China - Basic Background and Current Issues, Part III
(February 13, 2005)
Please note that we switched to a neutral position from a 100% long position in our DJIA Timing System on the morning of January 12th at DJIA 10,530. No new signals as of now. My partner, Rex Hui, is currently in Hong Kong and so the new section on our DJIA Timing System won't be finished until he gets back from Hong Kong (middle of next month).
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Note: Going forward, our charts section will be updated on Wednesday and Sunday evenings - concurrent with the updating of our regular twice-a-week commentaries. I personally feel these charts are invaluable. One can also do historical studies on them - as well as to see how the DJIA and the NASDAQ are currently doing relative to their 50 DMAs and 200 DMAs.
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Dear Subscribers and Readers,
Hopefully, most of you haven't gotten too bored of the "China Story" that I have been discussing for the last couple of weeks. If so, then you may be glad that this will be the last week that I will be discussing this topic (at least for awhile).
No matter what type of investor you are, however, I believe China is an important topic to discuss, as the country and as her economy will have an increasingly large impact on all our lives going forward. The reason why I have chosen to discuss China in my commentary over the last few weeks is clear: China is the real thing - and they are determined to exert an increasingly large impact on the rest of the world. The Soviet Union, the only rival to the United States during the Cold War Era, ultimately collapsed because of the lack of economic might and stability. Japan, declared the heir-apparent to the United States in the early 1990s fared much better but had failed miserably to live up to expectations. Rest assured - China has learned a lot of lessons from these two former powers. It is still not certain that China can do a better job than the Soviets or the Japanese as we progress through the 21st century, but in many ways, the Chinese is already one of the most open and most powerful economies in the world today. And so far, it shows no signs of slowing down...
Readers who are reading this commentary for the first time should go back and read Part I and Part II of the discussion about the basic background and the current issues about China. I will conclude the discussion of China with this commentary. In Part I and Part II, I discussed a little bit of history regarding the growth of the Chinese economy - along with its demand of various commodities such as energy and steel. I also discussed China's entry into the WTO and the opening up of its economy - helped by the increasing participation of her citizens on the World Wide Web. Of course, China also has her own problems, such as a mismatch of skills in her labor pool and a potential overcapacity in the production side of her economy. The most significant of all these challenges (and which is also a structural problem) is the lack of transparency and lack of oversight - a problem which is inherent in an economy without an established legal and financial infrastructure. I will continue our discussion of China by talking in more detail about this lack of transparency. I will then conclude this commentary by discussing a common misconception and what overseas investors can do to take advantage of the maturing and continued growth of the Chinese economy going forward.
Readers may recall the table of the top 25 global websites that I posted in Part I of our commentary on China. Number four was Sina, number seven Sohu, and number nine was Netease. It is interesting to note that even though these three websites attracted a huge audience and were the first to succeed in the Chinese market, they did not try to seek capital or financing in China. Rather, they are all listed on the NASDAQ. Even Baidu.com, number six on the list, is planning to list on either the NYSE or the NASDAQ as it seeks to do a $200 million IPO very soon. This is all summarized succinctly by John Thornton, the former COO and President of Goldman Sachs, who is now teaching at Tsinghua University (pretty much the most prestigious University in China) in Beijing: "... I have probably 20 CEOs in my class, all of whom built their own companies, ranging from small to large. When you ask them where do they want to end up, 20 out of 20 say they want to be a public company on the New York Stock Exchange or NASDAQ, or possibly Hong Kong. None ever says Shanghai." Let's put it in another way. If you were a very wealthy individual working in Shanghai or Beijing, would you put your money in a Chinese bank or a Swiss or bank based in the United States? The huge foreign direct investment inflows numbers into China have been well-documented, but it is interesting to note that capital flight from China into other countries (such as Hong Kong or the U.S.) have surpassed foreign direct investment inflows historically.
The fact that domestic companies in China refuses or are still having trouble gaining access to capital in the Chinese markets speaks volumes about the local financial (and legal) infrastructure. The lack of a local financial and legal infrastructure is directly reflected by a lawyer per capita ratio of 11,000 to 1 in China, compared to 300 to 1 in the U.S. and 600 to 1 in the UK; as well as an accountant per capita ratio of 9,650 to 1 compared to 166 to 1 in the U.S. and 412 to 1 in Hong Kong. More recently, the lack of transparency in China was brought home in a huge way with the bankruptcy of China Aviation Oil - the biggest business scandal since the collapse of Barings in 1995. China Aviation Oil, the sole Chinese importer of jet fuel, it filed for bankruptcy on November 19th after incurring $550 million in losses from selling oil forward contracts starting at $30 a barrel. It is interesting to note that the trades were initiated in the first quarter of 2004 but management did not find out about the losses until late October. Even then, they did not inform their shareholders until after mid-November. Another interesting fact is that the company was relatively transparent because it was listed in Singapore. The question is: Are there other Chinese companies out there that have been doing the same thing? And if so, when will we find out?
All this is not to say that the Chinese government is making an effort to regulate its markets and to build up its credibility. For example, the China Securities Regulatory Commission (the Chinese equivalent of the Securities and Exchange Commission) was created in 1992 and currently has 1,500 staff members. In comparison, the SEC was created in 1934 and has 3,100 staff members. While the number of staff members in the CSRC is impressive, it is still not an established organization like the SEC. Moreover, it should be noted that the SEC has in recent years been accused of being soft-handed and in "looking the other way" when it comes to policing the local stock market. The SEC likes to cite the lack of resources. One thing is for sure: If China is to succeed in building credibility in its financial markets, it will not only need to hire more resources but attract financial and legal talent away from cities such as New York, London, and Hong Kong.
One issue that is close to most Americans' hearts is the issue of the trade deficit with China. Should the Chinese revalue the Renminbi in order to stem the flow of goods from China? Is this important? Okay, maybe this isn't much of a misconception and maybe it isn't too important but let's talk about it anyway. As everyone and his dog know, the U.S. is running a huge trade deficit with China today. A significant number of Americans today would like to blame China and India for all their economic and social problems - from "killing job growth" because of an "unfair advantage" in the form of low wages, a decline of our manufacturing and IT sectors, to the huge superiority of Wal-Mart. First of all, the magnitude of the trade deficit is directly related to the consumer culture and the immense consumption of energy in the United States. Second of all, 90% of all Chinese would like to have the same "problem" that Americans have when it comes to the "disadvantage" of higher wages. In my commentary last week, I also mentioned that the entry of China into the WTO has resulted in her making significant concessions to the United States and other countries around the world. In many ways, China is now a more open country (economically) than the U.S., Japan, and Western Europe (and other similar size developing countries like India). Make no mistake: The issue of "outsourcing" or "offshoring" is already a 100 year-old trend that will only persist as we progress into the 21st century. However, I personally believe that the average American will only benefit in the long-run. Think of the offshoring of the textile, semiconductor, and auto manufacturing industries as examples that have resulted in much lower prices (and higher quality) for clothing, electronics, and automobiles.
You may now say: Well, this is all fine but what if the average American doesn't have a job so he can earn money and buy the goods from China or India? Well, consider this: It is projected that 65% of today's kids in kindergarten will work in professions that do not even exist today - similar to a trend that has existed in the United States since WWII ended). Do we really need manufacturing or simple accounting jobs that could be done in China or India or that could be completely automated? My guess is that the children of tomorrow will despise working in the manufacturing sector - not unsimilar to the views that we have regarding the agricultural sector today. Andy Kessler, a former hedge fund manager who had huge success in running a tech fund and getting out in time before the bubble burst in 2000, goes straight to the point in his article about Steve Jobs and the iPod. To paraphrase Mr. Kessler: Apple sold 2 million iPods last quarter. Apple ships the design to Inventec. Inventec slaps it together (in China) and books $4 in profits per player using cheap labor, while Apple books $65 per player as its well-paid engineers sit in air-conditioned offices in California. Ask the kids at the local elementary school if they want to work in the manufacturing sector when they graduate. Isn't the answer obvious?
Even if the above is all bad, it should be noted that there is a huge difference between something "Made in China" and "Assembled in China." In a way, China is merely an intermediary for exporting countries like South Korea, Taiwan, and Japan. Most parts are actually made in these three countries, and then subsequently shipped to China to be assembled into the final product - revaluing the RMB will not make imports significantly more expensive since China does not provide much "value added" to these goods. The following chart courtesy of Gavekal.com says it all:
There is no doubt that China has been running a huge (and increasing) surplus with the United States for the last few years. However, China is also running a trade deficit with the rest of the world (mostly Asian neighbors) at the same time! Most interesting of all, the trade balance of China has been consistently declining since 1998. Is China a menace? Is China unfairly hogging dollar reserves in order to keep her currency artificially low so she can export more goods? The fact of the matter is that revaluing the Renminbi would not do a single thing. If the United States wants to cut the trade deficit and import less consumer goods, then the dollar will need to devalue relative to most of the Asian currencies like the Japanese Yen, Korean Won, and the Taiwanese dollar.
A further extension to this issue would be the question of the trade or the current account deficit - is it really that important? Note that the current account deficit has historically been a bad estimate since it has grossly underestimated exports. For example, how does one estimate exports like university educations, downloadable software, and banking services - exports where Americans have a huge comparative advantage? Moreover, according to the IMF, the world had a $150 billion trade deficit with itself as early as 1997. Since the sum of all the surpluses and deficits has to equal zero, it basically means the system of measuring surpluses and deficits is inherently flawed. Another question would be: New York basically runs a trade deficit with many of the cities or regions in the United States. In terms or prosperity and wealth, how does New York rank compared to the rest of the major cities or regions in the United States?
I will now conclude our commentaries regarding China with the discussion of what I believe will be the best Chinese-growth-related investments going forward. Before I begin, it is interesting to note that American investors today are playing "The China Story" by either investing in commodities or in companies that produce commodities - such as steel, copper, or oil. I do not regard this as a good long-term strategy for a couple of reasons:
- Commodity plays are very cyclical and involves careful timing. Also, to be bullish on commodities will (more or less) mean that one is naturally bearish on the innovation capability of Americans, the Japanese, and the rest of the world.
- A more stable and sustainable strategy would be to invest in companies that will cater to the Chinese consumer market or to take advantage of the structural changes in the American economy because of China and India.
When investing in a developing country with promising growth going forward, a very important economic concept should always be kept in mind - the concept of economic "Acceleration." To put it briefly, the concept of "acceleration" takes advantage of the fact that income levels are usually distributed like a normal or a bell curve - with the mean right in the middle - not unlike most socioeconomic variables such as age, the level of education, or the average number of hours worked for a certain group of people in society. The following example illustrates the what will happen to the demand of automobiles as the average income level rise from US$5,000 to US$8,000 in a general society:
History has shown that individuals can start affording cars at an income level of US$10,000. When the average income level is only $5,000, the demand is miniscule (represented by the area to the right of the red line but under the blue line). Given a 60% rise in the average income level, however, the demand of automobiles does not only increase by 60%, but by an amount many times that percentage. The new demand in automobiles is now represented by the area to the right of the red line but under the green line. It is a very powerful concept, indeed, and should be kept in mind as investors start thinking about investing in China going forward. History has shown that the "threshold" for TVs is $1,000, university education $20,000, and financial services $30,000.
Following are some things that look compelling (and not-so-compelling) in the long-run:
- Shares in financial services companies that cater to the Chinese market, such as HSBC (HBC on the NYSE) - keeping in mind the "acceleration principle" that I mentioned earlier.
- Multinational brand names that one believes can do well in China and India (such as Coca-cola, Tiffany's, etc.)
- The post-secondary education market here in the United States (which I have outlined in an earlier commentary) because of the big "skills gap."
- It is still not clear to me who will be dominant in the Chinese internet market going forward, although it is already clear that companies like Yahoo!, Google, and eBay will continue to dominate the U.S. internet market in the future.
- Again, I don't believe in investing in commodity plays - to a certain extent, PCs and automobiles are now commodity goods. I would not be surprised if either Ford or GM declares bankruptcy (or be taken over by a rival) within the next ten years because of continued competition from Toyota and Honda.
Bottom line: No doubt, the "China Story" is the real thing as we continue to find opportunities in the investment arena in the early parts of the 21st century. At this point, we are still early in the game, but it is definitely wise (and never too early) to start learning about the basic background and the culture right now. The real "fireworks" will come as the Chinese becomes fully complied with the provisions of the WTO in 2007 and with the Summer Olympic Games (to be held in Beijing) in 2008. As income level in China rises, we will also see an "acceleration" in the demand of consumer goods - which is where the real investment opportunities lie. For now, there are still challenges and structural problems in China - problems that may take decades to overcome - but for now, China is definitely the best economic growth and investment story since the rise of the Japanese in the 1960s to 1980s (and these investment opportunities will be all open to foreigners, unlike the historic isolation of the Japanese).
Update on the markets: I still believe we are in a defined downtrend - despite the uptick in the markets on Thursday and Friday. I will provide more details in an email to my subscribers tomorrow evening.
Henry K. To, CFA