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Demystifying the Dragon:

Myths and Realities of Investing in China

Fabrice Jacob, CEO, JK Capital Management Ltd.

European Pensions & Investments Summit 2012

Grand Hotel Huis ter Duin, Noordwijk aan Zee, The Netherlands, May 15, 2012

This document is intended for professional investors as defined in the MIFID

China: A model that raises suspicions and fears The fastest growing economy in the world

Between 1990 and 2011 – China has grown faster than any other economy to become the 2nd largest in the world

2

Source: Bloomberg , World Bank, IMF – April 2012

3x

20x

5x

USD 357 Billion

1.6% of the world USD 7.3 Trillion

10.4% of the world

USD 317 Billion

1.4% of the world USD 1.7 Trillion

2.5% of the world

GDP 1990 GDP 2011

USD

22 Trillion USD 70.2 Trillion World

China

India

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China: A model that raises suspicions and fears An unprecedented economic recipe

Chinese growth model is unique

Five-year plans dictate the growth paths

Foreign players are kept on a tight leash. Many of them are forced to partner with local companies

Trade barriers are everywhere

Local companies in strategic sectors are heavily subsidized, especially those that invest overseas

Building infrastructures became a top priority 30 years ago, well ahead of any other Asian country

Any form of political opposition to the ruling party is systematically crushed

Yet, China received 10x more foreign direct investments than India in the past 15 years

3

China’s economic growth model is not unique in the principles it uses.

It is unique as it should have collapsed long ago.

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The biased prism of Western observers GDP growth under excessive scrutiny

At the beginning of each year the NPC gives its growth target for the year. In 2012, it raised concerns and took the

market down…

4

0

2

4

6

8

10

12

14

16

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

China’s annual GDP growth target

Official GDP Growth Target

Source: National Bureau of Statistics, Capital Economics - February 2012

%

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The biased prism of Western observers GDP growth under excessive scrutiny

…. and yet it has never been a good proxy for Chinese growth

5

0

2

4

6

8

10

12

14

16

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012E

%

China’s GDP growth vs official target

China GDP Constant Price Cumulative YoY

Official GDP Growth Target

Source: National Bureau of Statistics, Capital Economics - February 2012

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CPI was once a big subject in China. It no longer is but appears to have remained for many the indicator of

China’s health, with any spike raising the ghost of a “hard landing”

-5

0

5

10

15

20

25

Jan-05 Jun-06 Oct-07 Mar-09 Jul-10 Dec-11

Consumer Prices (% Change YoY)

FOOD NON FOOD OFFICIAL CPI

Source: National Bureau of Statistics, Capital Economics February 2012

The biased prism of Western observers CPI as the barometer of Chinese health

6

“Chinese inflation is up again [...] putting

China back in an old bind: How to support

growth without unleashing the dragon of

inflation?”

Financial Times 10/04/12

China’s GDP growth has become so important in western minds that every single macro data is

scrutinized by analysts who look eager to find signs of impending doom

An exceptionally cold month of March caused a spike, not mentioned by any Western newspaper

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False Ideas about China “China is highly dependent on exports”

Net Exports contribution to GDP

7

China 26%

India 18%

South Korea 50%

Taiwan 66%

Thailand 66%

Malaysia 81% 0%

20%

40%

60%

80%

100%

2005 2006 2007 2008 2009 2010 2011(Est)

China GDP Breakdown (Expenditure Approach) (2005 - 2011E)

Net exports Capital Formation

Government Consumption Private Consumption

Note: National Bureau of Statistics, Capital Economics – March 2012

Source: Bloomberg data - April 2012

Gross Exports as a share of GDP 2011

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False Ideas about China “China is highly dependent on exports”

And gross exports figures often do not reflect the true nature of Chinese exports

8

In China’s exports numbers, an iPhone accounts for $196, not for the $19 local added value

Imported Components from Taiwan, Korea, Japan

and the US: $177

China Components:

$11

China Assembly cost: $8

Apple’s profit: $404

Retail price breakdown of a $600 iPhone 4S

Source: KGI estimates – April 2012

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False Ideas about China “China is the United States’ largest banker”

US Treasuries outstanding: US$ 15 trillion

China total FX reserves: US$ 3.3 trillion

China’s reserves invested in US Treasuries: US$ 1.1 trillion

9

US Treasury Ownership

US Institutions and Individuals 42.3%

Social Security Trust 15.8%

US Civil Service Retirement Fund 7.1%

Other Public Funds 2.2%

Foreign Ownership 32.6%

of which China 7.6%

67.4%

Source: US Federal Reserve Bank as at December 2011

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False Ideas about China “Property prices in China have become unaffordable”

Property prices have risen in China, but salaries have risen even faster with the emergence of a large middle class

10

4% of sales are in Tier 1 cities, 69% are in Tier 3 where prices are 68% below Tier 1 (source: CLSA – April 2012)

50.0

60.0

70.0

80.0

90.0

100.0

110.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 E

Property Price to Wage Ratio (index 100 in 2000)

Source: National Bureau of Statistics, Bloomberg, Capital Economics - April 2012; Note: CE 2012 Estimates based on Q1 2012 data Note: CE 2012 Estimates based on Q1 2012 data

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False Ideas about China “There is no genuine demand for property in China, it’s all speculation”

The number of flats built every year in China often leads to the assertion that no matter how big the population is,

such demand has to be speculation. It is forgetting the unique combination of 3 factors:

Property ownership only exists since 1993

In most cities and because of the gender imbalance, a young man will find it very difficult to get married if he

doesn’t own a flat

Confucianism: A cornerstone of Chinese culture is “filial piety" (xiao [孝] in Mandarin Chinese), the attitude of

obedience, devotion and care toward one’s parents.

11

An urban couple with one child and two sets of parents has an ultimate objective to own 3, if not 4 flats.

The real issue is they are often not allowed to.

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False Ideas about China “There is no genuine demand for property in China, it’s all speculation”

Property ownership in China remains low, first time buyers drive the market while investors account for a marginal part

12

59%

34%

7%

0%

20%

40%

60%

80%

100%

Sep

-07

Ma

r-08

2Q

09

3Q

09

4Q

09

1Q

10

2Q

10

3Q

10

Oct-

10

Nov-1

0

Dec-1

0

Ja

n-1

1

Fe

b-1

1

Ma

r-11

Apr-

11

Ma

y-1

1

Ju

n-1

1

Ju

l-1

1

Aug

-11

Sep

-11

Nov-1

1

Dec-1

1

Ja

n-1

2

Fe

b-1

2

Ma

r-12

Property buyers’ profiles

First Time Buyers Upgraders InvestorsSource: CLSA – April 2012

53.8% 48.9%

24.0%

30.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Tier 1Cities

Tier 2Cities

Tier 3Cities

NationalAverage

Property Ownership in China - 2011

Source: CLSA – April 2012

This document is intended for professional investors as defined in the MIFID

China’s Challenges China is addicted to investments

Despite retail sales increasing by 15% year on year, China relies far too much on investments

13

Such an imbalance is unsustainable in the long run…

0.0

20.0

40.0

60.0

80.0Consumption & Investment (% of Nominal GDP)

Household & Government Consumption Investment & Inventory Building

Source: National Bureau of Statistics, Capital Economics – March 2012

This document is intended for professional investors as defined in the MIFID

China’s Challenges China is addicted to investments

Investments in infrastructures are still in strong demand: the freight train network example

14

... but for another few years, a high level of infrastructure investments should not be a concern

30 319

0

5 000

10 000

15 000

20 000

25 000

30 000

35 000

USA Germany France UK Japan Russia China IndiaFre

igh

t T

raff

ic (

10

00

to

n-

kilo

me

tre

/kilo

me

tre

) Freight traffic by rail

Source: CICC Research – February 2012;

Note: 2010 data for China, 2007 data for other countries

This document is intended for professional investors as defined in the MIFID

Demography is a real challenge for China in the long run as the population is ageing and the gender imbalance is

not closing

- 200 400 600 800 1 000 1 200 1 400 1 600 1 800

-

100

200

300

400

500

2000 2010 2020 2030 2040 2050

China's Population

Population above 60 Years Old (in Million)

Total Population (in Million) - RHS

China’s Challenges After having been a strength, Chinese demography will become a burden

15

China also faces other challenges along the road such as corruption and pollution

970

975

980

985

990

995

(m) China's labor force

Source: China Population and Development Research Center – March 2012 Source: US Census Bureau – March 2012

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A Top-Down approach:

Never stand against the wind !

The wind from Beijing is always the strongest

A Bottom-Up approach:

1. Check all connected transactions

2. Beware of auditors outside the big four

3. Keep a close eye on inventory and receivables

4. Both large cash balance and large debt is never a good sign Parmalat syndrome

5. Go on site very often, don’t take anything for granted !

How to invest in China? A combination of two approaches

16

China is not always easy to understand at close range, it becomes almost impossible from a distance.

The key to successful investments is proximity.

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