In today's Finshots, we talk about the Chinese stock market and the recent rally.

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The Story

Before we discuss the rally, let me ask you a more straightforward question: If you knew for sure that the Chinese stock market would explode in value tomorrow, how on earth would you go about investing there?

Well, the answer to that question isn’t as obvious as it may seem.

The Chinese government tightly regulates the stock market and foreign investors historically have had very little access to Chinese stock exchanges. For instance, Chinese companies primarily issue two kinds of shares. A-shares and H-shares. A-shares are generally only available to citizens of China and trade on either the Shanghai Exchange, Shenzhen Exchange or Beijing Exchange — all located in mainland China. As an outsider, it’s very hard to get a hold of these shares and even when you do, the government controls pretty much everything here.

H-shares on the other hand are listed on the Hong Kong Stock Exchange. They are more accessible to foreign investors because of the “One Country, Two Systems” principle — established when the British handed over control of Hong Kong to Chinese rule in 1997. Under this framework, Hong Kong maintains its own legal and financial systems separate from Mainland China. This includes its own currency (the Hong Kong Dollar), legal system, and a distinct stock exchange. So if you’re really looking to participate in the Chinese story, you could buy H-shares.

However, not all companies issue H-shares. Some massive companies like Lenovo and PetroChina (one of the largest oil and gas producers in the world) do it to access a wider pool of investors. But there are smaller companies that may not even want to list on the Hong Kong stock exchange. So there’s that.

Finally, you have tech companies like Tencent and Alibaba. As we already stated, the Chinese government restricts foreign investments in Chinese stocks and since these companies are deemed particularly sensitive, this control can be overbearing at times. However, to bypass these restrictions, companies like Tencent set up a holding company in the Cayman Islands, for instance, and sign a contract to share a part of the future profits with this entity. The holding company then lists on the US stock exchange on the back of this contract by issuing something called an ADR (American Depositary Receipt). It’s like a ticket that represents a foreign company’s stock. However, you don’t own shares directly.

This is how Alibaba went public in the US. And by now, you can probably see how complicated this stuff can get. This also explains why most people choose to invest in the Chinese markets indirectly through either ETFs (Exchange Traded Funds) or Mutual Funds. They rarely ever buy individual stocks.

And now that we have that out of the way, let’s talk about the rally.

Well, you could attribute some of this to the simple fact that Chinese stocks have been in the dump of late. And as the old adage goes, when you reach rock bottom, the only way to go is up. So considering the cheap valuation, some investors may be tempted to try their luck with Chinese stocks.

But wait — How come Chinese equities have been doing so poorly when the Indian stock market has been on the up these past 3 years?

Well, one reason could be the Chinese government’s dictatorial policies. Just look at the convoluted structure surrounding Alibaba. When you buy Alibaba in the US, you’re essentially buying a “ticket” (ADR), which in turn is backed by a promise from a Cayman Islands holding company. The holding company doesn’t hold “Alibaba” shares. All they have is a contract or an “economic interest” with the real Alibaba in Mainland China. And if the Chinese government walked in tomorrow and deemed the contract invalid, then you’d be holding worthless paper. That’s not exactly the kind of scenario that inspires confidence.

There’s also the fact that the Chinese government has a nasty habit of going after its own companies. Shortly after its US IPO in 2021, Didi (the ride-hailing giant) was investigated by Chinese regulators for cybersecurity and data privacy violations, leading to a ban on new user registrations and the removal of its app from Chinese app stores. Again, not the kind of stuff investors look forward to.

And finally, you have to talk about COVID-19 and how the Chinese economy has fared of late. The Zero-Covid policy backfired rather spectacularly as businesses were forced to shut down for extended periods even as other emerging economies relaxed restrictions. The economic slowdown in turn affected consumer confidence as people began to brace for an uncertain future. And finally, with multiple real estate companies going down, the Chinese public had to contend with losses on their investments and general unemployment. This had a visible impact on the stock market as well.

However, now that we’ve moved on from Covid, things are looking a little better. The Chinese economy could be on a path of recovery. For instance, China’s GDP grew by 5.3% year on year in the first quarter of 2024 — a result above market expectations according to an article in the Morning Star. Also, the Chinese government has been trying to prop up the stock market. State-owned companies have been buying Chinese stocks in an attempt to stabilize the market and it’s kind of working. Also, foreign investors have been coming back to China in the hopes that corporate earnings would improve.

Granted so far, the evidence has been rather underwhelming here, but everyone seems to be hopeful about the future.

And finally, maybe the rally isn’t much of a rally at all. Yes, the index representing some 300 Chinese stocks has been up. But it’s only been up about 7% since the beginning of this year. It’s not exactly world-beating returns. As they say, even a “dead cat” will bounce if it falls from a great height. So maybe this is just some respite for Chinese stocks that have been sliding for the better part of the last three years.

Until next time…

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