Investors’ Dilemma: Buy Stocks in Growing China, or Not?
Beijing’s hard-line policies and investing hurdles complicate the decision.
Art by Carlos Arrojo
This is a difficult one: Feast on the burgeoning bounty of China, whose stocks advanced 41% last year (versus 21% for the S&P 500), and you also fund the economy of a rising US superpower rival and ruthless dictatorship.
“It’s a conundrum,” said Chris Ailman, CIO of the California State Teachers’ Retirement System (CalSTRS), which has $275 billion in assets. With 2% of that in Chinese equities, his pension fund is one the largest China investors among US institutions. “You can make money there and you’re going to have growth, but it’s full of ESG issues.”
The environmental, social, and governance (ESG) stances of the Beijing regime fill many American asset managers with unease: the absence of civil liberties, brutal crackdowns on dissenters, opaque and sometimes patently dishonest financial disclosures. So US institutions have as a rule minimized their allocation to Chinese shares, or avoided them altogether.
The amount of US pension money invested in Chinese stocks was a paltry $161 billion as of two years ago, according to Yicai Global. That translates to about 1% of the total market value of all Chinese equities, $16.7 trillion. Given the political tension between the two nations, there’s doubt that the American allocation has expanded appreciably since. Considering that Chinese equities amount to a sizable 40% of the US market value ($41.6 trillion), the disparity in investing is remarkable.
Add in non-China investors from elsewhere and the foreign share of Chinese stocks is somewhat higher, albeit not much. Looking at stocks globally, using the MSCI All Country World Index, investors, most of them institutional, have just under 5% of their holdings in China.
“Is China a friend or a foe?” asked Ailman, in a recent interview with Bloomberg TV. “The answer is: both.” As a result, he and his investment committee wrestle with whether to overweight, underweight, or remain market neutral on Chinese securities.
A lot of institutional investors “have punted so far” when deciding whether to invest in China, observed Russ Ivinjack, head of fund management at Aon Hewitt Investment Consulting, and also one of CIO’s 2020 Knowledge Brokers All Stars.
Nonetheless, over time, China’s continued growth will increase its importance among equities worldwide, he said, so ignoring them will be difficult. Meanwhile, he noted, China is expanding its share of international stock indexes, which institutions use extensively, leaving them owning more Chinese stock anyway.
“The twin engines are the US and China,” Ivinjack pointed out. Investors “can’t keep their heads in the sand.”
China’s Growth Continues to Dwarf the US’s
Yearly GDP increases
China
US
10%
8.20%
8%
6.90%
6%
4.70%
4%
2.90%
2%
1.85%
0%
-2%
-4%
-4.30%
-6%
2015
2016
2017
2018
2019
2020
(estimated)
2021
(estimated)
China
US
10%
8.20%
8%
6.90%
6%
4.70%
4%
2.90%
2%
1.85%
0%
-2%
-4%
-4.30%
-6%
2015
2016
2017
2018
2019
2020
(estimated)
2021
(estimated)
China
US
10%
8.20%
8%
6.90%
6%
4.70%
4%
2.90%
2%
1.85%
0%
-2%
-4%
-4.30%
-6%
2015
2016
2017
2018
2019
2020
(estimated)
2021
(estimated)
US
China
10%
8.20%
8%
6.90%
6%
4.70%
4%
2.90%
2%
1.85%
0%
-2%
-4%
-4.30%
-6%
2015
2016
2017
2018
2019
2020
(estimated)
2021
(estimated)
Source: International Monetary Fund
A formidable enticement lately for investors is that China, the world’s second largest economy, has resumed its expansion after weathering the pandemic. Even though the coronavirus originated there, China appears to have pretty much stamped out the disease and has resumed its pell-mell growth.
Once fourth quarter numbers are in, China should log a 1.85% economic increase for last year, making it the lone major economy to grow in 2020, by the reckoning of the International Monetary Fund (IMF). That’s compared with a 4.3% shrinkage in the US. The IMF projects that China’s expansion will surge to 8.2% this year, with the US managing 4.7%. That reinforces the argument that shunning the world’s most populous nation, with its expanding middle class and energetic growth, is folly.
Breaking China
The Trump administration has waged a trade war with China that bars American investing in some Chinese stocks. In November, President Donald Trump issued an executive order banning US investments in 31 Chinese companies that the Pentagon says are linked to the country’s military, including Hikvision, Huawei, China Telecom, and China Mobile. Last week, the New York Stock Exchange delisted three of them. President-elect Joe Biden hasn’t elucidated his thoughts about investments in China, yet he clearly takes a dim view of the Beijing regime.
In light of China’s success, though, a compelling, if dispassionate, case exists for investing in China. Some US investors figure that buying stock in Chinese non-defense-oriented companies is morally defensible. In keeping with that credo, several US pension plans last year dumped their stakes in surveillance company Hikvision. That leaves a formidable lineup of consumer-focused concerns, such as online retailer video game maker Tencent or beverage producer Kweichow Moutai.
Such a dual-track approach is similar in spirit to Washington’s treatment of the Soviet Union in the 1970s and 1980s: Despite Moscow's backing anti-American movements in Latin America and Africa, US exports to Russia, of farm products like wheat and consumer goods such as Pepsi-Cola, were strong.
“This is a binary question,” mused Bob Browne, CIO of Northern Trust, which has a large institutional client base. He suggests formulating “an exclusion list” for investors, a formal guide to avoiding companies with direct ties to the Chinese military or government. “The challenge will be that the exclusion list might become uncomfortably large as the role of the Chinese government in the private sector—think Alibaba—grows over time.”
The Chinese authorities are cracking down on internet giant Alibaba, accusing it of monopoly practices, after founder Jack Ma displeased them with a speech knocking the nation’s financial system. Ominously, he hasn’t been seen in two months.
Despite all this, to a likely increasing number of investors, investing in China is slated to become a bottom-line necessity. Investors, observed Stuart Katz, CIO of wealth manager Robertson Stephens, have to realize that the Chinese will eventually supplant the US, and it thus offers copious opportunities. “They’ve showed that single-party rule and a state-dominated economy can make them a global power, able to plan for the long term,” he said. “And that they’ll inevitably pass the US as the world’s largest economy, by some estimates by 2035.” As Northern Trust’s Browne put the matter: “China has 8% growth, one of the few economies to be positive. You can’t ignore that fact.”
For sure, China is ramping up its high-tech industry, has forged a trade bloc with other Asian countries, and has set up an agreement with the European Union. Its companies are amassing a war chest of $179 billion in cash to enhance the nation’s productivity and output.
The Road East
For many US institutional investors, the best way to play China is indirectly, through index strategies, with the portions kept small. At the New Mexico State Investment Council, about 4% of its $30 billion in assets are in emerging market stocks, its most recent report indicates.
That’s mainly in the MSCI Emerging Market Index, of which Chinese names comprise a little less than half. CIO Robert “Vince” Smith calls that approach “benchmark awareness.” He added that his organization also has “a minor amount of private holdings,” about $60 million, in China-oriented private equity (PE) funds—two sponsored by TPG and one by Asia Alternatives.
The California Public Employees’ Retirement System (CalPERS) has had the most fraught China investing experience. Last year, Rep. Jim Banks, R-Ind., charged that CalPERS’s then-CIO, Ben Meng, invested the fund’s money in Chinese companies that threaten US national security or violate human rights. Meng is an American citizen of Chinese ancestry and previously worked for the Chinese government’s State Administration of Foreign Exchange, also known as SAFE.
The CEO of the nation’s biggest pension fund, Marcie Frost, replied that the program only invested in China via index funds. Neither Meng nor anyone else at CalPERS, she went on, chooses individual stocks for the plan to invest in. Meng resigned last year, apparently in the wake of complaints about his undisclosed holdings in three US-based private equity funds that did business with CalPERS—and seem to have nothing to do with China. Meng has not publicly commented on his departure.
The most avid China fans in the pension world are in Canada. The Canada Pension Plan Investment Board (CPPIB), Canada’s largest retirement fund, had C$119 billion ($94 billion in US dollars) or 26% of its total fund in the Asia Pacific region, as of its Sept. 30 report. Prominent among these markets is China. Over the past decade, the fund has plugged C$28 billion into mainland China investments and C$42 billion in Hong Kong securities.
Last fall, for instance, it bought a $100 million position in Chinese drug maker Chi-Med. The pension fund has large holdings in Alibaba, Tencent, and financial firm AIA.
Amid the political tensions between the US, a vital Canadian ally, and China, CPPIB has walked a careful line, not wishing to antagonize the Trump White House, nor upset Beijing.
“These short-term tensions, I do think, require some deft handling by the government, and by business leaders,” said Mark Wiseman, former chief executive of CPPIB, and now chair of the Alberta Investment Management Corp., in a Bloomberg interview. “But I think long run, and one thing to remember about China: They play a long-term game.”
For large institutions, investing in China’s top companies is increasingly easy, with more and more of them listing their stocks in New York, as American Depositary Receipts (ADRs). As of October, 217 Chinese companies listed on the three top U.S. exchanges (the New York Stocks Exchange, Nasdaq, and NYSE American) with a total market capitalization of $2.2 trillion.
With most ADRs, US investors have the assurance that the Chinese businesses comply with generally accepted accounting standards (those sold over the counter have laxer standards). That’s a comfort: Chinese companies are notorious for their lack of disclosure and fanciful bookkeeping.
But ADRs don’t cover a lot of Chinese stocks. Foreign stock buyers can gain wider access to Chinese offerings on the Hong Kong Stock Exchange, where transactions take place in Hong Kong dollars, which are easy to convert to US dollars or other currencies.
That still, however, leaves out a trove of domestic companies on the mainland. A non-Chinese institution has to win approval from Beijing to buy what are called A-shares, on the Shanghai or Shenzhen bourses—although the purchases are in yuan, which are tougher to convert to US dollars.
Trouble is, acquiring these holdings runs the risk of muddy and incomplete financial reporting. “Quarterly data can be a black hole,” said Steven Shen, EPFR’s manager of quantitative strategies. That’s one big reason a lot of US and Western institutions skip buying on the mainland.
Nonetheless, in the fullness of time, investing in China will make all kinds of sense to many investors. “The question isn’t why,” Shen said. “But when and how.”
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