What is China up to?

7/29/2021

According to the IMF, World Bank, and CIA Factbook, China currently produces around 25% of global GDP. Recent WFE data shows that Chinese exchanges (A-shares only) control 11% of global market cap. Any investor interested in a global allocation must include Chinese equities in their portfolio. Even if Chinese equities are specifically excluded, the impact of the Chinese economy cannot be removed from a diversified investment portfolio.

The leap from emerging to developed economy depends on a number of factors that facilitate the flow of capital, and some of these have been seemingly going in the wrong direction recently in China.

Rule of law: An ongoing issue – can investors count on ownership of assets?

• The reach and power of the CCP cannot be overstated.
• The VIE structure used for listing Chinese companies on US exchanges, which has been in place for many years, does not provide the same direct ownership of a corporation as a US stock.

Regulatory crackdown: China recently brought several enforcement actions against Chinese tech companies, which included suspension of new accounts and removal of apps from the marketplace. Different analysts have viewed ascribed varying possible motives to these actions:

• Cyber security issues for the Chinese state and people – this is the official reason stated for action against Didi following its recent IPO in the US.
• Consumer protection from monopoly power – this is the official reason stated for recent actions against Alibaba and Ant, as well as new restrictions on for-profit education sector in China.
• Political power – preventing the founders/owners of these companies from becoming a threat to existing power structure by reducing their wealth and stature within China.
• Realignment of sectors within the Chinese economy – this interesting theory by Noah Smith (https://noahpinion.substack.com/p/why-is-china-smashing-its-tech-industry) proposes that China is purposely removing profits from the consumer facing software industry in order to encourage entrepreneurs to focus resources on hardware and firmware sectors.

Transparency:

• The SEC is currently threatening to delist Chinese companies due to disagreements regarding financial audit practices. Although the companies are audited, China will not allow the auditing firms to release their workbooks to the SEC for inspection. It’s important to note that listing requirements in China and Hong Kong are more stringent than in the US, including profitability and share classes/voting rights.
• State owned enterprises make up 25% of the Chinese economy, but encompass 40% of listed companies. Although all Chinese companies ultimately answer to the government, SOEs have a somewhat different set of risks, and are not going away.

Various geopolitical struggles: The US/China relationship can be viewed as adversarial, although the two economies are interdependent. According to ustr.gov, China is the third leading export destination for US goods, while the US is the top export destination for Chinese goods and services. Any difficulties or disagreements must be viewed through this lens. Ongoing issues include:

• The assimilation of Hong Kong and Taiwan into China, eliminating their independence while still keeping their developed economies status.
• Border and ownership disagreements in the South China Sea.
• Human rights abuses, which have resulted in blacklisting of Chinese firms in the US.

What is actionable here? The large, dynamic and growing Chinese economy must, in theory, be included in a globally diversified portfolio. Whether or not an investor decides to maintain an explicit position in Chinese equities, we are all exposed to this large economy indirectly. Decisions to be made include:

• Share classes to include in any allocation to China. This may be a way to limit exposure to specific risks.

Share Type	Where traded	Currency	Notes
A-shares	Mainland China (Shanghai and Shenzhen)	Renminbi (Chinese Yuan)	Ownership by foreigners still somewhat limited
B-shares	Mainland China (Shanghai and Shenzhen)	US Dollars or HK Dollars
H-shares	Hong Kong Exchange	HK Dollars	Often correspond directly to A Shares
Red Chips	Hong Kong Exchange	HK Dollars	State owned companies
P-chips	Hong Kong Exchange	HK Dollars	Non-state owned companies
S-chips	Singapore	Singapore Dollars
N-shares	USA	US Dollars
ADRs	USA	US Dollars	ADRs of H-shares and red chips are often called N-shares
	Taiwan	Taiwan Dollars

Notes: A, B, and H Shares consist of companies that are primarily Chinese and are incorporated in China.  The other share types are incorporated in foreign countries, although the businesses exist within mainland China.  Many companies are traded using more than one of the share classes listed above.  Taiwan has a complex relationship with China, but economically, it is a separate state, and like Hong Kong, is a developed market. 

• Amount to allocate specifically to China. Emerging market indexes vary in China exposure, as well as share types.
• Active vs. passive exposure. Fund managers bring their own perspectives. Every index is a result of the decisions of a committee. All of these must be examined carefully.