China Shops While American Investors Drop

By Neeraj Chaudhary, Investment Consultant with Euro Pacific Capital

Unquestionably there has been a significant change in investor sentiment since the crash of 2008. The 50% decline in stock prices in 2008-2009 combined with the financial sector bailouts, the "Flash Crash" of 2010, and the continued demonization of our leading financial institutions, has helped shatter the public's faith in Wall Street. With U.S. stock markets essentially flat over the past 13 years (despite occasional heart-stopping volatility), many investors may have decided that long term equity investments are just no longer worth the risk.

It is important to realize however that this sentiment is not universal. On the other side of the world, the Chinese are showing no such hesitancy. There is mounting evidence to suggest that the Chinese government is in the midst of a voracious buying spree in which they are actively snapping up productive assets around the world. What do they know that we don't?

Data shows that in recent years U.S. investors have pulled money out of stock focused mutual funds and have instead piled into assets that at least appear to be less risky, such as bonds and money markets. When one considers the large unresolved problems that currently overhang the market, such as the Greek debt negotiations, the U.S. elections, and the perennial problems in the Middle East, one can understand the concerns that are keeping them on the sidelines.

Although these investors may be somewhat insulated from market volatility the protection comes at a very high price. With near 0% interest rates, bond investors are consistently losing to inflation (for more on how inflation robs you of your purchasing power. The world's central bankers - led by the Fed - have created a landscape where the shaky ground of the markets is surrounded by the quicksand of deteriorating cash. Investors have seemingly nowhere to run. But China seems undeterred.

A scant 10 years ago, China joined the WTO and began her rise to prominence on the world economic stage. Though today China possesses over $3 trillion in foreign exchange reserves, in 2001 Chinese reserves were estimated at a relatively paltry $200 billion. China has accumulated these funds by keeping her currency cheap, and socking away trade surpluses to the tune of hundreds of billions of dollars per year. And although the stash is growing, the Chinese are not simply sitting on this pile. They have been one of the leading global investors, strategically buying international assets that fit its growth plans. There is every reason to suspect that these trends will continue and accelerate.

For the first few years after her accession to the WTO, China was content to simply pile up foreign exchange reserves, accumulating both US Treasury bonds and agency (Fannie and Freddie) securities. Being risk-averse, and considering them the safest assets in the world, the Chinese were content to earn the lower interest income that these investments offer.

But in the past few years, China began to recognize that their savings were losing value in real terms. Beginning in 2007, they made the strategic decision to protect themselves from inflation by diversifying out of US dollar-denominated financial assets, and into the hard assets she required to grow her economy.

The volume of deals has been breathtaking, and the tempo is accelerating. According to the Heritage Foundation - which publishes the only publicly available, comprehensive dataset of large Chinese investments and contracts worldwide beyond Treasury bonds - Chinese foreign investment has gone off the charts:

• In 2007, Chinese sovereign wealth funds and state-owned enterprises bought stakes in or signed long-term contracts with at least 35 different firms for an investment total of almost $43 billion
• In 2008, the Chinese signed at least 57 deals worth a total of nearly $74 billion
• In 2009 - in the wake of the global financial crisis, and with virtually every investor in the world pulling back and hoarding cash - China signed another 76 deals worth $76 billion
• 2010 was the biggest year by dollar volume: 98 separate transactions totaling $110 billion
• Last year was the biggest year by number of deals, 111 investments for $94 billion

All told, the Chinese have spent $443 billion in nearly 400 separate ventures in every continent around the world. And yet, a simple analysis of these investments reveals a highly concentrated portfolio of holdings; if actions speak louder than words, then Chinese priorities are glaringly obvious. Over the past few years, they have deployed fully 80% of their cash into just four sectors: Energy (the lion's share at $172B or 39% of the total), Metals ($85B or 19%), Transportation ($60B, nearly 14%), and Power ($38B, just under 9%).

By geography, the Chinese first went shopping in Asia, picking up $115B worth of assets in their backyard. Then, choosing to ignore the niceties of international sanctions, the Chinese turned their attention to Africa and the Middle East, where they have plunked down at least $111B of capital. After that, they came to our front door in the Western Hemisphere, to the tune of $88B. Europe is home to $52B of Chinese capital. Australia is the largest single country investment, representing 10% of investment at $43B.

And they're not done yet. According to recent media reports, the Chinese are currently planning to deploy another $300 billion into "aggressive" investments. The trend is crystal clear. While some investors hold out, trying to time the market, China is buying up everything they can get their hands on.

But perhaps even more interesting than what is going on in the glare of the public spotlight is what is being done in private. In addition to its massive disclosed investments, China has begun to execute a parallel strategy in secret. With respect to gold, China kept a large scale purchase program under wraps for a full five years until 2009 when China's State Administration of Foreign Exchange (SAFE) announced it had spent the previous five years buying gold in small lots. Then, in April of that year, they publicly announced that they had acquired 500 tons of gold, and transferred it to the People's Bank of China. At current market prices, this single transaction is valued at nearly $28 billion.

One of the biggest questions that investors should ask themselves now is where the Chinese might decide to spend its considerable sums that continue to languish in debt instruments. There are reasons to expect that large scale purchases by the Chinese could support asset prices in whatever sector they decide to target.

If the trend of publicly disclosed and secret Chinese transactions continues, and if other developing markets holding piles of like valued U.S. treasury debt follow suit, the world could soon wake up to an even more intense kind of shaking, one where prices for agriculture, energy, and precious metals are continually increasing, and investors seeking apparent safety in dollars have instead lost wealth in real terms.

So as U.S. investors drift away from equity and commodity based assets in hopes of finding safety, they should in fact pay more attention to activities of those countries that will likely drive global markets for years to come. China is gearing up for what they hope will be a long period of economic expansion. American investors would be wise to take notice.

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To find out which economies we think stand to benefit from China's expansion, see the latest edition of Euro Pacific's Global Investor Newsletter.

Neeraj Chaudary is an Investment Consultant with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.