Have you played Xiangqi before? Xiangqi, also called Chinese chess or Elephant chess, is a popular strategy game played by Chinese people from all walks of life. With two armies battling it out on the chess board, it has a lot in common with International Chess, Indian Chess, Shogi (Japanese) and Janggi (Korean). A player’s quick tactics in opening the game and advancing pieces across the river—together with a well thought out strategy—are key elements to the ultimate victory of capturing the enemy’s general. But finding the right moves is not easy. The same can be said about investing in China, with COVID resurgences in major Chinese cities, lingering regulatory risks, property market distress, the start of an aggressive US monetary tightening cycle, and most devastatingly, the war in Ukraine. Have these recent events changed the momentum on the China growth board? Has your China investment approach changed?

The General cannot move outside the Palace

War in Ukraine

Market volatility in China had already been at an elevated level in recent months on slowing (but still above developed market) domestic growth, coupled with decelerating global growth and lingering fears of further regulatory clampdown before Russia’s invasion of Ukraine, which sent nervous investors into a frenzy and caused some to actively look for the exit. It is impossible to predict how the war will develop, but we unfortunately expect a prolonged period of fighting in Ukraine, with a quick resolution to the war and the sanctions on Russia unlikely.

Speculations and at times aggressive rhetoric on where China stands and its role in the conflict brought on more unease regarding Chinese assets, since any political action to support Russia could bring international sanctions. Speculations so far have remained speculations, and even as China refuses to condemn the Russian attack, it has made no move beyond the line in the sand. However, the close economic links with Russia continue. The ongoing war has disrupted the world’s supply chain as trade routes on land, air and sea experience interruptions. China is not immune to higher commodity and energy prices—or a global economic slowdown or possible deglobalization triggered by the war. Partly because its economy relies more on domestic growth and partly because it is not participating in western sanctions against Russia, in the long term we think China could be insulated from some possible spillovers compared to the most western countries.

Russia continues to trade with China in oil and gas. There are also talks of a new energy agreement between China and Russia that could include new oil pipeline projects and Chinese investment in Russian energy companies after sanctions drove the exit of western ones. Whether China’s economic cooperation with Russia would provoke an international response remains to be seen, but ultimately the war is driven by geopolitical power struggles and we don’t believe it’s in China’s interest to get involved or take any action that would result in a wide-reaching backlash at this time.

The Linked Horses formation grants safe but imperfect protection

COVID outbreak and lockdown, dynamic zero policy

The war is not the only deterrent to growth. Omicron outbreaks in China and the resulting citywide lockdowns in major hubs such as Shanghai are also raising growth concerns, as well as questions on whether the dynamic zero tolerance COVID policy is sustainable or the right approach for China. After the initial outbreak more than two years ago, the country has had remarkable success containing the pandemic up to the current flareups, with significantly fewer deaths than some of the other major economies, but it is now almost alone in putting the welfare of the most vulnerable in society ahead of economic recovery and market sentiment. Part of the hesitation in scaling back the restrictions and “living with the virus” we believe is the inevitable increase in deaths. China has so far been relying on domestically developed inactivated vaccines and is accelerating the development of its own mRNA vaccine. Meanwhile, it will continue to adhere to painstaking measures like travel restrictions, mass testing and large-scale quarantines to contain the spread of the virus.

It would be a mistake, however, to think that China is doing nothing about the economic toll. With stoppages in logistics, road transportation and manufacturing production in port and industrial cities, the government has reshuffled more of the container traffic from roadway to waterway, trying to ease some of the pressure from the disruptions in the flow of industrial goods. Some lockdown measures have recently been relaxed—there are different levels of restrictions and some neighborhoods are allowed a limited amount of movement and activities—and production has in fact restarted for many companies. China has promised to do more, hoping stronger monetary, fiscal and credit support would provide relief and buffer the overall growth shock that we believe should have a short- to medium-term in impact.

Although we think there is still room for Chinese interest rates and monetary policy to be more accommodative, efforts such as investment proposals in infrastructure, renewable energy and property support could help China get through this rough period. These stimulus efforts should carry a bigger weight toward the second half of the year, when COVID is—hopefully—under better control, and help the economy get back on track in the long run. It's also important to remember that China’s pace of growth, though slowing, is still markedly faster than the rest of the world.

Cannot fire the Cannon without a mount

Property market distress, regulatory clampdown

COVID resurgences have not only disrupted the global supply chain, they are also keeping the beleaguered housing sector down. And China's fixed income strategies are impacted by it. After last year’s regulatory clampdown on overleveraged housing developers sparked fears of contagion risk in the financial system, the government has since stepped back and turned more supportive, loosening credit controls and reducing home purchase down payment requirements in certain cities. But home sales, prices and construction have yet to regain a footing and recover from last year’s rapid declines before the Omicron wave and mobility controls hit. We expect volatility to continue in this sector at least over the rest of the year before a clearer policy is articulated and implemented.

That said, new guidelines to ease the rules governing escrow accounts (trusts holding pre-completion cash) appear promising, and if implemented, they could provide much needed liquidity to property developers after last year’s cash crunch and indiscriminate write-offs. State-owned enterprises (SOEs) are playing a greater role, moving in to carry out merger and acquisition (M&A) activities by acquiring projects or other assets from distressed developers.

We are optimistic that conditions will improve after the Omicron flareups ease, particularly for the better-capitalized companies with solid balance sheets and more readily-accessible funding channels. In the long term, we expect that these property developers will survive the current industry consolidation and emerge in an even stronger position.

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