By GRAHAM FROST 30/11/2007
China’s dramatic economic growth and a domestic market of 1.3 billion people have acted like a magnet for investment. Given that the stock markets connected to mainland China have enjoyed stellar growth for several years, it may be timely to point out that significant risks remain.
It rarely pays to invest simply in a robust economic growth story without examining the valuation and quality of the underlying investments. Mainland Chinese stock markets are trading on valuations equivalent to 50 years of current earnings. Locals, looking for better returns than the negative interest rates on offer at state controlled banks, have poured money into the market. Local authorities are speculating in markets too. Furthermore, a significant amount of company profits are actually made from share speculation rather than operations. That means if markets start falling it could trigger a downward spiral as lower equity prices mean lower profits, which means lower equity prices and so on.
What could trigger that? Investors believe that the China story is so powerful nothing can stop it. That may be true but it does not mean that the road for investors will necessarily be smooth. Chinese inflation has risen to 6.5% an 11 year high-that severely impacts the bulk of the population and could promote political unrest. Two thirds of China’s growth is from infrastructure projects, financed out of poor people’s savings. One suspects that the de-coupling theory (i.e. China will keep on going even if the US goes into recession despite 40% of its gdp being export related) has yet to be fully tested. The Chinese government is likely to face protest soon against its refusal to allow faster currency appreciation-either by protectionism from western governments or internal overheating due to inability to control money supply and local government spending ambitions.
What about the quality of its companies? Many only exist because of state subsidies or price controls. China has no record of technology development or innovation and ranks lowly in terms of patents applications and as a result has no world class companies. Production remains inefficient and massively polluting. The government is trying to adopt capitalist policies whilst remaining a one party communist state. No property rights and no welfare system are hardly conducive. How long can this situation last?
What to do about overheating? If China increases interest rates to a real level, that would require over 2% in hikes. That would be disastrous for state enterprises, increase non performing loans dramatically, and burst the stock market bubble. Increasing taxes is an anathema. It could revalue its currency, thought to be at least 30% undervalued, but that will involve massive write offs of accumulated foreign reserves and would put pressure on exporters. It would also pressure farmers, used to the protection of a low currency.
China maybe a long term growth story but investors should be aware it is not without risk.