Make the Biggest Gains in China's 'Gray Market' Before the Government Finds Out With This CEF

Includes: CAF, CYD, FXI
by: Money Morning

By Money Morning Editors

China is set to see its 10th year in a row of more than 9% growth in 2011. But that estimate is only based on the "official" Chinese numbers. The real growth is in China's "gray market." And that's where investors have the very real opportunity to find prodigious gains in the coming months.

Up to 90% of the money in China is hidden. It passes behind closed doors and between private citizens. The government never sees it. And that, more than anything, is what's building China's booming domestic economy.

If you want to make serious profits in China this year, don't look to official reports or big-name Chinese companies. Follow our lead to the country's newest industries and its smallest public companies to access the secret Chinese economy.

The Boom Is Back

If the United States has a growth problem, China has just the opposite. The world's second-largest economy is set to grow 9-10% this year, building on its strong rebound from the global financial crisis. Beijing is determined to accelerate China's transition toward a domestically centered economy, while stabilizing the country's prices and cutting government waste.

So in addition to strong growth numbers, investors can expect more disciplined, fiscally responsible, economic development. In other words, China is growing up. This means Chinese markets are going to be less volatile going forward. But its growth will also be more reliable and sustainable.

The World Bank expects China's growth will slow to 8.7% in 2011, but our chief investment strategist, Keith Fitz-Gerald, thinks that estimate is too conservative. According to Fitz-Gerald, 9-10% is more likely for 2011, and the number could reach as high as 12%.

Government policies and a rapidly emerging middle class will continue to drive economic growth in China. However, another major catalyst will be the so-called "gray market," which means cash that's outside the official system. There are thousands of ways to hide cash from the government in China. The country's households hide as much as $1.4 trillion (9.3 trillion yuan) of income that is not reported in official figures, with 80% accrued by the country's wealthiest people.

The average urban disposable household income in China is $4,866 (32,154 yuan) a year. That's 90% more than government figures. The top 10% of China's households take in $21,035 (139,000 yuan) a year, more than triple the official numbers. If these numbers are correct, it means that China's GDP is grossly understated, as is its income generation. And it demonstrates how much the West has misjudged the country's domestic economic progress.

Westerners have also underestimated the effectiveness of government programs, such as the 50-year "Go West" campaign to balance growth from the seaboard to the inner provinces.

The two biggest misconceptions that outsiders have about China are that it's solely dependent on exports and manufacturing, and that its Communist government will somehow interfere with capitalist development. If anything, Chinese-style Communism has proven remarkably fertile ground for the growth of capitalism.

Price Punch

Indeed, China's biggest problem is not generating domestic growth, but ensuring that it is balanced and stable.To that end, containing inflation and spurring consumption will be Beijing's main focus in 2011.

The People's Bank of China (PBOC), the country's central bank, began raising its inter-bank lending rates late last year. It increased reserve requirements for banks and allowed the yuan to gain a bit against the dollar. As a result, the yuan has been seen at record highs against the U.S. dollar. China's consumer inflation was at an all-time high late last year, but the country's swift corrections seem to be controlling inflation in 2011.

Rebalancing Act

In addition to stabilizing prices and containing inflation, China will continue its transition to a more domestically driven economy.

People too often think of China as the world's manufacturing floor. The reality is that China is working diligently to rebalance its economy with a greater focus on the service sector, especially services provided inside the country. And it's working. China's purchasing managers' index (PMI), a growth indicator, for the manufacturing sector is slowly falling.

But while manufacturing is slowing down, China's service sector is heating up. China's PMI for the non-manufacturing sector has been rising due to large investments and new government policies encouraging expansion of service industry companies.

From 2005 to 2009, the total volume of China's service trade rose to $287 billion from $157.1 billion. But just in the first half of 2010, service exports surged 31.7% to $166 billion. And the latest statistics from the Ministry of Commerce show China's service trade rose 17% for the entire year, and China's service exports now rank fifth in the world.

In 2011, Chinese authorities will lean heavily on the country's service sector to create jobs, as monetary tightening and a rising yuan squeeze manufacturers. A recent survey of employers ranked the services sector fourth for job growth. It predicted a net employment outlook of +54% in coming months. That trailed only the finance, insurance and real estate sector, which had a +55% rating.

In addition to more hiring, employers are paying higher wages. Every province and municipality in China experienced a rise in its minimum wage last year, with increases ranging from 12% to Beijing's 21%. With an employment picture that's very different than the one we're seeing in the United States, China has clearly hit its stride in a system that is both successful and unique to its strengths.

Historically, China has had the world's largest GDP in 18 of the last 20 centuries. Communist or not, the country is now resuming its place in the world order based on its population and aggregate purchasing power.

China's Driving Future

China supplanted the United States as the world's largest auto market in 2009. And 2010 numbers look great. For the first half, alone, car sales grew more than 30%. China sold 7.18 million auto units in that time, compared to 5.6 million in the U.S. And analysts believe the gap between China and U.S. auto sales will only grow from here on out.

China's automobile market is expected to grow by 15% in 2011. GM and its joint ventures increased vehicle sales in China by 33% to 2.2 million vehicles in the first 11 months of last year. Auto sales in China could even hit 20 million in 2011.

If you're interested in investing directly in China's booming auto trade, take a look at China Yuchai International Ltd. (NYSE:CYD), which manufactures and sells diesel engines, mainly distributed in China. CYD benefits from three uniquely Chinese trends: Rising consumer purchasing power, the Chinese infrastructure build-out and the development of transportation within China to move people, goods, and services around the nation.

Investors might also consider a closed-end fund such as the Morgan Stanley China A Shares Fund (NYSE:CAF) or an ETF like the iShares FTSE Xinhua 25 Index (NYSEARCA:FXI). The latter seeks to mirror the price and yield performance of the underlying index, which tracks 25 of China's largest and most liquid companies. At least 90% of the fund's $8.1 billion assets are invested in either Chinese shares or depositary receipts representing Chinese securities. FXI is a safe bet for overall Chinese economic growth.

However, CAF has better access to the country's gray market. Small business ventures that are often directly linked to gray market funds are traded only in A Shares -- and CAF is the one fund that allows Western investors access to these A shares.

It's also one of the best ways to profit from China's shifting growth model. Recent portfolio allocation of CAF shows 28% of its holdings were in consumer goods and services, 26% were in financials and 18% were in basic materials. It holds shares in companies that make products as divergent as auto components and beverages. And it has numerous stocks in the metals and mining sectors. Overall, CAF is a great way to access all of China's off-the-books funds.

Disclosure: None

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