Complexities of Investing in China

By: Toviya Slager  |  August 25, 2021

By: Toviya Slager

What makes the great investors stand out is their ability to move their money into growing markets before everyone else realizes the potential. Over the past year the political and economic relationships between the U.S. and China started changing tones. For some this is signaling the transition of international power from the U.S. to China, while others believe that China’s policies are hindering its expansion. China has embraced the phrase “the East is rising and the West is declining”. However, is it worth investing in the growing market?

The potential transition from the US being the largest international superpower to China has been discussed for more than a decade. In 2011 the Pew Research Center published results of a survey that showed a large part of western Europe’s population (France 72%, Spain 67%, Britain 65%, and Germany 61%) already believing that China will replace or already replaced the US as the world’s leading superpower. That narrative only strengthened during the COVID-19 pandemic as the Chinese Communist Party (CCP) marks their 100-year anniversary. Xi Jinping has changed the Chinese attitude towards the U.S. by telling them to focus on domestic race problems and remain uninvolved with Chinese policy. During earlier administrations the Chinese understood the US power and created less confrontation, but in recent meetings, the Chinese government has made it clear that they will no longer be bullied by the U.S. and will create their own sphere of influence.  This was made clear with imposing communist rule on Hong Kong and convicting, last month, the first man guilty of China’s National Security Law for protesting.

While China changes their tone and is expanding their political influence, their economy is also growing rapidly. According to a report by UK-based Centre for Economics and Business Research (CEBR), China is forecasted to overtake the U.S. as the largest economy by 2028. This is for a large part due to their stronger COVID-19 response than the US. The question remains: Does such growth create opportunity for the average international investor?

The easy answer is “yes”; a growing economy means expansion of companies will expand and the rise of asset prices. Many are in this camp. The Wall Street Journal reported in January that for the first time China overtook the U.S. as the leading destination for foreign direct investments.  In general, emerging markets are seen as locations for faster return on capital due to the frontier market concept. The idea is that frontier markets, such as the United States and Europe, are more developed therefore take more effort to grow than less developed markets. It is like most learning curves, where the development is fast at first, but gradually slows as you reach the “knowledge frontier”. Emerging markets have had many periods where they outperform developed markets but are also more volatile since they rely more on outside investors. China has been following this front for a while through their rapid expansion, and many investors assume that investing in the Chinese market will allow them to capitalize on this growth.

However, the Chinese government and market have come under attack, leaving investors skeptical. First, the Chinese government has forced companies to delist or transformed them into government entities. In July the large ride-hailing app, Didi, was told to pause their NYSE IPO; directly preceding China’s crackdown on Bitcoin miners, and blocking Ant’s record breaking $34 billion IPO. Additionally, the Chinese government announced on July 26 that private afterschool education programs must operate as non-profit organizations to help lower costs for families to encourage them to have more children. This news shocked the market and the MSCI China Index fell 4%. This is just one example of the unpredictability of Chinese regulators, causing international investors to feel uneasy.

Second, as many investors are considering Environmental, Social, and Governance (ESG) in their investing portfolio, China has many problems relating to human rights and environmental concerns. In 2020 alone, the amount of money allocated to ESGfunds has doubled, and many more funds are including ESG into their investing criteria. However, this creates issues when investing in China since they continue to violate human rights against the Uyghur population, and remains the world’s largest emitter of greenhouse gases.

Third, Chinese regulators seem to have distaste for large private corporations. For example, China blocked Ant’s initial public offering (IPO) after Jack Ma criticized the CCP. With that being said, companies may be compelled to remain smaller to prevent attraction from Chinese authorities.less companies will file for IPO and asset growth will remain limited, even if the economy is growing. The main problem faced by businesses is that the CCP prioritizes political control over economic efficiency, and therefore may never become 

Finally, the Chinese market is historically volatile; rising close to 50% one year and falling 20% the next. In fact, the last 5-year annualized return for S&P China 500 was 12.9%, but over the last 10-years it has only been 7.47%. This is relatively little compared to the US S&P 500 10-year return of 14.71% and 5-year return of 17.51%.

Nevertheless, there are still investors who look at these government regulations through alternate lenses. Most notably, Ray Dalio, founder of Bridgewater Associates and long-time investor in the Chinese markets. He feels that the crackdown on large corporations such as Didi are part of China’s long-standing policy for steady development of capital markets and entrepreneurship. In his view, the Chinese government runs the capitalist system and will crack down to protect the state where other countries may not have. In the case of the aforementioned company, Didi, the Chinese government feels the data they possess is too sensitive to allow them to go public. Ultimately, Dalio remains a strong believer that Chinese stocks should remain in a well-diversified portfolio.

All in all, whether to invest in China is not straightforward. Nonetheless, China’s growing influence is not to go unnoticed.. Although some view the government’s intruding policies as a hindrance to stable market growth, others see the policies as a protective measure for the general population.