FOR THE average investor, China is the source of all kinds of uncertainty. Regulatory action against social media and education companies has rocked share prices. Real estate companies suffer from government crackdown on debt and a liquidity crisis at Evergrande, a major developer. A ban on cryptocurrency transactions on September 24th caused the price of Bitcoin to fall. And a rush by provincial authorities to meet stringent national CO2 emission targets, coupled with scarce coal supplies, leads to power shortages, which in turn could weigh on both the economy as a whole and asset prices.
If investors expect Chinese politics to remain volatile, they could start charging an additional risk premium for holding a range of assets. “The intensity of the political change surprised investors,” says Chetan Ahya of Bank Morgan Stanley. “It is not clear to investors what the endgame is for each sector, so there is a lot of uncertainty and that uncertainty increases the risk.” In fact, a risk premium may already be looming on some assets.
In the past six months, the MSCI China Index, an index for stocks listed on the mainland and Hong Kong, has outperformed global stocks for over 20 years. Yields on Chinese offshore high-yield dollar bonds are around 14.5% higher than during the Covid-induced market panic in March 2020.
Analysts at Bank Goldman Sachs have tried to figure out what a change in the treatment of so-called socially important sectors – such as education, media and entertainment – could mean for private companies. Although private companies have always achieved higher returns on equity than state-owned companies (SOEs), recent policy changes will detract from some of their profits. The range of potential outcomes is vast, and depends in part on how much the private sector will generate SOE-like returns. In the most optimistic case, the MSCI China Index could already be undervalued by a double-digit percentage. In a more pessimistic scenario, it could be overstated by a similar amount.
Which case is more likely is more a question of politics than finance. The policies of any government have an impact on investment results and are closely followed by asset managers around the world. But monitoring and predicting the machinations of the Chinese Communist Party is no easy task for the experts, let alone the average Western financier. “Why would you play this game for an offshore bond investor? Politics could change, and that’s just not what they’re made for, ”said Alex Turnbull of Keshik Capital, a Singapore-based mutual fund.
In fact, investors in offshore facilities in the direction of China have cooled off. One way to gauge this is to compare the stock prices of Chinese companies that are listed in both the mainland and Hong Kong. Stocks tend to be more expensive domestically as China’s capital controls leave local investors few alternatives. But the gap has widened significantly: Onshore investors pay a premium of more than 45% for identical shares (see chart). The gap is roughly the same as it was during much of 2015, when domestic stocks saw a frenetic rally fueled by margin debt. That year, however, mainland-listed stocks were roughly unchanged. The growing wedge reflects the pessimism of international investors who are not constrained by China’s capital controls, rather than the optimism of mainland market participants.
However, not all assets come with a higher risk premium. The interbank credit markets have been calm so far (perhaps supported by liquidity assistance from the People’s Bank of China). Safe, state-owned corporations at the heart of the financial system have shown no signs of turmoil. On September 17, the Industrial and Commercial Bank of China, a state-owned lender and by some estimates Evergrande’s largest bank creditor, issued $ 6.16 billion in conditional convertibles, with no apparent fluctuations in the government bond and foreign exchange markets. This suggests that investors don’t seem to believe that the current problems will shake China’s capital control system.
What does a higher premium on some assets normally held by foreigners mean for China? The economic effect is limited for the time being. Although foreign ownership of government bonds has increased in recent years, corporate borrowing is still a very domestic affair. Foreign institutions own only 1.5% of the approximately 7.6 trillion yuan ($ 1.2 trillion) of medium-term debt in China’s corporate bond market. Some economists argue that China’s aging population will result in persistent current account deficits rather than surpluses that need to be financed by larger inflows of foreign capital. But these expectations have yet to be realized. The current account surplus fell to a 25-year low of 0.2% of GDP in 2018, but rose again in 2019 and 2020.
A broad risk premium, though the result of various government initiatives, would undermine another political goal. In recent years regulators have tried to encourage investors to exercise greater risk discrimination; For example, they allowed more corporate bond defaults to dispel the notion that the state will always bail out troubled companies. These efforts have had some clear results. The spread between the yields of onshore corporate bonds rated AAA and AA has increased from 1.7 percentage points two years ago to 2.3 percentage points today. Investors paid more attention to the credit fundamentals of Chinese companies.
Now these efforts have been ruined. Instead, investors are guessing where government policy might go next, and a flat risk premium applies, especially on assets that are most accessible to foreign investors. Rather than helping investors differentiate risk, the recent barrage of shocks has forced them to apply a broad brush again, with Chinese companies being the biggest losers from the shift.