New Tests Loom for Post-Olympic China

NOW THAT THE last medal has been handed out and Olympic flame in Beijing extinguished, could it be that China's bear market has finally crossed the finish line? Chinese stocks are down more than 60% from October's highs, a decline that dwarfs the 19% stumble by the S&P 500.

Chinese equities have been hobbled by a worrisome outbreak of domestic inflation, despite government efforts to keep prices in check. The economic slowdown in China's largest export market — the U.S. — proved another hurdle. Meanwhile, the fund flows that once fed emerging-market bulls reversed faster than a somersaulting Chinese diver.

These trends will take some time to play out, and in the meantime no one's sounding crazy optimistic while waiting for domestic Chinese demand to pick up the growing slack. "We're looking at a China that's truly at a crossroads," says Nicholas Consonery, an analyst at the Eurasia Group, a New York political risk advisory and consulting firm. "This post-Olympic period is really going to be a telling period for overall investment in China."

Investors anticipating a great crash or a revived boom will be disappointed, suggests Michael Pettis, a professor at Beijing University's Guanghua School of Management, who also blogs about Chinese financial markets. He sees a short-term post-Games letdown in the offing, along with a slowing of the rapid growth that's transformed China.

"At the beginning of the year, Premier Wen [Jiabao] said it was going to be a difficult year, and he wasn't kidding. Next year is going to be even more difficult," Pettis says.

According to the Economist Intelligence Unit, the consulting arm of the U.K. newspaper group, Chinese GDP growth is expected to drop to single digits, with projections coming in at 9.8% for 2008 and 9% in 2009, largely owing to the weaker outlook for net exports.

The flagging U.S. economy isn't helping matters, but it doesn't deserve all of the blame. The numbers also signal China's transformation from a source of cheap labor and low-quality manufactures to a more balanced, value-added economy. It is a trend the government supports. A double-digit growth rate is not evidence of prosperity; it's a steppingstone out of poverty.

David Riedel, president of Riedel Research Group, an independent equity research firm focused on emerging markets, describes the Olympic Games as an advertising coup for China.

"They were an attempt to change the way the world thinks about China, and I think they have accomplished that," he says. "After they're over, I think China has to get back to the hard work of truly developing an economy and society that can participate as an equal partner on the world stage. But with the Olympics, I think they will have gained a lot of respect from observers around the world, and now need to implement plans to justify that respect."

With modern China successfully marketed, it's back to the prosaic task of fixing whatever ails the stock market, and selling detergent.

Domestically, the rise of an urban middle class is advancing a consumer economy less dependent on exports. Riedel recommends a trio of advertising agencies as the likely beneficiaries. VisionChina Media (VISN), Airmedia Group (AMCN) and Focus Media Holding (FMCN). "If you have increased buying power among Chinese consumers, you're going to have more advertising and a higher level of media expenditures," he says. "Those three companies will benefit, and it's interesting that in the U.S., there's three of anything that provides exposure to the Chinese consumer."

A more traditional approach to China would acknowledge the political considerations that affect sectors such as energy, high technology and telecommunications, where the state retains major stakes. Consonery says government intervention has served to increase GDP growth by stimulating exports, and will continue despite the tectonic shift underway in China's economy.

"It's definitely true that there's been increased government willingness to protect Chinese exporting firms and take targeted measures to protect GDP growth numbers," he says. "There are signs there might be protections for some firms that are state-owned enterprises or national champions. That's tied to economic and political stability, which for them is the ultimate goal."

In energy, that means beleaguered refiner Sinopec (SNO) and offshore oil and gas explorer CNOOC (CEO) could benefit, as could communications behemoth China Telecom (CHA) and wireless giant China Unicom (CHU). The last few months have been volatile for each of these stocks — always a consideration for emerging market investors.

Conversely, many of the traditional Chinese industrial stocks listed on the New York Stock Exchange, such as engine maker China Yuchai (CYD), which has a small ADR float, might be ripe for shorting — or simply avoiding — as the economic shift takes hold. That's going to hit retail giants like Wal-Mart Stores (WMT) and Target (TGT), which are hunting out cheaper labor markets and scrambling to re-source their merchandise.

"Instead of making plastic toys and trinkets and sending them halfway around the world, making money on volume, they'll have to start making the innards of computers, the chipsets, the telecom switches — value-added products," Riedel says. "That is already starting to happen, and manufacturers of textiles and footwear are being priced out." To keep minting economic gold, China will need to master some new disciplines.