There’s more than one way to invest in China, says portfolio manager

(January 21, 2004) It may be understandable if Canadian investors are reluctant to partake of the potentially volatile feast in the Chinese economy, but they might want to consider a Chinese proverb: One cannot refuse to eat just because there is a chance of being choked.

While investing in China does carry the inevitable risks of other merging markets, investment strategists at AGF Funds Inc. say there are safer ways of filling the plate.

For a more focused appraisal of the Chinese market, AGF turned to Raymond Tse, senior portfolio manager at Nomura Asset Management in Tokyo and portfolio advisor to the AGF China Focus Class.

Tse says China posted one of the top economic performances for 2003, despite the slowdown seen as a result of the outbreak of severe acute respiratory syndrome (SARS) — an economic dampener Canadians are all too familiar with.

Despite the outbreak, China was host to economic expansion of 9%. This increase is expected to cool somewhat in 2004, but the Asian Development Bank is still calling for growth of 8% to 9%. Tse thinks this might still be a little too optimistic, and is calling for growth in 2004 to hit 7.8%. He says there are plenty of opportunities for profiting from China’s sustained expansion.

According to Tse, there are four investment themes to consider when making a play on China: the growth in exports and outsourcing, domestic consumption, infrastructure investment, and natural resources.

Exports and outsourcing

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Since joining the World Trade Organization (WTO), China has become one of the prime destinations for multinational corporations seeking skilled yet cheap labour.

“Multinational companies are investing in China, setting up production facilities and taking advantage of the inexpensive and abundant labour, coupled with the good supply of engineers,” says Tse.

“This process has been going on for 40 years,” he says. “It has accelerated since the WTO accession at the end of 2001. Since then we’ve seen sustained foreign direct investment flows over 30% year over year for two years now.”

These investments are now paying off, as China’s exports from these manufacturing plants have started to hit the world market, fattening the margins of the companies that located there. The increased demand for labour in the industrialized eastern coastal region has created a new middle-class, along with the usual ambitions for a more comfortable life.

Domestic consumption

“The average household income is growing very fast,” Tse says. “About 30% of the total population, living along the eastern coastline, are earning a very good income.”

The growth in income has fostered a consumer society, as the growing middle-class start spending their disposable earnings. Sales growth in personal computers, passenger cars, cell phones and real estate is staggering.

“The next pocket of growth from consumption will be the big-ticket items, including the first homes that these people are buying — and also their first car,” says Tse. “These are the big-ticket items that will carry the consumption story for the next four or five years, at least.”

Tse says that with the burgeoning manufacturing sector, the consumer goods that are being bought are generally produced domestically. The AGF fund he advises has taken a position in a local car company to cash in on the growing demand.

“In my opinion, we haven’t even seen the peak of this consumption cycle yet,” he says, pointing out that China has not yet undergone the revolution in personal finance that its neighbours have, with personal credit seen fueling even more consumption.

There is also the fact that much of the population is yet to participate in the economic revolution. “What we should not be forgetting is that 70% of the population — approximately 900 million people — are still living in the countryside making less than $1,500 US a year. But this is quickly rising,” Tse says.

The “fourth generation” leaders in Beijing have been trying to promote balanced growth, raising the income and standard of living for the inland peasants. Tse believes if this policy is successful, these 900 million people will form the “next wave” of consumption.

These people are not only economically isolated from the industrial coastal regions, but also geographically — a fact which Tse says will actually help to fuel growth as the government seeks to improve the country’s infrastructure.

Infrastructure

“Infrastructure is a very important segment — we’re talking about power plants, roads, bridges, tunnels,” he says, pointing out that unlike Japan’s expensive government projects in the 1990s, this work is badly needed.

“Infrastructure and logistics have been a bottleneck to economic growth in China,” he says. “A lot of the products were produced but not shipped to the customers quickly enough or cheaply enough. Intra-provincial doesn’t make business sense.”

China’s electrical system is badly in need of an overhaul, with many industrial areas underpowered. If China is to attract more industrial plants, it will need to not only increase power generation, but also improve the distribution network.

And like the manufacturing boom, infrastructure construction will require massive amounts of resources.

Resources

“China, being a manufacturing powerhouse, actually sucks in industrial material as inputs,” says Tse. By 2006, China is expected to account for more than 20% of the world demand for copper and aluminum, 25% of steel and 7% of petroleum.

Again, this is a commonly held opinion: Since China will outperform on the manufacturing side, a good investment strategy will include supplying them with raw materials.

But Tse says many investors made the mistake of discounting Chinese demand for commodities and bet on a soft market in 2003. Commodities turned out to be one of the best performing sectors.

Since his near-term outlook for China remains strong, Tse says investment in the natural resource sector is one of the most important themes to investing in China. In fact, it makes up the largest single sector of his fund at 30%.

Risks

Of course, this outlook is not without its flaws.

The stock market in mainland China is still very young, with just 12 years of trading. The domestic banking system is underdeveloped and some are concerned that the economy is already showing signs of overheating.

“In a nutshell, we feel this is not an immediate danger yet,” says Tse. “There are certain signs that China might be growing too fast, but Beijing officials are aware of that.”

One of the fortunate hold-overs from the days of hardcore communism is the tight control that the government holds over the financial system. While this is usually the kind of thing investors find distasteful in the developing world, it has its advantages in China.

Tse says the government is unlikely to tighten credit across the board, but will more likely opt for “credit-rationing,” with the central bank acting to cool only the sectors which show excessive growth or redundancy within the economy.

This preferential treatment for slower sectors of the economy might not go over well with capital markets in more developed economies, but if the Chinese government can pull it off, western investors will not likely complain.

Another risk is posed by the possible revaluation of the Chinese currency. China came under pressure in 2003 to allow its currency to float freely against foreign currencies. Tse says the domestic banking system is too weak to support a free-floating renmimbi and the central bank will not likely adopt the more volatile valuation policy.

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

(01/21/04)

Steven Lamb