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"They Will Buy More"

Financial Post

China is booming. How can you benefit? To find the answer to that question, the Financial Post sat down this week with four of the world's most knowledgeable investment experts.

Marc Faber, author of "Tomorrow's Gold -- Asia's Age of Discovery," editor of the Gloom, Boom and Doom Report and special advisor to Dynamic Mutual Funds was in Toronto. Joan Zheng, Greater China chief economist for J.P. Morgan, spoke to us from her office in Hong Kong. Chen Zhao, managing editor of Bank Credit Analyst Group's China Analyst was in Montreal. And Mark Mobius, managing director of Templeton Asset Management Ltd., joined us from Spain.

The global teleconference was organized by Dynamic Mutual Funds and stickhandled by Levi Folk, an independent fund analyst. Below, our four experts give their views on China's rapidly industrializing economy and reveal how you can make the most of the situation.

Q. What opportunities does China hold for an investor with a long-term perspective?

Marc Faber: The Chinese economy is probably about 50% to 60% of the U.S. economy already and in many sectors of the economy, China is larger than the U.S. China produces more steel than the U.S. and Japan combined and they are still importing steel. The markets for motorcycles, refrigerators, TVs, VCRs, handset telephones is larger in China than in the U.S. So in terms of units of production and units of consumption, China is already a huge economy and such an economy, obviously with 1.2 billion people that is growing anywhere, who knows, 5%, 10% per annum trend-wise, offers investors all kinds of opportunities.

I would also like to point out that as of today, if you went to a portfolio manager ... your portfolio would be benchmarked according to the Morgan Stanley world index. You would have 53% of your money in the United States but you would only have 8% in Japan and 3% to 3.4% in the rest of Asia, which would include Pakistan, India, China and those countries that have a combined population of 3.5 billion people. I don't think this adds up. I think people should have much less money in the United States, maybe only 20% of their money. I would have no money in the U.S. and 50% to 60% in Asia, ex Japan.

Q. Could you tell us a bit about who is investing in the region, Which multinationals? Which countries? Why?

Joan Zheng: I actually had a chat with the chairman with the American Chamber of Commerce in Beijing and he said that [of] the American companies, at least about 70% are making profits in China, like Motorola, GM, Coca-Cola. He also said that ... 40% of American companies actually are getting higher margins in China last year than in the U.S. and over 80% of American companies based in China said they would reinvest in China.

Faber: Wages in China are averaging about 7% of what they are in Taiwan and South Korea and probably about 3% of what they are in the U.S. and in Japan and then you don't have all the employee benefits that accrued or that are a cost to corporations in the U.S. like health care and so forth and retirement. So, basically, you can produce anything in China probably at least with 50% lower costs than in the United States and also at much lower cost than in Taiwan or South Korea.

Q. Why is the Chinese domestic market geared towards consuming Asian goods and not U.S. goods, because we know that China runs a large trade deficit with the U.S.?

Faber: Most American goods ... cannot compete with foreign goods. Take cars: A Chinese [person] is not going to buy an American car. He is going to buy, if he is rich, a Mercedes, a BMW, a Volvo, and if he is very rich, a Rolls Royce or a Bentley, and if he is middle class, he will buy a Japanese car. Moreover he can buy domestically manufactured cars by all the major car manufacturers. So, actually, the U.S. imports at an annual rate of US$125-billion of Chinese goods but they only export at an annual rate of US$22-billion to China and that won't change. The Chinese could revalue their currency by 50% and this relationship wouldn't change.

The reasons they are buying from other Asian countries is that their purchases are principally components for electronics and resources. In other words, oil and agricultural commodities, iron ore, copper and so forth.

Chen Zhao: There is a global kind of rationalization in manufacturing. You know that the Asians, the Japanese, the Koreans, the Taiwanese, the Hong Kong people, all those investors, all those Asian investors, they have put a lot of money in China.

I would say probably since the 1990s, you have a surge in Chinese exports to the U.S. At the same time, the rest of Asia exports to the U.S. plateaued, and declined in some cases. So this is really a structure shift. If you take Asia as a total, as a whole, yes, their market share in the U.S. did increase but not as dramatically as if you look at the Chinese exports to the U.S.

Why do foreigners want to invest to China? A lot of people are emphasizing cheap labour. It is a very important part of the Chinese competitive source but it is not only the one. There is a lot of countries that have got a lot of cheap labour but it doesn't mean anything. You have to have cheap labour, at the same time your economy has to be industrializing. This combination really makes the whole story more attractive.

If you have an industrializing economy, you know that the income level is growing and at the end of the day people will buy more. So that is why all these western car makers are making cars in China. Those automobiles are not made for exports. This is a classic example of an industrializing economy or per capital income growth and [that] then creates a new market.

Q. What about specific countries, sectors or shares for individual investors?

Zheng: So far, what we are have been seeing is that those targeting in global markets have been very successful because the domestic markets are growing but they are still quite segmented. So luxury goods and services are doing very well. So, for example, GM is doing well, and Honda ... and companies which are getting into luxury services like private education.

Faber: I think the 1990s were heaven for the multinationals because they went into countries like China, Vietnam, Russia and they have faced very little competition because the local companies, they didn't have the financing. They didn't have the know-how or the marketing skills and so forth. So basically the Coca-Colas, the Gillettes of this world, overnight they grabbed anywhere between 50% and 80% of a market but over time, partly as a result of the outsourcing process, locals have actually learned. They have acquired the technology, or stolen the technology, and they are now producing competing goods.

I think from here onwards, you should own the local companies ... The largest computer seller in China is not Dell, Compaq or HP or IBM, but it is Legend, and I think everywhere we see this trend of local companies taking market share away from the multinationals and therefore I would rather focus on the local companies.

An additional point is [that] in China, you have maybe 200 or 300 breweries today. In 10 years time, maybe there will be 10 less so there will be a consolidation in the industry where the strong companies will acquire weaker companies and therefore, I think that there will be also an opportunity to own a company such as Tsingtao and maybe eventually they will have a 50% share of the market such as Anheuser Busch has in the United States.

Zhao: One way to do it is to really look at different countries. If you think about Hong Kong in the '70s and '80s, Hong Kong was a very depressed economy. The manufacturers there faced intense competitive pressure. The economy was dying, everything was bleak. What happened then was that the Hong Kong manufacturers moved to Southern China. [It made things worse for a while] but after the process Hong Kong had a boom. They had a profit boom. They had a property market boom. Their economy was upgraded.

Who is the next Hong Kong, where the economy can benefit from China's industrialization process? One is, for example, Taiwan. I mean if you look at Taiwan, what is going on in Taiwan today is exactly like what went on in Hong Kong in the '70s and '80s.

The Taiwanese are the most -- have been the most aggressive investors in China. So now you have got about half a million Taiwanese businessmen operating in Shanghai.

Zheng: I still feel it is better to go through foreign companies with investment in China because then at least you can avoid accounting, although it is true that locals can copy very quickly.

I feel Taiwanese investors actually have the best chance to succeed. Not only do they have common country, language [but] also in terms of how to deal with the bureaucracy -- very well trained at home -- they already also have the first mover advantage.

Faber: China is basically resource poor so they have to import oil, palm oil, timber, copper, iron ore and so you know, for me, the easiest way to play China is to buy today coffee because first of all, the coffee price -- last year, the lowest price in real terms ever is very, very depressed by any standard and if the Chinese just go to the per capita consumption level of say the Taiwanese or South Korean, they will take up the entire coffee crop of the world.

Per capita oil consumption in China is only about one barrel compared to 17 or 18 barrels in Japan and South Korea and over 20 barrels in the United States. So you can actually play Chinese growth by buying commodities and forgetting about all the legal problems and market share problems the individual companies will have in China and about their profitability and so forth.

I personally wouldn't buy the electronic manufacturers of Taiwan because we had the hi-tech bubble and now we have a strong recovery on Nasdaq and I suppose that tech stocks, by and large in the world, especially in the U.S., are overvalued and when they decline they will pull down again the Taiwanese tech companies and the South Korean ones. So I would rather play China through natural resource or companies in Asia and Indonesia in Malaysia that are selling to China.

In the case of Malaysia, exports of palm oil have risen from 6% of total exports to now 26% of total exports.

Q. Is this what we see happening right now, why we have seen a spike of commodity prices?

Faber: Well, basically what we had was a weak global economic environment since 2000 and in spite of that, commodity prices are up in many cases by more than 100% from their low. In other words, somebody has been buying commodities and this somebody has been principally China. So if you are optimistic about the world like all the American economists and you believe that there will be synchronized growth, then commodity prices will go up much, much higher than they are today over a period of the next five to 10 years.

In addition to that, if you are optimistic about the world and about Asia, oil demand in Asia, which is now at the present time daily 90 million barrels, that will double in the next five to 10 years to anywhere between 35 to 50 million barrels. That will push up the price of oil much more than anybody thinks and you basically have these more than 20-year bear markets in commodity -- they have bottomed out in the period 1999 to 2001 and have now entered a major bull market, in my opinion.

Zhao: I totally agree with Marc on this one. I think the commodity story is the Chinese story over the next five to 10 years. Oil prices were at US$25-some a barrel during the recession [of] 2001, 2002 when the ... the developed economies were extremely weak. Who held up oil prices during this period? Only the Chinese economy was growing very rapidly. So that to me explained the whole story.

Q. Mr. Mobius, what Chinese companies do you own?

Mark Mobius: China mobile, China Petroleum and some of the H shares in Hong Kong like China Travel.

Q. How quickly can we see a middle class emerging as a key consumer for foreign products?

Zheng: Well, what I did was I used the first official survey on China's household asset and income distribution as well as financial investments and I calculated in a very rough manner. At the moment, you have 27 million households which can already afford to buy cars. So it is not a small number, although the size of the economy is still 30% smaller than California.

Q. What is going to prompt the average Chinese person to spend more money?

Zheng: [If] we look at overall regional sales or consumption growth, in fact, it is not strong by China standards. The reason is because you have a social welfare system still in transition. You have education costs rising very rapidly. So households need to save, save for old age care, for kids' education, for possible job losses, all those. So I think this will take at least another three years for this marginal propensity to consume to rise again, so that will be the time for us to see more consumption.

Q. What are the perils of investing in China? What about management, corporate governance and the banking sector?

Mobius: There is a lack of global knowledge in particular fields. Not enough managers in China who are capable of understanding what is happening globally, so you have to find people who understand these concepts. Also, they haven't had the experience of working in profit making enterprises, so the inefficiencies are very, very high, and that is the pool of management we have to draw upon, so it takes time and effort to get these people up to speed.

[As for corporate governance] that is a problem that is not specific to China. It was a problem for [investors in] Enron and WorldCom, we saw it with Bre-X, I am sure you remember that, it is a problem everywhere.

In emerging markets it is a little more salient because the punishment system and the justice system is not very good, so people commit the same crimes.

Zhao: A lot of people are saying that the Chinese banks will face a lot of problems. Yes, no question about it and a lot of people are also saying well, the Chinese banking has got too many [bad] loans ... that the banking system will collapse. This argument is completely rubbish. Think about the history of the world. There has never been a country where it runs a current account surplus that has a collapsed banking system. The reason is very simple. As long as you do not rely on foreign borrowing, the central bank can always bail out your banking system. The simple mechanism is just to print money, right?

Think about Brazil, why Brazil got into a crisis, why Argentina got into a crisis, why Mexico got into a crisis: The reason is that they borrow heavily and all of a sudden when foreign favour starts to put money somewhere else, the whole financing system collapsed, whereas this problem does not exist in China.

The problem with the Chinese banking system problem today is that they have too much liquidity. It is pretty much like the Japanese system. It will never collapse as long as Japan runs a huge current account surplus. Yes, they will have pretty lousy profits, that is true, but they will never collapse. So the crisis story, that is a horror story that is based on nothing but western journalist sensationalism.

Q. What about the U.S. current account deficit and the yuan? Will China have to revalue its currency?

Zhao: The Chinese sell a lot of stuff to the U.S. At the same time, they are buying U.S. treasuries. It serves the purpose for the Chinese. They export to the U.S. They solve some problems with the unemployment in the manufacturing business. It serves the U.S. too because the Chinese purchase of U.S. treasuries is a major force to hold down interest rates in the U.S., which in turn helps to sustain the spending power of the consumer. It will help the capital spending recovery, too. So really there is no reason whatsoever for the Americans to press the Chinese to revalue.

Q. But isn't [the low yuan] a drag on U.S. growth?

Zhao: No. The argument for the Chinese revaluation is that the Americans basically think -- some of the Americans think -- that Chinese exports are killing the manufacturing jobs in the U.S. That is totally wrong. The decline in the manufacturing business in the U.S. started in 1949. There has been a 50-some years trend. The American economy has moved into a post-industrial age. It is a natural evolution for America to reduce its manufacturing content in its economy, otherwise -- think about it -- if Chicago was still making textiles, the American per capita GDP would probably be still at $2,000.

Another point, what [goods do] Americans buy from China? Those goods are not manufactured in North America anyway. So if the Americans do not buy from China, they will have to buy the same goods from somewhere else at higher prices.

At the end of the day, you will not reduce your current account and trade deficit. That is the bottom line.
The final point I want to make is the Bush administration, they have to be careful what they ask for. If they get it, once they get it, they may not like it, right?

The fact that the Chinese are intervening today means that they are ... trying to create some inflation. So my point is this. When the Chinese inflation reaches 3%, 4%, sometime next year, they will reevaluate the currency by themselves. You don't have to push that, but once they revalue that currency, the Americans will probably face some kind of a shock because once they revalue, they will no longer buy [U.S.] treasuries. Once they stop buying treasuries, your interest rates will go up. Then you will have a lot of problems. So the Bush administration really has to think this through very carefully.

Q. Are we going to see China importing services from the U.S. as trade barriers come down?

Zhao: There is some misperceptions. The Chinese imports from the U.S. have gone up something like 40% a year. The rate of growth is very fast, of course, from a very low level.

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