China “uninvestable”

Throughout Australia’s five-year China divorce, one the of most interesting features of relationship breakdown is how much of it is led by Beijing. CCP structural constriction, paranoia and arrogance are its own worst enemy, consistently leading to glass-jawed overreactions, withdrawal from engagement and cancelled deals.

Now the world is witnessing the same phenomenon in China stocks as the CCP cracks down on any sector that it sees as any kind of threat to its power, handing investors their arses in the process. Via Goldman:

(Re)balancing socialism and capital markets

Recent regulations have signaled that the Chinese authorities are prioritizing social fairness/stability over the capital markets in areas that are deemed public goods or important to strategic policy goals. While these moves may help improve social equality over time, they have provoked the worst selloff for China since 2018, with AST companies collapsing 65% since last Friday, and China Tech losing another US$400bn in market cap in the past two weeks (US$1.2tn from mid-Feb).

Modeling fair values in a new normal

We divide the US$18tn total Chinese market cap into “Social” and “Private” and run different scenarios based on our profitability and ERP assumptions for private- (POE)and state-owned enterprises (SOE) to model regulation severity and impacts. The resulting fair values range from +23% in our Optimistic case (a near-term disruption)to -25% in a bearish scenario where the profitability of POEs converges to SOEs’. The wide-ranging outcomes imply significant short-term market volatility (and low Sharpe ratios) as investors stress-test and reprice their regulation expectations.

Moderating our view on offshore China, staying Overweight on A shares

“Uninvestable” has featured in many of our recent conversations with clients regarding investing in Chinese stocks but we would be hard-pressed to extrapolate the rather extreme regulations such as non-profit orientation and capital raising restrictionsto the whole equity universe, because:

1.The Social sectors in the POE universe amount to 35% of total listed market cap,and those that are at(regulation) risk (i.e. seeing relatively high price inflationover the past 5 years) represent only 25% of the full-universe market cap;

2.Some POEs in the Social sectors are already generating sub-SOE orsub-market-aggregate profitability, suggesting limited room for abnormaleconomic rent extraction without creating dead-weight loss to the system;

3.Given the emphasis and actualpolicy support from thegovernment ondeveloping foundational technologies and nurturing innovation to supporthigh-quality growth, we still are of the view that the authorities would bepragmatic when striking a balance between social/ideological goals and capitalmarkets in non-social sensitive industries over time;

4.The underlying demand in the digital economyis unlikely to be structurallydamaged by regulations if they are confined to select areas, although the share ofthe TAM could be more evenly distributed among industry players;

5.In our view,current investor sentiment is comparable to the 2015 market selloffepisodewhere China A experienced a peak-to-trough drawdown of 43% and 31%of market cap was suspended trading at one point. However,when concernsdissipated and confidence gradually recovered, foreign portfolio inflows resumedand surpassed previous highs roughly one year after the incidence;

6.Froma long-term macro perspective, the new regulations could potentially lead toa more balanced economy in terms of growth drivers and resource allocation, lowerGini Coefficient which is conducive to aggregate consumption growth, foster fairercompetition which is crucial for innovation and creativity, and lower systemic risk inthe highly levered sectors.

7.The overwhelming regulation concerns have overshadowedpolicy support inselect areas that are aligned with national development objectives, notablygreen energy, electric vehicle, enterprise/B2B software, semiconductor, and “NewInfrastructure”.

Trust the Squid to stay long. But the truth is clear. Enter Chinese stocks at your own very extreme sovereign risk.

The great and terrible news that comes from this is summed by Ambrose Evans-Pritchard:

Beijing would like us to believe that the great purge of China’s technology sector is akin to Teddy Roosevelt’s subjugation of the US robber barons a century ago.

Roosevelt’s trust busters confronted the Rockefellers and JP Morgans of the era, breaking up Standard Oil, US Steel and the railway monopolies. His Square Deal is the best known of America’s episodic responses to overweening and abusive corporate power, each aimed at preserving the country’s Jeffersonian spirit and preventing the rise of an entrenched oligarchy.

Xi Jinping is doing the opposite. His purpose is to bring all centres of rival power under tight control and reassert the total political monopoly of the Communist Party. He is striking on multiple fronts at once, and the tally so far is a 43 per cent fall in the Hang Seng Tech index since the peak in February.

It is presented as a form of commercial cleansing, a necessary step to ensure data protection against predatory business elites, as well as a blow for consumer rights and the spirit of equality. “I don’t believe for one moment that these are the true motives,” said Roger Garside, a former British diplomat in Beijing and author of books on Xi and Deng Xiaoping.

The clampdown has no regulatory consistency and is better understood as an intimidation campaign: a pre-emptive move by Xi’s faction within the party to eliminate threats.

It began with the Maoist “rectification” of Alibaba’s Jack Ma – a Davos fixture who thought himself a big enough superstar to stray safely from Xi’s party line – and has culminated (but not ended) in the carnage of the last three weeks. Tencent and Alibaba are both down 40 per cent from their highs, which matters for global investors. These two make up 10 per cent of the MSCI Emerging Market index.

Goldman Sachs says Chinese shares listed on foreign exchanges have lost $US1 trillion ($1.35 trillion) since February, mostly in New York. It has been an education for Western “tourist” investors who jumped on the bandwagon with no understanding of Xi Jinping’s political character.

“The Communist Party will destroy all value if that is the cost of protecting their strategic control. They won’t plan to do this, but they are ready to go there if necessary,” said Dominic Armstrong from the emerging market fund Horatius.

Armstrong said Beijing is picking on companies with foreign listings because the principal losers of the equity meltdown are foreign and US funds. Those who snapped up shares in the New York IPO of ride-sharing pioneer Didi Chuxing lost 40 per cent within two days.

There is no due process in this campaign. The regulators act as prosecutor, judge and jury. As always in Xi’s China, the purpose is chiefly political.

The booming $US100 billion industry for after-school tutoring has been more or less obliterated overnight. Beijing says the high-pressure coaching of pupils is wrecking the childhood and eyesight of children, though nothing has been done to end competitive examinations that lead to these excesses.

Cracking down on the tutoring industry, the state has taken back absolute control over children’s education.

The clampdown is patently aimed at restoring the absolute control of the state over education, on the Jesuit principle that if you have the child, you have the man. It also aims to keep out the bacillus of subversive Western ideology. The official document prohibits foreign access to the sector, whether through mergers, trusts or franchise chains.

Xi’s war on foreign listings is partly a response to America’s Holding Foreign Companies Accountable Act, which demands close scrutiny of the political and military ties of directors. “They don’t want American regulators prying into the books of these companies, which are state secrets,” said George Magnus, from Oxford University’s China Centre.

But it is also an attempt to force Chinese companies to list in Hong Kong, now stripped of its rule-of-law protections. To the extent that it works, it accelerates China’s retreat into semi-autarky, and does so before the country has achieved full technological take-off or come close to authentic parity with the West.

China’s struggle to make advanced semiconductor chips – the sine qua non for artificial intelligence and hi-tech supremacy – should have given Xi pause for thought. But hubris has prevailed. He has bought into the idea widely held by party cadres that America suffered a systemic heart attack with the banking crash of 2008 – almost akin to the sudden Soviet collapse in 1991 – and is now in deep structural crisis.

‘[Xi] is cracking down on the most dynamic digital parts of the economy. It is self-destructive and I think the outcome is that China will be going sideways by the late 2020s, stuck in the middle income trap.’

He discerns a uniquely favourable alignment of forces, a window of opportunity to bid for global ascendancy before India becomes too strong and China runs in its own demographic crisis.

“He thinks it is his carpe diem moment. But he is cracking down on the most dynamic digital parts of the economy. It goes against the kernel of the 14th Five-Year Plan and robs China of the innovation it still needs,” said Magnus. “It is self-destructive and I think the outcome is that China will be going sideways by the late 2020s, stuck in the middle income trap,” he said.

Xi has reversed the reforms of the giant state companies because they are needed for party patronage and control. He has installed party commissars inside private companies in what amounts to political nationalisation of the free enterprise sector. Now he is trashing their business models.

Any hope of a rapprochement with Washington is evaporating. The Federation of American Scientists says satellite pictures confirm intelligence reports that China is building 120 new missile silos in Gansu province, bringing the total new silos under construction to 250.

This suggests a tenfold increase in its strike force of long-range nuclear weapons. The FAS says it is the world’s biggest silo expansion since US-Soviet rivalry in the Cold War.

China has until now claimed the moral high ground by sticking to a “minimum deterrent” of 300 nuclear weapons, a fraction of US levels. The party mouthpiece Global Times said the expansion is urgently needed given the “increased risk of a China-US strategic collision”.

“China’s building of its strength must convince the US that if and when a war breaks out at China’s doorstep, the US will never win,” it said. The new Cold War has already come to this.

“Xi is rushing towards confrontation as hard as he can go. I began my career on the Cuba desk just before the Missile Crisis in 1963 and I have an awful sense of deja vu,” said Garfield.

President Xi may dial down his intimidation campaign on companies, having achieved his immediate political objective, but he has shown already that investments in Chinese assets are no longer safe.

To imagine that the intimate financial coupling of China and the West can continue for long in these geopolitical circumstances is beyond naive.

Yes, it is.

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