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Markets: Checking In On China
New York: October 03, 2005
By John R. Stephenson

China should clock in some impressive economic gains this year with many forecasters calling for growth to continue to spurt at a 9 percent annual rate or greater. That's good news for commodity prices around the globe as the surging Chinese economy has been one of the chief architects in the resurgent commodity boom. That's good news also for the ruling party who need economic growth to continue at a torrid clip in order to create meaningful employment for some 25 million new job seekers each and every year. But much of this growth is reliant on strong export markets. With the U.S. consumer clocking in a negative savings rate over the last few months it begs the question - when will the Chinese consumer do more?

The Chinese economy is focused on saving and investment — two sound pillars of building a solid economy. The problem? Their economy is overly reliant on economic growth from abroad. This economic model contrasts with that of the West which is dependent on consumer spending for most of its economic activity with the U.S. consumer being responsible for 71% of GDP. This is also true in Europe and Japan where the consumer accounts for 58 percent and 55 percent respectively of all economic activity. In China, the consumer accounts for 42 percent of economic activity.

But the American consumer is starting to falter with some of the lowest consumer confidence numbers in the last two years being reported. Worries over dismal job prospects and higher gasoline costs in the wake of hurricanes Katrina and Rita have started to take their toll. While this setback may be temporary, it is nonetheless worrisome and when coupled with a negative savings rate, it makes the American economy even more dependent on the inflated value of houses and stock portfolios to fuel a continued consumption binge. This is bad news for a world that is already overly U.S. centric.

So far Asian central banks (notably China) have been willing to subsidize the free-wheeling ways of the savings-short, overly indebted U.S. consumer by sopping up all the discounted U.S. Treasury bonds they can stomach. But the wealth effect that has allowed this consumption binge to continue has been aided and abetted by a climate of low interest rates. This low interest rate environment has occurred because the financiers of our lifestyle have been willing to accept low interest rates on our bonds in order to continue to ship cheap manufactured goods to our shores. But how long can the party last?

In China, household savings continue to surge, averaging some 17.5% in August on the back of strong nationwide income growth of 12.1%. But as China modernizes and moves from export-led growth to a more consumption-oriented economy, their reliance on foreign markets for prosperity will diminish.

Unlike Russia, which never had much of a tradition of capitalism, China has had a merchant class through much of its history. In fact, the period of strict communism in China lasted from 1949 to 1979 (a mere 30 years), meaning that there are still plenty of capitalists around in communist China. And these people know how to make things happen. With a strong culture of self-reliance, they have seized upon the opportunities presented from China's inclusion in world trade and have saved and invested wisely for their future. In part, this savings and investing has been dictated not out of pragmatism but out of necessity. With the end to "lifetime employment" and a weak social safety net, the Chinese have had little choice but to take charge of their own affairs.

But for the Chinese economy to become more balanced and open, this saving and investment needs to be directed toward domestic consumption. And it appears as if it might. Structural reforms are already under way in China to start liberalizing the economy which will begin the process of jump-starting more robust domestic consumption. For starters, draft legislation is in front of the Standing Committee of the National People's Congress which would double the threshold at which households would start to pay income tax to 1,500 yuan/month (US$2,225/year) from 800 yuan/year (US$1,187/year). This middle class tax relief could be extremely positive, as it would help spur consumption within a whole new Chinese demographic.

Not only that, but a move seems to be afoot to start expanding the social safety net which should help to reduce precautionary savings over time. The government has recently decided to expand an experimental program to divest state-owned shares in some 1,300 publicly listed enterprises. As well, much needed reforms in the banking sector seem to be taking shape with a likely further round of interest rate regime liberalization which would allow commercial banks to price loans according to the creditworthiness of borrowers before the end of this year.

A growing middle class, tax and banking reform are all hallmarks of a newly emerging China that should help spur domestic consumption. In an increasingly global world, the actions of one nation have a direct impact on the economy of another. With an increasingly protectionist Congress, indebted U.S. consumers and an asset bubble forming in the property markets and in the broader stock markets, a shift toward more internally generated economic growth could be just what the doctor ordered for the Chinese economy.

Investors concerned about the rising global imbalances should consider allocating a greater proportion of their investments toward stocks of commodity producers which should continue to benefit from a sagging U.S. dollar and a surging Chinese economy. Not only that, commodities have tended to zig when stocks and the broader economy zags, making them a relatively safe haven in a world that is increasingly interlocked and unbalanced.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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