How to invest in China

If an alien travelled to earth with an intergalactic self-managed super fund and picked up a newspaper looking for investment opportunities, he would be making a beeline for anything exposed to China. If you believe everything you read, the streets of China are paved with gold and executives are going to sleep every night on mattresses stuffed with hard currency. But for Australian investors, it’s just not as simple as just adding Chinese companies to their portfolios.

China is not a free market in the Western sense. Investors don’t simply walk in and start buying shares in companies. Navigating the regulatory minefield is not easy; in fact many advisers, economists and brokers say the best way to get exposure is not even through direct investment. So while we know there is a wealth of opportunity, the question is how to access it.

China has two stockmarkets: Shanghai and Shenzhen. The two cities both set up exchanges because they share a similar Melbourne–Sydney rivalry and were jostling to be China’s financial hub. Shanghai has gained the edge to become the dominant exchange and now boasts a value of about $US2.9 trillion, while Shenzhen is being positioned as a Nasdaq or Alternative Investment Market-style option for smaller companies.

In the past year, the Shanghai Composite Index has lost about 60% of its value. Shocked? Don’t be. In the preceding year it quadrupled in value, so compared to where the market was in 2006, it is still an overwhelmingly positive picture. But the Chinese market has several characteristics that differentiate it from other international markets. One is its extreme volatility.

“One of China’s most famous economists has described it as a casino, which wasn’t long ago '¦ it’s a bit confusing because a lot of the shares are locked up in state-owned enterprises,” says Macquarie’s head of China economics, Paul Cavey, who is based in Hong Kong. “There has been some structural reform, but I think a lot of people would still describe it as something of a casino.”

The volatility of the Chinese market is primarily caused by its extremely high level of retail participation compared to overseas markets. Reliable market statistics on the Chinese market are hard to find, but it is estimated that 60–70% of participation is from retail investors.

“Retail investors tend to make it more volatile, because they’re investing more for the short-term and they have a different way of looking at investments,” Cavey says. “Institutional investors are investing more for the longer term '¦ retail investors tend to make it more volatile because, you know, individual investors get scared more quickly, I guess.”

Morgan Stanley strategy analyst Allen Gui agrees. “The retail part [of the market] is still very high '¦ so this situation makes the market quite volatile and speculative, because basically the retail investors, they do not understand what the stock price implies,” he says.

The Chinese stockmarket was set up to enable the government to list state-owned enterprises, but it was only part-privatisation, with about 30% of the companies being listed. This has resulted in a comparatively small market and has contributed to its volatility. Although larger shareholders in Australian companies might be able to influence the boards of their investment targets, or even sit in non-executive roles, this isn’t really an option for many government-controlled Chinese companies.

Like almost everything else in China, investing directly in the Chinese market is tricky. If a mutual fund wants to invest directly, it needs to do it through a Chinese joint venture or through the Qualified Foreign Institutional Investor (QFII) program. QFII status allows companies to take advantage of relaxed capital controls that allow foreign institutions to invest in Renminbi-denominated equity and bond markets.

China caps the total investment allowed under QFII regulations – the current cap is $US30 billion, split between the organisations granted access to the program. There are only 58 companies on the list, including usual suspects such as UBS and Morgan Stanley, but also Australian companies AMP Capital Investors and Platinum Investment.

AMP Capital Investors invests in the market through its ASX-listed China Growth Fund, which has seen its net asset value decline 28.1% in the 12 months to July 2008, but has posted overall growth of 30.7% since its inception in 2006. Platinum Investment only gained QFII status in June and is not believed to have started buying Chinese shares thus far. The group has no plans to open a specific China fund, so investors are likely to gain exposure through its Platinum Asia Fund.

Direct routes into the Chinese stockmarket for individual investors are almost non-existent. Restrictions on foreign investment means overseas retail investors cannot trade freely on the Chinese exchange. But there are two other ways you can plug your money in China. The first is via Hong Kong and the second is right in your own backyard ... on the ASX.

The Hong Kong market – home of the Hang Seng Index – is more transparent than the Chinese exchange, with a market capitalisation of about $US3.5 trillion. Many of the largest companies on the exchange are from mainland China including PetroChina, Industrial & Commercial Bank of China, China Mobile, Bank of China and China Life Insurance. The Hong Kong market is more established than its Chinese sister, but it still features higher volatility levels.

“Retail investment participation in the Hong Kong market is also very important, so it does tend to be more volatile than some of the more mature markets in the rest of the world, but it is more sophisticated than the Chinese market,” says Macquarie Bank's Cavey..

There are three sorts of companies listed in Hong Kong: local companies; companies from China that have their main listing in Hong Kong; and companies that are dual-listed in Hong Kong and China. The draw for Chinese companies to list in Hong Kong is strong.

“It’s to help raise their profile,” Cavey says. “It kind of gives kudos. The company is seen as having a higher standing if it’s listed overseas rather than just listed in China.”

Aside from the Hong Kong route, there is another way Australian investors can put a piece of China into their portfolio and it’s a lot closer to home.

In Morgan Stanley's office overlooking Shanghai's most famous street 'The Bund', Allen Gui offers a surprising perspective for the Australian investor.

“It’s not necessary to come to the A-share [Chinese companies listed in China]. You can simply gain exposure to China’s growth from holding the natural resources assets in your own country,” Gui says. “We think it is actually quite safe and quite an easy way to get exposure to the China growth story. After all, a lot of Chinese fund managers are doing it!”