Once again, China is making headlines on the financial world stage. The world’s second-largest economy has cemented itself as an important global player, but the last few weeks have seen international investors move away after an extended period of disappointing performance.
Equities have continued to lag, while geopolitical developments are increasingly complicating China’s position. As well as this, the extreme debt in some sectors (look at Evergrande, for example) is casting a long shadow over China’s economic viability. So, what’s going on?
Let’s start with the economic data. China was one of the worst-performing major markets last year. The MSCI China index fell 22%, underperforming against US equities by nearly 50%. 2022 isn’t looking much better, either, as foreign investors dumped Chinese stocks worth a whopping $6 million over the first three months of the year.
Chinese stocks didn’t perform brilliantly throughout 2021. In fact, the benchmark index CSI 300 is only 4% above where it was at the end of 2019, as the first outbreaks of Covid-19 began to be reported. The Nasdaq Golden Dragons Index, which covers large Chinese tech companies listed in New York, fell by about a quarter. If you compare these performances with the S&P 500 and the technology-centric Nasdaq Composite, you can see that these have instead recorded increases of around 37% and 52% respectively.
On top of all this, there are a few other elements to consider:
- China has revised growth for 2022 downwards, to 5.5%. In fact, the country is facing multiple issues in the shape of a drop in demand, problems with supply and the broader weakening of its economic expectations.
- New Covid-19 restrictions; the city of Shanghai was recently locked down owing to a surge in cases in the area. Shenzen, a key city from a production point of view, has had to suffer similar lockdowns in recent weeks.
- The crisis in the real estate sector; a problem that began with Evergrande has continued, pulling in other real estate companies.
The combination of these elements is slowly but surely hampering the country’s growth, so much so that several foreign investors have fled (as we saw over the last month or so).
China’s disappointing performance
China’s role in the global financial system has changed significantly since the 2008 financial crisis. On that occasion, the country’s government injected a huge amount of money into the system to help offset a sharp decline in exports.
China already held the largest stock of foreign exchange reserves before 2008 and emerged from the crisis with three of the largest banks in the world. Since then, China has become the world’s largest exporter and the world’s second-largest economy. Today, the Chinese economy is growing apace, rivaling that of the US and becoming a key driver of global growth.
That said, it’s not all positive. China’s financial market performance has been disappointing, while political relations with the rest fo the world have often been complicated. As well as this, there are concerning levels of debt in some sectors, highlighted most clearly by the real estate crisis of last year. These issues have cast a shadow over the financial reliability of China.
The country’s role in global finance and the importance of its currency are not yet commensurate with its weight in the world economy. The Yuan is only now emerging as a potential reserve currency. The others – the US dollar, the euro, the Japanese yen and the British pound – all have well-established roles in global finance.
However, the renminbi is starting to play a significant role in international trade, as well as appearing in the reserve portfolios of central banks around the world. It is, therefore, likely to become a major reserve currency within the next decade, perhaps even eroding (but not replacing) the dominance of the dollar.
The state continues to play a central role in China’s economic dynamics, despite changes made after 2008 with a view to deregulating somewhat in service of the country’s economy. This central role occasionally puts the government in awkward positions, as we saw recently during the Evergrande saga.
Evergrande: the crisis in the real estate sector
Real estate giant Evergrande has proven to be something of an ongoing headache for the Chinese government. The crisis began towards the end of 2021, with the company unable to pay supplier and employee salaries as a result of enormous debts – to the tune of $300 billion.
The debt came a result of aggressive expansion, as Evergrande became one of China’s biggest companies. When the government introduced new rules to limit the borrowing of real estate developers in the country, the behemoth was forced to sell homes at a discount keep the business ticking over. As a result, it then struggled to meet interest payments on its debts.
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The situation is yet to be fully resolved. Evergrande avoided going bankrupt but, in just the past week, it returned to the headlines when it announced that it would be unable to publish its financial results for 2021 by the March 31 deadline (a process that is legally required for listed companies). The reason is that the auditing process won’t have been completed by then.
Evergrande is not the only company in trouble, either. Some nine developers – including Evergrande, Ronshine and Shimao – are having difficulty publishing their results. This could be read as a signal that all is not well in the Chinese real estate sector and that other accounts could have similar issues.
The recent history of real estate in China, with Evergrande being the clearest case, could be read as an indictment of the structural flaws of Chinese capitalism. Firstly, the real estate sector has grown exponentially and has become too large even relative to the size of the Chinese economy. Secondly, the reliance on private debt to finance economic growth comes with its own issues, particularly in an underdeveloped regulatory environment.
This all falls within the context of Xi Jinping’s attempt to intervene and redefine the balance of power between the public and the private in the Chinese economy. The Chinese government is not focused only on the real estate sector, either. The tech industry has also been targeted, with the aim of limiting its economic power.
The “war on tech” continues
Xi Jinping has been fairly unequivocal in his position towards China’s tech giants. This is to say that they should be at the service of the Communist Party, the sole body to lead the country’s economic growth. This attitude is at odds with, for example, the US government’s position, which is generally to protect and support its tech behemoths.
Think back to July 2021, when Didi – a Chinese ride sharing app – was listed on Wall Street and reached a valuation of near $70 billion. The Chinese government’s response was to block Didi from app stores for fear that the company and its users’ data could end up in American hands. This move had two major consequences:
- It caused significant losses for the company and its investors
- It acted as a deterrent for other companies considering going public on the US stock exchange
Similarly, e-commerce giant Alibaba was fined nearly $3 billion in April 2021 in a landmark antitrust case, less than a year after its own major IPO was blocked by regulators. The likes of WeChat and ByteDance have, for now, only received warnings.
The back and forth between big tech and the Chinese government could be seen as part of its the latter’s wider objective to strengthen its political power against large conglomerates. The message is that the Communist Party is leading the country and that embracing elements of capitalism is a means to achieve the goals of the nation.
From a financial point of view, this positioning weakens the tech companies, causing a decline in corporate performance. You can see this in the graph below, where the black line represents the performance of Chinese domestic companies, which has a comparatively high proportion of tech giants when compared to other indices.
Investing in China: a risk or an opportunity?
From an equity perspective, China’s heavy regulations and the pervading idea of “common ownership” are perhaps too impactful to consider China a true competitor to the US in terms of financial returns. On the fixed income side, Chinese Government Bonds cannot be compared to US Treasury Bonds when it comes to their diversification benefits.
The currency risk when investing in Chinese bonds represents a difficult risk scenario to manage, even if the Yuan has proven to be a more stable currency than that of most emerging economies.
Chinese bonds are an asset to be carefully evaluated and they are increasingly important in many bond benchmarks. In just one year, Yuan-denominated bonds became the third largest allocation in the global benchmark index for fixed income (the Bloomberg Barclays Global Aggregate Index). It is likely, then, that this trend will attract more and more investment flows to this asset class.
Chinese bonds offer both yield and diversification benefits, and Chinese bond yields tend to sit between developed and emerging market yields. Historically, they have shown relatively low correlation with government bonds from developed countries.