China's Growth Jumpstarts Neighbors

Robert Hsu, July 01, 2007

In the China Strategy Dispatch that I sent you on June 14, I talked a little bit about Hong Kong and how the city is celebrating the 10th anniversary of its return to China. Up until 1997, Hong Kong was a British colony. Now I want to fill you in on the rest of the story. The events that happened next were significant because they cemented China's status as a rising economic superpower.

The United Kingdom transferred power of Hong Kong to China in a ceremony at midnight on July 1, 1997. The very next day, July 2, marked the start of a two-year-long incident called the "Asian Contagion." Traders waged a speculative attack on Thailand's currency, the baht, and over the next six months, it lost more than 40% of its value against the U.S. dollar.

Other Asian countries in the region with large foreign debts and small foreign reserves also succumbed to speculative attacks against their currencies -- Malaysia, Indonesia, South Korea and the Philippines all followed Thailand's currency collapse. The worst-hit currency was the Indonesian rupiah, which lost nearly 80% of its value over the next 10 months, eventually culminating in the overthrow of the longtime Indonesian dictator Suharto.

This financial crisis in Asia was sparked by a combination of factors such as slowing exports, over-dependence on global speculative capital, rapid capital flight from foreign investors, excessive real estate speculation and general large foreign debt in the region.

The problem even spread to economically powerful Japan. The Land of the Rising Sun took a hit because it was still mired in recession, suffering from the fallout of its speculative bubble during the '80s.

At the time, several of my former colleagues at Goldman Sachs made a killing from short positions in Asian currencies. One trader, my friend Will, shorted the rupiah in a big way and made impressive profits of 150% in 1997. By early 1998, the Asian Contagion had spread throughout the entire Asia Pacific region, with only China, Hong Kong and Taiwan left unscathed. My friend Will then decided to short the Hong Kong dollar and the Taiwan dollar, the only two major currencies still left standing in Asia.

I advised Will not to sell short the currencies of Hong Kong and Taiwan because both central banks, especially Taiwan's, held huge foreign exchange reserves. Also, both Taiwan and Hong Kong had relatively little outstanding foreign debt. I also knew that Mainland China, a country immune to speculative currency attacks, would do everything in its power to defend Hong Kong now that it had been restored to the Motherland.

A big clash developed with hedge funds, Wall Street investment banks and emerging market mutual funds all siding against the central banks of China, Hong Kong and Taiwan. Global speculators shorted both the currencies and stocks of these regions while U.S. and European emerging market funds liquidated their Asian stock portfolios in a hurry.

Then, in a controversial move that was widely criticized by Wall Street, the Hong Kong central bank stepped in and bought $15 billion in stocks at the height of the crisis to defend its falling stock market. Supported by the Chinese central bank's increasingly deep pockets and political resolve, Hong Kong successfully fought off the global speculators. A few years later, the Hong Kong central bank liquidated the stocks it bought during the currency crisis, making over $4 billion in gains. As the second-largest holder of foreign reserves in the world, Taiwan's central bank also managed to emerge from the Asian financial crisis relatively unharmed.

Will got out of the short trade without a profit. He was very impressed by China's growing financial and economic might -- and so was I. More than any other single event, the Chinese central bank's strong performance during the Asian crisis changed my perception of Mainland China. I knew right then, back in 1998, that China's economic emergence was for real, and every serious investor and business executive in the 21st century needed to develop a China strategy.

Looking Towards Future Growth

Fast forward to the present. It's been 10 years since the Asian financial crisis first erupted in Thailand. Led by China's economic miracle, Asia has made a remarkable recovery. Stock markets hit hard during the financial crisis, such as South Korea and Hong Kong, managed big comebacks by riding China's coattails, significantly leapfrogging past the peaks they made before the crisis. The stock markets of Malaysia, Thailand, Singapore, the Philippines and even Indonesia came back strong as well, also trading above the highs made before the crisis.

As a rule of thumb, smaller Asian countries that integrated themselves into China's economic emergence prospered the most. The countries that didn't prosper grew at a much slower rate. Ironically, the only two major Asian stock markets still trading below their old highs in the 1990s are Japan and Taiwan, the two countries that held up relatively well throughout the disaster.

Japan has structural demographic problems holding it back, but Taiwan is a different situation. The Taiwanese stock market has lagged other Asian markets because of its government's reluctance to come to terms with China. Despite this, many Taiwanese companies have significant operations in Mainland China, and they will likely play catch-up to Hong Kong and Shanghai's stock markets, which have experienced huge run-ups over the past two years.

And Taiwan won't be the only economy playing catch-up to China. I believe other Asian peripheral stock markets with exposure to China will also make an effort to catch up to China's massive run.

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Some may interpret China's aggressive rise in prosperity to a desire to become a dominant superpower. But contrary to what many people think, China does not harbor any ambition for world domination. The Chinese do want to become a major regional power in Asia, and have formulated their foreign policies to promote that goal. China has always focused on its position around its neighbors, not what takes place in faraway lands dominated by other major powers.

By leveraging its newly gained economic power as a tool of diplomacy, China is quickly gaining popularity throughout East Asia. China has built highways and railways connecting it to neighbors in the south, such as Vietnam, Laos, Burma and Thailand, and sells billions of dollars of low-cost merchandise to them. Increasing economic integration with China is helping these countries prosper, and we'll continue to profit from the growth taking place there.

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