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Emerging market monitor: Chinese shares

September 2021

The case for active investing in China just got stronger

In the current fluid regulatory environment, investing in Chinese shares calls for an active investment approach.

Investors are routinely reminded of China’s uniqueness. Mostly it has been by way of positive surprises – such as the economy’s dramatic rebound from the Covid-19 pandemic. But lately a series of shocks have made it painfully clear that Chinese assets aren’t suited to a passive buy-and-forget approach.

During recent months, Beijing has taken the markets by surprise from a number of directions. It has cracked down on the technology sector and on Chinese companies listed abroad. But it was when the government banned profits on the country’s private sector tutoring market – estimated to be worth some USD100 billion – that investors truly felt the significance of Beijing’s interventions. This was merely reinforced when it then outlined a five year plan for a strict new regulatory approach, particularly to tech companies.

More than anything this demonstrated the unique risks of investing in Chinese equities. Even the relatively safer domestic market for Chinese A-shares has been roiled by recent turbulence. That matters for investors in emerging market equities – even those who don’t have direct holdings of Chinese stocks. And it is particularly true for those invested in mainstream index funds, given China’s heavy weightings in major market benchmarks. 

Shocks to the system

The first sign of trouble came towards the end of 2020 when the Chinese government put the brakes on Ant Financial’s record USD35 billion initial public offering and dual listing on the Shanghai and Hong Kong exchanges just days before the transaction was due to complete. Technology companies came under further pressure from efforts by China’s regulators seeking to lessen their monopoly powers, seemingly part of the government’s “equality vs. efficiency” drive. 
Fig. 1 - The price of uncertainty

MSCI China total return index, USD. Rebased to 01.01.2020 = 100

china index

Source: MSCI, Bloomberg, Pictet Asset Management. Data covering period 01.01.2000 to 13.09.2021

Chinese stocks listed abroad carry particular challenges. That’s not least because many sectors are officially closed to foreign owners, and the holding structures created to make foreign listings possible sit in a legal grey area.1 And while many companies are dual-listed, there is still a heightened level of sensitivity around the type of listing.
 

China's index footprint

Investors who hold Chinese stocks through allocations to mainstream emerging market indices have also suffered. 

Heavyweight

MSCI China market value as percentage of MSCI All Country World Index and MSCI EM Index

China percentage of markets

Source: MSCI, Bloomberg, Pictet Asset Management. Data from 13.09.2021.

The size of the Chinese economy and the increasing maturity of its market makes it a behemoth in the emerging market universe. China’s stocks currently account for 35 per cent of the MSCI Emerging Markets Index. And thanks to MSCI’s decision to start incorporating China’s domestically-listed equities, or A-shares, in its benchmarks from 2019, the country’s weighting in the index is set to increase. 

China's growing heft – which is also testament to success of Stock Connect, an arrangement that allows foreign investors to trade Shanghai- and Shenzhen-listed securities on the Hong Kong Stock Exchange– could eventually allow the mainland Chinese market to rival Wall Street. But that comes with significant caveats.

Even if China’s domestically listed A-shares have been a relatively safer bet during the sell-off, with investments flows into A-shares remaining strong, risks are multiplying there too.2

Chinese challenges

Beijing’s regulatory interventions during the past year have highlighted some of the biggest risks facing investors. A proper understanding of China’s political weather is clearly important. Other factors may be less dramatic, but are also important for investors to consider. 

The first is governance. The Chinese market has very different regulatory criteria for its companies compared to those in more developed markets. And so for active investors, the emphasis shifts to pursuing positive ESG practices when engaging with these firms. So while Chinese companies that are also listed in Hong Kong or New York – traded as H-shares or American Depository Receipts – have to meet strict governance rules, minority shareholders on the mainland have significantly weaker legal protection. Buying an index makes it impossible to separate out the bad from the good.

China may represent the future of investing, but it's a future strewn with potential potholes.

Second, there’s the matter of concentration. The A-shares incorporated into the MSCI indices are predominantly financial and old economy industrial stocks. The former are vulnerable to China’s high rates of corporate leverage. The MSCI China Index has dropped more than 30 per cent in dollar terms from its February peak – when the market was ebullient about China’s ability to overcome the pandemic and take advantage of a global recovery. 

The third factor is macro-economic policy. Beijing did a stellar job of steering the economy out of its steep pandemic-driven decline – China was the first major economy to more than recover pre-pandemic levels across most dimensions. It was just as successful after the global financial crisis a decade ago. But for investors, the detail determines which assets benefit. Is the government focusing efforts on domestic demand or export industries? Is its primary mechanism non-financial credit creation or is it through state spending?

Lastly, routine trading suspensions continue to bedevil investors in A-shares. It’s relatively easy for mainland-listed companies to suspend trading in their shares, and for periods of as long as six months. Indeed, half of all A-share companies had suspended their shares in 2015 during a severe bout of stock market turbulence.3

The opening up of mainland China’s equity market to foreign investors offers huge potential. But buying them through passive, indexed products is a poor choice. Being locked into an index provider’s share weighting exposes investors to a number of risks. It makes them over-exposed to the most vulnerable sectors as the Chinese economy faces significant rebalancing. And it doesn’t allow them to factor in differing qualities of corporate governance. China may represent the future of investing, but it’s a future strewn with potential potholes for the uninitiated.