Boom and Bust Cycles, Opening Up and the Maturing of China’s Financial Markets: An interview with Damien Horth

You may listen to this interview from HERE.

Damien Horth has over thirty years’ experience analysing financial markets. As a research analyst, he has covered companies in over 20 jurisdictions, including China, Hong Kong and Taiwan. He started his career in Australia and has since been based in London, Hong Kong and Tokyo. He spent over 20 years at UBS’s Investment Bank, moved to Hong Kong in 2005 and while Head of the Asia Pacific Research team, he led a major expansion of their now market-leading China research coverage. Damien currently consults and invests in a personal capacity. He holds a Bachelor of Commerce from the University of New England in Australia and completed the Advanced Management Program at Harvard Business School.  

Q1. Please introduce yourself and tell us about your current interests.

I have always been passionate about financial markets and was fortunate enough to fall into an equity research career that has taken me around the world. I have been a manager for most of the past 15 years but first and foremost see myself as a fundamental analyst and investor. I am particularly passionate about how technology can improve investment processes and am currently experimenting with the possibility of embedding AI into a fundamental investment process.

Q2. Please provide a brief overview of China’s financial markets. Some have commented that the domestic banking system has an outsized influence on the economy and that a more balanced system, with potentially greater foreign participation, would be of benefit to the country.

Chinese corporate financing remains dominated by the banking system with loans accounting for c.65% of corporate financing, bonds 26% and equity financing c.8%. In contrast, loans only account for 12% of corporate financing in the USA. This is not surprising given the importance of SOEs to the Chinese economy but in many ways, it constrains innovation and hence the potential of the Chinese economy.

A more balanced financial system (i.e. less dependence on the banks) would not only help drive riskier innovation, but it would also help diversify household and institutional savings options. I see this as particularly important now given the challenges facing the property market, elevated debt levels and the need to provide long-term income generating assets for the aging population.

My impression is the Chinese authorities understand this opportunity, but it is a balancing act because equities are risker, and the local equity market is dominated by retail investors. We have seen significant reform over the past decade and innovative initiatives such as Stock Connect. Many of these moves are designed to drive institutionalization and attract foreign capital and knowhow. I expect liberalization to continue because the authorities recognize that it will be a driver of economic growth.

The level of foreign participation in Chinese markets is a subject of debate and this can’t be considered in a geopolitical vacuum. That said, I think the mistake many foreign investors have made over the past decade was to assume that China would ‘naturally’ become more like ‘the West’. This has not been the case, but it also doesn’t necessarily mean there aren’t compelling investment opportunities.

Q3. Can you talk through the differences between the A, H and ADR markets. What role do capital controls play in how these various markets function, and more generally, how well do you think foreign investors understand China’s markets?

The Amsterdam Stock Exchange was founded in 1602 and the New York Stock Exchange in 1792, whereas the current incarnation of the Shanghai Stock Exchange reopened in 1990. China has developed at an incredible pace over the past 35 years, but we are still early in the modernization of the financial sector.

The least understood market outside China is the A-share market. This is the onshore market, which is RMB denominated and governed by the local legal/regulatory framework. The ADR market is partly governed by the US legal system, while H-shares are underpinned by Hong Kong law. There have always been material restrictions on foreign ownership, but access to A-shares has improved over the years with schemes such as QFII and Stock Connect. That said, the A-share market remains dominated by local retail investors (c.80% of traded volumes). The offshore markets are much less driven by retail investors.

One of the most unique aspects of Chinese markets is that many companies have listings on multiple exchanges and different share classes (e.g. A-shares listed onshore, and H-shares listed in Hong Kong). The closed capital account means that these shares are not fungible and often trade at very different valuations. This reflects a different cost of capital in the onshore market, partly because of the limited investment alternatives but also differing investor psychology.

The first Chinese ADR (American Depository Receipt) was listed in 1993, so it is notable that this wasn’t long after the reopening of the local stock exchanges. However, despite this, I have been surprised by the lack of understanding of the Chinese institutional framework, even from so-called highly sophisticated institutional investors. Knowledge has improved but, for example, fundamental structures such as Variable Interest Entities (VIE), which operate in a legal grey area, are still poorly understood.

Q4. While China boasts one of the world’s largest stock markets, it is still developing in many respects. What are some of the challenges you see in terms of cultural and human capital constraints, in addition to any legal and compliance issues?

The effective development of long-term equity capital markets requires an ecosystem of experienced and highly trained professionals. Obviously, I think high quality research is crucial, but experienced fund managers, auditors, lawyers, regulators, traders and bankers are also needed. This is an ecosystem which has evolved in the US and Europe over centuries whereas China had very little outside Hong Kong just thirty-five years ago. So, it is hardly surprising that there are material human capital constraints, particularly given that most of the rest of the world lacks Chinese language and cultural understanding.

It is important to remember that the regulatory and compliance framework around the world was created in part because of historical lessons. For example, the SEC was created in 1934 in response to the excesses that led to the 1929 stock market crash. The infamous Global Research Settlement in 2003, which radically changed the way equity research was conducted globally, was a response to a raft of irresponsible behavior during the tech bubble of the late 1990s.

I think China has done a fantastic job of integrating many global lessons into the regulatory framework. I have met with many regulators and have always found them diligent and keen to incorporate different perspectives. Albeit as is the case in most countries, their political overseers are not always focused on detail. Communication of regulatory action could be better, particularly as offshore investors and media don’t always understand the cultural context.

Q5. There have been experiments with integrating offshore experience to improve China’s financial markets, but this has been a stop and start process. What has been your experience?

UBS was the first foreign firm to be permitted full management control of an onshore securities firm, back in 2006. The aim was to bring the ‘global perspective’ to the China market and to bring the ‘local knowledge’ acquired from China to global investors. At first, this was a niche exercise because only Qualified Foreign Institutional Investors (QFII) could directly participate in the A-share market. That said, the ‘on-the-ground’ China perspective was very helpful to clients participating in ADRs and H-shares.

The launch of the Stock Connect programs via the Hong Kong Exchange in 2014 was an exciting development but it also highlighted the human capital challenges we discussed earlier. Offshore investors often have a different investment process to local investors (both retail and institutional) so there were very few people that understood both the nuances of the A-share market and the requirements of global institutional investors.

The liberalization process has broadly progressed, but the devil is in the details when it comes to leveraging foreign talent. Many licensing exams are still only available in Chinese and a major frustration in the research world is that foreign passport holders are unable to sit for the analyst license exam, even in Chinese. While I understand the need for cultural understanding, I think this is a missed opportunity for China, to access talent that can bridge understanding across the globe.

Q6. Many observers have noted the boom-and-bust cycles of China’s markets. What do you think drives these cycles and how can they be addressed?

In some ways, this is true for all equity markets. The cycles in China are, therefore, a function of fundamental human psychology (whipsawing between fear and greed) that is evident everywhere. At the moment, we are very much at the fear end of that spectrum when it comes to China, both for onshore and offshore investors. Interestingly, it is very unusual to see onshore investors so fearful. Each of the different markets (A-share, H-share, ADR) have their own dynamics, reflecting different sector composition, but corporate earnings power will ultimately drive valuations. As Benjamin Graham said, ‘in the short-run the market is a voting machine, but in the long-run, it is a weighing machine’.

Until the end of the past decade, most investors were hyper focused on the growth prospects of China. While the growth prospects of China were, and arguably still are, much better than most economies, it is always dangerous to extrapolate current growth levels into perpetuity (GDP growth, revenue growth or earnings growth). The same is also true at the bottom-of-the-cycle and even while China’s growth prospects are slowing, I think there is scope for ongoing attractive growth rates well into the 2030s.

China is often described as a ‘policy driven market’, which makes sense given the pivotal role the government plays in the economy but also in the microeconomics of each industry. This has been hammered home recently by the regulatory crackdown in the education and technology sectors. However, many of the boom cycles have also been a function of government action, whether it be the non-tradeable share reform of 2006 (a form of corporate governance reform) or the establishment of Stock Connect in 2014. Given how low investor expectations are now for further corporate reform, it would seem plausible that even minor progress would have an outsized impact on valuations.

Q7. There is a perception by many investors that China is not doing enough to unleash “animal spirits” and this is reflected in the poor performance of the stock markets. Do you think this is a fair criticism and how do you reconcile the short-term demands of investors with the long-term reforms China needs to create modern, efficient markets?

This is a balancing act and one that governments all over the world have struggled with. Innovation and risk taking are the lifeblood of economic progress, but a transparent regulatory framework and dispute resolution processes are also essential. This is particularly important when managing externalities (such as environmental damage) but also when it comes to issues such as fraud or other nefarious behaviors, which often arise when animal spirits run wild.

The incredible success of China’s economy since the reforms of 1978 has been a function of a strong central government and enough individual freedom for entrepreneurialism. Wealth inequalities, the geopolitical backdrop and Covid-19 have all focused stakeholders back on the ‘strong center’ in recent years. However, I am confident the entrepreneurial spirit remains robust and just needs time to adjust to the new political and demographic paradigm. There is hyper-ventilation about capital ‘fleeing China’ but I also see meaningful technological and business innovation (e.g. BYD, CATL and PDD).

It is fair to say that the regulatory clampdowns of the past few years have shocked many investors and the prospect of being arbitrarily blindsided has discouraged both FDI and portfolio investors. However, I also think that many foreign investors didn’t fully understand the Chinese system when capital was initially deployed. For example, the scale/influence of Alibaba and Tencent would have attracted regulatory scrutiny anywhere in the world (so investing at the valuation levels of 2020 was risky!). The nature of the clampdown was uniquely Chinese, but few societies would have permitted unfettered development of such large companies.

My personal view is that the authorities shouldn’t accede to the whims of short-term investors. An efficient market needs short-term participants, but this type of capital isn’t necessarily aligned with the best long-term interest of society. Longer-term investors (the distinction between short-term and long-term investors is an interesting and relevant debate!) are more naturally aligned with the long-term reform process and will be patient if the institutional framework is stable and broadly predictable.

Q8. Looking at a couple topical investment issues, what are your thoughts on the IPO markets in HK and China, and the knock-on effect for the investment community? When do you see them turning around? In addition, are you positive on the recent surge of new ETFs in Hong Kong, even in the face of limited liquidity concerns?

IPO markets are very cyclical and globally entered a downturn in 2022 as the Fed started increasing rates. The impact of this was exacerbated in Hong Kong because in 2021, there had been a ‘boom’ year, driven by large US-listed Chinese companies adding a Hong Kong listing. The recent slump has simply been a lack of demand, with weak markets a function of the disappointing Chinese consumer recovery post Covid-19 and the overhang of the property downturn. I don’t think we need a full-fledged property recovery to drive a recovery in IPOs but confidence that property has found a floor will be important.

The geopolitical backdrop is also an issue with some concerns that ownership of Chinese assets, including in Hong Kong, could be restricted or even frozen by the US if the political situation worsens. If we manage to get through the run-up to the November US election without any major deterioration in relations, that will help, but both sides of the US political divide have the potential to derail investor appetite.

The ETF boom is a different dynamic. In many ways, Hong Kong has been behind the curve on this trend, which has reshaped US and many other equity markets over the past couple of decades. I am in the camp that believes passive funds (including ETFs) are ultimately parasitic. Efficient markets need a group of knowledgeable people to sift through investment opportunities to determine which ones are good, which ones are bad and which ones are fraudulent. The active fund management community currently plays this role, in concert with research analysts and other experts, who all need to be compensated for their efforts. Passive funds currently free ride off these efforts but I think this will naturally find a ceiling, because the opportunities for surviving active managers will become plentiful.

However, we haven’t reached this ceiling yet in the US, so it would seem likely that ETFs will continue taking share in HK and China. Investors are correct to focus on liquidity challenges, but I suspect that is partly a function of the current market downturn and partly a function of global competition (i.e. HK investors can easily buy a Nasdaq ETF).

Q9. How have compliance and regulatory dynamics evolved in China? Is research independence protected or is this still a gray area?

Disentangling regulatory evolution and political evolution is difficult everywhere and this is certainly true in China. I think a lot of the recent criticisms of China comes from a lack of institutional and cultural understanding. For example, the position of the Party Secretary within corporations has recently become controversial but this role is not a new phenomenon, particularly for SOEs. In the past, many investors either ignored it or thought it was aligned with their interests. I am not suggesting that ‘things haven’t changed’ recently, but a lot of the regulatory change that has been characterized as momentous has in fact been rather incremental.

Research independence is a subject that is close to my heart, and I see it as a commercial imperative rather than just as a regulatory issue. If your research is biased, then your clients are unlikely to find it valuable. The biggest challenge for research analysts when publishing controversial research is the reaction of corporate management and, in my experience, Chinese corporates are not overly prone to retaliating against critical analysts, relative to any other country, particularly the US, where corporates are very aggressive. It will be interesting to see if this remains the case now that share prices are part of the KPIs for SOEs.

The IPO process is the most complicated aspect of the research independence debate, but this is well understood in regulatory circles, including in China. Arguably, the process (in all jurisdictions) has now become so structured that it is borderline impossible for a research analyst to provide any useful insight.

Q10. What role will Hong Kong play in the future evolution of China’s financial markets? The lifting of China’s capital controls does not appear on the horizon anytime soon, while at the same time, we’re seeing an expansion of the various Connect schemes to allow for more flows into and out of China. Are you optimistic about Hong Kong’s interconnector role and if so, where do you see the opportunities for young finance professionals?

I am very excited about Hong Kong’s future as a bridge between mainland China and the rest of the world. Financial services are the most obvious ‘connector’, but I see opportunities across knowledge industries where global collaboration can help drive better outcomes. Healthcare, education, technology and professional services are all areas where HK’s open capital account, international connectivity, legal system and educational infrastructure all help underpin a distinct competitive advantage.

The financial markets ecosystem that I was referring to earlier is incredibly well developed in HK and the mainland government has been crystal clear on their support of ‘one-country, two systems’, and making it sustainable. I agree that a fully open capital account in China is a long way off but even if that happens, the strength of Hong Kong’s human capital will provide HK with advantages.

My advice to young professionals in Hong Kong has been consistent over the past decade or so – go and spend a couple of years on the mainland and immerse yourself in the culture. For those that have done this, despite the challenges, it has almost universally paid off. Young professionals that have spent time in Hong Kong naturally have good global perspective and will usually have some Mandarin. Augmenting this knowledge with a strong cultural understanding of the mainland is exactly what you need to be a super-connector of the future.

My major concern for Hong Kong is the degradation of press and academic freedom. Investors need every insight into the opportunities and risks on the horizon. Robust and honest investigative journalism, opinion pieces and evidence-based insight is pivotal to the sustained development of efficient financial markets. Hong Kong is now just above South Sudan on the World Press Freedom Index and has even fallen behind Singapore. If this continues to degrade, my view is that it will undermine Hong Kong’s role as a connector and constrain investor interest in China generally (i.e. I believe that Hong Kong’s press freedom is important for China’s long-run growth prospects).

Q11. Geopolitics, especially the tensions between the US and China, are having a notable impact on foreign investment into China, as well as its trade relationships, especially in certain key sectors. Do you see geopolitics as a real threat to the free flow of capital and investment and how do investors manage these risks?

The free flow of capital has been constrained by design, initially by China through capital controls and foreign ownership restrictions, but more recently by the US, citing national security and political concerns. I suspect that this has already had negative implications for global growth, which is problematic for investors, not to mention everybody participating in a global economy. I get frustrated when vested interests characterize the geopolitical landscape as a zero-sum game, when there is overwhelming evidence that unfettered trade leads to better overall outcomes. While there have been relative winners/losers from the rise of China, there is little doubt that the world is a more prosperous place compared to 1978 when China started liberalizing, and 2001 when China joined the WTO.

Investors have little choice but to adjust to the new reality, and whatever comes next, while doing what they can to influence the prevailing discourse. Increased regulatory risk and increased policy uncertainty probably means that the global cost of capital has increased but ‘change’ will also present opportunities.

I think that the most important risk management tool for investors is to ensure that their investment process considers multiple possible future scenarios, not only from a geopolitical perspective but also from a policy and regulatory perspective at the industry level. Thinking through various scenarios in detail can help investors better understand the risk profile, and considering different perspectives may in fact highlight several unappreciated opportunities.

Q12. As China’s economy transitions to a more “normal” growth trajectory, how is this reflected in its companies? For years, high revenue growth tended to mask inefficiencies but with a new focus on cost/profits, as well as a need to understand and accommodate the role of the CCP, how is this changing China’s companies? Does it require a different type of management and how do you see this process unfolding in the coming years?

My impression is that most Chinese companies understood the importance of accommodating the CCP, it was offshore investors that misread that dynamic. However, I completely agree that the transition from a ‘very high growth’ economy to a more normal trajectory will be a big management challenge. In fact, you are already seeing evidence of a different fundamental management approach with material share buybacks announced by large technology companies such as Tencent and Alibaba, amongst others.

As you say, slowing revenue growth will cast sunlight on inefficiencies and managers won’t be able to depend on operating leverage to drive earnings growth. Successful managers in this new era will also need to be much more disciplined with their capital deployment than has been the case in the past. I think this will be particularly important for those companies deploying capital offshore. There is a big difference between selling products in markets such as Southeast Asia and Europe versus establishing local brands and/or manufacturing capabilities.

Q13. A common critique of China’s policy actions is its heavy focus on State-Owned Enterprises, at the perceived expense of private enterprise. The view is that the Party prioritizes SOEs over private industry and that this is a poor trade off if the goal is to encourage innovation, employment and growth. What are your thoughts on this and perhaps it might be helpful to share some of your experience analyzing and assessing SOEs.

I’ve had experience analyzing SOEs or quasi-SOEs from countries as diverse as Australia, Italy, Thailand, France, The Netherlands, Singapore and China. SOEs play an important societal role in each of these countries and just like private companies, some are well managed, and some could be better managed. The challenge for investors when analyzing SOEs is understanding the needs and incentives of the various stakeholders, including employees and customers. All too often investors miss this step and just examine the degree board/management focus on the needs of minority shareholders.

Circumstances dictate government and SOE management priorities, and most minority shareholders will understand that short-term pain often needs to be taken for long-term gains to accrue. During Covid, the pendulum of focus in most countries swung to the short-term societal goal of grappling with the scientific and economic implications of the pandemic. This now looks to be behind us, so the focus can swing back to the opportunities for SOEs to innovate while also driving efficiency.

In China, I think it is important to think about this from two perspectives. Firstly, the prioritization by the government of private companies versus SOEs and secondly, the intensity of focus on SOE reform. These issues are intertwined but distinct, particularly in critical industries such as autos, and the trade-offs you mention are a delicate balancing act.

Having said that, the messaging from the CCP is crystal clear on the focus on innovation and ‘new productive forces’. The message to SOEs is that innovation will be critical to your future success and if this requires trade-offs then those trade-offs should be considered. It also appears clear that the authorities appreciate the pivotal role that private enterprise will play in pushing innovation forward, so there is scope for the ‘pendulum of focus’ to swing back towards private companies, particularly as new over-arching regulatory frameworks have now been mostly clarified.

It looks to me that SOE reform is once-again potentially a meaningful opportunity for equity investors, particularly given the highly depressed valuations now prevalent in China (notably for H-shares). The high-level rhetoric is encouraging and tangible steps such as adding share prices to SOE management KPIs are steps in the right direction. As detailed plans emerge in the aftermath of the third plenum, this will be an important area to monitor.

Q14. Demographic challenges in China, and many other countries, are pointing to a grim future in terms of population growth and the aging of societies. How does China’s government respond to this challenge, and do you see financial liberalization as an important tool for preparing for this future? In the absence of children, how do China’s retirees ensure they have sufficient funds to retire?

China’s demographic challenge is different from much of the rest of the world because no one can even contemplate the prospect of immigration to China. This is controversial elsewhere, but it is at least a potential solution to these challenges in many countries.

GDP growth is a function of population growth and productivity growth. I presume this is why we now hear so much about ‘new productive forces’. The only clear solution for China is increased productivity growth and this is one of the mostly hotly contested spheres of debate in the macroeconomic community. This is because productivity growth has consistently disappointed globally in recent decades. Maybe the CCP has a unique solution to this conundrum.

I may be biased, but I do think that ongoing financial liberalization is a significant part of the long-run solution to these challenges. The limited social welfare net and an excessive dependence on the property market for long-term investment is an enormous financial overhang. If the population was to become confident that the local stock market could provide long-run stable returns (i.e. less boom and bust) this would encourage more productive savings. It would be ideal if these investment returns were a mixture of dividend yield and sustainable capital growth, although dividends have only recently become a focus for Chinese corporates. My impression is that the authorities appreciate this opportunity, but it is one of a long list of priorities.

Q15. What are your thoughts on the third plenum and what impact do you see it having on China’s and Hong Kong’s financial markets?

The initial market response has been muted but I think it is simply too early to tell. In my view, it has been clear since the end of last year that the authorities are listening to investor concerns and while regulation is never ‘finished’, the broad framework for the pivotal technology and financial sectors appears clear. As the rhetoric leading into the plenum was broadly supportive of a ‘pro-growth’ agenda, expectations were arguably a little elevated.

We will see more detailed plans over the coming months and as is always the case, execution of plans will be more important than the rhetoric. I think the high-level areas of focus should be encouraging for investors with a long-term perspective. SOE reform is a focus and ensuring a level playing field for private companies, including foreign companies, was also clearly articulated. Financial services liberalization, hukou reform, land reform and the fiscal relationship between national and local authorities are all pivotal areas for unlocking growth potential, and the high-level commentary was encouraging. Social welfare reform and discussion of raising the retirement age are also on the agenda.

The focus on ‘new productive forces’ for the long run makes sense, but investors are likely to remain wary about the growth outlook until it becomes clear that the property market has genuinely bottomed out. The prospect of a debt-deflation spiral appears to have receded but remains an overhang for markets, particularly IPO markets. I don’t think that there is any one government policy that will resolve this concern, but the mosaic of initiatives outlined are encouraging.

Q16. Please share any favorite books, blogs, podcasts or other resources that readers could use to improve their understanding of China’s financial markets, economy, reforms or any other related topics.

I have spent the past 15 years suggesting to anyone ‘new to China’ to read Richard McGregor’s book, ‘The Party’. I think this it is the best China 101 book out there and the follow-up, ‘The Backlash’ is also well worth a read. For anyone looking for a better understanding of the importance of Technology to the current geopolitical situation, Chris Miller’s Chip War is a must read.

Understanding assumptions and different scenarios is critical to equity valuation and in that sense, I really enjoyed Chuck Klosterman’s book ‘But What if We are Wrong?’.

Lastly, John Hempton’s Bronte Capital blog is a little esoteric, but it is always amusing, and it is useful to be reminded about the amount of fraud out there (globally).

If you or your company has a due diligence requirement or needs assistance on a fraud issue, corporate investigation, risk advisory, or other related matters, please contact us at info@kalavinkaadvisors.com or +852 2196 2727