China's growth in 2010 will be stronger than 2009

We think China is in a bit of a sweet spot this year. Aggregate GDP in 2009 was 8.7%. And then this year our expectations are somewhere between 9 and 10% GDP growth - which is actually an improvement on last year, because last year's first half was weak and second half was very strong.

If we look at the GDP composition last year, the vast growth came in from investments on the back of it huge stimulus package that the Chinese Government was implementing. Exports dragged GDP growth down and consumption was positive. So, investments ended up accounting for over 80% of GDP growth last year, consumption ended up being reasonable and exports were negative. The point we must remember is that China achieved this 8.7% growth with no contribution from exports - in fact, a negative contribution from exports.

Exports - only a whip cream on top of the cake

If exports grow on the back of a robust global recovery, China's GDP growth this year will not be 9% but closer to 12%. Exports are like a whip cream on top of the cake. Between consumption and investments, China can grow fairly easily at 8% per annum. - without any contributions on exports.

Exports were a drag on GDP last year and pulled down growth from the 10% - 12% levels to 8% levels. The two big growth years for China were 2005 and 2007. In both years, exports growth was strong and exports contributed to about 3% of the 11% - 12% GDP growth.

China tackling food inflation

In the midst of all this talk of inflation, we must remember that China was facing a deflation last year owing to an over capacity issue in many Chinese industries. Towards the end of 2009, PPI (Producer Price Inflation) and CPI (Consumer Price Inflation) started pulling rapidly, but there seems to be an abatement in inflation in Jan 2010. This abatement of inflation really comes on the back of the fact that food prices inflation which was building rapidly in Q-IV last year, is moderating quite quickly. In China, food constitutes 30 of the CPI index. China has a concept of strategic food reserves - much like the US has strategic oil reserves. The Chinese Government released some of its food reserves - rice, wheat and pork - into the market to cool food prices.

Stimulus package - what exit are we talking about?

The Chinese Government is spending the same amount of money this year as it did last year. The only difference is the orientation. Last year, about 70% of spending was directed to infrastructure build out. This year, partly on account of excess capacities and partly the disquiet among Chinese consumers, infrastructure spend is down to 40% of the total spend. Public health care will account for 25% of this year's spend. Public education is also a big area of spending this year.

All this talk of unwinding of stimulus packages must therefore be seen in context. China is spending on upgrading its infrastructure and upgrading the public health and education systems. This spending continues - it is only being reoriented.

Moving towards a higher consumption level

Chinese consumers bear 80% of the health care cost. Health care and education are expensive - just as they are elsewhere in the world. That is why the Government is targeting so much investment in public health and public education. Its not about buying popular support - its also a part of the strategy to effect a change from an investment led economy to a consumption led economy. Savings rate in China is a high 40%. The Government's view is that if it can absorb some of these ongoing costs relating to health care and education, it can release some of the savings to drive consumption.

This however is a slow process - the change is not going to happen overnight. It will take at least 5 years or more for consumption to move up from 35% of GDP to 50%. Over the next couple of years, investment will continue to be the engine that drives Chinese growth and they will need to ensure that investments are made in productive areas and not to further enhance excess capacities. For example, construction continues to be a big driver - but the Chinese Government is laying more emphasis this year in building schools and hospitals and not more airports. The airports part is already done. Likewise, when it comes to roads, the arterial roads that connect major cities are done - but there is a lot of work still to be done in building rural roads. That is a major focus area this year.

Chinese equities - among the cheapest in the region

Its interesting if you look at China for last 7 months, say from mid July last year, when we first launched the fund. The market went up 10-15% in a couple of months, then we got about a 7% pull back in the end of August. From there, we rallied around 20% and now with this correction in January, we are almost right back to where we were in July. China has definitely underperformed various other markets in the last 6 to 7 months.

The market made a bottom in July 09. There was obviously a much bigger bottom in Mar-April 09. I would call that as an extraordinary time. If the market goes down from here another 6%-7%, we would be right back to the July 09 bottom. I would say we have a 6%-7% downside from here and a possible 15%-20% upside from these levels.

I think the most important fact is that Chinese H-shares (the ones that are listed in Hong Kong) are now trading at 12.6 times 1 year forward earnings. That's at a considerable discount to its historical average of 15x and is among the lowest in the Asian region. Earnings are projected to grow at over 20% for this financial year - making this among the most attractive markets in the Asian region. On pure earnings growth - without the prospect of the PE coming back to its historical average - you have a prospect of getting a healthy 20% return on investment - just based on earnings growth.

The JP Morgan JF Greater China Offshore Equity Fund

We launched this fund in July 09. In India, the fund is offered through a feeder structure. About 50% of our fund is invested in China. The vast majority are shares of Chinese companies invested in Hong Kong. And then we have about 30% in Taiwan - the main opportunity there is technology. There we play outsourcing companies, companies that make I Pods and I Phones and net book computers etc. These are businesses that are witnessing strong growth - from first time consumers in emerging markets as well as replacement demand from existing users. About 20% of the fund is invested in Hong Kong - primarily property and real estate plays. Here again, many of these companies are really China plays - with their significant exposure to mainland China.