Investing In China's Slowdown

By Marc L. Ross, CFP, CPA®, CLU® | May 02, 2012 AAA

The seemingly unstoppable ascent of the Chinese economy has made for good fodder over the past several years. Long denied the benefits of ownership and the trappings of wealth that issue from conspicuous consumption, the participants in and beneficiaries of the People's Gross Domestic Product (GDP) have been "busting out" since shortly after the end of the Cultural Revolution.

The body economic, however, can only run so many marathons before inevitable fatigue sets in. To curb overheating, the state has raised bank reserve requirements and limited the extension of credit for multiple home purchases. Slowing growth in the United States and the eurozone is slowing the export machine, as well, and costly oil imports are proving burdensome. The reduction is growth is relative, though, and GDP growth still hovers at around 10%. Thus, as with any economic slowdown, one's misfortune may well be someone else's opportunity.

SEE: Investing In China

The Long March
Mao's death heralded the beginning of the slow, but steady decline in hard line Communist orthodoxy and the opening of China's economy to the West. The crouching tiger and hidden dragon that was Chinese capitalism began to emerge from beneath the shadow of Communism. Once a much smaller and more agrarian economy, China's gradual overtures to the movement were not lost on the international business community keen to access a hitherto untapped consumer market.

China saw opportunity in export markets for inexpensive goods, which has led to an ongoing U.S. trade deficit. Resource rich, China is a key source exporter of some of the more remote corners of the Periodic Table of Elements. Rare earths are a critical input in the manufacture of cellular telephones, fluorescent bulbs and other technology goods. Additionally, China is the largest owner of U.S. government paper, a point of consternation as much for deficit hawks in the U.S. as is the ongoing debate between the two countries about how China should adjust its exchange rate to ease U.S. deficit woes. The opening to the West and the rest of the globe has opened the wallets of the Chinese themselves, who are estimated by 2015 to occupy 20% of the global luxury goods market.

Its rapid ascent notwithstanding, China is undergoing change. The one-child policy is slowly translating into an aging population. Over the longer term, this shift will decimate the country's manufacturing base, but at the same time create the needs for a better developed social safety net to care for the increased number of its citizens of pensionable age. Given the external challenges that it faces, China must continue to promote internal consumer demand, private enterprise and greater foreign investment.

SEE: Top 6 Factors That Drive Investment In China

From Each According to His Net Worth, to Each According to His Return Requirements
China's shift to a more service-based economy in concert with its burgeoning, if uneven, financial markets, has spawned an array of products to invest in the new Great Leap Forward. But like Mao's program that promised benefits from collectivization and delivered penury and starvation, is this new wave a leap or an assault?

China's size and influence in the global economy and geopolitics is considerable, yet it remains an emerging market, even if closer to the surface than some of its peers. Direct, large scale investment in China is within the remit of endowments, pensions and sovereign wealth funds. Income inequality is still rife with the government favoring state-owned enterprises to smaller, more entrepreneurial endeavors.

As with Russia after the fall of the Soviet Union, those with ties to the ancient regime had, and have, the first mover advantage of crony capitalism, which results in self (mis)appropriation of land and business interests. Force of law and legal protection of private property rights have made headway, even if at a measured pace.

The analysis of Chinese companies is complicated by the existence of differing accounting rules and reporting standards. Then there are the issues of exchange rate and political risk, the latter not an insignificant consideration when parsing the financial opportunities of a nation dealing with a growing economy, but ambivalent about the degree to which to loosen the reins of social and political freedoms. Opaque legal structures can be a challenge to enforce, let alone comprehend.

The so-called variable interest entity is a device that Chinese companies use to engineer an end-run on China's restriction on foreign investment and preference for large state owned enterprises. The company seeking foreign investors establishes an offshore entity that ostensibly receives returns from the company and houses its corporate governance structure. The government's hand in exchange rate policy has tended to favor growth through investment, rather than internal consumption.

The development of robust capital markets remains a work in progress across several fronts (shares, fixed income and derivatives). Market forces are not entirely free to work, though some repatriation has been afforded multinational companies and institutional investors. Those endowed with Qualified Foreign Institutional Investor rights, such as endowments and large money center banks, may have better opportunities to invest in renminbi (yuan) denominated equity and fixed income markets.

SEE: Introduction To The Chinese Banking System

The Bottom Line
Not just an understanding of investment, but also of geopolitics, is critical. All of this being a challenge to navigate, individual investors would typically do better to find exposure through professional management with sources on the ground, facile in the local business climate, with the ability to source investment ideas with merit (mutual funds, ETFs). For the more ambitious, there exists NYSE-listed American Depository Receipts whose companies' accounting follows GAAP standards.

Select exposure to fixed income renminbi is available, but probably better suited to high net-worth investors, as limits on the amount of capital that they may expatriate remain at 20,000 Rmb/day (just under US$3,200) could leave an investor flat footed should he or she need to exit a position. These could fill a satellite allocation in a portfolio. An appropriate disclaimer might read "please read the prospectus, Red Book and Confucian Analects before investing."

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