China crackdown: unpacking the regulatory change

The Chinese equity market has been buffeted in recent months by a series of government interventions implementing tighter regulation over a number of sectors in the service economy − ranging from ride-hailing apps to online gaming and education providers. This collection of policy actions can all be linked back to the concept of "common prosperity", which is not a new idea, but one recently brought to the fore with a renewed vigour.

Common prosperity was deemed the "fundamental principle" of Chinese socialism at the 18th Party Congress as far back as 2012. The aim of the plan is to foster a more equal society. This should be achieved by creating the conditions of further household income growth, better public services, a stronger social safety net and a narrower income gap between different groups and regions, as well as between rural and urban areas.

This continues the project of the past decade of rebalancing the economy towards consumption − especially of the middle and lower portions of the population − and away from investment. Moreover, the intention is to avoid the "disorderly expansion of capital" by establishing a system of governance over platform economies.

The application of the principles of common prosperity has been seen in multiple sectors this year so far − with, in retrospect, the first significant shot across the bows being the last-minute scuppering of the IPO of Alibaba affiliate Ant Group (containing AliPay, China's largest digital payment platform with over a billion users) in October 2020. Didi Global − China's dominant ride-hailer − listed in late June in a $4.4 billion US IPO, only for China's cybersecurity regulator announce an investigation into the company two days later. Less than a week after listing, the regulator asked app stores in China to remove Didi's app. The authorities described the moves as to "guard against risks to national data security" and to "protect the public interest".

Next in line for scrutiny were private education companies in July, a sector described as being "hijacked by capital". Regulations banned companies teaching school curriculums from making profits, raising capital or going public, and prevented academic classes to children under the age of 6. The Chinese education technology sector, which had grown into a $100 billion industry, was transformed overnight, with stock prices of erstwhile stock market leaders plummeting accordingly. Online gaming (and now offline gaming in Macau) has also been a major target for regulators concerned about the implications on child health (and even eyesight) from too many hours spent in front of screens.

All of these moves make sense as part of a strategic drive to re-orient society − a re-ordering that seeks an "olive-shaped" social structure, with middle-income households at its core. To achieve this goal, the government must step in to alleviate spending pressures in education, healthcare, housing, elderly care and childcare. As such, corporates have a new goal − to prove that they are socially useful and that their business models are actively contributing to these high-level goals.

While the above regulatory interventions have been extremely painful for the performance of the relevant shares under scrutiny, a wider question has been haunting the Chinese equity market − namely, which sector is next and, perhaps more importantly, is the market still investable given the potential for business models to be regulated out of existence overnight if deemed contrary to the aims of the government?

This is a very real consideration and rightly the risk premia of the Chinese equity market in aggregate should rise to reflect this reality. Investors should also explicitly factor into their outlook whether individual companies are working towards or against the goals of the government. If they are at odds with the central focus of Communism with Chinese Characteristics then they remain at risk.

The rapid succession of sectors feeling the regulatory heat suggests the Chinese government remains relatively comfortable with the market impact of their actions and is unlikely to be deterred from their long-term goals, which are seen as essential to preserving the fabric of society (with social disorder one of the key threats to the Party's continued existence).

That said, it is clearly the case that not every sector is at threat. Several areas have clearly been highlighted as central to prosperous economic and social development, notably those companies whose business models support environmental improvement, social well-being, and of course provide goods and services to a prosperous middle-class that is the ultimate beneficiary of these actions.

Indeed, while the technology companies are under fire in many regards − whether it be Alibaba's $2.8 billion antitrust fine in April or tweaking rules around Tencent's teenage gamers − they also remain central to the social project that China is supporting, the strengthening of China's technology capacity in fields such as Artificial Intelligence and driverless vehicles. Severely reducing the profitability of these companies would imperil China's mission to achieve technological advancement, a core plank of the development plans of the government.

Moreover, the anti-monopoly push offers hope to smaller companies that have struggled against the industry titans enjoying considerable network effect advantages. Game developer NetEase has seen its share price suffer as a result of gaming regulation, yet management has also spoken of the benefits they expect from anti-monopoly actions that will enable them to strengthen their industry position relative to Tencent, the dominant competitor.

Lastly, there are broadly positive elements for markets and equity culture as the government looks to encourage equity participation for employees at corporates, and redirect investment flows away from the long-popular property sector towards a deepening capital market. With the government facing greater fiscal constraints due to increased provision of services to an ageing population, this could also lead to faster divestment from SOEs. And, of course, for those companies on the right side of the common prosperity drive, there are clear benefits to be had − such as the push for renewable energy. The ultimate goal is to create an affluent, aspirational, healthy middle class, which will provide a highly lucrative market for those companies providing goods and services that complement these goals.

Returning to the question of whether China is investable, the first point to make is that it is too big to ignore completely − both in terms of the scale of its economy and its dominance of emerging market equity indices. Indeed, there are clear corporate and sector beneficiaries of the common prosperity policy drive that provide excellent long-term opportunities. Yet it is undoubtedly true that at-risk sectors will see a permanent impairment to valuations.

One attraction of the Chinese market at the moment is low valuations, especially in the technology sector, where Alibaba and Tencent trade at or close to trough valuations. A reasonable case can be made that as and when the news flow dies down, current levels mark rewarding entry points into what remain key investment opportunities in China. However, it is very likely that longer-term expected valuation multiples must now compress to reflect the likelihood of ever-present regulatory overhang.

Given the volatility in Chinese equities, we have seen ripple effects moving across the wider emerging market universe. Perhaps the biggest beneficiary of equity flows out of China has been India. Whilst the MSCI China benchmark has fallen 12% this year (USD terms), MSCI India has risen an extremely healthy 26%.

One of the key attractions of India to both emerging market and global investors is that it can currently be seen as almost antithetical to China. The government may show elements of religious nationalism, but this nationalism does not extend into the business sector. Whilst the US operates in near-explicit opposition to China, India has been held up as a critical friendly power in Asia that can provide a bulwark to China's rise. With a pro-business government and an emerging investment cycle helped along by newly loose fiscal policy, China's loss has in many ways been India's gain.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in funds managed by the Global Equity (GE) team may involve investment in smaller companies - these stocks may be less liquid and the price swings greater than those in, for example, larger companies. Investment in funds managed by the GE team may involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The team may invest in emerging markets/soft currencies or in financial derivative instruments, both of which may have the effect of increasing volatility. Some of the funds managed by the GE team hold a concentrated portfolio of stocks, meaning that if the price of one of these stocks should move significantly, this may have a notable effect on the value of that portfolio.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Friday, September 24, 2021, 8:44 AM