Sunday, January 29, 2006

Recent purchase: iShares FTSE/Xinhua China 25 index

This is my piece for the Chinese New Year.

FXI is the ETF for the FTSE/Xinhua China 25 index, an index for the 25 largest companies in China. I entered this position in early January at $66.50, just prior to the portfolio start date for this blog. The chart below clearly illustrates how FXI (along with the closed-end China funds: CHN, TDF, ad JFC) experienced significant up-volume at the beginning of 2006, usually indicative of institutional accumulation.

In terms of the broader market, China ’s has been the worst performing in the world for the past three years. The Shanghai Composite Index ($SSEC) was more than cut in half since 2001 despite additional IPO’s. The ABC pattern in the fall (per Elliott wave analysis) was clearly discernible, culminating in a double bottom at the psychologically important 1000 level. Most importantly, the market sentiment was exceedingly bearish at the bottom, where most Chinese stock investors swore never to touch stocks again. All these contributed to my long term bullish technical view in this country.

Thoughtful readers must by now have multiple questions, How about the non-performing loans (NPLs) at Chinese banks? Aren’t they technically insolvent? How about the imploding property market in Shanghai? How about the social unrest I keep hearing about? Isn’t that country going to implode soon? As a contrarian, nothing tickles me more than fear and doubt about a certain region or class of investments I’m interested in, especially unfounded and superficial fear and doubt.

Chinese banks may indeed be in sorry shape where the NPLs are probably a lot more than the admitted 25% figure, but in view of China’s 800 billion and rapidly growing reserve, they could easily pay the left pocket with the right so to speak. There’s an urgent need to instill lending discipline, a need widely recognized and being addressed by listing the banks and making them more transparent. We have seen the successful listing of the China Construction Bank and Bank of China (not to be confused with the People’s Bank of China, the central bank) in Hong Kong, with the Industry and Communications Bank and Agriculture Bank to follow. With the likes of Citi, BAC and Deutsch Bank rushing head over heals to grab a stake, I fail to see a collapse here any time soon.

Real estate prices in Shanghai have seen rises of 300% since 2001 and have come down 20-30% since March of 2005 after a series of government actions to limit speculation. I’m sure soon we’ll hear parallels being drawn to the burst of the Japanese bubble and the ensuing 14 year slump. The truth is this bubble (It is a bubble when a 1200 sq ft apartment costs US$300k. I don’t care where it is in China.) was much smaller in scale. It was limited to the construction and banking sectors only. 30% down payments for residential hosing were uniformly enforced and there was no equity extraction by the consumers. The “flippers” and developers made out like bandits but the length of the boom and the inflexibility of the banking sector did not allow loans collateralized by inflated real estate which were the real source of Japan’s malaise. In all likelihood, this is going to be a correction lasting no more than 3-5 years. Meanwhile, development of China’s vast interior will continue. Those that bet on a commodity price retracement due to a Chinese slow down will be sorely disappointed.

I’ve seen quite a lot of “China collapse” arguments over the years, and I could never tell if the authors were afflicted with wishful thinking or simple ignorance. By the former I mean an easy out to rid a fierce competitor to the US without having to make any tough choices regarding education, fiscal responsibility and over-consumption. It’s more likely that these authors were just applying “western standards” to a vastly different country with growing pains. In my view, you can forget about a revolution making China a US-style democracy. It’s far more likely that the current ruling political class will commingle with the business elites to form the new social upper strata. Freedom and democratic institution will still advance, but in so far as demanded by commercial interests. I call this the Singaporean model which I consider the most probable outcome. Yet in the overall scheme of things, it still reresents progress and will make China a more formidable competitor.

If Greenspan and company can pump enough liquidity to keep afloat the US economy with a 6% current account deficit, why should China have trouble keeping afloat its economy with 800 billion in reserves and a national savings rate of 40%? I wish those “China collapse” stories will keep coming, as I haven’t done my buying yet.

A happy and prosperous year of the Dog to all!