China 2006

There is a strong case to be made for China entering another period of strong stock market performance after comparatively modest performance in 2004 and 2005.

	2003	2004	2005
MSCI China Index	81.09%	-0.80%	15.93%
MSCI AC Far East ex Japan Index	44.37%	16.96%	21.13%
S&P 500 Index	28.68%	10.88%	4.91%

Source: Bloomberg

·        We are seeing a recovery in domestic demand and consumer spending;

·        Investment is now rising again after a sharp slowdown in 2004;

·        Import growth is accelerating;

·        2006 is the year company profits begin to grow again;

·        This should play through 2006, 2007 and into 2008.

In the coming year we expect to see slower headline economic growth although we are still talking about growth over 9%.  But more importantly we are seeing a re-acceleration in domestic demand after the slowdown in 2004 and subsequent stabilization in 2005. 

The problem in 2005 was that in spite of 10.7% GDP growth domestic demand was weaker, growing only 7.5%. The weakness in demand came from falling construction activity (where the authorities did most of their tightening) and from a profit decline in sectors such as steel, basic materials, autos and semiconductors where excess capacity had built up.  The growth came from exports where China was taking market share from the rest of the world.

In 2006 this trend is reversing.  Construction and infrastructure spending has been growing since the last quarter of 2005.  These, combined with buoyant consumption and continued export growth means China's economy is firing again on all cylinders.  Imports are also growing again meaning a lower trade surplus. 

So while we should see slower overall economic growth in 2006 the environment will in fact be more favorable for domestic industry.

What happened to the hard landing?

The hard landing that many forecasters were calling for never happened.  The reasons behind this may surprise some readers:

• The overheating was confined to specific sectors rather than the economy as a whole;
• The economic data such as investment, money supply, credit growth and industrial activity was sufficiently reliable;
• The range of tools available to policy makers has increased in variety and sophistication;
• Therefore, the problems were identified soon enough and the response sufficiently tailored that the economy did not go into a tailspin.

In 2006 we can be confident that the prospect of a hard landing is now remote.  With stronger domestic demand, loosened monetary policy, no big inflation (or deflation) and an investment recovery underway even those sectors whose profits were most affected by earlier excesses will have a better year.

In short there has been no profit collapse, no bank crisis, no social upheavals and there is still plenty of policy room.

What should we expect in 2006?

The Renminbi Yuan should appreciate gradually and slowly against the Dollar somewhere in the order of 2-3%.  However, on a trade weighted basis it could weaken because we expect the Dollar to weaken against both the Yen and the Euro.

Interest rates in China should begin to normalize i.e. move higher.  China has been criticized for its refusal to deregulate interest rates and allow market forces to work.  But now China is privatizing its banking sector.

Structural reform of the Financial Sector and Capital Markets are and should be major themes in 2006.  We caution investors against direct participation in these but they are nonetheless critical for China's continued development.

Foreign Exchange Reserves growth should moderate as domestic recovery drives imports growth and a falling trade surplus but China will still be buying, and mostly Dollars.

Finally, the end of extensive low-wages driven growth is coming.  The pool of young workers is rapidly draining.  India, Bangladesh, Vietnam and Indonesia all offer lower wages and the marginal cost of additional labor in China is growing 10% a year.

China is moving into higher value-added economic activity.  Over the medium term it is going to look like another (very big) Asian Tiger.

So where's the action?

This is going to be a bullish year for commodities.  Fuels, materials and metals are all going to prices higher for longer.

Construction and infrastructure are both sectors on a strong recovery path.  This includes growth in roads, rail, ports and electricity generation.

Consumption is still strong but it is unrealistic to expect the domestic recovery to lead to an explosion here.  Consumers are already very active and growth will be steadier driven by the inexorable growth in the number of middle class consumers.

We need to watch out for an increase in inflation that will affect the downstream producers (of finished product).  In the last two or three years, intense competition and cheap labor has meant that that mid-stream producers (or industrial materials, components etc.) have not been able to pass on rising costs and so margins have been under pressure.  This is changing.

We expect a good year for raw materials and mid stream producers but a more difficult year for profit margins amongst the producer of finished goods.

In Conclusion

After a tricky period where China has had to manage a moderation in growth having identified excesses in certain sectors, the reputation of China's economic management ability has emerged considerably enhanced.

Some of the restraints, such as on monetary policy, have been eased and at the end of 2005 it was clear that domestic growth (as opposed to mainly exports growth) has resumed.  There are no signs of looming risks such as inventory build-up, significant inflationary pressures, high debt or financial sector instability.  Instead, the reality is quite the contrary.

We expect to see a positive environment in China persist through 2006 and 2007 and into 2008 which may be good for China, good for Asia and good for investors. 

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.

The MSCI China Index is a free float-adjusted market capitalization-weighted index of Chinese equities that includes Red Chips and H shares listed on the Hong Kong exchange and B shares listed on the Shanghai and Shenzhen exchanges.  The MSCI AC Far East Free Ex Japan Index is a market capitalization weighted index of over 450 stocks traded in eight Asian markets, excluding Japan.  The S&P 500 Index is a market capitalization weighted index composed of 500 widely held common stocks of US Companies.  These indices are not available for investment and do not incur expenses.

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