Is China Washed Up? Hardly

By AdviceIQ July 02, 2015, 09:24:26 AM EDT

Published in Morningstar

China is headed for the dumper. So goes the negative chorus on the world's second largest economy. Slowing growth, horrible air pollution ,a real estate bubble - the reasons given for the country's demise are numerous. But despite China's woes, its prospects remain brights. 

One positive indicator: The country's stock markets have rallied recently, finally catching up to the overall economy. The government has enacted reforms that have helped a lot.

Aiming to avoid rampant speculation and uncontrolled bubbles, previous policies erred on the side of safety and conservatism. One effective new step is the removal of limits on ownership of multiple accounts with varying brokers, which has led to over 12 million new accounts (known as domestic A-shares) opened in under a month.

But to its critics, China is in the same position as the kid who's trying to make the team, but is competing against the coach's son for the last spot on the roster. Nothing he does is ever going to be good enough in the coach's eyes; every good play he makes must be lucky.

Although it is such a major economic force  - the International Monetary Fund estimates it will be the largest contributor to world gross domestic product expansion for 2015 - some still regard it as not belonging on the world stage, let alone atop it. Many choose to simply ignore it.

This is a serious mistake. China is where long-term opportunities reside. While this also leads to short-term volatility and risk, the temporary anxiety is well worth the end reward.

The commodities market, which has long benefited from Chinese demand, seems to agree with this optimism: "Dr. Copper," as it is known, has rallied along with other base metals to yearly highs. This development argues against the view of pundits that the country's economy is weakening. We concur, and believe that the economy is settling into a secure and sustainable rate of growth.

Pessimists make much of China's economic growth slowing from its unsustainable annual rate of over 10% during the last decade, to a projected rate this year of around 7%. Left out is that the rest of the world is growing at half that rate at best, and despite all the cheerful talk of recovery and joy on Wall Street, the U.S. last year grew at just 2.4%.

More important, because China's GDP has grown so much over the last decade or so, a 7% increase now brings in more actual growth in total dollars than did 10% from a smaller base 10 years ago.

China's detractors say that it was growing too fast and was too reliant on exports. Real estate was in an obvious speculative bubble and the government had too much control; central planning doesn't work. (These last two come from the same people who missed the U.S. bubble, which resulted from loose monetary policy - and now they call for more regulations and federal oversight of an ever larger piece of the economic pie). Chinese inflation? Too high. Wages? Too low.

Fast-forward to the present. China's leadership acted to stabilize the economy. It had indeed been growing at an unsustainable rate (the highest single-year increase . was almost 14%), but the point of it was to pull as many people out of poverty as quickly as possible.

For a long time, massive government spending on infrastructure and cheap manufacturing meant for mass export were the basis of its economic development. This has changed into a more service and consumption-based economy (while still having a significant amount of real exports). The government is both loosening its hand, and actually selling off majority portions of state-owned enterprises to the private sector.

Private firms are now responsible for 80% of all employment, and virtually 100% of net new jobs. The government itself has stated that they could only help incubate and take things so far; afterward, experienced business managers must take over from government bureaucrats. Wages have risen at near double-digit rates for the last two years, yet inflation has remained tamed, so much so that if necessary Beijing could initiate a financial stimulus program.

Most important is the loosening of restraints on the trading of mainland A-shares and allowing a wider variety of standard trading practices, such as short selling. The China Securities Regulatory Commission announced in March that mutual funds will be able to trade between Shanghai and Hong Kong exchanges, foreigners will have access to Shanghai-listed shares, and Chinese citizens will be able to access stocks traded on Hong Kong's Hang Seng Exchange for the first time in history.

Shares on the Hong Kong Exchange (the city is semi-autonomous) currently are at a discount to those of the same companies traded on the mainland. This should narrow considerably with the benefits mostly in favor of the Hong Kong H-shares, as Chinese are finally able to invest outside of their own country, and keen on taking advantage of the newly available arbitrage, where they can play off the price differences on the two bourses. Shenzhen is expected to join the mix later in the year, and trading in commodities and fixed-income instruments should not be far behind.

Will there be missteps and corrections along the way? Of course, but that is natural for any dynamic economy, especially one growing and transforming at such high rates. One failed company or changing industry does not an economy ruin.

As far as that talented kid trying to show off his skills and being ignored by the coach? Perhaps it's not the player but the coach who is wrong.

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Partners  Mark J. Foley  and Tina Larsson manage the Pendo International Strategy for independent financial adviser  Pendo LLC in New York. Pendo LLC is a full-service financial advisor dedicated to providing objective investment advice and personalized investment management services to individuals and institutions. Partners Mark J. Foley and Tina Larsson are long-term value investors with an emphasis on international equity markets; they are frequent contributors to Advice IQ.

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