There is something amiss in China

We are often asked if we invest on the Chinese Mainland. The answer is a categorical “No”. To understand why, keep reading.

There is something amiss in China. We don’t proclaim to understand exactly what is happening domestically, yet we observe the political and economic landscape continually.

Here are a few of those observations:

  • In August, following the onset of the collapse of Chinese equities, Wang Xiaolu, a financial journalist for Caijing, was arrested for reporting in July that the Chinese government planned to stop propping up the stock market. Wang was then forced to confess on national television that he had brought “great losses to the nation and investors.”
  • Also in August, eight executives and board members of Citic Securities, China’s largest investment bank, were taken into custody as part of an alleged insider trading probe. By September, the general manager and two other executives from Citic Securities, China’s largest investment bank, had been arrested.
  • This brought the total number of those arrested or questioned by the Mainland’s authorities in relation to China’s stock market collapse to 197 as at August 31.
  • In November, Zhang Jianwei, a senior executive at China National Offshore Oil Corporation (CNOOC), the country’s third-largest state owned oil firm, was found dead in his Beijing office. This follows the death of seven government officials over a two week period in the same month. The cause of death for these officials was reportedly “unnatural.”
  • In December, Chinese billionaire, Guo Guangchang, chairman of Fosun Group and commonly known as China’s Warren Buffett, went missing forcing the suspension of Fosun’s stock. About a full week later, Guo reappeared at a company meeting. No one really knows where Guo went and the company simply said he was assisting authorities with certain investigations.
  • Also in December, prominent human rights lawyer, Pu Zhiqiang, was handed a three year suspended prison term by a Chinese court. He was found guilty of crimes including “inciting ethnic hatred” based on eight postings on Weibo (the Chinese version of Twitter).
  • Finally, in recent days, billionaire Zhou Chengjian, chairman of Chinese fashion firm, Metersbonwe, disappeared. No one knows where he is or when we will reappear.

Screen Shot 2016-01-12 at 1.02.26 PMThere is a clear consolidation of power taking place in China. President Xi’s corruption crackdown is real. Or at least the “crackdown” part is anyway. And the propensity to blame individuals for market movements in stock prices – not to mention closing the stock markets altogether on certain days – suggests to us that China is far from a market-based economy.

As we enter 2016 and at the writing of this note, the Shanghai Stock Exchange Composite Index is down by 10% since year-end; and the Chinese currency continues its depreciation as capital tries to flee the country. With government officials allegedly committing suicide and senior businessmen randomly disappearing, something is clearly amiss on the Chinese Mainland.

In closing, I recommend taking the time to read the following opinion by renowned Chinese observer, Bill Bishop. He paints an unsettling picture of internal dysfunction and what appears to be a power-grab by China’s President, Xi Jinping. 

As I am sending the newsletter the Chinese markets have opened up and the RMB fixing was set slightly higher. Crisis averted? I doubt it so long as Xi has made it so clear politics are back in command.

China’s new stock market circuit breaker mechanism is so poorly designed that the stock markets have closed early on two of the first four trading days of 2016. China’s markets have been volatile and dysfunctional for a long time but this week has seen a whole new level of craziness.

The widely held belief in the competence of Chinese policymakers came under pressure last year after the disastrous policies to first blow a stock market bubble and then try to stop the crash, followed by the poorly communicated and hugely expensive adjustment of the RMB fixing process. Investors though have short memories when greed is involved, and there was a modicum of confidence reappearing at least around the stock market by the end of 2015.

Now that confidence has been totally destroyed by the boneheaded design and implementation of the circuit breaker mechanism. Even if policymakers now modify or remove that mechanism they have dug themselves such a deep credibility hole, domestically and overseas, that even in as populous a country as China there may be a shortage of suckers for stocks.

Why do the policymakers keep making such stupid mistakes? Were they never that competent but just looked smart because there was so much low hanging fruit? Is China’s economy such a mess now that they have no good options left? Or has the policy-making process broken down under the centralization of decision-making under Xi Jinping, the diversion of attention to ideological work with shades of “better red than expert” amidst a cadre cultural revolution, the exodus of experienced financial regulators to both better opportunities in China’s financial sector and interrogations in padded cells, as well as the suffocating pressure of Wang Qishan’s Central Commission for Discipline Inspection (CCDI) inspection teams that justifiably went into all the financial regulators and top financial firms after the stock market crash?

The Chinese government desperately needs to restore confidence. Capital outflows have increased dramatically, good luck finding anyone in China who isn’t looking at their finances now with the expectation of RMB devaluation, and even diehard stock market boosters are having a hard time crafting coherent justifications that are convincing to even the greatest of fools.

So what can Beijing do? Expect the taking of a symbolic scalp, likely that of Xiao Gang, chairman of the China Securities Regulatory Commission (CSRC), along with the embarrassing removal of the new stock market circuit-breaker. Perhaps Fang Xinghai, recently installed at the CSRC but still double-hatted with his position on the Central Leading Group for Financial and Economic Affairs, would be a good choice, but even those moves would be more symbolic than substantive.

Will Xi see this mess as a political opportunity to be used to his advantage, especially now that we are well into the jockeying for the 19th Party Congress expected in late 2017, or will this mess be used against Xi? Premier Li Keqiang is at least titularly responsible for the economy, and there has been speculation growing for months that he will be gone at the 19th Party Congress. Perhaps he needs to go before then, to be replaced by Wang Qishan. I know, highly unlikely, but markets would probably love that move, both because Wang understands finance and economics and because such a reshuffling might spur hope that the corruption and discipline crackdown would ease.

I would not bet on such a move, and so long as Xi is making it clear that politics, not markets, are in command (政治挂帅), the odds increase that the upcoming Year of the Monkey will turn out to be the Year of the Bear.

-Bill Bishop

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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