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The China Colossus

The world is in the process of a paradigm shift. China has 1.2 billion people and sometime in the next few decades they will undoubtedly become the biggest economy in the world. The United States is the world's biggest economy at $11 trillion while China is a mere $1.1 trillion economy, bigger than Canada but no where near the economic colossus it appears destined to become. When you combine China's 1.2 billion people with India's 1 billion plus other Asian economies you have the makings of a potential massive trading block that could eventually overwhelm the Western economies in North America and Europe.

But the size of the Chinese economy is misleading. As reported in The Economist's World in figures and in an article in Strategic Investment by Dr. Marc Faber October 1, 2003 China is already the world's largest producer of cereal, meats, fruits, vegetables, rice, zinc, tin, cotton and in manufacturing products including textiles, footwear, garments, steel, refrigerators, TV's, radios, toys, office products and motorcycles as just a few. They are second in numerous others.

While the reported GDP of China is only $1.2 trillion it is suspected that it is even larger as numerous service type industries we take for granted are underreported or not reported at all. On a Purchasing Power Parity (PPP) (PPP tries to equalize a basket of goods in one country with a basket of goods in another country) the GDP of China is almost $6 trillion or more than half the size of the USA. On a GDP per capita China is obviously no where near the US's level and while China could surpass the US GDP sometime in the next few decades it would take even longer to equal GDP per capita.

China, despite being one of the fastest growing economies in the world over the past decade is still considered an emerging economy. GDP grew by 6.7% in the latest quarter and Industrial Production grew at one of the fastest paces in the world. They enjoy a small trade surplus with the world but with the United States it is quite large at $120 billion. Growing imports, particularly a wide range of commodities, is causing the trade surplus to narrow and some expect it could even go negative by next year. Foreign reserves are amongst the highest of any of the world's emerging economies and as a result they are huge buyers of US Treasuries and mortgage securities. This has actually helped prop up the US Dollar despite the huge disparity in the trade surplus.

China bashing has become popular particularly in the United States but also in Japan. The relocation of manufacturing jobs has been going on now for years but now even service sector jobs are fleeing to low cost countries such as China and India where there is a growing well educated population that speaks English. Over the past few years the US has lost upwards of three million jobs many of them to China. But the complaints of these job losses holds a two edged sword as it is US companies themselves that are firing workers at home then opening up shop in China and other low cost countries.

Japan has also gotten into the game of China bashing as they are being blamed for taking manufacturing jobs away there as well and importing deflation through mass cheap imports. Everyone even the Europeans are complaining about the pegged Yuan to the US Dollar and their ongoing refusal to revalue their currency upward. In the US Congress bills are being prepared to raise tariffs against China and Europe is also considering protectionist measures.

China's fixed currency has been a two edged sword. While causing dislocations outside the country and taking jobs away they raise the spectre of global protectionism if they leave their currency as it. It is clearly undervalued at these fixed levels of US$1=Yuan 8.28. By preventing the Yuan from rising they have allowed excess liquidity build up in the economy causing a bubble not dissimilar to Japan in the late 1980's and the US in the late 1990's. By revaluing upwards they would ease some global trade tensions even if it wouldn't stem the shift of jobs out of the rich western economies.

But revaluing their currency upward before the Chinese are ready to join the world of floating currencies could cause other problems not the least of which is curtailing the growing Chinese behemoth, raising inflation and risk destabilizing their shaky banking system which like Japan is in bad need of reform and laden with loan losses.

China has a huge disparity as well between the growing educated urban population and the still much larger rural population. The disparity between the wages of urban China and rural China is widening not narrowing. The rural population is migrating to the cities putting pressure on the cities that could prove to be very disruptive. The growing knowledge and education of the population is continuing to cause problems by demanding reforms and easing of freedoms from the former dictatorial communist regime that is still accused of human rights abuses by a host of world bodies.

And China plays a major role in world politics being front and centre in dealing with the North Korean crisis and has played at times a major role in the United Nations. It opposed the US invasion of Iraq and to many old cold war warriors this still leaves China on the opposite side despite the closer trade relations and the necessity to recognize China as a major globe player. Taiwan remains a sore spot but nothing is liable to change much there. China remains a formidable foe with a nuclear arsenal and the world's largest army. And they have now fully entered the space age recently putting a man in space returning him safely to earth.

But the real sore spot for China with the US remains the undervalued Yuan. But revaluing it upward is not necessarily positive for the US. While there might be some improvement in US exports the real problem as we noted above is the massive transfer of manufacturing and some service jobs from the US to China. Many of the US companies benefit from this and will be reluctant to support an upward revision in the Yuan. As well with China holding huge reserves of US Treasuries and mortgage bonds there could be upward pressure on interest rates to mitigate the fall in the US$ and as a result the Chinese would be losing twice on both falling bond prices and a rising Yuan. They could cut down their purchases of US securities or outright sell them.

A sector that would benefit from a rising Yuan and falling US$ is the gold sector. The Chinese are looking to add to their current low gold reserves. Indeed there has been musings that the Bank of China wants to hold proportional to their population what the US holds in gold reserves. This would require holdings of upwards of 12000 tonnes. As well the Chinese are opening the gold market to the population. There is considerable pent up demand in a population of 1.2 billion.

Canadian companies of course are all over China in banking, insurance, technology, telecommunications, oil and gas and mining to name but a few. We would love to mention all of the Canadian companies (and mutual funds that are either Asia or China oriented) that are in China but that is impossible. But one thing we have noted about Canadian companies in China, or at least those that are more or less dependent on their China operations, is that the stocks in some instances have taken off into the stratosphere. We want to mention a few and leave you with a chart.

The chart is a weekly one of the China Fund (CHN-NYSE) and the Greater China Fund (GCH-NYSE). These two closed end funds are both trading at substantial 20% plus premiums to Net Asset Value (NAV). Given the sharp rise in these stocks over the past several weeks (CHN up 150%, GCH up 95% in 2003) we can only say that the China based stocks may be becoming the new internet bubble. This is not to say that it is due for a big fall but our preference here would be to see a correction as the moves have been too far too fast and therefore they are vulnerable.

The same can be said for the Canadian stocks we are mentioning below. All of these companies are either in mining or oil and gas. The mining plays are Ivanhoe Mines Ltd. (IVN-TSX) (www.ivanhomines.com, 604-688-5755), Pacific Minerals Inc. (PMX-TSXV) (www.pacificminerals.com, 604-609-0598), QGX Ltd. (QGX-TSXV) (www.qgxgold.com, 905-689-9442) and Entrée Gold Inc. (ETG-TSXV) (604-687-4777). The Oil and gas play is Ivanhoe Energy (IE-TSX) (www.invanhoe-energy.com, 604-688-8323).

Barrick Gold recently took a position in QGX. All of the miners are exploring for gold, copper and other base metals in a resource rich region in the more sparsely populated regions of Mongolia. The result of all of this activity has been to send all of these stocks into the stratosphere. For that reason alone it is difficult to recommend them as buys and if you own them use stops. Our best pick of the bunch might be Ivanhoe Energy as it has exhibited more strength with a number of ongoing corrections in the uptrend. But for the most part they look like the chart of the China Fund and for that reason we recommend caution. But remember that there is a growing huge demand for metals coming from China and there are insufficient world resources to satisfy these demands.

China has been in on the front page a number of times lately. It should be because it does have the potential to become a Far East powerhouse possibly even supplanting Japan. Trouble is for the Western nations it is an old enemy and it is still in the grip of the Communist party and its secretive ways. The result is that it is not a close ally like Japan and it therefore adds an element of considerably higher risk. For investors they should take a close look at this growing colossus but be mindful of the risks.

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