Investing in China: Is the ‘oriental pearl’ losing its luster?

Editor’s note: The author is the editor-in-chief of the business channel at China’s People’s Daily.

BEIJING, China — For a long time, China has served as a sustained growth engine for the world’s economy. However, after a decade of miraculous expansion driven by exports and investment, China’s economy is slowing, and is moving away from the model that has served it so well.

Is the "oriental pearl" losing its luster? Or is it appreciating in value?

Jing Ulrich is especially qualified to answer these questions. Ms. Ulrich is the managing director and chairman of global markets, China at J.P. Morgan. She is one of the most prominent advisors to some of the world's largest asset management companies, sovereign wealth funds and multinational corporations.

Ulrich recently sat down and had an in-depth conversation in Beijing with Zhenyu Li, the editor-in-chief of the business channel at China’s People’s Daily.

In the first part of this series, Ulrich breaks down the major economic trends and the next big growth engine in China.

In the second part, the "Oprah Winfrey of the investment world" reveals the under-the-radar investment opportunities in China and shares her exclusive insights on the much-anticipated financial reform in the world's largest developing economy.

Here are excerpts from their conversation, edited and condensed by GlobalPost.

Zhenyu Li: As a well-respected advisor to some of the world's largest investors, you have witnessed first-hand how they react to China's economic slowdown. I mean their confidence toward China.

Jing Ulrich: Yeah, from my personal experience, I have seen enthusiasm toward China among some investors drop over the last several months, but I think global investors shouldn't overlook the opportunities in the world's second-largest economy because of its slowdown. On the contrary, the on-going consumption transition might well create some of the best opportunities to invest in the ever-changing developing economy.

For example, the continued rapid urbanization in China will unlock a new wave of opportunities. China needs at least $6.4 trillion to bring 400 million people into the cities over the next decade.

As more people move into the city, and with the increasing living standard of the average Chinese people, a lot of new opportunities will emerge from such sectors as education, e-commerce, media and other service industries.

Zhenyu Li: The latest official data from China showed that China's foreign direct investment growth reached a two-year high in June despite the economic slowdown. And I think the establishment of a free trade zone in Shanghai, the gradual liberalization of China's financial sector and a possible China-US Bilateral Investment Treaty also mean huge business opportunities for global investors.

But that's the big picture. To put it in a more specific way, in the next three to five years, what do you think will be the next big investment opportunity and new investment channels in China for global investors?

Jing Ulrich: Global investors are obviously watching the Chinese market very closely. Despite China’s slowing economy, it is still growing very rapidly in comparison to developed markets. However, China’s financial markets are also quite volatile. Many global investors would like to increase their exposure to China, but they are trying to find the suitable ways to invest in China, which involves equities, fixed income and also private equity.

Investors looking at China can also consider multinational corporations as good proxies for China's growth. For example, if you look at auto, luxury goods and industrial companies, a lot of them are Fortune 500 companies. They are global companies, but they have significant exposure to China.

So, from a global investor's standpoint, they will find the best investment opportunities whether they are in China or overseas to get the best exposure to China's growth story.

Of course, they also need to take into account risks involved. So, I think many investors we talk to around the world are trying to diversify their risks. They are investing across sectors, across asset classes and they are watching the Chinese markets with a great deal of interest.

Zhenyu Li: Talking about equities, you know, China recently further expanded the QFII quota, allowing global investors to buy more domestic stocks, bonds and money market instruments in the Chinese mainland. Actually, it almost doubled the quota to $150 billion. How do you see the interest levels among global investors at getting involved in China's A-share market? How do you see the market's potential in terms of return on equity?

Jing Ulrich: The recent QFII quota expansion provides some support for the A-share market. I feel that there are a lot of global investors who are very interested in investing in the Chinese markets, but they lack viable investment channels. China's stocks are among the cheapest in the world. For investors with a long-term appetite, I think the current market actually represents reasonable value.

Zhenyu Li: You said previously that you are bullish on the prospects of China's service sector. Could you be more specific about which industries you are optimistic about?

Jing Ulrich: Service sector and high-end manufacturing should be China's new economic drivers. We are optimistic about China's modern service sectors, such as e-commerce and logistics. E-commerce alone has tremendous room for growth since it is expected to grow at approximately 30 percent a year for the next few years, while the current market penetration is only about 6 percent of retail sales. We hold a bearish view on China's traditional heavy industrial sectors and low-end manufacturing. In the future, I think investors should focus less on the traditional industries and more on the emerging ones in China. Besides, such emerging industries like environmental protection, entertainment and media are also noteworthy.

Zhenyu Li: Okay, let's talk about the future performance of the A-share market. I know thousands of global investors rely on your expertise and sources to make their investment decisions. And your knowledge and expertise in China's stock market has made you a trusted source of investment advice. Then, what're your predictions about the performance of the A-share market in the second half of the year?

Jing Ulrich: Well, China's A-share market has been experienced a lot of challenges in the first half of 2013, partly because of the lack of earnings growth in some of the old-economy companies. China has also been experiencing slower economic growth, which is worrying to some investors.

But in the second half of the year, we think the Chinese stock market will begin to stabilize. It may not resume to a bull market in the near future, but we think current valuation is quite inexpensive.

If you look at the Shanghai composite index, the current valuation on a P/E ratio basis is about nine times this year's earnings, a historically low valuation. For investors with a long-term appetite, I think the current market actually represents reasonable value.

However, if you are looking for fantastic returns in the next several months, I don't think you should be overly optimistic, because the economy is still decelerating and there are some concerns about corporate earnings in the near term.

Zhenyu Li: What are your predictions about the performance of the A-share market in the next two to three years?

Jing Ulrich: In the next two to three years, we think the market should perform better compared to the last two to three years, because the Chinese stock market has been a bear market since 2011. In the next two to three years, we are anticipating new measures coming from the central government to rebuild the confidence of investors.

Also, the government is very proactive in terms of tightening regulations, improving corporate transparency, and also improving the accountability of management. I think when the IPO process restarts, possibly sometime later this year, more companies with higher quality earnings, representing a wide range of industries, will be allowed to list.

So I think on a longer term basis, meaning in the next two to three years, the market should begin to stabilize and perform a little bit better than in the last two to three years.

We noticed that there is a big divergence between economic growth and China's stock market performance. GDP growth has been above eight percent for the past many years, but the stock market's performance has been quite disappointing. Sometime in the next several years, we expect stock market performance to be more in line with GDP growth.

Zhenyu Li: You mentioned just now that to get the best exposure to China's growth, global investors need to look at not only China's domestic equity market, but also foreign companies that are good proxies for China's growth. Could you break down this idea more specifically?

Jing Ulrich: Yeah, global investors are always looking for ways to get exposure to China's tremendous growth. Besides looking at China's domestic stock market, I would also encourage investors to actually look beyond the borders of China for the best investment ideas. For investors with a global perspective, they need to think about where China's growth is coming from. I would say the strongest growth in the coming five to 10 years will be coming from Chinese consumer and the service sector.

To get exposure, investors could look at Hong Kong and mainland listed companies, but they also need to think broadly about global companies who can benefit from this rising consumer spending. These include auto companies and luxury goods companies, a lot of which may be listed in the US or Europe. Also to be considered are service companies which provide the necessary infrastructure to help China build up its social safety net.

So, to get exposure to China's growth, you don't have to limit yourself to buying Hong Kong and mainland listed stocks. You need to think more broadly about global companies that could potentially benefit from China's growth story.

Zhenyu Li: But the prerequisite is China can maintain a sustainable growth.

Jing Ulrich: Yeah, right.

Zhenyu Li: As you know, it is almost a consensus among economists that economic reforms would be vital, or to say, the only way to put China on a more sustainable footing. And reforming China's financial sector is considered a top priority. You said previously that global investors are really looking forward to China's financial reform. What do you think are the reasons?

Jing Ulrich: Yeah, the trends in China's financial reforms have been closely watched by global investors, because these reforms are essential for China to sustain a robust rate of growth. Another reason is that China's financial markets have not been as open as those in the Western countries. The reforms would gradually free up its financial markets and lower entry barriers for global investors to tap into the new opportunities China's markets have to offer.

Some of the key focuses of China's current round of financial reforms include making the yuan fully convertible by loosening currency controls further, reducing entry barriers to the capital markets for global investors and granting Chinese banks more freedom to set lending and deposit rates. I believe the pace of reforms will quicken in the coming years.

Zhenyu Li: The quickened pace of reforms in China's financial sector will certainly open more doors for the China operations of foreign banks, but as China's traditionally government-run banks evolve into market-oriented commercial banks, pushed by the reforms, it will also increase competition between the local financial institutions and overseas banks. Do you think Chinese banks are now ready for open competition with the established global banks? And how will foreign banks, like J.P. Morgan for example, react to the increased competition in the Chinese market?

Jing Ulrich: Well, Chinese banks dominate the local market, while foreign banks have less than two percent in combined market share. So, if you are looking at the domestic market, the Chinese banks obviously are doing very well. Foreign banks right now are niche players.

But in the global marketplace, Chinese banks haven't really made a lot of inroads as of yet. In the coming years, as the global financial system becomes more integrated, as Chinese banks keep expanding their branch networks overseas, they will begin to compete with foreign banks. But at this stage, most of the Chinese banks derive about 99 percent of their earnings in the domestic market.

As for foreign banks in China, as the country continues to further liberalize its financial market, they might embrace more growth opportunities in the future.

Zhenyu Li: Do you think there will be much room for cooperation between the Chinese financial institutions and foreign banks?

Jing Ulrich: Yeah, I think there is a lot of scope for cooperation. The Chinese banks are obviously very large in terms of assets and market capitalization. They are also among the most profitable in the world. In the US, you have some leading banks, which are trying to make inroads into the Chinese market, with a deeper understanding of complex financial markets that domestic banks can learn from.

We also think Chinese banks and foreign banks can cooperate in terms of helping Chinese companies go overseas. Many Chinese companies across industries are beginning to conduct M&A activities in the overseas markets; they are acquiring assets. So therefore, they will need financing, either from Chinese banks or foreign banks.

So I think as Chinese overseas investment increase, there is a lot of scope for cooperation between the Chinese financial institutions and foreign ones.