Investing in China: understanding the risks and rewards

The one thing invest­ment pro­fes­sion­als around the world are good at is fol­low­ing the mon­ey. It’s why all eyes con­tin­ue to focus on Chi­na. When for­eign direct invest­ment in the world’s sec­ond-largest econ­o­my surged recent­ly, at its fastest rate in over a decade, it peaked inter­est among wealth and asset man­agers. That’s because Chi­na has nav­i­gat­ed the coro­n­avirus pan­dem­ic well and is now see­ing a strong recov­ery.

This is like­ly to be high­light­ed by its lead­ers when China’s Com­mu­nist Par­ty turns 100 this year; iron­i­cal­ly their cel­e­bra­tions may well tout the suc­cess of cap­i­tal­ism. The country’s finan­cial mar­kets have deep­ened, diver­si­fied and matured of late, their size and liq­uid­i­ty are now more entic­ing to glob­al investors, just in time to make the most of record annu­al growth. Out­put has leapt 18 per cent year on year in the first three months, the fastest rate since records began in the ear­ly-1990s. 

“In the last few years, Chi­na has made great progress in reform­ing its equi­ty and bond mar­kets, while enhanc­ing access for for­eign investors,” says Arne Staal, chief exec­u­tive of FTSE Rus­sell. “Reform of China’s domes­tic cap­i­tal mar­kets has also paved the way for greater for­eign own­er­ship of main­land Chi­nese com­pa­nies.”

The invest­ment case is strong part­ly because many glob­al investors are huge­ly under­weight when it comes to Chi­na and their par­tic­i­pa­tion is sur­pris­ing­ly low. This is true for both glob­al equi­ty and fixed-income mar­kets; the num­bers are stark. 

The Chi­nese econ­o­my makes up 16 per cent of the world’s GDP. Its share of glob­al man­u­fac­tur­ing is close to 30 per cent, the same as the com­bined shares of Amer­i­ca, Japan and Ger­many. Chi­na also accounts for 14 per cent of all glob­al exports, yet it only makes up 5 per cent of the world’s equi­ty mar­kets.

“Right now, as an investor you can­not afford not to have expo­sure to Chi­na,” says Ronald Chan, chief invest­ment offi­cer at Chartwell Cap­i­tal. “Man­agers must look beyond the West­ern media head­lines about the coun­try and apply per­spec­tive, as well as log­ic, to invest­ing.” 

A red-hot bet for investors?

Already, cool-head­ed insti­tu­tion­al investors have been increas­ing their expo­sure. Chi­nese mar­kets are being added to some of the major glob­al equi­ty and bond indices. “It feels like investors are jump­ing on a band­wag­on right now,” says Mark Williams, chief Asia econ­o­mist at Cap­i­tal Eco­nom­ics.

The country’s inclu­sion in the FTSE Rus­sell, MSCI, Bloomberg Bar­clays Glob­al Aggre­gate and J.P. Mor­gan GBI-EM Glob­al Diver­si­fied indices, to name a few, should not be ignored. This is expect­ed to dri­ve hun­dreds of bil­lions of dol­lars of inflows.  

Let’s also not for­get that Chi­na was the only major econ­o­my to expand in 2020, albeit by a lit­tle more than 2 per cent, dri­ven by a surge in indus­tri­al pro­duc­tion rather than con­sumer spend­ing, dur­ing a year that was fraught with eco­nom­ic paral­y­sis else­where and glob­al lock­downs. 

At the same time, Chi­na has refused to rely on “heli­copter mon­ey”, unlike the Unit­ed States and oth­ers. This Asian behe­moth has not resort­ed to a demand-side stim­u­lus either, which has been deployed by some devel­oped economies. Its ortho­dox mon­e­tary pol­i­cy is in con­trast to what investors are observ­ing in many indus­tri­alised nations.

Right now, as an investor you can­not afford not to have expo­sure to Chi­na

“COVID-19 has seen glob­al cen­tral banks and gov­ern­ments engage in a syn­chro­nous mon­e­tary and fis­cal eas­ing that has exac­er­bat­ed the scarci­ty of safe, decor­re­lat­ing yield,” says Alan Siow, port­fo­lio man­ag­er at Nine­ty One.

Many indus­tries in Chi­na have also been exhibit­ing high and sus­tain­able growth over a long peri­od. The Chi­nese ecosys­tem of indus­tri­al sec­tors is increas­ing­ly deep and sophis­ti­cat­ed, from solar pan­els to COVID test­ing kits, rep­re­sent­ing growth oppor­tu­ni­ties not wide­ly avail­able in many oth­er mar­kets. The coun­try has also set a growth tar­get of at least 6 per cent this year. 

“The invest­ment case for Chi­na is strong. There is tremen­dous poten­tial for invest­ing in this Asian giant as part of a well-con­struct­ed total port­fo­lio,” says Nikesh Patel, head of invest­ment strat­e­gy at Kem­pen.

Turn­ing to the $16-tril­lion bond mar­ket, a ten-year Chi­nese gov­ern­ment bond offers yields of more than 3 per cent. A US equiv­a­lent will gen­er­ate close to half as much. When inter­est rates are rock bot­tom around the globe, it is not sur­pris­ing over­seas investors are pil­ing into Chi­na. 

“North­bound trad­ing vol­umes between Hong Kong and main­land Chi­na are also good indi­ca­tors of for­eign cap­i­tal flows and have increased ten­fold since 2017,” Chan at Chartwell Cap­i­tal points out. 

“The West needs to cast off its stereo­type of Chi­na as an unso­phis­ti­cat­ed work horse and sim­ply the world’s fac­to­ry. The coun­try is diverse and like Europe there is abject pover­ty in rur­al provinces, yet sophis­ti­ca­tion and dynamism across hun­dreds of Chi­nese cities. Shen­zhen now rivals Sil­i­con Val­ley as an inno­va­tion hub, with ener­gy dri­ving new prod­ucts and solu­tions, as well as cre­at­ing new mar­kets. In terms of patent appli­ca­tions, Chi­na had over four times more than the Unit­ed States in 2019.” 

The risks to China’s economy

The Year of the Ox, the Chi­nese zodi­ac sign that is known to be strong and tena­cious, inspire con­fi­dence, yet hates to be chal­lenged, is a good anal­o­gy for Chi­na in 2021. To date the country’s bank-financed eco­nom­ic mod­el has been reliant on strong exports and cap­i­tal invest­ment. This is unsus­tain­able in the long term, yet Chi­na has shown stub­born­ness in its shift to a more con­sump­tion-led econ­o­my. 

“There are also a whole range of addi­tion­al risks with Chi­na, even more so and mag­ni­fied when com­pared to oth­er emerg­ing mar­kets,” says Patel.

From the per­se­cu­tion of eth­nic minori­ties in Xin­jiang province to civ­il lib­er­ties vio­la­tions in Hong Kong or sabre rat­tling over Tai­wan, Chi­na is feel­ing the pres­sure. A wave of sanc­tions imposed by the UK, Euro­pean Union and Cana­da has rip­ple effects.

“You now have hyper-spe­cif­ic issues like forced labour and human rights abus­es of the Uighur Mus­lim pop­u­la­tion. This isn’t just con­tained to Chi­nese equi­ty and fixed-income mar­kets, there are large glob­al com­pa­nies that have ques­tions to answer here,” Patel adds. 

“ESG – envi­ron­men­tal, social and cor­po­rate gov­er­nance – report­ing is not manda­to­ry in Chi­na. Engage­ment efforts are often neglect­ed by com­pa­nies. There’s also a very high degree of state inter­fer­ence in ESG mat­ters of pol­i­cy and a huge dis­crep­an­cy between the inter­est of the Chi­nese gov­ern­ment and both share­hold­er and stake­hold­er inter­ests.” 

This is why a group of social­ly con­scious and reli­gious investors, as well as oth­er funds, have recent­ly ramped up pres­sure on West­ern com­pa­nies such as Zara own­er Indi­tex, H&M and Hugo Boss that source from Chi­na. They want trans­paren­cy and account­abil­i­ty on whether sup­ply chains deploy forced labour or lead to human rights abus­es. 

At the same time Chi­na denies all accu­sa­tions of abuse. There are also con­cerns to do with legal stan­dards and the sta­bil­i­ty of the country’s prop­er­ty mar­ket. For many man­agers, the coun­try can still be opaque. 

“Investors need to sep­a­rate the dif­fer­ences between pol­i­tics, econ­o­my and the com­pa­ny. These three things don’t cor­re­late with each oth­er all the time,” says Col­in Liang, head of Chi­na at RWC Part­ners. 

“Investors find it hard to ful­ly under­stand how Chi­na works under a one-par­ty sys­tem, both polit­i­cal­ly and eco­nom­i­cal­ly. Investors are often con­fused with China’s poli­cies domes­ti­cal­ly and abroad. Many pri­vate com­pa­nies, as opposed to state-owned enter­pris­es, are also very much immune to changes in GDP growth, mon­ey liq­uid­i­ty or any US-Chi­na con­flict.”

The long arm of Beijing

Chi­na also faces long-term issues. There’s a high debt bur­den with grow­ing cor­po­rate bank­rupt­cies, poor pro­duc­tiv­i­ty, the sup­port of flag­ging state-owned enter­pris­es and its age­ing pop­u­la­tion. Beijing’s appa­ratchiks can also change the rules on a whim. Investors looked on wide-eyed when Chi­nese reg­u­la­tors took a swipe at Aliba­ba with a $2.8‑billion fine for vio­lat­ing antitrust laws, a com­pa­ny that in the past has received exten­sive gov­ern­ment favour and sup­port.

“Investors should be aware that China’s mar­kets don’t oper­ate to the same rules as major mar­kets else­where. Reg­u­la­tors have aligned some rules as part of a push to join glob­al bench­mark indices. But it’s the unspo­ken rules that catch for­eign investors out. Many firms aren’t run for the ben­e­fit of share­hold­ers or with a pur­pose of max­imis­ing prof­it,” explains Williams from Cap­i­tal Eco­nom­ics.

“Some of the biggest list­ed firms are state con­trolled and explic­it­ly used as pol­i­cy tools. But pri­vate firms also have to do the state’s bid­ding. It doesn’t mat­ter how big or suc­cess­ful. In fact, the big­ger a firm is, the more it has to fol­low the leadership’s bid­ding. Just look at what has hap­pened to Ant Finan­cial, Aliba­ba and its chief exec­u­tive Jack Ma.”

There is cer­tain­ly a lack of under­stand­ing among glob­al investors beyond large and com­mon­ly owned stocks. Yet cut­ting through the opaque­ness of infor­ma­tion can play to an investor’s advan­tage. “There is an undis­put­ed need for local knowl­edge. Invest­ing blind­ly through an index or track­er will give you expo­sure to volatil­i­ty and the full suite of highs and lows that Chi­na offers,” says Chan.

Investors should be aware that China’s mar­kets don’t oper­ate to the same rules as major mar­kets else­where. Reg­u­la­tors have aligned some rules as part of a push to join glob­al bench­mark indices. But it’s the unspo­ken rules that catch for­eign investors out

The key piece of advice is to do sig­nif­i­cant home­work and real­ly under­stand the risks asso­ci­at­ed with onshore or main­land Chi­na invest­ments. This involves using an invest­ment process that com­bines both a top-down com­pre­hen­sion of the macro­eco­nom­ic and polit­i­cal themes and trends with a bot­tom-up knowl­edge of the com­pa­ny, sec­tor and wider mar­ket­place. 

“How­ev­er, I don’t think the Chi­nese mar­ket will be suf­fi­cient­ly open and wel­com­ing to West­ern stan­dards of insti­tu­tion­al due dili­gence to make it main­stream in the com­ing years; I don’t think onshore Chi­na will become main­stream until the 2030s,” says Kempen’s Patel. 

Besides mon­i­tor­ing dik­tats from Pres­i­dent Xi Jin­ping or macro­eco­nom­ic trends, ESG fac­tors are a sig­nif­i­cant con­cern for glob­al investors in the lead up to COP26, the Unit­ed Nations cli­mate sum­mit in Glas­gow. 

Chi­na is improv­ing, albeit from a low basis and dis­clo­sure is get­ting bet­ter. Many inter­nal poli­cies in Chi­nese are now laid out in Eng­lish. Reg­u­la­tors in Bei­jing are also push­ing bet­ter prac­tices, if only to clear the smog-laden skies that con­sume many cities. The coun­try has also com­mit­ted to peak car­bon by 2030. 

“ESG is a grow­ing pain. Head­lines and hor­ror sto­ries per­sist in the glob­al media on China’s envi­ron­men­tal record, how­ev­er Chi­na is clean­ing up its act. The one key dif­fer­ence that Chi­nese pol­i­cy­mak­ers have over their West­ern coun­ter­parts is con­trol of more levers. When Chi­na says it is going to do some­thing, it usu­al­ly can and will,” says Chan. 

“It’s pledged to be car­bon neu­tral by 2060 and is cur­rent­ly invest­ing dra­mat­i­cal­ly in core indus­tries to sup­port this. Chi­na is the largest mar­ket for renew­able ener­gy, so you will see a tsuna­mi of invest­ment in this sec­tor. Coal con­tributes to 65 per cent of China’s ener­gy gen­er­a­tion, but it is expect­ed that solar, hydro and wind pow­er will quick­ly take over in the com­ing decades.”

A future fuelled by megatrends

Look­ing to the future, wealth and asset man­agers should focus on the mega­trends. Urban­i­sa­tion, domes­tic con­sump­tion and the explo­sion of the Chi­nese mid­dle class will con­tin­ue to be in focus. The pop­u­la­tion with more than $10,000 annu­al dis­pos­able income is expect­ed to grow from 280 mil­lion to 680 mil­lion by 2030. Chi­nese mil­len­ni­als and Gen­er­a­tion Z are also becom­ing more dis­cern­ing con­sumers. 

Pres­i­dent Xi’s dual-cir­cu­la­tion strat­e­gy is part of this sto­ry. This involves Chi­na still being part of inter­na­tion­al cir­cu­la­tion, which involves com­pet­i­tive glob­al exports and trade, how­ev­er there is a move to improve domes­tic cir­cu­la­tion. This involves build­ing a vibrant home-grown econ­o­my with less depen­dence on imports. Investors hope this will bode well, at least for local demand. 

“China’s con­sump­tion mar­ket is expect­ed to dou­ble in size and reach a scale sim­i­lar to the Unit­ed States. Chi­nese brands are already cap­i­tal­is­ing on this oppor­tu­ni­ty, with strong nation­al brands such as Midea and Haier emerg­ing in Chi­na,” says Wen­chang Ma, port­fo­lio man­ag­er at Nine­ty One.

Shifts in demo­graph­ics don’t lie either. Chi­na is set to report its first pop­u­la­tion decline since 1949. A sig­nif­i­cant moment when you con­sid­er that its work­force could drop by 0.5 per cent each year to 2030, with a high­er bur­den for elder­ly care. Edu­ca­tion and tech­no­log­i­cal progress may not com­pen­sate for this slump and shift in pop­u­la­tion. This is like­ly to tem­per any gear change for Chi­na to over­take Amer­i­ca as the world’s largest econ­o­my.

“Let’s also not for­get Chi­na has been climb­ing the tech­nol­o­gy curve, try­ing to cap­ture high­er val­ue in the indus­tri­al sup­ply chain. Chi­na won’t suc­ceed in every seg­ment, but lead­ers in cer­tain fields will be able to do that. R&D spend­ing has also been increas­ing across the board. Cloud-based solu­tions, high-end man­u­fac­tur­ing and spe­cial­ty mate­ri­als are exam­ples where Chi­na has excelled,” says Liang at RWC Part­ners.

“Chi­na is also nev­er slow to adopt new inno­va­tions, either new prod­ucts such as elec­tric vehi­cles or new busi­ness mod­els in ecom­merce. We expect ram­pant busi­ness inno­va­tion will con­tin­ue and cham­pi­ons will con­tin­ue to emerge from new areas.”

That’s the thing. Chi­na nev­er fails to sur­prise. For good or bad, wealth and asset man­agers should be ready. 

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