Chinese Stocks: What Went Wrong

Note: This column was originally published on March 24, 2022.

Stumbling Out of the Gate

A previous column raised a question. Although China’s economy has soared, its stock market has not. Since January 1993, when Morgan Stanley Capital International first began to track the nation’s equity performance, Chinese stocks have trailed every one of the 10 biggest stock markets from that date. Why?

To begin, the launch of the Chinese stock market was something of a debacle. After a four-decade break, the Shanghai Stock Exchange reopened in December 1990, a scant two years before the MSCI China Index commenced. During those early years, market makers, regulators, and investors were each learning their roles in a country unaccustomed to modern capitalism. It is therefore unremarkable that, after the initial euphoria, Chinese stocks took a drubbing.

The timing was also unfortunate. As China’s marketplace attempted to work out its kinks, the country got sucked into the maelstrom of the 1997 Asian financial crisis. Technically, the crisis bypassed China, as it affected the currencies of neighboring nations. However, given both China’s proximity and strong trade relations, its equities were unavoidably affected. The five-month loss for Chinese stocks was a breathtaking (or, perhaps more accurately, heartbreaking) 60%.

Then came another event that was not China’s doing: the global technology-stock meltdown. Even the Pacific Ocean could not prevent it from reaching China's shores. From spring 2000 through autumn 2002, Chinese stocks traded roughly in line with their American counterparts. That performance not only hurt total returns, but it also disappointed investors who had sought geographic diversification. After all, while the United States entered a recession during that period, the Chinese economy boomed. Surely its stocks would escape the damage. But they did not.

Better Days

After their rough debut, Chinese stocks have righted the ship. Over the past 20 years, Chinese equities have roughly matched the afterinflation return posted by the stronger developed markets, and they have exceeded those of stock market weaklings such as Japan, Spain, and Italy. However, given the high volatility of Chinese stocks, their risk/reward profile has been less attractive. That much smoke should have produced more fire.

That adage applies even more strongly to China’s economic success. Over the past 20 years, the United States has increased its per capita gross domestic product by 20%, while China has done so by 400%. Yet the two countries have posted similar stock market gains (with, of course, the U.S. holding the risk/reward edge). That Chinese stocks did not lead from the onset is understandable. That they have not since taken full advantage of their country’s economic achievement is not.

Top and Bottom Lines

Unsurprisingly, Chinese businesses have been very successful at increasing their sales. Each year, Fortune ranks the world’s 500 largest companies, as measured by revenue. China possessed 10 such publicly traded businesses in 2002. It now hosts 124, three more than does the U.S. Those 124 Chinese companies generate more revenue than do all the organizations on Fortune’s chart from Japan, Germany, France, and the United Kingdom combined.

The challenge has been profitability. With Chinese companies, there’s many a slip ‘twixt the cup and the lip. When reviewing Fortune’s 2020 list, the Center for Strategic and International Studies compiled the average return on assets for, among others, the organizations based in the U.S. and China. The American companies recorded an average profit margin of 9.1% and a return on assets of 4.9%. For the Chinese businesses, those figures were 4.5% and 1.9%, respectively.

Are Chinese companies less profitable because of their home market? Although Chinese consumers are rapidly growing their income, their wages remain far below developed-markets levels. Chinese corporations therefore face pricing constraints that do not trouble businesses that operate in wealthier countries. Perhaps Chinese firms are quite efficient, considering their handicap.

It’s a reasonable supposition, but incorrect. In a 2021 survey of members of the U.S.-China Business Council, 95% of the respondents asserted that their Chinese operations were in the black. What’s more, 43% replied that their Chinese branches enjoyed higher profit margins than did their overall business, as opposed to 22% who stated the opposite. Thus, while Chinese companies struggle to convert sales to the bottom line, American firms do not.

(A 2019 publication by the Chinese Ministry of Commerce found similarly, reporting that “most multinationals have a return on investment in China higher than their global average.”)

Powerful Voices

The problem comes from the companies’ leading stakeholders: their major investors and their government. As Fuxiu Jiang and Kenneth Kim explain, in “Corporate Governance in China: A Survey,” publicly traded Chinese companies routinely have very large owners. In 2018, more than 80% of listed Chinese firms possessed a shareholder that held at least 20% of the company’s equity. These investors, write the authors, often use their powers to “expropriate wealth from minority shareholders.” For example, they may engage in related-party transactions that advance their other businesses at the expense of the company.

A related obstacle is the close connection between the Chinese government and ostensibly private enterprises. For example, Jiang and Kim report that in a 2007 study, 27% of Chinese businesses classified as nongovernment operations were nevertheless headed by former bureaucrats. Maintaining close ties with the government is essential for conducting business in China, but the relationship can also harm profits. For example, to ensure high employment, officials may pressure companies to hire more employees than they need.

Finally, Chinese legal protections have historically been poor. Happily, the authors write, the regulatory climate has improved dramatically over the past 25 years. The risk that a company’s assets will be commandeered by the government, or its intellectual property stolen by its rivals, has sharply declined. (Or at least it had, before President Xi Jinping began, as one writer put it, “kneecapping Chinese companies.”) Still, such concerns sometimes cause managements to forgo profit-maximizing strategies in an attempt to forgo legal problems.

Summary

The bad news for Chinese-stock enthusiasts is that the marketplace has dog-paddled over the past three decades. Early adopters would have been better off investing almost anywhere else. The good news is that conditions have since improved, permitting Chinese stocks to at least partially benefit from their country’s extraordinary economic growth. Whether progress will continue, or be halted by Xi’s “reforms,” remains to be seen.

End Note: This otherwise pessimistic column concluded on a faintly hopeful note. Too hopeful, as it turned out. Since the time of its publication, Chinese stocks have lost 7% in local terms and 17% when translated to U.S. dollars. Meanwhile, U.S. equities have gained 6%. My suspicion is that the bad news is now fully out and that Chinese equities will, at last, stage a rally. But the impediments to their long-term fortunes remain.