China is hard to ignore these days. It’s the second largest economy in the world and growing.
China’s effective Covid-19 response helped it to continue to grow in 2020, as other countries grappled with national restrictions.
China is changing. The country is transforming into a technology-intensive powerhouse from a producer of cheap low-tech goods. The “new economy” sectors such as technology and healthcare are growing faster than the “old economy” sectors like energy and materials.
Chinese investment markets are becoming more diversified as a result. Chinese equity and bond markets have low correlation to overseas assets because of the unique political regime, economic environment and market dynamics.
China market liberalisation
What makes China particularly interesting for investors at this time is the liberalisation of their financial markets. Foreign investors can now more easily invest in China, including the domestic market, through open-ended pooled funds.
What’s more, major indices (equity and bonds) are increasing the weighting to China to reflect this opening up of capital markets. It’s important that investors are aware of the shift of Chinese representation in their global portfolios.
China ESG risks
Of course, despite the attractive growth story, there are risks specific to investing in China, Environmental, Social and corporate Governance (ESG) concerns and political risks are widely covered by the media and Chinese companies are still behind developed companies in ESG standards and practices.
How do investors set the ESG boundary in navigating Chinese investments? We cover this in a separate blog entitled "China and ESG: considerations for responsible investors."
Chinese stocks can be listed domestically (also referred as onshore) or offshore. Stocks listed offshore are typically very large (>$200bn) firms predominantly in communication and retail sectors. Before the Chinese financial market opened, investors could only invest in these offshore stocks. Now the onshore market has been opened up.
There are a number of share classes in Chinese stocks and A-shares, listed domestically, have the largest market capitalisation (third largest stock exchange in the world). It is expected that at full inclusion, the weight of A-shares will increase four times in the MSCI Emerging Markets index (to 21% vs only 5% in November 2019), and this can take five to ten years.
The A-shares are particularly attractive for active management. Despite a surge in foreign capital inflow, the market is still dominated by retail investors and companies are largely under-covered by research.
However, below we highlight some specific risks for Chinese stocks.
- High volatility driven by retail investors’ short holding periods.
- Stock suspension is more frequent and can last longer (up to a few months) in China than in other markets.
Just like the stocks, Chinese bonds can be listed either onshore or offshore. The onshore bond market is the largest, representing 90% of the Chinese bonds market. The small offshore market will see some bonds issued in foreign currency, but this is very low compared to other emerging market governments that will have more sizeable “hard” currency issuance. Furthermore, the focus remains on government bonds because corporate debt liquidity remains poor.
Given the lack of issuance in debt in foreign currency, a key consideration will therefore be currency risk. Currency hedging is available for investors but the cost of hedging is still expensive so it is rarely used, and so investors should consider both the yield and currency movements when deciding on an investment.
We generally do not find the current yield on Chinese government bonds as particularly attractive. Yields tend to be broadly in line with emerging market bonds of a similar rating (Chinese government bonds are now rated A+ by Fitch). While the yields are above those of developed market bonds, the additional credit and currency risks need considering.
While index tracking investors will be getting additional China exposure over time as the index providers increase their weighting, in the short to medium term China is still under-represented. We prefer investing actively in China because the indices would mostly contain legacy and less attractive names (e.g. State Owned Enterprises) which is not the best place to benefit from China’s transformation.
Gaining China exposure through an active emerging markets equity fund is a sensible approach but the best approach for high governance investors is to have a standalone China allocation through a specialist active fund. This approach allows investors to address ESG considerations and provides the flexibility to adjust the overall Chinese exposure (both strategically and tactically).
If you would like to talk about this topic, please get in touch with your usual Barnett Waddingham contact to find out how we can support you. Alternatively, please contact me below.
For professional use only. The information contained in this article is provided for informational purposes only, and should not be construed as advice.
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