Commentary on Political Economy

Tuesday 5 March 2024

Foreign investors are right to view China as a ‘trade’


Mohamed El-Erian Mohamed El-Erian is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy · Mar 6, 2024


‘It’s a trade rather than an investment.” This is how a portfolio manager framed their purchase of Chinese equities on a recent Bloomberg show. It is consistent with a notable shift in the consensus view on foreign investments in China — from being a destination for long-term investments to more of a short-term speculative stop.

This framing aligns with a broader change in the Chinese economy. Once hailed for its repeated economic miracles that lifted hundreds of millions out of poverty, today it faces a perception of being on more shaky ground, at risk of succumbing to the dreaded middle-income trap — where countries struggle to transition from an economy where growth, typically, is heavily reliant on low costs and sizeable global demand.

Let’s start with the performance of the country’s stock market. After years of lacklustre overall performance, Chinese stocks have recently shown signs of a bounce. Since the start of February, the CSI 300 index is up about 11 per cent. That followed a long 44 per cent decline from 2021 highs.

However, despite the recent uptick in Chinese stocks, the interest of foreign investors seems predominantly tactical, more focused on quick profits than longterm investment opportunities.

At first glance, this shift seems preferable for China compared with the prior widespread characterisation in 2022-23 that its markets had become “uninvestable”. That perception stemmed from poor market performance, disappointing management of debt issues and heavy-handed market interventions by authorities in areas such as the technology sector that were sometimes hard to comprehend.

Yet this change in sentiment is too small to help China reduce what has become the clear and present danger of the “middle-income trap”. In that outcome, growth momentum dissipates, competitiveness erodes, financial robustness weakens and long-term foreign investments become even more elusive.

The main reason for these predicaments is that, over the past few years, many of China’s internal and external tailwinds have turned into headwinds. The current unfavourable alignment includes foreign direct investment at multi-decade lows and persistent outflows of portfolio funds, mounting domestic debt problems, growing economic insecurity among households, greater restrictions on Chinese businesses accessing foreign markets and technology and shaky real estate valuations.

This is being reflected in investor shifts beyond flows. The key benchmark for emerging market investors — the MSCI Emerging Markets index — has been heavily weighted towards China, meaning that every dollar managed passively would have an important part invested in China.

But MSCI’s EM index that excludes China, launched in 2017, is gaining increased attention recently from investors. The assets held by the iShares MSCI Emerging Markets ex-China ETF have risen to more than $10bn from just $120mn at the end of 2020. At the same time, the governing boards of a growing number of active institutional investors, including US pension funds, have mandated “ex-China” approaches.

Together, these developments seriously undermine the growth dynamism and financial status of China. They also heighten the costs for Beijing to pursue its non-economic objectives, from military build-up to exerting more influence in what is known as the Global South group of nations.

Also worrisome for China is that it would not take much for it to go from being threatened by the middle-income trap to ending up in it. Contributing factors could include additional domestic policy delays, worsening household confidence, a tightening of US trade and investment restrictions, reduced engagement from multinationals that still have large businesses in the country and more determined western efforts to counter China’s international influence.

China should find little solace in the recent performance of its stock market. These speculative “tourist flows” are not a leading indicator for more stable, long-term “resident flows”.

To attract the latter, the government needs three elements: decisive reform measures to facilitate critically-needed economic transitions, reduced tensions with the US and a shift away from the expensive expansion of international economic and financial influence.

In the interim, foreign investors are justified in regarding their ventures into Chinese stocks as short term.

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