China's Leadership Reshuffle Leads to Market Volatility

Last week, Chinese President Xi locked in his position for another five years. This will be the President’s third term, breaking from precedents that called on President Xi to step down after two terms (i.e., 10 years) and capitalizing on the 2018 abolishment of Presidential Term limits. Along with the third term, as part of the National Congress of the Chinese Communist Party President Xi announced leadership reshuffling, stacking the party with loyalists, and further consolidating his control over the party. The leadership changes included removing senior officials who had previously backed opening China’s economy and other market reforms raising concern about the direction President Xi is taking the country.

Currently, China is facing one of the slowest years of economic growth in a generation, a housing market teetering toward a meltdown, and increased geopolitical tensions. Moreover, China continues to maintain its zero-COVID rules, a major contributor to the country’s slowing economic growth. While we will discuss several of these factors in more detail in future posts, at present we focus on the initial equity and currency market reactions to the conclusion of the National Congress.

Equity Markets

Following the end of the National Congress of the Chinese Communist Party, Hong Kong and Chinese equities experienced large selloffs. In fact, the Hang Seng, Hong Kong’s stock market, experienced its largest selloff since the Global Financial Crisis in 2008.

Additionally, Chinese American Depository Receipts (ADRs) plunged even further as investors show increased wariness towards China’s investment landscape under the new political regime. The losses were led by Chinese tech stocks as investors fear that the Communist Party may continue to impose strict regulations and policy that could impact future growth. So far under the President's tenure, China has cracked down on the tech sector, implementing numerous policies that range from data protection to the use of algorithms. With a now stacked loyalist party, there is fear that President Xi's policies, which has consistently favored the state sector at the expense of the private sector, will remain unchecked.

As evidence of darkening investor sentiment, on October 24, Chinese tech giants tanked, with Alibaba, Tencent, Meituan, and Baidu each down more than 10% for the day. Falling equity prices push valuations for companies lower, making investments relatively cheaper. For example, Alibaba and Tencent– once trading at Price-to-Earnings (P/E) ratios of approximately 30 around two years ago – are now trading at P/E ratios of 9.1 and 15.8, respectively.

Currency Markets

Unlike most developed economies, China does not have a floating exchange rate. In a floating rate system, a currency’s price (i.e., exchange rate) is determined by the relative supply and demand for in the foreign exchange market. In contrast, China has a managed float system. In such a system, exchange rates are allowed to fluctuate from day-to-day, but the central bank will attempt to influence the exchange rate to maintain a desired range by buying and selling currencies in the market.

One of the primary goals of the People’s Bank of China (PBOC), China’s central bank, is to monitor and maintain the exchange rate of the Chinese yuan (CNY) to benefit the country’s exports (i.e., goods and services sold by China to other countries).  China moved from a pegged exchange rate system to the managed float system in mid-2005 under pressure from its major trading partners who argued that the CNY was significantly undervalued. By keeping its currency undervalued (i.e., cheap) China encourages foreign partners to purchase more Chinese domestic exports and reduces the competitiveness of other nations with relatively more expensive currencies. While the managed float system has allowed the CNY to appreciate (i.e., strengthen) from its pegged rate, studies suggest that the CNY is still substantially undervalued.

As discussed in our 4Q2022 Market Commentary, recent months have seen several extreme movements in global currency markets, resulting in a broadly strong US dollar (USD). The CNY is no exception, having lost more 13% against the USD in 2022. Wariness over Chinese markets have been building, with the CNY exchange rates steadily declining over the year amongst accelerating capital outflows. Following news of the Communist Party leadership reshuffle, on October 25, the CNY fell to its lowest level since 2007 as investors fled Chinese assets amongst fears of President Xi's consolidation of power. Further pressure for sustained capital outflows exists as market participants bet on additional interest rate hikes by the US Federal Reserve (Fed). As the Fed increases US rates, this puts downward pressure on CNY relative to USD.

Following this week’s depreciation, the PBOC has yet to directly intervene to support the weakening CNY. In fact, following the end of the Communist Party congress, the PBOC ended its streak of steadily fixing the CNY. This comes as an indicator that the PBOC is toning down its support for the currency and may be allowing for more market forces to drive the exchange rate. Overall, while a weakening of the CNY may serve as an indicator of investor wariness, the depreciation does boost the competitiveness of China’s exports, which may aid economic growth.

Conclusion

China’s financial markets, like much of the rest of the world, have experienced capital outflows in 2022. A weakening macroeconomic environment, restrictive policy decisions, and deteriorating financial conditions has contributed to recent drawdowns in the equity markets and downward pressure on the CNY.

While the Chinese markets will likely continue to experience volatility in the short-term, the long-term still suggests interesting growth opportunities for investors. As the second largest contributor to global economic growth, ignoring China in terms of both risk and opportunity is not advisable. Given the lack of transparency and changing landscape in China, investors seeking to hold exposure to China may want to focus on active strategies as opposed to passive. Active management can have the ability to identify investments in the segments of the Chinese economy that will continue to grow and may be better suited to adapt to changes in China’s regulatory and economic landscape.

SOURCES:

https://www.wsj.com/articles/chinas-xi-jinping-secure-in-power-faces-deepening-economic-challenges-11666622999

https://www.cnn.com/2022/10/25/investing/china-yuan-all-time-low-xi-jinping-third-term-intl-hnk/index.html

https://www.bloomberg.com/news/articles/2022-10-25/china-traders-to-parse-pboc-fixing-as-yuan-falls-near-weak-end

https://www.nytimes.com/2022/10/27/business/strong-dollar-global-economy

https://www.bloomberg.com/news/articles/2022-10-24/china-s-yuan-weakens-past-7-3-per-dollar-amid-growth-concern

https://www.investopedia.com/articles/forex/09/chinas-peg-to-the-dollar.asp

https://www.cnbc.com/2022/10/24/alibaba-tencent-shares-plummet-as-xi-jinping-tightens-grip-on-power.html

https://www.bloomberg.com/news/newsletters/2022-10-25/china-is-cheap-but-it-s-not-cheap-enough

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