You've got to admit that investing in Chinese stocks is never dull and could almost be characterized as manic-depressive. In the first three days of trading of this year, investors were treated to a roller-coaster ride which saw the Halter USX China Index end the first day of trading with a nice 4.4% gain . . . only to be followed by a 4.7% decline over the next two days.
Now, that's a bit more volatility than even weathered China hands are used to experiencing. This ugly sell-off was spurred in part by people taking profit (for tax reasons) in the new year, the diminished likelihood of a Fed rate cut (which put people in a bearish mood), and the People's Bank of China's announcement that Chinese banks would now have to keep 9.5% of deposits as reserves (the fourth increase in reserve requirements over the past seven months) in an attempt to cool lending.
While this is not a pleasant experience for longs, let me be clear about one thing: There's absolutely no reason to panic. In my opinion, the outlook for China stocks in 2007 remains as bright as ever because of the continued strength of the Chinese economy, robust earnings growth at Chinese companies, and a host of beneficial other economic developments. Furthermore, the fact remains that many listed Chinese companies are attractively valued in relation to their growth prospects, and I would urge investors to stay long with strong quality companies such as China Mobile
Let's take a quick look and make sure that I haven't lost my Foolish mind.
The Chinese economy
All right, I'll give you the fact that the Chinese economy is likely to cool in 2007, but it's not like the world's fastest-growing economy is going to fall off a cliff. According to a recent report by the Xinhua Economic Information Department, China's economy will post growth of merely 9.5% in 2007 -- down from an estimated 10.5% clip in 2006 -- due to a slowdown in global economic growth and tighter government curbs on investment in overheated areas such as housing and construction.
I don't know about you, but I think that a $2.5 trillion economy posting that type of expansion is still pretty impressive, especially since domestic consumption is starting to accelerate. According to the same report, retail sales of consumer goods are expected to increase by 15% in 2007, up from a 13.7% gain in 2006 and well ahead of the 12.8% growth in 2005. This increase in consumer demand bodes well from the prospects of companies serving the burgeoning Chinese middle class and should help these companies post yet another year of record profits.
Earnings growth
To say that Chinese companies have been thriving is a tad bit of an understatement. China's National Bureau of Statistics recently reported that in the nine months ended Sept. 30, 2006, Chinese industrial companies grew profits by an average 29.6%, up from a not-too-shabby increase of 20% in last year's period. This growth was driven by a whopping 54% gain in profits reported by private companies . . . and a 20% jump in earnings at state-owned companies. I don't think that it's much of a stretch to conclude that this trend will continue as private companies come to represent a larger part of the economy, as well as becoming more efficient in their operations. There are also two major economic developments that should further fuel shares of Chinese companies in 2007: the likely appreciation of the yuan and the introduction of a unified tax system that should significantly reduce the taxes the domestic companies pay the government.
The yuan and the tax code
With regards to the yuan: The Xinhua Economic Information Department is predicting that the yuan will appreciate 5% in 2007, compared with the 3.28% rise of the currency in 2006. While this might dent some exporters' profits, the vast majority of companies serving the domestic market will benefit as their earnings rise when reported in dollar terms.
Likewise, the central government is now considering scrapping the decade-old law that gave preferential tax treatment to foreign companies and imposing a unified tax code in 2007. In simple terms, that means that both foreign companies and domestic companies will have a corporate tax rate of 25%, down from the current range of 30%-33% paid by Chinese companies and up from the meager 14% rate currently enjoyed by foreign operators. Not only do the domestic players get a nice bump to margins, they also get a level playing field . . . one that few foreign companies will be able to compete on effectively.
Summary
All in all, I believe that Chinese stocks will have a good run in 2007 because of the reasons listed above. That's not to say there won't be gut-wrenching moments where investors feel like throwing in the proverbial towel, but the trend is clear: Stay long and strong Chinese equities. A little pain might yield a lot of gain.
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Fool contributor Will Frankenhoff is enjoying his time writing for the Fool more than reading The Financial Times, rooting for the Jints, or taking a nap. He welcomes your feedback. He does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.
