Guinness Atkinson Funds

Asia Brief - April 2005

Guinness Atkinson Funds
Investment Research Series


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China - The Opportunity of a Lifetime

Our long-term view on China is that the economy, which has grown on average by 9% a year, will sustain a growth rate of around 8% for the next 20 years. This view is based on the process that is now underway where years of infrastructure investment, deregulation and reform have given rise to a buoyant manufacturing sector. This has resulted in raising the standard of living for millions of people and creating wealth. We have not seen anything on this scale since the early days of American industrialization at the end of the 19th century and beginning of the 20th century.

The engine of growth has been provided by the program of mass-industrialization but this time under a market model rather than the old communist framework of central planning. During the 1980's it became clear that the economic system set up under Chairman Mao was no longer sustainable. The collapse of the former Soviet Union also brought home the realization that unless a workable economic framework was put into place the Chinese Communist Party's very existence would come into question.

China began its reform program some 20 years ago during which time it has ditched most of the key ideological beliefs that underpin the communist system. The most important shift has been the move away from ‘common' or state ownership to private enterprise. "To get rich is glorious," pronounced Deng Xiaoping, China's late paramount leader, in 1992. The consequences of this have been profound and the effects are being felt throughout the world.

The Desire for Riches

Over the last 20 years China has poured billions of dollars into infrastructure development—roads and bridges, power and telecommunications, sea port and rail links and urban development. This investment has been the reason why the economy has been growing at an average rate of 9% a year since 1978. This investment has also been critical in bringing China to the economic level it is today by allowing people, goods and resources to flow.

However, the fundamental change has been the ideological shift that now encourages people to work to better themselves. Private ownership first came through the scrapping of agricultural collectives allowing farmers to work for themselves and keep any surpluses. This was rolled out into urban enterprises, firstly, small businesses known as Town and Village Enterprises and now includes the very largest national industries. Entrepreneurs were given latitude to establish business; the law was amended to allow the establishment of joint-stock enterprises; stock exchanges were established in 1991 and 1992 in Shanghai and Shenzhen. Price controls which once ran throughout the economy were rolled back and now account for only 10% of economic activity.

China has also looked outward to see what else they can glean in their efforts to galvanize their economy. Foreign enterprises were encouraged to come to China, initially in designated areas called Special Economic Zones but subsequently have been allowed to set up anywhere in China. At first these businesses were obliged to have a domestic Chinese partner but this requirement too has fallen away in most cases. By 2007 under the terms of its entry into the World Trade Organization, all sectors must be fully opened to foreign, as well as domestic, participation. The benefits of foreign access have been to the advantage of both parties. China has gained access to technology and to technical and commercial know-how. Foreign businesses have gained access to a domestic and consumer economy that is growing faster than anywhere else in the world.

The Middle Class

The creation of a thriving domestic economy attests to the success of the government's efforts over the last 20 years. Allowing people to work for personal gain has unleashed the entrepreneurial drive and capacity for hard work and thrift that characterizes those Chinese in Hong Kong and overseas. The result is both an incredibly dynamic and competitive domestic marketplace and one that is seeing the emergence of an increasingly affluent middle class. It is this group that will ensure the long-term success of China's transition to a market model and will also very likely in time establish China as the world's largest economy.

If we were to define the middle class in China we would characterize it as consisting of college educated white-collar professionals with household wealth of around $36,000. When taking into account the relative costs of goods and services in China combined with the range of spending options open to an individual, this represents material spending power. In 1978 the number of households that could be characterized as middle class numbered 8 million, or 24 million people - the same number as in 1952. By 1991 the number had more than doubled to 18.5 million households and by 1999 had more than doubled again to 39 million. In 2002 the Chinese Academy of Social Sciences estimated the number of middle class households to number 50 million, or 120-150 million people. By 2010 the number is expected to reach 100 million households or 240-300 million people - equivalent to the size of the population of the United States. This would represent 23% of China's population which would be similar to the U.S. in the 1950's and Japan in the mid-1970's.

These are educated people, with talent in the world's fastest growing region and they have aspirations. A significant number of these people are now homeowners. Over the last five years the government has sold some 70% of public housing at deep discounts. This has had the effect of boosting households' net worth by some 30% (or $350 billion in aggregate) and has also raised home-ownership rates from 35% to 70% in many cities. Consumption patterns reflect all these changes. Ownership of goods such as radios, televisions, and refrigerators surpassed the U.S., in absolute terms, in the early 1990's. However, increased wealth and homeownership saw a surge in ownership of mobile phones and fixed lines which surpassed the U.S. in 2001 and 2002, respectively.

Looking ahead we are now expecting higher growth in air travel (10% in China vs. 1% in the US), in car ownership (growing 10% in 2005 and accelerating from there) and personal computer ownership is expected to increase over 20% a year to 2010 to 250 million computers. The increasing level of domestic economic activity has a number of implications. Firstly, it has the effect of boosting national wealth and creating a self-sustaining cycle of saving and investment. Secondly, increased activity will further enlarge the middle class which will underpin the economy in the long term, just as it does in the developed world. Thirdly, a vibrant consumer economy will reduce the volatility of China's economic cycle which hitherto relied on the single engine of government investment. Finally, it is hoped that the wealth created will find its way into the western provinces of China where there is real hardship. Although incomes here have risen, the income gap with the eastern provinces has never been wider and this is now a pressing issue.

Implications for Investors

At present China is largely viewed in terms of its effect on commodity prices and as a source of cheap imported goods. This is perfectly reasonable given what we have seen over the past five years where China has emerged as a significant factor in the world economy. The domestic economy remains less obvious to outsiders because its growth is derived from the success of its export manufacturing sector. However, the implications of domestic spending patterns and the level of consumption of related goods based on the growth and spending projections of China's middle class are huge.

To see how China's economic development fits into an investment framework we should consider the following:

We have reached an important stage in China's development where a measure of stability has been achieved. For the first time in living memory the government has managed to engineer a slowdown in economic activity without there being a collapse. A key reason for this has been the role played by the middle class who have continued to spend (and with a 40% savings rate can continue to do so). For investors in China, we are only five years into the story where the economy can feed and sustain itself. We have barely begun to scratch the surface of this opportunity.

The Guinness Atkinson Asia Focus Fund and China & Hong Kong Fund invests in foreign securities which involves greater volatility, political, economic and currency risks and differences in accounting methods. The Funds are non-diversified meaning they concentrate their assets in fewer holdings than diversified funds. Therefore, these Funds are more exposed to individual stock volatility than diversified funds.

This information is authorized for use when preceded or accompanied by a prospectus for the Guinness Atkinson Funds. The prospectus contains more complete information, including investment objectives, risks, fees and expenses related to an ongoing investment in the Funds. Please read the prospectus carefully before investing. Mutual fund investing involves risk and loss of principal is possible.

Distributed by Quasar Distributors, LLC (04/05).

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