China’s Great Wall of Money?

Ian Beattie, Manager of the New Star Pacific Growth Unit Trust, comments on the outlook for China:

Economic growth in Greater China has attracted foreign investors and fuelled strong gains in the stock markets of China and Hong Kong. Heavy investment has been made in fixed assets and infrastructure, with the urban residential property market also expanding quickly. The crucial dynamic is urbanisation. Globalisation and outsourcing have turned China into the workshop of the world, drawing workers from less productive, agricultural pursuits in the countryside into manufacturing in towns and cities: just like Britain in the Industrial Revolution. New jobs create new wealth and new consumers.

In recent months particularly, the markets have benefited from abundant liquidity. In Hong Kong, stocks in general performed well, with asset-heavy companies such as property groups and companies with exposure to China the standout performers.

In China, the huge trade surplus combines with foreign investment and a closed capital account to increase liquidity further. This has resulted in significant rises in the domestic A-share market but brings with it risks to overall economic stability. Overheating could result in increased asset price volatility and signal the beginning of an unsettling boom and bust phase for the economy. The Chinese government’s handling of the economy, however, offers reassurance. While a more aggressive stance on monetary tightening may be adopted in 2007, this is unlikely to be overly severe and the growth outlook for the Chinese economy remains positive. In fact, we think there is upside risk: the liquidity situation could lead to further gains. The Chinese authorities are managing the problems remarkably well but they do not have the tools available to fine tune the financial economy. With a fixed exchange rate (and a newly liberalising banking system) it is difficult to control monetary policy. We expect that the authorities will start to allow private capital to be exported, substituting official foreign exchange intervention. In this way – the huge build up in FX reserves, the vast amount of cash earning low returns at home and an undervalued exchange rate reminds us of Japan in the 1980s. A strong currency, financial and asset markets were the result and a “Wall of Money” spread throughout Asia and the rest of the world and, in its final stages ended up buying landmark properties, Van Gogh paintings and golf courses. It is possible that China may be headed the same way.

We also see most of these developments as very positive for the region as a whole. We think China will start to become a consumer and investor going forward.

Sectors Focus

Infrastructure

The Chinese government’s capital spending on infrastructure is expected to rise significantly over the coming years. Roads, railways and subway networks will benefit from aggressive spending growth. Other beneficiaries will include companies involved in construction materials; for example, Road King Infrastructure, which invests in toll roads and bridges and PYI Corporation, an investment holding company specialising in infrastructure and Beijing Capital International Airport.

Environment

The Chinese government is committed to battling environmental degradation and has launched a programme of investigations and prosecutions of domestic companies to ensure compliance. Key industries that stand to benefit from this and other ‘green’ policies include water treatment, air purification and natural gas supply and companies such as China Water Affairs Group, Guangdong Investment and Sino-Environment Technology Group.

Domestic consumption

Rising wages in China and increased fiscal spending on education, health and social security will have a positive effect on consumer spending. China Mobile, a long-term New Star holding, has already done particularly well from strengthening domestic demand, with its subscriber numbers growing and operational performance remaining healthy. Property is also a great play on both consumption and urbanisation. Despite people’s fears about overheating, we believe normal housing in China still looks reasonably good value relative to wages. Our favourite stocks include Shenzhen Investment and Guangdong R& F. For both shopping and property we like Hong Kong’s Hang Lung Properties (Mall developer).

The Pacific Growth Unit Trust has approx 30% exposure to Hong Kong/China.