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China SOEs: good or bad investment?

China's government does not have enough tools to manage leverage and provide liquidity to China's state-owned enterprises (SOEs) in case of a downturn, argues Jupiter's Alejandro Arevalo.
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The views of asset managers on Chinese state-owned enterprises (SOEs) are mixed. In a recent webinar organised by Premia Partners, the firm’s co-CIO David Lai and senior adviser Chen Zhiwu argued that SOEs present good opportunities. Thanks to China government’s reforms, their earnings and profits went up last year, on average, while they have been trading at lower multiples than private enterprises.

Nevertheless, they acknowledged that there are doubts about the quality of the financial data that SOEs report. Although SOEs have an implicit government support in case of difficulties, some asset managers prefer to steer clear of them.

Even credit ratings, which are among the first go-to measures of the quality of a company, cannot be relied on in China to the same extent as in more developed and less state-controlled markets.

In evaluating Chinese companies’ creditworthiness, Alejandro Arevalo, manager of the Jupiter Global Emerging Markets Corporate Bond Fund, told FSA he does not rely on credit rating agencies.

“We have seen many cases of SOEs with investment grade ratings, when they have ballooned their leverage to sometimes more than 10 times debt to EBITDA (earnings before interest, taxes, depreciation and amortisation),” he said.

“The ratings are the result of rating agencies expecting the government to bail them out,” he said. “This is not something that we are comfortable investing in.”

As a result, Arevalo’s fund does not invest in SOEs. “We want to invest in companies that can repay their debt from their own cash flow. We prefer to invest in the Chinese real estate sector, but only in those top tier companies that have already a strong track record and are well diversified,” he said.

No hard landing

Arevalo said he believed that there will be no “hard landing” in Chinese economy. At the opening of the 13th session of the National People’s Congress in early March, China’s prime minister Li Keqiang specified the target GDP growth in 2018 as 6.5%.

Arevalo noted that such specific target number is a departure from the past practice of aiming for the highest growth possible. “That to me is a sign that they are wiling to have good quality growth rather than just growth,” he said.

He also noted that the country is aiming, for the first time since 2012, to lower its fiscal deficit. “That is also good news, meaning that they are conscious of the leverage in the economy and that inflation will continue to be below the central bank’s target,” he said.

Another positive factor, according to Arevalo, is the government’s tackling of excess bank leverage. However, it also brings a risk of pushing regulations too hard and bringing volatility to the market, he warned.

Part of the Mark Allen Group.