Asia

Managing the regulatory risk of investing in China – for the long term

06 Sep 2021 | 3 minutes read
Ying Luo
Assistant Portfolio Manager,
Orca Asia Fund

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Some global investors are becoming apprehensive about investing in China due to uncertainty over government regulation of private industries. But is this justified? Should we be cautious of investing in China, and Asia more broadly?

This article offers a balanced context for investors based on our insights into the current investment environment in Asia.

Evaluating risk

The Orca Asia Fund invests throughout Asian stock markets, with substantial exposure to China. And recent regulatory risk has been at the forefront of our minds, even as the fund has since inception, outperformed the regional benchmark through risk diversification.

China’s investment case

There is no doubt that when global investors consider investing in Asia, they are attracted by the region’s historically strong economic and financial growth, while also considering potential risks. China is the largest regional stock market, and arguably the leader in both potential growth and potential risk.

Investors may be concerned by a lack of legal protection of intellectual property rights, incomprehensible regulations and supervision in certain sectors. And in some ways, those current investor concerns are ironic, as the Chinese government is regulating the economy more closely to Western standards ― so Western investors should become more comfortable with regional risk.

The Chinese government has been ramping up laws and supervisions across industries to protect consumers and encourage the next stage of sustainable development of the economy.

And while we do see more regulations coming in certain sectors, the near-term risk is largely that global investor fear could result in a sell-off. Our view is that the recent series of regulations and guidelines are long-term positives for a more sustainable growth economy.

The conditional pursuit of growth

China will no longer pursue high growth at any cost. The central government is fully aware of negative side effects that can accompany rapid economic growth. They are making efforts to change and improve the structure of the economy and society, in many ways closer to Western standards.

If global investors are able to look through their intentions over the next ten years, the recent regulatory crackdown is not a big surprise and hopefully it should be simple to predict future likely reforms.

The central government is attempting to bring the economy to a more sustainable and responsible path after a period of rapid growth over the last forty years. Former leader Deng Xiaoping’s 1980s target that they should “let some people get rich first, in order to lead and help other regions and people”, has largely been achieved. So, if that’s the case ― what’s next?

We would anticipate further wealth redistribution.

It should not be too hard for global investors to anticipate how this may look, because most developed economies have similar wealth distribution measures in place to ensure a bell-shaped income distribution curve with very two thin tails.

Put simply, we anticipate the government is likely to pursue a policy of taxing the rich and corporations, to fund a reduction in poverty and boost the middle class.

The goal is to achieve common prosperity and social harmony.

How will the government likely achieve this?

The tools are not uncommon to a Western observer: tax system reform, social subsidies for vulnerable groups, promoting charitable organisations, and regulating those industries that are taxing the masses.

Consider those tools in light of the following:

  1. Fairer markets.

    We have seen anti-trust regulations in particular against internet platform owners, such as Alibaba and Meituan, property price control in certain school zones, and enforcing Alibaba and Tencent to share ecosystems. The common purpose of anti-trust law globally is to attempt to ensure fair, competitive, and healthy markets. China is no exception.

  2. Social protections.

    We have seen social protection policies, including regulations of labour protection of casual workers, such as food delivery riders of Meituan. The regulation ensures minimum standards and social benefits for riders who are normally at the bottom of the social ladders. Again, this mirrors what we have seen in Australia.

  3. Privacy protection.

    We have seen the draft regulations for restricting big data-enabled price discrimination against existing customers, including internet platforms such as Meituan, Didi and Trip.com. The personal information protection law is expected to come to effect in November 2021. The days of abusing personal information to gain hefty windfall probably no longer exist for some firms. Instead, more sustainable business models are encouraged by the government.

  4. Tax reform.

    We should see more tax system reforms. The usual tax tools for the rich in developed economies, such as capital gains tax, inheritance tax, and property tax are likely to come but probably in a very mild manner and in stages. The preferential corporate tax rate for some companies might gradually be phased out.

  5. Progressive policies.

    We should likely see more policy support for carbon neutral themes such as renewable energies, high technology and innovation etc. High-quality development and efficiencies are highly encouraged. This is to ensure fairness in society and that prosperity is shared among the general public.

In summary, the purpose of the central government is likely to ensure a gradual redistribution of wealth to achieve a more stable, fair, and sustainable growth for the longer term ― which should be a much better and healthier environment to invest in.

While these changes are set to happen over coming years, we should not forget other significant developments. The pandemic has distorted many economies in the world and China has benefited from strong and fast domestic economic recovery, and less disruption to supply chains globally ― factors which are supportive of sustainable growth.

Current fund positioning

The Orca Asia Fund remains confident of the long-term growth of the Chinese economy. We view the recent tighter regulation as a step forward, rather than backward or negative intervention. However, we remain cautious on the near-term negative sentiment among global investors ― although we are fully committed to invest in China.

The Fund remains underweight Chinese stocks as at the end of September. Our regional benchmark is over 50 per cent exposed to China, and we believe that Asian investors should have a more balanced risk approach to the region. This is why we have larger weights in India, Indonesia, and through Southeast Asia.

The Orca Asia Fund may underperform Chinese bull markets as a result, but we also see more stable pricing in bouts of risky Chinese markets benefiting our investors.

The outlook ahead

We are currently actively looking for more opportunities in Chinese companies with potential higher growth and less policy risks. This is best summarised by the following criteria:

  • We like companies with an opportunity for consumption upgrade on a mass market theme, as purchasing power from more consumers increases ― such as diversified dairy producer Yili Dairy and home appliance manufacturer Gree Appliance.
  • We like companies benefiting from carbon neutral goals, including renewable energy related names, such as CHINT Electric and NARI Technology.
  • We like companies that have technological capability to equip enterprises with smart technology, such as Alibaba.
  • We like companies that can benefit in the long term on a consumption and service boost at attractive valuation after a recent sell-off, such as Meituan. But at the same time, we are focussed on not over-exposing our investors to Chinese economic or regulatory risks.

While the Chinese market offers some great long-term investment opportunities, they are more than matched by the exciting investment opportunities through Indonesia, Thailand, Singapore, Taiwan, and India.

Key takeaways

The current bout of Chinese market volatility should underscore the oldest message for stock market investors i.e. diversify risk exposure to protect your portfolio in negative periods.

We don’t believe Australian investors should be investing all their wealth in China. However, we do think that investors will benefit from exposure to an exciting investment region in the world. Western economies are unlikely to grow at more than 5 per cent in coming years, whereas Asia(ex-Japan) should comfortably exceed that.

This reaffirms our view that the Orca Asia Fund could offer an appealing exposure for an investor seeking diversification away from the current low growth, high inflation, high valuation, and rising interest rate environment in Australia.

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