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

BEIJING, The People’s Republic of China – It’s Day Two of my three-week trip here, and already I feel myself getting quickly reacquainted with this capital city.

If you’ve never been here, it’s hard to do this city justice with simple prose – and without sounding a bit cliché. Beijing – like much of emerging China – is special. And it deserves to be seen that way.

Beijing manages to be simultaneously frenetic and calm, and exudes an energy all its own. There’s no telling what’s around the corner or whom you’ll find here on a given day – literally. For instance, I found an immaculately detailed Ferrari in front of my hotel this morning, played pedestrian "chicken" with a custom Porsche Cayenne SUV in the crosswalk at noon and met world famous actor and Kung Fu legend, Jackie Chan, in the lobby this afternoon.

It’s easy to explain why I love this city.

I’m also fascinated by the political, economic and business intrigue that is making China one of the very best profit opportunities of our lifetime. If you want proof, just look at the most recent oil-supply deals that country has reached with Russia.

Energy Deals Assist Cold War Thaw

Not long ago, I wrote about how Russia and China were destined to be global partners when it comes to energy – and noted that it would be the United States that created the incentive for these two former Cold War warriors to link up. In a story published just a few months ago, I described how China’s energy foray into Iraq was the initial part of that strategy. Well now it’s time for Round Two of this strategy to unfold.

Russia and China recently 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.

The terms of the contract are fascinating – and illuminating. Russia will provide China with roughly 15 million metric tons of crude per year from 2011 to 2030, with much of the "black gold" flowing through the 1,030-kilometer pipeline that’s being constructed to run from the Skovorodino refinery in Eastern Russia to Mohe County in China’s Heilongjiang province. It’s a branch of the even bigger 4,700 kilometers (2,900 miles) East Siberia-Pacific Ocean Pipeline that’s currently under construction.


Additionally, during talks leading up to the oil-supply agreement, both nations talked turkey on such topics as natural gas, nuclear energy, coal, electric power and resource-industry-equipment manufacturing.

Is America Being Relegated to Spectator Status?

What China and Russia very clearly understand (and that the Western countries have totally missed) is that this oil-supply deal is just part of a much bigger strategic drama that’s being played out here.

For its part, China believes that the oil pipeline will greatly reduce the risks of its oil imports, the majority of which come through the China’s oil imports the vast majority of which come through the Strait of Malacca. (Interestingly, China’s nuclear subs were just on parade for the first time ever as part of the 60th Anniversary of the founding of the PLA’s Navy in Qingdao, Shandong Province).

Russia, according to Prime Minister Vladimir Putin, believes that an oil pipeline directly to China will give Russia a stable and reliable oil market in the East. Not only will this help Russia access the capital markets, but it can also help that country access hard assets from other sources, tightening Russia’s grip on the top energy markets in that region of the world.

Either way, this deal is a game-changer – both for the two countries involved (China and Russia), as well as for those who aren’t (the United States, for instance).
And if you take a minute to read between the lines, comments made by leaders on both sides point to a desire to have an even tighter China-Russia relationship in the years to come. This will really lock the United States out of the game, and will also wrest an increasing amount of energy-pricing control from the Organization of Petroleum Exporting Countries (OPEC) cartel – two developments that I’ve repeatedly warned readers to watch for.

Russian Deputy Prime Minister Alexander Zhukov used surprisingly strong language when he remarked last month that it is highly possible Russia would become China’s largest energy supplier in 15 years. China Vice-Premier Wang Qishan noted that the package including all aspects of construction, loans and crude oil trade would become "immediately effective," which is translated literally from Chinese and which means that he’s putting the Chinese bureaucratic machine on notice that this is a high-priority project not to be trifled with in any way.

With good reason, energy is a key to both China’s ongoing development and to stability in that region. I fully expect to see more deals like this on a variety of commodities and natural resources in the next 12 months to 24 months. View each deal as a sign of a growing regional stability that could contribute markedly to China’s growing leadership power, as well as to a global recovery – all of which are important developments for investors looking at this part of the world.

News and Related Story Links:

• AsiaOneMotoring.com:
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• JackieChan.com:
  Official Jackie Chan Web Site.

• Money Morning Market Commentary:
  How China is Beating the United States in the Global Oil Game.

• Wikinvest:
  China’s Energy Appetite.

• SteelGuru.com:
  Transneft and Rosneft ink agreement on oil supplies to China.

• Wikipedia:
  Skovorodino.

• Wikipedia:
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• Wikipedia:
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• Wikipedia:
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• UPIAsia:
  China’s Vulnerability in the Malacca Strait.

• FAS Strategic Security Blog:
  New Chinese Ballistic Missile Submarine Spotted.

• China.org:
  China concludes celebration of navy anniversary with grand fleet review.

• Wikipedia:
  Vladimir Putin.

• Wikipedia:
  Wang Qishan.

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

HONG KONG – The question came to me as I was standing on the floor of the Hong Kong Stock Exchange here. I’d be willing to wager that quite a few investors – both within China and back in the United States – are wondering about this, as well.

Here it is: Will China implement a long-rumored capital-gains tax, and risk (another) major sell-off as a result?

Only Beijing’s inner circle knows for sure, and that only stokes investor speculation. The uncertainty can lead to rampant, knee-jerk sell-offs each time the scuttlebutt of an "imminent" tax surfaces. And those rumors have been surfacing over and over again – since 1994. That’s the year that Beijing’s Ministry of Finance pronounced that income derived from stock trading was exempt from personal income taxation.

That means that billions of dollars have changed hands – tax-free – as far as Beijing is concerned. For westerners accustomed to normal taxation and mature financial markets, this is almost incomprehensible. Yet, for the Chinese government it makes sense. Not only does this tax-free status encourage active market participation from Chinese consumers who otherwise would almost certainly not bother, but it also attracts foreign assets to a market like a porch light attracts moths on a hot summer night.

This foreign capital has had two beneficial effects. It helps ensure that there’s an active market that’s always awash in liquidity. And it’s probably also helped China keep its economic growth rate at around 9% per annum, many economic experts and other commentators say.

But what’s good for the goose is not good for the gander. Turns out that as much as 40% of the profits reported at the corporate level on the Shanghai and Shenzhen stock exchanges in 2007 were derived from investments in other publicly traded companies – and not from ongoing operations in their "core" businesses.

No wonder western investors are scratching their heads in amazement at the volatile stock prices. Not only are huge chunks of the market driven by individual investors who don’t have to report their activities, but also corporations and other investors – many of who have transformed securities manipulation into a new art form – have been able to trade with relative anonymity for years.

That changed in November, when China’s Ministry of Taxation required investors to report income derived from stock trading even though it remains untaxable. Understandably, smaller investors fear that this is another "Big Brother" scenario like so many others that they’ve seen through the years. And corporations are being dragged – kicking and screaming – into a new era of greater visibility and more-complete financial transparency.

And that brings us full circle.

By western standards, China’s markets are still highly primitive on many different levels – including those related to individual reporting requirements. Yet they remain full of promise, too. And the increasing regulation – including the new reporting requirements we’ve detailed here – are another in a long and ongoing series of steps needed to bring China’s securities markets up to global standards.

Those changes are all very positive. And they’re ongoing. That’s why we have faith in the long-term potential for China’s stock market. And that’s why we believe you should, too.

[Editor's Note: "The View From China" is an investing travelogue chronicling Money Morning Investment Director Keith Fitz-Gerald's current journey through Mainland China. Fitz-Gerald last wrote about the mindset U.S. investors must adopt to profit from China's form of capitalism. Next up: What we can learn from China. For a detailed look at China stocks, please take a look to see how you can obtain a free copy of investing guru Jim Rogers' new bestseller, "A Bull in China."]
News and Related Story Links:

• Wikipedia:
  The Hong Kong Stock Exchange.

• Op-Ed Column: Rod D. Martin:
  Abolish the Capital Gains Tax.

• Money Morning Investing Travelogue Series:
  The View From China: The Single Secret That Will Put You on the Pathway to Profits.

In the latest move underscoring China’s push to create captive supplies of key natural resources, Blackstone Group LP (BX) is planning a bid for Rio Tinto PLC (RTP) that may include China’s sovereign wealth fund, according to several media reports emanating from Asia early today (Monday).

China Investment Corp., which in May paid $3 billion for a 9.4% take in Blackstone, has already denied this month that it might bid for the London-based Rio, which itself is already working to wriggle away from a $137 billion hostile offer from BHP Billiton Ltd. (BHP). Blackstone operates the world’s biggest leveraged buyout (LBO) fund.

But Blackstone has appointed lawyers and is in talks with banks and public-relations companies to position itself for the huge buyout offer, according to the London-based Daily Telegraph newspaper and Bloomberg News.

A BHP takeover of London-based Rio would concentrate supply of copper, iron ore and coal and may spur Chinese companies to step up global takeovers to secure raw materials. Although investors evaluating the reports sent Rio Tinto’s shares higher by nearly 2% in trading in Australia early this morning, not everyone believes the media reports are true.

“I don’t think China Investment Corp.’s current position in Blackstone is big enough to use Blackstone as an investment tool,” Lu Yizhen, who helps manage $640 million at the Shanghai-based Citic Prudential Fund Management Co., told Bloomberg.

But the pending potential buyout illustrates two key global trends that U.S. investors should watch closely – and capitalize on for substantial possible profits – as the trends play out. The rumored deal underscores:

• The inspired push China-based firms are making to lock up suppliers of key commodities – a push that has the blessing of their government.
• And the growing importance of so-called “sovereign-wealth funds,” the gigantic state-run investment pools that are projected to become dominant forces in global finance in the decades to come. Indeed, according to one estimate, the amount of capital held by worldwide sovereign wealth funds could grow from $3 trillion today to $12 trillion 2015. And that may be conservative, as some forecasts state that the funds could hold $20 trillion by the middle of the next decade.

Other buyouts announced late last week stand as additional evidence that these forces are already at work.

The List of Deals Grows Longer

In a buyout proposal announced late last week, China’s second biggest iron ore trader, Sinosteel Corp., has offered to pay $1.1 billion for Midwest Corp. Ltd. (PINK: MISKF), an Australian mining company.

Nor was Sinosteel wasn’t the only China-based company shopping last week, The Wall Street Journal reported. Northern Peru Copper Corp., a mining company based in Vancouver, revealed it received a $449 buyout bid from a duo of other state-run ventures from China: China Minmetals Nonferrous Metals Co. and Jiangxi Copper Co., (PINK: JIAXF). In a company statement released late Thursday, Northern Peru Copper said it supported the bid. A Minmetals spokesman declined to comment. Jiangxi Copper officials couldn’t be reached.

Even though Rio Tinto Chief Executive Officer Tom Albanese, recently described a prospective $137 billion merger with BHP as being “dead in the water,” the very specter of such a mega-merger has served as a wakeup call to many in the Chinese metals industry.

“The potential BHP-Rio merger has prompted Chinese companies to speed up overseas acquisitions to grab more resources,” Ma Hatian, an analyst with Beijing Antaike Information Development Co., told Bloomberg News. “China is repeating what Japan had done in the 1980s [and] that is to boost overseas investment to secure raw materials for development of its heavy industries.”

Too Big To Ignore

Indeed, if BHP and Rio did merge, the combined company would have market value of about $380 billion and annual sales of about $54.6 billion, based on 2006 figures. By contrast, archrival Anglo American PLC (AAUK) had revenue of only $33.1 billion last year. Even more critical: The combined BHP-Rio would control 38% of the seaborne iron ore trade, according to Australia & New Zealand Banking. China’s leaders fear that such an industry colossus would give suppliers greater leverage and lead to vastly higher prices for a country that is the world’s biggest user of iron ore and other key minerals.

Rio has spurned BHP’s advances, saying the latter company’s offer was way too low. And many experts believe it would take an offer of at least $200 billion for an industry player such as Baoshan Iron & Steel Co. Ltd., otherwise known as Baosteel, to get a deal done.

The government-owned Sinosteel has an initial joint venture with Midwest to develop two iron ore projects in Western Australia. But a merger would give the company a reliable supply of raw material for its operations.

“They want to get their hands on iron ore direct,” Gavin Wendt, a senior resource analyst at Fat Prophets Management, told Bloomberg. “It isn’t surprising given the extraordinary level of Chinese interest in Australian iron ore.”

The price of iron ore has risen for five straight years on increased demand from China, the world’s largest steelmaker. Many analysts believe prices will rise 50% next year.

Last week, Baosteel, China’s largest steelmaker, said it was seriously considering a bid for Rio Tinto. However it doesn’t look as though Rio is for sale. In addition to saying a deal with BHP was effectively stalled, Albanese, Rio’s CEO, said his firm had been approached with offers from other suitors, but isn’t interested.

“Lots of people have been calling, but we have not been engaging,” Albanese said in an interview with CNBC.

With Blackstone and China Investment now reportedly involved, the question now becomes: To engage, or not to engage? Only time will tell.

News and Related Story Links:

• Bloomberg News:
  Blackstone, China May Bid for Rio, Telegraph Says.
• Money Morning:
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• Bloomberg News:
  China’s Sinosteel Offers A$1.2 Billion for Midwest.
• Money Morning:
  Blackstone Booms on Its First Day of Trading.
• CNBC:
  Rio chief says BHP proposal "dead in the water."
• Money Morning:
  Chinese Steelmakers Set to Swing Back at BHP Billiton.
• Money Morning:
  The Iron Giant That Could Challenge the Chinese Mega-Market.
• The Wall Street Journal:
  Chinese Mining Firms Look For Assets in Australia, Canada.
• Fat Prophets Management.
• Gavin Wendt, Fat Prophets Management Head of Mining and Resources Management.
• Money Morning:
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An overwhelming majority of South Africa’s Standard Bank Group Ltd. (JNB:SBK) shareholders approved the sale of 20% of the bank’s assets to state-owned Industrial and Commercial Bank of China Ltd. (HKG:1398) – a $5.4 billion purchase, making it China’s largest overseas investment.

More than 95% of Standard Bank shareholders approved the sale of new shares at 104.58 rand ($15.32) per share and the sale of existing shares at 136 rand ($19.92) per share to ICBC, Reuters reported. The banks made the deal in late October, but shareholders hadn’t given it the rubber stamp until now.

Standard Bank is Africa’s largest lender, servicing 18 sub-Saharan countries. Meanwhile, ICBC is the world’s largest bank by market value.

"This agreement is definitely of economic interest to both parties, as well as a catalyst to cement the economic and trade ties between China and Africa," ICBC chairman Jiang Jianqing said in an October statement.

China’s Interest in Africa

African Business reports that trade between Africa and China grew at a rate of 40% a year since 2001. Last year, bilateral trade between the two was $50 billion.

While China has initiated trade with Africa in a wide range of sectors, its principle interest seems to be oil. China is growing at record rates and it needs commodities to sustain its pace. Sub-Saharan Africa has scores of oil and mineral reserves, and those reserves are in countries in dire need of infrastructure to elevate their economies and public image, above that of abject poverty.

Already, 14% of China’s oil imports come from Angola. About 60% of Sudan’s oil goes to China. The copper industries of Zambia and the Congo are flush with Chinese investments, as are the timber industries of Cameroon, Mozambique and Liberia.

This latest deal aligns China’s government with the largest bank in Africa, paving an inroad to the long-term, commodity-driven economic growth economists are calling for – beginning with a joint $1 billion global mining fund to invest in natural-resource projects between the two banks, Bloomberg reported.

In real terms, China’s government will get a piece of every new loan, every ATM fee, every credit card, etc. taken from Standard Bank.

And Standard Bank is doing its best to invest its latest mountain of cash into areas of growth:

"We will try to keep almost all the money that we can outside of South Africa because it is earmarked for growth in Africa and growth outside of Africa," Jacko Maree, Standard Bank CEO, told Reuters.

News and Related Story Links:

• Reuters:
  Standard Bank shareholders approve ICBC deal

• African Business:
  Standard Bank deal points to new China-Africa direction

I sat down last week with market analyst and Money Morning Contributing Editor Keith Fitz-Gerald for our monthly interview. In our last discussion, in mid-October, Fitz-Gerald specifically warned that stock prices in China could correct in November – just as they’ve done. China remains the greatest long-term growth story on Earth. But Fitz-Gerald warns that investors must research their investments well, and must be patient, as it "won’t be a straight ride up."

Here are some highlights from our interview…

WP: Keith, in our interview last month, in some of the columns you’ve penned for Money Morningand in the many discussions you and I have had, there were three recurrent themes – each of which has played out as you anticipated. We had the slight sell-off in China, a sell-off here in the United States, and a continued escalation in oil prices up to that psychologically important $100 a barrel price level.

So, what’s your take on what’s happening right now? And, more importantly, what’s next? Is this all just one of those periodic corrections that keep markets honest – and healthy? Or is it the start of something much more dramatic?

KFG: Well, those are very important questions.

In order to really get a handle on what we’re dealing with, I believe we need to look at the markets on two levels: fundamental and the technical.

From a fundamental standpoint, we’ve clearly got some challenges. That’s also true from a technical perspective. As a result, investors need to be thinking about how to protect their capital as well as where the next profits are likely to be found.

WP: Can you elaborate?

KFG: Absolutely. Fundamentally speaking, our markets are struggling with the triple specters of high oil prices, what I like to refer to as "an attention to deficits disorder" originating at the highest levels of our government, and lastly a dollar that has weakened to levels that were previously unthinkable. Each of these phenomena are well documented.

What’s really roiling the markets right now, though, is the fear of the unknown as it relates to the credit crisis and the potentially broad fallout any such spillover could have on the U.S. economy.

My belief is that the next shoe is ready to drop and that it’s going to spook a lot of people when it does. In fact, we’re seeing a little of that already.

WP: How so?

KFG: Well, Bill, as you’ve written yourself, many banks, homebuilders and financial institutions have yet to really come clean and put a real number on their credit-crisis exposure – direct or indirect.

WP: In some cases – and this is really worrisome – it’s clear that some of the players can’t even quantify what they’re facing. Others just seem to refuse to.

KFG: Well that’s just it. In particular, the largest financial institutions sell something called "collateralized debt obligations," or CDOs for short. These nasty little instruments are made possible by something called "conduits," which are really highly specialized financial instruments collateralized by mortgage debt and other assets. And here’s the important part: Most of these are being carried "off" the company’s sheets.

In real terms, this means that even though companies are not yet reporting them, they could potentially have hundreds of millions of dollars of exposure that has yet to be reported.

As long as these institutions keep selling their debt, the money will keep moving and this will not be an issue. However, if the buyers go away, the institutions originating the CDOs could be held liable for their funding in which case all of this money would have to be accounted for on the balance sheets. This will have a big impact on income statements, as well.

WP: This has to relate to the technical picture you’re seeing right now.

KFG: Clearly, the two are related. The trick though is that Monday’s post-holiday trading brought us down dangerously closer to the 1410 area on the S&P 500 Index. We view that as something called a "balance point" in our proprietary analytics. Should we fall below 1410, the picture really could become unpleasant.

WP: The market’s been flirting with that level all week. It seems as if the outlook is pretty bleak at the moment. Is it? Also, this might be a good time to talk about your strategic use of stop-losses. You’re one of the few investment pros I’ve interviewed through the years who spends as much time focusing on managing risk as you do on positioning yourself for maximum returns.

But let’s start with the market outlook. Your analysis sounded kind of dire.

KFG: I don’t think things are exactly "bleak," and I’ll give you two reasons why that’s so:

• First, if you’ve been using trailing stops as we all advocate here at Money Morning and The Money Map Report, you should be carefully taking profits as the markets fall. If not, it’s not too late to put stops in place in your portfolio – both to minimize losses and to safely move profits to the sidelines as market uncertainty escalates.
• Second, should we break through the 1410 level, you’ll actually be able to turn the correction into a major positive by using it as an opportunity to diversify your profits – and profit opportunities – in the months to come.

WP: Can you explain what you mean by that?

KFG: Many investors are currently sitting on portfolios dominated by U.S. stocks. As the U.S. market retrenches and the trailing stops I’ve mentioned gradually reduce their U.S. holdings, these investors can take those profits and use them to diversify into internationally oriented securities that are poised to advance no matter what happens here in the U.S. market in the month to come.

WP: Can you give some examples?

KFG: Absolutely. In fact, Bill, you’ve identified some of these yourself …. ….Boeing Co. (BA) and Yum! Brands Inc. (YUM), for instance. I also like ABB Ltd. (ABB) and PepsiCo Inc. (PEP).

WP: With Pepsi, you were one of the few to understand the huge upside investment potential of that very slick marketing campaign that "unofficially" capitalizes on the upcoming Summer Olympics in Beijing. [To read that investment report on Pepsi, and how it may have "outfoxed" rival Coca-Cola Co. in China, please click here. The report is free of charge.]

KFG: What you’re looking for are companies like Boeing, Yum, Pepsi, and ABB that are presently growing their overseas sales by double-digit rates. In particular, you want to home in on those companies that derive a substantial portion of their sales in markets outside the United States and which benefit from virtually unstoppable global trends.

WP: Such as China’s ongoing emergence, which will continue for decades…

KFG: Exactly.

WP: And you always note that these typically should be viewed as long-term investments, and not something timed for a quick payoff.

KFG: That’s exactly right. That’s why you have to manage your risk in the near term, since that gets you into the long run, where the dividends and profits really compound returns.

WP: I know you’re not really a fan of these strategies, but should investors be dollar cost averaging or doubling down right now?

KFG: As you said, I’m not a huge fan of doing that. Instead, I advocate a properly diversified portfolio with up to 50% of investable assets in something that I call the "safety and balance" category. Another 40% [roughly] should be focused on income, which has been shown to substantially dampen market volatility. And, finally, having covered those two bases, around 10% should be invested in carefully chosen speculative plays.

Despite what you hear from the pom-pom squad, it’s too early to wade – whole hog – back into the markets on the assumption that everything’s going to be hunky dory.

WP: What else can investors do?

KFG: If they are feeling opportunitistic, they can invest in any of half a dozen ultrashort ETFs that benefit from falling markets. My favorites right now include the Rydex "URSA" [Latin for "bear," as in "bear market"] Inverse S&P 500 Strategy Investment Fund (RYURX), which grows as the S&P 500 falls, and the brand new PROSHARES US FTSE/XI (FXP), which appreciates as the iShares FTSE/Xinhua China 25 Index (FXI) falls.

Of course, more-seasoned investors can also utilize "put" options, but those are an entirely different animal.

WP: Of course, you do quite a bit of that in your VIP trading services, such as The New China Trader. With that kind of service, it doesn’t matter what direction the markets are headed….you can always find profit opportunities.

KFG: That’s correct. We’re even starting to do a bit more with options in our monthly newsletter, The Money Map Report, although that still remains more of a globally focused newsletter that uses conventional equity strategies.

WP: Thanks for your time, Keith.

KFG: My pleasure – as always….

WP: We’ll sit down and chat with Keith again next month.

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• Money Morning Investment Research Report:
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Unlike the United States Federal Reserve, which seems to be content with a dollar policy of benign neglect, the Chinese central bank actually has real power and isn’t afraid to use it to protect and nurture the country’s economic health.

Most recently, China’s central bank – The People’s Bank of China – boosted the key reserve requirement for the nation’s commercial banks by half a percentage point to 13.5%. The central bank also raised deposit rates and key savings figures.

I realize that this may not strike readers as interesting at a time when the U.S. stock markets are struggling, but it provides an important confirmation of two things:

• First, it shows us just how strong China’s economy really is.
• And, second, it demonstrates exactly what the Chinese government is thinking when it comes to the next great step in that nation’s financial growth.

Let’s talk about the Chinese economy first.

Many investors are concerned that the bubble has burst, that all the profit opportunities are gone, and that somehow China is headed for a meltdown. Indeed, the real conspiracy theorists believe China has temporarily propped up the stock market in such a way that once the curtain comes down on the summer Olympics in Beijing next year, it’ll be "curtains" for Chinese shares, as stocks prices there implode.

They couldn’t be more wrong.

The interest rate hike is the ninth such increase this year alone. It’s an important step, a move intended to restrict the money flowing into the Chinese economy to curb what the People’s Bank of China refers to as "excessive credit growth."

Strip away the bureaucratic-speak that’s a common manifestation of central bankers the world over and what you’re left with is this: What China’s central bank is actually saying is that the nation’s economy is on fire.

According to the latest figures, in fact, China’s economy is surging at an annual rate of 11.9%, putting the country on track for a fifth-straight year of double-digit growth.

That’s impressive enough, but consider that this five-year surge follows 25 years of growth that averaged nearly 10% annually. The U.S., by comparison, advances at a 3% to 4% clip in a good year, and the average is probably half that, so we’re talking about growth rates in China that are four, five or even six times higher than our own.

If you consider that China is still primarily a cash-driven economy, and you compare what’s happening there to better-developed regional economies like Japan and Taiwan, the "official" growth rates are probably low … way low. In fact, it’s not crazy to believe that China’s real economy – the cash-based one that can’t be accurately measured on an official basis – is growing 15%-20% a year.

By increasing the reserve requirement, China’s central bank wants to encourage commercial banks to hold onto a greater percentage of their deposits, rather than recycling them as loans into the broader economy. Theoretically, this will curb the flood of capital that’s driving growth as everyone from normal China citizens to Western capitalists tries to profit from the "China Growth Miracle."

I’ll tell you right now that this rate increase by the central bank – like the increases that preceded it – will fail miserably.

Lending volumes have nearly doubled this year already and money-supply growth is actually accelerating. What’s more, the yuan is arguably undervalued by as much as 40%, and China’s stock markets are on a tear – even if you factor in the recent pullback.

And that brings me to what’s next in the Chinese financial markets.

With the way China’s markets have whipsawed investors in recent days, many people assume that the party’s over. [For an illustration, click here to track a month's worth of closing prices on the closely watched iShares FTSE/Xinhua China 25 Index (FXI) exchange-traded fund (ETF)].

Walking away now would be a mistake.

Indeed, when it comes to China, we’re still in the opening frames of what you can expect will be an exciting extra-inning ballgame. There will be many more volatile stretches like the current one. But each time – the present included – Chinese stocks will shrug off the fears and resume their march toward higher ground.

Here’s why:

• First, as we noted earlier, the economy is on fire. Hundreds of millions of people are trading stocks. It’s inevitable that most middle-class China consumers will want a piece of prosperity, meaning there’s still big blocks of cash that hasn’t yet entered the stock market.

• Second, you could argue the recent stock-price declines are, not surprisingly, being orchestrated by Beijing, although the country’s leaders would never admit it. Without boring you with the details, China’s getting ready to launch a stock-index futures market, so it’s entirely conceivable the government is making a concerted effort to knock share prices back to more-reasonable valuation levels before an even-bigger flood of capital hits the markets and pushes share prices far higher. Interest-rate increases are part of that effort to suppress stock prices. So are the instructions the central bank has issued to state-run pension funds, in which the fund managers are ordered to cut back on their holdings of China shares. That’s yet another source of potential downward pressure on stock prices.

• And third, this will result in an evening-out process that we here at Money Morning identified months ago when we suggested that investors avoid the China-based highfliers in favor of seemingly staid-and-boring companies that are actually superbly positioned to benefit "because of" the growth in China.

Case-in-point, consider some of China’s banks and insurance companies, which have been largely ignored in favor of sexier technology and industrial firms. These denizens of China’s financial-services sector have actually stabilized and even risen in value on several of the bigger down days recently. Part of that is associated with a record yuan parity rate of 7.4162 to the U.S. dollar.

That’s unlikely to change in the near future and the sector should see above-average returns in the next 12 to 24 months.

But investors will have to move with caution to make certain they don’t get burned in the interim. Beijing is notoriously secretive when it comes to many things, and protecting the yuan – as well as the future viability of the stock market – by pushing down near-term stock prices certainly qualifies.

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China Fire & Security Group Inc. (CFSG), China’s leading maker of fire-safety equipment and systems, has a $1 billion opportunity in its home market, thanks to a newly enacted fire code few industrial companies have complied with yet, an analyst wrote in a research note.

Michael H.V. Tieu, a China-technology stock specialist with investment researcher Brean Murray, has initiated coverage of China Fire & Security with a "Buy" rating, and established a target price of $19.

The Beijing-based company makes and markets industrial-grade fire-safety products, has the billion-dollar opportunity before it thanks to a national fire code that was put in place in April, Tieu wrote. But few are in compliance; indeed, in one major industrial sector alone, more than three-quarters of the major companies are still working to meet the new regulations, he said.

In related news, China Fire & Security yesterday (Wednesday) reported record revenue and earnings for the third quarter, with revenue jumping a much better than expected 44.2%, and net income soaring 187%. What’s more, the company said that by focusing on proprietary products – which carry much higher gross margins – overall corporate gross margins rose to 59.2%, also a new record.

All the results exceeded expectations.

For the quarter ended Sept. 30, China Fire & Security said that sales reached $11.6 million, up $3.6 million, or 44%, from the comparable quarter the year before. Operating income rose to $4.1 million, an increase of 253% from the $1.2 million reported during the third quarter of 2006. Net income rose 187%, from $1.5 million last year to $4.4 million in the third quarter of this year.

"We are pleased to report another consecutive quarter of record revenues," said Brian Lin, the company’s chief executive officer. "During this quarter, our top three customers are from [the] iron and steel, power, and petrochemical sectors."

In light of the record-breaking third quarter, China Fire raised its full-year estimate. Previously, the company had been forecasting net income in the range of $14.7 million to $15 million. Yesterday it boosted that to a minimum of $16.6 million.

Earnings per share should reach 60 cents on a fully diluted basis, compared with a prior range of 50 cents to 54 cents, the company said.

Formerly known as Unipro Financial Services Inc., China Fire & Security designs and manufactures industrial fire-safety systems. It also designs and installs industrial fire-safety systems, using its own products as the systems’ key building blocks. It markets these products, systems and services chiefly to companies in the iron-and-steel, power and petrochemical sectors in China.

The company’s three largest customers are Maanshan Iron and Steel Co. Ltd., Sichuan Dongfang Electronic Equipment, and PetroChina Co. Ltd. (PTR), accounting for approximately $4.9 million, or 43%, of the total revenue for the quarter, China Fire reported.

In addition to those mainstay markets, China Fire & Security has completed products for use in both highway and railway tunnels, tobacco warehouses, and a nuclear reactor – all facilities where the need for fire-safety measures are much higher than in conventional industrial facilities.

The company is now looking to move into such key business areas as transportation, wine-and-tobacco, ships and seagoing vessels, nuclear power plants, and public-space-markets. Those are all growth markets, given the emergence of a consumer class in China, and given that country’s position as a supplier of labor and components to the world. These also all represent a logical step for China Fire to make, since its products are readily adaptable to such uses, the company said.

China Fire & Security’s key products include linear heat detectors, and water-mist extinguishers.

In his research note – which was published last week, prior to yesterday’s earnings announcement – Tieu said that 80% of the 1,000 iron-and-steel manufacturers in China don’t comply with the new national fire code enacted in April. That equates to a market opportunity of almost $1 billion, said Tieu, who covers China-based technology stocks for Brean Murray.

China Fire & Security is a leader in this market, and its revenue pipeline is growing, Brean Murray added.

The $19 target price would represent a gain of 18% over the yesterday’s closing price of $16.09. China Fire’s shares actually soared $2.44 each, or 17.88%, after the company’s earnings report was released early yesterday.

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China’s trade surplus for the first 10 months of the year expanded by 59% to $212.4 billion, easily eclipsing the full-year record of $177.5 billion set in 2006.

According to figures released by the General Administration of Customs, October’s trade surplus rose 13.6% from the same month last year, to a new monthly record of $27 billion. The previous monthly high was $26.9 billion set back in June.

The massive influx of foreign currency into China has resulted in excess liquidity, soaring foreign reserves and rapid inflation – all three of which are irritating trade partners. Still, the Beijing government has refused to let its currency appreciate.

Trade partners, specifically the United States and European Union, insist that the undervalued yuan provides China’s domestic exporters a significant price advantage over competitors.

For the month of October, China’s trade surplus with the EU rose nearly 50%, reaching  $13.9 billion. According to the European Commission, the EU trade deficit with China rose by one-fifth last year, and is rising at a rate of 15 million euros an hour [the equivalent of $21.91 million an hour] – which is actually a higher rate than the one faced by the United States.

China is by far Europe’s largest source of imported goods, but the 27 member nations of the EU export less to China than they do to Switzerland.

 In October, China’s surplus with the United States rose 12% to $15.7 billion. The United States reported a $232.5 billion trade deficit with China last year.

The United States has historically led the charge in lobbying China to abolish unfair trade practices, but the European Union isn’t far behind. Admitting that the dialogue – and cooperation – with Beijing had broken down, European Trade Commissioner Peter Mandelson has been a leading critic of how European diplomacy has repeatedly failed to bring about changes in China’s economic policy. Mandelson has even suggested that the EU should follow the United States’ lead in levying trade sanctions against China.

In a four-page letter to the president of the European Commission last month, Mandelson referenced the "Chinese juggernaut," and challenged the EU to take a tougher stance, one more closely aligned with Washington, the International Herald Tribune reported.  He said that, China has "failed to respond to a policy of cooperation and dialogue," adding that current policies are "no longer delivering sufficiently credible results."

In the letter, Mandelson wrote that European countries should be more willing to use the World Trade Organization’s avenues of dispute resolution to enforce the rules, and noted that Europe’s nations "shall also need to maintain rigorous use of anti-dumping and other means of trade defense."

Since 2001, Mandelson says, the EU has brought only one case against China to the WTO; the United States has brought six cases during the same period.

In economics, "Dumping" is another word for "predatory pricing," and is the term employed in international trade circles when one country sells goods in another market for a lower price than it sells those same goods back at home. It’s a twofold strategy. It helps the exporter grab overseas market share. And, over the long haul, it can drive the targeted foreign rivals out of business, or at least weaken them so much that they’re vulnerable to a takeover.

Japan was once the global bad boy when it came to dumping. In a famous WTO case in the 1990s, photo giant Eastman Kodak Co. (EK) alleged that Japan-based rival FUJIFILM Holdings Corp. [formerly Fuji Photo Film Co. Ltd.] (FUJI) was using its home market of Japan as a "profit sanctuary," by largely blocking out foreign competitors. Then it "dumped" film in the U.S. market, eroding Kodak’s market share and its profit margins. Kodak lost the WTO case, Fuji built a modern film plant in South Carolina, and then digital photography leapfrogged conventional film much faster than anyone expected. Kodak has been an embattled corporation ever since.

Now China appears to have supplanted Japan as the dumping heavyweight; China is now the country that’s the most frequent subject of anti-dumping investigations, with 36 complaints brought against its exports in the second half of 2006 alone. The second-place country, Indonesia, had seven cases brought against it.

Indonesia was the second biggest target with seven cases brought against it.

However, anti-dumping measures aren’t all China has to worry about. Cash pouring into the country has also resulted in a higher rate of inflation. Food prices rose 17.9% in October from a year earlier, with pork soaring 55% and fresh vegetables spiraling 30%.

As a result inflation has been driven to an 11-year high of 6.5%. And most experts believe that figure is drastically understated.

"Food inflation has expanded into other categories – energy, labor and asset prices," Chris Leung, s senior economist at DBS Bank Ltd., told Bloomberg News. "Everyone in China is feeling inflation, especially the poor."

And the massive currency reserves aren’t really helping the country, either. That’s because the "money supply is growing very fast and that is [worrisome] because it may push inflation higher," Paul Cavey, an economist at Macquarie Securities Ltd., told Bloomberg.

China’s central bank – The People’s Bank of China – already has increased the proportion of deposits banks must hold in reserve nine times, a move aimed at reducing lending in the country. Three days ago, the central bank ordered lenders to set aside 13.5% of their deposits from Nov. 26, the highest proportion since 1987. The bank has also raised the benchmark one-year lending rate six times this year, and it now stands at a nine-year high of 7.29%.

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Throughout 2007, India has attracted more private equity investments ($10 billion total) than any emerging economy, including China, according to a report from the India-focused advisory firm IndusView.

Comparatively, China only attracted $8.3 billion during that period. Last year, China received $13 billion, compared to the $7 billion by India. Some of the India’s major private equity backers are The Blackstone Group LP (BX), Carlyle Group, Washington and Actis Capital, and Temasek Holdings, the investment arm of the Singapore government. And just announced, Wexford Capitol made its first private equity investment in India – a $100 million deal in the next 12 months through its Indian partner, Baseline Capital Advisors.

Real estate and infrastructure have been the main beneficiaries of outside investment, receiving $5 billion of the $10 billion of the private equity capital that flowed into the country, India’s Economic Times reported. Real estate brought in $2.6 billion and telecom took in $2.1 billion.

"India’s private equity market can expand four-fold, using deal value as a percentage of the gross domestic product and maintain the top slot ahead of China, its nearest competing economy, and the infrastructure sector will provide the necessary edge," Bundeep Singh Rangar, chairman of IndusView, told the Economic Times.

The Times also reported that India’s trajectory in attracting private equity investments has grown by 51% since 1998, currently accounting for 1% of its GDP. Comparatively, private equity accounts for 2.3% of the United States’ GDP, and 3.3% of the GDP in the United Kingdom.

India’s government estimates that the country will require around $500 billion in investments for road, energy, ports and airports – quickly needed infrastructure elements that will open further opportunities for foreign investors.

Money Moves the Markets

This item slipped under the radar of major U.S. news outlets, but it’s very important to mention – especially to globally focused investors – because it cements our philosophy on real growth.

Money moves the markets, but to use a sports metaphor, a good quarterback can’t throw touchdowns unless he has a good wide receiver. In this case, private equity firms are choosing India as a long-term investment because the country has a more favorable business climate – in part because of its democratic government, solid banking system and a large, and skilled, English-speaking work force – that takes investment money and makes it grow. 

India has also tightly managed its rapid growth with six interest rate cuts in the past 20 months. Some call it excessive, but the cuts have kept inflation and overspending in check.

Meanwhile, the new talk on China isn’t that it’s hot, but that it’s overheated.

That’s not to say India is making all the right moves. India may be hurting itself in some areas of growth, especially versus China. And while the country leads in private equity investments, it lags in foreign direct investment.

"Private equity investment is interesting but not the whole story. China has had $50 to $60 billion of foreign direct investment for several years, largely from companies in Japan, Korea and Taiwan, while India’s corporate foreign investment has been much lower," said Martin Hutchinson, Contributing Editor to Money Morning.  

And even though those are short-term issues, it also shows that India has more room to grow. It has a smaller base than China, but that base is more substantial. It’s not as reliant on exports, making its growth more organic, said Karim Rahemtulla an expert on India who is the founder and investment director of the Xcelerated Profits Reports, as well as the editor of the Smart Profits Report newsletter.

"Long term, I would bet on India," Rahemtulla said. "India has more potential because they are starting from a smaller base. They are two decades behind China in the area of infrastructure and manufacturing. Problem is that India does not have a great number of companies that foreigners can easily invest in." 

Investing in India

If government reforms, infrastructure development, and foreign investment continue to increase, then India may be able to make up some ground. But it’s going to be a tough road ahead, literally and figuratively.

There aren’t many places to look if you’re interested in getting in on India’s developmental push. A good place to start however would be Sterlite Industries India Ltd. (SLT). The company’s primary business is the production of copper in India. Sterlite’s copper cathodes and cast copper rods can be put to use in housing wires, electrical cables, and telecom cables. The company also mines bauxite and zinc ore, and produces aluminum conductors and other aluminum products.

A more diverse play might be the India Fund Inc. (IFN). The India Fund is a non-diversified, closed-end management investment company that invests in Indian equity securities. At least 80% of the Fund’s total assets are invested in equity securities of Indian companies. Its portfolio includes common stocks, warrants and short-term investments.

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One day after oil giant PetroChina Ltd. (PTR) made its debut raising $8.94 billion, Alibaba.com Ltd. yesterday (Tuesday) became the latest beneficiary of the frenzy over Chinese stocks. The business-to-business arm of China’s biggest Internet company, Alibaba saw its shares nearly triple after its initial public offering (IPO) listed its shares in Hong Kong. Shares bolted 290% from HK$13.50 to HK$39.50, giving the Hangzhou-based company a market value of $25.7 billion. When it was all said and done, the company had raised $1.5 billion, the most ever for a China-based Internet company.

The stock now trades at 155 times next year’s estimated earnings. By comparison, Google Inc.  (GOOG), whose stock has increased eightfold since its 2004 IPO, trades at 35 times its estimated earnings.

"It’s a high valuation, but if Alibaba can use its leadership position in the e-commerce market to get more Chinese businesses to pay for its services, it will justify it," Rafe Xu, an analyst at Sinopac Securities Asia Ltd., told Bloomberg News.

Alibaba allows small businesses to buy and sell products anywhere in the world. In the quarter ended June 30, Alibaba accounted for 43% of all transactions in China’s business-to-business e-commerce market. That is more than triple its nearest rival, according to estimates by Analysys International.

China Network Information Center estimated that China was home to 162 million Internet users at the end of June, second only to the United States.

"The market size is huge," David Wei, Chief Executive Officer of Alibaba, told Bloomberg.  He also said that there are more than 42 million small- and medium-sized businesses in China, all of them potential clients.

Alibaba also has a cavalcade of sister companies that include Taobao, a consumer site similar to eBay (EBAY), and Alipay, an online payment service similar to PayPal.  According to BusinessWeek, half of all online payments in China are through Alipay, which hosts approximately 50,000 users. Those users are estimated to make 780,000 transactions a day.

Alibaba also has some very powerful partners moving forward. Yahoo! Inc. (YHOO) owns a 40% stake in the company and tech giants Cisco Systems Inc. (CSCO) and Hon Hai Precision Industries Ltd. also have invested.

The company’s profit is expected to triple to 622 million yuan ($ 83.5 million) this year, Alibaba said in its listing prospectus. Goldman Sachs estimates earnings before stock-based compensation will be 1.24 billion yuan ($166 million) in 2008. Including those costs, profit is estimated to be 1.02 billion yuan ($140 million).

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