China is not only the largest economy in the emerging markets, carrying a roughly 35% weight in the MSCI Emerging Markets Index as of 31 October 2021, it is also the second largest economy in the world, behind only the United States.
China’s importance to equity investors is easy to grasp; building the conviction to make investments in China, has been harder. Since last year, we have seen a number of regulatory policy changes that have depressed share prices in high profile sectors in China, from online gaming to e-commerce to education and delivery services.
How can we make sense of what has been happening? In the first place, we must remember that the corporate sector in China is still relatively immature compared not just to the West, but to other emerging markets too: it is only a few decades since private enterprise was officially sanctioned. Alongside that, inevitably, the regulatory infrastructure is also relatively immature. And of course, China’s political system leans instinctively towards intervention and control, especially in areas which are deemed to have broader consequences for society; nor are policies shaped through transparency and political debate to the extent that they might be elsewhere. That just leads to uncertainty for investors, and uncertainty needs to be priced into equity markets.
Framework for considering risks
Even so, we can establish some framework for thinking about risks in a more interventionist environment in China. First, much of the recent regulation is concerned with issues which would be familiar anywhere: anti-competitive behaviour, anti-monopoly regulation, consumer protection, data privacy, cybersecurity; these are all right at the centre of regulatory efforts in the West too, and that is neither unexpected nor controversial. In other areas, however, regulation reaches right into the realm of social policy and addresses issues which elsewhere would be handled by politicians rather than regulators.
Second, it is clear that some sectors have heightened political sensitivity in China; strategic industries like finance, energy, healthcare, communications, media and internet services, are likely to be subject to greater scrutiny than industrial manufacturing, exports, consumer products, and so on. And third, the way companies behave also has a bearing on their vulnerability; those that aggressively maximise profits while sailing close to the wind, where regulation is concerned, are more vulnerable that those which seek to manage their own risks prudently to extend the duration of their business.
None of this is new: China has always been a place where the state exercises significant influence over commercial activity. In some industries, all the large companies are state-owned entities; in all sectors, the state is reluctant to let market forces alone determine outcomes. If this reduces the returns to corporate skill, which it probably does, then that will affect our view of fair values for companies; and if inconsistent policy-making raises uncertainty for investors, then that too must be taken into account when thinking about share prices. The challenge in pricing these risks – even when the rest of the market seemed ready to overlook them – has meant that the Trust has often had less aggregate exposure to China than the index, though this could change over time.
China’s importance for investors
But we believe it to be a mistake to be too negative, especially at a time when some share prices have declined significantly. In spite of the risks set out above, investors in successful Chinese companies have been handsomely rewarded over the last twenty years. China remains a country with high levels of entrepreneurial activity, and the government knows that it is the private sector which has created employment, innovation and unprecedented economic advancement in recent decades. We believe that the private sector in China will remain a critical part of China’s economic growth, and so China will remain a market that is important for us as investors, and for the results we can achieve for shareholders.
