Funds Europe – What are the top three risks facing China?
It’s important to acknowledge that risks exist with every investment and in every market. It is unfair to assume that just because China has been less invested in the past, that it is necessarily riskier than other markets. Yes, geopolitical risks exist in between countries, but if you look at the political risks within a country, China is perhaps more stable than many others. A recent Harvard study shows the central government has a higher approval rating than any developed market country has had for a leading party. You could call the political risks investors face in China more predictable in the sense that you are faced with governance risks which you may have greater awareness of, compared to other markets.
People tend to underestimate risk in developed markets and overexaggerate the risk in emerging markets, so as investors, that gives us an opportunity to accrue that risk premium. It is a common investor mistake.
Investing in China does come with risks, especially in the current geopolitical climate, set against the backdrop of US-China tensions – which are here to stay, no matter who wins the upcoming US presidential election. One thing that we have seen in the US, for example, is pressure from the White House on large institutional investors to consider their Chinese holdings. On the other end of the spectrum, we are also seeing increased demand for Chinese products from some clients as China improves its transparency metrics to index provider standards. As this has improved, we have seen Chinese equities and bonds start to be included in greater amounts in major indices, which has indirectly also put pressure on large institutional investors to consider which benchmarks to use and how much China allocation is within them.
I see three risks with China, the first being the capital transmission process: can they get an efficient capital allocation strategy moving funding away from levered state-owned enterprises (SOEs) into small-mid cap private enterprises?
Ageing demographics – the workforce is going to age substantially over the coming decade or two, so are they going to age before they get really wealthy? While GDP per capita has increased a lot, it is still relatively low versus developed markets standards, but the demographic picture converges with the developed world quickly.
Then liberalisation of capital markets – you saw where they tried to create a two-way currency flow, a lot of money tried to leave China and they had to stop that, because there’s a huge amount of internal savings with a desire for international diversification, so then you need to get international investors interested to invest in your country to offset that outflow. Liberalisation of capital markets, ageing demographics and capital transmission allocation would be the three risks I identify.
Ageing demographics is a big challenge – can they keep up with themselves? An obvious one is the trade war with the US continuing. We don’t think that’s going away and if you look at history, it has been there for a long time and we expect it to be there irrespective of the US presidential election result. The policy path may be a little clearer with a Democrat win, may be a little bit more predictable if the Democrats win, but that’s going to be there for some time, and it will continue to flare up. Technology will also be there. Finally, whilst it doesn’t look like it will materialise, a second wave of the coronavirus pandemic in China is a potential risk. China has done well from a policy perspective to control and react to the associated growth shock of the virus and lock down locally where there have been spikes, but that is a maintained risk for the whole world and China is not immune from that either.
The ageing population, with their increasing social and economic expectations, and the associated pension pressures will increasingly put further stress on government finances. If you look at the current pension provisions, there are some concerns around how well they are structured. Certainly, the existing China Public Pension Fund, the state’s DB scheme, is thought to be under increasing pressure to provide continuity of support for an ageing population beyond 2035. This is going to be a challenge, as is the broader issue of government indebtedness.
A particular area of interest is ESG. I’m struck by the really tangible increase in focus on ESG both by consumers and, to a certain extent, investors, and whether the Chinese economy – and particularly the manufacturers – will be able to retool away from mass-produced, throwaway goods into more quality, longer-term, sustainable products that many people are starting to demand in order to reduce both our impact on the environment and also our use of precious minerals. Whilst there are certainly green shoots of ESG focus in China, there is a sense that this has a way to go before it becomes mainstream.
China is the largest renewable producer in the world, it has the largest electrical vehicle market in the world and there are big internal concerns over food safety. I’m told a major conversation at Chinese dinner parties nowadays is around where the food comes from before people actually eat it. There is a recognition of environmental impact and that the Chinese are more aligned to the European standards and ideals, although from a different cultural perspective. However, there’s a realisation that they want to move to sustainable growth, and that’s not just on sustainable debt financing but also on the environmental sustainability.
We have to work with a lot of our US managers on ESG because it’s a relatively newer thing and they are behind European standards, so when we are appointing managers based in the US, we work with them on questionnaires and standards and expectations. We have done the same with our China manager search. We have an important role to play as an asset owner in helping different parts of the world adopt ESG standards which have been pioneered in the UK and Europe and create those global standards going forward.
As China internationalises and increases access, index providers and asset owners will be looking to organisations and agencies there to be able to demonstrate these types of international standards from an ESG perspective. From a balanced perspective, it’s fair to say China is behind on a number of different dimensions but it is making progress. Air Pollution Index is an interesting tangible example. If you go back to 2008 to 2010, Beijing had 120 or more days every year which were categorised as having severe air pollution, but in the last few years they have got that down to between 20 and 30. From an environmental perspective, things are being done to try and curb emissions, and that evidence of moving towards a more low carbon-type of industry and nation – which is really at the forefront of a lot of European investors’ minds – is coming through in different ways.
The other interesting aspect is the issuance of green bonds. China has been the biggest issuer of green bonds year-on-year since 2016. It’s a big economy, it’s a big country, and if you just look at it from an amount perspective that’s a little bit deceiving, but that’s another signal of the beginnings and continuation of a sustainable revolution.
People also tend to forget that China has four different carbon trading regimes while Europe is still trying to figure out how to do and implement something that works across all countries. Although those carbon tax regimes are low, China is at least experimenting and trying to see what works and moving in the right direction, which is more than can be said for other economies. It is, however, also worth reflecting on the fact that they might be the greatest renewable energy producer in the world, but they’re also the world’s biggest dirty energy producer. China still remains the biggest producer of fossil fuels and heavy coal production globally.
On the social side of things, globally, consumers are increasingly aware of where their goods come from and what the proceeds are being used for. This will have an impact on companies across supply chains in China in terms of product offerings and operating practices. But it is important for investors to understand differences in social norms and expectations within markets do exist, and so there will not always be consistency in views, opinions and operating norms. But it is always going to be easier to criticise those norms which we are less familiar with. It’s not that one regime is better than another, it’s just that they are different and when thinking about social issues, they can be raised from different perspectives.
On the governance side, this has been one of the bigger drawbacks and concerns for investors in terms of capital allocation to China, and similar risks have been prevalent across other emerging markets as well. It would be reasonable to say that ESG standards in China are poorer than what we might expect, but standards are improving and all markets have risks. When we think about some of the biggest ESG scandals in recent times, many of them have stemmed from developed rather than emerging markets, such as the Gulf of Mexico oil spill, Wirecard, Equifax. Governance is a key investment issue across all markets, and standards and expectations vary.
When implementing ESG views on investment decisions, it is important to assess issues with consistent principles, while understanding and appreciating that the application of those principles may vary based on different market structures and norms. When looking at governance structures, for example, investors want to ensure that as minority stakeholders, their rights will be protected. Within developed markets, investors typically will look for broad shareholder structures and professional management, while in emerging markets, it is more prevalent to see family-owned and operated businesses where investors may prefer to be aligned with the outcomes of the controlling entity.