Profiting From China's Growth With Sector And Macro Bets - An Interview With China Expert Shaun Rein, Part II

| About: iShares China (FXI)

Shaun Rein is the Managing Director of the China Market Research Group and a long-time contributor to Seeking Alpha. I interviewed him ahead of the publication of his new book, The End of Cheap China: Economic and Cultural Trends that will Disrupt the World.

David Jackson: What macro impact will China's shift to a consumption-oriented economy have on the rest of the world?

Shaun Rein: As China becomes a consumption oriented and more expensive society, that is going to have serious ramifications for the rest of the world. First, the West better get used to higher prices; China will start exporting inflation. Second, as the Chinese gobble up more commodities, that will cause tension with neighbors.

DJ: Which commodities in particular?

SR: Commodities have been hit in the past few months as speculators have fled the market and fears of a real estate collapse in China have emerged. I am pretty confident of a soft landing in real estate - prices have dropped because of government maneuvers to lower prices. There remains huge pent up demand on the retail side to buy homes. So long-term, China will continue to buy iron ore, oil (ETFs: OIL, USO, USL) and coffee beans (ETF: JO). I am terrible at calling market prices, but clearly long-term the demand for commodities will remain strong so investors should get in if prices drop too much.

DJ: What's the best way for U.S. investors to get exposure to Chinese real estate?

SR: Fears of a real estate meltdown are overdone. Pent up demand remains high, especially at the luxury level. I would suggest for more risk takers to scoop up shares of real estate firms that have strong branding at the luxury level - Shimao Property Holdings (OTCPK:SIOPF) and Soho China Ltd. (OTCPK:SOHOF) notably. I personally don't like Soho's buildings, but the market seems to keep buying. Another way would be to get exposure to commodities, like iron ore (think Rio Tinto (NYSE:RIO)) or copper (ETF: JJC) that goes into construction.

DJ: In the book, you predict that lower-end manufacturing will shift from China to other low cost production countries. Are there specific countries which investors should consider raising their long-term asset allocation to?

SR: I am actually very bullish on Indonesia (ETF: IDX), and investors should raise their long-term asset allocation there, but also should keep a close eye on the political situation to make sure it remains stable. I was in Indonesia last month to look around, and I liked what I saw. There was an optimistic feel, very different from when I first visited there in the mid-1990s when desperation prevailed. The country does not have the efficient labor pool that China has, but already companies in light industry like Adidas are relocating manufacturing there. Bankers told me their garment manufacturing clients were moving away from China to Indonesia. They also have 220 million people, so ultimately they will become an attractive market for consumer goods too if they keep growing at the 6-7% clip they have been.

I also like Vietnam (ETF: VNM), and it will continue to grow, but investors should be more cautious. Inflation there has been soaring 10-20% a year and the infrastructure is terrible. Restaurants price everything in USD because the Vietnamese currency, the dong, has been so volatile. Even getting from the airport to the center of Saigon takes far too long and the government just has not made the investments necessary for manufacturing at a world-class level. I prefer Indonesia over Vietnam right now.

DJ: Many investors prefer ETFs over individual stocks, particularly for foreign markets. Which ETF would be your top choice for exposure to China's growth and why?

SR: There's been a proliferation of ETFs covering China. They now include the SPDR China S&P ETF (NYSEARCA:GXC), the iShares FTSE China 25 ETF (NYSEARCA:FXI), the Guggenheim China Small Cap ETF (NYSEARCA:HAO), the China Infrastructure ETF (NYSEARCA:CHXX), the PowerShares Golden Dragon Halter USX China Portfolio ETF (NASDAQ:PGJ), and the WisdomTree Dreyfus Chinese Yuan ETF (NYSEARCA:CYB).

But investors need to be cautious about China ETFs. Many don't really give you a broad exposure to the whole Chinese market but to a narrow group of companies available to Western buyers. The iShares ETF (FXI), for instance, is overweight financials and other state-owned enterprises. When investing in state-owned enterprises you have to analyze growth potential from both a market and political angle. For instance, banks in China are more like political tools of monetary policy than money making machines. The government might force banks to open up credit lines to state-owned enterprises like China Telecom (NYSE:CHA) just to pump liquidity in the system, without regards to profits. Or the state oil giants like Petrochina (NYSE:PTR) might be forced to take a hit on profit margins to ensure gas prices to the population stay reasonable even if crude prices are soaring, so investors will lose even if oil giants in the rest of the world are making money.

If you are going to invest in China ETFs, you cannot just buy them and forget about them like you might DIA or QQQ in the U.S. They are not long-term stable bets, but highly volatile. You have to check monthly to make sure that the weighting makes sense. I prefer recommending people choose 10 stocks on their own or go with more actively managed funds because the managers are doing due diligence and are changing allocations as needed. I like Anthony Bolton's Special Situations China Fund at Fidelity. Anthony endorsed my book actually, but I know he is a savvy investor who actively is doing due diligence.

DJ: What could go wrong with the China story for investors? Should long-term investors be concerned about downside risk?

SR: Investors should be concerned about the risk of the U.S. provoking a trade war with China. President Obama has taken a strong stand recently, saying China is not "playing by the rules" and is rotating 2500 marines through Darwin. Many Chinese view this as an attempt to contain China and undermine its growth. In 2012, for the first time both China and America are having a leadership change in the same year. I worry that to cement power, leaders on both sides might appeal to hawkish factions calling for muscular responses, which could quickly spiral out of control and cause a trade war or worse. It is also tricky to shift the economy from exports to consumption without causing too much hardship to provinces like Zhejiang and Guangdong that are manufacturing focused. We already hear stories of factory owners in Wenzhou in the Zhejiang province fleeing because they owe too much to loan sharks and factories shutting.

The government needs to manage a fine line between causing a healthy shift and causing massive unemployment. So far the pain has been exaggerated in the Western press and everything is manageable, but if the eurozone collapses that could cause serious unemployment and thus social instability here. Long-term I think you would be crazy to bet against China, but there will some rocky times in the coming months. Smart investors will look at hard core data rather than phantom facts and fear mongering in the press.

DJ: Finally, tell us more about your book, and how it can help investors.

SR: My book is really meant to be entertaining yet informative. It should appeal to serious investors trying to grasp the big trends in China, but it is also meant for the everyday intelligent reader of The New York Times and listener of NPR that does not necessarily deal with China on a daily basis. It is not a highly technical book with lots of jargon. I have chapters on the "modern Chinese woman," the real estate sector, food safety, China's investment in Africa and Australia, and even one on lessons learned from China's sex industry as examples.

I take readers behind the scenes in China in each chapter with personal stories, to get a perspective not easily gotten in the Western media or from quick fly-ins into the country by investment analysts. The fun parts are my interviews with billionaires, senior government leaders in the senior leadership compounds, migrant workers and even prostitutes to help track China's evolution. But I also have a lot of hard-core data in there from my firm's research.

I hope readers enjoy the book. It hit #3 on Amazon's best seller list last week for new and upcoming releases for international economics, so I have been shocked by the welcome it has received so far. Hopefully audiences will enjoy the read when it officially comes out in March. The key is that the world needs to understand China better.

DJ: Thank you Shaun!

SR: Thank you!

Read part I of the interview »

Shaun Rein's articles can be found here. His new book is available for order on Amazon: The End of Cheap China: Economic and Cultural Trends that will Disrupt the World

Disclosure: Neither the interviewer nor the interviewee have any positions in any of the stocks or ETFs mentioned.

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