Is China’s political risk a bridge too far for investors?

A series of interventions by policymakers and regulators has caused significant volatility of late.

China is flexing its muscles and investors in the country are feeling the heat. A series of interventions by policymakers and regulators in recent months has unnerved many of the country’s fastest-growing companies and their shareholders. By the end of August, China’s stock market, as measured by the Shanghai Composite Index, had fallen 2% since the beginning of the year, and many individual stocks had fared far worse. Telecoms giant Tencent (SEHK:700) and e-commerce leader Alibaba (NYSE:BABA) were down 24% and 33% respectively.

These declines reflect growing anxiety that the Chinese government is retreating from its laissez-faire approach to the marketplace of recent years. Where the authorities were once happy to give free rein to private sector businesses generating huge amounts of wealth, they are increasingly determined to pursue their policy goals with aggressive regulation and reform.

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In particular, technology companies have found themselves in the firing line. Amid mounting government concern about the size and power of the largest Chinese tech businesses, new competition laws introduced earlier this year targeted the “platform economy” – those businesses using their technology expertise to sell services ranging from e-commerce to food delivery. Alibaba was hit with a $2.8 billion (£2 billion) fine. Ride-hailing firm DiDi (NYSE:DIDI) is facing a regulatory review of its cybersecurity.

New data protection legislation is also casting a shadow over China’s technology sector, with new rules on what data companies can collect and how they can use it. In the education industry, plans for a ban on tutoring groups making profits has sent shockwaves through private companies, with leading businesses losing three-quarters of their value. And in finance, the decision of Ant Financial to cancel its stock market listing came amid rumours that founder Jack Ma had fallen foul of the Chinese authorities.

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For investors, the question now is whether such turbulence means the risks of exposure to China’s stock market outweigh the rewards. These rewards have been generous – the average China-invested investment trust delivered share price returns of 130% and 332% over five and 10 years respectively to the end of August – but if China is no longer a free market, maybe it is time to retreat.

The global fund manager that’s selling China

One fund manager who thinks China now carries too much baggage is Simon Edelsten, who manages the Artemis Global Select fund. Edelsten became particularly alarmed last November when Ant Financial cancelled its stock market listing. Since then, he has sold all but one of Artemis Global Select’s Chinese holdings and reduced exposure to the country to less than 1% of the portfolio.

“There are occasions when you cannot ignore political risk,” says Edelsten. “In some ways, China’s moves are laudable. They want drivers for ride-hailing apps to have rights, shopping sites to be open to payment choice, kids not to spend too long gaming or being over-tutored, and web businesses to benefit society generally, rather than just enrich a few. But these actions demonstrate that shareholders’ rights are not a priority.”

Weighing up risk and reward

However, not all China experts feel the same way. Dale Nicholls, the manager of the Interactive Investor Super 60-rated Fidelity China Special Situations (LSE:FCSS), argues that the periodic interventions we see from policymakers in China are worth putting up with given the exciting potential the country has to offer.

“Regulation is a constant in China; any investor must accept and incorporate this into their risk and reward framework,” says Nicholls. “While we can’t predict the details of every single policy move, it is important to keep in mind the historical context and the longer-term goals that have been laid out: China has clear priorities for economic growth, including doubling its GDP per capita once again by 2035. A vibrant and healthy private sector is essential to achieving this aim.”

We have been here before, points out Nicholls. Three years ago, for example, China’s government made it clear it was worried about how much time Chinese youngsters spent playing online games. Shares in Tencent plunged 50% as a result – but from their low point in October 2018, they had rallied 200% by January 2021. The breadth and depth of the company, supporters argue, mean it will bounce back once again from recent setbacks.

Dzmitry Lipski, interactive investor’s head of funds research, shares Nicholls’ more upbeat prognosis. “Regulatory intervention in China is not new and recent actions are not aimed at derailing its economy but at strengthening and prolonging its growth trajectory,” Lipski points out.

‘Common prosperity’

For Western observers, the speed with which the Chinese government can move often comes as a shock. A political system that enables policymakers to make and implement decisions very rapidly has the capacity to generate substantial volatility – but it also means China can take action quickly on issues where Western governments get tied up in knots, from economic stimulus packages to climate change.

For President Xi Jinping (pictured above), the current priority is to encourage “common prosperity”. In August, he told the Chinese Communist Party Central Committee that the government had a responsibility to manage the balance of growth and financial stability. The committee, China’s most important political body, subsequently fired a warning shot across the bows of the wealthy individuals and businesses, warning it would move towards“reasonably adjusting excess incomes”, and encourage the rich to “give back more to society”.

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Ryan Hass, a senior fellow at the Brookings Institute, a think tank specialising in foreign policy, says it is too early to say how far China intends to go as it seeks to address income inequality. But Hass thinks policymakers are conscious of the international context to their endeavours and aware of the potential to undermine investor confidence. “Senior Chinese officials have sought to reframe the narrative around China’s regulatory tightening,” he points out.

He cites a recent briefing given by Han Wenxiu, a senior economic official in the Chinese government, who told his audience: “Common prosperity means doing a proper job of expanding the pie and dividing the pie…we will not kill the rich to help the poor”. Hass also points out that the Chinese state media agency Xinhua has published English-language editorials on common prosperity. One recent example concluded: “Common prosperity is not egalitarianism. It is by no means robbing the rich to help the poor as misinterpreted by some Western media.”

In which case, investors may be able to breathe a little easier. Certainly, the regulatory reforms of the past year or so have come as a shock to the system – and the Chinese show no appetite to back off from their crackdown. But the government also appears to be aware of the impact of its endeavours and keen to signal its intent to allow markets and entrepreneurs to continue to flourish.

Launch of new stock exchange is a positive sign

Actions speak louder than words, of course. But one positive sign was the announcement early in September – by President Xi himself – of the launch of a new stock exchange in Beijing. That will give Chinese companies raising money additional options over and above the exchanges in Shanghai and Shenzhen. Clearly, China still regards the stock market as an important potential source of investment capital for growing businesses; it will therefore be anxious not to frighten off investors.

One final point is worth considering. The fact that China’s political system allows regulators and policymakers to intervene much more aggressively than their Western counterparts may prove to have positive impacts too. Scandal-hit investors in the West have often had good reason to wish regulators had taken earlier and tougher action to curb market excess - and all too often it has been private investors who have suffered in the absence of such interventions.

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Authoritarianism has its advantages, in other words. Indeed, data just published by the Centre for Economics and Business Research suggests China will overtake the US to become the world’s biggest economy by 2028; that is five years earlier than previously expected, largely because China has been able to manage Covid-19 more aggressively than its international rivals.

Investors should be under no illusions. Political risk in China is very real – and can cause significant volatility. Still, it would feel very odd for long-term investors to completely avoid what is about to become the world’s largest economy.