February 2010

Is China blowing bubbles? A China thought piece

Both China and America are addressing bubbles by creating more bubbles and were just taking advantage of that. So we cant lose We have to be in everything because you never know whats going to happen in this world1 Lou Jiwei, Chairman and CEO of China Investment Corporation 28/08/09

A number of commentators and analysts have termed Chinas asset markets (primarily its residential property and the A share market) an asset bubble, but without fully explaining what an asset bubble is. While there is no standard definition2, it is generally accepted that a bubble occurs where the price of a particular asset has become significantly detached from its fundamental or intrinsic valuation (e.g.sub-prime, TMT in the late 1990s, Japan in the late 1980s). Given the fundamentals and valuations of an asset can constantly change, bubbles are by no means easy to identify. In this thought piece, we determine whether China really is in an asset bubble.

Inother words, financial crises are often credit booms gone wrong3. Unfortunately, the banking data in China provides only limited details on how the massive expansion in credit has been used during 2009. While there are few official numbers or estimates anecdotally, ahigh proportion of the banking-led stimulus last year found its way into the local equity and property market4. Estimates on the bank lending that ended up invested in asset markets (including commodities as well as equities, and property) have ranged between 20% and 70%. Anecdotes suggest that even corporates who did not want to borrow money from the banks were told to borrow money, and invested the proceeds. As a result liquidity in China became and remained abundant during 2009. Measures like M2 money supply grew 27.7% yoy in 2009, the highest in over a decade. As one would expect, this has significantly raised inflation expectations. Inflation risks are now on the rise in China as the consumer price index (CPI) turned positive to 0.6% in November 2009 and 1.5% in January 2010. This was its first increase since January 2009, and is expected to rise further during 2010. The two places where rising money supply and inflation will continue to have an outlet in China will be residential property and A shares.

The background
Following Chinas massive Rmb 4 trillion (US$585 billion) stimulus package announced last October and near Rmb10 trillion (US$1.3 trillion) expansion in credit during2009 and Rmb 1.39 trillion in January 2010, therehas been a steady stream of warnings over recent months ofoverheating and emerging asset bubbles in mainlandChina. In China, like the US, property and equity markets areclosely intertwined, and have been supported by a moderately loose monetary policy (i.e. low interest rates). Chinas cheap currency has also encouraged offshore capital flows at a time when the US Fed has pursued an even looser monetary policy than China. However, asset prices in China could inflate to dangerous levels if there are further delays in monetary tightening and the continued suppression of its currency. The market is justifiably concerned about credit growth. Itis generally accepted that this is often a powerful predictor of bubbles and subsequent financial crises.

The potential consequences

The question of whether China is rushing headlong into aliquidity-led bubble is one of the most important for local and global investors alike. It has repercussions across many markets, not just in China. As highlighted in a recent speech by Norman Chan, Hong Kong Monetary Authoritys Chief Executive, asset bubbles are the number one threat to financial stability in Asia 5. This is perhaps most obvious in the Hong Kong property market where mainlanders are an increasing percentage of buyers 1

(byrecent reports up to 20% of buyers at the high-end inHong Kong). However, it will also affect the pricing ofrisk and growth expectations across the Asia-Pacific region, and even globally. Most investors clearly acknowledge that China now has a pivotal role in global as well as regional markets. This is a position that did not exist in previous asset cycles.

likes of Goldman Sachs that China could overtake the US to become the worlds biggest economy by 2050 is an increasingly consensus view. AsChina rapidly urbanises (from a 45% urbanisation rateagainst 90% in most developed markets) incomes areforecast to grow strongly, and there will be growing demand for all types of goods and services (including residential property) from a growing wealthier urbanised population. However, as with technology and the internet in 19992000, there is the risk that a very good story can quickly turn into unrealistic expectations. As a result, a number of respected market commentators like the independent commentator Andy Xie and the hedge fund manager Jim Chanos have already termed Chinas property market a giant ponzi scheme6 or Dubai times 1,0007. These are supported byamazing stories of ghost towns like Ordos in Inner Mongolia8 and completely empty shopping malls in places like Dongguan9. The thought that this could be akin to a ponzi scheme comes from the fact that state-owned enterprises (SOEs) have been one of the biggest buyers and supporters of the property market since late 2008. Some estimates10 suggest that up to a staggering 60% of the transaction volume in the initial stage of the market recovery during the first half of 2009 were from SOEs. This leads to the interesting situation where SOE developers (like COLI, Vanke, China Resources Land, etc) funded by SOE banks (China Construction Bank, Bank of China, ICBC, etc) have been buying land from local governments (where land sales represent 40-60% of local government revenue) todevelop and then sell property to other SOEs for investment purposes. According to China Business News, a recent survey of 134SOEs in China highlighted that 70% are involved in real estate in either direct or indirect ways. However, only 16 of them are developers or real estate companies11. Companies in industries as diverse as chemicals, steel, textiles, and shoes have started up property divisions given the chance of a quick return in the property market can be much higher than in their primary business plagued by overcapacity. As a result, there has been frequent talk that Chinas situation is now starting to resemble Japans situation in the late 1980s. Even one of the smartest local property 2

A difference of opinions
The lack of market history and the quality of data in China leads to a very wide range of opinions as to whether China is heading into a bubble. The bulls dismiss the bears as investors who fundamentally have a limited understanding of the local market based on cursory visits to Beijing, Shanghai, Hong Kong, etc. On the other hand, the bears deride bulls for believing in the build it and they will come growth model where a good story leads to strong growth expectations being extrapolated too far into the future. The bears point out that business models and management teams are still far less proven and less tested in China through economic cycles, and therefore innately more risky. It all gets very emotional, and turns the debate polemic. Itends up as a black and white argument, however, as wehope to show, a lot of what one can analyse inChina tends to come only in shades of grey. We aim to present a more balanced view, and identify what could be potential tipping points in the argument for a bubble in China.

Analysing the China propertymarket

Chinas housing reform began in 1998 and has been aone-way bet for the majority of China homeowners. There are some very powerful positive forces at work inthe China property market. Residential property investment and growth has been a key driver, and is a strong part of Chinas GDP growth. As highlighted in numerous stockbrokers reports these positives include strong income growth, increasing urbanisation and low debt all of which have supported strong price growth in recent years. The strong macro fundamentals (high GDP growth, large current account surplus, high foreign exchange reserves, high savings ratio, etc) do not need tobe analysed here given they are well known and discussed by the market. Suffice to say, the view from the

developers, Vanke Chairman Wang Shi, recently compared China to Japan when he mentioned recent land prices in Beijing and Shanghai are like prices seen in Japan before the Japanese property bubble burst12. This is worth noting as local property specialists see Vanke as one of the smarter local developers at calling the market. Vanke is the market leader in China residential property market; however its market share is still only 2.3% (of national residential sales by revenue in 2008) given there are more than 30,000 property developers in China. The interesting similarities between China and Japan in the 1980s include the highly regulated nature of the economy, a Confucian ideology, a hard working population with a high propensity to save, robust domestic investment rates, tension in currency diplomacy, a shift in the geopolitical balance, etc13. The demographics of China will also become increasingly similar to Japan over the next 5-10 years as they turn lessfavourable in China as the decade progresses.

Charts 1 and 2 Affordability looking stretched Exhibit 28

Exhibit 28
16.0x 16.0x 14.0x 14.0x 12.0x 12.0x 10.0x 10.0x 8.0x 8.0x 6.0x 6.0x 4.0x 4.0x 2.0x 2.0x 0.0x 0.0x
National National Average: 7x Average: 7x

Property Price/Annual Price/Annual Income: Income: Four Four Major Major Cities Cities Property
Shanghai Shanghai Guangzhou Guangzhou Shenzhen Shenzhen Beijing Beijing

16.0x 16.0x 14.0x 14.0x 12.0x 12.0x 10.0x 10.0x 8.0x 8.0x 6.0x 6.0x 4.0x 4.0x 2.0x 2.0x 0.0x 0.0x

2000 2000

2001 2001

2002 2002

2003 2003

2004 2004

2005 2005

2006 2006

2007 2007

2008 2008

2009e 2009e

Source: CEIC, Morgan Stanley Research Exhibit 29 Exhibit 29

Source: CEIC, Morgan Stanley Research Source: CEIC, Morgan Stanley Research

Mortgage Payment/Annual Payment/Annual Income: Income: Four Four Major Major Mortgage Cities Cities
100% 100% 90% 90% 80% 80% Shanghai Shanghai Guangzhou Guangzhou Shenzhen Shenzhen Beijing Beijing 100% 100% 90% 90% 80% 80% 70% 70% 60% 60% 50% 50%
National National Average: 43% Average: 43%

Affordability is a grey area

Traditionally, to assess the health of aproperty market, most analysts would look at data like affordability. Normally house prices expressed as a multiple of household income, or as monthly housing repayments asa percentage of monthly income, are a standard measure in helping assess whether there is a property bubble. InChina the data suggests fuel for both bulls andbears. On the nationwide numbers, while property is by no means cheap, it does not look like it is in bubble territory at under 7x income or 43% of monthly income (Charts1,2). This compares to 10x in Japan in 1989 and 14x for Hong Kong in 1997. However, when we start to look at specific cities like Beijing and Shanghai, affordability looks a lot more stretched (over 13x income or 70%) and far more bubble-like. Again, while the affordability numbers in the major cities suggest a serious problem, it is possible that this just represents a mix problem in the housing stock. This is possible because developers have tended to focus more on high-end housing and there is perceived to be a shortage of cheap housing for the mass market in China. If this can be rectified affordability could look significantly better.

70% 70% 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009e 2009e

40% 40% 30% 30% 20% 20% 10% 10% 0% 0%

Source: CEIC, Morgan Stanley Research Source: Morgan Stanley Research Source: CEIC, Morgan Stanley Research

As our discussions with numerous property developers in China have highlighted to us, no one seems to have a reliable affordability model in China. However, many have pointed out that affordability does not work the way it does in the West. The peculiarities of Chinas one child policy and the living arrangements of families in China mean that for a young married couple to afford a house one needs to consider not just the joint income of the couple but also the income of their four parents. Therefore, affordability data in China is always likely to bemisleading and the bulls say massively understate housing affordability. This is quite a tortured argument.

Rental yields and inventories tell two sides of a story

As well as affordability data, the picture on rental yields and inventories is also extremely grey, and again highlights fuel for both bulls and bears. In China there isno real residential rental market to speak of, and certainly not one that can provide accurate yield or valuation data. What rental market there is suggests rental yields of 2% to 3%. Again highlighting the peculiarities of the China market, few property investors in China rent out their properties preferring to keep them as empty shells (to be sold after price appreciation for a capital return) rather than rent them out for an income return. In China the keydriver of property prices going forward seems to be as much rich peoples desire to preserve/enhance their wealth (using property as a store of wealth with the lack of alternative investment channels) as it is about mass-market affordability. Vankes Chairman Wang in his recent comments estimated certain first tier cities have seen over 80% of transactions come from speculative buyers. Though the inventory data (in terms of months of unsold property) is more readily available it also paints a pretty mixed picture. Again using Beijing as the example, in the 2008 downturn Beijings inventories were reported to be over 30 months (close to three years) which in a normal market would lead to a sharp price correction. However, in Beijing house prices only fell marginally during 2008 despite the disturbing inventory picture. In commercial property (Office and Retail) vacancy rates in excess of 20%, and 30% in the case of Beijing premium CBD office space, do not seem to lead to the normal or expected market adjustments. Commercial property in China seems even more dependent on a build it, and they will come mentality than residential property. Anecdotes14 like the emptiness of the massive Pangu Plaza development, right beside the Olympic Water Cube tends to confirm these impressions. There is even significant debate on the urbanisation number. An interesting piece of research authored by Pivot Capital15 last August highlighted that Chinas definition of an urban centre for urbanisation (population density of above 1,500 people per square kilometre) would exclude cities the size of Houston (2.2m people with density of

1,375/km2) or Brisbane (1.9m people with density of 918/ km2). This isaconfronting statement as Chinas reported low urbanisation rate around 45% is forecast to move towards global norms (in excess of 90%) providing significant demand support to the property market longterm. If Chinas urbanisation rate is considerably understated by official figures then it does not just question the long-term health of the property market but also many ofChinas other growth industries like automobiles, technology products, sportswear, etc that are all supported by Chinas growing urbanisation trends.

The China equity market

When looking at the equity markets in China one first needs to make a clear distinction between Chinas onshore market (China companies listed domestically in Shanghai and Shenzhen) and its offshore market (China companies listed in Hong Kong, Singapore US, etc). Chinas closed capital account means the onshore market is typically invested in by domestic investors, even though foreigners can invest through the Qualified Foreign Institutional Investor (QFII) scheme. However, these quotas are very limited16. The offshore market is mainly invested in by foreign investors, even though domestic investors can invest through the Qualified Domestic Institutional Investor (QDII) scheme, but again quotas are limited. The focus here is to discuss the onshore A share market because this is the most likely destination along with the property market for any excess liquidity in the domestic economy because of the capitalcontrols.

Onshore valuations seem stretched

On the surface, valuations in the onshore market look stretched when comparing the multiples that stocks trade on globally. Only two sectors, Energy and Financials, trade below 20x 2010 consensus estimates (Chart 3). These are traditionally low P/E sectors. The earnings of the Financials are dependent on the continuation of very low credit costs, and the earnings of the Energy sector are dependent on volatile oil prices. The rest of the A share market trades at between 20x and 32x. This compares to13.1x for the offshore China market (using the MSCI China as the proxy), 13.4x for the MSCI World index, 12.2x for MSCI Emerging Markets, 13.9x for the US, 4

andimportantly 17.3x and 13.2x for the Indian and Indonesian markets respectively. Both markets investors view with similar attractive long-term growth stories to China (Chart 3). Chart 3 Local Chinese shares are the most expensive in the world CSI 300 (CNY) Energy Materials Industrials Consumer Discretionary Consumer Staples Healthcare Financials Information Technology Telecommunications Utilities CSI 300 Market MSCI China MSCI Emerging Markets MSCI India MSCI Indonesia MSCI USA MSCI World 2010e P/E 16.7x 21.1x 21.4x 23.7x 27.6x 26.6x 14.4x 31.5x 31.3x 21.6x 18.3x 13.1x 12.2x 17.3x 13.2x 13.9x 13.4x

Interpreting the valuations

The differing views of international and domestic investors are demonstrated by the A share versus H share premium. Chart 4 shows the P/E premium that local investors will pay for similar earnings stream relative to international investors. As with everything in China, this can be interpreted in a number of ways. One view is that more experienced international investors are far more wary of the risks of Chinese growth disappointing than local investors, which would be an indicator of possible excessive optimism in the local market. Another interpretation is that they have similar views of the risks but also have a far lower cost of funds, and so it makes sense that they would pay more for the same earnings stream. Either way, if the two classes of shares were fungible it would be rational for a long-term investor to own H shares in preference to A shares. As mentioned, Financials as a sector in the A share market is trading on 14.4x forward earnings. But if credit costs deteriorate with some of the lending risks in the property sector, for example, the sector could easily be trading over20x like the rest of the A share market. Chart 4 Valuations favour H shares over A shares
Forward 12-month P/E for MSCI China and CSI300 index, 1998 to 2009
40.0 35.0
MSCI China 12-m forward P/E CSI300 12-m forward P/E 36.9x 30.6x 25.1x 24.0x 18.9x 13.1x 14.1x 16.4x 15.1x

As at 26 February 2010. Source: CSI, FactSet, I/B/E/S, MSCI, Goldman Sachs Research estimates.

So does the fact that local Chinese shares are the most expensive in the world mean there is a bubble? History is inconclusive. For example, the NASDAQ peaked at 100x earnings in 2000, well above current levels, though the broader S&P peaked at 25x in 2000 and the Dow Jones index peaked at 33x in 1929. The A share market itself peaked at 37x during 2007. So we are now at valuation levels in some sectors which have, in other markets, been indicators of significant future declines. On the other hand these valuation levels may be completely justified by future growth which would mean there is no bubble, whether this strong earnings growth occurs is the fundamental question which we are constantly testing.

30.0 25.0 20.0 15.0 10.0 5.0 0.0 Jan-98

4.9x 11.1x 6.4x 8.8x 9.8x

29.1x

15.5x 7.9x

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Source: CEIC, CSI, DataStream, FactSet, I/B/E/S, MSCI, Worldscope, GSGlobal ECS Research estimates.

Jan-09

Investors are also asking themselves what the appropriate risk premium is for companies between the two markets and particularly for companies and industries with lower transparency and less trading history. Again using the example of Chinas banking sector, can one be comfortable that the long-term credit history and credit risks in the banks will be materially better than previous cycles? In many cases there is insufficient historical data for long-term analysis, but the markets future estimates of nonperforming loans are still relatively low. The current market consensus on credit costs over the next couple of years is within the range of 50-70 basis points, similar to the average of the last five years which might not fully capture the risks created by the 2009 lending growth given the risk that lending standards have been lowered. The short-term focus of the market means it is still relatively comfortable believing asset quality will remain benign over the next 12-24 months as nonperforming loans from last years lending spree might take a number of years to surface.

In simple terms, many Chinese industries (like sports retailing, wind power, cement, steel, etc) offer higher growth, but they are also more fragmented and competitive. For example, there are close to a dozen listed sportswear retailers in China. Numerous industries are so new in China and have grown so quickly they are yet to be tested by adownturn. In looking at risk premiums, its also important to remember that most companies sustainable earnings streams are heavily influenced by government policy not just in the Banks and Property sectors, but in all four corners of the economy. If we look at the largest companies in China listed offshore (again asdefined by the MSCI China index) then policy-driven priorities often have to sit alongside shareholders interests, and from time-to-time depending on the policy priorities and settings of Beijing this can conflict with the profit seeking motives of minority shareholder interests (Chart 5).

Chart 5 Potential National Service requirements of Chinas largest listed companies MSCI China 1. China Mobile (HK) 2.  China Construction Bank 3.  China Life Insurance 4.  ICBC 5. CNOOC 6. Bank of China 7. PetroChina 8. Tencent Holdings 9. China Shenhua Energy 10. Sinopec 11. Ping An Insurance 12.  China Overseas Land andInvestment 10.9% 6.2% 6.1% 5.9% 5.2% 5.2% 4.3% 3.2% 2.5% 2.2% 1.8% 1.5% Ownership The grand plan requirement of China's largest listed companies Govt Govt Govt Govt Govt Govt Govt Mangt Govt Govt Govt Govt Develop TD-SCDMA as China's technology platform Lend to promote China's economic growth To develop a welfare system (and debt capital markets) inChina Lend to promote China's economic growth Help China become more self-sufficient in thesupply ofoiland gas Lend to promote China's economic growth To develop natural gas for China To maintain political stability/control through the internet Affordable coal for power users (given inflationary risks thru power tariffs) To provide refining capacity for China To develop a welfare system (and debt capital markets) inChina To develop affordable housing in China (acap and floor approach)

Source: MSCI, Five Oceans Asset Management. Weightings as at 26 February 2010.

Conclusion
Chinas property and equity markets often do not conform to the normal operating model that many investors in the West expect. For example, affordability, rental and inventory metrics in the property market do not seem to work in quite the same way as other property markets. Therefore, the evidence of a full scale asset bubble in either property or equities in China is far from conclusive despite the empty apartments, office blocks, shopping malls and hotels, and the strong recovery in the A share market. Though it is possible to identify areas of misallocation of resources in Chinas asset markets it is far harder to determine whether this is all pervasive. On a simple checklist, not all conditions for a bubble seem fulfilled (Chart 6). Chart 6 Not all typical bubble conditions are fulfilled Typical bubble conditions A compelling and exciting story that all investors can easily understand Cheap and easy credit with a high credit multiplier and loose monetary policy Friendly Government or regulatory policy Abundant market liquidity, and very high trading volumes High levels of investor confidence (that eventually turns into hubris) High levels of leverage Extended levels of valuation often well above historic norms/averages
Source: Five Oceans Asset Management.

China 4 4 4 4 7 7 7 High GDP Growth, growing among 1.3 billion people, increasing urbanisation Bank lending of Rmb 9.59 trillion in 2009 at low interest rates, Rmb 1.39 trillion in January 2010 Government policies to support property market as well as subsidise a number of industries Turnover in the A share market now the largest in Asia (including Japan) Number of A share account openings still relatively low versus 2007 Low loan-to-deposit/loan-to-value ratios, high savings rate, low household debt, debt to GDP Current valuations (PE, PB) close to historic averages (both onshore/offshore)

There has actually been a relatively low credit multiplier (loan growth/nominal GDP growth) in China over recent years below one times during 2004-08 (Chart 7). This suggests that China is not yet a full-scale bubble. It was only from 2009 that loan growth in China has aggressively expanded into the two to three times nominal GDP level, which normally acts as a warning sign for non-performing loans, credit quality, and the formation of bubbles. As with the Asian Crisis and more recently with sub-prime in the US, the credit multiplier normally needs to stay at an elevated level for a number of years before problems start to emerge, and to give time for a bubble to inflate.

Chart 7 A relatively low credit multiplier (%) Nominal GDP growth 11.8 16.7 22.1 34.0 36.0 25.9 17.3 10.1 6.0 5.3 8.4 10.4 10.4 13.3 17.5 17.7 17.5 18.7 16.6 8.0 13.0 Real GDP growth 3.8 9.2 14.2 14.0 13.1 10.9 10.0 9.3 7.8 7.6 8.4 8.3 9.1 10.0 10.1 10.4 11.6 13.0 9.0 8.7 9.8 Export growth 18.2 15.8 18.1 8.0 31.9 23.0 1.5 21.0 0.5 6.1 27.8 6.8 22.4 34.6 35.4 28.4 27.2 25.7 17.2 -18.6 13.4 CPI inflation 3.1 3.4 6.4 14.7 24.1 17.1 8.3 2.8 -0.8 -1.4 0.4 0.7 -0.8 1.2 3.9 1.8 1.5 4.8 5.9 -0.6 3.2 Loan growth 23.1 20.7 23.4 25.1 23.9 23.8 21.0 22.5 15.5 12.5 13.4 11.6 15.8 21.1 14.5 13.0 15.1 16.1 18.8 30.0 20.0 Deposit growth 29.9 29.0 29.8 26.2 36.6 33.1 27.3 20.2 16.2 13.7 13.8 16.0 19.0 21.7 16.0 18.9 16.8 16.1 19.7 N/A N/A Credit multiplier* 1.96 1.24 1.06 0.74 0.66 0.92 1.21 2.23 2.58 2.36 1.60 1.12 1.52 1.59 0.83 0.73 0.86 0.86 1.13 3.75 1.54 Loans / GDP 94.7 98.0 97.8 93.2 84.7 83.1 85.9 94.9 102.5 104.5 100.2 102.4 109.1 116.6 111.2 103.2 101.7 99.5 98.9 119.0 126.3

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e 2010e

Source: Citi Investment Research and Analysis estimates *Credit multiplier = Loan growth/Nominal GDP growth.

Bulls would say we would probably need to see the credit multiplier in China stay at the current level for a longer period of time to become really concerned about a fullscale problem. This seems a reasonable assumption however there is a strong need to continue testing this. While the credit multiplier has been low, this is mainly because of exceptionally strong nominal GDP growth. Credit has still been expanding at 15% to 20% for the past 10 years. We can also not be sure that we have full disclosure on total debt outstanding. The massive spike in bank lending during 2009 also coincided with a large increase in corporate debt issuance, which is not commonly discussed. There have also been a number of anecdotes

about Chinese banks moving loans off their balance sheets into wealth management products. There could also be significant debt hidden in local government financing vehicles. These are investment companies set up in local governments whose debt is not reported in official figures. Credit growth was probably therefore much stronger than has been reported. For 2010 a slowdown is planned to 20% bank credit growth (the PBOCs target is Rmb 7.5 trillion), still a large number in absolute terms. The key unknown is in the timing of any problem with China having pulled years of cheap credit into just one year. Theold IMF rule of thumb is it takes three years of 20-30% loan growth for NPL problems to surface. 8

Thekey question in China is what 10 years at 15%-20% and one year at 30% followed by another 20% means. Another condition of a typical asset bubble is when market participants assume significant amounts of leverage. While the numbers are naturally much harder to obtain in China there does not seem a large build-up in leverage on the numbers that are available (e.g. loan-to deposit ratios in the high 60s, loan-to-value ratios below 70%, high % of cash buyers, high savings ratio, low consumer debt, etc). China still has a very high percentage of property sales financed by cash (around 20-25%), or at least financed by relatively low loan-to-value ratios which are rarely above 65%. Again the risk is much of the leverage is off balance sheet in China. For example, local Government debt (which is highly dependent on land sales) is not reported in Chinas debt to GDP numbers, and property developers relatively high gearing ratios look even higher when one adjust for unpaid land premiums. But, the authorities in China have been very proactive in managing leverage as well as trying to contain asset prices, when compared to the likes of the Fed. They are quite bubble wary. For example, the increase in bank reserve requirements over 2004-07, and a variety of policies towards the property market during 2004-07 were introduced to combat what the authorities justifiably perceived to be an overheating market at that time. Investors can take a degree of comfort from the fact that the Chinese authorities have in the past shown a greater willingness to use monetary policy to target asset prices than most other central banks. In such a command-driven economy the authorities in China has a wide range of tools to cool asset markets. The Government has in recent months already flagged their intention to stabilise prices through taxes, interest rates, land policies, etc. A cap and floor approach seems likely to be pursued given the risks to social stability from rapid rises or falls in property prices. We also have not yet seen the Chinese version of the fabled indicator that a bubble has to burst. In Japans case this was famously when the value of the Imperial Palace grounds in Tokyo in 1988 were worth more than all of the real estate in the state of California. In late December though we saw Chinas largest ever land transaction at a price of Rmb 25.5 billion (US$3.7 billion). However, given

the size of the plot (4.38m sqm) in Panyu, Guangdong this worked at a price of Rmb 5,822 per sqm (US$852 per sqm). Therecord for a residential per sqm purchase happened in Shanghai the same week when China State Construction paid Rmb 32,500 per sqm (US$4,758 sqm). Still well below the level of high-end (rather than average) prices in Hong Kong or London, even if this is a very stretched point of comparison. For example, Hendersons Land sale of an apartment at 39 Conduit Road in Hong Kong last October at a reported price of HK$439 million (US$57m) equates to a price of US$9,200 per square foot, or close to US$100,000 sqm17. This beat the previous world record set in London, where a flat in One Hyde Park was sold for over US$90,000 per sqm. Recent high-end prices in Shanghai have been more like US$30,000 sqm. As with property, while A shares can hardly be termed cheap, and we would not recommend owning them (on an absolute basis, or relative to H shares) they also do not seem to be in full bubble territory. Bubbles also tend to inflate over the course of around three years and can have a parabolic explosion in prices towards the peak of the bubble. The A share market remains some 40% below its October 2007 high. However, we believe investors have to invest in China acknowledging the risk of asset bubbles, and have a strategy to manage bubble risk. This should ideally include high cash discretion, and the ability to short to manage portfolio risk. A number of H shares in Hong Kong are shortable, and there are an increasing number of exchange traded funds available. In the final stages of a market blow-off risk (when the share price ascent is near vertical) the ability to hedge and have high discretion on cash levels is highly desirable. We will be looking out for a range of top of the market indicators, including taxi driver anecdotes, Chinese corporates undertaking expensive M&A transactions on the global stage, etc. The problem is that identifying asset bubbles is a lot easier than identifying them in a timely manner. History has shown it is often as just as dangerous to call a bubble too early as not to call it at all. We will continue to look for tipping points, and maintain a dialogue with both bulls and bears to help our clients manage this risk.

Zhou Xin and Alan Wheatley, Reuters, Chinas CIC wealth fund muscles up as markets recover dated 28th August 2009 (http://www.reuters.com/ article/idUSTRE57S0D420090829) 2  http://en.wikipedia.org/wiki/Economic_bubble 3  Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 18702008 Moritz Schularick and Alan M. Taylor NBER Working Paper No. 15512 November 2009. 4  One estimate from Mr Wei Jianing, a deputy director at the Development and Research Center under the State Council on June 27, 2009, as reported by Chinese Business News (via Bloomberg) suggested that 20% of bank lending ended up in the A share market. This represented an estimated Rmb 1.16 trillion of loans invested in stocks in the rst ve months of 2009. 5  A speech given by Mr Norman T.L. Chan, Chief Executive of the Hong Kong Monetary Authority, at the Hong Kong Economic Summit on 14th December 2009 (http://www.info.gov.hk/hkma/eng/speeches/speechs/norman/20091214e1_index.htm 6  Andy Xie, Caijing Magazine, China Counts Down to the Next Bubble Burst dated 5th August 2009 http://english.caijing.com.cn/2009-0805/110220584.html 7  In a CNBC interview on 15 December 2009, Jim Chanos, President of Kynikos Associates said that China could be Dubai times 1000, or worse. http://www.cnbc.com/id/34433626 8  Chinas empty city Al-Jazeera News dated 10th November 2009: http://www.youtube.com/watch?v=0h7V3Twb-Qk#t=01m20s 9  Utopia, Part 3: The Worlds Largest Shopping Mall dated 18th August 2009 (http://www.pbs.org/pov/utopia/). New South China Mall (formerly South China Mall) in Dongguan, China is the second largest mall in the world after Dubai Mall. It has the most gross leasable area of any mall in the world; room for over 1,500 stores in approximately 7.1m square feet (659,612 square metres) of leasable space and 890.000 square metres of total area. Despite opening in 2005 much of the retail space remained empty in 2008 with 99.2 % of the stores vacant. http://www.thenational. ae/article/20080612/REVIEW/206990272/1042 10  Koyo Ozeki, PIMCO, The Chinese Real Estate Market: A Comparison with Japans Bubble dated December 2009. 11  http://www.china-cbn.com/s/n/000004/20100108/000000144489.shtml 12  Vanke Prepared for Bursting of China Property Bubble, Post Says Jian Guo Jiang, Bloomberg News, Published December 22 2009 (http://www. bloomberg.com/apps/news?pid=20601089&sid=ae8DfuMnzi.0) 13 Dylan Grice, SG Research, The lesson from Japan? China will be the biggest bubble the world has seen dated 15 September 2009. 14  Pivot Capital Management Chinas Investment Boom: the Great Leap into the Unknown dated 21 August 2009.http://www.pivotcapital.com/ research.html. Chinas denition of an urban centre includes, among other things, population density of above 1,500 people per square kilometre. By that denition Western cities like Houston (2.2m people with density of 1,375/km2) or Brisbane (1.9 m people with density of 918/km2) could technically not be counted as cities. Back in China, a lot of the so-called villages and townships are in fact highly industrialised. Qiaotou, home to 64,000 people, produces 60% of the worlds buttons and 70% of its zippers. Songxia with 110,000 people is the umbrella capital of the world: it produces 500mn umbrellas per year. 15  http://chovanec.wordpress.com/2010/01/03/beijing-tenants-ght-eviction and http://articles.latimes.com/2009/feb/22/world/fg-luxury22 16  http://en.wikipedia.org/wiki/Qualied_Foreign_Institutional_Investor 17  http://en.wikipedia.org/wiki/39_Conduit_Road
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Information in this document is current as at 22 February 2010 and is provided by Five Oceans Asset Management Pty Limited ABN 90 113 453 160 AFSL 290540 (Five Oceans). The document is intended solely for licensed nancial advisers or other wholesale clients. This document should be regarded as general information only rather than advice. It has been prepared without taking account of any persons objectives, nancial situation or needs. The information must not be copied or disclosed in whole or in part without the prior written consent of Five Oceans, and Five Oceans accept no liability whatsoever for the actions of third parties in this respect. It is presented for informational purposes only and is not to be construed as a solicitation or an offer or recommendation to buy or sell any securities. While due care and attention has been exercised in the preparation of the information, Five Oceans gives no representation or warranty, either express or implied, as to the accuracy, completeness or reliability of that information. Any opinions expressed in this document may be subject to change. Five Oceans is not obliged to update the information. The information must not be used by recipients as a substitute for the exercise of their own judgment and investigation. Neither Five Oceans nor any of their directors, employees or agents accept any liability for any loss or damage arising out of the use of all or part of, or any omission, inadequacy or inaccuracy in, this document.
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