From John Stepek, across the river from the City

Dear Money Morning Reader,

China is the future.

At least, that’s what people think. And who can blame them? China is now the biggest car market in the world, surpassing the US. It’s also the world’s biggest exporter, surpassing Germany.

It’s down to the clever way they run their economy, so China fans say. Not for them the vagaries of market capitalism. Command capitalism, where the state tells the banks what to do and who to lend to, is a much better model.

But China is more similar to the West than you might think. The root of its resilience to the recession, is a driving force that we are all too familiar with – cheap money.

That has a tendency to end in tears, as we saw in the West. So what could it mean for wider markets?

Is the China party set to continue?

The broad consensus these days is that China is unstoppable.

The country will lead the global economy out of recession. Commodity prices will remain at a high plateau forever. And China will rule the world by 2050.

But there’s nothing miraculous about China’s ongoing growth, says Julian Pendock of Senhouse Capital. China is merely following exactly the same policies as the West did after the economic collapse in 2008.

“The action plan for 2009 was, like in the West, for the government to step into the breach and ensure that economic demand was sustained. This is easier to achieve in a command economy than in a Western decentralised economy.” That’s because the government can just tell the banks how much to lend and who to lend it to.

“As the state-directed Chinese economy has appeared to react better to such stimulus, in contrast to the sluggish growth in the West, many are making the age old mistake of extrapolating this trend ad infinitum.” And why shouldn’t they? After all, investors know that the Chinese government will do what it can to “prevent any asset bubble from popping.”

The trouble is, as Pendock points out, that this is just the same as the ‘Greenspan put’. That was the belief that the Federal Reserve would always bail out Wall Street by cutting interest rates, which ended up causing so much trouble for the US. When investors believe that the government is underwriting their actions, they get careless. In China, property prices in many areas have surged despite huge oversupply. Meanwhile, extravagant and wasteful infrastructure projects are being undertaken.

It’s not all bad news. Not all the infrastructure work is unnecessary. The banking system is also likely to remain healthy for the time being. That’s not necessarily because it’s in great shape, but it could take some time for any problems to become obvious. Overall, Pendock is cautious, but he suspects the China party can continue for now.

The safest way to play China

However, he’s happier to play China at arm’s length – getting exposure via European companies which can profit from China’s growth, yet aren’t entirely dependent on it. Such companies are a lot cheaper than their Chinese counterparts, he points out.

That sounds sensible to us. Because there are other reasons to be concerned that China might be more ‘flavour of the month’ than the superpower of the future. Quite apart from issues such as questionable property rights and rule of law, there’s also a serious population problem.

China might be the world’s biggest car market. But what the China bulls don’t shout so loudly is that it’s probably the world’s biggest market for single women too. China’s one-child policy – pretty much the ultimate in state intervention – could ruin the economy’s long-term prospects.

A major predictor of war and civil unrest is the number of single young men in a country. And China has lots of those. In some areas, there are 140 boys for every 100 girls. The ratio for a society where the process isn’t artificially interfered with is more like 103-107 per 100. As The Times reports today, senior Chinese officials have warned that the number of bachelors in rural areas could “lead to a surge in crime and social instability.”

On top of that, fewer women means fewer children. That in turn means a more rapidly ageing population, slower economic growth, and lots of old people with no young workers to support them.

In short, China might not be facing an imminent collapse, but the blue-sky predictions of global dominance for the country are way off the mark. And if those predictions are disappointed, then the impact on the financial markets could be severe.

What you should be buying

So what should you be buying? Even Dr Marc Faber of the Gloom, Boom and Doom Report, a long-time fan of emerging market equities, notes that he is “disturbed by the near unanimous consensus that emerging markets will continue to outperform the US stock market.” For those looking East, suggests Faber, the most attractive play right now could be Japanese stocks, an asset class which MoneyWeek has been keen on for a long time. “The big surprise for 2010 could be weakness in the yen and Japanese government bonds, and strength in Japanese equities.” MoneyWeek publisher Bill Bonner also has Japanese stocks down as the buy side of his latest ‘trade of the decade’.

And if you’re wondering what else to buy apart from Japan, Faber also likes “high-quality large market capitalisation” stocks. That’s another vote for the defensive stocks which we’ve been tipping for the past year or so.

Until next time,
John Stepek

Turning to the markets...

The JSE all share index slumped 1.02% yesterday. The gold mining index slipped 1.58%. Resources fell 1.87%. Financials traded flat, down 0.06%, but banks managed to gain 0.1%. Industrials pulled back 0.56% and the platinum mining index traded flat, down 0.1%.

London's FTSE100 shed 0.71%. The Dow Jones slipped 0.34% and the Nasdaq fell 1.3%.

Tokyo's Nikkei closed down 0.58%. Hong Kong's Hang Seng lost 2.24%.

Brent crude is currently trading at $78.79 per barrel.

Spot gold's trading at $1,128.60 and platinum was last quoted at $1,577.50.

And here's how the rand is performing against the major currencies:
R/$7.44
R/₤12.04
R/€10.78