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Despite the optimistic talk, Wall Street has reservations about China

ayou idiotWith a bit of luck, you can make an amazing return by betting on a coin. Yet they risk losing everything in the process. The end result for investors is a high return adjusted for the risk associated with it, an idea most famously captured by the “Sharpe ratio”. This divides the expected return of the asset, minus the risk-free price an investor could earn by parking their money in ultra-safe government bonds, by its standard deviation, which is a measure of the volatility of the return. A ratio above one is good. The Sharpe ratio for a double or nothing coin is negative.

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These kinds of calculations are on the minds of Western financiers who have made or plan to invest in China. Over the past three years, risks associated with the country have accumulated. Power appears more concentrated than ever in the hands of Xi Jinping, China’s leader. His stance on business is volatile: he has swindled tech companies including Alibaba and Tencent; Alibaba subsidiary Ant Group was forced to cancel its US initial public offering in 2020. A string of top executives have disappeared. The most recent disappearance is that of Bao Fan, the chairman of China Renaissance Holdings, who was reported missing on February 17. Shares of the investment bank fell 50% before recovering slightly.

Relations between China and the West continue to deteriorate. America provided huge subsidies to boost the domestic industry. This month an apparently Chinese spy balloon was shot down. The prospect of an eventual conquest of Taiwan by China, and the West’s willingness to impose sanctions, as evidenced by the actions imposed on Russia, raise the possibility of a further economic estrangement between the two powers.

However, the rewards for China are tantalizing. This has been true for a long time, but not quite as much as it is now. The country is opening up after years of severe lockdown. Given the economic heft, a pickup in activity as Chinese begin to visit restaurants, travel and shop again means that the country alone can support a significant amount of global growth in 2023 and 2024. It’s worth it.

There are vocal supporters of both sides of the situation. On February 15th, Charlie Munger of Berkshire Hathaway, who is notoriously optimistic about China, hailed domestic companies as “better and stronger” than their US counterparts, and available at cheaper prices. He also downplayed the idea that China might one day invade Taiwan. In contrast, analysts at JPMorgan Chase Bank and Jeff Gundlach, a bond investor, called China “uninvestable” (although JPMorgan analysts later changed their minds).

However, private financiers are more cautious, and are reducing their exposure to the country. The private equity fund head says that although their company still sees opportunities in China, it is adapting its approach; Avoid any businesses that could end up ensnared in, for example, nasty supply chain disputes. Berkshire Hathaway has reduced its stake howevera Chinese electric vehicle manufacturer, and tsmca strategically important Taiwanese semiconductor company, in the fourth quarter of 2022.

The most comprehensive information on foreign investment is found in balance of payments data, which tracks financial and trade flows. These showed increasing “portfolio flows,” such as investments in equities or debt securities, into China in recent years, before turning sharply negative in 2022. They were only published after a delay: the latest numbers do not show the reopening. Real-time evidence on the flows is mixed. And while stocks are rallying and there is some evidence of modest inflows into mutual funds, Bloomberg data indicates that outflows from exchange-traded funds have continued this year so far.

This indicates a kind of fear among Wall Street’s finest. Even if they don’t want to say it publicly, concerns about Xi and Taiwan prevent them from embracing China. Perhaps the best way for Western financiers to get rich is not to put their capital at risk by investing in Chinese companies or stocks, which may falter on a government whim, but by providing investment services Wall Street is best for wealthy Chinese investors. Last month, it was reported that assets in China managed by Bridgewater, an investment firm that first launched in-house funds in 2018, had doubled, to nearly $3 billion. This work has the added advantage of not having to be justified by calculations involving the Sharpe ratio.

Read more from Buttonwood, our financial markets columnist:
Investors Expect Economy to Avoid Recession (Feb 15)
Stock rally undermines sacred investment base (Feb 7)
The last moments of the meme stock era (February 2)

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