Chinese reform: one step forward, two steps back
Two years ago I took a research trip to Macau. At the time, the tourist strip was a pulsating sea of humanity—the sheer number of Chinese tourists on short trips from the mainland was daunting for a North American used to a certain amount of personal space. Today, that same strip is far less busy. Visitor traffic into Macau is down significantly (20-40%), a result of a government crackdown on corruption and excess among the country’s government officials. Macau’s restaurant and tourism industries have been hit hard in response. One may think this is a negative sign, but in fact, it is the natural consequence of important and positive reforms happening in China.
Chinese reform is a big deal. Despite being the second largest economy in the world and experiencing decades of impressive growth, China suffers from structural challenges that hamper its future potential. Wasteful investment, corruption, poor legal structures and heavy government interference all contribute to a system that is fundamentally imbalanced and unstable. On top of this, the country suffers from excessive debt and severe overcapacity in key industries such as steel and construction. Fundamental reform is sorely needed to address these challenges.
Until recently, it appeared that the Chinese government was committed to tackling some of these issues. Dramatic crackdowns on government corruption have seen major public figures reprimanded for excessive spending and accepting inappropriate gifts; steps have been taken to gradually liberalize China’s financial system; and, the government has even acknowledged the need to reduce its share in state-owned enterprises. While these moves are no panacea, they all indicate incremental progress.
But as the saying goes…one step forward, two steps back. China’s commitment to reform wavered in recent weeks when economic weakness and stock market volatility reared its ugly head. In a stunning response to panicked investor selling, the government instituted a number of policies designed to prop up stock markets. Among them was a rule that major shareholders (with holdings over 5%) could not sell their shares in companies for the next six months.
Observation one: stocks don’t fall if no one is allowed to sell.
Observation two: if selling is only permitted when the government says so, it’s not much of a market.
It is hard to overstate the scale of interference this new policy demonstrates. China says it wants to liberalize its financial markets, but they appear unwilling to accept the negative consequences this liberalization would entail. It puts China’s financial reforms back several years. Currently, the prevailing assumption in the investment community is that China will reform—albeit gradually—and that it will somehow avoid an economic hard landing. Yet recent events remind us that this is not guaranteed and investors should not pin their investment strategies on the expectation that these scenarios will unfold.
While China’s leadership acknowledges the importance of reform, as do key institutions within the global financial community—such as the World Bank, which recently published a 37-page report that stated “without fundamental reforms, the current financial system will be unable to support any substantial reallocation of credit to support productive growth,”—Beijing will ultimately do what it feels are in its best interest. And with a GDP growth rate slinking to a decades-low 7%, reform may no longer be the near-term priority it once was.
For global investors, this means renewed caution around investing directly into China. Recent events certainly gave our team pause for thought—not only in regard to investing on the mainland, but also in Hong Kong, which is ultimately just another Chinese domain. Even for investors who will never invest directly into China, the question of reform is important to understand. Chinese growth is a major contributor to global growth and, arguably, reform is needed to return the country to a sustainable trajectory.
But we must not assume that Chinese reform is a done-deal.