Thomas Palley: "Investing in China: Fool’s Gold?"

I must confess to a prejudice. Ever since China became more open to commerce with the rest of the world, I have not understood the enthusiasm for investing in China, that is, the foreign direct investing, assets-on-the-ground type. Having worked with the Japanese, and knowing how hostile they are to any meaningful foreign role in their economic affairs, I never saw Chinese attitudes, at their core, as fundamentally different (although their playbook bears little resemblance to that the Japanese, who have the disadvantage of being a military protectorate of the US, despite the existence of the Japanese Self Defense Forces). Push comes to shove, the Chinese would have few inhibitions about nationalizing foreign assets.

Thus I find it gratifying that my views aren’t so paranoid as not to be shared by others. Thomas Palley, in his latest post, argues in a more specific and reasoned fashion as to why investing in China may not be all it is cracked up to be. His view is that while the Chinese don’t mind foreign investment to sell for export, they have little tolerance in foreigners serving domestic consumers (and serving the rapidly growing Chinese middle class is the wet dream of most consumer goods companies).

From 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.

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.