(and by now I mean any time in the few years to the next several decades)
A lot has been made of the opportunity to manage China’s increasing wealth, which is estimated to grow from USD 27.8 trillion in 2018 to USD 49.6 trillion in 2023 while generating USD 15 billion in annual revenues for global asset managers [1]. But not only is this a great opportunity for the major asset managers of the world, it is a great chance for individual investors to piggy back on a historic shift of asset allocation and financial market structure as China sets about building a more efficient savings/investment system for its citizens.
Context
Let’s take a look at a chart which many of you have probably seen some variation of before, and borrow an observation from William Bernstein’s The Four Pillars of Investing:
Jeremy Siegel’s well-known work on historical stock market returns which shows that investing in the US stock market has generated excellent returns over the past couple hundred years and vastly outperformed other investments such as bonds and gold. As Bernstein points out, such analysis ignores “survivorship bias”, meaning that US market returns look great because that was the market which survived while many others failed. Bernstein:
The global investor in 1790 would have been hard pressed to pick out the United States as a success story. At its birth, our nation was a financial basket case. And its history over the next century hardly inspired confidence, with an unstable banking structure, rampant speculation, and the Civil War. The nineteenth century culminated in the near bankruptcy of the U.S. Treasury, which was narrowly averted only through the organizational talents of J.P. Morgan.
But the US didn’t collapse, and grew to be the world’s largest economy and sole global hegemon possessing the main reserve currency.
Now let’s look at the Shanghai stock exchange’s historical returns:
Actually it’s delivered a very respectable CAGR of 11.5% since the end of 1990, shortly after the market re-opened after a 50+ year hiatus (S&P 500 averaged 8% growth excluding dividends over the same period). But you may also notice that today’s price isn’t any higher than early 2007, and if you bought in in 2008 or 2015, you have suffered significant losses.
So the market hasn’t moved in 13 years, and as a consequence has developed a reputation as a casino for insider trading and unprofessional retail investors. Shanghai, Shenzhen and Hong Kong stock exchanges have a combined market cap of USD 16 trillion[2] compared to total market cap of all US stocks of USD 35.5 trillion[3]. Burned by this experience, most Chinese savers/investors turn to real estate and wealth management products as investment tools.
Apartments as Financial Assets
Survivorship bias aside, the US experience does show that equity investing can be a highly efficient and effective way for investors to allocate capital and generate long-term returns. Let us look at the currently most popular form of investment for China today, real estate. It’s concrete, can be lived in, limited in supply (China has roughly the same land area as US, but the vast majority of China’s enormous population is crammed into roughly 2/3rds of China’s territory) all of which make it very attractive compared to an opaque and intangible stock market. And considering the breathtaking growth in property prices over the past 15-20 years, this has been the right play. Eventually however, China will have to turn away from real estate and towards equities, and this shift will be aided by a number of catalysts, not the least of which is that it will be one of the Chinese government’s top priorities to make this happen.
Data from a Survey and Research Center for China Household Finance at Southwestern University of Finance and Economics as reference in an article in WSJ by James T. Areddy
As you can see, China household investment is overwhelmingly skewed towards real estate and underweight public equities compared to the United States. We will begin to see a shift in the not too distant future for several reasons.
First of all, China property price growth is unsustainable—there simply isn’t much more room to go up. In cities like Shanghai and Beijing, ratio of property price to income, depending on source, varies from very high to outrageously high (I’ve seen data showing anywhere from 15x to 35x depending on how the average apartment location and size is defined). Perhaps the most accurate way to reflect is to look at gross rental yields, which in my experience are about 1-2% (before taxes, maintenance and operating costs). Apartments in many major cities in China are out of reach of a majority of people, even as first homes let alone as investment assets. And considering how pitiful rental yields are, an illiquid investment such as a second apartment can’t meet the income generating needs of a retiree.
While many people cannot afford these apartments, there is a segment of Chinese society that does indeed own many apartments, and while the percentage may be small, the absolute number is still quite large compared to other countries. These individuals/families may own several properties, not uncommon to be paid for entirely in cash with no mortgage (minimum down payment in China is 35% for first-time owners, 70% for second time and 100% after that). When someone owns multiple million-dollar properties and has paid for them in cash, you can be pretty sure they didn’t pay for it with salary. And when someone comes into vast sums of money and the stock market isn’t a reliable option, that wealth is going into real estate. This creates a couple of problems.
Evolving Government Revenue Model, Tax Structure and Social Composition
Land sales have been an important source of revenue for China’s government. Overall, they represented about 29% of total government revenue in 2017. Land sales are even more important at the local government level, in 2018 amounting to RMB 6.5 trillion compared to RMB 9.8 trillion of tax and other revenue, equivalent to just under 40% of local government revenue[4]. But land supply is regulated in a quota system controlled by the central government and there is a national red line limit for minimum amount of arable land which must be maintained. The central government has made it increasingly difficult for local governments to get land quota. Considering the supply chain risks caused by recent trade tensions and COVID-19, greater emphasis may be placed on food security and maintaining healthy supply of arable land.
Land supply will continue to get tighter, putting pressure on government finances. Eventually—and this has yet to truly materialize despite years of discussion—there will be property tax for residential property (there already is for commercial property). When this happens, owning several apartments, all but one or two of which are either empty or rented but generating pathetic yields, suddenly seems a lot less attractive. In order to minimize disruption, this tax will probably be rolled out gradually and in phases, but that lost revenue will have to come from somewhere. The land underneath the buildings is actually never privately owned but on long-term 50-70 year land leases. In theory the government could just take it back. But for all practical purposes, those dwellings belong to their owners, and taking them back would virtually guarantee widespread chaos and perhaps a total collapse of society. So property taxes will eventually be implemented.
Furthermore, people who make millions of RMB in cash, sometimes legitimately and sometimes not, are likely not paying the proper amount of income taxes. Personal income taxes in China account for 7.5% of government revenue in 2018 compared to 40.7% in the US. During the unprecedented growth of the past 20 years, this has perhaps been overlooked by government because of more pressing initiatives, but that will change too. And considering that everyone uses Alipay and Wechat Pay for so many transactions, such income and investments will be easy to track. Not to mention the PBOC creating a digital currency to replace cash (in my opinion a completed underrated, under-discussed development worthy of much more coverage), the government will have incredible visibility into and policing capability of all financial activity. So the country shifts from a nation of entrepreneurs, both legitimate ones and some less so (private company or government employees who enrich themselves at the expense of their organizations—and there are games to be played by almost any one in any function) to a nation of salaried employees. And salaried employees don’t own five apartments, they have one in which they live…and a retirement account.
The Rise of a Professional Asset Management Industry
Finally, the make-up of China’s market will evolve, shifting from retail to institutional. As of this past April, foreign institutions can apply for a license to open 100% foreign-owned asset management businesses in China to manage money for domestic investors. As these companies come in they will increase the level of professionalism in the market and help educate individual investors on long-term investing based on fundamentals rather than short-term trading. At the same time, China’s state-owned pension funds, insurance companies and other financial institutions will continue to grow, also contributing to the discipline, stability and size of the market.
In order to attract and retain these investors, the government will work to improve market regulation, making it more transparent and efficient. Insider trading and lax corporate governance standards such as dilutive issuances and related party transactions should decrease. As the market regulation improves it will also get more sophisticated. In order to protect investors, the government requires companies to overcome many hurdles before they can IPO. As of late 2019 there were about 580 companies in China waiting to IPO. Earlier in 2019 the STAR Market was launched, giving companies a path to IPO with a shorter approval process and without the profitability requirement of the other exchanges. We can expect the government to continue to take steps to make China’s stock markets more attractive to both domestic and foreign investors.
Why the Challenges can be Overcome
What could go wrong? With total debt at over 300% of GDP, China is one of the most leveraged economies in the world, which could lead to Japan-style economic stagnation. The government’s turn away from market-driven policy back towards more state control in recent years could be another cause for concern. On the other end of the spectrum, what if China’s savers don’t shift from real estate to equities? The government has actually been trying to reign property prices in for the past few years, imagine how much higher they could go if the government decided to stop holding them back? I’m not saying this change will be immediate. There’s no way the government introduces property taxes in the middle of a pandemic and global economic crisis. It will take time for investor psychology to change. But…
China has proven capable to building those things deemed crucial to its society and economy, establishing a more-or-less market economy system for ownership of production of most goods and services, excellent infrastructure, and is in the process of building a better healthcare system. Bottom line, China’s government can’t do all things at once, but if something is a priority, they will get it done. A well-regulated, efficient stock market is an important pillar of a strong, stable, prosperous economy and society. The size and growth of China’s economy has attracted attention from people and companies around the world. It is a complex and highly competitive market that has meant great success for some and huge failure for many others. But foreign investors don’t need to worry about the intricacies of how to out-compete. They can rest assured knowing that this is something that China wants and will do for itself, and they can benefit by joining along for the ride.
[1] https://www.oliverwyman.com/content/dam/oliver-wyman/v2/publications/2019/November/china-reentry-for-globals_v6.pdf
[2] https://www.hkex.com.hk/Mutual-Market/Stock-Connect/Statistics/Hong-Kong-and-Mainland-Market-Highlights?sc_lang=en#select3=0&select2=9&select1=8 using exchange rates of HKD/USD 7.75 and CNY/USD 6.69 as of Oct 10, 2020
