China Investment Status - It's Complicated

The United States (U.S.) and China are the world’s two largest economies. Since China’s admittance into the World Trade Organization (WTO) in 2001, the two nations’ economies have been increasingly integrated. However, in the last several years, there has been growing tension between the two nations, with some positing that the two countries are on a path to de-integration. Further, the quickly evolving regulatory landscape has left many revaluating the overall allure of investing in China.

“When individuals have the power not just to dream, but to realize their dreams, they will demand a greater say.”

— BILL CLINTON ON THE DECISION TO ADMIT CHINA TO THE WTO

President Xi Jinping’s leadership strategy has faced increased scrutiny by the U.S., and a flurry of escalating regulations has some questioning China’s future – and as a result its viability for investment. Recently, Chinese stocks have experienced their biggest slump since the Global Financial Crisis in 2008. From its peak in mid-February, the Nasdaq Golden Dragon China Index, which follows the 98 largest U.S.-listed Chinese stocks, has fallen by approximately 47% (See Exhibit 1). Historically, market corrections and pullbacks have been short-lived but Beijing’s continuous reform announcements have left little room for a sustained rebound. Given the prevailing economic and regulatory environment, coupled with extreme negative sentiment, it’s hard not to question China’s fortitude as a sustainable economic and financial power player.

China’s economic and geopolitical landscape is complex, to say the least, and the tidal wave of information being released makes it hard to sift through the noise. However, one thing is clear – there is no consensus on China’s future or prospect as an investment. Depending on one’s perspective, China can be construed as doom and gloom (the “Bear case”) or brimming with opportunity (the “Bull case”).  

A BRIEF BACKGROUND

While the U.S. has long been a dominant player, China wasn’t always a global superpower. China entered a new golden age during the post Mao era. This began in 1978 with Deng Xiaoping’s vision of a socialist market economy, which led to key economic reforms.

Looking back at China’s history, it’s not hard to see why China rethought their political and economic strategy in the late 1970s. Though a country with a rich history of long-lasting dynasties and power, it had slowly transformed into one of the poorest nations in the world. Significant social unrest and discontent eventually culminated in the Tiananmen Square travesty where thousands of protesters were killed. The Chinese Communist Party (“CCP” or “CPC”) seemed destined to lead China down a self-destructive path, similar to that of the Soviet Union. Something had to change.

Fast forward to 2012, more than a decade after China had re-entered the global stage, and when President Xi Jinping first came into power. China’s economic growth was on fire. For example, GDP skyrocketed from $191 billion in 1980 to an astounding $8.5 trillion in 2012 [[World Bank]]. Along with this unprecedented growth came widespread improvements in general prosperity and standard of living. Extreme poverty in the country plummeted from close to 90%, down to approximately 10% (See Exhibit 2). Newly appointed President Xi was given the benefit of a growing economy based on a blueprint that was well executed by his predecessors. However, most of the low hanging fruit had been harvested. The next chapter of the ambitious plan to return China to prominence would require a walk back to the past and a borrowed American concept.

THE CHINESE DREAM – MADE IN AMERICA

Much like milk & cookies, apple pie & ice cream, and hot dogs & baseball - Capitalism and the concept of the American Dream go hand in hand. The mindset that America is the “Land of Opportunity,” where anyone can get ahead with hard work and determination, has helped propel the U.S. economy forward for decades. In the 1980s, long before securing his bid to become China’s next leader, a young and curious Xi Jinping made his first trip to the U.S. This occurred during a time when the American Dream was alive and well on the shoulders of a growing middle class. In fact, it was on a small farm in Muscatine, Iowa where the future leader of China gained invaluable perspective on American culture. This may have been his starting point in developing his political rallying call - the Chinese Dream (See Exhibit 3).

While there are inherent differences between President Xi’s Chinese Dream and the American Dream, the core of the rallying call is quite similar. In a statement to China’s youth in 2013, Xi proclaimed “dare to dream, work assiduously to fulfill the dreams and contribute to the revitalization of the nation.” [[Wikipedia – Xinhua News Agency]] If this statement was paraphrased by a U.S. President nobody would recognize the difference. To flourish, an economy needs workers to both produce and take risks. Generally, individuals need incentives to do either. Through the idea of the Chinese Dream, and at a time when general household wealth was skyrocketing, President Xi was able to instill the ideal of opportunity to the nation’s approximately 1.4 billion people. With this combination, China’s future seemed rosy.  

To date, it seemed China was on a positive path under this model. Specifically, President Xi outlined two primary objectives to the Chinese Dream around two centenaries, which refer to two important 100-year anniversaries. At present, 2021 marks the 100th anniversary of the CCP. The milestone objective was for China to be a “moderately well-off society” by this year, specifically with the goal to double its per capita income from 2010. Recently, in a July 1st speech, Xi announced the realization of this goal. The second centenary, occurring in 2049, is the 100th anniversary of the founding of the People’s Republic of China. By this date, China’s objective is to become a fully developed, modern, and respected nation.

CHINA’S GREAT WEALTH REDISTRIBUTION

Though China is a self-proclaimed communist nation, it displayed a slow adoption of some capitalist market traits over the last several decades as it worked to achieve its first centenary objective. Over the last 30 years, the CCP has permitted a growing income gap in efforts to expand its economy rapidly (See Exhibit 4). In fact, a recent estimate reports that China’s top 1% hold 30.6% of its wealth [[WSJ]]. However, the prevailing notion was that this wealth would one day be re-distributed to benefit a greater share of the population. In reflection of recent actions coming out of China, it appears that this transformational shift may be occurring, moving away from a capital-centric view and back towards a more people-centric focus.

President Xi has increasingly pushed the “Common Prosperity” campaign into focus, calling for a more equal society with better social welfare and an emphasis on reforming income distribution. As part of this campaign, President Xi has strongly “encouraged” China’s largest companies and wealthiest individuals to increase their social responsibility by donating large sums towards achieving common prosperity. So far, the corporate tycoons are falling in line.  For example, Alibaba has pledged $15.5 billion, Tencent recently doubled its allocated funds to $15 billion, and Pinduoduo pledged $1.5 billion to social responsibility programs. [[WP]]

As we turn our focus to the current and future state of China, it is important to keep this background in mind. The Chinese Dream and Common Prosperity campaigns lay critical foundation as we analyze the recent actions of the CCP. Specifically, many of the CCP’s actions can be tied back to blueprints China has been working towards for decades.  

‍

THE BEAR CASE: IS IT ALL DOOM AND GLOOM?

THE TRANSFORMING CHINESE REGULATORY ENVIRONMENT

Though the “Common Prosperity” campaign is not new in China, President Xi has increasingly emphasized the Chinese government’s “principal role” in providing basic services for the people, strengthening the government’s hand in providing public services. This emphasis has been met with a tidal wave of regulations that have been referenced as “one of the biggest investment disruptions in modern times.” [[CSM]] Between November 2020 and August 2021, Beijing announced more than 50 specific regulatory moves, with more than 10 of these occurring in the last month (See Exhibit 5). While most of these regulations have focused on centers of innovation such as the internet sector, targeting the large tech giants, the crackdowns cover a wide range of industries. For example, in August alone, the government banned profits in the after-school tutoring sector, restricted online videogame access by minors, and rolled out significant new regulation on data collection practices, online content, and anti-competitive practices. Further, a five-year blueprint issued in mid-August called for intensified law enforcement and active legislation across a broad set of sectors. [[BBerg]]

Unlike the U.S., the Chinese single-party government can quickly enact new legislation with no checks and balances. In addition, the government has shown it is not afraid to release new regulation in quick succession, without waiting for markets and sentiment to level out before making additional changes. As a result, it can be hard to predict whether we are near the end of the crackdown wave or still in early days.  This has led to increased regulatory uncertainty and financial market turmoil for Chinese stocks (See Exhibit 6).

THE U.S. TAKES AIM AT CHINESE INVESTMENTS

Typically, uncertainty and risk are positively correlated. The increasing uncertainty surrounding China, paired with the country’s explicit resistance to transparency standards has renewed U.S. regulator concern. For example, the recent U.S. Holding Foreign Company Accountable Act (“HFCAA”) requires foreign companies to comply with U.S. auditing requirements.[[Harvard]] Currently, however, Chinese regulations effectively prohibit its companies from complying with this U.S. requirement. This disconnect could lead to a de-listing wave in a few years, where Chinese companies that are currently listed on a U.S. exchange are forced to exit the U.S. equity market.

In addition, the HFCAA requires foreign firms to formally disclose foreign government influence (e.g., the percentage of shares owned by government, and the name of CCP officials who serve on the board of directors). This comes in wake of an increased involvement of the CCP in private (i.e., non-state-owned) companies. For example, in April, the CCP took a 1% stake and a board seat in ByteDance’s key Chinese entity – the popular social media platform TikTok. Further, considering the Chinese government crackdown on Didi Global shortly after it listed on the New York Stock Exchange, the U.S. required Chinese companies to disclose the risk of government interference and ultimately temporarily halted approval of new Chinese Initial Public Offerings (IPOs). [[CNN, BBerg]] While these actions are all in the best interests of increasing transparency and protecting investors, it adds strain to the relations between the two governments and puts pressure on the interconnectedness of the two nations’ financial markets.

OTHER AREAS FOR CAUTION

Additionally, there are other areas that require consideration when determining the appropriate investment strategy as it relates to China. For example, when foreign firms choose to list on a U.S. stock exchange, they do so through an American Depository Receipt (ADR). However, Chinese ADRs are different than most other countries in that a Variable Interest Entity (VIE) is often used to conduct the IPO. Generally, when using an ADR, investors hold an asset that is tied to the underlying foreign entity. However, under the VIE structure, investors technically own equity in a shell company that has a contract with the underlying foreign equity to “pass through” the company’s profits. In this case, investors in the VIE rely on contractual agreements as opposed to direct ownership, which leaves U.S. investors without true rights to residual profits or control over management.

These VIE’s have always operated in a legal grey area from China’s perspective, and recently both the U.S. SEC and the Chinese government has called attention to the use of these structures. [[SCMP1 SCMP2 ]] Moreover, the U.S. has also taken aim to curb imports from companies that are associated with human-right abuses, further straining bilateral political relations between the two nations. There is also heating geopolitical risk as China continues to exert more control on Hong Kong, and its military expansion threatens regional peace if China threatens Taiwan.  Finally, some individuals may avoid investing in China for Environmental, Social, and Governance (“ESG”) reasons - an area where China is not a leader.

IMPACT ON COMPANIES

The increased regulatory scrutiny and heightened uncertainty can be seen in financial markets. Chinese companies have lost more than $1 trillion in market value since February 2021, with Chinese ADR’s broadly taking the largest hit (See Exhibit 7). The equity valuations of many Chinese companies have significantly declined and may continue to do so if the perceived country risk continues to rise. Looking at the classic risk vs. reward relationship, investors will discount the value of an asset when the perceived risk is higher. Whether the recent drawdown in the value of Chinese companies is an overreaction or not, at least part of it may be attributed to an increase in China’s country risk.

The actions of the Chinese government are directly impacting the bottom line of companies. Encouraging companies to donate large sums of capital for the “Common Prosperity” campaign reduces the amount of free cash flow firms have available to invest in things like innovation and research & development. Likewise, increased regulation is often associated with higher costs for firms as they may have to expend additional resources to comply with new legislation. This further draws down the profitability of the firm. Moreover, as regulation continues to advance to combat anti-competitive practices, firms may face increasingly large penalties and fines. For example, in the last six months Alibaba, Meituan, Vipshop, Pinduoduo and JD.com have been fined a combined $2.8 billion in penalties. According to George Soros, the billionaire founder of Soros Fund Management, the swift and sweeping regulations have caused “a perverse incentive not to innovate, but to await instructions from higher authorities,” putting downward pressure on China’s future economy. [[WSJ]]

Finally, the regulation impacts any multi-national company operating in China. U.S. companies have increasingly expanded into China over the years as it opened its financial markets and billions of dollars of profits are at stake if China continues to crackdown. In fact, Wall Street executives and top Chinese regulators recently resumed a China-U.S. Financial Roundtable to discuss China’s crackdown on the private sector as well as bilateral relations between the two nations. [[ yahoo.com]]

THE BULL CASE: RIPE WITH OPPORTUNITY

REGULATION FOR PROSPERITY

As described above, the recent widespread regulatory crackdowns have caught investors off guard, with professional investors openly questioning whether China is still “investable.. However, one could argue that each one of these government actions tie back to President Xi’s Chinese Dream. The notion of “Common Prosperity” in any modern and developed economy is a fleeting and sometimes a moving target. While China is generally classified as an emerging, rather than developed, country – this is an oversimplification. China has emerged and, like the U.S., is dealing with modern societal issues. These issues include social unrest, wealth inequality, and an independent younger generation with less nationalistic belief systems. Much of the recent regulatory actions seek to combat these issues.

While China is reverting to a more communistic society in some ways, it would be a disastrous mistake to completely de-integrate from global markets. Opening their financial markets and borders is a huge reason why China grew into a global superpower so quickly. It’s unlikely that China takes a hard U-turn which could risk all that has been achieved. So far, the CCP has shown no signs of reversing its commitment to open its $54 trillion market and continues to seek new investments and increased domestic competition. Given the symbolic nature of the first centenary, the CCP may be targeting specific areas of the economy in efforts to send the message that they won’t leave anyone behind, while also providing a stark reminder of who is ultimately in charge. In this way, President Xi may be trying to ensure his own people are in line with the cause as opposed to combating competing foreign ideologies.

INNOVATION AND THE UNICORN CLUB

Traditionally, China has not been considered a leading innovator. However, this notion is changing - a nod to the country’s emphasis on education. Just over the past decade, the number of college graduates rose by 73%. Already a mainstay in top U.S. universities, Chinese graduates are more than just book smart. Although more independent than previous generations, China’s youth are incredibly hard workers as had been displayed by the “996” (9:00am – 9:00pm, 6 days a week) work culture. The now illegal work schedule originated in the technology sector around five years ago, when the country’s nascent internet companies were racing to compete with Silicon Valley. While certainly unsustainable, the willingness of workers to adhere to this grueling schedule highlights the strong work ethic associated with the Chinese culture. Working with such a high sense of urgency helped Chinese technology companies (e.g., Huawei, Baidu, and Alibaba) catch up and compete with U.S. tech behemoths like Apple, Google, and Amazon.

Like in the U.S., China’s big technology companies are globally recognized as leaders in innovation. In fact, China is home to more than a quarter of all unicorns (i.e., private companies worth at least $1 billion). (See Exhibit 8) This is more astounding when benchmarked to 2013, when Alibaba was China’s only unicorn. Now, in terms of unicorns, no other country in the world comes close to the U.S. and China, and this trend has added fuel to domestic entrepreneurship and venture capital (VC) growth in China. According to the Center for American Entrepreneurship, Beijing and Shanghai accounted for $96.6B in VC investment from 2015-2017, while San Francisco and New York accounted for $115.6B. Despite the belief that China’s regulatory environment is a problem for business, China’s business ecosystem is expanding, and many new companies are experiencing great success.

CAPTURING CHINA’S GROWING CONSUMER MARKET

What has transpired in China over the past 40 or so years is nothing short of remarkable. Despite slowing growth over the past decade, China’s economy has grown at an average rate of over 9% per year since 1980. That is a remarkable feat given the pure size of China and is significantly higher than the U.S. economy, which has grown at just under 2.5% per year over the same time frame. This domestic economic growth has led to transformational advancements for China’s middle class. For example, in Beijing there were 77 thousand cars on the road compared to 5.6 million bikes in 1978 (See Exhibit 9). By 2018, there were 8.5 million cars compared to only 2 million shared bikes. This conversion can be directly attributed to China’s economic prosperity and a growing middle class.

In connection to strong economic growth, household incomes per capita rose from $262.92 in 1986 to $4,805.94 by 2013 [[CEIC Data]]. With Chinese household income still well below that of the U.S., further gains seem more likely than not. This adds to the long-term investment case for China given their population size. With close to 1.4 billion citizens, even a small increase to disposable income will have an exponential effect on the Chinese economy. Additionally, China continues to make progress on its goal to transition from a manufacturing-export based economy to a service-consumption led one. In 2019 consumption accounted for nearly 40% of China’s GDP compared to 68% in the U.S. [[CEIC data]] Given this wide differential, Chinese consumerism likely has much more runway to grow. When combined with real household consumption increasing at an average 9% per year, the rise of the Chinese consumer is one of the greatest secular growth stories in the world [[RBA]].

MUTUALLY DEPENDENT FRENEMIES

Even the most compelling reasons to remain bullish on China long-term are meaningless if either country is willing to de-integrate and move forward with a clean break. The “good news” is that the U.S. and China are more interconnected than both governments are willing to admit. Bilateral trade and business is the most obvious reasons for such entanglement. According to the U.S. Census, in 2020 the total value of trade between the two nations reached $560 billion. Even more telling is the fact that the U.S. is arguably China’s most important trade partner, accounting for 17.5% of China’s total exports. Separately, there are a disproportionate number of U.S. multinational businesses established in mainland China relative to the number of Chinese businesses established in the U.S. For example, roughly 20% of Apple and Tesla’s global revenues are generated in Greater China [[Statista; cnbc]] and they aren’t alone (See Exhibit 10). Moreover, the importance of the Chinese consumer to mature U.S. businesses is evident and can be seen in the overwhelming number of western companies willing to share intellectual property and data for a chance to capture market share.

In the financial markets, the story is similar. It is estimated that Chinese and American investments in each other’s stock and bond markets totaled $3.3 trillion at the end of 2020. One can assume these figures will only grow absent of government intervention. Further, for China to achieve its objectives, it needs access to foreign capital. As a result, China continues to make strides in opening its domestic financial market to international investors. Important milestones include the opening of the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) in 1990 and 1991, respectively; the establishment of the Qualified Foreign Institutional Investor (QFII) program in the early 2000s, the IMF adding the Renminbi as an SDR currency in 2016, as well as China’s inclusion in the MSCI Emerging Market index in 2018.

This is not to say increased bilateral political tensions and unexpected regulatory changes aren’t expected going forward. These are highly probable and will lead to heightened volatility in financial markets. However, the interconnectedness between the two nations makes it highly unlikely that a clean break and complete de-integration will occur between the two nations.

CONCLUSION

The desirability of Chinese investments is ambiguous and depends largely on the lens through which one perceives China. By simply reading the headlines over the past few months, it is clear that general sentiment associated with China is increasingly negative. However, given the rapid and deep selloff in Chinese equities, it is fair to wonder just how much negativity is already baked in to asset prices.

Admittedly, China’s markets are much more opaque than many developed countries and the speed at which new regulation is being rolled out increases the level of difficulty in understanding the Chinese investment landscape. The wide risk spectrum emphasizes a need for a more active approach to portfolio strategies that include Chinese investments. This includes ensuring a broad portfolio approach by avoiding a highly concentrated set of securities. Moreover, as Chinese ADRs face increased scrutiny, careful consideration should be placed on the structure of any Chinese investments.    

That is not to say that China should be completely written off as a long-term investment opportunity.  The country has made significant strides in the last 40 years and is an important player in global markets. The large population size and growing middle class makes the Chinese consumer an ideal target market for both domestic and multinational companies. Despite the growing risks associated with investing in China, ignoring a country that is projected to contribute one fifth to global growth with an expanding middle class could be a costly mistake.

‍