Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: foreign investment in China, a massive cyberattack, the boost to small banks from PPP, and a new critique of economic theory.

Foreign Investors Pile into China

Early in the COVID-19 pandemic, the developed world seemed ready to wean itself off Chinese exports. The Chinese Communist Party’s obfuscation of the outbreak accentuated the risk of doing business with authoritarian governments, and massive supply-chain disruptions suggested that the global economy had grown too dependent on Chinese exports.

Governments took note: The Japanese government announced a plan to spend $2 billion incentivizing companies to move facilities out of China, with the U.S. and Western Europe evaluating similar policies.

But the Chinese economic engine chugged along, bolstered by policy stimulus and a surge in exports of personal-protective equipment. Official economic data (usually fudged but still decent directional indicators) showed China’s GDP stabilizing to pre-pandemic levels by the summer.

Now, as the pandemic comes to a gradual end, 2020 is proving to be a banner year for the Chinese economy. A record $150 billion in foreign money has entered the country’s financial markets as investors hope to get a piece of China’s comparatively strong growth.

Facing paltry returns on government bonds in the West, fund managers have scooped up unprecedented amounts of national and provincial Chinese debt. Thanks in part to this influx of foreign money, the renminbi has gained more than 8 percent against the dollar since June, its strongest six-month performance ever. And stock issuance has hit its highest level in a decade, with China’s domestic exchanges listing $50 billion worth of new shares.

That’s been helped along by financial-system reforms. China’s new STAR market has made it easier for businesses that previously tapped Hong Kong’s more-developed financial system to list on mainland exchanges as well. And the government has rolled back limits on foreign ownership of financial institutions, opening more channels through which foreign money can enter domestic markets. Last week, Goldman Sachs announced it would take full ownership of its Chinese joint venture.

But Wall Street’s bet on China is not without risk: It comes at a time when Beijing is pushing to tighten its grip on the private businesses that drive a significant portion of the country’s growth.

A recent Wall Street Journal report noted that “the state is installing more Communist Party committees in corporate offices and encouraging them to play more assertive roles in decision-making.” The Chinese government routinely restricts access to credit for firms deemed insufficiently loyal, and has issued new guidelines to “continuously enhance the political consensus of private business people under the leadership of the party.”

The CCP put its new posture toward the private sector on full display last month, when regulators halted the IPO of Ant Group, the $35 billion payments firm founded by billionaire entrepreneur Jack Ma. Investors responded by dumping stock of Alibaba, the e-commerce giant founded by Ma, as well as Tencent and a host of other Chinese tech businesses.

Given the inefficiency of China’s state-owned enterprises, which return 60 percent less on assets than private firms, this crackdown does not bode well for the country’s economic growth. Since Xi Jinping took power in 2012, the return on investment for Chinese corporations (both private and public) has halved.

And China’s financial system is growing more vulnerable. In response to the pandemic, Chinese authorities expanded credit to already-highly leveraged businesses and local governments.

The cracks began to show in September, when China Evergrande Group, the country’s largest property developer, alerted regulators of solvency issues. The company’s bonds plummeted before state-backed investment firms stepped in with a $4.6 billion lifeline. That didn’t contain the damage: A string of defaults by both SOEs and private firms followed.

As the Center for Strategic & International Studies pointed out in a recent report, the Chinese “financial system becomes most vulnerable when Beijing’s credibility erodes and implicit guarantees on assets are suddenly questioned.”

Paradoxically, by neglecting to shelter SOEs from financial woes, the CCP is signaling its commitment to making the country more competitive. But in tandem with the private-sector crackdown, recent bond-market turmoil suggests that foreign investors are underestimating the risks to Chinese growth.

Around the Web

Hackers linked to a foreign nation breached a software platform used by several U.S. government agencies and most of the Fortune 500:

Hundreds of thousands of organisations around the world use SolarWinds’ Orion platform. The US department of Homeland Security’s cyber security arm ordered all federal agencies to disconnect from the platform, which is used by IT departments to monitor and manage their networks and systems.

Small banks get a boost from COVID-19 stimulus:

Small lenders . . . are doing far better than expected at the outset of the coronavirus recession—largely thanks to government money that passed through banks on the way to households and businesses. Stimulus and unemployment checks boosted deposits and kept borrowers from falling behind on their loans. The Paycheck Protection Program—the government’s small-business bailout—brought them new customers and kept old ones afloat.

Add Deutsche Bank to the list of businesses allowing employees to leave New York City.

Random Walk

Bloomberg ran a profile of Ole Peters, a physicist whose critique of economic models has made him something of a cult figure:

A physicist by training, his theory draws on research done in close collaboration with the late Nobel laureate Murray Gell-Mann, father of the quark. He’s also won over two noted thinkers in the world of finance — Nassim Nicholas Taleb and Michael Mauboussin — not to mention a groundswell of enthusiastic supporters in the Twittersphere.

His beef is that all too often, economic models assume something called “ergodicity.” That is, the average of all possible outcomes of a given situation informs how any one person might experience it. But that’s often not the case, which Peters says renders much of the field’s predictions irrelevant in real life. In those instances, his solution is to borrow math commonly used in thermodynamics to model outcomes using the correct average.

Peters uses the following game to illustrate how expected value can lead to faulty conclusions:

Starting with $100, your bankroll increases 50% every time you flip heads. But if the coin lands on tails, you lose 40% of your total. Since you’re just as likely to flip heads as tails, it would appear that you should, on average, come out ahead if you played enough times because your potential payoff each time is greater than your potential loss. In economics jargon, the expected utility is positive, so one might assume that taking the bet is a no-brainer. . . .

Suppose in the same game, heads came up half the time. Instead of getting fatter, your $100 bankroll would actually be down to $59 after 10 coin flips. It doesn’t matter whether you land on heads the first five times, the last five times or any other combination in between.

Now, say 10,000 people played 100 times each, without assuming all players land on heads exactly 50% of the time. (This mimics what happens in real life, where outcomes often diverge dramatically from the mean.)

True, but some people will get fabulously wealthy taking this bet. In fact, the “average” gambler in this game wins close to $16,000. If you like getting richer more than you hate getting poorer, you’ll take the bet. If not, you’ll likely decline the bet to avoid losing money.

Peters’s critique seems to be that people are risk averse, which is true. Utility functions used in economics reflect risk aversion — the commonly used logarithmic function says that utility increases by the square root of changes in wealth, so that losing $10 will hurt more than gaining $10 will help. Of course, it’s difficult to model an individual’s actual utility function, but the framework is useful for decision-making, and Peters’s critique doesn’t convincingly undermine the concept of expected utility as such.

–D.T.

 

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