Must Read for China Investors: Fact and Fiction in China

China is without question one of the biggest and most important markets for global investors to understand. Whether you’re a Bull or Bear on Chinese stocks, you need to understand how the Chinese economy will affect the companies in your portfolio, wherever those companies may be located.

Investors also need to be able to filter through the reams of incessant hype about China that flood the newswires, blogs, and television airwaves. While there is clearly massive opportunity in China, there is also an extraordinary amount of pure hype and sheer nonsense out there waiting to steer you off course.

For an intelligent, skeptical view on China, it’s hard to find a better analyst than Derek Scissors of the Heritage Foundation. Scissors debunked a number of popular myths about China’s stimulus package last month on Motley Fool.

Scissors is at it again in the latest issue of Foreign Affairs with “Deng Undone”. The scope of this article is more ambitious, taking on the question of exactly how real much of China’s market “reform” has been.

Former U.S. Treasury Secretary Henry Paulson, a perennial optimist, wrote in September 2008 that “China’s leaders today are committed to reform, at least so long as it improves the country’s political and economic stability.” But this is true only if one accepts a very dubious definition of “reform” and ignores overwhelming evidence that reform has stopped. Price liberalization, the core of market reform, has been partly undone. Privatization was stalled at first and then explicitly reversed. Initiatives to increase corporate competition are also being rolled back. The Chinese state is increasingly encroaching on even the relatively open external sector by restricting incoming investments and imposing taxes on exports.

The central government has recently reversed the outstanding progress in the liberalization of prices that China made during the first two decades of reform. The price of labor (wages) remains largely free from government interference, but that is manifestly not the case with the price of capital (the interest rate), for which the People’s Bank of China sets a compulsory and narrow range. Government intervention constantly distorts the prices of basic assets, such as land, often by simply forbidding or promoting transactions. The State Council sets and resets the prices for all key services: utilities and health care, education and transportation. Although the exchange rate has been loosened up over the past three years, the People’s Bank of China sets the daily value at which the yuan must be traded against the dollar. And currency fluctuation is still starkly limited: the daily movement of the yuan against the dollar is not allowed to exceed 0.5 percent. The market in China has never really determined the sale prices of many ordinary goods by itself, and the tendency over the past few years has been to further extend price controls for goods. The state’s complete control over grain distribution has distorted wholesale grain prices; a recent bout of inflation has prompted restrictions on the prices of retail food as well.

None of this is to say that investors should avoid China. But, as with any investment, it’s important to understand all sides of the story before you make your decision. Whether you agree with him or not, Scissors is a must-read for anyone considering an investment in China.

Comments

[hondaicivic:]

That idiot Derek Scissors doesn't have a clue when it comes to the Chinese economy or its politics. Watch this youtube video and you'll see stupidity in action. www.youtube.com/watch?...


^Note the comments that a bunch of other people left for him.

May 10 05:24 PM

[Sicall:]

I think most of the "hype" is actually waking people up to the fact that the world has changed dramatically in the last twenty years and the role and power of china with it. Having been there recently, yes there is government interference in many things that wouldnt be acceptable in the west and you have rightly pointed a few of them out.

I am not sure though about Mr Scissors comment on the youtube video that they have to buy US treasuries or keep the money under the mattress seems a bit naive if he thinks that. Keep your eye on the industrial metals market.

May 10 06:44 PM

[Living4Divi...:]

"The State Council sets and resets the prices for all key services: utilities and health care, education and transportation"

It would seem to me that there is no free market in china. Any investment in the above sectors would be subject to price controls. Price controls are profit controls.

I avoid state owned enterprises and utilities in china for there very same reason

Are there any truly free enterprises in china were business is allowed to make a profit?

May 10 07:24 PM

[Jasper M:]

"None of this is to say that investors should avoid China."

On the contrary, to the extent they are true, that is exACTly what this is saying.
Socialist dictatorships are Bad for Business.
It was easy for the Chinese to look like angels, climbing up from the state that Mao left them. But they are still way more socialist than, say, England, and I wouldn't do business there, either.

May 10 08:11 PM

[Alan Young:]

The fact that China's economy doesn't rely on free market pricing doesn't provide much of a clue about whether the stocks are under- or over-valued. After all, the market forces which Scissors apparently prefers didn't give us much of a clue about what our banks were worth a year or two ago.

On the video linked in Hondaicivic's comment, Scissors says China has no choice but to buy US bonds. That makes no sense. They are exercising many other choices already, buying Australian stocks, gold, and returning cash to their own economy via stimulus programs. This is not intelligent critique.

I'm eager to learn more about strengths and weaknesses in China's economy, the better to inform my stock-picking. I don't see any help here.

May 10 08:24 PM

[fawnpass:]

Yet another armchair analysis from across the world. I would advise the author to go to China and see for himself that he is off-base.

May 10 10:26 PM

[Jasper M:]

Alan,
I think the argument re "MUST buy bonds" is based on volume issues - little else they could direct their vast pile into that is big enough to absorb the purchases without driving up prices for their Next purchase. Not enough gold, not enough Aussie dollars.
Of course, if US depression drops Chinese export income, that'll be less of a problem.

May 11 01:03 AM

[anarchist:]

Forget China other than being a trader. The best China investments are Taiwan. Companies reports are more transparent and use friendly plus the China is buying into Taiwan.

May 11 01:50 AM

[Cor:]

Stupidity as such could exist in school debate or newspapers, but not in investment..

May 11 07:08 AM

[Spook:]

Yes, to really observe and understand China market, one have to visit China once and see it for themselves.

> I would advise
> the author to go to China and see for himself that he is off-base.

May 11 09:52 AM

[Spook:]

I think you are confusing with doing business and owning a business.

Doing business in China is the same as conducting business anywhere, in fact conducting business with a Chinese is far more easier than the western business person. All is based on trust, first impression and a short contract.

But owning a business in China is totally different, you don't want to do that unless you are a citizen, you are married to a local person, or you have the right connection. Otherwise its like investing on a ponzi scheme.


On May 10 08:11 PM Jasper M wrote:

> "None of this is to say that investors should avoid China."
>
> On the contrary, to the extent they are true, that is exACTly what
> this is saying.
> Socialist dictatorships are Bad for Business.
> It was easy for the Chinese to look like angels, climbing up from
> the state that Mao left them. But they are still way more socialist
> than, say, England, and I wouldn't do business there, either.

May 11 09:56 AM

[Tony Daltorio:]

Derek Scissors knows nothing about what is really going on in China. I doubt if he could find China on a map. Come to think of it, I doubt if he could find the US.

May 11 10:49 AM

[Dustinian:]

I disagree with most of the CFR when it comes to their articles on China. I am an avid reader of foreign affairs, and the may/june issue focusing on China was deeply disappointing.

May 11 01:44 PM

[ArtfulDodger:]

I agree with you exactly, Alan Young. Excellent points.

While politics must certainly have some sway on where and what we invest in, there are other issues to explore too.

When you compare the balance sheets and the growth potential of the stocks foreigners can invest in in China to similar ones in the US and other nations, China's companies shine like polished gold.

Moreover, when we compare China's and America's socialism, there is indeed more in the US. The Chinese do not have social security, medicare, maxicare, welfare, food stamps, racial set-asides, or a multi-billion-dollar prescription drug plan. Their tax structure is also much lower.

Neither do the Chinese have troops stationed in 120 nations around the world. Nor are they fighting two wars with no end in sight, thereby spending $400 billion a year, as the US is.

They also don't have $11.3 trillion in debt!

My one concern there, and at this point it's remote: a regime change that would turn them away from the current pro-business state that exists there.

Both Jim Rogers and John Rutledge have offices there and are heavily invested in China. They have no fear of the knocks so many people put on China.

Long numerous Chinese stocks.

On May 10 08:24 PM Alan Young wrote:

> The fact that China's economy doesn't rely on free market pricing
> doesn't provide much of a clue about whether the stocks are under-
> or over-valued. After all, the market forces which Scissors apparently
> prefers didn't give us much of a clue about what our banks were worth
> a year or two ago.
>
> On the video linked in Hondaicivic's comment, Scissors says China
> has no choice but to buy US bonds. That makes no sense. They are
> exercising many other choices already, buying Australian stocks,
> gold, and returning cash to their own economy via stimulus programs.
> This is not intelligent critique.
>
> I'm eager to learn more about strengths and weaknesses in China's
> economy, the better to inform my stock-picking. I don't see any help
> here.

May 11 11:14 PM