Why Investors Aren’t Flocking To China

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.

A full transcript follows the video.

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's certainly 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 some pretty 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's already happened this year, but China had a little bit of a roller-coaster ride, and they locked down investors' abilities to sell bonds when the Chinese market was crashing. Afterwards, they released a statement saying, "We don't understand why people don't want to invest in our bonds, but we're incentivizing 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 institutional investors. But one of the things they limited, first of all, they limited short-selling under the threat of arrest. So, you can't run a sophisticated 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're restricted on your ability to sell. So, your highest 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, which I think you have in most developing markets, which is that China could just up and decide to nationalize whatever it is that you own. It is a communist government in name. So, that's always a possibility. It has happened to investors before. It's happened in Mexico, it's happened in Venezuela, to name two just right off the top of my head. So, it's not an unreasonable fear to have about China. Additionally, something that's interesting about China is that the culture is obviously very different. It can be hard to parse through the regulations and figure out which ones they're actually enforcing, which ones they care about. We were talking earlier about loans, and figuring out which ones the government would definitely pay and 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's definitely a little bit of a minefield for the foreign investor who doesn't have a lot of experience, and has no way of knowing exactly what's going on internally.

Wathen: Right. To take 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 the London 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 and people 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 in Shenzhen, which is a city that is situated right on the border with Hong Kong. Some people opened up the Goldman Sachs Shenzhen real estate something or other -- I'm not 100% sure what the whole name was. They even spelled their name in Chinese. They spelled like Goldman 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. And that'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. A Nike sweatshirt could easily be, they could throw a swoosh on a sweatshirt and basically 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 in August 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 for Goldman 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 is not something that's available to American banks because of the regulation that we have here. They have this thing called an investment receivable. An investment receivable is basically a loan. It's a debt that's owed to the company, 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 for receivables. So, if an investment receivable 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 a problem of really bad disclosure. When it comes to financial institutions, the financial institutions you want to invest in are the ones that have great disclosures. The Wall Street Journal really ran with this story. They talk about how it's the equivalent of $2 trillion in loans that are now classified as these investment receivables. And they've grown about three times since 2013-2015. That's a two-year stretch, three times growth in that category, just because they're hiding what many people believe -- and in some cases, they probably are -- the bad loans in these investment receivable accounts.

Lapera: Yeah, which is definitely really interesting. This kind of follows, I don't know if our listeners follow China's debt problems, but China as a country has been getting in increasingly more and more debt. The official level of debt now is 2.5 times the gross domestic product. All of this vernacular here, loosey-gooseyness, is all tied together.

Wathen: Right. If we take 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 deal especially during the financial crisis and thereafter -- you could borrow money in the United States at 1% and take 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 the interest 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 the Chinese 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," so the world started bringing money to China, and then you have all 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't possibly repay them. You also get the over-investment, you get the Chinese government building houses that no one is going to live in, roads to industrial complexes that have no factories, things of that sort. This sort of hot money floating around in China has incentivized 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's top banking regulator, said that the hidden credit risk that's associated with investment receivables and other types of investments like this, it could be really bad for China's financial security. Which is crazy. Normally, top Chinese officials don't say, "Hey, we might have made an error in judgement, and this could be bad."

Wathen: Yeah. It's a particularly 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 implicit guarantee 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, a tangled web of bad incentives.

Lapera: Yeah. So, now that we've brought you down about China, (laughs), things could be a-changing. But it's not super certain, so don't get excited. I was joking with Jordan earlier that I 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%, but like we said, we don't really know what the number is. So, good news: They could sustain 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't necessarily solvency. There have been plenty of examples, even in the United States, where banks have been insolvent. It's pretty much well understood that Citigroup, at one point in time or another, has been insolvent several times over the last century. What kills banks is a liquidity crisis. It's when people take out their deposits. So as long as the government says, "Hey, deposits are fine," and as 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 investments is a totally different matter.

Lapera: Yeah. And the idea of a run on the banks in China is 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 that goes 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're going 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 a positive 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. You had 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 suddenly seeing them right off a lot more loans -- it's doubled in the last couple years. On the other hand, it means that banks are getting 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 investors don't necessarily demand of great performance 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 obviously everyone 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, but probably, 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 means when 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, I fundamentally 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 your average investor, and you're not going to be spending a lot of time fact-checking on everything, 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 interests in 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.com or by tweeting us @MFIndustryFocus. Thanks again to Austin Morgan, who's wearing a very dashing pink shirt, today's totally awesome producer, and thank you to y'all for joining us. Everyone, have a great week!