(Bloomberg) — Global investors are losing faith in China’s ability to navigate an increasingly complex maze of challenges.
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The war in Ukraine raises the specter of harsh sanctions being applied to Chinese firms should they proceed with plans to acquire stakes in Russian energy and materials producers. The risk of Chinese companies being delisted from the U.S. is growing. A housing slump is worsening. Record commodities prices locally may stoke inflation, while the highest Covid-19 infections since the Wuhan outbreak will weigh on already weak consumption.
President Xi Jinping’s crackdowns on the most profitable companies had already undermined investor sentiment before Russia’s war. Since the invasion, pessimism has turned into panic. A gauge of Chinese shares in Hong Kong has plunged 15% in the world’s worst performance among actively traded benchmarks. The yield on the nation’s junk bonds has climbed above 25% for the first time. Sovereign debt hasn’t been immune to the selling, with the 10-year yield rising to the highest since December.
While sanctions have weighed more heavily on Russian assets, China’s markets are the ones that matter globally. Russia’s stock market was valued at $781 billion at the start of the year, compared with a combined $19 trillion for mainland China and Hong Kong bourses. Chinese firms account for almost a third of the widely followed MSCI Emerging Markets Index, versus less than 4% for Russia before the index compiler reclassifed the country. China’s onshore debt market is worth about $21 trillion.
“Capitulation is starting to take place,” said Gilbert Wong, a quantitative strategist at Morgan Stanley, whose team predicted the rout in Chinese shares last year and refrained from joining the bullish consensus on China going into 2022.
The crisis of confidence is a challenge to Xi’s primacy, especially in a year when he plans to cement his third term as president. Xi has strengthened ties with Russia, as outlined in an extraordinary joint statement with Vladimir Putin shortly before the invasion. The two leaders made it clear they have closed ranks against the West, declaring there was no limit in the friendship between the two nations.
While China has continued to provide diplomatic support to Russia after the invasion, Beijing officials have also expressed concern about civilian casualties, vouched for Ukraine’s sovereignty and stepped up diplomacy with European nations while calling for peace talks. It’s also unclear how much financial support China will provide for Russia, with U.S. Commerce Secretary Gina Raimondo saying there’s no evidence Chinese companies are planning to evade American sanctions on Russia.
China remains acutely reliant on Western capital and technology, despite recent efforts to make the country more self-sufficient. Foreign direct investment topped 1 trillion yuan ($128 billion) last year, with about a third going into high-tech sectors, Chinese Commerce Minister Wang Wentao said this month. Xi told World Economic Forum attendees in January that he welcomed all types of “legal” foreign investment.
For many Western firms, the appeal of China is fading. U.S. businesses are hesitant about increasing investment due to rising regulatory uncertainties, pessimism over market access and economic growth concerns, according to a survey by the American Chamber of Commerce released this month.
Global investors have even less conviction, and are turning tail. Overseas investors sold more than $5.7 billion of onshore stocks this week through trading links with Hong Kong, the most since March 2020. The Hang Seng China Enterprises Index is trading at levels last seen in 2009, while a gauge of U.S.-traded Chinese shares has fallen almost 70% since last year’s peak.
Losses could deepen from here, according to Morgan Stanley analysts including Jonathan Garner, who correctly called the top of China’s stock bubble in 2015. The MSCI China Index could fall to around 62 points at the end of the year in a bear-case scenario, implying a 26% annual loss — worse even than 2021’s 22% plunge — according to a note earlier this month.
The risk of a united West hardening its attitude toward China is growing. Norway’s $1.3 trillion sovereign wealth fund this week said it was excluding Chinese apparel firm Li Ning Co. from its portfolio due to concern that the sportswear maker contributes to serious human rights violations in Xinjiang.
Investors are worried about the possibility of Chinese companies being kicked off U.S. exchanges. The U.S. Securities and Exchange Commission identified five Chinese firms this week that could be subject to delisting if they failed to comply with certain auditing requirements, unnerving holders of Chinese ADRs.
The flow of global capital into China’s sovereign debt is also starting to reverse. Foreign investors sold a net $5.5 billion of bonds in February, the most on record and the first outflow in 11 months. The notes have dropped almost every single day in the past two weeks, with yields on benchmark 10-year sovereign debt rising to 2.86%. Goldman Sachs Group Inc., Pacific Investment Management Co. and AllianceBernstein Holding have recently turned less bullish on Chinese bonds.
This may undermine China’s efforts to fund fiscal spending in order to meet this year’s 5.5% growth target. Total issuance will likely be 7 trillion yuan in 2022, according to Standard Chartered Plc estimates, with much of the supply likely in the first half of the year. China’s increasingly squeezed banking system would need to sacrifice lending to absorb the supply, leaving foreign buyers with an increasingly important role to play in the market, said Craig Botham at Pantheon Macroeconomics.
“This year China has probably found enough cash down the back of the sofa to make a reasonable go of things,” Botham, Pantheon’s chief China economist, wrote in an email. “That’s going to erode over the course of the year however, and the cupboard looks bare from 2023. Someone will have to borrow.”
The economy will likely need a lot of support. The housing market is rapidly cooling, with home sales falling since July and developers are increasingly facing default.
The average yield on Chinese junk dollar bonds — dominated by property firms — climbed to an all-time high of 25.8%, a Bloomberg index showed, reflecting deepening pessimism that companies will be able to repay their debts.
A record 56% of developers’ high-yield offshore notes traded below 50 cents on the dollar, according to Bloomberg Intelligence analysts Dan Wang and Daniel Fan. More than 30% of the notes could default this year, the analysts estimate.
Domestic consumption is weak as the country battles to control the spread of omicron. Data next week will likely show retail sales increased just 3% year-on-year in the first two months, according to the median economist estimate. Efforts to maintain Covid Zero in Hong Kong failed this year, leading to rocketing cases and one of the highest death rates globally.
China’s Premier Li Keqiang, announcing his final year as the country’s No. 2 official, said Friday the economic growth target for 2022 will be a challenge to meet. After saying China will become more open to foreign investment, Li waved goodbye and said “thank you everybody” in English.
(Updates to add details of China’s reaction to the war in seventh paragraph.)
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