Solving Sino: China Goes Long
This conversation, from Ernest Hemingway’s novel ‘The Sun Also Rises’, is the perfect analogy for how the pace of Chinese regulation has increased in the past year:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, then suddenly.”
At first, Ant Group’s halted IPO and restructuring raised eyebrows. Alibaba’s $2.8bn fine definitely had many sitting up in their chairs. But it was DiDi’s delisting from Chinese app stores, just days after its record-setting IPO, that had everyone standing up and asking: “What is going on over there?”
At a recent earnings presentation, with regards to China, Softbank’s founder and CEO, Masayoshi Son said:
“In terms of investing, we’re seeing a lot of new regulations coming out. I want to wait a bit longer to see what kinds of regulations there are, how far they extend, and what impact they have on the markets. Once we have a bit better view, then we would like to resume the investments.”
So, what’s the deal with the recent spate of Chinese regulation? Why have tech companies come under fire lately? If a company with as much influence as Softbank is looking to take a step back from investing in Chinese firms, should retail investors be taking the same approach?
The best place to start with any discussion of China is its government: The Chinese Communist Party (CCP). Since 1949, when the People’s Republic of China was established, the CCP has been in sole control of China’s government.
With the removed burden of election cycles determining their time in office, the CCP has time to plan. And plan. And plan. And plan. They love their plans.
China recently finalised their 14th Five-Year Plan (FYP) – a blueprint and set of key performance indicators for the country’s overall economic and social development. In addition to the FYP, which covers 2021 – 2025, China also released ‘Vision 2035’, a long-term roadmap for its economy.
The FYP placed strong emphasis on reducing carbon emissions and being self-sufficient in terms of its grain and energy production capacity.
For investors with interest in China, it’s an opportunity to gain insight into the CCP’s policy direction for the next five years, and possibly beyond. The FYP, together with Vision 2035, give incredible insight into what the next twenty years could look like. I’ll refer to that theorised Twenty-Year Plan as ‘C+20’.
Vorsprung Durch Technik
Audi’s slogan, “Vorsprung durch Technik”, may be German but it’s very appropriate for what the CCP has planned: progress through technology.
The CCP’s main considerations for C+20 can be thought of through three overarching categories:
- The population that will inhabit C+20,
- The economy that will sustain the population, and
- The regulations that will best guide this economy
China is in the midst of a demographic crisis.
China recorded 12m births in 2020, marking a drop for the fourth consecutive year, and its total fertility rate was 1.3, below the replacement level of 2.1 needed for a stable population. This prompted the CCP to eliminate its two-child limit and institute a three-child policy.
“Birth policies will be further improved,” the CCP said in a statement accompanying the announcement, “a policy that allows a couple to have three children will be introduced with supporting measures.”
Those supporting measures include policies related to education, healthcare and housing. China wants to make it easier, and more affordable, for people to raise children. In recent years it has passed a slew of legislation in an effort to reduce the costs of healthcare, and now it’s turning its attention more earnestly to housing and education.
Xi Jinping has repeatedly said that “housing is for living in and not for speculation”, and recent policy choices point to China finally following through on those words. The current focus is on stabilising housing prices, through increased mortgage rates for first and second-home buyers and placing a cap on the amount of mortgage exposure that banks can have. There has also been a renewed commitment to the development of government subsidized rental housing and scrutiny regarding developer financing.
In terms of education reform, there was global furore and confusion when China overhauled its private education sector, mandating that private tutoring companies re-register as non-profit organisations and barring them from listing on stock exchanges or raising capital. Billions were erased as shares of listed edtech companies such as Gaotu Techedu and TAL Education Group plummeted.
The sweeping changes were brought in as false advertising, corruption and pricing wars in the edtech sector caused the cost of education to skyrocket, and subsequently deepened education inequality as poorer families struggled to keep up. The next area of focus will most likely be the source of the anxiety that spurred the rush to private tutoring: China’s notoriously tough and highly competitive university entrance exam, the gaokao.
As China looks to build its population, expect increased potential for social mobility and wealth inequality to be big themes in all legislative pushes.
China plans to be a tech superpower in C+20, but not tech as we understand it today. Instead of Tencent and Google, or ‘soft tech’, Beijing wants to reorientate its economy towards manufacturing, or ‘hard tech’.
Semiconductors, artificial intelligence, genomics and aviation are a few of the industries that are receiving significant backing from the government. Growth in investment in research and development is a key target in the FYP, and it explains why a much more hardline stance has been taken with consumer internet companies. The CCP still wants capital to flow into China, but it wants it to flow towards where it believes it will be most beneficial, its manufacturing industry.
Xi Jinping has also emphasised “the fundamental importance of the real economy” and, after a year in which the pandemic wrecked global supply chains, it tracks that China wants to focus inwards. It’s a holistically nationalist strategy: shoring up supply chain integrity and ensuring national self-sufficiency above all.
Although it’s easy to think of China as a monolith, there are many moving parts to its government, and therefore many moving parts to its regulations and policy enactments.
Take the recent spate of regulatory crackdowns:
- Ant Group’s restructuring was led by the central bank as part of a broader focus on fintech companies acting like banks but benefitting from tech regulations.
- Alibaba’s fine was issued by SAMR, the State Administration of Market Regulation, for antitrust violations. This was part of SAMR’s push against anti-competitive behaviour and innovation-stifling market dominance.
- The crackdown on Didi was enforced by the Cyberspace Administration of China (CAC), a department established in 2011. The CAC is in charge of tackling all cybersecurity and data security concerns, and its actions will most likely gain the most attention going forward, as China has made cyber and data security a national security concern.
China has admitted that there are weaknesses in its rapidly growing digital economy, especially with regards to its data governance laws concerning security, privacy and cross-border data transfer, and that it has been reactive and slow to act.
This isn’t new. China’s first antitrust law only came into effect in 2008, whereas the United States implemented its first antitrust law in 1890.
Part of the speed of recent regulatory crackdowns, and why they seem to be coming swift and fast, may have a lot to do with China finally getting to grips with its regulatory environment.
Its first major piece of legislation regarding the security obligations of internet products, the Chinese Cybersecurity Law, was passed in 2016 and its law regarding the creation and use of data, the Data Security Law, was passed in June 2021. Its own version of the GDPR and POPIA, the Personal Information Protection Law, is still being drafted.
Essentially, that means expect more regulation and compliance investigations in the near-term. The FYP outlines the plan for a “Digital China”: a digital economy, a digital society and a digital government. All policy choices point to the regulatory environment being readied for that future.
It’s fair to be cautious about investing in Chinese companies. While there may be political machinations behind certain regulatory decisions, a much larger emphasis is on compliance. That’s difficult for retail investors to gauge and predict.
Editor’s note: I have avoided any Tencent exposure as the company plays a role as a tech VC in China, aiming to aggregate smaller tech companies into its platforms. That approach is in direct conflict with what the CCP is trying to do. I hold 3.5% of my total portfolio in Alibaba, as this gives me some exposure to China.
Be careful of buying Chinese index ETFs in an attempt to diversify away from Chinese tech. In most cases, the top constituents are all tech companies anyway.