Mike Dolan

LONDON (Reuters) – Paradigm lost?

Many investors have held the belief that China’s markets and currency would eventually be the center of global finance. This is despite the fact that China has suffered from a severe 2021 earthquake and February’s geopolitical turmoil.

Many leftfield shocks followed the COVID pandemic, still unfolding in China amid severe growth-sapping lockdowns. Asset managers now have to reevaluate their long-term beliefs.

There is much debate about China’s latest investment crisis among foreign funds. It is not so much cyclical or COVID-related.

For money managers who are growing in number, Russia’s invasion and subsequent Western financial sanctions have changed their calculus.

This invasion comes less than three weeks following the Olympics summit of Vladimir Putin and Xi Jinping, which cemented an alliance opposed to Western power in pursuit for a new order. It has fractured geopolitics. Beijing refused condemnation or to break ties.

Investors are now more concerned about the possibility of sanctions, either in the future by China or through Russian-related economic entities.

This is all on top China’s “common prosperity” drive 2021 which saw a string of crackdowns on financing activities, profit motives, digital commodity trading, online education and other financial activity.

An explosion in Chinese real estate and debt repayments that were in the background only increased the pressure. Now, “Zero Covid” locksdowns in Shanghai have reduced 2022 Chinese growth forecasts to below 4%.

Overseas investors have fled China in the last two months. The painfully low performance of Chinese stocks over many years and the main indices of this country are now between 20-30% lower than the world benchmarks.

Furthermore, investors have been forced to flee the once-prized fixed-income market due to the loss of significant yield premias from Chinese bonds relative to U.S. Treasuries. This is largely due to the Federal Reserve’s hawkish reaction to the recent energy price shock.

Complete the triangle was the sudden, plus-4% slide in the yuan’s offshore rate to the dollar in March. It was most likely the result of those outflows. Authorities were almost unaffected by it.

“To me, this is only the beginning of it,” stated Yves Bonzon (Chief Investment Officer, Swiss asset manager Julius Baer), adding that the yuan might weaken an additional 5% very quickly.

Graphic: and China Yield Premium – https://fingfx.thomsonreuters.com/gfx/mkt/akvezynmdpr/Two.PNG

Graphic: Foreign funds exit Chinese bonds – https://fingfx.thomsonreuters.com/gfx/mkt/lgvdwgxokpo/Four.PNG

Graphic: China stocks underperforming for 5 years – https://fingfx.thomsonreuters.com/gfx/mkt/dwvkryjzzpm/Five.PNG

TWICE IN A LIFE

Apart from the tactical market call Bonzon believes the world is changing and that the invasion of Ukraine meant that geopolitical considerations in cross-border investment were now crucial for the first times since the fall of the Berlin Wall 40 years ago.

He said that February’s invasion was one of “the two most significant inflection points” in his career.

Practically Julius Baer was the first to make changes to its long term strategic asset allocation. It removed Chinese equity entirely as a standalone “core” investment. Instead, it reduced direct Chinese equity to zero and merged that exposure with other Asia benchmarks.

China is not “uninvestable”, but it claimed that this will be the case only from now on on tactical or thematic grounds.

“Investor capital faces a risk of being de-rated by China’s government, as well as impairment due to Western sanctions should relations turn bad.”

It is possible that the view does not agree yet.

Others feel that this will also pass, and political and market conditions can quickly change.

Matt Quaife, Fidelity’s Asia Multi-Asset Head, argued that although the Chinese market will be difficult in the coming months there are some eye-watering valuation differences between tech companies located there and Western counterparts. Peak fear could offer potential opportunities over the medium-term.

However, the root of this investor fear is a lack of confidence in China’s political framework. It threatens the whole idea of internationalisation and the reserve or store of value of the yuan.

Gene Frieda, a strategist at PIMCO believes that the impact of Russia’s decision to freeze its foreign currency reserves has actually made it more difficult for the Yuan than it had been in the past.

Frieda said that China’s growing economic conservatism and the sanctions risk they pose to China are both working against the rise of the Yuan as a reserve currency. Russia’s experience shows that FX reserve sanctions can have a powerful effect on a country, causing currency non-conversion.

While the share of the Yuan’s global reserve weight is expected to continue rising, it will be limited in the mid-single figures.”

Graphic: Real Effective Exchange Rates – https://fingfx.thomsonreuters.com/gfx/mkt/zgpomljkopd/One.PNG

Graphic: Yuan share of world FX reserves – https://fingfx.thomsonreuters.com/gfx/mkt/byvrjnxqove/Three.PNG

The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed in this article are the author’s.

(by Mike Dolan. Twitter (NYSE::): @reutersMikeD. Edited by David Evans