ESG Regulations Could Increase Allure of China Investing

Last year reminded investors that investing in China, although it's the largest developing economy, carries plenty of risk.

Amid a severe regulatory crackdown enacted by Beijing, consumer education and online education equities, among others, tumbled. By the time 2021 drew to a close, the MSCI China Index plunged 21.7% while the MSCI Emerging Markets Index lost just 3.6%.

The calamity experienced last year wasn't the first time the Chinese Communist Party (CCP) targeted a specific industry for reform. It probably won't be the last and that's a reminder that investing in emerging markets, China in particular, carries ample risk that advisors need to make clients aware.

That doesn't mean the long-term case for investing in China should be ignored. In fact, some market observers argue that as the world adopts more environmental, social and governance (ESG) regulations, China is a market that stands to benefit.

Hear It Out

As advisors well know, the mix of China and ESG is not without controversy. The country is the world's largest polluter, meaning it earns poor environmental marks. As for China's shortcomings in the social and governance departments, suffice to say that's a multi-piece series unto itself and the crux of it wouldn't be flattering.

However, there are signs China is attempting to make some progress in the ESG department. At the corporate level, those include enhanced worker benefits, increasing prioritization of social impact and more environmental protection, among others.

“These new regulations came at a cost to profits in China’s internet sector. On September 2nd, Alibaba announced they will invest $15.5 billion USD into a 'common prosperity' fund by 2025,” according to KraneShares research. “Likewise, Tencent pledged $7.7 billion toward common prosperity. This money will go toward increasing subsidies for small and medium-sized enterprises and toward improving wages, insurance, and protection for gig economy workers such as couriers and ride-hailing drivers.”

Something for advisors to discuss with clients, particularly as they get more in tune with and curious about ESG, is that more ESG regulation can bear fruit at the equity level. Using the MSCI ESG leaders indexes for the USA, Europe, and China as the gauges, it's clear more ESG regulation provides a boost for Chinese stocks.

“In the less-regulated US market, we found ESG does not have a significant impact on performance over the past 10 years, accounting for a cumulative outperformance of 4.3%,” notes KraneShares. “In Europe, the opposite was true; ESG provided a consistent performance boost across the period, accounting for a total outperformance of 23.9%. In China, however, the effect was the most pronounced. Since the inception of the China ESG index on July 13, 2013, it provided a cumulative outperformance of 102.1%.”

Since 2013, the China ESG Leaders benchmark more regularly outperformed the MSCI China Index than did the U.S. and Europe equivalents relative to the non-ESG indexes.

China: A Credible ESG Destination

Advisors understand the China/ESG marriage can be a difficult one for many clients to stomach, it's one with increasing merit.

Add to that, it's actually less controversial than what is found in developed markets. Think about it. The toxic political environment in Washington, D.C. and allegations of greenwashing are elevating ESG skepticism in the U.S. China doesn't have to contend with that because Beijing can do as it pleases. Plus, Chinese ESG stocks are inexpensive relative to developed market peers.

“As investors look for new opportunities in 2022, China stands out with its more reasonable valuations following a year of regulatory catch up on data and climate issues. China equities may be poised for accelerated growth next year, and ESG could be the key to outperformance within China,” concludes KraneShares.

Related: ESG Ratings Are Going to Be in Spotlight This Year