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April 26, 2006

China: Embrace the Competition
by Axel Merk

Competition from China is going to intensify: we better stop whining and embrace it. We contrast how the US and Europe address China's rise differently; we suggest how we might be more effective at competing; and we discuss the fallout from the policies that are likely to be pursued.

The US consumer has been the primary recipient of cheap Asian imports. US policy makers have fostered consumption through monetary and fiscal policies, i.e. through low interest rates and low taxes. US policies have accelerated Asia's growth; while the intent of US policies has been to foster US growth, there have been serious unintended consequences. Notably, the stimulating environment - also fostered by much of Asia subsidizing their exports through pegged, low exchange rates - has caused a shortage of commodities worldwide, high commodity prices, and low consumer goods prices. Corporate America, faced with high commodity prices and an inability to pass on higher costs, had to accelerate its outsourcing to retain margins. The pressures have directly contributed to disappointing job and real wage growth. As we have pushed growth while dismantling the US manufacturing sector, the US current account deficit has exploded to over $800 billion in 2005 or more than 6% of gross domestic product ("GDP"); foreigners need to finance the current account deficit at a rate of over $2 billion every day, just to keep the dollar from falling.

In Europe, consumers have increased savings in recent years as they were reluctant to spend in a challenging economic environment. Asia is knocking on the doors of European consumers, and corporate Europe is feeling the pinch. Whereas the US economy is known for its flexibility, Europe is known for its rigidity. Corporate Europe is unable to adjust quickly enough to effectively compete with China. Many Europeans believe it is impossible to compete with "low cost China" and that protectionist measures must be taken to "preserve" European culture. The recent protests by French students reflect a fear many Europeans share that they don't want to give up the many social benefits - including job security. Europeans see China as a threat to their culture, they are scared they will have to adopt a Chinese lifestyle.

It is time to get rid of a myth: China is NOT a low cost country. China is a low wage country, but producers in China also face high raw material prices like the rest of the world; many regions in China face high transportation costs; the still under-developed infrastructure in much of China increases the cost of doing business; the regulatory/bureaucratic environment provides costs and challenges to producers. And notably, competition within China is cutthroat. It is not merely that the Chinese seem to be competitive by nature, but pro-growth policies ranging from pegging the Chinese yuan to the dollar to easy access to loans and other government policies have created too many businesses chasing each and every opportunity.

Successful investors in China understand the opportunities and challenges of the region. Investments in highly efficient, scalable enterprises make sense assuming there is demand for the products produced. They need to be large-scale investments to overcome high fixed costs and to operate profitably with a high volume, low margin business model. Investors in China take great care to have highly defined production processes with great emphasis on quality control. The attention to quality control has been partially the result of China's reputation a decade ago that 'made in China' referred to poor quality. Times have changed! A low skilled Chinese worker today may produce more consistent quality than a highly skilled Eastern European worker. Partially because quality is less of a concern with a highly skilled worker, less emphasis is placed on production automation and quality control in much of the West. The Chinese approach is more scalable and - at the end of the day - may yield superior quality. Also note that a couple hundred thousand of highly qualified engineers are entering the workforce every year in China. Indeed, the Chinese are aware that they cannot compete on cost -- investors concerned primarily about cost are moving on to cheaper places such as Vietnam. Instead, China is working feverishly -- and successfully -- to serve later stages in the value chain.

The way to respond to such a competitive challenge is to learn and adjust your own way of doing business. That does not mean Americans and Europeans have to work at Chinese wages. The US has the great advantage that it has a highly flexible economy. Unfortunately, well intended, but ill guided policies have pushed the US economy towards consumption and debt rather than investments. The US is now in such a weak position that no policy maker dares to call for changes that foster savings and investments rather than consumption; such policies may induce a severe recession in the short term. Yet it is precisely the medicine the US needs if it wants to prevent the risk of ever increasing pressure on the dollar as the current account deficit escalates. The rise of gold and dollar weakness over the past couple of years are warning signs of what may come should there not be a change in policies. Given the high consistency in fiscal and monetary policies in the US, we have little faith that such policies will be instituted.

Europe - because of relatively high consumer savings - is structurally in a stronger position to compete with Asia. However, rigid European structures are preventing corporate Europe from arming itself for competition. Executives waste time arguing over social benefits and wrangling with bureaucrats and local activists instead of being able to focus on repositioning the business to compete in a constantly changing world. If we do not want to adopt Asian wages in the West, we must compensate by providing incentives, rather than obstacles to invest. We have to think of ourselves as being a couple of steps ahead of the Chinese in the value chain; we must defend that position by constantly re-inventing ourselves. There are certain types of jobs that will not survive in Europe; there are also certain jobs that do not survive in China and have moved to Vietnam.

In the US, most agree that job guarantees such as the French students have been fighting for are bad for business. A company does an incompetent employee a favor by laying him or her off, so that he or she can find a more suitable job rather than wearing the company down in a dead-end career. Many Europeans think differently: it is inhumane to use an employee like a pawn, an employee must be able to plan to have a family and life. A capitalist may counter that it is an inefficient allocation of resources to pursue the European model, and that the threat of losing a job may be an incentive to work harder. In a more moderate interpretation, we argue that the best companies attract the best employees; many successful large enterprises pride themselves in low employee turnover - not because it is the law, but because they provide a fostering and productive environment. Let folks who look for job security work for companies that offer it. But do not hold back the companies that want to adapt. There will be "ruthless" companies with high employee turnover, but we doubt that these are the most successful ones in the long-term. Employee, employer and customer loyalty is a privilege, not a right.

Both Americans and Europeans need to get their act together quickly, as the rest of the world is not waiting. Consider LG, the South Korean electronics giant. After building a significant presence in much of Asia, they have not only started to conquer the more remote areas in China, but are ready to compete in the US. Last fall, Home Depot started to push appliances by LG aggressively; LG mobile phones are heavily promoted in various US markets. Western companies may have a very difficult time competing with someone who knows how to operate profitably on a large scale in Asia.

Unfortunately, our discussion is rather academic, as we do not see either the US or Europe fundamentally change. In the US, there is such an obsession with top line growth that the side effects - including an ever increasing risk to the stability of the dollar - may mushroom. And Europe will always be slow moving and not become an agile competitor. Having said that, many European companies have been able to compete much more effectively; with more reforms, these companies would be more daring in expanding their businesses within Europe, rather than shifting production abroad.

This does not mean that one cannot negotiate hard with Asia to help level the playing field. For example, the US or Europe could mandate certification of imports that they have been produced according to certain environmental standards. The automotive industry has long done this by requiring certain gas mileage on cars or standards on catalytic converters. Free market advocates are always reluctant to introduce such measures as they may easily be a back-door to protectionism. In the end, these are political questions that elected officials should decide upon.

As Asia is getting more ambitious, and the fallout in the US and Europe more pronounced, we are afraid protectionism may reign at the end of the day as the standard of living in the West is under pressure. In the US, the risk is that protectionist measures may scare away capital - capital needed to finance the current account deficit and to keep the dollar from falling. In Europe, protectionist measures will further discourage reform, further worsening its competitive position.

We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.

Axel Merk
Axel Merk is Manager of the Merk Hard Currency Fund

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks - with the ease of investing in a mutual fund.

The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Funds shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund's portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund's prospectus. Foreside Fund Services, LLC, distributor.

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