Things are looking very precarious in China right now. I'm sure most readers know that Evergrande, one of the country's biggest property speculators, was ordered into bankruptcy by a Hong Kong judge last week. The company's debt and other obligations amount to a staggering $300 billion - yes, that's "billion" with a B. Its assets (whose valuation may be debatable) are said to amount to $245 billion; but most of those assets are buildings it's erected, with apartments that it can't sell - or, if they're sold, the buyers may stop paying their mortgages if Evergrande doesn't deliver all it's supposed to. To make matters worse, the Hong Kong ruling may be stayed or overturned by a mainland China court, because if Evergrande were to collapse, it might well take a very large chunk of the real estate business in China - a very large part of that country's economy - with it. That could lead to massive social unrest, something the Chinese Communist Party wants to avoid at all costs.
Now we learn that the Chinese stock market is facing very serious losses. This is partly related to the Evergrande collapse and related issues, but also to blatant market manipulation by the Chinese Communist Party, which regards firms that grow too big as a threat to its dominance, and tries to control where investors put their money. Foreign funds are being withdrawn, local investors are running scared, and there are many other factors affecting the situation. Suffice it to say that everything's in a state of flux, and that's a very undesirable situation for those running China. They want things to be orderly, controlled, disciplined. The free market (not that the Chinese market is particularly free, but let's ignore that for now) is none of those things. Those two perspectives are colliding right now, with unpredictable results. If the Chinese government cracks down too hard in an attempt to restore stability, it could trigger unpredictable results on top of the existing uncertainty.
Ever since the pandemic, the US economy has surprised nearly everyone, while China’s economy has stalled. A real estate crisis is unfolding there, which could erase the savings of China’s new middle class, and Chinese stocks recently hit a multiyear low.
From where I sit, the risk-reward ratio for Chinese stocks looks bad.
To start, anytime you invest in a Chinese company, you’re investing alongside the Chinese Communist Party. Since he came to power in 2013, Xi Jinping has amplified the CCP’s influence over “private” Chinese companies. In effect, no business in China is private the way you or I think of a private company, with clear laws and boundaries separating it from the government.
The US-China Economic Security Review Commission summed this up well:China’s government has developed numerous avenues through which to monitor corporate affairs and direct nonstate firms and resources toward advancing the Chinese Communist Party’s (CCP) priorities. Within this expanded framework of government control, traditional definitions of state control in an entity no longer apply because any entity may be compelled to act on behalf of the Chinese government’s interest, regardless of the state’s formal ownership.
Chinese law explicitly requires people and organizations within the country to “support, assist, and cooperate with national intelligence efforts.” (I’ve mentioned this when sharing my concerns about TikTok and digital privacy.)
Investors also need to consider China’s accounting practices. Chinese companies don’t use GAAP or International Financial Reporting Standards. They generally use Chinese Accounting Standards, sometimes called China GAAP, which makes analyzing them more challenging.
Then you have the transparency issues. Over 250 Chinese companies trade on major US exchanges. Regulators had to threaten to suspend trading under the Holding Foreign Companies Accountable Act to get the Public Company Accounting Oversight Board (PCAOB) access to audits of US-listed Chinese companies. We’ve made some progress here, but the PCAOB reviews late last year led to an unprecedented $7.9 million in sanctions against auditors PwC Hong Kong, PwC China, and Shandong Haoxin.
None of this was too concerning when China’s markets were roaring higher. The CCP was happy to take foreign dollars to build its businesses and infrastructure. Everyone won.
But with China’s financial markets under pressure, and the real estate buoying its middle class at risk, do you really want to invest alongside a government that can change the rules at will and without notice?
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If the Chinese economy goes into a tailspin, it's going to have a massive economic impact all around the world. China is the manufacturing hub of the entire globe, the center of almost every consumer-oriented product the rest of the world wants. It also consumes vast quantities of natural resources to produce those manufactured goods. If it hiccups, the supply of those goods becomes questionable, and those countries that rely on selling their raw materials to China face a sudden and perhaps drastic decline in demand for them - meaning their income, and that of their leading businesses, plummets. The knock-on effects might be very dangerous for world stability. Wars have been fought for lesser reasons.
This could be serious. We don't know for sure yet . . . but I have a bad feeling about it. Meanwhile, follow the money in China: who has it, where it's being invested, and (perhaps most important right now) where it's being withdrawn from markets and industries. Where is it going? How is it being used? If it's being pulled out for safekeeping rather than reinvested, the fuel that runs the Chinese (and the world) economy is basically being drained - and therein lie consequences. Most importantly . . . what happens if the US economy follows China's example? If China dumps its US dollar reserves in the midst of an economic crisis, much of the rest of the world will follow suit and our currency will tank, taking our economy with it. Given that China (both its central bank and its citizens) is currently driving the world gold market, the US dollar is probably looking less and less attractive to them.
What's next? Your guess is as good as mine, but it's unlikely to be healthy for any of us.