China worse than India on regulatory woes, state-owned enterprise skew

Domestic markets up 22% this year, MSCI China down 12%

The Indian market has sharply outperformed its emerging market (EM) counterpart China, prompting several foreign funds to rethink their asset allocation strategies. On a one-year and year-to-date basis, the MSCI India index is up 52 per cent and 27 per cent, respectively. In comparison, the MSCI China index is down 7 per cent over a one-year period and 13 per cent year-to-date.

China’s underperformance comes amid Beijing’s crackdown against its internet companies, many of whom dominate its benchmark indices given their size and scale. The regulatory tightening by Chinese authorities has led to exodus of foreign funds from China's market, which are finding their way into other promising markets in the region such as India. 

China and Hong Kong together have around 40 per cent weightage in the MSCI EM index, India has around 11 per cent weight.

“The persistent shift in the regulatory environment in China makes it difficult to assess its impact on long-term growth and inflation, and the policy goal of common prosperity may potentially involve a more punitive tax and regulatory regime for the corporate sector,” said Hong Kong-based brokerage CLSA in a note last week.

The regulatory uncertainty has dashed investor confidence, forcing money managers to go underweight on China and increase India’s weightage despite concerns around valuations and earnings growth.

While China’s regulatory crackdown has been much talked about, another key reason for its underperformance is the dominance of state-owned enterprises (SOEs), many of whom have been laggards at the stock market.

As per CLSA, China’s largest firms in most industries are SOEs. Further, 91 of the 124 Chinese companies that are part of the Fortune Global 500 are government-owned enterprises.

Over a one-year and two-year time frame, the top SOEs of China have gained 11 per cent and 18 per cent, respectively. The private firms, on the other hand, have soared 42 per cent and 233 per cent. Moreover, the market cap split between SOE and non-SOE in the top 50 is 45 per cent and 55 per cent, highlighting how dominant government undertakings are.

To put the number in context, in India, listed SOEs (called public sector undertakings, or PSUs in domestic parlance) account for 10 per cent of India’s market cap, while private firms account for 90 per cent.

“Since 2003 when both India and China started to be noticed. Over the past five years, China was leading India until China’s recent shooting themselves in the foot incident. Will India’s private companies now drive India to big outperformance over the non SOE-reliant upside for China,” the CLSA note observers.

Currently, India’s is the only market in the EM big four where funds have an overweight stance.

Market observers say the performance of India’s largest 20-30 corporates—most of whom are in the private sector—boost prospects for the domestic market.

“Today, about 15-20 companies are driving 90 per cent of India’s profit growth. These companies are consistently growing their profits at 20 per cent and compounding free cash flow at 25 per cent. We expect them to continue to compound at this rate. There is nothing unusual about this. We have seen something similar play out in the US and Japan. This is how small economies have become bigger,” said Saurabh Mukherjea, founder and chief investment officer of Marcellus Investment Managers.

Currently, the biggest non-SOEs in the Asia Pacific region in terms of market value are Tencent (China), TSMC (Taiwan), Alibaba (China), Samsung (South Korea), Toyota (Japan), Reliance Industries (India) and Tata Consultancy (India).