The Case for Investing in China
China today remains a controversial topic for investors. Its extraordinary rise over the past four decades has attracted the attention of economists, policymakers, and institutional investors the world over. Yet, its speculative housing sector and dependence on debt-fueled growth has also worried many. The aim of this article is to discuss these aspects of China’s macroeconomic landscape, and to argue why China’s continued growth offers attractive opportunities for investors.
Even in an age of superpower competition between the world’s two largest economies, China remains a great opportunity for those looking to invest overseas. With a market twice the size of the Eurozone, one would be remiss to dismiss the Chinese market, which is only going to grow in the coming years. Many American multinational corporations draw substantial portions of their sales each year from the Chinese market, and these trade linkages will provide a buffer for worsening US-China relations. Indeed, as many commentators have predicted, it is neither party’s interest to decouple, since the costs of doing so are prohibitively high. While we will likely see some export bans in the high-tech sector, the rest of the economy will remain open. Despite the tit-for-tat trade war initiated by Trump, China has not taken any reciprocal actions on US corporations doing business in China. Apple, Starbucks, and GM have all continued their operations without interruption from the Chinese government. Indeed, these companies drew much of their sales from China during the pandemic while most of the world remained in lockdown.
The recent announcement of a dual-circulation model for the economy at the People’s National Congress will create new opportunities for investors in Chinese companies. The dual circulation model represents a shift in growth strategy from export-oriented growth to growth driven by domestic consumption, and will entail an increased share of national income to households. This will drive sales for China’s e-commerce giants, such as Alibaba, JD.com, and Pinduoduo, as well as for regular manufacturing companies. The shift in growth strategy away from the debt-fueled growth of past decades to slower but more sustainable growth spells good news for China’s long term economic prospects. The central bank’s willingness to accept RMB appreciation over the past few years reflects this shift, as an artificially low exchange rate regime boosts export competitiveness but reduces the purchasing power of Chinese consumers. By allowing the exchange rate of the RMB relative to the dollar to increase steadily, China’s policymakers are signalling that domestic consumption will take priority over exports. The new growth strategy also suggests that China will take steps to reduce, or even end its long-term policy of financial repression, or keeping interest rates on deposits low, thereby depriving savers of the interest on their savings. Because interest rates are lower than the rate of inflation, Chinese households have been forced to save a very large portion of their income in order to have enough money once they retire. This high rate of savings has had large impacts on other sectors of the Chinese economy, from lower rates of consumption, to speculation in the housing sector, as the ever increasing prices of homes makes housing a better store of wealth than savings in a bank. Furthermore, the People’s Bank of China’s recent experiments with a digital currency, or DCEP, reflects a desire to maintain competitiveness against China’s fintech giants such as Wechat Pay, and Ant Financial, which offers wealth management products that provide higher returns than savings in a bank. To maintain its competitiveness against the private sector, the PBOC will likely raise interest rates on deposits as well as on the DCEP.
Just as importantly, an end to financial repression will likely also reduce the excessive speculation in the housing market, which has concerned policymakers and investors alike. Higher rates on deposits will make saving in banks more attractive relative to speculation in the property market, thereby lowering demand. On the supply side, both central and local governments have introduced regulations to cool down the property sector. The central government has instructed state-owned banks to reduce its exposure to the real estate sector from 40% of overall loans to 32.5%, lowering the amount of credit accessible to real estate developers. Additionally, it has instructed local governments to set fixed dates for land sales, forcing property developers to bid more strategically rather than splurging for land whenever a new auction is announced, lowering the prices paid for property. Local governments have also imposed limits on purchases of second and third homes, and have raised the down payment on new mortgages all to stem the speculative property sector. This will inevitably lead to lower leverage in the property sector, a decline in home prices, and a more stable macroeconomic foundation in the future, notwithstanding the boom in the real estate sector over the past year afforded by easing monetary conditions. A cooling property sector means a search for yield that will benefit the stock market. While there are many well-documented instances of accounting shenanigans in Chinese companies, we should not dismiss Chinese companies outright. Each listed company in the Chinese stock market must undergo a rigorous vetting process, including audits by external accounting firms. Furthermore, as detailed by Hank Paulson’s personal memoir, Dealing With China, Chinese companies looking to list on a stock exchange enlist Western investment banks such as Goldman Sachs and JP Morgan to advise them and to underwrite their IPOs. These Western investment firms bring experience, professionalism, and knowledge when they advise Chinese companies, and we can trust their assessment of the long-term viability of their clients. Furthermore, Chinese companies listed on American stock exchanges, which have more exacting accounting standards for listed companies, provide an opportunity for investors to invest in Chinese equities at a lower threshold of risk. All in all, more Chinese companies go public through IPOs each year than companies from any other country, and it would be a mistake to dismiss this opportunity to invest in such a vibrant and dynamic economy.
Indeed, many of China tech’s companies are at the cutting edge of their field, and are on par with, if not more advanced than their Western counterparts. There are currently no American counterparts to China’s Alipay, or WeChat Pay, which each offer fintech services to hundreds of millions of people each day. For every Tesla, Twitter, and Amazon, there is Nio, Wechat, and Alibaba. China produces the most scientists and engineers each year, and this is reflected in the 58,990 patents produced in 2019, which is more than even the US’s 57,840 patents in the same year.
The Chinese government places a high priority on technological competitiveness, and has earmarked hundreds of billions of dollars for companies conducting research and development in these high tech fields. While China still lags behind the US on some of these high-tech fields, such as semiconductors, it is likely China will produce its own domestic champions in these fields within the next decade. Whatever one’s prejudices, therefore, Chinese tech companies are not to be sneered at. While the recent cancellation of the Ant IPO has spooked investors, we should not conclude that the Chinese government is cracking down on the private sector. Most Chinese companies are allowed to operate without interference, and it is only when companies pose a risk to financial stability that the government steps in. Regulators cracked down on Ant Financial not because of any animus against the private sector, but out of concern that Ant’s big data-driven lending model was excessively risky and not sustainable. For each loan that Ant underwrites, it only puts up 3% of the capital, while state banks put up the rest. While this strategy has its benefits, in increasing access to capital for entrepreneurs without collateral to start businesses, it also creates perverse incentives for Ant and shifts too much of the risk onto the public sector banks. Ant, in effect, is incentivized to create as many loans as possible and collect fees for doing so, while taking on very little of risk, which is mostly shouldered by the state-owned banks. Should these loans turn out to be unpayable, the banks, not Ant, absorbs most of the losses. By forcing Ant to shoulder more of the burden of bad loans and have some “skin in the game,” policymakers can prevent the moral hazard which comes with perverse incentive structures and create more stability in the financial sector while capturing the benefits of increasing access to credit to the private sector. The increased regulatory scrutiny on Ant Financial, therefore, is positive news for the stability of the Chinese financial system, and is a testament to the competence of Chinese economic policymakers and financial regulators. It demonstrates their willingness to pursue long term stability over short-term economic growth. Indeed, while central banks in most OECD countries instituted near zero, or even negative rates to stimulate the economy during the COVID-19 crisis, the PBOC has set the one-year loan prime rate (LPR) at 3.85% while keeping the five-year rate at 4.65%, expressing its commitment to prudent monetary policy and deleveraging. The recent interest in Chinese bonds is both a reflection of higher rates relative to yields on other government treasures, and a vote of confidence in the ability of regulators and policymakers to manage the economy. More stability and less systematic risk makes investing in China less risky, and will facilitate greater capital inflows into China in the future. Much media coverage of China lacks the nuance to explain complexities of incentive structures and financial risk, choosing instead to run sensationalist headlines about Jack Ma being detained by the CCP, which have no basis in reality. It is therefore all the more important to look at the facts rather than relying solely on one’s feelings. China’s macroeconomic outlook is positive, its economy will continue to grow, and it will soon overtake the US to become the world’s largest economy. For these reasons, many institutional investors such as Bridgewater, Goldman Sachs, and JP Morgan are all increasing their exposure to China. Those who fail to do so, out of prejudice or skepticism, will see their performance lag behind their competitors.
