China's Economy Is 40% Smaller Than Thought - So What!

By Keith Fitz-Gerald
Investment Director

In a report that is sure to send shivers down the backs of investors who have been blindly pumping money into China-related investments, the World Bank recently stated that China's economy is 40% smaller than previously thought.

The report also suggests that China will not become the world's biggest economy in 2012 - as everyone has been expecting - and said the nation is far poorer than most analysts think.

In our opinion, all this report means is that there's a lot more upside for savvy investors.

Clearly, there are major implications - particularly as the data affects aid and monetary agreements - so we don't want to dismiss it. But the fact is, reports like this are hardly unusual when it comes to emerging economies.

With their rush to riches, that's something investors too often forget. That's also why, over time, so many investors fare so poorly: They're so busy trying to get to the party, that they fail to notice that they're the last ones still there and drinking from the nearly empty punch bowl when the lights go out.

It's understandable. They've become so inebriated from the easy profits that they fail to see the big "Stop" signs that are in plain view.

We all know how that story ends. Those investors incur major portfolio damage by failing to factor in the periodic corrections like the one the Chinese stock markets are experiencing right now.

Unfortunately, too many investors make a major error in assuming that they can only make money in a market if there's a raging bull market in stocks. As we know, that's just not so. As long as an investor "follows the money" - a central component of the Money Morning/Money Map Report global investing strategy - and pays attention to the powerful trends that are always at play, profit opportunities can always be found.

The World Bank report is worth noting for several reasons. But here's a key point: Even after all the estimates for China are revised downward, its $5.33 trillion net worth is second only to the United States, which has a $12 trillion net worth. That means that, for all its supposed shortcomings, it is wealthier than such countries as Japan, Germany, France and the United Kingdom.

And even with the downward revisions, China still accounts for 10% of the world's gross domestic product (GDP), making it the second-largest economy in the world - again, bigger than such stalwarts as Japan and Germany.

When measured in terms of purchasing power parity, China accounts for nearly 10% of global output, yet its per-capita gross domestic product is a mere 9.8% of that of the U.S. economy.

In other words, the world's biggest "undeveloped" nation is rapidly chasing the world's "most developed" - and actually is ahead of many of the world's most sophisticated markets.

Imagine the potential when China really gets going!

So do the revisions tell the whole story?

Not by a long shot.

World Bank officials, like other government apparatchiks everywhere, have to take all kinds of "official" information into consideration when cranking their numbers. In fact, as part of this effort, they consider the prices of more than 1,000 goods and services in 146 countries - as measured in the local currencies - as they calculate the relative purchasing power parity between countries.

In doing so, they obviously place a huge emphasis on so-called "local information" - such as local prices and government-generated data.

That's good, since it helps determine global purchasing power more accurately.

And yet, this process is just as flawed - and is as full of holes - as earlier studies.

For example, China is primarily a cash economy, which means that trillions of yuan are circulated outside the "official" financial system. And that means the economy is growing at a clip that's much faster than the 12% rate that China's government is reporting - perhaps as much as 3% to 5% faster, making the annual growth rate 15% to 17%.

Compare that to the tepid 2% growth rate of the U.S. economy.

With regard to how this affects our investment capital, there are several important implications to consider. Chief among them: If China is, indeed, smaller than is commonly believed, the United States is much less likely to levy punitive trade actions that stymie China's economic development.

Once this report is fully digested, it could well mean that U.S. investments in China will accelerate, causing China's economy to increase its speed, too.

And that's important because it suggests the rules of the game have changed once again, especially when we strategize about how to best pursue profits from China.

At the present time, it's better to profit "from" China than to invest "in" China.

That's a Money Morning mantra, and it makes a lot of sense, when you consider it carefully.

Profit From China Without the Dangers of Direct Investments

Direct investments "in" China have become increasingly dicey, as many investors have discovered of late. It turns out that many of the most exciting companies trading on China's stock exchanges have actually profited because of their investments in other exchange-traded companies - somewhat of a "keiretsu-like" arrangement, and one that we've discussed quite frequently.

To the uninformed, this can transform certain China stocks into an unforeseen gamble. If one of these companies stumbles, or collapses, then the companies that invested in it all the way up the line will probably stumble, too.

No wonder some Chinese euphemistically refer to domestic investing as "stir-frying" shares.

On the other hand, international companies doing business in the greater Chinese region are positioned to profit "from" China's substantial growth. These firms tend to be stable and to produce longer-term profits, while dodging the "Wild West" kind of risk that some of their domestic counterparts seem actually to be courting.

These "global titans" provide another benefit to investors shrewd enough to understand this strategy: These firms have the added advantage of being traded in accordance with Western rules and with Western regulatory transparency - which adds a substantial amount of certainty to an equation that badly needs it at the moment.

Speaking of which, there's a substantial group of people who believe that China's going to collapse. We believe it won't, and for one very good reason.

By giving tens of millions of its citizens a taste of the "good life" of Western consumers, China has opened its version of Pandora's box.

Money Morning Executive Editor Bill Patalon calls it the "Baywatch Effect." And he's only partly joking.

At this point, China can't halt consumerism and shut down growth anymore than America could completely shelve democracy - even if China's economy is 40% smaller than we all thought before.

And that brings us around to how we play this news as investors.

Assuming you buy into our current "safety-first" strategy of "profiting from China instead of investing in China," one terrific avenue to travel is the one that leads to global titan service-providers. One solid play: the Zurich-based ABB Ltd. (ABB), which recently won $440 million worth of contracts to build a 2,000 kilometer electrical link that will ultimately provide power for 31 million people when it is completed in 2011.

Then there's Nam Tai Electronics Inc. (NTE), which makes electronic parts and sells them to China-based original-equipment manufacturers, or OEMs, for short. This company is poised to grow from the growing use of its products in China-made goods that are then sold to the rest of the world. With those relationships in place - and relationships, known as guanxi, are crucial in world of China-based business - the company logically will be able to transition to supplying parts for goods sold to the customers that are part of China's growing middle class.

The bottom line on China is that the World Bank report is important...just not for the reasons that many people will think when they first hear about it.

We see the data differently and regard it as a strong base from which to build in the years ahead.

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About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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