It is not surprising that the comments and analysis on the recent protests in China have been overwhelmingly negative. Even Goldman Sachs which said China may end zero-Covid earlier than expected in Q1’23 put a negative spin (“disorderly exit”) and projected a lower-than-expected GDP in Q4’22.

There is no question that Chinese authorities are almost literally pressed to the wall with no easy options here. But what if there is a positive way out? It is no secret to anyone, including Chinese leaders, that there is a need to re-balance the economy towards domestic consumption and the best way to do that is to shift sectoral incomes towards Chinese households. For whatever reasons though Chinese authorities have not done that over the years, with the bulk of any extra income still going to the corporate (both private but mostly state) sector and local governments.

  • The Covid pandemic has however accelerated their work on DCEP, their version of CBDC, which allows for targeted transfers directly into people’s accounts. I believe, this is an avenue which will be much more explored as China gradually eases off from its zero-Covid policy.
  • Over the years Chinese authorities have been particularly slow in building the institutional infrastructure of pension and insurance vehicles and social security as a whole. But there has been substantial progress on that front this year.
  • Chinese assets, and in particular equities, have had two consecutive years of underperformance and under an extreme case scenario a third one is a distant possibility. However, the current set-up favours the establishment of a small exposure.

The Chinese household balance sheet

Chinese households’ balance sheet looks very different to US households’ balance sheet. In the US more than 2/3 of household assets are in the financial sector, the rest is in real estate (this is on average; it varies a lot depending on the income percentile though). In China, the split is more 50/50.

Within financial assets, Chinese households hold almost twice more Cash and its equivalents than US households (in % terms of the total household assets). But, on the other hand, they hold six times less Bonds and other Fixed Income equivalents and ten times less pension and insurance assets (all vehicles which come under social security). Equity allocations are very similar for both Chinese and US households, at around 1/3 of all household assets (this is direct ownership of equities; US households’ overall equity exposure is much larger as they own financial assets through their pension schemes, for example). A snapshot of Chinese household balance sheet can be seen here and of US household balance sheet here.

Basically, Chinese households have too much real estate and cash, too little exposure to bonds, and pretty much zero ‘social security’ cover. The protest against zero-Covid come at an opportune moment when the authorities have also been trying to contain the implosion in the real estate market. With Chinese households using real estate as the main source for pension coverage, creating a genuine viable alternative has become the top priority for Chinese leadership (the topic got extended coverage in China’s 14th Five-Year Plan).

The Chinese social security system

China’s pension industry framework consists of tree pillars. The first one is the basic state pension comprising of the Public Pension Fund and the National Social Security Fund. The second one is the voluntary employee pension plan in which the employer and employee make monthly contributions. And the third one is the private pension.

In April this year, China’ State Council released a document which stated that building the private pension system infrastructure is where their priorities now stand. This was followed by an announcement at a State Council meeting in September of new tax incentives to spur the development of private pensions.

The point is that a combination of an aging population, inadequate tax base and very early retirement age (60 for men and 55 for women) would eventually put the state pension system into deficit. At the same time, the employee-sponsored pension scheme is extremely inadequate covering only a tiny proportion of the population. So, the development of the private pension system has indeed taken centre stage.

DCEP can be used to top up household income

Part and parcel of that is ensuring the growth in household incomes. The authorities have been extremely slow in shifting national income more towards the private household sector. It is not clear to me why, especially given their goal of inclusive growth and the recent heavy regulations on the corporate sector in that direction. But these protests could speed up that process. For example, PBOC has been at the forefront globally in developing their CBDC (the Chinese equivalent is called DCEP – Digital Currency Electronic Payment). They have already successfully employed that in several cities on experimental basis.

In the present environment the authorities can use DCEP to help them ease out of their zero-Covid policy by directing payments to households in specific cities, neighbourhoods, even apartment buildings, which are affected by lockdowns. This kind of real-time, targeted fiscal policy can be extremely beneficial – much more so than the blanket free-for-all fiscal policy the US did during the Covid pandemic.   

Chinese assets offer an opportunity

Where does this leave your exposure to Chinese assets? If you are an institutional Fixed Income investor, you should consider the possibility of large flows into Chinese government bonds by both domestic retail as well as private pension providers, based on the analysis above (to a smaller extent, the same holds true for Chinese equities). Otherwise, it is easy to find reasons (see below) to not have any exposure to Chinese equities, but selling now here on the back of (zero) Covid does not make sense to me. In fact, the opposite is a better option.

Case in point, there was a lot of positive signalling at the latest weekly Covid briefing yesterday. For example, the authorities plan to increase vaccinations among the elderly, a move which could mean intentions to start reopening earlier. Some local governments were criticised for implementing severe lockdowns and were urged to adhere to ‘reasonable’ requests from residents. It is even possible, though I doubt it, that Beijing even decides to fully open up.

But there are two main risks to Chinese equities. The first one is regulatory and it is well known. The developments there are still in progress but if you are long CQQQ or KWEB (these are/were the popular China ETFs among foreign retail investors) and still worried US ADR delisting risk, you should know that only a small percentage of these ETFs holdings is still in ADRs. For example, CQQQ has 131 holdings worth about $767m. Of those only 8% (of the holdings and 15% of the market value) are still US ADRs.

Basically, the ETF providers have converted most of their US ADRs to equivalent HK/China listings, so the risk of substantial loss from US delisting for the whole portfolio has substantially diminished. There are though still regulatory risks. For example, the Chinese authorities can ban foreign entities from owning any China/HK listed stocks. I think the probability of this is small.

It could be also the case that US regulators ban US entities from investing in China/HK listed companies. I think the probability of that is also small but bigger than the former above. But, anyway, both of these are possible in a full-on US-China confrontation ala US-Russia now, which is the second risk to Chinese investments, and which is of truly existential nature. If this is your view, either you should not be touching any China-related investments, or, if you are a probability investor, you should appropriately scale your China exposure.