Investment Strategies to Exploit Economic Growth in China

RECENT RESEARCH

INVESTMENT STRATEGIES TO EXPLOIT ECONOMIC GROWTH IN CHINA

By Burton G. Malkiel, Ph.D., Jianping Mei, Ph.D., and Rui Yang, Ph.D.

Editor’s Note: Jianping Mei has been a consultant and finan- indirect methods of investing in China’s future is likely to cial adviser to a number of the financial institutions men- provide the best risk/reward tradeoff for investors. tioned in this paper. Some of these institutions may have investments in securities discussed in the paper. China’s Future Growth he legendary movie producer Samuel Goldwyn ince the beginning of economic reforms two was quoted as saying that predictions are very decades ago, the economy in China has produced Thard to make, especially about the future. Sreal growth rates of between 8 percent and 10 per- Similarly, it is difficult to project the future growth of cent per year. We believe that China will continue to expe- companies and economies. Errors in forecasts are more rience exceptional growth for decades to come at rates the rule rather than exception. Nevertheless, we believe well above those of any other large country in the world. that there is an excellent probability that the growth of In this paper we first show why China will enjoy the Chinese economy will continue to be exceptionally growth rates of economic activity well above those in the rapid over the decades to come. We believe this to be a developed world. But economic growth does not neces- high-probability forecast for three reasons: 1) the mar- sarily translate into high-security returns. Indeed, returns ket economic institutions necessary for growth already from investments in Chinese equities have been unattrac- have been established and China already has enjoyed tive for the past decade, and corruption and corporate- years of success; 2) a pragmatic government will con- governance issues, as well as a variety of restrictions, tinue to guide the economic transformation of the econ- make direct investment in Chinese opportunities diffi- omy; and 3) there is an abundance of underutilized cult. But we also will show that Chinese equities now are human capital in China as well as the considerable sav- attractively priced relative to their earnings, their histori- ings necessary to fuel future growth. cal valuations, and their growth rates and that some risks In his excellent book on the Chinese economy, have been attenuated over time. We then will proceed to Gregory Chow (2003) demonstrates that an ostensibly examine the potential rewards and risks of the various communist government can adopt institutional changes indirect methods U.S. investors can use to access the that allow market forces to play a positive role in pro- Chinese market. For example, we will examine the lower- moting economic growth. The household responsibility risk strategies of investing in companies not necessarily system created a revolution in agriculture in the Chinese domiciled in China but that sell to or service Chinese economy. The energy of township enterprises played a consumers and producers and thus can profit from the vital role in the early years of China’s rapid growth. An rapid future growth of the Chinese economy. We con- open policy of encouraging foreign investment con- clude that a mixed strategy involving both direct and tributed to growth by allowing the importation of tech-

nology, capital, and managerial know-how. Moreover, hosted their first Olympic games in 1964 and 1988, the competition from private enterprises is acting as a respectively. Both Japan and Korea, two countries with spur to force state enterprises to become more efficient. entrepreneurial cultures similar to China’s, enjoyed long A pragmatic government, dedicated to the pursuit periods of economic growth and structural change from of economic growth, also gives us reason to believe that the period beginning with their planning for the rapid growth can continue. Whatever the merits and Olympic Games. China’s gross domestic product (GDP) demerits of the Chinese political system, years of exper- per capita is still quite low, similar to that of Japan and imentation have given government leaders first-hand Korea at the time they hosted the games. There is thus experience with the merits of a market-based system. no reason to believe that China is nearing the end of its The Chinese are unlikely to abandon such a successful rapid-growth period. Figure 1 shows the real growth of system. The consensus regarding market reforms that economic activity as well as the real equity returns of has been developed thus far, as well as the infrastructure Japan and Korea during the twenty years following plan- building undertaken by the government, will help pro- ning for the Olympic Games. vide a positive environment for future growth. Moreover, But by far the most important reason to believe that we expect continued structural changes that will trans- growth will continue is the high quantity and quality of form the economy increasingly to one that is market- human capital in China. Human capital in the form of a based and avoids the heavy hand of overregulation. skilled and hard-working labor force, as well as an The hosting of the Olympic Games in 2008 may entrepreneurial culture, is undoubtedly the most impor- well be a watershed event for the Chinese economy. The tant engine for economic growth in the future. And investment firm of Goldman Sachs has noted remarkable China has well more than 100 million potential workers similarities between China now and Japan in 1961 and eager and ready to join the labor force. No other devel- Korea in 1985, three years before the latter two countries oping country, except possibly India, has the available human resources and the accompanying ambition and FIGURE 1 culture to sustain growth at the level that is possible in Real GDP Growth and Equity Dollar Annual China. The Chinese have a great sense of their place in Compounded Returns. history and a high degree of confidence that they can Japan (1960–1980) and Korea (1984–2004) climb to the top again. As Chinese enterprises begin to 12 operate under more transparency and better legal pro- tections, and with China’s entry into the World Trade

10 Organization (WTO) and the increasing openness that such membership implies, we believe that the economy can continue to grow at rates well above the average in 8 the developed and developing world. In considering the competitive advantage of China in 6 an increasingly integrated world economy, it is important to underscore the important cost advantage enjoyed by 4 China. During the early 2000s it has been estimated that city dwellers in China earned about sixty cents per hour. 2 Peasants had incomes of about one third that amount and therefore ﬂooded into the cities seeking a better life with 0 Japan Korea greater economic opportunity. The investment ﬁrm of AllianceBernstein has estimated that foreign joint ven- GDP Growth Equity Return tures in the Chinese auto industry pay total compensation to labor of about $5 an hour. Total compensation Source: Goldman Sachs (2003 and 2004) costs in the U.S. and German auto industry are about $53

and $65 an hour, respectively. With The implications of these develop- a huge reserve army of cheap labor, ments for both investors and the China can continue to keep labor While wages are even lower in world economy are enormous. costs low. other parts of the developing While wages are even lower in Is Growth Sustainable? other parts of the developing world, only China offers an hile the outlook for world, only China offers an opti- optimal mix of not only low growth looks positive, mal mix of not only low wages but critics argue that wages but also high productivity W also high productivity and a rela- China’s high economic growth rate tively advanced supply-chain and a relatively advanced sup- may not be sustainable because of infrastructure. Moreover, highly ply-chain infrastructure. its input-driven growth model: skilled Chinese workers such as China depends on an increasing use engineers can be hired at a fraction of labor and capital inputs to manu- of the cost of similarly trained facture growth. This argument has workers in the West. This explains the enormous some merit because recent Chinese growth increasingly growth of foreign direct investment in China, as foreign has been driven by its massive infrastructure investment firms attempt to exploit the labor-arbitrage opportuni- as well as by speculative property investment in some ties. According to China’s Ministry of Foreign Trade and major cities. Investors are especially alarmed by the fact Economic Cooperation, foreign-related firms now pro- that recent economic statistics reveal that real investment duce more than half of China’s exports. in China accounts for more than 40 percent of its GDP, There always are scenarios where the growth fore- while consumption accounts for only about 40 percent. cast we have presented will not be realized. Rural unrest This compares with a 20-percent investment and 70-per- as the income distribution in China becomes increas- cent consumption share in the United States. This high ingly skewed is always a possibility. Political instability investment-rate coupled with low-cost labor reminds never can be ruled out. A not-fully-developed legal sys- people of the input-driven growth in many Asian coun- tem and a lack of credibility in the governance struc- tries before the Asian financial crisis of the late 1990s. As tures of Chinese institutions could interfere with the Paul Krugman (1994) correctly pointed out, input-driven prospects for growth. The Chinese banking system is growth without improvement in total factor productivity extremely fragile, nonperforming loans are high, and (TFP) will sooner or later hit the wall of diminishing China has had to rely on informal (often family-orient- returns and lead to a drop in future economic growth. ed) lending systems rather than its undeveloped capital Chinese consumption data could be somewhat markets to finance its growth. But the probabilities are underestimated, however, due to poor reporting. For high that China can overcome these difficulties and will example, one of the largest consumer sectors, the restau- become a global macroeconomic powerhouse and rant business, suffers from severe underreporting. develop world-class companies that can produce grow- Moreover, high investment rates were necessary to pro- ing profits. The growth of Chinese enterprises will provide the infrastructure required for the economy to grow. duce two kinds of economic ripples throughout the At the beginning of the 1990s, few highways linked world. First, Chinese companies appear to have an Chinese cities. Railroads were the only dependable almost insatiable appetite for raw materials such as method of public transportation. Since the 1990s, tens of petroleum. Second, the ability of Chinese manufactur- thousands of miles of highways have been constructed, ers to offer quality goods at low prices will have a pow- forming a large transportation network. In addition, many erful effect on global manufacturing companies. If airports have been built and domestic air travel has China manufactures and sells some product globally, its become common. While there has been property specula- price is likely to go down. If China needs to buy some- tion in some major Chinese cities such as Shanghai, most thing—such as a raw material—its price is likely to rise. of the Chinese urban population still lives in tight quar-

ters with few amenities. Therefore, there appears to be Continued economic growth is necessary to maintain ample demand to absorb high rates of urban real estate domestic political stability. development. And while nonperforming loans (NPL) are Investors must keep a close eye on China’s rocky high, they are largely the result of state financing of ineffi- relationship with Taiwan, however. China repeatedly cient state-owned enterprises. The total of NPL and has threatened military invasion if Taiwan declares its explicit government debt is low in relation to China’s GDP, independence. This carries the risk of dragging the and unlike other Asian countries that have faced financial United States into a military confrontation with China, crises, China’s foreign exchange reserves are large. which could be devastating for the global economy. The good news is that, because of increasing economic ties, Risk Assessment pressures are growing to find some common ground to olitical stability is of paramount importance for maintain the status quo. continued economic growth. While China is still Deterioration of the political relationship between Pa one-party state, and that party is the communist China and Japan is another potential economic risk. party, the government is one of the most pro-business While some trade and territory disputes exist between and pro-growth in the world. In recent years, the gov- the two countries, the real issue has to do with historical ernment also has adopted new policies to address animosity and the emergence of China as a world power. income disparity and social safety-net issues. While One of the lessons of World War I was that the emergence political control is still quite tight, the Chinese people of a new world power deeply affects the geopolitical increasingly enjoy more personal freedom. With its pol- interests of existing powers. Failure to find an accommo- icy objective of building a more harmonious society, the dation could lead to a serious setback for globalization. government is expected to quickly address major griev- Another major concern to international investors is ances of the population before they build up while China’s financial stability. Reports of gross mismanage- maintaining a tight control on political dissent. ment and corruption within the Chinese banks are

FIGURE 2

Rapid Increase in Chinese Domestic Savings (in U.S. dollars)

$1500

$1200

$900

$600

$300

$0 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: China State Statistical Bureau

alarming and call China’s financial stability into ques- Another important source of capital in China is for- tion. These problems are uncomfortably similar to the eign direct investment (FDI). Because of its relatively crony capitalism and nonperforming loan issues that welcoming foreign investment environment, China plagued many Asian banks before the financial crisis of replaced the United States as the country that attracted 1997. As noted above, however, China’s debt-to-GDP the most FDI in the world in 2004; China received more ratio is low and its foreign exchange reserves are high. than $61 billion that year. FDI has provided China not The saving grace to China’s antiquated financial only with much needed capital investment and technol- system is its high and growing domestic savings, illus- ogy; it also has provided China with access to global trated in figure 2. China has one of the highest savings capital markets. rates in the world, at more than 40 percent of national income. The accompanying rapid increase in savings Accounting Concerns deposits has alleviated the pressure of nonperforming and Corporate Governance loans. Moreover, by lowering its deposit rate to almost n China, investors have a vivid saying for investing zero, the central bank essentially is asking the popula- in Enron- and WorldCom-type companies. It is tion to subsidize its inefficient banking system. Thus, in Icalled “stepping on mines.” Unfortunately, in China’s the absence of a political crisis, we do not believe there short fifteen-year market history, false accounting has will be a liquidity crisis in the Chinese banking system. blown away investors’ wealth in too many instances. The government also is fortified by a U.S. $700 bil- The China Securities Regulatory Commission lion war chest of foreign exchange reserves. To some (CSRC), under the strong leadership of its Vice-Chair extent, these reserves provide an implicit insurance pol- Laura Cha—a former Hong Kong market regulator icy for China’s financial system. Recently, the govern- nicknamed “The Iron Lady”—has implemented numer- ment has used its massive exchange reserves to inject ous accounting and disclosure rules for listed compa- close to $100 billion into the ailing state banks to recap- nies and has enforced strict penalties against local italize them and prepare them for overseas listing. We accounting firms during the early 2000s. The strong expect that some banks, goaded by the pressure of enforcement of these rules has uncovered many skele- becoming internationally listed public companies, even- tons in the listed companies’ closets, and it has con- tually will transform themselves from simple govern- tributed to a 50-percent drop in the Chinese A-share ment purses to truly for-profit financial institutions. market index. As a result, investors now are keenly While the state-owned banking sector is grossly aware of the accounting and disclosure problems, and inefficient, it is worth noting the rapid spread of private market prices have adjusted to better reflect the risks as banking activity across China, especially in the affluent well as the opportunities involved in investing in south. This activity fills an important gap in the supply Chinese companies. of much-needed credit to private enterprise. According The CSRC also has amended Chinese corporate law to Xiao Feng, the chief executive officer of Boshi Fund to empower minority shareholders. Public investors are Management Co., private lending among relatives, given special voting privileges that essentially amount to friends, and neighbors may account for as much as one- veto rights on many corporate actions. This has forced third of lending in China. A study by Allen, Qian, and the majority of state-owned companies to react to the Qian (2005) comes to a similar conclusion. Because of grievances of public investors by materially increasing personal trust and family bonds, the default rates on pri- the quantity and quality of corporate disclosure. The vate loans is close to zero, in sharp contrast to the more painful experience of “stepping on mines” also has edu- than 25-percent default rate for loans of the state banks. cated millions of investors in China, particularly the Thus, China’s backward financial system is supplement- emerging institutional-investor community. The careful ed by a highly efficient underground banking sector, scrutiny of mutual fund analysts has revealed numerous which has provided the rapidly growing private sector accounting frauds including Eastern Electronics, a with much needed capital. Chinese version of WorldCom. Professional investors

have had an unambiguously positive influence. Newly with the P/E multiples for large U.S. S&P 500 compa- listed companies enjoy better pricing if they have large nies. Such an adjustment suggests that the Chinese institutional shareholdings, increased disclosure, and a stock market is maturing and moving away from one reputable accounting firm to approve their financial that was largely driven by speculation to one that is statements. more value-oriented and that better reflects the invest- China’s entry into the World Trade Organization ment risks described above. It also reflects the increas- has heightened public awareness of the importance of ing influence of domestic as well as foreign institutional corporate governance. It is remarkable that the official investors who are more sensitive to equity value. document of the 16th Congress of the Communist Party, Second, the invisible hand of the market gradually has published in November 2002, included the term “cor- replaced the visible hand of the government in deter- porate governance” and noted its importance for eco- mining IPO pricing. As a result, IPO pricing has become nomic reform. Now, it is common practice for considerably more restrained, reflecting greater uncer- government officials to mention poor corporate gover- tainty in companies’ prospects and also leaving nance and lack of fiduciary responsibility as the two investors with a decent compensation for the risk taken. main problems of Chinese corporations. There is broad Third, the recent valuations reflect a gradual con- awareness that unless China can improve corporate gov- vergence of market valuations of Chinese stocks to ernance, operational efficiency and technological those traded around the world. A unique feature of progress alone will not be sufficient to place Chinese Chinese equity financing is the coexistence of an alpha- companies on the world stage. While old habits die bet soup of A shares (sold to domestic investors), and B, hard, numerous enforcement actions have made H, and N shares (sold to Hong Kong, U.S., and other Chinese firms increasingly aware of the huge penalties foreign investors, respectively). Historically, these mar- involved in committing accounting fraud. We are well kets were segmented, with the domestic market valua- aware that large risks remain, but past problems that led tions influenced largely by short-term speculators who to severe declines in stock prices need not be the pro- drove the market valuations of A and B shares to very logue to continued unsatisfactory performance of high valuation levels (see figure 3). The opening of Chinese equities. China’s capital market since 2004 has caused the con- vergence of domestic valuation levels toward those of Will Economic Growth Be Reflected in overseas markets. As we can see, many domestic High Investment Returns? Why We Are Chinese stocks now sell at quite attractive valuation lev- Bullish on the Chinese Stock Market els compared with U.S. stocks. uring the early 2000s, while economic growth To compare relative valuation levels of Chinese roared ahead at more than 8 percent per year, equities, we selected fifty-nine relatively large Chinese DChina’s nascent stock market turned in a sur- firms. Their estimated long-term earnings growth rates prisingly poor performance. Despite improved earnings were obtained mainly from Boshi Fund Management and falling interest rates, China’s market index fell by Co., one of the largest mutual fund companies in China. more than 50 percent. Does that imply that China’s Price-earnings multiples (P/E) were obtained by dividing stock market does not reflect economic growth? the stock prices of the fifty-nine firms as of early 2005 by On the contrary, we believe the poor performance their earnings per share. We then picked a sample of sev- reflects encouraging structural changes in the stock enty-nine similar firms in the United States and obtained market, which have laid down a foundation for a sus- similar data. The estimated long-term growth rates were tainable bull market in the future. These changes obtained from I/B/E/S (the International Brokerage include, first, a welcome adjustment of market valua- Evaluation Service). Each Chinese firm was matched tion levels from an average multiple of forty to fifty with one or more U.S. firms located in the same business times earnings to a more reasonable average of about and industry. For example, Exxon Mobil in the United twenty times earnings for large companies, comparable States (8.6 percent expected growth, P/E of 15) was

FIGURE 3

Comparison of Valuation Levels across Different Markets in 2001 and 2004

PE December 31 , 2001 PE December 31 , 2004 10 0

0 Shanghai A share Blue Chip A shares B shares Red Chips H shares ADRs

Source: Boshi Fund Management Co. Shanghai Composite Index consists of all A shares traded on the Shanghai Stock Exchange. Blue Chip Index consists of 200 blue-chip stocks selected by Boshi Fund Management Co. B Shares Index consists of all B shares traded on the Shanghai Stock Exchange. Red Chip Index consists of sixty overseas-domiciled companies that have almost all of their operations in China listed on the Hong Kong Stock Exchange. H Shares Index consists of Chinese companies listed on the Hong Kong Stock Exchange. ADRs are the Bank of New York China ADR Index. coupled with China Petroleum (19.6 percent expected reasonable proxy for earnings growth. Under this growth, P/E of 18). Figure 4 presents the results of the assumption, figure 5 shows that Chinese stocks tend to analysis. We see that Chinese stocks tend to have higher have higher growth rates and lower P/E ratios. growth rates and lower P/E ratios. Moreover, growth-to- It is worth noting, however, that strong economic P/E ratios tend to be considerably higher for Chinese growth does not necessarily translate directly into earn- stocks. The attractiveness of buying stocks with high ings growth or equity returns. We know that the MSCI potential growth rates at low P/E multiples is that the China index has significantly underperformed the MSCI risk of P/E compression is minimized. Moreover, as the Emerging Markets index during the past ten years, growth is actually realized, the P/E may rise. As investors despite China’s stellar GDP growth. become more confident of future growth, stocks are We believe, however, that China’s equity market will often rewarded with higher multiples. more closely reflect its economic growth in the future for We also may compare entire markets rather than several reasons. First, China’s equity market is much individual companies using the same approach. We can more mature than it was in its infancy ten years ago calculate growth to P/E ratios for each national market. when many growth companies were not listed. At the The growth rate used is the ten-year growth rate of each time, the index was skewed by a few large companies country’s GDP from 1995 to 2004. Because corporate that entered with fairly rich valuations relative to their earnings and GDP growth tend to move together (in growth prospects. With the gradual development of countries with private ownership and improving corpo- China’s financial markets and access to global capital, rate governance), the real GDP growth rate may be a many blue-chip Chinese companies, such as PetroChina,

FIGURE 4

Valuation Comparison between Chinese and U.S. Companies (2005)

U.S. China U.S. China 30 0.7

0.6 25

0.5 20

0.4 15 0.3

10 0.2

5 0.1

0 0.0 Estimated Growth Rates (%) P/E Ratios Growth (%)-to-P/E Ratio

Note: The comparison is made between twenty-two comparable sectors in the United States and China. There are seventy-nine firms in the U.S. sample and fifty-nine firms in the Chinese sample. The P/E and earnings growth estimates for U.S. firms are derived from Bloomberg and I/B/E/S. Those from Chinese firms were provided mainly from Boshi Fund Management Co.’s internal research with some additional estimates provided by I/B/E/S.

FIGURE 5

Real GDP Growth-to-P/E Ratios for Various National Markets

0.6

0.5

0.4

0.3

0.2

0.1

0 a ia re ico ia ina Japan Chile Kong Ind Brazil Europe States Ta i wa n Korea gapo Mex Chin Thailand Indonesia Malays Argent Hong Sin United South

Note: Real GDP growth rates are from 1995–2004, except Indonesia (2000–2004). Ratios were based on March 2005 market prices for respective national market indices.

China Unicom, and China Merchant Bank, are now list- ciate its currency value. As figure 6 shows, during the ed on the Chinese as well as on international stock period of Japan’s most rapid growth, the Japanese yen exchanges. These companies have enjoyed earnings appreciated substantially against the U.S. dollar. growth commensurate with China’s economic growth. We do not expect that China will let its currency Second, we believe that recent corporate governance appreciate sharply against the U.S. dollar over the short reforms will lead to better treatment of minority share- term. It took more than thirty-five years for the Japanese holders. Moreover, as more privately owned companies yen to appreciate from 400 yen/dollar to about 100 go public, the personal fortunes of many managers will yen/dollar. Because of its large and growing labor force, be tied closely to the stock price. Thus, we foresee that Chinese leaders will wish to maintain an undervalued more and more companies will be run with an objective currency to make China’s exports competitive. But we of maximizing the stock price. Finally, we should note believe that large and growing trade surpluses are not that the MSCI China Index is heavily weighted with large politically sustainable in the long term. During 2005, state-owned enterprises and has underperformed the China allowed its currency to appreciate by 2 percent Dow Jones, Shanghai, and Shenzhen stock indexes. versus the U.S. dollar. We expect this is just the first step. China will be under continued heavy pressure Potential Currency Appreciation from the United States and the European Union to further benefit to investors from investing in adjust its currency to restrain its growing trade surplus. China is the likelihood that the Chinese ren- The pressure will be especially strong given the cur- A minbi (RMB) will appreciate in the future. As a rency’s large deviation from purchasing power parity. result of the rapid growth in trade and a high savings While the precise magnitude of the deviation is hard to rate, China runs a huge trade surplus with the United estimate, one interesting statistic is the “Big Mac” index States and has accumulated an impressive foreign cur- provided by the (London) Economist. As figure 7 shows, rency reserve, second only to Japan’s. Much like Japan at the end of 2004, the RMB appeared to be underval- in the 1980s, China is facing strong pressures to appre- ued by as much as 60 percent against the dollar. As a

FIGURE 6

The Appreciation of the Japanese Yen

Yen/Dollar Exchange Rates (1960–2004) JPY / USD

400.0

320.0

240.0

160.0

80.0

0.0 January 31, 1960 September 30, 1971 May 31, 1983 January 31, 1995 May 31, 2004

Source: Datastream

FIGURE 7 Estimates of Purchasing Power Parity: The “Big Mac” Index (December, 2004) $4.0 $3.75 $3.61 $3.5

$3.00 Korea Argentina Hong Kong Russia China $3.0 Euro Area Britain U.S.

$2.5 $2.36 $2.0

$1.5 $1.60 $1.54 $1.49 $1.26 $1.0

Source: The Economist

TABLE 1 Average Dollar Return and Volatility of Selected Markets, 1995–2004*

NUMBER OF NUMBER OF AVERAGE YEARS IN WHICH YEARS IN WHICH HIGHEST LOWEST VOLATILITY ANNUAL RETURNS WERE RETURNS WERE YEARLY RETURN YEARLY RETURN INDEX (UNITED COUNTRY RETURN (%) POSITIVE NEGATIVE (%) (%) STATES=100) Argentina -0.15 6 4 131.92 -46.55 248.83 Brazil 6.53 5 5 140.71 -45.72 206.81 Chile 2.40 3 6 80.43 -28.06 107.78 China 6.93 5 5 65.14 -20.62 220.04 Greece 11.62 6 4 87.17 -42.71 131.61 Hong Kong 5.42 5 5 68.30 -24.48 125.97 India 1.73 5 5 81.79 -30.16 152.33 Thailand -11.06 5 5 136.67 -75.48 170.43 United States 9.97 7 3 32.07 -23.36 100.00

*All average returns in this paper represent the annual returns including dividends, which when compounded produce the final wealth achieved by an investor who reinvests all dividends. Source: Datastream and authors' computation

result, we expect the currency to appreciate gradually in Open-End U.S. Mutual Funds the near future, offering dollar investors a natural hedge hile China’s growth provides an attractive against the weakening dollar. W investment framework, direct investment in the Chinese stock market undoubtedly is risky. As shown in Strategies for Investing in China table 1, the Chinese stock market was more than twice everal strategies are available to U.S. investors as volatile as the U.S. market during the 1995–2004 who hope to benefit from the continued rapid period, even though the U.S. market itself went through Sgrowth of the Chinese economy. Here, we present a spectacular boom-bust cycle. Moreover, there is also the advantages and risks involved in each. large firm-specific volatility for individual companies.

TABLE 2 Open-End U.S. Mutual Funds Investing in China (September 30, 2005)

MORNINGSTAR EXPENSE NAV TRAILING 5-YEAR RETURNS PRICE RATING RATIO % ($M) AV. ANNUAL (%) Alliance Bernstein Greater China 12.82 ### 2.00 49 8.84 Columbia Greater China Z 25.73 ### 1.64 95 8.67 Dreyfus Premier Greater China 21.12 ### 1.80 149 9.53 Fidelity China Region 18.08 ## 1.77 425 5.70 Guinness Atkinson China 19.33 ### 1.67 120 6.14 Matthews China 14.67 #### 1.50 411 15.99

Source: http://quicktake.morningstar.com/fund, http://finance.yahoo.com. All funds are no-load.

TABLE 3 Selected Closed-End Fund Shares (Data for October 2005)

MORNINGSTAR PREMIUM/ EXPENSE TRAILING 5-YEAR RETURNS PRICE RATING DISCOUNT RATIO % AV. ANNUAL (%) Jardine Fleming China Region (JFC) 12.18 ### -14.61 2.22 9.18 Greater China (GCH) 15.60 #### -14.72 2.28 15.41 China Fund (CHN) 24.07 ##### -0.90 1.41 31.14

Source: http://quicktake.morningstar.com/fund, http://finance.yahoo.com

Thus, it is imperative that investors have a broadly investments, the closed-end fund manager is not diversified portfolio to minimize investment risk. The required to sell portfolio holdings. This aspect is advan- easiest place to start is to buy mutual funds sold in the tageous when dealing with Chinese shares because the United States that invest in Chinese stocks. Based on transaction costs of buying and selling are quite large. relatively low expense ratios and reasonable past relative Another advantage is that investors may earn excess performance, we have selected six U.S. mutual funds for returns when buying at deep discounts, because the dis- individual investors; these are shown in table 2. counts on closed-end funds tend to mean-revert. Table 3 lists three selected funds based on past performance and U.S. Closed-End Investment Company Shares relatively low expense ratios. During 2005, two of those n alternative approach is to purchase closed-end funds sold at substantial discounts. Afund shares sold in the United States when they are selling at discounts from their net asset values. While the Investing through Hong Kong, Taiwan, and Japan price of a closed-end fund tends to deviate from its net ecause of better corporate governance, more profes- asset value (NAV) and therefore may not always be sold Bsional management, large exposure to the Chinese for full value, these funds can have certain advantages economy, and lower asset valuations, we believe many that make them suitable for investing in China. One Hong Kong-listed local companies are lower-risk invest- advantage is that, unlike open-end mutual funds, which ments than indigenous red-chip Chinese companies. tend to be forced to buy at market peaks and sell at mar- These Hong Kong companies include Li & Fung (a very ket troughs due to the fickle whims of fund flows in the successful outsourcing and trading firm), Shui On marketplace, managers of closed-end funds have more Group (run by Vincent Lo, nicked named “King of control over the timing of their purchases and sales of GuanXi” and the most consistently successful foreign securities. If investors wish to redeem their Chinese real estate investor in China), and HSBC and Hang Seng

Bank, two financial giants that are expected to generate European Union. While China has become an important more than 50 percent of their business from greater outsourcing center for Japanese companies, Japanese China. One very well-diversified Hong Kong company is companies there are increasingly making products for Hutchison Whampoa, a firm listed on the Hong Kong the domestic Chinese market. The steady growth of stock exchange with business hold- the Chinese middle class also has ings in financial services, infrastruc- created significant demand for ture, investments, manufacturing, Japanese products. The Goldman While investors may be put off real estate, retail, telecom, and utili- Sachs “China-related Japan stock ties. During the 1987–2004 period, by recent anti-Japanese basket” outperformed Japan’s stock Hutchison Whampoa provided protests in China, the simple market index (TOPIX) by 35 percent investors with annual dollar returns during 2003 and 2004. Assuming of 13.3 percent and outperformed truth is that the economies of continued economic growth in the Hong Kong market index. China and Japan are highly China, we believe Japanese machin- Hutchison and its management ery, chemical, transportation equip- complementary and China has have much the same reputation in ment, and steel companies will enjoy Asia as Berkshire Hathaway and become Japan’s third-most steady increases in demand from Warren Buffett in the United States. important trading partner China. Japanese companies likely to The company represents a well- benefit are Hitachi Construction diversified and lower-risk indirect after the United States and Machinery, Asahi Glass, Nippon method of benefiting from the the European Union. Steel, Mitsui & Co., Teihaiyo growth of China. Cement, Daikin Industries, and Because of increasing econom- Mitsubishi Electric. ic integration with China, some Taiwanese companies also offer unique opportunities Investing through U.S. Companies for capitalizing on China’s growth. Taiwan is the second ome U.S. companies also will benefit from China’s largest high-tech chip producer in the world. By Sgrowth. Wal-Mart purchased $18 billion of mer- expanding into China, many Taiwan chip makers have chandise in China in 2004. Wal-Mart has done more achieved a potent mix of technology know-how, world- than any other company in the world to put “Made in wide market access, and cheap labor, and they are very China” on the U.S. retail landscape. Wal-Mart also has well positioned to meet the needs of a growing Chinese considerable retail business in China. With its formida- market as well as demand from around the world. Two ble outsourcing and logistics network, Wal-Mart is examples are the blue-chips TSMC and UMC. Both also expanding rapidly in China, building many stores in are listed as American Despositary Receipts (ADRs) on urban population centers. While China is investing the New York Stock Exchange. Another long-term heavily in its transportation infrastructure, its distribu- financial vehicle is China Trust, the largest Taiwanese tion system is still antiquated and not efficient. This financial conglomerate. Because of its expertise in finan- gives U.S. companies such as UPS a significant advan- cial services as well as in real estate development in tage. While UPS still is making heavy investments in its China, we believe its business there is poised for con- China network and the business is not yet profitable, we siderable growth, especially if there is any warming of believe investors will enjoy significant earnings gains relations between China and Taiwan. when the network is up and running. ProLogis, which While investors may be put off by recent anti- is a real estate investment trust (REIT), offers investors Japanese protests in China, the simple truth is that exposure to both China’s transportation industry and its the economies of China and Japan are highly comple- real estate. Another successful U.S. company operating mentary and China has become Japan’s third-most in China is Yum! Brands, Inc. The company owns two important trading partner after the United States and the popular restaurant chains in China: KFC and Pizza Hut.

TABLE 4 Selected ADRs of Chinese Companies MARKET CAP PRICE (OCTOBER 10, 2005) (OCTOBER 10, 2005) IN BILLIONS ADR ISSUE SYMBOL EXCH INDUSTRY IN U.S. DOLLARS P/E OF U.S. DOLLARS China Unicom CHU NYSE Mobile Telecom $8.03 19.78 $10.09 China Mobile (Hong Kong) CHL NYSE Mobile Telecom 23.08 16.35 90.94 Petrochina Company PTR NYSE Oil & Gas Producers 78.81 9.04 138.57 China Life LFC NYSE Life Insurance 30.22 17.10 20.85 China Petroleum & Chemical SNP NYSE Oil & Gas Producers 43.70 7.24 37.89 China National Offshore Oil CEO NYSE Oil & Gas Producers 65.10 10.51 26.73 China Telecom Corporation CHA NYSE Fixed Line Telecom 36.43 10.00 29.48 Shanda Interactive Entertainment SNDA NASDAQ Internet Game 24.47 18.19 1.72

Source: Bloomberg

A rapidly growing but aging middle-class popula- ly to China or outsourcing their productions there—list tion with money to spend should bring new demand for their shares in New York as well. According to the latest many U.S. drug and medical equipment companies. count by the Bank of New York, sixty-one Chinese, 113 The propensity of the Chinese to save also should ben- Hong Kong, and 107 Taiwanese companies have ADRs efit asset managers. While China’s asset management traded on various U.S. stock exchanges. business still is in its infancy, AIG, Merrill Lynch, One advantage of investing through ADRs is that INVESCO, and Prudential have established footholds in one avoids the cost and difficulty of trading directly in China and have formed joint venture fund companies. overseas markets. Another advantage is that the listing While indirect investments in U.S. (as well as requirements of the U.S. Securities and Exchange Japanese) companies to gain exposure to China’s growth Commission demand a higher level of conformity to are lower-risk strategies, they are not pure plays. These U.S. accounting and reporting standards. Because the companies will enjoy rapidly growing opportunities in Chinese authorities tend to use these companies to China, but such activities still will account for only a showcase China’s development, internal monitoring of small percentage of overall revenue. Moreover, U.S. and corporate governance also tends to be stricter. Table 4 Japanese companies are subject to overall market move- lists some of the largest companies traded in New York. ment in the United States and Japan and thus offer Drawbacks to investing in ADRs are that they are fewer diversification benefits than more direct invest- less liquid than comparable U.S. companies and they ment in companies that do most of their business offer only a limited coverage of the large Chinese econo- in China. my. Thus they do not provide a way to obtain a diversified portfolio of Chinese stocks. Hence, institutional Direct Investment in Chinese Companies investors may consider the purchase of some blue chip Listed on U.S. Stock Exchanges A shares traded on the local Chinese exchanges to obtain he globalization of world capital markets has made adequate diversification. At present, qualified foreign Tdirect purchase of Chinese shares much easier institutional investors may purchase A shares on behalf because many local companies list their shares in New of their retail investors. To mitigate the risk of poor cor- York as ADRs. Moreover, many Hong Kong and porate governance, we recommend the purchase of Taiwanese companies that have substantial exposure to shares in certain more easily monitored sectors, such as China’s growth—either by selling their products direct- energy, transportation, utilities, and consumer goods.

TABLE 5 Large Chinese Closed-End Funds Selling at Deep Discounts (March 2005)

NAME PRICE (YUAN) SCHEDULED DISCOUNT MARKET CAP INVESTMENT LIQUIDATION DATE (%) (100M YUAN) OBJECTIVE Anshun 0.624 June 15, 2014 -43.0 18.72 Growth Fenghe 0.542 March 22, 2017 -47.72 16.26 Value Jinxin 0.496 October 21, 2014 -48.48 14.88 M&A Kerui 0.701 March 12, 2017 -41.2 21.03 Value Tianyuan 0.574 August 25, 2014 -45.7 17.22 G&V Yinfeng 0.532 August 15, 2017 -45.55 15.96 G&V

Source: Boshi Fund Management Co.; Lipper G&V-Growth & Value

Closed-End Investment Companies ing up and investors may enjoy large capital gains if Selling at Deep Discounts early liquidation is approved. Our major concern here ather than buying individual Chinese companies, is the corporate governance issue, however. Because Ran attractive strategy for institutional investors is many fund companies still are owned by the state and the purchase of Chinese closed-end investment compa- manager incentives and responsibility often are poorly nies trading at substantial discounts on the local aligned, there have been cases of personal enrichment Chinese stock exchanges. While these funds unfortu- at the expense of fund investors. After several regulato- nately are not available now for U.S. individual ry crackdowns, however, the general perception is that investors due to China’s currency controls, they are the fund industry now is one of the most transparent in available in limited quantities to institutional investors China. U.S. institutional investors can purchase these through the Qualified Foreign Institutional Investors shares through Morgan Stanley, UBS, Citicorp, and (QFII) program. These closed-end funds have the fol- other large financial institutions that have obtained lowing several advantages: QFII quotas. First, most funds currently trade at substantial discounts of more than 30 percent, twice the size of aver- Investing in Chinese Real Estate age discounts of similar overseas funds. A listing of the ne of the main drivers of the Chinese real estate largest of these funds is shown in table 5. Second, Omarket has been massive urbanization due to because of the lack of blue chip companies and the rapid industrialization and poor infrastructure (roads, presence of speculation (and possibly manipulation) in electricity, telephone service, etc.) in rural areas. The the domestic market, Chinese market indexes tend to Chinese urban population has almost tripled from 172 be unstable and costly to track. While China recently million to 502 million in twenty-seven years. In addi- has started to offer index funds and exchange traded tion, about 100 million Chinese migrant workers are funds (ETFs) to local investors, closed-end funds have working in cities. According to a United Nations study, enjoyed performance somewhat superior to the market by the end of 2015, Shanghai and Beijing are expected indexes over the past few years. Thus, closed-end funds to have a 50-percent population increase and will have offer advantages over indexing in the China market. more than 20 million inhabitants each. Such growth has Third, many of these funds have limited lives of eight to put tremendous pressure on urban land prices. twelve years. Thus, the discounts should converge to Most individuals and institutions have neither the zero at the liquidation of the fund, offering investors a expertise to evaluate Chinese property investments, nor potentially sizable capital gain. Moreover, because more the experience to navigate China’s complicated legal sys- and more Chinese institutional investors are holding tem. Poor liquidity and high transaction costs also make these funds, the pressure for earlier liquidation is build- it very difficult to turn a property into cash if funding

TABLE 6 Selected Natural Resource Funds (October 11, 2005)

MORNINGSTAR EXPENSE TOTAL TRAILING 5-YEAR RETURNS NAV RATING RATIO % ASSETS ($M) AV. ANNUAL (%) Fidelity Select Natural Gas 39.16 #### 0.94 1,940 13.31 ICON Energy 31.10 #### 1.35 993 20.71 RS Global Natural Resource 33.37 ##### 1.50 1,661 26.84 Vanguard Energy 56.02 ##### 0.31 8,777 20.09

Source: http://quicktake.morningstar.com/fund, http://finance.yahoo.com needs or investment prospects change. (Given the poor Conclusion corporate governance in most Chinese real estate devel- e are convinced that the Chinese economy is opment companies, we do not advise investors to pur- Wlikely to be one of the fastest growing in the chase property-company stocks at the present time.) world during the years ahead. Rapid growth provides However, both Hong Kong and Singapore are expected to the raw material for generous security returns. We approve the establishment of REITs dedicated to invest- understand the substantial political and governance ing in Chinese properties by 2006. The Chinese govern- risks that are associated with investment in China, but ment also is expected to approve the listing of REITs in no other developing country has the human resources the near future. These REITs should provide excellent and the accompanying ambition and culture to sustain vehicles for overseas investors because they will provide such rapid growth for years into the future. Moreover, liquidity, diversification, and growth potential. the pragmatism of the current Chinese leadership, which clearly is committed to rise to the top of the Investing in Natural Resources world economic order, gives us comfort that our invest- he substantial economic growth we anticipate for ment recommendations will prove to be profitable. T China and the increased consumption we project We have outlined several strategies that we believe for its huge population imply a growing demand for will allow investors to exploit the growth in China while commodities such as oil, iron ore, copper, and timber. minimizing investment risks. These include the pur- As a result of growing Chinese demand, the prices of chase of Chinese equities either directly or through many commodities, such as copper, are near their his- funds that own diversified portfolios of Chinese compa- torical high levels for the past twenty-five years. nies. Institutional investors especially should consider Commodities also are found to have low correlations closed-end fund shares that sell at substantial discounts with equities and bonds, making them a good addition from their net asset values. We also have recommended to a well-diversified portfolio. All portfolios should lower-risk indirect methods of exploiting the growth in include some exposure to natural resource investments. the Chinese economy through the purchase of such We recommend investing in natural resource equity vehicles as natural resource funds that should benefit funds rather than in a commodity futures fund. Equity from China’s seemingly insatiable appetite for raw mate- funds generally enjoy the same benefits as commodity rials. Moreover, we have suggested that a variety of com- futures funds but tend to have lower expense ratios as panies not domiciled in China will benefit from China’s well as provide dividend income. (One European low- growth through trade and/or foreign investment. Many cost exchange traded fund, however, the Easy ETF companies in Taiwan, Hong Kong, Japan, and even in GSCI, tracks the Goldman Sachs Commodity Index the United States have economic ties to China’s growth. with an expense ratio of only 0.45 percent annually.) Investors may do well to employ a mixed strategy that Table 6 presents a sample of natural resource equity uses some investments from each of the attractive alter- funds that offer investors low-cost investment vehicles. natives we have listed.

One final comment deserves attention. Securities is likely to improve substantially the risk-return tradeoff markets in the developed world are valued relatively of most portfolios holding U.S. domestic equities. richly. Bond yields are low, and risk spreads between risky and safe debt securities are near all-time lows. References Projected equity returns are at best in the single digits Allen, Franklin, J. Qian, and M. Qian. 2005. “Law, finance, given the very low dividend yields at which equities and economic growth in China.” Journal of Financial presently sell. It is clear that the amount investors are Economics 77: 57–116. being paid in extra return for bearing risk is lower than ————-. 2005. “China’s Financial System: Past, Present, has historically been the case. In such an environment, and Future,” Working Paper, Journal of Economic Literature Classifications 05, K0, G2, last revised July 21, 2005. investing in the growth of the emerging market econo- “China: Changing the Way The World Does Business.” 2005. my with the most rapid growth would appear to have a The Bernstein Journal III no. 1: (spring): 7–12. very attractive risk-reward tradeoff. Chow, Gregory C. 2003. China’s Economic Transformation. Finally, the investment strategies we have recom- Blackwell Publishers. mended have important diversification advantages for —————-. 2005. “Corruption and China’s Economic portfolios that are largely invested in developed markets Reform in the Early 21st Century.” Princeton University such as the United States. The correlations of the Center for Economic Policy Studies working paper No. 116 returns from many of the investment strategies we have (October). suggested with the returns from the broad U.S. stock Goldman Sachs. 2004. China Investment Guide. market have been quite low over the past several years. —————-. 2003. Dreaming With BRICs: The Path to 2050. For example, the five-year correlation between the Available on the World Wide Web at: http://www.gold mansachs.com/insight/research/reports/99.pdf. Chinese Shanghai A Shares Composite market index Krugman, Paul. 1994. “The myth of Asia’s miracle.” Foreign and the S&P 500 has been 0.40. The correlation of the Affairs 73, no.6: 62–79. natural resource funds and the U.S. market has been “The Big Mac Index.” The Economist (December 16, 2004). essentially zero. From an overall portfolio standpoint, Available on the World Wide Web at http://www.economist. investing to exploit the growth of the Chinese economy com/markets/bigmac/displayStory.cfm?story_id=3503641.