China turns against the tech tycoons
China turns against the tech tycoons
Jack Ma had a prescient warning for investors back in 2014: “Among the richest men in China, few have good endings.” Over the past year, he and Alibaba, the Chinese internet giant he founded in 1999, have been at the centre of a regulatory crackdown by Chinese authorities. The group was subject to a record fine of $2.8 billion in April of this year and has since agreed to contribute over $15 billion to the country’s “common prosperity” fund over the next five years.
Beijing’s interventionist approach to its corporate sector goes far beyond any one company, however. New rules and regulations issued by government agencies have dramatically changed the prospects for a wide range of companies and sectors.
Over the longer-term, we do not think these developments will derail the structural opportunity in Chinese equities. The huge growth in domestic consumption, fuelled by rising incomes, remains a powerful tailwind. The country is also home to some of the most innovative companies in the world.
In the short term, however, China’s tough new approach has not gone down well with investors. As Western equity markets have powered on to record highs, Chinese markets endured one of their worst sell-offs in years. Chinese stocks listed in the US – a near $2 trillion market at its peak – have fared particularly badly (see chart below).
There are also unfolding risks from developments in China's property market, as the country's second-largest developer now appears unable to cope with its huge debt burden. While this could lead to a slowdown in the property market, with knock-on implications for overall growth, we ultimately believe that the government will take measures to limit the risk of contagion.
A difficult year for Chinese shares listed in the US
NASDAQ Golden Dragon Index
Source: Refinitiv Eikon, Bloomberg
Chinese equities came under pressure early in 2021 as Beijing issued new anti-monopoly rules for internet companies and launched a number of investigations into companies in the sector.
Regulators then required the removal of Didi, a popular ride-sharing service, from local app stores – just days after its New York IPO. The move gave rise to concern that foreign-listed Chinese companies could come under threat. While authorities subsequently said that this would not be the case, additional measures provided little reassurance. In particular, private education providers – a sector that lured many overseas investors with its impressive growth – were required to convert into non-profit organisations.
The intrusive new approach reflects a combination of economic and strategic motives as well as a new focus on social equality - or "common prosperity." For example, the education edict should put an end to an unsustainable rise in spending on private tutoring, which may have been weighing on the recovery in consumption. It also showed the government is serious about combating inequality, as the companies in question were perceived to provide the children of wealthier parents with an unfair advantage.
Curbing spending on education could boost
Year-on-year % change
Many measures focus on technology companies. This scrutiny is not unique to China: “big tech” is under the microscope everywhere, due to its size, alleged anti-competitive practices and significant control of consumer data.
The response adopted by China is very different, however. For one thing, China’s political and governance system allows it to act far more quickly than Western governments could hope to. The measures also reflect social and strategic objectives that are unique to China.
Four reasons why the government has taken these steps
Robin Parbrook, Schroders’ Head of Asian Alternative Investments, considers Beijing’s underlying objectives.
There are several key motivations behind the government’s actions: national security, financial stability, social stability and mobility, and the “dual circulation” policy.
1. National security
This is best highlighted perhaps by the situation at Didi, China’s equivalent of Uber. It listed in the US, under the so-called VIE (variable interest entity) structure, which basically creates holding companies that enable Chinese firms to navigate rules forbidding foreign investors from ownership of certain key sectors, such as tech.
During its listing process, Didi highlighted how “good” its use of data was, suggesting it could track where government employees were going. This triggered alarm bells among the Chinese authorities about such data being available in a US-listed company and they asked Didi to halt the IPO process. Rather foolishly (with hindsight) Didi continued with the IPO and ended up in something of a quagmire, with its share price falling sharply.
The US Securities and Exchange Commission has since updated rules on audits of US-listed China stocks – and required the provision of much more information. We think this means that many Chinese internet stocks will need to move their primary listings to Hong Kong or delist from the US.
We don’t expect this to mean a disorderly unwind of Chinese stocks listed in the US using the VIE structure. However, the direction of travel from both US and Chinese authorities clearly means that it is unlikely that companies with data considered “sensitive” can keep their primary listing in the US.
2. Financial stability
Chinese authorities have become concerned with the risk of internet and fintech companies encouraging excessive consumer debt. They may have been worried by the emergence of competitors to state banks, which are one of the key arteries which China uses to direct the economy. Lastly, Beijing may also have been concerned by rumours of stress in traditional parts of the economy as a result of disruption from internet companies. With the risk of bad debts rising, reining in some of the internet companies more aggressive activities should lower near-term financial risks.
3. Social stability and mobility
With many middle-class Chinese being squeezed by higher mortgage payments, higher healthcare costs (for both themselves and aging parents) and spiralling private education costs, there appears to have been a decisive shift towards policies that encourage “levelling up”. A clear part of the agenda is to create a better environment to raise children, given China’s demographic time bomb.
The issues at stake are demonstrated by two sets of company results. French luxury company LVMH benefited from extremely strong sales of luxury handbags to the very wealthy in China. By contrast, branded soy sauce producer Haitian Flavouring saw weak results, as middle-class consumers traded down due to pressure on their disposable income.
There are also broader social issues at play, with the Chinese government deciding what is — and isn’t — healthy. The authorities have decided that much “social” technology is not positive, whether it is online tutoring, gaming or social media. Sport and exercise are now a policy priority. Going forward, we would expect more measures to try and achieve social objectives. These are likely to target areas such as property (reducing prices), insurance (provision of cheaper healthcare policies) and lower healthcare/ pharmaceutical charges.
4. Dual circulation
The final reason for the authorities to take more control of the Chinese internet sector may also be to do with China’s “dual circulation” strategy, which was announced in the 14th Five-Year Plan in March. The strategy emphasises self-reliance in critical areas (batteries, EVs, “internet of things”, AI, biotech etc.) and has an emphasis on promoting “hard” technology and innovation in key critical areas.
“Social” technology (i.e. internet stocks) no longer appears to be viewed as part of the “high-quality development” targeted in the Five-Year Plan and are not aligned with President Xi’s stated agenda to reduce inequality and promote sustainable growth.
The government therefore looks to have decided to take more control of what are huge companies and large parts of the economy to direct internet companies’ investment towards those areas considered much more strategic in the dual circulation strategy.
Our investments in China
We have select exposure to both Chinese government bonds and equities in client portfolios. We hold Chinese government bonds as part of the “defensive ballast” within portfolios. Their historical performance suggests that they can provide portfolio protection in the event of market drawdowns, while providing a higher level of income than developed market government bonds. They also stand to benefit from increased flows into the asset class, as China assumes a larger weighting in global bond indices.
Within equities, we hold one China-focused fund. While the fund has fallen from its peak in February, it remains in positive territory over the past year. We also hold emerging market funds with China exposure.
The flurry of regulatory actions has prompted us to question our approach to investing in China. We recognise that there is policy risk associated with investing in China and that the regulatory environment has become more uncertain than it was. However, while policy can be a headwind to certain sectors, it can also benefit others.
That leaves plenty of areas of activity that are broadly unaffected by the evolving regulatory environment. In particular, there are three themes that we think still look attractive: the rise of domestic consumption, “dual circulation” and energy transition.
The latter featured heavily in the recent Five-Year Plan, with China targeting 35% of all energy from renewable sources by 2030 and net-zero emissions by 2060. One stock that benefits from the trends is Wuxi Lead Intelligent Equipment, which designs battery production equipment for electric vehicle battery manufacturers. This is a clear area of Chinese leadership, with the country now the leading producer of lithium-ion batteries. Our exposure to this particular company comes through a global environmental fund – illustrating how Chinese companies are now considered to be market leaders by sector specialists investing around the world.
It is difficult to know how far the government and regulators will go to enforce their new strategic priorities. Further announcements cannot be ruled out. However, China has many successful companies that should still be able to thrive in the new environment. Moreover, regulatory and political risks are a feature of emerging market investing in general. It is always something that we and our managers factor into our analysis when allocating capital.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.