How To Profit From China’s Explosive Economic Growth

13 mins

How To Profit From China’s Explosive Economic Growth

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Why China matters

If you only know one thing about China, it’s probably this: it’s big. As in, 1.4 billion people big. As in, the world’s second biggest economy big. As in, expected-to-overtake-the-US-as-the-world’s-biggest-economy-in-the-next-decade big.

It’s already earned the titles of world’s largest manufacturing economy, world’s most significant global exporter, and world’s single biggest food producer. In fact, the country has 315 million agricultural workers alone – about as many as the entire US population. And even then, agriculture only accounts for 8% of its economy. That’s primarily because Deng Xiaoping – who took over from Chairman Mao as the country’s leader in the late ‘70s – started reforming the market, allowing private enterprise and opening China up to global trade. And those reforms unleashed explosive growth: between 1977 and 2017, China’s economy grew by almost 10,000%.

It was all driven by growth in sectors like manufacturing and materials production, which make up 40% of the Chinese economy. But as China continues to modernize, it’s now pivoting again – from a manufacturing-focused economy to one more reliant on services, such as tourism, retail, banking, and finance.

The biggest banks in the world are no longer the likes of JPMorgan and Citigroup: the top players are all Chinese. And thanks to the “Great Firewall” – which blocks Google, Facebook, and Twitter an entirely separate web ecosystem has flourished. That’s led to the stratospheric rise of behemoths like WeChat-owner Tencent and Amazon-equivalent Alibaba, minting billionaires across the country.

But not everyone’s been so lucky. China’s growth has brought with it massive inequality: while thousands have become mega rich, roughly a billion members of the population make less than $4,000 dollars a year, while the average wealth per person still isn’t very high – just under $10,000, versus the US’s $63,000.

There may be hope for them, though. China’s economy is forecast to grow fast over the coming years: around 5.8% next year. That might be disappointing by Chinese standards, but it’s miles ahead of the US’s 3.1%. The Chinese market will soon be too big for investors to ignore. Just as it’s inconceivable for an investor to disregard US stocks, it’ll be odd if you don’t invest in China. And fortunately, China’s making that becoming easier to do – if not altogether easy (more on that later).

So this Pack will teach you all the moves you need to dance with the Dragon, and make sure you don’t get shanghaied along the way. First off: what’s changing in China?

The takeaway: China may soon become the world’s biggest economy – and that means it’s too important for investors to ignore.

China’s financial liberalization

It’s fair to say China has a… complicated relationship with global financial markets.

China operates what is essentially a hybrid system. It’s still nominally a communist country, but private wealth is allowed and even encouraged – making it, to all intents and purposes, a capitalist economy. But there are also elements of state intervention you wouldn’t find in the West. The government controls all the big commercial banks and the central bank, for example, which enables it to actively manage the value of the nation’s currency, the yuan.

That control on currency markets directly affects China’s citizens, who are only allowed to convert $50,000 a year into foreign currencies. It’s also very difficult for foreign investors to take their returns out of the country: in fact, they couldn’t buy any Chinese shares until relatively recently. This lack of free money movement is very different to Western markets, but, in an effort to encourage foreign investment and grow China’s economy further, things have started to change. And that’s where you come in. Because nowadays it’s possible for everyday investors like you to get in on the Chinese boom.

It kicked off primarily back in 2002, when China launched the Qualified Foreign Institutional Investor (QFII) program, which allowed big foreign banks to invest in Chinese companies’ shares. In 2014, the Shanghai-Hong Kong Stock Connect appeared, enabling international investors to buy shares of companies in mainland China through Hong Kong brokerages. And in 2019, the Shanghai-***London* Stock Connect** launched, allowing London-listed firms to issue shares (or “depository receipts” – more on those shortly) in China, and vice-versa.

All of that sounds great, but the reality is less va-va-voom than it appears. The Shanghai-London Stock Connect comes with countless restrictions: it’s almost impossible, for example, to bet against Chinese stock prices. Likewise, very short-term trades – “day trades” – aren’t allowed. And daily trading volume is limited to $10 billion – a drop in the ocean compared to the US markets’ $380 billion daily average.

More worryingly, foreign ownership of Chinese companies is capped at 30%. If Chinese investors dumped a given stock, foreign investors could find themselves inadvertently holding more than 30% ownership. And if that happens, foreign investors will be forced to sell up at market price – which would, at that point, be plummeting.

Our point is that buying stocks in individual Chinese companies is difficult – but it’s by no means impossible. Next, we’ll walk you through the steps you’d need to take to buy your first Chinese stock.

The takeaway: China’s opening its doors to foreign investors, but there are still restrictions.

How to invest in China

The easiest way to invest in China is by buying and selling shares – bonds are much harder to get your hands on – so that’ll be our focus in this session. There are a few ways you could go about it.

Most companies offer a few different types of share: the most common among them are known as “A” shares, “B” shares, and “H” shares. Chinese companies trade A shares and B shares on Chinese exchanges, but foreign investors aren’t allowed to buy them unless they work in China or are employed by a Chinese-listed company. China’s H shares are easier to buy: they’re listed in Hong Kong, which is a much more open market. You’d just need to find a broker that offers access to the country’s stocks.

The most straightforward way to own shares in a Chinese company is to buy those that are listed on a Western stock market. Over 150 big Chinese companies are listed in the US – including e-commerce giant Alibaba and oil titan PetroChina – and you can trade their shares just like you would an American firm’s. Technically known as “American Depository Receipts” (ADRs), they’re Chinese shares that have been purchased by US banks and then reissued in America.

ADRs look and behave like your garden variety US shares: they’re traded on American exchanges and their value is tied to that of the underlying company’s shares. But there are also differences. You may have to pay an additional service fee to the bank that issued the ADR, for one. And sometimes an ADR’s value will differ from the value of the original stock (if, say, there’s lots of demand for the ADR but not for the stock in China).

Plus, if you buy an “unsponsored” ADR – that is, one that’s been created without the approval of the underlying Chinese firm – you’re having to trust that the issuer is legitimate. If they were to go bust, your ADRs could be worthless. These unsponsored ADRs also trade “over the counter”, rather than on a stock exchange, which means it can be slower and more difficult to find a buyer when you come to sell.

For a less direct way of getting exposure to the Chinese market, you might just want to buy stocks of US companies that derive a big chunk of their revenues from China. Chip-maker Qualcomm, for example, makes around 50% of its revenue from China. Buying its stock would be, in part, a bet on China.

But if you really want to keep your holdings diversified and your risk low, a fund might be the way to go. More on that next...

The takeaway: The easiest way to buy Chinese shares is if they’re listed on US exchanges – though you can also try investing via Hong Kong or in China-dependent US companies.

The (small) index fund revolution

There are dozens of exchange-traded funds (ETFs) out there that track the value of multiple Chinese stocks – both the market as a whole and specific sectors. In fact, you might already have money in China via one of them. Index providers MSCI and FTSE are increasing the weighting of mainland Chinese shares in their benchmark indexes. So any investor with a diversified global stock ETF that tracks those indexes indirectly owns Chinese shares.

But don’t count on them as a way to diversify your portfolio. You’d be forgiven for thinking that the world’s second-biggest economy would make up the second-largest share of stocks in a global equity index. Not so: even after the boost in weighting, mainland Chinese shares will still comprise just a tiny fraction of these global indexes. So if you want real exposure to China, you’ll need to go for a China-specific fund.

An ETF tracking mainland Chinese shares could be good news for you over the next few years. As the big global indexes gradually increase their holdings of China A shares, the many billions of investment dollars that track those gauges should eventually lead to an influx of cash to the mainland Chinese stock market, driving prices up. Invest now, and you might get in on the action before the rush. Or it might all go to pot. That’s investing...

That’s not just investing: that’s investing in China. Because remember: whatever you choose to invest in, you’re bound to be exposed to some uniquely Chinese risks. Those are up next.

The takeaway: Chinese shares are being included in more and more index funds – but still not as much as other countries’.

The dangers of China’s government

China is, to put it simply, unpredictable.

The Chinese government’s tight control on almost everything – which has become even tighter under current leader Xi Jinping – means a stock’s fortunes can change on a whim. Companies have been thrown into turmoil after CEOs who have got on the government’s bad side have vanished. And while financial markets in the West are treated as distinctly independent from any government, company, or even economy, markets in China are just another tool to be used for the benefit of the Chinese people.

In short, when markets are moving in a way that’s not conducive to China’s rise, the Chinese government will intervene fast. If a particular company that’s important to national interests falls on hard times, the government will bolster that company by any means necessary. And it doesn’t matter how successful a company is if it runs afoul of the authorities: nothing will protect it from the hurdles the government decides to place in its path.

On top of that, you often won’t really know what’s going on with your investments. Chinese accounting, auditing, and governance standards are different to Western ones – and generally not as strict. That, unsurprisingly, means the number of major frauds among publicly traded Chinese firms has been high over the past decade: prominent examples include SinoForest, Real Gold Mining, and China MediaExpress Holdings.

That’s one reason why you might want to diversify your investments across a variety of different companies. But even then, you’ve got to reckon with the challenges of China’s economy, too…

The takeaway: China’s government can destroy a company at the drop of a hat – so you might be in a stronger position if you diversify across companies.

China's economic future

As anyone who’s read our Trade War Pack knows, the US-China trade war has taken its toll on China. Punitive tariffs on Chinese goods have reduced demand for their products and hurt companies’ bottom lines, and they’re also much of the reason its manufacturing industry shrank throughout much of 2019. Some economists even think the trade war could reduce China’s economic growth by as much as 5%. Risk-averse investors, then, may want to avoid the country altogether until a resolution’s been reached.

China’s economy faces other threats too. The country’s infamous one-child policy – now defunct – means its population is growing old, fast. By 2050, the number of retired people for each Chinese worker is forecast to triple: there’ll be an estimated 48 retirees for every hundred workers. Compare that to Asia’s other big economy, India, where there’ll be just 22 retirees for each hundred workers. This demographic shift could sap China’s growth, with those who do work spending all their time and money looking after others.

And notably, China might have a debt problem brewing. Since the global financial crisis, the government has spent big on supporting the economy. That’s inflated China’s debt, which has more than doubled over the past 20 years. It’s now three times the size of its economy, and China’s going to have to pay that money back at some point. Sure, some economists think it’ll be fine to do just that: the going looks good for now, with the Chinese economy expected to grow more than 6% in 2020. But others argue it’s only going to be very tricky indeed if growth continues to slow. China could find itself in a vicious circle, where the debt it pays leaves less to spend on other projects, which could itself slow down growth. They’re also keen to point out that the country hasn’t had a major recession in more than 40 years – and that’s a winning streak that might come to an end at some point…

So now you know the people pulling the strings in the People’s Republic, and the dragons that might be hiding round the corners in the Red Dragon. So that just leaves you with a decision to make: will you be a bull in a China shop, or are you a bit Pooh Bearish about its future chances? Best not to tell Xi if you are...

In this Pack, you’ve learned:

🔹 China is forecast to become the world’s biggest economy – so it’s become impossible for smart, globally-minded investors to ignore

🔹 As the country’s modernized, its services sector has become dominant – particularly Chinese internet companies like Alibaba and Tencent

🔹 China’s made it easier for foreigners to invest in its markets, and more of its shares are being included in foreign indexes (though not as much as it’d like)

🔹 If you do want to buy shares, you can do it via an exchange-traded fund, a Hong Kong broker, a US listing, or an ADR🔹 If you do own Chinese shares, you’re at the mercy of the Chinese government – which can force you to sell them, or hurt companies it doesn’t like

🔹 But you’ll have a front-row seat to China’s growth, which is forecast to continue at around 6% a year – though it’s at risk from the trade war and an aging population.

Now test your knowledge with our quiz.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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