CHINESE DRAGON AND THE INVESTMENT VIEW

The economic growth in China would affect not only Pakistan but the whole world in all spheres of life.

By FARID KHAWAJA
Jan 09 - 22, 2006

Last month, China jumped up to number fourth rank in the world economic rankings, behind US, Japan and Germany. Most economists doubted Chinese growth statistics and expected the government to be understating the true growth. Finally, the government announced the revision in the GDP, by adding new categories in the services sector.

This led to a revision of 16.8% in the GDP of 2004, making the overall GDP rise by as much as USD283bn (to put things in perspective, the revision is more than twice the amount of Pakistan's GDP). After this revision, the Chinese economy has outgrown developed OEC economies like Italy, France and United Kingdom and at the current rate, the Red Dragon is growing at a pace four times faster than the growth in Japan and Germany and twice the growth of US. The drag from an economy of the size of USD1.93 trillion growing at rates above 9% has changed the global economic landscape, leading to a commodity boom, twin deficits in the US and an energy crisis. For an investor in Pakistan, it is imperative to understand the significance of the Chinese economy and its impact on the investment scenario.

COMMODITY BOOM

If you thought oil was the only commodity rising like a spire, then do take a look at the statistics. Just over the year, the Commodity Research Bureau Index is up more than 22% YoY. With an investment to GDP ratio as high as 40%, China has become the price setter and mover in the commodity market. The country's drive towards industrialization has propelled the prices of metals like iron, copper and aluminum as well of cements. The Commodity Research Bureau CRB Spot Index is at 347.8 up by 66% since 2000, crossing the previous all time high of 341 made during the 70's oil crisis. The story with oil prices is all well known (and well felt) by all. The interesting fact is that, China's consumption of oil is still less than its proportional consumption of other commodities. To use an argument presented by Mark Kiesel of PIMCO on the investment blog of October 2005, China's demand for oil still has to catch up its demand for other commodities in-line with the size and the needs of its population. The argument goes like this, China has 20% of the world's population and its consumption of commodity mirrors this proportion. It is consuming 30% of the world's coal, 26% steel, 21% soybeans and 20% copper, while in comparison its share of consumption of oil is less than 10% of total world's consumption. Hence, the demand has to rise to match the levels consumed of other commodities. The demand pressure from a rising and urbanizing China would continue to keep oil prices on the high side, until some capacity is added to the refineries (which would take atleast 6-7 years). Some analysts might say that the high oil prices would drive the demand down and would lead to a slow down in Chinese economy (and in turn reduce demand to restore equilibrium). Also the Chinese economy is expected to slow down into what is being called as a soft landing. However, even after the slow down the GDP growth in China is expected to be above 8.5% for the next two years (slower than current levels of 9.5%). 8.5% for any economy of the size of China is extra-ordinary growth by all standards!

RENMINBI AND THE US DOLLAR, A TALE OF TWO CURRENCIES

With the recent appreciation in Chinese growth numbers, there would be further pressure for an appreciation of the Renminbi. The accusation on China is that after it entered WTO, it deliberately kept its GDP growth number low, so that it could benefit from the preferences given to low income countries. The US criticizes China for keeping the Renminbi artificially low, which in turn leads to low price of Chinese products in the foreign market and hence, boom in Chinese exports. Last year, China did go for a minor appreciation of the currency (2%) as well as a move away from fixed exchange rate to a trading band. However, there is still pressure by the US government on China to further appreciate its exchange rate to a 'fair' level. The boom in Chinese exports has led to accumulation of record levels of trade deficits in the US and in turn made the US Fed raise interest rates. A further revaluation of the Renminbi could lead to pressure on the Yen and regional currencies as we saw earlier this year.

However, the more important development on the side of the currencies is threatening the US dollar. As I write this article, the Financial Times of today (6th Jan 2006), carries the bold headline that China plans to diversify its assets into other currencies, a move which could send the greenback tumbling down and change the global investment scenario as we know it altogether. According to the news, currently 70% of the Chinese reserves are invested in dollar denominated assets. The Chinese government announced yesterday that in order to improve the operations and the currency structure, they plan to move to other currencies. Such a move can have a massive impact on the global financial markets. Currently Chinese reserves are estimated to be around USD1000bn, a shift of these assets could lead to a rise in alternative assets like Euro and trigger the much anticipated fall (due to the instability of the US deficits) of the USD. Either way, the economic competition between US and China, would continue to have its impact on financial and geo-political environment of the world.

INVESTMENT VIEW

The economic growth in China would affect not only Pakistan but the whole world in all spheres of life. Already a struggle to acquire energy sources has started. The US expansion of control over Middle East is a well known (and criticized) strategy and China has signed agreement with Iran (not the most favored country by the US) to ensure its energy supply for the next 20 years. Hence any political tensions between the US and Iran are likely to take a larger impact.

For a domestic investor, the developments in Chinese economy are certainly very important. Those who could have seen the growth in China and its rapid urbanization could have entered the bandwagon of the commodity boom much earlier. Has the commodity boom reached its end? I think it has reached its middle and until China keeps on growing, the demand for commodities would be sustained. Over-investment would lead to cyclical fluctuations but the Chinese government seems to be doing a good job at managing the business cycles and would avoid any hard landing of the economy. Until the time China continues to grow, the boom in commodities and oil would continue. Unfortunately, Pakistan has still not able to get its Commodity exchange operational, however, investors can take exposure through indirect plays, like sugar, textile and oil and gas sector. Dubai is also in the process of establishing a Commodity exchange, which might provide an investment option for domestic investors. Energy Funds, like the one recently floated by PICIC seems an interesting option (though I have not seen the details and would avoid giving an explicit recommendation).

The most important development which investors should keep a tab on is in the currency market. Any shift in the asset class away from the dollar could lead to a long bear run on the dollar. Already the fundamentals do not support the greenback and the shift can be the trigger for the downfall. Pakistan's foreign reserves are still predominately in USD, a diversification of assets might be a prudent strategy. In my next article, I would continue on the theme of the global commodity boom and commodity trading.