New Year for China: 2008

With China’s GDP growth rate reaching over 8% over the past 5 years, China still may be in it for another year. China looks good for the long run, but their short run bubble may be a risky investment. With the Olympics coming and FDI in 2007 reaching 67.3 billion dollars, the highest in the world, China may have risk of a slow down. Problems include their 1.5 trillion USD forex reserve and their appreciating currency which are at the forefront of news.

Expectations have been rising faster then China knows how to deal with. While 5 years ago China and other emerging markets were performing at roughly the same level as US markets, in 2007 MSCI emerging market index beat the S&P 500 by over 20%. Everyone wants to get a piece of China, but policy changes may have an effect on this double digit growth. One of these big policy changes is updating their currency policy. Right now while it is slowing fluctuating to a fixed basket of currencies, in 2008 it will be allowed a wider margin to fluctuate. Their growing forex reserve of USD will also start to affect their currency.

In the near term the Olympics sound like the best thing that China can do, but looking at it from the other side it can also be bad. With China having the Olympics they have not allowed their economy to lose any steam in growing. This growth is unprecedented and most likely cannot keep going up after the Olympics. Even though China has recognized that too fast of growth can be a bad thing, I personally do not think enough will be done before the Olympics to slow growth. With interest rates already above 7% and a slowly appreciating currency, for either of these values to move sharply in their respective directions, China’s bubble may burst. With the U.S. lowering their interest rates because of domestic problems that will only increase Chinese inflation.

Quick Look at China’s Currency Policy Position

As we all know there has recently been pressure on China to appreciate their currency because of the trade imbalances seen in Europe and America. As well, other East Asian countries are running into problems with their markets because China’s currency is doing so much better then theirs. Here is a quick run down of the problems, which can help you to analyze the situation.

The biggest problem is that China’s currency is undervalued by as much as what some people think is up to 35% given them a huge advantage in the global marketplace. Over the past years the United States has lost over 2 milllion manufacturing jobs to China.

China’s holding of US treasuries is especially dangerous sitting at over 1.4 trillion US, because overtime we have given up control over our long-term interest rates to foreign nations. The amount of US treasuries held by foreigners has hit a startling number of almost 40%. This is one of China’s big techniques for currency and exchange rate manipulation, and could possibly continue to even higher numbers.

While China may not fold to foreign pressures, they also run into problems in their own country. Some of these problems include inflationary pressures because they cannot accumulate foreign reserves at the same pace as their growing economy, decreased consumer spending which is already a very small percentage of their GDP compared to net exports, and loss of manufacturing production and wage pressures for these jobs if appreciation continues.

Treasury Secretary Henry Paulson will be in Beijing next month to discuss many of these factors that has put China in this position. We will have to wait till next month to see if we may see what happened in July of 2005 when China first appreciated their currency. Articles can be found anywhere online on this topic and I think it is a great idea that if you invest in China to look into learning about China’s currency situation.

Regional Policy Reorientation and its Dilemmas: China’s Past Affecting the Future

Developing the coastal regions for so long during the Mao period has left a huge disparity between the economies of the interior and the coast. The gap is so large that even though the interior in some areas is growing at the same rate as the coastal regions, the absolute gap only grows larger because of the disparity of their starting points.

While the six and seven five-year plans were based on the system that economic development would diffuse into the center from the coastal regions, this was not a good idea in the long run and did not work out. This plan was laid out it what’s called the “latter step theory” which though that the interior could absorb what was going on in more developed areas. This had not worked because the infrastructure was not there in the interior to even transferring these new technologies.

Even after this was seen not working, in 1988 under Deng Xioping, they used the “modification of regional development policy,” which continued again with the diffusion policies of the past. The only good thing that came out of this time period was the eighth five-year plan, which helped to focus more on industries instead of just building up regions. Price reforms also came along with this plan. He also started the Yangtze River Valley Development Program, which was intended to integrate China’s interior and coastal regions, but ended up not working.

Only when Jiang Zemin came into power did the serious problems of the growing disparities between coastal and interior areas become a major issue. This situation brought about the ninth five-year plan, which discussed the growing disparities and called for three-component solution. First, larger investments would go towards the building up of the interior. Second, continued support for underdeveloped areas, and encourage coastal cities to transfer resource intensive and labor-intensive industries to move their locations. This plan emphasized to investors the abundance of natural resources, and the amount of labor available in the interior. While this was a good plan, there ended up being many problems complete this.

Budget deficits have grown and were being taken care of by excessive money creation and borrowing which led to increased inflation and debt to foreign nations. Even though a fiscal contracting system was being used during the 1980’s it put pressure on the central government’s budget. This increased inflation gave reason to reshape the fiscal foundations of China. This was needed if China wanted to continue the same growth pattern.

In order to start fixing problems there needed to be better interaction between the center and the local people. Public interest needed to be put in front of specific interests of individual provinces. There would also be a new system for collecting taxes. Instead of the contracting system they would be moving to a tax assignment system, which created separate local and central taxation systems.

Rural enterprise development was also very important to fixing regional policies. This would help with moving overseas investment to the interior and pushing coastal provinces to help out poorer interior provinces. There are they key components of the program. First, new credit policy was put into place so that more money in loans could be given to rural areas. Second, better tax incentives were given to industries in the interior to spark production. Third, there would be a transfer of labor-intensive industries to the interior. Many of these advantages and investment vehicles would be phased out by 1995 when business has reached a solid point.

Even though many changes have been incorporated into policy reform, deficit remains a problem for the central government and has prevented a major shift in regional development. Overseas investments need to be increased in the interior in order to close the inequitable distribution of wealth, and growth needs to increase ten fold in the interior to compare to the coastal regions.

Rural China left behind

After having the opportunity to visit a rural farming community in China it made me realize many things about China’s impressive growth. It is not an efficient growth, but an inefficient one. We see skyscrapers and massive Olympic structures being constructed every month but this is only a small part of China. Outside the two great cities of Beijing and Shanghai some small communities with de-collectivized farms hardly have any paved roads, and some have none at all. While we see this huge growth in China now, I do not believe that this growth is sustainable. My main reasons are as follows:

1. No infrastructure between inner and coastal China exists. During my visit to a small village the people said the one paved road was a gift from the government last year. It cost 2.2 million RMB or the equivalent of almost $300,000 USD. This was also one of the first villages in the area to receive a paved road. The scary thing about this fact is that the village is only about 1.5 hours outside the Beijing city limits. They had been transporting the food produced on their land via small carts to the closest village 5 miles away. From there they could transport their food on paved roads to the city. For the first time small communities are getting roads that will finally bring buses to and from the big cities.

2. Beijing’s growth has been very rapid and resulted in many people losing their homes. 60 million people have been pushed off their land because of the growing city. While this number seems bad, it is even worse than some may imagine. China’s version of social security for rural residences is based on a system of land holding. Families are given plots of land that they can farm on. This land is considered enough to support themselves, but when this land is repossessed, they are given no other form of support other than a small sum of money, that does not compensate for the true value of the land.

3. De-collectivization has worked well over the past few decades, but this system is not efficient or effective for China’s growing population and booming economy. These small farms cannot feed 1.3 billion people. While food can be imported, that comes at a price that is much higher than farming within the country where food can be produced and sold at artificially low prices.

While China continues to grow, I think that the huge amount of growth we have been seeing cannot be sustained at the same pace as in the past. There are many obstacles that China must overcome in order to continue to grow, which I will be covering later.

China: The Red Dragon

Over the course of this month I will be posting a series of articles on the Chinese economy. Just so you all know, I have been studying here at Beida for the semester or as foreigners call it Beijing (Peking) University and have come across some interesting realizations about China and their economy. While I do think this double digit growth they have been going through it true even by United States calculations, we do not see what this growth actually looks like and how long this is sustainable for. We see their stock market quadruple, and ADR’s skyrocket on U.S. capital markets but you get a new perspective when you are living in it. The questions that I will be looking at and the series or articles I will be posting will be on a wide range of topics about the Chinese economy. Please feel free to post comments and or suggestions of future articles for this month. Stay tuned for new articles.

Investing in Africa

China’s market is getting harder and harder to understand; if they are in a bubble and how long it will last, or if there will be a correction and when, is a major topic with the coming Olympics. So I thought I would move the topic to another area. While there have been huge amounts of FDI in Asian countries, especially China, most people have been overlooking Africa. Global FDI levels for 2006 put Africa at 2.7% with investments equaling $36 billion.

Africa is in its growing stage. Africa’s GDP is expected to grow by 6.2% in 2007 according to the IMF which means it would grow faster then the world economy. Ghana’s stock market was even the world’s third best performing market last year, and Egypt topped that list. Africa is so filled with investment opportunities with a growing infrastructure, many more businesses will be able to begin operating in Africa. This is without even mentioning the abundance of natural resources spread across Africa.

There are already some opportunities to invest in Africa right now through ETF’s such as EZA, and GAF. Both have been increasing over the past year. Do some research and this may seem like a good opportunity for you. This could be a good spot to hedge against the U.S. markets.

Is This Rate Cut Good for the U.S.?

As we all saw on Wednesday, the Federal Reserve made equal 25 basis point cuts to the Federal Funds Rate and the Discount Rate. While we are happy that core inflation is not going to be a large problem with this rate cut, and that we are easing rates in a growing economy where we just saw the U.S. economy grow at an annualized growth rate of 3.9%, I believe that many other problems will arise.

While lowering rates will bring along a lower borrowing cost I do not think that our economy needs this. Doing this will only bring people to spend more money on things they do not need. As we saw already companies that sold necessities like The Procter & Gamble Company(NYSE:PG) and Johnson & Johnson(NYSE:JNJ) have both been doing well though the subprime market problems.

Lowering rates now will also bring problems to the dollar and eventually make everyday products more expensive. This problem will arise in the future because with lowered rates the USD will keep depreciating. The Euro, Canadian Dollar, and the Yuan have all made decent gains over the past months against the US dollar, and will continue this appreciation with lower rates in the US. The weak dollar will also hurt oil prices and we now have the potential to see $100 a barrel oil prices in the near future. This means that if your heating your house with heating oil you going to be paying more then you’re used to seeing.

Bailing out the market by lowing rates is not a cure right now; it is only putting a band-aid on the problem. Lowering these rates is also telling reckless investors and subprime borrowers that the Federal Reserve will always be there in times of worry. These problems will not disappear by just pouring more money into them. Another big problem that arises when lowering short-term rates is that it hurts long-term rates. While giving people who have adjustable rate mortgages and lower reset price, people who can afford long term fixed mortgages are going to be paying higher rates. These continuous rate drops may only be feeding more problems to come in the housing market.

All we can do now is wait to see what the outcome is of these rate cuts. Often it takes months for our economy to realize the effects of multiple rate cutes. For now watch commodities closely as they are often a hedge against the stock market in periods of lowering rates.

Oil is Out. Ethanol and Alternative Power Coming In

With oil prices hitting $92 a barrel and could possibly go higher, corn and soy ethanol are sounding pretty cheap and are beginning to be a real alternative, not just something we talk about. E85 can even be found for under $2.00 a gallon in cities scattered across the United States, where gasoline sits almost a whole dollar higher.

Companies like Archer Daniels Midland Company (NYSE:ADM) and U.S. Global Investors Global RES (MUTF: PSPFX) are hitting highs on rising gasoline prices. While oil supplies are disappearing at a rapid pace, ethanol has finally become a cheap alternative to oil. Companies like Pacific Ethanol Inc. (NASDAQ:PEIX) and MGP Ingredients (NASDAQ:MGPI), which are trading at lows, could be staged for a comeback if oil prices continue to stay at highs.

It’s easy to forget about these renewable resources when oil comes back down, but remember renewable resources never go away. Prices can only get cheaper as interest grows and new technologies are invented to produce ethanol as well as other sources or energy cheaper.

Rising oil prices have also brought more attention to alternative energy such as solar power. Just recently HelioVolt raised $101 million for producing their flexible solar panels. SunPower Corp. (NASDAQ:SPWR) as well is making solar panels for homes and businesses that want to become more energy efficient. While in the past alternative energies have not been embraced, this could be the time to start noticing their benefits to society. Historically oil prices have increased during the winter seasons and that is what we are heading into.