Zaks Investment Advisory Service

On China, Part I

We devoted two of our previous programs to global economic development. We highlighted the colossal changes of recent years: the transition of hundreds of millions of people from planned economic frameworks to market ones, and the globalization of world trade. The term “globalization” has turned into something of a profanity in certain circles, but in reality this process helps all countries, both developing and developed ones. The world economic growth rate has accelerated in recent years. However, economic growth (i.e. a rising gross product) and higher stock exchange prices are far from synchronized events. In one of our previous programs, we compared the economic and financial developments of European countries with that of China, and found out that no direct link between the economy and stock exchange prices exists. In order for stock prices to rise, it’s not enough for the economy to grow as a whole, but the company whose shares are being traded also needs to earn a profit. And this is not the same thing. Despite all their problems, on average, the capitalization of developing countries’ exchanges – ones like Russia, Brazil, India and China – has grown. They developed especially quickly in the past two years. As I have already mentioned, the total market capitalization of the two main Chinese exchanges is about three trillion dollars. That is more than the capitalization of the Frankfurt exchange. It is impossible to ignore developing countries, nor should this be done; but before investing money there, it is essential to analyze the associated risk.

Let us start with China, a country important to us in all respects. China’s modern economic history began in the 1990s, when Deng Xiaoping resumed reforms and created special economic zones that began to attract foreign capital. The Communist Party, even while completely controlling the country’s political and social life, made a decision to privatize a part of state property and give private companies a chance to grow. As a result, China’s economy represents a strange combination of extremely dynamic private companies and inefficient state enterprises, many of which still survive exclusively thanks to cheap state bank loans. But the share of state companies is constantly falling, and now stands at about 30 percent of the Gross Domestic Product (GDP). The size of the Chinese economy is fairly difficult to determine: it all depends on how one values the yuan, by the official exchange rate or in terms of purchasing power parity (PPP). According to the official exchange rate, China’s GDP is $2.4 trillion, which is the world’s forth-largest after the United States, Japan and Germany. If valued using PPP (which, by the way, is a very imprecise method), China’s GDP goes up to $10 trillion, which is second-largest after the United States. But converted to per capita terms, China’s GDP drops to 80^th place in the world, even if calculated using PPP. Thus, even though China’s economy is enormous, the country is still poor.

The Chinese exchanges were created at the very start of the 1990s. They operate in two cities: Shanghai and Shenzhen. The initial euphoria, both on the part of the local population and foreign investors who saw gigantic opportunities in China, resulted in fairly fast price growth. But with time, between 2000 and 2005, the Chinese exchanges lost half their value. Why did this happen? Mostly because the companies that were issuing shares were not interested in their shareholders. In developed Western nations, the idea that a company functions in order to maximize the welfare of its owners -- the shareholders -- is an axiom. But in China, many of the state companies (and up to a certain point in time, they comprised the majority of the Chinese exchanges) issued shares in order to gain access to fairly cheap capital. What was then to be done with that capital was something for the company management rather than the shareholders to decide, especially since most of the shares continued to remain in state hands. Instead of trying to set up efficient production, many state companies continued to retain a vast number of salaried employees – simply because the country’s leaders feared unemployment and social instability. Some companies used the capital to expand, failing to account for the consequences and losing money. Others used the capital to repay bank loans.

In addition, the Chinese exchanges lacked the market discipline that characterizes Western countries. In developed countries, if the share price of a certain company falls, there is a probability that another company – having decided that the price has fallen low enough – will buy it (something called a “hostile takeover”). In the process, the share price of the target company goes up. In China, however, this was impossible since most of the shares remained in state hands. In the absence of such market mechanisms, share prices of many companies simply continued to whither, staying down for many years at a time. In addition, due to government influence, information often became available to officials before it could reach investors. As a result, stock trading based on confidential information (the so-called “insider trading”) became extremely widespread. As we can understand, ordinary investors did not like this one bit, and as a result all shares began to trade at a discount, i.e. below the price they could have been if insider trading did not exist.

At a certain point, the Chinese leadership realized that China’s exchanges could not function without undergoing significant reforms, and that a market economy could not function without stock exchanges. The reforms were launched in 2004 and 2005. And they turned out being pretty successful: since the start of 2006, the market has gained about 360 percent (over the same span, our S&P 500 went up by 22 percent)! In our next program, we will talk about how you can invest in Chinese markets – this is not very easy to do. But for now, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.