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How to Profit From China's "Hot Money" Investment Strategy

Stock-Markets / China Stocks Jul 17, 2009 - 12:21 PM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes: China made headlines around the world this week when it revealed that its foreign reserves had eclipsed the $2 trillion market for the first time, rising by a record $178 billion in the second quarter – thanks to a flood of “hot money” that flowed into the world’s most promising economy.



But the “hottest” investment money may soon be flowing from China back into the United States – thanks to an accompanying development that didn’t even make the news (let alone headlines) here in this country. This will translate into windfall profits for U.S. investors with holdings in the “right” kinds of companies, and in the long run should bolster the U.S. dollar.

This other, below-the-radar development was China’s decision to relax the rules that guide its company’s overseas investments. In a clear attempt to boost investments beyond its borders, China has changed some of its rules to make it easier for its companies to make foreign investments, and to use foreign financing for those deals.

Why China’s “Hot Money” is Headed Our Way

The new rules – which take effect Aug. 1 – will make it lots simpler for China-based firms to make major investments here in the United States – no small deal at a time when credit and other forms of capital remain scarce. This development is especially bullish for U.S. investors holding stocks in U.S. companies involved in such industries as oil, gold, natural resources and high technology, as well as companies that possess strong global brands, since these are precisely the kinds of companies China-based firms will be on the prowl for.

Once the rules take effect, Chinese companies will no longer have to report foreign currency transactions, or go through China’s central bank. Instead, these firms will be able to buy foreign currencies in whatever market they happen to be operating in, and will even be able to borrow from the banks in those markets as a way of fueling direct overseas expansion. Lastly, China-based firms doing business abroad will no longer have to repatriate assets, meaning they will be able to take their foreign profits and directly reinvest them overseas.

China is making this bold move for a number of reasons. Obviously, Chinese leaders want their country’s economic expansion to continue unabated, and these investments will provide China and its companies with access to leading products, cutting-edge technologies and badly needed natural resources – much of it at bargain prices, since many of the top target markets are mired in recession.

But a key incentive for these liberalized rules has to do with China’s aforementioned foreign currency reserves, an estimated 70% of which are held in dollars or dollar-denominated assets. By allowing its companies to make direct investments, and by no longer forcing them to repatriate foreign currencies, China believes its dollar-based holdings won’t keep rising at an accelerating rate.

At first blush, that sounds like it would be bad for the greenback. Surprisingly, the reality will be quite the opposite.

Defusing the “Nuclear Option”

For many investors concerned about the outlook for the U.S. dollar, the threat that China will stop buying U.S. Treasuries – or even worse, might “dump” the U.S. government debt – has provided fodder for something known as the “Chinese Nuclear Option.” The basic premise is this: China, fed up with the United States’ spendthrift ways, and overly liberal uses of debt, finally gets fed up with the losses it’s been taking on its U.S. investments and opts to dump both U.S. dollars and U.S. debt – a move that crashes the U.S. economy.

This scenario is a popular one within the conspiracy crowd. The doom-and-boom merchants also seem to like it.

But what these folks don’t understand is this: China can’t stop buying U.S. Treasuries, and can’t cease to accumulate U.S. greenbacks – even if its leaders wanted to.

In fact, based on my 20 years of experience in the region, I expect China to accelerate its Treasury purchases throughout the rest of this year and into 2010, which will come as a shock to all those expecting U.S. Treasury sales to crater. But I also expect the Red Dragon to take a few other steps that also will catch most western observers by surprise.

Before I get to that though, let’s talk about why China’s not going to start dumping dollars anytime soon and why the so-called “nuclear option” is actually a benign threat:

  • China needs our trade and the money that comes with it – so you can expect reserves to continue to climb. In fact, my guess is that we may see Chinese currency reserves rise to as much as $3 trillion less than 36 months from now – and that’s even after China’s economic leaders take steps to slow down the pace of growth it the country’s foreign reserves!
  • China finds itself the unanticipated position of needing America. And America of needing China. Many people may not like it, but that’s a different story. Even if the Chinese wanted to stop buying our bonds and trading in our dollars, there is not another currency on the planet with enough liquidity at present to absorb the overflow. The euro came close a few years ago, before it ultimately failed. And that means that China is stuck with Uncle Sam – and Uncle Sam with China.
  • Thanks to the record inflows in the second quarter, China now has $2.13 trillion in currency reserves, some 70% of which is dollar-denominated. That means that China can no longer afford to see the U.S. dollar dumped. If that happened, China’s economic future would be put at risk – something that Beijing is not about to let happen. Indeed, China must continue to support the greenback, or risk a complete meltdown. So it will find a way to “deal” with the growing U.S. debt load. At the very least, we may well see China at least maintain its current pace of Treasury-debt purchases; and it may well step up its Treasury purchases for the rest of this year and throughout 2010.

China: The Planet’s Most Promising Profit Play?

Just this week, China reported that its economy expanded at a faster-than-expected 7.9% for the second quarter – even spawning talk of a “V-shaped” economic rebound. After China’s growth rate was reported to have slowed to 6.1% in the first quarter – the worst showing in a decade – economists said the best investors could hope for for was a “U-shaped” recovery, and perhaps not even that.

Past statistics will now probably be revised higher, a fact that led HSBC Holdings PLC (NYSE ADR: HBC) China economist China economist Qu Hongbin to boost his forecast: He’s now forecasting growth of 8.1% this year, and is forecasting growth of 9.5% in 2010 – up from prior estimates of 7.8% and 8.1%, respectively. China’s recovery will be broad and deep, and will be due to inherent health, and not just because of the $586 billion economic stimululs package the country announced last November – a stimulus we said at the time was designed as much to benefit the West as it was to boost China’s domestic health.

It now appears that assessment was completely correct.

For folks who think China’s all about control, these loosened foreign-investment rules and faster-than-anticipated growth should serve as a real eye-opener. China is a communist country in name only. Driven by an intense need to maintain its growth and the desire to become a respected member of the global Tier One fraternity, China is rapidly becoming one of the world’s most effective and efficient capitalists.

The new financing rules will help China build on its recent successes in at least three key ways, by:

  • Enabling China-based firms diversify abroad, making them more globally competitive, and much more flexible in terms of the opportunities available to them. I see this as an extension of something I said way back in 2007, when I mentioned that Chinese companies – in the truest Confucian tradition – would view the credit crisis as an opportunity to be capitalized upon rather than a burden to be endured. Investors can China-led and funded mergers and acquisitions to jump significantly in the next 24 months. Investors who take the correct positions ahead of time can expect to profit handsomely – in both the near-term and over the long haul.
  • Helping Beijing balance the needs for constant internal growth against the ever-growing international reserves requirements it now sees developing around an increasingly fragile U.S. dollar. Expect Beijing to be especially active in the use of the multi-country-swap agreements it recently put in place as a means to this end.
  • Creating ways to help China offset the economic risks associated with its concentrated dollar holdings. Investors can expect to see escalating pressure on the World Bank to create special drawing rights and/or China-led currency equivalents as this situation develops further.

There is no doubt that some people will view what I have told you today with fear. Others will greet this news with hostility. Both reactions are to be expected in an era of increasingly protective legislation emanating from one of the worst financial crises on record. But I also think these are both the wrong viewpoints to embrace.

You see, I smell opportunity.

As noted above, the relaxation or outright removal of these foreign-investment curbs by China is simply another strategy designed to slow the accumulation of dollar-denominated reserves and to reduce the risks associated with the shaky greenback.

But China-based companies will go on a shopping spree, seeking out the world’s biggest bargains. And right now, some of the biggest markdowns can be found in the U.S. market. The bottom line is this: In making these moves, China has essentially installed a big neon arrow that tells us where the hot money is headed – specifically, right into companies involved with oil, commodities and currencies. Companies with high-tech know-how will be prime takeover targets.

And, given the growing affinity China’s emerging consumer class has with top global brands, companies that control the world’s most-popular brands will be the recipients of capital infusions – if not outright buyout offers.

Oil and commodities are a literal no-brainer. If China wants to slow down the accumulation of reserves in U.S. dollars, and there isn’t another currency that’s widely held enough and liquid enough to take the greenback’s place, natural resources and hard assets are the most logical place to be.  We’ve been on this trend for some time, now.

The same holds true for currencies. History demonstrates time and again that strong economies produce strong currencies. From the Romans to the Babylonians in ancient times, to the English, French and Spanish in the Age of Exploration, and even to the dollar and yen in more-recent decades past, the strongest currencies always belonged to the countries with the strongest economies, and with the strongest assets, to boot.

Right now, that all describes China.

To position yourself for profit, consider starting with one of EverBank’s WorldCurrency Access Deposit Accounts – for Chinese renminbi. Not only is it the only deposit account of its kind in the United States, it’s also insured by the Federal Deposit Insurance Corp. (FDIC). As another possible profit play, consider establishing a small position in the WisdomTree Dreyfus Chinese Yuan Fund ETF (NYSE: CYB). As an exchange-traded fund, or ETF, that tracks the Chinese yuan, it’s easy to trade and even easier to own if you don’t want to hassle with direct currency ownership.

Investments such as this one benefit from strong growth backdropped by a system of stability.
Expect both.

Zhou Xiaochuan, governor of the People’s Bank of China – that country’s version of the U.S. Federal Reserve – recently ruled out any sudden shifts in China’s foreign-currency-reserves-management programs, telling Bloomberg News that his country’s central bank will continue to be invested to “ensure liquidity, safety and returns.”

China will be a big beneficiary from such a stable strategy – as will investors who understand these new rules and apportion their capital accordingly.

[Editor's Note: Fifteen trades. All profitable. Since launching his Geiger Indextrading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 14 for 14, meaning he's closed every single one of his trades at a profit. And he did this during one of the most volatile periods for the U.S. stock market since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.]

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