1 - Expert eye on China - BNP Paribas Investment Partners - Q1 2012

FOURTH QUARTER 2011 REVIEW AND OUTLOOK The fortunes of China’s financial markets diverged during the fourth quarter of last year. The domestic A -share market saw an acceleration of the downtrend in December, despite anticipation of more pro-growth policies in 2012, finishing the year 21.6% lower (Shanghai Composite index). China sceptics remained at their vocal best during the quarter predicting an imminent crash in the property market, banks and the China economy as a whole. The official Purchasing Managers Index (PMI) fell 0.8% to 50.4% in November, and then to 49.0% in December, which rattled markets. These levels had not been seen since the height of the global financial crisis in 2009, while this time around, China is less able to provide massive stimulus as back then.

With the impending economic slowdown and inflation trending downwards China onshore bond markets were buoyant in contrast, with the yield on 5-year government bonds dipping below 3% and those of AAA-rated corporate bonds decreasing from 5.7% to around 5% during the fourth quarter. In what has been a tumultuous year for China credit, lower-rated bonds and those issued by local governments have seen their yield spread against government bonds remained at high levels in the fourth quarter. Convertible bonds have been affected by lower stock market valuations.

However, offshore bond markets in RMB (‘dim sum’ bonds) were weak over the fourth quarter, with the average RMB offshore bond yield increasing by 1.2%. Worries about the ability of the Chinese authorities to manage a soft landing and the lower perceived quality of bonds in the offshore market increased the volatility of yields during the quarter.

The RMB increased in value by 1.35% against the USD and a healthy 5.7% against the Euro, with both the non-deliverable forwards market and the offshore RMB markets signaling that with the trade balance in decline, appreciation policy may be paused, though this has not played out in reality as yet.

For Professional or Private Use Only and Not for Public Distribution - Q1 2012

Expert eye on China

CONTENT

Fourth Quarter 2011 Review 1and Outlook

Quarterly Theme: 3 RMB Internationalisation

News Item: 3Investor access to China

Investment Focus: 4China bond markets

2 - Expert eye on China - BNP Paribas Investment Partners - Q1 2012

OUTLOOK

For the time being, uncertainty reigns in the China economic outlook, which is likely to weigh on stock valuations and corporate profits. Valuations have not been this low for some time and could be a catalyst for re-assessing the growth potential of the world’s second largest economy. For the time being, however, several overhangs remain. The first is that earnings revisions may not have bottomed and the IPO pipeline remains strong. These are dragging on equities, especially on smaller-cap stocks. In a nutshell, we see great potential for long-term investors, as these levels of valuation are generally associated with strong gains.

The key question in 2012 will be for when the switch from bond to equity exposure will be most profitable.

All is not lost however, as softening economic conditions are positive for China’s bond markets in the short-term. We expect the yields of government bonds and highly-rated corporate issues may continue to trend lower this quarter. We estimate the central bank will increase liquidity injections and let for the RMB appreciation policy to continue through 2012. However, lower-rated bonds, including those issued by local government financing vehicles, may remain volatile.

Performance (%) in USD, net of fees I share (%)

Inception Date Dec Last 3M YTD Last 12M Last 24M* Last 36M* Last 60M* Since inc.**

China QFII Bonds

FLEXIFUND Bond RMB 03/12/2010 1.35 3.84 6.37 6.37 5.87

70% Shanghai Exchange Corporate Bond Index + 30% Shanghai Exchange Treasury Bond

2.14 4.01 8.53 8.53 8.70

Excess return -0.79 -0.17 -2.17 -2.17 -2.83

management fees: 1.00%

FLEXIFUND Money Market RMB 27/07/2007 0.88 1.51 6.10 6.10 4.80 3.29 5.15

Cash Index representing the demand deposit rate in China (RI) 1.33 1.59 5.19 5.19 4.61 3.28 4.75

Excess return -0.45 -0.08 0.92 0.92 0.20 0.00 0.40

management fees: 1.00%

China A Shares QFII

FLEXIFUND Equity China A 16/12/2004 -7.68 -7.99 -28.93 -28.93 -15.45 6.36 5.85 19.96

MSCI China A Net Return Index -8.83 -8.70 -22.91 -22.91 -13.08 12.66 6.48 16.94

Excess return 1.15 0.71 -6.03 -6.03 -2.37 -6.29 -0.63 3.02

management fees: 1.50%

FLEXIFUND Equity Small Caps China A 16/02/2007 -11.17 -9.30 -30.89 -30.89 -10.80 13.33 10.59

CSI 500 (PI) -15.41 -14.06 -27.75 -27.75 -8.49 27.31 15.94

Excess return 4.24 4.76 -3.14 -3.14 -2.30 -13.98 -5.35

management fees: 1.75%

* annualised performance** annualised, see inception date columnSource: BNP Paribas Investment Partners, as at 31/12/2011. Past performance or achievements are not indicative of current or future performance.

Fund performance

3 - Expert eye on China - BNP Paribas Investment Partners - Q1 2012

RMB INTERNATIONALISATION HAS NOT STALLED Beijing started the RMB internationalisation process in mid-2009 by promoting it as a trade settlement currency. The motives are four-fold: to increase international influence, reduce currency risk for both trade and financial transactions, sustain trade finance by using RMB as an alternative financing currency when USD finance dries up, and to push financial reforms so as to upgrade the structure of the economy.

After two years of explosive momentum, the process seems to have stalled. This is seen in the fall in cross-border yuan settlements, decline in RMB deposits in Hong Kong and fall in the CNY-CNH yield spread in 4Q11. The latter is also indicative of a fall in the speculative demand for RMB due to fading expectations on RMB appreciation. We beg to disagree. The process is only evolving into a more sustainable, albeit slower pace. Beijing has introduced new initiatives to keep the process going, including approving the usage of RMB for FDI in China, allowing more Chinese entities to issue RMB bonds in Hong Kong and sanctioning the RMB-QFII scheme.

China’s trade balance with the G3

Sources: CEIC, HFT (HK), as at 31/12/2011.

The Sino-Japanese collaboration, announced on Christmas day 2011, of using the RMB for trade and non-trade transactions is a major step towards expanding the foreign demand base for RMB. Since China imports a significantly bigger amount from Japan than from Europe and the US (Chart), by paying Japanese exporters with RMB1, China is allowing more RMB to accumulate in Japan. If Sino-Japanese RMB trade settlement expands significantly in addition to Hong Kong, the dominance of the USD in Asian trade could be eroded. Further, Japan’s decision to hold buy Chinese bonds in their reserves may mark the start of a long-term process for accepting the RMB as a reserve currency.

Meanwhile, the rapid development of offshore RMB market has created market signals for the Chinese system because the RMB traded in Hong Kong is largely market driven. Growth of the CNH market will also put pressure on further liberalisation of China’s domestic bond market. The development could go the Japanese way in 1984, when the rapid development of the euro-dollar and euro-yen markets bid away some of Japan’s best corporate borrowers, forcing the Japanese banks

to reinvent themselves by lending more to the small and mid-sized enterprises (SMEs). Such development will make a profound change in China’s financial landscape where SMEs are still starved of credit. A relaxation of the Chinese SMEs credit constraint will facilitate the growth of the private sector to help productivity growth and economic flexibility in the rebalancing effort.

RMB; WE’VE GOT IT; NOW WHAT TO DO WITH IT? The rapid development of offshore RMB market raises the question of where can offshore RMB holders go with their money? From a private investors point of view the possibilities were limited; until recently that is. In December 2011 a long awaited new opportunity arose for Investors in Hong Kong; the RMB QFII (or RQFII). The Chinese securities market regulator (the ‘CSRC’) granted licenses to Chinese asset managers and brokers with a Hong Kong subsidiary. Quotas are not new for cross border investment concerning China. In 2002, the CSRC launched the first batch of QFII (Qualified Foreign Institutional Investor) licenses; access to this quota has been highly in demand by international investors ever since.

What is RQFII adding to the pallet?

The new RQFII license allows the licensed product-providers to offer (mainly fixed- income) products denominated in RMB, investing in mainland China, to the public in Hong Kong. Compared to what is now known as the “traditional QFII”, there are a few significant differences. The most apparent is the currency denomination currency. Where the traditional QFII products are mostly denominated in Euro, USD or Yen, the new RQFII will be RMB-denominated, in line with the investment currency of quota -funds.

The most significant difference, however, is the difference in the investment universe. For the RQFII scheme the inter-bank bond market is included, which is not the case for the traditional QFII. The impact? The inter-bank bond market dominates the onshore fixed income market, accounting for as much as 97% of the total issuance. There isn’t a significant difference in yield between the inter-bank bond market and the exchange- traded market, but it does add depth and liquidity to the investment universe, in terms of types of bonds, issuers and maturities.

Is RQFII the new and improved QFII?

No, the RQFII scheme will not replace the traditional QFII. In fact, in tandem with the RQFII licenses, new licenses and quota for the traditional quota are granted. The differences in currency denomination currency, investment universe and target investors between the two schemes provide for a harmonious coexistence, with each vehicle playing its own role.

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China's trade de�cit with Japan will facilitiate RMB internationalisation

1 Assuming the Japanese exporters are willing to settle in RMB.

4 - Expert eye on China - BNP Paribas Investment Partners - Q1 2012

INVESTMENT FOCUS: CHINA BOND MARKETS Given the internationalisation of the RMB and the additional facilities proposed by the Chinese government to make onshore investments available to outsiders (QFII, RQFII and Central Bank facilities), many investors are increasingly seeking a piece of the RMB action.

The two main investment areas that benefit from these positive developments are the onshore RMB bond market and the offshore RMB bond market. China’s government bond market is the largest in Asia, though due to the dominance of the country’s economy, seen as a percentage of GDP the level of government borrowing is quite reasonable. The corporate bond market is a relatively new development, though one that is increasingly encouraged by the authorities in order for companies and local governments to diversify their sources of funding away from traditional bank lending.

• The onshore RMB bond market amounts to approximately RMB 20 trillion in outstanding issuance, of which the majority government bonds are thinly traded on the interbank market – most insurance companies and commercial banks in China hold such bonds to maturity. The majority of corporate issues are, however, listed on the country’s main stock exchanges. This segment of the market is of special interest to international investors due to the large spread between highly-rated corporate bond issues and those of government bonds – though the former may be state- owned enterprises or other state-sponsored entities.

• Onshore corporate bonds must be rated by at least one of six Chinese rating agencies. In some cases these rating agencies are established as joint ventures between a Chinese entity and an international rating agency, such as Moody’s, using the same quantitative and qualitative criteria to arrive at their conclusions. Actual defaults in China’s bond markets are relatively unheard of – though recent newsflow would suggest to the contrary.

Major Onshore bond types by markets

Source: WIND, December 2011

• The offshore RMB bond market is a recent development, linked to the internationaliszation of China’s currency. The exponential increase in deposits of RMB held offshore, notably in Hong Kong, due to relaxed trade settlement rules in 2010, has resulted in a major increase in corporate issuance in 2011. At first limited to government agencies

and state-owned banks, the market (coined as ‘Dim Sum’ in reference to the Hong Kong culinary specialty) grabbed the attention of investors with the issuance of a bond by Mc Donalds in early 2011. Many international companies have followed suit. However, the quality of issuers deteriorated through the year and yields increased significantly on China credit concerns. We believe the market has huge potential.

• Lastly, in a speech during the fourth quarter, the new chairman of the stock market regulator in China (CSRC) reiterated his support for further development of the bond markets, including the possibility of a ‘high yield’ segment being launched. We believe that investing in line with policy in China generally yields good results!

Though China’s bond markets are developing fast, few investment products exist for international investors. To capture this investment opportunity, BNP Paribas Investment Partners and HFT Investment Management have been active in this space since 2010 and 2011 in the onshore RMB and offshore RMB space, respectively, and have built up pioneering expertise in this area.

RMB bond credit yields (onshore) as of December 2011

Source: Wind,ChinaBond

Central Bank Bills

Mid-term Notes

Commercial Papers

Policy Bank Bonds

Company bonds

Bonds with Warrants

Convertible Bonds

Chinese Government Bonds

Enterprise Bonds

Inter-bank Market96.9%

Inter-bank &Exchanges

Exchange Market3.1%

AA rated corporate bond

AAA rated corporate bond

China government bond

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The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes.* BNP Paribas Investment Partners Asia Limited, 30/F Three Exchange Square, 8 Connaught Place, Central, Hong Kong.

** “BNP Paribas Investment Partners” is the global brand name of the BNP Paribas group’s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.

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