Playing the China Card on the Street


By Amey Stone Signs had already begun to emerge in April that China's efforts over the past year to tamp down economic growth to a more sustainable level weren't working too well (see BW, 5/3/04, "Headed for a Crisis"). Then, fears that a Chinese bubble might burst and wreak havoc on the global economy began contributing to a downdraft in U.S. stocks. And when China's Finance Minister said in mid-May he was "confident" a soft landing could be achieved -- and investors started to believe it -- markets in both countries began to rebound.

Call it coincidence, but U.S. investors have good reason to maintain close watch on China -- even if they aren't invested in the region. During the past three years of global economic weakness, China's growth has provided much of the new demand, especially for raw materials, that kept economies in Asia, Latin America, and, indirectly, the U.S., chugging along.

Expansion into China has also provided some important sales growth for major multinationals, such as Motorola (MOT), Intel (INTC), and General Motors (GM). Many other global giants are just getting sales going in the country (often done through joint ventures with Chinese companies) but are already pegging future growth on reaching some of China's 1.3 billion citizens.

TARGETED SECTORS. "It's clear that when China slows down, everyone is going to feel it," says Edmund Harriss, portfolio manager of the Guiness Atkinson China & Hong Kong Fund (ICHKX). But he, like most investors in the region, isn't expecting more than a ripple or two from a slowdown to reach U.S. shores. For now at least, the betting among many investors is that China's central government will be able to engineer the much desired landing without crippling its economy.

"It's not true that a bust is inevitable," says Harriss. His bank and business sources in China show that lending growth is no longer accelerating, investment is starting to slow, and the midsize companies that could get squeezed first by the slowdown are holding their own. Says Harriss: "There's a reasonable chance that we'll get through this, that this is just a period of excess that can be brought in control."

One reason investors in the region aren't too worried is that Beijing's efforts at limiting investment spending are restricted to specific industries like cement, aluminum, steel, and real estate. Plus, they're mostly targeted at slowing development in the urban coastal areas, not the rural inland provinces. "What the market misread is that this is very selective," says Frank Holmes, chief executive of U.S. Global Investors, which manages the China Region Opportunity Fund (USCOX). For American investors, that means only a few stateside companies, U.S. Steel (X) for one, should be directly affected by Beijing's measures.

STRONGER MEASURES? For most U.S. companies, "their penetration into that market so far is so small that this is just not going to affect them," says Rose Papp, portfolio manager of the Pioneer Papp America Pacific Rim Fund (PAPRX), which invests in American outfits that do lots of business in Asia, such as AIG (AIG) and Intel. She believes companies in the portfolio "can continue to grow and build share [in China] even if the economy is slowing a little bit."

Papp cheers Beijing's efforts to limit expansion this year if it wards off inflation and leads to steadier, long-term growth. "I'm all for that," she says. China's aim is for long-term growth of around 7% (instead of the 9.7% it achieved in the first quarter). "Over the long term," she says, "that's very healthy for companies doing business there."

The risk remains, however, that China won't be able to slow its economy without taking more draconian measures. For example, if inflation goes above 5% -- it's currently 2.8% -- the government is likely to raise interest rates, says Harriss. Many analysts are already building rate hikes into their forecasts, says Stephen Kolano, who trades international equities for Boston Company Asset Management.

GLOOMIER PICTURE. Higher interest rates could be particularly damaging to already fragile consumer spending in China, says Harriss. High savings rates and minimal use of credit already keep spending low, and if banks pay more interest on deposits, that could motivate the public to sock away even more cash, he worries.

"It could be a hard landing instead of a soft landing, and then things get ugly," says Trip Jones, managing director of sales at SunGard Institutional Brokerage. Trouble in China would spell trouble for other Asian countries, too -- especially Korea and Taiwan, which export heavily to China. It would also wallop emerging markets in Latin America that tend to provide a lot of raw materials. Just like China's last bust in 1995, the ripples would eventually reach U.S. shores.

"People are concerned this could lead to a second Asian crisis," says Robert Smith, president of New York investment firm Smith Affiliated Capital. "The jury is still out on that score."

BUBBLE MARKS. The bursting of America's own tech bubble in 2000 is also likely contributing to investor unease about China's plans. Peter Cohan, an author and independent management consultant in Marlborough, Mass., says he developed an internal "bubble meter" during the tech bust, which China set off in November, when Cohan happened to be in Hong Kong.

"China has some of the same hallmarks," says Cohan. "A lot of excitement, a suspension of investment discipline, a lot of excess borrowing." Add to that opaque reporting, which fuels fears that initial disclosures of small problems could snowball into major fiascoes, and it's easy to see why investors' bubble meters have been triggered.

For now, however, many international investors are betting that China's efforts to slow its economy will preempt the bubble, choke off current excesses, and prove beneficial in the long run to companies invested there. That outcome seems reasonable for U.S. investors to bank on -- but it's worth remembering that it's not yet in the bag. Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist


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