By Mike Dolan
LONDON – Paradigm lost?
A long-held view among many investors that China’s currency and markets would one day sit at the centre of world finance to match the second biggest economy in the world looks bruised at best after a torrid 2021 and February’s geopolitical quake.
So many leftfield shocks have followed the COVID pandemic – still playing out with gusto in China amid draconian, growth-sapping lockdowns – that asset managers are being forced to look again and rethink long-term convictions.
The main debate among overseas funds on China is how much of the latest investment funk there is cyclical, COVID-related and merely a temporary reset of political priorities – or how much tears up the vision completely.
And for growing numbers of money managers, Russia’s invasion of Ukraine and the dramatic Western financial sanctions that followed has indeed changed the calculus completely.
Coming less than three weeks after Vladimir Putin and Xi Jinping’s Olympics summit cemented an alliance opposing Western power in the pursuit of a new world order, the invasion has fractured geopolitics as Beijing refused to condemn the attack on Ukraine or break ties with Moscow.
Sanctions risk, whether hypothetical in the event of any future military activity by China itself or by association with Russian economic entities, has ratcheted higher for investors.
And all this on top of China’s “common prosperity” drive in 2021, which saw serial crackdowns on the financing activities and profit motives of its digital, commodity trading and online education sectors.
A Chinese property sector bust and related debt workouts in the background merely added to the pressure and now “Zero Covid” lockdowns in Shanghai and elsewhere over the past month have seen 2022 Chinese growth forecasts slashed to 4% and below.
As overseas investors headed for the exits over the past two months, the painful underperformance of Chinese stocks for much of the past 5 years has resumed again in earnest and its main indices are between 20-30% below world benchmarks since 2017.
What’s more, the evaporation of the substantial yield premia on Chinese bonds over U.S. Treasuries – due largely to the hawkish Federal Reserve reaction to the latest energy price shock – has also seen investors flee once-prized fixed income market there too.
And to complete the trinity, a sudden 4%-plus slide in the yuan’s offshore rate against the dollar in April was the biggest monthly move in 12 years – likely resulted from those outflows and was virtually unopposed by the authorities.
“To my mind, this is just the start of it,” said Yves Bonzon, Chief Investment Officer at Swiss asset manager Julius Baer, adding the yuan could weaken another 5% quite quickly.
Graphic: Yuan and China Yield Premium – https://fingfx.thomsonreuters.com/gfx/mkt/akvezynmdpr/Two.PNG
Graphic: Foreign funds exit Chinese bonds – https://fingfx.thomsonreuters.com/gfx/mkt/lgvdwgxokpo/Four.PNG
Graphic: China stocks underperforming for 5 years – https://fingfx.thomsonreuters.com/gfx/mkt/dwvkryjzzpm/Five.PNG
TWICE IN A LIFETIME
Aside from that tactical market call, Bonzon is one of those who thinks the world has changed and the Ukraine invasion meant that a geopolitical consideration in cross-border investments was now essential for the first time since the Berlin Wall fell 40 years ago.
February’s invasion was “one of the two most important inflection points in my career,” he said.
Practically, Julius Baer’s first change to its long-term strategic asset allocation was to remove Chinese equity as a stand-alone “core” investment altogether – reducing direct Chinese equity investment to zero and lumping that exposure into wider Asia benchmarks instead.
China may not be “uninvestable”, it said, but from now on that would be only on a tactical or thematic basis.
“Investor capital is at risk not only of de-rating due to increased regulation by the Chinese government but also of impairment as a consequence of Western sanctions should diplomatic relations turn sour.”
The view may not yet be consensus.
Other asset managers feel this is too will pass and politics, markets and investment theses can change very quickly.
Fidelity’s Asia multi-asset head Matt Quaife argued this week that while the next few months would be very difficult for Chinese markets there were some the eye-watering valuation gaps between certain tech companies there and Western equivalents and peak fear may offer opportunities in the medium term.
But at the heart of all the investor squeamishness is a growing lack confidence in the political parameters around investing in China at large, damaging the whole premise of internationalisation of the yuan as a future store of value or reserve currency.
PIMCO strategist Gene Frieda reckons the fallout from the move to freeze Russia’s foreign currency reserves actually clouded greater use of the yuan rather than enhance it – as some argued over recent months.
“Sanctions risk to China and indeed China’s increasingly conservative economic policies work against the yuan’s rise as a reserve currency,” Frieda wrote. “The lesson from Russia is that sanctions on FX reserves can be potent, effectively forcing currency non-convertibility on the country.”
“The share of the yuan’s weight in global reserves, while still set to rise, will likely be capped in mid-single digits.”
Graphic: Real Effective Exchange Rates – https://fingfx.thomsonreuters.com/gfx/mkt/zgpomljkopd/One.PNG
Graphic: Yuan share of world FX reserves – https://fingfx.thomsonreuters.com/gfx/mkt/byvrjnxqove/Three.PNG
The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own
(by Mike Dolan, Twitter: @reutersMikeD; editing by David Evans)
