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    China Business
     Jan 16, 2008
SPEAKING FREELY
Investing in China: Fool's gold?
By Thomas I Palley

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

Americans tend to disregard history. Henry Ford, founder of the Ford Motor Company, famously declared bluntly, "History is bunk", while US novelist Gore Vidal calls the US "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 US.

One critical factor is China's attitude to foreigners. That attitude is captured by the Great Wall of China, which provides a metaphor for the country'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 had a large trade deficit with China, owing to British demand for tea, and it demanded the right to sell Indian opium in exchange. When China refused, Britain used military force to open China's market, and the ensuing sale of Indian opium resulted in massive addiction.

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 in 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, driving 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.

Thomas I Palley is the founder of the Economics for Democratic and Open Societies Project.

(Copyright 2008, Copyright Thomas I Palley)

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.


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