Why Voluntarily Leaving China (or Being Forced to) Does Not Undermine Fiduciary Duty

The duty of a fiduciary is to obtain the highest possible earnings for those investors under their care. But to find conflict between “divesting” from China – or even just divesting strategically from certain industries – and fulfilling one’s fiduciary responsibility is a false dichotomy.  Here’s why.

Simply put, China is a bad investment and to avoid it or to institutionally or personally “decouple” from it should not be controversial. China does not allow foreign ownership of its enterprises, so there’s really no upside to shareholders who either own variable interest entities (VIEs) or invest via passive investment vehicles like exchange traded funds (ETFs) and other products driven by indices to continue to hold these risky equities in their portfolios.

Due to national security risk factors, human rights violations, state control and manipulation of businesses, internal economic instability, political uncertainty after the 20th Party Congress, and more, China is no longer a lush garden of endless earning potential. We continuously see tens of billions of dollars in Western investment capital being wiped out time and again from investments in China with calamities like failed IPOs (Didi), preemptive delistings from the NYSE (PetroChina, et al.), real estate crashes (Evergrande), and floundering declines in market value after political stunts like the recent Party Congress that saw the ouster of former leader Hu Jintao in embarrassing fashion.

China also continues to play the game that it is a “developing” economy and an “emerging market”. There is keen interest to formally remove these monikers from the world’s second-largest economy that has relied on these labels to guarantee the influx of billions in development assistance from international non-governmental organizations and investment capital. But at present, China continues its “have our cake and eat it too” as an official developing economy; one that happens to also be a global foreign aid donor via international organizations and runs its Belt and Road Initiative (BRI), a huge emerging markets development program. This looks like a developed country, not an emerging one like Indonesia and Pakistan. Meanwhile, China continues to soak up all the capital it can absorb as a major component of massive emerging market index funds and mutual funds.

The idea that a fiduciary cannot wholesale “get out of China” without undercutting its obligations to seek the highest returns for investors needs to be reconsidered. To claim that there is some “duty” to clients to be invested in China is nonsense. Why would there be a duty to be somewhere where the risk factors are so amplified?

Some big-picture stats to consider:

• The World Bank projects China’s economy will continue to slow throughout 2022 and that a lack of evolution in its growth model will keep its economy “unsustainable”.
• China was unable to meet its 5.5% growth target thus far.
• Michael Pettis: “Until the country begins its difficult adjustment, it can continue to grow rapidly only with the piling on of more nonproductive investment, creating more inflated growth.” Source.
• “Official industrial value-added fell by 2.9% in April, and will likely decline by similar margins in May.  Property sales officially fell by 39% y/y in April, car sales declined by 47.6%, and excavator sales fell by 61%. Consumption is falling sharply as a result of Covid restrictions, with headline retail sales down 11.1% in April and even online sales from Alibaba’s Taobao and Tmall (undoubtedly hurt by delivery problems) are down 25.6% y/y. These are not small declines—they reflect a massive disruption to the regular operations of China’s economy, and they have continued in May from the declines in April.” Source.
  • “Over a longer horizon, China’s growth outlook is constrained by demographics, falling productivity, and more significantly, the failed structural reforms of the past decade. […] With the property market and the financial system in distress, it may take several years to close that output gap, even if policy is more supportive. “ Ibid.
• “ Imports, driven by domestic economic activity, are lagging far behind the boom in exports as Chinese producers scramble for foreign markets to offset the lack of domestic demand.” Source.
  • “2022 has demonstrated, a current account surplus can also go hand in hand with uncoupling, as foreign claims on the Chinese economy are unwound.” Ibid.
• FDI – increased FDI numbers are deceptive for variety of reasons:
  • “China’s FDI includes investment from Hong Kong and Macau – its two special administrative regions – and Taiwan […] “Hong Kong has long been the single largest source of FDI into mainland China during the past four decades, accounting for over a half of the overall value” Source.
  • “so-called tax havens of the British Virgin Islands and the Cayman Islands have also traditionally ranked high as major investment sources for China. […] That means investments into mainland China from Hong Kong, Singapore and the so-called tax havens are not only from subsidiaries of foreign multinationals, but also from firms set up by mainland businesses.”  Ibid.
  • “Direct investment [into China] from the other parts of the world, though, fell by 19.6 per cent between 2010-20.” Ibid.

Recent foreign investor weariness towards China is due to China’s unpredictable regulatory changes, its “Zero-Covid” policies, and defaulting real-estate market, which comprises 28% of China’s gross domestic product. This lack of confidence was demonstrated in multiple ways:

• “The MSCI China is down 26% year-to-date, similar to the Nasdaq, and underperforming the MSCI Emerging Markets Index.” Source.
• overseas investors became the net sellers of mainland shares
• the offshore real estate credit market collapsed
• emerging market fund equity allocations to China reached the lowest number in three years
• Goldman Sachs predicted no earnings growth for MSCI China Index constituents in 2022.
• “An American Chamber of Commerce (AmCham) in China survey in May found that 51% of respondents have already delayed or decreased investments” Source. (mostly due to Covid though)
• BlackRock Investment Institute added U.S.-China competition to its list of top 10 geopolitical risks for 2022.

To be a good fiduciary entails appropriately managing and minimizing risk in the stewardship of client money. To do this, one should be avoiding China, not lean into it. The risks are increasing and returns are less certain than ever before. To say that one must be in China to be a good fiduciary completely undercuts the base premise of fiduciary duty and displays what I think is an unhealthy bias toward authoritarianism and non-market economies.