Perhaps no investment opportunity has captured the imagination of investors more than China in recent years. China's gross domestic product (GDP) has grown at an average annual rate of nearly 10% since 1978, according to the World Bank. The country is home to approximately 17.72% of the world's population as of March 2024.
As China continues to drive global economic growth, problems are inevitable. The trade war between the United States and China has brought some uncertainty to the future of both countries. The World Bank says China needs to make major changes if it is to achieve long-term sustainable growth.
Before investing in China, investors should consider the pitfalls, understand the risks and rewards, focus on shareholder-friendly companies, and stick to investments they understand.
Important points
- China's urbanization is expected to continue beyond 2030, resulting in impressive economic growth.
- Risks associated with investing in China include its communist structure, regulatory differences, and insider trading.
- Investment opportunities in China include U.S. companies based in China, mutual funds, ETFs, and more.
China and urbanization
Urbanization alone has led to China's impressive economic growth, and the country will continue to urbanize. It took 30 years of economic reform for China's population to move from rural to urban areas, and China's urbanization is expected to take another 20 years or more.
Many things have to happen as people move from an agricultural lifestyle to an urbanized lifestyle. Cities need to be developed and built, which requires growth in infrastructure, commerce, and other services.
The economy changes when individuals stop working simply to sustain themselves and instead begin to specialize. That specialization requires more education, and educated societies are usually wealthier societies. As per capita wealth increases, so does the quality of life. During this process, businesses begin to sprout, many of which generate significant wealth for their shareholders.
China just a few years ago is often compared to America just before the industrial revolution. Other than some basic differences between the two, this is a pretty accurate comparison. Growth in the 21st century will likely be China's, just as 20th century growth was America's. This growth is likely to generate trillions of dollars of economic output in the near future, which is why many continue to consider investment opportunities in China.
$18.53 billion
Estimated GDP of China in 2023 by International Monetary Fund.
Understand risk and reward
To make the most of an investment in China and its associated rewards, a prudent investor must have a clear understanding of the risks involved. A detailed analysis of all the potential risks of investing in China is far beyond the scope of this article, but understanding the basic layout will give you a solid foundation. It is important to understand that risk should not prevent you from investing. However, as investors, we should strive to properly understand and manage the risks.
First of all, China is still a communist country. Therefore, despite adopting free market principles, the rules governing public companies in China differ from those in the United States.
Chinese stocks are traded on the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Both exchanges have listing requirements similar to U.S. exchanges. Companies must regularly report financial statements, conduct audits, and meet other size and capital requirements. Beyond that, the rules and norms are different and this is where things get blurry.
Not only do Chinese accounting standards differ from U.S. Generally Accepted Accounting Principles (GAAP), but there are also many regulatory differences. One common difference is insider trading in company stock.
insider trading
Insider trading is intensively regulated in the United States. The integrity of market-based systems is based on the assumption that securities transactions are not manipulated by corporate insiders. In 2008, China banned major shareholders from trading in the month before a company releases its financial report. However, academic research shows that insider trading remains a problem in the country.
A 2013 study published in the International Journal of Accounting and Financial Reporting found that China's insider trading laws still “lag behind the rest of the world.” Scholars have continued to reach similar conclusions in recent years, amid reports that Chinese executives have made suspiciously timed profitable stock trades just before major stock price events.
Chinese companies use Chinese Accounting Standards (CAS), also known as China's Generally Accepted Accounting Principles.
Optional mosaic
Investors looking to get a piece of the China investing story have a wealth of investment products available. As expected, some options are much better than others, and some should be avoided completely or left to the most sophisticated investors.
Domestic investment
Many investors may be interested in sticking with what they know: American companies are growing operations in China. These companies can offer the best of both worlds: the benefits of a publicly traded, U.S.-regulated, GAAP-compliant company and the potential for profit growth from China.
A good example is “Yum!” Brand (YUM), owner of Pizza Hut, KFC, and Taco Bell. These chains are growing rapidly in China, which is a source of revenue for the company. Other large companies that derive the majority of their profits from China include Nike (NKE), Starbucks (SBUX), and Apple (AAPL).
Investors interested in owning shares in companies listed on Chinese exchanges should look to professionally managed funds focused on China. Many asset managers offering China-focused funds have analysts based in China who visit and vet companies before investing. Many of these funds hedge their renminbi (or renminbi) exposure to the U.S. dollar, mitigating another source of risk for U.S. investors. Some of these funds have higher expense ratios than domestic equity funds. This is also something to consider before jumping in.
Another consideration is exchange traded funds (ETFs). With so many options focused on Chinese stocks, it's relatively easy to passively invest in a wide range of China-based companies.
More than 40 China ETFs are traded in the US. The companies have combined assets under management (AUM) of $20.46 billion and an average expense ratio of 0.77%.
Direct investment in China
Investing directly in Chinese companies can be difficult as China restricts the inflow of funds from foreign investors. Those wishing to make direct investments should consider focusing on China's blue-chip companies. These companies are quickly established, have strong financial operations and a larger shareholder base, providing investors with greater security in a region still characterized by uncertainty.
Many Chinese companies also list directly on US stock exchanges. Years ago, these companies were the darlings of the market. But in recent years, virtually all of them have come under increased scrutiny because investors can no longer trust their financial statements. Unable to regain investor confidence, the stock prices of many Chinese companies listed in the United States have fallen sharply.
Still, this category offers disciplined investors the opportunity to find some attractive opportunities that are easy to research and trade. Transparency is also improving, as the U.S. Securities and Exchange Commission (SEC) has the power to bar foreign companies from listing in the U.S. if auditors do not provide information on request.
China's economic outlook
So what's in store for the Chinese economy? The country has made progress in recovering from the coronavirus pandemic and continues to influence “other developing countries through trade, investment and ideas.”
Economists predict that the country's deflation will subside in 2024, and that the domestic economy could continue to experience low inflation into the next year. According to the World Bank, China's economy is expected to grow by 4.5% in 2024. Domestic growth, stable exports, and positive changes in investor sentiment could lead to increased corporate profits and economic recovery.
Among the risks facing China, analysts cite potential problems in the real estate market, government debt (especially at the local level) and continued declines in foreign direct investment (FDI).
Is China a good place to invest?
It depends on the type of investors involved. There is no doubt that it has great potential. China is home to approximately one-fifth of the world's population, and its economy is huge and continues to grow at a fast pace. Low correlation with other major global markets is also a great diversifier. However, there are concerns about China's rising debt, the overall sustainability of economic growth, and the country's political policies. These types of risks will be uncomfortable for many people.
Can foreigners invest in China?
China has worked to make it easier for foreign investors to invest in its companies. However, this is still a difficult process and should be avoided in most cases. For most foreign investors, the best way to gain exposure to China is through mutual funds or ETFs, or by investing in companies from your country that have significant operations in China.
What is MSCI China?
MSCI China is an index created by Morgan Stanley that captures the performance of over 700 large and mid-cap companies across China.
conclusion
Investing in China can be a very rewarding experience. However, there are certain risks that investors should be aware of before committing their money. Government regulations can make it difficult for foreign investors. Other factors, such as geopolitical or economic risks, may also prevent you from depositing funds in that country. But if it can be maintained, there are ways to take advantage of China's growing economy, including stocks, ETFs and domestically traded mutual funds. Be sure to consult a financial professional to ensure that investing in China is in line with your goals.
