What’s So Great About China?

What country is basically carrying the world economy, both as a resource vacuum and with its growing middle class? China. Which country outside of the US fixed income investor is the largest financier of the US? China…again. When it comes to investing, few people are bearish about China. It’s fast replacing the US as the engine of growth worldwide. It’s 1.4 billion people can turn something as unglam and ordinary as a touristy Taiwenese pineapple cake into an item so hot that Taiwan barely has enough pineapples to keep China visitors buying. In short, China is to the world economy what Oprah Winfrey is to book sellers.

Sure there are China naysayers out there. Their argument is that China banks are riddled with bad loans from real estate projects gone sour, and nobody truly knows how bad it is because China is not transparent.  China’s had this problem before with its big four government owned banks and basically did what the US government did by creating an entity to buy up all that bad debt in order to keep the big four’s books squeeky clean. How bad is the real estate and credit bubble in China? Agnes Deng, the portfolio manager at the closed-end Greater China Fund (GCH) run by Baring Asset Management Asia Ltd. in Hong Kong says China’s non-performing loans are actually quite low.  The banking crisis that the bears are forecasting will take China down from its pedastal may never prove valid.

“From where we sit here in Hong Kong, I personally don’t believe there is a credit or asset bubble in China,” Deng told Forbes recently.

“A lot of money has been going into construction and that kind of debt is heavy in the overall banking system. But it is reasonably OK. In terms of property, we don’t believe there is any national bubble for the property sector. We do see it in the first tier cities like Beijing and Shanghai, but notice that the overall demand and economic growth in China has been quite steady over the last many years and that growth will continue to carry out the momentum we have seen in the last two to five years. So we will eventually adjust to some of the oversupply in construction projects in the pipeline,” she says. “I wouldn’t bet on a housing developers crash or a broadbased asset bubble in China. The leadership in Beijing should be able to solve this issue.”

China’s central government has been forcing a slowdown of the national economy. Inflation remains high, mostly due to consumer demand, a stronger currency, higher incomes, and imported inflation from commodities. However, the government has taken a special interest in reducing demand for residential construction and existing properties.

If the government is successful at keeping inflation in check, then China’s growth might not be in the double digits, but investors expect it to remain well above 7%.  Housing will trend higher, but grow below inflation levels of 5.5%.  A gradual appreciation of the currency, the yuan, and higher incomes is making Chinese consumers richer. It’s a homogenous society, so if one Chinese person likes Twinkletoes shoes, then a million more are sure to like it, too, says Deng.

Her $443 million fund is overweight real estate, but underweight financials compared to the benchmark Russell Greater China index. She holds China Construction Bank — their biggest holding currently — and the Industrial and Commerical Bank of China, both state owned. Even though banks are an underweight for the fund, Deng thinks China banks are solid assets for long term investors.

China Construction Bank’s loan to deposit ratio is less than 80%, so it is not leveraged at all, she says. For banks, if you have 10 dollars and lend out 75 cents, you’re conservative. If they have 10 dollars and lend out 100, they’re Goldman Sachs.

The People’s Bank of China has been requiring banks to keep 20% of their reserves in central bank reserves as a guarantee. China’soverall non-performing loans (NPL) is below 2%, even though the market is thinking the numbers are higher because some government development projects have gone sour.  “If you include those projects since the financial crisis of 2008, then the NPL ratio is still going to be below 5%,” she says, cheerleading for China’s financials. “As an aggregate amount, five percent is quite big. Computed with the overall loan book that the China Construction Bank or Chinese banking overall has, then it is really quite small. China’s banking regulators have done a good job getting the financials to deleverage quickly after 2008.”

Deng’s take on China has paid off. The Greater China Fund’s sales growth percentage as of March 31, 2011 was 10% compared to a sell-off in the China fund category averages of 22%. Deng’s fund’s long term earnings percentage is 20.3% compared with 16.3% for the Russell Greater China index and 15.9% for the category average.

Year-to-date, the Greater China Fund has outperformed the iShares FTSE Xinhua China 25 (FXI). Both are down on the year thanks to their real estate and banking positions, but the FTSE China is down 1.7% as of July 31, 2011 and GCH is down 1.1%. Over the last 12 months, GCH has clobbered the FTSE China, up 11.4% to the iShares’ gain of 2.7%. Deng’s fund has even outperformed the Matthews China Fund (MCHFX), up 8.7% and another closed-end competitor from Boston, the China Fund (CHN), which is up 6.3% YTD. Since the fund launched in the early 1990s, its beat its benchmark. It’s up 9.1% as of June 30, 2011, while the benchmark Russell Greater China is down 0.5%.

Besides real estate, the fund is also overweight telecom and technology. On the telecom side, Deng likes China Unicom (CHU) because it is the only wireless mobile provider that uses the iPhone and iPad, and Apple (AAPL) dominates China’s tablet market.

“China Unicom sells iPhones and iPads and that’s a big plus for that stock. China Mobile, China Unicom and China Telecom all use different technology, so Apple is just China Unicom,” she says. “China Mobile is 3G and uses a home grown technology that the overall big brand names do not use. China Mobile ends up losing market share because of that and China Unicom gains market share. We still like China Mobile because it trades at a discount, but China Unicom is more of a growth story and that is the main reason why investors invest in China…for growth.”

On the tech side, it’s SINA Corporation (SINA) all the way. Sina’s an internet and social networking powerhouse that runs the weibo platform, a China microblog that has more users nationwide than Twitter has worldwide.

“China’s internet penetration is still low. There is a long way to grow. Many China internet stocks have been quite expensive, like Tencent Holdings a few years ago it was around $2 to $3 and now its around $140. Baidu (BIDU) has always been expensive, but they just keep reporting amazing earnings with upside and that has them trading at fifty times p/e because they are growing phenomonally.”

Not too long ago, the Chinese government, in its attempt to lend a fig leaf to its offshore political rival, Taiwan, allowed for Chinese nationals to travel to the island. Politically, the permission slip is like Washington letting Americans travel to Cuba and bring back cigars. While Chinese aren’t returning from Taiwan with cigars, they are returning with Taiwan’s signaturepineapple cakes. As a result, says Deng, Pineapple cake sales are up 40% year over year because of China demand. China’s growing relationship with Taiwan is also good for Taipei listed companies.

What’s so great about China is basically what’s been great about China for the last 10 years. When 1% of the population earns enough to buy an automobile and trades in a bicycle for a Buick, it makes China General Motors’ biggest market; it drives the fundamentals behind oil futures over $100 on average in the years ahead. When the same amount are eating more, it drives the price of soybeans as much as the weather and keeps farmers from Iowa to Parana, Brazil with a reliable customer.

The International Monetary Fund expects China to grow around 9.1% in 2011.



Kenneth Rapoza, Contributor

Covering Brazil, Russia, India & China.





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