By FAY REN & MICHAEL FLITTON
Concerns surrounding the tightening of market regulation in China have been growing.
In July, a flurry of actions from the authorities has provided sufficient impetus for a broad sell off. In July, the onshore China market declined 7.3% in USD, Hong Kong’s Hang Seng Index declined 9.6% and its China internet sector index fell by 27.3%.
Proximate cause of the sell-off
The catalyst for investor alarm was initially the regulatory reaction to the IPO of ride-hailing giant Didi, which was then followed by a crackdown on private tutoring companies within the education sector and a steady stream of announcements targeting perceived abusive practices by large consumer internet platforms.
The actions of the Chinese authorities can be perceived in different ways depending on the intellectual prism used. For some it is a logical, and methodical progression of allowing innovation to proceed, and then reasserting regulatory control when bad practice becomes evident, in the process restating China’s long-term social prerogatives.
For others, it provides evidence of the Communist ideology bashing private capital.
The reality is probably somewhere in between.
However, markets struggle with this type of cognitive dissonance, lurching instead between competing narratives. July appears to have been the period when investors could no longer reconcile news flow with the narrative of regulatory catch up, and instead switched en masse to fear.
The broader picture
However, regulatory action is not unique to China. The broader agenda against tech platforms, globally, is coalescing around two critical areas: anti-monopoly and data security. In this regard, China has common cause with Europe and, to an extent, the US. Without the need to follow a legal process, the tools for correction in China are more sudden and draconian. Due attention should be paid to the relative immaturity of Chinese regulatory systems. Communication is, at best, choppy.
Communication feeds the idea that regulations are a determined attack on private capital and foreign investors. In reality, it is our observation that the regulatory initiative in China is sporadic and fragmented, as agencies tend not to communicate with each other. It may be the lack of consideration for foreign investors on which these decisions are made, which they later tried to rectify via a call held with global investors and Wall Street banks on the 28th of July.
In our view, there are several distinct yet sometimes overlapping regulatory dimensions, led by different agencies, which should not be conflated.
- Fintech (Peoples Bank of China – PBoC): Ant Financial
- Antitrust (State Administration for Market Regulation – SAMR): Alibaba/Tencent/Meituan et al.
- Data & Network Security (Cyberspace Administration of China/Ministry of Industry and Information Technology – CAC/MIIT): Didi Global
- Special case: Education (Education Ministry): TAL Education et al.
In most cases, policymakers are catching up with a digital economy that has seen rapid expansion over the past decade, putting up the necessary infrastructure to govern these businesses where laws have been lax or lacking altogether.
FinTech and the case of Ant Financial
The recent series of events can be seen to have started with the blockade of the Ant Group IPO in November 2020.
This was a direct consequence of Alibaba group founder Jack Ma’s ill-judged speech criticising the Chinese financial system.
The section which created most stir ran as follows (English translation):
“Collateralisation with a pawnshop mentality is not going to support the financial needs of the world’s development over the next 30 years. We must replace this pawnshop mentality with a credit-based system rooted in big data using today’s technological capabilities. This credit-based system is not built on traditional IT, not based on a personal relationship-driven society, but must be built on big data, in order to truly make credit equal wealth. Even the beggar must have some credit, without credit, you can’t even beg for food. I think every beggar is (can be) creditworthy.”
The speech triggered further scrutiny of Ant’s business model, which revealed what the authorities judged to be systemic risks. Fintech businesses in China (and elsewhere) are looking to offer traditional banking and lending services but simultaneously sidestepping some of the regulations that traditional banks operate under.
Part of the Tech in FinTech comes via the strategy of offloading much of the credit risk and leverage to the banks that they cooperate with. Given the velocity of expansion, unchecked growth in the sector could potentially lead to a financial crisis, which the regulators are pre-empting by taking steps to de-risk the system. But even before Ant’s ordeal, there had been various policy maneuverers impacting the FinTech sector. The eradication of the fast-growing peer-to-peer (P2P) lending platforms a few years back falls under the same narrative. That tightening followed the exposure of Ponzi schemes and loss of life savings of ordinary citizens, incidents which caused considerable consumer unrest and protest. China’s political regime is not fully proofed against these uprisings so the authorities will always be prone to react strongly when they arise.
Antitrust and platforms
Payments is another area where we perceive growing regulatory unease. Two companies (AliPay and Tencent Pay) collectively process circa 90% of the country’s digital payments. The likely introduction of a Central Bank Digital Currency (CBDC) can be seen as the government trying to gain access and exert more control in this arena.
The Chinese government targets specific behaviours that are seen to go against the government’s long term objectives of maintaining social stability and prosperity. Platform based industries will remain in the firing line given their dominant positions and deep integration into many peoples’ lives. However, unlike P2P, we continue to believe that the government in China is not trying to eradicate these businesses.
Companies like Alibaba and Tencent have a place. They facilitate the digitisation of millions of Small and Medium Sized Enterprises (SMEs) and build highly efficient logistics and cloud infrastructure that improves ease of doing business, communication, and living standards. However, the government wants to reign-in aspects of their businesses that are causing negative social repercussions. In recent years, there is a perception that there is less innovation and more rent extraction taking place. For example, discriminatory algo-based pricing in e-commerce or the harsh working conditions of the riders for food delivery businesses. The rationale is to avoid the formation of South Korean style chaebol conglomerates and the unwanted, extreme wealth divergence such as exists in the US. These reforms are generally logical, although they are proceeding in a jittery manner.
Didi and Data Security
The cases of Didi and the Education sector should be seen separately. For Didi, an example has been made as regulators perceive the company deliberately flouting implicit rules. There have been soft warnings for some time about US listings and the gathering of sensitive private data. Geopolitics certainly forms part of the equation. Bytedance pulled its IPO for this reason. But Didi seems to have tried to go under the radar of regulators with a rapid IPO, which caught the authorities flat footed and prompted the post IPO crackdown. Furthermore, Didi, which has some of its servers based on California, is also part of a wider fortification on data and network security encompassing cybersecurity, national security, and personal data protection. Some of the issues here have common cause with the GDPR programme of regulation that has been instituted across Europe.
New laws are being drafted to layout the framework of a long-term national data strategy as the digital economy generates an explosion of data, to be considered a strategic national resource. Discussions are taking place globally on how data should be collected, transmitted, and harnessed, particularly as geopolitics is going to play an increasingly significant role going forward (think US and its stance on Huawei). China is not an exception.
Private Online Education
Education represents a sensitive issue for the Chinese government. It has been targeted specifically because there’s scepticism as to what extent education should be profit-seeking and its contribution to social inequality. Educational Technology (EdTech) is a great use of technology if deployed well, but a trawl through Chinese social media (e.g. Weibo, the Twitter equivalent) reveals many complaints. Players in the sector place more emphasis on getting parents to sign up to as many classes as possible, capitalising on their competitive anxiety, creating mental and physical health issues for children, with opaque and high fee structures and sub-quality tutors (as majority of the capital raised is deployed in marketing). Materials that should have been taught in schools were instead being taught in after-school classes, and children without access gets left behind.
It is a sector that has caused quite widespread societal grievances at a time when the government is facing increasing demographic problems and trying to encourage people to have more children. We have avoided investing in Education precisely due to the dubious practices of the companies mentioned above.
There is a political imperative for the government to placate growing discontent of the growing middle-class from these intrusions. In the past, anti-corruption and environmental clean-up initiatives were welcomed. Other sectors that could potentially face more regulations are in high expenditure areas such as healthcare and real estate (which has already begun), to contain the financial and psychological burdens of their population and encourage consumption in other areas as China transitions away from an export-led economy.
China’s listings undergoing change
The bridging point between the education sector and the broader market decline seen in July is the mention in one of the communiques of VIEs (variable interest entities).
VIEs are structures which allow Chinese firms to list overseas and in Hong Kong, often via a Cayman incorporated entity. This is an existing point of concern, and a legitimate one, for investors. Owning a VIE is akin to owning a derivative of a business. The structure is not ideal from either the US the Chinese regulators’ perspectives. From the US perspective, it is incredibly difficult to audit the underlying businesses. High profile frauds such as Luckin Coffee have only exacerbated those apprehensions. And for China, it raises the issues of national security, hinders effective taxation of business owners (highly difficult to trace overseas assets) and access to these successful tech companies by domestic investors.
VIEs exist in a legal grey area, a fudge to allow firms to raise capital in foreign markets, but now so endemic (US$2 trillion in market capitalisation) that to flatly ban them would cause a systemic collapse, of the market and confidence in China. We do however believe there will be incremental tightening of the structure. Already, we have seen more stringent registration approvals of new businesses, higher scrutiny of asset flows, and foreign listing restrictions for those businesses with access to user data, discouraging companies with over 1 million users’ data to list overseas on national security grounds. Despite regulators stating that they do not disapprove of ADRs, the likelihood is that companies will be encouraged to list in Hong Kong or onshore. US listings will become increasingly rare.
What will happen next is mostly conjecture. Volatility is likely to remain high in the months ahead as there will certainly be further regulations to come. We will continue to monitor developments closely. In the meantime, we have taken several, prudent measures to lower risk in the Cerno Pacific strategy.
China businesses currently represent 47% of the portfolio, spread across Hong Kong (30%) and the onshore A-share market (17%). Alibaba and Tencent have been trimmed, with the resulting capital redeployed into existing business orientated software positions. We have also begun the process to switch the remaining Chinese ADRs (Bilibili & Trip.com) into their Hong Kong listings.
It is our view that recent events are not, in essence, the product of any deep seated xenophobia. It stems, we think, from a mismatch between societal objectives and China’s version of Big Tech, and often in response to populist grievances. In that respect, the issues are more universal and are perhaps been grappled by China more efficiently and with plausibly better longer term impact than in the West. Seen in the Chinese context, there is a clear desire to better align the interest of companies to the welfare of its citizens in a distinctive form of ‘social responsibility’. The moral of the story is that business models that clash with these interests will be curtailed.
Innovation remains a long-term opportunity in China even while the authorities clamp down on elements of the internet sector, where the emphasis has deviated into profit extraction.
But innovation is of course not limited to the tech platforms.
In China, consumer internet has been a prime example of business model innovation, but they only represent one piece of the Pacific portfolio relative to B2B digital services, industrial supply chain and healthcare. The Chinese government’s long-term goal is to strengthen strategic areas such as semiconductors, cloud, healthcare, industrial supply chain, software, and green energy that contributes to real high-end technological advancement detailed in their 14th Five Year Plan.
These are areas that sit squarely within the mandate of our strategy and forms part of the import substitution trend that we have mentioned previously, where we have been and will continue to add exposure to in the Fund.