The China Syndrome circa 2010
Posted by Larry Doyle on June 17, 2010 8:15 AM |
With ongoing issues here in the U.S. and more so in Europe, clearly global investors need to focus more on investing in Asia generally and China specifically, correct?
I do not disagree that investors need a global perspective, but as with any investment let’s open our eyes and assess risks before diving into the deep end of the pool. Remember, Wall Street analysts touting Asian investments are in the business of selling products. Let’s navigate further and find some independent analysis.
Today’s Financial Times provides just that from Michael Pettis, a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
Pettis provides a healthy degree of caution about investing in China as he writes today, Don’t Read Too Much Into the Performance of China Markets:
We normally assume that stock prices represent the market’s best estimate of growth prospects, but this is not always the case.
In a well-functioning market various strategies interact, ensuring that markets are reasonably liquid, reasonably consistent, and reasonably able to allocate capital efficiently. But from time to time, liquidity shocks or sharp increases in financial distress can undermine the value of certain information, especially information necessary to fundamental investors, and so shift the whole market into speculative mode.
Well-functioning financial markets can and do break down, but when they return to stability they do a fairly good job of allocating capital. But for a market to perform this role well, fundamental investors must have the necessary tools and information to profit from their capital allocation decision. The most basic requirements for fundamental investing are good macroeconomic data, accurate and intelligible financial statements, a stable regulatory framework, limited government intervention, and a clear understanding of the corporate governance structure.
China lacks all of these. Macroeconomic data is improving, but is still quite poor, which is perhaps to be expected in a country changing so rapidly. Financial statements are often questionable, in no small part because Chinese universities are unable to produce as many accountants as China needs. The regulatory framework is changing and evolving quickly, and often in unexpected ways, and the government has little hesitation in intervening in markets for policy reasons.
Most importantly the corporate governance structure is opaque. It is not clear whether managers act to maximise shareholder value, enterprise wealth, local employment, or other factors not subject to economic analysis. All this uncertainty means that fundamental investors must use too high a discount rate, in effect, pricing themselves out of the market except when it is trading at extraordinarily low levels.
In other words, in China it is very difficult to follow a fundamental investment strategy. Speculators, on the other hand, have a huge variety of tools at their disposal. Insider trading is common. Opaque corporate governance and ownership structures can cause sharp fluctuations in corporate behaviour. Illiquid and fragmented markets allow determined traders to cause large price movements. Regulations change often.
In addition, the single most important participant in the market, the government, often behaves in ways that are not subject to economic analysis. Take most fund managers out for late-night drinks and they will readily admit that the two most useful pieces of information that they crave is information about changes in underlying liquidity conditions and information about which way the government would like to see markets go.
A market driven mainly by speculators, and with little to no participation by fundamental or value investors, is not a market that spends much effort evaluating and discounting long-term growth prospects. It is driven largely by fads, technical factors, liquidity shifts, and government signalling. These markets may tell us many things, but they are not telling us much about growth prospects.
Wow, for a minute there I forgot Pettis was talking about markets in China and thought he had turned his focus to Goldman Sachs and our domestic markets.
The simple fact is whether in China or the U.S., the presence of global governments in our markets has never been greater. Global governments are clearly doing everything within their midst to maintain investor and consumer confidence. It may be hard to quantify the governments’ presence and actions, but we can not deny these realities.
Thank you Mr. Pettis.