Chinese Stock Market Risks — Full Breakdown & Transcript

[00:00] China has been home to the most extreme economic growth in human history. In four short decades, the nation has gone from a struggling backwater filled with poverty to this. A nation of glistening skyscrapers and more Gucci stores than you can poke a stick at.

[00:14] The driver of this growth has obviously been its embrace of the free market and opening itself up to international trade. The nation has always had huge potential, given that historically, for 1900 out of the last 2000 years, it has been the largest economy on earth.

[00:28] But now, it is finally realising this potential once again. Seeing this sustained growth, people are obviously keen to jump on board. Millions of dollars have been made by millions of people, and any logical investor would

[00:40] be foolish to not have exposure to the largest growth market in the world, right? I spend a fair amount of time chatting to channel viewers on Discord, Patreon and even in the comment section of the video, and it's probably one of the questions I see the most.

[00:52] Mr. Economic Man, how can I invest in Chinese company stock? Now I don't want to sound rude, and I promise I absolutely mean this in the nicest possible way, but if you have to ask someone on YouTube how you can invest in Chinese equities, you

[01:05] absolutely should not at all be investing in Chinese equities. In fact, even for more seasoned investors, the market for Chinese companies is not exactly the promised land of double-digit annual returns you might think it is.

[01:18] This is because there are a few major problems that have yet to be overcome. The stock market in China is both too regulated and not regulated enough. Which sounds silly, but let's explore it by looking at this piece by piece.

[01:32] How is the Chinese stock market over-regulated? How is the Chinese stock market under-regulated? And why does this mean that most investors probably shouldn't be investing in these markets? And, alright, alright, if after all of this you are still interested in learning how to

[01:46] actually buy shares in China, I will show you how, but don't say I didn't tell you so. This episode of Economics Explained, and all episodes like it on spicier, less advertiser-friendly content,

[01:58] would not have been possible if it wasn't for our amazing supporters on Patreon. Please consider supporting the channel so we can continue to cover exciting topics like these, while also gaining access to a range of really cool benefits like our exclusive Q&As which are held every Saturday.

[02:12] So, head on over to patreon.com slash economics explained. Now some people may not know this, but the various stock exchanges around the world are mostly non-government companies. Something like the New York Stock Exchange, for example, which is by far and away the largest exchange in the world, is just a regular old company.

[02:30] They are just a marketplace provider, similar in many ways to eBay, only instead of facilitating the exchange of unwanted Christmas gifts, they facilitate the exchange of shares in publicly listed companies. Companies like the New York Stock Exchange actually do a really good job of looking like a federal entity.

[02:46] They work in an old historic building plastered with American flags, reminiscent of any other government building in BC, but they are not. They are a regular company, the same as any other. The New York Stock Exchange in particular is actually owned by another company called

[03:01] Intercontinental Exchange, or ICE for short. But to be honest, they have become less and less fond of that abbreviation over the years. Intercontinental Exchange actually owns similar stock markets all over the world, which gives

[03:14] listing companies the ability to be traded on more exchanges than just the one that sits on Wall Street in New York. What this means is that you can actually buy shares in the New York Stock Exchange as well as buy shares on the New York Stock Exchange.

[03:27] And guess where you can buy shares in the New York Stock Exchange? That's right, on the New York Stock Exchange. Confused? Good because to be honest the whole process is actually far more simple in the Chinese markets There are two dominant stock exchanges in China the Shanghai Stock Exchange and the Shenzhen Stock Exchange

[03:45] These two markets actually draw an interesting parallel between the New York Stock Exchange and the NASDAQ, respectively, in that one is a fair bit larger, but tends to list stocks in more established industries, and the other is slightly smaller,

[03:57] but has a larger listing of up-and-coming entities like tech companies. It also must be noted that the Shenzhen Stock Exchange is both geographically and financially very close to the Hong Kong Stock Exchange.

[04:09] Now, the big difference between these two mainland exchanges and their Western contemporaries is that they are owned by the government. The Shanghai Stock Exchange is a government agency just the same as the tax department or the military.

[04:23] Given that China is at least in theory a communist state, the government sees the exchange of stocks as a public service that they will handle. Now, this causes a few key issues. For starters, it means that the government has control over what companies get listed and what companies do not.

[04:38] In a perfectly fair and impartial system, this wouldn't necessarily be an issue, but in this particular market, it might be. The other problem it causes is that the barriers to entry are just more difficult to get through.

[04:51] There are a long list of requirements to be a publicly listed company, above and beyond the normal requirements of a privately owned company. This is true even in the United States. These requirements will be broken up into requirements from the federal government and

[05:03] requirements of the exchange. Normally to meet all of these requirements, the businesses that are being listed will employ the help of an institution like an investment bank, who will also help to ensure the process goes smoothly, as well as underwriting the deal if it does not.

[05:18] What this means is that there are multiple entities involved that stand to make profit. The investment bank and the stock exchange are all directly compensated by how many listings they can get on board. In China, this isn't really the case.

[05:31] The exchanges are funded by the government, so if a business doesn't get listed or it takes four years for it to reach IPO, oh well. The same sorts of limitations are true for when a company does actually manage to get listed. Rules around things like ownership structures, reporting standards and who can buy the shares are very limited.

[05:48] For example, buying shares directly as a foreign investor is not allowed without significant betting. And even if this does get approved, you are limited in your selection. For example, I, Mr. Economics Man, am an Australian citizen.

[06:01] If I wanted to invest directly into an American company, no problem. I just contact my brokerage and tell them to buy Apple or Amazon or Bank of America or whatever. It's just as easy, if not easier, than buying shares on the Australian Stock Exchange.

[06:14] Now, if I wanted to buy shares directly on the Shanghai Stock Exchange, that's a very different story. chances are 99% of you watching would not be eligible at all because you need to meet at least one of these criteria.

[06:28] Have a permanent China residence card, be an employee of a listed company and be participating in that company's equity incentives, i.e. senior foreign executives that get paid in bonuses and stock options, work in China,

[06:41] or be the owner of a corporation with operations globally as well as within China. And for those of you that meet that last standard, how you doing? patreon.com. Even if you do meet these criteria, you have to go through a robust background check

[06:55] and you are only able to buy non-voting shares in the company, meaning that you will share in profits and capital appreciation, but you can't vote on company decisions like who sits on the board of directors. China really does not want any foreign influence in their major corporations.

[07:09] For those of you who don meet this criteria well you out of luck sort of but don worry there is still a way I promise Anyway these severe limitations mean that these exchanges are not great at raising capital which is in essence what stock exchanges were made for

[07:25] Because of this, you will find that the largest listed corporations are mostly state-owned corporations that have a small share of equity, something like 10% owned by the general public, with the rest of it being owned by the state. Since these corporations have other objectives

[07:40] besides simply being profit generators, their performance is less than amazing, or certainly less amazing than you would expect from a nation with such strong growth. We have said it many times before on this channel, that the stock market does not equal

[07:54] the economy, and almost any time we have said it, it has been because the stock market has been doing really well, while the wider economy has been doing really poorly. In China, it's almost the opposite. Due to these limitations, you will find that even most Chinese investors don't dabble

[08:09] heavily in the stock market as their western peers, preferring instead to accumulate real estate. But that's a topic for another video. Spoiler alert, you probably shouldn't buy real estate in China either. Now weirdly enough, this over-regulation has caused a major problem

[08:25] with under-regulation. Businesses need funding. That's how they grow and expand and conduct research and development. It's why the stock market exists. Before shares, people couldn't invest into businesses without being a partner in that business which meant that they were

[08:39] liable for the issues in the business. If the business gets sued or can't pay its loans, it might be the investor's house on the line. Needless to say, this wasn't very popular and it meant that some ventures just didn't

[08:51] get the funding they need to get off the ground. The same is true in China and there are all manner of companies operating in the nation that want funding to expand but will find it difficult to get listed on the Chinese stock exchanges. So what are they to do?

[09:04] Well, list on another stock exchange, obviously. Historically, the Hong Kong Stock Exchange has been a very popular choice for this, given its close proximity to mainland China, as well as its distinction as a separate economic entity.

[09:16] But, as most of you will know, the distinction between the regions has been blurring more and more every day. Because of this, more and more companies have been looking to places like the New York Stock Exchange, which has actively been encouraging this participation.

[09:29] Remember, the New York Stock Exchange is a company. They want to get listings so that they can get paid. This causes some other issues for potential investors. Cooking the books or reporting financial figures that are factually untrue has been a major

[09:43] problem for these companies. Now, the listing process in any given exchange is supposed to account for this. Typically, the exchange and the underwriter they go through to get listed would be liable for any misinformation that goes into an offering, so both of these institutions do thorough

[09:58] audits before anything makes it to the trading floor. However, there is a sneaky backdoor solution available to companies that may or may not be completely honest operations. A reverse merger is when a private, unlisted company buys up control of a publicly listed company and then merges into one to make one big publicly listed company.

[10:20] So, if you were a devious and potentially fraudulent businessman that wanted to take advantage of the hype surrounding the Chinese economic miracle, this is what you would do. Create a business in China doing anything or nothing at all.

[10:33] It really doesn't matter. Nobody's going to check. Just make sure that you have a legit looking warehouse and a website that checks out. Then, get your accountant to start generating reports that look like the business is receiving massive revenues and making massive profits.

[10:46] Keep this up for a few years and then you move on to the reverse merger stage. At this point, you find a company that is listed on an exchange that you want to take advantage of In this case let say you going big and go after the Holy Grail the New York Stock Exchange You are going to want to find some small company with a low market capitalisation maybe some

[11:06] old sickly business in an irrelevant industry. Let's call it Dunder Mifflin. Now some companies like Dunder Mifflin here can have a market capitalisation as low as $25 million, which is obviously a lot, but to complete a merger, the dubious businessman

[11:21] only needs a controlling interest in the company, so it's possible to get away with as little as 51%. Once this company is acquired, the two will merge to form a new entity that will maintain its listing on the New York Stock Exchange. At this point, the previous public business can be

[11:35] completely liquidated. Anything that was previously owned will be sold off to try and recruit some of that $12 million. And depending on what the business had in terms of real estate, inventory and hardware, this could actually earn back a good majority of this cash. Once this is done,

[11:50] the business may change its name to reflect something more reminiscent of a Chinese company. Let's call it the totally legit manufacturing company of China. Cool. Then it can be promoted to new investors as a way to directly get into an up-and-coming

[12:02] Chinese operation without having to jump through all the hoops of investing through something like the Shanghai Stock Exchange. Some investors might still be wary, but that's okay. You can just pay off some public figure like Bill Clinton to speak about the growth of

[12:15] the Chinese market. And yes, this actually happened. With this, unsuspecting investors will start pouring money into the stock, and now it's finally time to capitalize. You can do this in two ways.

[12:27] The first is that you take all of this invested capital and use it to pay yourself a massive salary as the CEO, or use it to pay another business that you own as a consulting expense. The second way is to sell off your own shares in the public market

[12:39] once they have appreciated to a nice healthy valuation. A good dodgy businessman will do some combination of both of these. Now, you might be asking yourself, well, isn't this illegal? And yep, it absolutely is.

[12:52] But typically the people involved in pulling off these operations have connections that will see that they never see punishment for these types of actions. Or if worse comes to worse, they can always launder their money out following the steps in our video here.

[13:05] Sounds great, right? Now I bet you're asking yourself, how do I invest? Well, there are a few ways to get exposure to Chinese companies. The first is, of course, to go into business directly with a business partner in China.

[13:17] This is, again, highly risky, but it's obviously the most direct method. The second is to buy up companies listed in exchanges outside of mainland China. Businesses like Alibaba, Tencent, and Xiaomi all have listings on international exchanges in order to attract wider funding.

[13:34] And finally, you can get access to stocks traded exclusively on Chinese exchanges by using an Exchange Traded Fund or ETF. This is basically just buying up a security which will in turn buy up shares on the Chinese

[13:47] exchanges through a company that has been greenlit by the Chinese government. iShares through BlackRock has this on the NASDAQ listed under the ticker NCHI and there are plenty of other examples out there. But here's the last word of caution.

[14:01] Yes, China has seen amazing growth and it will no doubt continue to grow into the future. I can see that, you can see that, and any other investor out there can also see that. This means that the anticipation of future growth in the economy has already been priced into these shares.

[14:17] That's why the performance of even these well-managed indexes has been good, but not quite as mind-blowing as the rest of the economy. Hi guys, I hope you enjoyed the latest video. If you did, please consider liking and subscribing.

[14:30] This video is made possible by our patrons over on Patreon, so if you enjoy these videos, please consider supporting the channel like these awesome people did. Thanks guys.