Hong Kong-listed Chinese property developer Evergrande has hit the headlines and for all the wrong reasons: it’s all but bust. With total liabilities estimated to be $310 billion, a balance sheet eye-wateringly over-geared and recent monthly sales halving from June to August, the position is more than precarious. Homeowners who have pre-paid for as-yet unfinished accommodation are worried they have lost their money. Investors see the company’s bonds trading at little more than $30 cents in the dollar as the default risk mounts. Individuals with capital at risk are demonstrating vociferously online and on the streets, an embarrassment to the Chinese authorities; state-owned Chinese creditor banks (collectively on the hook for billions of dollars in potential bad debts) are thumbing their calculators and taking rapid stock of their risk exposure, not only to Evergrande but to the wider property sector should the system crack.

 

It’s all distinctly unhappy, reminiscent of the state of nerves in 2015 when gambling-mad private speculators tested the volatile Chinese equity market limits almost to destruction, only more pernicious this time because of the direct link with bricks and mortar and the real economy. While the company is now engaged in an asset fire sale and the government has appointed restructuring advisers, it remains to be seen what the authorities will do to minimise the damage. Opinions are divided: some believe for political and social imperatives that, as well as the need to maintain market stability and confidence, there must be a support mechanism, a bailing out. Others think the government may take a harder, more cynical view that Evergrande is not a state-owned enterprise, many of the prospective ‘homeowners’ are in fact property speculators, punters and their money are soon parted; much of the investment is foreign, let it go bust and watch the fools weep into their hankies; serves them right. Time will tell which path they take sooner or later.

Analysis of a collapse

But how did this corporate assets-built-on-sand collapse come about? A mixture of poor management, abysmally inadequate governance, bad risk-assessment by both the company and its creditors, egregious speculation and a lack of effective regulation, certainly. Recent actions by the authorities to restrict access to easy credit arguably provided the catalyst for the resulting significant chain reaction. It is this latter which is important, for there is much more to this than meets the eye; we have touched on the subject in previous columns; now is a good time to explore more deeply.

1979-1989 Deng opens the door to Western capital, even if just a little

As China continues the long-term process of re-balancing its economy, reducing the over-reliance on relatively low-value sub-contracted exports of materials and components to the West in favour of a more sophisticated domestic economy, one in which China promotes domestic consumption and takes innovation and intellectual property leadership in critical global sectors including pharmaceuticals, aerospace and defence systems, automotive technologies, and electronic hardware and software applications, a perceptible shift in official attitudes to foreign capital and state control is taking place. We need briefly to turn the clock back five decades to understand where we are today.

 

In the period from Mao’s Cultural Revolution in the mid-1960s to the premiership of Deng Xiaoping beginning in 1979, China operated a rigid system of ultra-orthodox, hard-line Marxism, ideologically, politically, socially and economically. It was Deng who realised that the Soviet model of “keep-everyone-equally-poor-and-miserable-all-the-time” risked limiting the duration of the Chinese Communist Party (CCP), but further, that deep self-obsessed national introversion would severely limit the ability to export such communist ideology abroad and would inhibit China from capitalising on its potential, despite its huge population, to be a significant world power to rival both the United States and Russia. Deng’s new orthodoxy was gradually to open China up to western capital albeit on the strict condition that only suitably approved investors would be allowed in, everything else was screened out. The genie was out of the bottle.

 

Fast forward to the early years of General Secretary Xi’s premiership nearly a decade ago and this orthodoxy was subtly but perceptibly altered: China would be open to all external capital unless the interests of the investors behind it were inimical to those of the CCP. Many strings were still attached, particularly relating to CCP governance regimens and the submission of intellectual property rights (a major objection of President Trump’s) but the realty was that what Xi introduced represented a fundamentally different mind-set. It was the backdrop against which all major western democracies beat a path to Beijing’s door wanting to grasp China’s expansionist coat tails in the great boom ride of its neo-colonialist infrastructure projects such as the New Silk Road and the maritime String of Pearls. It heralded the creation of the new Asian Investment Bank and George Osborne’s “Golden Era” of relations with China, more cynically known in the corridors of the Foreign Office as “Operation Kow-tow”. The UK was far from alone in deliberately and cynically holding its nose over the bad bits with China simply to enjoy the considerable long-term dividends.

Xi plots a different course; mailed fist in a not-so velvet glove

Since the 2016 meeting of the Central Committee of the Chinese Communist Party, General Secretary Xi has been rapidly consolidating his personal grip on power, particularly having appointed himself sole commander of China’s security service and the military. Anointed with the official title of ‘Core’ at that meeting, and more latterly with the additional nomen of ‘People’s Helmsman’ and abolishing the restriction on the number of Presidential terms allowed to be served, and with his doctrines of “Thoughts on Socialism with Chinese Characteristics for the new Era” formally incorporated in to the CCP Party Handbook (and as of last month, also formally introduced as a compulsory part of the curriculum in all China’s schools), be in no doubt that Xi is Emperor in all but name. It is against this backdrop of total power that he has been tightening the screws both domestically and abroad, taking China down a much more hawkish path. The persecution of Uighur Muslims, the illegal annexation of Hong Kong, the long-standing and continuing suppression of Tibetans’ rights, the obfuscation and deliberate frustration of the World Health Organisation investigation into the origins of Covid, escalating tensions in the South China Sea, military clashes with India in the disputed Hindu Kush, all are the obvious examples even in only the recent past.

Policy revision: tightening on every level, in every sense

But at home, Xi is well aware of the power of the big, global multi-media platforms and their ability to manipulate and disrupt normal democratic processes. That technology represents both a significant threat and a major opportunity. China’s development of cyber capacity is deliberately designed to exploit this capability in its confrontation with its competitors and those by whom it feels threatened. Domestically, within a communist society, his latest ‘reforms’ of the technology sector and all types of online activity with heavy-handed and far-reaching regulation are designed with one aim in mind: to retain direct control of all Chinese data, whatever the source and origin, and to manipulate it in favour of the state. Data is power.

 

Elsewhere, as global supply chains have become disrupted thanks to the dislocation created by the responses to Covid, Chinese authorities have clamped down with criminal sanctions on all forms of market abuse to try and restore stability to highly volatile commodity markets, particularly those such as copper, steel, cement and coal in which often China is the swing consumer globally. As we have mentioned in previous columns, against a backdrop of rapid economic recovery from the pandemic (notwithstanding that China’s economy was one of the very few to grow last year despite the first quarter collapse) both globally and domestically, and wary of overheating commodities and assets and rapidly spiking inflation, the authorities have been heavily restricting access to credit. Which directly links to the Evergrande story. But again, this is not just a nudge on the policy tiller; something much more profound is happening. Those relaxations in attitudes to foreign investment discussed above, with all the elements of capitalist undertones behind them have introduced market forces creating societal imbalances (a story not dissimilar to the effects of QE in the West); such imbalances are subversive: A Very Bad Thing.

 

Further, with one of the very highest debt/GDP ratios among all major economies (total debt/GDP estimated at 270% of which the corporate sector alone is 160%), financial and economic instability represents a significant risk, particularly for a country intent upon disintermediating the dollar strategically in favour of its own as the preferred or dominant global reserve currency, any weakness in China’s currency in response to financial stress would undermine China internationally. Xi recognises the incipient threats to the CCP and its authority and its plans should a taste of freedom and wealth become a perceived right and an expectation.

Re-socialisation: evolution or revolution?

It is no coincidence at the celebrations earlier this year for the centenary of the founding of the CCP that Xi appeared dressed in a Mao suit, that garment heavily pregnant with symbolism, framed against vast, outsize images of him and Mao in similar poses together. The language of the occasion was one of enduring national virtue, of strategic ambition and confidence spiced up with defiant sabre-rattling about Taiwan, all designed to reinforce mass faith in Xi personally, and the CCP. In the West such political cult is both difficult to understand and in many cases anathema. But in societies such as communist China or North Korea (even more extreme given it is a 100% closed society), such devotions are far from unusual. However, nor are they risk-free. Xi might exercise near-total control but he’s not immortal either as a human being or a political leader. However closed and controlled a society China is, nevertheless that sniff of capitalism and its associated wealth, and even if only a glimpse of some western freedoms, which together add up to the temptations of perceived decadence, have allowed a significant proportion of the population a view of the outside. Enthusiasm for more must be countered as unhealthy, anti-social and anti-socialist; conformity relies on the Leader combining persuasion and coercion in appropriate measure. The risk to Xi is that his reforms are judged domestically as repressive and there is resistance or subversion; the key is to keep the military and secret police on side. In the West where we remain hampered by the prevailing attitude towards others that “you don’t subscribe to our values so yours must be wrong” it is difficult accurately to judge the direction of the political wind within both the Politburo and the broader CCP about how enduring Xi’s appeal is and, as importantly, what the succession plans are in the event of his political demise or physical incapacity.

 

This quiet but profound revolution was summed up best in a political blog, the “Li Guangman Ice Point Commentary” at the beginning of September, published online internationally but clearly with Chinese state clearance (if not, the author is already hard at work repenting down a salt mine, as might be this one). It is worth quoting (courtesy of Ambrose Evans-Pritchard and the Daily Telegraph):

 

‘But the revolutionary mood was made all clear this week [in the blog]. His diatribe was re-printed across the state-run media with the clear blessing of the regime. “Everyone can feel that a profound change is taking place”, he said, proclaiming an end to China’s love affair with Western culture and “return to the essence of socialism”. It was framed as a fight to the death with the West, the unvarnished Xi doctrine’.

More than theory: the effects are with us, palpably visible today

And while this is a long-term change of emphasis within a 25-year strategic plan, the relevance of it is immediately visible. There are two clear examples this week. One is the direct effect of that re-socialisation of Chinese society programme on companies such as Evergrande, deflating the asset bubble. The other at the strategic level is the West reacting to change too. A vocal critic of Beijing, Australia has been subject to months of punishingly high tariffs on its exports to China; this week the US, the UK and Australia announced a tri-partite treaty to support the building of a new nuclear-powered (explicitly NOT nuclear-armed) Australian submarine fleet to counter the rapidly developing Chinese naval strength. It is a robust response on the face of it; however, in the game of geopolitical power-broking and sowing division, while protesting vigorously about the descent into a new Cold War, China will be well satisfied that two members of the West’s key ‘Five Eyes’ defence intelligence group are missing. New Zealand is compromised by Jacinda Ardern’s government having signed a trade and investment treaty with China earlier this year, while Canada is in electoral purdah. Further, not only is the EU predictably absent having also signed an investment agreement with China this year, but in aligning with the UK and the US, Australia has broken off a £47.6bn submarine building contract with France (France was contracted to supply Australia with diesel boats), causing further ructions in the Western defence camp.

Investment perspective

From an investment perspective the Jupiter Merlin Portfolios have limited direct exposure to China. However, the Chinese authorities’ economic strategies to curb excess demand and to blunt near-term inflation together are already showing signs of slowing economic activity in the second half of 2021, and which may persist in to 2022; the knock-on effects on the broader global economy will be evident (until the pandemic, it was estimated in a normal year that China’s economy alone contributed 30% to the annual rate of total economic growth), perhaps taking some of the steam out of the recovery momentum. Longer-term, as ever the effect will be most evident through the barometer of bond yields and exchange rates, risk and term premia.

 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

The value of active minds – independent thinking:

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Fund specific risks:

The NURS Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request. The Jupiter Merlin Conservative Portfolio can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Jupiter Merlin Income, Jupiter Merlin Balanced and Jupiter Merlin Conservative Portfolios’ expenses are charged to capital, which can reduce the potential for capital growth.

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