Leave it to the mainstream media, from CNBC to Newsweek, to hammer a particular investment theme when it’s all a bit too late. As they became enthused with the “Tiger Miracle” of the late 1980s, just before the collapse, and as cover stories raged about technology investment, just before it took an 80% haircut, now China is all the rage. You can’t escape it. Intuitively it may even make “sense”. After all the demographics are on your side.
The bells of joy regarding China have been ringing for the last three to five years, to the point that one wonders, is this the modern day El Dorado? Will Chinese growth ever slow down? Should I not be investing in what is being billed as the “next economic superpower”? Everything ranging from booming oil prices to the collapsing prices of electronics is being linked to the perma-growth story that is China.
It is true that China’s usage of oil has been a factor, and that its mega capacity in all things electronic coupled with its low cost of production has made it an economic engine to be reckoned with. As the Bank of China gives lip service to calls for openness, it has continued to amass colossal reserves making it one of the top global funders. Its share, for instance of US Treasury bond holdings has been whispered to be around 22% of all outstanding debt. This basically means that it has one of the largest claims on the US Dollar assets in the world, and it has become a key player in the global currency casino. So in many respects, China has earned itself a role of money broker to the global financial system, and has a firm grip on the market for goods. It has also made baby steps toward a more liberalized banking system. All this has been happening for nearly a decade, but the proverbial “party” is over for the time being, at least when it comes to China as an investment option.
China’s entry into the WTO in 2001, increased the trade boost engendered by the opening up of China as a production powerhouse and flooded global markets with cheap Chinese goods, all the while maintaining its position as one of the world’s top two destination for foreign direct investment (FDI), adding, according to the US State Department, $64.0 billion for a cumulative total of $563.8 billion through the end of 2004.
This situation has created, not only a flood of dollars, but also a GDP growth rate, which has averaged an eye-popping 9% over the last few years. This has not only been the result of the massive influx of direct investment, but also the because of the amassment of a large surplus with the US, its main trading partner. This appears to be a relatively unsustainable position, as it has created a protectionist drive in the US, and to a lesser extent in Europe, aimed at correcting this imbalance and pushing the Chinese to moderate their competitive edge.
Most recently, there have been loud calls for China to reevaluate its currency, the Yuan, which has been pegged to the Dollar for decades and which is thought to give China an unfair advantage, as it is accumulating a large amount of $ reserves, and in counterpart, glutting many electronics and even car production markets. So to a large extent, the road to Chinese economic dominance is paved with an unfair advantage, that of an artificially maintained exchange rate.
In a developed world where 9% usually refers to unemployment rates, especially in Europe, China has awakened the speculative juices in most players and observers, large and small. However, the path to liberal and open system, is paved with uncertainty. So while the future of China as a powerhouse is not in question, we must remember that China is a one party dictatorship, that the gap between rich and poor has grown immensely, and last but not least, one of the pillars of its growth, in my opinion, the currency peg to the US Dollar, is in its final gasps of air. Soon, China will remind the over anxious, that it succumbs to the laws of economic cyclicality and that its opaque social and political system will need to be reformed, for it to truly embark on sustainable development.
Take advantage of China by buying cheap LCD televisions, but be very careful when you are pondering an investment. Lured by the hype, you will surely get bulldozed. For one, I have included a chart of the China Fund, a US traded proxy for Chinese companies. Obviously, and since a picture is worth a thousand words, one can see that the time to be positive on China was just before the turn of the century…As the Chinese stocks topped and rolled over, the media, and so called “analysts” have continued to aggressively promote investing in China. The results, much like those of internet stock buy ratings in 99, would have been awful.
As the China fever picks up steam all around, and is seen as a “must own” by many portfolio managers and speculators, the pressure is on to get in on the action.
Henry Blodget, a pillar of the high tech bubble and ex star-analyst at Merrill Lynch, is adamant that China is not the place to be, especially for the individual investor. Since A Shares, which trade in local currency are not open to foreigners, investors are left with broadly two realistic choices to take advantage of the China story. Obviously, becoming a Qualified Foreign Institutional Investor, which facilitates transactions in local shares and ventures is a cumbersome affair reserved mainly for large institutions and requires a hefty $10 billion to set up.
The first option is to look at proxy markets which can be expected to benefit from the Chinese economy. Hong Kong stocks have had a good record at mimicking the state of affairs in China, but they tend to be extremely closely correlated to US markets as well, so in that sense, they are not purely a bet on China. But at least, Hong Kong has tougher listing requirements and thus tends to get better quality companies than Shanghai and Shenzen. As recent headline calamities confirmed, there are a lot of fundamentally weak companies or even shell companies in the local market that have caused local players serious heartache, leaving thousands with unrecoverable losses.
The second option is to look at Chinese companies, which have listed in the US, in the form of an ADR (American Depository Receipt). The caveat here, according to Mr. Blodget is that these are companies that have contracts in China but tend to be offshore entities, and this causes two problems: 1) if governance is not tight enough, the profits and losses may not be clearly reflected in the companies’ financial statements, 2) due to the companies’ structures, there may be a significant time lag in the flow of information. Within this option, there are also several country funds (see chart). While this may be, on the surface, the least risky way to go, its performance has been worrying of late, and the reporting suffers from the opaqueness of China’s overall compliance laissez-faire.
So as China roars on toward becoming the world’s largest trade partner, there is, as Blodget put it a China paradox, since as “the economy is screaming along, China’s domestic markets are sucking wind—and have been for years”. One would not gather this fact from reading the headlines and raving articles penned on China. It seems lately that most media has focused on China as a new frontier for easy money. It tends to back this claim with the notion that one billion people are laboring hard to become rich, simultaneously. But the truth is far from clear, even on this point, as mainland rural China is stuck in low growth-low employment cycle, and China’s new billionaires, have built their fortune on cheap labor. From that perspective, China appears like more a booming emerging market, than a prospective member of the G8. And while it is difficult to see any speeding up of the democratic process, there will be no change in the perception that China is a treacherous place to do business.
The pivotal point in China’ prospects is how it manages to control its growth rate in order not to jeopardize the safety of the banking system. Periods of hyper growth, such as the last decade, has lead to relatively relaxed credit policies from banks, which could well come back to haunt them should the economy turn sour. It is estimated that non performing (bad) loans are on the rise in China and that the country would need to maintain a very high GDP growth rate in order to avoid a full blown banking crisis.
Markets in general tend to be a discounting mechanism, i.e. they incorporate expectations, well before these expectations become reality. As such, we can see that the real smart money “excitement” over China began nearly six years ago, as early movers saw the boom from trade that China would reap. Of course, individual investors cannot time their moves perfectly, but what is worrying for someone looking at entering now, is that a near perfect peak or top of sorts seems to be in place sine 2003 (see chart). This is quite relevant since it shows that China, as an investment is diverging wildly from China as a macroeconomic story.
The fact that China now has a massive surplus vis a vis the US and Europe means that there will be pressures from all sides to cool off China’s growth. This scrutiny will likely cause more loosening of the currency peg, and more protectionist measures, in areas such as textiles and electronic goods. If one is very eager to benefit from the long term trajectory of the Chinese economy, my guess/estimate is that the safest way is to invest in US and European companies that are increasing their presence in China. The first ones that come to mind are Motorola in the goods arena, and Union Bank of Switzerland in services.
As it stands, India appears to be the next China, but we’ll leave that to a future piece.
