Updates on China

As long time investors in emerging markets, we have followed developments in China for many years. Recently, we’ve attended a couple of interesting presentations on China and want to report on them to you. The Federal Reserve Bank of San Francisco hosted a presentation by David Loevinger, who is posted in Beijing as the Minister-Counselor for Financial Affairs at the US Department of the Treasury, and we hosted a meeting in our San Francisco office with Professor Burton Malkiel, most well known for his classic text, A Random Walk Down Wall Street. Malkiel is “on tour” now in support of his new book, From Wall Street to the Great Wall.

Malkiel sets the historical context for China’s current charge up the rankings of national economies by noting that for centuries – and as recently as 1820 – China had by far the largest economy in the world, producing about one third of the globe’s output. After complacency and humiliation in the 19th century, the Chinese suffered through its civil war, the Japanese invasion, and the period of Mao’s rule. Currently China produces about 6% of the world’s output (versus about 27% for the US), but is expected to become the largest economy in the world within 20 years. Its stunning growth rate will inevitably decline from the current 10% per annum, but will likely remain among the highest in the world.

China has and is continuing to invest vast sums to develop its infrastructure – highways, ship and air ports, power generation facilities, etc. Its powerful central government and lack of a free press has allowed the development of large projects largely regardless of the interests of adverse parties. The extension of infrastructure investment to the middle and western regions of the country is expected to unlock further underutilized economic resources. Meanwhile, China’s age-old emphasis on education, underscored by the Communist Party’s goal of literacy for the masses without regard for gender, has provided a huge, relatively productive workforce.

This progress has lifted many millions out of poverty and created a very large Chinese middle class. Even the profession of private “wealth management” has entered nominally communist China. Our CEO, Tim Kochis, serves as Chair of the International Advisory Panel for the Financial Planning Standards Council of China.

China’s recent growth has changed the entire calculus of world trade and could put China in conflict with other economic powers for scarce resources. China’s leadership faces many serious internal risks as well. Income distribution has grown more skewed than it is in the US and is seen by the Chinese government as a potentially destabilizing threat, especially as media penetration increases. Similarly, corruption among government officials as well as in private enterprise remains an enormous obstacle to progress. Geopolitically, China’s sometimes tense relations with Tibet, Taiwan, and Japan remain unresolved, though Ma Ying-Jeou’s victory in the Taiwanese presidential election a few weeks ago may signal a dampening of Taiwanese sentiment for sovereignty.

Like the population of the US and other developed countries, the population of China is aging rapidly. As Loevinger put it, “China will grow old before it grows rich.” But the Chinese have one of the highest savings rates in the world – reflecting both the need to provide for one’s old age, and very low productivity of savings in the economy. The ability to lay off some financial risks via insurance products is poorly developed, and the national social safety net is still the family.

For those of you who find developments in emerging economies as fascinating as we do, we recommend The Elephant and The Dragon, by Robyn Meredith. Addressing India as well as China, the book elaborates on the historical context for the modern development of these two very different countries and discusses the many implications for the future.

Investing in China

The Dimensional Fund Advisor (DFA) Emerging Markets Core Equity fund (formulated, largely at the behest of our firm, in April 2005, as an amalgam of three previously separate DFA funds) is our primary vehicle for actually accessing Chinese equities for our clients.

To be eligible for inclusion in one of the DFA emerging markets funds, a country must demonstrate both commitment to a free market economy and a sufficiently well developed stock market. On the first score, a country must have a sound legal system evidenced by property rights protection, the ability to enforce contracts, and reasonable treatment of foreign ownership (no unreasonable taxes, ownership restrictions or restrictions on repatriation of capital). On the second, the stock market (in the case of China, we’re referring primarily to the Hong Kong stock exchange on which Chinese “H shares” are traded) must be well organized with a minimum $10 billion in market capitalization, have ample liquidity, and a sufficient number of publicly traded companies. Prior to 2007, DFA judged that China and the Chinese stock market had not met these criteria. (Russia remains the other notable country whose market is not currently included in DFA emerging market portfolios.) Despite the fact that China’s stock market was almost 12% of the MCSI Emerging Markets index (second only to South Korea’s 16%), there were no Chinese stocks in the DFA emerging markets portfolios at this time last year.

After a series of legal reforms in China, DFA decided to begin adding listed equities of Chinese companies to its portfolios beginning in July 2007. At the end of February, trading had progressed to the extent that Chinese stocks were 9.7% of the Emerging Markets Core Equity portfolio’s value. To mitigate single country risk, DFA maintains a 12.5% limit on the securities weight in the portfolio of any single country. Brazil is currently capped by that limit and South Korea, Taiwan, China, and India are expected to reach the limit over time. The complete exclusion of some countries (described previously) and the single country limit result in meaningfully different country weights, and therefore returns, between the DFA Emerging Markets Core Equity fund and those of published emerging market indexes. Recent returns are shown below.

Consequently, our clients shouldn’t be surprised if our emerging markets performance differs (better or worse) from some commonly published measures. We believe that the benefits of these structural parameters will outweigh, over time, whatever “tracking error” occurs as a result.

This is, of course, only the beginning of opportunities for our clients to invest in China. Other…or additional…excellent fund choices may arise for investing in China’s public markets and, eventually, we expect direct private equity investment opportunities as well.

Mike Fitzhugh and
Jason Thomas, Ph.D.