China Dreams

Roughly three decades ago, rising Japan was a national obsession in the U.S. Business gurus like Peter Drucker were declaring Japan “the most extraordinary success story in all economic history,” and the U.S. was awash in fancy Japanese cars and newfangled electronics. Americans were at once frightened and wowed by the new global power (remember the movie Gung Ho?) and began flooding Japan with hotheaded investments, only to kiss their money goodbye when the country’s speculative bubble burst. Today’s obsession with China is eerily similar. And the parallels to Japanomania (a Far Eastern export economy, a cheap currency and a boom in stocks and real estate) raise questions about whether it all might end in tears.

The answer for investors depends on their time horizon. China is different from Japan. For one thing, its population is 10 times Japan’s. Its demographics are better. And whereas Japan’s growth tumbled after less than a decade of hype, China (whose GDP of $5.9 trillion last year overtook Japan as the world’s second largest economy) has spent the past 30 years growing at nearly double-digit speed and is the world’s biggest exporter. It is also the world’s second largest oil importer and the biggest buyer of iron and copper, luring more resources into its economic engine than any other country in the industrialized world. Indeed, many analysts expect China to overtake the $14.7 trillion U.S. economy in under a decade and to double its size in the next 30 years. Whereas Japan’s middle class was reaching its peak when its economy rivaled the U.S.’s, China’s rising middle class, with its anticipated economic might, has only begun to emerge. For all these reasons, famed investor Anthony Bolton, one of Britain’s most successful fund managers, ditched retirement last year to move to Hong Kong and run a China fund.

(See “Is China Serious about Economic Reform?”)

Of course, for every China bull, there is a bear. Hedge-fund heavyweight Jim Chanos, who predicted the troubles that brought down companies like Enron and Tyco, thinks China is on the verge of collapse. A boom in Chinese bank lending over the past several years has driven up real estate prices and saddled Chinese lenders with a flurry of faulty loans, which, by Chanos’ estimation, could lead to “Dubai times 1,000 — or worse.” China’s undeveloped financial sector has prevented its citizens from growing their savings, and its laborers are becoming weary of paltry wages. That has put upward pressure on the prices of China’s ultra-cheap factory-churned goods and turned up the heat on the country’s authoritarian leaders.

This litany of troubles, combined with rising inflation, oil-price spikes and a sputtering global recovery, have already taken a toll on the market. U.S. stocks, far more diversified and sophisticated, outperformed Chinese stocks by 3 to 1 last year, even though China far outpaced the U.S. in economic growth.

(See pictures from the world financial markets’ meltdown.)

So why would Americans want to invest in China? First off, it all depends on how long you’re willing to stay in the game. Short-term investing in China is risky. But few economists would dispute that in the long term, China’s overall trajectory is up. The regime is savvy enough to realize that to keep up its growth, it has to move away from cranking out cheap stuff sold in Walmart and improve the lot of its consumers. The Communist Party’s latest five-year plan pledges to increase social services and workers’ pay. And this is an autocracy that won’t likely meet the same fate as those in the Middle East; Chinese youth are more intent on improving their lives through economic growth than abrupt political change, which mitigates political risk, says Edmund Harriss, manager of Guinness Atkinson’s China & Hong Kong fund, based in London. Inflation is a problem, but the government is already tightening the spigot and has tackled far worse before. And China — unlike Japan, whose economic collapse came on the heels of a sharp rise in the value of its currency — is letting the yuan appreciate slowly, which keeps its cheap exports chugging while it works to rebalance its economy and put more spending money in the pockets of its people.

Indeed, investing in China is less a matter of deciding whether to do it than figuring out how and where to begin. Already there are over 400 mutual funds with the word China in their name, more than triple the number five years ago. A record number of Chinese companies listed on U.S. stock exchanges last year, though stock picking among firms with a reputation for dodgy accounting is a tricky business. Investing in China’s currency is a possibility, but only in small doses and mostly through oddball schemes, since the yuan is not traded internationally. (TIME columnist Zachary Karabell did find a way into the renminbi via a new offering at the Bank of China. See sidebar.) Broader international funds are also an option, depending on their amount of exposure to China. Many exchange-traded funds try to mimic the country’s overall growth by tracking various indexes, but their track records are thin, and their methods can be shoddy.

(See “Is China Facing a Japanese Future?”)

The best plays on China over the past few years have been the ones that put real China experts to work. To really know if a Chinese company is worth the investment, “you have to visit the factory,” says New York City–based financial adviser Lewis Altfest. There are low-cost China- and Asia-focused mutual funds, such as the Matthews China fund or the Fidelity China Region fund, whose fund managers do just that. And like the Chinese economy, these funds have enjoyed double-digit growth over the past decade. The question is whether they can continue to pull it off. Stellar returns were a lot easier 10 years ago, when the world was less hip to emerging-market growth. Bullish investors have poured nearly $17 billion into Chinese stock funds in the past five years alone, leaving parts of the market overvalued.

It’s also worth remembering that the S&P 500 can be a China play. People in China are getting richer fast, and many of the West’s top companies are already doing a brisk business there. Goldman Sachs predicts the Chinese will be buying a third of the world’s luxury goods in less than a decade. All the better for swanky outfitters like Estée Lauder and Tiffany. More cars were sold in China last year than anywhere else, a much needed boon for U.S. companies such as Goodyear and Ford.

No one knows how fast China will open the floodgates to investors or foreign firms. The People’s Republic still has a heavy hand in its economy, much to the chagrin of U.S. companies operating there. The regime’s handover of power in 2012 — when China’s current Communist Party leaders retire and a new generation takes the helm — is another wild card, which could result in an even bigger role for the state. But in the case of China, at least, the assumption that a state-run economy cannot achieve long-term success may turn out to be wrong. As Goldman Sachs’ Jim O’Neill warns, it would be naive to think that China’s model is doomed simply because it is not the American way.

(See “China Takes on the World.”)

Indeed, China often defies expectations. Take the government’s recent announcement that it wants to slow growth to make room for more pressing priorities, like the environment, social welfare and corruption. Not only does this fly in the face of Western economic norms; it separates China from the ranks of other emerging markets. Addressing those other priorities will require patience. But when thinking about a nearly 4,000-year-old civilization, it’s worth taking the long view.

See photos of the making of modern China.

See how America can find a way forward on China relations.