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Breaking Out the Good China, Part 4

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Ideas on profiting from Chinese economic growth.

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Editor's Note: This is part 4 in a multi-part series. See also Part 1, Part 2 and Part 3.

The question at hand, assuming that my optimistic view of the short term and long-term growth prospects for the Chinese economy is valid, is how can the American investor best take advantage of this opportunity. A preliminary consideration, however, is to appreciate some of the risks that investing in the Chinese economy entails. Like any other type of investing, higher potential returns should be viewed with an appreciation of the potential risk that those returns will not be achieved – or worse. I offer this admonition because, although I am not a market professional, I have found many ways to lose money over a lengthy legal career. (It's not hard; anyone can do it.)

First, notwithstanding its stellar performance this year, the Chinese stock market has proven itself quite volatile in the recent past. As recently as July 28, 2009, the Shanghai Composite Index fell 5% in one day. According to US press reports, the retrenchment resulted from a concern, reported in the Chinese press, that the Chinese Government had directed the two largest government owned banks to limit the making of loans for the remainder of 2009. In the United States, notwithstanding that the US Government provided hundreds of billions of dollars in "bail out funds" to many financial institutions, it failed to require that the institutions use the money to make loans.

Although the bailout of our financial system appears to have provided stability -- and even returned profitability -- to the critical financial sector (putting aside that it was many of these same institutions that sent the economy spiraling by making unjustifiable bets on derivative instruments, the risks of which were not understood from the bottom level to the top), the disbursement of these taxpayer funds has thus far not done very much to stimulate the economy. (In fact, a US Government study disclosed last week that lending by US banks decreased 2 ½% in the second quarter of 2009 from the first quarter.)

In China, the Government can direct (and has directed) the banks to stimulate the economy by making credit available to private business ventures. But this ability to manage from close to the highest Government levels underscores the susceptibility of the Chinese economy to directional errors in fiscal and financial policy that could much more quickly manifest in negative economic results. That the Chinese policy makers have been correct thus far in avoiding much (but certainly not all) of the economic turmoil that has beset the Western World, does not mean that they will continue to be correct. I, however, would bet on them to be a lot more correct than we are and have been in the US I expect China to use the authority their form of government gives to continue to move forward.

Second, it is possible that the Chinese stock market is already in the "bubble zone". It would be irrational not to consider the possibility of a significant adjustment in the Shanghai Composite Index. Unanticipated events, such as the spread of a more virulent form of swine flu in China this coming Winter (which they will go to great extremes to avoid) could have an impact on market values. I do not incidentally see any international disputes as affecting the Chinese economy. They understand that to some extent, at least, the growth of their economy is tied to friendly relations with the US and I doubt anything will happen to seriously upset the apple cart(s) in that regard.
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No positions in stocks mentioned.

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