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Economics: China: Let the Good Times Roll
New York: August 15, 2005
By John R. Stephenson

Increasingly, getting the China story right is becoming a key ingredient to investment success. The sheer size of China and its rapid industrialization, to say nothing of the attempted takeover bid of Unocal by CNOOC (a Chinese state-owned oil & gas company) has a lot of people in the west thinking about the implications of a more China-centric world. In resources, as in manufacturing, China is the dominant factor, driving much of the world's demand growth for raw materials and decimating margins of domestic manufacturers. For those who believe in the China story, a favorite investment theme has been to buy the shares of producers of raw materials and to sell the shares of high-cost domestic manufacturers that are in competition with China. But has China run too far too fast?

That question is being hotly debated in boardrooms and brokerages across the country. For many, the answer is yes . Pundits have been predicting a dramatic slowing of the Chinese economy (the so called "hard landing") for some time now. A dramatic slowing of the Chinese economy would have the potential of sending the global commodity and financial markets into a tailspin. To bolster their argument, the Cassandras point to the fact that China has been on a tear for some time, that their banking system is over-run with bad debts, that government is constantly interfering with business and that the country has recently established real estate controls in the major urban areas in an effort to curb speculation. But is this slow-down scenario realistic?

For our money, it's not! For starters, the Chinese economy surged at an annual pace of 9.5% in the last quarter alone. Not to mention that capital spending on transportation, energy, communications as well as basic infrastructure has been increasing steadily. Entrepreneurs are thriving, infrastructure is being upgraded and even though wages are growing (8-9% per annum) labor unit costs are still falling. With worries of inflation fading (and hence concerns about government controls to cool the economy) a slowing economy doesn't appear to be in the cards in the near term. In fact, Chinese authorities seem more concerned about the specter of deflation (falling prices) than with rising prices and as a result they have taken action by relaxing credit standards across the board. All of this points to one conclusion — growth will remain the order of the day in China.

Nowhere is this more evident than in the auto sector where the Chinese auto market is already the third largest in the world (after the U.S. and Japan) with annual car sales clocking in at 3.7 million units. But with strong domestic demand, some analysts are predicting that China will surpass the U.S. as the number one car market in the world by 2015. With car sales expected to explode, China has been on a tear to secure energy supplies from around the world.

Bejing has gone out of its way to court the Russians in an attempt to secure access to oil for its growing needs. Recently, the Russians agreed to build a large oil pipeline connecting the oil fields in Siberia to Northern China. But even though China imports roughly half of its oil needs (a proportion that is likely to increase), it uses far less oil on a per capita basis than other large industrialized nations. And while CNOOC was rebuffed by American lawmakers in its attempt to buy UNOCAL, look for Chinese companies with their lower cost of capital to start bidding for foreign energy concerns in the near future. One likely stomping ground? The Canadian oil sands, that boast the second largest reserves of oil and gas outside of Saudi Arabia.

Figure 1: Per-Capita Oil Consumption

Source: BCA Research 2005

Ironically, with the surging demand for cars, one industry that appears ready for a shakeout is the Chinese steel industry. With some 550 steel mills in operation across the country, most of which do not have sufficient size (scale) to be cost-competitive, a wave of rationalization is probably in the offing.

While there are a few exceptions to the strong China story, most of these are hard to find. China, with a buoyant labor market, cheap manufacturing and a seemingly insatiable appetite for commodities is likely to go on another tear. For a while, it looked as if commodity prices might be ready for a tumble as China started to stockpile commodities (particularly lumber and copper) in the face of higher prices (2003 and 2004). With some recent destocking of commodities and continued growth at home, it looks all too likely that China is set to rock the world of commodities. Not only that, but in inflation adjusted terms, commodity prices are still extremely low when viewed from a long-term perspective. This is welcome news for commodity suppliers and a nightmare for domestic manufacturers who are forced to compete with such a low-wage country.

Investors looking to profit from the continued upward march in the Chinese economy should purchase the shares of companies that supply the commodities that China desperately needs as it continues to expand. Suppliers of copper, lumber and oil and gas are likely beneficiaries of China's rapid growth, particularly some of the Canadian oil and gas producers that are benefiting from strong prices and secure supply. Oil, an already hot commodity, is likely to get a lot hotter before this is over.

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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