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Holly LaFon
Holly LaFon
Articles (7844) 

Royce Funds - Investment Opportunities Open as China’s Economy Enters Its New Five-Year Plan

January 24, 2013 | About:
Dilip Badlani is an analyst for Royce & Associates and has 12 years of investment industry experience. Having grown up in Hong Kong, Dilip shares his recent impressions on China's evolving economy, as well as observations about investment opportunities, after meeting with more than 20 companies in Shanghai, Beijing, and Hong Kong nearly two decades after his first trip to mainland China in the early 1990s.Under the guidance of Deng Xiao Ping, China began massive economic reforms in the 1980s, eventually becoming the world's manufacturing center. Along the way, Hong Kong, which was previously full of factories, became a service economy catering to companies interested in doing business in China.

When Great Britain's lease on the island was about to expire in 1997, the impending handover to China created uncertainty and anxiety over Hong Kong's future. The Special Administrative Region (SAR) has since become more and more economically dependent on China, yet it takes pains to distinguish itself, as the slogan "one country, two systems" acknowledges.

My first visit to China was on a trip with Hong Kong schoolmates in the early 1990s. Back then, visiting China was considered roughing it. Hong Kong was among the most cosmopolitan cities in the world, and Shanghai paled in comparison. There were few modern hotel chains operating in the city and very few global brands present. Yet the Hong Kong & Shanghai Bank's old building on the Bund showed the promise that the city held. After all, Shanghai was known as the "Paris of the Orient" in the early 20th century and boasted a lively expat community, including several British, French, and American members.

Today, Shanghai has gone to new heights, boasting Michelin-starred restaurants, luxury brand shops, and the offices of major global financial institutions. Indeed, one of Shanghai's vice mayors, Tu Guangshao, stated in 2010 that, "In the long run, it is impossible for China to have two international financial centers," according to a report issued by the Brookings-Tsinghua Center for Public Policy, the Beijing branch of the U.S.-based Brookings Institution. "China will finally have only one financial center and that is Shanghai."2 As is often the case, there will be an impact on Hong Kong.

Beijing was the first city in China to develop a subway system, with its first line opening in 1969. The subway system was relatively slow in developing until recent decades when both Beijing and Shanghai undertook massive subway expansion projects. Shanghai's system, which opened in 1995, is the largest network in the world, while Beijing's is the fourth largest.

The fares on the subway systems are also relatively reasonable, with tickets costing approximately 30 cents in Beijing and approximately 45 cents in Shanghai. Tourists, business travelers, and locals quickly come to appreciate these extensive networks; the cities' traffic jams are notorious. The number of cars and motorcycles in China increased by 20 times between 2000 and 2010, and China is now the largest new car market in the world.3 The government is continuing to invest in the commuter rail network in China to offset the increased congestion on the roads. From 2009 to 2015, China plans to build 87 mass transit lines in 25 cities at a cost of approximately $160 billion.4

While the pace of economic activity on the ground was still vibrant during my recent visit, there were concerns about how the slowdown in Europe would impact the local economy. China is still an export-driven economy, and Europe is China's largest trading partner. Therefore, the slowdown in Europe has affected the pace of economic growth in China. The country's current account surplus was cut in half between 2007 and 2009, and by 2011 had fallen to 2.8% of GDP.5

China's policy makers have been implementing five-year plans since 1953.7 These plans are meant to serve as guidelines to local officials to calibrate their actions with those of the highest levels of Chinese leadership. China's twelfth five-year plan—released in March 2011 as a guideline for the economy between 2011 and 2015—calls for a restructuring of the economy. The plan lays out an increase in domestic consumption, a shift to higher valued-added manufacturing, an increase in energy efficiency, and a clean-up of the environment.

Increasing domestic consumption's share of China's GDP will be critical to ensuring more balanced growth going forward. There have been measures put in place to increase the wages of local workers, which should drive increased consumption. Over the last 24 months, there have been announcements in several provinces of increases in the minimum wage to the tune of more than 20%. While these wage increases will hurt the profitability of companies on the ground and reduce their export competitiveness, they are beneficial to U.S. and European companies that sell into China. An increase in disposable income will buoy the spending power of these consumers.

Case in point: fast food. It is hard to walk around Shanghai or Beijing without running into American chain restaurants, which are as prevalent there as they are stateside. The growth plans of large U.S. restaurant operators call for significant unit store growth in China as there are still several developing cities that will follow the path of Beijing and Shanghai. One of our investments, which we believe will help us target this growth, is a German manufacturer of commercial kitchen equipment. This company is one of the leaders in making best-in-class equipment that is energy efficient, which operators will view as critical as the cost of energy in China may rise over time.

After decades of being closed off to the world, Chinese consumers have seen their travel restrictions ease over the past decade. While Chinese citizens still lack the flexibility that citizens in the West have, they have embraced their expanded travel privileges. The first half of 2012 saw about 38 million Chinese citizens travel abroad, representing an increase of 18% over 2011.8 By 2020, the WTO estimates that approximately 100 million Chinese tourists will travel outside of China.9 We have invested in several global brands that are likely beneficiaries of Chinese consumers who use their purchasing power overseas.

As these Chinese citizens travel overseas, they will better appreciate the diaspora of their countrymen: more than 50 million people of Chinese descent are estimated to be living outside of China.10 In Singapore, the Chinese represent the majority of the population,11 while in Malaysia, Indonesia, and Thailand they make up five to 10 million people.12 One of our investments is a leading publisher of Chinese-language newspapers and magazines in Hong Kong, Malaysia, and North America. The company should be a beneficiary of Chinese consumers and immigrants traveling overseas.

Traveling abroad naturally causes one to rethink one's own country, just as rising incomes cause people to demand other improvements in quality of life. China's environment has suffered from the break-neck pace of economic growth. The air in Beijing takes a toll on the lungs, and there are days when the smog heavily obscures skyscrapers and historic monuments, as I witnessed on my recent trip.

One of our investments is a Swiss-based company that manufactures ventilation systems. Its systems filter pollutants out of the air and have a high-heat recovery that reduces energy needs. As the next wave of construction in China occurs, buildings will need such systems in order to ensure the comfort of their inhabitants and to meet environmental expectations.

China is critical to any investor—it is the second-largest economy on the planet. While the growth rate that China has enjoyed over the last three decades has been truly impressive, it may no longer be sustainable. In order to maintain a more balanced economy, a slower growth rate may indeed be preferable as the country adapts to its massive infrastructure, nurtures middle class consumption, and maintains stability. This slower growth rate will still represent ample investment opportunities that we will continue to monitor.

1Wikipedia, http://en.wikipedia.org/wiki/File:Prc1952-2005gdp.gif

2China Briefing, http://www.china-briefing.com/news/2010/07/26/china%E2%80%99s-financial-center-shanghai-or-hong-kong.html

3The Guardian, [url=ttp://www.guardian.co.uk/environment/2011/aug/24/china-cars-green-vehicles]ttp://www.guardian.co.uk/environment/2011/aug/24/china-cars-green-vehicles[/url]

4Sohu, http://business.sohu.com/20100323/n271038342.shtml

5International Monetary Fund, http://www.imf.org/external/pubs/ft/wp/2012/wp12100.pdf

6The World Bank, http://www.worldbank.org/content/dam/Worldbank/document/cqu_apri_2012_en.pdf

7BBC News, Asia-Pacific, http://www.bbc.co.uk/news/world-asia-pacific-12639898

8China Daily, http://www.chinadaily.com.cn/china/2012-08/22/content_15697736.htm

9China Internet Watch, http://www.chinainternetwatch.com/1470/100-million-chinese-tourists-will-travel-outside-china-by-202/

10China.org.cn, http://www.china.org.cn/china/NPC_CPPCC_2012/2012-03/11/content_24865428.htm

11Department of Statistics, Singapore, http://www.singstat.gov.sg/pubn/popn/population2012b.pdf

12Department of Statistics, Malaysia, http://www.statistics.gov.my/portal/index.php?option=com_content&view=article&id=1215%3Apopulation-distribution-and-basic-demographic-characteristic-report-population-and-housing-census-malaysia-2010-updated-2972011&catid=130%3Apopulation-distribution-and-basic-demographic-characteristic-report-population-and-housing-census-malaysia-2010&Itemid=154⟨=en

Important Disclosure Information

The thoughts expressed in this piece are solely those of Dilip Badlani and may differ from those of other Royce investment professionals or the firm as a whole. Mr. Badlani's thoughts and opinions are given rendered as of the date of each posting and may change without notice. This piece is not intended to be investment advice or a recommendation to invest in any securities, region or country. There can be no assurance with regard to future market movements. Data from third party sources used in the preparation of this piece may not have been independently verified by Royce, and Royce does not guarantee its accuracy. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements.

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