Is China uninvestable, redux

Good Morning. On Thursday, for the second day in a row, markets in both the US and in China expressed robust pleasure with the actions of their governments — the Federal Reserve’s clearer policy stance in the US, and the pro-market comments of vice-premier Liu He in China. Today I take a closer look at the latter bout of enthusiasm and whether it makes any sense. Email me: [email protected]

Is China uninvestable, again?

Six month ago I wrote a newsletter with titled “Is China uninvestable?” The impetus for the piece was repeated interventions by the Chinese state bureaucracy into industries from education to alcohol. The chilling hand of official power gripped the big tech platforms most tightly, and those shares — some listed in the US — had tanked over the previous half year. The piece did not answer its titular question directly, but instead concluded that the risks were not priced in:

China may not be uninvestable. But the stock market as a whole is still expensive, given that the party is cracking down on the symbols and sources of wealth and inequality, and has little incentive to consider the fate of foreign investors.

It’s time to ask the same question again, as the Chinese government faces a new set of pressures, and policy seems to be shifting. Here is a chart of the performance of mainland China, Hong Kong, and US-listed Chinese American Depositary Receipts since the start of 2021:

Investors in Chinese stocks have continued to suffer since that earlier piece. And here are the price/earnings valuation ratios, in a 10-year perspective:

The stocks, especially the US listed ones, have become cheaper relative to their historical valuations levels. Are the risks priced in now?

One might be encouraged by the comments of vice-premier Liu earlier this week, which suggest that President Xi Jinping’s strident approach to reform has been tempered by the need for stability. Liu said the government would “actively introduce policies that benefit markets”, “boost the economy”, complete the reform of the internet sector “as soon as possible”, and generally promote stability and predictability. Here’s a little gem of bureaucratese:

Any policy that has a significant impact on capital markets should be co-ordinated with financial management departments in advance to maintain the stability and consistency of policy expectations.

The standard narrative for this turnabout is that Xi is looking ahead to the 20th party congress this autumn. Before his unprecedented third term as the party’s general secretary is made official, he wants calm on all fronts. But markets are beset not just by policy uncertainty, but a laundry list of other concerns, including:

• That China’s Covid outbreak could before long rival Hong Kong’s in severity, and that in combination with the country’s zero-Covid policy, might mean wide and lasting lockdowns.

• That the war in Ukraine could put China on the wrong side of international sanctions, should it provide Russia with economic or military support.

• Potential delistings of Chinese companies from US exchanges over audit concerns.

• A slow-motion real estate crisis that can only be solved with mountains of capital that would otherwise go to a more productive use.

• Rapidly slowing economic growth combined with cost-push inflation.

• Weak credit growth in an economic system that is highly dependent on it.

For the time being, Liu’s comments have stopped the bleeding. Shares have risen smartly in the past few days, with the most beat-up issues rising most. The hard question is whether the apparent shift in policy will last until the party congress or beyond.

It is worth noting that we have seen something very much like this movie before, just eight years ago. As George Magnus’ book Red Flags tells it, the set-up was not unlike today’s, with a reform-minded government supporting the stock market as other problems, specifically in real estate, mount:

It all began in 2014, with the anti-corruption drive in full swing. In China’s real estate market, sales and prices were dropping . . . With the real estate market off-colour, investors and households started to put money into the stock market, aided and abetted by the central bank . . . and state media, which encouraged people to buy equities, even suggesting it was their patriotic duty.

It did not end well, as a 2015 announcement of tightening margin debt rules (presumably an effort to cool things off a bit) led to a market collapse that did not bottom until January of 2016, despite various state propping-up efforts.

This historical anecdote does not encourage confidence in the Chinese government’s ability to support the stock market in the face of poor fundamentals and spooked retail shareholders.

To make the same point another way, China’s stock market is tilted heavily towards retail investors. Are these investors going to show sustained speculative appetite for stocks at a moment when their faith in their core asset — property — has been badly shaken? Here is a chart of Chinese house prices from Pantheon Macroeconomics’ chief China economist, Craig Botham:

And here is home sales volumes:

Try this little thought experiment: if the above was happening to US home prices and sales, what would the S&P 500 be doing?

Try a third angle on the same point. What stock markets like, as Americans know too well, is loose credit conditions and rising leverage. But China is struggling to create credit growth. Credit data for February was a notable disappointment, despite recent reforms designed to encourage borrowing and lending. As Botham sums up:

Monetary policy has become easier in recent months, but bank lending continues to slow, growing just 11.2 per cent year-over-year in February, from 11.8 per cent in January. The monetary transmission mechanism is functioning poorly . . . What is worse, the areas of growth in lending do not look that supportive for the economy. Short-term lending to corporates is accelerating, but long-term lending, and lending to households, continues to slow . . . Bank credit is . . . primarily providing bridging loans and working capital for firms struggling to survive.

China’s government has steered the country’s economy through treacherous straights before. But even after the current crisis recedes, global investors considering buying Chinese securities must make a political calculation. Once Xi emerges from the party congress secure in his third term, will his reforming instincts have softened — or will the moderating impulse expressed by Liu prove to be a blip?

I am not qualified to answer this question, but I will close with the views of two more seasoned China observers than myself. Here is Andrew Batson of Gavekal Dragonomics, in a note called “Please bring back the old China”:

The odds are, however, that this is a change in short-term tactics, not long-term strategy . . . the reality is that Xi has consolidated power within the Communist party more effectively than either of his predecessors, and no real rival has been permitted to emerge. The 20th party congress later this year is certain to endorse his bid for a third term. The unforgiving advance of time means there will be even fewer holdovers from the “old regime” in that third term than there are today. Xi’s various slogans and objectives have been written into law and Communist party doctrine, ensuring their survival. For longer-term investors in Chinese companies, the hope must be that he pursues those goals with a more careful hand in the future.

Hope is not an investment strategy, though. Here is Diana Choyleva of Enodo Economics, in a note to clients:

Long-term, bottom-up investors, who may be tempted by the low valuations of China’s platform [tech] companies, need to consider not only picking their timing but also the fact that the easing of the comprehensive crackdown on those firms is much more likely to be political manoeuvring than a genuine change of heart.

I spoke to Choyleva on Thursday, and asked her whether the Chinese stock market was uninvestable. She replied that, for international investors, it was. She agrees with Batson that moderating forces in the government will be replaced by pure apparatchiks once Xi secures his third term, and that timing the inevitable tightening of the regulatory apparatus will prove impossible.

One good read

From Anatol Lieven, an essay on Russia’s true ruling elite — not the so-called oligarchs, but Vladimir Putin’s inner circle of siloviki — largely former members of the Soviet intelligence and security establishment, all committed to the notion of Russia as a great power.