China's Reforms Boost Stocks; South Korea's Plan Falters

Key Takeaway

• China's SOE reforms, including performance metrics and anti-corruption measures, are driving investor confidence and boosting stock prices.
• South Korea's corporate value-up plan lacks strong incentives, with limited company participation and uncertain political support for tax cuts.
• European companies are reducing dependence on China, shifting sourcing to India, Bangladesh, and Vietnam despite higher costs.

Value Traps in China and South Korea

China and South Korea, both known for their manufacturing prowess and educated workforces, are currently facing challenges in their financial markets, which are showing signs of becoming value traps. This situation has prompted both governments to take measures aimed at improving market valuations.

In China, the government has adjusted the performance evaluation methods for its largest state-owned enterprises (SOEs) to include metrics such as return on equity. Senior management is now being assessed based on stock market performance. As of the end of 2023, government-controlled firms accounted for about half of the total market capitalization. Beijing's approach includes both incentives and penalties, with company bosses motivated by career concerns and the fear of President Xi Jinping’s anti-corruption campaign. This has led to a positive response from investors, who are buying into the reform story, thereby driving SOE stocks higher.

In South Korea, President Yoon Suk Yeol’s administration has introduced a corporate value-up plan to address the "Korea Discount," where the Kospi Index trades below book value. The plan includes naming and shaming firms that do not prioritize shareholder returns. The Korea Value-Up Index, set to be introduced in the third quarter, is inspired by Tokyo’s successful "shame index." However, Seoul’s program lacks the strong incentives and penalties seen in China. For instance, a website launched by the stock exchange on May 25 to encourage voluntary company disclosures on plans to boost shareholder returns saw participation from only three companies.

Macro Headwinds and Market Reactions

Global asset managers, wary of geopolitical tensions between China and the US, are looking for new investment destinations. South Korea is seen as a viable alternative, given that Japan is already a crowded market. However, the effectiveness of South Korea's value-up program remains in question. The ruling party has discussed cutting the inheritance tax, which could be a significant incentive for the chaebol, but cooperation from the liberal opposition party, which holds a parliamentary majority, is uncertain.

In contrast, China’s SOE value-up program appears more robust. The combination of incentives and penalties has led to improved operating metrics and a rally in SOE stocks. This has created a positive feedback loop, encouraging further improvements. "Investors are actually buying the reform story this year, sending SOE stocks higher," the source noted, highlighting the effectiveness of China’s approach.

European Companies Decoupling from China

European companies are increasingly seeking to reduce their dependence on China, driven by heightened scrutiny from Brussels on Chinese goods. Richard Laub, CEO of Dragon Sourcing, noted that European countries are catching up with the US in this trend. "The big trend right now is for companies to reduce their dependence on China," Laub said. This shift is particularly evident in non-food retail industries, where companies are looking for alternatives to Chinese suppliers.

William Fung, deputy chair of Fung Group, emphasized the global nature of this push. "Customers are saying that, I don’t care what you do William, just get me to 30 per cent outside of China, and sometimes even more," he said. Naveen Jha, who runs a clothing and textiles sourcing business in China, observed that European businesses are increasingly sourcing garments from India, Bangladesh, and Vietnam, despite higher costs and longer lead times.

Analysts caution that this push to de-risk is unlikely to severely impact China’s overall exports. Increased shipments to Chinese-built factories in alternative manufacturing hubs like Vietnam and Mexico, along with the competitiveness of domestically produced goods, are mitigating factors. "So far we’re seeing more of a musical chair type scenario," said Maersk CEO Vincent Clerc, indicating that while the destinations of Chinese goods may change, the volume remains consistent.