This article lists all the risks of investing in Chinese stocks (that I can think of and read about), in both Hong Kong and the US stock market.
By the time I finished this writing, I have 30% of my portfolio in Chinese stocks, split 2:1 between $BABA and $KWEB.
Real Estate Bubble
The people in China have always been putting their life savings in the housing market, instead of the stock market like in the US. One of the reasons could be the Chinese tradition of everyone (especially guys) needing to have their own house, in order to start a family. Besides, it is said that the real estate prices can only go up, right? (2008 flashback)
This has made buying a house in China enormously expensive, with a house price-to-household income ratio of 19 in the biggest “tier-one” cities such as Beijing or Shanghai, 10 in tier-two and seven in tier-three cities. The average ratio in the UK is about 10 and in the US it is four.
The problem worsens as 20 of the top 30 property firms in China have breached at least one of three debt redlines set down by the Beijing government to rein in real estate speculation, with Evergrande making the headlines lately. The collapse of Evergrande — which employs 200,000 people and indirectly sustains 3 million jobs — might cause a serious chain reaction in the country, and make domestic and foreign investors lose billions.
Variable Interest Entity (VIE) Structure
Under Chinese law, foreign ownership in certain (most) Chinese industries is prohibited. So, a company that desires to raise capital overseas has to create a Cayman Islands listed shell company (no real business, no office, no employees), then create a complex web of legal agreements to give the shell company a claim on the profits and control of the assets. This is called the VIE structure.
Through this structure, investors only own shares of the shell company instead of the actual underlying Chinese company. Therefore, at its most extreme, China is completely within its legal right (even if it was illegal, would the CCP care?) to declare all these VIEs worthless, which would wipe out trillions of dollars from international shareholders invested in these VIE companies.
However, some companies, like $BABA have upsized their share repurchase program from $10 billion to $15 billion through 2022, which means they will be buying back the ‘fake shares’ like the rest of us.
Policy Change
A few months ago, Chinese regulators published reforms that will make private firms teaching the school curriculum ‘non-profit organization’, as Beijing aims to overhaul a sector it says has been “hijacked by capital.” The new regulations ban firms that teach school curriculums from making profits, raising capital, or going public. This should be a good thing for the young generation in China, who are being put under unimaginable pressure by their parents and teachers, to ace the Gao Kao exam.
China’s strict limits on how long minors can play online video games just got stricter. The rules released recently tightened restrictions to curb online game addiction among schoolchildren, which Chinese children and teenagers are barred from online gaming on school days, and limited to one hour a day on weekends and holiday evenings.
Let’s not forget the news where China suspended the $34 billion IPO of Ant Group, the largest FinTech company in China owned by $BABA, just two days before its planned listing, right after Jack Ma criticized the Chinese financial system.
The CCP has been asserting greater control over its private companies, particularly companies like $BABA and Tencent that have extensive data on over a billion Chinese citizens. They are the easy target if the crackdown by the CCP continues.
Delisting Fear
$DIDI, a $39 billion ride-hailing company in China, announced that it would delist its shares from the New York Stock Exchange due to concerns about data security. Just six months ago, $DIDI raised billions of dollars from American pension funds and international investors in their initial public offering, ignoring objections from the CCP. This makes investors fear that other Chinese companies in the US would be delisted too. This year, it is estimated that nearly 250 Chinese firms had a total market cap of $2.1 trillion (which is declining every day) trading on American exchanges. It would cause chaos if some of the big names got delisted.
Under the latest regulation, auditing firms have to be subject to inspection by the Public Company Accounting Oversight Board (PCAOB) for all public securities in the US. While more than 50 jurisdictions have worked with the PCAOB to allow the required inspections, two historically have not: China and Hong Kong. If governmental authorities don’t allow the auditors of foreign companies to open their papers to PCAOB inspection for three consecutive years, the companies could be prohibited from trading in the US.
Even though the ADR shares trading in the US is fully convertible to ordinary shares in Hong Kong in the case of delisting, a crash in share price is most certainly inevitable.
Common Prosperity
China seeks a private sector more in line with the CCP’s common prosperity goal — aims that Wall Street investors most likely can’t help with. $BABA pledged to ‘donate’ 100 billion yuan ($15.5 billion) to help narrow the nation’s wealth gap by 2025, while Tencent said they would invest 50 billion yuan. This is definitely bad for the investors as the money could be distributed as dividends, used to do share buyback, or invested in the business itself.
As a company that generated $29 billion of free cash flow in 2021, the donation probably won’t hurt $BABA too much. However, who knows if they will be asked for another 100 billion after 2025. On the bright side, the capital spent will be used to help lift millions of Chinese from poverty, which in the long run will benefit the economy and all the companies in China.
China’s Growth Slowdown
The world’s second-largest economy grew by a weaker-than-expected 4.9% over a year ago in the three months ending in September, down from the previous quarter’s 7.9%. Factory output, retail sales and investment in construction and other fixed assets all weakened.