After much deliberation, we decided to remove our China equity exposure earlier this year. We have maintained a position in China’s equity market since our founding in 2014. However, China has become more brazen and controversial during these eight years. Thus, we decided to reduce this allocation in 2021 and ultimately sell in 2022.
This decision was caused by two primary concerns:
First is China’s significant representation within the emerging market index. As of 3/31/22, China represents nearly a third of the entire emerging market index.
Investing in emerging markets, by its nature, is risky. Not only is there company-specific risk, but there is also currency risk, geopolitical risk, default risk, etc. To have a third of your emerging market portfolio in a single country is even more dangerous.
Second is China’s disregard for religious, civil, political, and economic rights. We do not want to invest in a country engaging in atrocities. China is committing genocide against an ethnic minority population. China is using censorship and propaganda to whitewash its true history. China dismantled and took over a free society, Hong Kong, in 2020, and the results have been chilling. China ‘disappears‘ its vocal critics, including very high profile individuals, including tennis player Peng Shuai, Premier Zhao Ziyang, and billionaire Jack Ma.
This country is looking more and more like a totalitarian regime rather than an authoritarian one. The word “totalitarianism” was first used in the 1920s by Italian fascist theorists to describe then-Italian Prime Minister Benito Mussolini’s fascist government. For Luigi Sturzo, totalitarianism represented “the centralization of political and economic life, suppressing all freedom of action and transforming the powers of the state into a single power, both executive and administrative, and thereby reducing it to true dictatorial power.” While authoritarian regimes force the individual to submit to a warped and one-sided sliver of society, totalitarianism is the exaltation of the state above everything else, including both the individual and society.
In short, we do not think it wise to invest capital into a country that commits these acts. Even if we put our moral issues aside, investing in China looks quite risky. Capital markets in states that limit their people’s freedoms tend to underperform versus those countries that place a high value on personal freedoms.
Our concern with China was one that slowly built over the years. As a recap, here is how we got here.
How We Got Here – China’s Economic Growth
When China opened its economic doors 30 years ago to the world, the U.S. and the rest of the western world saw an opportunity. Not only could western countries benefit economically by investing in the most populous country in the world, but perhaps they could fundamentally change China. The hope was that political and human freedoms would follow economic freedoms.
The western assumption was that economic freedoms and democratic freedoms were two sides of the same coin. And to some degree, perhaps they are. We assumed that China would soon be on the same path as Japan, Britain, Germany, and France post World War II.
This, of course, did not happen. China’s growth has come in the context of stable communist rule, suggesting that democracy and growth are not mutually dependent. The Chinese Communist Party has embraced the private sector and capitalism while maintaining a strong political system. There is even strong evidence that the CCP strengthened its political positioning during this period. After all, the average Chinese citizen’s well-being has improved over the past 30 years as their wealth and economic freedom and improved. As a result, and quite ironically, the CCP was able to use capitalism to further its communist goals.
Return to Socialism
The CCP has been able to justify its trickle-down economic policy as a concept of socialism “with Chinese characteristics.” It allowed the government massive philosophical leeway to grow its economy.
However, General Secretary Xi Jinping thinks China is now ready to return to economic socialism (somewhat). The new catchphrase from the CCP is “common prosperity.” Under this banner, the government is targeting the country’s tech giants, banning private tutoring (education is more equitable this way), implementing a daily three-hour video gaming limit, banning “sissy-looking” boys from television programs (their awful words, not mine), and even passing a three-child policy.
Xi Jinping has revived Mao Zedong’s mantra: “east, west, south, and north, the party leads everything.” A troubling aspect of this effort to reassert control over the economy is a renewed push to develop CCP party organizations within private and state-owned companies. The idea that a political party, especially one committed to communism, should seek to embed itself in companies and exert control from within is one that should cause worry.
American companies operating within China and American investors in Chinese companies are faced with the unsettling prospect of a CCP organization inside their company with an unclear agenda and overlapping lines of authority with the company’s managers.
There is limited transparency over how party organizations make decisions, what aspects of a company they seek to control, what accountability (if any) they have to a company’s shareholders, and what information is with outside parties. While the CCP’s efforts to control companies are not new, the CCP is undertaking an unprecedented effort to achieve this goal.
We do not think this will turn out well for shareholders. As we all know, central planning like this is difficult to maintain, and it is the primary reason why communism is a failed philosophy. It is extremely difficult for a government to control the economy via its considerable number of businesses for the many tastes of a vast number of people in a complex world. Governments have never been able to find a way to run an industrial enterprise efficiently. I don’t believe that China has suddenly discovered it.
Because of this extreme bureaucratic interference, I would not be surprised to see Chinese companies becoming less competitive and less profitable over time.
Investing in Free Emerging Markets
Instead of investing in broad-based emerging market index funds that include a large Chinese position, we are instead allocating capital to a freedom-weighted emerging market index. This alternative index uses quantitative personal and freedom metrics to drive its investment philosophy. The fundamental philosophy behind this thesis is that freer markets grow more sustainably, experience faster recovery, and use their labor and capital more efficiently.
This decision did not come lightly. After all, China is the second-largest economy in the world. Not including China within one’s portfolio omits a large swath of the global capital markets. Further complicating the matter was that many of our clients had sizable capital gains. Would our clients be willing to pay taxes on those gains? In other words, would they be willing to put their money where their mouth is?
We reached out to these clients to discuss our thoughts and concerns. To our delight, they shared the same concerns, and they all stated that they would be willing to realize those capital gains and remove Chinese equities from their portfolios.
Ultimately, we decided to invest only in emerging market countries that value both personal and economic freedoms. Not surprisingly, China did not make the cut. Neither did Russia.
As always, if there is anything we can do to assist you with your financial objectives, please do not hesitate to contact us. We are happy to help.