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New Chinese Economic Growth Cycle

Executive Summary: The health of the Chinese economy continues to be a long-running concern for investors globally. These concerns primarily stem from four major philosophies. First, the Chinese economy has been investment led which is structurally distorted and unsustainable. Second, there is a global slowdown in demand for Chinese products and the manufacturing sector has come under scrutiny due to the fear of oversupply and waning competitive advantage. Third, investors are concerned that the balance sheets of domestic banks are over-stretched, driven by accumulated leverage in the property space, manufacturing sector and local government spending. Consequently, there is a widespread belief that the banking system is effectively insolvent and will be doomed to collapse in the not-so-far future. Finally, investors worry that the dynamics of the Chinese demographic is negatively skewed, as age growth outpaces wealth growth. In short, the Chinese economic growth story may have come to an end. We at Bin Yuan Capital have conducted proprietary research to address above areas of concerns and conclude the following: Chinese economy has been transforming from a manufacturing and investment story to consumption story. There is clear evidence that the service sector is taking over the importance of the manufacturing sector which has made the economy more balanced. We believe the high per capita savings to debt ratio, the ongoing urbanization process, and positive household cash flow categorically underpins the Chinese consumption growth story. In regard to the manufacturing sector, we found that after recent year’s severe competition and consolidation, some Chinese firms have become domestic bellwethers and even global leaders with the following advantages:

a. A large cost competitive, well-educated, and skilled labor force. b. Strong productivity c. Large investments into R&D and fast adoption of new technology d. Well-developed and well-integrated industrial supply chain e. Large economies of scale

We believe the Chinese manufacturing sector will stay very competitive at a broader level from low end to higher end that is outstanding among emerging country universe. The Chinese economy has transformed to enjoy the dividends from its large population and skilled labor force. These structural changes have reflected in the quality of corporate earnings. The profitability and cash flows generated by companies in the service industry, in general, are much better than those in the manufacturing sector. The profitability and cash flows of higher value added manufacturing firms are much more robust than those that produce low end products. This structural transformation has resulted in a larger, and higher quality selection of investable companies.

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Regarding concerns on debt, we believe that the overall situation is not that dire, and that the chances of a crippling financial crisis in China within the next few years is low. The health of China's economy is supported by a high home ownership ratio and relatively low financial leverage. Moreover, financial debt has been transferring from the traditional manufacturing sector to the healthier services sector which makes the debt distribution more balanced. Finally, we believe Chinese banks are not in danger of experiencing a cash shortage. We have discussed this concept in more detail during our first and third quarter review and the Liquidity Report issued earlier this year. These positive structure developments may be overlooked by investors. We believe that the Chinese economy is entering a virtuous circle propelled by wealth creation, and domestic consumption and investment, particularly amongst the younger population. Improved manufacturing and service sectors have supplemented each other in fostering healthy economic development. Part 1: Positive Domestic Economic Structural Development Chinese economy has structurally changed that the service sector is taking over the importance of the industrial sector. In recent years, the GDP growth contribution has shifted from manufacturing and infrastructure investments to consumer spending and services. In the 1990’s, the service sector contribution to the overall GDP was 27%. By the 2000’s was 40%, and reached a record high of 59% in the first half of 2016 (Chart 1). In contrast, the contribution of the industrial sector to the GDP plunged from 58% in 1988 to less than 38% in early 2016. Chart 1: GDP contribution by sectors

Source: Wind, Bin Yuan Capital Rising disposable income and high consumer confidence led to a transition to consumption The strong economy and high income growth in the past 20 years have made Chinese much wealthier today. The emerging middle class has powered consumption moving away from basic living necessities to higher value added products and services. Durable sales have grown fast in the past 15 years. Automobile sales, for example, grew from zero private car ownership in the late 1970s to 3.9 million passenger vehicles in 2005 and 21 million in 2015. Travel for leisure was nonexistent in late 80’s and by 2015, Chinese tourists have spent 3 trillion RMB (US$460 billion).

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The faster growth of the service sector versus industrial sector has made the economy more balanced. Unlike the oversupply situation in infrastructure and manufacturing, the service sector is in short supply. It became a major growth driver in 2015, replacing the industrial sector. Is this consumption pattern sustainable? We believe the combination of a high household saving ratio, low household debt, increasing urbanization rate, and higher household cash inflow than outflow will continue support this ongoing consumption story.

a. Healthy household balance sheet The Chinese household has a tradition of saving more than spending. The household savings ratio rose to 30% (Chart 2) with household debt ratio to GDP of 40% in Q1 2016 (Chart 3). This high savings ratio and low debt have made spending increase possible, and after the 2008 global financial crisis, spending indeed started to go up. Chart 2: Saving ratio

Source: Wind, Bin Yuan Capital

Chart 3: Share of household debt to GDP, Q1 2016

Source: Economics think-tank, BCG Institute, Bank of international settlements, Bin Yuan Capital

b. Lower property burden

A high home ownership ratio with low leverage has left Chinese households with more cash to spend on consumption. 90% of the population owns the residence where they live in (Chart 4). In the past 12 years, the household asset allocation has shown a reduction in property, from 62% in 2004 to 54% in 2014, and the trend is continuing. The non-real estate assets that have increased the most in the period were financial assets (Chart 5). Chart 4: Home ownership ratio

Source: Wind, Bin Yuan Capital

Chart 5: Income and savings allocation

Source: Southwestern University of Finance and Economics, Bin Yuan Capital

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c. Urbanization generates growth China is still in the middle of the urbanization process. Currently, slightly more than 50% of the population is classified as urban, up from less than 20% in the early 1980s (Chart 6). Spending behavior change when people moving away from rural to urban provides demand for consumption. The structural change has reflected in corporate earnings The profitability has transferred from industrial sectors to the broad service sectors in the same period. Due to the short supply, the nominal growth rate of services is higher than real growth rate because of the uptrend of prices, indicating the service sector enjoys much better pricing power. Chart 7 shows the divergence trend of service CPI and PPI since 2012. Chart 6: Urbanization rate in China

Source: Wind, Bin Yuan Capital

Chart 7: CPI and PPI

Source: Wind, Bin Yuan Capital

Due to the price inflation differences, the profitability of the service sector has been higher than the lower value added industrial sector in recent years. Using A share listed companies as proxy, excluding financials, the return on equity ratio of service sector was close to 10% in 2015, compared to only 5.9% in the industrial sector (Chart 8). The net margin presents the same story. The net margin of service sector excluding financials, was 183bp higher than that of industrial sector (Chart 9). Chart 8: ROE comparison

Source: Wind, Bin Yuan Capital

Chart 9: Net margin comparison

Source: Wind, Bin Yuan Capital

Consumption summary Since China’s economic reforms started in late 1970s, huge wealth has accumulated and the living standards have significantly elevated. With urbanization progressing and a lower household financial burden, Chinese consumer spending story will continue. The economy is on track to transform from early stage of industrialization to a more sophisticated manufacturing and

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consumption stage. On the other hand, with more favorable government policies on redistributing wealth, the consumption power of lower income group will be further released. Part 2: The Structural Improvement in The Manufacturing Sector China industrial sector has stood out from the emerging country crowd with key competitive advantages. In the past thirty years, the quality of the labor force and manufacturing technology has significantly improved. Today, China has a large number of educated and skilled laborers, a well-developed infrastructure that make logistics highly efficient, economics of scale, a well-developed manufacturing supply chain and available capital for investments. These advantages shall support China manufacturers to stay competitive at a different level and some of them are becoming globally competitive companies. Vertical Industrial Sector Development The success of China’s economic reforms had been aided by an abundant supply of cheap labor and land. The People’s Commune in the agriculture sector, established shortly after the communist party took over in 1949, directly involved 90% of the population. Even a lot of economic results were not as expected, the community concept in the agriculture sector had been critical in transforming the scattered individual family based labor force into an organized village-based labor force. This transformation facilitated the transition from an agrarian population into an industrial workforce, lubricating the industrialization and urbanization process. Fortunately for China, as the era of globalization emerged, its organized cheap labor supply easily absorbed the outsourced manufacturing jobs from developed countries. This globalization and outsourcing, in turn, has helped China reform.

a. Improved labor force One of the benefits China has gained from globalization was the significant improvement of the labor force. Multinationals have brought in technology and management knowhow. Combined with a highly regard for education, China has accumulated a large number of well-educated and skilled labor force. China has transformed from benefiting from a demographic dividend (a large amount of low skilled cheap labor) to a human resource dividend (large amount of skilled labor). In the past thirty years, Chinese labor force has changed significantly both quantitatively and qualitatively. At the time China started economic reform in early 1980s, the available population for the industrial sector was much less than today, and with limited education level and much lower cost. In the early 1980s, 20% of the 900 million population (180 million) lived in cities and were available to work in manufacturing. The amount of employed workforce with above junior education was only 30% (Chart 10) with annual cost of the manufacturing labor less than US$ 200 per year in 1980s (Chart 11). The labor supply increased significantly since then. In 2015, 55% of 1.35 billion (740 million) was available for industry and services. Thanks to the education system reform and the desire for higher education, the quality of today’s work force has significantly improved. In 2015 80% of the

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workforce has received junior high certificate and above comparing to 30% 30 years ago. The fast expansion of the economy has also helped to train a large number of experienced workers and different level managers. Chart 10: Level of education in the workforce

Source: Wind, Bin Yuan Capital

Chart 11: Labor cost

Source: Wind, Bin Yuan Capital

Another important factor enhancing the workforce quality is the reverse brain drain – students are now coming back to China after studying abroad. 80% of the 350 thousand students returned to China today as much better opportunities in China (Chart 12).

b. Improved productivity China has experienced a strong positive correlation between productivity with training, education and experiences. With improved skill, output of per unit of labor has increased continuously. (Chart 13) Chart 12: Chinese Student study abroad

Source: Wind, Bin Yuan Capital

Chart 13: Labor productivity

Source: Wind, Bin Yuan Capital

c. Increased automation

To stay competitive, Chinese corporations have invested in system automation and robots. As we can see below Chart 14, the industrial robot shipment ratio in China has increased quickly in the past few years and taken 30% of the total global shipments in 2015.

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Chart 14: China Industrial Robots Shipment

Source: IFR, Bin Yuan Capital

Automation has significantly improved the efficiency of Chinese Enterprises. We take Shunfeng Express medium-sized logistics center as an example (Table 1). An automatic sorting machine reduces the workers to 30 from 120 to complete a 20 thousand units sorting job, a two thirds reduction in workers. Automation also decreased error ratio from 1% to less than 0.1%. Total operating expenses for 5 years reduced from 36 million RMB to 24.5 million RMB. Table 1: Shunfeng Express Automation Economic Analysis

Automation sorting Manual sorting

Number of required workers 30 120

Unit labor cost (Thousand) 60 60

Annual labor cost in China (Million) 1.8 7.2

Equipment investment (Million) 15 0

Equipment maintenance cost (Thousand) 100 0

Total operating expenses for 5 years (Million) 24.5 36

Payback period (Years) 3 /

Error ratio of product 0.1% 1.0% Source: Shunfeng Express, Bin Yuan Capital

Another example of automation and robot usage is Guangzhou Guangri. After the company upgraded its production line by installing automated system and robots for welding, it has reduced nearly two thirds of the labor input. The individual part production time decreased from 3 minute to 0.9 minute, the production yields increased from 98% to 99%.

d. Moved up the value chain The overbuilt manufacturing industry has struggled in the past three to four years and was forced to consolidate and invest in technology to move up the value chain. China export data indicates that the composition of Chinese export goods has changed through the time. Lower value added agricultural products, for example, decreased from 23% to 2.5%, while higher value added machinery and telecom equipment increased from zero to 55% in the past three decades. Total high-value-added products accounted for 77% of total exports in 2014 from 5% in 1980 (Chart 15). (We define pharmaceuticals, machinery, telecom, telecommunications, electronics, and automotive related products as high-value-added products) The labor force distribution has also shown that Chinese economy has been moving away from low-end industrial to higher value added industrial and service sectors. The proportion of

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employment in the industrial sector has reduced very fast. The service sector has increased to 42% of total in 2015 from 17% in 1985 (Chart 16). These changes are evidences of the economic structure shifts. Chart 15: China export product composite

Source: Wind, Bin Yuan Capital

Chart 16: Proportion of employment by sectors

Source: Wind, Bin Yuan Capital

Competitiveness from a Global Perspective (horizontal comparison) China manufacturing is still competitive compared to both developing and developed countries. For most of the emerging countries, the situation of less advanced infrastructure and short supply of organized skilled labor will not change much in the future. An economy is not efficient without infrastructure built up to establish industrial production value chain. The shortage of skilled labor is a bottleneck for both production capacity increase and the cost of labor. In the emerging economy, Asia is still viewed as a major manufacturing outsourcing destiny. India is the second largest country in population with good literacy ratio, however, from the discussion with a few manufacturing companies that have business in India, we were told that the bureaucratic government project approval process and poor Infrastructure made the establishment of a manufacturing facility very difficult. As a result, the second largest populated country, India, may not become a major destination for the global manufacturing industry in the foreseeable future.

a. Skilled labor force Chinese government has been paying attention to education. China launched “nine-year compulsory education” program since 1986 to make sure all the children have opportunity to finish study at junior high school. The total literacy rate in China reached 96.4% in 2015. With the educated and skilled labor, China labor productivity is 5 times higher than Cambodia, for example. Chart 17 below shows the productivity comparison between China and other major Asian emerging countries.

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Chart 17: Labor productivity (output per unit of labor)

Source: Wind, Bin Yuan Capital

China is still self-sufficient in labor supply. The economic development is not balanced as western area is still much less developed. The cost of labor is only one third of that of the east coast. With the same government system, culture and language, the infrastructure connection and government policy support, the western area is attractive for manufacturing. The movement of manufacturing facilities to western China is already happening. Western part of China has enjoyed higher GDP growth in recent 3 years than east coast. After 2009, the GDP growth in central and western China were higher than eastern area. We expect that in 2030, based on current growth rate, the less developed region in China will contribute 50% of total GDP, compared to 40% in 2002 (Chart 18) Chinese labor force is still cheaper compared to developed countries. Chinese engineers are much lower paid. An engineer in China is only 14% of the cost compared to a US engineer (Chart 19). Chart 18: GDP contribution by region

Source: Wind, Bin Yuan Capital

Chart 19: Cost of engineers

Source: Wind, Bin Yuan Capital

China will continue to supply large number of engineers. Based on OECD estimates, the highly educated population in China will reach to 27% of global total, the highest globally in 2030. This continuous supply of quality human resources is sufficient for China to stay highly competitive. (Chart 20)

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Chart 20: Share of highly educated population aged 25-34 among G20 and OECD countries (2000 vs 2030 forecast)

Source: OECD, Bin Yuan Capital

b. Economic of scale

The scale of the economy is one of the key competitive advantages that no other country can replicate. Using transportation as an example, China has built extensive and well advanced roads, railways, airports and communication network. In 25 years, the country has constructed 120 thousand kilometers’ highway (Chart 21). China has surpassed the United States in terms of total highway mileage in 2015. In over 10 years, China has built 19 thousand kilometers high speed railway, with a speed of 250- 300 kilometers per hour. China is the only country that has high speed rail network. The main cities of China are all connected by road and rail. Take Shanghai Disney catchment area as an example, 300 million people now live within three hours travel time. The other one billion Chinese are within three hours flying time from Shanghai. This supper connectivity has greatly improved economic efficiency. The logistic build up is only at its middle stage. In the next Five-Year plan, China will continue to construct 20 thousand kilometers high speed rail (Chart 22). Chart 21: China's fast growing transportation infrastructure

Source: MOR, Wind, Bin Yuan Capital

Chart 22: The order on hand HSR

Source: UIC, CICC, Bin Yuan Capital

This extraordinary scale and huge domestic market, give China significant efficiency advantages. China is the biggest auto manufacturer making 20 million vehicles a year. To support this large amount of vehicle production, a much scaled auto parts supply chain is needed. This scalability has made many smaller players less economically efficient. The large number of engineers help construct infrastructure efficiently. The population with engineering education was just 250 thousand 15 years ago and accumulated to more than 30 million today. This abundant manufacturing capacity combined with large supply of quality human

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resources would make it easier to service a smaller scaled economy. The large number of engineers, for example, will make the after-market maintenance and service easier.

c. Integrated supply chain The manufacturing industry in China is highly integrated. Chart 23 demonstrates that in the global IT hardware industry, Chinese firms are getting competitive in almost all the segments along the supply chain. The integrated supply chain provides shorter lead time, quicker response to requests and better service to customers. Chinese players are not competing only on price anymore. Service and efficiency are becoming increasingly important. Chart 23 Overview of Technology Industry between Countries

Source: Bin Yuan Capital

d. Technology advancement

What China has done successfully that many other emerging countries did not do was reinvesting the capital accumulated from export-led growth into strategic infrastructure and technology. In addition, the country used its huge domestic market exchange for technology (open the market for foreign direct investment). The combination of the government decisiveness on reform and market economy made this possible. Today, China possesses advanced enough manufacturing capabilities that are ahead of the emerging universe and competing with the top global firms. China has gone through three stages in manufacturing development. In early 1980s manufacturing was dominated by Taiwanese and Hong Kong trading companies. The products were mainly OEM low end electronic components, toys, and textiles. Later, multinationals moved in and began producing more sophisticated products mainly for re-export purposes. The Chinese government at the time made a strategic decision insisting that multinationals find a local partner to transfer technology through a joint venture format. Multinationals got cheap labor, cheap land, lower taxes and the local market. The Chinese got technology and management knowhow. In those years, Chinese local manufacturing facilities were small in scale and poorly organized. By the late 1990s, Chinese producers started to gain scale and produce quality of the products. Take home appliances as an example. Chinese firms developed quickly and mostly from garage sized plants and now dominate in the market in China.

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Today in our company research of factory management, the local firms are well advanced compared even to 10 years ago. Some of them are as good as the multinational factory facilities. 15 years ago, when Nokia, Nortel, Cisco, Motorola were dominant in the telecommunication equipment industry, very few would ever think of that Huawei, a Chinese firm, would become a top player in the space and that the US government would classify the firm as a threat and block its products from entering into the US market. China manufacturing industry has successfully becoming very competitive and have been replacing multinationals in domestic market. If they do OEM today, it will be higher value added products. In recent years, protectionism has crept back and globalization has slowed, and may reverse in future. To stay competitive, Chinese firms have invested in advanced technology. China is way ahead of any emerging countries regarding investment in R&D and the achievement of technology development. The number of patents granted is second behind Japan and US (Chart 24). Chart 24: Number of patents granted

Source: Wind, Bin Yuan Capital

IP protection has always been a concern. China has recognized the importance of the IP protection to encourage innovation. IP protection started to become important to China’s domestic firms as they increased their own investment into technology and research. There are many cases in court related to IP abuses, as the filing of patents has increased significantly in the past 10 years (Chart 25). Chart 25: Changes in patents granted

Source: Wind, Bin Yuan Capital

Chart 26: Overseas M&A

Source: Wind, Bin Yuan Capital

In addition to investment in R&D, Chinese firms have started to purchase technology by acquiring foreign firms. In first quarter 2016, China firms have spent 70 billion USD in technology merger and acquisition which was unthinkable some years ago. (Chart 26)

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Profitability comparison High value added manufacturing has high profitability. Chart 27 and Chart 28 illustrate that lower end manufacturing has the lowest ROE and net income profit margin, while the high end manufacturers delivered higher ROE and higher profit margin. Those industrial stocks hold in the Bin Yuan’s strategies delivered highest profitability and will be our investment focus in the space. (The manufacturing sector consists of 1,900 stocks. High end manufacturing (partial) consists of 326 stocks (instrumentation manufacturing, electrical machinery and equipment and automotive manufacturing); Low-end manufacturing (partial) consists of 125 stocks (textile, chemical fiber, smelting and pressing of nonferrous metals); Bin Yuan's High-end manufacturing pick consists of 4 stocks.) Chart 27: Return on equity comparison

Source: Wind, Bin Yuan Capital

Chart 28: Net income margin comparison

Source: Wind, Bin Yuan Capital

Summary China has an old saying that favorable climatic, geographical and human conditions bring in good fortune. China was fortunate with all three when it started its economic reform in the 1980s -- a large supply of hard working cheap labor hungry for a better life (favorable human conditions), cheap land & cheap global commodities to build infrastructure (favorable geographical) and the government’s push for economic reform combined with globalization and outsourcing of production by developed economies (favorable climatic). As a result, the economy has enjoyed high speed of growth since then. The country has accumulated a substantial level of social wealth and built an advanced infrastructure that little developing countries can compare. Chinese economy has been transforming from population dividend to skilled labor dividend. The efficient system combined with skilled labor make Chinese economy still very competitive. For consumers, it will be a virtuous circle that more wealth has been built, the more they (particularly the young population) spend and invest. Industrial and service sectors have been supplemented each other to foster a healthy economic development. There are still many issues and challenges ahead including financial resource allocations, wealth redistributions and government roles in the economy, to name a few, but we should not be blinded by solvable short term problems and overlook the long term trend. We believe we could find long term investment opportunities in companies developing advanced technology and becoming globally competitive and a broad based service sector that provide high value added products to consumers.

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Bin Yuan Capital

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