Profiting from the Gateway to China

Robert Hsu, September 07, 2006

With a population of seven million, Hong Kong is only the size of a large Chinese city, yet it plays a special role in China's unprecedented economic development: The former British colony acts as a connecting link between China's Communist regime and Western capitalist powers. Since China resumed control of Hong Kong in 1997, the region is benefiting hugely from China's economic emergence, thanks to its superior legal and financial systems. I expect that to continue, giving us a good opportunity to make some money in the process.

If you're confused about whether Hong Kong is a part of China or not, you're not alone. China actually lost Hong Kong to Great Britain in 1842 after the First Opium War. During the 19th century, there was a great deal of trading between British and Chinese merchants. China exported its tea to Britain, while Britain traded silver to China. Britain operated on the gold standard, so it was very costly to purchase enough silver from other parts of Europe to satisfy Chinese appetite. The British turned to opium as an alternative commodity because it was cheaper to produce. As a result, China's imports of opium increased fivefold from 1821 to 1837.

Chinese government officials were concerned about the health effects of opium and attempted to prevent the British from importing the drug into the country. Conflict soon broke out, initiating the First Opium War. Britain prevailed, and the Qing Dynasty government was forced to cede Hong Kong to British rule.

After World War II, even as Great Britain moved towards increasingly socialist policies, Hong Kong developed a fervently capitalistic system of its own. The mercantilist freewheeling culture continued after China regained control nine years ago. Under Beijing's "one nation, two system" policy, Hong Kong retained its highly-regarded legal and civil service structure from British colonial days. And China has promised that Hong Kong can continue its autonomous practices until 2047, exactly 50 years after the 1997 transfer of power.

Cashing In on Hong Kong's Success

Back in 1949, when the Red Army took control of southern China, Mao Zedong ordered the troops to leave Hong Kong alone. Mao believed that Communist China needed a nexus point to deal with the West, and Hong Kong would play that role. Mao may have been wrong about a lot of things, but he was right about that.

Located near the southern tip of China, Hong Kong has acted as a capitalist gateway to China ever since. It quickly became a major shipping and commercial destination for goods entering China. During the Korean and Vietnam Wars, when economic sanctions were imposed against China, large quantities of Western goods entered the Mainland through the city.

Today, Hong Kong is the richest city in China and a major international center of finance and trade, and a city I always enjoy visiting. (In fact, I'll be attending a conference there this month.) According to data collected by noted economist Milton Friedman, the average per capita income in Hong Kong rose from 28% of that in Britain to 137% in the 40 years that preceded its return to Chinese rule.

From miserable poverty, the residents of this tiny overcrowded region with no natural resources have achieved a level of income one-third higher than the residents of their former colonial ruler. That same entrepreneurial spirit is driving the economic miracle taking place on Mainland China today, now that the government has opened the door for private enterprise.

With its own currency and central bank, Hong Kong has a per capita GDP over $30,000 -- ranking number-two in Asia and roughly on par with Japan -- and is a successful showcase of free enterprise economics. Hong Kong also has one of the flattest and lowest tax rates among developed economies as well as the highest concentration of billionaires per capita.

With Hong Kong's history and its role as the gateway to China as the foundation, there are three specific trends that we want to cash in on:

1. Excellent growth: We've heard a lot about China's amazing 11% growth rate; Hong Kong's is actually not far behind. GDP grew by an impressive 7.3% in 2005, on top of an 8.6% surge in 2004. Exports grew by 11.2% and imports by 10.2%. This strong merchandise trade reinforces Hong Kong's status as a gateway for goods going into and out of Mainland China.

Even the tourism industry in Hong Kong is booming. The total number of tourists arriving in Hong Kong increased by 7.1% to 23 million in 2005. This is mainly thanks to an exponential increase in the number of visitors from Mainland China. Because of lower duties, Mainland Chinese tourists love to shop in Hong Kong and, on average, spend more money shopping than tourists from more affluent locations such as the U.S., Europe and Japan.

2. Windfall profits: Hong Kong's dollar is pegged to the U.S. dollar, so Hong Kong generally follows U.S. monetary policy. When the Fed hikes interest rates, Hong Kong tends to do the same. Until China's yuan becomes a free-floating and fully convertible currency, it works to Hong Kong's advantage to stay pegged to the dollar because it keeps the region tied to global financial markets.

Hong Kong's free currency exchange status also makes it a magnet for attracting billions of speculative capital seeking to profit from the yuan's likely multiyear appreciation. As we've discussed, I believe the yuan will appreciate significantly in the coming years, and companies that operate in the yuan could see profits boosted on the order of 50% just because of currency appreciation alone.

Add organic growth to that, and you get a powerful combination. Many of our stocks (Already a member? Click here to sign in and view the list of stocks I'm referring to...)will reap these added profits. Hong Kong will as well because global currency speculators park money in Hong Kong by purchasing financial assets there as well as H shares on the Hong Kong exchanges. These investments in Hong Kong help the local economy.

3. Strong ties to Mainland China's explosive growth: Because of its reliable legal and accounting standards, Hong Kong's financial markets have become the top choice for quality Chinese companies to go public. Large global investors also place a higher level of confidence and trust in Hong Kong's financial system, and many of the companies we invest in are traded on the exchanges there as well.

Hong Kong experienced a brief recession in 2003 caused by the SARS crisis, an outbreak of a highly contagious pneumonia-like disease that originated in Asia. However, afterwards Hong Kong bounced back strong. Its benchmark Hang Seng Index has doubled since the summer of 2003 -- more proof that sell-offs are almost always good buying opportunities when the long-term fundamentals haven't changed.

To help speed up Hong Kong's economic recovery after the SARS crisis, Beijing enacted the Closer Economic Partnership Agreement (CEPA) in June 2003, which further integrated the economies of Hong Kong and the Mainland. CEPA allows Hong Kong-based professional service businesses, such as banks and law firms, to gain access to Mainland China's huge market. Tariffs were also eliminated on goods originating from Hong Kong to the Mainland.

In addition, China removed restrictions on travel to Hong Kong that same year. Around that same time, an interesting thing started to happen. Back in the 1990s, people in Hong Kong who spoke Cantonese instead of Mandarin often viewed visitors from Mainland China with disdain. The wealthy especially disliked Mainlanders -- even as Hong Kong business leaders tried to develop good connections with the powerful government officials in Beijing.

While staying at the Regent Hotel (now the Intercontinental) around that time, I spoke Mandarin to my wife and got dirty looks from two well-dressed local women. They probably thought I was from Mainland China. After that, at high-end establishments in Hong Kong, I spoke English to get better treatment from the staff.

Things changed after the SARS crisis. As Mainland Chinese tourists became increasingly affluent, an economically weakened Hong Kong changed its attitude towards Mainlanders. During a trip there in 2004, I discovered that the staff at most hotels and restaurants had learned to speak Mandarin. Now when I'm in Hong Kong, I speak Mandarin more often than English.

The people of Hong Kong have learned to ride the unstoppable wave we now call the China Miracle.

The Best Way to Play Hong Kong

The most effective way for us as individual investors to participate in Hong Kong's rising prosperity is through the iShares MSCI Hong Kong Index ETF (AMEX: EWH). You can benefit from Hong Kong's growth in one single investment. This exchange-traded fund has a low expense ratio of only 0.84% each year and has returned an average of 20% per year over the past three years. It's dominated by holdings in the financial and property sectors, which account for 50% of the ETF. This is good because these two sectors directly reflect the growing amount of money pouring into Hong Kong.

I'll admit that an exchange-traded fund may not be as exciting as some individual stocks, but I hope you get a sense for how much Hong Kong benefits from China's growth and why we want to profit from that. In addition, EWH is generally lower risk than many individual stocks because it reflects an entire market, providing built-in diversification.

As you can see from the chart, EWH sold off with other "emerging market" stocks in May and June but has rebounded strongly. It is currently trading at $14.02 and now back in an upward trend. I expect it to rise to $19 or higher over the next 12 months for a nice 25% gain -- and that doesn't include the yield we will earn while we hold it.

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