- Mar 26, 2023
- 3 min read
Updated: Apr 15
Tectonic level changes
"Do you know how big is a billion? Just imagine every person tossing a coin at you at the same time."
This was how one of my flatmates used to whimsically describe the scale, the 'massive-ness' of China and its potential market opportunity when I used to live in Shanghai.
Some weeks back, Mark Mobius, a seasoned investor renowned for his bullishness on emerging markets and China said that he "cannot get his money out". Mr Mobius' experience might have just come down to a technical glitch in his personal bank account but the media obviously loves to blow this out of proportion to create headlines.
Capital controls have been existent since China's opening up and market reforms decades ago. Companies and investors who were first movers into the country know and understand this. There are many ways in which flows of capital are designed, structured and moved in and out of China - the VIE model, SAFE registration, and designated cash pools.
That said, earlier this year, regulators in China also published an article guiding the application and use of long-term foreign debt in China. Among other finer details, it states that the process has become more substantive rather than procedural--more explicit approval is required for companies in China wanting to bring in foreign debt.
In simple terms, there are no more “FYIs” when it comes to moving money in and out of China.
To complicate things further, the SOFR rate which sets the benchmark for most USD-denominated lending had risen dramatically over the last twelve months, in quite the opposite direction to the China’s benchmark lending rate. The macroeconomic forces at play—both global and local—seem to be discouraging the flow of foreign capital to and from the country.
There is a nagging feeling that the narrative on China, in spite of its huge market, has been changing at the tectonic level.
The new playbook.
For years, fund managers have profited from arbitraging risk premiums between emerging and mature markets of the world. The principles of investing are simple:
Money should go to where it has the lowest risk (note that familiarity with markets drives risk as well)
The lower the odds of something happening, the higher the expected return i.e. Tails drive everything.
Therefore, the playbook reads: Borrow USD to invest in the emerging markets of China and the rest of Asia.
Lately that playbook has somewhat changed: Emerging from a pandemic-induced recession, one would expect the central banks to maintain its low interest rate policy to drive economic growth. But they had been slow in addressing the rapid bloating in asset prices which subsequently peaked in 2022. China, on the other hand, which had been closed out from the rest of the world due to geopolitical tensions decided to go in the opposite direction.
Short-term dollar-based deposit rates today have elevated to roughly five percent, which meant investors get a relatively decent return for not doing anything. Not very long ago, a five percent return was the benchmark for investing in a 'stable market' and not doing anything with your money yields anywhere from 0.3% to 0.5%.
Under this new playbook, many fund managers are finding it incredibly difficult to justify their dollar-based investments in emerging markets. For China, there is an added wrinkle of politics at play.
Last year, the Chinese government announced slashing the compensation for senior executives at Chinese investment banks. State-run financial firms and regulators were not spared either as part of the reforms highlighted at the recent two sessions. Even Bao Fan, the deal-making rock star of many tech darlings in China and chief of brokerage firm, China Renaissance, went missing only to re-surface some weeks later with news that he was assisting the authorities with investigations.
The anti-corruption narrative obviously doesn’t go down well against the already gloomy broader macroeconomic backdrop and simply reinforces China as an “un-investable” market.
Faith.
Some believe that all of this started in Shanghai after Jack Ma's controversial speech in 2020 and also part of China's push for common prosperity. Either way, all of this seems to be the un-intended consequence of doing well or achieving outsized returns.
If you are facing high cost of funds and still have to contend with limited returns in a regime that is unpredictable, largely state-controlled and “anti-greed”, it can be really challenging to convince asset allocators to put more money there. The billion-people story which used to be a highlight also doesn't sell as well as before.
Embracing policy is a choice for investors offshore but a necessity for firms operating in China. That said, ultimately one just needs to be a believer--a believer in the policies and directions set forth by the incumbent few who are in power, and possibly a lot of faith, something which happens to be incredibly difficult to come by these days.