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Investing in China is challenging but the market offers huge potential Back  
Despite the current debate over whether or not the Chinese economy will experience a ‘hard landing’ in 2005, investors should not lose sight of the longer-term consequences of China’s rapid integration into the world economy. George Huguet says that its impact on the global economy will grow rapidly, and investors should adjust their strategic asset allocation thinking accordingly.
China will profoundly affect the future pattern of global production and trade. China’s total merchandise trade is now running at $650 billion a year, or six per cent of world trade. By 2010 this share is expected to rise to 10 per cent, and China will likely export more manufactures than France, Germany or Japan.

But investing in China presents complex challenges. Should one invest in China? And, if so, how? From an asset allocation perspective, investors should include China in their strategic benchmark (ie consider China as part of their long term holdings.) In particular, China’s emergence provides additional impetus for adopting an investable global benchmark. Investors should also invest in China indirectly, particularly via multinational companies active in China, and through Hong Kongg, Taiwan, and other Asian markets.

China is a favored destination for Foreign Direct Investment (FDI) because of its large market ($1.3 trillion), sharply increasing domestic demand (per capita income doubling every 10 years) and vast supply of low-cost labor. China now accounts for four per cent of world output; if current growth rates are sustained, the Chinese economy will be larger than the US economy by 2045.Going forward, China’s rapid economic transformation and development of its capital markets will present investors with an increasingly broad range of opportunities and financial instruments.

Despite explicit attempts by the Chinese authorities to curb the current investment boom, the acceleration of global economic activity this year will substantially reduce the prospect of a recession in China in 2005. The Chinese economy is expected to grow by at least eight per cent per annum for years to come. Inflation in China is running at only 3.5 per cent per annum vs. 20-30 per cent ten years ago. China is also running a current account surplus equal to 1.5 per cent of GDP and has a massive war chest of $450 billion in reserves. Most importantly, China is a very open economy (in fact twice as open as the US) and exports 25 per cent of output.

China’s rapid growth and integration with the world economy is not unprecedented. For example, from 1953 to 1973 (the year of the first oil shock), the Japanese economy grew at an average 9.4 per cent per annum. In this period, the yen strengthened versus the dollar by 1.5 per cent per annum and the Japanese stock market returned in dollars roughlyy 14.3 per cent per annum. For global investors, the opportunities presented by China today may be similar to those facing investors evaluating Japan in the 1950s.

The Chinese government promoted its stock market 14 years ago as a means of liquefying its holdings in thousands of State Owned Enterprises (SOE’s) - a legacy of the Communist era - and is still by far the largest shareholder in China. At the end of 2003, the capitalization of the Chinese stock market was US$538 billion, making it the world’s eighth-largest market, with more than 1,300 companies. However, the combined Morgan Stanley Capital International float-adjusted (investable) market capitalisation of China, Hong Kong SAR, and Taiwan is only 1.5 per cent of the world total.

This weighting in part reflects China’s closed capital account system where only certain classes of shares are available to foreign investors.

The recent implementation of Qualified Foreign Institutional Investor (QFII) status has allowed some institutional investors very modest access to the A Share market, with up to a two-year lock-up. Because the A share market is immature, and most of the companies listed suffer from poor profitability, low transparency, and weak corporate governance, investors should consider other alternatives first to benefit from a China ‘play.’

One way retail investors can access China is through Chinese companies that trade in New York via American Depository Receipts. Another is through Chinese ‘H’ shares, which trade in Hong Kong. In fact China-related companies account for roughly 30 per cent of the capitalisation of the Hong Kong market as a whole. At 11 times forward earnings, the MSCI China index, which includes both H shares and ADR’s, trades at a modest premium to the forward p/e of emerging markets as a whole, but well below that of developed markets. And of course well-diversified emerging market and global mutual funds can provide retail investors a means of playing China indirectly.

China’s emergence represents a favorable shock to both global demand and supply. In the first instance, China will certainly serve as an engine of Asian growth; however, in addition to ‘first order’ effects, there will be ‘second order’ effects not yet fully anticipated by the market. For example, China’s outward FDI is currently running at $3 billion a year, the largest among emerging markets. Given China’s concerns over energy security, over time it is likely to acquire foreign oil assets and other natural resource assets.

The Chinese economy, a self-styled ‘market socialist’ experiment, faces enormous challenges, including insolvent banks, weak institutions, microeconomic inefficiency and tensions with Taiwan, to name a few. But its impact on the global economy will grow rapidly, and investors should adjust their strategic asset allocation thinking accordingly.

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