Asia's Economic Rebound: Sustainable and Deepening
Ivy Funds

August 2009

Frederick Jiang
Portfolio Manager, CFA
Ivy Pacific Opportunities Fund

Several successful initial public offerings (IPOs) in China have captured global attention and raised questions about whether the world’s third largest economy and its equity market may be beginning to overheat. While Chinese government officials are sending out signals that they want lenders to be more cautious amid boom-like stock market conditions, we see signs of a broad and sustainable economic recovery not only in China, but in Taiwan, Singapore and South Korea.

High IPO demand from domestic Chinese investors

We attribute late July’s investor euphoria over IPOs such as China State Construction Engineering (CSCE) to the very high level of liquidity present in the domestic Chinese equity market, the A share market. The company is one of the largest public works managers in China, employing 122,000 professionals such as engineers, planners and architects, with interests in housing and commercial property development.

Shares of China State Construction were offered only to domestic Chinese investors on July 29 and they were embraced with an enthusiasm that has become typical of the Shanghai equity market, where share trading volume on July 29 eclipsed the combined trading volume of the U.S., London and Tokyo stocks markets. Individual investors drive the Shanghai market to a much larger degree than the U.S., where trading is dominated by institutional investors.

The CSCE IPO drew 1.85 trillion yuan in trading orders (about $275 billion), a more than 35-fold oversubscription (Ivy Pacific Opportunities Fund did not participate). That’s more than the stock market capitalization of Norway, Russia and several dozen advanced and developing nations. China State Construction was the world’s biggest initial public offering in 16 months, and entirely domestically financed. Foreign investors in China such as U.S. mutual funds can only participate in Chinese IPOs on the H share market, whose shares are traded in Hong Kong.

The changing shape of growth

Rather than see high domestic Chinese investor demand as a sign of a “bubble,” we see it as

• a healthy confirmation of the increased wealth and power of China’s emerging middle class
• a sign of public confidence in future economic growth and employment prospects
• the continuing development of a broad-based and sustainable equity culture.

In fact, in one week in mid-July, more than 550,000 new equity trading accounts were opened in China (Source: Financial Times). To put that figure in perspective, that’s approximately seven times the total number of shareholder accounts of Ivy Pacific Opportunities Fund.

What we are seeing across China and much of Asia is that the shape of growth is shifting. In just the past few weeks, economic indicators reported in Taiwan, Singapore and South Korea suggest that the second quarter was better than expected and that export demand is recovering, driven largely by consumers in China as well as other developing markets. Within China itself, the recovery has had a distinct V-shape. Taiwan, for example, is benefiting from increased economic ties to mainland China. These measures include permitting Chinese investors to take ownership stakes in Taiwanese businesses, direct aviation links and increased shipping traffic between the two countries.

Smaller cities enjoying stimulus benefits

To benefit from China’s apparent resurgence and shift from export growth to self-financed infrastructure and consumer spending, we have maintained a diverse mix of Chinese companies.

We are especially optimistic about consumer, infrastructure and 3G (third generation) telecom growth in China’s smaller Tier 3 and Tier 4 cities (defined as areas of 2 to 4 million people; by comparison the Chicago metro area has 2.8 million people). The housing market in these areas appears healthy, buoyed by a successful government stimulus plan that’s been ongoing since November.

We expect more A and H share market IPOs to come to market in China in the coming months, including an oil company, construction companies and property developers. Recently, we participated in the H share market public offering in Hong Kong for Beijing Building Materials Group Co., Ltd. (BBMG), the largest cement maker in the Beijing area (BBMG was a holding at one time, but subsequently sold from the portfolio). BBMG also develops commercial property in the Beijing-Bohai Gulf region and says it is using the IPO proceeds to double cement-making capacity to 30 million tons in 2010.

In the coming months, we believe China’s GDP (gross domestic product) growth will remain fundamentally strong and not overheat. In fact, based on what we learned during a three-week trip we took across China in June, we would not be surprised if the Chinese economy continues to provide positive surprises as government officials act to reign in excessive speculation. China’s central bank said July 29 it will use market tools to control lending growth and affirmed a “moderately loose” monetary policy to support the nation’s economic recovery. Recently, China Construction Bank Corp and Industrial & Commercial Bank of China (ICBC), the nation’s two largest banks by assets, say they will cap second-half new lending at about 200 billion yuan each. ( ICBC represented 3.2% of the Fund’s net assets as of June 30, 2009.)

India still a growth star, too

During the past quarter, we were fortunate to have had an approximate 9 percent allocation to Indian stocks ahead of India’s election this spring, and this benefited our quarterly results. We believe that over the long term that the Congress party victory in India bodes well for infrastructure investment and free market reforms. India is less dependent on trade than most of Asia, and although it faces huge budget challenges, we think domestic demand growth is likely to remain strong over the long term.

Outlook

If current growth trends continue, within a year the size of China’s economy will eclipse that of Japan, which is currently suffering a severe recession. Compared to developed markets, we think Asia will continue to benefit from a rate of high savings and relatively low levels of consumer, corporate and government debt. Many Asian countries other than Japan also enjoy favorable demographic trends that should help fuel continued growth. Unlike most Western governments, China does not need to borrow to spend money on programs aimed at rekindling growth, and China appears to be using its ample resources to its advantage. This includes increasingly using its global financial clout to convince commodity trading partners to use the RMB as a currency in trade, replacing the U.S. dollar.

Past performance is not a guarantee of future results. The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 31, 2009, and are subject to change due to market conditions or other factors. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. The fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. As indicated, the Fund may purchase securities of companies in initial public offerings (IPOs) or shortly thereafter. The prices of securities purchased in IPOs can be very volatile. The effect of IPOs on the Fund’s performance depends on a variety of factors, including the number of IPOs the fund invests in relative to the size of the fund and whether and to what extent a security purchased in an IPO appreciates or depreciates in value. As the Fund’s asset base increases, IPOs often have a diminished effect on the Fund’s performance. These and other risks are more fully describe in the fund’s prospectus.

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