Chancellor: Bringing down the Red Curtain

LONDON (Reuters Breakingviews) - Investors received a rude shock last month when Beijing abruptly changed the rules for Chinese education companies listed in the United States. With one stroke, shares in TAL Education and New Oriental Education and Technology became almost worthless. The Nasdaq Golden Dragon Index of Chinese stocks listed in New York fell to half its peak. Investors suddenly realised their legal claims on these foreign listings were extraordinarily weak. Foreign investments on the mainland may not be much safer.

People walk by an electronic board showing the Shanghai and Shenzhen stock indexes, on a pedestrian overpass at Lujiazui financial district in Shanghai, China May 16, 2019.

Chinese companies listed in the United States used a complex offshore structure, known as a variable interest entity, which allowed them to evade restrictions on foreign ownership of Chinese media and technology companies. VIEs were always a questionable arrangement, neither condoned nor explicitly repudiated by Beijing. Western investors were able to receive dividends from the mainland company but had no legal claim on its assets. This crucial bit of information was available to any investor who read the listing documents. Most apparently couldn’t be bothered. By the time they’d woken up it was too late.

As with the VIEs, Western investors in China pay too little attention to “jurisdictional risk”, according to Stewart Paterson of Capital Dialectics. While investments in the West are protected by the rule of law, China’s financial markets are characterised by the “rule by law”. What this means is that Beijing has the final say on how capital is allocated and who gets paid and who doesn’t. Many companies in China, especially state-owned entities but also some private firms, answer to internal party committees that can put the interests of government patrons above those of shareholders. As a result of this and other policy distortions, Chinese equity returns have lagged. In the past five years, the S&P 500 Index has gained twice as much as China’s benchmark CSI 300 excluding dividends.

Overweening business leaders risk more than just their fortunes. Xiao Jianhua, former chairman of high-flying insurer Tomorrow Holdings, disappeared from a Hong Kong hotel in 2017 and hasn’t been seen since. Local media reports at the time said agents dragged him out of the Four Seasons in a wheelchair with a bag over his head. The government has since taken over and restructured his company. Last year, Alibaba’s Jack Ma fell from grace and the flotation of Ant was pulled. Ma’s great mistake was that he encroached upon the turf of China’s state-controlled banks, which he accused of harbouring a “pawnshop mentality”. Property companies who cross Beijing’s “red lines”, capping the use of leverage, are next in line, says Paterson.

Western investors in China’s bond markets face a different set of problems. “Red capitalism” resembles a shell game in which debts are shuffled around the financial system with little regard for legal niceties. For instance, when a wealth management product issued by a Shanghai branch of Beijing-based Huaxia Bank defaulted in 2012, the losses were picked up by an apparently unrelated credit guarantee firm. Non-performing loans are often moved from local government funding vehicles to state-owned banks, and from banks to asset managers. Where losses finally end up is a political decision.

The question of which Chinese debts are covered by sovereign guarantee remains murky. This concern is not merely academic. China is in the throes of one of history’s greatest credit booms. Since 2008, the ratio of non-financial debt to GDP has more than doubled to reach 289% by the end of last year, according to the Bank for International Settlements. Several state-owned enterprises have defaulted on their debts – a previously exceedingly rare occurrence. The country’s national debt, which rose last year to 67% of GDP, appears manageable but when contingent liabilities are included, the true figure is probably much higher.

Despite its tough treatment of shareholders in foreign-listed companies, Beijing remains keen to attract foreign portfolio inflows. The mainland stock markets opened to Western investors in 2014, followed by the bond markets in 2017. Last year, the stock of foreign onshore portfolio investment in China reached over 5 trillion yuan, up five times since 2014. Portfolio flows have continued rising. So far this year, foreign purchases of Chinese onshore stocks and government bonds were up 50% compared to 2019, according to the Peterson Institute for International Economics.

Westerners are attracted by the size and liquidity of China’s financial markets. The mainland stock market offers diversification benefits for global investors. Chinese government bonds yield more than their American equivalents. In recent years, index providers have raised the weightings for China in both equity and bond indexes. Asset managers who shun China run the risk of underperforming their benchmarks. Their greatest risk, however, is that they end up as collateral damage in a New Cold War, says Paterson.

Globalisation is slowly going into reverse. In recent years, China has been involved in tariff wars with the United States. The use of Chinese technology in Western telecoms, nuclear and other vital infrastructure has either been banned or come under review. Australia’s forthright demands for an international investigation into the origins of Covid-19 led Beijing to impose punitive tariffs on many Australian imports, including coal and wine. Western portfolio investments in China could provide President Xi Jinping with a potential bargaining chip if international relations with the United States and its allies continue to deteriorate.

Furthermore, if China’s financial system eventually collapses under the weight of excessive debts, Beijing will have to consider which debts to honour and which to repudiate. One thing is certain: the interests of international creditors won’t be a high priority. When China’s communists took power in 1949, one of their first acts was to repudiate foreign obligations. Fifty years later, a large state-owned investment company, known as Guangdong International Trust and Investment Corp, defaulted on its foreign bonds. Investors had assumed that GITIC’s liabilities carried the implicit backing of the state. Nope.

Chinese 10-year government bonds currently yield around 200 basis points more than U.S. Treasuries. Whether this yield premium adequately compensates foreign investors for the risk of non-repayment is increasingly questionable.

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