Communist China Only in Name

Includes: FCH, FXI, GXC, HAO, RSX, TRF
by: Rakesh Saxena

The larger-than-life portrait of Mao Zedong was clearly fodder for the millions of Chinese peasants and workers watching last week’s grand parade on television. Because those occupying the podium at the Gate of Heavenly Peace knew full well that the ideals and agendas of the 1949 revolution had long been abandoned. And despite President Hu Jintao renewing his commitment to socialism, China is in no danger of turning into a proletarian state at any point in the next few decades.

On the contrary, there is every reason to believe that Mao Zedong is turning in his grave. Foreign and domestic equity has flourished in China’s special economic zones since the early-1990s and, of late, land ownership laws have been amended to encourage private holdings.

Last year’s global meltdown may well shattered China’s near-term growth targets. But the IMF now forcasts that a GDP expansion of 9% for 2010 is within the realms of reality, given, in particular, Beijing’s aggressive infrastructure spending plans.

Many governments in the region expressed concern that the Beijing celebrations were dominated by a display of military hardware. But the message to international investors was crystal clear: do not doubt our ability keep dissent in check. The loss of jobs in late-2008/early-2009 has certainly created the potential for social unrest in the Chinese hinterland; however, fears of a second Long March are unfounded. “This is the era of state capitalism, and this state is fully capable of maintaining law and order to defend the gains it has made,” said a Toronto-based Chinese dissident. “Under state capitalism, the state itself is both the commander-in-chief and the capitalist-in-chief.”

Critics of Vladimir Putin point to the similarities in the current economic systems of China and Russia. (In fact, many Republican’s have warned that Barack Obama is taking America along the same route). Some students of state capitalism have also made structural linkages between the state-controlled economy of China on one hand and Islamist Iran and the dictatorships of Central Asia, the Middle East and Africa on the other; but that is a subject for another forum.

For our present purposes, if state capitalism is the new ideology of our times, it is important to ascertain the prospects for private equity in environments which represent half-way houses between a free market and a centrally-planned socialist economy. Templeton’s Mark Mobius says that he is still buying Russia’s OAO Gazprom (OTCPK:OGZPY) because it is trading at half the valuation attributed to Houston’s ConocoPhillips (NYSE:COP); for the record, the Kremlin controls over 60% of Russia’s US$1.3 trillion economy and has a majority stake in Gazprom.

“Comparative valuations in Russia and China will always appear attractive since one major equity holder in those markets, i.e. the state, can afford to wait for years before recording capital gains,” explained a Mumbai mutual fund manager who finds another Russian resource major, Lukoil (OTCPK:LUKOY), very attractive at current levels.

The China story is based on Beijing’s ability (or otherwise) to keep the economy firmly on track. Amongst Hong Kong investment circles, China is a straightforward “10x10”, i.e. 10% GDP growth for at least 10 years. “If you are playing China long term, overheating is not a concept which figures in your strategy,” a director of a China-specific hedge fund wrote in a private circular to his partners. “The Communist Party, communist only in name, is determined to stay in power and to keep China competitive at any cost.”

Due to the state’s military strength, and the willingness to use that strength if and where needed, state capitalism as a system in certainly sustainable. International asset managers are not going to ignore the relatively profitable opportunities state capitalism offers today merely on account of any human rights considerations. The challenge is to pick genuinely “undervalued” winners.

This writer’s skepticism of the relative value scenario is due to the fact that, under state capitalism, the state controls the dissemination of data and information. Key claims laid out in forecasts are almost impossible to verify. And abrupt changes to existing legislation can alter the valuation fundamentals at short notice.

Disclosure: Short OTCPK:OGZPY and OTCPK:LUKOY