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China – The New Investment Frontier

By: Jonathan L. Passmore & Ping Zhou

The next great frontier for international investment is China and Benefits and Pensions Monitor’s Annual Report on EAFE & Emerging Markets kicks off with an examination of why China offers potential for pension fund investors. Jonathan L. Passmore and Ping Zhou, of GE Asset Management, examine that country’s emergence as an economy of significance.

Long a significant presence on the world stage due to its history, culture, and sheer size, China entered the 21st century intent on establishing its bona fides as a major economic power. Not content with the competitive edge provided by cheap labour, China is improving its standing through innovation, educational excellence, and a new role as a consumer, all adding to its global résumé and creating a highly attractive region in which the world’s leading companies want to do business.

It would be easy to equate China’s appeal purely with its size, but even more important is the country’s emergence as an economy of significance when the rest of the world is struggling. First of all, some numbers:

Keep in mind, however, that collection of economic data in China is an imprecise science at best. However, the trends are clear.

The currency (Renminbi), pegged to the US Dollar at 8.28/$, is regarded by regional competitors as seriously undervalued, giving China a clear and unfair advantage in their view.

China’s Economic Role And Demographics

An economy of such complexity, poised between the legacy of state ownership and the new world of privatization, is tough to analyze. Two main themes warrant attention:

First, China has moved a long way from its role as a supplier of cheap goods to the world. Textiles and clothing are still very important to China’s economy, but its economy is moving up the value curve in an increasingly significant way. Electrical engineering products are becoming an important source of revenues, both from the export market but also from satisfying the needs of China’s growing domestic economy. In addition, China is not simply acting as a supplier/exporter, it is also a consumer and importer of goods and services. This fast-growing economy is importing products for recycling into a variety of exports, to provide raw materials for resource-hungry industries, and to satisfy the needs of its rapidly growing consumer class.

In resources, China has a voracious appetite for raw materials unavailable domestically in the quantities required by such a large country. As a result, commodities such as iron ore, copper, zinc, pulp, and oil are resources whose future global pricing will be at least partially dictated by Chinese appetites. Investment opportunities will arise by identifying companies that can benefit from China’s inadequacies and that are able, in these relatively early years of China’s development, to establish a close working relationship with leaders in the country’s bureaucracy.

The third leg of China’s economic position is its role as a competitor. China’s competitive role in supplying low-cost goods is much better known than its increasing ability to compete at the more sophisticated end of the value chain. As China solves the qualitative puzzle (helped by legions of multinationals eager to set up business in the world’s newest growth engine), its competitive status will rise sharply, to the consternation of all but the best global manufacturers. The second major theme is regional demographics, specifically the migration of China’s population from rural areas to urban settings. Such moves have an economic impact at the local and national levels. Wages should be kept in check as new entrants to the job market move from rural areas (prolonging China’s cost advantage for many years to come). New jobs will be needed, forcing the government to create jobs or encourage foreign employers to set up shop (shouldering their share of the investment burden).

As the employed population increases, consumption will increase, raising GDP per capita. Higher living standards will increase demand for higher value items such as homes, cars, cell-phones, and TVs, creating opportunities for suppliers of such products. This scenario is not without its own problems. Some forecasters estimate that 10 million new jobs a year will be needed in China to satisfy migration from rural areas – no small task. Employment created by domestic companies will require levels of financing that may not be available from China’s banking system. Stretched by massive non-performing loans, local banks are reluctant to lend money to start-up operations, limiting the potential for the new business class to gather momentum.

In summary, China’s emergence as a supplier, consumer, and competitor, along with its generally favorable demographics, suggest a multi-generational economic development phase. With the country’s acceptance into the World Trade Organization and its selection as the sponsor of the 2008 Summer Olympics, the determination of the Chinese authorities to take their country to the next level become very apparent.

In the meantime, development finance and ideas will largely come from foreign corporations willing to participate in joint ventures in return for a piece of the Chinese pie. Global multinationals, such as General Electric, are very active in China and view the market as one of great business opportunity in the coming decade.

Political & Economic Change

What is the political background in China that has allowed these changes to take place and how has one of the world’s foremost communist nations changed its philosophy so radically?

China has been undergoing economic reform for more than 20 years, moving steadily away from the Central Government Plan of earlier years to a market driven economy. By opening up its borders to the international community, China’s leaders have accepted that outside influences will play a larger role in shaping the China of the future. The state is not planning to cede control, but Beijing seems to accept that a new culture of openness is essential to sustainable development of this huge country. Political stability is on display following the unusually smooth transfer of power at the Sixteenth Party Congress earlier this year, the first time such orderly transfer has occurred in the country’s history. China is also adopting a more ‘global’ foreign policy approach to the rest of the world. Its silence on Afghanistan and Iraq and its willingness to act in concert with other regional powers to defuse tensions on the Korean Peninsula are significant for their lack of belligerence. As a major regional power, China’s significance will extend beyond the economic realm in the years to come.

Politics is a powerful motivator, but a qualified workforce is needed to support any expansionist dream. China has excelled in educating its workforce. Long a country where a strong education is regarded as essential, China’s universities are now turning out more than two million graduates each year. With the availability of such qualified personnel, foreign direct investment is running at record levels and, with a government committed to quadrupling the size of the economy by 2020, the framework appears to be in place for China to continue its growth for years to come.

Potential for broad political and economic reform does not come risk free and China confronts many difficult issues. The growing economic disparity between rural China and the fast expanding coastal regions creates widespread public disaffection. Weaknesses are evident in the social security system, in the financial markets, and in corporate governance. Basic laws do not offer adequate protection and the banking system is currently unable to support the growing economy. Corruption is widespread, hampering the introduction of western methods of doing business at a critical moment in the country’s history.

SARS Outbreak Illustrates Problems

The recent outbreak of SARS illustrates the problems that any society may face when confronted with such a concern. In the case of China, the desire by the authorities to downplay the severity of the outbreak backfired amidst widespread condemnation. If China had wanted proof of its position in the world at large, it had to look no further than the ability of the virus to export itself from southern China to other parts of Asia and beyond. China’s new global position demanded that it act in a globally appropriate fashion and, initially, it failed to do so. Subsequent actions, including quarantines and the replacing of officials, have boosted confidence in China’s ability to keep the virus in check. Fears remain and the local economy has been hurt by the outbreak as travel and tourism slows, retail patterns change, and trade across affected borders diminishes. The long-term impact of SARS will partly depend on China’s ability and willingness to take additional tough actions quickly and transparently when necessary.

How can investors participate in the bright future offered by developing China? Institutional investors can consider several types of investment, including stocks widely available to foreign investors (H-shares and Red Chips), newly-available domestic stocks (A-shares), and ‘China plays,’ companies heavily involved in exporting to China. Some mutual funds have invested in the country. Generally, China is not an easy country in which to invest at the moment, particularly for the retail investor, but as transparency and liquidity improve, investment opportunities should multiply.

China represents an historic opportunity for investors and business leaders alike, as the country’s development moves into top gear. Somewhat akin to Japan in the 1980s, the sight of a foreign country getting to grips with the realities of Western business models and opening its borders on the scale that exists in China is a very rare event. As Japan has demonstrated, there are many severe risks. The enthusiasm exhibited by many multinationals for the China opportunity should coexist with a caution that derives from lessons learned in the recent past. With appropriate due diligence, China’s entry into the mainstream of the global economy will be a cause for celebration for all.

Jonathan L. Passmore is a senior vice-president, portfolio manager – international equities, and Ping Zhou is a portfolio manager – international equities, at GE Asset Management.

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