Chinese Stock Market for foreign investors: An opportunity or a trap ?

Disclaimer

The information presented here is for information purpose only. It should not be seen as an investment advice or endorsement of any financial instruments in particular. Before making any investments kindly consult your financial advisor.

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Investing in stock market of other countries is becoming a popular form of portfolio diversification. Funds like PGIM Global Opportunity (among others) make it easy for retail investors in India to get exposure to the top global companies around the world. And not just in India; the trend can be observed in many countries around the world.

But do you know, a globally diversified portfolio (while providing a hedge) also makes us vulnerable to geopolitical and currency risks?

Chinese Regulatory Crackdowns

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Recently, a regulatory crackdown in China caused a great deal of panic among investors around the world. These investors had their portfolios exposed to companies operating in China. The Nasdaq Golden Dragon China Index (which tracks performance of Chinese companies listed in US) saw a great selloff as a result, erasing billions of dollars from the market. Similarly, the shanghai composite index suffered great headwinds (which seems to continue as I write this blog post) over uncertainty of China’s corporate future and anticipation of further crackdowns. Personally speaking, my investment in a Chinese equity fund went down by 13 percent, with signs of further downturn. 😦

China Shanghai Composite Index reacting to Chinese Crackdown on Education and Tech Companies.

What does this event mean for people looking to diversify their investments in China? Does the lure of investing in one of the most advanced economy in the world outweigh the risks that come with the so called political uncertainty of the Communist Party of China (CPC)’s regime ?

Not so uncertain

While such market-shaking events can send well-established investment funds and stocks into existential crisis, there is something important that we miss when explaining so called ‘uncertain developments‘.

These events are not very uncertain if you look at it from the Chinese perspective. Investing in foreign equity (especially those of nations which are not ‘western type democracies’) does come with risks. But these risks, in context of Chinese stock market, can be mitigated and managed well if you understand the political philosophy of China.

A misunderstood nation

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In order to asses the risk associated with investing in Chinese stocks, it is very important to understand what is “Socialism with Chinese Characteristics“.

The West likes to believe in the narrative that “capitalism” is the main driver behind China’s economic miracle. But this is a half truth. The Chinese political system is very unique and it merges free market ideals with Marxist-Leninist ones, creating a hybrid socioeconomic system. This can sound quite esoteric to the outside world, but let us try to understand it in simple terms.

What is Socialism with Chinese characteristics ?

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Socialism with Chinese characteristics refers to the policies of the Communist Party of China (CPC). It is a hybrid model of governance based on two core ideas :

• Marxism–Leninism
• Deng Xiaoping Reforms

What is Marxism ?

Marxism (named after Karl Marx) is an idea that examines the effect of capitalism (private ownership of companies) on society, and argues that communism is a better solution for socio-economic upliftment. Communism, in simple terms, defines a social and political arrangement where the means of production is owned collectively by people (the workers) rather than by privileged private owners. A Marxist society is a classless society, and quite utopian in a sense that there is no class struggle involved (i.e., issues like income inequality and worker exploitation is non existent.)

The role of Lenin

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Lenin took Marxism to a different level all together. He proposed that communism can only be established through dictatorship of the working class. This dictatorship, he said, should be lead by revolutionary vanguards (select members of the working class who are class-conscious, politically advanced and possess leadership skills.) In simple terms, he meant that a one party dictatorship representing the proletariat (working class) can make the dreams of Marx come true by paving the way for communism.

Deng Xiaoping Reforms

But hardcore Marxism–Leninism backed fired in china under the leadership of Mao, pushing the country into a social and political crisis, an era which is known as cultural revolution.

When the power came into the hands of Deng Xiaoping, things began to change. Deng Xiaoping introduced reforms which is known as Dengism.

Dengism is nothing but an improvisation of Marxism–Leninism and Mao’s ideas to suit existing socio-economic conditions of China. Deng Xiaoping believed that Chinese upliftment can only be realized through modernization. At the same time, he wanted this modernization to sync with existing Chinese ideology and traditions. He was basically looking for a trade off between capitalism and socialism.

Deng believed that capitalism can increase productivity because it is based on the idea of incentives and self-interest. Capitalism was no doubt the reason behind the prosperity of the West, something Deng saw himself as he travelled the world. Deng, however, argued that socialism and capitalism are “peas in the same pod”, and that to truly achieve socialism, China must go through controlled capitalism. The capitalism he was proposing was hybrid. He wanted to harness the potential of free market forces without violating the socialist path (Marxism). He believed that a single party dictatorship can use capitalism cautiously to modernize Chinese society without comprising with Marxist ideals. And thus Socialism with Chinese characteristics was born.

Xi Jinping Thought – The current guiding principles of CPC

Xi Jinping is the current president of the Communist party of China. He improvised Deng Xiaoping‘s theory and also the reforms made by Deng’s successors (like Jiang Zemin and Hu Jintao) to create a political theory which is called Xi Jinping Thought.

Xi Jinping Thought defines what socialism with Chinese Characteristics should look like in the current era. Xi’s idea of good governance involves taking a people-centric approach for development, and creating a sustainable economic ecosystem fueled by innovation. While Xi considers free trade as an essential economic driver, he also stresses on the importance of using it carefully by creating a balance between capitalism and socialism.

How does CPC policies affect stock market of China?

In recent month we have seen CPC exercising heavy regulatory measures to ensure that power and wealth does not concentrate into the hands of a few business monopolies.

Do you remember the story of Jack Ma? He happened to criticize the political system of china, saying that new technology and big data can offer better alternatives for determining credit-worthiness of individuals and businesses than depending upon old collateral system controlled by CPC affiliated banks. And he even called the traditional state controlled financial systems an old man’s club run by people with pawnshop mentality. Not a wise thing to say when your fate lies in the hands of a dictatorship !

The CPC suspended Ma’s ANT Group IPO and sent a strong message to the corporate community in china that if you mess with the party’s principles, you are screwed !

Sweeping Reforms

In recent weeks we saw Chinese companies like DIDI taking a blow for abusing market dominance and misusing users data. We also saw how the new education policy caused companies like TAL to lose market value. (According to this new policy, private tuition companies should declare themselves as nonprofit organization and are barred from making profits. In simple terms, it’s an attempt to prevent private companies from taking over the education sector – a move that resonates with CPC’s core idea of socialism.)

The future of Chinese Stock Market

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The crackdown on Chinese companies should not be seen as an unexpected black swan event. If you understand what socialism with Chinese characteristic is, you will realize that such regulatory shocks are quite expected.

Socialism lies at the heart of Chinese society, and CPC will never let ‘untamed capitalism‘ destroy it. Unlike the West, China will never allow private entities to get so big that they become a threat to CPC and to the socialist ethos that guide the nation’s policies.

CPC justifies its regulatory stance by arguing that formation of monopolies and uncontrolled capitalism can lead to income inequality. It can also expose China to problems of modernization that are plaguing western democracies. Problems like financial bubbles, hyperinflation, workers exploitation, climate crisis and so on.

Stock market is like a Legal Ponzi scheme

The stock markets in western democracies (like US) works like a Ponzi scheme. The gains in the market is a result of capital infusion, often in an uncontrolled manner. The older investors are paid off by the money of new investors and the cycle goes on. Uncontrolled money printing pays a significant role in keeping this Ponzi scheme going. As long as the governments keeps printing new money, the stock markets will continue to get capital inflows.

But there is a problem with such an approach.

The valuations of stocks often reach unreasonable levels backed by the superficial assumption about an asset’s future profitability. There are no robust regulatory framework to prevent such irrational asset bubble from building up. We have seen the crisis that such bubbles can create in 2008.

Stock Market with Chinese Characteristics

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Chinese government wants to avoid the perils of an unregulated financial system. In simplest terms, the CPC wants stocks markets to be what it is supposed to be — a way for companies to raise funds, create value and reward the investors with genuine profits. This is very different from the idea of stock market in the west. The CPC actively monitors the state of capital markets in China, and would to anything to ensure that the financial power does not concentrate in the hands of few.

(In the West, is it completely normal to expect 100 percent gains on a stock that does not even turn a profit. All you need is a wishful thinking, a herd mentality, and uncontrolled money printing by the government. It is completely normal to seek double digit returns even when the economy is going into recession.)

The Bottom-line

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If you want to play stock market like the Ponzi game, then I would suggest that you avoid Chinese stocks. The CPC will never let you make irrational profits by gaming the system. You can do that in a hyper-capitalist society with lose financial regulations (where stock markets move in opposite direction of GDP often due to uncontrolled money printing), but China has very tough regulatory framework for financial markets, and it’s not possible to game the system in anyway. Regulatory crackdowns are an important tool for CPC to ensure that the stock market reflects the reality rather than irrational exuberance.

My Chinese equity fund is down 13 percent, but I am not selling it away because I believe that Chinese stocks are good for long term investment. China follows what is called ‘Dual Circulation‘ meaning that while some industries are very much under the control of state, others run on free market model giving foreign investors a chance to benefit. If you do invest in China, expect the returns on your investment to be much more reasonable in the long run. The returns will often be in line with the country’s economic development.

Also keep in mind

When investing in the stock market of China, keep in mind that sectors like Education, Healthcare, and Banking will stay in strict regulatory control and there is not much opportunity there for foreign investors. If you are not an expert in fundamental analysis and geopolitics, I suggest that you invest in a broader index ETF like the Shanghai composite or Golden Dragon. The risk with index eTFs are much lower as they offer broad diversification across different sectors. Also, don’t put all your eggs in one basket and only risk the capital you are willing to lose. This is the most important advice on investment in any kind of equity markets.

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