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New Risks, Opportunities on Horizon for China Stocks

Happy National Day. On the first of October 63 years ago Mao Zedong stood before 300,000 people at Tiananmen Square to announce the establishment of the People’s Republic of China. Now the day

Happy National Day. On the first of October 63 years ago Mao Zedong stood before 300,000 people at Tiananmen Square to announce the establishment of the People’s Republic of China. Now the day is celebrated as National Day, the start of a week-long holiday called Golden Week. And in just over a month China faces a political transition that will be far less dramatic but that will present significant new risks and opportunities for China stocks investors.

After Mao’s historic proclamation China swung between a Stalinist centralized economy and radical Maoist experiments. The Stalinist periods were inefficient, and the Maoist years were disastrous. Then soon after a full-fledged move to market reforms in 1978, China hit on a dynamite economic model: exploit rock-bottom labor costs to build exports and attract foreign investment, and invest lavishly in fixed assets.

A negligible economic player in 1978, China now stands behind only the U.S. as a world economic power.

But the model is fraying. Higher labor costs and a weak global economy decimate exports and foreign investment. Extravagant investment after the global financial meltdown in 2008 spawned high inflation and overinvestment. Economic growth is sinking.

Now on November 8 China will convene 18th Party Congress to select new leaders to deal with economic policies. There’s little if any suspense about who will take over the Party and government. Vice President Xi Jinpeng has long been expected to replace Hu Jintao as president and Party general secretary.

There is also general agreement that big changes are needed. One China-based securities firm has stated that “radical new thinking” is needed in two areas:

*A major downgrade in economic growth targets.

*A much smaller role for the government in the economy.

“The new leaders NEED to change the direction because there is no more room for rapid growth” an experienced analyst at the China-based brokerage told Equities in an email. “Exports are dead, consumption is slowing …; more investments will create more long-term problems, so there is no way out if continuing to pursue economic growth.”
Preventing a hard landing will be crucial.

“A slowdown seems inevitable in the next 5-10 years, and the real threat is that all the bubbles created during the last decade may burst, such as property,” the analyst said. “Imagine the damage done if property prices fall by 30-40%.”
On the second point, despite more than 30 years of market-oriented reforms, the government is heavily involved in the giant state-owned enterprises that dominate the economy. According to the analyst, the SOEs are now saddled with overcapacity and bad debts.

New leaders are expected to allow the private sector more room to expand and raise funds. But the analyst said most private businesses are small, have lost much of the advantage of cheap labor and generally lack innovation.

But there will be new opportunities among privates firms, according to Andy Mantel, founder and CEO of Pacific Sun Advisors.

“The next President Xi Jinpeng was former governor of coastal Zhejiang Province where there (are) a lot of private enterprises” Mantel told Equities in an email. “Reforms in many respects are at the point of no looking back, including RMB internationalization. Directing financing to private enterprises will increase via the equity and debt financing (bonds/loans).”

Mantel likes consumer electronics, household durables and transportation plays, including airlines and expressways.
Cathay Pacific (CPCAY) and Air China (AIRYY), like other airlines, are “extremely cheap on an historical basis” and will cash in on booming outbound travel of mainlanders.

Mantel also favors Taiwan-owned laptop casing designer and maker Ju Tseng, a play on huge internal demand for notebook and tablet computers and tablets.

China’s markets will be closed this week; Hong Kong will close Monday and Tuesday. End

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