China: Down, but Not Out

As many of you know, when it comes to long term investments, I'm a big fan of China. In late 2007, China equity valuations were getting frothy and it was only a matter of time until there was a correction. I never imagined that the correction would be quite this big. At its peak in 2007, the MSCI China Index was trading at 32x earnings and 5.3x book. Today the Index is trading around 10x earnings and 1.6x book. I am hesitant to call China an outright "Buy," but if the earnings multiple gets down to 7 or 8 and the book multiple approaches 1, I'll likely begin adding to my position. As you can see, China is trading at quite a discount to the U.S. equity market (currently demanding a forward P/E of 14). Below I have identified some of the pros and cons to an investment in China.

Pros:

• Population of 1.3 Billion with a burgeoning Middle Class
• Household debt amounts to only 13% of GDP (compared to 100% in the U.S.)
• More conservative banking system, less exposure to toxic assets
• Public Debt is around 18% of GDP (compared to over 60%, and growing, in the U.S.). This allows China to use aggressive fiscal policy in order to stimulate demand.
• Lower commodity prices = Increased purchasing power
  
• Export weakness isn't as a big of a factor as many believe - value-added from domestic exports accounts for only about 18% of GDP (meaning China shouldn't be too reliant on a Western recovery)
  
• Government is spurring consumption through rebates on durable goods (12-13% rebates)
  
• Government has decreased the corporate tax rate from 35% to 25%
• Strong retail sales (up 13.8% YoY over the Lunar New Year Holiday)
  

Cons:

• Accelerating urban unemployment (currently at around 4.3%, but if it reaches around 8%, officials say social unrest could take place)
• Unreliability of Chinese economic data
• If Chinese consumers continue to increase savings, domestic demand will continue to weaken
  
• Nationalized corporations (good in a bad economy, bad in a good economy)

Bottom Line:
Most of China's growth is being stunted by a decline in domestic spending, but given China's pristine public balance sheet, they have the means to implement the necessary stimulus to get the country back on track. The economy is likely to get worse before it gets better (due to rising unemployment), but the stimulus should help kick-start the economy in the second half of '09. If China can become more self-sufficient by spurring internal demand, this global recession may prove to be a blessing in disguise. An economy fueled by internal demand is a powerful force to be reckoned with. Definitely something to keep an eye on.