China Rallies as Corruption Crackdown Intensifies…

Of the various market developments while I was on vacation, the most notable in global markets was the accelerating (if somewhat extended near term) rally in Chinese equities which justified the tactical overweight stance and preference to India since Q2. I highlighted banks and real estate exposure as likely beneficiaries of a reversal in extremely bearish positioning and flows; all China had to do was avoid the much feared implosion and indeed the macro data has been modestly improving since April, just as the last few unreconstructed China sell side bulls capitulated. Of course, the credit/GDP ratio continues to trend higher (with credit growth at 19% y/y in Q2) and the risk of a systemic crisis over the next few years remains very real, triggered potentially by deposit flight from the core banking system amid chronic corporate duration mismatching. As well as receding fears of an imminent growth crash, global investors seem to be positioning for the ‘through train’ implementation from October (with both HK and China net equity inflows rebounding since June), when barring technical issues as divergent settlement structures are patched together international investors will be able to trade A shares via the HK exchange while mainland investors will be able to trade H shares via Shanghai, subject to quotas both ways.

While ultimately this should see the H share premium over mainland stocks erode on a sustained basis, it’s unclear whether mainland retail flows into HK will outweigh foreign arbitrage flows back in the early months. The average H share index premium over mainland stocks has traded in a 7-11% range in recent weeks. Most A-shares that are dual-listed are small-caps that trade at a premium on mainland exchanges to their HK prices and indeed the overall market traded at a premium regularly in 2012 until H1 last year. The powerful H-share rally of recent weeks has provided double digit arbitrage opportunities in leading financial names with some individual names like Ping An Insurance Group (an attractive secular exposure, as covered in a recent note) as wide as 15%. In investing as in economics the ‘free lunch’ isn’t meant to theoretically exist, but this one is being served on a silver if slightly grubby platter. Back in the April 4th note on Chinese banks (which were widely seen as toxic at the time) I noted that: ‘The high profitability of Chinese banks versus pre-crisis US and European peers will help absorb the inevitable spike in NPLs. A lot of bad news is in the price for Chinese banks and reality is likely to be a little less awful than feared if a full scale real estate crisis can be avoided…’ The rally since suggests a growing number of investors are taking that more sanguine view and alongside the ‘surprise’ rally in materials and industrials trading at mid-single digit multiples, it’s been a classic case of there being a price for everything.

While the services PMI was weak reflecting the on-going real estate slowdown (and as I’ve emphasised, from Macau VIP revenues to slowing top end real estate and watch sales, the widening corruption crackdown which is now targeting the military elite and the Shanghai administration has been a key factor in suppressing what was always hugely wasteful money laundering related activity), near term SOE restructuring/pension fund reform news flow should further boost sentiment. Investors will probably bet for now that Xi’s centralisation of power, unprecedented since the Mao era, is a harbinger of a more radical economic overhaul that will boost flagging productivity growth and ever rising credit intensity.

Of course, Russian bulls thought that of Putin’s autocratic tendencies not so long ago too but he institutionalized rather than tackled corruption, making patronage the bedrock of his political power. The Xi parallel is possibly more with Yuri Andropov, the pragmatic and worldly KGB chief who briefly headed the Soviet Union before Gorbachev and to tackle plunging productivity and pervasive graft began an anti-corruption and economic liberalization drive that attempted to modernize the system without compromising the Party’s monopoly on power. Had he retained power through the 1980s rather than being succeeded prematurely by Gorbachev, there would have been a lot more ‘perestroika’ and a lot less ‘glasnost’ and the USSR would likely have limped on for another decade or longer rather than collapsing in chaos. Beijing has drawn the lessons…