Why am I shorting Chinese stocks?

introduction

When most Westerners think of China, we often think of a few things:

• China’s liberalized economy and authoritarian and illiberal social institutions, which in China are called “socialism with Chinese characteristics.”
• Mass manufacturing, i.e. “Made in China”
• Huge and dense cityscapes such as Beijing, Shanghai and Shenzhen
• Geopolitical threats to the United States, South Korea, Japan and Taiwan
• TikTok and the disputed US ban

When discussing Chinese markets in Western circles, some other topics also regularly crop up:

• The ongoing trade war between the United States and China
• China’s changing demographics and rising middle class
• The Chinese Communist Party’s crackdown on tycoons such as Jack Ma and Bao Fan

Due to a cacophony of reasons, which I will explain in detail in this article, I will go short on the Chinese stock market in a pair trade with a long position on the US markets.

I believe that the steady trend of the MSCI China ETF (MCHI) since its market debut will continue and investors would be better off avoiding the Chinese markets moving forward.

The trade war between the United States and China

The United States and China have been locked in a trade war for some time, with both sides working to impose tariffs and sanctions on the other in order to enable easier competition from domestic companies.

A Biden administration spokesperson posted the administration’s thoughts when the new tariffs were announced a few weeks ago:

China’s unfair trade practices regarding technology transfer, intellectual property, and innovation threaten American companies and workers. China is also flooding global markets with artificially low-priced exports. In response to China’s unfair trade practices and to address the resulting harm, President Biden today is directing his trade representative to increase tariffs under Section 301 of the Trade Act of 1974 on $18 billion in imports from China to protect American workers and businesses.

Definitions

Recently, the Biden administration imposed larger trade tariffs on China, further strengthening the trade war that the Trump administration started in 2017.

These definitions include the following:

• Increase interest rates to 25% on:
  • Face masks, lithium-ion vehicle batteries, medical gloves, permanent magnets, ship-to-shore cranes, and some steel and aluminum products
• Increase interest rates to 50% on:
  • Semiconductors, solar cells (complete and partial), medical syringes and needles
• Increase prices to 100% on:

These trade tariffs are intended to limit the ability of Chinese companies to compete with local companies. The U.S. electric vehicle market is one battleground where cheap Chinese electric vehicles can compete with the offerings of Tesla Motors Inc (TSLA), which currently dominates most of the U.S. electric vehicle market.

This is bad news for big-name Chinese stocks, which will see much less demand in US markets now that the price of their products has doubled. These definitions are unlikely to disappear or change anytime soon, because they are one of the few policy designs put forth by the Biden administration that has truly bipartisan approval.

Block applications

Add to that the recent potential ban of the Chinese-owned app, TikTok, by the US, resulting in its sale within a year, and we see a bigger picture of how much control the US is willing to exercise over Chinese-owned companies in order to prevent China from collecting data on citizens. Americans.

While ByteDance, TikTok’s parent company, has said they will file a lawsuit against the Biden administration for violating the First Amendment (free speech clause), it is unlikely that a federal court will rule in their favor, in my opinion. Instead, I think this gesture from the company is mostly intended to delay time for a future with more favorable regulators.

Despite ByteDance’s current stance of not selling TikTok, TikTok will likely be banned or sold to a US-based competitor. The case is so high-profile that ByteDance cannot escape moving the company into its own US subsidiary. With all eyes on them, at the end of the year ending in 2025, ByteDance will be forced to act.

Semiconductors

The biggest concern for Chinese technology stocks is the country’s inability to obtain new semiconductor technology from the West. Dutch company ASML Holding NV (ASML) has a complete monopoly on extreme UV lithography machines, which are currently best-in-class machines for semiconductor manufacturing. The Biden administration was able to convince the Dutch government to force ASML to halt several shipments of old lithography systems to Chinese companies, as well as to completely ban the sale of UV machines to them.

If you want to read more about ASML and its monopoly, I wrote about that last month here.

The inability to access these machines means that Chinese companies will need to invent their own machines, or access them through dark channels smuggled from other countries. Either way, it will be very difficult, and will put China behind in terms of technological progress in semiconductors for years, if not a decade.

These machines aren’t something you can start building overnight, and even ASML doesn’t manufacture all the components in-house. Chinese companies are also set to be banned from purchasing from these other suppliers as well, limiting their ability to participate in global technology exchanges.

Geopolitical tensions

Aside from the trade war, there is a risk of a real war on the horizon. China has had a very long history with Taiwan, and I won’t go into too much detail here, but the long and short of that history is as follows:

• The civil war of the 1940s and 1950s saw the Chinese Communist Party take control of mainland China
  • This is the clique that is still in charge today, and it is the clique that President Xi represents
  • The Nationalist clique that lost the war fled to Taiwan and ran a concurrent government claiming all of mainland China
• Today, Taiwan and China operate as separate political and economic entities, despite each claiming sovereignty over China and Taiwan in its entirety.

Russian treatment

The biggest risk facing the Chinese stock market is an invasion or blockade of Taiwan, because of how the West might respond. If the CCP decides to crack down on Taiwan and declare war, they will likely get the “Russian treatment,” as I call it; This means a complete shutdown of international trading of their shares, withdrawal from Western companies, and complete sanctions on monetary systems such as SWIFT. This is what happened to Russia after its invasion of Ukraine in 2022.

Related ETFs have not performed well.

The concern of a complete financial embargo on China in the wake of a potential invasion of Taiwan should be enough to scare off all potential US-based investors. Investors’ investments in RSX and ERUS (shown above) were liquidated at virtually zero and received very little of their holdings in the Russian economy. These companies are still in business, but the stock in them is worthless.

The United States will almost certainly participate in any escalation of the war in Taiwan, as President Biden emphasized in 2022. This commitment means that China will not only face the kind of financial sanctions that would liquidate and destroy all investor holdings in funds like the iShares China Large-Cap ETF ( FXI) and MSCI China ETF (MCHI), but also a military escalation that could lead to the collapse of the entire market.

Pair trading

So what do I do with this thesis? I am too risk averse to short the Chinese market outright, but I will accept that in pair trading. I will be short the Chinese markets with shares of FXI, the Chinese large-cap ETF mentioned above, and I will short the US markets with the SPDR S&P 500 ETF (SPY).

Since the two ETFs trade differently, we should see a divergence between them based on the quality of the underlying companies. General market trends should push both funds to the same level, which means that their “beta,” or the amount by which stocks move due to general market forces, is almost neutral. There are more sophisticated ways to make a portfolio completely market neutral, but this is enough for my purposes.

FXI has a moderate correlation with the SPY, which means we should expect it to perform alongside the SPY on most days, but likely not as strongly. This is where we will see the divergence that will bring returns in trading the pair.

This trade will benefit from the stagnation in Chinese markets and the risk premium imposed on stocks (they are undervalued by their Western counterparts) compared to sustained growth in US markets. It also carries a huge payoff in the event that a “black swan” occurs, which we do not expect, sinking Chinese markets such as getting the “Russian treatment” from the West for its aggression towards Taiwan.

Conclusion

Chinese markets face many threats that investors should take seriously. The escalation of the trade war between the US and China, the escalation of Chinese threats against US ally Taiwan, and the general trend of stagnation in the market, make the Chinese market ripe for long/short pair trading against the US markets.

I intend to do this trade for the foreseeable future and will reevaluate it in 2025 when the decision on TikTok is made. Once TikTok is sold or banned, it will set the new tone for US-China tech relations, which is vital to this thesis.

Thanks for reading.