China's Tectonic Shift

Posted June 10, 2008

While China hoped that the Beijing Olympics would focus world attention on the country’s stunning accomplishments, 2008 has been a difficult year for China and for investors in Chinese companies. The local Chinese stock markets suffered a decline of almost 50% from their levels in late 2007. The buildup for the August Olympics emboldened human rights activists to protest China’s policies in Tibet, and violent riots broke out in Tibet itself. And then came the horrific tragedy of China’s earthquake, with more than 85,000 people dead or missing and another 300,000 injured. But I believe that the lasting legacy of the cataclysmic Sichuan quake will be a tectonic shift towards a freer China, an enhanced image of the Chinese government, and a renewed commitment to encourage rapid growth in the poorer central and western regions of the country. And the recent declines in Chinese stock prices have provided investors with a very attractive entry point to correct the substantial underweighting of China in the investment portfolios of most individual and institutional investors.

The government’s actions after the quake contrast sharply with China’s response to the 1976 Tangshan earthquake and with the U.S. government’s response to Hurricane Katrina’s devastation of New Orleans. In 1976, when a quarter of a million people perished, the government’s response was slow. Moreover, like the initial reaction in Myanmar, China closed its doors to assistance from the outside world, and national leaders made no effort to visit the site of the disaster. Moreover, the propaganda department denied the severity of the 1976 calamity and banned the media from covering the tragedy.

Today the government’s response has been markedly different. One hundred thousand troops were sent in to help with disaster relief. Prime Minister Wen Jiabao flew immediately to the disaster area, and he has been seen frequently on TV at the front line overseeing the relief effort. President Hu Jintao, acting more like a politician than an authoritarian leader, has visited tent-making factories and has urged plants to run “at full gear” so that 900,000 tents could be sent quickly to the affected areas. To be sure, the first instinctive reaction of the apparatchiks running the propaganda agencies was to ban reporters from visiting the site. But reporters ignored the ban, and it was later lifted.

The Chinese government’s response also contrasts starkly with the U.S. response to Hurricane Katrina. President Bush waited for two days to visit stricken New Orleans and flew over the disaster area without landing. The U.S. government response was widely viewed as inadequate and ineffective and helped send Bush’s popularity ratings to new lows. Premier Wen, in contrast, has become a populist hero.

Moreover, the “firewall” that surrounds the internet in China has been severely breached. Countless bloggers have heaped praise on the rescue effort but have also been unafraid to offer sharp criticism of officials who supervised the construction of the shoddy schools and buildings that crumbled when the quake hit. Ordinary citizens have rushed in to help, independent of any planning by the government. The surge of patriotic fervor has even muted the voices of those criticizing China’s policies with respect to Tibet.

Prof. Benjamin Friedman of Harvard University has argued that economic growth eventually leads to increased political freedom. Some China hands have been skeptical that the Friedman hypothesis applies to China. The 2008 earthquake may well prove to be a defining moment in China’s development into a flourishing civil society with increased personal freedom and with a government that is less distrustful of its own citizens.

China’s troubles over the past year provide an excellent opportunity for international investors to increase their holdings of the stocks of Chinese companies that trade in Hong Kong (so-called “H” shares) and New York (so-called “N” shares) as well as in open capital markets around the globe. The following factors suggest that the equity securities of Chinese companies are more attractive today than has been the case for some time.

First, the long-run economic effects of the quake are likely to be positive. To be sure, in the short run China will be subject to increased inflationary pressures because a substantial share of the pig population has perished, and the destruction of some irrigation systems will hinder agricultural production for some time. But in the long run the Chinese government is likely to redouble its efforts to bring the kind of economic success that has been achieved in the eastern part of the country to the poorer central and western areas.

Second, the stock market’s decline during 2008 has increased the attractiveness of Chinese equities. Warren Buffett, Alan Greenspan, and other observers worried that Chinese stock prices toward the end of 2007 were at bubble levels. But the growth of earnings for Chinese companies remains strong, and price-earnings multiples have declined to levels consistent with those in other world financial markets. Hence PEG rates (the ratio of the price-earnings multiple to the expected long-term growth rate of company earnings) have become very attractive relative to other world markets. While no one can forecast short-term movements of stock prices, we do know that valuations today are far more attractive than they have been for some time.

In addition, investors in the equities of Chinese companies are likely to benefit from the continued appreciation of the Yuan. China has let its currency appreciate by approximately 5% per year since it loosened the peg between the Yuan and the U.S. dollar two years ago. It is highly likely that such appreciation will continue, since China still has probably the most undervalued currency in the world. As the Yuan appreciates against the dollar, U.S. investors will own a share of Yuan earnings that will translate into increasing dollar values over time.

Chinese stocks are also good diversifiers. While China is not decoupled from the rest of the world, the movements of its economy and stock markets have tended to have a low correlation with other world markets. Of course in times of great distress we can’t be overconfident of the benefits of diversification since all markets tend to move together. Still, China is expected to grow rapidly in 2008 while the U.S. economy is likely to crawl to a standstill.

Finally, most investors are severely underweighted in their exposure to China. China has 5% of the world’s GDP at official exchange rates. When adjusted for purchasing power parity, China probably has about 10% of the world’s economic activity. The exposure of most individual and institutional U.S. investors to China is substantially lower than 10%. It is not sensible to be underweighted to an economy that has enjoyed the most rapid growth rate of any major country in the world over the past 25 years.

Since Deng Xiaoping reintroduced capitalism into China, the Chinese economy has enjoyed an unprecedented growth rate in output and income that has averaged close to 10% a year after inflation. Under Mao, socialism meant shared poverty. Deng proclaimed, “To be rich is glorious”; under his leadership, hundreds of millions of Chinese have been lifted out of poverty, and China’s national income (adjusted for purchasing power) has become the second largest in the world. By liberating the energy of the Chinese people, Deng provided a stunning example of the power of free market capitalism. China’s current leaders give us some hope that at least some degree of political freedom will follow. That would be good news for all who value freedom – and good news for investors in China as well.

Mr. Burton Malkiel is Chemical Bank Chairman’s Professor of Economics at Princeton University and author of “From Wall Street to the Great Wall” (W.W. Norton 2007).