By Larry Luce, editor
Mutual Fund Monitor

       There is no doubt that great changes are occurring in China.
       One part of the story, the manufacturing boom, has gotten the attention of the media. It seems that nearly everything we buy is made, or at least assembled, in China. Politicians are concerned that manufacturing jobs formerly held by U.S. workers have been exported to China, and are now being done by Chinese workers.
       What, in fact, is happening, and what does it mean for investors?

       The U.S. runs a trade deficit with China, meaning that we import a great deal and export little. The trade deficit rose to $103 billion last year, the U.S. importing $125 billion from China (by U.S. calculation) and exporting only $22 billion to that country.
       The engine driving exports is low wages. Wages in China are about 7% of those in South Korea and Taiwan, 3% of those in the U.S. (Financial Post, Canada, 9/18/03, page 8).
       If you focus on the U.S.-China trade deficit, you might get the impression that China exports only, imports nothing, and uses its profits to invest in U.S. Treasuries.
       But China does import from other countries, $250 billion from other than the U.S. in 2002. The nine countries that border China had a combined trade surplus of $26.5 billion with China (Financial Times, 10/28/03, Comment).
       Note in passing that the U.S. figure of $22 billion, while modest, represents a tripling over the past 10 years. The U.S. sells aircraft, soybeans, fertilizer, and numerous other things. Many services, including U.S. law firms, have initiated operations in China.
Is China Industrializing?
       Various observers say that China, in fact, is industrializing. Chen Zhao of the Bank Credit Analyst Group describes it as a “classic example” of per capita income growth that is creating new markets (FP 9/18/03).
       In terms of units of consumption and units of production, the Chinese economy is already huge. The market for refrigerators, TVs, motorcycles, VCRs, and handset telephones is greater in China than in the U.S. (FP 9/18/03).
       China produces more steel than the U.S. and Japan together. (Yet it still imports steel).
       China has 1.2 billion people and is growing at 5 to 10% per year.

The major question, as for any developing country, is when will the middle class emerge?
Joan Zheng of J.P. Morgan studied the recent official survey (the first ever) on household assets, income distribution, and financial investment. She found that 27 million Chinese households can already afford to buy autos (FP 9/18/03).
       However, consumption growth is not strong. Zheng thinks that this is due to a social welfare system that is still in transition. Education costs are rising rapidly. People must save for education of their children, for their old age, for possible job losses. Great savings have been placed in U.S. Treasuries.
       She thinks that it will take at least three years for this “marginal propensity to consume” to rise to the hoped-for level of consumption.

       Worldwide, this year has seen a surge in commodity prices. Commentators seem agreed that this has been driven by China’s need for metals, energy, fabrics, and food.
This has caused a fourfold rise in shipping rates, an all-time high. Bulk carriers are booked until well into next year. (FT 10/27/03).
       What does this mean for the U.S.?
       The freight market generally provides early warning for producer prices. Deutsche Bank predicts that U.S. producer prices will rise by 4.5 percent in 2004, compared to 3 percent this year (FT 10/27/03).
       Tim Bond of Barclays Capital agrees, stating that imported goods in the U.S. will be higher, helped in this direction by the dollar’s devaluation against the major trading currencies.
       (As usual, not everyone agrees. George Magnus at UBS thinks that commodity prices and freight rates are not likely to be significant. Labor costs will remain determining. Rising prices and rates will be absorbed by China’s ability to produce goods cheaply.)

       Michael Cox and Jahyeong Koo, of the Dallas Federal Reserve Bank, think that China should not be a threat to the U.S. (FT 10/28/03).
The trick here is to avoid protectionism. They note that protectionism doesn’t work. Steel, autos, and textiles have been among the most protected U.S. industries in recent decades.        All of them continue to lose ground. The blunt fact is that absence of competition causes a company to grow “sluggish and inefficient” over time. Eventually the industry effectively disappears, and the jobs along with it.

       They think that any nation getting richer, including China, should be cause for celebration.
China currently has an advantage in low-wage manufacturing. True, this is creating a “vast reorganization of the international division of labor.” This is forcing other countries to shift their efforts into what they do best. (In the case of the U.S. this is such as high-value services and technology, activities creating higher paying jobs.)
       This will bring “wrenching changes,” to be sure. But, say the authors, “that has always been the price of progress.”
       China has not been the first country to be feared because of low wages. Japan, Taiwan, South Korea, Singapore, Brazil, Mexico, and others have at one time or another been “cast in the role of cheap-labor bogeyman.”
       Nor will it be the last. The authors think that other countries, perhaps India, will follow the path of export-led growth.
       Chen Zhao adds that the notion of Chinese exports killing manufacturing jobs in the U.S. is “totally wrong.”
       He notes that our manufacturing business has been in decline in a 50-year trend. The U.S. economy has moved into a “post-industrial age” and it is natural for the manufacturing sector to take a lesser role.

       What is cause for concern is the fact that the Chinese own so many U.S. Treasuries. You can say, with equal logic, either that the Chinese are financing the Iraq War, or the day-to-day operations of the U.S. government. Take your choice.
       The danger is that if they stop buying Treasuries, our interest rates will go up.
       Zhao thinks that, whenever the Chinese revalue their currency against the dollar, they will stop buying Treasuries. He thinks that they will do this by themselves next year, when Chinese inflation reaches 3 or 4%.
       He thinks it counterproductive to demand revaluation now, as it will only advance the rise in interest rates and all the attendant problems this will bring. He cautions the Bush administration, in considering whether or not to demand revaluation now, “to think this through very carefully.”

       It is not easy to compete in China, but some U.S. companies are doing so. Eastman Kodak operates 8,000 retail outlets and five manufacturing plants in China. Other players include Coca Cola, Yum Brands, and Motorola.
       Joan Zheng talked with the chairman of the American Chamber of Commerce in Beijing. He said that of the U.S. companies operating in China, 70% are profitable. He cited Motorola, Coca-Cola, General Motors. Some 40% got higher margins last year in China than in the U.S. And, 80% of American companies in China said that they would reinvest.

       Marc Faber, Asian expert and Barron’s Roundtable veteran, thinks that most American goods cannot compete with other countries in the Chinese market. (FT 9/18/03).
He uses autos as an example. A rich Chinese will buy a Mercedes, BMW, or Volvo. If very rich he will buy a Rolls Royce or Bentley.
       A middle class Chinese will buy a Japanese car. He can buy domestically manufactured cars by all the major manufacturers.
       He believes that the Chinese could revalue their currency by 50% and no change in the U.S. trade deficit would occur.
       He also thinks that the Chinese imports from other Asian countries are mainly either components for electronics, or resources such as oil, food, iron ore, copper, etc.

       Marc Faber thinks that the simplest way for an investor to play China is by commodities. This avoids the necessity to pick companies, a difficult exercise.
       Commodities investment is tricky at the least, and I doubt that any readers want to take it up. Price New Era (PRNEX) or other resource-oriented mutual funds, would be our vehicle here.
       Faber also thinks that local companies are better going forward than foreign companies. He notes that the top computer seller in China is not Dell, IBM, HP, or Compaq, but Legend, China’s largest PC manufacturer.
       He thinks that this is a trend. In the 1990s international companies had easy pickings. They could sell in China, Vietnam, or Russia with little local competition. Now there is competition, and he thinks that the edge will go to the locals.
       However, Mark Mobius, manager of Templeton Emerging Markets (EMF), reports some difficulties here. Managers of Chinese companies have, in general, not had the experience of working in profit-making companies. Their inefficiency is “very, very high” (FP 9/18/03).
       Corporate governance is also not good. This no longer appears unique to emerging markets, given the revelations in the U.S. of Enron and WorldCom. In emerging markets, Mobius says, it is a “little more salient,” given deficiencies in the justice system.
In his fund February 2003, Mobius held just 4.5% in China stocks (plus 7.6% in Hong Kong, where many companies invest in China and which is sometimes thought of as a proxy for Chinese investment.)

       No clear conclusion for investors emerges from the above. It does seem that Price New Era and other resource funds should be revisited. It seems that now is a good time to start following it more closely.
       In addition, Templeton Emerging Markets should be looked at in a new light.
Finally, we want to see just how managers of general international funds are tuned into the new developments. Given the caliber of recommended fund managers, it is doubtful that they would be asleep at the switch.
       And, in fact, we have already noted that Julius Baer International Equity (BJBIX) recently took positions in mining companies that sell their raw materials to China (MFM 6/03). Also, Longleaf International (LLINX recently added to the Buy-and-Hold Recommended List) reported Yum! Brands as one of its five largest holdings (MFM 10/03).
       Editor’s Note: Larry Luce is editor of Mutual Funds Monitor, 1412 Spruce St., Berkeley, CA 94709, 1 year, 12 issues, $79. Published since 1985, Mutual Fund Monitor specializes in buy-and-hold no-load mutual fund investing.