Reshaping the global investment map

ontext there are several reasons why it is having a big effect. For example, China is growing far more rapidly than the rest of the world. China’s GDP grew by 8% last year while global output increased by about 3%. Even if the Chinese figure is exaggerated – and China’s official statistics are notoriously unreliable – consistently high growth in such a huge country is bound to have a substantial impact.

Also much of China’s rapid growth is being focused on its export sector. While domestic demand is growing relatively slowly a huge amount of effort – perhaps too much in relative terms – is being put into external trade.

Cheap manufactured

The effect is particularly strong in manufacturing. Cheap Chinese manufactured goods are undercutting their competitors in many areas.

For investors the rise of China can be as much a source of frustration as of interest. Foreigners who want to invest in China face numerous regulatory barriers.

In addition many of the most dynamic enterprises are not open to stockmarket investors. Many companies are either foreign owned – sometimes by Western firms but sometimes by firms from Hong Kong or Taiwan – while many others are private.

But it would be wrong either to conclude that it is impossible for foreign investors to benefit from the rise of China for its impact will be global. The problem is how to identify those areas that are likely to benefit and those that are likely to lose. It is possible to identify at least five channels through which the rise of China will affect the global economy and markets.

Deflation

Perhaps the best known effect of China’s rise is its deflationary impact on the world economy. Cheap Chinese goods are frequently said to be undermining the pricing power of other firms. With a huge supply of cheap but highly productive labour many see China as a threat to the global economy.

An extreme form of this argument was recently stated in an article in the Financial Times by two Japanese ministers. Haruhiko Kuroda and Masahiro Kawai argued that:

“The entry of emerging market economies – such as China and other east Asian nations – into the global trading system is a powerful deflationary force. Their combined supply capacity has been exerting a strong downward pressure on the prices of goods in industrialised countries.” (“Time for a switch to global reflation” FT December 12th 2002).

But many authorities would argue that such arguments are overstated. First, there are other deflationary pressures on the world economy besides China. A substantial proportion of the world’s industrial capacity is not being used because it is not sufficiently profitable. Under such circumstances it is clearly easier to scapegoat China than to grapple with the decrepit state of many industrial enterprises.

In addition the numbers suggest that China’s deflationary impact is exaggerated. Morgan Stanley, an investment bank, has recently estimated that imports from China account for less than 2% of Japan’s GDP and just over 1% of American GDP.

So cheap Chinese exports are benefiting Western consumers while providing a problem for less efficient Western corporations. But it would be a mistake to overestimate the impact of cheap Chinese goods on the world economy.

Inflation

Although it is well known that China is a source of deflation in the world it is less understood that it is also a source of inflation. Although China’s exports are surging so are its imports.

Michael Hughes, the chief investment officer of Baring Asset Management, points out that whether China’s imports cause inflation depends on the capacity in the sector. Consumer goods are unlikely to rise in price because there is plenty of spare capacity but natural resources are likely to become more expensive.

Sectors

The deflationary and inflationary impact of China’s rise point to the sectors which are likely to be winners or losers from China’s rise. The most recent Merrill Lynch survey of Asia fund managers showed some clear trends in this respect.

When asked which sector is likely to benefit most from the rise of China some 37% of Asia fund managers said basic materials and 14% said resources. In contrast 20% said technology was most likely to be the loser while 17% said general industrials.

Countries

There is substantial overlap between those countries that are likely to benefit from the rise of China and the sectors that are likely to do best. In particular, those countries that are big producers of raw materials – such as Australia, Russia and South Africa – are likely to benefit from China’s rise.

For many others the situation is less clear-cut. For example, south east Asian manufacturers are likely to find it hard to compete with Chinese manufacturers but the region is likely to benefit from greater tourism from China. The extent to which the rise of tourism can offset the squeeze on manufacturing is a topic of debate.

Mr Hughes of Barings is optimistic. China’s rise will, in his view, help to bolster south east Asia. “There is a multiplier effect developing in the region,” he says.

Hong Kong and Taiwan are in a special position relative to China. Both areas are suffering from a “China shock”, including falling land prices and rising unemployment, as much of their industrial capacity relocates to the mainland. But although the short term adjustments may be painful both are likely to benefit from being integrated into what is often referred to as “Greater China”.

Foreign companies

Generally foreign companies which have used China as an export base have done better than those which have tried to satisfy domestic Chinese demand.

Numerous foreign companies have established operations in China to benefit from the China boom. Indeed China has become the world’s largest destination for foreign direct investment on the back of such hopes.

But this does not mean that foreign companies in China are necessarily making huge profits. Those that are doing well can face problems remitting their profits to the West and in any case they often want to reinvest back into China.

Those which try to sell goods into the huge Chinese market are likely to find it particularly difficult. Andy Xie, an economist at Morgan Stanley in Hong Kong, points out that such companies face enormous competition. “Price wars happen all the time,” he says.

Those that do well in China are likely to be those which provide the Chinese with something they cannot get inside China. For example, Mr Xie points out that McDonald’s and Starbucks have proved successful as they are taken to represent American culture.

But making profits in China is often far harder than many foreign businessman recognised. A recently published book by Joe Studwell, the editor of the China Economic Quarterly, spells out in painful detail the problems foreign firms can have investing in China (The China Dream published by Profile Books in 2003).

Maximum impact

For all of these effects to have the maximum impact it will necessary for China to continue on its path of rapid growth. However, it is certainly possible that the high growth trajectory will be interrupted in some way. Most notably China’s rising levels of debt could cause serious problems.

Whatever happens to China the effect will be felt globally. The rise of China is changing the shape of the investment world.