Is China Still Investable?
Author: Regina Chi
October 1, 2021
A “Common Prosperity” agenda that seeks to reduce income inequality might turn out to be a very good thing for the citizens of the People’s Republic of China, but Western investors in Chinese equities might be forgiven for seeing it as a very bad thing for them. As a group, China stocks have not performed well for months now, as the country has grappled with slowing economic growth and continuing fears of a COVID-19 resurgence. And since the summer, when President Xi Jinping rejuvenated the idea of Common Prosperity to address income inequality – which has risen sharply since the early 1980s, according to the World Inequality Database – the market declines have only continued.
For investors, China’s Common Prosperity push may raise the spectre of radical wealth redistribution or a wholesale retreat from the hybrid capitalism that has defined the country’s remarkable economic growth since the early eighties. Some observers, fearing the worst, have even floated the idea that China stocks are “uninvestable.” Yet such worries might be premature. While the significance of China’s policy shift should not be underestimated, it also should not be misunderstood. And over the longer term, investors may continue to find opportunities in Xi’s China – if they can recalibrate both their expectations and their strategies.
Common Prosperity has been part of the Chinese Communist Party’s lexicon since at least the 1950s and Xi has undertaken not only its resuscitation as a Party-approved phrase, but also its formalization as policy. At root, it addresses rising income inequality by focusing on what party officials see as the three great pressures on one’s life in China: property, healthcare and education. While these pressures may be no different from the stresses people in developed countries are facing today, Beijing has been regulating the first two of those for many years, but education reform has been the missing link. In late July, various news outlets reported on the government’s crackdown on private education – a favoured sector among investors, and a US$120-billion industry in China, according to Reuters – by effectively turning existing tutoring companies into non-profits and no longer issuing licences. The goal is to reduce the cost burden on parents and the strain of extra work on children, in hopes that doing so will help reverse demographic decline.
The explicit targets of Common Prosperity, however, align with other policy shifts in recent months. Among them, we are seeing more regulation of platform companies operating in the digital economy, which for many years had been allowed to grow and gain scale, attracting significant capital commitments. Now, however, they face intense regulation that limits their scope – and, in some cases, disrupts their business models. The Chinese government is committed to deep reforms with a strong emphasis on antitrust law enforcement. It wants to set legal frameworks for the digital economy, fintech, artificial intelligence, big data and cloud computing. More details will come when Beijing unveils its Data Security Law, its Cyber Security Review (which would establish governmental veto power over foreign listings) and its Personal Protection Law, which will regulate how companies collect and use data. Even so, these laws are already having a profound impact on China’s digital landscape – and on its formerly high-flying tech upstarts.
Xi has also pledged to reform corporate China to place more emphasis on the concerns of stakeholders and less on the demands of shareholders. Ultimately, the crackdown is all about imposing tighter Party control on the country’s top firms, aligning the private sector with the government’s political and social goals. Under the new governance paradigm, China appears to be trying to check the rise in corporate power and rebalance the economy in favour of labour, which could result over the long term in declining profits for private companies.
So, given all this, is China still “investable”? The short answer is yes. In fact, the ultimate intention of Chinese policymakers is the long-term sustainability of China’s economic and social development, alongside better allocation of resources and capital in the pursuit of relative equality. Still, while the roadmap is clear, the journey may not be smooth for investors. To navigate China’s changing landscape successfully, it may become critical to focus on sectors that are aligned with China’s policy priorities, including, for instance, those related to decarbonization and localization of the economy, but which are also consistent with global industry trends and led by competitive corporate champions. Most of all, investors should focus on quality companies that generate high returns and have stability to cope with periods of volatility and economic slowdown.
Even if investors apply such criteria, however, headwinds may remain for stocks, at least in the short term. Credit conditions in China are tight; investors might choose to wait until there are meaningful signs of easing. They might also want to see real progress on the ongoing offshore audit dispute between the U.S. and China, as well as a clear line of sight as to when the regulatory reset will be finished. Finally, the impending end of the U.S.-China Phase 1 trade deal at the end of the year could spell the beginning of a new trade dispute.
Over the longer term, however, these factors do not negate the potential of the world’s second largest economy for Western investors. Nor should Xi’s renewed focus on Common Prosperity. In important ways, Beijing is addressing the same social and economic stress points Western democracies are – but in its own characteristic way. While lawsuits and new laws will take years to effect change in the West, China can and will accomplish reforms through government fiat. Westerners might not like that very much, but it does not mean opportunities will evaporate. Investors will just have to work harder – and shift their focus – in order to find them.
Regina Chi is a Vice-President and Portfolio Manager at AGF Investments Inc.
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