This question keeps being asked by the media and asset managers. In the past year, the asset manager of one major US bank published a note asserting that “China is still investable”, while the investment banking arm of the same bank asserted that China is not. One large ETF provider helpfully created an “emerging markets ex-China” ETF to cater to investors who do not believe China is investible. Banks and asset managers tend to answer this question differently depending on the extent to which they are invested in the Chinese market.
The fact that we are even discussing whether foreign investors should be allocating to the world’s second largest economy speaks volumes. Questioning whether China is investable is not like taking a view about whether you think a particular stock market is going up or down. It is saying that regardless of which direction the market may move, China is not a worthy investment destination because its risks outweigh the potential rewards.
Why is this question being raised? There are many policy developments that have raised concern. But at the core, there appears to be a substantial gap between investor expectations and reality. There are three important areas where this gap is acute: the link between economic growth and market returns, the level of economic growth, and the nature of policy.
The link between economic growth and investment returns
More often than not, investor enthusiasm for China has emanated from the spectacular rates of growth that the economy has experienced since the 1980s. It is often forgotten that China’s equity and bond markets are relatively young. This has two important implications. First and foremost, the set of investment opportunities – represented by the sector composition of the equity market – bears little relation to the GDP. Consequently, economic growth does not necessarily imply earnings growth, and certainly not when measured in foreign currency terms.
The implications of a relatively short market history mean that investors – foreign and domestic alike – have little experience in how crises are handled. The first Chinese corporate bond default took place in 2014. Since then, far fewer defaults have taken place than what would be expected in a market of that size. This implies that investors do not have sufficient precedents to look to in assessing how problems are resolved. Inevitably this leads to risks being mispriced. Mispriced risks are a recipe for disappointment.
The awesome level of economic growth
Nothing captures the imagination more than the spectacle of high levels of growth. Here, China delivered. But how did it do so?
China’s growth is not the product of some sort of secret sauce. Its economic trajectory can be plotted through two distinct eras. The first era starting from the late 1980s until the mid-noughties is the simplest: China allowed the import of foreign technology and management skills to replace those that failed. It allowed market prices to replace state planning for signaling production. In other words, China was catching up while becoming more efficient.
China benefitted from a low starting point. It also benefitted from a demographic advantage in the form of a huge pool of underemployed labour in rural areas. Economic growth is the product of interaction between labour growth, investment growth, and technology. All three factors were working in China’s favour simultaneously, while the rest of the world opened their markets to Chinese imports, further boosting growth.
The second phase of growth relied heavily on investment. As China caught up technologically, the “catching-up” advantage of importing new technologies dissipated. Nonetheless, China was able to sustain a high rate of growth because of investment. Investment became an ever-larger share of GDP, while GDP growth remained constant. What does this mean? It means that the returns on investment had been declining.
This is not a complicated phenomenon. The returns on investing in the first bridge or high-speed rail is high. The returns on the second, and third is inevitably less. China already has some of the world’s most advanced infrastructure. How much growth can further investment generate?
Much of the investment growth has gone into property development. By some measures, the property sector represented 25% to 30% of GDP growth, while property investment represents about 14% of GDP. In the US, by contrast, it is 5%. These high numbers would be less concerning if China had a genuine shortage of housing. It doesn’t. On the contrary, there is ample evidence that property growth is a fully-fledged speculative bubble. The problem with speculative bubbles is that demand will be strong only if prices keep rising. But once prices stop rising, demand disappears.
The cracks that have appeared in China’s housing market since Evergrande’s debt crisis have rightly concerned the government. Some mortgage holders have started to pause payments to developers. It remains to be seen if new policies – which are tantamount to subsidies – will succeed at achieving more than simply postponing a painful adjustment. Property represents about 80% of household wealth in China, compared to 30-40% in the rest of world.
How can China sustain growth in the future? Demographics will not be any help. Overinvestment is very evident in many sectors. Technological “catch-up” is behind us. Foreign demand will not be supportive in a world turning away from globalisation. This leaves only one potential source of growth: domestic consumption.
The myth of China’s “uber-competent” government
Perhaps the biggest gap between investor expectations and reality centres around perceptions of the level of competence of China’s government. Many people assume that China’s success is a product of its system. They also assume that just because China’s governance model has been successful in the past, it will be successful in the future.
China’s experience, however, shows that there is little that is unique about the country. Its experience is like that of Japan, South Korea and others. The only thing that is truly unprecedented is the sheer size of the transformation because of the size of the country. But the larger the country, the more complex is the task of management when tailwinds turn to headwinds.
There have been many recent policy missteps that demonstrate that China’s system is not fit for the purpose of managing a complex economy. The crackdown on large technology firms is a prime example. Anti-trust regulation is a feature of the regulatory landscape in all advanced economies. The same is true of data management and privacy rules. In the case of China, however, these rules came in with little public discussion with stakeholders. Another example is the shake-up of the private education system. China’s judiciary does not have the independence necessary to challenge government action.
For an economy to grow efficiently, investors need to allocate capital to those areas where returns are expected to be highest. In China, it is the government that decides the investment priorities, while also leaving investors with little recourse when rules are changed. The role of government is not to enable the market to work efficiently, but rather to control the market to achieve its policy objectives.
None of this is new. Investors have had a good idea of how the Chinese system works. They have looked the other way because of the seductive power of high GDP growth numbers. It is often said that when the winds are strong, even turkeys can fly.
China cannot continue to grow at anywhere near the levels of growth it has seen in the past three decades. Its future growth rests entirely on its ability to generate consumer-led growth. This is perhaps the only area where risks offer investors reasonable return potential. But it is also worth remembering that even here risks are meaningful. Household consumption can well be impacted by the negative wealth effect of falling home prices.
China’s market is likely to perform strongly as Covid restrictions are relaxed. We wouldn’t think of this as an opportunity to increase broad exposure to the market. Rather, it is an opportunity to refocus exposure to those few areas that are likely to witness growth.