I've written several columns on China over the past several years with the common theme being to avoid it as an investment. This column will be no different, but I will address the current issues unfolding there, what's transpired since I last wrote about China in November, and why it's important for investors to continue to follow it, even though they should not be allocating capital to the country.
In a few days, on March 14, Xi Jinping will celebrate the two-year anniversary of his appointment as the President of the People's Republic of China. Since accepting that role, he's begun a rolling and expanding series of purges of the Communist Party leadership, both civilian and military, which has resulted, so far, in the public claim of 14 generals from the People's Liberation Army (PLA), and 39 members of the national legislature being disciplined for graft and corruption.
It is most likely that this process will extend beyond the national level to the provincial and local governments. It is being pursued now for one primary reason: The country must gain the confidence of foreign investors. If it fails to do so, and very soon, the risks of the economy beginning to slip backwards and into recession and deflation are high.
The reason for this is that the country is now facing what is known as the "middle income trap." I explained the middle income trap situation in general and how it was affecting China shortly after Xi Jinping took office in 2013, in this piece.
What is important for China in the immediate and near future is that the country was already a decade behind schedule in preparing for the challenge of the middle income trap when the global financial crisis of 2008 occurred. When the crisis hit, Xi's predecessor, Hu Jintao, was forced to focus the country's financial resources on offsetting the manufacturing contraction with investment in real estate and infrastructure programs, and shoring up the financial sector.
This robbed the country of both the time and the domestic capital necessary to invest in preparing for the challenge of the middle income trap and has now presented it with a serious economic and financial situation.
A developing country can grow itself from an agrarian economic base into a middle income country by way of infrastructure investment that creates the opportunity for a manufacturing and real estate expansion. However, moving from that into a developed country state, which requires a strong and stable services and technology sector, must be done quickly, as a great leap, and requires effort to be completed successfully.
This concept is especially important in China because the country's original movement from an agrarian economy to a manufacturing one was planned in the late 1950s and expected to occur very quickly, rather than steadily. It was called the "Great Leap Forward," and ended in disaster. At that stage, the decision to "leap" instead of grow the economy was a choice. Moving from manufacturing to technology, however, requires a leap and is not a choice.
The reason this is important now is that making the leap from manufacturing to technology, and becoming a country with a developed economy in the process, requires a stable, strong and growing manufacturing sector from which to make the leap. China is now beginning to lose its manufacturing base to other Asian countries with lower labor costs before they've made the leap to becoming a technology center, which requires massive domestic and foreign investment to be successful.
The result now is that domestic capital necessary to invest in technology is being siphoned away to shore up the manufacturing, real estate, and financial sector and away from technology. This of course worries foreign investors, and in order to offset those concerns the country must do other things to assure the owners of foreign capital to continue to bring capital into the country. Hence, the primary reason for the crackdown on corruption and the easing of foreign investment rules.
The country is desperate to attract foreign capital to prevent getting caught in the middle income trap. In the process it was able to push up the value of the Shanghai Stock Exchange Composite Index about 40% in just the last two months of 2014. Since then, however, it has moved sideways and those returns have not shown up in American Depository Receipts (ADRs) of Chinese companies.
The bottom line for U.S. investors considering investing in China is that the best move is to continue to watch the process unfold. The risks of failure to complete the leap are high.
Get an email alert each time I write an article for Real Money. Click "+Follow" next to my byline on this article.