China Announces Reforms, But Is It a Buy?

Chinese shares were the big outperformers yesterday, as the iShares China Large-Cap ETF (FXI) rose more than 4% on positive sentiment surrounding details announced from last week’s “Plenum” of the Communist Party.  Interestingly, the initial reaction to the conclusion of the “Plenum” was one of disappointment, but we’re seeing a reverse “devil in the details” effect. In other words, the more details we get, the more the market likes the reforms that are being enacted.

While there were several reforms announced, the two that were positive catalysts for Chinese shares were :  1.  The relaxing of the one-child policy to allow couples where one person was an only child to have a second child, and 2.  The loosening of regulations for private companies to offer IPOs in the Chinese stock market. (Currently it is very difficult for private Chinese companies to list on any Chinese exchanges, as the process takes a very, very long time and is extremely onerous.  Public listings in China are dominated by majority state-owned companies.)

Both of these reforms contributed to a broad rally in Chinese shares. Specifically, anything childcare-related (for obvious reasons) led markets higher, as did Chinese investment banks (again for obvious reasons).

In total, the reforms announced have led to some pretty bullish calls on China, and many have called the economic reforms the biggest since the mid-1990s.  But, the question remains “Is China a Buy Here?” and I’m not sure the answer is as clearly “yes,” as the market seemed to imply yesterday.

Keep in mind that we’ve seen a big whipsaw in Chinese shares. Recall that, in the middle of last week, they were hammered after reports surfaced that the Chinese government will reduce the 2014 GDP expected growth rate to 7.0% from 7.5% this year.  Additionally, let’s not forget that there is lots of concern about a property bubble in China. (Over the weekend, monthly stats showed housing prices up 9.6% over a year ago in October.) And, the People’s Bank of China is still actively trying to drain liquidity form the system. (Remember SHIBOR rates spiked again at the end of October before the PBOC added liquidity.)

These reforms are a positive for China long term, but it’s going to take a long time for these reforms to be implemented (meaning years). And, while ultimately more children and more IPOs are a positive for childcare product markets and investment banks, we’re still a long way from that translating to the bottom line.

Longer term, does this make “China” a better place for capital than it was before?  Yes, it does.  So, maybe there‘s an argument for an IRA allocation, but I don’t think the reforms from the “Plenum” are reason alone to get “bulled up” on China right now—not in the face of potentially slowing growth and a central bank trying to drain liquidity from the system.

As far as “what’s next” for China, the official 2014 GDP growth rates should be released in the next few weeks (again, 7.0% GDP growth is the expectation) and also the results of a “debt audit” the Chinese government is conducting on local and federal debt. The debt estimate is around 60% of GDP, but the quality of that debt will also be scrutinized because many China “bears” think bad debt (specifically that which is tied to real estate) will be a major negative on the Chinese economy and market (although they’ve been saying this for a couple years now, too).

The results of the GDP growth estimates and debt audit over the coming weeks will be a lot more important to the near-term direction of Chinese shares than the reforms just announced.  Bottom line is while there is a “value argument” to be made on China given FXI is down year-to-date and well off multi-year highs hit in late ’10, the doesn’t appear to be a clear, well-founded trend to capitalize on.