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US funds ignore China tiff, turning to world's second-largest economy to solve a trillion dollar problem: where to find yield

Jodi Xu Klein in New York jodi.klein@scmp.com
·10 min read

In the first of a two-part series on global capital flows, Jodi Xu-Klein reports on how American institutional investors and fund managers are looking beyond the lowest point of US-China relations to pour their funds into Chinese stocks, bonds, exchange-traded funds and other assets in search of higher returns in an age of zero interest rates.

On January 22, two days after a new occupant was sworn into the Oval Office, a Beijing-based provider of vaping products and e-cigarettes listed on the New York Stock Exchange, the first Chinese company to tap Wall Street for funds even as US-China relations deteriorated to their worst point in decades.

Backed by Sequoia Capital in an initial public offering led by Citigroup, RLX Technology's shares soared by as much as 158 per cent in their trading debut from their US$12 offer price before closing the day at US$29.51, valuing the three-year old start-up at US$46 billion, almost three-quarters of the market capitalisation of the century-old British American Tobacco.

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RLX's rise was barely a surprise. The average value of new listings by Chinese companies rose 204 per cent last year in the United States, outpacing the 49.6 per cent gain by American IPOs or the 30.9 per cent increase among European companies, according to Bloomberg's data. Shares of BeiGene the drug maker soared 22 times since July while NIO the Tesla challenger tripled in value over six months.

"The US is just awash with liquidity, a lot of money sloshing around," said Adam Lysenko, analyst of China's international investment flows at Rhodium Group. "Investors are just going to keep investing in China until they can't any more."

A store displaying RLX Technology's vaping products under the RELX brand in a shopping centre in Beijing on January 22, 2021. Reuters alt=A store displaying RLX Technology's vaping products under the RELX brand in a shopping centre in Beijing on January 22, 2021. Reuters

Flush with zero-interest capital unleashed by the Federal Reserve to bolster an economy wrecked by the coronavirus pandemic, US private equity funds, asset managers and pension fund investors had been making a beeline for China over the few months in search of yield.

Encouraged by signs of the world's second-largest economy mostly back to pre-pandemic levels of production, they have snapped up Chinese stocks, bonds, exchange-traded funds and other financial assets available to them under the country's tightly controlled capital account.

Source: Seafarer Capital Partners alt=Source: Seafarer Capital Partners

BlackRock, the world's largest money manager, with US$8.7 trillion of assets under management, is one such investor. The New York-based investment manager said in January that it saw "a clear case" for allocating more of its portfolio to assets exposed to China.

UBS Global Wealth Management, which invests US$2.7 trillion for ultra-wealthy individuals, expects "China equities, fixed income, and currency to shine" amid a robust economic recovery and stimulus support. Ray Dalio, founder of the US$148 billion Bridgewater Associates hedge fund, said his All Weather China strategy fund reported an annualised return of about 22 per cent for the 22 months from inception to the end of July for investors.

American investors owned US$813 billion worth of stocks and bonds issued by mainland Chinese companies at the end of 2019, according to analysis of the Treasury data by Seafarer Capital Partners, an investment advisory firm focused on emerging markets. That's more than triple the US$368 billion in holdings three years earlier.

While 2020 data is not yet available, "it is reasonable to assume that the value grew even larger due to A-share inflows and market appreciation," said Nicholas Borst, director of China research at California based Seafarer.

China's economy expanded 2.3 per cent last year with a pre-pandemic pace of over 6 per cent in the fourth quarter. The economies of the US and Eurozone contracted by 3.5 per cent and 7.1 per cent respectively, according to the International Monetary Fund (IMF).

The IMF projected China to grow by 7.9 per cent this year, outpacing 5.1 per cent in the US and 4.2 per cent in the Eurozone.

"I expect US investment exposure to China to continue to increase in the years ahead," said Jay Pelosky, founder and chief investment officer at TPW Advisory, an investment adviser in New York. "China was the first into Covid-19 and the first out of [the pandemic], and the only major economy that's showing year over year growth."

The gap in economic growth resulted in discrepancies in bond returns. Slower growth in the US has prompted the Federal Reserve to slash interest rates to stimulate the economy, a policy that drove inflation-adjusted Treasury yields precipitously to negative 1 per cent, according to Mitsubishi-UFJ Financial Group's report.

The rate cut by the world's most powerful monetary authority was quickly followed by central banks around the world, unleashing an estimated US$8 trillion of low-cost capital, all in search of higher returns. In contrast, China's government bonds are paying 3.23 per cent to holders.

"As a fixed income investor, if you can offer me a 3 per cent yield on a 10-year government paper with an appreciating currency, I will want that," Pelosky said. "And I'm going to want a lot of it."

That appetite propelled investors to look for direct ways to invest in China, an avenue that had been hitherto off-limits to offshore capital due to the country's capital controls.

Until recently, typical ways to invest in Chinese securities have been through US-listed Chinese companies, China-focused exchange-traded funds, a tightly controlled foreign investors' quota (QFII) to China's A-share market, or a cross-border investment channel called the Connect via Hong Kong.

One example is the iShares MSCI China ETF, the leading index fund tracking large-cap Chinese stocks, which rallied 12 per cent this year. The BlackRock-managed fund had US$6.56 billion of net assets at the end of 2020, counting Alibaba Group Holding, Tencent Holdings, Meituan, JD.com and Ping An Insurance (Group) among its 604 stocks.

Access to China's capital markets has widened considerably in recent years. In July 2017, a scheme called the Bond Connect was created for overseas investors to buy yuan-denominated debt in China's interbank bond market via Hong Kong.

The six-year-old Stock Connect scheme that allows global funds to invest on the Shanghai and Shenzhen exchanges via Hong Kong was expanded in November to link up with the Star Market, the bourse created to help China's home-grown technology champions raise capital.

China's regulators also scrapped the foreign ownership limits on investment banks, brokerages, mutual funds and futures companies, fulfilling their commitment under the World Trade Organization (WTO). That prompted JPMorgan Chase to seek the first fully US-owned license in the country for a range of financial services from securities to asset management, all in time for the New York bank to mark a century of doing business in China. Goldman Sachs also has plans to buy out its Chinese partner, to make its onshore investment banking operation fully US-owned.

Attracting foreign capital is strategically important to China as the nation's economic policy shifts from an export-dependent model to domestic consumption in the so-called "dual circulation" strategy.

As part of the plan, China loosened up investment policies and overtook the US last year as the world's top destination for new foreign direct investment, including mergers, acquisitions and investments directly into businesses.

China's moves suggest the nation is also keen to attract foreign capital to its financial markets. That could not have come at a better time for funds that have been historically underinvested in the country because of the various barriers of entry.

US investors accounted for only 6.5 per cent of the Chinese equity market's capitalisation, according to Seafarer, compared with 15 per cent in Japan and more than 25 per cent in the UK.

In the debt market, even including government bonds, US investors made up just over 2 per cent of the US$12 trillion of the Chinese onshore bond market in 2019, Seafarer data show. US capital held 12 per cent of debt in Japan and 39 per cent in Indonesia.

World's top 10 IPO markets as of first nine months of 2020. SCMP Graphics alt=World's top 10 IPO markets as of first nine months of 2020. SCMP Graphics

There are still plenty of challenges investing in China where foreign capital flow was strictly controlled until recently. For one, onshore bond ratings have long been criticised for not providing nuanced credit information. More than 70 per cent of the issuers are rated above "AA" investment grade near the top of the local ratings spectrum.

Regulatory intervention in the markets can continue to wreak havoc on investments, with one recent example being the halting of Ant Group's US$34.5 billion initial public offering in Shanghai and Hong Kong.

Some investors' enthusiasm had also been damped by financial scandals involving US-listed Chinese companies, such as the accounting fraud by Luckin Coffee, the Xiamen-based pretender once dubbed "China's Starbucks".

During the twilight days of Donald Trump's presidency, the White House unleashed a torrent of executive orders that blocked American investors from holding Chinese stocks listed on US exchanges for a variety of reasons from alleged human rights abuses in Xinjiang to supposed ties to the Chinese military.

Those executive orders, which remain in place two weeks into Joe Biden's presidency, may take time to reverse. The litany of import tariffs slapped on Chinese products by Trump are still adding costs to American consumers, while Chinese technology companies from the drone maker DJI to the 5G communications equipment giant Huawei Technologies are hamstrung from using US hardware.

US-China relations remain an overhang, as the 46th American president is yet to hold a phone conversation with his counterpart Xi Jinping, with whom the two have had many decades of working relationship.

"The aggressive imposition of financial sanctions against Chinese companies is going to be seen as an aberration, not as a policy that's likely to be continued," said Pelosky.

Hope may be on the horizon. The Biden administration has put a stay until May 27 on Trump's order to ban more than 40 Chinese companies from US capital markets, pending a review.

"It's a sensible thing to do," said David Dollar, senior fellow of the John L. Thornton China Center at the Brookings Institution. "The signal to Wall Street is that the Biden team is going to take a close look at these measures and see what the objective is and the costs."

Biden's new cabinet members, from the State, Commerce to the Treasury departments, "are probably in favour of preserving open markets and trade, in that the Treasury takes a traditional role to defend the integrity of markets and capital markets," Dollar said.

"There are always geopolitical risks investing in China," he added. "But up until now, the economic relations have continued, even though there are geopolitical problems. Americans are underweight China, so it's natural that different American interests are trying to invest in Chinese stocks and bonds as part of a diversified portfolio. That makes sense."

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2021 South China Morning Post Publishers Ltd. All rights reserved.

Copyright (c) 2021. South China Morning Post Publishers Ltd. All rights reserved.