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Economics: China and Commodities
New York: November 02, 2004
By John R. Stephenson

Last week, the Chinese Government did something it hadn't done for nine years - it raised interest rates. The effect? Commodity prices tumbled sharply with the Goldman Sachs commodity index dropping by 3.7% on Wednesday. So far, copper has tumbled 14% and nickel is down 20% all because investors are worried that growth in China (and hence commodity demand growth) is slowing.

To be sure, China is the significant factor in the global growth of the commodity sector with Chinese demand accounting for all of the growth in the world demand for copper, 99% of the growth for nickel and 95 % of the growth for steel. Not to mention strong demand for oil all at a time when Russian oil supplies are being constrained by Putin's petrol politics. Overall, while China only represents 4% of global GDP, it has accounted for 35% of overall global growth. Because of the signifgance of Chinese demand for commodities and a long-term growth trend that is favorable for increased demand for commodities, this sector has attracted many "fast money" investors. Loosely regulated investment funds, or hedge funds, have been particularly active in the commodities markets since they represent a clear opportunity with a discernable trend - at least for now.

But is a modest official lending rate increase of only 27 basis points (0.27%) to 5.58% really that big a deal? Probably not. The purpose behind the move was to try and slow the explosive growth that the Chinese economy had been experiencing and to gear the economy toward a soft landing rather than a more typical boom bust cycle. This was a necessary step that the government took to try and rein in an economy that has been growing at over 9 percent a year with an inflation rate of 5.2%. In our opinion, of greater significance than the rate increase, is a move to abolish the credit restrictions that were placed on the banking sector. By, in effect, deregulating the banking sector (by removing credit restrictions) which previously limited the charges that bankers could levy to no more than 1.7 times the official lending (government) rate, last week's announcement has helped move the Chinese banking sector towards alignment with international standards.

Any attempt by the Chinese government to develop a market-based banking system is a positive development that investors should welcome as a prelude to China eventually floating its currency. In accordance with a World Trade Organization treaty, the Chinese are set to float their currency in 2007. Currently, the Chinese currency (the Renminbi) is pegged to the U.S. dollar at an artificially low exchange rate, which has only served to exacerbate the trend of American consumption of cheap overseas goods. No doubt, the raise in Chinese interest rates spooked some investors, most particularly commodity investors, but in our view, this pullback represents a buying opportunity and not a case for additional worrying. With all of the hot money in oil and commodity stocks, there is likely to be increased volatility in this sector for the foreseeable future as traders view any rise in interest rates, no matter how overdue and minute, to be a signal that demand for oil and other commodities is about to take a tumble. That is unlikely.

The long-term growth trend is well established and unlikely to reverse course in the foreseeable future. With a population in excess of a billion people, with a per capita income that is one-sixth the American level, China is a country that is on the move. Not only figuratively but literally as some two hundred million Chinese have left poverty stricken western China to move within 100 miles of the east coast or industrial heartland of the Chinese coast in search of economic opportunity and new employment.

Figure 1: Stocks with China Exposure

Source: Company data, CSFB estimates

The Chinese people are amongst the hardest-working and most frugal people on the planet with a national savings rate approaching forty percent of their incomes. Not only are the Chinese frugal (saving and investing a large proportion of their wealth) but they also have highly developed commercial skills. So strong is the potential for China in the years to come that investment commentator Jim Rogers has said "The best capitalists live in Communist China". This fact, and the other fundamentals, have not gone unnoticed with Investment bank Goldman Sachs forecasting that in the next forty years China will overtake the U.S. to become the world's economy. For our money, China and commodities still offers attractive opportunities for investors, most particularly in the energy sector.

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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