China flags a new dawn for reform

Positive data from China shows the country's economy is proving more sturdy than expected, and in the wake of the Bo Xilai controversy a real reform program looks to be underway.

At a time when the eurozone is sinking deeper into recession, investors have cheered signs that the Chinese economy is proving more robust than expected.

The Shanghai Composite index jumped by 1.8 per cent yesterday, amid signs that China’s monetary easing is taking effect. Lending by Chinese banks climbed to 1.01 trillion yuan ($US160 billion) in March, well above the 800 billion yuan that economists had been expecting.

And analysts are tipping that GDP figures out later today will show that the Chinese economy grew at a solid 8.3 per cent clip in the first three months of this year compared with a year ago.

In an interesting research note, GaveKal analysts Arthur Kroeber and Joyce Poon sound a note of caution for investors. They argue that there are now signs the Chinese leadership is finally getting serious about structural reforms.

"That is good for medium- and long-term growth. But it is bad for many Chinese companies in the short term – and worst of all for the companies who did best in the past decade who make up the heaviest weightings in Chinese equity indices.

"Over the next few years investors should underweight or sell these 'ex-winners', and buy the firms and sectors who will benefit from the emerging new growth model.”

Kroeber and Poon acknowledge there’s reason to be sceptical about the pace of structural reform. After all, the Chinese leadership has spoken endlessly about 'rebalancing' the economy away from its heavy reliance on infrastructure investment, and towards more efficiency and domestic consumption. But so far little has been achieved. "The obstacles to reform – local governments addicted to land sales, and state-owned enterprises addicted to monopoly rents – are large and powerful."

But they argue that last month marked a critical turning point. "The fall of maverick leader Bo Xilai, around whom much of the anti-reform statist camp had rallied, signalled an end to factional disputes. Public statements from central and local leaders since the annual parliamentary meetings in early March point to consensus around financial and market reforms. And premier Wen Jiabao’s recent statements about 'smashing the monopoly of the big banks' are little short of astonishing” (Tinker, Tailor, Bo Xilai, April 12)

They point out the reform program will have its costs, particularly as for the winners of the last decade – banks, property companies, and materials and energy firms – whose profits have been artificially boosted by their access to cheap capital, land and resources. "As these prices are adjusted these firms will see their margins shrink.”

On the other hand, sectors where productivity has been artificially suppressed should boom. According to Kroeber and Poon, "investors should sell the ex-winners and buy service and consumer companies that will benefit from reforms.”

But they caution investors to be careful. For the past decade, Chinese firms have been able to lift their profits by boosting output.

"Over the next decade, the winners will be those firms that best manage their cost structure. Even in the winning sectors there will be plenty of losing companies who do not understand the new paradigm.”