June 2011Putnam Perspectives

Four views on China

Daniel J. Graa, CFA David Morgan Timothy E. Codrington John J. Morgan

Key takeaways

Inflation in China will likely

peak this summer and be followed by an end to policy tightening.

The emerging markets story writ large

Daniel J. Graa, CFA, Portfolio Manager, Putnam Emerging Markets Equity Fund

Chinas banking industry

offers long-term growth opportunities for investors.

Record-high food
prices could slow the development of Chinas consumer base.

With annual gross domestic product growth averaging approximately 10% over the past decade, Chinas economy is expanding much faster than developed nations struggling to recover from the Great Recession, and is leading the way for emerging-market growth (Figure 1). At the same time, Chinese equities have underperformed emerging markets for the past two years, dragged down by inflationary pressures from Chinas overheating economy. However, the Chinese equity market may be poised to turn that performance around, propelled by strong domestic growth stories in sectors like technology, industrials, and alternative energy. Year-to-date through March 31, the MSCI China Index edged ahead of its broader emerging-market counterpart by 0.83 percentage point, after lagging by more than 9 percentage points for the previous 12 months. In our view, once the Chinese government demonstrates that inflation can be controlled without crippling liquidity, Chinese equities may become more attractive investments.

With continued growth

on the horizon, there are investment opportunities in natural resources that are in short supply in China.

Google may be the top search engine in most countries, but not in China, which is dominated by Internet search engine Baidu.

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J u n e 2011| Four views on China

Figure 1. Economic growth without peer Gross domestic product, constant prices (percent change)
China
16% 12% 8% 4% 0% -4% -8%

United States

Japan

United Kingdom

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: International Monetary Fund, 2011.

From plows to personal computers In three decades, China has moved from having a largely agricultural economy to being a significant player in manufacturing and an emerging player in green technology. Chinas manufacturing model is shifting from the production of low value-added to high value-added exports. No longer are Chinese companies simply part of the supply chain in the global market. Many Chinese companies are manufacturing goods that compete with those of the worlds leading companies in developed markets. For example, the worlds fastest bullet train in service, CRH380, which links Shanghai and Hangzhou and is designed with a top speed of more than 230 mph, is made in China. And Chinese companies hope to sell the train to foreign markets looking to expand highspeed rail, including the United States. In the technology sector, the manufacturing and assembly of personal computers, notebooks, and tablets for global tech companies such as Apple and Dell takes place in China. In addition, Chinese companies are working on creating brand names such as the laptop computer Lenovo. Google may be the top search engine in most countries, but not in China, which is dominated by Internet search engine Baidu. China is also evolving into a global competitor in the online gaming industry.
2

Again last year, Chinas auto industry surpassed that of the United States in terms of vehicles sold. In 2010, auto sales in China totaled 18 million, outpacing the 11.5 million sold in the United States1 (Figure 2). It may not be long before Chinese cars begin to take off in the U.S. market, much like Hyundai and Toyota did in past decades. China is also focused on becoming a leader in green technology. China lacks the natural resources to be more independent in deriving energy from fossil fuels. At the same time, the government is directing a move away from polluting industries in its infrastructure development. As a result, in just five years, its wind power industry grew from infancy to the largest wind turbine market in the world. The government is also trying to stimulate more domestic consumption and, particularly since the 2008 financial crisis, to become less reliant on the debt-laden U.S. consumer. To encourage spending, the government is investing in health care and education. This measure is intended to relieve the Chinese population from having to save as much money as they did in the past for these services. Growing the middle class with better-paying jobs has also fueled consumer spending.

Bloomberg, 2011.

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Figure 2. China now has the worlds largest car market Vehicle sales (millions of units sold)
United States
20M

China

15M

10M

5M

2005

2006

2007

2008

2009

2010

Source: Bloomberg, 2011.

As home to one fifth of the worlds population, China has the potential to build its own domestic consumption engine. By the end of 2010, emerging-market consumer spending had already outpaced U.S. consumer spending, representing 33.5% of the worldwide total, versus 27% for the United States (Figure 3). By 2015, emerging-market Asian consumers are expected to outspend their U.S. counterparts.2 It is also projected that by 2020, China alone will surpass the United States in total consumption.3 Challenges for China Now the worlds second-largest economy, China has grown at an extraordinary rate, with its economy doubling in size every 7 years. In 2011, growth is projected to fall between 8% and 10%, which marks a slowdown for China, but is still enviable by any standard. Yet Chinas rapid ascent is not without challenges, and one of those challenges is inflation. According to Chinas National Bureau of Statistics, the Consumer Price Index grew 5.4% year-over-year in March, up from 4.9% in February.

Questions remain about whether the Chinese government can preserve a healthy growth rate without letting inflation get out of control. In an attempt to rein in inflation, the government increased reserve requirements for banks and raised interest rates several times in recent months. Still, it is difficult to gauge the duration of the monetary tightening and its impact on global markets. Another issue, raised by many developed nations, is whether China is carving out an unfair trade advantage by not allowing its currency, the yuan, to appreciate. It is clear that some among the Chinese leadership are concerned that such appreciation would be harmful to Chinas export trade and are resistant to it. However, faster currency appreciation would help relieve inflationary pressures. In our view, many indicators point to inflation in China peaking in the summer of 2011. After that, there may be more confidence in the markets and the economy, and the central bank will likely put an end to policy tightening. Subsequently, equity markets should have the ability to move higher. Many challenges still face China, but as the centers of power and influence in the global economy shift and change, the investment outlook is likely to be full of opportunities and volatility for investors. (See page 7 for the funds top ten holdings.)

2 IMF, UBS, 2011. 3 Credit Suisse, 2011 3

J u n e 2011| Four views on China

Figure 3. Emerging markets drive a greater share of global consumption Percent share of global consumption
Emerging markets
40%

United States

35%

30%

25%

20%

1991

1992

1993

1994

1995

1996

1997

1998

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E

Source: JPMorgan, 2011.

Policy restrictions challenge banks in the short term

David Morgan, Analyst and Portfolio Manager, Putnam Global Financials Fund

Chinas banking industry remains in its infancy, relative to the history of banking in developed economies, but we believe this rapidly growing sector offers long-term growth opportunities for investors. While China has experienced meteoric growth, its future evolution from an emerging market to a developed one depends on establishing a sound financial system. Over the past decade, China has addressed its weak banking system, which was held back by governmentdictated lending to insolvent state-owned enterprises. Authorities established a new regulatory structure, removed non-performing loans from the banking system, and found strategic foreign partners to aid in the reorganization and listing of the banks in the public market, a process that began in 2005. The government also relaxed rules on investment options, pricing controls, and product options.

Today the publicly traded stocks of financial companies, which are generally extremely liquid, include banks, insurance companies, securities companies, and property developers. Banks have grown with the economy. In March 2011, Chinas National Bureau of Statistics reported that deposits totaled 75.3 trillion yuan, representing an increase of 54.5 billion yuan compared with a year earlier. Near-term challenges Even with reforms, Chinas financial system has structural constraints and is still heavily controlled by government policy. Several key hurdles remain: restricted capital accounts, the lack of convertibility of its currency, the liberalization of interest rates, and the further development of a fixed-income market. There are also current headwinds to equity market appreciation, including rising inflation, skyrocketing real estate values, and the overextension of credit, particularly to finance local government projects. The government has instituted a number of policies to combat these risks, including tighter property lending requirements and loan provisions, higher interest rates

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and reserve requirements, and increased capital requirements. For the banking sector, the policies have slowed lending growth and curtailed near-term profit growth prospects. Indeed, new loan growth has slowed this year, with outstanding loans totaling 49.5 trillion yuan in March, representing a drop of 352.4 billion yuan from a year ago. We believe these short-term policy measures are unlikely to derail the long-term structural growth prospects of the financial industry or the economy as a whole. Financial companies represent an opportunity to take part in this secular growth by providing financing to the retail borrower and small and midsize businesses.

Current headwinds to equity market appreciation include rising inflation, skyrocketing real estate values, and the overextension of credit, particularly to finance local government projects.

Skyrocketing food prices are a nagging concern

Timothy E. Codrington, Analyst and Portfolio Manager, Putnam Global Consumer Fund

Chinas food sources are subject to the rising costs that are causing pressure worldwide. A growing middle class has resulted in increased consumption of meat, and corn imports have grown to support the demand for cattle feed. China may also become a net importer of wheat this year, after its crop suffered the worst drought in 50 years. Rising wages Rising wages have driven Chinese consumption, supporting the governments goal of expanding its middle class and raising consumer standards. Chinese workers have flocked to well-paying manufacturing jobs in recent years. In fact, the average income of city dwellers rose more than 10% annually from 2002 to 2009, according to CLSA Asia-Pacific Markets Research. Rising wages have put pressure on profitability, however, leading some global companies to relocate manufacturing from China to countries with cheaper labor such as Indonesia and Vietnam. The fluctuation in the manufacturing sector has created more opportunities for Chinese companies to emerge, build their own brands, and attract consumers and investors a necessary evolution if China hopes to rely more on its own consumers. Our long-term view is constructive on Chinese consumer stocks, as well as on global companies with exposure to Chinese consumers. Rising wages have meant more
5

While some aspects of inflation, such as rising wages, have helped China grow its middle class, one type of inflation could hinder Chinas efforts to develop its domestic consumer base: food prices. The cost of food makes up about one third of Chinas consumer price index, and food price inflation edged up 11.7% in March, from 11% in February.4 If left unchecked, rising food prices could even curtail domestic consumption. Although its middle class has grown significantly in the past three decades, China still struggles with high poverty levels. The World Bank estimated that 4% of the population (roughly the population of California and Pennsylvania combined) was living on less than $1.00 per day in 2007. Given the political turmoil in other parts of the world, sparked in part by rising commodity prices, managing food inflation is a priority for the Chinese government and will likely drive additional monetary action.

4 National Bureau of Statistics, 2011.

J u n e 2011| Four views on China

The World Bank estimated that 4% of the population (roughly the population of California and Pennsylvania combined) was living on less than $1.00 per day in 2007.
consumer spending. To meet the demand, the retail sector has grown. For example, more than 1,000 new department store outlets opened from 2004 to 2009. Wireless phone use has also been on the rise, with the number of mobile phone users growing to 796 million by mid-2010, up 16% from a year earlier.5 Near term, the risk to this scenario remains rising food prices, which are already weighing on the Chinese consumer. Worldwide, rising food prices have pushed 44 million people into poverty over the past year, according to the World Bank. Finding a way to manage food prices is crucial for China to advance its economic development strategy, avoid a reversal of fortune for its middle class, and prevent any increase in poverty. But China is not alone. There are other sovereign wealth funds seeking to invest in natural resources. This trend among sovereigns may drive more merger and acquisition activity in the natural resources sector as global companies and governments try to secure raw materials and boost production. Factors leading the charge The Chinese government is committed to developing its infrastructure, such as new airports and rail systems, and to increasing urbanization. China lacks adequate domestic sources of raw materials and must import a lot of its supply. Building infrastructure is a steel-intensive effort, and China has become the worlds largest producer and consumer of steel. The need for steel has led to an increasing demand for iron ore and metallurgical coal for domestic production. China has been the dominant consumer in these markets as well (Figure 4). Auto manufacturing is another surging industry in China. To supply it, China needs aluminum, steel, and rubber. Figure 4. An insatiable appetite for steel Steel use and outlook

Chinas voracious appetite tightens commodity market

John J. Morgan, Equity Analyst and Portfolio Manager, Putnam Global Natural Resources Fund

In the past decade, Chinas roaring engine of growth has created tremendous demand for raw materials. The worlds second-largest economy is also the worlds largest consumer of raw materials and resources such as iron ore, copper, and steel.6 Recognizing that other nations with recovering economies will soon be vying for more of the same resources, China is also trying to stay ahead of its needs and acquire its own sources. With the formation of a sovereign wealth fund the China Investment Corporation in 2007, China has put together a state-run organization to seek global investment opportunities, including producers of resources such as mining and energy companies.

Source: World Steel Association, April 2011.

5 CLSA Asia-Pacific Markets Research. 6 Congressional Research Service, 2010; USGS 2009 Minerals Yearbook.

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Producers of primary commodities outside of China may be well positioned in todays market to fuel mergers and acquisitions because supply growth has barely kept up with demand.
Mergers and acquisition potential The global supply of many raw materials may experience further market tightening over the next two to three years. Opportunities exist in global natural resources, particularly in the areas where China is in short supply. Although dominated by China, global demand for raw materials has additional sources besides China. Demand is on the rise from the United States, Europe, Russia, and Brazil, as well as from those Southeast Asian countries that are expected to experience higher economic growth next year. Producers of primary commodities outside of China may be well positioned in todays market to fuel mergers and acquisitions because supply growth has barely kept up with demand. The balance sheets of many of these producers are healthy, but organic growth has become a challenge. Producers are looking for other mines where they have ownership of the land, or where there may be properties for acquisition. With tight supply and growing demand, the pursuit of raw materials by emerging markets, led by China, is likely to continue, driving global mergers and acquisitions in the natural resources sector. Putnam Emerging Markets Equity Fund
Top 10 holdings as of April 30, 2011 Samsung Electronics Gazprom Industrial Commercial Bank of China Sberbank of Russia Petroleo Brasileiro China Construction Bank Banco Bradesco Vale Lukoil PDG Realty Empreendimentos e Participacoes Holdings represent 29.14% of the portfolio. Holdings will vary over time.
7

Chinas largest stocks may become future global brands

Top 10 Chinese companies by market capitalization
Company Market Cap (US$B) Industry

PetroChina China Construction Bank China Mobile Bank of China CNOOC China Petroleum China Life Insurance China Shenhua Energy Ping An Insurance Bank of Communications

$322.0

Integrated oil company Commercial banks Cellular telecommunications Commercial banks Oil exploration and production Integrated oil company Life/Health insurance Coal Multi-line insurance Commercial banks

237.8 185.3 148.9 112.9 109.5 93.5 90.7 69.9 55.9

Sources: Bloomberg, Morgan Stanley Research, April 2011.

By market cap, Chinas largest companies rival the largest anywhere else in the world.

J u n e 2011| Four views on China

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