China’s Tax Reform Sends Mixed Messages

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China has implemented across the board tax reforms aimed at alleviating the huge income disparity between state owned enterprises and those not connected to them by increasing their dividend payments to the state by 5% by 2015. While anything to lessen the power of SOE’s in the economy is generally a good plan economically, this aspect of the plan seems a timid first step in the direction of opening up China’s still very much command and control economy. What is more interesting is the proposal to liberalize interest rates on savings and allow a more market oriented approach.

The details of the approach have not been made clear, but anything that improves the flow of information through the banking sector is a welcome change in China. In the West this is being hailed as an income leveling package, a typical ‘soak-the-rich’ scheme all the rage in the U.S. and Europe in the aftermath of the bailouts of the financial system and the advent of too big to fail banks and their too big to jail executives. But, in reality moving some of the profits from the SOE’s to the central government is no guaranteed recipe for income redistribution. It is just altering who gets to pick who wins and who loses from the profits generated by China’s economically-sheltered class.

This is not SOE reform of the kind that is being resisted in my home country of Vietnam, where the debts of major SOE’s like EVN, Vinashin Lines and the contagion of the banks that lent them the money dwarf the ability of the economy to rationally deal with them. This is more similar to what goes on in Malaysia when the sitting government wants to curry favor with the electorate by raising the tariffs paid by state oil giant Petronas to pay for public works projects.

China’s state owned refiners were just granted a boon with the liberalizing of the pricing mechanism for fuels. Firms like Sinopec (NYSE: SNP) and CNPC have been racking up huge refining losses due to the government’s unwillingness to allow the price of diesel and gasoline to rise and fall with oil prices. Now that there is hope that those firms will be able to more properly operate their businesses without government support any profit they generate will be taxed at a higher rate.

The rest of the plan is typical Western mixed economic theory, which includes higher minimum wages and incentives to invest in assets. These moves will raise the price of rural labor above their market wage and replicate the same problems endemic to the West, a permanent sub-culture of low-skilled, permanently unemployed people. Lower paying jobs will migrate around Southeast Asia towards places like Vietnam, Cambodia and now Myanmar, and the rural poor these policies are designed to help will fall far short of their intended goals.

The income gap between rich and poor in China is a function of the same types of policies that have created income inequality in the West: too many controls on fundamentally important industries like energy production and banking and a patchwork of reactionary policies that attempt to fix the problems created by these conditions in the first place. Moreover, discussions have been held on implementing property taxes and a classic progressive income tax, both of which have seen staunch opposition, which is a good thing. But, with a GINI index of 0.47 China is in a state where the potential for civil unrest is high and a placating of the lower classes will have to take place.

Instituting a progressive income tax, while completely in keeping with Marxian economics, would be the wrong approach as all tax increases are regressive at the margin and will only exacerbate the problem by retarding savings growth for low income workers.

These changes will begin a structural shift in the Chinese economy, which will stop blowing bubbles in infrastructure spending and real estate development and start blowing them in financial assets and consumer goods items. But, these changes, especially to interest rates on savings will improve the capital structure of China’s banks as growth will be fueled by a higher savings rate rather than central bank rate manipulations and central government infrastructure spending. For this reason, I like playing the traditional insurance business as a long-term mechanism to play China.

I like AIA Group for its exposure to China and growth – volume of new business rose 24.8% year over year across the region. It is the major component of the iShares MCSI Hong Kong ETF (NYSEMKT: EWH) at 14.6% of AUM. Net earnings nearly doubled in 2012, and the best growth was seen in the relatively mature markets of Singapore, Malaysia and Thailand, meaning it was pulling market share in the process. I would be wary of the general Shanghai Index at this point and focus on income generation plays.

As the yuan becomes more important as a regional trading currency, the Dim Sum Bond market will continue to mature. The PowerShares Chinese Yuan Dim Sum Bond EF (NYSEMKT: DSUM) is yielding 3.1% currently and has rallied nicely with the rise in value of the yuan since September of 2012. The fund has seen $50.7 million in AUM flow in, a 400% increase in AUM over that time. China is managing the rate of ascent versus the U.S. dollar by buying U.S. treasury bonds again. The latest T.I.C. Report makes this clear. This new set of policies is designed to change China’s economy from an export-driven one to a domestic demand-driven one while it exports any inflation via a strong yuan to its regional trade partners. This will make yuan-denominated corporate bonds a very strong growth market in the years to come.


Peter Pham has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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