The Birth of the Chinese Middle Class and its Implications

The creation of a thriving domestic economy attests to the success of the government's efforts over the last twenty years. Allowing people to work for personal gain has unleashed the entrepreneurial drive and capacity for hard work and thrift that characterizes those Chinese in Hong Kong and overseas. The result is both an incredibly dynamic and competitive domestic marketplace and one that is seeing the emergence of an increasingly affluent middle class. It is this group that will ensure the long-term success of China's transition to a market model and will also very likely in time establish China as the world's largest economy. If we were to define the middle class in China we would characterize it as consisting of college educated white-collar professionals with household wealth of around $36,000. When taking into account the relative costs of goods and services in China combined with the range of spending options open to an individual, this represents material spending power. In 1978 the number of households that could be characterized as middle class numbered 8 million, or 24 million people – the same number as in 1952. By 1991 the number had more than doubled to 18.5 million households and by 1999 had more than doubled again to 39 million. In 2002 the Chinese Academy of Social Sciences estimated the number of middle class households to number 50 million, or By 2010 the number is expected to reach 100 million households or 240-300 million people – equivalent to the size of the population of the United States. This would represent 23% of China's population which would be similar to the U.S. in the 1950's and Japan in the mid-1970's.

These are educated people, with talent in the world’s fastest growing region and they have aspirations. A significant number of these people ate now homeowners. Over the last five years the government has sold some 70% of public housing at deep discounts. This has had the effect of boosting households’ net worth by some 30% (or $350 billion) And has also raised home-ownership rates from 35% to 70% in many cities. Consumption patterns reflect all these changes. Ownership of goods such as radios, televisions, and refrigerators surpassed the U.S., in absolute terms, in the early 1990’s.  However, increased wealth and homeownership saw a surge in ownership of mobile phones and fixed lines which surpassed the U.S. in 2001 and 2002, respectively.

Looking ahead we are now expecting higher growth in air travel (105 in China vs. 1% in the U.S.), in car ownership (growing 10% in 2005 and accelerating from there) and personal computer ownership is expected to increase over 20% a year to 2010 to 250 million computer. The increasing level of domestic activity has a number of implications. First, it has the effect of boosting national wealth and creating a self-sustaining cycle of saving and investment. Second, increased activity will further enlarge the middle class which will underpin the economy in the long term, just as it does in the developed world. And third, a vibrant consumer economy will reduce the magnitude of China’s economic volatility which hitherto relied on a single engine of government investment. Finally, it is hoped that the wealth created will find its way into the western provinces of China where the real hardship is. Although incomes here have risen, the income gap with the eastern provinces has never been wider and this is now a pressing issue.

The Yuan’s Worth

There has been  endless speculations about when and how the Chinese currency, the yuan, will be adopted to the world financial markets.

Chinese officials repeatedly have said they intend to move to a more market-based exchange rate, but insist this would occur only after essential financial and economic reforms are implemented.

 Right now, China’s yuan is pegged at 8.28 to the dollar. Critics, especially U.S. manufacturers, have said the rate offers Chinese exporters a significant competitive advantage.

Treasury Secretary, John Snow has put significant pressure on the Chinese to let the yuan float.

Our assumption is that Washington can press the Chinese for a certain degree only. However once Beijing have enough, they may harden the line and flex the political muscle that’s been on the back on the strong economy. This would be in turn negative in effect on both sides.

Chinese ADRs under pressure from investor uncertainty

The stock market has been choppy so far this year. Reasons?

It is really the same old stuff we’ve been talking about for weeks —earnings have been good, inflation reports have been bad, and we continue to see signs of an economy slowdown. Fears over stagnation continue to grip the market.  The only “new” story is one that many investors don’t like to see after getting loaded up on oil stocks this year. Oil prices started to ease and fall back to the $50 range. Obviously, in case oil remains in that range, it will help ease inflation concerns. But as we’ve seen too many times from the volatility of the energy market, it will take much lower prices before the market tends to believe the rally in energy is finished.

As consumer sentiment weakened in April, according to research from the University of Michigan, major U.S. indices have fallen with it.

Now, heads been turned at the U.S. economy as it grew at a 3.1% annual rate during the first three months of the year, the slowest in two years, as inflation inched higher. The slowing growth and rising prices revived talk of stagnation, a troubling economic condition that combines the worst of both worlds and defies easy solutions.

And if it wasn’t enough, investors are still remembering the lessons learnt from 51Job Inc.: the moral hazard. We can testify that moral hazard is not only a theoretical concern but also a practical and persistent hindrance to long-term investment in the Asian region.  Moral hazard effects Asia’s markets in many ways—and ironically, nor is it always to investors’ detriment, at least at first glance. Indeed, in some cases of moral hazard, investors may be “bailed out” of their worst mistakes. However, the heart of the problem is that moral hazard encourages reckless and wasteful use of capital; this raises the cost of doing business, and introduces volatility into the markets and economies that might not otherwise be present. The most common form of moral hazard in Asia arises when governments offer various forms of loss mitigation to individuals, companies and investors who have made poor economic decisions.

Despite all these uncertainties, we believe future growth is coming from Asia and unless we know what to invest in, we may miss the boat.

First quarter performance of recommended Chinese ADRs

Research reports are good only if investors can benefit from it. Keeping this old wisdom in mind, let’s see how did our “Mainland China for Investors, 2004 Q4” research measured up so far.

For those who bought it, it was worthwhile. We rated four Chinese ADRs among thirty to STRONG BUY.

Measuring up against the DJIA since the release of the report in April 7th, the best one is ahead by 10%. The other three are ahead by 9%, -0.5% and –2%, respectively.

In other words, the four stocks we recommended are ahead of the market by 4% on average since inception!

The chart on the bottom shows the relative performance of those stocks. The red tape is the DJIA.

The other stock we released to the public is our stock of the month for May: PetroChina Company Limited(PTR). The article above this one explains from another angle why we think PetroChina is a good investment. We were reluctant to pick a highly volatile Chinese internet stock to be a stock of the month, however it would have paid off better so far.

But remember. The long term will reward the nimble growers and we believe those companies we picked will continue to deliver quality results coupled with investors’ appreciation.

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