JPM China Strategy 112410

8/8/2019 JPM China Strategy 112410

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Asia Pacific Equity Research24 November 2010

China StrategyShort-term cautious, medium-term positive

China

Frank LiAC

(852) 2800-8511

[email protected]

Peng Chen

(852) 2800-8507

[email protected]

Lan Deng

J.P. Morgan Securities (Asia Pacific) Limite

See page 33 for analyst certification and important disc losures, including non-US analyst d isclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making thinvestment decision.

Relative index performance

50

150

250

350

450

550

Nov-05 Nov-06 Nov-07 Nov-08 Nov-09

HSCEI Index SHCOMP Index MSCI China

Source: Bloomberg.

We take a short-term (1-2M) cautious view on MSCI China, whichcould experience correction pressure from concerns about likelytightening measures to be taken by the Chinese government. These couldinclude: (1) monetary measures such as RRR and interest rate rises, andcredit quota controls to sterilize excess liquidity; (2) fiscal policies suchas a possible slowdown in government-sponsored investment projects;and (3) administrative measures such as price caps on soft commodities.

We maintain our medium-term (12M) positive stance on MSCIChina because: (1) the risk of inflation running out of control in Chinahas been exaggerated, in our view, as: (a) food inflation has contributedto 71% of the headline CPI inflation since July, and the sharp rise in

food and agricultural prices is mainly driven by excess liquidity flowingout of the property market into the agricultural produce market; and (b)price caps on soft commodities will help reduce inflationary expectations;(2) we still see an overall solid economic and corporate growth outlookfor China; (3) the liquidity situation is still accommodative for equitiesdue to ample excess reserves in the banking system, and money flowingout of debt markets and bank saving accounts into equity markets; (4)MSCI China is trading at what we believe to be an undemandingvaluation of 15.0x FY10E P/E, below its long-term average trailing P/Eof 16.0x; and (5) MSCI Chinas increasing attraction on Rmbappreciation expectations. The key, in our view, is whether thegovernment can reign in the inflationary pressure. Before it has achieved

this, it is unlikely to loosen its tightening measures, which could have anegative impact on Chinese share performance.

Key sector views: We are positive on: (a) insurance; (b) IT; (c)consumer, especially luxury consumption names, retailers, and menswear;(d) service industries such as IT outsourcing, healthcare, auto after salesservice, and education; (e) economic housing beneficiaries; (f) coalmachinery; and (g) banks. We are negative on: (a) mid-stream processingindustries such as steel and aluminum; (b) paper; and (c) IPPs andrefineries, on a possible delay of electricity tariff and refinery productprice rise due to inflation concerns. Finally, we prefer wind poweroperators to wind power equipment producers.

China top picksJPM RIC Mkt cap EPS Y/Y grow th (%) P/E (x) P/BV (x) ROE (%) Div. yld (%)

Rec tic ker (US$MM) 2010E 2011E 2010E 2011E 2010E 2010E 2010EPing An Insurance Group - A OW 601318.SS 76,520 20.5 35.8 25.6 18.9 3.7 17.0 0.8Industrial and CommercialBank of China - H OW 1398.HK 256,609 27.3 18.7 10.6 8.9 2.6 22.5 3.5Belle OW 1880.HK 16,119 33.1 25.3 34.8 25.4 6.5 19.8 1.4Lenovo Group Limited N 0992.HK 7,149 n.m 78.0 46.8 26.3 3.8 3.2 1.1VanceInfo Technologies Inc. OW VIT 1,509 29.6 29.7 53.4 41.2 8.0 16.2 0.0

Source: Company, Bloomberg, J. P. Morgan estimates. Share prices and valuations as of 22 November 2010.


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Frank Li(852) [email protected]

Table of ContentsWe take a short-term cautious view on MSCI China .............3

Rising concerns about possible near-term tightening measures...................................3

Rally could resume if inflation is contained...........................8

Sector views ...........................................................................17

China Model Portfolio (CMP) adjustments ...........................28

Model portfolio adjustments......................................................................................28


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We take a short-term

cautious view on MSCIChina

We take a short-term (one-two months) cautious view onMSCI China, which could see correction pressure due tomarket concerns about possible tightening measures to beadopted by the Chinese government to contain risinginflationary pressure, especially after a notable stockmarket rally in China since late September.

Indeed, a similar situation occurred earlier this year, withthe market experiencing rising volatility on the back of

the turmoil triggered by tightening measures. MSCIChina lost 11.2% in less than one month following theRRR increase on January 12, 2010the first RRR risesince 2H08, which was deemed as a signal for Chinasmonetary tightening at that time.

Figure 1: Price movements in basis p oints (as of November 19,2010)

0

50

100

150

200

250

300

27/Oct/08

27/D

ec/08

27/F

eb/09

27/Apr/09

27/Jun/09

27/A

ug/09

27/Oct/09

27/D

ec/09

27/F

eb/10

27/Apr/10

27/Jun/10

27/A

ug/10

27/Oct/10

MSCI EM MSCI China

Source: Bloomberg.

Figure 2: MSCI-China YTD price p erformance by s ector

16.5%

14.7%

8.2%

8.2%

8.1%

5.7%

5.4%

2.6%

2.4%

-0.6%

-7.0%

-10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0%

Health Care

Energy

Consumer Disc

Telecom

Industrials

MSCI China

Consumer Staple

IT

Financials

Materials

Utilities

Source: Bloomberg. Updated as of November 19, 2010.

Rising concerns about possible near-term tightening measures

The markedly higher-than-expected headline CPI inOctober (which was at 4.4%oya versus the consensusforecast of 4.0%) and reported skyrocketing of foodprices (prices of 18 vegetables monitored by thegovernment rose by 62.4% Y/Y in China in the first 10days of November) mean that the government may haveto adopt more stringent tightening measures to curbrising inflationary pressure.

We believe these measures could include: (1) monetary

measures such as RRR increases, rate rises, credit quota

controls and enlarged issuance of PBOC notes, to

sterilize excess liquidity; (2) fiscal policies such as a

possible slowdown in government-sponsored investmentprojects; and (3) administrative measures such as price

caps on certain soft commodities.

Figure 3: ChinaConsumer price index

-2

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008 2009 2010

-10

-5

0

5

10

15

%oya %3m/%3m, saar

%oya%3m/3m,saar

Source: CEIC, J.P. Morgan estimates.

Figure 4: Chin aHeadline CPI and CPI inflation

-5

0

5

10

15

20

02 03 04 05 06 07 08 09 10

%oya, both scales

CPI

Core CPIEnergy & food



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Figure 5: ChinaHeadline CPI, food pric es and non-food CPIinflation

-4-2

02

46

810

2002 2003 2004 2005 2006 2007 2008 2009 2010

-5

0

5

10

15

20

25

%oya, both scales

CPI

Nonfood CPI

CPI: food

prices


(1) On the monetary policy front, our economics teamnow looks for two more 50bp RRR increases in comingmonths, and three 25bp rate rises next year, with the next

interest rate increase coming in possibly by 1Q11.

That said, there is a risk that Chinese authorities willchoose to increase RRR or interest rates even earlier thanour forecast if Chinas November and Decemberinflation data turn out to be significantly above ourexpectations, given the Chinese governments preferencefor adopting pre-emptive measures to contain inflationarypressure. Such monetary tightening policies, if adopted,could hurt market sentiment for Chinas stock market.

Figure 6: ChinaReserve requirement ratio s for fin ancialinstitutions

Source: CEIC, J. P. Morgan estimates.

That said, we believe the above monetary tighteningmeasures will only have limited success in sterilizing the

excess liquidity in China. This is because:

(a) One RRR rise will only sterilize about Rmb350billion of liquidity in the banking system, which does notseem enough to sterilize the excess liquidity created bythe money inflows into China, as indicated by the muchlarger scale of foreign exchange reserve accumulation inChina (US$194 billion in 3Q10, or a monthly average ofUS$64.7 billion).

(b) On one hand, an interest rate rise can send a strongsignal about the governments determination to solve the

negative interest rate problem, thus reducing the pressurefor the migration of Chinese residents deposits out of

banks. On the other hand, a rate rise will increase theinterest payments for Chinas enterprises. Moreover, aninterest rate rise will widen the spread between thebenchmark interest rate in China and that in the US,which could attract more hot money into China. Theconcerns about hot money inflows on the wideninginterest rate spread between the US and China shouldhelp limit the magnitude of the interest rate increases inChina.

(c) The government may want to reduce the new loancreation quota for FY11, and ask banks to adopt a moreevenly spread lending practice in FY11. Local press hasreported that the FY11 new loan creation target will be

limited to below Rmb6.5 trillion from Rmb7.5 trillion forFY10. (Source: finance.sina.com.cn).

Hence, the market may be wary of the uncertainties onthe monetary tightening front until the Central EconomicWork Conference, Chinas most important annualofficial economic conference to be held in earlyDecember each year, brings about more clarity on themonetary tightening front.


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Table 1: Summary of the monetary policy tone at the Central Economic Working Conference

Year Overall monetary polic y tone at the Central Economic

Working Conference (CEWC)

Policy in the Central Economic Working Conference (CEWC)

2004 To enhance and improve macro-regulation, promote reform andopening-up, push forward economic structure adjustment andtransformation of economic growth pattern and realization of all-round, balanced and sustainable economic and socialdevelopment.

The government plans to further enhance and improve macro-regulation toensure a stable and comparatively fast economic growth; push forwardstructural adjustment and transformation of the pattern of economic growth;boost economic system reform to ensure all-round, balanced and sustainabledevelopment; coordinate domestic development and the opening up andimprovement of international competitiveness; establishment of a harmonioussociety.

2005 To maintain the continuity and stability of the macroeconomicpolicy, improve the quality and efficiency of economic growth in aneffort to realize fast and healthy development

The government will step up efforts to maintain the momentum of fasteconomic growth; promote the development of sectors concerning agriculture,farmers and rural areas; promote innovation and adjustment of the industrialstructure to build an energy-efficient and environmentally-friendly society;promote the coordinated development of regional economies; further links withthe outside world; address issues concerning the rights and interests of the

people

2006 To realize a sound and fast economic growth The government is committed to enhancing and improving macro-regulation tomaintain and boost the momentum of economic growth. It will focus more ondeveloping the rural economy and promoting the building of a new socialistcountryside. Other issues on the governments 2007 economic work agendaincluded pushing forward optimization of industrial structure, promotinginnovation and urbanization, and further enhancing social harmony.

2007 To prevent economy overheating and inflation CEWC reiterated the goal of avoiding economic overheating and widespreadinflation, while at the same time maintained a stable and relatively high level ofgrowth. On the policy front, the summit announced a shift to what the

authorities term a tighter monetary policy stance from a neutral one, alongwith a continued neutral fiscal policy stance for 2008.

2008 To maintain a stable and relatively fast economic growth The government pledged to maintain stable and healthy growth next yearthrough an active fiscal policy and moderately easy monetary policy. Inparticular, the government will increase spending substantially and cut taxesnext year to increase support for job creation, agriculture, social security,education, energy conservation, and small and medium-sized enterprises.Regarding the exchange rate, the government reiterated that China will keepthe yuan essentially stable at reasonable levels. Meanwhile, the governmentemphasized stable and healthy development in both property and capitalmarkets.


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2009 To reiterate stability and continuity and focusing on supportingdomestic demand, particularly private consumption, going intonext year.

As expected, the descriptions of proactive fiscal policy and an appropriatelyaccommodative monetary policy stance were unchanged in the statementfollowing the conference. On monetary policy, while the conference

emphasized the continuity and stability of the policy stance, it also highlightedthe importance of flexibility, suggesting that the pace of credit expansionshould be managed and adjusted according to changes in the global anddomestic economies. Credit support should be channeled to sectors withgreater impact on employment, new strategic industries, and small andmedium-sized enterprises.

Source: PBoC.

(2) Fiscal policy adjustment: The government couldtighten control over the approval of new investmentprojectsThe downshift in Chinas FAI growth since mid-2010

has moderated somewhat in 4Q10. That said, if we look

at the ongoing and new investment projects, we find that

the growth rates of ongoing and new investment projects

actually have seen a declining trend since July FY10.

Figure 7: ChinaOngoing and new fixed-asset investmentprojects

0

10

20

30

40

-50

-25

0

25

50

75

100

2006 2007 2008 2009 2010

%oya, ytd, both scales

On-going projects

New projects

23.8

26.7


In the near-term, we believe the Chinese government willprobably tighten control over new investment projectapprovals so as to help suppress the inflationary pressure.Hence, we still expect some further moderation in privatereal estate investment growth given the expected increasein supply and the governments curb on speculation and

investment demand.

That said, we hold our view that Chinas overall FAIgrowth will remain rather resilient in 2011 because of:

(a) the increased investment from public economichousing front;

(b) the expectation that we should see new investmentprojects kicking off by the end of this year and early nextyear, with FY11 being the first year of the 12th Five-Year Plan. Normally Chinas fixed asset investment

growth tends to see a rising momentum in the first threeyears of each Five-Year Plan, before slowing down in thefourth and fifth year of each Five-Year Plan.

Figure 8: Chinas average nominal and real FAI growth in eachyear of th e past Five-Year Plans (7th to 11th)

19.823.6

32.3

17.514.2

16.920.5

23.5

10.27.5

0.0

10.0

20.0

30.0

40.0

1st yr of FYP 2nd yr of FYP 3rd yr of FYP 4th yr of FYP 5th yr of FYP

N ominal FA I g rowt h R ea l FA I g rowt h

%

Source: CEIC, J.P. Morgan Economics.

(C) Our observation that the manufacturing FAI shouldget a boost from the expected recovery in the domesticand export capital goods demand in 2H11.

(3) Possible administrative measures such as pricecaps on soft commodities

One of the powerful toolsets of the Chinese governmentto fight the rising inflationary pressure is to adopttemporary price caps, as it did in late 2007/early 2008.

This time was no exception. On November 17, 2010,Chinas State Council announced that the government isready to put temporary price controls on daily necessities,to step up the supervision and to regulate the marketorder of major agricultural produces, and to crack downon speculative activity in soft commodities such as cottonand corn, in order to contain inflationary pressure.Meanwhile, the government has promised to offertemporary subsidies to low-income families. Local pressquoted Premier Wen as saying that efforts would bemade to ensure adequate market supplies, improvesubsidy systems, make price controls more targeted and


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effective, and to strengthen market supervision. (Source:Xinhua News)

In our view, these policies, which are targeted at selectagricultural products, will hurt certain consumer staplesectors which are put under price caps.

That said, the price caps should help reduce inflationaryexpectations, and a possible crack-down on thespeculation about soft commodities may help alleviatethe pressure arising from the hoarding of agriculturalproduce. Hence, the positive effect of theseadministrative measures should not be underestimated.

Given that it will take a relatively long time to containinflationary pressure through interest rate increases, the

Chinese government might be inclined to use temporary

price controls as a fast-track mechanism to contain theinflationary pressure.

For instance, the Chinese government successfullycontained inflation in 2008 through price caps on softcommodities and natural resources in late 2007/early2008, on top of a supply side improvement for porkproducts as well as a demand slowdown due to theexternal final demand deterioration since early 2008.

As shown in Figure 9, Chinas CPI inflation peaked at8.7% in Feb-08, one month after the adoption of the pricecontrol measures.

Figure 9: The Chinese government s pric e cap in Jan-08 and subsequent mo deration i n headline CPI towards 2H08 (%)

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08

0

20

40

60

80

100

120

CPI (LHS) MSCI China (RHS)

CPI peaked out at 8.7%oya in Feb 2008

CPI yoy growth fell to 4.9% oya six months after the adoption

of price caps measures .

China introduced administrative measures to

control prices for oil,energy, utilities, and

essential food itemsl in Jan 2008.

Source: Bloomberg, J.P. Morgan estimates.


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In a sense, the temporary price control measures asadopted by the Chinese government should be seen as

preemptive measures to prevent the nascent inflationaryrisks from running out of control, i.e. spiraling into avery high-single-digit level.

From this perspective, the price-cap measures couldpotentially reduce the inflationary risk underminingChinas healthy economic growth, and hence, reduce therisk for Chinese equities.

Rally could resume ifinflation is contained

Despite the possible near-term correction pressure, we

maintain our positive view on MSCI Chinas

performance over the next 12 months.

Once inflation pressure is contained, we could see the

resumption of the rally. Two potential major drivers of

the rallyliquidity and solid economic and corporate

growth outlookremain largely unchanged.

(1) Inflation pressure still manageable;hyper inflation is not likely

We maintain our view that: (1) the risk of inflation

running out of control is exaggerated; and (2) any sign ofthe government successfully containing inflationarypressure could touch off a new round of rally as webelieve the Chinese stock market has already priced in alot of bad news about surging inflation, and the Chinesestock market tends to perform well under a mildinflationary environment.

The risk of inflation running out of control in China

may be exaggeratedWe believe the Chinese economys demand bottomed outin 3Q this year, and is far from facing a state ofoverheating. The recent sharp rise in CPI was mainly due

to the sharp rise in food and vegetable prices, rather thandue to a broad-based price increase caused by overalleconomic over-heating.

Notably, food inflation on an average has contributed to71% of the headline CPI inflation since July, with therest coming from non-food inflation. Among the4.4%oya headline inflation in October, the food

component contributed 3.3%pt to headline inflation,followed by 0.65%pt from residence component and

0.37%pt from the medicine and medical care component.Figure 10: Consumer price indexInflation is back

-2

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008 2009 2010

%oya %3m/%3m, s

%oya

%3m/3m,saar

Source: CEIC, J.P. Morgan Economics team estimates.

Figure 11: Producer price Inflation i s elevated

-12

-8

-4

0

4

8

12

2002 2003 2004 2005 2006 2007 2008 2009 2010

%oya

Producer prices Producer prices(PBoC)Producer prices

(NBS)


Figure 12: Headline CPI and core CPI inflationLed by f oodprices

-5

0

5

10

15

20

02 03 04 05 06 07 08 09 10

%oya, both scales

CPI

Core CPIEnergy & food



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Table 2: Percentage contribution to headline CPI growth (%oya) by component

Headline Food Clothing Household facilitiesand articles

Medicines andmedical care

Traffic andcommunications

appliances

Recreational,educational, andcultural service

Res id en ce To bac co andAlcoholicproducts

Weight 100.0% 33.2% 9.1% 6.0% 10.0% 10.4% 14.2% 13.2% 3.9%

Jan 10 1.50 1.21 -0.04 -0.07 0.23 -0.05 -0.17 0.33 0.06

Feb 10 2.70 2.03 -0.12 -0.05 0.24 0.01 0.11 0.40 0.06

Mar 10 2.40 1.70 -0.10 -0.04 0.25 0.00 0.04 0.44 0.07

Apr 10 2.80 1.93 -0.12 -0.03 0.28 0.00 0.06 0.59 0.07

May 10 3.10 2.00 -0.11 -0.02 0.32 0.01 0.09 0.66 0.07

Jun 10 2.90 1.87 -0.09 0.00 0.32 -0.03 0.13 0.66 0.07

Jul 10 3.30 2.23 -0.07 0.01 0.33 -0.07 0.16 0.63 0.06

Aug 10 3.50 2.46 -0.11 0.02 0.33 -0.06 0.17 0.58 0.06

Sep 10 3.60 2.62 -0.14 0.02 0.34 -0.07 0.17 0.57 0.05

Oct 10 4.40 3.31 -0.12 0.03 0.37 -0.05 0.13 0.65 0.06

Source: CEIC, J. P. Morgan economics.

Hence, while we do not rule out the possibility of the CPIapproaching or even briefly breaking the 5% inflationmark in the coming month or two, we hold our view thatthe chance of CPI running out of control, i.e. CPIescalating into a high-single-digit level, remains small.

This is because:

(1) There is no shortage of food or agricultural productsin China. The state grain reserves remain at a high levelafter three consecutive years of a bumper harvest.

(2) The sharp rise in food and agricultural prices ismainly driven by excess liquidity flowing out of theproperty market (which has been under the governmentsclamp-down) into the food and agricultural productmarkets.

As shown in Figure 13, prices of grains such as cottonand white sugar have suffered a sharp fall on news of apossible price cap and crack-down by the government.

Figure 13: Cotton settlement price in Zhenzhou CommodityExchange

0

5000

10000

15000

20000

25000

30000

35000

19-Jan-10 19-Mar-10 19-May-10 19-Jul-10 19-Sep-10 19-Nov-10

1st m settlement price for cotton

Source: CEIC.

Figure 14: White sugars settlement pri ce in ZhenzhouCommodity Exchange

0

2000

4000

6000

8000

19-Jan-10 19-Mar-10 19-May-10 19-Jul-10 19-Sep-10 19-Nov-10

1st m settlement price for white sugar


Figure 15: Corns settlement price in Dalian CommodityExchange

15001600170018001900200021002200

19-Jan-1

0

19-Feb-1

0

19-Mar-

10

19-Apr-

10

19-May

-10

19-Jun-1

0

19-Jul-1

0

19-Aug-1

0

19-Sep-1

0

19-Oct-10

19-Nov-

10

1st m settlement price for corn


Meanwhile, according to www.agri.gov.cn, the wholesaleprices of vegetables such as leek and lettuce in theBeijing wholesale market dropped by 39% and 31% fromNovember 10 to November 20, respectively.
http://www.agri.gov.cn/http://www.agri.gov.cn/


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Figure 16: ChinaAgricultural index

172

174

176

178

30-Oct-10 1-Nov-10 3-Nov-10 5-Nov-10 7-Nov-10 9-Nov-10 11-Nov-

10

13-Nov-

10

15-Nov-

10

17-Nov-

10

Agricultural retail price "The basket" agricultural retail price

Source: www.agri.gov.cn.

Hence, we expect Chinas food and agricultural prices togradually stabilize in early FY11 on improving supplyconditions, and a potential government invention.

(3) The high base effect will kick in as we approach 2Hnext year, which should result in headline CPI inflationgradually fading away by mid next year.

In other words, other things being equal, the base effectshould translate into CPI inflation going up H/H in 2HFY10, before going down H/H in 1H FY11.

Figure 17: ChinaHeadline CPI forecast and base effect in 2010

1.5

2.72.4

2.83.1 2.9

3.3 3.53.6

4.44.0

3.6

0

1

2

3

4

5

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10

Headline CPI and base effect

%oya

Headli ne CPI

Base effect's contri bution to

headlin e CPI


Figure 18: ChinaHeadline CPI forecast and base effect in 2011

4.1

3.2

4.2 4.1 4.04.6 4.4

4.1 3.9

3.0 3.2 3.1

0

1

2

3

4

5

Jan-11 May-11 Sep-11

Headl ine CPI and base effect

%oya

Headline CPI

Base effect's contrib utio n to

headline CPI


(4) The governments recent moves on RRR rises andpossibly interest rate increases in coming months shouldbe seen as pre-emptive moves to contain inflationaryexpectations, in our view, which could help reduce therisk of hyper inflation in China.

Hence, we expect Chinas food and agricultural prices togradually stabilize in coming months on improvingsupply conditions, and potential government invention,which should help remove a major driver of inflationarypressure in China.

In our view, the risk of inflation running out of control inChina is exaggerated.

Notably, the sharp fall in Chinas equity market, withMSCI China index down by 6.2% from November 8 toNovember 22 should have already priced in a lot of badnews about the risk of the inflation rising out of control.

Hence, any sign of inflation pressure being containedafter a series tightening measures should be takenpositively by the market, touching off a new round ofrally for the Chinese stock market, in our view.

Chinese equities tend to perform well in the early stages

of monetary tightening

Overall, we believe a scenario of accelerating economicgrowth coupled with mild inflation pressure would beaccommodative for Chinese equities. Under such ascenario, we could see the potential for both solidearnings growth and multiple expansion for Chineseequities.

Notably, within the last around of the bull market from2005 to late 2007, MSCI-China still managed to surge by97% from January 2007 to October 2007, even thoughCPI inflation rose notably from 2.2%oya to 6.5%oyaover the same period. The rally did not fizzle out until
http://www.agri.gov.cn/http://www.agri.gov.cn/


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late 2007, when the headline CPI broke 7%-level andwhen intensified tightening measures from the Chinese

government eventually battered the rally.

Figure 19: The MSCI-China index p erformance and th e headline CPI inflatio n in th e 2007 bull mark et

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Jan/07 Apr/07 Jul/07 Oct/07 Jan/08 Apr/080

20

40

60

80

100

120

CPI (LHS) MSCI China (RHS)

CPI peaked out at 8.7%oya in Feb 2008MSCI China surged 97% from 1 Jan

2007 to 31 Oct 2007, despite a jump in

CPI inflation from 2.2%oya in Jan 2007

to 6.5% in Oct 2007.

%oya

Source: CEIC, Bloomberg, and J. P. Morgan Economics.


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Figure 20: H-shares index perfo rmance and tight ening measures in 2007

5000

9000

13000

17000

21000

2007/1/1 2007/2/1 2007/3/1 2007/4/1 2007/5/1 2007/6/1 2007/7/1 2007/8/1 2007/9/1 2007/10/1 2007/11/1 2007/1

HK$

RRR hike

by 50bps on

Jan 5

RRR hike by50bps on Feb

16

RRR hike by

50bps on April 5

and April 29

respectively

Increased downpayment

requirement for the 2nd house

RRR hike on

Nov 10

RRR hike on

Oct 13

on May 18, PBoC raised lending rate by18bp and deposite rate by 27bps

respectively, raised RRR to 11.5%;

widened CNY daily trading band from

0.3% to 0.5%.

RRR hike by

50bps on July 30

RRR hike on Sep 6

Charge of a penalty of

equivalent to 20% of land

premium for idle land to

developers

PBoC raised lending

rate and deposite

rate on Sep 14

MoF to issue Rmb1.5

trillion special treasury

bonds

on Aug 21, PBoC raised

lending rate and deposite rate

by 27bp respectively

Further tightening on foreign entities

entering into high-end property

development

On May 30, Ministry of Finance (MOF)

announcement of the stamp duty tax for

stock transactions increase from 0.1% to

0.3%.

The market bitten by US

sub-prime spillover and

consequent credit

contraction.

The expansion of QDII

program. Mkt rallied.

Enforcement

of LAT. Mkt

dropped.

Establishment of the China

Investment Corporation

starting with an asset size of

US$200 billion.

on July 20, PBoC

raised lending rate and

deposite rate by 27bp

respectively

on March 18, PBoC

raised lending rate and

deposite rate by 27bp

respectively

H share declined on

the concern of

policy tightening.

Announcement of the

DII scheme. Mkt rallied.

Gasoline and diesel

prices increased

The market have been pushed up

high by the belief that the

government would not want to

see the market going down before

the Chinese Party Congress.

Market

prime c

slowdo

RRR h

Source: Bloomberg, J. P. Morgan estimates.


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(2) Solid economic and corporate

growth outlookOn one hand we maintain our view that the governmentwill take a series of tightening measures such as RRRrises, interest rate increases, credit quota controls, or aslowdown in the approval of the investment projects tocontain the inflationary pressure in China. This, in turn,may have a negative impact on Chinas economic growthin the short term.

On the other hand, we expect the government to avoidstamping out the economic recovery which kicked offonly in August. In other words, we expect thegovernment to strike a balance between containing

inflationary pressure and maintaining the underlyingeconomic growth.

Hence, while a number of deep cyclical sectors which arevery sensitive to the investment growth in China, such assteel, aluminum, and heavy trucks, may take a hit in thecoming months, the risk of Chinas overall economysuffering a major economic slump is exaggerated, in ourview.

Leading indicators suggest that Chinas economy hasbeen on a steady upturn since 3Q FY10: Chinas NBSmanufacturing PMI continued to rise for threeconsecutive months in August, September and October,

from 51.2 in July to 54.7 in October.

NBS manufacturing PMI now firmly stays above theexpansionary threshold of 50. This suggests that theeconomys mid-year downshift is mostly over, andconfirms our view that Chinas economic growthbottomed out in 3Q FY10.

Figure 21: ChinaManufacturing PMIs

30

40

50

60

2004 2005 2006 2007 2008 2009 2010

Index, sa

China: manufacturing PMIs

Markit PMI

NBS PMI

Source: CEIC, J. P. Morgan Economics.

Figure 22: ChinaIP and PMI outpu t

-20

-10

0

10

20

30

40

2004 2005 2006 2007 2008 2009 2010

30

40

50

60

70

80

%3m/3m, saar Index, sa

Real IP

Output (NBS)

Output (Markit)


Figure 23: China: IP and PMI orders-to-invento ry ratio s

-10

0

10

20

30

40

2004 2005 2006 2007 2008 2009 2010

60

90

120

150

%3m/3m, saar

China: IP and PMI orders to i nventory ratios

%Real IP

New orders to

inventory r atio (NBS)

New orders to

inventory r atio (Markit)


Moreover, regarding Chinas underlying economic

growth, we believe the steady pick-up in growth

momentum will come from the solid expansion in

domestic demand. First, private consumption maintains

the robust growth due to the governments dedicated

measures to boost households disposable income. This

trend has been reflected in the sequentially improving

readings in retail sales.

Figure 24: ChinaRetail sales gro wth

5

10

15

20

25

2002 2003 2004 2005 2006 2007 2008 2009 2010

-5

5

15

25

35

%oya

%oya %3m /3m , saar

%3m/3m, saar



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14



Secondly, on the investment front, overall FAI growthshould remain fairly resilient in 2011 (rising about 20-

25%) because of:(a) the expected sharp increase in public economichousing investment;

(b) our belief that a new round of investment projectswill kick-off by the end of this year and early next year.FY11 marks the first year of Chinas 12th Five-YearPlan, and the first three years of Chinas Five-Year Plansare normally characterized by rising fixed assetinvestment growth;

(c) Manufacturing FAI should remain steady as globaldemand growth could reaccelerate in mid-2011.

Table 3: Chinas FAI growth

China FAI (RmbMM) FAI grow th rate (%oya)

2010E 24,028,304 23.8

2011E 28,549,327 18.8

Source: J. P. Morgan Economics team estimates.

Third, against the backdrop of the economic recovery inwestern countries on QE2 measures, we could see arising momentum in Chinas net trade as of 2H11, whichcould give Chinas economic growth an additional boost.

Table 4: Global economic outlook

Real GDP (% over a year ago) Real GDP (% over previ ous period, saar)

2009 2010 2011 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11The AmericasUnited States -2.6 2.7 2.5 1.7 2.0 2.5 2.0 3.0 3.0 4.0Latin America -2.4 5.7 4.1 9.1 2.4 3.1 4.4 6.0 3.4 4.2

Asia/PacificJapan -5.3 3.5 1.1 1.8 3.9 -1.5 0.5 1.5 1.8 2.0

As ia ex Janp an 5.6 8.9 7.2 7.2 5.5 7.1 7.5 7.5 7.7 7.7China 9.1 10.0 9.0 7.2 8.1 8.7 9.5 9.1 9.3 9.3India 7.4 8.3 8.5 8.5 8.0 8.9 8.0 8.5 8.6 8.9EuropeEuro area -4.0 1.7 1.6 3.9 1.5 1.5 1.0 1.5 1.8 2.0Germany -4.7 3.5 2.6 9.5 2.8 2.5 2.0 2.0 2.0 2.0France -2.5 1.6 1.6 2.7 1.4 1.5 1.5 1.0 2.0 2.0Italy -5.1 1.0 1.3 1.9 0.7 1.0 1.5 1.0 2.0 2.0Norway -1.2 1.6 2.4 1.9 3.7 2.5 2.0 2.0 2.5 2.5United Kingdom -5.0 1.7 2.3 4.7 3.2 1.5 1.0 2.5 3.0 3.0

Emerging Europe -5.3 3.7 4.0 3.8 -1.0 5.4 4.0 4.3 4.6 4.7Glob al -2.2 3.7 3.0 3.9 2.6 2.7 2.7 3.4 3.4 3.8Developed markets -3.5 2.5 2.0 2.8 2.2 1.6 1.5 2.3 2.4 3.0Emerging markets 1.3 6.9 5.7 7.0 3.7 5.7 6.1 6.5 6.0 6.2

Source: J. P. Morgan.

Hence, we maintain our view that Chinas overalleconomic growth will remain solid in FY11, with ourFY11 real GDP growth forecast at 9%.

Table 5: Chinas real GDP growth

Chinas real GDP growth - %q/q, saar Chinas real GDP growth - %oya10Q1 4.2 3.610Q2 3.9 4.010Q3 2.4 3.810Q4 2.6 3.3

11Q1 2.7 2.911Q2 3.3 2.711Q3 3.4 3.011Q4 3.8 3.4

Source: J. P. Morgan estimates.

Table 6: Chinas economic growth drivers

China: Economic indicators

2010E 2011E

Real GDP, % change 10.0 9.0Consumption 4.6 4.7Investment 5.0 4.8Net trade 0.4 -0.4

Source: J. P. Morgan Economics team estimates.

Meanwhile, given that the corporate profit growthnormally follows that of the economic growth, theeconomic growth recovery as of July has now translatedinto steady upward revisions of consensus earningsestimates for MSCI China for three consecutive monthssince August.

Notably, the consensus FY10 and FY11 earningsestimates for MSCI China were both increased by 1% in


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October, on top of the 2.6% and 1.6% upward revisions,respectively, in September.

Should the upward earnings revisions continue in thecoming months, Chinese equities performance shouldreceive additional support.

Figure 25: ChinaOne-month cons ensus FY10 earnings esti materevisions for MSCI China

Consensus 1m earnings estimate revision

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Feb/09 May/09 Aug/09 Nov/09 Feb/10 May/10 Aug/10 Nov/10

FY10E consensus earnings revision

FY11E consensus earnings revision

Source: Bloomberg, J. P. Morgan.

Figure 26: ChinaConsensus earnings estimate revisions forMSCI China (EPS in Rmb)

3

3.5

4

4.5

5

5.5

6

6.5

Feb/08 May/08 Aug/08 Nov/08 Feb/09 May/09 Aug/09 Nov/09 Feb/10 May/10 Aug/10 Nov/10

2011

2010


(3) Liquidity situation stillaccommodative for equity performance

We hold our view that the liquidity situation is stillaccommodative for equity performance, despite thecurrent monetary tightening measures. This is because:

(1) Chinas excess reserves in the banking system arestill ampleIt is difficult for the government to fully sterilize the hotmoney flowing into China on the back of QE2 in the US,unless China decides to do a major currency revaluation.Our view on Rmb appreciation, however, is that theChinese government will continue to favor gradualappreciation rather than a big one-step Rmb appreciation

due to possible concerns about the loss of jobs in theexport sector. Should this be the case, it could be difficult

to fully sterilize the money inflows into China, eventhough the government could scale up its quantitativecontrols for liquidity management.

The overall liquidity situation in China should stay loosein November/December, despite the recent 50bp RRRincrease. This is because the central banks liquiditywithdrawal has been more than offset by a pickup in FXinflows and seasonal outflows of government depositsfrom the PBoC into banks.

Our rates research team believes that the excess reservesin the banking system, a barometer to gauge the overallliquidity situation, would likely stay at an ample level of

around Rmb900 billion in November, before risingfurther to Rmb2 trillion in early December.

Figure 27: Chinas excess reserves in the banking system

Excess Reserve

0

500

1000

1500

2000

2500

3000

J an -06 Oc t-06 J u l-07 A p r -08 J an -09 Oc t-09 J u l-10 A p r -

Rmb bn

JPM for ecasts

Source: CEIC, J.P. Morgan Rates Research.

Meanwhile, the latest monetary supply growth data alsoconvey a similar message of improving overall liquiditycondition in China, with the M2 sequential trend growthhaving accelerated from 13.4% 3m/3m saar in July to22.2% in October. That said, with the expected monetarytightening, we believe we could see a moderation, but nota collapse, in M2 growth in coming months.

Figure 28: ChinaM2 sequential grow th (%, 3m/3m saar)

0

10

20

30

40

50

Oct-00 Oct-02 Oct-04 Oct-06 Oct-08 Oct-10

M2 growth , %3m/3m saar



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(2) More capital flight into the equity markets frombond markets

Given rising inflation concerns and falling bond yields,coupled with a perception of improving fundamentals inthe equity market, we have started to see a major trend ofcapital flight into the equity markets from bond marketsin China.

According to the latest statistics from Wind, domesticmutual funds have diverted their capital from bondinvestments to equity markets, with the percentage shareof total investments allocated to bond assets falling from15.1% of total assets in 2Q this year to 13.7% in 3Q,while the percentage share of total investments in stocksrose from 65.3% in 2Q to 73% in 3Q.Figure 29: Mutual funds asset allocation to stocks and bonds (asa percentage of total fund assets)

73.665.3

73.0

12.1 15.1 13.7

0.0

20.0

40.0

60.0

80.0

1Q10 2Q10 3Q10

Stock Bond% of total funds

Source: Wind.

Figure 30: The bond market index

126

128

130

132

134

136

138

3-Aug-10 17-Aug-10 31-Aug-10 14-Sep-10 28-Sep-10 12-Oct-10 26-Oct-10 9-Nov-10

ChinaBond Exchange Treasury Bo ChinaBond Interbank Aggregate

Source: Bloomberg.

(3) Deposits being diverted to stock marketsOn back of the two-month stock rally since September 10,we find that an increasing number of deposits in Chinaare being diverted to Chinese equity markets.

In October, despite a month-on-month increase ofRmb340 billion in M2, Rmb deposits merely recorded anincrease of Rmb176.9 billion, and retail deposits suffereda decline of Rmb700.3 billion.

Figure 31: Monthly Rmb deposits and retail deposits

0

500

1000

1500

20002500

3000

Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

-1000

-500

0

500

10001500

2000

Overall deposit (Rmb bn) Retail deposit (Rmb bn)

Source: CEIC.

We believe the difference is a function of more margindeposits with brokers, i.e. more deposits are beingdiverted to broker accounts ready to be invested in the

equity markets. Indeed, in October, incremental margindeposits for security trading are estimated to be aroundRmb600 billion, which are counted as M2 but not asRmb deposits.

(4) MSCI Chinas valuations stillundemanding

MSCI China is among the worst-performing indices inthe EM market, underperforming MSCI EM by 3.7%YTD, due to the markets concerns about monetarytightening and economic slowdown risks throughoutmost of this year.

Notably, based on consensus EPS growth forecast of24.8% for FY10, MSCI China is trading at a 15.0xFY10E P/E, and 2.4x FY10E P/BV, versus the averagetrailing P/E of 16.0x, and average trailing P/BV of 2.1xsince 2000.

With MSCI Chinas earnings-based valuation nowstanding below the long-term historical averageanundemanding level, in our viewwe believe that themarket has already discounted a large part of the policytightening risks.

Notably, the Chinese stock market at currentundemanding valuations may actually turn out to be abetter investment channel than the property market andthe agricultural futures market.


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Figure 32: MSCI China has und erperformed MSCI EM by 3.7%YTD

80

85

90

95

100

105

110

115

1/Jan/10 1/Mar/10 1/May/10 1/Jul/10 1/Sep/10 1/Nov/10

MSCI EM MSCI China

Source: Bloomberg.

Figure 33: MSCI China trailin g P/E ratio

0

5

10

15

20

25

30

35

Nov/00 Nov/01 Nov/02 Nov/03 Nov/04 Nov/05 Nov/06 Nov/07 Nov/08 Nov/09 Nov/10

long term avg PE=16.0x (since year 2000)

Current=15.0x

x

-1 std dev = 11.4x

+1 std dev = 20.6x


Figure 34: MSCI China traili ng P/BV ratio

0

1

2

3

4

5

Nov/00 Nov/01 Nov/02 Nov/03 Nov/04 Nov/05 Nov/06 Nov/07 Nov/08 Nov/09 Nov/10

long term avg PB=2.1x (since y ear 2000)

Current=2.4x

x

-1 std dev = 1.4x

+1 std dev = 2.8x


(5) Rmb appreciation expectations makeHK-listed Chinese stocks attractiveassets for global investors seeking Rmbassets

With the rising attraction of Rmb assets on the back ofRmb appreciation expectations, and with the expectedsignificant liquidity inflows into EM due to QE2 indeveloped economies, we believe Hong Kong-listedChina stocks, at their current attractive valuations,especially after the under-performance of MSCI Chinathis year, represent a collection of attractive Rmb assetsfor global investors.

Figure 35: J.P. Morgan and consensus Rmb f orecasts

6.0

6.4

6.8

7.2

7.6

8.0

8.4

Dec 04 Sep 06 May 08 Jan 10 Sep 11

J.P. Morgan

ConsensusJ.P.Morgan forecast:

end Dec 10: 6.60

end Mar 11: 6.50

end Jun1: 6.40


Figure 36: Monthly forex reserve accumulation, US$B

-40

-20

0

20

40

60

80

100

billion US$

03 04 05 06 07 08 09 10


Sector views

From a macro strategy perspective, we are overweight on:(1) insurance which benefits from interest rate rises; (2)IT, which has been a big laggard this year, and whichstands to benefit from the expected rising momentum inChinas exports in 2H11 on the improved economicoutlook in western countries; (3) consumer, especiallyluxury consumption and menswear names, as well asretailers; (4) service industries, such as IT outsourcing,healthcare, auto after sales service, and education, whichcan normally pass on the inflationary pressure, and whichstand to benefit from more policy support in the coming12th Five-Year Plan in China; (5) economic-housing

beneficiaries such as BBMG; (6) heavy machinery, suchas coal mining machinery which has suffered from acorrection over the past month; (7) nuclear powerequipment, natural gas, and water treatment; (8) telecomequipment, which stands to benefit from Chinasexpected big investment in the telecom sector in 12thFive-Year Plan; (9) banks, which tend to outperform in arate rise cycle; and (10) China commodities, such ascement, whose demand is driven by domestic enddemand rather than by global demand.


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We are overweight on:

(1) Insurance

Insurers benefit from interest rate risesThe investment environment has proved to be verychallenging for insurers for most of 2010 with bondyields trending lower since the start of the year and adelay in deposit rate rises. Fortunes have been reversedwith PBOC finally deciding to raise one-year lendingrates and time deposit rates by 25bp on October 20, 2010.This was the first increase since the last interest rate cutin December 2008. As a result of this unexpected interestrate rise, bond yields have also trended upwardsubstantially with the 10-year government bond yieldnow ~50bp higher than before.

Rising interest rates are positive for insurers, as insurerscan invest new money from insurance sales and oldmoney from maturing fixed income investments at higherreturns. Bonds account for 54% of total investments forChinese insurers, while deposits account for another 33%.The returns on bond and deposit have trended lowersince 2009 and the recent rate increases should give themuch needed uplift to insurers.

The immediate impact of the interest rate rise should bean increase in the return on deposits given the automaticre-pricing mechanism on some of the negotiable deposits.We estimate a 25bp increase in interest rates would result

in approximately a 0.5% increase in net income. For theimpact on bond investments, the magnitude ofimprovement would depend on the duration of the bondportfolio. Insurers with shorter-duration bond holdingsshould benefit more as bond yields increase. We estimatea 25bp increase in bond yield would result in a 0.2% to0.5% increase in net income for large life insurers. ChinaLife is likely to record less of an uplift, according to ourestimates, than its closest peers given its longer bondduration and hence lower reinvestment frequency.

If rising interest rates prove to be sustainable in thelonger term, insurers can increase investment yield

assumptions used in deriving EV and NBV. Chineseinsurers have had a history of marking to market theirinvestment return assumptions. We include thesensitivity analysis here despite the fact that we generallybelieve an upward revision is unlikely for 2010,especially for China Life and Ping An, as they havealready assumed more aggressive investment yieldassumptions than have peers. We note that CPIC is likelyto record the most uplift in the value of its existingbusiness, while Taiping Life is likely to see the highestincrease in the value of new businesses. The slightdrawback in rising interest rates is that bond portfoliossuffer from marked-to-market losses, adverselyimpacting book value and EV.

We maintain our positive view on the insurance sectorgiven the improving investment outlook driven by acombination of rising interest rates and stronger equitymarket performance.

Our top pick within this sector remains Ping An-A due toits profitable life insurance franchise as well as stronggrowth in other business operations.

Figure 37: Government bond yields have trended upward sincethe unexpected interest r ate rise by PBOC in October

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

5-year 10-year

Source: CEIC.

Figure 38: Recurrent return on deposits has trended lower since2009 for China Lif e

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

0.0

1.0

2.0

3.0

4.0

5.06.0

7.0

5-year deposit rate (%) Return on deposits (%) (RHS)

Source: CEIC, China Life. Note: We use China Life as a proxy for the insurance sector.

Figure 39: Recurrent return on bond investments has trendedlower in 1H10 because of lower bond yields

3.6

3.8

4.0

4.2

4.4

4.6

4.8

Jul-06 Dec-06Jun-07Dec-07Jun-08Dec-08Jun-09Dec-09Jun-10

2.0

2.5

3.0

3.5

4.0

4.5

5.0

China Life (%) 10-yr govt bond yield (RHS)

Source: CEIC, China Life. Note: We use China Life as a proxy for the insurance sector.


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Figure 40: Impact of a 25bp increase in investment yield assumption on insurers actuarial data

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

China Life Ping An CPIC Taiping Life

Improvement in value of in-force business Improvement in NBV Improvement in EV

Source: Company data. Note: Based on 1H10 actuarial disclosures, except for Taiping Life (based on 2009 data).

Table 7: Valuation summary for Chinese insurers

B'berg Price PT P/E P/BV P/EV Implied NBM Rating U

C'cy cod e 23-Nov-10 Dec-11 FY10E FY11E FY10E FY11E FY10E FY11E FY10E FY11EChina Life-H HK$ 2628 HK 33.45 37 23.3 19.1 3.3 2.9 2.5 2.2 27.4 21.8 N China Life-A Rmb 602628 CH 22.35 27 18.2 14.9 2.6 2.2 2.0 1.7 20.1 15.5 N Ping An-H HK$ 2318 HK 89.35 105 33.6 24.7 4.9 4.1 2.9 2.4 25.2 18.8 OW Ping An-A Rmb 601318 CH 56.26 76 24.7 18.2 3.6 3.1 2.2 1.8 17 12 OW CPIC-H HK$ 2601 HK 31.25 40 30.2 21.8 2.7 2.5 1.9 1.7 22.2 16.6 OW CPIC-A Rmb 601601 CH 22.31 29 25.3 18.2 2.2 2.0 1.6 1.4 18.4 13.4 N PICC HK$ 2328 HK 11.68 7.2 30.2 26.4 4.2 3.6 n.a. n.a. n.a. n.a. UW CTIH HK$ 966 HK 27.6 36 43.6 30.1 3.9 3.4 3.0 2.4 37.1 24.5 OW


(2) IT sector

Chinas IT sector is the fourth-worst-performing sectorso far this year, with the sector rising only by 2.6%versus a rise of 5.7% for MSCI China.

Against the backdrop of a global economic recovery, wecould see rising momentum in 2H FY11. This, togetherwith solid domestic demand, could translate into ITsectors out-performance from here.

Within this space, we like Digital China, Vanceinfo(VIT)a diversified IT services company, with qualitymanagement and strong execution capabilitiesandLenovo, which should benefit from the expectedrecovery in the US as well as in China.

(3) Consumer (especially menswear,

retailers and luxury names)As highlighted in our previous strategy notes, we believeconsumer names offer the best adjusted risk-reward ratio.The combined effects of the ongoing re-rating andconsistent earnings growth amid the economic upturnsand downturns should bring about notable rewards forthe long-term investors of quality consumer stocks inChina.

In the consumer sector, we believe the menswear,retailers and luxury consumer sub-segments offer thebest growth profile.

(A) MenswearWe have long held the view that the menswear segmentwill show strong growth potential in the coming three tofive years.

We believe the menswear segment, which is still not welldeveloped in China in terms of menswear consumptionper capita (US$291 p.a. in China, compared withUS$1,175 p.a. in the US and US$1,489 p.a. in Europe),has significant room for growth, as Chinese men becomemore brand and fashion conscious, and start to spendmore on purchasing branded menswear.

As noted before, according toEuromonitor, menswear

could record a 17.7% CAGR in its retail sales in Chinafrom 2006 to 2011, notably higher than womens wearCAGR of 11.7%, children wear CAGR of 9.2%, and theoverall apparel markets CAGR of 14.2%.


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Table 8: Different apparel segm ents CAGR of retail sales inChina

CAGR (2006-2011)Total apparel market 14.2%Menswear 17.7%Womenswear 11.7%Children wear 9.2%

Source: Euromonitor.

In light of the strong secular growth potential, we believethe menswear segment could represent a good investmentopportunity in China. Leading companies in Chinasmenswear sector, such as China Lilang and Trinity, couldbenefit from such a secular growth trend.

(B) Retailers

Normally, retailers, as a middlemen, tend to benefit fromrising inflation. Companies such as Intime DepartmentStore and Belle should benefit.

(C) Luxury itemsWe believe that the consumption of luxury items isquickly taking off in Chinas tier-one cities beforespreading to tier-two and tier-three cities, which couldprove to be a powerful trend to last in the next five years.

Rising momentum of wealth accumulation: Chinas

rich is getting richer

According to Mckinsey research, China is expected tohave more than 4 million wealthy households (annualincome of over Rmb250,000 p.a.) by 2015. This shouldput China in fourth place in the global standings based onthe number of wealthy households, behind the US, Japan,and the United Kingdom.

At present the wealthy account for less than 1% of urbanChinese households, but this demographic segment isgrowing at 16% per annum. Notably, about half ofChinas wealthy consumers were not classified as suchfour years ago, and more than half of those who will bewealthy in the next six years are not wealthy today.

At present, geographical patterns characterize thissignificant accumulation of wealth and growing luxury

consumption in China. We find that the highestconcentration of wealthy families is in the eastern andcoastal regions of China, i.e. areas that have historicallyled the country in terms of opening up to the outsideworld and economic reform. Notably, around 30% ofthese wealthy families are located in Chinas four largestcities, Beijing, Shanghai, Shenzhen and Guangzhou.

Table 9: Top five countries in terms of num ber of wealthy people(2009)

Country Number of people growth(000 people)1 USA 2,870 16.5%2 Japan 1,650 20.8%3 Germany 860 6.4%4 China 477 31%5 UK 452 8%

Source: ACMR.

Table 10: ChinaDisposable incom e per capita of differenteconomic classes (Rmb)

Lowincome

Lowermiddleincome

Middleincome

Uppermiddleincome

Highincome

Highesincome

2000 3634 4624 5898 7487 9434 13311

2005 4885 6711 9190 12603 17203 287732008 7383 10196 13984 19254 26250 43614CAGR over 2000-2008 9.20% 10.40% 11.40% 12.50% 13.60% 16.00%

Source: ACMR.

The pattern of disposable income growth in China hasbeen widespread as the benefits of economic successhave trickled down to all classes. The above table showshow different economic classes fared from 2000 to 2008,and a distinct trend is that the higher the class, the higherthe CAGR of disposable income over the period.

The low-income groups per capita disposable incomegrew from Rmb3,634 in 2000 to Rmb7,363 in 2008,translating into a 9% CAGR over the period. In contrast,the highest income class grew from Rmb13,311 toRmb43,614 over the period, translating into a CAGR ofover 16%, far outpacing the growth of the low-incomegroup.

Figure 41 shows that with higher growth rates, the

affluent section of Chinas population has continued to

swell, and the number of wealthy families with assets

worth more than US$1 million has grown. From 2003 to

2009, the number of these wealthy families increased

from 141,000 to 453,000, representing a CAGR of 21%

over the period.

Going forward, we forecast that this number will increase

further, reaching 697,000 households by 2012,

translating into a CAGR of 15% from 2009 to 2012E.


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Figure 41: ChinaNumber of households with assets aboveUS$1 millio n

000 households

141179

223

305

437 417453

529

609

697

0

100

200

300

400

500

600

700

800

2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E Source: ACMR.

Typically, entrepreneurs and corporate leaders, Chinas

upper crust, have been growing in number and in their

level of wealth. According to Hurun Research, in 2009,

Chinese individuals with a net worth of 1 million

totaled around 875,000 with a 6.1% Y/Y growth. There

were 55,000 individuals with a net worth of over 10

million, with an even higher growth of 7.8% Y/Y. In

2009, there were 1,900 individuals worth over 100

million and over 300 billionaires in China. A key trend

among Chinas millionaires is they are typically 15 years

younger than their western counterparts and their wealthis growing more rapidly.

Figure 42: Size of Chinas rich and super-rich

Source: Hurun Rich Report.

China's luxury market: Soon-to-be worlds largestChina has experienced a rapid expansion in consumer

affordability since 1990s. Consumers have grown inaffluence and more importantly become moresophisticated and knowledgeable of the Westernconsumption model.

Notably, many luxury brands have already positionedthemselves to tap the significant growth potential ofChinese consumers, with Louis Vuitton, Bally, Gucci andFerragamo being among the first wave of retailers toopen outlets in China back in the mid-1990s. Chinasluxury consumers will undoubtedly constitute a centralcomponent of the long-term growth strategies of theseluxury brands, in our view.

Chinese luxury markets potentialHighlights

1. Sales of luxury goods grew by 12% in 2009 to US$9.6

billion, accounting for 27.5% of global luxury sales.

2. The Chinese Academy of Social Sciences has estimated

that by 2015, China will be the largest luxury market

globally, overtaking Japan.

3. At least 50% of Hong Kongs and Macaus luxurybusiness is generated by PRC customers.

4. According to the Hurun Report, from 2008 to 2009, thenumber of people in China worth over Rmb10 million

grew by 6.1% to 875,000, with most born after 1970; thenumber of people worth over Rmb100 million grew by

7.8% to 55,000, with most of them born after 1966. We

believe the Hurun Report may have understated the

number of rich people and their wealth, because

traditional Chinese culture promotes the virtues of

modesty, and we believe the rich tend to keep a low

profile and understate their wealth.

5. The ratio of males to females of this new wealthy class is

skewed heavily towards males at a ratio of 7 to 3.

Figure 43: Luxury po int-of-sale openings i n China, 2008

Source: Annual reports of companies, company websites, discussion with public relations

departments of luxury brands, BCGs direct calls to 1051 retail outlets, BCG analysis.


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China is expected to surpass Japan as the worlds largestluxury market in the next five to seven years. Over the

past two decades, spurred by the rapid growth of thenumber of affluent Chinese families, global luxurybrands have been investing heavily to maximize returnson this trend. This is reflected in the strong growthexperienced by the size of Chinas luxury retail sectorfrom 2005 to 2009, with the number of luxury points ofsales doubling in that period.

Luxury consumption taking off in Chinas interior

areasThe acceleration of economic growth in Chinas tier-twoand tier-three cities, and Chinas interior regions such aswestern and central China, is beginning to have adramatic impact on the development of luxury

consumption in China.

As affluence ripples through the country, the importance

of these previously untapped regions and cities has

grown significantly. According to a study by Bain,

consumers in tier-two and three cities accounted for more

than 60% of the growth in Chinas luxury consumers in

2008 and 2009. China has approximately 150 cities with

population exceeding one million residents and

consumers in these cities are increasingly

indistinguishable from those in major cities.

Figure 44: Geographic evolution of Chinas wealthy households(MM)

Source: Mckinsey Global Institute, Insights China by Mckinsey 2005 Chinese Consumer

Survey. Note: This geographic evolution of the location of Chinas wealthy consumers will

be a defining trait of the future expansion of the countrys luxury sector, supported by a

more even distribution of wealth over the whole of China.

According to Wealthy Chinese Consumer Survey, in2008, there were an estimated 1.6 million wealthyhouseholds in China, with 35% of them located outsidetier-1 and tier-2 cities. In 2015, there will be an estimated4.4 million wealthy households, a CAGR of 15.54% overthe period, with 40.9% of these families located outsideChinas tier-1 and tier-2 cities. This trend is a clearindication of the geographical evolution occurring amongChinas wealthy classes, with a much higherrepresentation from Chinas tier-two and tier-three cities,and from Chinas western and central provinces.

(4) Inflation beneficiariesWe also like inflation beneficiaries, such as retailers,which are capable of passing on the rising costs to endcustomers, as well as certain upstream commodities, suchas coking coal and gold which are perceived as aninflationary hedge.

Indeed, as shown in Figure 46, leading companies inthese sectors all outperformed the MSCI-China indexduring the past inflation up-cycle from January 2007 toOctober 2007.


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Figure 45: Inflationary beneficiaries performance during the past inflation upcyle

60

110

160

210

260

310

360

410

460

510

560

Jan/07 Mar/07 May/07 Jul/07 Sep/07 Nov/07 Jan/08 Mar/08

PARKSON CHINA COAL YANZHOU COAL ZHAOJIN M INING

CHINA LIFE PING AN INSURANCE ZIJIN M INING M SCI CHINA

Source: Bloomberg.

(5) Banks

We believe banks will be winners in a mild inflationaryenvironment, as higher inflationary pressure tends totrigger more interest rate rises down the road. In general,as been proven in the previous rate cycle, a rising-rate

environment is positive for Chinese banks from twoaspects: (1) margin story as banks benefit from wideningbasic banking spread due to large existence of demanddeposits, as well as better credit pricing power; and (2)asset quality implications from a strong economy.

Figure 46: Banks outperformed MSCI China in a rising-interest-rate environment

Source: Bloomberg, J.P. Morgan Economics. Note: H-share banks only include the period

since when BoComm was listed in late June 2005.

In most cases, interest rate increases only apply totime deposits, while demand deposits rarely aresubject to rate movements. Given that the percentageof demand deposits is significant (at over 45% inmost listed banks), the pickup in average deposit

costs tends to lag that in lending yield typically,unless the rate increases are significantly asymmetricin favor of time deposit rates.

In the early stage of a rate increase cycle, inparticular, the NIM expansion was also driven by therepricing gap as Chinese banks tend to be more assetsensitive, namely faster repricing in assets thanfunding. This also helps NIM expansion.

Meanwhile, when rates move up, typically theycome amid overall credit tightening in view ofstrong economy. A tighter credit supply alsoimproves banks credit pricing power, which ispositive for effective loan yield enhancement. Suchtightening also typically leads to a market rate spikeahead of a benchmark policy rate movement, whichis also positive for banks treasury spread in theirbonds portfolio and interbank assets. This may stillapply in the current rate cycle.

Lastly, implicitly while funding costs may still moveup, if an increase in rates is based on strongeconomy, typically they will display a strongcorrelation with the equity market performance. Thiswill lead to favorable deposit mix changes as moreretail investors channel their savings into the equitymarket. This mitigates actual funding costs pickupindeed, which is also positive for NIM.

Lastly, typically while rate increases reflect inflationoutlook, they also implicitly imply a strongeconomy. We believe the underlying economic


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outlook remains strong. This has very positiveimplications for asset quality, which could help

boost confidence in next years earnings outlook.

Figure 47: Banks NIM trend in vi ew of potential in terest rate rises

2.80%2.71%

2.63%2.56%2.42%

2.52%2.25%

2.66%

3.02%3.17%

2.55%2.48%2.42%

2.33%

2.93%

2.27%2.24%

2.85%2.95%

2.91%2.99%

2.00%

2.20%

2.40%

2.60%

2.80%

3.00%

3.20%

2004 2005 2006 2007 2008 1H09 2H09 1H10 2H10E 2011E 2012E

Medium JSBs Big state-owned Source: Company data, J.P. Morgan estimates.

We, thus, argue that inflation is less of an issue as longas the underlying macroeconomic trend remains intact.Banks tend to perform better in an inflationary cyclethan in a deflationary cycle.

As shown in Table 11, the positive earnings impact froma 25bp interest rate increase will be in most cases about3%-4% additional earnings growth in 2011. Our bankingteam has factored in its models two more rate increases

in 2011 and another two in 2012.


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Table 11: Sensitivity analysis of banks earnings for every 27bp rate increase

ABC ICBC CCB BOC BoComm CMB Citic Minsheng Huaxia SPDB SZDB Average.

Lending yield impact 24 24 24 21 24 23 23 25 25 25 25 24

Loan as % of avg. assets 49% 49% 51% 55% 54% 59% 59% 57% 50% 56% 59% 55%

Interbank yield chg 25 25 25 18 25 25 25 30 30 30 30 26

Interbank as % of assets 5% 5% 5% 9% 7% 10% 11% 13% 28% 13% 13% 11%

Investment yield 10 10 10 10 10 10 10 15 15 15 15 12

Invstment as % of assets 28% 28% 26% 20% 23% 18% 18% 13% 10% 16% 16% 19%

Asset yield chg 15.9 15.9 16.3 15.2 17.1 18.1 18.3 19.8 22.0 20.1 20.8 18.4

Rmb demand as % of total deposi 53% 49% 53% 39% 48% 54% 46% 48% 45% 51% 31% 47%

Rmb time as % of total deposits 42% 46% 43% 43% 47% 41% 49% 51% 55% 48% 69% 49%

Unaffected (FX deposits etc) 5% 5% 4% 18% 5% 5% 5% 1% 0% 1% 1% 4%

chg in total deposits costs 10 11 11 11 12 10 12 13 14 12 17 12

Deposits as % of funding liabilities 91% 91% 91% 81% 80% 84% 84% 86% 73% 86% 85% 84%

Interbank cost 15 15 15 20 20 20 15 30 35 30 35 24

Interbank as % of funding liabilitie 8% 8% 8% 18% 19% 15% 15% 13% 26% 13% 13% 15%

Debt cost 5 5 5 5 5 5 5 10 10 10 12 7

LT debt as % funding liabilities 1% 1% 1% 0% 1% 1% 1% 1% 1% 1% 2% 1%

Funding costs chg 10.8 11.7 11.1 12.3 13.2 11.5 12.4 14.9 19.1 14.2 19.0 13.8

Impact on net interest spread 5.1 4.3 5.2 2.9 3.9 6.6 5.9 4.8 3.0 5.9 1.8 4.5

11E avg. IEAs 11,102 14,456 11,528 10,967 4,113 2,639 2,226 1,914 1,136 2,171 767 51,917

11E avg. IBLs 10,394 13,512 10,860 10,205 3,746 2,424 2,141 1,788 1,042 1,902 747 48,368

Earning impact (Rmb mn) 4,811 5,445 5,051 3,105 1,562 1,485 1,071 836 387 1,254 131 20,327

FY10E net income 128,645 163,783 139,641 101,937 39,925 26,190 34,181 27,172 11,355 26,923 8,896 580,004

Impact to earnings growth 3.7% 3.3% 3.6% 3.0% 3.9% 5.7% 3.1% 3.1% 3.4% 4.7% 1.5% 3.5% Source: Company reports. J.P. Morgan forecast.

We recommend that investors accumulate higher-betamedium-sized banks, which should benefit more fromrising rates, given: (1) better NIM expansion in view oftheir higher L/D ratio and faster re-pricing, as well asmore SME loans; and (2) reduced concerns about assetquality which depressed their valuation more in periodsof economic uncertainty. Our current mid-cap bank toppicks include Citic-H and Minsheng-H, and our large-captop pick is ICBC-H.

(6) Service industries such as IToutsourcing, healthcare, auto after salesservice and education

Education: Rising demand for education due toChinas favorable demographics

China has one of the largest addressable studentpopulations in the world. In 2008, China had a much

larger base of 201 million K-12 students vs. 56 million

students in the US. For college students, China had 20

million students vs. 19 million in the US in 2008 (see

Figure 48). China also has a high proportion of young

people in its population (50% population is in the 5-39

year old age group); this large demographic should

continue to support long-term growth in the post-

secondary career enhancement market.

Figure 48: High base of s tudent population (millions)

1328

20120

304

56 19

0

400

800

1200

1600

Population K-12 Students College Students

China US

Source: U.S. National Center for Education Statistics; IDC, NSBC. All data are for 2008.

An average Chinese family spends 3.8% of its disposal

income on education vs. 2.1% for a US family. As more

and more Chinese middle-class families become affluent

with higher disposable incomes, the demand for quality

education is likely to increase as well. The spending on

education in China is expected to grow at a CAGR of

20.7% from 2008-2013, according to IDC.

We believe XRC TAL Education (XRS US) and New

Oriental Education (EDU US) will benefit from the rising

demand for quality education service in China.


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IT outsourcingWe like Chinese IT outsourcing service firms, because

we find the sustained growth of Chinas IT servicesindustry has been driven by a number of global factors

that are providing momentum for the industrys continual

expansion: (1) diversifying risks from India as global

companies look to shift some portion of their offshoring

budgets away from India; (2) offshoring in China as a

part of global companies China business development

strategy, building on an already established presence in

China; (3) cultural proximately to Japan, Korea and other

Asian countries opening up opportunities; and (4) the

emergence of Hong Kong and Singapore as corporate

hubs, driving up near-shore demand.

Figure 49: Global IT services offshoring to China

2.4 2.83.3 4

56.3

7.6

0

1

2

3

4

5

6

7

8

2008 2009 2010E 2011E 2012E 2013E 2014E

2009-2014E CAGR of 22.4%

Source: IDC, J.P. Morgan estimates. Note: Figures denote outsourced IT spending by

global companies to Chinese IT services companies.

Notably, on the domestic front there is a growing trend ofincreasing domestic demand for further expansion of theindustry. We are seeing rising demand from domesticcompanies as they upgrade their IT and operationalinfrastructure as they aspire to become world-class globalcompetitors in terms of product offering and customerexperience. In addition, government backing for ITservices is mounting, with central and local governmentsinvesting in developing nationwide infrastructure fortransportation, healthcare, and education which includeconsiderable spending on technology and IT spending.

That said, historically Chinas investment into the ITsector has lagged behind that of more developed nations.As a percentage of GDP, China spent only 0.2% in 2009,compared with 2.3%, 1.5% and 1% for the UK, the US,and Japan, respectively. Using the banking industry as anindicator of Chinas comparatively low level of ITspending, while in terms of assets, Chinas bankingindustry is similar in size to that of the US, in 2008 theUS banking industry invested 10x more into IT than didChinas banking industry. We see this as evidence of theembedded growth potential of Chinas IT outsourcingindustry and the magnitude of the catch-up Chinaneeds to address.

Figure 50: IT spending as a percentage of GDP

2.3

1.51

0.20

0.5

1

1.5

2

2.5

UK US Japan China

Source: IDC, IMF.

Going forward, the sustained development of Chinas IT

outsourcing industry will be characterized by three majorgrowth themes: (1) strong government support; (2)expansion to tier-2 cities; and (3) growing M&A activity,in our view.

We like VanceInfo Technologies within this segment aswe believe it has one of the best management teams inthe China IT outsourcing space, in view of: (1) goodcorporate structure to support growth and the companytargets to double headcount to 20,000 over the next two-three years; (2) strategically expanding into otherindustry verticals, such as finance and transportation; and(3) good experience in working with US/Europe clients -

potentially diverting dollars from India to VIT; and (4)focus on organic growth rather than acquisitions.

Auto after sales serviceWe believe Chinas auto service industry represents an

attractive investment story. First, we believe Chinas car

after-sales market has significant growth potential

because: (1) the countrys passenger vehicles fleet should

see a major expansion in coming years; (2) the share of

after-sales revenue as a percentage of the dealerships

total revenue is rather low compared with that of mature

markets, and is set for major expansion with the aging of

the passenger vehicles fleet in coming years.

Passenger vehicle fleet should see a major expansion in

coming years

Chinas passenger vehicle fleet has experienced a strong

growth over the past decade. In 2000, there were

approximately 8.5 million vehicles. By 2009, it was 48.5

million, representing a 21% CAGR over the period. We

forecast this growth to continue on the rising upward

trend. From an estimated 60.69 million in 2010, we

project Chinas passenger vehicle fleet to grow to 217

million by 2020.


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Table 12: Chinas pass enger vehicle fleet expansio n

Year No of cars on the road

(MM units)2000 8.542001 9.942002 12.022003 14.792004 17.362005 21.322006 26.202007 31.962008 38.392009 48.452010E 60.692011E 74.062012E 89.092013E 104.542014E 120.932015E 138.36

2016E 156.762017E 173.082018E 187.992019E 202.602020E 217.00


Figure 51: China's passeng er vehicle flee expansion (MM units)

0

50

100

150

200

250

2000 2002 2004 2006 2008 2010E 2012E 2014E 2016E 2018E 2020E


In sharp contrast to the mature markets such as the US,

Chinas after-sales market is still at an early stage of

development, and with the gradual aging of the passengervehicle fleet, we should see Chinas after-sales market

enjoying strong growth in coming years. Normally,

demand for after-sales services rises the most once

passenger vehicles enter the fifth year of their service

life.

According to ACMR, the percentage of passenger

vehicles that have been in use for more than three years

in China will rise from approximately 50% in 2008 to

66% by 2012, indicating that the number of vehicles in

need of maintenance and repair should grow significantly

from here.

Compared to the mature US market where new car sales

comprise typically 57-59% of the total revenue for

dealerships, we find that new car sales tend to account

for 85-90% of Chinese four-in-one dealerships revenue,

indicating strong growth potential for Chinas auto

services industry in the years to come. This should be

positive for Chinas auto after-sales companies such as

Zhongsheng Group Holdings.

We are negative on mid-streamprocessing industries, paper, capitalgoods, IPPs, telcos, toll roads and wind-power equipment

We are negative on:

(1) Mid-stream processing industries, such as steel andaluminum, given the unfavorable combination of fallingdemand on the back of the monetary tightening but risingraw material costs;

(2) Paper on peaking margin concerns;

(3) Capital goods plays, such as heavy truck sector due to

the negative impact from the monetary tightening;

(4) IPPs and refineries, on the possible delay ofelectricity tariff and refinery product price hikes due tothe governments concerns on the inflation front;

(5) Certain industrials such as wind power equipment onpossible oversupply concerns.


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China Model Portfolio (CMP)

adjustmentsAs of November 19, 2010, our model portfolio had risen

by 18.2% since January 1, 2010, versus a 5.7% gain in

MSCI China during the same period. Since December 31,

2004, our model portfolio has outperformed MSCI China

by 126.5%.

Over the past month, among others, our model portfolio

has been helped by Geely, Zhaojin Mining, Glorious

Property, Agile Property, and CNOOC, which rose by

16.2%, 15.7%, 11.3%, 10.6% and 10.6%, respectively.

On the other hand, detractors from performance included

China Merchants Bank-A, China Resources Power, Bankof Communications, and China Railway Group, which

dropped by 13.8%, 9.7%, 9.4%, and 8.6%, respectively.

Figure 52: Since 31 December 2004, our CMP has outperfo rmedMSCI China by 126.5%

50

100

150

200

250

300

350

400

450

500

Dec-04 Jul-05 Feb-06 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09 Mar-10 Oct-10

JPM China Portfolio

MSCI China

Source: Bloomberg and J. P. Morgan.

Model portfolio adjustments

Switching from China Mobile back to UnicomIn September, we took profit on Unicom and ChinaTelecom before switching to China Mobile, as a tacticaltrade to play the short-term catch-up for large-cap bluechips after the underperformance over the China indexfor most part of the year as global funds moved to snapup large-cap laggards in the China universe.

Now that the tactical trade is over, and China Unicomsshare price has declined by 8.5% from October 20 toNovember 19, underperforming MSCI China index by7.1%, we see more value in Unicom. As a result, we cutour weight for China Mobile from 10% to 2%, and addUnicom back into our model portfolio with a weight of5%.

Our telecom analyst Lucy Liu, who has been positive on

Unicom, noted the following three positive drivers forUnicom:

(1) A pickup of 3G monthly subscribers over comingmonths coupled with stable 3G ARPU.

We think the market still pretty much focuses on the top-line prospect of the company, i.e., 3G monthly subs and3G ARPU. Near-term earnings might be less indicativegiven the potentially accelerated 3G handset subsidies incoming quarters (one-off expense at the beginning of thecontract), which would result in a sharper V-shapedgrowth of the bottom line. A key question for such amarket share challenger is whether the opex in the near

term could successfully translate into top-line growth. Inthis regard, we remain confident in the pick-up ofUnicom's monthly 3G subs over coming months, whichwe believe will be driven by:

a) The handset supply issue of iPhone 4, Lephone andother smartphones, which partly dampened 3G subsgrowth in the past quarter, should be resolved fairlyquickly, according to the company. The recent launch ofthe iconic smartphone models such as Samsung Galaxy Sand Nokia 7C should further enhance the value chainadvantage of WCDMA.

b) Further improvement in handset distribution. Unicomsigned an agreement with Bestbuy in the past month forWCDMA handset sales, similar to the agreement signedwith Suning previously. We believe a further leverage ofpublic distribution channel is important for the companyto reach out to the mass market.

c) With the above two points fostering the gross additionof 3G subs, we expect subscriber churn will be bettermanaged by the company in light of the increasingcontribution of contract customers than in the past. Thecontribution of contract customers amounted to 19% of3G net adds in 3Q, up from 5% in 1H10.

Moreover, we see further upside to the marketexpectation of 3G ARPU, which has surprised the marketpositively in the past quarters. We believe the take-up ofsmartphone adoption and higher contribution of contractcustomers will help stabilize ARPU further.

2) Free cash flow to largely turn around in the next one-two quarters.

We expect CUs FCF to turn positive as early as in 1Q11in light of its improving operating cash flow and the


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stabilization/slight decline in capex next year. We expecta strong recovery in FCF profile over coming years to

showcase the improvement in operations and alleviateinvestor concerns about near-term earnings.

3) Undemanding valuation

Based on our estimates, CU is currently trading at 1.1xP/B and 4.3x 2011E EV/EBITDA, despite a relativelyhig

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