China: Consequences of the Sleeping Lion Awakened

U.S. President Barack Obama has begun a nine-day tour of Asia at a time when the U.S. economy is struggling to emerge from a deep recession. But nothing looms bigger than China, the largest holder of U.S. debt (around $797.1 billion, up 10% this year), that has emerged from the global economic downturn in an ever stronger position. When Obama sets foot in China for the first time, he will confront a dramatically altered balance of power between the two nations.

Two Decades of Explosive Growth

This seismic shift is driven by China's astonishing economic growth over the past two decades and has accelerated during the global financial crisis. Its 9% to 10% annualized GDP growth rate in the past two and a half decades is unprecedented in world history.

In 1992, Chinese gross domestic product (GDP) was less than 7% of America's GDP. By 2000, the figure topped 12%. When Obama won the election in 2008, the Chinese economy had grown to equal more than 30% of U.S. output. New data show that China is on track to grow more than 8% in 2009, driven by high industrial output and retail sales.

Impressive Stimulus Package…and Working

During this global recession, China's astonishing growth did slow down, but unlike most developed economies, China never entered a recession.

The Chinese have launched the world's biggest investment program (about $585 Billion) after the start of the financial crisis last year. Beijing's stimulus program is estimated to amount to about 13% of Chinese gross domestic product, making it almost twice as large as the U.S. program and close to five times the size of its German equivalent.

The government's massive economic stimulus program has transformed the country into an enormous construction site. As a result, China’s industrial production rose 16.1% year-over-year in October, the most since March 2008 and a slide in exports eased to 13.8% the slowest pace this year. However, behind the impressive economic data, troubles might be lurking.

China Bubble Forming

China’s purchases of dollars to prevent appreciation gave it foreign-exchange reserves totaling $2.3 trillion in the third quarter, the world’s largest. Meanwhile, its sale of Yuan to keep it fixed to the dollar contributed to a 29% jump in its money supply, and the peg helped spur more than $150 billion in speculative funds from overseas in the past six months, according to China International Capital Corp.

China's main index, the Shanghai Composite, has gained 52% this decade and rallied 75% this year alone as government stimulus and record lending drove the nation’s economic recovery. (Fig. 1, click to enlarge) State-owned banks have begun issuing new loans, leading to a 150% increase in lending compared with 2008.

In addition to playing the stock market, a lot of the money is being diverted into houses and land. There are also reports of excess capacity created by the aggressive stimulus effort. Record apartment prices and a high flying stock index this year are prompting warnings against "financial risks" and the development of bubbles in real estate markets.

Yuan-Dollar Peg Angers Many

Beijing has kept the Yuan pegged at about 6.83 per dollar since July 2008, seeking to help manufacturers battered by the collapse in demand abroad. The Yuan advanced 21% in three years from July 2005. (Fig. 2 & 3, click to enlarge)

The discontent about China’s currency peg to the dollar isn’t confined to the U.S. Capitol Hill, corn growers, steelmakers, and textile companies. From Mumbai to Bangkok, Asian companies also say Chinese rivals have an unfair advantage because of the Yuan-dollar link. The dollar has declined 14% in the past year against the currencies of six major trading partners, while other neighboring currencies of China have strengthened.

For instance, South Korea’s won gained 8% against the Yuan in the past six months. Japan’s yen has risen 6%, while India’s rupee gained 6% and the Thai baht 4%. This has prompted Asian central banks this year to increase their holdings of U.S. dollar assets, including Treasuries, to prevent their currencies from appreciating and thus making exports more expensive relative to China’s, all the while blaming Beijing.

China Quashes Yuan Policy Speculation

Most expect that in Obama’s meetings at the Asia Pacific Economic Cooperation (APEC) summit and then in Beijing, China’s fixed-rate policy will likely be part of the discussion. On that note, investors are seeing a rising Yuan. Twelve-month non-deliverable forwards for the Yuan in Shanghai are signaling trader bets on a 3.5% gain from the spot rate of around 6.83.

However, in what seems to be an official effort by Chinese authorities to dismiss the renewed speculation of Yuan appreciation in the near term spurred by a recent language change from The People’s Bank of China, on Saturday, the state-controlled Chinese news agency Xinhua reportedly said that the government would not allow the currency to gain against the dollar in the short term. Goldman Sachs (GS) also just reiterated its three, six and 12-month forecasts for the Yuan to stay at 6.83 against the dollar.

Yuan to Appreciate…Eventually

China’s drive to create jobs and maintain social stability through export-led growth means politicians aren’t ready to loosen controls on the currency. In addition, China’s trade surplus will probably be half last year’s level at $200 billion, which means a bit less pressure on the Yuan to appreciate. The U.S. doesn’t want a stronger Yuan either because that would cause a collapse in the dollar in the short term.

Over time, China will likely be under pressure to open and let the Yuan appreciate in the next 24 months, and possibly as early as the 2nd half of 2010, albeit at a very gradual and modest pace, while most likely still pegged to the dollar. Eventually, the Yuan will appreciate considerably due to China’s high growth rate and its population’s high savings rate (35-50% range) .

On Nov 11, in Singapore, World Bank chief Zoellick calls the dollar's role as a reserve currency "relatively secure," but says over the next 10-15 years the Yuan (Renminbi) will provide an alternative once it is internationalized.

Strong Growth Prospect

China is a communist country with capitalist power. Despite China bears’ prediction of a Chinese size collapse, for a country with such a tremendous resource base and centralized system, busted bubbles in sectors most likely will not derail the country’s global leadership path started over two decades ago.

In a speech a few days ago at a conference organized by the Monetary Authority of Singapore, International Monetary Fund (IMF) Managing Director Dominique Strauss-Kahn called on Asia to play a leading role in guiding the global economy to a new, more sustainable path for global growth.

The IMF expects Asia’s GDP growth, driven mostly by Chindia, to be 5.75% next year—almost double the 3% rate forecast for the global economy. Specifically, the IMF projects China annual growth to be 8.5% and 9% for 2009 and 2010 respectively. In contrast, advanced economies annual growth in 2010 is projected to be about 1.25%, following a contraction of 3.5% in 2009. (Fig. 4, click to enlarge)

Chinese Exposure Desirable

China’s surging asset prices, a dollar collapse and a double-dip global recession are the biggest risks investors face in 2010. But many analysts are bullish on China for the long-term as 500 million educated and unemployed Chinese spur greater domestic spending and production.

Yet, Americans are estimated to have only 2% to 20% foreign stock exposure. That means Chinese stocks represent probably a low single-digit percentage, at most, in the average portfolio. With very few high investment return prospects, China is one market that should be given some serious consideration as part of a long portfolio.

There are many ways to play the Chinese market. The following are just a brief overview of some that I will discuss in this article.

B Shares

For investors interested in adding some Chinese exposure, B shares are a good bet for those who hold dollars and want to benefit from China’s fast economic recovery. The shares traded at an average discount of 49% to their A-share listings, according to BNP Paribas.

China's dollar-denominated B shares at the Shanghai Stock Exchange jumped 9.42% to 251.19 points last Friday, posting an 18-month high. The surge mainly resulted from market expectations of Yuan appreciation.

Though it is difficult to pick a good individual B shares stock right now as most are probably fully valued, it is best to avoid stocks of property developers as a way to minimize the risk of a potential real estate bubble. According to Morgan Stanley (MS), the sector’s share price has gained about 155% on average in the past year.

ETFs

An ETF is a convenient way to invest in China. But it could be a bumpy ride as a three-year measure of volatility for China ETFs is more than double that of the S&P 500.

The two most popular China ETFs are iShares FTSE/Xinhua China 25 Index (FXI) and SPDR S&P China (GXC). Both of these are very heavily weighted towards financials. On the other hand, PowerShares Golden Dragon Halter USX China (PGJ) has only about 6% exposure to financials, and has been around since 2004.

For currency plays, the WisdomTree Dreyfus Chinese Yuan (CYB) and Market Vectors Renminbi/USD ETN (CNY) are two ETFs specializing in the Yuan. But a recent WSJ article cautioned investors about the pitfalls of the Yuan ETF because it is in a contango market similar to that of the United States Natural Gas Fund (UNG).

Consumer and Commodity Blue Chips

Since B shares and China ETFs may have more risks and volatility than some might like, blue chip companies with an increasing presence in China could be a less risky way to ride the Red Dragon.

Chinese President Hu Jintao recently said that the government is focused on expanding domestic spending, “especially consumer demand” to strengthen the economy. This could present opportunities for consumer-related stocks. U.S. blue-chip companies such as Wal-Mart (WMT) and McDonald's (MCD) are likely to benefit from this trend.

Similarly, with China’s insatiable appetite for all natural resources, non-U.S.-based producers such as BHP Billiton (BHP), Rio Tinto (RTP), and Vale S.A. (VALE) could also provide good portfolio diversification.

Nevertheless, I would advise against commodity futures ETFs due to the intensifying regulatory scrutiny and the potential “rolling effect” commonly experienced in a contango market as discussed in my previous article.

Author's Disclosure: No Positions

Comments

[beijingpaddy]

Besides ETFs and B shares, US retail investors can buy into many Chinese stocks via the Hong Kong Exchange using Etrade's Global Trading Platform. I have been using it for a long time and like its smooth process. Most times I find it cheaper (as fewer people are chasing the stocks) to buy in HK than buying ADRs on the US exchanges. Also often stocks trade cheaper on the HK exchange than the same company does in Shanghai.

disclosure: I don't work for Etrade and am not in the stock business
but do own lots of Chinese stocks.

2009 Nov 16 08:20 AM

[China Interest]

The similarities between China now and Japan in the late 1980s have substantial overlap. Be cautious folks! I live in China and not all things are what they seem.

2009 Nov 16 09:14 AM

[Tony Petroski]

The title said "Consequences of the Sleeping Lion Awakened."

I missed reading anything about that. Instead I read an article touting the mightiness of China and the Chinese economy.

Note to the communist handlers: In english the phrase is "sleeping giant."

2009 Nov 16 09:23 AM

[Gem Hudson]

So all the world will buy all the other world their own green car factory on the American exchange for the dollar and all the world will sell their Obama-mobile each one to another on the exchange now for the wane and all the world will have an equality exchange rate.

Herny Ford sold his model T by the Car that kept on running and running and his cars ran more reliable than that of the horses and to assembly one car after another made his cars more affordable for every man that have a decent job and that's America

2009 Nov 16 09:46 AM

[Mike from NYC]

China can thank American policy, or rather the lack of it, Corporate America's strive for ever greater profits and the gluttony of Americans to buy and buy, for its rapid rise to the top, financed by the former wealth of American consumers.

No doubt China's brilliant policy of pegging the yuan to the US$ has helped it conquer one and all in industrial output. Once again, another group has outfoxed and out-thought American policy makers and the brilliant politicians for more than 30 years.

The US economy has had no 'real' growth for almost 30 years as others have profited from our own stupidity, greed and slothiness.

2009 Nov 16 10:31 AM

[Alan Young]

No argument with the economic analysis, but there's no news there. The investment ideas are a hodgepodge of the obvious and the obscure.
How do you buy B-shares from the US?

2009 Nov 16 10:48 AM

[Tom B]

You are exactly right. Japan had a lot more going for it, and in the 1980's than China does now, and yet, it proved to be a bubble.

Having said that, I wouldn't short China over the next 24 months.....


On Nov 16 09:14 AM China Interest wrote:

> The similarities between China now and Japan in the late 1980s have
> substantial overlap. Be cautious folks! I live in China and not all
> things are what they seem.

2009 Nov 16 11:55 AM

[HaavBline]

You do not own the English language, my friend. You are not even from England.

Go to India and you will know what I mean instantly.


On Nov 16 09:23 AM Tony Petroski wrote:

> The title said "Consequences of the Sleeping Lion Awakened."
>
> I missed reading anything about that. Instead I read an article touting
> the mightiness of China and the Chinese economy.
>
> Note to the communist handlers: In english the phrase is "sleeping
> giant."

2009 Nov 16 12:25 PM

[User 443773]

You can make good arguments for cashing in on chinAs economic success and it's highly reflationary policies for about another 9 months. Then inflation will cause problems. This happens but the really important point is that you cannot do investment strategy and geopolitics in linear fashion beyond s cycle. Investment pros do this all the time. GDP is on this trend, technology is on that trend.... Ergo this is what things will look like in 10 years. China has the balance sheet strength now to satisfy the bulls expectations. 3-5 years from now it won't.

2009 Nov 16 12:44 PM

[Ryan in Shanghai]

I absolutely 2nd the comments by China Interest.
I also live in China and the massive bubble that has been allowed to develop is painfully obvious. To make matters worse, the locals haven't been though any recent bubbles and believe price appreciation in luxury apartments is guaranteed at 10%/year.

20-40 years from now, I'm certain that China will be very powerful and very important.

However, when bubbles inflate, investors frequently forget the values of a) INTEREST INCOME b) INFLATION and c) OPPORTUNITY COST.

The current "gov't expansion plan" that is keeping the economy running is just throwing lighter-fluid on the fire to keep it from flaming out.


On Nov 16 09:14 AM China Interest wrote:

> The similarities between China now and Japan in the late 1980s have
> substantial overlap. Be cautious folks! I live in China and not all
> things are what they seem.

2009 Nov 16 01:58 PM

[Ryan in Shanghai]

Tom B-

I don't think the central gov't will allow the bubble to pop before the end of the World's Fair 2010, even if it did massive damage to the economy. So I'll give you 12-months, but I doubt it will make it for a full 24-months.

On Nov 16 11:55 AM Tom B wrote:
> You are exactly right. Japan had a lot more going for it, and in
> the 1980's than China does now, and yet, it proved to be a bubble.
>
>
> Having said that, I wouldn't short China over the next 24 months.....
>

2009 Nov 16 02:01 PM

[William Legrand]

So, per the article, China is buying vast amounts of U.S. dollars and massively devaluing the Yuan through new issuance. That's not a healthy economic engine, more like one on the brink of mass recession/contraction if exports fall.

2009 Nov 16 04:48 PM

[bob adamson]

To William Legrand -

Well said. However, if (and this is open to debate) the Chinese government still retains sufficient control of the levers of economic and social control domestically, a dramatic shift of the domestic economy (and of labour and other resources) from serving export needs to greater service of domestic infrastructure and consumption needs might be possible, buffered by large foreign currency reserves, and even welcomed by all concerned. This despite short term domestic economic dislocations.

This is not to say that such a shift is planned or desired, only that it may be a possible option for China if its exports falter significantly.

On Nov 16 04:48 PM William Legrand wrote:

> So, per the article, China is buying vast amounts of U.S. dollars
> and massively devaluing the Yuan through new issuance. That's not
> a healthy economic engine, more like one on the brink of mass recession/contraction
> if exports fall.

2009 Nov 16 05:16 PM

[Mad Hedge Fund Trader]

inh I have long sat beside the table of Mckinsey & Co., the best management consulting company in Asia, hoping to catch some crumbs of wisdom. So I jumped at the chance to have breakfast with Shanghai based Worldwide Managing Director Dominic Barton when he passed through San Francisco visiting clients. These are usually sedentary affairs, but Dominic spit out fascinating statistics so fast I had to write furiously to keep up, sadly letting my bacon and eggs grow cold and congeal. Asia has accounted for 50% of world GDP for most of human history. It dipped down to only 10% over the last two centuries, but is now on the way back up. That implies that China’s GDP will triple relative to our own from current levels. A $500 billion infrastructure oriented stimulus package enabled the Middle Kingdom to recover faster from the Great Recession than the West, and if this doesn’t work, they have another $500 billion package sitting on the shelf. But with GDP of only $4.3 trillion today, don’t count on China bailing out our $14.4 trillion economy. China is trying to free itself from an overdependence on exports by creating a domestic demand driven economy. The result will be 900 million Asians joining the global middle class who are all going to want cell phones, PC’s, and to live in big cities. Asia has a huge edge over the West with a very pro growth demographic pyramid. China needs to spend a further $2 trillion in infrastructure spending, and a new 75 story skyscraper is going up there every three hours! Some 1,000 years ago, the Silk Road was the world’s major trade route, and today intra Asian trade exceeds trade with the West. The commodity boom will accelerate as China withdraws supplies from the market for its own consumption, as it has already done with the rare earths. Climate change is going to become a contentious political issue, with per capita carbon emission at 19 tons in the US, compared to only 4.6 tons in China, but with all of the new growth coming from the later. Protectionism, pandemics, huge food and water shortages, and rising income inequality are other threats to growth. To me this all adds up to big core longs in China (FXI), commodities (DBC) and the 2X (DYY), food (DBA), and water (PHO). A quick Egg McMuffin next door filled my other needs.

2009 Nov 16 05:33 PM

[akj01]

A run of the mill article that says nothing new, just rehashing the same old. China is a dangerous country to invest in because of the high likelihood of its confrontation with the U.S. in the future. FXI has not moved much in the last 8 months; compare that to other country ETFs including EWG, EWO, etc., especially EWO which represents rinky-dink Austria and covers Eastern Europe expoasure of the Austrian bank. The smart money knows what is in the future.

2009 Nov 16 05:41 PM

[Chris - Long Beach, CA]

I think the metaphor of China as a 'sleeping lion' should be "china: the sleeping panda". It's more cute that way. =)

2009 Nov 16 05:48 PM

[William Legrand]

To bob adamson:

China is heavily invested in infrastructure and manufacturing capacity build-out under the assumption of sustained year-over-year GDP growth of at least 8-10%. Without massive and growing exports to support its already-built capacity, much of China's economy will collapse. Through heavy-handed manipulation of currency by the Chinese government, China's urban population has yet to achieve an average income level or enough savings to support a large-scale transition of its manufacturing capacity to domestic consumption anytime soon. China's huge-majority rural population is far too destitute to drive domestic manufacturing consumption anytime for decades to come (and China wants to keep it that way for now due to limited natural resource availability, such as dwindling fresh water reserves and ever-present risk of famine).

China and the U.S. are tied at the hip. Neither can economically survive without the other right now because the inter-dependencies run too deep. As the U.S. dollar changes value (only downwards as of late), so must the Chinese yuan in lockstep, otherwise both countries suffer near-immediate negative repercussions.

2009 Nov 16 06:10 PM

[NoGambler]

China Interest, I believe most of us would like to hear more from you on this!

Can you perhaps amplify a bit for us? Thanks.

On Nov 16 09:14 AM China Interest wrote:

> The similarities between China now and Japan in the late 1980s have
> substantial overlap. Be cautious folks! I live in China and not all
> things are what they seem.

2009 Nov 16 06:10 PM

[DHH]

etrade is terrible for buying HK stocks. it's like $30 a trade.


On Nov 16 08:20 AM beijingpaddy wrote:

> Besides ETFs and B shares, US retail investors can buy into many
> Chinese stocks via the Hong Kong Exchange using Etrade's Global Trading
> Platform. I have been using it for a long time and like its smooth
> process. Most times I find it cheaper (as fewer people are chasing
> the stocks) to buy in HK than buying ADRs on the US exchanges. Also
> often stocks trade cheaper on the HK exchange than the same company
> does in Shanghai.
>
> disclosure: I don't work for Etrade and am not in the stock business
>
> but do own lots of Chinese stocks.

2009 Nov 16 06:36 PM

[DHH]

online: boom.com


On Nov 16 10:48 AM Alan Young wrote:


> How do you buy B-shares from the US?

2009 Nov 16 06:38 PM