Inner Circulation - China's New Growth Engine

"Inner Circulation" - New Engine Driving China's Economic Recovery

As the most important policy framework laid out in the 14th 5-year plan, the concept of “inner circulation” (內循環) has been highly anticipated to be the answer to China’s current economic dilemma.  While there is no official definition, it is generally referred to the circulation of purchasing power within China’s domestic consumption system. In general, “inner circulation” is mainly driven by:

1. return of high-end consumption from overseas retail market,
2. the rise of larger local brands, and
3. stable growth from consumer staples

China achieved rapid economic growth over the past decades via the “outer circulation” - by importing large amount of technology, natural/ human resources and foreign investment on the one hand, and exporting most of their factories’ finished products back to the overseas market on the other hand. However, this outer circulation has been clogged since 2019 due to:

1. the rise of de-globalisation and protectionism,
2. global recession (so lower demand for China’s export), and
3. US’s increasing restriction on exporting core technology/ funds to China

In fact, when we looked back at China’s economic development in the past few years, it is not difficult to spot that  inner circulation is not something new – it is largely an extension of China’s effort to switch from an export/ fixed-asset investment driven society into a domestic consumption-driven one. Despite a recent surge, China’s consumption as a percentage of GDP still stands at 39%, which is much lower than the US’s 70% and Japan’s 55% [1].

With ongoing uncertainty in COVID-19 development and the current traffic lockdown in the western world, the link between China’s “inner circulation” and the global “outer circulation” remains challenging in the near term. This makes the need to develop the inner circulation more imminently.

Circulation Should Not Be Restricted to Consumption Only

In our opinion, the concept of “inner circulation” should not be restricted to the consumption sector. We could also extend it to the capital market – not only does it represent the inner circulation and the multiplying effect of China’s banking system fund flow within the domestic financial system, but it also represents the return of China American Depositary Receipt (ADR) from the NASDAQ to the China’s stock market. Investment funds will stay and “circulate” in the onshore A share market, or at most in the Hong Kong market, to help increase China stock markets’ depth, width and liquidity.

Domestic Consumption and Technology R&D to Benefit

In terms of sector implication, accelerating inner circulation should directly benefit the high-end consumption industry as overseas shopping paradises are becoming less accessible to mainlanders, while price differences are narrowing with less taxes in mainland China. This reinforces our positive stand on China’s consumption sector.

As the import of core technology from US/ Europe becomes increasingly difficult, we expect more policy and funding support on the research and development (R&D) of domestic high tech industries. The recent successful listing of China’s largest semiconductor foundry in the A share market is a strong evidence of such government support. This trend should also benefit certain technology equipment manufacturers. However, technology companies which are heavily relying on imported core parts (e.g. CPU for mobile phone) will suffer in the near term, if they cannot yet find a local replacement.

China Economy: First-in-First-Out?

On the macro front, the V-shape recovery of China’s economy continues as key economic data (e.g. GDP, value-added services industry, fixed asset investment growth) rebound from the negative territory (see Diagram 1 and 2). While China’s Purchasing Manager’s Index is expected to stay expansionary in the near term, it has largely returned to pre-COVID level. However this momentum is set to slow. Serious flooding in Southern China and the second wave of COVID outbreak in certain cities have also caused temporary disruptions to economic activities, especially construction, which was a key driver to the economic rebound in Q2.

Hang Seng Tech Index - Hong Kong's Answer to a Nasdaq Style Tech-Oriented Index

In our previous issue, we mentioned that the importance of China ADR is escalating rapidly, as US-China political tensions heighten. As a key milestone, the Hang Seng TECH Index was finally launched by Hang Seng Indexes Company (HSIC) on 27 July 2020. This new index will be taken as Hong Kong’s answer to a NASDAQ style tech-oriented index, and will track the 30 largest technology companies by market cap that pass the screening criteria.

The new index was launched in view of the rapid blossoming of new businesses in the technology sector and the increasing number of technology companies that are listed in Hong Kong, as well as to meet the fast-growing interest in this investment theme among investors.

According to HSIC, IT-related companies accounted for 33.2% of Hong Kong market’s total market cap at end-June 2020, up from 14.6% at end-2017.  In terms of trading volume, this group of stocks represented 27.6% of the total in 1H20, surging from 16.3% in 2017.

The index universe covers Hong Kong-listed companies that have high business exposure to selected technology themes, including internet, fintech, cloud, e-commerce and digital activities. Eligible candidates are further screened by whether they operate via a technology-enabled platform, their research-and-development expenses-to-revenue ratio, revenue growth and liquidity. After this screening, the top 30 stocks in terms of market capitalisation will be selected as index constituents. (See Diagram 3)

Fast-Entry Mechanism to Cater for the Upcoming China Unicornipo

The index will be reviewed on a quarterly basis with a weighting cap of 8% for an individual stock. There is an IPO fast-entry mechanism – an IPO stock will be added to the index if its market cap ranks among the Top 10 of the existing constituents at the market close of its first trading day. The addition will normally be implemented after the close of the 10th trading day of the new issue. For secondary listing stocks, only the tradable portion in Hong Kong will be counted in free float-adjusted market cap.

Strong Return Likely to Draw Investors' Attention

The Hang Seng TECH Index recorded a return of 36% in 2019 and 46% in YTD 2020, according to back-testing data from Hang Seng Indexes Company Limited. It significantly outperformed the Hang Seng Index (HSI), which posted a return of 11% in 2019 and a loss of 2% in YTD 2020. (See Diagram 4).

HSIC is positioning the index in line with the level of the Hang Seng Index (HSI) and Hang Seng China Enterprises Index (HSCEI) which are its two most successful index products. We believe the new index should follow the path of HSI and HSCEI in winning market acceptance, i.e. gradually supported by ETFs and derivative products (e.g. index futures and options).

We take the move as positive for Hong Kong equity market liquidity and fund flows in general, as a potential Hang Seng Tech Index-based ETF and other fund launches will trigger positive fund flows into constituent stocks. Moreover, under the current Mutual Recognition of Fund Scheme between mainland China and Hong Kong, onshore investors will be able to invest in tech Index-linked fund products once they become available.  As a gauge, the existing total AUM benchmarked against HSI and HSCEI Index is US$19.6bn/$5.4bn respectively [2].

Healthy Consolidation in Tech Sector Represents Good Re-entry Opportunity

As we expect more ADR secondary listings to take place, and more unicorn tech company IPOs in Hong Kong, the Hang Seng TECH Index‘s comprehensiveness in terms of providing a holistic leading technology-based company equity index is likely to improve over time. This will provide a positive feedback loop, thus reinforcing our long-term positive view on China’s tech sector. However, with the recent strong run in China technology sector, the official launch of Hang Seng TECH Index seems to have marked the near-term peak. We continue to expect a healthy consolidation in the sector, but long-term investors should regard this as a good re-entry opportunity.

[1] Source: Bloomberg as of end 2019

[2] Source: Factset, Datastream, Hang Seng Indexes Company, Morgan Stanley Research. Data as of July 20, 2020

The above charts are for reference only and does not represent current or future performance.