Interest rate hike nudges China toward market-focused economy
By Andrew Countryman, Tribune staff reporter. Tribune staff reporters James P. Miller, John Schmeltzer and Barbara Rose contributed to this report
Published November 7, 2004
China's surprise decision to raise interest rates may represent a dramatic shift in how the government tries to manage its surging economy, but several experts said it poses little threat to investors, and might even offer them opportunities.
Taking a page out of Federal Reserve Chairman Alan Greenspan's book, the Chinese central bank pushed rates 27 basis points higher late last month, to 5.58 percent, in the face of a surging economy and inflation running at more than 5 percent. A basis point is .01 percent.
It was the first hike in nine years, and analysts expect more to follow.
China captivates countless investors who consider it the ultimate emerging market. They look at a nation with roughly 1.3 billion consumers and an economy advancing 9 percent a year, and see gold.
Rising interest rates, of course, are generally considered a negative for stock investors. But in this case, experts said, an economy moving that quickly can handle a tap on the brakes.
The rate hike, however, does represent an important shift, they said.
"This is only the first rate hike and it sends a signal that the government is willing to use market-based measures of raising interest rates to cool the economy," said Pamela Chan, portfolio manager of Eaton Vance's Greater China Growth Fund.
She said they're shaping up to be "gradual and cautious" increases totaling about 1 percentage point over 12 months.
Some experts anticipate a series of hikes that could raise rates 2 percentage points. But Shanquan Li, a portfolio manager at Oppenheimer Funds and former senior researcher at a Chinese government think tank, said he believes the next move is further off than people expect.
"China needs the growth," Li said. "The central government didn't want to dramatically slow the economy. That's obvious."
He said higher rates might slow the pace of new development, but existing projects and consumer appetites aren't likely to be seriously threatened.
"The basic demand is still there. It's very strong," he said.
Indeed, because of the government's central role in managing the economy in China, analysts said the key to slowing its growth lies there.
Guang Yang, senior vice president and lead portfolio manager of the Templeton Global Opportunities Trust, said the government has already taken steps to slow investment in areas with too much capacity and redirect it toward electricity and transportation to reduce bottlenecks to growth.
Having government-run banks simply cut lending sharply overall would be "much more effective than an interest rate hike," he said, in part because businesses' return on capital is running at 10 percent to 12 percent.
"If they can borrow at 5 or 6 percent, that's still a pretty good deal for them," Yang said.
Indirect but influential contact
For investors, exposure to China is often indirect, through companies that supply it with capital goods such as information technology and raw materials and equipment for construction.
China's rapid financial surge, for example, has played a prominent role in the powerful upturn that Peoria-based Caterpillar has seen over the past 12 months.
Chinese entities have been buying Caterpillar's heavy equipment to construct new factories, boost mine production, and expand highway and rail infrastructure.
In addition, China's hunger for steel, coal and other raw materials has driven up commodity prices, spurring increased activity at iron-ore, coal and copper-mining sites, and fueling a burst of new orders for Caterpillar earthmovers and other mining equipment.
Caterpillar spokeswoman Kelly Wojda said the company has been affected in the past six months by previous government efforts to slow the economy, particularly curbs in construction project spending, although that has been offset by growth in other areas.
"Long term, we're still very positive about the growth opportunity China represents," Wojda said. "If these short-term actions can bring the growth rate to a level the Chinese economy can sustain, that's a positive for our goals in China."
Other area companies with significant operations in China run the gamut from consumer-focused firms like Oak Brook-based McDonald's Corp. and Chicago-based Wm. Wrigley Jr. Co. to high-tech firms such as Schaumburg-based Motorola Inc. and Lisle-based Molex Inc.
McDonald's has launched an ambitious expansion in China, and a spokeswoman said it would not be affected by the interest rate hike.
"We're very much focused on moving forward with having 1,000 restaurants by the year 2008, which is the year the Olympics are in Beijing," said Anna Rozenich. Currently, McDonald's operates about 600 restaurants in China.
Ten percent of Motorola's sales last year were in China, where the company long has been one of the largest multinational investors and the country's leading maker of cell phones.
Rate hikes are aimed more at capital-intensive industries and are not likely to affect China's surging consumer electronics market, which is growing by more than 20 percent annually, said Cynthia Meng, consultant with market research firm Adventis Inc.
"The driver for consumer demand is coming from the increase in levels of wealth, modernization and urbanization," Meng said.
Asia has been a significant driver of electronic components manufacturer Molex's sales, for example, with sales in its Far East South region, which includes most of China, jumping 33 percent in its recently completed fiscal first quarter. That region's revenue of $190 million topped the $177 million in its Americas region.
Wrigley cited sales growth in China for helping to drive a 23 percent increase in Asian sales in its third quarter.
For other companies, the benefits of Chinese economic growth are less direct. In an October regulatory filing, for example, Chicago-based jetmaker Boeing Co. cited "strong economic growth" in the U.S. and China, in particular, for helping to improve global air traffic levels.
Key to commodities
Many experts have looked to commodities as particularly vulnerable to a Chinese economic slowdown. China has a voracious appetite for raw materials, consuming an estimated one-third of global steel and coal production, about one-fifth of copper and more than 40 percent of cement.
"Those are very meaningful numbers," Yang said.
After the announcement of the rate hike, shares of copper giant Phelps Dodge dropped almost 4 percent in a day, while aluminum giant Alcoa took a nearly 3 percent one-day hit. Alcoa shares have yet to close above their pre-hike level.
David Cooley, senior director of international equity investment at Armada Funds, said the situation may be more negative for investors with indirect exposure through investments in Australia and Canada--two resource-rich exporters to China--or in Japan's capital goods sectors, such as information technology and machine tools.
"It hangs a little bit of a cloud on the horizon that's going to be pretty hard to blow away," Cooley said.
But economist Donald Straszheim, president of Straszheim Global Advisers, who closely follows China, said the fear of a slowdown choking off demand for basic commodities is probably overblown.
He still predicts strong demand for copper, steel, aluminum, cement and other materials, and he sees buying opportunities if prices continue to drop when rates go up.
Li said many suppliers have three- to five-year deals that China is not going to want to terminate. "They have long-term partners, long-term contracts."
Chan, however, said she is cautious about many Chinese companies in the cement, chemical and metals sectors that are highly leveraged.
She and others point to real estate as being potentially vulnerable to rate hikes.
"The office and commercial real estate markets are more at risk due to overinvestment in the past few years," Chan said, but she believes increased demand and easing of an oversupply have bolstered the residential market.
Policy trend a positive
Several economists said the true importance of the rate hike is the use of monetary policy to influence the economy.
"There is a lot of significance that they're getting more market-oriented, and that is the biggest impact of any," Cooley said. "I think this is a nudge in the right direction toward being a free-market economy."
Li said, "The transition of economic policy decision-making is very significant."
But in an economy still so heavily managed by the government, Straszheim said, "you can't expect these rate hikes to have all that much effect in that portion of the economy.
"This is more of a symbolic tightening measure than it is a measure that's really going to slow the economy a great deal," he said.
Going forward, several analysts said they expect growth to slow only a percentage point or so from the current 9 percent.
"Seven to 8 percent is still a very attractive number compared to other developed markets," Yang said. "Overall, I think there's still very strong fundamental demand."
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