Why emerging markets will weather China’s regulatory crackdown just fine

Most emerging-market investors have little choice but to stick with China as its size and importance force investors to maintain their exposure
With previous China-led sell-offs having given way to rallies, emerging-market stocks could recover sooner than many think

Nicholas Spiro

Published: 1:00am, 6 Aug, 2021

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Are Chinese stocks uninvestable? That the question is being asked is an indication of the extent to which global investors have been taken aback by the ferocity of Beijing’s regulatory crackdown on sectors ranging from education to technology.

In a report published last week, investment strategists at Goldman Sachs said the word “uninvestable” featured in many of their conversations with clients regarding the outlook for Chinese equities.

The education sector has borne the brunt of Beijing’s regulatory assault, with academic tuition groups forbidden from making profits, raising capital or going public. The scale of the wealth destruction during the past fortnight would make anyone question whether it is safe to put money into Chinese shares.

Since details of the clampdown on the industry were leaked on July 23, the share prices of TAL Education and New Oriental Education – two of the largest US-listed Chinese education companies – have plunged 72 per cent and 67 per cent respectively.

In a report published on July 30, US investment adviser Evergreen Gavekal said the share prices of Chinese education firms make for “some of the most traumatic viewing” since the 2008 global financial crisis and “reflects a landscape upended by government action”.

People stand outside a Xueersi outlet, a private educational services provider owned by TAL Education Group, in Beijing, on July 26. The share prices of TAL Education and New Oriental Education – two of the largest US-listed Chinese education companies – have plunged 72 per cent and 67 per cent respectively since July 23. Photo: Reuters

While the escalation in political and regulatory risk in China has weighed on sentiment across asset classes, emerging markets are the most vulnerable to financial contagion. In 2005, China’s weighting in the MSCI Emerging Markets Index – a leading gauge of stocks in developing economies – was only 7.6 per cent. Today, China accounts for 37.5 per cent of the index.

The world’s second-largest economy also dominates JPMorgan’s Corporate Emerging Markets Bond Index, which tracks the performance of dollar-denominated corporate debt in developing countries. China constitutes 26.3 per cent of the index – Hong Kong makes up a further 6.7 per cent – and is expected to account for nearly 43 per cent of the gross issuance of emerging market corporate debt this year, according to JPMorgan data.

Beijing’s widening regulatory crackdown at one point last week wiped a staggering US$1.5 trillion off the value of Chinese shares listed in the mainland, Hong Kong and the United States. It comes at a time when emerging markets are facing a fierce resurgence in Covid-19 infections, especially in Asia, and a weaker recovery than in advanced economies.

Developing nations’ stocks have lost a further 5.5 per cent since June 28 and are barely in positive territory for the year. By contrast, the MSCI World Index, a gauge of stocks in developed markets, is up 15 per cent this year.

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China’s growing presence in emerging market stock and bond indices is now seen as a vulnerability, particularly for popular passive investment vehicles that track the performance of an index rather than attempting to outperform it.

However, the fact is most emerging-market investors have little choice but to stick with China. The sheer size of the economy, the breadth and depth of China’s markets and the crucial role of China’s tech sector as the key driver of stock markets in developing economies force investors to maintain their exposure.

Those who took a longer-term view of China during the policy-induced sell-off in 2015 were handsomely rewarded. The surprise devaluation of the yuan – which contributed to a collapse in Chinese and emerging-market shares – was a distant memory by the spring of 2016 as policy adjustments by Beijing helped improve sentiment.

This time, the spillover effects are less severe. One of the most notable aspects of China’s regulatory clampdown is the lack of contagion, particularly in debt markets. While emerging market corporate bond spreads surged towards the end of 2015, they rose only modestly last week.

Regulatory uncertainty in China could still end up having a bigger impact on broader sentiment. Even so, the fact that the bulk of Chinese bonds are held by domestic investors limits the scope for widespread contagion.

Furthermore, there are already signs that the steep declines in Chinese stocks are encouraging investors to buy the dip. Chinese equities are enjoying their longest stretch of net purchases by foreign investors via trading links with Shanghai and Shenzhen since late April, according to Bloomberg data, driven by cheap valuations relative to US shares.

Active fund managers are particularly well-placed to capitalise on sectors of China’s economy that benefit from Beijing’s prioritisation of self-sufficiency to counter US curbs on Chinese tech companies. Semiconductor stocks have surged since Beijing intensified its regulatory interventions.

While the slowdown in China’s economy is concerning, and the government’s increasing hostility towards the private sector even more troubling, emerging-market investors remain heavily exposed to China, whether for good or for ill. With previous China-led sell-offs having given way to rallies, emerging-market stocks could recover sooner than many think.

Nicholas Spiro is a partner at Lauressa Advisory