By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

XIAN, People’s Republic of China – During the politically charged period in the late 1980s and early 1990s – when China believed it really needed friends – a small number of Western companies ignored the controversies and refused to abandon the market.

Global investors will recognize some of the names: The Coca-Cola Co. (NYSE: KO), Johnson & Johnson (NYSE: JNJ), and ABB Ltd. (NYSE ADR: ABB). In the years since, their courage and commitment has been rewarded with hefty market shares, growing profits, and a position of trust that’s very tough for an outside firm to obtain.

These firms also have guanxi.

Loosely defined as “connections,” guanxi is actually a Chinese word that refers to the very fabric of how relationships work, and how business is conducted in this growing Asian nation. In fact, trying to better describe just how important this concept actually is, some sociologists have actually likened it to “social capital.”

While the definition itself may seem a bit hazy, one fact is crystal clear. The best relationships and biggest profits in China are built upon the trust and long-term interactions embodied by this deceptively simple term. Global investors who take the time to understand what guanxi means – and to identify the companies that actually have it – can expect to reap the biggest windfalls from their China-focused profit plays.

A Different Point of View

Talk about “connections” to a Westerner, and the odds are good you’ll get a negative reaction. In the West, a connection can come down to one person owing a second person a favor. But in China, guanxi is about increasing one’s personal standing, about getting respect and about giving it, too. It literally encapsulates every aspect of Chinese society.

(For connections,” that’s actually something of an oversimplification; some sociologists have actually likened it to “social capital.” But even that doesn’t capture all of the nuances that make the Asian culture so fascinating to watch and study.

Contrary to beliefs here in the West, guanxi has nothing to do with bribery or corruption – although there is admittedly a very fine line here, just as there is anywhere in the world where power, money and profits intersect).

And while some forms of guanxi can be built up immediately, as my example involving Coke, J&J and ABB demonstrates, the most powerful and profitable benefits of guanxi can take considerable periods to amass.

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The same is true for individuals, which is why most Chinese seem to spend inordinate amounts of time and money establishing, cultivating and maintaining their guanxi networks. Needless to say, once these connections are forged, they are nurtured, treasured and even guarded, for they can last a lifetime.

Guanxi starts with decency and fairness. If a company delivers their products on time – and honors its promises to the governing authorities and its workers – that firm is demonstrating “trustworthiness.” The company is reliable, dependable and can be counted on. Those qualities all enhance the firm’s guanxi.

Companies that didn’t stick with China, that seemed to pass judgment on the country and its precepts, or that tried to push a Western agenda, very rarely experienced any kind of overt or official rebuke. Instead, these companies discovered that they’d been shuffled aside. And their chance to be a real “player” in China was gone.

Guanxi’s New Role in the “New” China

Westerners who are still coming to terms with modern China will likely attribute this to what they believe is Beijing’s centralized authority. As state-operated enterprises (SOEs) decline in number, so-called “government guanxi” is losing its influence. And with good reason: The growth in entrepreneurship here has created legions of companies that are no longer dependent on state sponsorship for profits.

As China continues its emergence as a global economic superpower, even a social norm as old and established as guanxi is finding a new role. Properly constructed guanxi relationships will help global investors identify future trends, potential profit opportunities and even the players best positioned top pursue them.

In that sense, it’s a bit like the proverbial “old-boys network.” The companies with the connections will be best positioned to capitalize on the new projects, markets or potential partnerships. The companies that lack guanxi will read about the new deals in the newspaper after they’ve been finalized.

With their finely tune sense of “fair play,” it’s not surprising that many Westerners will want to cry “foul” when it comes to this aspect of guanxi. But here’s the thing: In China, connections are fair play. They’re completely legal. And it’s been that way for 5,000 years.

If anything, my experience in Asia over the last 20 years suggests that people without guanxi are the ones who should be worried.

So that begs the question: Absent traveling here three or four times a year and spending as much time as I have here in Asia over the past 20 years, how do you go about developing your own guanxi? Even better, how do you identify the companies with the powerful connections and the best profit potential?

When searching out investments, look for companies or profit opportunities that manifest the following three qualities. As we’ll explain, the presence of these three qualities makes it a near certainty that guanxi connections are present, as well. Those three things to think about are:

Consistency: Look for companies that have been in business here for a long time, and whose management teams have a strong track record. Western investors have a well-chronicled fixation on startups. And there’s a real temptation to concentrate on the newly formed companies in the potentially hottest new industries. But here’s a stunning fact: Most of China’s fastest-growing and most-profitable companies right now are the ones transitioning from a purely state-owned status. These firms either want to become private ventures outright, or to become new companies that are aligned with such major national initiatives focusing on large infrastructure projects, environmental issues and pollution control and energy. It’s no surprise that the companies with guanxi will have the best success landing business in areas the government has deemed to be so important.

Investors searching for more-aggressive, smaller companies should look for companies that have locked up special licenses, operating contracts or market franchises. These usually come about as a result of the collective guanxi of that company’s executive management team. One great example is a small, educational company that I discovered recently. It’s one of only a small group of firms granted an ultra-rare license that allows it to stream its Internet content all across China.

Patience: Here in China, executives often work for years before they are trusted enough to manage their first major deals. When I first came to Asia, a senior executive bluntly told me that he wouldn’t even begin to trust me until after we’d met at least three times. Even then, he said, that trust would be superficial, at best. When I asked why this was so, he informed me that “we Chinese see so many hotshots who come here expecting to get ahead and we only get to know them on the surface. There is no use for that.”

In his view, “we must see each other over a period of time to get to know one another.” Only then, he informed me, would our “truest character” emerge. And that would put in place the building blocks for a relationship built upon long-term trust.

It was a bit of insight that I’ve never forgotten. And neither should you.

When it comes to picking investments in China, you can’t learn everything there is to learn about a company from a “tip sheet,” or from an initial public offering (IPO) prospectus. It’s important to review management and even meet senior company officials, if possible. And if you can’t meet there in person, establish your own guanxi with someone who can.

The important thing is to learn what makes them tick over time. Just because a company is new doesn’t mean it’s the next sure thing – particularly in China.

Deliberateness: Thanks to its commitment to market reform, China has made more economic progress in the last two decades than it did in the previous 2,000 years combined. Despite the still-accelerating pace for change, however, the investors who succeed here will be those who tackle this process in a steady, measured manner.

To better understand what I mean, compare what’s happening here in China with what’s taking place in the United States. China is right now weathering the global economic storm by spending the money that it spent years saving for a rainy day. And with foreign reserves estimated at $2.3 trillion, it can rain for a long time before China’s economy gets too soaked to function.

What’s more, China’s outlays might well be better described as investments as opposed to expenditures. Beijing is spending money on expanding capacity and infrastructure that will help its economy grow for the long haul, even as it creates wealth in the near term. To a trained eye, it’s clear that the plans were put in place in a way to capitalize on the connections in business, industry, finance, and government. The country’s actions have been very deliberate. And very shrewd. Given all these considerations, the payoffs will be substantial for the country in general – as well as for investors who are shrewd enough to participate.

On the other hand, the U.S. is trying to borrow its way out of a problem that was created by debt in the first place. And it’s compounding that error by using that borrowed money to create “work” programs and to finance voter-appeasement bailouts. Neither of these actually fixes the problems at hand. Even worse, however, is that neither creates any long-term value. But both will end up sticking us with the mother of all credit card balances.

It’s no surprise to us that China is still on track for 8% economic growth. It proves that old adage that says “it’s who you know that counts.”

Especially in China.

News and Related Story Links:

• Money Morning Special Report:
  Investment Risks in China Outweighed by Growth Prospects.
• Wikipedia:
  State Run Enterprises.
• Wikipedia:
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• Wikinvest:
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Back in mid-June, more than 75% of the investors responding to a CNNMoney poll said they were planning to buy stocks – many of them aggressively.

Of the 41,572 people polled, it now looks like those 31,179 bullish investors kept their word.

The Standard & Poor’s 500 Index has zoomed 15% since those investors were polled (and 53% from its March 9 market bottom).

Let’s face it. A 75% bullish inclination is a disproportionately high percentage. It’s way out of the norm. 

What those 31,179 bulls are telling me is … well … we’d better watch out. Statistically, the individual investor excels at making the wrong decision at precisely the worst possible time. I view this survey as yet more evidence that the “herd” may once again be heading down the wrong path.

After the collapse of Lehman Brothers Holdings Inc. (NYSE: LEHMQ) investors yanked more than $120 billion out of equity mutual funds. That’s more than the total amount of money investors poured into these funds during 2007 and 2008, a period when exuberance was at its height, according to Money magazine.

And after the S&P 500 hit its March low, most people missed the subsequent rally – 32% through June 23, when the CNNMoney poll was concluded – a run-up that could have mitigated their enormous losses.

The disturbing reality is that investors chase hot money and hang onto losers.  Most individuals have an awful sense of timing – as well as an unending tendency to act irrationally.

According to a recent Dalbar/IFA study, over-exuberant investors can lose a lot of money.  For example, the S&P 500 returned 11.81% a year on average between 1989 and 2008.  The “exuberant” gain-chaser scored 4.48% in the same time frame. Factor in inflation and the average investor gain disappears completely (See accompanying chart). You could have done better in a bank savings account!

Hope For the Best, Prepare For The Worst

That brings us back to the two most pressing questions of our time:

• What’s going to happen next?
• And what should we do about it?

Although pundits are spewing forth about an “improved” outlook for the U.S. economy, history tells us that we’re more likely to see a stock-market correction in the near term.

Over the last half a century, stock-market rallies that follow the horrific declines we’ve seen over the past 24 months are typically followed by a secondary decline of 14% to 50%.

What will happen after that is anybody’s guess. According to a study by Ned Davis Research, any secular bull market that followed a recession in the last 100 years resulted in gains in excess of 60% during an 18-month stretch. In situations where that rally was actually the catalyst for a resurgent economy, stocks averaged 110% over the next 36 months.

But we also have to remember that the bear market that started all this grew out of the worst financial crisis since the Great Depression. According to longtime investor Jeremy Grantham, the record deficits, stimulus packages and bailout packages have "reduced to guesswork" any market forecasts (as reported in CNNMoney).  That’s probably why Grantham recently warned clients: “If you feel overconfident about anything, take a cold shower and start [analyzing] again. Just be patient. In our strange markets, you usually don’t have to wait too long for something really bizarre to show up.”

Here at Money Morning, I’ve been counseling readers for more than a year to think long term. My advice is to preserve your wealth by navigating the near-term chaos. Stifle the knee-jerk urges to buy or sell.  If you succumb to the urge to follow the herd, the crowd will inevitably lead you down the wrong path. And probably at the worst possible moment.

Instead, follow these five strategies:

1. Position Your Portfolio: Develop a portfolio structure you can live with – such as the 50-40-10 allocation model we recommend in our monthly sister publication, The Money Map Report. That way you can take all sorts of economic contingencies into account, while still maintaining a steady course that emphasizes sound “safety-first” choices, portfolio stability and high income. How much stability should you be looking for? Our 50-40-10 model is typically 30% less volatile than the broader markets. But it can dramatically outperform the broader indices on the upside.

2. Limit Your Losses: Invest no more money than you can afford to lose. This sounds simple, but you’d be amazed at how many of the thousands of investors I’ve talked with through the years still don’t get it. They view themselves as “investors,” when they’ve actually become “speculators.” One Texas man I know lost half his wealth during the past two years. When I asked why he’d put so much money at risk, he shrugged and replied: “Because I could.”

Get your strategy in place then pick specific investments that keep you within the guidelines you established. Focus on global stocks with high dividend yields. And make sure you include a healthy dose of energy, technology and inflation-resistant holdings. Such stocks tend to blossom at the first signs of a real recovery – just like they have after every other documented economic downturn in history.

And finally, always make sure to manage your risk. Limit speculative positions to 2% to 5% of your overall portfolio value. That way even a total loss in one holding won’t be enough to eviscerate your portfolio.

3. Avoid Surprises: In my talks with audiences all around the world, listeners are often the most surprised to learn that successful professionals  don’t wake up with thoughts of how much money we can make each day. Instead, we think about two things from the time we get up until the time we go to bed:

• What’s the most likely thing that could cause me to lose money today?
• And how can I avoid that?

In other words, concentrate on understanding what it is that you don’t know. And then make sure to steer clear of that potential pitfall. It’s an approach that helps you make better decisions. Don’t swing for the fences and risk a strikeout each time you come to bat. Instead, make up your mind to go for much-higher-probability singles and doubles. Risk aversion should be your new mantra, especially now.

4. Risk Less – By Saving More: This is actually a neat little trick. Classic market theory holds that to generate bigger returns, you have to have to take on more risk. That’s true – as far as it goes. But here’s what that adage doesn’t address: By taking some simple steps to save more, you can actually accumulate wealth more quickly than by the increased levels of risk most investors are relying upon at the moment.

5. Don’t Let Yourself Get Whipsawed Out of the Market: Investors who prepare for only one kind of market are the most susceptible to panic selling. To them, investing is an all or nothing propostion. As we highlight in Money Morning, you’ve got to prepare for both “up” and “down” markets. And you do so with some simple hedging strategies. Hedging, after all, isn’t just for hedge funds. In fact, everyday people just like us can use them very effectively, which is why we encourage our readers to do so. You see, if you’ve prepared for “up” and “down” markets, you no longer have to actually “predict” what the markets are going to do. Then you can focus on finding quality companies with real earnings, a healthy dose of overseas sales and high income.

Once these five strategies are in place, you can turn your money loose to do the work it wants do for you. And you can sit back and enjoy beating the so-called “smart” money – practically no matter what the stock market does next.

[Editor's Note: As Money Morning Investment Director Keith Fitz-Gerald's market analysis demonstrates, success as an investor requires knowing when to act.

But it also requires knowing where to look.

Like under the Eiffel Tower.

The French Oil Ministry has confirmed there is a 40-billion-barrel reserve under that historic landmark - enough to fuel total U.S. oil demand for 5.2 years, according to the Energy Information Administration.

For more information on The Money Map Report, as well as on the oil cache beneath the Eiffel Tower, please click here.]

News and Related Story Links:

• CNNMoney.com:
  Make fear and greed work for you.
• IFA Institutional Investors:
  The Average Investor’s Return Compared to Indexes.
• GMO LLC:
  Waiting For Markets to be Silly Again (Jeremy Grantham).
• Ned Davis Research:
  Official Web Site.
• Money Morning Investment Research Report:
  Make Inefficient Markets Work For You.
• Money Morning New Market Rules Series:
  Five Wall Street Whoppers And Why You Need To Know Them.

Most Americans will view China’s effort to dethrone the U.S. dollar as the world’s main reserve currency as one of the biggest economic threats that this country will have to face.

But the reality is that this tectonic shift in global finance – and the economic shockwaves that will result – could provide investors with some of the greatest profit plays they’ll see in their lifetimes.

No matter which camp you’re in, the China-spawned changes are headed our way.

In 1990, the U.S. banking system was 2.3 to 2.7 times the size of its counterpart in China. Today, however, the situation has been reversed, and there is much more of an imbalance. In fact, China’s banking system has 25 times the reserves of the U.S. Federal Reserve.

At some point, the United States will no longer be able to dictate international monetary policy. Unfortunately, as our monetary policy aptly demonstrates, Washington seems to be the only player involved in this game of high-stakes global finance to not understand just how this is destined to play out.

U.S. leaders continue to employ monetary policy as a weapon – despite the fact that most of the rest of the world views the U.S. dollar as a liability.
At the end of World War II, virtually the entire world functioned on dollars. By some accounts, 100% of the world’s money supply was the dollar. Today that figure has dropped all the way down to 19%, says Rochdale Securities LLC analyst Richard Bove, a noted expert on the U.S. banking system and Federal Reserve.

Now that the federal government has deployed a few trillion dollars more as bailout bucks, it’s clear that the greenback has lost its mojo and the U.S. government has lost its international monetary leverage.

Why is this worrisome? History tells us that the countries with the strongest economies tend to also have the strongest currencies. It may take awhile for the latter to catch up with the former, but the relationship is highly correlated relationship – suggesting that China’s on the rise economically, while its currency is advancing with the unstoppability of a diesel locomotive operating at full throttle.

So if the U.S. dollar gets derailed as the world’s chief reserve currency – as we’ve repeatedly predicted is destined to take place – the world’s next reserve currency is likely to be China’s yuan, known officially as the renminbi.

Washington says that won’t happen, since Beijing takes steps to keep the yuan from being fully tradable. That’s true enough. But Beijing also understands that the dollar is a liability – which is why China’s leaders are going to great lengths to establish the yuan as a viable currency all its own, while simultaneously minimizing the Red Dragon’s dollar-based exposure.

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In the last six months, for example, China has signed at least $95 billion in swap agreements, under which it can trade directly with countries for payment in yuan. The countries that sign these deals are getting huge discounts from China in exchange for their participation – and for buying goods from China. And the deals enable China to do an end run around the entire dollar-based currency trading system.

When it comes to this long-term plan to boost the yuan’s importance, China is waging a campaign on multiple fronts. This past spring, for instance, China organized a meeting in Moscow – attended by representatives from Brazil, India and Russia – where the main goal was to supplant the U.S. dollar as the world’s main reserve currency, replacing it with a yuan-led market basket of currencies, one that is simply backed by China’s renminbi, or perhaps even one based on the International Monetary Fund’s so-called Special Drawing Right (SDR).

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today, the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar.

My guess is that this gathering in Moscow was merely the first of many such meetings that we’ll see take place around the world in the years to come. Expect the list of attendees to grow, as well.

Given all that we now know, the real question becomes: What happens if China succeeds and the yuan displaces the greenback as the world’s top transactional currency?

The list of potential implications is very long, and includes several scenarios that are almost apocalyptic. But most of the outcomes raise as many questions as they answer.

Let’s consider the Top Five:

• Global Gloom Leads to U.S. Doom: The U.S. dollar goes into freefall for the simple reason that if no country has to hold dollars any longer, they won’t. Instead – thanks to the ragged state of the U.S. government’s finances – many countries will dump greenbacks fast as they can, which will only put additional pressure on an already-strained U.S. financial system, which in turn will further damage our economy.
• Inflation Inflates: Inflation will strike here with a vengeance, as anything bought, sold or priced in dollars will instantly rise in price to offset this fall.
• Repatriation Risk: With the dollar serving as the world’s de facto currency, U.S. companies bear very little exchange rate risk when the time comes to repatriate assets or make currency-related adjustments. That would change overnight and prices throughout the value chains would rise sharply to compensate.
• Money Costs More: The cost of money itself would rise. If the dollar falls, not only will there be massive selling pressure against it, but the cost of borrowing it will rise dramatically as lenders raise rates to cope with the increased risk of dollar-based transactions.
• Death By Debt: And finally, if there is another reserve currency, other countries will no longer have to buy our debt, and you can guess where that will leave us – especially given the fact that we’ve taken on trillions in new debt to help finance our way out of our current mess.

My best guess is that we won’t see any one of these things in isolation, but will instead experience a blending of several or all of them. To the extent that China continues to absorb our inflationary influences, buy our debt in measured doses and maintain its reserves, we’ll probably have a measured decline in the value of the dollar – but not the catastrophic fall many in the doom, gloom and boom crowd are predicting. At the same time, I also see the IMF change course in the next few years to reflect China’s increasingly substantial influence and monetary power.

On the individual investor level, this clearly provides a new set of influences that most investors have yet to grasp. Most will perceive what I have said as a threat, but I believe the correct way to view this is that there will be a whole new set of opportunities coming our way.

Some of those opportunities will be obvious – like the need to invest in currencies and commodities that are of interest to China. Others, like direct investments in China’s yuan, will require special insight, a good investment guide, or a leap of faith.

The bottom line – and the most important thing to remember – is this: No matter how this plays out, there will always be an upside for investors who are willing to seek it out.

News and Related Story Links:

• Money Morning News Analysis:
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• Money Morning News Analysis:

  Geithner Opens Up Debt Dialogue With China, but the Dollar Still May be Doomed.

• Wikipedia:
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• Money Morning News Analysis:

  China Seeks to Dethrone the Dollar, Transforming the Yuan into the Dominant Global Currency.

• Wikipedia:
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• Money Morning News Analysis:
  By Stepping Up to Sell China’s Bonds, Standard Chartered and HSBC May Accelerate the Yuan’s Acceptance as a Global Currency.
• Money Morning Market Commentary:
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• International Monetary Fund:
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A $15 billion deal for liquefied natural gas (LNG) involving Australia, China and global-oil heavyweight Exxon-Mobil Corp. (NYSE: XOM) has prompted many investors to worry that China may be using its global-markets muscle to “paper over” cracks in the global economy.

In reality, however, this mega-deal is a harbinger of what’s to come, and highlights the road that global investors must travel in their journey to maximize their own investment returns.

If you feel like you need a guide on that journey, just look to Australia. That country seems to be setting the pace when it comes to obtaining both a way out of the global financial crisis and an important new trading partner that could benefit their nation for years to come. What’s happening there could be a model we’d best learn from.

As we have noted repeatedly here at Money Morning, when China buys, it buys big. Most recently, China’s global resource acquisition spree has centered on Australia (after tours through Canada, Africa, the Middle East and South America).

By some accounts, the timing couldn’t be better. Following the recent arrest of four Rio Tinto PLC (NYSE ADR: RTP) employees in China last month on corporate espionage charges, the two countries needed to do something mutually beneficial to smooth over relations. For China, the acquisition is viewed as a way to save face and further its strategic interests. For Australia, this deal is a source of cash that will flow right into the government coffers and help the country rebound from the global financial crisis.

The transaction involved a place most people here have never heard of – Barrow Island. Located about 30 miles off the northwest coast of Australia, and about 80 square miles in size, Barrow sits atop a supply of natural gas – a portion of which that will now be liquefied and sent to China.

According to the terms of the deal made public recently, Australia is going to process and ship some 15 million metric tons of the fuel each year – enough for this deal to be worth roughly $15 billion over the life of the contract.

Development of the project is expected to create 6,000 jobs initially, with another 3,000 to follow. It’s also expected to yield some $6 billion for the Australian government, which – like most governments around the world – can really use the money, since it’s still struggling to come to terms with the global financial crisis.

Not surprisingly, like most deals involving China these days, this one has sparked controversy on a number of different levels.

Naturally, there are the obvious environmental issues. According to conservationists, Barrow Island is home to a number of endangered animals, which is why environmentalists are pushing for the liquefied natural gas plant to be built on the mainland.

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But Australian Environmental Minister Peter Garrett dismisses that notion. Speaking to various Australian media outlets, he’s stated that he doesn’t believe there will be “unacceptable impacts.”

As you might expect, that’s ignited a firestorm – akin to the environmental debates we’re used to seeing in this country. Australian Sen. Bob Brown, leader of the “Greens” party, groused that Canberra has put economic interests ahead of those of wildlife and the environment.

What makes this transaction important – and worthy of study – is that the deal is a window into the future. In an increasingly global economy, as mega-dollar international deal proposals become more and more commonplace, the players will have to find a way of addressing the inevitable political battles.

And that’s particularly true when one of the parties is China (as will also be the case on an increasing basis). With the LNG deal, the ink had barely tried before Australian Labor representatives were leveling charges that Canberra’s conservatives had sold out. Many, who seem to feel that a pact reached with China is tantamount to making a deal with the devil, are saying that the diplomatic cost of doing business is steamrolling the concepts of human rights and democracy. But others view such a transaction in much more pragmatic terms.

After all, they say, $6 billion is still $6 billion.

This is not a simple issue and it’s complicated by the fact that China sits on the world’s largest pile of excess reserves – more than $2.3 trillion by some estimates. And the Asian dragon is going to spend or invest that capital as it sees fit, no matter what happens with the U.S. dollar, Western budget deficits, or the global economic recovery.

And it’s not because China wants to spend this money … it’s because China has to spend that money. It’s a matter of the country’s long-term survival.

As we have said a number of times here in Money Morning, China must engage in transactions beyond its borders to ensure that it continues to have borders. Deals like this are not about world dominance. They’re aimed at avoiding “social unrest” – the two-word phrase that scares Beijing more than anything else.

This is why Chinese leaders have been so resolute in their drive to lock up supplies of raw materials and other key commodities.

For the most part, governments are caught between citizens who get uncomfortable at the thought of selling valuable national interests to a trading partner they don’t really know or understand and their own corporations, which desperately need two things to maintain their own global competitiveness: access to China’s low-cost manufacturing capacity, and market share (revenue) from what is the fastest-growing market on earth.

To be better able to deal with – and feel comfortable about – what’s transpiring in an increasingly global marketplace, Westerners need to start understanding what’s really at stake. And they need to also dispense with their own misperceptions.

Take the whole Unocal Corp. transaction of 2005. It failed because U.S. interests were appalled that a Chinese company could acquire “national interests.” Yet few took the time to understand that most of Unocal’s assets are actually located in Asia — which is why the Chinese tried to buy it.

For instance, not only did the United States slam the door in China’s face when China tried to buy Unocal Corp. Chinese National Offshore Oil Corp., or CNOOC (NYSE ADR: CEO) tried to acquire Unocal for $16 billion to $18 billion. Following a vote in the U.S. House of Representatives, the bid was referred to U.S. President George W. Bush. The reason: The deal was said to have “national security” implications. CNOOC withdrew its bid and Unocal subsequently merged with Chevron Corp. (NYSE: CVX).

Then there’s the whole human rights argument, which inevitably comes to the front of the line whenever China is involved in a deal. Detractors logically highlight the fact that China’s record doesn’t fit with our own. Yet, in doing so, they forget the West’s history. The high and mighty, history reveals, weren’t always so high and mighty. In short, we’re not perfect, either.

On one hand we espouse free markets and the premium of economic choice. So why is it that we can’t stand to have the tables turned when it comes to China’s economic freedom? The West has engaged in direct economic investment abroad for years. Shouldn’t China be allowed to do the same thing?

Then there are the concepts we’ve used to justify our own actions particularly when it comes to foreign direct investment. We’ve argued (and continue to argue) that our investments in distant locales will help spread democracy, improve human rights, nurture educational excellence and contribute to the free-market efficiencies that will allow the global economy to function much closer to peak efficiency. And we’ve used the increase in taxable revenue, local employment and even training as reasons to justify our actions and our interests.

If you adopt an objective, global perspective, and see things as China does (understanding its general objectives in the process), there is really only one conclusion a U.S.-based investor can reach: The changes under way are inevitable. Fight them, if you must, but realize it’s at your own cost, and understand the once-in-a-lifetime investment opportunities you’ll be missing.

Or embrace them and ride along – which is not only the path of least resistance: It’s also the most profitable trail to take.

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• About.com:
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• Money Morning News Analysis:
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• Money Morning Analysis:
  China Continues its Commodities Binge with Brazilian Oil Deal.
• Wikipedia:
  Unocal Corp.
• Money Morning News Analysis:
  What Companies Are Profiting From China’s Commodities Crusade?
• Wikipedia:
  Peter Garrett.
• The New York Times:
  China Says Australian Is Detained in Spy Case.
• CNNMoney.com:
  China arrests 4 Rio Tinto employees.
• Wikipedia:
  Barrow Island.
• WhiteHouse.gov:
  George W. Bush.
• Wikipedia:
  Liquefied Natural Gas.
• Money Morning News Analysis:
  The Three Reasons China Will Lead the Global Rebound.
• Money Morning:
  China Landing Natural Gas Deals as Prices Plummet

If you’re looking for the next “Big Oil” play, bet on Beijing.

As we’ve been reporting for the past several years, China has been on a global commodities shopping spree, which includes locking up every source of oil that it can. The Red Dragon has cut deals in Africa, South America Russia and the Middle East – and won’t stop there. Even the mainstream news media is finally becoming aware of this crucial trend.

But here’s the thing. It’s not enough just to know that this is happening. In order to profit, an investor really needs to understand why it’s happening – and to invest accordingly. Investors who lack this insight may make the strategic misstep of betting heavily (or exclusively) on the Western heavyweights – Exxon Mobil Corp. (NYSE: XOM), BP PLC (NYSE ADR: BP) or Royal Dutch Shell (NYSE ADR: RDS.A, RDS.B) – while ignoring the oil sector’s real growth story, which is China.

Just this year alone:

• China and Russia have signed a multi-billion-dollar, intergovernmental agreement to construct an oil line from Russia that will supply oil directly to China. Actually seven agreements in one, the terms depict a deal worth trillions of dollars – including a 20-year oil contract to pump Russian oil to the Chinese market. In return, China has agreed to provide a total of $25 billion in loans to Russian oil companies Transneft and OAO Rosneft Oil Co. China even gets a cut of Rosneft’s production, as part of the deal.

• In Africa, China’s CNOOC Ltd. (NYSE ADR: CEO) and Sinopec Shanghai Petrochemical Co. (NYSE ADR: SHI) are teaming up to buy a $1.3 billion stake in Angolan offshore development rights from U.S.-based Marathon Oil Corp. (NYSE: MRO). A key point of note: Angola – historically one of Exxon’s favorite investment targets – has recently overtaken Nigeria as Africa’s biggest oil producer.

• While noting that it’s hardly a done deal, The Wall Street Journal did report earlier this month that China National Petroleum Corp. (CNPC) is interested in buying all or a part of Argentina’s YPF SA (NYSE ADR: YPF) for $14.5 billion.

• In Africa, China’s CNOOC Ltd. (NYSE ADR: CEO) and Sinopec Shanghai Petrochemical Co. (NYSE ADR: SHI) are teaming up to buy a $1.3 billion stake in Angolan offshore development rights from U.S.-based Marathon Oil Corp. (NYSE: MRO). A key point of note: Angola – historically one of Exxon’s favorite investment targets – has recently overtaken Nigeria as Africa’s biggest oil producer.

• Reports continue to circulate that CNPC will be taking the majority stake in Iraq’s Rumaila oilfield from BP. Rumaila is Iraq’s biggest oil field, producing more than a million barrels of crude oil per day.

• And China has become quite chummy with Brazil’s Petroleo Brasileiro (NYSE ADR: PBR). Petrobras is developing a huge new offshore field – one of the biggest new discoveries in decades, in fact – and any deal would include a production-supply agreement.

This flurry of deals hasn’t been a surprise to Money Morning readers. Even so, it’s worth taking a moment to look at some of the key catalysts behind many of these deals. Let’s look at the Top Three:

• Nervous Reserves: China is sitting on the world’s largest pile of cash – more than $2.3 trillion by some estimates. With an estimated 70% of that, or about $1.61 trillion, in U.S. dollars, there is no question it’s a huge source of financial firepower strength at a time when global markets are uncertain, if not downright weak. But it’s also a liability, too, in that China can’t diminish its high-concentration of greenback holdings without pushing the dollar off a cliff. So buying oil is a great way for China to diversify its reserves without kneecapping poor old Uncle Sam.

• Those Not-So-Free “Free” Markets: China has less faith in the “free” markets than the West does. Ironically, the United States and other Western powers are partly to blame for Beijing’s free-market skepticism. For instance, not only did the United States slam the door in China’s face when China tried to buy Unocal Corp. [now a part of Chevron Corp. (NYSE: CVX)]  a few years back, but when former U.S. President George W. Bush invaded Iraq, the war summarily cut off China’s ability to source oil from that Middle East member of the OPEC 12 (the Organization of the Oil Producing and Exporting Countries). Prior to the invasion, Beijing really didn’t consider the need to diversify China’s foreign-oil sources so our military action prompted their economic reaction. Now the genie’s out of the bottle.

• Peerless Perspective: China’s leaders know that they must lock up oil supplies at a time when the Western world can’t seemingly be bothered to understand that this is a zero-sum game. In other words, China views the global financial crisis as an opportunity to be exploited for economic gain and the security of its people, not as a problem to be solved. China understands the big picture, and even though we apparently painted it, the West doesn’t.  By scouring the earth for oil at a time when the West is hamstrung by the global financial crisis, not only is China able to strike more favorable deals at more favorable prices, but it’s locking up huge supplies of commodities for its own use for years, even decades, to come. In doing so – and this is the part of the equation so many experts don’t get – these resources are no longer available for our use here in the United States, which has major supply and pricing implications for this market.

Bamboozled by the Western media – which has perpetuated the “global-recession-means-lower-demand” story – it simply hasn’t dawned on most people here in the West that China doesn’t care about the major long-term impact this global buying spree will have on our economy.
Besides, this whole story thesis is flat out wrong. While the recession is definitely dampening our use of oil and gasoline, China’s oil demand is growing by more than 20% a year. And of the 8 million barrels a day that China already uses, half comes from imports. Beijing sees those as troubling statistics, which means that China:

• Absolutely must lock up as many significant external supplies oil as possible right now.

• And must accelerate its domestic exploration-and-processing efforts at warp speed.

Nor is this a static situation. China’s auto market is growing by 50% a year. It’s already the world’s largest, having passed the United States earlier this year. In fact, according to some estimates, China will have more cars on its roads in the next 20 years than all those we currently have in this country – even if you include the engine-less “restoration project” your next-door neighbor’s son has sitting under an oak tree in their back yard.

China’s never known high prices and its consumers haven’t either. So they don’t care like we do about what “price” is posted at the pump. Sure, you can argue as many Western analysts do, that China’s fuel is highly subsidized, but so what? That’s a moot point. Consumers who remember what it was like back when gasoline was 99 cents a gallon aren’t going to grouse about how it now costs $6 a gallon – these newly minted motorists will merely see gasoline as just part of the cost of having a car.

Because it understands its need for continual economic progress – as well as the role oil has to play to make that a reality – China is doing whatever it takes to guarantee future supplies, including structuring deals in ways that have caught Western companies by surprise. For instance, China’s companies are looking at how they can get a deal done by giving the other party something it actually needs. Moreover, in a move that’s as frustrating to Western leaders as it is surprising, many of these deals come with no strings attached. I suppose you could call it the “Red Dragon Option” – although Western firms would do well to embrace these as potential Harvard Business Review case studies.

After reading this overview, a U.S investor might want to conclude that China’s already got this one wrapped up and that “any resistance is futile.” But that’s not necessarily true. While China’s grown by leaps and bounds in terms of its financial sophistication when it comes to these deals, the country still lacks the relative exploration-and-production technology to go after the deep-water reserves and complicated fields where most of the still-undiscovered oil remains. Those are also the same kinds of locations where natural gas may be the better bet.

And that suggests that investments in both sectors – including deep-water drillers and companies that specialize in natural-gas liquification -may pay off for investors anxious to dine with the Red Dragon, instead of being listed as an entrée on the menu.

[Editor's Note: The global economic recovery will create an estimated $300 trillion worth of global-investing-profit opportunities. To find out how to capitalize and profit, you just need to know where to look.

And for that, you need a guide. As part of a new report, Money Morning Investment Director Keith Fitz-Gerald details "the $300 trillion global recovery that nobody's talking about" - as well as the six "lifetime" profit plays this powerful global money wave will open up to those who understand what's really playing out on the global investing stage right now.  To read this report, please click here.]

News and Related Story Links:

• Money Morning View From China Series:
  China Pursues Worldwide Growth Opportunities Caused by the Global Financial Crisis.
• CNNMoney.com:
  China: The new Big Oil.
• Money Morning Special Report:
  What Companies Are Profiting From China’s Commodities Crusade?
• Money Morning Market Commentary:
  Despite its Decline, Oil Remains a “Must-Have” Profit Play.
• Money Morning View From China Series:
  China-Russia Oil Accord a Sign of a Changing World.
• Wikipedia:
  Iraq.
• Money Morning News Analysis:
  Energy Development in Iraq Faces Political Obstacles, but Could Prove a Boon for China.
• Wikipedia:
  Organization of the Oil Producing and Exporting Countries.
• Money Morning Commentary:
  How China is Beating the United States in the Global Oil Game.
• Wikipedia:
  Rumaila Oil Field.
• Whitehouse.gov:
  George W. Bush.
• Money Morning Buy, Sell or Hold Series:
  Buy, Sell or Hold: Brazil’s Petrobras Will be Poised for Big Gains When the Economic Recovery Kicks Off in Earnest.
• Money Morning Special Report:
  The Three Reasons China Will Lead the Global Rebound.
• Money Morning News Analysis:
  CNOOC Taps Overseas Markets with Awilco Takeover. 

With the Standard & Poor’s 500 Index up 47% from the lows it reached in March, many investors are feeling intense relief.

But with one or more institutional traders making bets that suggest a bearish end to 2009, the question becomes: How do you read this information and what do you do about it?

I’m struck by a sense of déjà vu.

In September 2007, there was a $900 million options wager that became known as the “Bin Laden Mystery Trade.” Widely believed to be a massive downside bet on the S&P 500, it was a combination of options totaling 120,000 S&P call options contracts (NYSE: SPY).

Because of its size and the way it was placed, the trade appeared to nervous investors as if somebody, somewhere “knew” something about the S&P 500 being in for a big tumble. Not surprisingly – in this always-anxious, post-9/11 era – speculation about the trade took on a life of its own. In addition to lighting up the chat rooms and conspiracy hotlines, it quickly went mainstream. I recall being asked about it several times on various radio shows and at investing conferences around the world.

I wasn’t a popular guy because, instead of playing to the conspiracy theories, I saw another explanation based on 20-plus years of professional investing. As it turns out, I was correct and the trade was some derivation of a “box-spread” options trade.

In case you missed the original article, here’s a quick explanation. A box trade is a highly specialized transaction that professional traders or sophisticated institutional investors use on occasion to “box” in the market and guarantee a pre-set level of profits, an acceptable level of risk, or – as may have been the case for that particular trade – it may have been designed to enable an investor (institutional or otherwise) to obtain below-market-rate financing.

This time around, there’s a slight wrinkle in that the options seem to be a so-called “put-ratio spread” that expires in December. This transaction calls for an investor to buy a number of “put options,” and then to sell more “put options” of the same underlying stock and expiration date, but at a different, lower strike price.

It’s a limited-profit, unlimited-risk options strategy that is used when traders think the underlying issue – in this case the SPY – will experience a little volatility in the near future.

According Andrew Wilkinson of Interactive Brokers Group Inc. (Nasdaq: IBKR), an investor last month purchased a “ratio put spread” that expires in August. Wilkinson told Forbes.com that the investor established the bearish trade by using 120,000 “92″ strike puts against 240,000 “80″ strike puts, a 2:1 ratio established at the equivalent of 920 and 800 on the S&P 500. But as the markets rallied, this investor appears to have closed this trade in favor of a similar strategy involving December contracts.

According to Wilkinson, the trader then moved the long strike up to 95 (the equivalent of 950 on the S&P 500) and sold an additional 240,000 “82″ strike puts that would have provided a defense against a market downturn of 14.5% at the time.

Clearly, there is a wide margin for error and a big zone for potential profits if the S&P 500 loses steam. (For reference, the S&P 500 closed yesterday (Tuesday) at 994.35).

In its current form, the options trade appears to have spread out to the point where the ratio spread is no longer clearly visible, or has morphed into an entirely different strategy. But the disproportionately large open interest of 182,157 contracts at 95 and 153,387 contracts at 80 in December seems to suggest that there is still a somewhat sizeable number of traders positioned for a potentially bearish end to 2009.

In addition, based on similarly large and disproportionate open interest in contracts that expire next month, traders seem to have spread their bets out over the third and fourth quarters, which means they’re apparently less concerned about the actual timing of any bearish move than they are the actual direction. While they don’t mention this in the options textbooks, institutions tend to concentrate their positions in the months coinciding with quarterly earnings reports, since there is more liquidity and depth than in the calendar months.

As of press time, there were concentrations exceeding 100,000 put contracts at the following September strikes: 80, 88, 91 and 95. Any or all of these could be used in conjunction with December contracts to profit if the S&P 500 does drop.

So what does this mean and what can individual investors do about it?

Never one to let the old “X-Files” theme song fade away in my head (okay, I’m a bit of a conspiracy-theorist at heart…), I find it interesting that the initial trade as reported by Wilkinson was 120,000 options contracts. In an era of multi-legged contracts – accounting for hundreds of millions of shares – it’s ironic that two disparate trades made nearly two years apart (the “Bin Laden Trade” of 2007 and this latest transaction reported on by Interactive Brokers’ Wilkinson) both involve that same number of contracts. Folks tempted to read deeper into the tea leaves than I am may conclude that something sinister is in the works, but at the end of the day I think it’s probably nothing more than a coincidence.

As for what this latest trade could mean – well, as was the case with the “Bin Laden Trade,” I suspect that there’s nothing untoward at play here, either. Therefore, I chalk up the increasingly large positions to savvy traders who understand – as we do – that with the S&P’s massive surge since early March, a pullback from current levels is not only likely, but probable.

My view is that it’s only logical that traders – the shrewd lot that they are – will want to prepare for that contingency.

If you’re of the same opinion and want to play along, there are a number of ways to do so. However, the actual moves you make will depend a lot on your preferences as an investor – as well as your risk tolerance.

For instance, if you’re options savvy, you could assemble a put-ratio spread of your own using similar strikes. That way, depending on how far and how fast the S&P 500 falls, you could be sitting on some potentially large windfall gains – while those who didn’t prepare for this contingency are forced to conduct financial triage on their investment portfolio.

Of course, if options spreads are not your cup of tea,  you could simply buy a handful of cheap SPY put options, and hope the “lottery” pays off: After all, depending on how deep out of the money you go, your chances of winning would be about the same.

Or, you could buy a specialized “inverse fund,” such as the Rydex Inverse S&P 500 Strategy Fund  (RYURX), which actually appreciates as the S&P 500 drops. If you prefer “high-test” investments, you could also opt for a double- or triple-leverage investments – such as the  ProShares Ultra S&P 500 Exchange-Traded Fund (NYSE: SSO), or the ProShares UltraPro Short S&P 500 ETF (NYSE: SPXU).

But tread lightly. In an era where central bankers around the world continue to play “risk taker of last resort,” there are no guarantees that we’ll see the “normal” market behavior – the market behavior we would normally expect to see after such a torrid advance in a major bellwether index. Things could just as easily power up in a hurry if the markets – and the investors who comprise those markets – become more confident … regardless of the reasons why. In cases like that, these bets would turn into losers in a big way and in a big hurry.

[Editor's Note: The global economic recovery will create an estimated $300 trillion worth of global-investing-profit opportunities. To find out how to capitalize and profit, you just need to know where to look.

And for that, you need a guide. In a free Money Morning Webinar tomorrow (Thursday) afternoon, Investment Director Keith Fitz-Gerald will detail the "$300 trillion global recovery that nobody's talking about" - a recovery that will create some of the most profitable investment opportunities that we'll see in our lifetime. Fitz-Gerald will outline this opportunity, as well as some specific companies global investors might want to consider. To find out more about this free Webinar, please click here.]

News and Related Story Links:

• Money Morning Web Summit:
  Official Web Site.
• Money Morning Special Report:
  How the Economic Rebound and China’s Emergence Will Help Create a $300 Trillion Profit Opportunity For Investors.
• Money Morning Special Report:
  The ‘$900 Million Conspiracy’ Trade That Wasn’t?
• Money Morning Special Report:
  The $900 Million ‘Mystery Trade’
• Wikipedia:
  The Sept. 11 Attacks.
• WiseGeek.com:
  Box Spread Options Trade.
• Wikipedia:
  Box Spread.
• Online Option Trading Guide:
  Put-Ratio Spread.
• Wikipedia:
  Put Options.
• Forbes.com:
  S&P Bear Play.
• Voptions:
  
  Ratio Put Spread.

If you want a stable dividend, focus on global companies.

Dividends still matter. But you have to know where to look.

A record setting 367 companies reduced their dividends during the second quarter, no doubt leading many shell-shocked investors to conclude that income is dead.

But there’s more to this story. A total of 283 companies actually said that they boosted their payouts, and an even-larger group of companies maintained their current dividend payouts, Standard & Poor’s Inc. reported.

Not surprisingly, each of the two groups of companies featured some defining characteristics. The companies that had cut their dividends were largely domestic in nature, or at least had a decidedly domestic emphasis. By and large, the firms that were able to maintain or even boost their quarterly payouts were internationally focused, with the potential for some explosive business growth in the world’s key emerging economies.

A Tale of Two Markets

To understand the divergent fortunes of the two groups of companies, just look at the divergent performance of the two world economies that are most talked about today: The United States and China.

At the time of this dividend report’s recent release, the U.S. stock-market benchmark – the Standard & Poor’s 500 Index – was up a respectable 7.26% so far this year.

By comparison, China’s Shenzhen 100 Index had quietly risen 110.10% during that same period.

Such a steep run-up in stock prices often spooks investors. That’s understandable. We always evaluate such situations with caution, too.

But while most investors are worried China’s stock market could take a tumble, we would look at it as a minor near-term setback – and a major long-term profit opportunity.

Even with the double-digit – or triple-digit – run-ups the stocks of many China-based companies have already experienced, many Chinese companies remain stunningly compelling buys, especially when they feature solid dividend payouts, as well.

And China’s not the world’s only upbeat investing opportunity. The story is much the same in other parts of the world, too. Right now, there are more than 100 international income funds that feature yields of 6% or better.

So how do you tell which companies have a promising payout future? Or which ones figure to be dividend duds?

There are three key areas to examine.

International Sales: It goes without saying that fast-developing economies such as China and India will almost certainly leave their U.S., European and Japanese counterparts in the dust.  Therefore, it makes sense to begin the hunt for the world’s best dividend players by looking at companies with a significant business exposure to these and other emerging markets.

If this causes you to step out of your investing “comfort zone," well, let’s just say that’s great.

Some 74% of the world’s economic activity currently takes place beyond U.S. borders, so it makes no more sense to confine yourself to U.S.-only investments than it does to make the same mistake twice.

My favorites include companies that derive 40% or more of their sales from the Pacific Rim, as well as from China. The fact that China’s been growing at a double-digit clip for years means that other countries in that region are experiencing spin-off growth. Taiwan, for instance, has solid manufacturing ties with Mainland China – and the relationship between those two one-time political sparring partners is closer than ever, thanks to several trade agreements signed in recent months.

Granted, one can make all sorts of arguments about the sustainability of China’s growth, but history shows that you are better off hitching your wagon to strong horses than weak ones. Because most people still tend to view China as a Third-World, Communist-led, economically backward country, they’re often stunned to discover that China has had the world’s largest gross domestic product (GDP) for 18 of the last 20 centuries.

And it soon will again – and probably a lot sooner than most investors are prepared to accept.

In fact, I’m predicting that China’s stock markets could have a larger market capitalization than their U.S. counterparts within the next five years, but that’s a story for another time.

Payout Ratios: This is one measure that allows you to gauge the relative security of your investment in any given company. In case you’re not familiar with the term, a payout ratio is the percentage of a company’s profit that it pays out to shareholders in the form of dividends.

While there are exceptions, if the payout ratio approaches 100%, and the choice I’m considering is not a Canadian Trust or Limited Partnership created expressly for dividend-payout purposes that, to me, constitutes a waving red flag. If business conditions plummet, or management doesn’t have as good a handle on cash flow as it thinks it does, any decrease in earnings will obviously affect future dividend payout plans.

On the other hand, if the payout is around 50%, history suggests that this is a sustainable level and that management is unlikely to severely decrease the company’s dividend payment. That’s barring a catastrophic earnings reversal, of course.

Distribution Source: Thanks to all manner of accounting tricks – politely called “adjustments" in corporate accounting-speak – it’s harder than ever to determine where a company’s income is coming from. For example, some investments – especially Canadian Income Trusts and shipping partnerships – prefer to pay dividends from available cash flow, as opposed to bottom-line profits, like most other public companies.  That can increase the aforementioned payout ratio, and can also mislead investors as to the sustainability of future dividend payments.

But you should look anyway.

Generally speaking, dividends come from earnings, making them reasonably predictable. The stuff that isn’t predictable is often the result of special distributions based on short-term or long-term capital gains. Because this type of income often results from one-time sales of assets, or from accounting transactions, they are usually paid semi-annually or annually (as opposed to being paid quarterly, which is the common practice among most U.S. public companies). And while these “special dividends" can provide a nice bump in payments, don’t confuse this type of payout with the cash you received from ongoing operations.

The other type of payout that can throw a monkey wrench in things is called a “return-of-capital" event. While it can result in big cash payments that investors enjoy tremendously, it’s not a regular payout, either. Like the short-term and long-term distributions we just discussed, return-of-capital transactions are not part of regular earnings. They’re typically the result of tax savings, depreciation or other changes in the assets a firm owns. Write-downs and write-ups are good examples of what I’m talking about here.

Either way, return-of-capital transactions are a danger sign in my book because the firm may be trying to return your original investment – which is a strategy often pursued when a dividend cut is imminent and not yet announced.

And that’s the last thing you should want right now.

[Editor's Note: As this dividend-strategy story illustrates, the global financial crisis has changed the rules of the investing game forever. Investors who want to succeed will have to look in new places for new types of companies. But just because the process is different, doesn't mean it has to be harder. In fact, Money Morning Investment Director Keith Fitz-Gerald says that the financial crisis has set the stage for a $300 trillion global recovery that will feature some of the most profitable investment opportunities that we'll see in our lifetime. In an upcoming Web summit, which is free of charge, Fitz-Gerald will outline this opportunity, as well as some specific companies global investors might want to consider. To find out more about this free Webinar, please click here.]

News and Related Story Links:

• Wikipedia:
  Shenzhen Stock Exchange.
• Investopedia:
  Dividend Payout Ratio.
• Money Morning:
  Free Webinar Link.

For U.S.-centric investors who question whether it’s really necessary to invest in “risky” overseas markets, here’s an important fact to consider: It’s China – not the United States – that’s leading us back from the brink of a global financial collapse.

At a time when the U.S. economy continues to wrestle with joblessness, a housing hangover, and heightened inflationary fears due to a questionable central bank “exit strategy,” Beijing just reported that China’s economy advanced at a 7.9% clip in the second quarter, up from 6.1% in the first quarter.

This is well ahead of what most mainstream analysts had been projecting – particularly those who were writing the Red Dragon’s eulogy back in January – but as we’ve been telling Money Morning readers since the start of the New Year, China could well be on track for growth of 8% or more this year.

If you factor in the cash that’s not included in official state statistics – but that does influence economic growth – it’s possible that China’s growth rate could grow by an additional 3% this year and as much as 5% in 2010.

That’s not likely, mind you, but it is possible. And Beijing knows it.

Largely attributed to China’s massive $586 billion stimulus program, the country’s economic acceleration may seem startling when juxtaposed against the travails of other major markets and the United States in particular.

While Corporate America has admittedly buoyed investor sentiment with some better-than-expected earnings of late, many stalwarts continue to struggle. Take General Electric Co. (NYSE: GE), which is widely regarded as a global company, and which saw its profits drop 47%. Credit spreads remain tight and lenders are certainly in the pits as has been amply displayed by CIT Group Inc. (NYSE: CIT), which teeters on the brink of bankruptcy. Moreover, consumers continue to struggle in the United States, Europe and Japan.

In China, however, there’s a very different story coming to light. Thanks largely to an emerging middle class of 330 million people (more than the population of our entire country), Chinese consumers are coming into their own. With savings that are as much as 35% of earned income and a desire to have what we have, goods are flying off of store shelves. The expected increase in Chinese consumer spending in 2009 is greater than the forecasted consumer spending increases in the United States, Japan and the Eurozone combined.

At the same time, China’s property markets are rising again, and home values are increasing as well. Automobile sales, always a litmus test for consumer health in any developing country, are up 48% from last year and are accelerating so rapidly that China is already supplanting the United States as the world’s largest car market – a full three years ahead of my projections.

But, critics ask, what happens when the music stops? They’re worried that once the money runs out, China’s markets could crash all over again.

To China’s credit, the government acknowledges that there still are challenges and, as a seasoned China watcher, that gives me comfort. I find it reassuring to see that China’s leadership understands the game they’re playing. In fact, there are three key areas that could trip up the country’s global-growth strategy, but to keep that from happening, China’s leadership is focusing carefully on each of the three: unemployment, lending and currency.

Let’s look at each one in detail.

Unemployment: President Hu Jintao and his cabinet are acutely aware that if unemployment gets out of control, social unrest will become a major problem. So China’s leadership will do everything it can to ensure that this doesn’t happen.

Most Westerners will no doubt read into this comment with an emotional overlay, especially when the media has been filled in recent weeks with stories of the waves of riots and killings in China’s Western Xinjiang region. But, they shouldn’t. The Uyghur riots, while extremely unpleasant by any measure, are racially motivated clashes. That’s not to downplay the tragic nature of this violence, but the very nature of these riots does suggest that the chance they’ll spread beyond the largely Muslim region is minimal.

What concerns Beijing when it comes to unemployment is that riots spawned by shortages of basic human needs are a very different phenomena because they could prompt a now-divided and largely indifferent populace to unite against the government across a much broader geographic area.

And that would not only risk China’s growth, but powerful ruling elite, too, which is why Beijing is so insistent on direct stimulus benefits that keep people working. If it hasn’t dawned on you, yet, I’m sure it will in short order – China is playing it smart.

Here in the United States, Washington took its turnaround plans to Wall Street.

But in China, Beijing has taken its plans to Main Street.

While our leaders continue to pay lip service to unemployment, they really don’t care so long as protected (and connected) institutions remain standing when they should have been put out of their misery.

Lending: Since this crisis began, China has largely avoided the financial plague that has devastated Western economies. This is due in large part to historically tight restrictions on local banking practices and the confinement of derivatives and other potentially toxic financial assets to a few externally focused banks. But now Beijing has a different issue to contend with.

To ensure that the stimulus programs flow freely throughout China – and have the beneficial impact that Beijing hopes – Beijing’s bankers have more recently liberalized lending and reserve requirements inside China. This has resulted in an explosion of debt that many Western analysts believe will come back to haunt China in much the same way the lending orgy here continues to haunt U.S. financial institutions today. They’re entirely different forms of lending, but the concerns seem to be inseparable.

To be fair, that might be the case. However, the thing to keep in mind is that China is not just changing the rules in isolation the way the United States did leading up to the financial crisis. Instead, we’re seeing stronger internal controls being developed, increasingly strict layers of banking supervision being installed, and a general rise in the quality of borrowers – all at Beijing’s insistence.

The result of all this is that China’s financial system should become increasingly stable even as it grows by leaps and bounds.

Obviously there will be fits and starts, but this is a far cry from the warped system U.S. investors have been forced to rely upon to date – a system whose hallmarks seem to be inept leadership, somnambulant or sleazy regulators, conflicted lenders and greedy Wall Street executives who focus on profits no matter the cost.

Chinese Currency: Many Western observers worry about China’s intentions when it comes time to purchase our debt. I think that’s overblown. The real question is what Beijing will do to manage the concentrated U.S. dollar risk it currently faces.

 
To the extent that China can keep a lid on its unemployment situation and maintain control over its banking system, expect China to maintain the status quo and to continue its purchases of U.S. Treasuries and U.S. dollars. But don’t expect it to sit still. China is acutely aware of the highly concentrated risks it faces because of its ongoing dealings with the United States.

Therefore it’s logical to expect China to diversify its holdings with additional oil, gold and resources purchases in the months ahead. Not only will resource-specific investments help hedge the $2.3 trillion currency-reserve risk China bears, but if the dollar collapses such “hard-asset” investments will maintain much of their value and will be eminently tradable via the $120 billion in yuan-based swap agreements that China has assembled.

Here’s one final thought to consider.

Unlike the West – which views the financial crisis as a burden, a mistake, or a bad dream to be lived through – China’s leaders see this as the most significant opportunity of a generation. It’s a chance for their country to establish itself as a leading global power.

That’s why China will continue to pull further ahead. And that’s why U.S. investors who don’t wish to be left behind can no longer ignore China.

[Editor's Note: Fifteen trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 15 for 15, meaning he's closed every single one of his trades at a profit. And he did this during one of the most volatile periods for the U.S. stock market since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.]

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Individual investors who still hold any doubts about Mainland China’s future growth potential should take a long hard look at Airbus SAS, the Pan-European commercial airliner maker that is now building airplanes in that country.

When Airbus recently announced the delivery of its first China-built passenger jet, it was more than just the usual bit of corporate PR. It was an admission that any company that wants to remain a global leader in its industry will have to embrace China as a customer – and probably as a partner.

Airbus – a subsidiary of defense giant European Aeronautic Defense and Space Co. NV, also known as EADS NV – said it assembled the A320 passenger jet in a plant in Tianjin, China’s sixth-largest city. The factory is 49%-owned by a Chinese consortium, and is expected to produce another 10 passenger jets this year alone.

The China connection doesn’t end there, either: The just-completed A320 will be sold to a leasing company and eventually put into service by Sichuan Airlines Co. Ltd., a regional carrier.

Both Airbus and its U.S. rival, The Boeing Co. (NYSE: BA), understand that the Chinese market is crucial to their futures. Boeing has said that China will become the largest aviation market outside the United States by 2028, with the mainland set to require 3,700 additional aircraft – worth more than $350 billion – in that time. Airbus, which projected a slightly lower figure of about 2,800 aircraft, hopes to see its market share rise from about 30% now to about 50% in the next couple of years.

In the near term, the global downturn has left China’s carriers feeling the pinch, too, but it’s the long term that has companies such as Airbus and Boeing feeling both excited – and worried.

In many industries, partnerships represent the price of entry. And in the long haul, China has ambitious plans of its own. In the commercial airliner business, for instance, it is already developing a regional airliner and more recently has launched plans to design and build a globally competitive jumbo jet of its own.

The Rise of China as a Powerhouse Market

One of the hallmarks of any great economy is its ability to produce technically complicated machinery. I’m not talking flat screen TVs here but stuff like spaceships and, closer to earth, commercial and military aircraft. While Airbus is a partner right now, the point is that China is moving up on the technology scale both hard and fast. Faster, in fact, than most Westerners realize.

But the rollout of a completely Chinese-built Airbus A320 highlights something else, the significance of which is lost on most investors: It’s not really about Chinese airplanes or even the fact that China is making something new. The real key here is that Airbus – like many companies – understands that the Chinese market is growing so fast, and has the potential to be so huge, that that it has to invest there, and do so as a partner, or risk getting left behind.

Chances are good that Airbus understands something else that I’ve been telling investors since I first visited China nearly 20 years ago: There will come a time when China makes the transition from just being the world’s biggest manufacturer and becomes the world’s biggest market. In the long run, it’s not about China the export machine – it’s about the Red Dragon’s transition into a full-fledged consumer market.

With more than 300 million people – the majority of whom save an average of 35% of their income, China’s quickly emerging middle class is by itself potentially larger than the entire U.S. population. And the top 2% of China’s academic community – I’m talking the best and brightest only – is larger than our entire university population.

The bottom line: China not only has the capability to produce entirely new and different products, but its consumers increasingly have the ability to buy them.
Consider Snow Beer. Most people have never heard of the ubiquitous green bottled stuff because it’s sold only in China. Yet according to beer-market-researcher (yes, they do exist) Plato Logic Ltd., Snow Beer sold about 6.1 billion kiloliters of beer in 2008, up 19.1% from the year before – outselling such former brand leaders as Bud Light and Budweiser.

Not surprisingly, Snow Beer is a partnered product – the result of a collaboration between China Resource Enterprise Ltd., and London-based SABMiller PLC (OTC ADR: SBMRY) news portal alibaba.com reported.

Maybe this won’t surprise you, but it never fails to surprise the majority of people I talk with when they learn that China is now the world’s largest beer market, having surpassed the United States as early as 2001.

It’s much the same story with cars. For the past four months running, China has been the world’s largest automobile market. There are still a dozen or more automakers slugging it out for Chinese consumers’ hearts and minds, but all the biggies are there – including the only profitable business unit of General Motors Co., the Japanese, European makers and more. China this year also became the world’s largest producer, consumer and exporter of light-duty electric automobiles.

China Profits Poised to Zoom

And that brings us back to Airbus.

After delivering the 10 planned A320s from its Tianjin factory this year, Airbus plans to deliver aircraft at a rate of four a month by the end of 2011. Overall, Airbus expects to deliver 70 A320s to China in 2009 – a total that includes jetliners built in Europe.

But it’s just not enough, notes Airbus China President Laurence Barrons. In fact, the executive told the China Daily that the “ramp-up [production] capacity of 48 planes a year is insufficient to meet [domestic] demand.”

It’s not surprising, then, that Airbus is planning on boosting production to 286 aircraft a year in Tianjin, which puts the China production facility on par with Toulouse and Hamburg, where the company has its European plants. Ultimately, and again here’s the really important stuff, there’s no reason in the world why Airbus won’t begin selling Chinese-made aircraft overseas to non-Chinese carriers within the next few years. Not only will this further pressure Boeing, but also it demonstrates yet again that there isn’t an asset class on the planet that won’t be affected by China’s growth – a point that I’ve made so often that it’s basically become a Money Morning mantra.

Speaking of which, Chinese domestic air passenger growth would make a western air exec drool. According to China’s Aviation Administration, domestic traffic is up 17% to 56.9 million in the first four months of 2009, at a time while international traffic fell 17% to 5.6 million. Some consider that a wash, but get this: Over the past 30 years, air passenger traffic rose at an average annual rate of 16% – reaching 190 million at the end of 2008.

In a statement issued on April 8, Li Jiaxiang, the director of the Civil Aviation Administration of China, stated that China intends to boost travel to some 700 million trips a year by 2020. And that underscores yet again the projected growth in China’s middle class strength. Somebody’s going to be paying for all that travel. My own travel experiences in China suggest that it will be the Chinese Yuppies, or “Chuppies.”

With the increase in demand has come an escalation in quality – of products and services. Gone are the days when flying Air China meant taking your life into your own hands and ghostly silent terminals at a few scattered airports. Also gone are the formerly ubiquitous souvenir shirts depicting overcrowded aircraft with parts falling off as they zoom skyward.

Flying in China today is a wonderful experience that I look forward to each time I visit China. The airports are modern and well staffed, the security is generally excellent and the flight crews are as sharp as they get. Increasingly, the aircraft are mostly all new – a welcome change from some of the timeworn airframes I routinely hop aboard when traveling back here in the United States. Of course, having real food with real silverware is a nice perk, too, in an era when a boxed lunch sets you back seven bucks.

Now, before you guys jump all over me with comments about state subsidized travel and the like, I know – you’re right. But that doesn’t change the fact that air travel in China is a throwback to an earlier – and eminently more pleasurable – time when travel was an experience to be enjoyed, and not just time spent getting from Point A to Point B, as is now the rule in the Western world.

In a recent interview, the president of Sichuan Airlines Co. Ltd., showed me that China understands the path to take to win in the global game of business when he said that “when air travel becomes a consumer pastime, that’s when you will see the real peak of aviation demand and industry growth.”

That’s true of virtually every market in China these days – which is why investors better not miss their flight: The Red Dragon’s domestic market is just getting ready for takeoff …

[Editor's Note: Fifteen trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 15 for 15, meaning he's closed every single one of his trades at a profit. And he did this during one of the most volatile periods for the U.S. stock market since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.]

News and Related Story Links:

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• Air China:
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