An active investor’s perspective

China has always been a difficult market to access and navigate, but with enough time and effort it was eventually possible to overcome the main challenges. However, over the last five years, and particularly in 2022, the situation has changed. For many, the risks now outweigh the opportunities. Many are leaving, and those remaining are also rethinking their future: do we stick it out, or is it time to go? Gerard van Swieten, Nick Laursen and Max Bagger of Laursen van Swieten look at this question from an investor’s perspective.

How to value staying in China?

Investors generally calculate the value of an investment based on:

• Cost: This is the cost of investing or staying (such as living or operational costs).  
• Projected return: These are expected future cash inflows or saving rates. 
• Opportunity cost: What returns do investments / jobs with similar levels of risk offer?

China has seen a long period of (relatively) low costs and high growth. This made most investment valuations look good – perhaps too good. It is therefore essential to revisit investment valuations frequently and reassess the risk and projections.

Let’s revisit the outlook for the next five years as of July 2022.

Risk factors of investing/staying

The current systemic risks faced when having a business or investment in China are:

1. Increased uncertainty fuelled by geopolitical tensions. Despite Beijing staying predominately neutral on the Russian invasion of Ukraine, China’s relations with the European Union and United States (US) have worsened and are unlikely to improve soon. The situation has been aggravated by increasing concerns about Chinese military action regarding Taiwan. For business, the increasing frictions in relations between China and ’the West’ mean more security measures, more protectionism towards key technologies and industries, more trade measures against China, more Chinese focus on self-reliance and an increasing decoupling of supply chains on both sides. 
2. More workforce challenges. This is a complex matter. China has a large population but a declining workforce. Wages are rising, but are growing faster than productivity. The birthrate is low, and people retire at an average age of 54.[1] There are shortages of skilled labour and simultaneously relatively high urban youth unemployment (18.2 per cent),[2] as college graduates want different jobs to what is on offer. This factors combined makes it challenging for a business to get the human resources they need at an acceptable price.
3. More infrastructure, real estate, state-owned enterprises (SOEs) and government activity. The real estate sector, in broad terms, makes up about 30 per cent of China’s gross domestic product (GDP), of which infrastructure accounts for about seven per cent.[3] This level of infrastructure expenditure is high when compared with the US, which is roughly 2.4 per cent.[4] SOEs make up around 30 per cent of China’s GDP, far exceeding the share in developed countries.[5] This trend continues as China takes extensive public measures to support its economy, showcased by its new US dollar (USD) 75 billion infrastructure fund.[6] The problem with so much money locked up in fixed assets and the state sector is that it inevitably leads to low-performing assets and takes funds away from other investments, such as the education system or supporting small and medium-sized enterprise growth.
4. More default risk and credit tightening. Many companies in China (Chinese and multinationals alike) must wait a long time for payments upon the sale of products and services. As a result, they often delay payments to suppliers/vendors, who, in turn, do the same thing. Few companies sue their customer unless as a last resort. In addition, access to bank financing for working capital is often difficult to obtain, unless with mortgage security or strong government support. This risk of longer delays and more defaults will likely continue as China is working to restructure, manage and reduce debt reliance of local governments, corporations and households.
   
   Despite these efforts, domestic debt is projected to increase further in 2022.[7] The majority of this debt is state-owned, which many experts believe makes it manageable, but considering that, as of mid-2022, banking assets were measured to be 218 per cent of GDP, managing such amounts will be an arduous task.[8] The Chinese bond market has further seen high outflows of foreign capital earlier this year, which may take some time to return given the Evergrande default on foreign bondholders and current geopolitical tensions.[9] This credit tightening is necessary, but it reduces economic growth.
5. More government direction and control in the economy. Government control and direction of the economy have always been significant in China, but seems to have expanded further over the last 10 years. The ‘tech crackdown’ of 2021 reminded everyone that every sector is under the control of the government. In 2022, the COVID lockdowns further showed the extent to which China will enforce national objectives. At the same time, there is more state-guided development and funding of high-technology research and development (R&D). This highly active role of the state in the economy means strong support for R&D in specific fields, but also carries the risk of over-reliance on government support, technological blank spaces, and a lack of technological exchange with other countries. The Chinese leadership has been pragmatic and able to adjust where needed, but there is a risk that this flexibility may be decreasing. 

In summary, these risks paint a challenging picture, but great challenges often come with great opportunities. After all, the Chinese word ‘crisis’ (危机) is made up of the characters for ‘danger’ (危险) and ‘opportunity’ (机会).

Earnings potential of investing/staying

Aside from continuing a profitable operation in China (if that is the case), the benefits of staying include the following:

• China will maintain growth and development against all odds, even if the rest of the world slides into recession, as it did in 2008. The Chinese Government and people have a unique ability to keep moving forward despite significant challenges. As mentioned, many of the current problems are not new and have been successfully managed in earlier years. One way or another, COVID-19 will be dealt with as well. 
• National, regional and municipal governments will offer unprecedented incentives to those companies, technologies and individuals wanted for local development plans. This support will continue and likely expand as more companies and people leave. 
• Access to certain sectors will increase for the foreign companies still willing to invest and expand in China. This access will come with widespread government support, especially for large-scale projects. 
• The government will instruct Chinese energy companies to keep energy prices within a manageable bandwidth (as they have been doing) to avoid inflation and stimulate production and exports. 
• As other competitors leave or deprioritise China, more market access and share become available to those who stay and those who decide to enter the market. 
• In time, employee wages, interests and expectations will adjust to the market.

Trust and confidence

The above factors are important, but not exhaustive or determining. Case-specific factors (such as company, management, industry, technology) generally play a greater role. The most critical factors are, however, trust and confidence. If this is missing, there is no basis for any investment. Concerning‘staying in China’ investment, this is perhaps the most significant change in recent years. The lockdowns and geopolitical developments have deeply affected the personal connection that many foreign nationals/investors/entrepreneurs had with China. Trust can be restored, but it will require a clear positive outreach from China. Whether that happens remains to be seen.   

Laursen van Swieten (LvS) is an expansion-focussed active investor. LvS helps technology companies achieve and maintain global leadership through: 

• Active support for cross-border expansion, growth, and turnaround;
• Investment coupled with active management and access;
• Extensive experience and access in Asia and Europe.

Our team moves companies through challenges that require a thorough understanding of local circumstances and global markets. We back the next generation of global champions with hands-on support, target execution, domain expertise and investment.

[1] At 54, China’s average retirement age is too low, The Economist, 24^th June 2021, viewed 19^th July 2022,  <https://www.economist.com/china/2021/06/22/chinas-average-retirement-age-is-ridiculously-low-54>

[2] Lemaître, Frédéric, China is no longer attractive to foreign companies, Le Monde, 21^st May 2022, viewed 19^th July 2022, <https://www.lemonde.fr/en/international/article/2022/05/21/china-is-no-longer-attractive-to-foreign-companies_5984212_4.html>

[3] Pinheiro de Matos, Luís,. China’s real estate sector: size does matter, CaixaBank Research, 17^th January 2022, viewed 19^th July 2022, <https://www.caixabankresearch.com/en/sector-analysis/real-estate/chinas-real-estate-sector-size-does-matter>

[4] How Does US Infrastructure Spending Compare Internationally? BRINK, 27^th June 2021, viewed 19^th July 2021, <https://www.brinknews.com/quick-take/how-does-us-infrastructure-compare-internationally/>

[5] Chan, Bernard, China’s much-maligned SOEs should be seen more as social enterprises, South China Morning Post, 30^th July 2021, viewed 19^th July 2022, <https://www.scmp.com/comment/opinion/article/3143004/chinas-much-maligned-soes-should-be-seen-more-social-enterprises>

[6] Hou, Xiangming, and Yao, Kevin, Exclusive: China plans $75 billion infrastructure fund to revive economy, Reuters, 5^th July 2022, viewed 19^th July 2022, <https://www.reuters.com/world/china/exclusive-china-set-up-infrastructure-fund-worth-75-bln-revive-economy-sources-2022-07-05/>

[7] China’s Debt to Climb to Record in 2022, Government Adviser Says, Bloomberg, 6^th July 2022, viewed 19^th July 2022, <https://www.bloomberg.com/news/articles/2022-07-06/china-s-debt-to-climb-to-record-in-2022-government-adviser-says#xj4y7vzkg

[8] China: Bank assets to GDP, Global Economy, viewed 19^th July 2022, <https://www.theglobaleconomy.com/China/bank_assets_GDP/>

[9] China Opens Exchange Bond Markets to Overseas Investors, Bloomberg, 27^th May 2022, viewed 19^th July 2022, <https://www.bloomberg.com/news/articles/2022-05-27/china-opens-exchange-bond-markets-to-overseas-investors>