2011 China Outlook: The Red Dragon Takes Its Next Step Forward

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If the United States has a growth problem, China has just the opposite. The world's second-largest economy is set to grow 9-10% this year, building on its strong rebound from the global financial crisis.

Furthermore, Beijing is determined to accelerate China's transition toward a more domestically based economy, while stabilizing prices and cutting government waste.

So in addition to strong growth numbers, investors can expect more disciplined and responsible economic development.

"Coming from this very strong growth that we have seen recently, China should be able to ease gently into a more sustainable rate of growth in 2011 and the medium term," said Louis Kuijis, senior economist and the main author of the World Bank's China Quarterly Update.

The World Bank in November raised its forecast for China's 2010 gross domestic product (GDP) growth to 10%. According to World Bank estimates, China's economy grew by 10.6% in the first six months of 2010 and logged a "still surprisingly strong" 9.6% third-quarter expansion.

The World Bank expects China's growth will slow to 8.7% in 2011, but Money Morning Chief Investment Strategist Keith Fitz-Gerald thinks that estimate is too conservative.

"I think we're more likely to see 9-10% growth next year," said Fitz-Gerald. "It may be even closer to 12%."

Money Morning Outlook 2011
Sharply focused government policies and a rapidly emerging middle class will continue to drive economic growth in China. However, another major catalyst will be the so-called "gray market," which consists of cash that the government has not accounted for.

"The gray market simply means cash that's outside the system," said Fitz-Gerald, who claims there are "thousands" of ways to hide cash from the government in China.

China's households hide as much as $1.4 trillion (9.3 trillion yuan) of income that is not reported in official figures, with 80% accrued by the country's wealthiest people, Credit Suisse Group AG (NYSE: AG) said in a recent report.

The average urban disposable household income in China is $4,866 (32,154 yuan) a year, or 90% more than official figures, according to the report. The top 10% of China's households take in $21,035 (139,000 yuan) a year, more than triple the official figures.

"If these numbers are correct, it means that China's GDP is understated – as is the income generation over there," said Fitz-Gerald.

According to Fitz-Gerald the scope of China's gray market shows that many Westerners have misjudged the progress the country has made transitioning to a more domestically based economy.

Westerners also have underestimated the effectiveness of government programs, such as the 50-year "Go West" campaign to balance growth from the seaboard to the inner provinces, says Fitz-Gerald.

"The two biggest misconceptions that Westerners have about China are that it's solely dependent on exports and manufacturing, and that the fact that they're communist will somehow interfere with capitalist development," he said. "If anything Chinese style communism has proven remarkably stable."

Price Punch

Indeed, China's biggest problem is not generating growth, but ensuring that it is balanced and stable.  To that end, containing inflation and spurring consumption will be Beijing's main focus heading into the New Year.

Inflation in China hit a 28-month high of 5.1% in November, drawing the attention of officials worried about food prices. Food prices have a one-third weighting in the calculation of China's consumer price index (CPI), and an 11.7% rise in food prices contributed to 74% of the CPI growth in November.

Figures from southern Beijing's Xinfadi market, northern China's largest agricultural produce distribution center, indicated the weighted average price of vegetables at the market for the first 10 months of 2010 rose 20% to 30% from last year's level, according to Xinhua, China's state-run news agency.

China International Capital Corp. (CICC) believes consumer prices ebbed in December rising by just 4.5%. However, Bank of America Corp.'s (NYSE: BAC) Merrill Lynch unit forecasts a 4.8% increase in December prices, and Credit Suisse on Monday said that prices could exceed 6% by midyear, following "a brief pause over the next two to three months."

Chinese Premier Wen Jiabao has been especially vocal of late.

"I can tell everybody, the government has complete confidence in tiding over this difficult stage," Wen said in a recent radio address.

The People's Bank of China (PBOC) surprised the markets on Christmas Day by raising its one-year refinancing rate — the interest rate it charges when lending to banks – by 52 basis points to 3.85% and increasing the benchmark deposit rate by 25 basis points to 2.75%.

A Reuters poll showed investors see the benchmark one-year deposit rate rising to 3.25% by the end of 2011.

The PBOC also has increased reserve requirements for banks and allowed the yuan to gain against the dollar.

"The government appears to have given a signal that it will use both interest rates and the exchange rate to fight inflation, including imported inflation," a senior trader at a Chinese commercial bank in Shenzhen told the Economic Times. "The yuan's rise will still be measured, possibly slightly more than 5% in 2011, while politics have an intermittent impact."

An informal poll of China-based dealers over the last week showed many of them expect the yuan to gain roughly 6% percent in 2011, hitting 6.25 per dollar late next year.

The yuan yesterday (Tuesday) hit an 18-year high against the U.S. dollar, as the greenback sank to 6.6251 yuan.

The currency may gain even more this month, as Chinese President Hu Jintao is set visit to the United States in mid-January. China often lets the yuan appreciate slightly ahead of major political events and to calm tensions before visits.

It's likely that China's monetary tightening in 2011 will take place mainly in the first half of the year, according to JPMorgan Chase & Co. (NYSE: JPM) and Morgan Stanley (NYSE: MS).

Rebalancing Act

In addition to stabilizing prices and containing inflation, China will continue its transition to a more domestically driven economy.

People too often think of China as the world's manufacturing floor. The reality is that China is working diligently to rebalance its economy with a greater focus on the service sector. By raising rates and squashing inflation Beijing also is attempting to keep the manufacturing sector from overheating.

And it's working.

China's manufacturing purchasing managers' index (PMI) fell to 53.9 in December from 55.2 the previous month, which is perfectly fine with policymakers who are hoping to curb inflation and rebalance growth.

"A slower but still robust pace of manufacturing expansion is welcome because overheating is a risk policy makers want to avoid," Shen Jianguang, a Hong Kong- based economist at Mizuho Securities Asia Ltd. who has worked for the European Central Bank (ECB) and the International Monetary Fund (IMF) told Bloomberg. "Another rate hike could come as soon as this month."

But while manufacturing is slowing down, China's service sector is heating up. China's PMI for the non-manufacturing sector rose to 56.5 in December, from 55.2 in November.

"On one hand, the rebound (in non-manufacturing PMI) was caused by large investment in the service sector," Li Xunlei, chief economist with Guotai Junan Securities, told The People's Daily. "On the other hand, it was influenced by government policies encouraging the service sector."

The service sector accounted for 42.6% of China's GDP in 2009 – a 0.8% increase from the year prior, according to the National Bureau of Statistics. That compares to more than 70% in the United States, but is still a long way from less than 20% in 1990.

China's service exports now rank fifth in the world. The latest statistics from the Ministry of Commerce show China's service trade rose 17% last year.

From 2005 to 2009, the total volume of China's service trade rose to $287 billion from $157.1 billion. But service exports surged 31.7% to $166 billion in just the first half of 2010.

Chinese authorities will lean heavily on the country's service sector to create jobs, as monetary tightening and a rising yuan squeeze manufacturers.

"The [service] sector can be very employment-intensive and it's domestically based," Paul Heytens, Asian Development Bank (ADB) country director for China, told China Daily in an interview. "We see it has enormous potential in the future and it should be developed further as part of China's efforts to move its driver of economic growth away from export-oriented industries to domestic sources."

China rarely reports official labor statistics, but the urban unemployment rate stood at 4.1% at the end of September, with 9.05 million urbanites registered as unemployed, according to the Ministry of Human Resources and Social Security. The rate dropped from 4.2% at the end of the second quarter and 4.3% at the end of 2009.

In the first nine months of 2010, China created 9.31 million new jobs in urban areas, exceeding the annual target of 9 million for 2010.

Furthermore a survey released last month by employment firm Manpower Inc. found that Chinese employers felt the fourth quarter of 2010 would be the most dynamic labor market since the survey began in 2005. Some 53% of employers expected to increase staffing levels, while 2% forecast a decrease in hiring and 32% predicted no change.

The outlook for the services sector was one of the brightest, with a net employment outlook of +54%. That trailed only Finance, Insurance and Real Estate, which had a +55% rating. Of the 36 countries surveyed by Manpower, China had the most optimistic employment outlook.

In addition to more hiring, employers also are paying higher wages. Every province and municipality in China experienced a rise in its minimum wage last year, with increases ranging from 12% to Beijing's 21%.

With an employment picture that's very different than the one we're seeing in the United States, Money Morning's Fitz-Gerald says China has clearly hit its stride in a system that is both successful and unique to its strengths.

"We think we wrote the book on capitalism," he said, "but the reality is China has had the world's largest GDP 18 of the last 20 centuries – so communist or not, they're simply resuming their place in the world order based on their population and its aggregate purchasing power. This is not going to continue in a straight line but over all the trend is very clearly up."

Investing in China

When it comes to investing in China, there are plenty of options.

One way to go is to invest in the country's fast-growing auto sector.  After supplanting the United States as the world's largest auto market in 2009, China's vehicle sales surged 30.45% in the first half of 2010 to 7.18 million units. That compares to 5.6 million for the United States.

And analysts believe that gap will only grow from here on out.

Fatih Birol, chief economist for the International Energy Agency (IEA) says that today 700 out of every 1,000 people in the United States and 500 out of every 1,000 people in Europe own cars. But in China, only 30 out of 1,000 people own cars. And Birol thinks that figure could jump to 240 out of every 1,000 by 2035.

China's automobile market is expected to grow by 15% in 2011, according to General Motors Co. (NYSE: GM) China President Kevin Wale.  GM and its joint ventures increased vehicle sales in China by 33% over a year ago to 2.2 million vehicles in the first 11 months of this year, the company reported earlier this month.

Auto sales in China could even hit 20 million in 2011, according to data compiled by Booz & Co.

"China's auto market is the largest in the world and it's the fastest growing," said Fitz-Gerald. "That's why I like China Yuchai."

China Yuchai International Ltd. (NYSE: CYD) is engaged in the manufacturing and sale of diesel engines, which are mainly distributed in China.

"CYD benefits from three uniquely Chinese trends: rising consumer purchasing power, the Chinese infrastructure build out, and the development of transportation within China to move people, goods, and services around the nation," said Fitz-Gerald.

Investors might also consider an exchange-traded fund, or basket of Chinese stocks. Two such funds are the Morgan Stanley China A Shares Fund (NYSE: CAF) and the iShares FTSE Xinhua 25 Index (NYSE: FXI).

The FTSE Xinhua 25 Index ETF seeks to mirror the price and yield performance of the underlying index, which tracks 25 of China's largest and most liquid companies. At least 90% of the fund's $8.1 billion in assets is invested in either the actual Chinese shares or depositary receipts representing those securities.

However, Fitz-Gerald prefers the Morgan Stanley China A Shares Fund.

"I particularly like CAF because one of the things the gray market economy makes very clear is that small business ventures will be amply rewarded and most of those companies are traded only in China A shares," he said. "And CAF is the only fund that gives U.S. investors ‘direct access' to the A-shares."

It's also one of the best ways to profit from China's shifting growth model. A recent portfolio allocation of the fund showed 28% of its holdings were in consumer goods and services, 26% were in financials and 18% were in basic materials.

CAF also holds shares in companies that make auto components and beverages, among other products, and has numerous stocks in the metals and mining sectors.

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