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The Unpredictability of Beijing

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How should investors approach China? For some time now, it has almost become orthodoxy to presume that China – with the world’s largest domestic market and years of dramatic GDP growth – is a place where lucrative returns are on offer to all those who venture there. It was economic considerations which led the European Union down a very different diplomatic path to the United States on the issue of China; Germany in particular has spearheaded efforts to promote engagement with the country in the hope of taking greater advantage of its markets. In April, MSCI became yet another financial institution to offer its clients large exposure to China, with its launch of thematic indexes designed “to help investors capitalise on transformative trends.” These products seem to reflect the idea, undoubtedly shared by many governments, institutions and investors that future growth will be driven by an increasingly dominant China.

As MSCI’s Global Head of Derivatives Licensing and Thematic Indexes, Stephane Mattatia, said at the time:

“We have identified long-term structural trends that are expected to transform global economies, drive innovation and redefine business models. They have significant growth potential and are increasingly important drivers of earnings and equity returns. Unlike traditional, backward-looking investment approaches that focus on past winners, thematic investing reflects a future world that may be very different from the past.”

However, MSCI’s launch has come at an awkward time for investors in China. The markets in the Far East have been rocked by a number of events that have led some to reconsider the extent of their participation in the space. Since the start of the year, President Xi has instigated a number of crackdowns on various important industries, reminding the markets that China’s model of government invariably brings a degree of unpredictability that can problematise exposure to Beijing. Many, including George Soros, are questioning whether investments in China are really as lucrative as they might seem.

In July, Vice Premier Han Zheng echoed President Xi’s proclamation at China’s 19th National Party Congress in November 2017 in declaring that: “housing is for living in, not for speculation.” The housing ministry subsequently announced that “the regulators [were to] launch a probe into new construction by property developers, the use of illegal funds for mortgages and the deduction of rental deposits.”  This, along with measures seeking to reduce the amount of debt such companies could take on, has had the effect of significantly slowing growth in the property market. The announcements set in motion a rush to sell-off assets and provoked a number of “bankruptcies, defaults and cut-price takeovers.” In turn, this also led the bond markets to question the reliability of Chinese corporate borrowers given the number of property developers defaulting on their loans. Whilst never formally announcing a regulatory crackdown on the sector, the government has deliberately sought to slow growth in a market that makes up around a quarter of the Chinese economy. Is the fact the government is willing to do this a problem for investors in the country?

This crackdown played out at its most spectacular with the recent Evergrande crisis. Stricter rules on leverage, along with measures that have reduced property sales, caused a crisis in liquidity that means Evergrande is struggling to service its debt. The risk of the country’s second largest developer defaulting on what is estimated to be around 37 billion dollar in debts has caused borrowing costs to increase dramatically, “with the yield on an index of dollar-denominated junk bonds climbing to about 15%, the highest in about a decade.” On Tuesday another developer, Fantasia, defaulted on debt payments. Many would argue this has been caused by political posturing. In a bid to reassert his socialist credentials and tackle the perceived problem of inequality, fueled in part by rising property prices, President Xi has pushed many indebted developers to the point of collapse. Some would of course say that cooling this market is no bad thing. But the manner in which the Chinese government can – and does – intervene in such markets, sometimes with very little notice, is a significant risk for investors to consider.

Investors in China’s technology sector have certainly found this to be true this year. Perhaps in order to tame a huge tech sector that was threatening to evade the government’s control, and to take giants like Jack Ma down a peg or two, Xi has overseen sweeping measures to rein in on private enterprise. Beginning dramatically with the thwarting of Ant’s IPO in November 2020, since then the government has introduced measures against gaming content, online health care and smart delivery, to offer just a few examples. Xi’s vision of “common prosperity” – which seeks to narrow the widening wealth gap between rich and poor – has manifested itself in an attack on the large-cap tech companies which, for many, are a symbol of this inequality. Little wonder that the Hang Seng Enterprises Index is “this year’s worst-performing major stock gauge globally.” Can investors be sure that any sector is safe from sudden regulatory action whenever it becomes politically convenient?

MSCI’s China Indexes

Such concerns are reflected in MSCI’s own indexes. The MSCI China Index, MSCI China IMI Index and the MSCI China All Shares Index have all seen significant declines after peaking in February. More widely, ETFs have seen a sharp outflow of capital out of China-based funds and into those exposed to other emerging markets: “the assets of five prominent EM ex-China exchange traded funds surged 41 per cent to $1.5bn during August, taking their year-to-date growth to 442 per cent […] the jump comes as net inflows in to global emerging markets ETFs – in which China is by far the largest weight – slowed to $696m in July as Beijing’s regulatory crackdown widened.” That this has largely coincided with the issues explored above is hardly a coincidence. A difficult time, then, for MSCI to launch a new range of Chinese thematic indexes. But is this at all relevant to the longer-term picture?

One might argue that volatility has always been present in the Chinese market. As Jeffrey Kleintop points out in the Financial Times this week, there has been a bear market in Chinese stocks in seventeen of the last twenty years, “usually driven by some policy issue.” One might go on to argue that investors are generally offered larger returns to compensate for this volatility. China is, after all, still an emerging market, despite its size and power, with governance standards that do not correspond to those of developed Western economies. In a one-party state, the government can and does move very quickly in a way that shocks stock markets and – at least temporarily – drives down share prices. The kind of market fluctuations that you see in almost all emerging markets are therefore to be expected. But as MSCI would no doubt argue, this does not mean that long-term growth is (necessarily) fundamentally affected.

The trajectory of growth in China over the past few decades of course suggests that investors with an exposure to the market will ultimately achieve strong returns. Many have pointed out that the government is frequently reforming industries in a jarring way but, so far at least, this has not prevented longer-term growth. Indeed, China reformed its healthcare sector in 2018, in a similar way to how it is approaching its tech companies now. In the aftermath, companies in the space grew significantly. As a result, many investors are using the current crackdown as a chance to buy the dip, taking advantage of (what they believe will be) short-term volatility to reinforce positions at potentially discounted prices. Past precedents would suggest that this might well be the case, and that MSCI is correct to be assured of long-term opportunities.

But will past precedents always continue to hold up? Will crackdowns always continue to be temporary? Will economic considerations always continue to trump social and political visions? Maybe, maybe not. The unpredictability of Beijing – the impossibility of knowing what the government will do next and under what motivations – means this is simply impossible to answer.

The problem for investors considering exposure to China is that – to adapt Churchill’s observation of Russia – it is a riddle, wrapped in a mystery, inside an enigma. One can never be sure which industry may be targeted next by a sudden regulatory crackdown, and what the consequences of this might be. The way in which government of the country is organised means that entire markets can be distorted at whim, and there is not much anyone can do about it. This risk has, so far, been compensated by lucrative returns; with all previous storms having passed. However, given just how unpredictable the country is, can anyone be sure that this will always prove to be the case?

The opening months of MSCI’s new China indexes should serve as a warning. The CCP works in unpredictable ways, and sometimes in a manner that is deliberately economically damaging. For this reason, returns in China can never be taken for granted.

Author: Harry Clynch

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