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