As global investors dump US and Japanese stocks, China’s beaten-down markets are suddenly looking more attractive.
The debate over whether China is “uninvestable” has plagued Xi Jinping’s government since late 2020. That was back when Xi’s Communist Party cracked down on tech platforms, starting with Jack Ma’s Alibaba Group.
It hardly helped that Xi’s draconian Covid-19 lockdowns drove China’s growth into the red. Or that Xi’s party was slow to add fresh stimulus to Asia’s biggest economy when it arguably needed it most.
Now, China has a unique opportunity to shine as a bastion of stability as the US and Japanese economies face fast-mounting challenges.
US employment growth is slowing, spooking global punters who had grown used to the economy adding 200,000-plus new jobs per month. The US Federal Reserve, meanwhile, has been slow to cut interest rates as inflation has remained stubbornly close to 3%.
Adding to the drama is extreme political polarization at a moment when Americans prepare to pick a new president on November 5. This, against the backdrop of the US national debt topping US$35 trillion.
In Tokyo, markets are in abject trauma following the Bank of Japan’s July 31 rate hike. On Monday, the Nikkei Stock Average fell the most since “Black Monday” in 1987. Though stock prices later stabilized, fears of additional BOJ rate hikes have global investors on edge.
A big worry is the “yen-carry trade” blowing up. Since 1999, when the BOJ first cut rates to zero, investors everywhere have been borrowing cheaply in yen and using those funds to bet on higher-yielding assets around the globe.
This explains why sudden moves in the yen can savage asset markets in New York, London, Dubai, Seoul and Shanghai. And raise questions about hedge funds everywhere blowing up.
All of this presents China with a chance to appear above the fray. To be sure, there’s an argument that China could indeed offer the calm that global investors seek. Particularly as events from Washington to Tokyo ring alarm bells.
Yet this requires Xi’s team to step up efforts to revive the narrative that China is moving upmarket as an investment destination.
A decade ago, Xi pledged to let market forces play a “decisive” role in decisions about economic and financial policy. A few years later, in 2015, a sudden plunge in stock prices slowed the reform process.
At the time, China Inc circled the wagons. Beijing directed waves of state funding into markets, suspending trading in thousands of companies, scrapped all initial public offerings and enabled mainlanders to pledge homes as collateral on margin loans. It even rushed out buzzy marketing campaigns to encourage stock-buying as a form of patriotism.
This treating-symptoms-over-reforms pattern has played out time and time again during Xi’s tenure. All of which explains why marshaling the state-sector-industrial complex to save the day, again, could backfire.
That episode, and others since then, exemplify why gains in Chinese shares too often haven’t been matched by moves to champion the private sector, increase transparency or strengthen corporate governance.
In recent years, investor disappointment sent capital fleeing China. Between late 2021 and early 2024, a $7 trillion rout in mainland shares shook global markets. Though Chinese stocks have stabilized somewhat since, the Shanghai-Shenzhen CSI 300 Index is still down 13.5% this year.
The question now, with price-to-earnings multiples trading at 13 versus 22 for the Dow Jones Industrial Average and 23 for Japan’s Nikkei Stock Average, is whether China is a “buy.”
“Chinese assets are expected to become a better choice for global funds in this round of global market turmoil triggered by the expectation of a US recession,” says Zhang Qiyao, analyst at Industrial Securities, arguing that the market boasts low valuations and improving fundamentals.
Analysts at Shanghai Securities said in a note that they “think a deep correction in the Japanese market has limited impact on China’s A-shares. Funds are expected to flow back into A-share. We believe that increased uncertainty in the overseas market and increased expectations of a recent interest rate cut by the Federal Reserve may prompt funds to seek safe havens.”
There are many risks to consider. One is the so-called “yen-carry trade” blowing up. The rebound in the Nikkei this week, a day after the market collapsed, was a relief for investors everywhere.
But the fact investors are buzzing about “contagion” effects is not a great sign as these things go. Nor is the yen’s continued upward trajectory after a powerful rally that’s already unnerving global markets.
It’s also worth noting that officials in Tokyo are preparing for the worst. Early next week, BOJ Governor Kazuo Ueda will be questioned by a parliamentary committee. Lawmakers are clearly spooked by the market freakout over a rather gentle July 31 rate hike.
Part of this paranoia reflects memories of what happened back in 2006 and 2007, the last time the BOJ tried to move rates away from zero. Back then, the central bank managed to get rates up to 0.5%.
The recession that followed still haunts Tokyo. By 2008, the BOJ was slashing rates back to zero and restoring quantitative easing. What lawmakers want answered are questions about whether Japan will suffer a rerun of that episode.
Ueda can’t say, of course. No one can. No Group of Seven nation has ever held rates at zero or near zero for 25 years. Or conducted a 23-year QE experiment, one that’s now backfiring on Asia’s second-biggest economy.
The uncertainty factor here is rather epic. It stems from the yen’s role as a key funding currency. Over the last quarter century, the most crowded trade anywhere has been borrowing cheaply in yen and redeploying those funds in higher-yielding assets around the globe.
This yen-carry trade explains why big yen rallies tend to pull the floor out from under asset markets from New York to Seoul. The yen’s 13% surge since a July low shoulder-checked global markets.
There’s concern now about similar dynamics in the Chinese currency. “The next carry trade unwind could be the yuan,” says Khoon Goh, the head of Asia research at ANZ.
On Monday, the yuan rallied against the dollar along with the yen. This move could bolster the China-as-safe-haven argument as markets from New York to Tokyo gyrate.
Yet to build trust among global investors, Beijing needs to step up efforts to improve Chinese capital markets. That’s the key to increasing the appeal of the yuan as the key currency in trade and finance.
“If they really wanted to de-dollarize China’s trade, preferably shifting at least some of it into renminbi over time, China’s leaders would need to ensure two things,” says Louis Gave, analyst at Gavekal Research.
“The renminbi should remain a stable, not excessively volatile, currency. Given the size of China’s export industry, currency stability was always a policy priority, but the drive to internationalize the renminbi made it even more important.”
Gave notes that it’s also important for Chinese government bonds (CGBs) to begin outpacing returns on US Treasuries. “If China was going to convince the central banks of Thailand, Indonesia, South Africa or South Korea to move some of their reserves from US Treasuries into CGBs, then the reserve managers at these central banks would have to be rewarded for their courageous decisions to shift away from the US dollar,” Gave said.
Sure enough, he adds, “in the years that followed, returns on CGBs crushed the returns from government bonds in the US, Germany and Japan — the world’s other major bond markets. China’s outperformance is almost as striking as the capital destruction endured by Japanese and German bondholders. Over the last 10 years, China has been the only major bond market where US-dollar-based investors were able to outperform US inflation.”
Over the last five years, Gave notes, “none of the big government bond markets have kept abreast of US inflation, but again CGBs have outperformed the others. And over the last three years, CGBs are the only bonds that have delivered positive nominal returns, although not enough to keep up with US inflation.”
Yet reforms have been uneven. News late last month that Beijing is increasing opacity surrounding the flow of capital – limiting daily data on the amount of capital international funds deploy into and out of China – is a step in the wrong direction.
Those signals came the same week as the China Securities Regulatory Commission (CSRC) pledged to improve market operations, strengthen comprehensive research capabilities, deepen response mechanisms to manage market risks and hone regulations for trading.
Still, the extreme volatility from New York to Tokyo could restore China’s appeal as a reliable investment destination. Xi’s team just needs to shift the reform process into higher gear.
Follow William Pesek on X at @WilliamPesek