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Investing in Foreign Economies – Why Government Bonds are Problematic

We speak to a lot of different investors who have a significant interest in investing in the Chinese economy, and for good reason.  If you look at potential investment opportunities across the world, it’s difficult to ignore the Chinese success story because it offers you high growth that outstrips US inflation, but the risk is somewhat muted when compared to traditional emerging markets because of China’s standing in the global economy.

When it comes to global diversification, China seems like a really great place to deploy some money.  And many turn to government bonds in order to do so.

Chinese Growth Potential

But before we get to the bonds themselves, it’s worth ruminating a bit on the Chinese growth story as a whole.  Just a decade ago, China found itself at the peak of an incredible run of growth where it achieved double digit percentage GDP improvements even from a very large base.  This was mostly driven by aggressive trade agreements, a rising middle class, domination of global supply chains, and cheap labour that gave it a decisive market in all sorts of manufacturing.

The World Bank described the pace of growth as the “fastest sustained expansion by a major economy in history”.  This rapid development lifted some 800 million people out of poverty and solidified China’s position as a global force in the marketplace.  It was a period of growth that we haven’t seen anywhere else in modern times, at least at that scale.  We will likely look back on it in time as one of the most remarkable turnarounds in economic history.

The economy has matured somewhat since then and growth figures have come down as a result, but it still delivers exceptional growth numbers year after year.  The game is not nearly over and thanks to very specific government policies, the country is determined to expand even further – leveraging the advantages they’ve built over the previous decades.

We’ve seen a disproportionate focus on technology in an attempt to rival what’s happening in San Francisco, London, and Tel Aviv – and that is beginning to pay dividends as they evolve their economy from one that is reliant on cheap manufacturing, to a diversified economy that can compete at a high tech level with the best of the best.

It’s clear that the road ahead for China is bright and investors around the world are clamouring to get a piece of the action.  As far as long-term investment value goes, there are few economies that can deliver the yields that we’re expecting from China – on a reasonable risk / reward profile.

The big question is, how should you look at getting that exposure?

The Allure of Chinese Bonds

One common investment that is considered is the bond market and it’s not difficult to see why Chinese bonds have garnered so much attention.  From the outset, it is the second biggest fixed income market in the world with over $14trn in market capitalization across a wide range of different bond instruments.  This menu of options gives investors more control over their bond allocations than can typically found in other high-yield markets.

In addition, the fact that these bonds pay real interest after of inflation of around 3% makes them extremely attractive when compared to the rest of the developed world.  This is buoyed by a Yuan that’s going up in value, compared to the declining purchasing power of the US Dollar thanks to the near infinite money printing we’ve seen over the last year or two.  This is likely to continue into the medium and long term future thanks to good macro-economic conditions, strong interest rate differentials, and an insatiable foreign demand for Chinese assets.

Some have suggested that the global backlash on China-dominated supply chains that has been cruelly exposed during the COVID-19 pandemic might be a significant headwind here, but we don’t think that’s likely.  The truth of the matter is that China still holds all the cards in terms of providing high-quality products at scale, at affordable prices – and it will be very difficult to turn that around.  As the world economy slowly moves back to normal, we’re expecting service as normal to resume.  It’s very unlikely that we’ll see a massive, coordinated effort to reverse the gains of globalization that gave China this foundation in the first place.

Another important component of the investment case is the fact that Chinese investments have been much less correlated to the other emerging economies than most people realize.  Because of their scale and the closed nature of the economy – you are afforded some protection from emerging market risk while still capturing good returns.  They’ve almost transcended what we think of as an emerging economy and are in a league of their own.  This fits into the perfect Goldilocks zone when it comes to a lot of investor mandates because of the favourable risk-reward profile.

When you look at all these factors, these bonds really do seem like sound investments from the outside and it’s no wonder that they’ve been one of the key investment vehicles that have attracted so much attention.  They represent some very rare yield that doesn’t require significant risk to be taken and institutions and individuals alike have been piling in as a result.

But there is more here than meets the eye.  There is one key component of the picture that makes these bonds problematic, and we think that it’s something you should be taking very seriously.

What Are These Bonds Funding?

As investors, we are looking to maximize our returns while satisfactorily managing our risk profile.  As such, it’s tempting to focus only on the quantitative measures and ignore any additional externalities that come as a result of our investments.  But we can’t do that in this case – especially when it comes to China.

China’s political situation and their tense relationship with the USA makes this investment prospect slightly trickier.  We must ask the question about what our bond investments are going to fund as it has social and ethical implications for our standing as investors and the future socio-political context that we operate in.  China has come under scrutiny from the West because of the way they run their nation state and how their government controls every aspect of what happens within the borders.  It’s safe to say that tensions are high, and we have to take that into consideration when we look at investment opportunities like this.

When you dig into how these funds are being used, an unsettling truth bobbles to the surface.  A very significant proportion of these funds are going fund military investment on the Chinese side.  As a country, they are doing all they can to cement their position as the ascendent global superpower and to do that, they need a highly functional military that can rival that of the USA.  As such, huge amounts of foreign investment is being funnelled into this cause to build up resources, technology, personnel, and the like – at massive scale. This is nothing new of course, this is indicative of a growing country with large ambition, but when it’s China – you are forced to pay attention.

This context is incredibly important when considering investing in Chinese bonds because it has a material impact on the macro-economic and socio-political standings of the two global superpowers.  It’s not something that should be ignored, and it sets this type of investment apart from the rest.  You have to ask yourself whether you are on board with the way that these funds are going to be spent.  You might think that it doesn’t actually affect you, but it will over the long run as global positions shift.

This sentiment was confirmed by the executive order signed by the USA late last year that banned American investors from funding certain publicly traded Chinese military companies, for fears that it was emboldening the military and raising the level of national security threat.  It was met with lots of debate within the investment community, with some raising concerns about how this limits the freedom of investors – a decidedly un-American idea – but what cannot be denied is the seriousness of the situation.

If you are uncomfortable with funding the Chinese military, or even just with the idea of the military-industrial complex in general – then these are red flags that you should heed.  Chinese bonds are incredibly problematic, and one would do well to stay away from them if at all possible.

Luckily, there are better alternatives that allow you to gain exposure to the Chinese economy without directly funding their military efforts

Investing in Expanding US Companies

There are a number of different ways to gain investment exposure to the Chinese growth story, but one of the most exciting ones is to jump on the American rocket ships that are targeting China as new expansionary opportunities.  There are a wide range of different US-based businesses in a number of industries that see Chinese expansion as the next step in their journey and you can be a part of that growth.

When you invest in one of these companies, you eliminate the concerns about military spending while still gaining access to the consumer growth that you’re looking to be exposed to.  These companies represent a suitable proxy that gives you the best of both worlds.  It also has the added benefit of being much more aligned with what you’re already comfortable with – so you’ll have a much better understanding of things from the get-go.

One key factor here is that you want to be investing in companies that already have proven product-market fit and have delivered traction at scale in the US market already.  You don’t want to take on any unnecessary early stage risk by betting on companies that haven’t proven themselves.  Ideally, the Chinese expansion should simply represent a new market entry with technology that has a solid business model and a clear road map to long-term sustainability.  If you get this right, you’re well positioned to benefit from the Chinese macro-economic growth and massive consumer landscape, while also being able to sleep at night without any moral or ethical guilt.

But how exactly do you find these companies in the first place?

The Summer Atlantic Capital Solution

Here at Summer Atlantic Capital, we’ve helped numerous clients access opportunities of this type – it’s the reason that we exist.  We are a private equity firm that specializes in taking companies with a novel technology and helping them enter the Chinese market through joint ventures, licensing deals, or distribution deals.

“Investing in Chinese bonds compared to other sovereign bonds is no doubt a sound investment, but do you really know what your money is going towards? Maybe it will be used for Government initiatives that may not align with your beliefs? By investing in US enterprises that have a footprint in China investors can take advantage of the benefits the Chinese economy offers while having a stronger risk/return ratio that typically is associated with growth companies. At the same time your investment dollars will be directly supporting US based companies.” said Summer Atlantic Capital US Chief Executive Officer, Michael Calderone.

Our sister company, Summer Atlantic Capital China will directly invest into each deal, and has an incredibly talented team on the ground that makes sure that everything is operating efficiently.  SAC China is industry-agnostic but do pride themselves on working with those exciting technology companies who have something really innovative to offer to the market.

Summer Atlantic China’s investment fund offers unparalleled access to these sorts of deals, allowing you to invest alongside us – leveraging our expertise, networks, and track record to get in on the most exciting expansion stories you could imagine.

And on top of all that, Summer Atlantic China’s investment fund is actually backed by state owned government funds, so you get the same risk protection as you would if you were buying a bond directly.  It really is a win-win scenario all round.

If this sounds of interest, be sure to get in touch today and let’s see how we can work together.