Threat of Politicization of Economy Drives Investment from China

By: Dave Rudd

Director of?Sandbox Limited

Foreign businesses have been pulling money out of China at a faster rate than they have been putting it in, says August data from the Chinese State Administration of Foreign Exchange.

And what I'm now seeing is the absolute devastation of the Chinese economy. We’ve seen massive layoffs in China and companies ranging from Apple to Taiwanese Semiconductors and even Mattel Toys have left the country.

While they may be leaving for a variety of reasons ? some of them may be exaggerated ? a significant belief seems to be fears about the politicization of the Chinese economy and its impact on companies investing and manufacturing in China. These are concerns about the vulnerability of the economy to the whims of the CCP (Chinese Communist Party).

There are clear signs that politicization of the economic system is on the country’s agenda. In an article in the Diplomat, Dr. Benjamin Tsai –?Director of Analysis for Asia at TD International (TDI) and former U.S. government intelligence officer on Northeast Asia and the Middle East?–?discussed its Third Plenum this year.??

In July, the Third Plenum officially endorsed “Chinese-style modernization” as the updated and “correct” interpretation of China’s “reform and opening up” policy, which started in 1978. “Chinese-style modernization” affirms the reformist legacy, but redefines it to de-emphasize the role of economic development in China’s modernization. This had been the central task under Chinese president Xi Jinping’s predecessors ? Jiang Zemin and Hu Jintao. Under Xi, this prioritization has been all but abandoned.

“Chinese-style modernization” posits that “spiritual civilization” is just as important as?“material civilization.” In the People’s Republic of China political parlance, “spiritual civilization” is code for political control.

The Third Plenum commits to further reforms, but not necessarily market-based reforms.?Beijing again signaled that economic reforms must take place in the context of greater CCP control and Xi’s centrality in economic policy. “This is not new, as we have seen this tendency develop in the past decade, particularly since 2018,” says Tsai.

The implications of the Third Plenum reforms are not all bad news for multinational corporations and foreign investors.? While it gave no indications that Beijing is moderating its industrial policy, which has caused tensions with the West, the Plenum resolution outlined institutional reforms that, if implemented, could help drive growth in consumer spending and create opportunities for foreign businesses. Although consumer spending remains sluggish, the sheer size of the Chinese consumer market presents opportunities for foreign investors. As well, the consumer sector is generally not subject to restrictions that may apply to technology-related industries. Of note, US consumer giants Starbucks, McDonalds, and Costco have all announced plans to increase their presence in China. This is evident in the uptick in Chinese ETFs with retail holdings in July following the plenum.

There are currently about 30 to 40 US dollar denominated Chinese ETFs and some of them have a history going back to 2006. Looking at Chinese ETFs with long histories, we're left with two that might be representative of the market.

One is the iShares China large cap ETF which has about $5 billion US.

Looking at this combined with Golden Dragon Invesco ? a very well-known smaller fund with smaller securities ? we see a disturbing trend.

The Invesco Golden Dragon ETF went from $10 in 2005 to near $70 in February 2021. That's a nice run.

However, since March 2021 at the height of COVID and the US Fed low-rate initiative, it went down to what roughly $17 in the next 19 months. That is a massive decline. It dwarfs what went on in the infamous mortgage rate debacle of 2008/09.

The largest ETF is the iShares China ETF with assets in excess of $5 billion. It lost more than 50% in the 19 months beginning February 2021. That is equivalent to the equity collapse during the

mortgage rate crisis when the S&P 500 dropped 60 % in 2008/09.

But the S&P recovered and then went on an historic run whereas China markets continued to flounder. The difference was the massive, unprecedented liquidity provided to western markets for several years. We all remember QE and its successors as tidal waves of money kept financial institutions whole and investments secure.

Is there another downturn coming? This would be shocking to anybody invested in China, especially public funds like the Canada Pension Plan which had been quite public about its very active participation in Chinese private markets.

If we start with 2005, the Chinese ETFs outperformed the S&P. However, beginning in 2016, the performance of the two markets started to diverge. Incidentally in 2016, Xi was designated Core Leader which is an honorific designed to venerate his leadership and move it beyond/above the will of the CCP. Wiki describes the designation as a vital centre and is a Leninist-style designation with significant non-legal weight, but carries Mao-like indisputable authority.?

Xi was re-elected in 2018 and pushed through legislation removing term limits which was a wake-up call to investors.

The flight of foreign investment from China is not just about the fear of a politicized economic system. Since coming to power, Xi's tenure has witnessed a significant increase in?censorship?and?mass surveillance, a deterioration in?human rights?(e.g. the?internment of Uyghurs in Xinjiang), the rise of a?cult of personality?around his leadership, and the removal of term limits as noted previously. Markets get nervous around concentrated power which, usually, inevitably pivots to a demand for fealty. There is significant historical evidence showing this.

The impact of these political machinations is clearly apparent in the Sandbox chart below. Since March 2020 (COVID start) Chinese ETFs are the worst performing of the 40 or so MSCI-based country ETFs. Indeed, COVID may have accelerated the trend. Ironically, India has been the performance leader. The big question is: will Xi reverse course, or double down like other presidents for life?

Comments?? I’m interested in hearing yours. Reach out to me at [email protected] or (9) David Rudd | LinkedIn. Or visit the website at Sigma Sandbox | The Next-Level Differentiator for Investment Advisors

Sandbox is a?highly visual,?interactive app for?understanding and?building investment portfolios. The visual interface helps users examine and improve their portfolios. Its complementary public and private fund data is unique, yet simple to navigate and investors can integrate their own data and portfolios with Sandbox data for more focused analysis.?