Why We Don't Own 'China'

I think I understand the economics and politics of China pretty well. I was a defense attaché in Myanmar (Burma) in the 1990s and watched as China supported the vilest form of dictatorship, one that enslaved its own people in forced labor and pocketed the money the Chinese paid for the privilege of plundering the natural resources of Myanmar. I continued to follow China as a geopolitical analyst in the US Intelligence Community. And I have continued to research and analyze it from an economic and investment point of view more recently.

Not long ago I sent a note to my friend and colleague in the business, Vivian Lewis, the doyenne of international investing and editor of Global Investing stating why I remain wary of the "incredible opportunity" in China. I wrote:

I...am a bear in the China shop. There is much to marvel at, but the air pollution, water pollution, lack of enough potable water (occasional floods notwithstanding), failure to regulate, failure to know if the distant reporting is accurate, climate of fear if plans are not met, increasing ethnic unrest, and a population that, like all before them, will increasingly expect real wages for real work, all conspire to create an economy that will grow, but in fits and starts. I say they're ready for a fit...

Clearly, China is a growth engine. But so is that cute little tiger cub some idiot bought and took home to his ranch that now roams the property voraciously dining on whatever it chooses. There is no question that China is a growing teenager. Copper is often a proxy for growth in that it is used across so many sectors and industries in construction, infrastructure and manufacturing. Global copper use has fallen in the past decade, but China's voracious appetite has compensated for it.

With any commodity, however, it's all about supply and demand. With demand growing faster than production, China is today the world's leading importer of copper ores, concentrates and refined copper. This fact, however, gives me yet another reason, this one geopolitical, to be wary of buying the "just buy China and sit back and enjoy the ride" mantra.

China's rising dependence on outside sources renders it vulnerable to supply chain risks, prices beyond its ability to manipulate, and the possibility of a backlash against their nation for their heavy-handed strategy of bedding down with the worst of the world's dictators in order to assure their supply. My macro-economic and geopolitical concerns are not limited to copper, but to every commodity every growing nation needs: coal, oil, gas, copper, iron, other industrial metals, aggregate, etc.

No one really understood the depths of the despair that led to the Arab Spring before it was in full flower. The despots China has chosen to deal with could be next. In Zambia and Sudan and the (insert joke here: "Democratic Republic of the") Congo, the autocrats who rule by graft, corruption, kickback, favoritism and raw military might can fall from this earthly vale with one bullet.

Internecine warfare is not unknown in such places. Yet China has placed its future in the hands of these current overlords. In many cases they have alienated the very people who might have enough juice to be the next strongman by currying favor with the current set.

There are the occasional good deals China has made with developed nations like Canada or truly developing nations like Brazil, but mostly they are dealing with the unsavory, the unstable, or the under-developed with poor infrastructure. In addition to the above, Laos, Afghanistan and Ecuador, three other resource-rich areas China is courting, do not exactly have the ability to move product the way a Canada or a Brazil does. And China often makes the situation worse by insisting on importing Chinese labor, depriving the locals of even the subsistence jobs that such investment often brings.

Beijing doesn't have a lot of flexibility or alternatives. As a latecomer to the developed world, they must accept that other nations are vying for these same commodities, as well. But the known reserves in stable nations with steady leadership and good infrastructure are already pretty well sewn up. Yet the Chinese political system cannot risk a slowdown that would ignite social unrest. I don't envy them this task. I take no pleasure in reporting these facts. But just as I thought "the 21st century belongs to Japan" hype of the 1980s was well overblown, and said so at the time, I believe the current "the 21st century belongs to China" hype is equally overblown.

At our firm, to participate in any growth of China without the high level of risk we would take if investing there directly, we simply avoid companies based in China and instead purchase the shares of natural resource companies in nations whose corporate governance and ethics we respect.

Companies in the energy sector, particularly the thermal coal industry and the leaders in liquified natural gas, as well as the industrial metals giants in copper, steel and coking coal all provide something the Chinese desperately need, so we can share in China's growth without ever buying a share of a Chinese company. BHP Billiton (BHP), Vale (VALE), Freeport-McMoran (FCX), Southern Copper Corp. (SCCO), Total (TOT) and BP (BP) all come to mind. That's the way we do it. If, on the other hand, you believe that growth will slow, you might want to consider a position in YXI, the ProShares Short China 25. I would caution that we use such inverse funds only for short periods of time. For the long term, "staying" short simply doesn't pay.

Disclosure: We are currently long TOT and, for the short term only, YXI.

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