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We were bullish on China for all of 2009 (outside of our call in July for a slight correction); we are not short China right now but we are not long it either.   

One of our more important themes for 1Q10 and potentially for the whole year will be our call on China.  We think there are a number of factors that are going to cause the growth machine to slow in the first half of 2010, thereby causing the market to underperform in the intermediate term. 

Importantly, the long-term TAIL story for China is still very strong.   

One way to think about China in 2010 is in terms of QUALITY GROWTH versus SPECULATIVE GROWTH.  From the recent actions of certain Chinese officials it’s clear that they don’t like the US and blame us for the financial crisis.  How ironic is it that they borrowed a page from the playbook that brought on the financial crisis.  The Chinese have flooded the system with so much money in a short period of time that the pace of growth cannot be maintained.  I don’t want to call it a bubble, but structural bubbles (in money supply and housing) are a threat to China’s growth rate, on the margin. 

The financial crisis put pressure on the Chinese government to stimulate an economy that was humming along at a very strong pace.  The Chinese economy has long been viewed as export dependent.  While exports are important for the Chinese economy the industrials side of the economy is now far more important.  It’s amazing to think that the Chinese economy barely missed a beat as the economies of China’s largest export markets - U.S., Europe, and Japan - were falling off a cliff.

(1)    Money supply growth slowing.  Right now the central bank has not stated a 2010 target for growth in M2, but had a 17% goal last year.   The actual growth rate was more than 25% for 2009, peaking at 29.7% growth YOY in November.  We think that money supply growth could be cut by 1/3 of its current pace.

(2)    Loan growth slowing in 2010. Chinese banks extended 9.21 trillion Yuan of loans in the first 11 months of 2009, compared with 4.15 trillion Yuan in 2008. We think loan growth could drop by at least 1/3 of its current pace.

(3)    Bullish on the Chinese currency. The Chinese Yuan appreciated +18.7% between 2005 and 2008, but has been basically flat for the past 18 months. This will change, when the Chinese government decides to appreciate both lending and currency rates again in 2010. We think that currency appreciation will be at least +3-6% in the coming 6-12 months.

China is not alone as most of Asia is raising interest rates.  Australia’s central bank raised borrowing costs by 0.25% on Dec. 1 to 3.75% after increases in October and November.  The Bank of Korea recently kept its benchmark rate at 2%, but it is likely to be 3% by the end of 2010. 

Similar to our view that “HE WHO SEES NO BUBBLES” (Bernanke) needs to remove his current unsustainable and unreasonable monetary policy of “extended and exceptional”, the People’s Bank of China has altered its policy verbiage from “appropriate increases” in lending to “moderately loose” monetary policy. 

Also, on December 27th, Premier Wen Jiabao said last year’s doubling in new loans had caused property prices to rise “too quickly” and that he “pledges to cool” China Property Prices. On January 7th, 2010, the Chinese sold 3-month bills at a rate of 1.37%. That was the first explicit interest rate hike in the last 5 months.

 Yesterday, the People’s Bank of China raised the proportion of deposits that banks must set aside as reserves by 50 basis points starting Jan. 18.

Since the initial debut of our CHINESE OX IN A BOX theme, there was a widely publicized article on the NY Times that fames short seller, James Chanos, who is bearish on China.  While we agree with Mr. Chanos in many respects, China has been in a BULLISH FORMATION, much like the S&P 500, up until today when the TRADE line broke.  That being said the issues with China are real.  There is an overcapacity issue with excess retail square footage space and limited increased capacity for those industries already sourcing product from the Chinese.

Howard W. Penney

Managing Director