With the Chinese government cracking down, foreign investors are reassessing their exposure to China. It is a balancing act between capitalising on the lucrative opportunities the country offers and protecting portfolios against the apparent arbitrariness of the government. The attentive investor can nevertheless hold on to a common thread.
According to Thomas Gatley, China analyst at GaveKal, investors with exposure to China should keep in mind four major themes: reforming the rule of law, the “dual circulation” economy, promoting communal prosperity and promoting family values. Gatley was speaking in a recent interview with Fondsnieuws, Investment Officer Luxembourg’s sister publication.
Four policy trends
One clear, much-discussed trend that has emerged in China during the pandemic is the dependence of many Chinese on online services. “The big internet companies are profiting from this dependence to the great displeasure of the government. Companies that threaten to become more powerful than the Chinese Communist Party are unacceptable. Legislation and regulations are being implemented at a rapid pace to curb the exorbitant growth of certain companies”.
China is also pushing for a “Dual Circulation Economy”. “To prevent it from becoming dependent on the US, it is rolling out a strategy that prioritises domestic consumption, while keeping the country open to international trade and investment. Within China itself, for example, the government is removing bottlenecks that could thwart internal competition”.
A third theme is the “Common Prosperity” policy, or the promotion of common prosperity. China wants to reduce excessive incomes and encourage high-income individuals and companies to give more back to society.
“What we in the West usually do is tax income and property, mainly of the upper class. In China, it is much more difficult to use taxes to pull money away from the richest part of the population. Many people have two or three houses but a low income. The Chinese government has to prevent changes in the tax system from causing people to sell their real estate, because that would cause the whole market to collapse.”
According to Gatley, it is likely that the Chinese government will increase the pressure on companies to pay more income to the lowest paid workers. In principle, they will do this by focusing on flexible workers such as delivery drivers. In China, 85 to 100 million people work in the “flex economy” and these workers are usually paid less than the minimum wage. On the other hand, they will invest in services. Education, child care, health care will become easier and cheaper to access for an increasing number of Chinese.
The Chinese government is really worried about the demographic development of the country. Nowadays, a family is allowed to have three children, but the willingness to have offspring has declined considerably. Having children is simply very expensive, and those costs are mainly in the aforementioned services such as education, health care and so on. Logically, this corner of the market is also where the crackdowns take place, said Gatley.
The “safe” sectors
This month, Cathie Woods, CEO of US-based Ark Invest, announced a “drastic” reduction in her exposure to Chinese equities. Woods cited as the catalyst a series of sweeping regulatory changes imposed by the Chinese government on the country’s online education sector over one weekend in July. According to her, this measure indicated that the government’s pursuit of “common prosperity” had become its main concern.
According to Catley, despite Woods’ reaction being very late, it is not unwise to reduce exposure to certain sectors in China. “All investors in that country want to know how firmly the government is intervening in those sectors. In my opinion, an investor should therefore ask himself the following question: what is the government’s interest? The gaming industry is a good example of a sector in which the government has no interest, which means that the government can, and probably will, take a very hard line on it.
Many investors think that there are so-called safe sectors such as semiconductors, electric vehicles and new energy, because these are policy priorities. It is indeed true that the government favours specific sectors, but there are a number of problems. One major problem is that companies that receive a lot of government support face periodic blow-ups. There are companies that, despite having huge amounts of money flowing into them, turn out to be a total scam like the Wuhan-based chip manufacturer HSMC. That company had a huge factory and never made a single chip. This could happen because every province has its own semiconductor champion and money is spent too easily.
The more important, the higher on the sanctions list
A second important problem, according to Gatley, is that the more important a sector is to the Chinese government, the higher it gets on the list of sanctions and embargoes from the US. One of the pearls of policy was Hikvision, a producer of security cameras. They have fantastic technology and a whole mountain of government contracts, but they ended up on the US blacklist and were thrown out of MSCI. Investors would do well to keep monitoring the US government entity list to see if more companies get non-traded status.
So-called “safe” sectors are much more expensive than the well-known internet companies that trade for 20 times earnings with solid and continuous growth, said Gatley. “The darlings of the Chinese government are available for as much as 60 times earnings or more, and in the near future those companies will not be paying dividends. All the money is going into capital investment, research and development.”