Point of View

The emergence of China as an economic power, and the development of its stock markets in Shanghai and Shenzhen, is having a major impact on capital markets in the region and the world. And as China liberalizes its stock markets, institutional investors are lining up to take advantage of the country’s strong growth.

Northern Trust recently hosted a panel discussion on investing in China featuring Michael Mandelbaum, a foreign affairs professor at Johns Hopkins University; Alex Banker, director of investments for Yale University; Paul Kasriel, chief economist at Northern Trust; and Andrew Smith, chief investment officer of Northern Trust Global Advisors, the firm’s multi-manager investment practice.

Point of View: Will China’s rise transform Asia into a dominant region? If so, what implications would this have for the United States economically and politically?

Michael Mandelbaum: I think one has to separate the economic from the political. China is driving the economic rise of Asia. However, while China’s economy is already having a major impact on the entire world economy, its political role lags considerably far behind.

The United States remains the predominant political and military power in Asia, and I think that’s likely to continue for the foreseeable future for three reasons. First, the United States simply has more military power than any other country, including China.

Second, global political leadership requires a certain outward perspective and a good deal of experience, which the United States has. China is a newcomer and it will take some time for the Chinese to feel comfortable operating in all aspects of international relations. In addition, China’s focus will be inward for the foreseeable future. Its highest priority is to lift hundreds of millions of its people out of poverty.

Third, to be a political leader, a country must enjoy the trust of other countries. The United States has built up a lot of trust and a general sense of confidence during the past six decades, especially in Asia. Most of China’s neighbors, however, harbor suspicions of one kind or another of China. They want the United States to maintain a substantial political and military presence in East Asia to counterbalance China.

Meanwhile, China’s economic growth has been good for the U.S. economy on balance. So, part of the task of American policy in East Asia and globally is to make sure that the frictions that inevitably arise from rapid economic growth in China and elsewhere do not derail the cooperative relationship between China and the United States and other countries.

Point of View: What role do you see the United States and the Eurozone playing as the Asian economies continue to develop? As investors, what should we examine to identify future economic success stories, and how can we potentially profit from them?  

Paul Kasriel: As a result of an expanding middle class, there will be increasing demand for a more highly educated workforce and a more sophisticated financial infrastructure, both of which can be provided by the United States and the Eurozone. The United States likely will be called upon to provide an umbrella of “peace and tranquility” in the region, freeing the governments to focus on economic development rather than regional frictions. One potential negative factor could be an increasing protectionism emanating from the West, most likely the United States.

Three factors will enhance the probability of continued economic success and therefore profitable investment opportunities in developing Asia: first, impartial and well-defined legal systems, especially with regard to private property rights; second, less government planning; and third, independent monetary policies that strive foremost to maintain the purchasing power of the region’s currencies.

Point of View: To succeed in a global financial marketplace, each country must establish modern, functioning financial markets. What is your view on the Chinese investment market, its risks and opportunities? What is the optimal way to invest in China?

Andrew Smith: The impact of China’s emergence from insulated agrarian economy in the early 1980s to a global trading economy is unprecedented. With an educated low-cost workforce, excess manufacturing capacity and trillions spent on infrastructure, China has become a formidable competitor in many global industries. Foreign direct investment in China combined with the country’s economic reforms has stimulated a robust domestic economy growing at rates unmatched by developed economies. Qualified foreign investors have an opportunity to participate in a secular growth story as China shifts gears from a poor Third World country to a modern consumer economy.

As for risks, despite recent progress China remains a centrally controlled emerging market with a nascent market infrastructure. It still needs to improve efforts to enforce and monitor securities laws, and is prone to government intervention. All of these are significant risk factors for foreign investors. Emerging markets are prone to rapid cycles of explosive growth and sudden retrenchment. Capital controls on the Chinese currency make investing and repatriating capital riskier than in Western markets.

We advocate diversifying risk when investing in China. There are a number of QFII (qualified foreign institutional investor) funds available to access China’s dynamic domestic A-shares market. In addition, larger financial and resource stocks can be purchased on Hong Kong’s H-shares market. An investor can supplement exposure to the A and H shares with large Chinese companies that trade on Western markets. The fast-paced Chinese market rewards local knowledge, so hiring money managers who combine local access with a well-established investment process is vital for long-term success.

Point of View: Yale is an institution that has successfully invested directly in China A shares. What advice would you offer to those contemplating a similar program?

Alex Banker: Check first to see that your institution meets the minimum requirements set forth by the Chinese Securities Regulatory Commission (CSRC), which are pretty stringent in terms of capital size and length of track record. Also, be sure you have the operational and compliance infrastructure to support your planned investment strategy. The CSRC is revising its compliance requirements for QFIIs, and they are likely to be quite demanding.

Finally, it’s important to identify strong and reliable local partners for legal, custody and brokerage services. Our custodian, and our sub-custodian in China serve as our primary liaisons with the Chinese regulatory authorities. Timely and accurate communication is critical in responding to regulatory requests, particularly when responses are due in a matter of days.

Point of View: What is China’s strategy with its QFII program? Is this a means of trying to “prop up” high valuations with artificial restrictions limiting the availability of A shares?

Alex Banker: No. One of the overriding goals of the QFII program is to bring long-term, professional investors into the local market. People with experience evaluating corporate strategies, performance and management teams will help bring a sensible investment discipline to the A-share market, rewarding companies with strong corporate governance, reporting transparency and financial performance. I think the Chinese genuinely expect that foreign investors will help make the local markets more efficient.

Andrew Smith: Economic growth and an improved standard of living is critical to future social stability in China. China’s economic plan is to dramatically increase foreign investment in the domestic stock market to stimulate economic growth and replace the dependence on its banking system for capital. The QFII program is typical of the struggle to balance central control and market openness, allowing foreign investors access to China’s domestic stock market while maintaining central controls on China’s currency valuation and balance of payments. China also values Western investment expertise and the stabilizing influence of long-term Western investors on the volatile Chinese market. For the foreseeable future, there appears to be a strong alignment of interests between China and Western investors.

Point of View: China’s equity markets saw strong appreciation from late 2006 through most of 2007. This year, there has been a major sell-off. Should investors be concerned about this volatility, or is the long-term China story sufficiently compelling to warrant investment?

Alex Banker: Trying to time markets is a fool’s errand. China is a compelling long-term story.

Economic growth and an improved standard of living is critical to future social stability in China. China’s economic plan is to dramatically increase foreign investment in the domestic stock market to stimulate economic growth and replace the dependence on its banking system for capital.

Paul Kasriel: The long-term China story is a very positive one, but not necessarily the short-term story. The Chinese economy is experiencing inflation in the price of goods, services and assets. This is because the Chinese central government is loosely pegging the yuan to the U.S. dollar. This forces the Chinese monetary authority to purchase dollars with freshly printed yuan, which floods the economy with yuan, resulting in inflation.

Eventually, and possibly sooner rather than later, the Chinese monetary authority will have to sever the yuan-dollar peg and effectively tighten domestic monetary policy to combat inflation. This could produce a monetary shock to the Chinese financial system and economy. In the short run, this could hurt Chinese investments. In addition, the Chinese central and municipal governments need to reduce their interference in the economy, which contributes to an inefficient allocation of resources that could hold back future non-inflationary real economic growth.

Point of View: What impact will continued strong Chinese economic growth have on commodity demand and pricing? Do commodities remain a good investment for the long term?

Paul Kasriel: Industrial commodities are likely in a long-term bull market but could be hampered as the U.S. recession — which I believe we are in — weakens global economic growth. If the United States should experience a relatively severe recession with a muted recovery, which is my base-case scenario, the demand for developing Asia’s exports could be adversely affected, and the demand for industrial commodities will weaken in the short run.

The agricultural commodity boom is less affected by cyclical factors. The two billion-plus combined populations of China and India now can afford to purchase more foodstuffs. Even with an expected cyclical decline in crude oil prices, the demand for biofuels is expected to grow. With world grain inventories at 60-year lows, this combined food and biofuel demand for agricultural products would be expected to keep the bull market of agricultural products intact.

Michael Mandelbaum: As long as economic growth continues in China and in India and the rest of Asia, there will be a heavy demand for commodities, which will exert upward pressure on oil and on other commodities, including food. I think the outlook is for continued upward pressure on commodity prices, which raises the specter of inflation.

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