Why Investors Arent Flocking To China

By Jordan WathenMarketsFool.com

China has been making headlines recently for imploring foreign investors to buy into the Chinese exchanges.

In this week's episode of Industry Focus: Financials, Gaby Lapera and Jordan Wathen explore the investing climate in China today and why foreign investors are so hesitant to dive into it. Find out why investing in Chinese companies is so risky from a regulations standpoint, the uneasy situation of the popularity of investment receivables in China (and one recent development that has made it a bit less scary), a few of the many ways that China's regulations are isolating the institutional investors the country wants to attract, and more.

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A full transcript follows the video.

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This podcast was recorded on Dec. 12, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, December 12, 2016. My name is Gaby Lapera, and joining me on the phone is Jordan Wathen, one of The Motley Fool's top business analysts. How's it going, Jordan?

Jordan Wathen: It's going all right. I'm just trying to stay warm in December.

Lapera: Really? I thought you were in North Carolina. I figured it couldn't be that cold down there.

Wathen: Well, I've already got accustomed to South Carolina weather, so North Carolina is cold.

Lapera: Apparently, the polar vortex is going to swing down from the Arctic Circle and make it especially cold. Get ready. I think that starts on Tuesday.

Wathen: Oh, great. I'm excited for that.

Lapera: Talking about global climate. We're going to stay away from that one. Let's talk a little bit about China. There has been some news about China in the financial markets recently. I just want to start with the fact that China really wants investors in its markets, but investors are saying, "Hey, no thanks, China. It's nice of you to invite us to the party, but we're really not interested. We're going to go to Suzie America's party instead." Not to be weird about it. And there's a few different reasons for this. One of the main ones, I think, is that China has a very different culture when it comes to the idea of a "free market." Right? I don't know. Let's start with the foreign exchange news, which came out recently. Do you want to talk about that, Jordan?

Wathen:What's happened recently is that China has been limiting the amount of money that companies and individuals and basically everyone can take out of China. This has gone on for a long time, but more recently, there was a change to where companies can only withdraw something like $5 million a day from China in dollars, versus $50 million a day previously. So, as far as business goes, that'scertainly a limitation. When you look back more broader,when you think about China and markets, especially as it relates to stock and bond markets, is that last year, during a crash in the stock markets in China, they put somepretty strict limitations on how you could invest or whether you could even buy or sell.

Lapera: Yeah,absolutely. I don't know if you guys remember this after all the financial craziness that'salready happened this year, but China had a little bit of a roller-coaster ride, and they locked down investors' abilities to sell bondswhen the Chinese market was crashing. Afterwards, they released a statement saying, "Wedon't understand why people don't want to invest in our bonds, but we'reincentivizing them in XYZ ways." But it seems like there's a little bit of a gap between them realizing, "Ah,yes, we have blocked people's ability to allow the market to function as it should.This is why people don't want to come to our bond party."

Wathen: Right.I think one of the things, too,as individuals, it's kind of hard to understand maybe the needs of institutionalinvestors. But one of the things they limited,first of all, they limited short-sellingunder the threat of arrest. So, you can't run asophisticated long-short strategy, which turns off all the hedge fund managers in the world. And then, you have a matter where, if you own more than 5% of a company, you'rerestricted on your ability to sell. So, yourhighest conviction ideas, you had better have a whole lot of conviction in them, because you could potentially end up holding them for a long time. Basically,you could end up holding them into perpetuity or until China decides, "OK, fine, we'll let you sell."

Lapera: Yeah. I think there's also this fear, whichI think you have in most developing markets, which is that China could just up anddecide to nationalizewhatever it is that you own. It is a communist government in name. So,that's always a possibility. It hashappened to investors before. It's happened in Mexico,it's happened in Venezuela, to name twojust right off the top of my head. So, it's not anunreasonable fear to have about China. Additionally,something that's interesting about Chinais that the culture is obviously very different. It can be hard to parse through theregulations and figure out which ones they'reactually enforcing, which ones they care about. We were talking earlier about loans, andfiguring out which ones the government would definitely payand which ones the government wouldn't pay. It's something that's really hard to know unless you're in China, or, potentially, from China,and you understand all of this and you have connections back home to talk to about this. It'sdefinitely a little bit of a minefield for the foreign investor who doesn't have a lot ofexperience, and has no way of knowing exactly what's going on internally.

Wathen: Right. Totake a step back, the kind of people that China wants to invest,they don't want small-time mom-and-pop Americans to open a $50,000 brokerage account and buy stocks. They want real, tangible, lots of money. And an institutional investor, if you have, say, you have theLondon Exchanges, you have the Canadian Exchanges,you have the American Exchanges. What's the real reason you would go to China in light of all these matters? There are plenty of global markets where trading is more free and the rules are more well established andpeople take them very seriously. So,there's kind of a high bar, to be willing to go to China.

Lapera: Absolutely. And then, on top of that, you have the fact that it's both strictly regulated and not all at the same time. The example that comes to mind for me is that inShenzhen,which is a city that is situated right on the border with Hong Kong. Some people opened up theGoldman SachsShenzhenreal estate something or other -- I'm not 100% sure what the whole name was. They even spelled their name in Chinese. They spelled likeGoldman Sachs spells their name. So you have this company that could be mistaken for Goldman Sachs (NYSE: GS). Even in the same year, some guy opened up his own bank called The China Construction Bank, and there was already a China Construction Bank,and he just pretended to be part of the same bank, and he totally wasn't. He opened up a whole fake branch of a bank. Andthat's just something that you don't see happening in other countries.

Wathen: Right. That's an interesting risk, too, because that extends beyond even the financial area.I actually looked at this, the Goldman Sachs fake in China. It actually had a website that looked just like Goldman Sachs. They used a similar font and everything, to basically knock off the brand name. That extends even to apparel. ANikesweatshirt could easily be, they could throw a swoosh on a sweatshirt andbasically steal that IP, too. So,that's something that, as investors, you have to worry about,because a lot of companies, not just financial companies,but a lot of companies survive on their brand name. If that can be easily lifted and used by someone else. There's not much value to it.

Lapera: Right. This story came out inAugust of 2015, and Goldman Sachs said they were looking into it, but I haven't heard anything on the news since then. If you happen to work forGoldman Sachs, and you know what ended up happening to Goldman Sachs Shenzhen,please let me know. (laughs) Another thing that's been really big in the news lately is China has decided to use this method of funding, labeling loans, that is really interesting, and isnot something that's available to American banksbecause of the regulation that we have here. They have this thing called aninvestment receivable. An investment receivable is basically a loan. It's a debt that's owed to thecompany, but it has a lot more favorable accounting provisions than you would get for a loan. Additionally, Chinese banks don't have to keep reserves in place forreceivables. So, if an investmentreceivable were to go belly up, Chinese banks don't have to have any capital in reserve to minimize the effects of that. Which allows the banks to use more of their capital, but is also super risky.

Wathen: Right. It's aproblemof really bad disclosure. When it comes to financial institutions, thefinancial institutions you want to invest in are the ones that have great disclosures. TheWall Street Journal really ran with this story. They talk about howit's the equivalent of $2 trillion in loans that are nowclassified as these investment receivables. And they've grown about three times since 2013-2015. That's a two-year stretch, three times growth in thatcategory, just because they're hidingwhat many people believe --and in some cases, they probably are -- the bad loans in theseinvestment receivable accounts.

Lapera: Yeah, which isdefinitely really interesting. This kind of follows,I don't know if our listeners follow China's debt problems, butChina as a country has been getting inincreasingly more and more debt. The official level of debt now is 2.5 times thegross domestic product. All of thisvernacular here,loosey-gooseyness, is all tied together.

Wathen: Right. If wetake a step back, let's go back more than a decade,let's go back to 2005. China says to the world, "OK,fine, our currency is undervalued, we will let it appreciate." So,investors around the world hear that and they think, "Wow, here's a chance to make tons of money if we know,directionally, China's currency is only going to go up in value." So, if you're an American, the move, if you can do it, is to basically take dollars and go buy Chinese currency, and hope for the exchange rate to change in your favor. At the time -- and this was a big dealespecially during the financial crisis and thereafter -- you could borrow money in the United States at 1% andtake it to China and earn 5%. So,not only were you earning the difference in exchange rates as they fluctuated, but also what they call positive carry, or theinterest rate differential, by taking your money overseas.

Lapera: Yeah. That's really interesting. This all ties together into what we were talking about earlier, which is that theChinese government can kind of do whatever it wants when it comes to financial markets and their currency, which makes investors abroad trust it a lot less.

Wathen: Right. Basically, what it did was tell the world, "Hey,bring all your money to China," sothe world started bringing money to China, and then you haveall this money circulating around the economy. And when there's tons of money going around, that's when you get these big underwriting errors, that's when you get these loans for businesses that couldn'tpossibly repay them. You also get the over-investment, you get the Chinesegovernment building houses thatno one is going to live in, roads to industrial complexes that have no factories, things of that sort. This sort of hot moneyfloating around in China hasincentivized a lot of bad investments.

Lapera: Yeah,and it's interesting, because it does seem like China is starting to realize that this is not good for them. Sheng-Fu Lin, who is China'stop banking regulator, said that the hidden credit risk that's associated withinvestment receivables and other types of investments like this, it could be really bad for China's financial security. Which iscrazy. Normally, topChinese officials don't say, "Hey, we might have made an error in judgement, and this could be bad."

Wathen: Yeah. It's aparticularly big deal because,when you think about banking and China,it's a totally different world. Many of the loans that are underwritten there are underwritten on the basis of political favors, or because a company has an implicitguarantee from the government. In a lot of cases, these loans weren't made because someone thought, "Hey,this is a great credit risk." These loans were made because, "Oh, well,you know what, the government will probably bail this out later." Right? It's just -- I don't even know how to describe it -- it's just a heaping problem, atangled web of bad incentives.

Lapera: Yeah. So,now that we've brought you down about China, (laughs), things could be a-changing. Butit's not super certain, so don't get excited. I was joking with Jordan earlier thatI am the best person for this show because I'm so risk-averse that I just fit in with all the financial stuff perfectly. (laughs) So, there's a company, PineBridge Investments, has said that China's big five banks could absorb the hit even if 15.5% of its loans are bad. Technically, the official number for how many loans are bad in China is 1.8%, butlike we said, we don't really know what the number is. So, good news: They couldsustain a loss of up to 15.5% of their loan value. Bad news: we have no idea what it actually is.

Wathen: Yeah. One of the things you have to understand is, what kills banks isn'tnecessarily solvency. There have beenplenty of examples, even in the United States, where banks have been insolvent. It'spretty much well understood thatCitigroup, at one point in timeor another, has been insolvent several times over the last century. What kills banks is a liquidity crisis. It's when people take out theirdeposits. So as long as the government says, "Hey,deposits are fine," andas long as the Chinese people think there's no risk to these banks going under, they can exist and basically earn enough money over time from their good loans to basically paper over their losses. As long as there's no run on the banks,so to speak, then these banks will exist whether or not they're good investmentsis a totally different matter.

Lapera: Yeah. And the idea of a run on the banks in Chinais a little bit more difficult because the Chinese government could just say, "Sorry, the banks are closed."I mean, you can do that in the United States, too, but they can also trap all the foreign investments and everything in China and just be like, "It's all ours now. Don't worry about it."

Wathen: Exactly, and thatgoes back to what we were talking about earlier. Basically, China has, through a number of ways, made it much harder for capital to leave the country. If it doesn't leave the country,no one is going to take it out and put it in their closet or under the mattress, they'regoing to keep it in the banking system or securities or whatever. Preventing that capital flight, in some ways, flows through to the banking system.

Lapera: Yeah. Another thing that is apositive development, although it might not seem so at first on the surface,is that the Ministry of Finance in China is allowing banks to write off more bad loans. Originally, it was really difficult to write off a bad loan. Youhad to go to the Ministry of Finance and ask permission for each loan you wanted to write off. But, they've made it a lot easier, which is, I guess, bad in the sense that we're suddenlyseeing them right off a lot more loans -- it'sdoubled in the last couple years. On the other hand, it means that banks aregetting better at identifying bad loans quickly, and potentially, it could help out credit risk, because banks are going to be less likely to make bad loans, in theory, potentially.

Wathen: I think the thing here, too, is that investorsdon't necessarily demand of greatperformance all the time. But they do demand honest reporting. If a bank is coming out and saying its books are perfect all the time,no one wants to invest in it because obviouslyeveryone knows that banks write bad loans,it just happens, it's part of the business model that some loans will go bad. So, if anything,investors are more fearful of the bank that reports no losses than the bank that reports a reasonable level of losses over time.

Lapera: Absolutely. You can't be right 100% of the time.I think this brings us toward the conclusion of our show, which is: you can invest in China if you want to, butprobably, for the average investor,it's a much better idea to look for stock ideas in your own backyard,just because you know what's going on here. You know what the laws are, you know what the social contracts are, you know what it meanswhen you buy stock in a company here, or if you buy a bond here. And you don't 100% know what's going to happen in China,unless you're some kind of expert. If you are, more power to you.I'm not saying it's impossible to understand China, Ifundamentally believe that is a bad statement.I think you can understand whatever culture you want with enough time and study. But, if you're just youraverage investor, and you're not going to be spending a lot of time fact-checking oneverything, you're probably better off just investing somewhere that you know.

Wathen: Right.I think that's a good disclaimer for anything.I think you need to understand any investment. But, we're the banking show, primarily --if you think about banks,the performance of any given bank is inherently local. Especially in the United States, you have all of these tiny banks littered across the country who underwrite loans in just a few cities and even rural areas. I think investors will find it much easier -- not easy, but much easier -- to find an edge at home than they would overseas,just for all the reasons we've mentioned today.

Lapera: Yeah, absolutely. That brings us to the end of our show. Thank you very much for joining us, Jordan.I would like to remind listeners that we are going to do the book list show on December 19th, which will be the Financials show. If you have any last books you'd like to include on the list, email us at industryfocus@fool.com.I'm really excited for that show because I think it's one of our best shows every year. With that, I will sign off. As usual,people on the program may have interestsin the stocks they talk about,and The Motley Fool may have recommendations for or against,so don't buy or sell stocks based solely on what you hear. Contact us at industryfocus@fool.comor by tweeting us @MFIndustryFocus. Thanks again to Austin Morgan, who's wearing a very dashing pink shirt, today'stotally awesome producer, and thank you to y'all for joining us. Everyone, have a great week!

Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.