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China ranks among the world’s great nations and cultures with a proud history and the possibility of a flourishing and prosperous future. The combination of exceptional intellectual capital, a strong work ethic, and, currently, low cost of labor capital (with a surfeit of human labor available), combined with a mercantilist economic system that, to some degree at least, rewards entrepreneurialism and foments capital formation, has provided China an incredible run these past few years.

But China – viewed as a macro investment rather than as a nation-state or a culture -- is not the economic juggernaut many “me too” reporters and commentators have assured you it is. In fact, I currently see China as having one of the higher “country risks” you could invested in. The US just went through a residential real estate bubble so we know how devastating they can be. I believe China will either experience a similar bursting of residential housing prices or will have to take draconian measures to avoid one, resulting in higher interest rates and higher inflation. If kept under control, China may – just -- skate through. If not, the cure will be worse than the disease.

Longer term, I see China following the path of so many nations before it. As the lowest labor cost provider, it has had an edge for some time. If that equation changes and workers elsewhere work for less, China stops being the low-cost mercantilist provider. This has not sunk in with foreign companies; the weaknesses I describe below are masked thus far by foreign direct investment there, with inflows of a record $105 billion in 2010.

There are clouds on China’s horizon, some of which will be solved, others of which may be solved, but not within the typical investor’s 10-year investment time frame. Since China is priced for perfection, any crack in the armor may cause a panic out of Chinese stocks. There will be exceptions and we will strive to identify them. But here are some longer-term problems to keep in mind when reviewing Chinese companies as a recipient of your risk-averse dollars...

A restive population, or, “How ya gonna keep ’em down on the farm after they’ve seen Beijing?”

America’s agrarian economy was transformed forever when countless American men returned after WWI unwilling to return to the steady rituals of farming. If you think travel to Paris was an eye-opener to a bunch of young men from Kansas, and Oklahoma, imagine what the vistas, thoughts and endless possibilities provided by the big city, not to mention the Internet, will do to young men in Szechwan, Yunnan and Qinghai Provinces.

Too many “analysts” project China’s growth in a straight line from the recent past through today into the infinite future. Britain did not grow in such a straight line. Germany did not. The US did not. No nation does. I believe it will happen in China the same way it did in the nations that have already experienced it. Farm kids subsisting on rice and dried fish will move to the cities and happily labor for next to nothing for the first few years. It’s new, it’s exciting, you can now afford to eat meat or poultry twice a week, maybe you and your roommate even share a motorbike. But it is simply human nature that the thrill wears off and you’d like chicken three times a week or you’d like to have your own motorbike. The pressure-to-increase-wages genie is out of the bottle and there’s no putting it back in.

Possible labor unrest

At the very least, China will experience the same issues that inevitably arise with any nation’s growth. Either other nations will undercut its cheap labor as Chinese laborers begin to see that with just another 10% rise in wages they can afford the health care and better diet that the party bureaucrats now enjoy; for an additional 10% they might purchase the freedom and independence an automobile represents; for an additional 10% they might be able to care for their aging parents, etc., etc.

Chinese workers are no different from American, Japanese or German workers. Each in their time had numerous laborers willing to work for a pittance so they could have a better life for themselves and their children. Each in turn began to demand higher wages as being only fair, given the experience and talent they gained, which leads to increased productivity. Wage inflation is inevitable when disparity exists to the degree it exists in China.

Then of course there is technology. What happens if wealthier nations undercut Chinese labor costs with robotics? Yes, a Chinese worker will currently work for lesser wages than an American worker. But the kind of assembly-line jobs creating mass consumer products that currently fuels China’s growth lends itself to automation. Why pay transportation costs to send raw materials overseas and ship product back, the essence of a mercantilist economy, if you can use machines that work 24/7 to convert raw materials into product in the nation of consumption? If that happens, the whole China Miracle falls apart. It is a miracle built upon labor that is both cheap and compliant. If the developed world chooses automation at the old homestead, imagine the whirlwind of wrath from tens of millions of unemployed young people with no future.

A centrist, statist economy

To keep “control,” China is hewing to the economic model that has historically proven least flexible and most likely to produce false numbers and inferior products. Stalin’s Five-Year Plans and Mao’s Great Leaps Forward produced, on balance, mostly fake numbers and shoddy workmanship. When one measures only the “output” rather than the processes themselves, the result is school roofs that collapse on children; the adulteration of milk with melamine and cyan uric acid; and eye shadow (and children’s toys) poisoned with excessive lead. There are those who would say my criticism of centrist autocracies is unfair, that these were isolated incidents. I must respond they are indeed isolated — to economic systems that reward the cutting of corners and reward dishonesty in production.

Military adventurism

Economic success need not lead to military aggression. Yet in China’s case it seems to have done just that. For a culture that many believe “takes the hundred-year view” China seems in quite a rush to assert itself against its neighbors. In the past six months alone, Beijing declared that the international waters of the South China Sea “are a core national interest;” they seized nine Vietnamese fishermen near the disputed Parcel Islands; created an international incident with the ramming of a Japanese Coast Guard vessel; and conducted (a first-ever) live-fire military exercises in Tibet near the Indian border. This is not just an economic issue. China seems hell-bent on creating a sphere of power around its borders. Thus far there has been no push-back. There will be.

Political adventurism / aggrandizement

This is an issue both within and without. Trying to maintain power over what is on paper still a communist political system presiding over a free-market economy -- but is in fact a political autocracy presiding over a mercantilist economy -- is not easy. It may not even be possible. Again, if they push too hard there will be a backlash. So far, they’ve gotten away with combining and exercising military, political and economic clout controlled by a powerful central government. We should not forget that economic rival India fought a land war with China along their shared border as recently as 1962, and Vietnam did so in 1979. This latter war was started by China because Vietnam was meddling in internal affairs in Cambodia, a nation China considered its client state if not its vassal state. So what happens if China attempts to pursue hegemony over even geographically-closer US allies like Taiwan, Korea, or Japan?

Inflation

All governments want to see some inflation, no matter what they say. Inflation allows them to borrow from unsuspecting citizens in their own nation and abroad looking for “safety” by investing in government bonds. These governments then repay the principal many years later in dollars, yuan, Euros or rubles which have significantly lower purchasing power. In China, Inflation is a major risk both for economic and social stability reasons. Rising prices betray the government’s claim that inflation is in check. As factory workers see their real wages fall (in terms of purchasing power), they withdraw their labor and move elsewhere. Just last month, some factory owners reportedly supplied return train tickets for their workers for the Lunar New Year holiday. Otherwise, they feared, they might not see them return. Stagnant manufacturing job wages and ever-increasing real estate prices are not a prescription for success.

A paucity of water, food, and basic resources

Lost in all the chatter about China’s (current) rare earth hegemony is the simple fact that China must import more than 50% of the oil, gas and iron it needs to build a modern infrastructure. It must import nearly 70% of its copper. Its food production is iffy in the best of years and will decline as more farmers abandon rural poverty to take better-paying jobs in the cities. China has roughly 1/5th of the world’s population, but only 1/14th of its fresh water supplies, with about half of that coming from the high mountains and plateaus of Tibet. Of the water Chinese citizens do get, much of it is polluted upstream by manufacturing plants that paid off the right provincial officials so they would turn a blind eye to what happens downstream. The situation is no better in the air that they breathe. And even in rare earth elements, in which China currently controls 97% of the world’s annual production, its reserves at the current rate of production are less than 20 years – after which China will become a net importer of these materials.

One of the problems of a free press is that they report in great depth on the areas to which they are allowed access, but poorly or not at all where reportage would be dangerous or uneconomical. For that reason, the problems of the USA and other democracies is well-known; China’s problems are not.

Yet simmering ethnic strife; horrible air and water pollution; a lack of fresh potable water; poor corporate governance standards; the need to create 24 million new jobs a year; an aging population with no social safety net; a banking system that is used for political goals and therefore instructed to loan where politicians decide, not where responsible bankers decide; and a statist government that engenders false reporting from the hinterlands by its draconian punishment of those who fail to deliver, do not bode well for a straight-line progression of success for China.

I note all these factors not to denigrate China and what it has accomplished, nor to completely eschew investing there. There will be times when I will recommend China or Chinese firms. But right now I prefer to place the bulk of my and my clients’ portfolios in other nations that have what China wants and needs: Canadian oil and gas, from companies like Encana (NYSE:ECA), Cenovus (NYSE:CVE), and Imperial Oil (NYSEMKT:IMO); US timber from firms like Plum Creek (NYSE:PCL), Potlach (NASDAQ:PCH), and Weyerhaeuser Co. (NYSE:WY); Australian minerals miners like BHP; Singaporean oil services and shipbuilding firms like Keppel Corp (OTCPK:KPELY) and Sembcorp Marine (OTCPK:SMBMF) and, most of all, US and other food and fertilizer producers like Archer Daniels (NYSE:ADM), Mosaic (NYSE:MOS) and Potash (NYSE:POT) all leap to mind.

I see these providers who meet China’s needs from outside as enjoying good corporate governance with significantly less likelihood of upheaval. China has intellectual resources in abundance and a population not afraid of hard work. It is all those areas above, however, that cause me to recommend caution right now.

Disclosure: We, and/or those clients for whom it is appropriate, are long ECA, CVE, IMO, PCL, OTCPK:KPELY, MOS.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.



Disclosure: I am long ECA, CVE, IMO, PCL, OTCPK:KPELY, MOS.

Source: The Great China Jugger-Not