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Go-Slow Approach to Fast-Growing China

TheStreet.com Ratings Staff

The Chinese New Year is likely to burst in with a bit more flair than usual this week, as China prepares to welcome the world to this summer's Olympic Games, but the country's financial markets might not show the same sparkle going forward, at least in the near term.

China and Hong Kong have been profitable destinations for investments over the past several years, and the Chinese economy has been on a tear. But recent weakness indicates that these hot markets have gotten ahead of themselves. Also, some economists wonder about the sustainability of China's growth rate, which zoomed to more that 11% annually for the past two years

For one thing, China's infrastructure might be unable to cope with the ever-increasing demand placed upon it. Economists wonder if electricity production can be sustained at a level that will meet growing consumption. (Consumption of electricity, the magnitude and rate of expansion of which is commonly used a proxy for growth of an emerging economy, has been estimated as growing in China at 15% annually.)

While mutual funds that focus on Chinese investments have rewarded their holders with generous returns in recent years, steep losses in the past few months have dampened the enthusiasm of many investors.

An accompanying table contains open-end mutual funds, exchange-traded funds and closed-end funds with at least 75% of their respective portfolios targeting Chinese-domiciled or Hong Kong-listed investments.

Although returns remain in the double-digits for the 12 months ended Jan. 31, each of the funds surrendered considerably more than 10% in the most recent three months.

The recent weakness in the valuations of Chinese investments might be viewed by some as a buying opportunity. But the many challenges facing the nation's economy in the intermediate term might dictate a go-slow approach to investments in that region.

The emergence of China as an economic and manufacturing powerhouse has generated considerable interest by fund investors. A total of 921 U.S. open-end mutual funds own an aggregate $71.5 billion in 337 Chinese and Hong Kong investments, while 62 ETFs hold a combined $21.0 billion in 179 investments there. Forty-five closed-end funds own an aggregate $3.6 billion in 136 investments in those markets.

A nearby table lists China-domiciled and Hong Kong-listed investments with total holdings of at least $1 billion by U.S. funds.

China's current account trade surplus represents a huge 7.2% of the nation's GDP. Over the years it has enabled China to accumulate vast foreign currency reserves, now totaling some $1.5 trillion. China's use of this huge pool of funds will significantly influence its economic future.

Some time in the near-term to intermediate future -- possibly after the 2008 Summer Olympics -- the curtain might start to fall on China's stellar introduction into the global economy. Given its recent readings of strong consumer price inflation of 6.5%, a global slowdown or recession would act as an automatic stabilizer and reduce China's growth rate back to more sustainable long-term levels.

The next few years may be very difficult for China's citizens, especially if the specter of unemployment arises and threatens the country's somewhat tenuous social fabric.

The possibility of social unrest presents a very real danger for Chinese leaders, and they are likely to pull out all stops to prevent it from occurring. Measures to minimize social unrest might include avoidance of closure of plants and the propping up of marginal businesses.

Present concerns aside, China is now a clear regional and global powerhouse. To state that "all roads lead to China" is befitting of its place in the modern world. "Resource economies" such as Australia and Brazil depend on China to buy their minerals and other commodities. Japanese and U.S. investors pour billions into China in the form of foreign direct investment to build production capacity.

China's growth tide may recede in the near term as the nation's economy pauses to catch its breath and digest its growth.

Of course, few observers doubt that the long-term prospects remain anything but favorable.

The key piece that China and other emerging Asian economies require is a genuine middle class of citizens to build its own internal consumption bases and reduce dependency on export demand. Without this, a global imbalance persists, with two-thirds of the world supplying goods and one-third buying them. That is not an optimal long-term investment scenario.