The Guru's Corner

Go east, old man

Commentary: Why and how to play China

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SAN ANTONIO, Texas (IndexRx) -- No doubt about it: China is hot.

The Chinese stock market continues to soar, despite repeated warnings of a bubble. The iShares FTSE/Xinhua China 25 FXI, +0.63% exchange-traded fund is up more than 120% over the past twelve months. Is it too late to invest in China?

All indications are that the newest superpower will surpass the U.S. by mid-century -- if not sooner.

While you should expect a bumpy ride, China is still poised to grow rapidly for at least the next several decades. In fact, I will go so far as to issue the following prediction:

By the year 2050, China will be a more important and more powerful economy than the United States.

On paper, the evidence is mounting. From gross domestic product growth, to education, to investment, to health, to technology, China's trend lines point uniformly upward. In person, the case is even stronger. The gleaming, modern Chinese cities that dot China's Eastern seaboard make all but a few American cities seem almost underdeveloped (or at least unsightly and technologically unsophisticated) by comparison.


Communism vs. capitalism

This shift in global leadership will occur because China's communists are beating U.S. capitalists at their own game. China is determined to achieve wholesale economic transformation, and its leaders are drawing on historical lessons from the West: Innovate, if you wish to grow. Educate, if you wish to innovate. Enforce property rights in activities that demand investment, but do not put property rights ahead of all else (especially if most of the property in question belongs to foreigners). Give entrepreneurs access to markets and credit. Build infrastructure, if you wish to keep the economic machine functioning smoothly. China is doing all of these things, arguably better than its trans-Pacific rival.

Of course, China currently lags the U.S. by a substantial margin in the one column typically given the most weight on the economic scorecard: GDP per capita. In 2006, the U.S. produced GDP per head of $44,244; the corresponding Chinese statistic was a mere $2,055.

But consider this calculation: Assume that China and the U.S. grow indefinitely at the respective average real annual rates predicted by the Economist's Intelligence Unit for the years 2007 through 2011. This would imply 8.8% per annum growth in the case of China, and 2.8% growth in the U.S. Assume, for simplicity, that both countries experience zero population growth (this assumption probably biases the calculation in favor of the US and against China, given the latter's lingering one-child policy). Under these assumptions, China will pass the U.S. in terms of GDP per capita in the year 2061. If we perform the same calculation in purchasing power parity terms, China will take the lead much sooner -- in 2038.

Even if (as seems likely) China's recent red-hot growth cools, China's GDP (currently $2.7 trillion, vs. $13.2 trillion in the U.S.) will probably surpass that of the U.S. by the mid-century mark. Some of this growth will come about via payoffs to Chinese investments in infrastructure and education. In addition, China can still do a great deal of catching up simply via technological borrowing (and stealing). It will do so with an educated, hard-working, like-minded population of over 1 billion eager to make the necessary investments, and without the barrier of an outdated installed capital base.

Whether or not you think China will eventually be the world's economic king, you might want to brush up your Mandarin.

China and you

But what does this mean to you, the U.S. investor (and future resident of a less-developed country)?

First, be willing to look farther (much farther) west than the Silicon Valley when making investment decisions. While for at least one-half century Americans have taken for granted that the U.S. would be the most reliable source of investment opportunities, this presumption is beginning to crumble.

Second, be not afraid (at least not about the long-term) -- you needn't worry about missing out on the benefits of Chinese growth, thanks to the ready and increasing availability of ETFs like FXI that mirror the performance of Chinese companies, and funds like iShares MSCI Pacific Ex-Japan ETF EPP, -1.39% that provide exposure to China's regional trading partners.

Finally, although the region appears to be a solid long-term play, be prepared for large and inevitable corrections. There are signs that China's stock market is currently overvalued, and recent swings demonstrate that when the bubble bursts, it will do so quickly.

How then, should you play China?

Carefully. China is still very much an emerging financial market, and many segments of the Chinese economy are not yet publicly traded. While we have come to expect broad diversification from ETFs, over ninety percent of FXI's holdings are concentrated in just four sectors: energy, industrial materials, telecommunications, and financial services -- with over forty percent in the latter.

One way to increase diversification would be to buy both FXI and individual Chinese stocks that are not part of the index -- for example, travel operator Ctrip CTRP, educational provider New Oriental EDU, +1.06%, and online gamer Netease NTES, -1.73%.

Another would be to buy EPP in lieu of (or in combination with) FXI. EPP does not invest directly in China, but rather in more established countries -- Australia, Singapore, New Zealand, and Hong Kong -- whose stock markets tend to move in synch with but less dramatically than China's. Although EPP, like FXI, is heavily concentrated in financial services, it is much more diversified otherwise. And because EPP does not invest in Chinese stocks, the effect of corrections to the Chinese market will be dampened (though still potentially severe).

Here's one last point to bear in mind, as worry about a "Chinese bubble" increases: Bubbles often inflate well beyond the maximum proportions envisioned by efficient markets theorists. One need look only as far back as 1997 to recall an overvalued U.S. stock market that continued to soar for another four years. Had you sold in 1997, you would have missed one of the biggest bull markets in history. For those currently claiming that China is experiencing a bubble, it could be a case of being right at the wrong time -- always a costly proposition.

Better to enter China cautiously, for example, through dollar-cost averaging.

And regardless of what happens in the short run, China is here to stay.

Jesse Czelusta co-edits, along with his father Lawrence Czelusta, the Index Rx investment letter. Jesse has a PhD in economics from Stanford University. He doesn't own any of the stocks mentioned in this report. (
