ChinaAug 17 2017

What are the risks with mainland China?

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What are the risks with mainland China?

China’s economic growth trajectory, while on a downward curl since the days of its 10.64 per cent GDP back in 2010, is still outshining that of the UK and US put together.

According to data from the Organisation for Economic Co-operation and Development, these two developed economies are expected to grow in 2018 at 1.02 per cent, 2.38 per cent respectively, compared with 6.39 per cent for China.

In fact, according to the OECD data (see chart, below), China's GDP, both actual and forecast, has vastly outstripped the OECD average since 2009.

No wonder economists are concerned about a knock-on effect from a Chinese slowdown being felt globally.

But while the figures look good, it is important to remember that China is still an emerging market as far as investment risk is concerned.

There are still reasons for caution when it comes to investing in mainland China, not least the need for continued capital market reform (and a lack of political interference from the Chinese government).

Government interference has long been a bone of contention, and to some extent, still remains so, according to Gary Monaghan, an investment director based in Hong Kong for Fidelity International.

He opines: “Government intervention remains a risk, but with greater qualified foreign institutional investor (QFII) quotas, the expansion of Stock Connect and change in foreign exchange policy (from US$ focus to a basket of currencies), we are seeing signs of less centralised control.”

Similarly, Cyrique Bourbon, portfolio manager for EMA at Morningstar Investment Management Group, comments: "Perhaps the most frightening [risk] to an investor is government intervention.

"We have seen Chinese authorities move on more than one occasion to distort prices, with trading halts and short-selling bans used to stem capital flows.

"Moreover, there are hidden layers of government intervention from within private companies and capital allocation.

"The most notable has been the use of privately-owned banks to implement government policy."

As a result, the reality is, according to Mr Bourbon, that one cannot guarantee whether the state-owned enterprises receive preferential treatment.

Chart: OECD, UK, US and China GDP growth, actual and forecast, 2009 to 2018

Charles Sunnucks, assistant fund manager on Jupiter’s Global Emerging Markets team, comments: “While investors have, since the early 1990s, been able to access Chinese companies via overseas listings (namely Hong Kong), the domestic A-share market has been largely overlooked due to investability issues.

“Giving foreigners gradually greater access to the local A-share market has been a 15 year long process, which started in 2002 when China allowed a select number of institutional investors to invest directly into A-shares via the ‘qualification institutional investor’ (QFII) programme.”

Accessibility has since evolved, and most flows into the A-share equity market are now done via the ‘stock connect’, which is essentially a bilateral loop linking the Hong Kong exchange with Shanghai and Shenzhen.

So historic issues over accessibility may become just that - historic, with more investors getting potentially greater access than before to some dominant domestic stocks, such as Agricultural Bank of China, Hangzhou Hikvision Digital Technology and PetroChina.

RMB

Some managers have expressed caution over high levels of currency control.

For example, there have been issues over exchange rates and high capital account controls over the Renminbi, which in the past has put some international investors off getting into China.

Victoria Mio, co-head of Asia-Pacific equities and chief investment officer for China at Robeco, believes the moves made to improve this will have a positive effect. 

"We think China's government has measures for effective capital outflow controls and only a gradual pace of US$/CNY depreciation will happen.

"In general, most Asian and emerging market currencies have fallen against the US dollar in the past two years, but appreciated against the dollar this year.

"We therefore do not expect further large-scale currency weakness; in fact, the Chinese currency has appreciated by approximately 3 per cent this year."

Mr Sunnucks is of the same opinion: “For policy makers, greater foreign participation in Renminbi (Rmb) denominated investments - in this case, due to index inclusion - is part of a far grander ambition to make the Rmb a truly global currency.

“In aiming to achieve this, policy makers have been very methodical in the way that they have gradually liberalised domestic interest rates, and steadily corrected capital market imbalances, to pave the way for a managed relaxation of capital account controls.

“Ultimately, as the breadth and depth of accessible investable Rmb products like A-shares grow, so too should the power of the Rmb rise.”

Market reforms

China’s market accounts for approximately 21 per cent of world turnover and 10 per cent of the world market cap.

However, Mr Sunnucks believes for greater inclusion of A-shares in global indices there will need to be further market reforms.

He says: “Greater change would likely have to be accompanied by further market reforms by the Chinese regulator.”

One of the reforms recently put in place was a crackdown on company directors suddenly deciding to suspend trading in shares.

Mr Monaghan says this is still a concern, but not as big a worry as it had been a few years ago. “There is a risk of A-share companies suspending, making it difficult for investors to sell their shares. 

“However, following the suspension of numerous A-shares in 2015 after a market correction, the regulator has clamped down on this practice and we have seen very few suspensions since.”

But with more international institutional investors owning A-shares, this could put more pressure on company boards to adhere to international standards on corporate governance and social responsibility.

One would hope the regulator acts to clear up many aspects of the market, including the domestic financial services arena, and improve investor knowledge among domestic investors.

A report from the South China Morning Post in July revealed how widescale corruption, including ‘Ponzi-style’ investment schemes, have caused misery for thousands of investors.

Since the financial markets were opened in the 1990s, Chinese savers have been looking for opportunities to invest, but do not necessarily know how to screen for financial risks.

This has led to the government having to take action against such schemes as the Shanxinhui (Kindness Exchange) scheme, which has scammed tens of thousands of people out of their money, according to the report.

Open outlook

That said, a higher level of corporate governance and a more open outlook has been evidenced in listed corporations, and particularly among China's technology companies. 

FTAdviser' sister newspaper the Nikkei Asian Review reported in July that Chinese technology companies are expanding their reach across south-east Asia, and participating in higher levels of merger and acquisition activity than in previous years.

For example, the Hangzhou-headquartered but NYSE-listed Alibaba Group Holding has been buying and creating platforms and distribution bases on the mainland and globally since its listing in 2014.

Moreover, company management teams in China and, indeed, across Asia are being more careful about how they allocate capital, paying closer attention to capital expenditure and potentially allowing for the redistribution of cash to shareholders through dividends or share buy-backs.

According to Eric Moffett, portfolio manager of the T Rowe Price Asian Opportunities fund: "We are clearly seeing signs of improvement emerging, which could result in sustained optimism for Asian equity markets.

"Reduced costs are flowing through to expanding company margins, while greater capex discipline is likely to continue improved return on capital, as well as allowing companies to potentially return more cash to shareholders via dividends or by buying back shares. 

"Investors will most likely be prepared to pay for the prospect of greater capital returns, leading to a potential further re-rating of the Asian equity market."

Mr Moffett's fund does hold Alibaba, but a significant proportion of his fund is invested in mainland China. 

China37.7%
South Korea18.2%
Taiwan11.8%
India9.6%
Hong Kong5.9%

Financial deleveraging

Other moves by Chinese regulators include their stepping up efforts of financial deleveraging. According to Victoria Mio, chief investment officer, China, at Robeco, this is a risk, although she is not "so worried".

Ms Mio explains: "The ongoing liquidity tightening has led to visible adjustments in domestic financial asset markets, particularly those of bonds and commodities. The equity market is also negatively impacted.

"Investors may worry the ongoing regulatory tightening will lead to prolonged disinflation and growth slowdown, but we believe maintaining economic stability will be the government's priority ahead of the 19th party congress. Therefore, the government will keep policy flexible to prevent growth from slowing down too much."

Mr Bourbon adds: "While market regulations have been improving, mainland China exposure carries many risks that warrant a margin of safety."

Property tightening

Ms Mio also believes there could be an issue with property tightening, after the rebound of the property market forced policy markers to step up tightening measures, with stricter purchase and loan restrictions implemented in large cities. 

She says: "In the near-term, the tightening may cast some doubts on China's sustainability of recovery, however investment growth will likely fill in the gap. Also, property companies are cash-rich so their investment will not slow down this year, and liquidity may likely flow into the equity market."

simoney.kyriakou@ft.com