Andrew Hunt is CEO of Hunt Economics and former Advisor to Dresdner Asset Management in Asia. Ben Ashby is a former Managing Director of the Chief Investment Office at JPMorgan.
What do Goldman Sachs’ new wealth management joint venture with Industrial and Commercial Bank of China (ICBC) and hedge fund billionaire Ray Dalio have in common? They are both part of a galaxy of global financial investors who want greater exposure to Chinese financial markets because they believe the country’s rise to power is inevitable. We think they are wrong.
We think of many of the arguments Dalio made in the column “Don’t be blind to the rise of China in a changing world“published in the Financial Times on October 23, 2020, can be denied today, while others will likely be over time. The Chinese market may well” open “to foreigners, but if it justifies more of their capital is another matter.
At first glance, the prospect of increased Chinese savings in financial markets seems to justify this excitement, as do Chinese stocks becoming a bigger part of global investors’ portfolios.
We calculate that it would take at least $ 6 trillion in overseas assets, at current exchange rates, to rebalance the deposit-rich portfolios of domestic savers so that their distributions resemble those of China’s neighbors. And, as Dalio pointed out in the FT, “the world is underweight Chinese stocks and bonds,” which account for 3% or less of foreign portfolios rather than a “natural” weighting of over 15%.
So far so factual. But many international financial institutions are hoping that a “normalization” of financial sector policy, a rebalancing of portfolios and continued debt-fueled growth will create a windfall that they should position themselves for now. This is where we go our separate ways: We don’t expect any fundamental changes for the foreseeable future due to the realities of the Chinese economy.
Most of the country’s household wealth remains locked in bank accounts, and outflows abroad are tightly controlled. As a result, the banking system is vast: China’s share in global deposits is roughly double its share in global gross domestic product.
The main function of Chinese banks is to facilitate government policy, however, by promoting economic development in accordance with the country’s communist principles. They need to ensure that key sectors have an immediate supply of cheap credit, supporting an economy that maximizes output, not profit.
This model has necessarily financed the deficits of the entire business sector since the late 1980s, when economic reform began. We estimate that the average deficits correspond to 16% of GDP per year. This necessarily had an impact on lending, savings and regulation.
To keep the economy strong, financing costs have been eliminated; real interest rates have been negative for much of the past 40 years. Understandably, the reluctance to charge borrowers a lot meant even less to depositors. But heavy regulation has been used and capital flows tightly controlled to ensure that they leave most of their wealth in the bank.
If the Chinese government considers a standardization of its approach, it will be faced with a difficult choice. The authorities can either allow the markets to allocate funds to companies seeking to maximize their profits, or continue to direct capital to the many people who destroy shareholder value. In the latter case, investors should accept that Chinese financial markets serve no real economic purpose and that long-term returns are likely to be limited.
As noted investor Ben Graham observed, “The stock market may be a short-term voting machine, but over time it is a weighing machine.”
Without the underlying profit-maximizing engine, it’s hard to see Chinese stocks deliver the kind of return investors expect. This means the country’s savers are likely to lose out with any long-term passive investor who follows Dalio’s GDP-weighting approach – a strategy that failed during the Asian financial crisis of the late 1990s. But all change radical in the behavior of companies would not align with the economic objectives of the decision makers.
A difficult situation would also arise if more national funds were allowed to leave the country. Any deregulation of savings markets would likely drain China’s precious foreign exchange reserves to dangerously low levels.
While these reserves are large in nominal terms, their sufficiency for an economy the size of China remains an open question. Additionally, if savers were to rebalance to regional standards, we will see the banking system face a loan-to-deposit ratio of at least 180%, hampering its primary function of providing cheap credit to businesses. Corporate finance costs would also soar, triggering numerous restructurings that would further hurt investor returns.
For the foreseeable future, therefore, Chinese banks and businesses simply cannot afford to let domestic savings go. And the outlook is increasingly negative even with these savings stuck at home. With already high debt levels, a slowing economy and a growing percentage of underperforming loans after years of unprofitable lending, Chinese banks will be increasingly in trouble and their ability to issue new loans will diminish. This partly explains China’s motivation to attract more foreign investors. Promising normalization and securing new sources of capital helps delay tough decisions.
All of this before the practical considerations Dalio barely mentioned, such as the implications of placing money in a country with capital controls or meeting the demands of national regulators and investors, especially when these are in danger. increasingly focus on environmental, social and governance principles, as well as navigating an increasingly bitter and tense geopolitical rivalry. No one knows what the right risk premium is for all of this.
In any market the size of China, investors will quickly have the opportunity to make easy gains. Since hedge funds tend to have short-term horizons, Dalio could well take advantage. But we believe the potential rewards will eventually wear off.
Worse yet, if China is unable to reform its domestic economy or if the international political situation deteriorates further, even capital withdrawal can become problematic. If this happens, rushed investors and businesses will have time to repent at their leisure.