Zaks Investment Advisory Service

China: Economic and Financial Dichotomy

China keeps amazing us. We’ve already gotten used to its astounding economic growth -- last year the Chinese economy grew at a rate of about 10%. This accomplishment comes on the heals of a similar performance the previous years, probably the most sustained economic growth in modern history, as the chart below demonstrates.

Data compiled by Hitotsubashi University (Japan)

For investors around the world, even more impressive was the performance of the Chinese stock markets. In 2006 the Chinese stock market grew extremely fast, by some estimates (Dow Jones China Index, Shanghai Stock Exchange Composite Index) at a rate of approximately 100%. The Morgan Stanley Capital International China Index went up by 79 percent. By any measure, in 2006, the Chinese stock market grew faster than any major stock market in the world. In addition, the Chinese markets reached another milestone: the total capitalization of the Shanghai and Shenzen stock exchanges reached one trillion dollars.

Unfortunately for many investors, last year’s performance was an exception rather than a rule. For a number of years the Chinese stock market was a laggard. Below, for example, is a chart of the Shanghai Stock Exchange Composite Index from 2000 through 2005:

Source: Shanghai Stock Exchanges

The average return for these years was approximately -3.7% (that is negative 3.7% annualized), despite the fact that during this period the Chinese economy was growing at a rate of about 9% on average, faster than any large economy. Even if we took a look back even further, we would see that historically, Chinese exchanges were performing sub-par. The Shanghai Stock Exchange index doesn’t go back further than January of 2000, but Dow Jones was collecting data on Chinese markets for 13 years, from January 1994. Here’s a more historical view of Chinese stocks using Dow Jones China 88 Index.

Source: Dow Jones and Company

We can see that the index was higher in 1997 than it is today. The average annual return during the last 14 years was a paltry 5%. For comparison, the S&P 500 grew by approximately 11% (total return). This seems counterintuitive: how is it possible that for many years the economy was growing extremely fast but the stock market was not? The answer, of course, is that the stock market does not price “the economy.” The market is mainly concerned with profits, interest rates, and taxes. During this period, the inflation rate in China was pretty low (for example, 1.8% in 2005). Likewise, corporate taxes are reasonable, varying from 15% to 33%, depending on whether the enterprise is located in a preferential economic zone or not. The problem then, is profits.

The Chinese economy is a mixture of private and state-owned enterprises. The state-owned companies do work for the benefit of the majority owner, the state. The state does not necessarily seek purely financial benefits, however. Frequently, the primary goal is in keeping full employment and social stability. Because of this, the state very often subsidizes inefficient enterprises. It usually does so through the banks, most of which are also partially state owned and whose stocks usually trade at a discount compared to similar-sized Western banks. Private companies, on the other hand, very often see the goal as increased market share, not increased profits. They keep the prices of their goods artificially low, even as the cost of their resources (oil prices, labor costs) goes up. Though the revenues and the sheer size of these companies grow, they are often not very profitable. Investors, in turn, price their stock accordingly. The induced lending to inefficient state enterprises has saddled the banks with large non-performing loans.

During the 2005 – 2006 year, the Chinese government attempted to clean up the banking system. In an attempt to instill market discipline, it privatized several big state banks, Industrial and Commercial Bank of China being the largest of them. In order to make their shares more attractive, the government wiped out a large portion of the bank’s non-performing loans prior to the initial public offering. The privatization constituted a huge transfer of wealth from taxpayers to investors. Goldman Sachs, Inc., which participated in the offering, apparently made about $4 Billion dollars in the transaction.

Of course, individual investors cannot get in on such insider deals. Still, they could have received excellent returns had they invested in China-related funds during 2006. Nonetheless,, investors face the question: was 2006 a fluke or did it manifest some fundamental changes in the Chinese markets? What can we expect in the future? There are several factors to consider: Will China continue its economic reforms or will a more conservative group come to power in this one-party country and attempt to re-centralize the economy, as is happening in Russia? Will the rampant corruption adversely affect economic development? Will China manage to maintain social stability, even as the gap between the rich and the poor continues to grow?

Although we don’t know the answers to these basic questions, there are a couple of key factors that may, to some extent, illuminate the situation. The Chinese government keeps the currency, Yuan, artificially low so that its export-oriented economy continues to perform – and in the process continues to employ millions of workers. The trade surplus with the United States is growing, prompting the US government to pressure the Chinese to revalue the Yuan. Even though the Chinese are very reluctant to let the Yuan grow, they do let it fluctuate within a rather narrow band. It is probably safe to assume, therefore, that in the near future the Yuan will continue to appreciate against the dollar, thus adding to the total returns on Chinese funds. Also, it seems that at least for now, the more pragmatic faction of the Chinese Communist Party will retain control, thereby allowing growth to continue.

What are the vehicles the US investor could use to invest in Chinese stocks? There are several closed-end funds, such as The China Fund (NYSE symbol CHN), The Greater China Fund (GCH), and Templeton Dragon Fund (TDF). There are also two Exchange-Traded Funds: FXI, which, according to the prospectus, seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the FTSE/Xinhua China 25 index; and PGJ, which seeks results that correspond generally to the price and yield (before the Fund's fees and expenses) of an equity index called the Halter USX China index(SM). Also, there are a number of mutual fund companies created funds, which invest in Chinese and Hong Kong stocks.

As any investment, these vehicles are risky, probably more so than some domestic funds, as they carry additional political and exchange rate risks. Nevertheless, investors may consider them in order to diversify their holdings and participate in this large and potentially growing market space.