About the Author: Perth Outcry is the founder of Life + Liberty Indexes and creator of the FRDM index.
Last week we witnessed the largest protests in mainland China in decades. To avoid further unrest, China’s leaders began to gradually roll back Covid controls, even as authorities cracked down on protesters. It’s a step forward and a step back for freedom of expression in China. And for equity investors, the real risks remain.
We see four main elements of autocracy risk – heightened risks when investing in countries with authoritarian rule, such as China.
First, an autocratic political environment can lead to misplaced priorities. Companies often have to prioritize the interests of the state over the interests of all other stakeholders, including their customers and shareholders. It’s a business cost that investors end up subsidizing.
Second, in autocratic countries, capricious government actions can destroy shareholder value overnight. Companies can be nationalized, restricted from their core activities, prevented from making profits or raising capital – or all of the above. And corporate leaders can disappear or otherwise be coerced into actions detrimental to shareholders.
Third, due to a lack of transparency standards and generally poor rule of law, companies in autocratic regimes often have opaque ownership structures. Investments can directly enrich autocrats and their associates, and investors often have limited visibility into the beneficiaries of their investments.
Finally, companies in autocratic regimes often use substandard accounting practices that lack international oversight. Additionally, due to a lack of freedom of the press, there is no independent verification for data from companies or governments. Investors are left in uncertainty as to the accuracy and reliability of the data.
Recent developments in China have not reduced or eliminated any of these risks. After all, we’ve seen the government crack down on entire industries, just as it cracks down on peaceful protesters. Until meaningful changes that improve freedom measures in markets and society are enacted, stagnation or crisis remain two likely outcomes for China in the medium to long term.
So what should investors do? Fortunately, the emerging markets universe offers plenty of options for investors who want to participate in the asset class’s strong growth potential, without funding autocracies.
One option is to look to freer countries where businesses have the incentive to grow and innovate, and have the flexibility to meet global market demands. Many emerging countries have strong institutions, strong rule of law and free movement of people and capital.
Chile, for example, is a relatively freer emerging market in South America with open trade policies, private property rights, and high levels of personal and economic freedom. It is also one of the best performing stocks in emerging markets this year due to its diversified commodity exposures.
Taiwan is another relatively free emerging market and a world leader in semiconductor technology. Warren Buffett, signaling a stock bottom, recently took a large position in
Semiconductor manufacturing in Taiwan
(symbol: TSM). The
iShares MSCI Taiwan
ETF (EWT) quintupled (yes, 5x) the
iShares MSCI China
ETF (MCHI) over the past 10 years.
Chile and Taiwan both rank much higher in freedom measures than China. The Cato Institute and Fraser Institute publish a Human Freedom Index and dataset that ranks 165 countries from most free (#1) to least free (#165) using 82 indicators of personal and economic freedom. Taiwan ranks 19th and Chile 28th. China ranks 150th out of 165 countries. It’s not the worst of the EM universe though; Saudi Arabia ranks 155th and Egypt 161st. For comparison, the United States is currently ranked 15th.
Of course, risks are inherent in investing in any developing market, even the freest ones. Chile recently elected a new government, raising concerns about the dismantling of its business-friendly environment, and Taiwan is under constant threat of invasion. But so far we have seen the strength of Chilean institutions and checks and balances at work. And with Taiwan, as with the Russian war in Ukraine, the highest investment risk lies with the autocratic aggressor. Emerging market investors should be much more concerned about their exposure to China than their exposure to Taiwan.
Other emerging countries such as India, Indonesia and Mexico enjoy freer governance than their peers on average. They also provide additional opportunities for investors looking to capture value in markets benefiting from decoupling trade, as companies around the world diversify their supply chains away from China.
Effective due diligence includes understanding the risk of autocracy and the drivers of a healthy and sustainable emerging market. China’s protests are a beacon of hope in a country whose medium to long-term investment prospects look bleak. Fortunately for emerging market investors, when it comes to finding the growth stories of the next decade, there are plenty of opportunities in countries that have already laid the foundations for personal and economic freedom in place.
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