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Guinness Atkinson Asia Brief
August 2005
Edmund Harriss
Fund Manager Asia Focus Fund, China & Hong Kong Fund
The past year has been momentous for China and for investors in China. The performance of China's economy through 2004 and 2005 shows just how far China has come on the road towards the creation of a market economy. For the first time ever, China's economy has been through a boom followed by a period of administered restraint without the economy going bust. Growth has remained above 9%; inflation did not rise beyond 5.3%; non-performing loans did not skyrocket at the banks; businesses were able to gain access to credit and inventories did not build up; incomes and wages rose, profits rose and exports kept on growing at more than 30%. During this period China continued to recapitalize its banking sector and began the privatization process by listing the Bank of Communications. In July, China revalued its currency and moved towards the creation of a flexible currency regime. We now have proof that China's economy has critical mass, depth and momentum.
The Currency Problem
The revaluation of China's currency together with a mechanism allowing it to fluctuate is a significant advance. In itself a move of 2.1% will make little practical difference to exports, to the US trade deficit with China or to the accumulation of foreign reserves. However, it represents shift in thinking.
In the public debate we have heard many raised voices telling China why it should revalue its currency. But what of the domestic pressures on the Chinese leadership? We don't hear much about those. Where there are pressures on US manufacturers there are also pressures on Chinese producers.
When China set about reforming its inefficient industrial sector it closed down tens of thousands of businesses. Over 25 million people lost their jobs. Economic growth of at least 7% is required to find jobs just for the people entering the workforce; faster growth is required to absorb the losers from China's reforms. So when considering the social pressures caused by unemployment in America as a result of cheap imports, these pressures are multiplied many times back in China where welfare and other state support is in short supply.
The key driver of economic growth and, in particular, job creation, is in export manufacturing. Labor-intensive assembly and production is the immediate answer to the problem. China is eager to produce higher value-added goods such as electronic goods which raise incomes and consumption. Already such items are now the largest Chinese export by value.
The textile and garment manufacturing sector has been overtaken in this regard but it is still a major employer. The margins here are wafer thin, a result of many players and the pressure applied by customers such as Walmart (which has already said a rise in costs by 10% would cause a switch in supply away from China to Bangladesh, India and Vietnam). Profit margins here are so thin that a 2% currency rise hurts and a 10% rise will kill many of these businesses. The resulting additional unemployment and increase social pressure is politically unacceptable.
The debate within the Chinese government has been intense and has been going for a couple of years. The opposing argument which has been carefully put by Alan Greenspan and Secretary Snow is that China's economy is opening fast and is exposed to more and more external pressures. It will be better served by a flexible exchange rate to absorb some of these pressures.
China's decision to alter its currency policy, as we have seen is necessarily a political one as well as an economic one. The timing of the decision was wholly political and precedes the visit by President Hu Jintao to Washington in September.
So China has now moved. It revalued and also introduced a mechanism that sets a rate against a basket of currencies where the currency can move +/- 0.3% against the previous day's rate. On this basis if the currency moved up 0.3% every day, it would appreciate 10% in 31 days. For the present the currency will be managed much more tightly. The reasons are that the Central Bank wants to give banks time to adjust to the new system; no currency hedging instruments exist; and finally the economy, businesses and expectations need to time adjust.
China looks outward
The first move to make waves was the acquisition of IBM's personal computer business by the Chinese company Lenovo. Voices were raised that this gave rise to security issues; that the Chinese government and the military would gain access to vital secrets. Then came CNOOC's bid for Unocal; voices were raised once again that security issues were at stake and China would use Unocal's oil for possibly military purposes. After that came Haier's bid for Maytag although on this occasion no one could think of any security implications surrounding the sale of a maker of washing machines. So what is going on? Do Chinese acquisitions really represent a threat and if so, what kind of threat?
As China's economy develops and opens up the competitive environment becomes tougher. Consequently, a number of the richer companies are looking for an edge, a way to outstrip their competitors. To do this they need a brand and they need to build management teams and technological skills. They can do this organically, which can take years and carries the risk of failure, or they can buy it in. In Lenovo's case the acquisition of IBM's loss-making PC business made perfect sense. In a stroke they outsourced executive management, business strategy and product development and in so doing they are looking to dominate the Chinese notebook PC market. CNOOC's bid for Unocal was about boosting oil and gas reserves - in Asia, not the paltry 70,000 barrel per day production in the US - but it was also about technology. CNOOC has oil reserves in the South China Sea that it is unable to exploit properly because it does not know enough about deep water drilling. Unocal does from its fields in the Gulf of Mexico. Haier was looking to acquire a brand in Maytag rather than take time to build one itself. Too bad that Whirlpool didn't want a revitalized competitor and was prepared to pay more to ensure that.
We expect to see a lot more of these types of acquisitions in the future, in US, Europe and elsewhere. Chinese businesses are desperately short of skills, as one would expect given their recent emergence into the truly commercial world. The energy sector remains as exception. The ferocious response to CNOOC's overtures caught many by surprise, not just the Chinese.
The silence from the Administration during the saga was deafening. The desire to secure energy supplies is not just a Chinese quirk, it would appear. But in the broader scheme of things, Chinese companies are on the acquisition trail. A stronger currency will assist them in that goal.
The threat then is this: There is a new economic power emerging that has enough depth and momentum behind it to alter the existing order. As we pointed out earlier, successive short term interest rate rises made zero difference to long term rates - something that the Federal Reserve and Treasury were unable to explain convincingly. Then China changed its currency policy and long term Treasury yields moved more overnight than they had moved in 18 months. This clearly creates economic challenges and political ones. There will be a lot of puffery, as we have had recently. But China is a part of global and local economic life whether we like it or not.
The Guinness Atkinson Asia Focus Fund and China & Hong Kong Fund invest 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.
As of 7/31/05, neither the Asia Focus Fund nor the China & Hong Kong Fund held any shares of Wal-Mart, IBM, Lenovo, Unocal, Haier, Maytag, or Whirlpool. As of 7/31/05, CNOOC composed 2.77% of the Asia Focus Fund and 6.23% of the China & Hong Kong Fund. Each Fund's holdings may change at any time due to ongoing portfolio management and should not be considered a recommendation to buy or sell any security.
Opinions expressed are those of Edmund Harriss and are subject to change, are not guaranteed and should not be considered investment advice.
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.
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