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Investing in China: Fool’s Gold?
Copyright Thomas I. Palley
Americans tend to disregard history. Henry Ford declared bluntly,
“History is bunk,” while Gore Vidal calls the U.S. “the United States
of Amnesia.” Usually, this disregard has few consequences, but
sometimes not. That may be so with investing in China, where history
suggests profits will be far below expectations, possibly making those
investments fool’s gold.
China’s history is completely different from that of the United States
and it has left deep imprints on China’s politics. Therein lies the
trap for investors and policymakers who ignore history and wishfully
think market forces will inevitably make China just like the United
States. (read more)
One critical factor is China’s attitude to foreigners. That attitude
is captured by the Great Wall of China, which provides a metaphor for
China’s long history of isolationism and xenophobia. A second critical
factor is the legacy of China’s humiliating defeats in the unjust 19th
century opium wars with Great Britain. At the time, Britain was
importing large amounts of tea and silks from China, and demanded the
right to sell Indian opium in exchange. As the opium trade grew, not
only did it cause massive addiction, it also caused a damaging monetary
outflow of silver from China. That prompted China to stop the trade,
and Britain then turned to military force to keep China’s market open.
This historical experience has made China nationalistic and profoundly
averse to foreign exploitation, which is why history is so relevant for
investing in China. As a result, China will never allow itself to
be exploited by foreigners. For investors, the trouble is that China
views making profits from the Chinese market as a form of exploitation.
When foreign investments are for exports, China has viewed the profits
as being earned abroad. Difficulties only arise when the goal is
production for the domestic market. This explains why profitability on
such investments has historically been so low, and why so-many
joint-venture investments with Chinese partners have failed. It also
helps explain China’s persistent refusal to enforce foreign owned
patents and copyrights that apply to medicines, movies, and music.
The lesson is that companies are likely to be disappointed regarding hopes of profiting from China’s massive domestic market.
That has special relevance for American banks and insurance companies.
China will allow these companies to invest and modernize its financial
services infrastructure, but the profit pay-off is questionable. The
same holds for auto companies, which China will allow to transfer
technology and build modern plants. As long as the production is for
export, those plants will be allowed to earn large profits. But once
they start selling in the Chinese market, profits will likely shrivel
under burdensome restrictions and theft of technology, ideas, and
designs.
Stock market investors face a different case of fool’s gold, with stock
prices being artificially inflated by China’s under-valued exchange
rate and capital controls. That makes prices vulnerable to changes of
policy.
The under-valued exchange rate has contributed to China’s massive trade
surpluses, and China has had to buy dollars and sell yuan to prevent
its exchange rate appreciating. That has expanded China’s money supply,
and Chinese investors have bought stocks to earn higher returns and
protect against inflation, which has driven up stock prices. Capital
controls have also played a critical role by limiting investments
available to Chinese citizens. Since money cannot leave the country,
they have been forced to buy local stocks. Hence, the explosive
appreciation of the Shanghai stock market, which has spilled into the
Hong Kong market.
China’s government has profited from this bubble, as it has been able
to sell state-owned companies at high prices. Wall Street has also
bought into the bubble, telling Main Street investors that the
appreciation of Chinese stocks reflects China’s growth prospects rather
than its artificial market. However, come the day that China allows
external investment by Chinese citizens, Chinese stock prices are
likely to suffer as local investors move to diversify outside of China.
That potentially makes long-term investing in China’s stock market
another case of fool’s gold.
The bottom line is that when it comes to China, investors would be wise to remember all that glistens is not gold.
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