China is recovering from the multi-year lockdowns employed on the population to try to combat covid-19. Western executives that have recently traveled to China to reinstate business ties have said that China’s economy is picking up where it left off, and that an economic boom is just around the corner. But is it really?
Chinese Consumers Are Still on the Sidelines: Since the lockdowns were lifted, the Chinese economy has been slow to recover. The Chinese consumers had a tendency to save their money during the lockdowns, and appear to some observers to retain a reluctance to spend. This may be a result of the extent and duration of the lockdowns that could translate into financial uncertainty for Chinese consumers. More and more there are signs that consumer demand is weak to the extent that deflation risk is showing its potential. This could provoke the central bank to do some quantitative easing to suppress interest rates, and provide more cash for the consumer. Despite the low rate of core inflation, food prices for fruits and vegetables increased by 6 to 10%, but were offset by a decrease in the price of pork products by about 7%. Non food prices fell by about 0.6% further pointing to weak demand. With its massive population, China’s consumers would be the ideal force to drive an economic recovery.
Regulatory Clampdowns: Chinese regulators were already busy with clampdowns in the tech sector before covid-19. Such mechanisms as the Communist Party maintaining committees in larger corporations to review board decisions have already been in place. Outside of the state-owned enterprises, the ruling party appears to want to place a collar around entrepreneurship. Anti-espionage laws, especially concerning the management of data, have been tightened and have been used to jostle Western firms. Companies such as the Mintz Group, Capvision, and Bain, have experienced their offices being searched and/or employees being arrested over data security breaches. These firms have been known to facilitate other outside companies that come to China by providing them with advice and expertise about local laws, customs, and who are the best people to deal with. It isn’t clear why these actions by regulators were taken, but rumor has it that these firms or employees have had insights into economic activities in the Chinese province of Xinjiang, where China has been accused of utilizing forced labor. Such hassling has caused certain Western companies to call it quits and move out.
Chinese Millionaires Want Out: Many established Chinese millionaires are leaving China for other parts of the world. This includes moving most of their assets to other physical locations and into other world currencies. Although these people are not all entrepreneurs, they believe that the government could find a way to step in and curtail their business or professional success at any moment. Chinese President Mr. Xi Jinping has made it clear that the communist mantra for China is to equalize monetary rewards throughout the society. Understanding this point, what would the impact be on a hard-working Chinese individual’s personal fortune, and what would be the impact on motivating younger generations of Chinese to put in the long hours and hard work to become a success, only to have their rewards “equalized” in the name of communism.
Legal Briefings Are More Common: Chinese laws concerning data, intellectual property, and security are in a constant state of change, requiring prospective investors to seek more legal briefing before investment steps are taken. Before Western executives travel to China, they are more likely to be briefed as to what to say and do in the event of a run-in with Chinese authorities. Joint ventures of Western and Chinese firms often find it safer to keep the Chinese data on a separate computer system to avoid mishaps that would land sensitive data on the Western counterpart’s computers. This leaves foreign companies with a need to have an action plan set up ahead of time to deal with unforeseen risks before opening up in China. All of this adds to the cost of doing business there.
Protection of Liquid Assets: More prevalent are concerns that a foreign business’s funds and other liquid assets could be frozen or confiscated in the event of unanticipated geopolitical conflict. This concept has spawned a workaround that would involve the Western company creating a local company in China that would borrow operating and transaction funds from, and pay them back to, Chinese banks, thereby limiting the influx of foreign funds to China. In the event that these assets would be seized, they would technically belong to the Chinese bank. Gains or profits would then be remitted directly to the Western company’s home offices in another country.
Western Sanctions Already Restrict Activities: Investors interested in China should never overlook the lengthy amount of sanctioning already in place by Western countries. More than 9,000 Chinese companies have some form of Western sanctioning inhibiting their doing business with Western companies. Correspondingly, the Chinese government has also applied regulatory restrictions that limit a firm’s ability to maneuver the Chinese landscape. For Western executives this lack of wiggle room drives them to make cautious movements to keep them from inviting disaster. An effort is underway in the U.S. to strictly regulate what is sent to or set up in China in the way of advanced semiconductors, artificial intelligence, and quantum computing. America’s allies have already established or are contemplating similar regulatory actions. The trend does not show any signs of reversing as the business environment in China continues to deteriorate.
Concerns Over Chinese Banking and Currency: Although Chinese banking authorities have announced recently that the central bank has plenty of tools available to protect the Chinese Yuan, a serious risk of bank runs has been observed by foreign investors and financiers. A new national regulator, The National Administration for Financial Regulation (NAFR), has found itself with the daunting task of unwinding risky financial practices that pervade through China’s financial sector. Then it must deal with a seemingly overwhelming amount of debt in the society, much of which resides on bank loan books. Dodgy accounting practices have enabled certain lending institutions to hide some of their bad loans complicating the overall assessment of the Chinese banking sector’s financial health. The usage of the so-called “bad bank” that carries and manages bad loans from other banks has been in place, but the process of using it is slow and cumbersome. Letting the banks fail has also been tried, but that has a tendency to lead to runs on deposits which the government wants to avoid. To top it off, the Chinese government has been on a campaign to stomp out corruption in the ranks of banking mid-level managers and executives making it tricky on who to deal with.
Mountains of Debt to Deal With: Many regional and local governments are over their heads in debt. This dates back to the great real estate booms that took place before the covid-19 lockdowns. Local governments and their investment vehicles (LGIF) have borrowed extensively to serve the infrastructural growth, but now the growth has subsided and the money must be paid back. The specter of a wide range of defaults looms on the horizon that could mandate government or central bank intervention, and divert resources needed to stimulate the economic recovery. In the least respect the investors holding the shaky bonds or debt instruments will be unable or unwilling to invest more to make the economic recovery succeed.
Conclusions: In past years I have had some success investing in China via the Matthews family of mutual funds. This was over a decade ago during the halcyon days of growth before Mr. Xi Jinping became president. If as a private investor you do believe that China’s growth will continue to outpace the rest of the world, take a look at the following:
Matthews Pacific Tiger, MAPTX (44% in China);
Matthews Asia Innovators, MATFX (61% in China).
Sources: The Economist, Spooked, June 17th, 2023.
The Economist, Graftbusters, June 17th, 2023.
The Economist, Enter the Investment Police, June 24th, 2023.
South China Morning Post, China’s Deflation Risk Rose in June amid
Weak Demand, With Consumer Inflation Flat and Factory-gate
Prices Dipping Further, by Mia Nulimaimaiti, July 10, 2023.