The autumn breezes in Northern China signal the resumption of industrial and investment activities after the summer low season. The industrial activities have one negative consequence — a worsening of the air quality, a challenge that the region has to contend with.
In Beijing for example, the PM2.5 concentration monitored by the US embassy shows that the monthly index grew more than threefold between August and December in 2016, and similarly in 2015.
The central government recently launched a campaign to help the Beijing-Tianjin-Hebei region and neighboring provinces control pollution this autumn and winter, which may bring some positive changes to the situation this year.
The plan involves reducing industrial output in Beijing, Tianjin and 26 other cities (“2+26″ cities). The proposal, for example, recommends a 50 percent cut in iron and steel output in Tangshan, limiting electrolytic aluminum production to 30 percent+ of the production capacity, as well as capacity reductions in thermal power, cement, chemicals and other heavy-polluting sectors.
Despite some concerns around the policy execution, our assessment on the impact of these policies and the feedback we have received from affected companies suggest otherwise. In fact, the momentum of this execution has been strong and the plan has become a key component of China’s economic reform, bringing significant impact on the economy and related stocks.
Our view is that stringent environmental measures will help produce noticeable economic benefits. In many industrial sectors, a small number of companies creating heavy pollution are able to cut product prices as they evade their environmental responsibilities, penalizing most competitors which abide to environmental regulations.
The recent environmental measures will help correct market inefficiency by closing down outdated capacities in those polluting sectors, while enabling an increase in industrial product prices to improve companies’ profitability and financial health.
The success of this approach has been proven in last year’s supply-side reform which focused on the steel and coal industries: the coal industry saw net profit margin jump to 11 percent as of the first seven months of 2017, versus 1.2 percent over the same period last year, while the steel industry’s profitability rises to 3.9 percent this year, from 2.4 percent over the same period in 2016.
The debt to assets ratios of these two sectors also retreated from their highs by 1.8 percentage points and 2.1 percentage points respectively.
This round of environmental policies has extended the supply-side reform to cover aluminum, construction materials and thermal power sectors, and we believe this would result in improved corporate earnings and debt leverage across more industrial sectors.
More importantly, China’s economic growth path has moved away from seeking GDP growth at the expense of environmental pollution. Based on the Ministry of Environmental Protection’s preliminary study on green GDP, the loss from environmental pollution, in a narrow sense, accounts for approximately 3.5 percent of GDP, while reaching as high as 7 percent in Hebei province.
If we take factors like resource depletion, environmental degradation, ecological destruction and pollution treatment into consideration, Hebei province’s GDP expansion is close to zero or negative. This goes to show implementing environmental measures is key to supporting economic growth, rather than viewing such moves as causing a burden to the economy.
From an equity market point of view, this round of environmental measures (between August 2017 and March 2018) is expected to be the most effective to date, and will deliver stronger-than-expected impact to the outdated capacities in the polluting industries.
As such, we believe there will be further upside in the valuation and profit forecasts for some of the listed companies including steel, aluminum, cement and thermal power, where there is still room for capacity reduction.
We also hold a more optimistic view over the banking sector which can benefit from lower bad debt ratios.
Great opportunities in the Chinese equity market can be found in those companies that reap better-than-expected benefits from the structural reform, in addition to those in emerging industries such as internet/IT sectors.
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