Schwab Center for Financial Research

Why New Reforms Make Chinese Stocks Attractive
A white paper by Michelle Gibley, Director of International Research

Investors should look past the slower rate of economic growth in China and focus more on the potential for an improvement in the quality of growth, which could benefit Chinese stock prices. In late 2013, the Chinese government outlined an ambitious reform plan in an attempt to overhaul its economy. These reform plans could create the next phase of growth in China and have a positive impact on Chinese stocks even before they are enacted. Valuations of Chinese stocks could rise—both because higher-quality growth typically commands a higher valuation and because investor sentiment is quite negative on China. In this wide-ranging conversation, Michelle Gibley shares her views.

Michelle Gibley CFA, Director of International Research, Schwab Center for Financial Research Michelle Gibley conducts stock market research and analysis, specializing in international markets. She is co-author of the Schwab Market Perspective and writes monthly articles on Schwab.com covering specific international topics. Gibley is a member of the Schwab Investment Strategy Council.

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Executive Summary • China’s comprehensive reform plan could create higher-quality, more sustainable growth, reducing uncertainty for investors. The main drivers for optimism are the potential impacts on the financial sector and consumer spending. • Financials could experience improved profits and a reduced risk profile, despite concerns to the contrary. The reforms could open up new business opportunities for banks and shore up the health of local government borrowers, a key client. • Consumer spending might receive a boost. The reforms to rural land rights and the household registration system could improve incomes as well as propel the next stage of urbanization and productivity gains in China. Additionally, the loosening of the one-child policy could provide a minor lift to consumption. • Chinese stocks currently trade at a significant valuation discount to both their historical average and the broader emerging market equity universe. Patient investors who can endure volatility can use periods of uncertainty as potential buying opportunities. • We believe risk-tolerant investors should overweight China’s stock market within their allocation to emerging market stocks. We advise that investors consider mutual funds and exchange traded funds (ETFs) that invest in largecapitalization Chinese stocks, which could benefit over the next year or so because of their discounted valuations.

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What is the idea in a nutshell and how did it come about?
The impetus behind the idea is that China’s comprehensive reform plan, announced at the Third Plenum government planning session in November 2013, could create the next phase of growth in China. This next phase might be characterized by slower, yet higher-quality, more sustainable growth, even if only a portion of the reforms are actually implemented. As a result, valuations could rise as higher-quality growth typically commands a higher valuation and because investor sentiment toward emerging markets— and China—is quite negative. We believe equity investors who have the risk tolerance to ride out potentially significant volatility should consider investing in Chinese stocks.

This seems to be a shift away from your advice in early 2013 to avoid investing in China because of the risk of a subprime-like bubble. Are the reforms enough to justify this significant change in your view?
Most investors realize that no investment view lasts forever. After all, when conditions change, so do the investment implications. We had a negative view on China until the fall of 2013, when we moved to a neutral stance because we believed that the country’s growth could accelerate in the short term—and because Chinese and emerging market stocks were reflecting a lot of downside risks, which appeared to be lessening. Structural issues in China’s economy prevented us from moving to a positive stance. As a result of the Third Plenum in November 2013, reforms to address many of these structural issues in China came sooner and are more comprehensive than we expected, leading us now to move to a positive stance toward Chinese stocks. In addition, Chinese stocks, as represented by the MSCI China Index, have underperformed the MSCI Emerging Markets Index over the past four years ending December 2013, and now appear inexpensively valued relative to their historic relationship to the emerging market universe.

Investor sentiment is depressed—reforms could improve the outlook.

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Our earlier negative view was based on concerns about a credit bubble and that high levels of debt could hinder future growth. A Lehman-like credit crisis is still a slight possibility. However, we believe the credit issues are manageable— bad loans will gradually rise, but not surge. We believe China’s government has the tools to stem a financial and economic collapse by using a combination of the following: injecting liquidity into the banking system, devaluing the currency, and/or stimulating growth if it slows too much by ramping up infrastructure spending.

What is driving your positive outlook–valuations or the structural reforms in China?
It is a combination of the two–valuations appear inexpensive and have a catalyst for change. We think the market will begin to anticipate some longterm improvement in the quality of China’s economic growth due to the reforms. Additionally, as shown in the chart below, we believe stocks are pricing in a lot of potential bad news. The price-to-trailing earnings of the Chinese stock market is at a discounted valuation to the emerging markets universe and well below its historical average. The valuation of Chinese stocks can improve along with reform momentum—even before the reforms are fully implemented—as stock markets typically look ahead and discount the future, not the past.
2.00

Chinese stocks valued at a discount to emerging markets

1.75 1.50 1.25 1.00

Relative valuation

0.75

0.50

20 0

6

20 0

7

20 0

8

20 0

9

0 201

1 201

2 201

3 201

MSCI China Index P/E relative to MSCI Emerging Markets Index P/E

Source: FactSet, Bloomberg and MSCI. Where equal value is at 1.0, a larger/smaller number relative to 1.0 denotes China is more expensive/less expensive relative to emerging markets. As of January 8, 2014.

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Chinese stocks valued below historical average, price in a negative outlook
25
22.8

20
18.7 17.5

20.0 18.6 17.4 15.5 14.0 12.1 11.2 11.0 12.1 14.1 13.6 13.6 11.8 9.4 9.6 8.8 11.2

Ratio

15

10

5
20 0 4 20 0 5 20 0 6 20 0 7 20 0 8 20 0 9 0 201 1 201 2 201 3 201

MSCI China Index Trailing P/E Ratio Average

Source: FactSet, Bloomberg and MSCI. Blue line is 10-year historical price/earnings average of 14.3 times trailing earnings. As of January 3, 2014.

So what are you advising that investors do to act on this idea?
We suggest keeping emerging market equity exposure equal to your long-term strategic allocation, but overweight China within the emerging market equity allocation. We believe investors should consider buying mutual funds and ETFs that invest in large-cap Chinese stocks as they could benefit the most over the next year or so because they have the most discounted valuations in relation to smaller-cap funds. This Investing Idea does have significant risk associated with it, so investors need to be prepared to tolerate the volatility that is likely while the Idea plays out.

Consumer and small-cap stocks are often cited as good plays to participate in China’s next stage of growth. What are your thoughts on those?
Consumer sector and small-capitalization Chinese stocks are commonly viewed as the best ways to participate in China’s transition to consumption-led growth and reform to the large, state-owned companies, respectively. While these stocks could benefit the most over three to five years, they appear expensively valued now and we prefer a diversified portfolio of large-cap Chinese stocks at this point. Additionally, the 2014 opening of the IPO window, allowing companies 6

to take their stock public in the mainland Chinese markets where small-cap stocks typically trade, after being closed since October 2012, could divert money toward new offerings and away from existing small-cap stocks.

Commodities were seen as a way to participate in China’s growth in the past. Is that still the case?
Commodities and commodity-oriented countries—countries that have high dependence on commodity exports to China—were typically viewed as tied to China’s economic growth in the past due to China’s construction-led economic model. On the extreme end, China constituted over 40% of global demand for many industrial metals. However, commodity prices and the performance of commodityoriented countries came under pressure in 2013 due to China’s economic slowdown, increased supplies of commodities and rise in the U.S. dollar. While there could be short periods of catch-up performance by commodities and commodity-oriented countries, we continue to maintain a neutral view over the long-term. This is because we believe China’s economy is shifting to a less commodity-intensive economic model, and many commodities experienced significant increases in supply in recent years.

China is ahead of the emerging market universe in taking steps to restructure its economy.

Why do you have a positive outlook for China but not emerging markets overall?
Our neutral view on emerging market stocks overall stems from our view that countries that comprise a large weight of the MSCI Emerging Markets Index have fundamental economic problems that could hinder intermediate-term growth. These problems, such as persistently high inflation or reliance on commodity exports, will not go away or be fixed easily. In addition, there appears to be little political appetite in these countries to begin difficult reforms at this time. Also, the U.S. Federal Reserve’s reduced pace of bond buying (“tapering”) could be a risk to the stocks and economies of countries with current-account deficits. The currencies of countries dependent on foreign investment due to current account deficits are vulnerable because rising U.S. Treasury yields boost the attractiveness of the U.S. dollar on a relative basis. A falling currency can create inflationary pressures and prompt monetary tightening, squeezing growth further.

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Emerging market countries with fundamental concerns Weight in MSCI EM Index Brazil India South Africa Russia Indonesia Turkey Chile Peru Total 10.9% 7.2% 7.1% 5.9% 2.3% 1.7% 1.5% 0.4% 36.9% X X X X X X X X X Commodityoriented exports X Current account deficit X X X

Source: MSCI, The Economist Intelligence Unit, IMF WEO. As of November 30, 2013.

On the other hand, low stock valuations and depressed investor sentiment are positive offsets, giving stocks of emerging market countries room to rebound. Additionally, we believe emerging market equities still deserve a position in investors’ portfolios. This is due to ties to global growth, which we believe is improving; diversification benefit in terms of lower stock correlations to moves of developed market stocks; and growth opportunities as incomes rise and create a middle class in emerging market countries.

What is the investor sentiment toward China and emerging markets?
The combination of China’s economic slowdown and the prospect that the U.S. Federal Reserve would taper its asset purchases resulted in investors adopting an extremely negative stance toward China and emerging markets in 2013. Additionally, investors generally distrust Chinese banks and believe reforms and credit risks are negative for both bank profits and Chinese equities. During the second quarter of 2013, global emerging market funds (stock and bond ETFs and mutual funds combined) had the biggest quarterly net outflow of money since the 2009 crisis according to EPFR Global. And global fund managers polled in August of 2013 indicated a net 19% underweight in global emerging market equities, the lowest level in nearly two years, according to Bank of America Merrill Lynch. Meanwhile, the more narrowly-defined asset class of Chinese stock mutual funds experienced net outflows for every month from March through November of 2013, and in 29 of the last 36 months through November 2013.

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3,000 Net monthly mutual fund flows in millions of $ 2,000

Investors have shunned Chinese mutual funds

1,000 0 –1,000

–2,000

–3,000
. 10 . 11 . 11 . 12 . 12 . 13

Dec

Jun

Dec

Jun

Dec

Jun

Source: Morningstar. As of November 30, 2013.

What are the main reasons for your optimism on China?
The two main reasons for optimism are the impact of China’s reforms on the financial sector and consumer spending. Financials, the largest weight in large-cap indices, could experience improved profits and reduced risk. While many bears on China focus on the negatives for banks, there are positive offsets. Fiscal reform could reduce the concerns about the quality of local government loans at banks, which is a factor in the valuation discount for Chinese banks stocks. Fitch Ratings indicated the reforms may be credit positive for local governments. Additionally, China is moving toward a market-based government yield curve, which could steepen and increase both investment returns and profit potential for financials. The existing low long-term government bond yield currently creates a ceiling on profits of banks and insurers. Lastly, we expect the reforms to open up opportunities in investment and corporate banking. The financial sector has an outsized impact on Chinarelated large-cap ETFs due to the large weights in these funds, as seen below.
Assets (in $M) 5,869 870 1,061 Financials Weight 55.8% 31.3% 38.2%

ETF Name iShares China LargeCap SPDR S&P China iShares MSCI China

Ticker FXI GXC MCHI

Source: BlackRock, State Street Global Advisors. As of December 26, 2013. For illustrative purposes only and not a recommendation of any specific investment product or strategy. Holdings are subject to change without notice.

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Consumer spending , meanwhile, could get a boost from the reforms to rural land rights, the household registration system and China’s one-child policy. The land reform likely puts more money in the hands of farmers because they would be able to transfer land-use rights and “monetize” their land or use the land as collateral to secure bank loans. Reform of the country’s household registration system would give migrants access to public services in smaller cities, and could increase mobility of the labor force. As people move from the farm to the city they typically add to economic growth as they become more productive, producing higher-value goods and services. In addition, incomes are likely to rise with the move to cities, which typically generates more spending; while the loosening of the one-child policy could also provide a minor lift to consumption.

What are the most important reforms in China to watch?
China listed 60 “concrete tasks” in a comprehensive plan to restructure the country by 2020. While the reforms are intertwined and complicated, we believe there are six key economic reforms to watch. • Reforms to rural land rights. We believe these could be historic. The change will allow farmers to transfer and leverage land as collateral, which could put money in low-income consumers’ pockets and increase mobility. It also has the potential to increase food output if land is consolidated into larger farms. However, local governments’ financial position could deteriorate if the land rights reform reduces government revenues from land sales. • Changes to household registration. Migrants don’t have access to public services such as health care, primary education, low-income housing and social security unless they have an urban household registration card, also known as “urban hukou.” Reforms to household registration laws could extend access to public services to millions of migrants in small and midsize cities, and increase the mobility of the labor force. When combined with reforms to rural land rights, this could propel the next stage of urbanization and productivity gains in China. Although an increased payout by stateowned enterprises (SOEs) is expected to be used to pay for social services; giving migrants more rights could be a drain on local government finances, which are already strained.

Land rights and household registration reforms could propel the next stage of growth.

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• One-child policy loosening. This change could add to consumer spending and improve sentiment, but could also increase the burden on social spending and temporarily reduce the size of the workforce if women go on maternity leave. We believe the amount of media attention on this reform is outsized compared to the economic impact, which we believe is likely to be only a minor boost. Prior exceptions to and ways to circumvent the rule, as well as the high cost of raising a child are likely to reduce the number of couples wanting to take advantage of the new policy. Analysts are estimating the potential for an additional 1 to 2 million births a year, a 6 to 12% increase from the 16.4 million births recorded by the United Nations in 2011. This potential boost would only impact a very narrow portion of the Chinese economy. • Fiscal reform at the local government level. This could be a big positive, as it is slated to create better transparency and improve the financial health of local governments. In 2010, local governments were responsible for over 80% of fiscal spending, but collected just 45% of the country’s tax revenues, according to The Economist. Another potential positive development is the change in the performance evaluation system for local governments. China is moving away from “growth at all costs” toward including debt levels and qualitative factors such as the public well-being and ecological protection in assessing performance. Fiscal reform could reduce the concerns about asset quality risk at banks and has the potential to reduce some of the imbalances that have propelled the property market. • State-owned enterprises (SOEs) will have to juggle competing goals. In the past, SOEs benefitted from protectionist policies that likely resulted in inefficient enterprises. These companies were treated as an arm of the state, there to maximize employment rather than profits. The government has declared that SOEs will remain a foundation of the economy. However, it wants to improve the vitality of SOEs by adapting to a market-based environment and better management practices that focus on efficiency and return on investment (ROI). SOEs could see their profits reduced as input costs rise to market-based prices and the payout ratio to the central government is raised to 30% by 2020, from a current range of 5% to 20%. The dividend ratio of the “Big 4” banks is already about 35%, so no change in large banks’ payout is expected in the near term. We are skeptical about the degree to which SOE reform will actually occur due to incompatible goals. In order for pricing power, profits and ROI to improve, some companies would likely need to shutter to reduce oversupply in some industries. This could cause job losses and social unrest, something the government is simultaneously trying to avoid. 11

• Financial system reforms. Financial reforms have led the reform agenda over the past year, and are likely to continue to do so in our opinion. Lending rates moved toward market-based pricing and a deposit insurance plan is forthcoming, while moving to market-based deposit rates is expected to eventually happen. Competition on deposit rates is likely to increase the cost of funding for banks, but higher loan pricing and the ability to offer new products will offset some of the pressure. China is also moving toward a market-based government yield curve, which could steepen and increase both investment returns and profit potential for financials. The yield curve has been held down artificially by the closed nature of China’s financial system, where state-owned banks are the primary owners of long-term government bonds. State-owned banks are likely to invest more in risk-based assets in the future to match their increased funding costs. This could result in rates rising as these investors sell government bonds. Also, as foreigners are allowed to participate to a greater extent, they may demand a higher yield than the suppressed yields accepted by state-owned banks. We also expect the reforms to open up opportunities in investment and corporate banking. China’s currency, the yuan, is also expected to gradually move toward market-based pricing. However, moving toward a market-based financial system has significant risks—please see the risk section below for details.

What are some of the risks associated with this idea?
Overall, this Idea is only for investors that can tolerate potentially significant volatility. However, we believe times of uncertainty are likely to be buying opportunities. Near term risks over the next six months could result in growth or the pace of reforms disappointing, which is likely to test the patience of less-disciplined investors while providing patient investors with buying opportunities. China’s policymakers will be walking a tightrope to balance the reforms with economic stability. • The pace of reform momentum could slow or reverse and could cause renewed skepticism by investors and a sell-off in Chinese stocks. • Tighter financial conditions and slower growth could increase the possibility of bankruptcies and bad debts on loans issued by banks, individuals and companies. In response to government “stealth tightening” to clamp down on shadow banking and excess credit, both government and corporate bond yields began to rise in November 2013, and prompted the postponement of 12

some bond issues for infrastructure projects. As a result of the rising costs and tighter access to credit, economic growth will likely continue to slow. However, we believe the slowdown in economic growth and reduced access to credit will be moderate, and not cause a hard landing in China’s economy.
Tighter financial conditions in China are a risk

5.0 4.5

Yield (in percent)

4.0 3.5 3.0

2.5

2.0

20 0

7

20 0

8

20 0

9

0 201

1 201

2 201

3 201

4 201

10-year benchmark government bond yield–China

Source: FactSet, JPMorgan Chase. As of January 3, 2014.

Risks over the next one to two years: • Profits of banks (the largest weight in Chinese large-cap indices) could be hurt by increased competition. • China’s financial system is still vulnerable to the after-effects of a rapid increase in speculative debt between 2009 and 2013. Local government debt nearly doubled in two years by June 2013, to 17.9 trillion yuan ($2.95 trillion), with nearly 40% of the debt maturing in 2014 according to an audit performed by the Chinese government. A negatively reinforcing feedback loop of credit events could occur if reforms happen too quickly or growth slumps too far. This could happen if problems build on each other—where multiple large defaults cause other defaults, such as bank closures or the failure of suppliers to the bankrupt companies. Sectors of concern include property developers, local governments and small- and medium-sized businesses. • Financial system reforms carry risks. China’s central bank has indicated some small banks may be allowed to fail. The government’s crackdown on shadow banking has contributed to continued liquidity crunches. Periodic surges in the Shanghai Interbank Offered Rate (Shibor) could result in a rise in defaults 13

by shadow bank borrowers, such as property developers, local governments and small- and medium-sized businesses, if the government oversteps or miscalculates. Additionally, cleaning up the banks is likely to result in “deleveraging,” where distressed assets are written down and/or sold. A revival of “bad banks” like China Cinda Asset Management Company, which had a successful 2013 initial public offering (IPO) launch in Hong Kong, can help banks offload their own distressed assets, as can financial asset exchanges (FAEs), which help facilitate sales of collateral banks seize from bad loans. Over the next one to two years, a Lehman-like credit crisis is still a slight possibility. However, we believe the credit issues are manageable—the amount of bad loans will gradually rise, but not surge. We believe China’s government has the tools to stem a financial and economic collapse by using a combination of the following: injecting liquidity into the banking system, devaluing the currency, and/or stimulating growth if it slows too much by ramping up infrastructure spending.

The mix of positive and negative factors, as well as their timing, is somewhat confusing. Can you help clarify?
It’s important to note that we believe there are downside risks to China’s economy due to past credit excesses and the reforms. But we believe a lot of concerns are already reflected in the stock market. It is possible that credit events and lower economic figures don’t end up hurting stocks. To the extent that stocks do get hit on these concerns, we believe they are likely to be buying opportunities. Here’s a helpful table representing our perspective on the timing of positive and negative factors.
Time frame Near term (less than 1 year) Next 1–2 years Factor Disappointment in pace of reform Tighter financial conditions Consumption accelerates Fiscal reform Steepening yield curve raises bank profits Deposit rate competition cuts bank profits Multiple significant credit events Long term (3–7 years) Small bank(s) fail Property prices fall by more than 20% Negative Negative High Medium Impact Negative Negative Positive Positive Positive Negative Negative Probability High High Medium Medium High High Medium

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Some of the reforms have been eyed for a long time– why has the time come for real action on reform?
Overall, the pace of implementation of reforms is uncertain and likely to be uneven. But we believe that even if just a small portion of the reforms are enacted, this could result in significant changes and improve the intermediateterm outlook. Some of the reasons we believe China’s government will tackle reforms include: • We believe the old economic model was running out of steam and that China’s leaders know this. China’s economy has become increasingly reliant on debt to generate growth; yet each dollar of debt was generating ever smaller returns in terms of growth. Fitch Ratings estimated that between 2009 and 2012, each 1 yuan in new financing generated only 0.30 yuan in new gross domestic product (GDP) versus 0.71 yuan before the global financial crisis. • As income levels rise, people tend to aspire for an improved quality of life and become less tolerant of corruption, threatening the stability of the Chinese government. Fiscal and SOE reforms could reduce corruption, while financial system reforms could address imbalances that are favorable to government-related entities to the detriment of individuals. • China’s President Xi and Premier Li have only just begun decade-long terms that end in early 2023, while the terms of the remaining five members of the top leadership council, the Standing Committee of the Politburo, may end in 2018 if the prior rule on retirement age is enforced. Now is the time to begin the long process to transform the economy in time for leaders to cement their legacies. • President Xi concentrated his power in 2013, and we believe stronger leadership is necessary to break the vested interests that could stand in the way of pushing through difficult reforms. However, concentration of power is also a risk, as unlimited power can lead to corruption or unilateral decisions. • Reforms to the financial system occurred at a brisk pace in 2013. The goal of implementing reforms in the Shanghai Free Trade Zone by March 2014, and target “replicable” and “expandable” financial system reforms that could be used on a national basis by the end of 2014, indicate the government has the disposition to act.

China’s old economic model was running out of steam—the time is ripe for change.

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Is there a risk China’s property bubble bursts?
There are certain locations in China where the property market looks “bubbly,” but these conditions are due in part to a supply shortage and lack of investment alternatives. Supply hasn’t kept up with demand due to restrictions on available land; this encourages developers to hoard land, further restricting supply and putting upward pressure on prices. Also, China’s effort to improve the supply of “affordable” homes continues to disappoint. Limited investment alternatives have resulted in wealthy households using property as a place to park savings. As a result, the rate of vacancies is high but the inventory available for sale is low. While property prices have increased, incomes also have rapidly risen. Lastly, the low use of debt to purchase property means a U.S.-style property bubble burst is unlikely in our view. That said, we are concerned about the speculation evident in smaller, “third-tier” cities. However, the reforms to rural land and migrant rights could result in a movement from farms to these cities, help absorb some of the excess supply, and potentially even create additional demand. It is difficult to pinpoint what would cause a sudden shift of confidence by property owners. There is the potential that, as part of China’s reforms, a rapid implementation of a large property tax could result in a rush by property owners to offload property. This could cause a fall in prices and crisis of confidence. The creation of a robust property ownership database is a precondition for the tax, and therefore a broad-based implementation is not likely in the near term. China’s government has been trying to crack down on the property market since early 2010 with a series of measures. But the biggest impact was a price decline of 2.2% from August 2011 to the low hit in July 2012, after which prices have been increasing according to a 100-city home price index published by property consultancy SouFun Holdings Limited. If harsher regulations transpire, property developers could be unable to pay debts if sales are sufficiently hurt. The corporate sector could be an unexpected source of trouble. State-owned enterprises in particular have loaned to property developers, taking advantage of their access to low-cost bank funding to enter non-core businesses such as lending.

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We believe China’s property market is likely to continue to be volatile as the government loosens its influence and implements land supply and fiscal reforms. However, we believe a large scale burst with reverberations throughout the economy such as that experienced in the U.S. is unlikely.

Has anything changed in the erosion of China’s competitive advantage against the U.S.?
China’s competitive advantage of lower manufacturing costs has been threatened in recent years, due to rising costs of labor, real estate and transportation, as well as a rise in the yuan. The size of China’s workforce has likely peaked due to the lingering unintended effects of the one-child policy, which took effect over 30 years ago. As a result, the labor market is fairly tight, resulting in wages having a tendency to rise. While the reforms to loosen this policy could help, new births won’t contribute to the size of the workforce for quite some time. Transportation and real estate costs have risen dramatically over the past decades. Importantly, China’s government has allowed the yuan to rise 27% since mid-2005 and 11% since mid-2010, making China’s exports more expensive and less competitive. In fact, the changing manufacturing cost equation in China has contributed to a “re-shoring” of production from China back to the U.S. China’s competitiveness is unlikely to improve significantly without investment in productivity-enhancing investments such as technology and automation. Also required is a focus on addressing skills deficiencies by reforming the education system to improve critical thinking; creativity and innovation; collaboration and teamwork; and professionalism. However, this is not a barrier for this Investing Idea to work. Exports are not the major contributor to growth that most people believe them to be, and production capacity can be redirected toward the domestic market, away from exports.

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YTD contribution to China’s GDP growth in percent

16 12

Net exports contribute little to China’s GDP

8 4 0

–4

–8
9 0 201 1 201 2 201 3 201

20 0

Investment contribution Consumption contribution Net exports contribution

Source: FactSet, National Bureau of Statistics of China. As of December 27, 2013.

What is the prospect for a wage price spiral in China, leading to sharply higher inflation?
China’s workforce size is peaking and we believe incomes will continue to rise, both in urban and rural areas. However, we don’t believe China has reached the “Lewis Turning Point” where demand for labor far outpaces the supply of labor and results in wages spiraling higher very quickly. This would happen when there aren’t workers available to move from the farm to manufacturing to improve productivity and economic growth. A January 2013 paper by the International Monetary Fund estimates that this turning point will be reached between 2020 and 2025, as China’s labor pool currently has an excess supply of about 150 million people, and that the excess will decline to 30 million by 2020. One of the reforms is to make SOEs more efficient and use market-based pricing for inputs. As a result, we believe excess capacity, evidenced by producer prices being negative for nearly two years through November 2013, is likely to close. This is likely to result in job losses, ease the tight labor market, and reduce the pressure to increase wages. Additionally, the household registration reform could also ease the tight labor market. Migrants could leave the farm and increase the size of the labor pool, producing higher-valued goods

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(which effectively increases the productivity of labor), and slow the upward trend in wages. Lastly, we believe Chinese manufacturers are increasingly looking at ways of adding automation to raise productivity and be less vulnerable to rising wages.

What might happen that would change your outlook for this idea?
There are various factors that could change our outlook. Some examples would be: • If China’s economic growth slows too far too fast, and results in multiple midsize credit events, a negative feedback loop could reverberate through the economy. This would hurt consumer and business confidence, reduce spending and hiring, and further hinder growth. • If monetary policy tightens too quickly, either by raising interest rates or reducing access to credit, this could result in a hard landing that creates a negative feedback loop. • If property prices fall significantly for multiple months due to a rapid increase in inventory from sellers, this could create a crisis of confidence. It could also catalyze a string of loan defaults that hurt banks and property developers as well as high net worth investors and companies that have entered the property market as ancillary businesses.

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Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV). International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodityrelated products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time

shares are held. Investments in commodityrelated products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value. Past performance is no guarantee of future results. Sections of this article contain forward-looking statements which reflect the author’s best judgment based on factors currently known but involve significant risks and uncertainties. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Terms and Definitions The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. The MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips and P chips. With 138 constituents, the index covers about 85% of this China equity universe.

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