Why high oil prices are good news for investors in Asia

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China's leaders don't really have the popular touch. President Hu Jintao is rarely photographed kissing babies, while Premier Wen Jiabao doesn't often open village fetes. As heads of a one-party state, they don't need to worry too much about electioneering.

But in the last couple of weeks, top politicians have been doing quite a bit of flesh-pressing. Chinese TV carried pictures of a shirt-sleeved Wen being shown around factories in Guangdong, while fellow Politburo colleagues were snapped looking fascinated by widget-making machines in other parts of the country.

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The reason? Lots of small Chinese exporters are on the verge of going out of business and the government is keen to show them that it understands their pain. After all, business failures mean job losses and mass unemployment is the last thing that China wants.

There's a hatful of reasons why China's manufacturers are under pressure. Slowing US and European demand is one. New labour standards and higher wages is another. But the last straw is high oil prices, which have pushed up the cost of getting their goods to the West. All of a sudden, their competitive edge is vanishing and so are their profits.

Now, it might sound like a bad thing if Chinese firms are going out of business. But while expensive oil is set to cause a lot of pain in the short term, in the long run it will be good not just for China or the rest of Asia, but for us investors as well. It will put economies on a stronger footing and create new investment opportunities for us. Let me explain why

Why Asia needs to move beyond cheap goods

Asia's rapid growth has been built on making things more cheaply than Americans and Europeans can, and then shipping them around the world to Western consumers. Every major economy except the city states of Hong Kong and Singapore has followed this path to development. Then, as countries become wealthier and more industrialised, they move up the value chain to more sophisticated goods, services and stronger domestic demand.

Japan did this first, then South Korea and Taiwan. Some others, such as Malaysia and Thailand, are part of the way there. More, like Vietnam, are just beginning. China and India, by virtue of their size, occupy an in-between situation parts are well developed, while other areas haven't even begun the process.

This move up the value chain is a vital part of becoming a developed economy there's no example of a country where generally high standards of living exist alongside high levels of employment in textiles sweatshops. Emerging Asia will have to continue along that path if it wants to reach its full potential.

But there's another reason why Asia must move beyond being the world's low-cost workshop sooner rather than later. That reason is high oil prices.

The make-it-in-Guangdong-and-ship-it-to-Glasgow model that's powered Asia these last few years began gathering momentum in a time of much lower fuel prices. That made cheap labour attractive, even when you had to add on the cost of getting the goods to the West. But with shipping costs rising, it's no longer such a money-spinner.

As the cost of Asian goods rises, buyers are starting to consider keeping factories much closer to hand either in their home countries, or in neighbouring developing states, like Eastern Europe or Mexico and Central America. Yes, wages are higher but that might be offset by lower transport costs.

Rising cost is a big issue for the whole Asian business model. As MoneyWeek readers will know, we think that oil has risen too high and will fall back in the near future (see our cover story this week for more). But that's not a long-term solution. Firstly, oil is still going to be much more expensive than it was five years ago. Secondly, the slowdown in demand growth is only temporary, and in due course we expect oil to go much higher.

This is bad news for Asia. Exporters are already feeling the pinch of the slowing US and European economies as we mentioned in Money Morning a few weeks ago, thousands of firms may go out of business in China's Pearl River Delta region alone. The government looks set to slow the pace of renminbi appreciation against the dollar (since a higher currency makes exporters less competitive), increase lending to small firms and hand out tax rebates. But that's only a short-term solution the long-term one is to get out of these industries.

High oil prices will push Asia into the next phase of growth

And that's why high oil prices are in fact just what Asia needs. Lower profits in these sectors will encourage firms to move up the value chain, and give governments an incentive to stimulate domestic demand and encourage more trade within the region.

Of course, not all Asian low-cost exporters will go out of business. Firstly, many will continue to have a competitive advantage, although they may have to restructure. Goods made in the fast-growing coastal provinces of China may shift to factories further inland, where costs are lower, or to Vietnam or rural India. Secondly, as inter-region trade improves and the whole area becomes wealthier, there'll be much more demand for their products within Asia rather than the US and Europe. Asia is going to be undercutting Western factories for a long time.

But it does mean that there will be severe pressure in some areas to shift into new sectors. That's great news for investors, because it means even more investment opportunities.

Consider firms like Suntech Power and WuXi PharmaTech. Although they're listed in New York, they're Chinese businesses and fast-growing ones at that: both saw profits rise by more than 100% year-on-year in the first quarter of 2008. Suntech is one of the world's leading designers and manufacturers of solar power products, while WuXi is a research and development outsourcing company for several Western pharmaceutical firms. This isn't unskilled work like textiles, or even putting together consumer goods like washing machines. It's skilled research work and high-tech manufacturing.

Now we wouldn't recommend buying into Suntech and WuXi right now. The fact that they are high-profile Chinese success stories means investors have bid up their stocks to the point where they look pretty expensive. But there are other, less well-known players out there across a range of sectors, and those are the Chinese stocks we're going to be hearing a lot more about in the future we'll be talking about some of them in future emails.

The bad news for workers in the West is that having undercut our blue-collar industry, Asia is on the path to doing the same with white-collar work. The shift from West to East has barely begun.

Turning to the markets...

Asian markets were mixed last week, but the bear market remained firmly in place, with most markets still clearly in a down trend. Local company news reinforced the negative sentiment from Wall Street, with many companies missing earnings forecasts, especially in the export and electronics sectors.

Vietnam was the main exception. After plummeting two weeks ago on the back of a larger-than-expected cut in fuel subsidies and fears over what this would do to corporate profits, the index rebounded 4% this week, and is now up more than 9% on a month ago. Having given back all their bubble phase gains, Vietnamese stocks have stopped freefalling and it looks as if the market may be bottoming. However, with growth slowing and inflation at 27% in July, the economy still has plenty to contend with over the next few months.

In an otherwise downbeat week, there were reports that China South Locomotive, the country's largest train vehicle manufacturer, may try to raise $1.5bn from a dual initial public offering in Shanghai and Hong Kong. The listing would be a test of investors' nerves, since at least eight IPOs have been delayed or cancelled in Hong Kong this year, according to Bloomberg.

However, the infrastructure sector remains hot, buoyed by Chinese government plans to invest around $180bn in the railway system by 2010. China Railway Group and China Railway Construction, the two state-owned firms that have a duopoly over railway construction in the country, raised $5.5bn and $5.4bn in November 2007 and March 2008 respectively.