When the current China boom began in the 1990s, many Wall Street types suggested the tangential approach. Instead of investing in China directly, buy into companies involved in fuelling the Chinese economy, ranging from scrap metal companies to the companies that are selling sophisticated electronic equipment for the telecom boom. Ericsson and Nokia, in this approach, are China plays.
Increasingly, however, investors are seeing that the solution is to go where East and West have actually met and entwined so that they can integrate using local management, while keeping overall control safely outside.
Playing the Mainland through Taiwan
For example, Steve Champion, CEO of the Taiwan Greater China Fund deduced that playing China through Taiwan would pay dividends – starting by investing in Taiwanese companies themselves. Since 2003, the fund changed its name and strategy and now concentrates on Taiwanese companies with major mainland involvement.
Quoted on the NYSE, the US$100 million closed-end fund, which invests mostly in high tech electronics companies such as Hon Hai Precision Ind. Co, Taiwan Semiconductor Manufacturing Co, Asustek Computer Inc and United Microelectronics Corp, but also in more mundane companies like the China Steel Corp and Formosa Plastics Corp, has shown over 25% appreciation during the last year.
"Taiwanese companies can operate almost like local companies, with the same language, the same cultural background, and the older ones at least have some experience of the old regime," Champion said. "but Taiwan got a 20 year start on the global economy compared with the Mainland, and it is so far ahead of the game for accountability, accountancy, management standards, so that it gives you better risk control."
John Paul Ho, Managing Partner of Crimson Ventures in California takes a broader perspective. What Champion says about Taiwanese management applies to most of the Overseas Chinese Diaspora, "so you can combine that brand of skilled management with ownership in any country that offers secure governance." And of course there are many candidates, but the US$600 million venture fund portfolio he has grown since 1993 includes famous companies like Acer, but also companies like Silitech that makes cellular phone keypads in China for customers like Nokia, Motorola, Sony Ericsson, Siemens, Lite On, and BenQ. Equally representative is Waffer, with customers such as Dell, BMW, Daimler Chrysler, and Carl Zeiss, which has opened a magnesium component facility in China using technology transferred from Dow Chemical.
Ho attributes the amazing growth of China's economy to such foreign direct investment. "China is getting US$50 billion a year FDI, US$250 billion in the last five or six years," Ho said. "That is more than Japan and Germany received since World War II, and that's been the real driver of Chinese growth. Even China's domestic growth is investment-led. It's derivative of all these Chinese workers getting good jobs with these multinationals, such as Toyota, Motorola, Dell, Siemens and Nike who are bringing in modern processes, technology, management and training."
Unfortunately, it's hard to participate in this unless you are a major multinational, but Ho argues that "you can get a proxy for that, by buying their suppliers and arbitraging the global supply chain. You buy companies in the developed world, whether Europe, the US, Japan, Taiwan or Singapore, which go directly into China as a 100% owned subsidiary, and then use their cash flow, customer base market position and manufacturing know-how and leverage China, in just the way Dell has, to build up a globally competitive position that can take advantage of Chinese low cost manufacturing, and can compete globally as an exporter and also as suppliers to the multinational corporations working in China at the high end of the market.? And then, he adds, once you have set up a successful export platform, you can tap the Chinese domestic market such as it is, while getting all the control and protection of a developed country government structure.
The export-led growth also ensures such companies against cyclical change in the Chinese economy, because they only sell into the high end of the Chinese market. After all, he points out, "The middle class is still relatively poor, but the top 10%, the upper class, are the ones buying Toyotas, and Dell computers. They go for quality – which is where you can make big margins." But once you have got them in there, there is question of what to do. For a time there was an idea that you needed local fixers with influences, but he dismisses that. "If you are competing in China, you compete on quality and efficiency, not on murky relationships with the state sector. But western firms often take a superficially common-sense approach. They hire mainland Chinese workers, who have not had the experience you need," Ho said.
In contrast, Ho has built up a stable of managers who can go into China and make things work. Crimson Ventures has 15 companies operating in China, and Ho claims that "by and large they have all been pretty successful. No governance or corruption risk. All the factories we build are 100% owned by us – we do not do joint ventures, do not partner with state enterprises, do not have local partners. We staff them ourselves with teams either from the overseas Chinese community, or locals who have worked with multinationals."
"These are the guys who can make it work," says Ho, who is clearly fascinated, but not mesmerized by the Chinese economic boom.
Ian Williams is a New York-based journalist writing on politics and economics.
Excerpted from Morgan Stanley's Global Economic Forum notes, October 7, 2005:
The CNY regime shift on July 21, 2005, marked the beginning of a gradual process through which greater currency variability will be permitted. But in order to allow the market participants in China to learn to deal with currency volatility, USD/CNY is likely to remain constrained for the rest of 2005. In 2006, greater currency flexibility is likely to be permitted for USD/CNY, with implications for USD/Asia.
Beijing's focus is to gradually introduce greater flexibility, not drive USD/CNY lower to resolve the US C/A deficit. USD/CNY's variability will remain highly constrained for the rest of the year.
The US Treasury has announced that the release of its semiannual report on exchange rate regimes will be delayed until November. However, with the bilateral trade deficit between the US and China likely to breach US$200 billion for 2005 (US$162 billion in 2004), political pressure from the US, in particular from Congress, will rise later this year and again early next year. While I don't believe China will be coerced by the US, political noise could again lead to speculative pressure on USD/Asia.
Premier Wen said on public television (in March this year) the CNY will be kept "essentially stable this year". First, the daily variability will be increased to fully exhaust the – .3% band. Thereafter, the band limit will be widened. Second, Beijing may have a negative crawl rate against the reference index.
Another construction boom?
Excerpted from UBS Investment Research A Radical Rethink of the China View, Sept 23, 2005: Suddenly, things look very different … In short, it looks like we're in the middle of another construction boom-just the opposite of what we've been saying over the summer. And the apparent upward trend is suddenly very strong. We'll see what the August and September data tell us, but unless they drop sharply on a month-on-month basis, we're very likely to see a continuation of 30% y/y growth rates. And this already puts us back at the pace of the 2002-03 "boom" days.
How long can it last? We can't say for sure … but it could well be more sustainable than we earlier thought possible. On the one hand, most official policy statements clearly state that the authorities don't want to go back to the overheated, speculative days of the past.
On the other hand, however, most of the official concern was not focused on the pace of construction per se, but rather on the amount of speculative leverage being generated in the economy. Remember that bank credit growth peaked two years ago at around 25% y/y, with more than 80% y/y growth in short-term speculative property lending – By contrast, today overall lending growth is quite stable at 13% y/y, and short-term credit indicators are far more well behaved than in 2003.
In other words, even though construction activity is picking up rapidly it doesn't look nearly as bad from the macro/financial side, since developers don't seem to be financing through speculative borrowing. Of course a continued construction rally should eventually pull the credit growth numbers up again, and at that point the authorities would be forced to tighten. But that could well be another few quarters down the road, or even longer.
Here are the new potential implications, as we see them:
Stronger demand for steel, cement, aluminum and other basic materials
Stronger demand for construction machinery
As a result, a more rapid import recovery and a better pricing environment
Stronger overall GDP growth going into 2006
Better export numbers for China's main overseas suppliers, and in particular Japan, Korea and Taiwan
RMB reform – another symbolic move
Excerpted from BNP Paribas Peregrine's Sept 26 2005 China Economics: The PBOC allowed the non-USD foreign exchange rate floating band to widen from 1.5% to 3% plus and minus the mean, but kept the USD exchange rate band unchanged at plus or minus 0.3% per day. Of course, this should be seen as a positive move and a continuation of the RMB reform process. The PBOC is keeping its promise to allow more RMB fiexibility. We think the latest move meets the PBOC's internal target for a comfortable non-USD foreign exchange rate range. A 3% floating band was also the central bank's practice after 1994 and before the Asian Financial Crisis in 1997/1998.
However, from a practical point of view, this latest widening of the forex trading band is more symbolic than an actual change. This is because RMB-USD transactions still account for more 95% in China's foreign exchange market. As long as the USD/RMB rate is restricted, it is hard to see a meaningful change in non-USD foreign exchange rates or any significant impact on China's external sector performance. Further, market traders can always conduct hedging transactions.
Nevertheless, it is one step towards eventual RMB marketisation. China fully understands that the July 21 reform programme has not resulted in a ceasefire of the emotional battle that the international community (the US in particular) has been waging. China's domestic political and economic reality does not allow it to satisfy international desire for a large-margin RMB appreciation. What China can do is execute currency reform in phases, keep the process moving. As long as the reform is progressive, the RMB will ultimately meet international expectations.