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Should You Buy What China Buys?

It is true that China with its extremely competitive manufacturing sector whose productivity is rising rapidly, and India with its very low cost but increasingly sophisticated service sector have a deflationary impact on the world, which certainly played a part in the "jobless" US recovery since 2001. But, as the industrialization of particularly China is progressing at a breakneck speed, and as real incomes and standard of livings are rising rapidly, China's voracious appetite for certain goods and commodities has over the last two years also inflated some sectors of the global economy through its incremental demand. Moreover, because of the large size of the Chinese economy its growth has by itself become a driver of other countries' economy, as it sucks in imports from them.

China has a steel production capacity of 260 million tones - rising to 330 million tons in 2005, which is larger than the one of the US and Japan combined but it still requires importing steel in order to cover its growing needs. China's domestic reserves of iron ore, however, only cover the production of 90 million tons of steel, fueling a voracious appetite for iron ore from countries as far as Brazil! In 2003, China became also the world's largest user of copper, its share of the world's copper demand having risen from 6% on 1990, to 12% in 2002 and more than 20% presently. Its cement production and own demand is five times the size of the US cement industry! China is also a huge user of pulp and paper. No wonder, since it publishes every day 82 million newspapers compared to 55 million in the US. China has the world largest cellular phone market with 200 million subscribers and is with its 330 million smokers by far the largest consumer of tobacco.

So, should, therefore, investors buy everything China is buying? Before jumping enthusiastically into the "China investment theme" there are a few considerations investors should take into account. China is relatively resource poor and, therefore, its need for industrial commodities will only increase over time, as its industrial production continues to expand and as net capital formation remains strong. Conversely, China has an unlimited supply of labor, as more than 700 million Chinese still live in the countryside and are now gradually moving to the cities in order to be integrated into China's industrial society. Moreover, flushed with foreign exchange reserves and overwhelmed by a tidal wave of foreign portfolio and direct investments it has the necessary capital to fund any capacity expansion for manufactured goods. As a result, there is in China cut throat competition for consumer goods such as TVs, appliances, motorcycles, cars and cellular phones. In 1999, China's domestic cell phone manufacturers had a combined domestic market share of just 3%. Today, 36 domestic manufacturers hold more than 50% of the cell phone market, which has become glutted and where prices are collapsing. The problem with investing in China's huge and rapidly expanding consumer markets is that new capacities can nowadays thanks to instant communication and information as well as very efficient transportation be brought on stream in no time. Does a shortage of DRAMs develop, any quantity of new capacities can be brought on stream within 18 months, which then depress prices once again. Moreover, if a foreign company launches a sophisticated and highly profitable new product in China, you can be sure that almost instantly numerous local Chinese companies will copy the product and flood the market, thus depressing prices and margins. Thus, the manufacturing in China is characterized by vast overcapacities.

The conditions in the commodities markets are very different. Since commodity prices were in a severe bear market since 1980, little new capacity has come on stream in the last few years with the result that the mining capacity utilization rate stands now at 95% or higher. In addition, from the time exploration begins to the time new substantial reserves come into production, a minimum of 7 years elapses. Therefore, production capacities for most industrial commodities cannot be increased meaningfully in the short term, which means that cycles of rising commodity price tend to last 15 to 30 years. So which commodity should one buy given China's lack of resources and existing supply constraints?

Particularly sensitive to industrialization and rising standards of living is the energy market. The industrialization of the North American continent lifted annual per capita consumption of oil from one barrel to close to 30 barrels. In the cases of Japan's industrialization between 1950 and the early 1970s and South Korea's industrial rise between 1965 and 1990, per capita oil consumption rose in both countries from one barrel to 17 barrels. But here is the scary part. Despite its rapid growth, China's per capita consumption of oil is still just a tad north of one barrel of oil per year. Moreover, the entire Asian region with 3,6 billion people or 56% of the world's population and the world's fastest growing economies of China, India and Vietnam still only consumes 20 million barrels of oil per day, which is less than the US consumes with 285 million people. Simply put, the US has a per capita consumption of oil that is more than 12 times larger than Asia, where rising standard of living - the move from bicycle to scooter to car, the proliferation of shopping centers, office complexes, hotels and entertainment venues, increased traveling, and larger homes - and industrial development, as well as rapidly growing populations and urbanization mean that oil demand doubles every six to ten years. Thus, it is doubtful that the oil producers who currently produce 78 million barrels of oil per day, but whose own oil requirements are themselves soaring due to fast population growth among OPEC countries, will be able to accommodate a doubling of Asian oil demand to around 35 to 50 million barrels of oil per day within the next ten years or so without very significant price increases. Investors should, therefore, overweight oil companies with large oil and gas reserves such as Chevron Texaco, British Petroleum and the Russian oil producers but avoid the now popular but expensive Chinese oil stocks, which lack substantial reserves. In addition, as oil prices are likely to surprise on the upside and drive exploration, oil drilling and service companies such as Schlumberger, Halliburton, and Diamond Offshore should be purchased as well.

Compelling are also the fundamentals of food products. Taiwan, South Korea and Hong Kong have per capita consumptions of meat, sugar, coffee, dairy products, wine, beer and fish eight to ten times larger than China. With rising standards of living in China and other Asian countries, food products richer in protein than rice will proliferate and put enormous upward pressure on food prices at a time of declining food production in China. Therefore, investors should also be long a basket of agricultural commodity futures consisting of wheat, corn, sugar, coffee, and orange juice futures, or own large tracts of agricultural land.

But before jumping recklessly into commodity futures, and iron ore, steel, pulp and paper, nickel, aluminum, fertilizer and copper producers investors should be aware that some commodities such as copper and nickel have already had huge price gains, as the "China appetite for resource play" has become well recognized by speculators. Moreover, China's economy is overheating and will, in my opinion, experience a severe slowdown in the near future, which will lead to a commodity inventory liquidation and depress prices temporarily. Moreover, whereas I am a strong believer that a long-term up-cycle for commodities began in 2001, investors should be aware that for individual commodities price cycles are of far shorter duration (see figure below).

I would also like to point out that since all asset classes including commodities, bonds, stocks and real estate rose in price in 2003, it is conceivable that everything will decline in 2004!

Still, the long term fundamentals of commodities, particularly of oil, are by far more compelling than the ones of US equities - this especially since according to several historians including Arnold Toynbee, rising commodity prices have always turned up the war cycle, as the drive to secure the supply of finite and scarce resources intensifies. This should be particularly true for China whose economic Archilles heel is lack of water, food, oil and other industrial commodities!

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