Falls Church, Va.—Late last week, two new announcements came out of China that should have consequences for the global markets.

For starters, China’s Banking Regulatory Commission (CBRC) announced that Qualified Domestic Institutional Investors (QDIIs) are now allowed to invest in overseas financial markets. Although the initial impact will be quite small (USD15 billion, with only 50 percent of it initially permitted for stock investments), the significance of the move is huge.

Chinese retail investors are finally given the chance to venture outside the home market; I expect that the government’s imposed quota will be quickly breached and lifted relatively soon. Even if 5 percent of the domestic A-share market cap is diverted to other markets, the impact will be much larger–north of USD100 billion.

Because Hong Kong will be the first market Chinese investors will tap, inflows of this sort will make a difference. This is before you consider the USD5 trillion in Chinese savings.

Of course, the main reasons that the Hong Kong market will initially receive more of the inflows is because it offers the opportunity to invest in Chinese-related stocks at a discount to the domestic shares (through the so-called H-shares, which are Chinese companies listed in Hong Kong) and the fact that there are quite a few quality global companies listed in the Hong Kong market that offer international exposure. As the chart below depicts, the H-shares market has underperformed the A-shares market this year, and consequently, it trades at a big discount to the domestic market.


Source: Bloomberg

This is the reason behind the Hong Kong market jump on Monday, a purely news-driven knee-jerk reaction, which also helped a couple SRI recommendations hit new 52-week highs. The two companies I recommend that trade on Hong Kong’s H-shares market are Datang International Power and Sinopec, both in the Alternative Holdings Portfolio. Although, investors shouldn’t expect these stocks to go up in a straight line, Datang trades in Hong Kong at a 48 percent discount to the A-shares, while Sinopec trades at a 38 percent discount.

Short-term considerations aside, the long-term significance of the CBRC move is of paramount importance to the global financial markets as Chinese portfolio outflows gradually become a part of the global market system.

The above can be easily linked to one of SRI’s long-term investment themes regarding Asia: the return of local investors to their home stock markets. This is happening for the simple reason that investors are optimistic about their country’s future and, therefore, more willing and eager to participate in the changes that are taking place. Given the scale of the socioeconomic evolution in Asia, local investors are coming back “institutionalized.”

What I refer to are changes in the pension systems across Asia; pension funds in India and China, for example, can buy equities for their portfolios for the first time. In addition, investing schemes like US-style 401-K plans have been implemented in South Korea and Taiwan and are planned for other countries, including Thailand.

What’s underway in Asia will have long-lasting, positive consequences for the markets, as countries have realized they need to do more to be able to pay for pensions as people retire. So they’re creating mandatory, defined contribution schemes within which individuals will have more choices for investment styles. They’ll be able to generate better returns than prevailing, extremely conservative pension schemes.

The main idea is to allow a little more exposure to equities. In Taiwan, for example, the equity ceiling for the labor pension fund was raised from 30 percent to 40 percent. In Thailand, the government pension fund’s ceiling for domestic equity investment is expected to be raised to 30 percent; the fund has also begun to invest in foreign markets. In India, private-sector pension plans are now permitted to invest up to 5 percent in equities.

Although the implementation of these proposals takes time, it’s important to note the concentrated effort to cultivate and institutionalize an equities culture in Asia following the American prototype. At the same time, individual investors are starting to feel more comfortable allocating a bigger portion of their assets to the equity markets, providing additional leverage to the effort.

This is undoubtedly bullish for Asia’s markets, as the move is being coordinated by governments and is more difficult to reverse. As institutional assets increase, Asian markets will gradually exhibit characteristics of more-mature markets.

Short Term

The other announcement made by the CBRC was a warning on market risk. Although the regulators acknowledged that “the market is on the right track with improved investor confidence,” they also warned for “increasing market irregularities when new investors rush to the market.” As a result, the CRBC has announced that it will continue to monitor insider dealings and market manipulation and take action when necessary.

I’ve written previously that the Chinese market has reached very dangerous territory. (See SRI, 28 March 2007, The Great Unknowns.) This doesn’t mean that it can’t go higher, although some kind of correction–even for consolidation purposes–should occur.

It’s not difficult, then, to see why the Chinese authorities are worried and that they will try to calm speculation to the best of their ability. And they will need to be vigilant, given reports that Chinese brokerages are opening 300,000 new accounts per day.

That said, the fundamental problem with the Chinese market is that, as companies deliver the earnings and analysts continue to raise their estimates, the eventual outcome will be that companies earnings will disappoint big time–something that’s already started to happen. Consequently, a reassessment of the situation, by analysts and investors alike, will need to take place in the process, increasing market volatility.

Turning to the global markets, I have no problem conceding that they aren’t once-in-a-lifetime opportunities to pick up value, but at the same time, they aren’t–as a whole–insanely expensive. The latter becomes more important given my view that recession isn’t in the cards yet; companies are generally undergeared, and a lot of investors continue to keep away from the public markets, instead preferring the more-alluring game of private equity. Of course, a market correction, in the context of a market that’s run too far too fast, can work miracles in extending the current bull run.

But corrections aside, the bull market can continue as more fresh money is trying to find its way into the global financial markets. The above-mentioned trend of Chinese QDIIs investing overseas will become one more source of funds. Another source can be found in the foreign reserves that a lot of countries currently have.

Since the beginning of the year, there’s been a lot of talk regarding decisions made by several countries to diversify some of their reserves into equities. China is one of them, having established the State Foreign Exchange Investment Corp to do just that, with an initial capital of USD300 billion. Russia is another country contemplating the same, with starting capital of USD100 billion. Other oil producers have expressed interest (e.g., United Arab Emirates, Kuwait, Norway, etc.), and the list goes on, with estimates putting the assets of these “state funds” at more than USD2 trillion.

As I’ve mentioned before, 2007 will make for a very interesting and volatile year. The above can only increase the excitement for both the long and the short sides of the market. Watch this space.

Fresh Money Buys

If you’d like to add to your positions in Portfolio recommendations or allocate new funds, focus on the following markets, in order (for both countries and sectors): South Korea, Hong Kong (real estate, publishing, infrastructure), India (pharmaceutical, banking), Malaysia, Russia (telecommunications, energy), Singapore (telecommunications, banking, industrial), Europe (pharmaceuticals, oil, industrials, communications equipment, media), Japan (industrials, banking), China (consumer, power, oil), Taiwan (telecommunications, technology) and Macau.