HOW TO BUY CHINA

The industrialization of China is progressing at breakneck speed, creating a voracious new consumer economy that makes America look small by comparison. China's steel production is already larger than those of the United States and Japan combined, but the country must still import steel to cover its growing needs. Its demand for cement is five times that of the U.S. cement industry. China is already the world's largest cellular-phone market, with 200 million subscribers, and the largest consumer of tobacco, with 330 million smokers. Now China's emergence as a consuming nation is creating a kind of mania in investment markets--a sense that you can't go wrong if you "buy what China buys."

The problem: this doesn't mean much at a time when China is buying everything. Investors need to discriminate. China is relatively resource-poor, and therefore its need for commodities will only increase as industrial production continues to expand and as net capital formation remains strong. Conversely, China has an unlimited supply of labor, as more than 700 million Chinese still live in the countryside and are only gradually moving to the cities to join the industrial economy. Moreover, flush with foreign- exchange reserves and foreign portfolio and direct investments, it can fund any capacity expansion for manufactured goods.

As a result, there is cutthroat competition for consumer goods such as TVs, appliances, motorcycles, cars and cellular phones. In 1999 China's cell-phone makers had 3 percent of the domestic market; now 36 domestic manufacturers hold more than 50 percent of the glutted market, and prices are collapsing. Thanks to instant communication and efficient transportation, new capacity now comes on stream in no time. Moreover, if a foreign company launches a sophisticated and profitable new product in China, numerous local rivals will copy it almost instantly and flood the market, thus depressing prices and margins.

The commodities markets are very different. Global prices were in a bear market from 1980 to 2001, when they started rallying on demand from China. Mines producing everything from nickel to copper are now running near capacity. Since it takes at least seven years to bring new reserves online, cycles of rising commodity prices tend to last 15 to 30 years. Energy is particularly sensitive to rising standards of living. The industrialization of North America lifted annual per capita consumption of oil from one barrel to close to 30 barrels. By comparison, China's per capita consumption of oil is a tad north of one barrel per year.

Across Asia, the world's fastest-growing economies (China, India, Vietnam) are going to see oil demand double every six to 10 years as consumers move from bicycle to scooter to car, fill new shopping centers, travel more widely and trade up to larger homes. Oil producers already face soaring demand from their own fast-growing populations. It's doubtful they'll be able to meet a doubling of Asian oil demand, to 35 million to 50 million barrels of oil per day, within the next 10 years or so without very significant price increases.

These trends favor oil companies with large oil and gas reserves like ChevronTexaco, British Petroleum and the Russian oil producers, but not the now popular but expensive Chinese oil stocks, which lack substantial reserves. With oil prices likely to surprise on the upside and drive exploration, oil-drilling and -service companies such as Schlumberger, Halliburton and Diamond Offshore are also likely to benefit.