Investing between the lines in China
Despite policy uncertainty and a high equity risk premium, investors in Chinese assets who accurately interpret the sector can reap large rewards
Except for lawbreakers, most investors around the world analyse the same information when they make asset allocation calls.
In the West, policy transparency has improved to the point where some now argue that the United States Federal Reserve should revert to a murkier decision-making process because investors are taking on too much risk, thanks to Fed promises of long-term low interest rates.
Then we have China, where sometimes no one is sure what is going on.
This has many downsides - including a high risk premium - but we have to admit it also makes for a more exciting investment environment.
Take the report broken last week by state-owned CCTV. The television station reported alleged violations of foreign exchange rules by another state behemoth - Bank of China.
According to the report, which included secret filming and a fake wealthy client, BOC is helping to "launder" money for rich clients who want to send abroad more money than allowed under the mainland's capital control rules.
So what is going on? The fact is, we do not know for sure. So we also do not know the investment implications.
A few possible interpretations are listed below:
Scenario 1: This is a report ordered by or planted by Communist Party officials to send a message to the private-sector rich. If so, this has implications for the yuan and the offshore bond market, as it may indicate that Beijing is worried about selling pressures on the currency and the whole capital account liberalisation process.
- Scenario 2: This is an attempt by a state-owned media giant considered the party mouthpiece to show its independence. Some argue the news outlet did not even get the report right - that this activity is essentially sanctioned by state authorities.
If so, the investment implication would be the opposite of the one above; that is, Beijing is happy to relieve some of the upward pressure put on the yuan by the perpetual trade surplus.
Scenario 3: Beijing is gunning for rich people. We could get another round of takedowns of entrepreneurs - start checking the Forbes or Hurun list of China's most wealthy and avoid the shares of companies owned by them.
- Scenario 4: This is a sign that political purges and anti-corruption drives that affected other major state-owned enterprises - think PetroChina - now have the financial sector in their sights. Short at least BOC, and for the more adventurous, go long the bank or banks most likely to be in favour.
Of course there are some who know exactly what is going on, but for most investors in Chinese assets, accurate interpretation of this, and so many other events, can be very rewarding - just as poor interpretation will be costly.
One thing history has taught us about investing in China is not to worry about following the letter of the law.
Administrators often test policy reforms by allowing flagrant rule-breaking. That way, if things do not work out, they can just "crack down" on violators without rewriting the rulebook, since it officially never changed.
A prime example is the internet sector - now hugely capitalised on overseas markets, mostly the New York Stock Exchange. Yet technically, foreigners are prohibited from investing in this sector.
Slippery corporate advisers come up with a structure that pays the profits made by companies like Baidu to a shell company in the form of "consultancy fees" and such. That shell company then pays the international shareholders. Crazy, but so far workable.
It also means the rug can be pulled out at any time - as was almost the case about three years ago, when New York and Beijing regulators were arguing over accountancy disclosure issues.
Chinese internet stocks back then experienced a brutal sell-off, creating a huge investment opportunity for those who waded in at the time.
Of course, policy uncertainty explains the high China equity risk premium. It explains why high-flying investors like Anthony Bolton took a bath on Chinese small-caps a few years ago.
But it also supports a thriving industry of China watchers. And as they say - no risk, no reward.