Get ready for a tidal wave of buying in Chinese stocks

I wrote last week that for all the mutterings about booms and bubbles in China, it might actually be one of the best buys in the world at the moment. This view was met with a fair amount of sniffy scoffing from most mainstream analysts. They may be quite right in their sniffiness, but I was pleased to see a supporting view come out today from boutique research firm GavKal.

Right now, they say, it is “fashionable to make fun of China’s roaring equity bull market by highlighting that it is driven by retail punters who care little for valuations, business strategies or management quality.” But to look at it like this is to rather miss the point.

I have pointed out the parallels between the Japan of the 1970s and 1980s and the China of today several times before, but GavKal make another point on the matter. They see the “single most important long-term financial development” globally as the internationalisation of the renminbi, a process that “is now going into overdrive” given that the International Monetary Fund (IMF) is soon to vote for renminbi to become a special drawing rights currency.

This could be seen to neatly parallel the liberalisation of the yen after 1980: it was made fully convertible, a change that pulled hugely underweight global investors into Japan and was one of the main drivers of the decade-long bull market that ended with seven of the top ten firms by market cap in the world being Japanese banks.

Move on to today and it is hard not to see the same happening with China. Right now its equities make up 0% of the World MSCI index and 1.7% of the MSCI All-Countries index. Ask any fund manager and he will tell you that he gets his exposure to China via global firms that do business there rather than from firms listed there. China may account for 15% of global GDP, but its companies make up an “inconsequential part” of most institutional portfolios.

But if renminbi usage grows further (it is already the fifth most used currency in Swift (Society for Worldwide Interbank Financial Telecommunication) settlements), China begins to embrace currency deregulation, and as a result, all index providers are forced to upgrade China’s weight in global indices, “the wave of ‘forced buying’ of Chinese equities could end up being a tidal wave which sweeps away the very idea of index investing”.

Right now, everyone outside of a few Chinese retail investors, everyone is “short/massively underweight China”, or at the very least will be once global bond and equity indices start to reflect the reality of a China more open to foreign investment flows. That can’t last.