Investing in China's Next Boom

In the West there is the myth of inscrutable Asia, the mysterious East riddled with corruption, insider dealings, shadowy plots and secret designs known only to insiders. Of confusion, trickery and subterfuge used to disguise overt actions.

Usually these conceptions are contrasted with Western openness, directness and transparency. We all know the truth is far more complex than this; the West clearly has its share of insider dealing, and with regard to the next China boom, the facts are right there on the surface for all to see.

China is about to experience a massive boom.

How can this be, you ask? China has too much capacity relative to domestic demand; as foreign (export) demand falters, China's overcapacity will cause massive layoffs, workers will lose their jobs in factories and will have to return to their homes in the countryside in vast numbers causing a collapse in the real estate bubble dependent cities that were built on the back of the export boom.

The Chinese urban real estate bubble, which was built on an assumption that export growth and foreign investment would continue indefinitely at the same rapid pace, will crash. The over-leverged homeowners will lose their second or third speculative apartments (the average Shanghai apartment was recently selling for more than twenty times average annual Shanghai earnings), damaging the corrupt state owned banks that supported bad lending not just in real estate but in industry as well. The poorly run state owned companies (representing the vast majority of the capitalization of the Chinese stock market) that over-invested in real estate, infrastructure and manufacturing during the export boom will collapse feeding back into the banking system which needed to be bailed out before and even during the boom.

How much bad debt will those state-owned (read: corrupt and inefficient) banks be forced to write off? What will happen to all of the secondary and tertiary (many also state owned and supplied with capital by friendly state owned banks) industries dependent on the boom (cement, steel, autos, etc) that must now crash? How could there possibly be a boom?

Most Western observers of China know little of the reality of China. During their brief but often frequent visits, they see the tall new buildings in the cities, the huge numbers of cars and fancy new shopping malls, and they say "until you've seen it, the scale of the thing, you can't understand." or "you just don't get it, go and see."

What those observers miss is the big picture. The big picture is what sits outside of the cities. And what sits outside of the cities is a place called China. A very large, very poor, very crowded, rural, agricultural country. Of China's 1.3+ billion people, 70+% (850 million+ people) live in the countryside under conditions that we in the West would consider to be little above subsistence levels, growing wheat, rice and vegetables (with the occasional fish farm mixed in) with the most rudimentary tools on tiny barely sufficient plots of land. Most of the wealth that the countryside does have comes from transfer payments from their children working in offices and factories and stores in the cities (that were built on that export bubble we recently seem to be hearing a lot about).

That is China. The cities are a debt financed (banks lending to companies, not consumers, though there has been a lot of speculative lending in real estate) export bubble. The countryside is poor and aging rapidly. And the Chinese authorities know this and have stated this clearly on many an occasion.

So where is the boom you ask? Right on the surface. On the land, that is. Because China just created a new set of regulations allowing farmers to, get this, sell their land! Now in China, all land for almost the entire period that the Communist party has been in power has been owned by the party. All land belongs to the state, city dwelling apartment owners can rent land for seventy years. Rural people are allocated land by local party and government (sort of the same thing in what is effectively a one party state) officials in their villages for fixed periods of time. There is no private ownership of land. Period. Especially rural land.

This approach, of government owned land is central to the very self conception of Communist China. In China, the Communist party is called the Gong Chang Dan. That means the communal wealth or property party. And in a traditionally rural country like China, wealth has for ages been one and one thing only. Land (we all remember the Good Earth by Pearl S. Buck from high school, right?) When the party owns the land, the masses (read: Joe the farmer), not the landlords (read: greedy capitalist running dogs) own the land. This is the very basis of the Great Helmsman, Chairman Mao Ze Dong's Communist revolution. The wealth - the land - belongs to the people, and the people are represented by their glorious Chinese Communist party.

So on October 12th, when China revealed its new land reform policy (couched in politically correct language of course) - "lease their contracted farmland or transfer their land use right" - there was an earthshaking revolution in Communist China.

And, the place to, to see it all was Tian An Men square in central Beijing, where I have on good authority that what is left of Mao Ze Dong glorious corpse, spun very, very rapidly, many, many times in his great crystal sarcophagus when the news was announced that land was to be privatized and farmers would be allowed to once again, after sixty years of Communist party rule, actually own and sell their land.

But let's get to the point. How can you, the intrepid investor, benefit from this mega-trend? In very simple terms, the peasants can now sell their land. So many of them will sell their land, at perhaps not the best prices, and others (greedy landlords) will buy up the land, aggregate it and apply modern farming techniques in order to profit from more efficient production.

The newly capitalized peasants will likely head to the nearest sizeable town or city, start a small business and/or party hardy and will very quickly make a down payment on a shiny new apartment. They will buy a new washing machine, air conditioner and TV as well as some furniture. Perhaps a motorcycle, scoorter or used car might also be in the cards. Then they will hold a banquet to celebrate their new urban (dare we say, bourgeois) status.

How to play this? Individual stocks are risky and corporate governance is not what it is in the US (and, clearly, it is not sufficient in the US). So sector ETFs might be the best way to go.

Which sectors will benefit most?

Real estate, most likely, but agriculture related and basic consumer goods as well as motorcycles and inexpensive automobiles related shares should do well. Steel, mining and commodity plays should also benefit. If you buy individual stocks, remember to buy a basket as Chinese corporate governance is not like American corporate governance (I mean, it's worse; it’s a really sad reflection on US corporate governance today that I have to spell it out). The head of China’s largest electronics retailer was arrested by the central government a la Russia recently, so do buy a basket if you buy individual Chinese ADRs and remember to mind your stops.

If you want to play it safe, I recommend the Claymore/AlphaShares China Real Estate ETF (TAO). It contains many first rate,very well established and highly respected Hong Kong based real estate companies (Hong Kong has first world standards of corporate governance) that do very substantial business in mainland China and are well positioned to benefit from the coming China urbanization real estate boom, including:

• Cheung Kong
• Henderson Land
• Swire Pacific
• Sung Hung Kai Properties

It seems to be bottoming around 10 dollars from a high of around 25 a year ago, and it has a P/E of less than 8 and a price to book of only .46. That is pretty cheap. The real estate growth trend should last for many years, so at these depressed levels this could be a buy-and-hold-forever ETF in your portfolio (unless it gets way overvalued, of course.)

And if the dollar devalues against the RMB, that will give your gains some extra oomph in dollar terms!

Disclosure: The author is long TAO.

Comments

[huangthomas:]

No matter how you massage the facts, the real estate market is collapsing in China.

2008 Dec 09 10:58 AM

[oneoldude:]

Chinese provincial farmers are among the most conservative persons on planet earth. Their savings rate is extraordinarly high, and with good reason, given the scarcity and expense of health care and the lack of a social safety net for retirement.

To presume that provincial farmers, en masse, will simply sell their only source of income to take a chance in the big cities and to presume that they will completely change their thousand year old traditions in an instant is a presumption that is hard to swallow. Even harder to swallow is that even if they did sell their only income source, that they would go on a spending spree that is completely a-typical for that group of people.

If you had said that, over time, as the provincial farmers die off that their property would be sold and the proceeds passed on to their children (if that is even possible in China) and that their city dwelling children would go on a spending spree, then that is a reasonable supposition. But that will take time, a lot of time. And with the RE market crashing in China, I suspect that the boom you describe will perhaps begin to occur some time in the future, but not right now. Timing will be the thing.

2008 Dec 09 11:53 AM

[huangthomas:]

In China, land use is well planned. Even with 1.3 billion population, they are self-sufficient in foods, which is essential from strategic consideration. Only once in a few years, they need to import small quantity of wheat. In southern China, rice is harvested three times a year. China is a leading force in plant biology and genetics.

2008 Dec 09 01:01 PM

[Alan Young:]

I can't believe this.

Even if you have all your facts right, your projection is speculative; and even if you have that right, you have your investment thesis exactly backwards.

Or maybe I'm just too slow to understand why I should invest in a bubble that's about to crash, by your own account.

(disclosure: long on China, and on REITs, but not on Chinese REITs).

2008 Dec 09 02:54 PM

[chinesetrader:]

Have you read the law? It's only a recognition of a system that is, not in law, but in actual fact, already practiced for many years. The land will not be 'owned' by farmers, and also not 'sold', but merely the idea of long-term rental of land by farmers to investors, which allows many large companies to conduct their business in countryside China, ie. TRE.TO and Stora Enso, is more clearly defined by laws.

Will farmers go and rent their land to everyone and anyone? Are farmers easily and happily renting their land now? Well, only under extreme pressure and only land they really can't use. Mountains perhaps.

In any case, even if the average farmer could live a life of luxury in cities - the average land owned by Chinese farmers is 1 - 3 mu (660 - 2000 square meters / 0.06 - 0.2 ha) and not worth all that much to anyone, going rates in the south are Y50 - 300/mu/year) - I severely doubt that they would want to do so in large numbers. Have you lived in a Chinese city for a longer period of time? In cheaper areas? Have you dared to open the windows to let the diesel exhaust and other poison in? Many farmers live in a relatively unpolluted area and won't want to move to horribly polluted cities.

oneoldude has it right - Chinese farmers ARE THE MOST CONSERVATIVE PEOPLE ON EARTH and if you expect them to sell out and go on a shopping spree... you better plan on a long long time waiting.

2008 Dec 09 11:15 PM