Why China’s army stocks are flat despite PLA’s growing might

China’s Army Day, on August 1, this year coincided with the 90th anniversary of the founding anniversary of the People’s Liberation Army (PLA). The climax of festivities was a massive field review involving 12,000 servicemen and 600 pieces of weaponry, more than 40% of those being seen by the public for the first time. Differing from parades of the past, which emphasized style and panache, the review was wholly about flexing China’s military muscles and striking an offensive posture.

Held at Zhurihe, Asia’s largest military training base, the event had no bands, choruses or cheering audiences. Instead of parade uniforms, all participants wore combat fatigues. Adding to the serious atmosphere, Xi Jinping gave a sharp speech underlining China’s absolute determination in defending its territorial integrity.

The new format was designed to kill several birds with one stone. First of all, it was intended to send a message to China’s adversaries, particularly India, with whom the PLA is currently engaged in a standoff at Doklam. Secondly, Xi Jinping’s prominence at the review was meant to boost his own standing and intimidate party rivals. Lastly, through demonstrating the fruits of China’s military modernization efforts, the review sought to rally the citizenry around the party-state in a time of trouble.

The defense sector is the country’s most resistant to liberalization

While China may consider those objectives to have been well-served, one sector did not respond well to the Army Day review. After nearly two weeks of resurgence, defense stocks petered out almost as soon as the celebrations ended.

China’s defense equity market has been bearish since the second half of 2015. Defense stocks slid 18.58% in 2016 and 16% in 2017’s second quarter. Out of 93 investment funds specializing in defense, only 19 posted positive returns in the second quarter. Forty-two funds reported net losses of between 10 to 19%.

In the run-up to Army Day, from July 18 to 31, the market expanded by 3.31%. But the momentum did not sustain. So far this month, defense shares have dipped 2.52% and the downward trend is likely to continue for the remainder of August.

The bearish track is due to a number of factors. The defense industry’s mixed-ownership reform, which aims to introduce private capital to China’s state-dominated defense sector, is progressing at a slower pace than expected. But this is hardly surprising since the defense sector is the country’s most resistant to liberalization. Its best technologies and most valuable assets are still held by state-owned enterprises with vested interests in delaying reform for as long as possible.

Lack of transparency is also an issue influencing investor decisions. Strict information control in the defense sector increases uncertainty and investment risks. In such an environment, investors without insider ties – i.e. most retail investors – are more hesitant to get involved.

There is also a sense of disappointment in the military leadership. Xi has championed defense industry mixed-ownership reform in the past, but made no mention of it in his much-hyped Army Day speech, creating further confusion regarding the reform’s future. Coupled with the transparency issue, this has negatively affected investor confidence.

The bearish performance of defense stocks is a reflection of investor frustrations with industry reform. While the impressive Army Day field review aroused public confidence in China’s military, it failed to cause a turnaround in the equity market. Some analysts are pinning hopes on reforms to the ownership of arms research institutions attracting new interest in the listed arms of defense corporations. But for now it looks like the downward trend will continue through the third quarter. 

Follow the author on Twitter @MrZiYang.