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Economics: The Chinese Money Machine
New York: May 20, 2005
By John R. Stephenson

You've read the headlines. It's in the news every week. Hardly a day goes by where there isn't some story about the spectacular growth in China. The facts are staggering. China is a nation of 1.3 billion people that is rapidly industrializing and where an economic miracle is just beginning. Most of the Chinese economic miracle involves some 250 million people that live in the major urban areas near the coast. For the rest of the country, the miracle has yet to begin. Yet growth, by any standard, is amazing. Industrial production is running at a 16.6% growth rate (year over year) while the overall economy has been growing at 9.5% per year. This compares with an economic growth rate in the U.S. of 3.6%. While China represents just 4% of global GDP, it has accounted for 35% of overall global growth. The question for investors is - how to profit from the Chinese money machine?

While the U.S. Congress and politicians here fret about cheap goods from China and unfair trading practices in general, investors are scratching their heads trying to figure out a way to benefit from the China story. Over the last decade, China has been expanding its manufacturing capacity and using its ample supply of cheap labor to flood the world markets with low cost goods. But in some sectors of the Chinese economy (such as automobiles and steel), this rapid capacity expansion has outstripped demand, causing prices to fall.

And yet, as China's economy booms, its stock market is tanking. In June of this year, the Shanghai composite index hit an eight-year low. The reasons are many. Perhaps it's the fact that while growth is high, profits are low. Margins (profits) for Chinese firms have been squeezed between fierce domestic competition on the one hand and the need to import huge quantities of U.S. dollar denominated commodities to fuel the manufacturing boom on the other hand. As well, there are no uniform accounting standards (such as U.S. GAAP) that Chinese companies need to conform to in preparing financial statements. Of course, this deprives investors of a key virtue that they look for in stock market investing - transparency. Just how bad a problem is this? It's bad enough that the Shanghai exchange is considered even less transparent than that of the Nigerian stock exchange.

But if stock market investing in China is problematic, are direct investments that U.S. or European firms are making in the country more successful? Probably not! Huge multinationals that set up shop in China are quickly forced to compete in an environment where piracy and counterfeiting are rampant. With consumer electronics, DVDs as well as designer fashions and even automobiles all being knocked off by Chinese firms, the profits for manufacturers is clearly the missing ingredient in the Chinese economic boom. The name of the game in China is market share, at any cost.

So, how to profit? If you can't beat them and you can't join them, then the best solution is to sell something to them that they need. Better yet, sell them something that they don't make themselves and can't do without. The answer is to sell them commodities. No matter how smart you are or how cheaply your labor force is willing to work, if you haven't got the oil in the ground or the zinc or copper you're going to have to buy it. China has no choice but to buy these commodities on the world market to satisfy their tremendous growth and to keep the economic miracle alive.

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 the strong Chinese demand for oil all at a time when Russian oil supplies are being constrained by Putin's petrol politics.

In oil, as in base metals, China's appetite has seemed, at times, insatiable. With commodity prices being set at the margin, the incremental demand from China for all commodities is indeed significant. In the sixteen years since 1988, the worldwide demand for oil has risen from 64.95 million barrels/day to 82.15 million barrels/day with European demand up 16%, U.S. demand up 18% and China's demand up 175%. Of course, China started from a much lower base, however, its demand has risen over the eighteen year period by 3.98 million barrels/day versus the U.S. who experienced an absolute demand growth of 3.08 million barrels/day. China has currently surpassed the oil consumption of Japan, the world's second largest economy. China is now the second largest (after the U.S.) oil-consuming nation in the world. Not only is the Chinese demand for oil large, but it is likely to remain strong for some time with various economists estimating that overall the worldwide demand for oil will likely increase by 25%, all at a time when production remains flat.

With the GDP (a broad measure of economic output) per capita for China clocking in at $5,600 versus that of the U.S. at $42,000, China has a way to go before the economic miracle runs out of steam. The likelihood of a sustained downdraft in the market for commodities that China doesn't produce internally is small. For starters, China has an ample supply of hard working and cheap labor from which to draw to sustain the economic miracle. This is coupled with strong demand for cheap manufactured goods from around the world and a government that is pro-development. To date, some 250 hundred million Chinese have left the poverty of western China behind and moved to the coastal region in search of economic opportunity. So robust is the growth that Goldman Sachs has forecast that, in less than 40 years, China will overtake the U.S. to become the world's biggest economy.

But for investors who don't happen to have an oil well or zinc mine in their backyard the next best thing is to invest in companies that do. One area where the Chinese themselves are showing interest, but the rest of the world has been slow to recognize, is the tremendous oil and gas reserves that are situated in Canada's oilsands (Canada has the second largest oil reserves in the world after Saudi Arabia). Even though the energy sector in Canada has soared some 150% since 2002, the rest of the world seems largely oblivious to the tremendous potential resource that lies in these vast fields. Investors looking to add some oomph to their portfolios should take a close look at the companies and countries that are supplying the commodities necessary to make the greatest economic miracle of our lifetimes possible.

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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