Hello, everyone. Thank you for joining us today here in Hong Kong. I’m David Soh from the RBC Asian Equity Team.

We have recently published an article titled China’s new long march ahead A necessary evolution in a shifting geopolitical environment. And we are joined by the lead author and my colleague, Siguo Chen. Siguo, tell us about yourself.

Hello, everyone. My name is Siguo. I work in the RBC GAM Asian investment team, and China is my key focus area. We recently put out a thought piece because we wanted to recognize that while a lot of things are uncertain today, there is a long-term investment opportunity here.

I agree. It’s a very timely discussion. We’ve also received a lot of questions for today’s conversation, and most of them are about economic growth in China. How should we think about this? Can China grow when the global economy is slowing down?

There’s no doubt there’s a lot of challenges. These days, not a single day goes by without us seeing news about COVID-19 or tension between China and the US. But, when we look at China, beneath all these challenges, there are more fundamental changes going on. And I think the starting point for our discussion today can be that the growth model for China is structurally changed. Investment-driven growth, export-led growth used to play a very important role in getting China to where it is today. But already in the past several years, the economy has been increasingly led by domestic consumption, service sector jobs, and the tech boom. So, yes, global trade may slow, but China’s dependency on trade is also slowing. In this thought piece, we want to provide some insights on the four major trends that we believe corporate China is pushing through.

Right. And those four major initiatives are, companies are relocating, businesses are moving up the value chain, traditional old industries can still grow, and the visible hand is back in new growth initiatives with investments and policies.

Yeah. That’s right. And I also want to talk about how the team approaches investing longer term in a changing China.

Good stuff. Should we dive right in, then? The first one—companies relocating.

Okay. This one needs to be understood in the context of China’s relationship with the US. Trade relations between the two countries were only normalized in the early 2000s. For example, at the time, Bill Clinton was referring to this as a historic step towards continued prosperity in America, reforming China, and peace in the world. So you can see how much optimism there was at the time, and China has definitely benefitted from this globalization. For two decades, Chinese export grew 13 percent a year. So that’s more than double the pace of global trades.

What a—what a contrast to the ongoing trade war that we’re seeing today.

Frankly, the public sentiment in the US towards China, and vice-versa, are—are not as positive as it used to be.

Unfortunately, that’s true. So the Chinese companies are working to diversify their production base already. It actually started about a decade ago, way before the recent tariff hike.
People tend to see Chinese companies as businesses located in China, leveraging on cheap labour, mostly from value manufacturing. But increasingly, Chinese companies are relocating themselves to even lower-cost countries, or they choose to be closer to their customers such as in the US or Europe. So we kind of see this relocation trend as sort of a social distancing, but on a corporate level.

And—and how do they do when they move overseas? They no longer have that home ground advantage.

The companies that have the knowhow in what they do thrive wherever they are. There is this leading Chinese apparel manufacturer that they do manufacturing for top local brands in sportswear and fast fashion. They started relocating about 10, 15 years ago, before the—all this trade tension even started, and now have about one-third of production based in countries like Vietnam and Cambodia. What’s impressive is that this company still maintains its super-high ROE levels, despite major operational changes.

And what about the companies that move closer to their customer base?

A good example for this is this Chinese auto glass maker. It’s the largest OEM glass maker for autos globally. They’ve made decision to move closer to their US customer, I think back in 2015, and now they have roughly 20 percent of their production based in the US. And that definitely helped them navigate the trade war a bit better.

Chinese exporters consider relocation but show lower interest in moving to the U.S.

Saying that, I think the US is no longer a—I mean, a popular destination for Chinese companies. A recent survey showed that the interest of moving to the US has dropped drastically. Obviously, the growing tension between the two countries here is not helping.

Got it. And the second major initiative was moving up the value chain. So what’s the message here?

The message here is about R&D and technology. Chinese company have been increasing their R&D spend aggressively for at least a—a decade now.

Key players in IT and biotechs are spending well above 10 percent of annual sales in this. Now, given the recent tension between China and the US, there’s going to be a lot of focus for Chinese companies and the government to move up the technological ladder.

So this again is about moving from low-cost value manufacturing to advancing technology at a global level.

Right. I think—and it’s really not as far-fetched as some may think. If we rank companies globally on annual R&D spend, number four is this Chinese tech company that spent over US$15 billion in 2018 alone. Most global tech giants don’t even spend that much. Nowadays when we meet Chinese management, we can sense that R&D is not only a matter of business success, but also a crucial part of survival for them.

That reminds me of a recent article from our EM team colleagues. They also talk about an emerging tech war and how China is accelerating tech investments, seeing it as mission critical. And you mentioned there was innovation in Chinese biotech as well.

Just to be clear, Chinese biotech is still way behind the US, especially in early stage research such as mechanism discovery or new targets identification. But we need to keep in mind that China is already the world’s second-largest pharmaceutical market and Chinese regulators are very keen to make high-quality drugs available in China, in—in areas like oncology or diabetes. The Chinese regulator have really been shaking things up in the past few decades. They pushing—they’re—they are really pushing companies to innovate and deliver. And to those that do, they are rewarded with fast approvals. Listing rules are also being changed so that even loss-making biotechs can have access to capital. I would say this is one of the most exciting spaces in China at the moment.

But—but isn’t the world increasingly skeptical about how much they can trust Chinese companies? Take the recent UK 5G rulings, for instance. How does this impact Chinese companies? Can they still become a part of the global value chain in cutting-edge tech and health care?

Arguably, they already are, and there’s been a surging interest for new drug developments, both in China and globally. Outsourcing research to CDMO companies is a major trend in the health care space. The China champion here has built one of the world’s largest research teams and is already the third largest CDMO in the world. So two-thirds of the revenue is from large global pharma companies that lead research in different therapeutic areas.

That’s—that’s mind-blowing, really. So not only are Chinese companies outspending their global peers on R&D, they’ve come to specialize in innovative R&D so much that global leaders are outsourcing it to them. The third major trend—growth in traditional industries.

Yeah. That—in there, what we want to highlight is that simpler, traditional industries are also changing. Firstly, digitalization. China’s internet giants have been spearheading digitalization for more than a decade, and everybody knows that. And the government is also very enthusiastic about 5G rollout now. So we think these factors are going to translate into productivity gains, not just for large corporates, but also small and traditional business.

That’s a good point, actually. During the COVID-19 lockdown, the Chinese household managed quite well, thanks to the high level of digitalization. And I’m sure it also helped to push digital penetration even further.

Correct. Traditional industries are evolving, becoming digital, and getting more sophisticated. It’s happening everywhere. Take the logistic market, for example.

Logistics is very old, traditional business. International players have been in China since the ‘80s. But over the last decade, the logistic market in China has grown massively in size and it has become much more e-commerce-driven. Recently, we’re seeing industry consolidation, with the top five players more focused on economy of scales.

I get it. The industry’s structure is changing.

Yeah. It’s a fundamental change. Another example we like is the property management markets.

As you know, David, owning a property is the most universal aspiration in China. The top 10 Chinese property developer has an aggregate sales of RMB4.5 trillion; that’s about 10 times what it was a decade ago. But prices are elevated. And the question now is, can these developers grow another tenfold from here. The Chinese government is clamping down on housing price speculation, which is going to put pressure on developers. However, property management is growing rapidly. The great thing about property management for investors is that it’s not as cyclical and the addressable market is much bigger, given it’s still fairly new in China.

And the last point in the article was the visible hand is still on the steering wheel. I like this witty subtitle.

Well, it’s very true. The party has always seen economic growth as a very top-down policy, dating back to something like 1953, the first five-year plan.

In that sense, it should be quite predictable. What are some key policy directions that the team is observing?

One we’ve been very focused on is the next wave of urbanization. Urbanization was first mentioned in China’s eleventh five-year plan, covering I think 2006 to 2011, and it was a success. Migrant workers left farms and got jobs in factories, unemployment rate went down, income levels went up, and household consumption also increased a lot.

But isn’t China already very urbanized today?

It’s at 60 percent today, and normally that would be close to saturation.

Urbanization 2.0 is something we talked about which used more reforms intended to break down the physical constraints and bring a larger number of people and companies together. Digitalization is a major enabler in this, along with things like high-speed rail. AI and big data also come into the picture, for managing a physically larger and faster-moving city.

I—I think I see a common theme in the four major trends you walked us through. Even this one is more tech-knowledge-based, it’s more tech-based, and we’re trying to challenge how cities and industries and business models traditionally work. A lot of innovation, with focus on productivity.

Picture this, right? China has five megacities today. The average population for one of these are nearly 110 million people. By 2030, it’s going to reach 120 million. Each one of those cluster are five to six times the city the size of New York City.

One cluster is about the size of the entire population of Japan, actually. Fascinating stuff. So what are the investment implications from all this? Can you share more about how the team invests in China?

Simply put, we want to highlight that things are changing. China’s growth rate, we’re not like a decade ago. And more importantly, the growth driver will not be the same.

To some extent, it’s a work in progress, isn’t that?

It is. The government, companies, people, they’re all trying to figure things out together. What I want to share are key trends, in terms of where we are, the efforts appear to be directed as well.

I—I like that. The investment case for Chinese equities are pretty clear for most people, I think. The size of the economy is already two-thirds of the US

The population is four times;.

The number of listed companies are already similar to that of the US. But we’re saying that investors should not simply get exposure to the asset class because it’s very dynamic in there and things are changing.

Exactly. There is a lot of bottom-up work required, not just for company-level due diligence, but also to understand how each industry is evolving, what type of governmental reform will take place, et cetera. A good example is what MSCI China Index looked like 10 years ago. Back then, the top 10 companies were all SOEs, but today half of them are private. The sector industry mx is also massively different. Chinese A-shares started to get included. That’s only recently and its weight is increasing.

That sounds like a lot of bottom-up opportunities.

There are, but it requires a lot of work and that’s what we focus on in our Asian equity team here. Everybody has their own sector expertise; they leverage on their own knowledge in the sector across Asia. On top of that, we meet regularly with companies, industry experts, and regulators. We also do extensive in-house research, including due diligence checklist and team discussions. Yeah. So it is a lot of work.

Then how is China from a corporate governance or ESG point of view, especially since RBC Global Asset Management is committed to integrating ESG in its investment process?

There’s room to improve, but that’s a good thing. We see an encouraging trajectory of how companies’ management have changed over the years, especially private companies.

Management generally are much more aware of shareholder returns and are focused on dividends and buybacks; corporate governance as well. Some are saying E and S are lagging G, but I believe the environment and social, first and foremost, has a lot to do with disclosing the right data. Hong Kong Exchange made it a requirement to make disclosure on ESG materiality in early 2020, and in Shanghai and Xinjiang are expected to basically follow suit. So there is progress here. Market access still has room to improve but this appears to be headed in the right direction as well, as we can see with the Stock Connect.

Thanks, Siguo. I think this overall adds very good perspective. So we may continue to see COVID-19 and trade war in the headlines, and markets may continue to be volatile. But if we take a big step back, there’s a bigger picture here, that corporate China is really working hard to reinvent and transform itself.
There’s no saying what China’s growth rate will be for the next coming years, and, yes, it’s likely to slow. But we see some clear, high-quality growth drivers in place, like the four trends you explained for us. And China’s still likely to outpace average growth rates in developed markets.

Also a very important thing here is that Chinese equity, especially A-shares, show very low correlations with other assets. So it can be a very good diversification tool for global asset allocators.

As market access and ESG improves, it’s also likely to see funds in-flow from foreign investor over the long term.

So you see the current buzz around Chinese equities, especially A-shares, to be somewhat structural and long term.

That’s what we believe. And it’s driven by both fundamental growth and market dynamics. But again, I want to emphasize, it’s not the asset class itself, at least not just itself. But really, the bottom-up stock picking up—picking—stock-picking opportunities in this market that get us excited about China and A-shares. We’re on the ground meeting companies to find the next China champion, because we believe having a focused, high-conviction strategy is the way to go here.

That’s refreshing. So the team’s strategy is really just focusing on the best businesses in China, ones with strong long-term prospects, regardless of where they may be listed, be it Hong Kong, China Mainland, or the US. Excellent. Shall we wrap it up here, then?

Sounds good. Thank you, everyone, today for joining us.

Thank you for joining. Cheers.

Cheers.