China’s risk experts are planning downgrades

The situation in the South China Sea and Taiwan Strait continue to ring alarm bells for China's foreign policy risk

Euromoney’s latest survey for Q3 2021 is under way, and the results are likely to prove illuminating, not least for investors in China weighing up the country’s mounting issues.

Regulatory uncertainty, rising foreign policy tensions and a slowing economy compounded by an energy crisis – which is also feeding into the much publicised debt crisis at property developer Evergrande – are all combining to make China’s experts more cautious, as the world’s most populous country loses its lustre.

Compare that with the prevailing attitudes towards China’s assets, which improved during the second half of 2020 and into 2021, notably as faith in the authorities was reinforced by effective pandemic control.

This of course enabled the economy to reopen and get back up to speed relatively quickly after GDP contracted on a real terms basis by 6.8% year-on-year in Q1 2020.

It also propelled China into 38th place in the survey’s global risk rankings, putting it broadly on a par with Spain and Lithuania based on Euromoney’s risk metrics, making it a high-ranking tier 3, medium risk investor domain.

What has changed?

Initially the regulatory crackdown had no major impact on China’s risk profile, ostensibly because the economic rebound offset it, and also because it was perceived to be largely confined.

Survey contributor and ABN Amro senior economist Arjen van Dijkhuizen says it began in November 2020 when the authorities presented new rules for fintech firms and halted a large IPO of Ant Group, the financial company affiliated with e-commerce giant Alibaba and owner of the online platform Alipay.

“Later on, Alibaba was fined, and Ant Group was ordered to restructure, but it soon became clear that these actions were not just a personal vendetta against founder Jack Ma," explains Van Dijkhuizen.

“In the course of 2021, Beijing broadened the crackdown to other fintech firms and online platforms (and bitcoin), but also to sectors such as online education and entertainment/gaming.

“For reasons of national security and data protection, the government also tightened rules for mergers and acquisitions and foreign IPOs, including banning variable interest entities that Chinese firms often use to circumvent regulation.”

Van Dijkhuizen says that while the measures taken were surprising, mainly reflecting a lack of communication – which, incidentally, highlights the Achilles’ heel of China’s country risk profile, its very low score for information access/transparency – they are part of a broader strategic plan to improve regulation of the often under-regulated internet-related parts of the economy.

As Van Dijkhuizen goes on to explain, the authorities sensed an urgency during the pandemic to also address concerns of national security, data protection, antitrust issues and improving competition.

The 14th Five-Year Plan, for 2021-25, launched the concept of “dual circulation”, stressing the importance of reducing China’s dependence on foreign technology and critical imports (such as semiconductors), and improving the functioning of domestic markets.

“The crackdown also goes hand in hand with other goals, such as reducing social inequality and supporting family values,” Van Dijkhuizen says.

“China’s Communist Party is putting more focus on traditional socialist goals and promoting common prosperity, a term first mentioned by Deng Xiaoping in the 1980s. Recently, president Xi Jinping pledged to reasonably adjust excessively high incomes, and encourage high-income groups and companies to give back more to society.”

Foreign investors have clearly been spooked by the crackdown of the Chinese Communist Party (CCP) on various sectors of the economy, particularly in the last six months, says another of Euromoney’s China experts, Marco Vicenzino, director of Global Strategy Project.

This has created a certain degree of fear and uncertainty, he says. “It leaves many investors in limbo with a kind of guessing game as to which sector is next.”

This, he believes, will see many investors reduce their portfolio in China – although not all, as the Chinese market is simply too big to avoid.

China’s Communist Party is putting more focus on traditional socialist goals and promoting common prosperity 

 - Arjen Van Dijkhuizen

“For these investors, it's essential to understand China's political climate, where it's heading and avoiding certain sectors, particularly those with greater political exposure,” says Vicenzino.

“Fundamentally, investing in China involves an enormous political dimension and risk. Whereas directors in western companies are primarily accountable to shareholders, those of Chinese companies - whether operating at home or abroad - are ultimately accountable to the CCP, and its internal dynamics.”

Consequently, Vicenzino says, Chinese corporate entities will struggle to fulfil their true potential in the longer term.

Van Dijkhuizen, meanwhile, expects the regulatory campaign to continue – affecting other sectors, including consumer services, and public services such as education, healthcare, media and entertainment, but not hi-tech manufacturing.

Investors will get used to this process, and communication from Beijing should improve, he believes.

“In our view, this regulatory crackdown is not so much a ‘general attack on tech’, but rather an attempt by the Chinese leadership to shift resources to high-tech manufacturing which it sees as the key driver of China’s technological advance.”

Beyond regulation

Yet China’s risks are multiplying in other ways.

Economic growth, for one, is decelerating. A fuel crisis is developing, and the publicised difficulties at property developer Evergrande signify something more substantial is going on. This is being reflected in China’s share prices, which are still taking a tumble.

Chien Szu-Min, an associate research fellow at the Taiwan Institute of Economic Research, is one of Euromoney’s survey contributors who is planning to downgrade China.

She sees longer-term risks associated with the Evergrande crisis depending on the follow-up actions of the government.

The real estate risks and the hit to confidence brought about by the debt crisis will worsen China’s economic slowdown.

The fall in consumer confidence will act as a drag, compounded by inflation occurring largely because of power cuts, which in turn will constrain private consumption.

“The power curtailment is expected to continue across more than ten provinces until March next year. This will result in the cessation of production and a state of energy instability for up to six months, which inevitably poses an immediate risk to business operations,” says Szu-Min.

Foreign policy risks

Szu-Min also sees China’s foreign policy as a source of risk that is adding to investors’ uncertainty.

Due to the human rights issues in Hong Kong and Xinjiang, western countries must focus on the issues concerning the Taiwan Strait and South China Sea.

Whether it is the Aukus security partnership between the US, UK and Australia, or the Quadrilateral Security Dialogue between the US, Japan, Australia and India – establishing partnerships for regional security network dialogues and technology and supply chain cooperation, etc – the Taiwan Strait and South China Sea will likely remain tense.

“China will continue to send military aircraft to fly over, but it will also cause relations between neighbouring countries of the South China Sea, Vietnam and the Philippines and China to become more intense than ever.”

Vicenzino points out that the geopolitical competition and the inherent risks between China and the West has been going on for decades.

“The main difference is that the leaders of the CCP have been aware of this contest, prepared for it and operating on this premise for decades,” he says.

“The CCP has been considerably ahead of the curve in this ongoing, and exponentially growing, struggle for influence regionally and globally. For many years, the CCP has been engaged in the strategic long game against the West – making the generational investments of time, efforts and resources.”

He says the Aukus initiative was long overdue and that other similar, and much-needed, arrangements must increasingly materialize over time and form part of a broader strategy by western and democratic countries for dealing and managing relations with the CCP, and whenever necessary confronting it head on.

“Western leaders, in both public and private sectors, mostly fell asleep at the wheel for far too long. They eventually experienced a rude awakening, largely through the Covid crisis, to the rawness and realities of the CCP.

“For decades, western politicians naively believed that China would eventually democratize through greater economic prosperity and opportunity. On the other hand, most western corporate leaders focused purely on profits and remained practically aloof to politics, some intentionally and others naively. The reality of the geopolitical competition is now on full display.”

Downgrades coming

Van Dijkhuizen says that ABN Amro has downgraded China’s real GDP growth forecast for 2021 from 9% to 8.3% and that the Evergrande crisis only adds to the risks.

“It looks likely we will see some form of ‘mixed solution’, with debt restructurings (to deal with the moral hazard issue) on the one hand, and intervention to limit systemic risks on the other,” he says.

“Beijing has the tools to interact and engineer a longer-term solution, both in financial terms but also in governance terms. Indeed, a similar mixed solution was found for the asset management company Huarong earlier this year, although that was a state-owned company while Evergrande is a private firm.”

Szu-Min will be also downgrading China’s risk scores because of the power cuts causing supply chain disruption to Apple, Tesla and so on.

The Evergrande crisis is a prime example of the broader systemic challenges that the CCP faces 

 - Marco Vicenzino

“If the shortage of coal and gas continues, the power crisis may go on to next year and that will definitely have a negative impact on China’s economy. In addition, the Evergrande debt crisis will [as mentioned] lead to a reduction in private consumption.”

Vicenzino says that regardless of current challenges, China will inevitably increase its position as a leading global economic power over time. However, its real potential will continuously be hindered – at home and abroad – by a lack of transparency, and other accompanying and related factors, particularly emanating from the political realm.

“The Evergrande crisis is a prime example of the broader systemic challenges that the CCP faces. How it ultimately deals with it, and other similar and inevitable crises, will have serious implications for decades to come.”