Global Alpha 2009 : China

Stripping away all the hype (and gloom) the consensus still is that China and Asia will be the dominant Alpha generators in 2009. SMSF and HNW investors should remain overweight these economic growth engines and should continue to use capital protected products as the preferred mechanism to invest.

There are three key but often overlooked factors behind this analysis:

1. China’s massive foreign exchange reserves are the product of a sustained policy of under valuation of the Remnimbi, making China’s exports aggressively cheaper than competitors. This massive pot of money is already being used to fund internal consumption drivers which will sustain the PRC economy at close to 8% GDP growth in 2009.
2. China in particular has not experienced a credit bubble anywhere near the extent or magnitude of the rest of the world – and hence the impact of the great global de-leveraging which the rest of the world is now seeing will be far less pronounced in China and on her domestic economy than the rest of the world.
3. Capital protection continues to be the lifeline for many investors and for those fortunate to have used protected products in recent times, the significant outperformance of protected portfolios compared to traditional “long only” managers (in particular, index hugging funds) has moved protection into the realm of the mainstream. That being said, it’s vital to be discerning about the precise mechanics of the protective mechanism used – and we provide some handy tips to better assess products and their risk management technology.

Lets turn to an assessment of each of these key points:

China’s growth will continue...but with a new focus on the “hinterland”

China’s leadership is well aware that internal political and social legitimacy is directly linked to maintenance of the economic growth “miracle” of the last 30 years. Alpha has actively been engaging in analysis and thought leadership including through participation in the “Think Global” BRIC study tours, through our stewardship of our “Asian Lions” and “BRIC 40 Plus” investments, and through careful dialogue with leading Chinese commentators. It’s clear that managing the economy and growth are key to the legitimacy of the PRC leadership. Professor Xi Su Wang (the “Think Global” eminent scholar) highlighted in his work with us that the ravages of the Cultural Revolution were driven by farmers and urban poor who vented their frustration at the lack of social and economic progress onto the ruling “elite” who they blamed for the problems. Many of the current crop of PRC leaders experienced the Cultural Revolution as children and are determined to avoid a repeat of the problem. (Apologies for such an abbreviated history of China’s last 40 years, but it does illustrate the point).

It’s now estimated that economic slowdown in China has led to the loss of millions of jobs, especially amongst the rural and urban poor. Without check this has the potential to lead to civil unrest, prompting President Hu Jintao to publically state at last week’s Politburo meeting that: "Whether we can turn this pressure into momentum, turn challenges into opportunities, and maintain steady and relatively fast economic development … is a test of our Party's capacity to govern," said President Hu, who is also general secretary of the Communist Party.” (Sydney Morning Herald, 1 December 2008).

And in response to this test, the PRC has a huge war chest to deploy. The total reserves of the People’s Bank of China are now worth over US$1.8 trillion, and this massive amount is:
“...a sum of money equivalent to the combined annual GDP of Africa and the Middle East, and three times the bail out package in the US.” (Paul Cavey, Macquarie Capital Securities head, China Economics, in “Australia/China Connections,” Nov 2008, p. 20).

It’s these reserves that are being tapped for the 4 trillion Yuan (A$897 billion) economic stimulatory package which has just been announced by the PRC. The impact of this package is expected to add about 1% to China’s GDP growth – and the deeper benefit is that its target (the massive Chinese hinterland) is an area where contribution to GDP growth is starting from a lower base than the already overheating coastal cities.

It’s this observation that is leading seasoned China watchers to predict the likely success of the stimulatory package. Huw Mckay of Westpac’s economic research team is on the record as stating that: “...the Chinese economy will be responsive to stimulus, both fiscal and monetary, and should be back on its feet again soon after a modest hiatus....China has the potential to surprise forecasters on the upside in 2009...” (Huw Mckay, Westpac banking Corporation in “Australia/China Connections,” Nov 2008, p. 20). Like most informed commentators, McKay expects that the stimulus will be targeted towards the hinterland regions and their basic infrastructure needs – and that this will bode well for the Australian economy and our commodity exports to the region.

China’s banking system is in good shape.

Well, it is and it isn’t! The Chinese banking system has been insulated from much of the speculative credit bubble which formed in the Western economies in the last 5 or so years – largely through the use of central Government planning and controls which have greatly reduced the levels of credit supply into the Chinese economy. As Paul Cavey notes: “...contrary to expectations of an unsustainable credit bubble, it looks like bank lending in China has been only just enough to grease the wheels of the rapidly growing economy. The reason is China’s banking sector has been effectively held in a straitjacket. The banks have been ordered not to lend...” This has led to the accumulation of the massive foreign currency reserves noted above. Although Chinese bank lending growth of 16% pa is a large number, unlike the US where credit has expanded to 180% of GDP in the last 5 years, China credit supply has fallen from 125% in 2003 to around 100% currently. So China’s problem is in fact how to increase credit supply, rather than how to stem the tide of business failures that will result from sharp contractions in credit supply as in the US and most western economies.

Capital protection will remain a key ingredient for Asian investment

It’s obvious that capital protection has added value to investment portfolios...I say “obvious” because it’s only in hindsight that most advisers can measure how useful capital protection can be. Now isn’t the place to argue the merits of the new approach to capital protected investing (we’ll have that discussion in full at the next Alpha Conference), but its clear that scared and sceptical investors are unlikely to risk capital in the next 12 months without some form of capital protection. The alternatives – cash or fixed income – deprive investors from much needed growth; and aren’t a long term solution to the search for investment alpha.

Taking a look at consensus forecasts for China and Asian economic growth it’s clear that this is a region that any investor worth their salt has to be actively seeking better ways to invest into:

Many investors have experienced reductions in the exposure to growth assets which traditional CPPI style protected products have experienced in the last 6 months. Key to avoiding these “de-leverages” is to focus on the specific assets within the product, the costs of the product and its protective mechanism, the degree of initial leverage...and (most importantly), the starting levels of the underlying assets. With asset prices at levels more than 50% below 12 months ago, and with the strong GDP growth levels predicted for Asia and China in the chart above, a strong rationale for investing right now can certainly be made.

Alpha will continue to offer our flagship “Asian Lions” portfolio in our POWER Shares range – watch out for the substantial revamp of POWER Shares which will be released early in the New Year. By combining growth with the strong potential for outperformance using protected products in volatile times, no investor or adviser should feel the need to allocate new money to fixed income or cash over the next 12 months.

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