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Decoding the Chinese Economy Puzzle
by: Jim Trippon
Even casual investors know by now that China is undergoing one of the largest economic booms in history. In less than two decades, fifty million Chinese have risen to the middle class. The country is on course to overtake Japan as the world's second-largest economy.
China's
explosive growth has attracted the attention of the world's
business community as the next great market for goods and
services. As the editor in chief of the China Stock Digest,
my focus is more specific. I and my staff in Mainland China,
Hong Kong, Taiwan and the United States are looking for the
greatest investment opportunities in the world's fastest growing
economy. But investor safety is paramount.
We
see double-edged potential. Successful Chinese companies will
be able to reap the growing wealth of the most populous nation
on the planet within their own domestic markets. What's more,
companies that trade on the Shanghai, Shenzhen, Hong Kong
and Taipei markets will also continue to enjoy explosive growth
in exports to the United States and Europe. The U.S trade
deficit with China is now above $27 billion per month. The
European Union's trade deficit with China was $62 billion
last year. China has become a world-class export colossus.
To
foreign eyes, the People's Republic of China (PRC) may seem
like something of a golden goose. China's gross domestic product
(GDP) grew by more than 9% last year. Since 1980 the GDP has
never grown less than an astounding 8% per year. Labor productivity
has more than quadrupled in the past decade. Global Insight,
Inc. projects Chinese exports growing in value to almost one
trillion U.S. dollars in 2006, shooting above the one trillion
mark by 2008.
With
eye-popping statistics like these, what could possibly go
wrong? What do investors need to know to avoid the pitfalls
inherent in unfamiliar foreign markets? Almost half a trillion
dollars in direct investment has poured into China over the
past decade. That doesn't include the forgotten portion of
Greater China, the ultra productive breakaway island of Taiwan.
What
guidelines govern the China Stock Digest to protect investors?
Let me share some tips that are born of our two decades of
investment experience in the Chinese markets.
Too
Many Exchanges
If
there is one reservation that I come across in countless conversations
with investors, it is the fear of dealing with mysterious
markets half a world away. That is not a trivial issue. Let
me explain why.
Chinese
stock markets are composed of four unique stock exchanges.
They are the Hong Kong, Shanghai, Shenzhen and Taipei markets
and they are run under three different market systems.
The
stock exchanges in Shanghai and Shenzhen are run by the People's
Republic of China, which is still learning its way in the
financial regulatory area. By contrast, Hong Kong's stock
exchange operates much like the London Stock Exchange. The
Taipei Stock Exchange is run according to Taiwanese rules,
which are also similar but not identical to the regulations
in London and New York.
Therefore,
one of the issues investors have to consider with regard to
risk is that Hong Kong and Taipei have a history of financial
regulations and legal systems that are fairly well established
and reliable. The Chinese exchanges in Shanghai and Shenzhen
are operating in a country that has explosive economic growth,
but their regulatory infrastructure hasn't yet caught up.
That's true in any emerging market, and it does create an
added level of risk in the PRC.
To
be specific, issues such as intellectual property protection,
financial disclosure, corporate governance, and the issues
about to the amount of information that gets released to a
potential investor all create a higher level of risk dealing
in the Chinese markets than you would have in a more transparent
or more regulated market such as New York or London.
In
addition, the Chinese market system is still evolving and
emerging from a complex financial and political history. There
is a confusing variety of shares to be understood. There are
"A," "B," and "C" shares traded on the Shanghai and Shenzhen
exchanges. There are "Red Chips." "H," "N," and "L" shares
traded in New York, Hong Kong and London.
Most
of these shares we deliberately avoid. Nevertheless, here's
a brief primer so you won't be misled by terminology when
an alphabet soup of share offerings confronts you:
- A
shares are usually held only by Chinese residents and are
denominated in Yuan (also known as renminbi), the local
currency of the People's Republic of China. As of 2003,
Qualified Foreign Institutional Investors or QFIIs were
authorized to trade in A shares in Shanghai and Shenzhen.
All QFIIs must have at least $10 billion in assets under
management, but China's foreign investment rules are being
relaxed
- "
B shares are designated for foreign investors and are denominated
in foreign currencies on the Shanghai and Shenzhen exchanges
- "
C shares are owned by state-run corporations and are not
yet publicly traded
- "
H shares are stocks of companies incorporated in China and
listed on the Hong Kong Exchange and some foreign exchanges
such as Singapore
- "
N shares are stocks of companies incorporated in China and
listed on the New York Exchange, sometimes as over-the-counter
(OTC) shares
- "
L shares are stocks of companies incorporated in China and
listed on the London Exchange
- "
ADRs and ADSs. These are American Depository Receipts and
American Depository Shares traded on the New York Stock
Exchange and the NASDAQ
- "
GDRs. Global Depository Receipts are traded largely on the
London Stock Exchange
When
dealing with companies from the People's Republic of China,
we want to focus exclusively on companies that are listed
on the New York Stock Exchange as ADRs or ADSs. There's a
very important reason. In order to qualify as an ADR or ADS,
foreign companies must step up to the stringent disclosure
requirements of the NYSE in order to maintain their listing.
We feel strongly that sticking with companies that meet these
standards gives us an essential layer of protection against
investment risk. With regard to stocks that trade in Hong
Kong and Taipei, we feel that the regulatory systems there
are much more advanced, and we feel we can put much more reliance
on the information released by those companies.
What's
more, we want to investment in companies that furnish investors
with real time trading data and multiple sources of news about
current corporate events. It is our opinion at the China Stock
Digest that companies which are traded on the NYSE are much
more likely to meet this standard.
The
A Share Blues
Despite
China's staggering economic growth, the A share market has
lost half of its value in the past five years. That's an astonishing
number. While the economy grew by 50%, an astonishing 70%
of investors within Chinese markets lost money according to
a recent survey.
It
is small wonder that the Chinese people squirrel trillions
of dollars worth of their savings into shaky banks with low
interest rate returns. Because the Shanghai and Shenzhen exchanges
have an appalling reputation for corruption and outright fraud,
we have avoided these markets like the plague. Only five percent
of all 1,400 listed stocks have made money during the economic
boom of the past five years. Many investors lost their life
savings on those two markets while investment capital poured
into China.
Things
are changing at last. But the situation had become so embarrassing
that a moratorium was placed on new listings on the Shanghai
and Shenzhen exchanges. As capital markets dried up within
China, companies were forced to arrange financing with bank
loans as their only option.
Finally,
the Beijing government has seen the need for reform and has
introduced major changes to regulate the behavior of listed
companies and the markets themselves. The Chinese Association
of Chartered Certified Accountants (ACCA) proudly announced
recently that China's accounting standards had at last come
into compliance with accepted international conventions. The
government has called for new financial reporting standards
and a loosening of restrictions on foreign capital to bring
new money into the system.
The
changes may be working. This year the Shanghai Composite Index
has risen by 43%. The moratorium on listing new companies
is being lifted. But the question remains, will the recovery
last? Have the reforms been sufficient to make the mainland
a secure place for all foreigners to invest? We at the China
Stock Digest don't think so.
The
Shanghai Index is still more than 25% below its 2001 peak.
There is still no sense of assurance that investor's capital
won't be wiped out again by wild speculation and manipulation.
More foreign money and piecemeal reforms are not the answer.
Fundamental structural change and rigorous policing are essential
to restoring confidence in the unruly Shanghai and Shenzhen
exchanges.
Visit
China's stock exchanges and you will see gleaming towers,
with gargantuan trading floors. They give a casual visitor
the impression of a modern, highly advanced system. But internal
exchanges are far from meeting that standard. The rules allowing
greater foreign investment within Chinese exchanges are simply
not enough. Changes to allow the beginnings of options and
derivative trading still don't allow investors to manage risk
efficiently.
For
the time being, we will stick with ADRs listed on the New
York Exchange and the NASDAQ. We want investments that are
fully compliant with North American securities regulations.
And, we prefer companies that are value plays, providing a
dividend to investors even when international market forces
cause occasional setbacks in emerging markets as happened
recently.
The
Corruption Problem
The
problem of corruption in the Chinese economic system doesn't
begin to match the near criminal economy of Russia, but it
is a problem that needs to be managed.
We
believe that China is making extremely serious and aggressive
attempts to put a viable regulatory infrastructure in place
and to hold people accountable when they are caught cheating
the system.
Consider
what happens when you get caught engaging in corporate corruption
in the United States. In the case of Enron for example, some
of the executives went to jail and some of the executives
have never even been charged. By contrast, China may take
extraordinarily harsh measures in cases of serious corruption.
Corporate criminals of the worst kind might even face a firing
squad. Perhaps that sounds extreme, but we believe that China
is very serious about corruption. The PRC understands just
how important corporate integrity is to retain the confidence
of foreign investors.
It
is true that the PRC may not have the infrastructure in place
to catch all forms of corporate corruption. But the message
from the Chinese leadership is clear to us. They expect corporate
officers to be transparent in their financial dealings, and
they expect executives to conduct themselves with integrity.
We believe the government is actively trying to get the systems
in place to be sure that does happen.
We
have an added protection at the China Stock Digest when considering
an investment. We want to make sure we know who is checking
the books? We give special consideration to a prospect company
if it has a well-regarded audit firm such as Price Waterhouse
Coopers, or Ernst and Young doing the accounting. We want
to have every assurance that it has good internal controls
for the auditors and extensive training programs for the people
examining the books. If a company meets those standards, we
can probably give more credence to its financial statements
than we could to a financial statement from an auditor that
we've never heard of before. That makes it a much better investment
prospect, worthy of our serious consideration.
Is
Big Brother Your Investment Partner?
One
of the facts about investing in large cap Chinese companies
that are vital to the nation's economic interest is that you
will often have an unintended investment partner: the Central
Committee of the Communist Party flanked by the various government
institutions that carry out macro-economic policy.
Large
companies in China are still going through a transition away
from state control. China is slowly moving from a state run,
centrally planned economy in which the government did own
all the businesses to a free market capitalist economy. The
PRC government is actively trying to get individuals involved
in the ownership of businesses and is encouraging successful
businesses to go public on world financial markets. China
needs foreign investment and business expertise.
Because
of China's history, it would be surprising if the government
didn't hold a large stake, even a controlling stake in most
major national corporations. In some cases, state ownership
or control is not productive. Some Chinese companies are bloated
and inefficient. They desperately need to go through a restructuring
or an improvement in their policies and procedures and strategies.
Obviously those are the companies that we avoid.
On
the other hand, a part of the Chinese economic miracle is
that so many large companies are extremely efficient and very
aggressive. For instance, China's national offshore oil company
(CNOOC) made a strong attempt to acquire UNOCAL in the United
States during 2005. In fact, the Chinese offer to acquire
Unocal was stronger than the winning bid. CNOOC actually offered
a higher price in cash than Chevron offered to buy Unocal,
but they weren't successful in acquiring it was because of
political issues in the US Congress. It was not because they
weren't a competitive player in the capitalist arena. CNOOC
has gone on to successfully clinch deals for petroleum in
Canada, Nigeria, Sudan, Ecuador, Indonesia and a host of other
countries among the so-called "stans," - the countries left
over from the breakup of the Soviet Union. CNOOC is more aggressive
and capitalistic than many U.S. oil giants.
Our
correspondents within China believe that many Chinese companies
have become more competitive than their U.S. counterparts.
As a matter of fact, that's one of the reasons they're eating
our lunch on the world scene. The United States has a huge
trade imbalance with China because they are more productive
than we are in the manufacturing sector and in labor costs.
The
challenge for investors considering taking a position in large
cap enterprises in China is to be well informed. That's not
always easy because access to information is limited and restricted
by the Chinese government. Sales of some shares are not tradable
currently under the rules of SOEs (State Run Enterprises).
It is still an economy undergoing transformation. That means
it is likely to be volatile and, it is not for the risk-averse.
When
Will It End?
As
we said when we began this special two-part series, former
Chinese Premier Deng Xiaoping signaled a sea change in government
thinking during the 1980's when he made a number of important
declarations, saying, "To get rich is glorious!"
The
Premier also broke with the usual communist assumption that
poverty was tolerable as long as everyone was equal. He said,
"We should allow a portion of the population to get rich first."
That may have seemed like heresy to communist ideologues at
the time, but it was an important sign that major change was
coming.
Two
decades of economic expansion and foreign investment in China
have proven to be essential to social stability in the PRC.
It's estimated that a growth rate of less than eight percent
a year could result in mass unemployment and social unrest.
The
Chinese leaders have chosen controlled transition to a capitalist
model, and they have no option to return. Their only option
is to grow the economy aggressively. That's why we at the
China Stock Digest are so interested in China as an investment
opportunity.
All
of us at the China Stock Digest have spent considerable time
in China, and we agree that the People's Republic of China
may in fact be more capitalist than the United States at this
point in time.
China
is actually more competitive and more capitalistic than the
United States for a number of reasons. For one thing, the
Chinese are fortunate in that they don't have herds of aggressive
plaintiff attorneys looking to make up causes of action in
order to loot various industries as we have seen throughout
the United States. Admittedly there are some problems created
by a lack of regulation. The Chinese face severe environmental
problems in industrialized areas. Lax enforcement can create
serious worker safety problems as we have seen with numerous
fatal coal mining accidents this year. But the absence of
over regulation removes a heavy burden from the backs of business
owners. Of course, we deplore carelessness that leads to such
disasters.
But
the absence of heavy-handed micro regulation removes a heavy
burden from the backs of business owners. That is just one
of the reasons China is much more productive than we are and
in most manufacturing settings, much more competitive than
we are.
As
rigid and controlling as the Chinese state may appear to outsiders,
we believe we see the government's true face. We know the
problems away from the tourist showpiece cities, and we know
that much of China remains desperately poor. China must continue
on the road of aggressive expansion. It has no other choice.
Sometimes the government may be too aggressive when it strips
farmers of their land and rights in its drive to build essential
projects. But China has no options except mega growth.
The
real face of China's government is one of determination. The
proud Chinese are determined never to go through another period
of chaos and revolution. The government is determined to foster
a healthy capitalist economy, even if the transition may seem
too slow for some investors.
China
is looking for a leading place on the world stage next to
or even superior to the United States during this century.
Nothing will stop this drive. Mature economies simply cannot
provide investors with the growth that China offers.
We
believe that investors with a tolerance for volatility will
see the Chinese economic miracle as an essential part of a
forward-looking portfolio.
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