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Why You Should Stop Investing in China

Why You Should Stop Investing in China
Do more with what you’ve earned.

Financial advisors for successful professionals, executives, and business owners.

Whenever we onboard a new client, many are shocked to find that they have some of their money allocated to Chinese stocks. Most people have a smattering of U.S. stocks, S&P 500 index funds, an international fund, and even perhaps a REIT. Some have gains and some have losses. Our job is to find out what is worth keeping and what is not. 

Once we start to go through this process, people are shocked when they see a sizable allocation to China. Many international funds, including most emerging market funds, have a large allocation to the country.

Our recommendation 100% of the time is to sell it all.

This was not always the case. As many of our clients are already aware, in 2022 we chose to completely eliminate our exposure to Chinese equities. 

We have maintained a position in China’s equity market since our founding in 2014. Afterall, China’s economy was growing at a blistering 7% annual rate. It was also seen as a country that was going to enhance its democratic freedoms along with its economic freedoms. The future looked bright. 

However, this never happened. China reversed course and has become more brazen and controversial over the past few years, especially with its repression in the Xinjiang region and its escalating tensions with Taiwan. Thus, we decided to fully remove China from our funds. 

Here is our reasoning. 

China’s Economy is Big

The decision to remove China was not an easy one. China is the second largest economy in the world, surpassed only by the U.S. Even though China is still an emerging economy, it is still a force to be reckoned with. 

Why We Excluded China

The decision to remove China from our portfolio was spurred on by two primary concerns:

Concentration Risk

China’s representation within the emerging market index is massive. As of 5/24/24, China represents nearly 27% of the entire MSCI Emerging Market Index. 

Investing in emerging markets, by its nature, is risky. Not only is there company-specific risk, but there is also currency risk, geopolitical risk, default risk, etc. To have nearly a third of your emerging market portfolio in a single country only amplifies this risk. 

A large allocation like this is a double-edged sword. When things go well, like China’s stock market performance between 2005 – 2015 (up 200%-300%), they go really well. However, when things go sideways, like it has over the past 3 years (down 10%-20%), China’s large allocation really weighs on the rest of the benchmark. 

China’s Ethical Concerns

China’s disregard for religious, civil, political, and economic rights. It doesn’t feel great to put your hard-earned dollars into a country that commits these atrocities. 

  • China has committed genocide against an ethnic minority population. 
  • China is using censorship and propaganda to whitewash its true history. 
  • China dismantled and took over a free society, Hong Kong, in 2020, and the results have been chilling. 
  • China ‘disappears‘ its vocal critics, including very high profile individuals, including tennis player Peng Shuai, Premier Zhao Ziyang, and billionaire Jack Ma.

Jack Ma

On the Verge of Totalitarianism

China is looking more and more like a totalitarian regime rather than an authoritarian one, which should be concerning for all. 

“Totalitarianism” was first used in the 1920s by Italian fascist theorists to describe the Italian Prime Minister Benito Mussolini’s fascist government. 

For Luigi Sturzo, totalitarianism represented

“The centralization of political and economic life, suppressing all freedom of action and transforming the powers of the state into a single power, both executive and administrative, and thereby reducing it to true dictatorial power.”

While authoritarian regimes force the individual to submit to a warped and one-sided sliver of society, totalitarianism is the exaltation of the state above everything else, including both the individual and society. 

In short, we do not think it wise to invest capital into a country that commits these acts. Even if we put our moral issues aside, investing in China looks quite risky. Capital markets in states that limit their people’s freedoms tend to underperform versus those countries that place a high value on personal freedoms.

How We Got Here – China’s Economic Growth

The China that we see today did not look like the same country 10-15 years ago. Back then, there was a lot of optimism by western countries that China was beginning to put its communist ways behind it. 

When China opened its economic doors 30 years ago to the world, the U.S. and the rest of the western world saw an opportunity. Not only could western countries benefit economically by investing in the most populous country in the world, but perhaps they could fundamentally change China. The hope was that political and human freedoms would follow its economic freedoms.

The western assumption was that economic freedoms and democratic freedoms were two sides of the same coin. And to some degree, perhaps they are. We assumed that China would soon be on the same path as Japan, Britain, Germany, and France post World War II. 

This, of course, did not happen. China’s growth has come in the context of stable communist rule, suggesting that democracy and growth are not mutually dependent. The Chinese Communist Party (CCP) has embraced the private sector and capitalism while maintaining a strong political system. There is even strong evidence that the CCP strengthened its political positioning during this period. After all, the average Chinese citizen’s well-being has improved over the past 30 years as their wealth and economic freedom have improved. As a result, and quite ironically, the CCP was able to use capitalism to further its communist goals.

Return to Socialism

The CCP has been able to justify its trickle-down economic policy as a concept of socialism “with Chinese characteristics.” It allowed the government massive philosophical leeway to grow its economy. 

However, General Secretary Xi Jinping thinks China is now ready to return to economic socialism (somewhat). The new catchphrase from the CCP is “common prosperity.” Under this banner, the government is targeting the country’s tech giants, banning private tutoring (education is more equitable this way), implementing a daily three-hour video gaming limit, banning “sissy-looking” boys from television programs (their words, not mine), and even passing a three-child policy.

China's Communist Party owes it all to colonialism - UnHerd

Chinese Communist Party’s 100-year celebration in July 2021| Source: BBC

Xi Jinping has revived Mao Zedong’s mantra: “east, west, south, and north, the party leads everything.” A troubling aspect of this effort to reassert control over the economy is a renewed push to develop CCP party organizations within private and state-owned companies. The idea that a political party, especially one committed to communism, should seek to embed itself in companies and exert control from within is one that should cause worry. 

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Financial advisors for successful professionals, executives, and business owners.

Government’s Hand

American companies operating within China and American investors in Chinese companies are faced with the unsettling prospect of a CCP organization inside their company with an unclear agenda and overlapping lines of authority with the company’s managers. 

There is limited transparency over how party organizations make decisions, what aspects of a company they seek to control, what accountability (if any) they have to a company’s shareholders, and what information is with outside parties. While the CCP’s efforts to control companies are not new, the CCP is undertaking an unprecedented effort to achieve this goal. 

We do not think this will turn out well for shareholders. As we all know, central planning like this is difficult to maintain, and it is the primary reason why communism is a failed philosophy. It is extremely difficult for a government to control the economy via its considerable number of businesses for the many tastes of a vast number of people in a complex world. Governments have never been able to find a way to run an industrial enterprise efficiently. This is the fundamental fallacy of socialism. 

As economist Milton Friedman stated (paraphrased), “the state ownership over the means of production impedes technological progress due to the competition being stifled.” I don’t believe that China has suddenly found a way around this basic truth.

Because of this extreme bureaucratic interference, I would not be surprised to see Chinese companies becoming less competitive and less profitable over time.  

Investing in Free Emerging Markets

Instead of investing in broad-based emerging market index funds that include a large Chinese position, we are instead allocating capital to countries that rank high on civil, political, and economic indicators. These countries include, among others, Taiwan, Chile, Poland, and Brazil. We are keeping a close eye on Taiwan, especially with the recent provocations by China. But for now, the country remains a staunch bastion of freedom. 

The fundamental philosophy behind this thesis is that freer markets grow more sustainably, experience faster recovery, and use their labor and capital more efficiently. 

It is crucial to highlight that, in line with our philosophy, we do not invest in Russia, particularly following the 2022 invasion of Ukraine. The U.S. banned all new investments in Russia soon after the invasion, rendering this decision somewhat redundant. However, we had already exited all Russian securities before the invasion, reaffirming our earlier stance.

As always, if you need assistance with your financial goals, please don’t hesitate to contact us. We are here to help.

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