It might seem beneath Chinaâs dignity to compare it to Drew Barrymore. After all, China is a 5,000-year-old culture with a venerable history of wisdom. From China comes Taoism, Confucius, and fireworks. Drew Barrymore, fine actress that she is, adorable though she may be, is just an actress. Yet China may learn something from Drew Barrymore in the next five years and be better off for the lesson. She is one of Hollywoodâs few child actors who made the transition from being a cute face advertising Puppy Chow dog food to becoming a Playboy pin-up, all the while keeping her career path firmly on an upward slope. The Middle Kingdom faces an equally delicate challenge today, with far more at stake.
China’s consumer revolution: from workship to fleamarket
China must go from being the worldâs workshop to becoming the worldâs flea market. Or, in economic terms, China must swap its engine of economic growth from exports to domestic consumption to keep the boom going and keep its population from open revolt. It must learn to consume at the level that it has learned to produce. Thatâs nothing short of an insurrection in economic thinking.
But beneath the sooty skylines of Chinaâs cities, a plastic revolution is brewing. Like many uprisings, the signs preceding it make it predictable. But, contrary to conventional wisdom, itâs going to come before the Olympics in 2008. That means that the time for a change in investment strategy is today. And if the strategy outlined below is correct, the wealth boom thatâs been generated by Chinaâs 20 years of industrial growth may look trifling compared to what comes next.
China’s consumer revolution: is the resources boom over
A key question on the minds of many investors is whether the resources boom is over. On Australian TV recently I saw a journalist asking an iron-ore miner whether the boom is âas good as itâs ever beenâ. âItâs better than itâs ever been,â he replied. These are words that should strike fear into the hearts of resource investors. When itâs better than itâs ever been, history tells us that it tends to go downhill soon afterwards.
What everyone is asking themselves is: just where are we in the commodities cycle? If China has been the engine of global commodity demand, doesnât that mean the China boom and the resource boom are inextricably mixed? Surely an overheating China will lead to falling resource prices? But perhaps these questions are predicated on wrong-headed assumptions. Abandoning the resource story as an investment theme simply because it is old would be bad investing. If the resource bull market is secular, as Jim Rogers and other commodity bulls claim, it will last years, not months. Long-term investors donât need to change anything. And if the resource boom is merely cyclical, it will not collapse, it will simply give way to some other, more attractive, asset class. In either case, the pertinent question remains whether Chinaâs appetite for raw materials will be the single best-yielding investment theme over the next 24 months. When you put the question that way, the answer is quite clearly ânoâ.
When I say the resource boom is over, what I mean is that it has already undergone its greatest growth phase. The greater future earnings growth will come from an entirely different category of businesses in China, which is where investors should be looking today. Donât get me wrong. You may still make money in firms like BHP in the coming years. But China is already the worldâs largest producer and consumer of steel. It is the worldâs second-largest consumer of oil. With such a voracious appetite for raw materials, there are only two real possibilities for prices.
China’s consumer revolution: inflation or increased capacity
The first is that Chinese demand is becoming inflationary and driving up resource prices to the point at which they become a drag on economic growth. With Chinese growth at 11.4% in the second quarter and official interest rates rising, this is a real prospect. The second possibility is that, over the next 18 to 24 months, new productive capacity for raw materials will start to come on line, or at least begin to be factored into the prices of raw materials. Ramping up production of commodities does not happen quickly. There are capital constraints and physical constraints. You canât just open a mine because you need more copper.Yet it is the nature of commodity cycles that high prices attract new investment and bring on
line new capacity. This eventually brings down prices as more producers enter the market. The notable exceptions this time around may be energy and precious metals. Prices for these two sectors are driven both by real physical scarcity and a large geopolitical risk premium, which, given events in the Middle East, doesnât look like vanishing anytime soon.
For all other resource sectors, however, we may be seeing the maximum
gap between supply and demand. Either demand will fall because of inflation and the lower economic growth it inflicts on the global economy, or supply will increase as it comes on line. In either case, resource prices will moderate. You may disagree. But for now, letâs assume that the old investment thesis in China â a resource boom driven by an export strategy â is giving way to a new thesis. What will it be? And what can you do to profit from it? The economist Thorstein Veblen wrote that, âIn order to stand well in the eyes of the community, it is necessary to come up to
a certain, somewhat indefinite, conventional standard of wealth.â He was writing about what he termed âconspicuous consumptionâ, an emotional and psychological imperative to show the Joneses that you are not only keeping up, but you are also moving up.
Veblenâs observation is interesting, but also superficial. Even if consumption is conspicuous and vain, a whole economic superstructure must exist in order for individuals to indulge in looking, feeling, and acting wealthier. Certain institutions must exist in order for a commercial economy to bloom. China doesnât have those institutions yet. But it needs them â and that is why they afford such a great investment opportunity.
China’s consumer revolution: economic policy
So far, Chinaâs economic policy has largely been driven by a basic political reality: the more Chinese that are employed with rising wages, the fewer potential protesters in the streets. The Communist state fears idle hands even more than the devil covets them. In a country where atheism is official state policy, busy hands may not do the Lordâs work, but at least they donât make mischief, throw Molotov cocktails, or take to the streets with banners and pitchforks.
The policy has been full employment, directed by state planners and driven by a relentless boom in fixed-asset investment. It has worked like a charm to promote stability and, for now, prosperity â at least in the coastal cities. Per-capita incomes are rising. Savings rates remain high. Signs of affluence are everywhere. And with the twin forces of foreign direct investment and the fixed-asset boom, job growth has managed to swallow up the endless supply of migrants making their way to Chinaâs booming cities. It is the largest internal migration of labour in world history, and so far it has not produced a revolution. Thatâs a major accomplishment by any standard. And now the stage is set for the next phase of growth.
China’s consumer revolution: the end of fixed-asset investment
You can view Chinaâs coastal cities as a kind of eastern version of suburbia, except, of course, that they are based on densely populated urban areas. An infrastructure for an urban economy has been created with the fixed-asset boom. Apartments are ready for living in and for flipping as investment properties. Starbucks crank out the coffee to keep busy workers buzzed. Factories hum. Neon shimmers. Urban China purrs with the sound that onl
y a city of several million fortune seekers can make. It is open for the business of capitalism. And the business of capitalism is selling the dream of prosperity to as many people as are willing to buy it.
But the fixed-asset boom has run its course. The government does not want further runaway investment and is already acting to rein it in. Instead, increased domestic consumption must replace it as the main driver of Chinaâs growth. And this is where the new opportunities lie.
China’s consumer revolution: commercial infrastructure
It takes certain kinds of institutions to make a domestic economy function on a day-to-day basis. At a basic structural level, it comes down to the fundamental elements of commerce: credit, insurance, energy and transport. We take these things for granted in the West only because they have been around so long that they are embedded in our economies. They are akin to the respiratory, skeletal, circulatory and immune systems that combine to create a human being.
The same systems will arise in China as well. And they will be provided not by the government, but by the private sector. Future state investment in China will be directed at the rural areas that have not yet visibly benefited from the nationâs new-found prosperity and will be directed at keeping them employed and making them feel wealthier. Failure to do that will lead to turmoil, violence and rebellion in the countryside. So the stateâs attentions will be focused on the rural population. It will fall to the private sector to power the next stage of the urban economy.
China’s consumer revolution: who will benefit?
Firms such as those mentioned below (see end of article) will be vital in that process. And there will be other ways to invest in Chinaâs domestic growth story. Many firms will be smaller and have faster earnings growth than the ones Iâve mentioned. But the transition from export growth to consumption growth begins with important steps. Without changes in the energy, credit, insurance and transportation industries, dozens of other profitable ventures will not be possible. But with the key institutions of a domestic economy in place, Chinaâs consumption boom could match â and even dwarf â the post-war growth of the American economy, making investors in the blue-chip stocks that enabled the boom very happy.
There are risks, of course. Maintaining stability for a nation of 1.3 billion with an economy thatâs growing at 11% a year and undergoing a transition to a different growth model is a tall order. It is made somewhat easier by the fact that it means turning over the development of Chinaâs economy to market forces.
That doesnât mean all will go smoothly, but if you wait for the opening ceremonies in Beijing in summer of 2008, you may well miss the early and most robust growth in Chinaâs shift to a consumer economy. Beyond todayâs gritty surface lies tomorrowâs gleaming reality. China has become its own biggest customer. If your investment strategy does not take this into account, you may be missing out on the biggest investment opportunity of the next ten years.
Dan Denning is managing editor of Port Phillip Publishing and the former editor of Strategic Investment. His 2004 book, The Bull Hunter, showed how and why the Industrial Revolution took place in 18th and 19th century Britain, and how understanding that process can help investors today.
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How to profit from the changes occurring in China
A model portfolio of the companies that make up the domestic growth story in China would have to include a representative from each of the key institutions in the domestic economy. The following firms should grow rapidly, given their role in Chinaâs domestic future.
Citigroup (C:NYSE, $48). Standard & Poorâs upgraded Chinaâs official credit rating in late July, noting that the government has made progress overhauling the financial system. While the accuracy of the later statement remains to be seen, the improvement in Chinaâs sovereign credit rating from A-minus to A is a good sign for the commercial lending business. Citigroup is currently vying with SociĂ©tĂ© GĂ©nĂ©ral of France to buy 85% of Chinaâs Guangdong Development Bank.
If successful, it will put the American bank into the Chinese market as a retail lender. And even if itâs unsuccessful, it will not be the last bid by Citigroup. China remains one of the great untapped markets for consumer credit in the world. And with the state interested in getting out of the banking business and Citigroup keenly interested in getting in, an acquisition seems likely to be only a matter of time.
Boeing (BA:NYSE, $79). If the decline and fall of Airbus as a model for state-led industrial development isnât enough to make you sweet on Boeing, consider this little titbit: US exports to China grew by nearly 37% in the first five months of 2006. China is now the third-largest market for US exports and one of the largest components of that export growth is industrial and capital goods, especially in aerospace. The growth of intra-state travel in China will not just be a matter of convenience and prestige, but a vital part of the growing connections that make up an integrated economy. With Boeingâs 787 Dreamliner set to crush the A-380 in head-to-head sales (if, in fact, the A-380 ever sees mass commercial production), Boeing has more than one source of growing earnings.
Chinaâs domestic growth will only sweeten the bottom line, and off itâs recent correction, Boeing is firmly on a long-term upward trend that makes it not only a great China-related investment, but a long-term winner for globalisation. Your biggest risk with Boeing is even higher fuel costs. If these are driven by war in the Middle East, not only will jet fuel be more expensive, global economic growth will slow and people will travel less. While thatâs bad for commercial aviation, itâs perhaps a boon to Boeingâs military business.
China Life (2628:HK, HK$13) is the largest player in Chinaâs new insurance market. Insurance is another institution of Western civilisation that we take for granted largely because itâs become a commodity: cheap, with plenty of options and lots of competition. Not so in China â at least, not yet. China Life is in the perfect position to capture some of the enormous premiums for insurance that Chinaâs growing middle class is sure to pay as it looks literally to insure its rising levels of success.
Foreign insurance companies will certainly participate in the development of the industry. But current restrictions mean that foreign firms will be investors in Chinese firms, and that Chinese firms will benefit the most from capturing the regular cash flow that comes from a vast pool of premium payments. It is simply too cash-rich an industry for the government to ignore. Local firms will be favoured, and China Life is the best of the local firms.
CNOOC (883:HK, HK$6.7). In early June, Husky Energy (HSE:TSO, C$79) announced that its offshore oil exploration project with the Chinese National Offshore Oil Company (CNOOC) had yielded a find greater than two yearsâ worth of total Chinese national oil production. Itâs just that kind of offshore potential that has China lining up to explore the disputed coastal waters of the South China Sea, among other locations. China is well aware of its strategic vulnerability to Middle East oil and the dangerous chokepoints that oil must pass through just to make it to Chinese shores. That is why Chinese investment in a d
iverse portfolio of energy sources will continue. As the market for refined transportation fuels in China takes off, particularly the retail market, look for CNOOC to add assets and grow reserves and expect global investors to bid its shares up.
Category: Geopolitics