Understanding Chinese Financial Market Struggles
The People's Republic of China was the only major economy that reported growth in 2020, during the COVID-19 pandemic. Two years on, its equity market is down 50% since February 2021 despite its central bank cutting interest rates two times this year. How has China struggled to bounce back from the COVID-19 pandemic?
While Chinese equities currently trade at similar multiples to other emerging markets, they remain cheaper than most developed markets in spite of a higher expected growth rate. The underlying rationale for market participants requiring a premium compared to developed markets is China’s housing market debt crisis and the government’s increasing unpredictability since 2021.
Figure 1. MSCI China All Shares ETF vs Emerging Markets
Figure 2. Value and Growth Measures Across Different Markets
As per Figure 1, other emerging markets outperformed MCHI by about 12% over the past 5 years. Prior to late 2021, Chinese equities were outperforming with the recent reversal likely being attributed to two factors – governmental concern over losing face and China’s housing market debt crisis.
Fear of Losing Face
As per Figure 1, Chinese equities rebounded faster than emerging markets in the COVID-19 crash with China’s rapid response to the outbreaks being a major contributing factor. In contrast, looser restrictions in countries such as the US, India, and Brazil led to pervasive outbreaks. While most countries have eased restrictions, lockdowns continue in China. Lockdowns of major Chinese cities such as Shanghai, which remained locked down for six months in 2022 have coincided with the recent decline in equity markets.
Figure 3. MSCI China All Shares ETF vs Major Events
Despite recurrent outbreaks, China remains the only OECD nation that has abstained from the adoption of the AstraZeneca, Pfizer, and Moderna vaccines despite their better efficacy rates compared to Chinese vaccines. [1] Political analysts have speculated that China is waiting for the dissemination of its mRNA vaccines to demonstrate the advancement of its biotechnology. [2] While the US refuses to adopt Chinese vaccines, China’s abstinence from prominent vaccines has demonstrated prioritisation of politics and national pride above the public’s best interests.
At a financial conference in October 2020, Jack Ma, the founder of Alibaba and arguably the face of corporate China, criticised the “outdated supervision" [3] of financial regulation for stifling innovation. In criticising the government, Ma’s company Ant Group’s IPO was cancelled by regulators, citing “significant change”4 in the regulatory environment. In addition to Ant Group being ordered to overhaul its financial business, an antitrust probe was launched into Alibaba Group Holding. Such a probe was not an isolated incident as evidenced by a significant increase in the number of anti-monopoly cases and fines in 2021. [5] In contrast, the Chinese Communist Party (CCP) is promoting stronger, better, and bigger state-owned enterprises (SOEs). Given that two SOE steelmakers recently announced a merger set to create the world’s third largest steel firm [6], the recent surge in anti-monopoly cases appears to carry political motives as opposed to economic interests. Given that China’s private firms have been mandated to serve the CCP’s interests, increasing compliance costs have presented a further bottom-line risk for companies. Unsurprisingly, the market’s adverse reaction and consequential demand for greater multiple premiums appear to remain justified.
Easily Aggravated
The CCP remains fearful of losing face to diplomatic developments in Taiwan which normalise Taiwan’s independent status, with China’s Foreign Ministry spokesperson Wu Qian calling out US House Speaker Nancy Pelosi for her visit to Taiwan, deeming it a “serious provocation"[7]. Just days after Pelosi’s visit, China held military exercises around the waters of Taiwan, with escalations of geopolitical tension inciting fear into the Chinese equity markets. As geopolitical tensions between China and the world continue to rise, the markets appear to be pricing in a risk of war over Taiwan and further trade frictions with China.
[8]
Housing Market Debt
In UNIT’s 2021 article9 regarding China’s housing market debt, the housing crisis was described as “less of an earthquake and more of a controlled demolition gone wrong.” Despite recent cuts in mortgage interest rates, the housing market continues to show room for the downside, with official data highlighting falling sale prices and investment. Contributing to market uncertainty, many Chinese homeowners have stopped paying their mortgages in fear that their pre-purchased homes will remain unfinished. Deutsche Bank analysts have estimated the size of mortgage boycotts to be 1.8 – 2 trillion yuan, or 4-5% of Chinese mortgage lending.
Figure 4. Household Balance Sheet Assets in China as of 201910
According to ANZ, there are pre-emptive signs of deleveraging with the ratio of pre-construction sales to sales of existing homes dropping over 30% to 6.5 from Q2 2021. Although boycotts will cause short-term market pain, they are set to accelerate the deleveraging process by “differentiating financially strong developers from their weaker peers”11.
Given that the average Chinese household has 40% of its total assets in real estate, a weak property market has sent consumer confidence to historic lows. Low consumer confidence translates to lower business sales and subsequent declines in the equity market. However, China’s household savings rate of 23% of GDP (compared to the global average of 7%) has strengthened the ability of households to weather income shocks.
Figure 5. China Consumer Confidence (Bloomberg)
Figure 6. Interrelationships between China’s housing market and other sector
Conclusion
Holistically, authoritarian regulatory policies and uncertainty within the housing market have forced investors to price in additional risk, resulting in justified equity valuations at present. Despite a housing market poised to recover, unpredictable policy changes and government crackdowns could send international investors fleeing yet again. On the bright side, the unique direction China is heading would mean greater diversification benefits for foreign investors with exposure to the Chinese market. I will delve more into the diversification benefits in my next publication.
References
[2] https://www.voanews.com/a/china-s-bet-on-homegrown-mrna-vaccines-holds-back-nation-/6587593.html
Longmei Zhang, et al., “China’s High Savings: Drivers, Prospects, and Policies,” International Monetary Fund, December 2018.
[3]
https://entrepreneurshandbook.co/the-speech-that-cost-jack-ma-37-billion-dollars-5ad42393c9ba
[4]
Ant IPO halted by China over "significant change" in regulatory environment - GCC Business News
[5]
[6]
China Adds to List of Steel Giants With New Mega-Mill Merger - Bloomberg
[7]
https://apnews.com/article/taiwan-china-asia-beijing-b252479810add6a225fa1e4a6d441983
[8]
iShares MSCI China ETF as a proxy for MSCI China Index
[9]
https://www.unitunimelb.org/2021/09/22/wake-me-up-when-september-ends/
[10]
Yang Li, Xiaojing Zhang, et al., “China’s National Balance Sheet – 2020 (中国国家资产负债表2020),” Center for National Balance Sheet, National Institution for Finance and Development, Chinese Academy of Social Sciences, December 2020.
[11]
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