China shifting to consumer economy

(November 12, 2004) By now, the only way to have avoided hearing “China is an excellent growth investment” is to have been living in the proverbial cave. Investment in China has been trumpeted so many times over the past few years that you might assume that it’s too late to even start, thinking that you’re missing the boat.

That’s just not the case, according to Richard Wong, director of Asia (ex-Japan) equities at HSBC Asset Management. Like any sector analyst, he may have a vested interest in promoting the opportunities in the field, but he does make a fairly compelling case.

While the initial boom in the industrial expansion produced huge returns for some investors, Wong says China is now beginning its transformation into a consumer-driven economy, as prosperity moves inland from the industrialized coastline.

The Chinese economy remains strong, with GDP growth hitting 9.7% for the first half of 2004. Foreign investors continued to pump money into the country, with direct investment rising 18.8% on a year-over-year basis in the first eight months.

Inflation has been a concern for some Western investors, with August showing a 5.3% annualized growth rate in consumer prices, but Wong says this is largely due to the volatile food sector, after a poor harvest. Inflation also remains high in construction materials, such as cement, aluminum and steel.

While interest rates have risen recently, he says it is not an effort to stifle growth, but is in preparation for opening the banking sector to foreign competition.

“On the financial side, the banking sector has been reformed and the banks will enjoy a cleaner balance sheet going forward,” Wong says. “We think that over time the commercial banks will see better loan quality.”

Wong downplays the political risks involved in China, saying the U.S. has become more supportive lately of the “one China policy,” which views Taiwan as an integral part of China’s territory. With U.S. support for Taiwan waning, he says it is unlikely the island will push for official independence. The status quo should be maintained, as China is expected to largely ignore the issue unless provoked by such a declaration.

Another risk facing China is its ongoing power shortages, which Wong expects to persist until 2006, but he says the worst has already passed. Brownouts were frequent in the past couple of years, as electrical demand outstripped production and distribution capacity.

The government mandated an austerity program, which prioritizes residential use and requires the industrial users to shut down periodically. While this may sound counter-intuitive for a country trying to attract investment, it does help to shore up domestic consumption of power goods.

Of course, investing in China carries the same risks, to varying degrees, as any other foreign investment, including currency valuation risks. Virtually the entire market can be considered “growth oriented.”

The overall Chinese market consists of three main stock exchanges, the best known being in Hong Kong, with two on the mainland in Shanghai and Shenzhen. Due to its historically closer ties to Western capitalism, the Hong Kong market is geared toward attracting foreign investors, offering trade in H shares and the so-called Red Chips.

H shares are generally the private enterprises that have flourished in Hong Kong prior to its repatriation to China. The Red Chips are the recently privatized government entities, such as China Mobile, the nation’s largest wireless communications operator.

On the mainland, both exchanges offer trade in A shares, which are traded in renminbi, the Chinese currency, and originally only available exclusively to Chinese investors. There are also B shares, which were originally only available to foreign investors and traded in either U.S. or Hong Kong dollars.

Wong says it is likely that Beijing will soon lift the restrictions on Hong Kong shares to allow domestic investment, as it did with mainland B shares a few years ago.

Wong says governance rules in Hong Kong are far more stringent than in Shanghai or Shenzhen, making H shares and Red Chips more attractive from that perspective than the A-share market on the two mainland exchanges.

He points out that Heng Seng-listed companies tend to use the world’s top auditing firms to assuage investor fears, but such safeguards did little to prevent problems in the U.S. His message is clear: Hong Kong’s market is as mature as those in the U.S.

But Wong says the Chinese markets are highly inefficient, allowing stock pickers to add value to their portfolio through research.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/12/04)

Steven Lamb