The pros and cons of investing in China

In a world where it’s hard to find attractive investments, China has suddenly appeared on my radar screen.

After an appalling 2008 which saw that nation’s index of A shares fall 61% in dollar terms, the Chinese bourses have made a cracking start to 2009. This week the CBN 600 benchmark index was up nearly 24% for the year-to-date.

Some analysts now suggest that the Chinese economy, the third largest, could be the best thing to happen to the global economy this year, with growth perhaps reaching Beijing’s target of 8%.

The positives supporting that optimism include:

• An economic recovery plan that is bigger, being implemented faster and is better focused than America’s – a fiscal stimulus equivalent to 7% of the economy over the next two years, compared to 3% for the US.

• New bank lending is soaring following the scrapping of credit quotas and government pressure to finance building of infrastructure – up by the equivalent of $120 billion or more in January alone.

• Consumer spending remains remarkably resilient – retail sales in December were up 19% on year-before levels. The burdens of personal debt that weigh down the American and British economies are absent in China.

• Power consumption is rising again and residential property sales volumes are picking up, helped by lower mortgage rates for first-time buyers.

• Two major problems of the recent past – inflation and an avalanche of speculative capital from abroad – have disappeared.

• Massive resources are available to stimulate domestic demand to offset shrinking exports, without the high risks and uncomfortable choices of other major economies – China has $2 trillion in foreign reserves and one of the world’s highest savings ratios.

• It is still largely a command economy in the hands of highly-trained technocrats who can rapidly and forcefully implement policies to counter the impact of the global crisis. They can act with far fewer of the foot-dragging effects of political consensus-seeking and pandering to special interests found in the West and Japan.

Nevertheless, the extent of the collapse in Chinese equity values last year delivered a painful lesson for those who believed that Asia would ‘decouple’, or largely escape, the economic consequences of the global credit crisis.

The amazing boom in China’s economy, although deriving its strength from many factors, was based on an export-driven industrial revolution. Last year it became clear that the glorious years of globalisation were coming to an end, that China’s exporters were going to face really tough times. Investors panicked, asset prices collapsed.

Those who suspect that the recent strength in Chinese shares is just a rally in a bear market that will soon resume, suggest the following negatives:

• The agony being experienced in the export sector, which has seen many thousands of enterprises bankrupted and 20 million rural migrant workers lose their jobs, has only just begun.

A decade ago, exports accounted for about 20% of China’s economy; today they are twice as important.

David Roche of the respected Independent Strategy investment consultancy warns: “In 2009, China’s exports could fall 20% or so – every 1% fall causes a contraction of 0.6% in domestic GDP.” He’s talking about possible negative growth of 12%!

• Capital investment in manufacturing is unlikely to grow in an environment of shrinking corporate profits, while households are likely to become more cautious about spending, bringing contraction in the important residential property sector.

Contractionary forces in exports, private-sector capex and consumer demand will neutralise much of the state-driven stimulus, and may even prove strong enough to negate it.

• “Stimulus only works directly on the command economy side of the economy, which is primarily the infrastructure sector and the banking system,” argues the CLSA Asia-Pacific Markets strategist Christopher Wood.

“The export area is almost exclusively private-sector and therefore largely outside the authorities’ scope to manipulate.”

• There is huge potential for replacing export demand with domestic demand – for example by redirecting resources towards healthcare and education. But it will require great changes to bring that about. Manufacturing skills and plant are quite unsuited to meeting the needs of services such as hospitals and schools.

The changes will take many years to implement and command a high price in terms of lost economic growth.

Deutsche Bank is forecasting a W-shaped recovery as the strong bank lending growth currently being experienced is not sustainable, private-sector capital investment will fall sharply, and the fiscal stimulus will start to lose impetus next year.

It predicts economic growth will fall back to a new trough in the first half of 2010 before the switch from foreign to domestic demand brings about a sustainable recovery.

However, Richard Wong of Halbis HSBC argues that if Beijing’s current stimulus package seems to be failing: “Additional measures such as income tax cuts, salary increases for state workers and the possibility of issuing shopping coupons should stimulate spending.”

The jury is out on whether the plus factors are going to outweigh the negatives.

This suggests one of three equity investment strategies, depending on your own views, circumstances and philosophies:

• If you remain very cautious about the outlook for global economic recovery and China’s capacity to resist them, then it’s too early to invest. Ignore China for the time being, even if you are optimistic about its long-term potential.

• If you are optimistic, but cautious, you may consider some careful buying of ETFs (exchange-traded funds listed on Western markets). The best prospects would seem to be those linked to growth of A shares, rather than of Hong Kong’s benchmark Hang Seng index. And/or purchases of huge Chinese companies that the Chinese state will regard as too big to fail, or even to cut their dividends, listed in Hong Kong or in the form of US depositary receipts.

• If you believe that the Chinese markets have bottomed – Fullermoney strategist Eoin Treacy says China “shows the best base formation development characteristics of any globally significant market” – then you may wish to start accumulate ETFs and/or individual shares which have already shown bounceback potential.

Jim Rogers, the well-known China bull, says he is investing – in “sectors that the Chinese are pushing to develop such as agriculture, water, infrastructure and tourism.”

• This article was written by Martin Spring and was published in On Target, a private newsletter on global strategy. Email Afrodyn@aol.com


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