Investment Newsletter The Dragon Code Q2 2015

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1 Investment Newsletter The Dragon Code Q2 2015

2 Meet our investment professional Mike Shiao hief Investment Officer, Invesco Hong Kong Biography Mike Shiao is responsible for managing the Greater China (China, Hong Kong and Taiwan) equity portfolios at lnvesco Hong Kong. He was previously the Head of Equities for lnvesco Taiwan Ltd, where he was responsible for the Taiwan equity team and for managing a Taiwan domiciled unit trust. Mike received his Bachelor's degree from National Chung Hsing University and his Master of Science in Finance degree from Drexel University. Q What is your view on the 'Mutual Recognition of Funds'? On 22 May, the China Securities Regulatory Commission (CSRC) and the Securities and Futures Commission in Hong Kong announced the Mainland-Hong Kong Mutual Recognition of Funds (MRF) initiative, effective on 1 July bout 100 Hong Kong -domiciled funds and 850 mainland funds are eligible to be sold in each others markets 1, subject to initial quotas for flows both ways of Rmb300bn (calculated on a net purchase basis). The MRF is clearly a major breakthrough in the opening up of China's capital account and Renminbi internationalization. This is also a confirmation of Hong Kong's status as a key financial hub and gatekeeper for China's in- and out- capital flows. In our view, the MRF will be favourable for the Hong Kong market as this scheme provides another channel for the cash-rich mainland investors to diversify their assets away from shares.we believe the liquidity impact would be more significant for Hong Kong funds because of their smaller size relative to their onshore peers. Despite MRF being a major milestone, we do not expect a dramatic increase in liquidity flows initially, considering the quota, the size of the eligible equity universe, the size of the mutual fund industry and market cap. The scope of the scheme will likely expand over time. Q What is happening with the Shanqhai-Hong Kong Stock Co ect? In pril, we saw strong interest in H-shares coming from the mainland China investors, who were using the southbound quota of Shanghai-Hong Kong Stock Connect. One catalyst for the rally in H-shares was a decision by China regulators back in March to allow Chinese mutual-fund managers to direct buy H-shares through Stock Connect. For the first time since its launch in November, we saw the daily quota limit triggered. There was discussion on raising the quota by over 30% to accommodate heavy capital flows. What is also encouraging is that China reached a tax agreement with Hong Kong in early pril to eliminate any tax on capital gains from the sales of mainland shares by Hong Kong domiciled investors. With quotas likely being lifted and tax matters clarified, flows to and from China via the connect channel are certain to gain more interest. Q Will the recent relaxation of mortgage restrictions and property taxes in China boost the property market? In March, the government authorities had a joint announcement to relax mortgage restrictions by lowering down payment restrictions that were tightened in an effort to cool down the overheating property market. t the same time, the Ministry of Finance announced a transaction tax waiver for homeowner properties held for more than two years prior to selling, down from the five-year requirement set before. This will shorten the required time to hold a property before selling. Despite the boosting efforts, in our view, it all comes down to supply and demand. Looking at the long-term population trend, population between years old- the prime age group for housing demand- will decline 9% by 2020 from the peak in Despite the government using variety of tactics to shore up the property market, we believe the property oversupply situation in China will persist in Estimated by CSRC and SFC, as at Mar 2015 (eligible China shares funds) and as at Dec 2014 (eligible hk domiciled funds) Source: Goldman Sachs May 25, The Peoples Bank of China (PBOC), Ministry of Housing and Urban Rural Development (MOHURD) and China Banking Regulatory Commission (CBRD) This document contains general information only. It is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. There is no guarantee that the securities mentioned above are currently held or will be held by Invesco funds in the future. It does not represent a recommendation to buy/hold/sell the

3 China s Local Government Financing Vehicles Debt Swaps Well on track The Chinese government has introduced a massive debt swap program that addresses the local government liabilities. This could fundamentally alleviate investors' concerns about the Chinese financial systems in the recent years. Shortly after the release of Document No 43, China's Ministry of Finance (MoF) issued a RMB 1 trillion quota for local governments to convert local government financing vehicles (LGFV) debts into lower-yielding municipal notes. Further, the government also revealed full details of the debt swaps as well as a deadline to complete them. The bottom line is, we believe this is a proof that China is on track with the local government reforms. Origin of LGFVs The origin of LGFVs can be traced back to 1994, when the Chinese government prohibited local governments from issuing bonds or borrowing directly from banks. This led to the creation of LGFVs as off-balance sheet sources of funding for local government projects, although the scale was not massive at all. In recent years, the situation further magnified, and resulted in more than 10,000 LGFVs being created following China's enormous stimulus package in The spending on big projects, with poor collateral and overstated cash-flow estimates led to a mismatch of assets and liabilities. No. 43 shows commitment Document No. 43 was a circular that was released by State Council in October 2014 to tackle the root cause of LGFVs, by increasing greater transparency in the local government liabilities structure. ccording to the document, from 2016 and beyond, all government funded projects will need to be financed by municipal bonds issued by provincial governments, and no longer through LGFVs or other means. The debt raised by local governments would also be included in fiscal budgetary planning. The central government made it clear a quota on local government debt would be set, limiting any excessive investment in the future. With greater accountability and transparency, we believe these measures limit the future build-up of unnecessary debt. Introduction of debt swaps In a matter of months, the government has revealed how No. 43 will be implemented. Local governments will be able to issue RMB 1 trillion in municipal bonds to be swapped with existing LGFV debt maturing this year. This swap arrangement represents 54% of the amount of local government debt due to mature this year (RMB 1.9 trillion). The government has made it clear that these bonds should be purchased by the banks that made loans to the LGFVs as part of a swap. Moreover, RMB 600 billion in new bond issuance was approved for infrastructure projects and financing purposes. This means that instead of LGFV loans on banks' books, local governments will have the same amount in municipal bonds. This is essentially a transfer of off-balance sheet debt into more formal fiscal liabilities The 53.8% ratio is used when distributing 1 trillion amongst local governments. 1 trillion will cover maturing 'direct debits' (e.g. LGFV bank loans) and be swapped into longer tem muni bonds (e.g. 5-7 yr with 4% rate). This document contains general information only. It is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. There is no guarantee that the securities mentioned above are currently held or will be held by Invesco funds in the future. It does not represent a recommendation to buy/hold/sell the

4 Greater transparency Compared to the past, funding practices of local governments will see a marked improvement in accountability and transparency as LGFV loans are replaced with government backed bonds. They will also benefit from better financing due to lower rates, longer debt durations and higher credit rating compared to LGFV loans. With lower financing costs and longer repayment schedules, with the possibility of being able to roll over the bond, the local governments will have greater flexibility in repaying their existing debt. By migrating to more formal financing channels, municipal bonds will be officially included in broader government debt-to-gdp ratios, giving market participants greater transparency to China's true debt profile. In addition, the asset-liability mismatch of the past will improve dramatically as municipal bonds take the place of LGFV debt. Lower bank credit risks and manageable NPL From the banks' perspective, potential non-performing loans (NPL) associated with LGFV debt will decrease, resulting in a large reduction in bank credit risk. s such, NPLs will be under control and manageable. The lower risk-weighting attached to municipal bonds also means the required reserves for the banks will decline given the lower default risk associated with government bonds compared to LGFV loans. While the sharp decrease in credit risk for banks is certainly positive, the trade-off of having lower-yielding municipal bonds is weaker bank margins. There are also other factors that will work against bank profits. Interest rate liberalization may be positive for banks in the long-term, but in the short-term, competition among banks will increase with the liberalization. s a result, net interest margins (NIM) will likely shrink. Moreover, the economic slowdown will weigh on loan growth as demand slows. Recent financial reform efforts certainly show the Chinese government is committed to cleaning up the shadow banking system and local government financing vehicles. However, the near-term earnings risks are still too high to be bullish on banks despite the positive longer-term benefits of financial reform. Conclusion We have already seen a strong commitment on the "game changing" initiative towards LGFVs. In particular, the unveiling of No. 43 and its implementation via the LGFV debt swaps are China's first steps in addressing financial system vulnerabilities. In fact, financial system risk has been one of the key concerns among foreign investors for years. We believe the introduction of the debt swap should help alleviate investor worries and thus, reducing risk in the banking sector. With banks making up a quarter of the MSCI China index, the reduction in financial system risk is undoubtedly positive for Chinese equities looking ahead. This document contains general information only. It is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. There is no guarantee that the securities mentioned above are currently held or will be held by Invesco funds in the future. It does not represent a recommendation to buy/hold/sell the

5 IMPORTNT INFORMTION on current market conditions, are subject to change and may differ from other Invesco investment professionals. ll data are sourced from Invesco dated 09 June 2015 unless otherwise stated. This document contains general information only. It is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. Nor does this constitute a recommen-dation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. DC15Q (P 565) Investment involves risks. Past performance is not indicative of future performance. The opinions expressed are based on current market conditions, are subject to change and may differ from other Invesco investment professionals. This document contains general information only. It is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. There is no guarantee that the securities mentioned above are currently held or will be held by Invesco funds in the future. It does not represent a recommendation to buy/hold/sell the

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