Consolidation in China's funds industry is imminent as slower economic growth is certain to erode profits, argues Henry Zhao Xuejun, Beijing-based CEO at Harvest Fund Management, one of China’s oldest fund-management companies

Zhao, one of the most experienced executives in China’s 13-year-old mutual-funds business, says that two things have changed recently.

First, the Communist Party’s latest five-year plan stresses the need for slower economic growth. Although this is not the first time there has been a call for slower growth – such as in the immediate wake of the 2008 financial crisis – the momentum of such a fast-paced society has meant that GDP growth had continued to accelerate.

This time, however, the economy has grown too large to avoid an actual deceleration, and its export-driven model has reached the limits of growth. That means GDP growth is likely to fall to 7-8% for the next year or so. More importantly, the pattern of growth is changing.

Over the long haul, this should be good for financial services, because it is meant to boost the spending power of China’s populace, but in the short term the transition is likely to be painful, as it will involve the past decade’s expansionary monetary and fiscal policies switching to tightening mode.

For fund-management companies, that means profits are going to suffer, at least for the short term. Corporate earnings for listed companies will decline, and growth in price-to-earnings and other valuation metrics will slow.

That’s troubling, given that China’s stock market is already a laggard, says Zhou. He notes that, over the past 10 years, China’s stock markets enjoyed an annual increase of 10% in value, versus 16% for global emerging markets. A slower economy means less liquidity, and lower expected returns on equities.

“The mutual-funds business or asset-management business in China is going to face a hard time for the next five years,” Zhao says, because if investment returns decline, investors will pull back – but at a time when the market sees more entrants and steeper competition. The industry’s total AUM declined by Rmb100 billion in the first six months of 2011, to Rmb2.3 trillion ($356 billion).

“Already, revenue is not growing, and AUM is not growing, but costs are higher,” Zhao says.

This situation will probably result in consolidation. For established brands such as Harvest, this may not be bad news, because Zhao expects assets to concentrate among the top five to10 players. It may also prompt regulators to give the industry more breathing space, such as smoothing new product approvals, opening alternative investment products or funds of funds to mutual-fund companies, or allowing key staff to own shares in the business.

But this is speculative, as the China Securities Regulatory Commission has not indicated any specific plans for such measures.

In the meantime, Chinese fund houses must take steps to prepare for leaner times. For Harvest, its Hong Kong subsidiary, Harvest Global Investments, is a key tactic to help it become a regional business, provided Beijing authorities allow the so-called ‘mini-QFII’ business to open. HGI is also developing alternative investment products, to broaden the firm’s expertise.

It is also keen to introduce more overseas investment products for the qualified domestic institutional investor (QDII) scheme, particularly for other, higher-return emerging markets. Zhao says demand from domestic investors for international exposure will be revived over time, although he acknowledges that expectations of an always-rising renminbi is a hurdle that needs to be overcome.

This is a big issue that will eventually be addressed. Zhao believes it is in the government’s interest to reduce its dependence on its dollar holdings, and to ultimately encourage households to diversify their assets globally.

But more immediately, the industry needs to convince its existing clients that mutual funds can add value.

The mediocre market and a tendency for retail investors to ‘buy high and sell low’ has meant most investors have lost money over the past two years. Ultimately, the industry needs to continue its efforts at client education while creating more products with lower volatility and more reliable returns.