Churchouse Letter
December 2011         by Peter Churchouse

A Tale of Two Emerging Markets

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Diana Olteanu-Veerman of Green Investments Ltd contributed to this report.

This past month saw us spending time in two rather different emerging markets – Sri Lanka and China. The visit to Sri Lanka was more in the nature of a “getting to know you” visit while that to China was rather more focused on that country’s “hard asset” markets. But the visits almost inevitably invite comparisons of life, economy, investment in the two very different environments. While China is still regarded as an emerging economy, it is rather more “emerged” than is the case for Sri Lanka.

The basic statistical comparisons of the two countries (Figure 1) show some anticipated results, but also some unexpected findings.

Figure 1: Comparing Sri Lanka and China Economic Indicators 2010

Economic Indicators China Sri Lanka
GDP per capita, (USD 2010) 4,393 2,375
GDP growth (Annual %) 10.3% 8%
FDI, net inflows (USD millions current) 185,081 478
Agriculture (% of GDP) 10% 14%
Industry (% of GDP) 45% 27%
Gross savings (% of GDP) 51% 25%
Unemployment (% of total labor force) 4.3% 7.6%
Inflation (annual CPI %) 3.3% 5.9%

Source: The World Bank

At US$4,393, China’s GDP per capita is almost twice that of Sri Lanka’s US$2,375, but recent economic growth rates are not that dissimilar. From a quite similar base in 2001, China has grown its GDP in US$ terms at a compound rate of over 17% to more than quadruple per capita GDP up to 2010, while Sri Lanka’s still respectable 12% compound growth has roughly tripled per capita GDP. The power of compounding!

Chart 1: GDP Growth in Sri Lanka/China from 2001-2010

GDP Growth in Sri Lanka and China from 2001-2010. China Compound Annual Growth Rate (CAGR) between 2001-2010 was 17.3%, with its GDP per capita in current US$ rising from 1,042 to 4,393. Sri Lanka's Compound Annual Growth Rate (CAGR) between 2001-2010 was 12.4%, having risen from 832 to 2,375.

Source: The World Bank

China’s export driven growth is perhaps even more impressive when set against China’s over 20% appreciation of the RMB against the USD$. In the case of Sri Lanka, it has achieved its growth against over 20% depreciation of its currency, something that must have helped its export industries to some extent.

Chart 2: Exchange Rate Changes for Sri Lanka and China

Change in Exchange rates in Sri Lanka and China's currencies to the US$ from 1995 to 2011. It shows the depreciation of the Sri Lankan Rupee (LKR) from 52.43 to 110.16 vs the appreciation of the Renminbi (CNY) from 8.32 to 6.48.

Source: Oanda

Sri Lanka’s economic progress has been held back by more than 20 years of civil war. That is now over, and it appears the economic clock is ticking a lot faster again. Agriculture as a percentage of GDP is not too dissimilar between the two countries, but China’s manufacturing contribution is way ahead of that of Sri Lanka, as would be expected after 20 years of rapid industrialization and investment that has been a central part of China’s economic model. This is also reflected in China’s six times larger electricity consumption per capita.

But interestingly, Sri Lanka’s vehicle population is way ahead of that of China, probably reflecting the importance of the ubiquitous “Tuk Tuk” that ply the roads of many Asian countries – but not China.

Urbanisation has occurred at a rapid clip in China with rural population now comprising about 55% compared with Sri Lanka’s still very high 85%. If trends in other Asian countries are anything to judge by, Sri Lanka may be in for a very rapid push from rural areas into the cities, which is likely to have very major implications for housing demand, housing construction and prices. Certainly, that has been China’s recent history, and is likely to be a continuing story there as well over the coming decade. Urbanisation in Sri Lanka is in its infancy.

Interestingly, despite the very obvious differences in economic development, Sri Lanka’s literacy rate at 91% is high, perhaps reflecting in part the development of a formal education system during the country’s colonial regime, and its continuance, even under considerable duress subsequently.

Figure 2: Sri Lanka/China General Information 2010

Population, Education & Infrastructure China Sri Lanka
Population (millions) 1,338 21
Country Size (square km) 9,327,480 62,710
Population Density (people per square km) 143 333
Rural Population (% of total) 55% 85%
Literacy Rate (% of adult total) 94% 91%
Electric Power Consumption (kwH per capita) 2,455 402
Motor Vehicles (per 1000 people) 37 61

Source: The World Bank

The Sri Lanka visit took us south from Colombo to the historic city of Galle, and its famous old port district. This area has recently been declared a UNESCO heritage area, and it is extremely encouraging to see the renovation works being undertaken to a great many buildings, construction of new roads, streets and improved infrastructure. The south of Sri Lanka was devastated by the December 2004 tsunami, and the remains of that devastation are still evident. However, with the help of foreign aid from a great many nations and organizations and a lot of local determination, a significant rebuilding process has been undertaken. Any visit to Sri Lanka would hardly be complete without a visit to the hill country surrounding Kande in the middle of the island. This is the home of some of the world’s largest tea plantations, begun by the British more than 100 years ago, and still in active production and expansion. Tea production techniques have barely changed over this period, and much of the machinery used in the factories dates back almost 100 years and bears the names of old English or Irish manufacturers. The machinery is in fine working order after many generations of use – I wish I could say that about my computers!

It is in the area of infrastructure that the differences between Sri Lanka appear stark. China is streets ahead in this respect, as reflected by its much higher savings rate that helps fund infrastructure development.

The drive from Shanghai to the city of Wuxi can be undertaken on an almost brand new dual three lane highway, where your chosen chariot can whisk you along at 120-130km/hour. Sri Lanka has no such high-ways (though one is nearing completion), and one’s journey speed is dictated by the pace of the slowest vehicle on the roads, the Tuk Tuk. Average speeds of 40-50km/hour are more the norm, and the national speed limit is a mere 70km/hour!

Sri Lanka desperately needs investment. If it cannot fund it domestically, opening the doors to foreign investment might be a good strategy. Its savings rate of around 25% is not too shabby, but is still lower than the averages in most parts of Asia.

Ease of doing business in Sri Lanka ranks a relatively poor 102 com-pared to China’s 79, Hong Kong’s 2 and Singapore’s 1. While this ranking is not great it is considerably better than India’s 134 and Philippines’ 148. However, a lot could be done to ease the blockages to doing business in Sri Lanka and capture more of the global investment dollars. For example, in the very simple business of “hard asset” investment, any foreigner looking to invest in land and property is required to pay a transfer tax up to 100% of the purchase price. This is hardly conducive to attracting much needed foreign money.

Chart 3: Ease of Doing Business Index 2010 Rankings

Ease of Doing Business Index 2010 (1 = most business-friendly regulations). Singapore = 1. Hong Kong = 2/ Japan = 18. Thailand = 19. Malaysia = 21. Vietnam = 78. China = 79. Sri Lanka = 102. Indonesia = 121. India = 134. Cambodia = 147. Philippines = 148.

Source: The World Bank

By contrast, China actively provided tax and other incentives to attract foreign investment in its early days of modernization of its economy.

This proved so successful that China has from time to time promulgated policies to stem the inflow of foreign investment on concerns of its potential inflationary impact. This would be a quality problem to have to deal with in Sri Lanka’s case.

Sri Lanka and China Stock Exchanges: a David and Goliath Story?

Somewhat unexpected, the Colombo Stock Exchange market is much older compared to the largest Chinese Stock Exchange in Shanghai, which has opened its doors in December 1990. However, their growth and development patterns could not be more different: China has seen amazing growth in its stock markets since 1990, the number of listed companies on the Shanghai Stock Exchange going from 10 companies in the early 1990s to almost 900 in 2007 with a market capitalization of over 2,500 billions of USD. The market cap — including both stock ex-changes at Shanghai and Shenzhen — at almost 3000 per person has reached levels similar to those in developed markets.

However, the listed market has also seen an enormous amount of volatility despite few derivative products and short selling restrictions, volatility more typical of stock exchanges in the initial development stages and for markets with large retail participations.

Despite their accelerated development both Chinese stock exchanges — Shanghai and Shenzhen — are highly insulated from the capital markets and international investors, because of the market segregation in different share classes (for foreign and domestic investors) and the currency strait jacket.

Sri Lanka’s stock market is tiny by comparison with that of China. In terms of market capitalization in relation to GDP, at 40% Sri Lanka’s market cap is about half of China’s 81%. But Sri Lanka’s fledgling market has provided extraordinary performance over the past couple of years. It fell, along with most markets in the 2008 financial crisis, but following the end of hostilities in the country, the index has rallied fourfold.

The Colombo Stock Exchange has followed a slower paced and a rather convoluted path for development. In its incipient form, it has been set up by the British in late 19th century to trade shares from some of the large plantations companies in the country. The current form of the Colombo Stock Ex-change dates from 1982 and lists more than 200 companies with a total market capitalization of over 20 bn USD.

Chart 4: Colombo Stock Exchange All Share Index 2007-2011

Colombo Stock Exchange All Share Index from 2007-2011.

Source: Thomson Reuters Eikon

Chart 5: Shanghai Stock Exchange Composite Index 2007-2011

Shanghai Stock Exchange Composite Index from 2007-2011.

Source: Thomson Reuters Eikon

The sheer size of the Chinese Stock Exchanges in comparison to the Colombo Stock Exchange is staggering: top 20 companies listed on the Shanghai/Shenzhen stock exchange represent more than 100 times the market cap of the top 20 companies listed in Colombo. Sri Lanka’s largest listed company (John Keels Holdings PLC) at US$1.28billion is dwarfed by China’s largest listed company (PetroChina Co. Limited) with a market capitalization of more than US$250 billion.

Figure 3: Sri Lanka – Top Listed Companies by Market Capitalisation

Sri Lanka
Sector Company Name RIC Market Cap in Millions of USD
Industrials John Keells Holdings PLC JKH.CM 1,280
Non-Cyclical Con Carson Cumberbatch PLC CARS.CM 965
Non-Cyclical Con Bukit Darah PLC BUKI.CM 917
Telecom Sri Lanka Telecom PLC SLTL.CM 744
Non-Cyclical Con Ceylon Tobacco CTC.CM 673
Financials Commercial Bank of Ceylon PLC COMB.CM 664
Telecom Dialog Axiata PLC DIAL.CM 557
Financials Hatton National Bank PLC HNB.CM 417
Non-Cyclical Con Nestle Lanka PLC NEST.CM 406
Non-Cyclical Con Distilleries Co of Sri Lanka PLC DIST.CM 379
Cyclical Con Aitken Spence PLC SPEN.CM 374
Non-Cyclical Con Cargills Ceylong PLC CARG.CM 363
Financials Lanka ORIX Leasing Co PLC LOLC.CM 346
Cyclical Con Asian Hotels and Properties PLC AHPL.CM 36
Financials Sampath Bank PLC SAMP.CM 273

Source: Thomson Reuters Eikon

Figure 4: China – Top Listed Companies by Market Capitalisation

Sectory Company Name RIC Market Cap in Millions of USD
Energy PetroChina Co Ltd 601857.SS 250,742
Financials Industrial and Commercial Bank of China Ltd 601398.SS 177,575
Financials Agricultural Bank of China Ltd 601288.SS 119,855
Financials Bank of China Ltd 601988.SS 90,676
Energy China Petroleum & Chemical Corp 600028.SS 81,460
Energy China Shenhua Energy Co Ltd 601088.SS 67,613
Financials China Life Insurance Co Ltd 601628.SS 58,343
Non-Cyclical Con Kweichow Moutai Co Ltd 600519.SS 34,982
Financials China Merchants Bank Co Ltd 60036.SS 32,544
Financials Ping An Insurance (Group) Co of China Ltd 601318.SS 27,451
Financials Shanghai Pudong Development Bank Co Ltd 600000.SS 25,802
Financials Bank of Communications Co Ltd 601328.SS 23,829
Non-Cyclical Con Wuliangye Yibin Co Ltd 000858.SZ 23,189
Financials Industrial Bank Co Ltd 601166.SS 21,428
Financials China Citic Bank Corp Ltd 601998.SS 21,400

Source: Thomson Reuters Eikon

The God of Money – the Only Deity that Matters in China!

While both countries have mixed populations with minority groups, China’s population is dominated by Han Chinese. Sri Lanka’s population is about 70% Buddhist, and feels it. Buddhism is very evident and there seems to be a constant flow of colourful religious or semi religious ceremonies taking place at all levels of society. Like other Buddhist nations, the principles of Buddhism do seem to guide much behavior at different levels of society. In China’s case the only deity that seems to matter is the god of money!

In some ways Sri Lanka’s market is more accessible for foreigners to invest than China’s, especially the stock market which is open to all foreigners with a local bank account whereas in China foreigners can only access the market through a qualified foreign institutional investor pro-gram (QFII). Repatriation of stock trading proceeds is permitted after a 10% dividend withholding tax and there is no capital gains tax.

There is as yet no ETF available for investing in Sri Lanka.

Foreign ownership is permitted in Sri Lanka across some areas of the economy but there are still restrictions and red tape in place.

Sri Lanka’s broad economic condition is one of a powerful need of in-vestment in a cross section of sectors, from industry, tourism, housing, roads, ports, electricity. China, by contrast can be argued to be suffering from over-investment, with increasingly more investment being wasteful and inefficient.

This seems particularly evident in much of China’s property markets. There is no doubt a great need for housing, office space, retail and recreation facilities, but the current conditions are probably unsustainable. In a great many cities vast amounts of completed housing stock lie sold but empty. It is quite common to visit large very attractive developments of many hundreds of houses and/or apartments which have been sold during construction, completed, handed over to the owners and then never occupied. It is not uncommon to see whole developments where the properties have been handed over to owners 12 – 18 months ago, and where no more than 10% – 20% are occupied.

And a considerable numbers of buyers have paid in full, in cash for these properties. Amongst the projects that we have seen recently it is not un-common for about 50% – 75% of units to have been bought with 100% cash during the construction period, with say 5% – 10% being paid off by cash during the construction period following a substantial deposit being paid at the beginning, with the balance being funded by bank mortgage. Such properties might cost buyers at least US$200,000, and a great many cost many multiples of this.

This does not jive as a country with a per capita GDP of US$5,000 or thereabouts.

Where is all the cash coming from? We all know that the published statistics in China are often very dubious. We also know that China has a substantial “grey” economy, and this may be a source of cash for buying of real estate. Finally, as we have seen in other property bubbles in the region, banks often under-report their lending to the real estate sector, reporting loans to “working capital”, industrial use, manufacturing and so on, but the borrower may be simply diverting such borrowings into real estate assets.

Thus while from the developer’s point of view, the real estate may have been bought with cash, it does not mean that there is no debt involved in the actual transaction.

The actual levels of debt that have been applied to purchases of real estate are probably much higher than the banks report as “real estate” lending.

So the risk to the banking system from a widespread steep fall in real estate prices may be much greater than consensus thinking expects.

The rafts of policy initiatives that have been aimed at slowing the pace of speculative activity and borrowing in the China property market have been starting to work in recent months:

  1. Volumes of property transactions in Tier 1 and Tier two cities are down approximately 50% from Q4 peaks in 2010.
  2. Average sales prices (ASP) for primary transactions in Tier 1 and 2 cities are off approximately 15% from Q4 2010 peaks.
  3. Inventories are rising in most major cities with some cities now carrying 25 – 40 months worth of sales in inventories. Average for major cities is around 15 months, up from a low of about 4 months in 2009.
  4. Land sales across the country in money terms are now in negative growth territory, but anecdotal evidence suggests that prices have not come down officially due to a range of institutional factors.
  5. According to statistics produced by the National Bureau of Statistics average residential prices are showing month on month declines for about half of the 70 cities included in the surveys. The number of cities in this negative growth pattern has been steadily increasing over recent months.
  6. A crude affordability index, the ratio of average household in-come to average house price, is about 10.5 times for the country as a whole, and as high as 20 times in some tier 1 cities. By comparison, for most developed markets, the ratio in “normal” times is about 3 – 5 times (US is currently about 3 times and the UK is at about 5 times; Australia considered the most expensive market in a developed economy has an affordability ratio of about 6 times).
  7. Loan growth nationwide is still running at around 16% growth YoY, but is well down from its rate of close to 35% in 2009, early 2010. Official statistics suggest that about 20% of all lending goes to real estate (including mortgages and loans to property companies), but I reckon the real figure is way higher as many loans that are classified as “corporate loans” in fact end up in real estate of one kind or other.

Property Sales Revenues, Margins and Cash Flows are Likely to be Under Pressure in 2012 for Many Developers

In this environment a great many developers are offering big price dis-counts of 20% or more on new releases of residential units. This will inevitably put pressure on margins and profits across the board for the developer community. We can expect to see further downgrades of sales and earnings forecasts for the sector in the coming months. Investors closely follow developers’ contracted sales numbers which most major listed developers report on a regular basis. In the coming year companies that can maintain flat or even slightly down sales will probably be viewed as outperformers.

Pressure is building on many developers who are finding cash flows being squeezed and the risks of not being able to service debt rising. Non-performing loans (NPLs) at China’s banks from the property sector can be expected to increase sharply in the coming months. However, most of the China developers listed in Hong Kong have manageable debt loads and most have somewhat better access to borrowing than many of their local peers. Hence I do not expect to see widespread distress in the China developer group listed in Hong Kong, but that is likely to be a very different story for a great many smaller developers in China. There is estimated to be more than 60,000 property development companies in China!

While the property sector story in China looks grim on the basis of these (and many other) statistics, there are factors that suggest the outcome may not necessarily be a total meltdown in the sector and for consumers.

  • There is still very deep genuine end-user demand. According to UN forecasts China could see rural urban migration to the tune of around 151 million people in the coming decade.
  • This alone would drive demand for around 3.5 billion sq m of housing (nearly 38 billion sq ft).
  • In addition, reform of the hukou system which prohibits migrant workers from taking up residence in the cities in which they work will also increase demand for permanent housing in the major cities.
  • The household affordability figures quoted above do not account for the very substantial “grey” income that exists in China.
  • Household incomes in nominal terms has grown rapidly in recent years in urban areas, and although it has not kept pace with house price increases in many major Tier 1 and 2 cities, it is closer to being so in many other cities.
  • Households in China are not highly leveraged (unlike a great many western societies) and the household sector savings rate has in fact risen in recent years from a ratio of aroun16% of GDP to around 23%.
  • A great many properties have been bought with cash in the past two – three years.
  • Loan to value ratios (LTVR) for mortgages have tradition-ally been around 70% in China which provides a solid equity cushion, and there is a low probability that households will simply hand the bank the keys and walk away, like in the US.
  • While property sales have fallen sharply in most Tier 1 and 2 cities, sales in smaller cities where for the most part price appreciation has been more modest, have continued to re-main strong. This has kept floorspace sold at the national level running at about 13% up on last year.

China Property stocks listed in Hong Kong have been adversely affected by the constant rounds of policy initiatives aimed at stemming asset price inflation, and broader inflationary pressures that have been part and parcel of the China policy settings of the past 18 months or so.

From a couple of months ago we have been suggesting dipping the toes back into the China property stocks again. The valuation case is reasonably compelling. The sector is trading at a very deep discount to net asset value of around 60%, very similar to the levels reached in the after-math of the Lehman event in 2008. Almost without exception, stocks in the sector are trading at single digit multiples on 2011 earnings, and more than half are trading at PE’s of 5 or less. This is right at the low end of historical experience.

Apart from the valuation case our view has been more driven by macro factors:

  1. The property and inflation cooling initiatives have been working in the past few months, bringing with it a view that the authorities might be at the end of the property tightening cycle. The heavy boot of government might just start to ease off the brake pedal.
  2. The Euro crisis, threat of recession there and risks of sharply slower growth in the US would likely provoke a policy response in China towards a more easing bias of policy settings.

This latter argument has played out in the past week with the first obvious sign of easing shown in the cut of the reserve ratio requirement (RRR) imposed on China’s banks by 50bp. This move was somewhat earlier than I expected but had the predictable reaction of providing an immediate boost to China shares, and particularly China property stocks listed in Hong Kong.
While taming inflation is a core objective of policy makers in China, rising unemployment and the threat of social discontent that this would likely bring is of much greater concern. This has the potential to under-mine the leadership’s credibility and provoke much more serious consequences for the regime than a modest bout of inflation. With some signs of cooling on the inflation front, as well as significant signs of a cooling of the economy generally, it should not be surprising to see a measure of easing.

Figure 5: Top 5 China Developers Listed in Hong Kong

Name Market Cap (HKD mm) Share Price (HKD) P/E (2011) Est. NAV (% discount)
China Overseas Land & Investment 114,905 14.06 8.0x -10%
China Resources Land 72,248 12.40 10.8x -45%
Evergrande Real Estate Group 49,892 3.35 4.3x -68%
Country Garden 44,452 3.00 6.2x -40%
Longfor Properties 42,190 9.70 7.9x -51%

Source: Thomson Reuters, Bloomberg Portwood Capital

On the property front there have also been some other minor signs of easing in certain locations. For example the definition of “normal” housing in Beijing has now been widened to include properties selling for up to Rmb38,880/sq m (Approx. US$6,120/sq m). Properties de-fined as “normal” housing are subject to lower rates of transaction taxes that both buyer and seller are required to pay.

The threat of a likely surge in bankruptcies and property related NPLs in the domestic banking sector also provides some motivation for easing some administrative and monetary restraints imposed on the markets in the past year or so.

More easing can be expected as the economy slows in the coming months.

Such a reversal of policy is likely to provide a significant fillip to shares of Hong Kong listed China property companies, such as the top property developers listed here.

In what is perhaps a strange twist, the Euro crisis may provide the back-drop for a rebound in China property shares as the threat of recession in Europe and slower growth in Asia brings pressure for easing of tighter monetary and fiscal policy settings that have been in place in China over the past 18 months or so.

Our move back into China property shares a few months back was predicated on our observations that the policy initiatives were indeed slowing the bubbly China property sector, and that policy tightening would likely slow and then eventually reverse. The Euro crisis has hastened this out-come.

Don’t worry about the world coming to an end today.
It’s already tomorrow in New Zealand.
– Adapted from Charles Schulz

Chart 6: China Overseas Land & Investment Ltd 2006-2011

China Overseas Land & Investment Ltd stock price from 2006-2011.

Source: Thomson Reuters Eikon

Chart 7: China Resources Land Ltd 2006-2011

China Resources Land Ltd stock price from 2006-2011.

Source: Thomson Reuters Eikon

Chart 8: Evergrande Real Estate Group Ltd 2009-2011

Evergrande Real Estate Group Ltd stock price from 2009-2011.

Source: Thomson Reuters Eikon

Chart 9: Country Garden 2007-2011
Country Garden share price from 2007-2011.

Source: Thomson Reuters Eikon

Chart 10: Longfor Properties Co Ltd 2009-2011

Longfor Properties Company Ltd stock price from 2009-2011.

Source: Thomson Reuters Eikon

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