Finding the balance in China

Increasing regulatory scrutiny is feeding uncertainty in the Chinese equity markets and has once again raised the question of whether the local Chinese equity market is ‘uninvestable’ from a policy perspective.

The latest changes in the regulatory environment that have disrupted equity markets should be viewed as a challenge, rather than a hindrance, for investors. Chinese officials are managing the world’s second largest economy through the balancing act of the short-term growth trajectory of the Chinese economy with the longer-run policy objectives aimed at creating a much more sustainable economic environment. History shows us that these changes to address the latter are often made when the economy is the strongest.

Admittedly for select sub-sectors, such as education, the recent regulatory changes have altered the long-term fundamentals. However, for much of the Chinese investment universe, the long-term positive growth outlook has not changed, even if the global investor sentiment towards Chinese assets has been shaken.

Further regulatory reforms are still possible for some of the ‘new economy’ industries where the Chinese authorities see the need to balance social outcomes, such as youth protection and appropriate social benefit coverage for workers, as well as improving the competitive environment by allowing smaller players to compete with industry leaders.

Regulatory action in the name of economic, financial or environmental stability will always be a feature of investing in China. But this should be contrasted against the many years officials have spent in creating more open and deep capital markets to encourage foreign investment.

It’s also worth recognizing that regulatory change is not a negative term, and can in fact create investment opportunity. For example, ambitions to become self-sufficient in semiconductor manufacturing and software development as well as achieving greenhouse gas reduction targets mean certain industries stand to benefit from policy tailwinds in the medium to long-term.

The Politburo meeting at the start of August provided more insight into the economic and regulatory policy direction for the rest of 2021. On the economic outlook, the Chinese government recognizes the imbalances in economic recovery. Small and medium enterprises and low-income households have lagged during the current economic recovery and there are signs of slowing in the country’s manufacturing base. This implies that fiscal policy could do more of the heavy lifting in supporting growth for the rest of this year, especially as the 2021 government bond issuance is running below this year’s quota and can be stepped up. Monetary policy has shifted to a neutral stance now, after some modest tightening in the first half of the year. However, this position could also shift if growth momentum eases further.

Chinese equities are no stranger to large corrections

Source: Bloomberg L.P., J.P. Morgan Asset Management. *08/02/21 - 30/07/21. Data reflects more recently available as of 02/08/2021.

It is impossible to predict the bottom of any market correction, but the current downturn is far from unique in the context of the Chinese market, even if the cause is different. The correction in 2015/16 was the bursting of a stock market bubble featuring excessive retail participation. U.S.-China trade tensions hit Chinese equities hard in 2018 as well as a drive to de-leverage the corporate sector. This time around, fiscal and monetary policies are in a more supportive position, especially considering the moderating growth momentum and uncertainties from a pick-up in COVID-19 cases. The current stalemate between policy makers and investors may only be resolved with greater communication on future policy changes to allow time for businesses to adapt and investors to regain confidence in the long-term investment prospects in China.