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[TTHQ Staff]

BEING STREET SMART ____________________ Sy Harding CHINA AS A BELLWETHER? December 10, 2004. A number of years ago I predicted China was the country most likely to give the U.S. serious competition as a world power in coming years. The response was skepticism (to put it mildly). Communist systems had collapsed around the world and China would obviously continue to be a backward, over-populated nation unable to even feed its own people. Being ignored was China’s bold move to bring about a free-market economy within a communist political system. That it has worked is an understatement. In just a few years China has become a sizable force in international economics and trade. It has become an important producer and consumer of the world’s products, so influential that the energy demands of its booming economy are blamed for the spike up in oil prices of the last two years. Thanks to the world-wide revenues it receives in U.S. dollars, which it currently recycles into U.S. bonds, China is also becoming an important cog in the financing of U.S. debt. China is also flexing its muscles in the area of international trade. It recently finalized an accord with nine other Asian countries aimed at creating the world’s largest free-trade zone, with the goal of decreasing the influence of the U.S. on international trade. Countries involved have a total population of more than two billion people. That’s a lot of consumers. In yet another sign of China’s emergence as an economic power, IBM, which introduced the personal computer to the world in the 1980s, announced this week that it is selling its PC business to Chinese computer company Lenova Ltd, in a $1.7 billion deal. The acquisition boosts Lenova from eighth place to third place among global computer makers. There is no doubt that China has grown to considerable international influence in a relatively short period of time. So much so that economists are concerned that if its booming economy is in a bubble and it should burst, it would have a domino effect on economies around the world. The Chinese government has the same concern and has been taking steps to let some air out of the bubble by raising interest rates. The problem is that central banks, including the U.S. Federal Reserve, do not have a very good record of cooling off overheated economies. They most often overdo it and send economies into recessions. We may be able to get a clue of what will happen to China’s economy by looking at its auto industry. When prosperity comes to an individual, or an entire population, the prosperity usually shows up first in a new car in the driveway. Chinese consumers did not deviate from that pattern. As Chinese consumers earned more and felt more prosperous, auto-sales in China grew dramatically over the last five years, but then became ballistic, growing more than 60% a year in each of 2002 and 2003, and beginning this year with a leap of 40% in the first quarter. To handle the growth, auto-makers built plants and built plants until there are now more than 100 auto plants in China churning out cars to meet the demand. Volkswagen, General Motors, and Honda are the three largest foreign companies with substantial joint venture investments in auto plants in China. However, last spring the Chinese government realized that defaults on car loans were running at more than 50% in the cities of Beijing and Shanghai. It cracked down on easy credit. That sent the auto sector into a tailspin. Not only have auto sales flattened, but profit margins have collapsed. Two years ago profitability for auto-makers in China was a mouth-watering 28% compared to 5% globally. In a recent report Credit Suisse First Boston estimates profitability dropped to 20% last year, and is still falling as manufacturers cut prices to try to move inventories. The Chinese stock market, like the stock markets of non-communist countries, anticipates problems well in advance. So it should not be surprising that the stocks of Chinese auto companies have plunged an average of 40% this year. In those ‘old days’ when the U.S. was in the same stage of its industrial and economic development, when the auto industry was the most important sector of the economy, the auto industry was also a fairly accurate bellwether for the entire economy and stock market. That is, when the auto industry went into a tailspin it almost always pulled the rest of the economy (and stock market) down with it. I believe the problems that have beset the auto industry in China raise the odds that China’s central bank will not be successful in bringing China’s economy in for a soft landing. If I’m right, then the next question will be whether China has really reached the level of international importance that a serious plunge in its economy would spread domino-like around the world. For now that should not be of concern. The market is in its favorable season. It is even in the three months (November, December, and January) that are typically the most positive months within the six-month favorable season. However, next year, as we enter the usually most troublesome first two years of the next Four-Year Presidential Cycle, China’s economy needs to have our attention, perhaps even more than our own economy. Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.