Six Reasons To Buy China Soon

For nearly three decades, China has been the fastest-growing country in the world. With a rate of savings and investment exceeding 35 percent among its 1.3 billion people, and foreign reserves that already top the planet, it is set to become the most important country in mankind's future."
-- Jim Rogers, Legendary Investor

So is it time to buy China yet?

Two weeks ago we noted that India looks like a buy. After bottoming out in July, various India ETFs are now trading at multimonth highs.

Shanghai, though, continues to look ugly. The Chinese stock market has been a downer for all of 2008... and even with the Olympics finally here, the mood hasn't brightened yet.

click to enlarge

courtesy of Yahoo! Finance

As with India, a number of factors came together to hit China hard. But also as with India, a bottom could be just around the corner.

Here are a few reasons why China is shaping up to be a buy. Not yet, perhaps, but soon.

Reason to Buy China #1: The Silly Season Is Over

Chinese investors went through a mania phase last year. There were tales of lines half a mile long snaking out from the doors of the local stock brokers. In April 2007 alone, nearly 4.8 million new trading accounts were opened in China -- more than the prior two years combined.

All these new buyers led to a silly season for Chinese stocks. You could see it in the difference between Shanghai A-shares and Hong Kong H-shares...

At one point, companies with dual listings in Shanghai and Hong Kong were getting as much as an 80% premium on the A-shares price. This was a reflection of Chinese capital controls -- it's still tough for mainland Chinese to get their money out -- and naive buyers who wanted to play at any price.

Now that the frenzy has subsided, real values are starting to show up again. The hot money has burned itself out, providing opportunities for those who see longer-term value and aren't out to just flip a quick buck.

You see this pattern play out over and over again when a new opportunity comes to a place. Investors get excited and lose their heads, they push things way too far, and then the market comes crashing back to earth. That's when the patient players get interested.

Reason to Buy China #2: Oil Is Coming Down

As of this writing, crude oil is more than 20% off its near-term highs. It looks like oil could be heading for the $100 mark -- a possibility we pondered in "What If the Price of Oil Implodes."

One of Asia's greatest challenges has been keeping a lid on inflation pressures. It's not easy to grow like crazy without seeing the price of basic goods and services rise too quickly.

Oil closing in on $150 a barrel threatened to swamp Asia with inflation on a local level -- as the price of transport, food, and fuel went up -- and also to cut into export profits as shipping costs rose.

With oil backing off, China and India can breathe a little easier. The fear that high-priced oil might kill the Asian miracle is lifting. That gives them more time to tap alternative energy solutions and build economic strength at home.

Reason to Buy China #3: The Locals Are Optimistic

The news reports mostly focus on the bad things -- civil unrest, government crackdown, pollution and so on. That's the nature of the beast mostly... for the most part, good news isn't as interesting as bad.

But a recent survey from the Pew Research Center shows that most Chinese feel positive about where their country is headed. According to the survey, 86% are "content with the country's direction." (That's up from just 25% six years ago.)

Perhaps even more surprisingly, six in 10 Chinese reported being satisfied with their jobs. And 70% were in favor of China's shift toward a free-market economy.

The biggest concern in the Pew Survey? Rising prices. But that concern is addressed by the fact that oil is headed down these days -- not marching higher as it had been for most of the year.

Reason to Buy China #4: The Growth Is Still There

China has had an amazing run, growing its economy at a near double-digit pace since the early 1980s. But the dragon isn't done yet -- not by a long shot.

Global Insight, an economic consulting firm, forecasts that China will overtake the U.S. as the world's largest manufacturer in 2009. This is as much because the U.S. base is shrinking, even as China's is growing... but that still counts as an eye-opening stat.

Plus for the longest time, China was seen as the world's source for low-tech goods. Chinese factories were known more for sneakers, trinkets and cheap plastic toys than items of real value...

That's all changing now as China moves up the quality food chain. Now we are seeing savvy companies like China Medical Technologies (CMED) produce some of the most sophisticated high-tech devices in the world. As China gets better at enforcing intellectual property laws, its high-tech skills will only increase... and profit margins, too.

Reason to Buy China #5: Personal Savings and Domestic Demand

Perhaps even more impressive than China's long-term growth rate is the personal savings rate.

Americans spent more than a dollar for every dollar they earned in 2006. The U.S. savings rate actually went negative. The Chinese, meanwhile, salt away 35 cents for every dollar they earn.

Just imagine how much extra money you'd have on hand if you'd managed to save 35% of your income, year in and year out, ever since you started working. Then just think of all the things you could buy with that cash.

Part of the reason the Chinese save so much is because there's no real social safety net. But that's changing, too: As the Chinese economy evolves, things like insurance and healthcare and retirement plans grow more affordable.

The upshot is, at some point, China's big savers will feel a little bit more comfortable spending some of that cash they've saved up. And the newly minted middle class in China are already taking a hard look at things like cars, air conditioners, washing machines and so on.

As local economies grow, the locals themselves feel more comfortable spending a portion of their ample savings. That in turn leads to more domestic growth, which leads to a more positive outlook, which in turn increases spending. Chinese domestic demand is headed into a virtuous cycle that could run for decades.

Reason to Buy China #6: Huge Foreign Reserves

In balance sheet terms, China is rich... massively rich.

We've already seen what can happen when cities and counties go bankrupt. The residents of Orange County, California, got a nasty taste of that. Jefferson County in Alabama was on the brink this year, too. (As with Orange County in 1994, they took on some really dumb trades.)

So it's not good when some regional authority -- be it local or national -- is running short on cash. China doesn't have that problem. If anything, they have the opposite problem. Economist Brad Setser estimates that China has somewhere between $2.3 trillion and $2.4 trillion in excess reserves.

That's a lot of dough... enough to make a 20% down payment on the entire U.S. economy! And hundreds of billions more roll in every quarter.

Point being, money can't always prevent bad things from happening. But it sure can fix a lot of things. If China has to take extra steps to keep economic growth on track or keep the domestic demand side humming, it certainly won't be stymied by lack of funds.

Not Just Yet, But Soon

So there you have it. For the six reasons above (plus a number of others not mentioned), China's long-term outlook looks very strong.

Because of that, and because of the depressed state of Chinese equities right now, some China plays look more favorable than they have in years. I wouldn't pull a long trigger on any of the China ETFs just yet. There's plenty of time for the technical side of things to firm up first. But I would definitely keep a close eye on things.

One last quick thought: One of the ironies of markets is that the biggest profits often come not when a good situation turns itself into a great situation... but rather when a bad situation becomes good.

This is because investors are so naturally predisposed toward optimism. So when "good" becomes "great," some of the optimism premium was already built in, and the upside isn't always as strong (until the blow-off phase arrives).

But when bad morphs into good, or even simply to "less bad," there is room for large (and safe) gains, as renewed excitement creeps in after an extended absence.

That's where it feels like we are with China... waiting for the bad to turn good, which it soon could.

And aside from big picture trading opportunities, there are a number of smaller Chinese growth companies -- many of them traded on U.S. exchanges -- that look very appealing here and now. Stay tuned!

Comments

[RLLH:]

You could add reason #7, they aren't governed by U.S. politicians.

2008 Aug 13 11:46 AM

[Truth or Talk_:]

But how real is that GDP? - how much of the 40% fixed asset investment contribution is the good stuff?

2008 Aug 13 03:38 PM

[Universal H...:]

Reason #7b: The "Free Market Economy" in that Communist country is, in most respects, freer than ours...

2008 Aug 13 04:12 PM

[Chandler Lutz:]

Great Article! I have to disagree that over the long run a super high savings rate is not always a good thing...After all, how do you get people to spend money in the face of a downturn if they save so much??...Japan couldn't figure it out throughout the 1990s. China's obviously not facing that right now, but it's something to keep in mind.

I do have to say that you have to pick Chinese stocks very carefully. First, I don't believe any numbers provided by Chinese companies that aren't traded on an SEC regulated exchange. Also, many Chinese companies are situated in very precarious competitive positions. These companies are trying to "move up the value chain" and produce more technologically advanced products. This may be great for China as a country but could present a difficult scenario for investors since these firms have no history of producing such products so it may be difficult for investors to judge the company's competence. Also, China's companies are going to start competing more directly with firms firms in many developed countries especially those in southeast Asia. How that competitive landscape plays out often very difficult to determine especially given uncertainty in the international currency markets

I know I've been rambling but I just want to say one last thing: A growing GDP does not necessarily mean success for investors. Jeremy Siegel in his book "Future For Investors" cites a study that found that stock returns are actually negatively correlated with gdp growth given that gdp growth is positive.

2008 Aug 13 05:24 PM

[johnthebear:]

The following should help shed some light on the question: I agree with Mr. O'Brien's analysis.

In my view, China may be down a couple of years, just like the rest of the world. Then it would be the time to buy China, but not now.

China's Negative Economic Outlook

by: Kevin O'Brien posted on: July 02, 2008 |

Certain recent developments in conjunction with prevailing global economic trends appear sufficiently serious to warrant a current economic assessment of the People’s Republic of China [PRC] and a review of China’s sovereign credit risk.

U.S. ECONOMIC TRENDS

The U.S. economy is experiencing a significant contraction as U.S. consumer spending continues to decline. Housing prices have plummeted as the rate of both residential and commercial mortgage delinquencies continues to increase. At the end of the first quarter of this year, nearly nine million borrowers held mortgages exceeding the value of their homes, and this number is expected to increase significantly. The U.S. economy shed 80,000 jobs in March according to the U.S. Department of Labor, the largest loss in five years. Average U.S. household debt is 85% higher than in 2001, and continues to increase as consumers take on greater levels of debt in response to rising commodity prices, particularly food and energy costs. Delinquency and default rates for credit card debt, automobile loans and student loans continue to rise rapidly, as delinquencies have increased from less than $300 billion in 2005, to $715 billion in 2008; representing an increase of nearly 150% within 36 months. The present economic stress will likely be compounded by an expected record number of bank failures. U.S. consumer spending is predicted to continue to decline as consumers experience increasing commodity price inflation and credit contraction.

In a report dated May 19th, Oppenheimer analyst Meredith Whitney warned:

The real harrowing days of the credit crisis are still ahead of us and will prove more widespread in effect than anything yet seen. Just as strained liquidity pushed so many small and mid-sized specialty finance companies to the brink, we believe it will do the same to the U.S. consumer. We believe losses will only accelerate further and far worse than the most draconian estimates.
Ms. Whitney also estimates about $2 trillion of credit card lines will be removed by 2010, cutting the credit available to U.S. consumers by nearly half.

CHINA’S ECONOMY DEPENDENT ON U.S. CONSUMER SPENDING

The significance of the negative short- and mid-term U.S. economic outlook is especially troubling to China’s export sector, which is the primary hard currency earnings producer for the Chinese government. As U.S. consumer spending continues to retreat, the economic effect is anticipated to produce severe structural pressures on China’s export-driven domestic economy due to significantly decreasing external demand.

PERVASIVE INFLATION IN CHINA’S DOMESTIC MARKET

China’s economy continues to experience pervasive inflation which is particularly manifest in such consumer sensitive sectors as energy (e.g., petroleum prices which have more than doubled over the past twelve months) and food staples (e.g., the price of food, which increased 23% just during the month of February). Chinese consumers have benefitted from the state control of energy prices, which has also resulted in the loss of over 50% of the value of Sinopec shares within the last six months as the government continues it attempt to control fuel costs for consumers. Such trends are unsustainable for a country with a population in excess of 1.3 billion and which imports approximately 78% of its petroleum. Data published by the U.S. Energy Information Administration indicates that China’s increase in oil demand represents a majority of the total global increase in demand. With increasing demand and relatively flat domestic production since 1986, China’s reliance on petroleum imports is expected to continue, subjecting the government to additional economic stress.

In its semi-annual Economic Outlook published this month, the Paris-based Organisation for Economic Co-operation and Development [OECD] expressed concern regarding the threat posed by persistent inflationary pressures manifest in China’s domestic market. China’s consumer price index was officially reported at 7.7% in May and 8.5% during April, and remains above its January level of 7.1%. Taking into account China’s industrial consumption of commodities and that China produces very few commodities domestically and is therefore reliant on global sourcing at prevailing prices to procure raw materials for its manufacturing industry, the OECD expects wage and price inflation to erode China's export competitiveness.

The OECD report states:

Coupled with ongoing weakness in external demand, exports and the pace of market share gains are projected to slow markedly.
Such an outcome raises the risk of political instability resulting from increases in urban unemployment and other factors as discussed in this assessment.

ACTION

The following trends and events are identified as material to an assessment of China’s near- and mid-term economic outlook:

The extent of dependency of the Chinese government on hard currency earnings derived from manufactured exports supported largely by U.S. consumer spending.
The depth of the retreat in U.S. consumer spending and the high probability of a prolonged contraction of the U.S. economy.
The fundamental dynamics responsible for China’s domestic wage and price inflation and the increased risk of political instability attributable to the rising cost of imported consumer and industrial commodities, reduced demand for export products, and a significant increase in urban unemployment.
The rate of increase of China’s petroleum consumption and the dependency of China’s export manufacturing sector on petroleum imports.
China’s ability to maintain the global competitiveness of Chinese manufactured goods in the face of rapidly increasing transportation costs.
Government debt statistics evidencing an unsustainable overreliance on debt financing, particularly short-term debt, to sustain economic growth.
Repudiation by the Government of China of $260 billion of its sovereign debt and the pending reclassification of the Chinese government’s sovereign credit rating into ‘Selective Default’.
Upon an evaluation of the foregoing, Sovereign Advisers issues a Negative Outlook for the domestic economic prospects of the People’s Republic of China and a Negative Outlook for the safety and performance of government bonds issued by the People’s Republic of China.

2008 Aug 13 05:30 PM

[TERN:]

Repudiation by the Government of China of $260 billion of its sovereign debt and the pending reclassification of the Chinese government’s sovereign credit rating into ‘Selective Default’. --------
You have to make it clear that this concerns the long-repudiated debt of the old "Republic of China".
Maybe the court case and the publicity will make the government change its mind and decide to honour these old debts after all.

That would be hugely positive.

2008 Aug 13 08:59 PM

[From India:]

Anyone who thinks about buying India now is a fool. I live in USA and I am currently vacationing in India. Its true that People are spending like crazy. But look at the prices of everything around here, they are going over the roof. I suspect the real inflation here is around 25%. Wages are increasing, and the demand for everything is way up. Heavy urbanization, extreme pollution and migration of farming people from Rural areas is definitely going to weigh heavily on food prices. Inflation is going to kill this economy and I dont suspect it is going to moderate soon (even though the recent government prediction is that it will moderate by 2009 second quarter to around 8%). People saving in the banks are earning a negative real rate of return when you look at Indian bonds yielding about 10% currently. I dont know how long people will still keep saving their hard earned cash in banks. (As you may have noted, the Real Estate developers are supposed to be scrambling to raise cash for their projects)

I believe the Risk free rate to be around 16% with inflation around 13% (Govt measure, and also without any regards to current Domestic Bond Yields and a paltry risk premium of 3%). With a COE of around 16% (Without even considering a Country premium) , your risk is not rewarded unless you make more than 16% and I dont think that it is an easy task to find decent valuations.

If you ask me, even the domestic investors are lame, without any understanding of risk-reward. I will refrain from investing in Indian stocks that are Export oriented at the least. However, the domestic sector may still be a viable option (if the ADRs are available).

I am negative India. And my advise is to refrain from buying at this time. Wait, they have a lot of scope on downside. The risk reward ratio is totally skewed.

2008 Aug 13 09:23 PM

[investor88:]

Agree with views of "From India." Recent history suggest China is correlated with India so in the next year or two China like India is unlikely to perform from a equity investment viewpoint, or you have to be cautious and sceptical. Long term everybody agree India and China have a bright future, grow faster than the developed economies.

2008 Aug 13 10:47 PM

[techy:]

I am not bullish on india, but i kind of disagree with "From India" on that inflation being 25%.

i hope he is not including the price of a house...which has gone up 1000% in some locations in the past 4-5 years.

according to me the biggest cost of of living in india is commodities and energy.

and if i am not wrong, the cost of commodity and energy is almost same all over the world (+-5%), so if inflation in india is 25%, then it has to be atleast 15% all over the world.

i am not in india but i have family and friends and if we exclude the housing thing, inflation is definitely not 25%, yes it is more than 7-8%, but that is mostly due to commodities and energy skyrocketing all over the world.

by the same measure real inflation must more than 6-7% even in usa. (cost of gas itself is more than 30% YoY)

another thing, if the currency of india is not depreciating against USD, then it does not matter if inflation is 20% or 40%, for a non-indian investor.

and in the past 2-3 years, indian currency has appreciated against the dollar.

From India: you sound like an elitist.....when you say wages are rising....what do you expect, inflation is high but wages to stay stagnant??

2008 Aug 13 11:32 PM

[James Lewis:]

China is a Tiger - NOT a Dragon.

In terms of Inflation India is probably nearer 15% - 16%
It has to be said that 1000% increase in property price also reflects a very worrying statistic. China has seen 500% gains. Anything over that (regardless of fundamentals) really reflects enviroment of extreme inflation.

I also believe that India and China are two completly different economies. And that analysing the future of one to predict the other is useless. I believe the single most important thing about where China is heading has to do with the huge reserves the government has and the pro-growth/pro-employm... government officials back-pockets policies.

China just spent 80 billion USD on the Olympic Games to show the rest of ther World its power etc etc.

They really would not think twice about spending 200-400 billion USD out of the 2+ trillion they have to stimulate demand during the next few years of hardship.

China's cushion is huge.

2008 Aug 14 12:30 AM

[fxtrader07:]

www.investorsinsight.c...

people tend to extrapolate trends and usually do not expect major interruptions or deviations. The business cy<cle is neiter dead nor can it be cheated over longer periods of time. China is going to get a heavy recessionary fallout from the recession that arrives in the usa and europe. the stock market there is signalling it all year.
in that downturn it will be seen how robust and of what quality china#s growth really is/was. and regarding the forex reserves: they may soon find themselves in a position where they will have to spent billions and billions to rescue once again their own banking system. the us-subprime sector looks like prime when compared to china#s lending standards. watch out below.
therw ill be a time to buy china with both hands. it hasn't arrived yet. similar with india - though their economy has different problems than the chinese and might overall weather the coming months better

2008 Aug 14 04:38 AM

[Pipo:]

As Jim Rogers says investing in China in 2008 is like invsting in the United States in 1907.

The prospects are brilliant for medium to long term players. Visit a good Jim Rogers Blog at jimrogers-investments....

2008 Aug 14 06:31 AM

[From India:]

Techy

For the starters, India calculates Inflation using Wholesale Price Index (WPI): www.rediff.com/money/2....

I am being shocked at what I see at the retail level, at the Department Stores. On your next visit here, you will be surprised too. :)

When did we start excluding Housing from Inflation? Housing's share is about 20% worldwide ( or even more, can someone please supply the statistic?). I see no reason in excluding Housing from the basket as you are suggesting. Actually if you look at it, it is even more the reason to consider it seriously at this juncture: All this while, irrespective of the Housing Prices appreciation , the renting costs remained low, with the rents not having gone up noticably (I am no "Elitist" as you were suggesting - only a handful pockets of people were experiencing the housing price increase in the last 5 years, mainly in the technology areas). But now, everyone is starting to see and feel it. My own parents have started seeing people withholding from renting unless they are being rewarded with huge rent increases (around 20%). www.bls.gov/cpi/cpifp0...

No disrespect but just noticing something: You are being a true techy: Being a non-US investor, you were saying that it doesnt worry you what the underlying Economy's inflation rate is, since you feel currency exchange appreciation takes care of the equation: Please dont invest with out consideration of the fundamentals. That will not bode well for long term returns. In that case may be you should invest in Zimbabwe :) ( Disclaimer: I am just kidding, no serious offense).

It is true that one doesn't need to worry abt local currency's inflation if we are valuing companies in $. I just happened to start noticing something about one company's market capital and then it stuck me: That the WACC could be extremely high. RIL's market cap is around 3Trillion (local currency - I am not kidding). I dont know what kind of growth rate would support that kind of market cap. May be, all Indian companies should now start loading up on Debt.

One other thing: India was able to grow fast, as it had enormous amounts of labor available with out companies resorting to wage increases (not a lot other than technology and BPO). I believe they were able to satisfy Aggregate Demand with out major price level increases in the last few years - without resulting in major inflation. I mean with out Aggregate Supply curves shifting that much. The economy was humming and exports were good. Now I believe the times have dawned for major shifts. Anticipated inflation itself is 13% so I dont understand how it cannot feed into major AS curve shifts. In fact, this maynot bode well for Developed economies like US which were fed by cheap exported goods. (I think this is also true of China eventhough the underlying economies have major differences - structural?)

Even though Indians saved massively earlier, I am not sure the same will continue. Flow of foreign capital was good (even though it may have dried up now - need to locate real figures now), but with a negative real rate of savings, will they keep saving? ( I am suspecting they will not from whatI am seeing - there is a huge splurge). If domestic savings dry up and with Govt competing for foreign Capital, what will be the ramifications?

Overall, I dont think the times have come to start taking long term positions in India. Wait and you will be rewarded.

PS: Techy, I am no Elitist. Wagres should increase. But I am worried about unwinding of a spiral - of price level increases. I just happened to read this article and about India and thought I should express some of my concerns. India is long term story, but may be not now. I am passing it.

2008 Aug 14 08:40 PM

[toxxum:]

I was living in China for quite a few years and I wouldn't touch Chinese equities with a broom. Rapidly ageing population (in 2020, there will be more pensioners than people under employment); the environmental damage is estimated to eat up 10% of its GDP; the huge currency reserves are a result of the government printing money and then buying foreign currencies to keep the Yuan low; increasingly civil unrest (51,000 incidents last year alone); banking sector is burdened with huge non-perperforming loans; statistics are notoriously unreliable and mostly fake (how do you collect GDP data from the authorities of 30 provinces which are not fully computerized, yet publish monthly stats on the 2nd day of the following month??); the central government is desperately trying to hold to its powers by spending huge amounts on censorship (ever heard of the "China Great Electronic Wall"?); 70% of the population live on less than USD 1,000 per year etc etc.

Be careful before you invest. I was running a company with a few hundred people and I can assure you that what you read in your local newspapers does not reflect reality!

2008 Aug 14 09:16 PM

[daniela:]

Toxxum, great comments. China is not consumer economy. It is based mainly on exports. I would not touch China unless we really know how economic situation really looks like. That means fall of communist regime. It's good that author is buying into regime's happy numbers. Makes their economy go, economy keeps going. lalala-all is well.

2008 Aug 15 11:56 AM

[brick:]

when do countries like china ever escape the manufacturing mode and produce high quality goods that create real growth and a real competitive opportunity? i dont see that trend so where is the sustainable growth from a country with an anti-capitalism culture?

2008 Aug 20 10:21 AM