Reports that a leading asset manager is delaying the launch of a Chinese bond fund indefinitely are a clear sign that the facade around Chinese stocks’ and bonds’ environmental, social and governance record may be lifting.

In recent years, rising investment in Chinese stocks and bonds coincided with a boom in ESG investing. Of course, investing in China on an ESG basis has always been a difficult sell. Despite this, many Western investment funds championed China as a land of ESG-related opportunity — even pushing for its stocks and bonds to have greater weighting in emerging markets indices.

On the environmental front, climate activists have long argued that investment in Chinese state companies can hardly be considered beneficial. Some firms stand accused of releasing more greenhouse gases than entire developed nations.

Read: Canadian pension plans named as passive beneficiaries of China’s crimes against humanity: report

On the social front, investors have ignored the rising social risks of investing in Chinese companies involved in forced labour and internment camps in Xinjiang and Tibet. In fact, a new report from U.K. think tank Hong Kong Watch and Sheffield Hallam University found many of Canada’s federal and provincial pension funds are passively invested through MSCI emerging markets and MSCI china funds in 12 Chinese companies with known links to forced labour.

On the governance front, investors have had to overlook the ugly reality of investing in a country where one man can wipe out whole industries at the flick of a pen. Even after President Xi Jinping’s crackdown on the technology and education sectors, the reaction from foreign investors was muted.

BlackRock Inc.’s late-coming Damascus moment followed the Communist Party of China’s 20th Congress in October. There, its general secretary took the opportunity to purge moderates and double-down on threats against Taiwan — all without showing serious signs of reversing restrictive coronavirus policies. It’s also now expected that Jinping will further tighten China’s harsh policies against sexual minorities and feminist communities, all to further his vision of a conformist society.

Tensions in the Taiwan Strait looms particularly large and is quickly climbing up the risk register of many firms. Research by the U.S. State Department has warned that a blockade by China of Taiwan would spark US$2.5 trillion in annual economic losses to the global economy. This would be larger than the global economic loss in the 2008/09 financial crisis.

Read: Sounding board: Institutional investors making Canada’s approach to China unsustainable

Given all these storm clouds, it’s no wonder asset managers are starting to respond to pressures and launching emerging markets products without exposure to China. But where does that leave institutional investors?

First, institutional investors — including defined benefit pension plan sponsors — should dispel the rose-tinted notion that investing in the world’s most populous nation represents economic opportunities without acknowledging its downsides. When it comes to its financial markets, a nuanced perspective is required to avoid clear risks and benefit from opportunities.

Broadly speaking, institutional investors must consider mitigating the very real ESG risks by limiting active holdings in Chinese bonds, stocks and passive holdings in specific exchange-traded funds and emerging markets funds heavily weighted towards China. In turn, ESG advisors must also draw up a new matrix of ESG considerations that take into account the new dimensions presented by China, including reviewing their ESG portfolios now.

Of course, there will be private venture capital funds and those with large, global portfolios that are willing to endure the risks and potential losses. But for DB plan sponsors, an exposure audit is vital.

Second, there’s an urgent need for proper regulation when it comes to ESG. This should sit alongside blacklists banning investment in companies complicit in crimes against humanity.

Finally, investors should throw their weight behind growing efforts to create emerging markets funds that cap China’s weighting or remove it entirely. The global economy’s current exposure to Chinese stocks and bonds is dangerous and unsustainable.

These are the views of the author and not necessarily those of Canadian Investment Review.

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