Fixed Income Boutique

China’s ongoing volatility: A movement to address ESG challenges

The Chinese government’s recent legislative crackdowns focus on the “social” (S) factor of Chinese corporate ESG regulation. The government’s goal is to increase the population’s real living standards by lowering the cost of living and raising children, reducing wealth inequality, curbing Big Tech monopolies (similar as in the US with Facebook/Google), and fighting corruption.

An ageing population poses a demographic challenge for any country, and just like most of Western Europe, this is an issue that China is dealing with. Currently, many young Chinese couples don’t want to have children or even marry because of the soaring cost of property and raising children in the cities. This is also a long-time problem for many other Asian countries.

China is serious about building a cleaner, fairer, and sustainable society. For example, the “environmental” (E) factor is addressed in the Chinese government’s Carbon-Neutral roadmap including its 2060 emission target. Therefore, any corporate or sector standing in the way will be punished. All recent regulatory moves targeting expensive education and living costs, internet monopolies, and dirty coal plants are really about addressing ESG issues on corporates, especially some large profit-centered private enterprises.

On regulation/execution, China adopts a Civil Law system (same as Continental European countries, in contrast to Anglo-American sovereigns) combined with a strong central government. This makes the government involvement more engaged, resulting in knock-on effects, such as the recent spill-over selling from even education-unrelated sectors. Indeed, the Chinese credit market is a very technical and a somewhat leveraged market.

Where is this leading?

Any sector deemed ‘Bad ESG’ could be targeted by the Chinese government. As highlighted by Bloomberg:

“What’s clear is that firms which profit from activities that are deemed to generate substantially negative social externalities are likely to face restrictive regulation risk. Firms that create addictive and violent mobile games targeting young adults, firms that are big polluters, firms that target students with predatory loans, etc.—these are likely to be in the crosshairs of Chinese regulators. Secondly, this forceful clampdown elevated the importance of ESG investing to a new level. If we think about it, China is offering us an interesting and radically different lens through which to consider ESG. If there was ever a clear argument for superior return from ESG investing, it was about avoiding regulatory risk. Green investing makes sense if you expect an unfriendly policy toward coal and fossil fuel usage. Avoiding tobacco stocks makes sense if you expect greater government taxes and other disincentives put into place to discourage smoking.”

Against this backdrop:

  • The Chinese government still supports SOE, but not without differentiation --- more direct support for important ones.
  • The Chinese complex has a large debt stock. but the country continues to deliver an elevated growth rate and is an economy with high savings rates, which supports this stock of debt.
  • It is not in the interest of the Chinese authorities to provoke a credit crisis, as lending rates would increase significantly and provoke further stress and social turmoil, which the government is seeking to avoid.
  • China has been a magnificent beta play. It remains highly attractive, but differentiation is key going forward.
  • The authorities will thus advance on its long journey, step by step, to limit social inequalities, limit moral hazard, deliver risk-based differentiation in credit markets, increase competition, reinforce the authority of the Party, whilst at the same time promoting economic growth and the expansion of capital markets.

After 30 years of unparalleled growth since joining the WTO, there are several dislocations and distortions that the authorities are looking to address and will continue to do so. This will create bouts of volatility after which the authorities will step in. These will be attractive opportunities for sophisticated investors. The “road to normalization” is probably not dissimilar to that of the US Federal Reserve. After highly accommodative monetary policy since 2009, with renewed fiscal expansion, rising inflation, etc., China too needs to move the market progressively away from the established status quo and wean the market off ultra-low rates and quantitative easing. This journey towards medium- to long-term normalization will also be done step by step and will create volatility and thus opportunities, for active credit investors.