China’s recent regulatory crackdown and the consequent impact on its financial markets have caught the attention of worldwide media and investors. (A recent post by my colleague Peter Roberto explores the regulatory backdrop.) Given the current environment, I’ve been receiving numerous questions asking if now is the time to double down on Chinese equities. Potential investors are wondering if the recent bounce in some of the hardest-hit stocks could be a sustained run. My belief is that, over the shorter term, headline risks remain elevated for Chinese equities. In the long term, continued economic growth in China may present attractive opportunities for value creation. To avoid potential landmines, however, active management is critical.

From Growth to Sustainable Growth

China packed a century and a half of GDP growth into a short span of about 30 years. In 1990, China accounted for 1.27 percent of global GDP. In 2020, this number had risen to 18.34 percent. According to the World Bank, in 2013, China surpassed the U.S. to become the world’s largest economy in terms of purchasing-power parity. The speed and scale of this rise led China to several excesses and an inequitable distribution of economic growth. As a result, the impetus for Chinese Communist Party policy has shifted away from pulling millions of people out of poverty through rapid economic growth to a new focus on “common prosperity” through sustainable, balanced growth. The flurry of new regulations reflects the recalibration of the party’s economic agenda.

Similar Goals, Different Approaches

The regulatory paradigm in China has emerged from goals that are not too dissimilar from what governments in the developed world are endlessly debating. For example, China’s new regulations focus on preventing monopolistic behavior and encouraging competition, data privacy, and security. They are also designed to provide the masses with access to affordable, quality housing, education, and health care. The difference in China’s approach is that its authoritarian government was able to act unilaterally to implement legislation without any transparent political or public parsing process.

Lack of Transparency, Higher Risk Premium

While different industries have been at the epicenter of the regulatory clampdown at different times, China’s overarching goal is to check the rise in corporate power and rebalance its economy toward consumption. The desired effect is to raise the share of wages and reduce the share of corporate profits in the country’s GDP. But the impact across sectors and industries will be far-reaching and differentiated. Despite high rates of GDP growth, corporate profitability in the aggregate could face headwinds. The lack of transparency into profitability, as well as the potential for additional regulatory moves, will make investors assign a higher risk premium to Chinese equities. Consequently, Chinese equities could trade at a higher discount to the rest of the emerging markets universe.

Wide Divergence in Performance

The MSCI China Index has declined 11 percent year-to-date. The shares of Chinese companies that have been in the crosshairs of the regulators have seen much steeper declines. Shares of Alibaba, for instance, have dropped about 26 percent, and those of TAL Education Group have tanked an eye-popping 93 percent. The new regulations will affect the future profitability of these companies. In addition, in the case of TAL Education, they will make the company’s business model defunct. Not all companies and industries are bleeding equally, however. Industries that support the government’s agenda and priorities have been quite resilient to the effects of the regulatory crackdown. This includes companies in high-tech manufacturing, renewable energy, autonomous driving, 5G technology, and semiconductor chip manufacturing.

Should Foreign Investors in Chinese Equities Make a Paradigm Shift?

The answer is yes and no. What worked in the past may not work in the future. What works in other parts of the world may not work in China. As in the U.S., the broad Chinese indices have had a greater weight in technology stocks, causing them to suffer from the same top-heavy malaise. Given the recent regulatory reset and the ongoing efforts of the government, however, the sector breakdown of the Chinese indices could change. The equity returns of the current behemoths may be tempered. The growing Chinese middle class will be the consistent theme, but the way to invest in this theme will be defined by the government’s actions.

On the other hand, the recent events underline the political and regulatory risk of investing in China. Although this risk appears accentuated, it is not different from the past. If anything, regulatory action has not kept pace with the Wild West growth seen in certain industries, but this fact does not make the near-term disruption less painful. In the longer term, if regulation evolves, becoming more consistent, well understood, and properly implemented, it could lower the risk of investing in previously unregulated industries.

Is It Time to Jump into Chinese Equities?

China is the elephant in the room with a $15 trillion economy and a population of 1.4 billion. Several of its large companies are credible global competitors now trading at very attractive relative valuations. Many babies got thrown out with the bathwater recently, and these companies may present enticing entry points. As a result, the opportunities are tempting.

But investors should take care. Chinese equities need to be approached with caution, and investors’ return expectations need to be moderated. China’s economy was already slowing after the strong recovery from the COVID-19 crash. The spread of the Delta variant has been weighing on economic activity. And now the regulatory crackdown has reduced visibility into the fundamental attractiveness of certain businesses.

Ultimately, the dust will settle, and investors will realize that some of this regulation was long overdue. Investors will need to add regulatory risk assessment as a critical element in their fundamental analysis toolkit for Chinese equities. Passive strategies are not built to incorporate this close analysis. Therefore, investors may want to consider an active management approach to investing in China, as well as in the broader emerging markets.

The MSCI China Index is a free float-adjusted market capitalization-weighted index designed to measure the performance of equity securities in the top 85 percent or market capitalization of the Chinese equity securities markets as represented by H shares and B shares.