China’s markets set for global stage

Arguably, the biggest event of 2014 for investors is China’s Stock Connect program, which joins stock markets in…

Arguably, the biggest event of 2014 for investors is China’s Stock Connect program, which joins stock markets in Shanghai and Hong Kong.

China has taken a number of steps to structurally improve its domestic credit markets, increase the overseas use of its currency, the yuan, also known as the renminbi, and allow selected investments in its local stock market. But Stock Connect, which started Nov. 17, is the tipping point that I believe sets the stage for the ultimate inclusion of China in global equity and fixed-income benchmarks in the years to come.

Stock Connect allows the purchase by foreign investors of 568 A-share stocks listed in China. They represent about 60% of the Chinese market cap. China represents approximately 76% of global emerging markets as measured by market cap. And don’t forget that China has the third-largest bond market in the world, at $6.95 trillion (compared with the U.S. debt market at $17 trillion).

As important as the financial implications are, this large-scale opening signals that China’s policymakers will continue their reform path. They calculate that stronger companies make for a stronger economy, more employment and more stature on the global stage. Importantly, for the first time, this program doesn’t require an investor or fund company to get any prior government clearance before buying Chinese securities.

MAJOR BENCHMARKS

So this brings us to the first point, that Stock Connect gives clear visibility to inclusion of Chinese equities in major benchmarks. The only remaining issue is that in the first stage of the Stock Connect rollout, only $2 billion of equities per day can be purchased. That is a small number, but does anyone doubt that it will increase?

Of course, that assumes that investors will want to buy Chinese equities. In the past, this was a given but more recently, media coverage of the Chinese marketplace and the Chinese economy has been almost universally negative. But there are bright spots to be found.

EARNINGS GROWTH

First, consider that earnings — corporate profits — have been growing in China despite the doom and gloom that one reads about. The historical three-year earnings-per-share growth of the SME-ChiNext Index of midsize companies in China was 16%, as of Nov. 11. Profits at large-cap companies, as measured by the CSI 300 Index, have increased 13% annually over the past three years.

VALUATIONS

Valuations for Chinese equities also are among the most attractive in the world, with the CSI 300 at about 11 times earnings. Additionally, the yuan has been relatively stable, backed by huge amounts of currency reserves even though the trade balance of recent years has largely evaporated.

Last, interest rates paid by corporate borrowers are the highest they have been for at least five years, allowing room for them to fall.

No doubt, there are risks and downsides to consider when looking at adding exposure to China.

Real estate prices are falling or appear to be on the verge of decline. It is also difficult to get a handle on the real amount of nonperforming loans currently held by China’s banks, which could affect both the Chinese consumer and the private sector.

High credit growth and opacity about the large over-the-counter “wealth management product” debt can be added to the list of concerns.

SUBSTANTIAL RESOURCES

But China remains the world’s second-largest economy and its resources are substantial. Moreover, the risks are well known to investors and regulators. Market reform may not move as fast as investors would like, but it is generally heading in the right direction. Eventually, there is a tipping point that structurally and symbolically marks a major step with long-term implications for investors. I believe the Stock Connect program is such a point.

Jan Van Eck is chief executive of Van Eck Global, a mutual fund company and ETF sponsor.