Should investing in the second largest economy in the world seem like a daunting experience to the private investor? A big, growing economy has plenty of good investment opportunities, but there are some pitfalls to watch out for. In March, 2021, equities in mainland China endured a selloff of 15% in two weeks. The state responded by encouraging state-owned businesses such as insurance companies to go in and buy stocks on the decline to help stabilize market pricing. But the March, 2021, selloff pointed out two important areas of improvement in China’s stock markets: They are more professionally managed and interwoven with global markets than before, and their state-controlled economy’s mannerisms can impact the outside world. To ease investor concerns let’s take a closer look at Chinese stock markets from an outsider’s perspective.
Shadow Banking Effect: Financial maneuverings in the Chinese economy have been influenced in the past by shadow banking. Shadow banking is defined as a financial system consisting of lenders, brokers, and other credit intermediaries that fall outside the realm of traditional regulated banking. Shadow banking enabled China’s state-owned banks to sidestep deposit limitations by moving money into “wealth-management products”, some of which wound up in shadow banks. These fund investments would offer high yields (over 10%), but still had informal guarantees from state-owned banks giving investors the feeling that these investments were as safe as bank deposits. In 2016 shadow banking represented about 28.5% of total bank assets. Regulators then entered the scene and closed the door on shadow banking by pressing banks to open legitimate subsidiaries to manage the wealth-management products (funds) in much the same manner as asset-managers. The subsidiaries are allowed to invest in equities (banks cannot), but they can’t provide any guarantees.
Growth of Mutual Funds: Professional fund management is growing in China. Institutional investors’ holdings in China have increased from about 30% in 2012 to about 50% last year. This should bring up the average daily trading volume generated by institutions to 50% in a few years. On-line investing has enabled many individual investors to choose between a variety of funds with just a click. The trend has been for funds to gravitate from plain-vanilla to more sophisticated quant-driven and absolute-return funds. At this rate of growth, the size of professionally managed funds in China could nearly rival that of the asset-management industry in the U.S. by 2029.
Foreign Banks: Foreign investment banks that for many years have been limited to what they could do in China are now finding avenues and doors opening up to them. Foreign banking executives are now realizing that the disadvantages of being a foreign operator in China are disappearing. One thing that hasn’t disappeared, however, is the attitude that investment in China is a long-term project for foreign investment banks. Startup costs are large owing to the wide amount of licensing a foreign bank would need to operate, including having teams of expert staffers for underwriting and risk management already in place before opening up.
The presence of state involvement in Chinese investment still looms large. Regulators have the authority to reign in on foreign investment banks in a heavy-handed way, such as turning up unannounced for a random inspection. Many Chinese companies in need of financing will still give a large portion of that business to state-controlled banks. Foreign financial firms will need to maintain a good relationship with the state as well as their own portfolios to be successful.
Taking Money Out: There has always been a concern that foreigners might find it very difficult to pull their investment capital out of China. However, owing to Hong Kong’s stock-connect program, cross border trading volume has increased 40 times since 2015, and repatriations have been reduced from six months to two or three days. There are still rigid rules set by the state that govern this process—particularly in respect to foreign exchange as the yuan is carefully managed. Money moves a lot easier across borders, but still faces headwinds of rules while in China. One example involves the utilization of trading profits from equities that typically must be moved out of the country before being reinvested into bonds. Further, currency hedging is better accomplished offshore although it is more expensive. On the upside, China’s commodities markets are larger and more liquid than those in the U.S. This is driven by the limitation most Chinese investors face while investing offshore. China’s commodity futures provide an insight to what global commodities prices should look like.
Interpreting Public Information: In China stock markets can be driven by rumors, memes, and internet posts more so than any other markets on earth. The information derived from Chinese stocks and bond markets is harder to interpret, and can be restricted by the Chinese regulatory environment. Analysts in China use generally accepted techniques, but must also factor in this regulatory system as it can have major impacts on growth. China’s generally accepted accounting principles and auditing standards may differ from those in Western countries providing an impact on comparative fundamental analysis that’s hard to evaluate.
Room for Future Growth: In spite of recent growth in foreign investment, there appears to be much room for further growth. Foreigners hold about 5 % of Chinese equities shares and 3% of Chinese bonds, compared to foreigners holding about 25% of U.S. equity shares and about 30% of U.S. bonds. Foreigners still view bond risk in China as being murky or difficult to assess. Despite traditional worries that Western economic forces would take control of China’s banking system, top executives have recently complained that the system isn’t open enough to western capital. Even President Xi has declared that China must be confident in its system, which would lead it towards opening up more to the outside.
Conclusions: I currently own a position in a Chinese power company, and have owned various other individual stocks of Chinese companies from time to time. I’ve also had some successful investments in mutual funds. I think the average private investor should consider using a fund investment vehicle for investing in China as fund managers in the Chinese market will be appraised of the aforementioned pitfalls, and have better ears to the ground about what is rising and what isn’t.
Sources: Over the Great Wall, The Economist, March 20, 2021.
Investopedia.