The China Fairy Tale

Will the Shanghai index reach 10,000 by end 2008? Will China be the #1 global economic power by 2010? Will the yuan reach 6.8 against the USD prior to the Olympics? The answer to all three has a high YES probability. I used to whack Chinese stock markets as being bubblish, however, I now think it has more upside to go before correcting. Yes the markets there are expensive but super bull runs do result in a over extended valuations.

Global investors usually see China through 3 things only:

a) China's sizzling trade surplus

b) the yuan's appreciation

c) the Shanghai stock market barometer

This gives all a blinkered view of what's really happening in China, and the consequences of their growth, might and power.

The stock markets in China, even if it lost 50% in value overnight won't stop the real economy posting 9%-11% growth pa.a. for the next 3 years minimum. Now, this is after growing on average of 10%p.a. since the 80s. The compounded growth rates have basically reach a stage where China's economy is already right up there in the top few. Any further growth spurts will put them firmly on track to be #1 within the next few years.

China stock markets are only a small percentage of GDP. Even at current lofty levels, the market value of all mainland stock markets adds up to less than 38% of China's GDP. That percentage is an indicator of how much of your GDP is listed. Malaysia has one of the highest ratio in the world, above 80% of GDP is listed. Just look around, the only things left unlisted are the kopi tiams, mamak stalls and laundry shops. If your business starts to make RM1m-RM3m a year, you have evryone pounding on your door to get you listed, by hook or crook. In the US, the figure is skewed at 180% of GDP because a lot of listings are foreign companies. But if its just US assets, the figure is even lower than Malaysia's. The higher the ratio, the higher the "beta" due to bull/bear rallies. Hence the Malaysian economy gets a strong multiplier effect during bull runs, and vice versa. On the same not, we can surmise that the impact on China's economic engine will be very limited, either way, by their stock markets.

There is also another fear that China relies heavily on exports to grow, and the current recessionary factors in pockets of the US economy may cause damage to Chinese exports. Plus the recent trade sanctions against China exports will hurt China's growth engine. That is a big fallacy, China's growth relies more on its domestic economy than exports. Chinese exports only make up 40% of China's GDP. If last year's export growth was flat, the Chinese economy would still be putting up annual growth rates of between 8%-9%p.a., not too shabby.

Another factor is that more than 60% of Chinese exports are actually foreign companies operating in China and re-exporting back to US and EU. So, if there is a slowdown on the demand side, the Chinese import side would also see a near corresponding slide (importation of materials and related items necessary for production). US is also becoming a less important destination for exports - over the last 12 months, exports to US grew just above the 10% level year-on-year, but exports to the EU grew nearly 50% over the same period. The US has to be careful as US exports to China & HK totaled US$73bn in 2006, and that is the 3rd biggest export market for the US. Any further bullying tactics by US lawmakers can backfire with dire consequences.

Rising prices in oil, gas and other commodities necessary for production are thought to be hurting China's manufacturing prowess. The truth is, China is the capital for global manufacturing, and the main reason for the jumps in prices for most commodities is the China factor. However, the relative cost savings and productivity gains by operating in China outstrips the price increase in commodities, oil or gas. Even with labour wages rising double-digits p.a. for the past 10 years, the relative gains in productivity and unit labour cost still makes China very competitive. By being a production capital for global companies, it created a lot of jobs, and hence improved the per capita income steadily in China as well. This in turn fans the domestic economy, which is a big plus for any foreign company operating or manufacturing out of China. Even if labour wages rises 15%p.a. for the next 5 years and fuel reaches US$100 per barrel, manufacturing out of China will still be very cost effective.

Beijing will allow the stock markets to crash after the Olympics - that's the coffee-shop talk. There are usually lull periods after the build up period leading to the Olympics, so softer market conditions in all areas are to be expected. Whether they will have a big market correction after the Olympics depends a lot on where the indices are then. Olympics is but one event, are we saying that Beijing will STOP all projects after Olympics? However, Beijing also realises that you cannot have a stock market that is always on a rise. And there are good reasons to "allow" the market to find its feet after the Olympics. Judging by the level of concern from Beijing whenever the markets goes into a mini correction, makes me think that there is more to the coffee-shop thesis. The way they have massaged the markets, Beijing really don't want a big correction, but it also knows it doesn't want a very very strong bull run to run out of hand. Hence the QDIIs and the asking of H-share companies to relist in Shanghai, and the plans to allow individuals to invest directly in HK listed shares. All are valves created to lessen the liquidity swishing in the system. Hence, it does look like uptrend is secured right up till Olympics, and you can say the same for the property side as well. After that, who knows!

The yuan will be a reflection of China's economic power. The US harping on China to revalue the yuan is a wrong tactic. If you get the yuan to appreciate 25% overnight, all it does is to shift some of the big-ticket items to a another place/nation where its cheaper to produce, and it won't be USA. Just the location of production changes.

Why Beijing is slow to appreciate the yuan? Mainly they know that there are still a lot of "shit" within the Chinese economic and financial systems. On the economic front, many areas of the economy still have tax credits and tax breaks on many imported items. Their financial system is still very immature, and the huge amount of bad debts in most Chinese banks needs to be worked down. Part of the reason why the bigger banks have been allowed to have foreign shareholders (usually banks only) is to tap on their expertise to work down the bad debts. A very large cancerous spot in their economic system is the inefficient state enterprises. The good ones are manned by very good people and they get listed easily. For every Petrochina there are literally hundreds of debt ladened state companies. Hence Beijing is buying time for the "shit" to be minimised while the going is good.

The other point being, if you just harp on the yuan as a deliberately under-valued tool to load up on the trade surplus - that's a myopic view. The yuan is but a small tool in explaining why MNCs choose to operate in China. Cost is one small thing, their huge domestic economy is a big factor, and the concentration of similar suppliers brings about economies of scale. A study showed that a 25% revaluation in the yuan would wipe only US$20bn from the US$800bn trade deficit (2006) after 2 years.

Hence, the China fairy tale is unlike the Cinderellas or Snow Whites of the world, this one will come true. This China fairy tale is NOT a fairy tale. To those who think that China will implode horribly after a few more years, they are likely to be very wrong. We all must think, behave and plan as if China will be the #1 global economic powerhouse, even now, because that is not a possibility but a certainty.