If you are a keen follower of financial markets it won’t have escaped your notice that Chinese shares have had a terrible few days – and a dismal 2021 thus far. The average fund in the Investment Association China / Greater China sector is down around 10% in the past week, and by as much as a quarter from a peak in mid-February. So, what’s going on, and what should investors do?
Tech kept in check
Throughout this year the Chinese government has become more interventionalist towards listed companies, looking closely at issues such as competition, data protection, consumer rights, employee’s rights, and wellbeing. In April, e-commerce giant Alibaba was fined $2.8bn by regulators, who said it had abused its market position. Prior to that, its affiliated digital payments and financial business Ant Group was forced to pull a stock market listing and now faces a mandated restructuring that means it has to act more like a bank than a tech firm.
DiDi, the ride hailing service similar to Uber (but much more besides) also fell foul of the regulator amid unspecified issues of privacy and data security. This came days after it listed in the US and attained a valuation of over $80 billion on its first day of trading. The ongoing probe means it has had to stop adding new users and app stores have had to remove its popular app. Unsurprisingly, investors have taken fright and shares have halved since their peak. Meanwhile, food delivery company Meituan’s shares have fallen over 30% after the authorities issued new guidelines on conditions for delivery workers.
These and other individual company interventions are part of a broader industry crackdown on technology companies as the government lines up a ‘Personal Information Protection Law’, imposing stricter measures on how tech companies store user data. Unlike many Western governments, Chinese authorities are not comfortable with businesses having more data on citizens than they do – and this is having widespread ramifications for a sector that has grown very rapidly and, in some cases, with a rather relaxed attitude to sticking to the rules.
There is also a geopolitical angle. US-listed Chinese enterprises will be required to allow US regulators to audit their financials or risk delisting, so there is concern in Beijing that sensitive data might be shared in order to comply. For some time now China has been taking steps to reduce the degree of interconnectivity between the two economies, and this is spilling over into capital markets.
More recently, a further state intervention broadsided a whole sector, private education, or more specifically after-school tutoring. This area has grown rapidly, particularly during last year due to COVID disruptions. The announcements not only threaten to eliminate foreign investors from much of the sector but actually bans companies that teach school curriculum subjects from making profits.
Tuition businesses will be prevented from setting up as Variable Interest Entities of ‘VIEs’, which are offshore vehicles allowing foreign investors to own Chinese companies listed overseas, and those focused on this part of the market will have to be ‘not for profit’ organisations. There is also a small indirect hit to other companies, for instance internet businesses where it is assumed there will no longer be any significant online advertising from the after-school education industry.
The specific reference to VIEs in the regulations poses the question of whether other companies set up in this way will face increased scrutiny going forward. These structures are not officially recognised by Chinese regulators and some fund managers, for instance Stewart Investors, have long been sceptical of them because they give foreign investors an economic interest in Chinese businesses but without any voting rights or other means of control.
More broadly, the surprise intervention in education has raised concerns that other sectors such as certain internet companies and drug makers could find themselves in a similar position. Consequently, the perceived risk of Chinese equities as a whole has risen and share prices have fallen.
As far as after-school tutoring businesses are concerned, companies that derive all or much of their revenue from this segment of the education industry are now essentially uninvestable. In this instance, it appears the government was motivated to take action to address concerns surrounding stretched family finances, overworked children and unequal educational opportunities – but it still came as a complete surprise to investors who in many cases had assumed that educational companies were of overall benefit to the nation rather than an area that might be subject to draconian measures.
Fund managers we have spoken to generally consider this an exceptional situation in a sector with special sensitivity rather than a precedent for Chinese assets more broadly. However, the internet and e-commerce sector, already firmly in the spotlight, can expect a wave of more prescriptive rules around data and competition and to be made to stick to them.
What does this mean for investors in China?
Recent events highlight the opaque nature of the regulatory environment in China and lack of legal protections for investors. The government can essentially decide how much and for how long businesses – and investors – can make money and this can change rapidly. Authorities can be expected to wield power pragmatically, but that may not be enough for investors that have paid a high price for assets without accounting for risks of greater government intervention and increased compliance. The lower valuations for Chinese equities we are seeing are the inevitable consequence of this realisation among investors.
Another lesson is that the government are not particularly worried about hurting share prices, especially where a primary listing is in the US (as is the case with DiDi and Alibaba) and where the company possesses a lot of data. To what extent they care more broadly about market sentiment remains to be seen, but there is no evidence that the Chinese government has become less supportive of privately owned companies generally. Most regulatory changes in China are likely to be made for good for the long-term health of China’s economy, and it is clear private firms are the engine of China’s growth and job creation. It is likely then that authorities will continue to view foreign capital as a positive element, even though US listings may be further clamped down on rather than just discouraged.
Overall, the recent measures either seem to be aimed at clipping the wings of powerful, potentially monopolistic tech giants or addressing ‘sensitive’ areas. There will still be great opportunities for investors in China over the long term as there is room for many companies to grow strongly, especially in fast-growing consumer markets. . Innovation is, afterall, a key pillar of China’s five-year plan, and for tech firms digitising the economy helps brings down costs for consumers. They will need to operate in keeping with the principle of ‘common prosperity’, though, which is the overarching goal of Chinese authorities.
A further silver lining might come from smaller and mid-sized companies benefiting from the upheaval. Some actively managed funds stand to capitalise from their industry knowledge and regulatory insight to help navigate the market. We still endorse exposure to China in portfolios but prefer to allocate to a fund manager with expertise and a significant presence in the region to keep on top of developments. Passive funds have been some of the largest casualties of the sell-off thus far as they have heavy exposure to some of the most affected companies such as Alibaba and Meituan.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.