On the Road with the Russell 20- 20

Two weeks in China and Hong Kong

Yafei Yin
May 26, 1997

Introduction

The Russell 20-20 is a non-profit association, chaired by Mr. George Russell, whose members are 20 of the largest US pension-funds and 20 of the most influential money managers in the US, representing US $1 trillion (25% of total US pension funds). The mission of the association is to identify investment opportunities in emerging markets of the world for American pension funds.
Russell 20-20's fact-finding trips to selected places among emerging economies in the world take place once every year since it was established in 1990. The China and Hong Kong trip this year was the second trip (the first was in 1993) and included about 60 people.
The trip journey officially started in Wuhan, a city of industry and commerce in the heart of China, on the 5th of May when the delegation arrived to get on board Merchant Ship Queen. On the evening of May 6, the delegation stopped at Jingsha and the port city of Shashi. Every place we went we received warm welcoming banquets and presentations by the major local city and province leaders. Then the delegation spent three days and four nights on board the MS Queen, traveling from Hubei Province to our destination, Chongqing City. Along the Yangtse River to the site of the Three Gorges Project, we received an excellent briefing on the world's largest dam project. Once the Project is completed, at some locations the river will be raised by nearly 600 feet allowing ocean-going freighters to travel its full length from Shanghai to Chongqing. The Project offers great opportunity for economic progress and faces a significant challenge in the relocation of over one million people who have lived and worked along the river from generation to generation over hundreds of years.
We stayed three days in Chongqing, where we visited the "Panda Zoo" and a food manufacturer, "Tingye," plus received business presentations and banquets. The delegation traveled by a charter aircraft from Chongqing to Beijing where met with the vice governor of the People's Bank of China and Vice Premier Zhu Rongji as well as high ranking officials from the CSEC (the securities commission).
From Beijing we again traveled by the charter aircraft to Hong Kong where a mix of western investors and Hong Kong government, business and investment leaders provided us with their views on the economic impact of the return of Hong Kong to China. Highlight of the activities in Hong Kong were Mr. Tung Chee-hwa's speech at the ending banquet.
It was the second time for me to join Russell 20-20 trip to China and Hong Kong. There were the changes that impressed me most compared the first trip taken in 1993.

1. Chinese government officials tend to be more open, enthusiastic, money making minded and less bureaucratic.

During the delegation visit in Wuhan city, the governor of Hubei province came to meet the delegation straight from the train station after his business trip without taking nap. To sell Sichuan province, not included in the formal visiting schedule of Russell 20-20, the vice governor of Sichuan Province got on board the MS Queen from 500 km away by car to give presentation, answer questions and meet with individuals who were willing to discuss more. In the informal meeting with Dean LeBaron's guest, the vice governor of Guizhou Province, some questions from the members sounded sharp and sensitive, and the answers by Lou Jiwei were surprisingly and friendly true, without zig-zag game, and stimulated the communication and narrowed the gap of two groups of people from America and China.

2. Quality of Chinese government officials is greatly improved compared with what we saw and felt in 1993's trip to China.

Members of our delegation commented that government officials in Shanghai and Beijing seemed better prepared about economics, for example, than in 1993, and that certain of the presentations were very impressive. Such as Lu Youmei, the president of Yangtse Three Gorges Project Development Corporation, who very efficiently delivered information in just more than half an hour on how they are doing on the Three Gorges Project, from its history to the strategic planning, from the relocation schedule to the property development plan, from original budgeted funds to the progress of the project, the total funds needed, investment return analysis . . . made the delegation very impressed. Other examples like vice mayor of Chongqing, Xu Zhongmin, Vice Governor of the People's Bank of China, the general manager of CITIC . . . are also very energetic, knowledgeable, fast response, articulate and know exactly what they are doing, what they want to sell, what they want to get, to reach their goal which gave us confidence with an extra plus.

3. Stronger sense in competition.

Competition stays in every aspect of Chinese life, which we did not see when we were there in 1993. The mayor of Wuhan, the first city the delegation visited, said to the delegation: "Please come back to Wuhan again after you visit Chongqing, then you will know that the projects and conditions we offer for foreign investments are better." Lou Jiwei, vice governor of Guizhou Province, humorously asked someone in the delegation: "Do you know geographically how far Guizhou is from the sea? Comparing Guizhou with Chongqing in the distance to the sea, which one is much closer?" The answer is Guizhou is located much closer to the sea than Chongqing which is a disadvantage for Chongqing's campaign. What he really wanted to tell us is that Guizhou has better transportation . . . "come in, please, we welcome you!"

Trip Notes

May 5-May 6, Wuhan City, Jinsha and Shashi City in Hubei Province.
Presentation by the Governor of Hubei Province, Mr. Jiang Zhuping.

Hubei Province is located at the middle reaches of Yangtse River making it a unique place joining north and south, east and west, with a geographical land covers 185,900 sq. km and a population of 58.23 million. Hubei is rich in water resources with two rivers, Yangtse and Han, flowing through. Economic strength of Hubei ranks over average in China. Average GDP growth rate in the past 6 years was 12.9%, which is 1.1% higher than the nation's average. Schooling system looked stronger with 190,000 students registered on campus in 1996, more than 400 research institutions and nearly 900,000 staff working in it, ranking the fifth of the country.
Foreign capital wanted for the last three years of this century is about US $9 billion, and sectors to be encouraged for foreign investments are infrastructure development, export-oriented manufacture, high-tech area and technological renovation of outdated enterprises. What the province could provide for foreign investors are efficient service, guaranteed return (for some infrastructure projects), skilled management and a well-established legal system, while relying on only preferential policy about tax treatment in the past.
In recent years, the priority of State investments has been focused on the combination of regions and sectors, giving emphasis to the areas along rivers and trunk railway lines. The competitive advantages of Hubei is in its unique geographical location, which will make it one of the preferential regions in State industrial policy and regional arrangement meaning the province could enjoy more support in resources from the central government.

Briefing of Investment Environment in Wuhan.
Mayor of Wuhan City, Mr. Wang Shouhai.

Wuhan, the capital city of Hubei province with a seven million population and 8,467 square kilometers of land, is the center of the economic geography of China. The distance from Wuhan to Beijing, Shanghai, Hong Kong, Guangzhou and Chongqing are all about 1,200 Kms. Its industrial base, metallurgy, machinery and textile were especially competitive in China with products including heavy- and super-heavy-duty machine tools and numeric control grinders, industrial boilers, power station boilers, generators, a wide range of textile products, and so forth. The GDP growth rate of Wuhan is 15% in the past six years, which is 4% above the country's average. Wuhai was one of the biggest trade centers with the value of the foreign trade being ranked No.2 in China after Shanghai. In comprehensive strength of technology and education, it is ranked No. 3, and the city enjoys the same preferential policies as the coastal area in China. Also Wuhan has been heavily using foreign investment, and 106 of the world's largest companies are knocking on the door, 25 of which have landed including Citroen Automobile Co. of France, Coca Cola of US, Pilkington of UK, NEC of Japan, Philips of Holland and the New World Group of Hong Kong . . . and so forth. Banking and heavy industries will be promoted as new development targets. Infrastructure, iron and steel, automobile, machinery, high-tech industry, agricultural exports, town and village enterprises, finance, insurance, commercial, tourism, real estate, consultant services, etc. are available for foreign investors. Invested methods include equity joint venture and contractual joint venture, wholly foreign owned enterprises, compensation trade, share purchase, contract and leasing, securities, BOT, etc.
May 7- May 9, Traveling from Hubei to Chongqing by MS Queen's Ship. Briefing of the Three Gorges Project, by the General Manager, Mr. Lu Youmei. Before we travel on board the ship from Hubei Province along the Yangtse River to the site of the Three Gorges Project (TGP), we visited the head office of China Yangtse Three Gorges Project Development Corporation and the dam site. General Manager Lu Youmei gave a presentation about the project.
TGP is the largest project in China, and probably in the world. After its completion, the occurrence of flooding will be reduced from once in ten years to once in one hundred years; the Yangtse River will rise by 600 feet providing an installation of power generating capacity of 18,200 MW, equivalent to a replacement of 40 to 50 million tons of raw coal combustion each year; navigation channels will be deepened and widened making it possible for a 10,000-ton ship to reach all the way to Chongqing from Shanghai; and transportation costs will be reduced by 30%.
The construction period of the project is 17 years, and it will take about 20 years to finish the whole project. The total cost on TGP is 90.09 billion RMB and will reach 200 billion at the end of the project, in which 60% of it is for the project itself and 40% is for inundation treatment and resettlement according to the price of 1993. The majority of funds needed will be financed by the country itself, and the shortfall is expected from domestic loans, foreign loans or listing shares. The funds borrowed will be paid back by the income from the power generation of Genzhouba Power Plant and TGP Power Plant during construction as well as the income from the increased tax of 0.3 cent/KW in the power networks all over the country since 1992, determined by the State Department of China. The IRR of the TGP is about 15.6-14.8%.
The Three Gorges reservoirs will completely or partially inundate two cities, 11 counties, 114 towns, 1,599 factories and enterprises, 250,000 mum (similar to an acre) of cultivated land. The biggest challenge to the TGP is that about 1 million people need to leave the place where they have lived from generation to generation to resettle in new places. On the other hand, housing, factory, farming for about 1 million immigrants are providing opportunities for investments. Mr. Lu Youmei convincingly stated that foreign capital will be warmly welcomed to participate in real-estate and re-building industry activities.

Dam Site Visit.

After the presentation in the morning of the 9th, we were driven to the dam construction site. It is a huge place as one's eye could see, very magnificent. The first stage cofferdam was being removed and a temporary shiplock was being excavated. We were told there are about 20,000 employees working at the dam construction site, but we saw only a few bulldozers and cranes working. The whole site sounded very quiet. Our TGP employee-escort explained to us that the project has hired and purchased some of the most advanced machinery in the world, so that most onsite employees were working in the machine. We were still puzzled we saw one bulldozer working alone in the valley, but no truck was there to remove the soil being excavated.

Briefing of Sichuan Province by Vice Governor Li Dachang.

The economic aggregate of Sichuan Province is among the first rank in the country with a GNP of 298.5 billion yuan in 1996, making up 4.4% of the country's total and 30.7% of the total of the ten provinces in the west of China. Of the total output in the country, its power generation represents 11.6%, color TVs 14.9%, steel 5.4%, and fertilizer 9.6%.
Sichuan, enjoying the reputation of one of the superpowers in natural resources in the country, is rich in water power, minerals, biological resources. 140 million kw of waterpower base of Sichuan is now the largest in China and its 132 sorts of proven reserves, 46 of which rank from the first to fifth in the country, include vanadium, titanium, lithium, silver, ferrous and so forth, in which vanadium reserve is 69% of the country's total and titanium is 91% of the country's total as well.
Sichuan enjoys competitive advantages in scientific research , technical know-how and human resources. Compared with other areas, its science and technology is especially well developed. Aerospace and aviation, nuclear energy, cable telecommunication, biological engineering, high polymer chemistry, and biochemistry are all in leading positions in China.
The province's target in their Ninth Five-Year Plan (1996-2000) is to reach a growth rate of 10% in GDP, fixed assets investment accumulated to 500 billion RMB (US $60 billion), and foreign capital wanted about US $3 billion or so. Investment priorities will be given to Railway, Highway, Aviation, Natural gas and petroleum, Electronic Information Industry, Machinery Industry, Construction and Building Material Industry, Beverage and Food Industry, Tourist Industry and so forth.
What the province will provide to attract foreign investors is a package of preferential policies in taxation, foreign currency, credit, land use, production and management, goods import and export, human resources and labor management, mineral resource exploitation, and relevant local fee policy as well.

May 10-May 12 in Chongqing
Briefing of Chongqing Investment Environment by Vice Mayor of Chongqing, Xu Zhongming.

Chongqing is the largest city on the upper reaches of the Yangtse at 30 million people, it may be the largest city in the world. Relying on a market of 200 million people in Southwest China, Chongqing is a traditional commodity exchange center. With a first-class airport accommodating 40 airlines, including a regular line to Hong Kong and charter flights to Bangkok and Nagoya, convenient railway and highway networks, the Golden Waterway of the Yangtse River, and a modern telecommunication system, Chongqing is closely linked with the other parts of the country and the world. From automobiles and motorcycles to toys and clothes over 3,000 varieties in 28 categories the value of Chongqing's products exported abroad in 1996 was up to US $1.4 billion.
Industry is the mainstay of Chongqing's economy, in which automobiles and motorcycles, metallurgy, chemicals, machinery, electrical appliances, electronics, food, building materials, glass, ceramics and chemicals are especially competitive in China.
Joint ventures in Chongqing have done very well. In 1996, Sino-US joint venture Puyi Briggs & Stratton Engine Corporation profited 30.4 million; a Sino-Japanese joint venture, Qingling Motors Co. Ltd., has 24% of the total market share of light trucks in China; a Sino-French joint venture, Chongqing Air Liquid Co., profited over 34.65 million. A great number of large overseas companies have started doing business there.
To reach the city's aggressive target at the end of the century as the largest financial center, information center, and largest production base of synthetic fiber a well-developed economic central metropolis on the upper reaches of the Yangtse River Chongqing's leaders encouraged the delegation to participate in the development of areas in export-oriented agricultural projects, banking, joint venture investment funds, and whatever sectors combine Chongqing's competitive advantage in resources and cheap and skilled labours.
The Vice Mayor of Chongqing vowed to offer the best policies (even more preferential than offered in Shanghai Pudong and China coastal cities), services, and convenience for foreign investors in China. "A measure to our success is to make our investors make more money from Chongqing," he added.
One delegate asked: "What fields in Chongqing do not allow foreign capital participation?" "That might be arms and drugs," the vice mayor answered.
The vice mayor declined the possibility for allowing foreign investors to participate in the exploration of natural gas in the form of buying ownership at the moment, maybe in the future versus delegate's question. The vice mayor also explained that business like Edward R. MacPherson does in the States, and Mr. Lu Youmei does for China Yangtse Three Gorges Project Development Corporation is allowed to contract to private company in a small to medium scale of business, but the large one like Three Gorges Project is definitely not allowed to the private sector.

Company Visit (Tingyi).

During our stay in Chongqing, we were offered the chance to visit Tingyi, a Taiwanese-owned food manufacturer which manufactures, distributes, and sells instant noodles, rice crackers and drinks in the PRC. (Its holding company was listed on the Hong Kong Stock Exchange with trading code 322.) The owner of Tingyi is a capital investor who succeeded in his past oil trading business and started investing in China's food market in 1989. Investment in the Chongqing plant was about US $10 million and the other three plants located in China's Tianjin, Guangzhou, Hanzhou, respectively.
The factory looked very neat and operations are obviously run in an orderly manner. Five production lines are all purchased from Taiwan. All products produced here use the same brand name which was specially created for their products in China. Except for a few senior general managers from Taiwan, all other employees are locals. The dormitory is provided by the company and the local employees received relatively higher wages than employees of state-owned companies.
The quality of the products looked good compared with the local one and it tastes good (I only tasted one of their rice crackers). A box of 250g rice crackers costs about 2 RMB Yuan, equivalent to a quarter US dollar, which I believe could satisfy all consumer groups in China, fitting both rural and urban markets. We were also told their products sold very well and the operation margin of the plant in Chongqing is just about the same as in Taiwan. The profit they have earned so far looked pretty.

May 13-May 14, Beijing
Meeting with the Vice Governor of People's Bank of China, Mr. Yin Jieyan.

Mr. Yin first briefed the delegation on the banking system in China and then answered questions. Functioning as China's central bank, People's Bank Of China (PBOC) had completely left the lending business in 1994 and positioned its role as macro-economic manager of China by monetary policy-making. Under the PBOC, the Chinese banks are classified as Policy Bank, including Nation's Development Bank, Import and Export Bank, Agriculture Development Bank; the State-Owned Commercial Bank, including Bank of China, China Construction Bank, Industrial & Commerce Bank, China Agriculture Bank; the Shareholding Bank, like China Communication Bank; the Banking Conglomerate, including CITIC Bank, China Everbright Bank; China Regional Development Banks and China Cooperative Banks. Regarding China's property development, Mr. Yin confirmed that PBOC has granted approval for a few Chinese commercial banks to start mortgage business for Chinese citizens with about 10 billion RMB in total scheduled. The loan term could last 15-20 years. In this way, it will help country's property development in ordinary housing. Mr. Yin disagreed with 35% bad loans in China's banks, and around 20% of it is possible he said. The figure 20% includes a great deal of overdue payment, and the real dead loan part does not exceed 2% he added. However PBOC has targeted a reduction of 2%-3% in bad loans this year. Regarding the questions about stability of HKD after Hong Kong returning to China on July 1,1997, Mr. Yin explained that "one country, two system," the nation's basic policy, will be no doubt be implemented after July 1. Both sides will manage the currency on their own systems and both sides will join the IMF, meeting as independent representatives. China has PBOC to manage RMB. In Hong Kong, the HK dollar, pegged to the US dollar, will remain constant, making HKD not likely to depreciate alone. In case some unpredictable events happen during the Hong Kong transition period, as political insurance, USD reserves of 60 billion in Hong Kong and Hong Kong USD reserve of 100 billion land fund, together with a 120 billion USD reserve in China are strong enough to keep confidence for our currency.

Conclusion

Summing up what I learned from the two week fact-finding trip with the Russell 20-20 in China and Hong Kong, first of all, I was convinced of China's diminishing systematic risk of investments. As George Russell said, "China is going to be the biggest economic explosion and investment opportunity the planet has ever seen or ever will see." That has become the consensus in the business world internationally. As an investor, we need to examine further the risk side of China's investment environment, especially systematic risk factors.
China, politically, is no doubt stable. The fact that China's paramount leader Deng Xiaoping passed away a few months ago resulted in a different political climate from our first trip in 1993. Imagine the severe power struggle during a power transition in every politically-centralized country; however, everywhere we were in China, no one we met mentioned politics from senior government officials; Chinese people who escorted us; ordinary local citizens; taxi drivers. Chinese people today dressed very well and looked pleasant even in the undeveloped upstream area of the Yangtse River and Dazu Stone Sculptures, about 200 km away from Chongqing City. It left the impression that no one is now worried about China's political power restructuring. It might mark the orderly and peaceful consolidation of power that have been under control of the new generation of leaders headed by Jiang Zemin, and the social confidence toward it that is already widespread. The 15th Party Congress in September of this year will allow China to concentrate on economic development for the long period.
Looking at macro-economy, the China central bank (PBOC) started managing its macro economy through monetary policy in 1994. It has successfully controlled inflation from recorded double digit inflation rates in 1993, 1994, and 1995, to 6.2% in 1996 and 6.0% in the first quarter of this year. The PBOC, supported by an intensified fiscal policy implemented by the General Tax Bureau, is managing China's emerging market economy. Such injection of market economic systems, consistent with western countries, will make China's economy predictable . . . and this is extremely meaningful to investors.
China's effort on legislation has accomplished much in recent years, but it is still far from investors' expectations. We received information from a number of American speakers (accountants, lawyers, joint venture managers) that "Chinese laws and regulations are frequently unclear, sometimes unavailable and often arbitrarily enforced." Actually, economic legislative work of China was rooted at the beginning of China's economic reform, and the models of laws and regulations were something adopted from the west. In other words, on the one extreme, there were no laws and regulations governing the market economy under the old system; on the other extreme, the legal system of the US is being adapted for the new system. The level of China's legislative work is somewhere in-between. Apparently, the direction of China legislative work improves toward the American model. As the government of China has vowed to intensify the institutionalization and implementation of laws and regulations, risk considerations about them are diminishing.
Let's look at currency. China completed the convertibility of the RMB current account in 1995, which has satisfied IMF's requirements for emerging markets. As the vice governor of PBOC said, "China will keep its currency status in concert with about 140 countries in the world and will likely make it fully convertible (capital account) in four to five years." Since RMB has been managed by PBOC in 1994, exchange rate moved from 8.45 in 1994, to 8.32 in 1995, to 8.3 in 1996, and is currently quoted at 8.3. As we know, China's foreign reserves hit US $120 billion, and China's exports have picked up since the second half of 1996 and are continuing to grow. Although China's interest rate faces a further cut, there are reasons to believe the exchange rate of RMB/US$ will remain in the range of 8.3 to 8.55 in a three to five year period.
Secondly, I am convinced that investing in China's listed shares is an attractive opportunity at the present stage for pension funds.
There is a contradiction of expected returns between project investment and stock investment in China at the moment. As we all learned from the trip, investment returns on infrastructure and power sectors of China, which have the largest demands for investment, are not likely to exceed 15% under present productivity levels, while an average return over the past five years in the US stock market was about 16%, and in the Hong Kong stock market was about 38%. Apparently, stock investing in both the Hong Kong and China markets would gain a higher return.
Policy priority issues need to be looked at always. To resolve the inefficiency in state-owned enterprises, China's Guizhou Province has decided to select the best companies to go public, in this way receiving both investment and public pressure for upgrading management to improve profitability; allow companies of medium quality to be merged with foreign companies or powerful companies with skilled management in China; and let the worst 15% of companies go bankrupt, according to Vice Governor of Guizhou Lou Jiwei. I very much believe these are the country's policies being practiced everywhere in China. Among listing applications, usually the most competitive companies are allowed to list "B" shares or Hong Kong "H" shares according to SCRC. Imagine, only 28 China "H" share companies presently exist and 38 new listings of China "H" shares have been approved, as well as 86 China "B" share companies with an approximate GDP of $800 billion, there are obviously historical investment opportunities from a long-term view.
What's more, 50 Red Chips, representing about 10% of Hong Kong market capitalization, are emerging as a new asset class and remain the best way to capitalize on both acquisition and organic growth. Red Chips have parent companies who, in turn, are under the umbrella of China's most powerful organizations. Most Red Chips were formed when the Hong Kong arms of large mainland entities undertook back-door listings in the 1980s. Retired and part-time Hong Kong business leaders and western professors were hired, running businesses on the cutting edge way which had succeeded. A few Red Chip's fundamentals have been ranked on the top quartile compared with 33 Hang Seng Index (HSI) components since beginning of 1996. They are growing very fast through asset injections. Many Red Chip parent companies have made it clear that they will continue to inject assets into their listed vehicles at low PE multiples, boosting their market capitalizations. Two Red Chips became member of HSI last year and more will enter this year soon. Although an average P/E ratio of Red Chips have been bumped up higher than Hong Kong blue chips, the competitive advantages of these Red Chips combined both in financial resources and management skills on the Hong Kong side and government support on the mainland China side are believed to generate sustainable earnings, making the "buy high, sell higher" wave of Red Chips continue.
Let's look at capital side, one expert said to the Russell group in Hong Kong. An efficient cycling of large amounts of China savings would be the solution to solve China's state-owned companies and low efficiency in its banking system. China's savings now are about 5,000 billion RMB if 20% of it flowed into the stock market, China's stock market would treble. I believe this could be the strategic driver of the China government to work hard in perfecting both related laws and regulations governing the stock exchange, promote liquidity, and improving the quality and quantity of new listings to provide even mature investment opportunities.
On the risk side, the systematic risk in China, as analyzed above, seems to be controllable, yet the unsystematic risks of investments are still prominent issues. As we learned from the trip, in the transition to a new market order dominated by a market force replacing the past one, everything was under planning. Things change very fast. Due to the market pricing system, some sectors which were very profitable in the past are now losing money, such as petrochemicals. To the contrary, some sectors that used to lose money are becoming earnings giants, such as transportation, mining excavators, and so forth. Profit is being socially re-allocated from sector to sector. Versus the great uncertainty during the transition, the liquidity of stock investing might help pension fund investors stay a little bit away from such unsystematic risk, which, at some times, is uncontrollable, until the market becomes further disciplined.
Thirdly, I am convinced of China's and Hong Kong's favored investment timing.
During the visit in Hong Kong, a number of speeches given by Victor Fung and Tung Chee-hwa have effectively cleared some major speculations on Hong Kong's sovereignty on its return to China. The social confidence toward Tung Chee-hwa, as the next leader of the Hong Kong Special Administrative Region (SAR), and Aason Chan, as head of the government servant, in the most current poll was up to 90%. Hong Kong people generally look comfortable to the return, in which social stability is guaranteed. The SAR will retain a high degree of autonomy in all matters except foreign affairs and defense; Hong Kong's independent judiciary is convened and protected. Presentations by US Consul General Richard A. Bouch, the Chief Executive of the Stock Exchange of Hong Kong, and the Chairman of Peregrine all assured us that a majority of the negative factors on the transition and economy of Hong Kong were digested, and Hong Kong's economic fundamentals, favorable tax, together with efficiency, excellent management, quick markets, and especially openness in information, as well as an upward investment momentum, are pushing the market to hit a three-year peak.

- Yafei Yin