Chinese investment markets reveal their biggest tails

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I am truly shocked to see the events unfold in the Chinese investment markets.

Throughout the year, the Chinese Communist Party (CCP) has steadily restricted the freedoms of its citizens, driving down the stock prices of some of the world’s largest companies. While this power not so bare struggle between economic and political factions is as old as modern societies, it is no less tragic. This rings especially true for the Chinese population. The gradual increase in their standard of living and political freedoms now seems about to be reversed. Unfortunately for investors, the CCP’s consolidation of power reveals that the country remains much more centralized than believed. Consequently, it is more dangerous and costly, which bodes ill for portfolios and global growth.

Repressions and crack-ups

It’s been a crazy year for investors in China. First, the CCP suppressed Chinese technology companies. What started with a dismantling of alibaba of jack ma, spread to other companies and sectors. Under the guise of cleaning up anti-competitive practices, the CCP wields its influence over some of the world’s largest corporations, imposing crippling fines and threatening to dismantle them. Stock values ​​plunged in response.

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The prices of many top Chinese tech stocks have fallen dramatically this year. Source: Koyfin

More recently, real estate developer China Evergrande Group (Evergrande) made headlines. Heavily in debt, he is on the verge of default. Evergrande’s staggering level of debt worries the systemic consequences, especially as it’s not alone. Here too, change government policies catalyzed concerns. New “three red linesThe policy prevents property developers from refinancing their debt, a common practice many have built their business on. With few other options, liquidations seem likely, as evidenced by stock prices.

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Share prices of Chinese property developers have also fallen recently. Source: Koyfin

Centralization points the tip of its nose

In my view, these are not unrelated events. Rather, they reflect the growing centralization of China’s political economy. Government control increases. Although still present, there has been a clear shift in political leaning away from the (relatively) decentralized liberalism of Deng Xiaoping’s reforms that fueled China’s growth. “China has entered a new stage of developmentand worrying at that.

It bears repeating that most major economies today are mixed economies. They are neither completely decentralized, laissez-faire capitalist nor entirely controlled by centralized state control. Rather, everyone – from the capitalist United States of America to socialist Cuba – exists on a spectrum of political-economic freedom. However, it is no coincidence that the greater a country’s economic freedom, the more prosperous its citizens. Freedom creates decentralization.

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Countries with greater economic freedom have significantly higher per capita income and prosperity. Source: Fraser Institute

The government is a centralizing force. Policies limit the scope of possible behaviors to the few permitted behaviors. Ultimately, this centralization breeds instability by concentrating risks and creating points of systemic weakness. For example, bank capital regulation was a major cause of the Great Financial Crisis in 2008. They “pushed” financial institutions into similar trades that ended up deteriorating in tandem. Similarly, subsidization of favored domestic industries, such as oil production, ties economic fortunes to volatility in commodity markets. It can wreak havoc like in the 1998 Russian financial crisis.

China’s various policy shifts are doing just that, but in their preferred ways. The CCP dictates “appropriate” debt parameters for banks, removing those decisions from lenders. This is to decide on how many platforms merchants can sell goods on, tweak app functionality, criticize pricing tactics, control content, etc. As in other cases, the forced homogenization of business practices will eliminate diversity, dynamism and, ultimately, economic health. Therefore, Beijing’s centralizing economic interventions are of concern.

The big tails of centralization

In terms of investing, I consider the tails of China’s return distribution to be fattening. The business environment is changing. The possible gain and loss scenarios for Chinese companies are now likely wider than expected. Connected businesses and favored industries have likely grown beyond what would have been possible in a freer and more competitive market. The recent withdrawal of CCP support – and even outright hostility – is creating more dramatic and frequent negative scenarios, as we are seeing now. No longer protected, the risk of ruin increased dramatically and suddenly.

These thicker tails speak to important investment implications. They reflect a higher return uncertainty. Changing political landscapes significantly weaken confidence and increase the rates of return demanded of investors. This results in lower stock market valuations and higher bond yields and spreads. Simply put, investors will demand more compensation for the greater risk.

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Investment distributions with larger tails have greater probabilities of events producing large gains and losses. Source: Live Cable

Compare that with a more liberal economy. Laws and regulations are more difficult to change when legislative majorities and judicial approvals are required. The rules change less frequently and dramatically. This greater decentralization of power gives participants more leeway to act on their own judgments, which reduces concentrations of economic risk.

Thus, investors can be more certain of the investment risks they are underwriting. The distributions of expected returns have finer tails. Required rates of return are lower, equity valuations higher, and bond yields and spreads lower. As a result, investments in economically freer developed markets trade at a premium to those in similar emerging markets.

Decentralized systems are the cheapest and therefore the most productive

In other words, decentralization reduces the cost of economic capital. Capital is more than money. These are (all) the people, plants, equipment and technology essential to production.

Thus, lower capital costs—or more productive capital—result in higher output. The abundance of capital enjoyed today (historically speaking) is not accidental. It is another manifestation of the prosperity created by free markets and political liberalism.

Chinese investments are re-evaluated downwards in the context of increasing centralization

In my view, the recent declines in China’s investment market reflect its growing centralization. Investors simply underestimated how important tails in the distribution of returns are for many Chinese companies. They were not sufficiently suspicious of the CCP’s economic controls and are now suffering the consequences.

Rather, the Chinese government explicitly asserts its influence over large swaths of the political economy. the early Hong Kong takeover, the escalation of hostilities in Taiwan, the dissolution of major tech companies and changing rules for property developers are all examples of Beijing’s shift in policy direction. No longer favorable to Western capitalism and liberalism, this new tactic is, in my opinion, more dangerous for investors. The longer and deeper China’s centralization, the more I expect Chinese investment to re-evaluate.

The sad lesson I hope I’ve learned

Investment markets are reacting to the drastic change in China’s political and economic environment. The increase in CCP dissolutions, investigations, interventions, and rule changes surprised many. These seem to be linked to other geopolitical behaviors as well.

There are many lenses through which the situation can be viewed. From an investment perspective, I prefer to apply a centralization/decentralization framework. Beijing appears to centralize political and economic power, which should lead to greater economic fragility, lower productivity and reduced prosperity. It is truly sad to see the CCP reverse its decades-long course that has lifted hundreds of millions of people out of poverty.

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Millions of people escaped extreme poverty when China liberalized its political economy. Source: BBC

It is no coincidence that freer economies are more prosperous. Freedom increases decentralization, which reduces risk concentrations and lowers the cost of capital. These favorable conditions enhance productivity and wealth creation.

Opportunities in Chinese investment markets remain uncertain. Fortunately, you don’t have to be a political expert to assess a country’s economic direction. Following the framework discussed here may suffice.

China’s current centralizing course is tragic. It plays in real time for everyone to see. Hopefully other countries will take notice and reverse theirs to more decentralized and freer market avenues.

About the Author

Seth Levine is a professional institutional investor focused on selecting high yield bond positions for a financial services company. He is also the creator of The Integrating Investor where he blogs on topics related to macroeconomic and investment strategy. Seth holds a Bachelor of Science in Mechanical Engineering from Cornell University and is a CFA charterholder. You can learn more about Seth at www.integratinginvestor.com and follow him on Twitter at @SethLevine2. Please note that all views and opinions he expresses are solely his own and do not reflect those of his current or former employers.

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