Email from Legend Capital in Hong Kong

[HenryTo]

Following is an email that I got from Ms. Sophia Yan, second-in-command at Legend Capital, a research/investment advisory/VC firm that specializes in Chinese investments but are based in Hong Kong. Following is her email in response to the following BCA daily commentary on China:

http://www.bankcreditanalyst.com/public/story.asp?pre=PRE-20050127.GIF

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I prefer the views of Gavekal to BCA which is less specific and simply descriptive. I don' t agree with BCA's bullishness in China because the biggest capitalization stocks in H share index are the China oil stocks, which have been enjoying a rising oil price YOY.

I found the current sentiment is extremely bullish re: China which makes me feel a bit nervous. E.g., the biggest steel plant in the world was recently set up in China. Nearly all the big foreign car manufacturers have all set up shop in China during the past couple of years. These investments will lead to oversupply in the short term and should be deflationary to such products to the rest of the world. Another example is the heavy oversubscription of an IPO of a China white wine manufacturer called Dynasty. The investor luncheon was so crowded and I could not find a seat for myself!!

China has been developing over the last 26 years since 1978 but the ups and downs in between can kill. I am very caustious towards Chinese stocks over the next 6 to 9 months and I think there will be a sharp correction given the fact that Chinese shares has been the best performing stock category since the global correction after 2001.9.11

Current problems facing the Chinese economy is a further slow down of fixed asset investment, which was up 40% in 2003 and 25% in 2004. This sector is definitely in an overheating condition and has not cooled down sufficiently. Fixed asset investment accounts for more than 40 % of GDP now but consumption cannot replace investment as a growth driver overnight due to the low purchasing power of the rural population. The Chinese consumer market is at the moment a market of around 300 to 400 mn of urban/coastal population but not yet a 1.3 bn market yet.

Moreover, China is now in a classical stage of an economic bottleneck. She is facing a shortage of electricity, transportation capacity and labour!!

The shortage of labour is intriguing to me because it is not a shortage in an absolute sense with 1.3 bn population but it is a shortage at the current wage level which has remained the same for the past 10 years. Five years ago the Chinese government spent a lot of money to improve infrastructure in the wild west and subsequently, private industrial investment poured in and workers subsequently refused to work in the coast industrial belt. They preferred to work near their homes. Coastal employers thus have to pay up in order to attract workers to stay. The Chinese government is now doing the same in the north eastern region of China which used to be its heavy industrial base. So five years down the road northern eastern labour will not be coming to the southern coastal industrial belt. Coupled with the one child policy since 1980 and a mismatch of education and skills required. Some friends from China suggested that the labour shortage is structural and may last for 10 years.

The above will mean a rising labour cost and should be negative to the H share index - which may actually be forming a double top technically and may suffer badly from a reversal of global liquidity - possibly due to a strengthening of the USD in 2005. Non-USD assets such as Aussie, Euro should also face the same blow.

(Gavekal had produced a very good piece on this topic)

But of course, when there is a crisis there will be an opportunity. After the imminent shake out and Chinese shares become undervalued again, there will be a lot of investment opportunities. I think consumption shares with a brandname and certain Chinese tech plays will emerge to be the winners. The former will benefit from a rising consumption power while the latter reveals China's significant cost advangtage in the trained labour sectors. Chinese engineers and programmers are really cheap. Sectors to be avoided will be the ones with overcapacity such as iron and steel, autos, cement etc.