Taking Stock: China – the emergence of political risk for the investor?

In November, the strong rally on Chinese stock markets paused as demonstrations spread throughout Chinese cities in response to an apartment block fire that caused ten deaths. Protestors claim that the apartment doors were locked as part of Covid-19 lockdown restrictions.

Demonstrators are calling for an end to testing and travel restrictions. Some call for political freedoms, an end to censorship, and the resignation of President Xi Jinping.

The Shanghai Composite Index fell just under 1% on Monday, was up just over 2% at close on Tuesday and is still up over 5% this month.

In this commentary, we discuss the reliance on Chinese stocks in light of the demonstrations. We conclude that the Chinese Communist Party is caught in a trap of its own making and that social and political instability may need to be considered by investors when investing in China.

Demonstrations demanding easing lockdown restrictions may be replaced by demonstrations over large Covid-19 infections and deaths in the absence of world-class vaccines and the widespread inoculation of the elderly.

The origin of the rally

Chinese stock market indices, whether the shares traded in Hong Kong (mainland companies’ shares listed in the territory) or the benchmark SZCE Shanghai Composite, had a torrid year until November. They had underperformed all other major developed and emerging market indices and were down by approximately a third.

The underperformance was driven by a combination of weakening economic growth, fear of a meltdown in the property sector and rising tensions with the U.S. that have led to talk of ‘deglobalisation’. A significant factor behind the first theme, weakening economic growth, has been the draconian approach taken by the government to contain the spread of Covid-19.

But the global stock market rally this month, driven by talk of decelerating U.S. interest rate hikes, led to a substantial outperformance from Chinese stocks. They were helped by weeks of rumours of an imminent easing of Covid-19 restrictions on movement (before the current outbreak). The central bank has been easing monetary policy, cutting interest rates in August, and the government has pledged support for banks exposed to property loans.

But the hope of an imminent easing of lockdown restrictions has gone into reverse after fresh Covid-19 outbreaks. Quite suddenly, according to official sources, Covid-19 infections are now at record levels (40,000 plus) and climbing.

The CCP is caught in a trap of its own making

Frustration at the harsh lockdown laws has triggered occasional demonstrations before. Still, the public broadly accepted that it was the price to pay for a relatively low number of infections and deaths compared to other countries.

But riots last week at the Apple manufacturing plant in Zhengzhou and the current wave of demonstrations triggered by the apartment block fire suggest that public acceptance of restrictions is wearing thin. Protestors increasingly demand political freedoms and an easing of Covid-19 restrictions.

The problem for President Xi Jinping, who is closely associated with the lockdown policy, is that the country’s healthcare system is not equipped to cope with a large increase in infections should lockdown restrictions be lifted. The domestic-made Covid-19 vaccine offers less protection than the western versions, and many elderly Chinese have not been vaccinated.

The Chinese Communist Party (CCP) is caught in a trap: criticised for being over-bearing on people’s freedoms in the name of Covid-19 but unable to ease restrictions on movement for fear of being blamed for what will undoubtedly be a steep rise in infections and deaths.

A new bargain with the public?

Dictatorships can buy time by providing ‘bread and circuses’ (i.e., economic growth) and by meeting the protestor’s demands. The concessions can, of course, be revoked at a later date.

Beijing may decide to boost public spending (the bread and circuses) and simultaneously ease lockdown restrictions in return for an end to demonstrations. It will clarify the consequences of any easing of restrictions to deflect blame.
Such a policy would support economic growth and indicate a willingness to listen to the public.

But it would be an acknowledgement that the current policy has failed; it will highlight the relative weakness of Chinese vaccines (which the CCP has hailed as a triumph of Chinese science) and the poor state of public healthcare outside of the large cities.

Furthermore, Beijing will never be sure that the public has bought into the new bargain and will accept a rise in Covid deaths in return for greater freedom of movement. And it may continue calls for an end to censorship and a change of political leadership.

Investors may be about to see a more pro-growth Covid-19 strategy emerge from Beijing, but with it, the rising risk of social and political instability. Dictatorships are always more fragile than outside observers believe them to be.

Disclosures:

1. No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision. 
2. Investment Risks: There are risks associated with investing in securities and past performance is not indicative of future results.  Always seek professional advice before investing. 
3. Not Legal/Tax Advice: This financial commentary is not intended to be, and should not be construed as, legal, regulatory, tax, or accounting advice. Always seek professional advice and consult with your legal counsel, tax and accounting advisors when contemplating any course of action.