International investors in Chinese companies face growing risks

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Some people are kind of calling this the Chinese Lehman moment.

They don’t know which sector might be the next.

China is very much not invited to the party.

It really is a treacherous market.

Here’s a big question for 2022. How on earth do you make money from investing in Chinese stocks? 2021 was the point where for global investors putting money to work in China really hit the mainstream. This hit the skids in dramatic fashion.

In August a clampdown on profit-seeking education companies hammered stocks in that sector. Next came video games. Now the big risk comes from property, where developers are crumbling under mountains of debt. Mix in the new variant of Covid, and does investing in China still make sense?

It’s a few months now since some of the top global investors said that China was uninvestable. And yet Chinese stock prices have been marching higher over the past 18 months. So some investors are clearly making money. One strategy being employed by domestic investors is to invest along with the Chinese Communist party. But needless to say, this raises some ethical issues for many global investors.

We’re almost living in a kind of rolling crackdown when it comes to China’s approach to international investors now. The signs have been there for quite a long time. You look back to the end of 2020 and the IPO of Ant Financial was torpedoed at the last minute. Last year we had a series of unexpected salvos against all kinds of different elements of the Chinese stock market. What is going on?

Well, I think, really, the Chinese Communist party has decided that private businesses in China represent some kind of a threat. In the case of the Ant Group, this was clearly true because it was projected that Ant Financial was going to have a market capitalisation greater than the biggest state-owned Chinese bank. There’s also another very significant data privacy and data control dimension.

In other words, the Chinese Communist party is simply not happy with huge amounts of data being in the hands of private companies. It wants greater oversight and it wants greater control. So what we’ve seen, really, in this rolling crackdown in which the share prices of Alibaba, Tencent, DiDi, and many of the other big Chinese private tech company names have been hit is a haemorrhage in value.

Yeah. I mean, Chinese markets clearly lagged far behind other big benchmarks last year. You see about a 5 per cent move in the CSI 300 benchmark of Chinese stocks, whereas the S&P 500 moves up something like 26 per cent. China is very much not invited to the party when it comes to global stocks.

Many of the names that I just mentioned – Alibaba, Tencent – they were the go-to stocks for international investors. A lot of people are saying that there is value in the Chinese market, but it’s a bit like the Chinese phrase fishing in murky waters. If you delve your hands into the murky water, you might come up with a big fish, but you don’t know it’s there before you put your hands in.

So what a lot of investors are saying is that the way to stay in China and make money out of it, frankly, is to do what Xi Jinping wants you to do. Is to align yourself with his agenda. Now, it strikes me that that’s fine as long as you think you really understand what that agenda is. To your mind, what do you think are the priorities and how can investors coalesce around that?

There are certain areas in which this definitely seems to be a winning strategy. For instance, there are 43 military-themed stock market funds in China, and they saw a 205 per cent increase in their value in the year to the end of June 2021. Another one, of course, in a very different aspect of the economy is climate change.

China really is doing an awful lot when it comes to deploying climate-friendly technologies. Renewable energy, electric vehicles, and a host of other things as well. And what we’re seeing in that area is a huge amount of domestic Chinese money flowing in to funds that invest in those areas. But to be honest with you, a lot of people are really confused.

They don’t know when the next bomb is going to explode. They don’t know which sector might be the next for the Xi Jinping administration to target. And that makes it really treacherous.

Speaking of which, the property sector accounts for, what, a third of the Chinese economy. We’ve obviously seen Evergrande, the property developer, get itself into some real difficulty with the amount of debt that it had taken on. But it’s not just Evergrande. There are plenty of other property developers in China that are in a similar situation.

And investors don’t feel like they have a good sense of whether the state will step in every time to bail them out. What’s going on there? How big of a risk is this to the Chinese economy and also to investors?

I think the key thing to understand here is that the unwinding of Evergrande is a symptom of a much bigger issue. And that issue is repairing the Chinese growth model. It’s as fundamental as it comes. This is going to take at least 10 years to achieve.

There’s a school of thought that, look, what happens in China stays in China. This is all interesting and it’s definitely a potential economic drag, but it’s not likely to have tendrils that ensnare other bits of the financial system globally, whereas some people are kind of calling this the Chinese Lehman moment. Is the truth somewhere in the middle?

A lot of this stuff is insulated from the outside world. The main expression of the property meltdown, for instance, is in the offshore bonds that have been issued by property developers. And there we are seeing huge haircuts for international investors. So that’s not nice at all.

But aside from that we haven’t seen massive spillover effects. The one big spillover effect, I think, that will become more and more apparent is going to be simply that China has for at least two decades been the leading generator of global GDP growth. And if the Chinese economy slows, as it is very strongly now, then, of course, that may no longer be the case. We may even move to a situation in which the US is leading global growth rather than China.

Going back to some of the more granular Chinese crackdown measures, one area that they’re really uncomfortable with is overseas listings. It’s this vast system of variable interest entities where, effectively, Chinese companies can list abroad and global investors can buy something that very much approximates normal shares in these companies, but without troubling some of the restrictions that China has on foreign ownership. Beijing is clearly keen to see a stop put to this outflow of companies onto public markets elsewhere. What is its driving force here?

This is a really big issue. The number of Chinese companies listed on US stock markets has reached over 250. And their total market capitalisation in May last year was about $2.1tn US dollars. So it’s not small change by any means at all.

Now, the question is also pretty fundamental. The question is, do these companies, Chinese companies listed in the US, deserve to be invested in? Or are they just a withering asset?

Now, while this is all going on, as you say, the inflows into China globally are still there. And there’s a number of some of the biggest asset managers you can think of – Goldman Sachs Asset Management, JPMorgan Asset Management, Schroders, and Mundy – all of these massive global firms are trying to get a foothold in China itself to sell their products, effectively, to this new Chinese middle class and to this huge generation of Chinese pensioners that’s coming through.

They feel like they’ve got local partners, they’ve got local expertise, and this is something that they can work on for the really long term. Are they taking on a huge political risk here? Or is this an opportunity?

I think there are risks all over the park. One is the political risk. We spoke about the ethical questions that might surround investing in a Chinese military-themed company. That’s obvious. There are governance questions that abound in the Chinese stock market… not just the relationship of a company to the Chinese Communist party, but also much more granular stuff like, what’s the percentage of the free float of a company? Who’s on the board? What’s the transparency yardsticks that that company adheres to?

And really, can you understand their accounts? And we haven’t even mentioned the big topic, which is regulatory risk. The risk that Xi Jinping will wake up one morning and decide that where you’ve put all of your client’s money in China is now off limits. It really is a treacherous market. And yet, as we discussed at the beginning, there are major and very attractive returns to be made if you can navigate through the shoals of all of these uncertainties.

Yeah. Similarly, is there a possibility that Xi Jinping could wake up one morning and say, I don’t want western asset managers to be selling products to the Chinese population?

Chinese stock markets still need the expertise of foreign investors. They don’t so much need the money, but they definitely need the expertise. And this is what the technocrats that run China’s financial system still often talk about. And I think from any objective standpoint, that’s also true.

So if China remains keen on modernising its economy, on getting the best research and the smartest money flowing in, I think the possibility that they might just simply shut down this avenue for foreign money to get into Chinese stocks is very low.

But you need nerves of steel. It’s going to be a testing few years. Thanks very much, James.

Thank you.

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