Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14

Source: FactSet, MSCI, Goldman Sachs Global Investment Research. Source: Bloomberg, Local stock exchanges, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 23 September 11, 2014 China

#4: End game for B shares  The B-share market, founded in 1992, was originally designed specifically for foreign investors, but domestic individuals have been allowed to participate since 2001. However, we believe the market is losing its relevance (or its capital raising/allocation function), as evidenced by its falling turnover, and decreasing number of listed stocks. The Stock Connect scheme may further jeopardize its strategic value, in our view.

 We believe the inactivity of the B-share market is partly driven by the very narrow universe (only 104 listed B shares), relatively more complex trading procedures compared to A shares, and foreign currency risk for mainland investors, all contributing to the valuation discounts that B shares are being priced at relative to their A-share tickers.

 B-to-H share conversion seems an effective tool to resolve this legacy issue. We believe B to H conversion offers several advantages: 1) it allows companies to access offshore financing, which is more favorable than onshore funding given the interest rate spreads; 2) illiquidity overhang issues related to B shares would ease; and, 3) listing offshore may enhance a company’s image.

 Three companies have successfully converted their B shares to H in recent years and created meaningful re-rating/trading opportunities during the process. Overall, we believe B shares with stronger balance sheets (especially cash and current assets) are better positioned for the conversion.

Exhibit 56: The relevance and importance of the B-share Exhibit 57: B-share discounts to A have gradually market as a capital intermediary have declined normalized, but still at meaningfully high levels -30% RMB mn -35% 4,500 114 4,000 112 -40% Number of B shares 3,500 110 -45% Cap-weighed B- 3,000 to-A premium 108 -50% (RHS) 2,500 106 -55% 2,000 104 1,500 -60% 6M ADVT 102 1,000 -65% Average B-to-A 500 100 premium -70% 0 98 -75% 2009 2010 2011 2012 2013 201 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: CEIC, Goldman Sachs Global Investment Research Source: Wind, Goldman Sachs Global Investment Research

Goldman Sachs Global Investment Research 24 September 11, 2014 China

#5: Competition between Shanghai and HK Our Global Macro team estimates that equity liquidity in China could reach US$165bn/day, or roughly 70% of regional (Asia-Pacific) liquidity, in 2020, compared with 40% now; and Shanghai could become China’s financial center and dominate China’s equity liquidity by then. However, we do not think Hong Kong will be marginalized due to the rise of Shanghai because:

 As long as the “one-country, two systems” framework remains in place in Hong Kong, and China continues to adopt its current judicial system (civil law based with local characteristics and influence from the CPC) and regulation on information flow, we think Hong Kong will remain the only Chinese city (or Special Administrative Region) where the regulatory and judicial frameworks are aligned with Western practices.

 The rising prominence of Shanghai is predicated on China’s gradual and eventual capital account convertibility. However, we do not think the opening up of the capital account will lead to only one-way capital flow (into China) as:

. Cross-country, empirical evidence suggests the relaxation of capital controls tends to stimulate two-way portfolio investment flows;

. Our interactions with domestic Chinese investors suggest that there is still significant demand for outbound investment and asset diversification from China, which should benefit Hong Kong in the long term.

 Assuming ongoing policy support from China and the determination for the Chinese government to reform its financial markets remains in place, we believe Hong Kong has the necessary qualities to retain its status as a leading financial hub, specializing in connecting China to the rest of the world given its status as China’s offshore Rmb center, and providing asset management services to institutional investors and high net worth individuals in the region.

Goldman Sachs Global Investment Research 25 September 11, 2014 China

Exhibit 58: Shanghai’s cash equity turnover is already 2X Exhibit 59: ...but we still expect HK (HKEx) to capture a that of HK... significant portion (in nominal terms) of China’s outward investment flows through the Stock Connect

(RMB bn) Shanghai Shenzhen HK Combined inward and outward flow at HKEx (USD bn) 160 HK's share of combined inward and outward flow - RHS 140 2,500 100% 120 2,000 100 80% 1,500 80 60%

60 1,000 40% 40 500 20% 20 - 0% 0 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: CEIC, Goldman Sachs Global Investment Research. Source: Goldman Sachs Global Investment Research

Exhibit 60: Removal of capital controls tends to stimulate two-way investment flows

Inward portfolio investment in Outward portfolio investment in equities as % of GDP equities as % of GDP 70% 60%

UK UK 60% 50%

50% 40% 40% US US 30% France 30% Germany France Japan 20% 20%

10% Japan 10% Germany Korea Korea 0% 0% T-9 T-6 T-3 T-9 T-6 T-3 T=0 T+3 T+6 T+9 T=0 T+3 T+6 T+9 T-15 T-12 T-15 T-12 T+12 T+15 T+18 T+21 T+24 T+27 T+30 T+33 T+36 T+39 T+12 T+15 T+18 T+21 T+24 T+27 T+30 T+33 T+36 T+39 Note: Year when all capital controls were lifted (T=0): UK: 1979; US:1974, France: 1990; Korea: 1993; Japan: 1991; Germany: 1981

Source: Bloomberg, Goldman Sachs Global Investment Research.

Exhibit 61: HK is still enjoying its first-mover advantage in terms of amassing Rmb liquidity, which seems sticky

Leading Offshore RMB Centres RMB bn Customer initiated and institutional payments. Inbound + Outbound traffic. Based on value. 1000 Total RMB deposits

RMB top offshore centres weight and rank RMB adoption worldwide (Jan 2014) Hong Kong (excluding China and Hong Kong) 800 UK 26% China, 3% 31% 600 Other Singapore 25% 23% Countries, 24% Taiwan 9% 4% 400 USA 7% 4% Jan 2014 Singapore Other countries split France 7% 200 7% Jan 2013 Australia 5% Taiwan 6% 0 3% Luxembourg 4% Hong 3% Kong, Germany 4% Jun-12 Dec-12 Jun-13 Dec-13 Sep-12 Sep-13 Mar-13 73% 0% 5% 10% 15% 20% 25% 30% 35%

Source: CEIC, HKMA, Monetary Authority of Singapore, SWIFT Watch.

Goldman Sachs Global Investment Research 26 September 11, 2014 China

#6: Human capital and capex We expect China to account for almost 25% of global equity market capitalization by 2030, primarily led by its robust economic growth and continuing financial market deepening, coupled with what we view as reasonable assumptions on normalized equity valuation. Against that backdrop, we see significant business opportunities centering on the following areas:

 DM investment flows (both new buying as well as customary portfolio trading);

 Growth in domestic EM institutional business as domestic saving pools become more institutionalized;

 Addressing the domestic retail investor base;

 Primary issuance, placements;

 Derivative and structured product businesses as equity and related options and futures markets become larger and more liquid;

 Proprietary activities;

 Related businesses- including stock loan, custodial services, foreign exchange settlements, and advisory work- that will be driven by larger and deeper equity markets.

To give a rough sense of the magnitude of the potential ‘plain vanilla’ revenues, we have calculated potential fees on: a) the US$3.9tn of primary issuance that we estimate may transpire over the next 15 years; and, b) secondary market commissions (based on average market cap, 100% annual turnover ratio and 10bp commission rate. Using conservative estimates, these add up to about US$360bn of revenues over the next 15 years or a simple average of US$24bn annually. Given the diverse array of generally more profitable businesses that complement these core equity intermediary activities, the business opportunity is clearly meaningful and could be several multiples of these base figures, in our view.

That said, competitive pressures will probably intensify and the competitive landscape will gradually evolve as the revenue opportunities become more recognized. Specifically:

 Stronger local players will no doubt emerge and change the competitive landscape, leading to more M&A and international expansion.

 The ‘war for talent’ will also become a real issue as financial intermediaries compete to attract capable and experienced people, especially for those who can apply ‘local’ knowledge and investment framework to the increasingly integrated HK/China market.

 The incentive and pressure for localization will increase for global investors: Coverage footprints will expand, demand for local language capabilities will increase as the client mix shifts more towards domestic institutions, and management pressures (for global or regional intermediaries) will intensify given inevitable tensions between local norms/objectives and a given firm’s broader culture and goals.

 The potential revenue opportunity will likely come with a higher cost base, since a greater local focus makes it harder to have scale efficiencies across geographic borders, i.e. a ‘hub and spoke’ model will become more difficult to deploy. This will also make it harder for financial firms to manage through the cycles that will inevitably take place within the context of the longer term structural trends.

Goldman Sachs Global Investment Research 27 September 11, 2014 China

Exhibit 62: Economic growth tends to lead to Exhibit 63: We forecast China to represent almost 25% of financial/capital deepening global market cap by 2030 Cap to GDP ratios GDP per capita (USD) As % of global market cap share 1.3 Cap to GDP ratios, adjusted for valuations 16,000 100% Cap to GDP ratios, unadjusted China 1.2 90% Other EM GDP per capita (right) 14,000 25% 80% DM Asia 1.1 Brazil, Russia, EM and India 53% A clearer relationship 12,000 70% 11% 1.0 60% DM Europe 17% 0.9 10,000 50% 7% 0.8 40% 8,000 30% 15% 0.7 N. America DM 20% 46% Less clear relationship 6,000 0.6 25% 10% Forecast 0.5 4,000 0% 1990 1995 2000 2005 2010 2015 2020 2025 2030 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: WFE, IMF, Goldman Sachs Global Investment Research Source: PBOC, various Central Banks, WFE, IMF, Goldman Sachs Global Investment Research

Exhibit 64: China already has an active and sizeable equity market, but it needs more soft infrastructure capex to support further growth China (SH+SZ) Hong Kong Singapore London New York Equity market cap (US$bn) 3,949 3,101 744 4,429 24,035 Dec 13 Avg daily equity market turnover (US$bn), 31.8 6.1 1.1 12.3 169.5 2013 Issuance, IPO + FO (US$ bn), 2013 70.2 48.8 7.4 47.5 190.3

# of companies >US$1bn by market cap 901 377 94 422 2,317

# of companies >US$1bn by free float cap 337 230 51 363 2,097

Size of bond market as % of GDP, 2013* 50% 71% 83% 242% 216%

Avg daily FX turnover (US$bn), 2013* 44 275 383 2,726 1,263

Assets under management (US$tr), 2012* 0.6 1.5 1.2 7.3 39.6

Employees in the financial sector (000') 294# 239.9 190.1 367.7 599.0

Finance employees as % of total 5.3%# 6.4% 5.4% 7.4% 6.6%

Total number of CFA* 2,919 5,777 3,235 7,219 55,013

Note: * referring to the whole country; # referring to SH only. Source: HKMA, WFE, AsiaBondOnline, TheCityUK, SFC, CEIC, Wind, CFA institute, GS Global Investment Research.

Exhibit 65: International brokers may need to increase their coverage footprint in China A # of stocks 35 HSCI 30 CSI300

25 CSI300 ex A-H dual listed

0 0123456789101112131415161718192021222324252627282930>30 # of Bloomberg estimates

Source: Bloomberg.

Goldman Sachs Global Investment Research 28 September 11, 2014 China

Appendix

Exhibit 66: China A could add positive portfolio effects even during market upturns, mainly due to their low return correlations with regional and global peers Annualized (total) returns (US$) and volatility, MSCI universe, past 10 years

MSCI AC # of China-A China-H China-A MXAPJ China-A MSCI EM China-A World months Return 43% 45% 43% 45% 43% 47% 43% 32% Risk 28% 20% 28% 18% 28% 20% 28% 13% Expansion 46 Correlation 40% 33% 31% 33% Optimal weight 21% 79% 19% 81% 21% 79% 14% 86% Return 14% 21% 14% 18% 14% 20% 14% 13% Risk 32% 27% 32% 18% 32% 20% 32% 12% Slowdown 54 Correlation 64% 48% 47% 34% Optimal weight -16% 116% -5% 105% -4% 104% 3% 97% Return -53% -49% -53% -51% -53% -54% -53% -41% Risk 36% 37% 36% 31% 36% 34% 36% 25% Contraction 12 Correlation 72% 71% 69% 63% Optimal weight 69% 31% 35% 65% 39% 61% 32% 68% Return 8% -31% 8% -37% 8% -40% 8% -42% Risk 27% 30% 27% 26% 27% 25% 27% 20% Recovery 8 Correlation 34% -3% 2% -28% Optimal weight NM NM NM NM NM NM NM NM Return 13% 14% 13% 12% 13% 12% 13% 8% Risk 32% 27% 32% 22% 32% 24% 32% 17% Full period 120 Correlation 59% 48% 47% 39% Optimal weight 23% 77% 26% 74% 31% 69% 39% 61% Note: Returns are expressed in annualized total returns (CAGR) for MSCI indexes in US$; Risk: annualized standard deviation of monthly returns; Correlation: between monthly returns of both asset classes; Optimal weights are calculated based on a hypothetical two-asset-class portfolio that maximizes the Sharp ratio with risk-free rate being assumed to be the period’s monthly average three-month US Treasury Bill yield.

Source: FactSet, MSCI, Goldman Sachs Global Investment Research.

Goldman Sachs Global Investment Research 29 September 11, 2014 China

Equity basket disclosures

The ability to trade the basket(s) discussed in this research will depend upon market conditions, including liquidity and borrow constraints at the time of trade.

The Securities Division of the firm may have been consulted as to the various components of the baskets of securities discussed in this report prior to their launch; however, none of this research, the conclusions expressed herein, nor the timing of this report was shared with the Securities Division.

MSCI disclosure

All MSCI data used in this report is the exclusive property of MSCI, Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced or redisseminated in any form and may not be used to create any financial instruments or products or any indices. This information is provided on an “as is” basis, and the user of this information assumes the entire risk of any use made of this information. Neither MSCI, any of its affiliates nor any third party involved in, or related to, computing or compiling the data makes any express or implied warranties or representations with respect to this information (or the results to be obtained by the use thereof), and MSCI, its affiliates and any such third party hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. MSCI and the MSCI indexes are service marks of MSCI and its affiliates. The Global Industry Classification Standard (GICS) were developed by and is the exclusive property of MSCI and Standard & Poor’s. GICS is a service mark of MSCI and S&P and has been licensed for use by The Goldman Sachs Group, Inc.

Goldman Sachs Global Investment Research 30 September 11, 2014 China

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Goldman Sachs Global Investment Research 31 September 11, 2014 China

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Goldman Sachs Global Investment Research 32 September 11, 2014 China

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Goldman Sachs Global Investment Research 33