Investing in China: Fool’s Gold?
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.
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.
Copyright Thomas I. Palley
January 16th, 2008 at 5:33 am
You make some fair points. But, also I think China’s attitude to foreigners may be changing. Also, there is a growing Chinese middle class who will increasingly consume. China offers good returns for the smart investor
January 17th, 2008 at 8:01 pm
All the ad hominem attacks aside, the facts are that the Chinese are not allowed to ship money out of the country (not necessarily a bad thing given their current situation and the last Asian financial crisis) and the exchange rate is still undervalued. These are facts and they are the causes of the sky-high Shanghai valuations and the trade surpluses.
February 6th, 2008 at 9:51 pm
I appreciated your article. You might enjoy “The Capital Question of China”, written in the early 1940s by Lionel Curtis. It explains the differences between China and the West back in the 1930s. The author shows how globalism had spread to China in the 1930s, the goals of which were much the same as today — to create new consumers for the devloped countries. The major difference was that back then the newly industrialized corporations of the West wanted to sell China finished products, whereas today they want China to produce finished products for them and in time to consume those products too. Mr. Curtis’s book gives many differences that have some bearing today. It discusses how the Chinese did not believe in the concept of contracts, and considered them to be goals, not mandatory agreements enforcable by law. According to Mr. Curtis, because the West tried to force the Chinese to honor contracts in the 1930s they rebeled and killed some foreigners and the foreigners fled from China. Mr. Curtis seems to believe that the loss of China from the global market at the time considering the huge investments the West put in place there, contributed to the Great Depression. Much is likely differentt now but it appears some things are the same. It is especially optimistic to expect the general population in a country that has for centuries believed in Communism to suddenly adhere to liscense and patent agreements even if the ruling party might be given private incentive to try and encourage adherence.
I disagree with the previous blogger’s idea that China has not been a fairly closed country — of course their poor treatment is part of the problem, but it is hard to ignore that the concepts of ancestor worship and their adherence to tradition is inward looking, not worldy. That said, just because the Chinese have different concepts than the West it is no reason for bloggers to equate the recognition of those differences as prejudice. Anger towards the examination of difference highlights their own intolerance to difference.