Australian Financial Review
September 6, 2021
For those with a subscription, the link to the latest AFR piece is below.
What you thought you knew about investing in China is wrong
The reality is that under Xi Jinping, the where and how of investing in China have changed.Mark Tinker
For those without, (including me) the following is the text I sent through. Incidentally, the rather vainglorious headline is theirs!
The summer months in the Northern Hemisphere generally see lower levels of trading and liquidity, as most of the key decision makers head to the beaches and the juniors manning the desk understandably tend to be more risk-averse than the boss who actually gets paid to take the risk. As such books are flat, or rapidly flattened, and we often see jumpy and volatile markets. This year was no exception, except that the two main events – the hit to the Chinese Education Stocks at the end of July and the chaotic US withdrawal from Afghanistan in the middle of August – are more than the usual ‘noise in thin markets’. Both have profound medium and long term implications for markets, implications that the key decision makers will now be pondering on as they return to the office. Covid permitting naturally.
They used to say under the previous regime of Hu Jintao and Wen Jiabao that while we knew the Who and the When of investing in China, we still needed to work out the Where, the How and the Why. The Why was obvious, the desire to participate in the cashflows emanating from the fastest growing large country in the world and for the other two we concluded that the Where was in New York and the How was via ADRs and the artifice of the Variable Interest Entity or VIE structure. This pragmatic device meant that the company was deemed to be simultaneously 100% owned by the Chinese (to suit the Chinese regulator) and 100% owned by western investors (to suit western regulators). Everyone turned a blind eye, not least the assorted ESG benchmarks, which ignored the clear governance risks associated with the structures, a number of which emerged in late July when the Chinese government decided to change the ability of companies in the Chinese for-profit education sector to actually make profits. These included a number of VIE structures, but the dash for the exits by western investors dragged in all the other Chinese VIE stocks, most noticeably the tech giant AliBaba as well as benchmark “China stocks’ like HK listed Tencent. The fact that these two also dominated a number of Emerging market ESG benchmarks has been rather awkward for many.
The reality is that under Xi, the where and the how of investing in China have now changed. You can still participate in cash flows emanating from the Chinese economy, but you need to do it on China’s terms, which now means buying stocks via Hong Kong or Shanghai exchanges. The VIE and ADR structures are now effectively dead. You also need to recognise that the standard western model of privatisation and leveraging of public goods in order to provide a rentier class with annuity income is not going to happen in China. The Chinese authorities are for the 99%, not the 1%. Self-serving Wall street types and Hedge Funders are declaring that this is terrible for the Chinese economy, but as a net exporter of capital, China doesn’t need western savings to finance its capital investment and this latest move suggests that the reason for allowing western involvement thus far has been much more about efficient ‘market pricing’ than access to capital. As far as the Chinese are concerned, the US can sell all its Chinese stocks at fire-sale prices, and they will be more than happy to pick them up.
August of course saw another US withdrawal, not capital this time, but physically and militarily from Afghanistan and while most focus has been on the Geo-politics and the How, rather than the Why, it happened, we believe that this also has important implications for investors. The reality is that the US first went into Afghanistan as part of the last Cold War against Russia and had remained there as part of its New Cold War against China. It has now been pushed out. Landlocked Afghanistan is right in the middle of the One Belt One Road (OBOR) project linking China to Russia, the Gulf and the West and the crucial role that the countries of the Shanghai Cooperation Organisation, (SCO) who are essentially Afghanistan’s immediate neighbours (plus India) have played in the return of the Taliban should not be under-estimated. OBOR will now accelerate and the 70% mobile penetration in Afghanistan is likely to be moved straight to Huawei.
Meanwhile, in addition to untapped reserves of metallurgical coal, Oil and Gas – all of which would be eagerly picked up by energy-hungry China – Afghanistan is estimated to have an abundance of high tech and ‘green’ materials such as Copper and rare earths as well as famously being described as ‘The Saudi Arabia of Lithium’. This will be a magnet for capital from the rest of the SCO with western investors unlikely to get much of a look in, even if their ESG filters were to allow them.