Unless you’ve been asleep for the past 10 years, you know that the hot investment ideas all come from China these days. It makes sense. With 1/5th of the world’s population, and a stronger desire to gain “developed country” status than any other country in the world, China has presented everyone with strong growth opportunities.

Unfortunately, most investors just don’t get it. They’ve been buying up stocks just because they say “China” in their names. It’s just like 1999, when people bought stocks just because they ended with “dot-com.” And we all know how that turned out.

I’ve been laying it all out to Sleuth readers for a while now, and I thought it’s about time we put together a report on some of these ideas. So here it is… First, I’ll be discussing China’s unquenchable thirst for buying up the whole world…

Investing in China :: What Will China Buy Next?

In a Sleuth article earlier this summer, we reported the inconvenient truth that M3 is increasing at 12% a year.

M3 is the fullest measure of the U.S. money supply… and it is going up three to four times faster than the GDP itself.

The Fed’s irresistible desire to print more fiat dollars helps explain why the world is saturated with liquidity right now. And many of those dollars have conveniently found their way into the war chests of the world’s top ten sovereign wealth funds (SWF’s).

Morgan Stanley estimates these funds now control $2.5 trillion dollars. Relatively speaking, SWF’s are already equivalent in size to roughly half the gross official reserves of all countries.

And if these government-backed hedge funds weren’t large enough, Morgan Stanley estimates their reserves will increase to $5 trillion by 2010 on their way to hitting $12 trillion by 2015.

China alone holds somewhere around $1.2 trillion in foreign exchange reserves. These reserves are traditionally invested in liquid assets like U.S. Treasury bonds. Buying U.S. Treasuries enables China to peg the RMB to the greenback.

We knew China’s thirst for American Treasuries wouldn’t last forever. Nothing does… not even the world’s greatest empires.

So earlier this year, when China decided to set up its own sovereign-wealth fund, your editors became somewhat suspicious. This fund enables Beijing to shop for assets more exciting than stodgy, old government bonds. China can effectively take a chunk of that $1.2 trillion and search for things where it might make a better return… things like old-school British banks and white-shoed American PE funds.

Investing in China :: What better way to own the world, right?

But when we read that China, for the second consecutive month, has been a net seller of U.S. securities, we stood up and took real notice.

China sold a net $6.6 billion of U.S. securities in May following net sales of $5.8 billion in April. The last time China sold U.S. securities for two consecutive months was during January/February of 2004.

We said that if this move proves to be more than a passing trend, this could put further pressure on the U.S. dollar. Well, that may be the case.

In The Turning Point in China’s Economic Development, editors Ross Garnaut and Ligang Song point out:

“China has or is fast approaching reached the turning point in its economic development, at which ’surplus’ labour from agricultural employment in the countryside ceases to be available to drive the growth of the modern economy; so that labour becomes scarce and valuable; forcing large real wage increases and real exchange rate appreciation; which generate structural change towards more capital-intensive and technologically sophisticated industrial structure at the relative expense of labour-intensive manufacturing and agriculture; and changes fundamentally the character of China’s interaction with the international economy.”

I’ve always believed China’s path for floating the RMB would take place in three distinct stages. First, China would clean up the state banking system. Second, Beijing would gradually liberalize capital account convertibility. Finally, the Chinese RMB would be allowed to float alongside the dollar, euro, yen and pound.

We may be on the verge of reaching step number two. Meaning, China’s appetite for U.S. dollars may not be with us too much longer.

This may help explain the gradual shift taking place on Beijing’s shopping list.

But the real question is… If you had a $300 billion shopping budget and you knew the world’s demand for U.S. dollars was about to fall as M3 kept growing at a double-digit pace, what would you buy?

Secondly, this report wouldn’t do anyone justice if it doesn’t discuss the most recent Chinese development… Now, Chinese citizens can use Hong Kong dollars to buy shares on the Hong Kong market…

Investing in China :: China Blesses Hong Kong

Beijing recently announced that it would permit mainland Chinese citizens to invest in the Hong Kong stock market. The proposal allows Chinese citizens to open accounts at the Tianjin branch of the Bank of China, and then sell renminbi (RMB) and buy Hong Kong dollars without limit for the purpose of buying shares in Hong Kong.

The news sent the index of Hong Kong-listed shares in mainland companies up by 8.74%, their biggest one-day rise since May 2000. This should also go a long way in easing speculative pressure on the Shanghai A-share market.

This is probably the most important financial development in China since their entry into the World Trade Organization in 2001. So we were all a little surprised the announcement was delegated to page six in the Financial Times on the day the news came out.

Once again, the cover story that day focused on the U.S. liquidity crunch. If you’re looking for liquidity, there’s arguably no better place to turn than China.

China had accumulated foreign exchange reserves in excess of $1.33 trillion at the end of June. Total national household savings in China are estimated to be roughly $2.2 trillion.

With regards to the “bigger picture,” releasing capital account control is the next step towards the eventual flotation of the RMB. This move should allow many on Capitol Hill to take a deep breath.

China took the first step towards currency liberalization in December 1996, when it made the renminbi convertible for current account transactions, removing both quantitative and regulatory restrictions on the use of foreign exchange for current account transactions. China’s WTO accession in 2001 has also been seen as a catalyst for capital account liberalization and currency convertibility.

For lack of a better description, the current account is the difference between a nation’s total exports of goods, services and transfers to its total imports of the same. Relaxing the current account has allowed Chinese manufacturers to feed American consumers. Thus far, this has been primary fuel feeding the Chinese economy.

A current account deficit occurs when a country’s total imports of goods and services are greater than the country’s total exports. This situation makes a country a net debtor to the rest of the world. See U.S.

A current account surplus is just the opposite. Exports of goods, services and transfers are greater than imports. See China.

The next natural step in liberalization is the capital account. Once again, for lack of a better description, the capital account is the net result of public and private international investments flowing into and out of a country.

Allowing mainland Chinese citizens to invest in the Hong Kong stock market signifies the most significant move to date by Beijing officials to liberalize the country’s capital account. This policy will allow the roughly $2.2 trillion conveniently stashed underneath one billion or so mattresses to find a better home with a better return.

But don’t go expecting the Chinese to float the RMB anytime soon. They are firm believers in gradualism. It’s taken more than 10 years to get from current account liberalization to this point. I would suspect it’s going to take many more before we reach full floatation.

But let’s forget the currency issue for a moment. The real winner here is undoubtedly the Hong Kong market, especially H-share companies that don’t have either a Shanghai or Shenzhen listing.

As Zhao Xiao, a professor of Beijing’s University of Science and Technology, said: “Remember, if all Chinese money can go to Hong Kong, then many global firms will favor listing in Hong Kong.”

But things aren’t always peachy when it comes to growing– and deregulating– Asian economies.

Investing in China :: Costs of Growth

Unfortunately, the costs of growth are often ignored in financial forums. That’s why we’re dedicating this last section to the environmental impact China’s massive industrialization places on both their own country as well as the greater global community.

We hope this report shows a side of China often neglected in the mainstream media.

We owe a great debt of gratitude to two individuals whose research went a long way in the development of this report. First, we would like to thank Elizabeth C. Economy, author of the essay “The Great Leap Backward? The Costs of China’s Environmental Crisis.” We would also like to thank James Kynge, former China Bureau Chief for the Financial Times and author of the book China Shakes the World.

You can find a copy of Ms. Economy’s essay in the latest issue of Foreign Affairs. Many other scholars, editors, and interested parties contributed to this essay without their direct knowledge. We believe the proper attention to their research on this particular subject is long overdue. We thank them for their support.

Investing in China :: The Costs…

Air

-The percentage of China’s energy needs supplied by coal: 70
China must construct a new coal-fired power plant every week just to keep pace with demand.
-The average life expectancy of a Chinese city traffic police officer: 43 years
-The chief culprit for his abridged life: air pollution
-The number of reported premature deaths in China caused by respiratory diseases related to air pollution on an annual basis: 400,000
-The actual number: 750,000 (According to the World Bank… Beijing didn’t want to release the actual figure due to fears of inciting social unrest.)
-The combined number of individuals who died at Hiroshima and Nagasaki as a result of atomic bomb related causes: 410,000
-The number of pollution related protests that took place in communist China in 2005: 51,000
-The number of doctors your editor visited for an unidentified lung ailment he developed after living in Hong Kong for less than two years: 3
-Total amount spent to cure his “cough”: $1,000-plus
-The number of people China will re-locate to newly developed urban centers between 2000 and 2030: 400 million
-The population of the United States: 302,730,255
-The number of the world’s 20 most polluted cities that call China home: 16
-The year China will emit twice as much carbon dioxide as all of the OECD countries combined: 2032
-The number of new nuclear reactors needed to be built each month from now until 2070 to make any difference to global carbon emissions: 4
-The most optimistic forecast regarding the time it takes to build one nuclear reactor: 36 months

Land

-The percentage of China’s landmass that remains uninhabited: 50
-The percentage of humanity crowded onto just 7% of the world’s cultivatable land: 20
-The distance China’s Gobi Desert continues spreading annually: 1,900 square miles
-The percentage of the entire country that is now desert: 25
-The percentage of China’s agricultural land that receives ample amounts of acid rain: 33
-The amount of annual Chinese grain production contaminated with heavy metals: 12 million tons
-The number of Chinese citizens who died as a result of the famine that immediately followed Mao’s Great Leap Forward: 30 million
-The total number of Chinese who died as a result of Mao’s policies: 80 million (Chen Yizi: July 17, 1994, Washington Post (“Great Leap Forward, 1959-61”)
-The total number of deaths attributed to both World Wars: 70 million
-The number of tropical logs shipped worldwide that the International Tropical Timber Organization estimates are bound for China: 1 in 2
-The total area of rainforests, the “lungs of the planet,” destroyed each year: 24,000–30,000 square miles
-The total area of West Virginia: 24,231 square miles

Water

-The ratio of China’s 660 cities that have less water than they need: 2 in 3
-The number of years before cities in the Northeast China could completely run out of water: 5-7
-The amount Beijing commissioned to divert river water to address the problem: $60 billion
-This represents the largest civil engineering project since the Great Wall.
-The percentage of China’s city aquifers deemed polluted: 90
-The Yangtze River received 40% of the country’s sewage, 80% of it untreated.
-The number of Chinese who drink water contaminated with animal or human waste: 700 million
-The number of doctors your editor visited after drinking one glass of Hong Kong tap water: 2
-The number of days that the single glass of water confined him to his bed: 10
-The ratio of fish species native to the Yellow River now extinct thanks to pollution: 1 in 3
-The percentage of the East China Sea, one of the world’s largest fisheries, now rated unsuitable for fishing: 80-plus
-The percentage rated unsuitable for fishing as of 2000: 53
-The largest exporter of fish to the United States: China
-Melting glaciers in Tibet threaten to flood both the Yangtze and Yellow Rivers.
-The year scientists now warn rising sea levels could submerge Shanghai: 2050

The Affects Here at Home

-The number of Chinese made toys Mattel decided to recall: roughly 1 million
-Thus far, the number of deaths directly attributed to this incident: 1 (Zhang Shuhong, owner of Lee Der Industrial, a company that made toys for Mattel, hanged himself in a company warehouse shortly thereafter.)
-The U.S. Environmental Protection Agency estimates that on some days, 25% of the particulates in the Los Angeles atmosphere originated in China.
-The U.S. Environmental Protection Agency recently reported that one-third of the nation’s lakes and nearly one-quarter of its rivers are now so polluted with mercury that children and pregnant women are advised to limit or avoid eating fish caught there.
-Scientists estimate that roughly one-third of that mercury settling in the United States comes from other countries, China in particular.
-China spews around 600 tons of mercury into the air each year.

According to Elizabeth Economy, “The environmental degradation and pollution cost the Chinese economy between 8 percent and 12 percent of GDP annually…water pollution costs of $35.8 billion one year, air pollution costs of $27.5 billion another, and on and on with weather disasters ($26.5 billion), acid rain ($13.3 billion), desertification ($6 billion), or crop damage from soil pollution ($2.5 billion).”

Meaning, there seems to be great economic incentive to aggressively address this catastrophic problem. And as James Kynge points out…it’s not that the world lacks the resources to support China’s growth, it’s simply that the world does not have enough resources to cater to 1.3 billion Chinese behaving like Americans.

These are all areas of Chinese growth that will surely be developing stories in the future. So I keep my eye on it pretty closely.

Sincerely,
Christopher Hancock, Penny Sleuth