Research Embracing China’s economic shift through the Total China Concept 2018 | ftserussell.com Introduction The China equity market landscape has changed dramatically since FTSE Russell became the first international index provider to launch mainland indexes back in 2001. The number of Chinese listings domestically and abroad has grown rapidly as has its share of emerging market equity portfolios. The problem for international investors is that historically the majority of them have only been able to access China via Hong Kong and overseas listings. As the mainland China equity market continues to open to overseas investment the ability for international investors to gain access to this large and growing market has become easier. Therefore, the questions for international investors are whether they need to include China A shares in their existing China portfolios, and what to do with their existing holdings of overseas China? This paper highlights that to gain a complete exposure to China equities investors need to diversify across all the different China shares classes. The total China concept provides a mechanism to gain access to Chinese listed equities globally and to have diversified sector representation as China continues its development path towards value added manufacturing, and a consumer and service-based economy. China’s giant steps: addressing the current phase of its economic development In 2010, China set a target to double GDP in the decade to 2020. As shown in Exhibit 1, from 2010 to 2016, the GDP of China expanded from USD 6.1 to 11.2 trillion. It is now the second largest economy in the world after the US on a nominal GDP basis.1 The rapid expansion has been driven by export orientated policies. For decades the country benefited as the manufacturing hub of the developed world as global companies took advantage of lower labor costs. The build-up of production capacity led to significant trade growth and resulted in one of the largest worker migration transfers—from the country side to the cities—in recent history. 1 Source: Worldbank.org end of December 2016. FTSE Russell | Embracing China’s economic shift through the Total China Concept 2 Exhibit 1: China’s rapid economic expansion: Nominal GDP (USD trillion) 25 20 15 10 5 0 2001 2004 2007 2010 2013 2016 2019 China Japan United States Euro area Source: IMF, data as of April 2018. Forecasted data is used from 2017. China is in the process of shifting its economic policies from export oriented to service- and consumption-driven. A few examples of the recent established policies and reforms that support the transition are: “Made in China 2025” – a strategic plan issued by Premier Li in May 2015 to move China up the manufacturing value chain by focusing on 10 strategic industries.2 “SOE and Supply Side Reforms” – during the 19th Party Congress (October 2017) it was reemphasized that improving the competitiveness of State Owned Enterprises (SOEs) and dealing with excess capacity in the Industrials and Basic Material industries will continue to be key focus areas for policymakers.3 “Encourage Entrepreneurial Spirit” – policymakers released guidelines in September 2017 to encourage entrepreneurship. The government has vowed to protect Intellectual Property Rights and to further ensure fair competition.4 The transition is evident in the industry breakdown of China’s GDP as shown by Exhibit 2. The economic dependency on heavy industries is diminishing and being overtaken by services as living standards improve and salaries increase. 2 Source: CSIS, Center for Strategic & International Studies, https://www.csis.org/analysis/made-china- 2025 3 Source: PWC Hong Kong November 2017, https://www.pwchk.com/en/research-and- insights/publications/china-s-19th-party-congress/business-review-of-china-s-19th-party-congress.pdf 4 Source: The State Council, The People’s Republic of China, September 2017, http://english.gov.cn/policies/latest_releases/2017/09/25/content_281475884052944.htm FTSE Russell | Embracing China’s economic shift through the Total China Concept 3 Exhibit 2: A new service-based economy emerges from mid-2000s: China GDP by Industry (%) 60 50 40 30 20 10 0 1975 2005 1960 1963 1966 1969 1972 1978 1981 1984 1987 1990 1993 1996 1999 2002 2008 2011 2014 Services Industrial Agriculture Source: Worldbank.org, data as of December 30, 2016. As the shift in economic policy continues, consumer spending will be of greater importance for further GDP growth. China has the ambition of becoming a high- income economy, from a moderate-income level as defined by the World Bank. The gross national income (GNI) per capita has quadrupled since the mid-1990’s to USD 8,259 but is still only 11% of the GNI per capita of the largest economy in the world, the USA. The threshold for high-income status was USD 12,476 in 2016 according to the World Bank.5 Exhibit 3 indicates that the GNI per capita growth for China has slowed in pace over the last couple of years. The ambition of becoming a high- income economy is dependent on the transition of the country to a more services- oriented and consumer based economy. Moving up the manufacturing value chain is also of importance as larger profit margins can boost the domestic manufacturers.6 5 Source: https://blogs.worldbank.org/opendata/new-country-classifications-2016 6 Source: IMF October 2013, “Enhancing China’s Medium-Term Growth Prospects: The Path to a High- Income Economy”, https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Enhancing-Chinas-Medium- Term-Growth-Prospects-The-Path-to-a-High-Income-Economy-40977 FTSE Russell | Embracing China’s economic shift through the Total China Concept 4 Exhibit 3: China playing catch-up: GNI per capita, Atlas method (USD) 60,000 50,000 40,000 30,000 20,000 10,000 0 2007 2014 2001 2002 2003 2004 2005 2006 2008 2009 2010 2011 2012 2013 2015 2016 China Euro area Japan South Korea United States Source: Worldbank.org, data as of December 30, 2016. Although China has one the largest middle-class populations in the world, on a relative basis only 6% of the urban population was classified as upper middle-class in 2010. The McKinsey Global Institute has forecasted that the number will grow to 51% by 2020.7 With an increase in wealth among the population in China it is prudent to assume that consumer habits will change and discretionary spending will increase in tandem with the new wealth. The transition of the economy needs to be supported by innovation. Using R&D spending (% of GDP) as a measurement for innovation, Exhibit 4 illustrates that only the US, Japan and Germany rank higher than China. The policymaker’s plan of turning China into a “great modern socialist country” by 2049 requires three main investment pillars—innovation and new technology, reducing inequality and increasing green development.8 7 Source: McKinsey Insights China: Meet the 2020 Chinese Consumer, https://www.mckinsey.com/~/media/mckinsey/global%20themes/asia%20pacific/meet%20the%20chinese %20consumer%20of%202020/mckinseyinsightschina%20meetthe2020chineseconsumer.ashx 8 Source: PWC Hong Kong November 2017, https://www.pwchk.com/en/research-and- insights/publications/china-s-19th-party-congress/business-review-of-china-s-19th-party-congress.pdf FTSE Russell | Embracing China’s economic shift through the Total China Concept 5 Exhibit 4: Increasing the budget for innovation: R&D spending (% of GDP) 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2001 2003 2005 2007 2009 2011 2013 2015 China Germany United Kingdom Japan United States Source: Worldbank.org, data as of December 31, 2015. China is still a global leader in manufacturing but is shifting from low to high-value added manufacturing. China has emerged as the global leader in automation with the highest stock of industrial robots in the world. From 2009 to 2016, the average yearly growth in the supply of industrial robots in China was 20% - 25%. In 2016 China consumed 30% of the world’s total supply of robots. Despite the domestic demand, foreign robot manufacturers are responsible for 70% of the sales of robots to China. Increased automation is a clear sign of an increase in the sophistication of China’s manufacturing industry.9 The robotics industry is part of 10 strategic industries outlined in the “Made in China 2025” plan. Besides robotics, examples of other strategic industries are: information technology (IT) and new-energy vehicles and equipment. The growth of the IT industry hasn’t gone unnoticed as the largest company listed in Asia is Tencent with a market capitalization of USD 492 billion.10 Maybe less known is that China is the largest market for plug-in electrical vehicles, in 2016 China represented 49.5% of global sales.11 9 Source: IFR.org December 2016, https://ifr.org/downloads/press/Executive_Summary_WR_2017_Industrial_Robots.pdf 10 Source: FTSE Russell end of December 2017 11 Source: EVvolumes.com end of December 2016, http://www.ev-volumes.com/country/total-world-plug-in-vehicle-volumes/ FTSE Russell | Embracing China’s economic shift through the Total China Concept 6 The untapped domestic Chinese equity market China’s domestic equity market has become the second largest in world with a market capitalization of around USD 9 trillion12, as highlighted in Exhibit 5. However, international investors historically have only had access to a small proportion of this market. Using the current access points of Qualified Foreign Institutional Investors (QFII), Renminbi Qualified Foreign Institutional Investor (RQFII) and the Stock Connect programs international investors represent only 2.3%13 of the mainland equity market. Exhibit 5: Market-capitalization of domestic listed companies in 2017 (USD trillion) 35 30 25 20 15 10 5 0 United States China Euro area Japan Source: Worldbank.org, data as of December 29, 2017.