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THE “CHINA SYNDROME” -- SHOULD YOU INVEST?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
July 13, 2004

IN THIS ISSUE:

1.   China’s Pseudo-Capitalism

2.   The Risks Of Investing In China

3.   Damn The Torpedoes, Full Speed Ahead

4.   Investing In Fads Rarely Pays Off

5.   Conclusions

Introduction

There is no dispute regarding the meteoric growth in the Chinese economy over the past 20 years or so.  In 2003, the Chinese economy grew at almost 10%, a figure unheard of in a mature economy like that of the US.  The financial news media is full of stories about the Chinese economy, and investment sponsors are seeking to capitalize on the latest investment “fad.”

Internet websites, direct-mail promotions and even many brokerage houses are now touting investments in the Chinese economic “miracle.”  Investors are being wooed by the thought of investing in the continuation of an economic expansion that is unparalleled in modern times.  However, many of these so-called investment opportunities are simply too good to be true.  There are many usual – and unusual - risks associated with an investment in China.

While it is true that the Chinese economy has grown at an astounding pace, there are also risks that are unique to China and its form of government.  Remember, in China you have a communist government trying to balance totalitarian control with free market capitalism.  At best, this is a delicate balancing act.  At worst, the Chinese miracle economy could come crashing down around the government’s head, as it did in the 1980s and 1990s.

As I have often written, two of my best sources of information are Stratfor.com and The Bank Credit Analyst.  Since Stratfor.com tends to concentrate on geopolitical issues, and BCA economic issues, I rarely have an occasion where I can draw upon both sources for the same subject matter.  In the case of the Chinese economy, I am fortunate in that both of these valued sources have written extensively on the subject in recent months. 

The only problem is that they disagree somewhat on the eventual outcome.   Yet when two great sources disagree, the result is often even greater knowledge.  BCA has a positive view of the future of the Chinese economy, while Stratfor.com takes a more cautious approach.  The result is that I can pass along some of the best thinking in the world on this issue, and throw in a few of my own thoughts as well.  So, read on.

Background – The Pseudo-Capitalistic Chinese Economy

The People’s Republic of China has always lent itself to superlatives.   Its borders contain the highest mountain peak on dry land (Mount Everest), the only man-made structure visible from space (the Great Wall) and the largest human population of any other country.  It is China’s large population – 1.3 billion - that gives it one of its greatest advantages in the global economy, and offers the greatest potential for foreign investment.

After the rise of communism in China in the late1940s, the probability of converting the Chinese populace into consumers looked pretty slim.  However, in 1978, the Chinese government embraced a bold new set of economic reforms designed to modernize the mainland Chinese economy.  While many in the West view these reforms as a return to capitalism, the Chinese government insists that the reforms are still rooted in socialism.  To do otherwise would threaten the communist government.

The Tiananmen Square uprising in 1989 forced the rest of the world to see that China was still, indeed, controlled by a totalitarian government.  However, this display of force threatened to derail China’s global economic ambitions.  As a result, the Chinese economy got another shot in the arm in 1992 when the late leader Deng Xiaopin stepped up economic reform and further opened up the Chinese economy to foreign investment.

Since then, the Chinese economy has acted as if it is on steroids.  Since the implementation of the first economic reforms, the Chinese economy has grown ten-fold, from $147.3 billion in 1978 to $1.4 trillion in 2003.  The Chinese economy is widely expected to reach the $4 trillion mark by the year 2020.  China has now become the world’s primary source of manufacturing, accounting for 50% of the world’s footwear, 75% of the world’s toys, a growing share of electric and electronic products, etc., etc.   Read the labels:  MADE IN CHINA.  They’re everywhere.

In the late-1980s and mid-1990s, economic booms were accompanied by a surge in inflation (over 25% in both cases), forcing the Chinese central bank to ramp up interest rates and create a hard landing for the economy.  During the current boom, however, inflation has stayed more subdued, with inflation of only 4.4% for the 12-month period ending May 31, 2004.

Risks Of Investing In China

While the economic statistics discussed above make a strong case for investing in China, there are also some good reasons to either reconsider, or proceed only with great caution.  It is important to remember that even though the Chinese government has embraced capitalism to a certain extent, it is still a totalitarian communist government.  Many of the major industries and most of the largest banks in China are state-owned, which means that they will not necessarily play by the West’s rules.

Nowhere is this lack of playing by the rules more evident than in the Chinese banking sector.  In a recent article, Stratfor.com discussed the problems in the banking sector, as follows:

“There are extremely serious problems with China's economy in general -- and with its banking system in particular. The only issue on the table is whether the behavior of China's authorities reveals deep concern or outright panic. That is an interesting question -- and not a trivial one -- but it does not cut to the heart of the problem, which is that China, contrary to popular perception or even its extremely high economic growth rate, is in serious trouble and is desperately searching for a soft landing -- a landing that might not be available…
…It is our view that China, which got started later than other Asian economies, is on course to be the third Asian meltdown in this generation. The euphoria about China until very recently -- and China's assiduous attempts to stoke expectations -- tracks with what happened in the rest of Asia.
The core problem in Asia -- a problem that the Chinese government is trying to address belatedly -- is that its banking systems do not allocate capital based on market forces. Loan decisions are made out of political and social considerations, and real interest rates vary depending on these relationships. Long-term business relationships in Asia receive favorable treatment from banks regardless of the actual business case to be made for a loan.
Of equal importance, these are debt- rather than equity-driven economies. The major source of financing does not come from sale of shares in businesses, but from direct loans. There are two reasons for this. The legal structure of Asian corporations gives limited rights and protections to shareholders, who do not collectively control corporate boards. Therefore, maximizing shareholder value is not a driving consideration. It also means that a core measure of economic performance -- the rate of return on capital -- is not a critical variable.
The core problem is that, over time, the allocation of loans based on non-market consideration, means that the economy, lacking market disciplines, behaves in irrational ways. Most important, the disciplines of market economies -- from foreclosures to recessions -- don't happen. Essentially unhealthy businesses continue to grow due to the infusion of debt. The infusion of debt has a number of positive results. It maintains social stability, keeps the political system functioning and it allows banks to avoid non-performing loans. It also has a single devastating effect -- it creates an economy that is kept alive by pyramiding loans that undergird an increasingly dysfunctional system.”

Stratfor is also concerned regarding the level of liquidity in the Chinese economy.  Since the Chinese currency (yuan) is pegged to the dollar, China has effectively been in an easy-money environment because of US Fed policy.  While that has been good for the US, it has flooded the Chinese economy with liquidity. 

Thus, Stratfor credits China’s growth not from investment returns, but from easy access to cheap loans from state-controlled banks.  Lending in China rose 21% to a record $1.9 trillion in 2003, and increased another 20% in the first quarter of 2004.  This raised fixed investment to $106 billion in the first quarter, an increase of 43%.

While Stratfor does recognize that the Chinese government has taken steps to curtail lending, especially in saturated industries such as steel, cement, aluminum and real estate, they state that bank and local government officials have ignored the central government’s rules, leading to even more over-investment.

Stratfor is not the only source of pessimism on the Chinese economy.  A recent article by William Pesek, Jr. on Bloomberg News echoed the concerns voiced by Stratfor.com.  He states that China’s money supply growth is around 20% per year, and that some analysts believe that China is in the midst of an “unsustainable investment bubble.”

With the memories of the high tech bubble of the 1990s fresh in our minds, we must pay close attention to these warnings.  However, all the news isn’t bad.

Damn The Torpedoes, Full Speed Ahead

If I had to summarize BCA’s latest analysis on China in light of Stratfor’s comments, I’d have to say it would come down to “that was then and this is now.”  In other words, while BCA will admit that problems still exist in the banking sector, they are confident that the reforms being implemented in the Chinese banking system are effectively addressing these old problems.  In effect, BCA would argue that the situation isn’t getting any worse.

In the July 2004 issue, BCA makes the following observations about the concern over a hard landing (recession) in the Chinese economy:

“There is no disputing the fact that China is experiencing a powerful investment boom.  Capital spending reached 43% of GDP in 2003, far above the peaks of previous cycles…At the same time, it should be noted that increased investment has been matched by a huge surge in private savings…China’s overall current account is still in a small surplus.   In contrast, the US investment boom in the late-1990s was much less sustainable because it was not supported by higher savings, and the result was a major rise in the current account deficit.
The authorities have responded to excesses in some sectors by clamping down on credit.  This appears to be working with bank lending to the construction sector in deep decline in recent months, and overall measures of money and credit growth coming off the boil.
It is also very important to remember that China is still at a very early state in its economic development and there is enormous need to build up the infrastructure…Per capita incomes in China are still very low so there is massive catch-up potential with the rest of the world.  In that sense, a savings-driven investment boom is not a major cause for concern.
While the debate over China’s economic outlook centers on a hard versus soft landing, the irony is that there may not be much of a landing at all.  It is quite possible that China’s economy will be able to sustain growth of 8% to 10% for some time without generating any major problems.”

This last piece of information is important since Stratfor makes the case that the Chinese economy must grow at least 7% per year just to absorb the additional workforce entering the market.  So, it would seem possible that a sustained 8% to 10% growth might be viable and sustainable without causing inflation problems.

BCA ends its analysis of China by discussing inflation.  As I stated above, inflation has not gone out of control during this boom cycle, currently holding at 4.4%.  BCA believes that, if inflation can be held near current levels, there will be no need for the authorities to clamp down on the economy.

Analysis Of The Two Positions

When you have two trusted sources of information providing contradictory insight, it usually means that there is a high degree of uncertainty in the subject being analyzed.  I think that is exactly the case in China.  Since drastic economic reforms in 1978, the Chinese economy has had its share of booms and busts.

Stratfor says if you liked the bust in the Japanese economy, you’ll love what’s going to happen in China.  To some extent, the situations are very similar.  Bad loans are kept on the books for political reasons, and real estate prices are increasing to unsustainable levels.  The Chinese people are also great savers just like the Japanese.

However, we know from the Japanese example that the main reason its economy has not improved is because Japan has not taken the tough steps necessary to rid its banks of bad loans and has not allowed unviable corporations to go out of business.  BCA would argue that China is taking these steps and, while it hasn’t done anything to clear the books of past bad loans, at least things aren’t getting any worse.

It is also reported that China is seeking to privatize many of the state-owned businesses and banks, which will require a great deal more transparency.  If China truly wants to sell off these businesses, it will have to take care of the old problems first, or they won’t find many takers.

I believe that the Chinese economy may be headed for short-term problems as Stratfor.com points out, but I also think that the long-term outlook for China is good.  The recent growth of the economy has resulted in a growing Chinese middle class, and an increasing number of wealthy entrepreneurs.  They now know what a powerhouse the Chinese economy can be, and I don’t think they are going to go back.

The Chinese government is also taking early and strong steps to keep from repeating the disaster that befell the Japanese and other Asian economies.  While no one can guarantee that China won’t suffer the same fate as its Asian neighbors, at least China has the benefit of hindsight in regard to those other Asian economies.  Will they learn from others’ mistakes and aggressively crack down on cronyism and politically motivated loans?  Only time will tell.

Fad Investing Rarely Pays Off

This brings us back to the question on everyone’s mind, “Should I invest in China?”  While I see the potential long-term benefits of investing in China, I also see that most of the opportunities being presented to investors today are nothing more than investments cobbled together to take advantage of the China “fad.” 

As an investment professional for almost three decades, I have seen many fad investments that have boomed and then burst.  Each time, investors are wooed by siren songs of large profits and can’t-miss opportunities.  All too often, the reality is one of poor returns and even financial ruin.

There’s a saying in investing that says if everyone is starting to invest in something, that’s the best time to get out.  One of the most recent examples of this was the flight into tech stocks in the 1990s.  While it’s true that many people made money in tech stocks, most investors didn’t.  That’s because most investors caught onto the fad late in the game, and invested in late 1999 or early 2000, just in time to ride the market down 70% or more.

There are several characteristics of fad investing that I think will help you to determine whether it’s best for you to invest in China or not:

Halbert’s Observations On Fad Investing

1.    Fad investment promoters will seek to validate their claims by saying how the “smart money” is also involved in this investment.  That’s right, but what they don’t tell you is that the “smart money” invested in the latest craze long ago, and did so only after extensive research. 
I recently received a promotion for an investment newsletter that justified its existence by stating that the Carlyle Group has decided to make extensive investments in China.  While that may be a good reason to invest through the Carlyle group, it’s not necessarily a good reason to trust the advice of this newsletter promoter.
2.    Speaking of newsletters, it seems that for every fad there is a proliferation of newsletters and E-Letters claiming expertise in whatever new fad is popular.  This happened during the Internet fad, more recently in the gold fad, and is now very evident in the China fad.  However, simply going to China doesn’t make you an expert in Chinese investing any more than going to Yellowstone makes you a Park Ranger.
On several occasions I have written about how newsletter writers are not required to publish both winners and losers, as registered investment professionals are required to do.  Sure, they may have a recommendation that made 600% just as they claim, but they may have also had five more that lost everything. 
No regulation requires them to disclose the losers.  So, if you are interested in a particular newsletter, ask for a complete list of all of their recommendations and their results.  Or better yet, check with the Hulbert Financial Digest where newsletter writers’ recommendations are independently tracked.  Of course, not all investment newsletters provide such information to Hulbert.  You can check out Hulbert’s service at:
http://cbs.marketwatch.com/commerce/hfdProduct.asp?pname=hfd
3.    Many times, fads woo investors by presenting a reasonable sounding business plan with unrealistic projections.  For example, a Chinese investment promoter may try to get you excited by saying how if a certain percentage of the 1.3 billion Chinese population buys a product, the company will be wildly successful.  Remember that a vast majority of the Chinese population lives in the rural interior where poverty abounds.  These people won’t be buying cars, TVs or other trappings of modern life for a long, long time.
4.    Another observation I have made is that the investors who make the good money in markets that turn out to be fads are those that get in early and get out early.  The problem with getting in early is that this requires that you know about the opportunity long before it is highlighted on the financial news shows and the subject of e-mails and direct mail offers.  By the time you hear of an opportunity by direct mail, you probably should assume it’s too late to get in for any decent profits.
5.    Finally, it has been my observation that those that do best in new investment opportunities are those that turn the decisions over to professionals.  This one is somewhat related to my #4 point above, in that professional money managers generally know about new opportunities before individual investors.  You may get tired of my saying that this is the best way to invest, but I firmly believe it.  While I do not represent any investment professionals who specialize in Chinese investments, I still believe that you should only invest in China under the direction of an investment professional who is subject to US securities regulations.

Don’t get me wrong, I think that there is additional upside potential for certain Chinese investments.  However, as we all learned from the 1990s tech stock experience, not every company that claims to have a sure-fire business plan is going to be successful.  The problem was then, and is now, trying to separate the eventual winners from the losers. 

Conclusions

It is clear from Stratfor.com’s analysis that they do not believe that China can pull off its banking reforms and provide a “soft landing” for the economy.  However, it is equally clear that the editors of BCA believe that the reforms in China could very well work and that the economic boom could continue.

As for my opinion, I think the “easy money” has already been made in China.   However, continued global investment in China also shows that additional opportunities are available.  Just remember that the Chinese economy is not like ours.  It is controlled and manipulated by the government – a communist government at that. 

The fact that two respected sources like BCA and Stratfor.com disagree about the economic outcome in China indicates that there is a great deal of uncertainty in this market.  On the positive side, investing in uncertainty can lead to rich rewards.  However, on the downside, it can also lead to large losses.  Thus, you should consider any Chinese investment to be an aggressive part of your portfolio, and should be limited accordingly.  You should also only invest with seasoned investment professionals who not only know the business potential of an investment, but also the political implications of investing in China as well.

Very best regards,

Gary D. Halbert

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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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