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Putting the Recent Selloff into Perspective
New Capital China Equity Fund Update
What was the cause of the recent drawdown and how are the long-term plans of the Chinese Government connected? Is there any logic behind the increasingly stringent regulations that are quickly coming into force across multiple industries and sectors? In this compelling article, Jeff Li and Daisy Li draw on their in-depth understanding of Chinese culture and history to make sense of the current reforms and how they are playing out in the Chinese investment universe.
What is happening in the China market?
The China equity market experienced significant drawdown this month, especially for Chinese companies listed in Hong Kong market (H-Shares) and US market (ADRs).
The trigger event was the far more stringent than expected Chinese education sector (K12 tutoring sector) regulation announced last Friday (23rd July). The Chinese government had been signalling proposed increased regulation in this sector for months - and indeed the market expectation has been steadily trending down to adjust for potential regulatory risk - but not enough. The actual regulation was far stricter than previous assumptions.
According to the new government regulation aiming to “reduce burdens of students”, all institutions offering tutoring on the school curriculum will be registered as non-profit organizations, with no new licenses granted. Consequently, as listed companies in the education sector in China are mostly related to school curriculum tutoring businesses (as this is where the largest amount of money is spent in education by each Chinese family), this has essentially invalidated the whole business model and made the $100bn sector irrelevant overnight.
A secondary consequence of the regulation is the far-reaching levels of panic, particularly amongst foreign investors concerned about fundamental property rights protection in China. It has added further fuel to the increasingly prevalent narrative about the Chinese government: “if the Chinese government can do this to the education sector, they can do this to any other sector, therefore, nothing is safe in China”.
We are indeed noticing a reduction of China exposure, and not simply in the education sector by foreign funds in last few days. Accordingly, we are seeing Chinese stocks behave as they would during periods of financial crisis.
What is the Chinese government trying to achieve?
The education sector regulation came on the back of the regulations placed on internet platform companies and the real estate sector. Many investors it seems are concluding that regulation in China is random and that the market is simply un-investable.
However, for those who follow the China market closely, the Chinese government’s moves are far from random. There is some clear logic behind what the Chinese government is trying to achieve which we have discussed in detail in our recent monthly commentary.
We believe that the Chinese government are focusing on four key policy areas:
1. Increase birth rates
• China is aging quickly. Low birth rates are more an economic, social and cultural issue than a policy issue. Even though China has announced the three-children policy allowing each couple to have three kids, we think the impact of this policy will be limited.
• The key issue is the high cost associated with raising children with education and extreme property prices in catchment area of good schools effectively out of reach for most parents. The government has started to effect reforms, which we saw in Shanghai earlier this year focusing on property in catchment areas.
• There are as of yet no clear solutions to a complex issue and so we believe this will continue to be a key area of policy going forward.
2. Carbon neutrality
• Reducing carbon emissions by 2030 and achieving carbon neutrality by 2060 is China's commitment to the world. Given the US is increasingly in competition with China, this is the key area China would like to spearhead, establishing common ground with the rest of the world.
• This will be challenging for China. On one hand, the manufacturing industry has higher carbon emissions than the service industry, and as the world's factory, China is also looking to maintain the weight of manufacturing in its economy. On the other hand, China is still at the development stage and rising incomes per capita results in producing more carbon. Europe and US carbon emission peaked in the late 2000’s, yet the US are still aiming for carbon neutrality by 2050, meaning developed countries have more than 60 years to reach carbon neutrality after peak carbon emission, whereas China only has half of the time.
• China will need to cut capacity in carbon heavy industries AND promote new energy AND improve efficiency. Therefore, we expect to see: 1) supply side reform in traditional industries, which is structurally positive for some commodities; 2) supportive measures for the development and penetration of new energy; and 3) continued investments in efficiency improvement measures.
3. Anti-monopoly/preventing capital from expanding in a disorderly fashion
• The anti-monopoly focus on the internet platform economy is promoting competition and regulating behaviours; there is no plan to dismantle these platforms.
• We expect continued regulatory pressures on Chinese internet companies as a result. It will however take time for the government to set up the regulatory framework. We see the Chinese government focusing on the following areas:
• Monopolistic behaviour: Alibaba has been fined for pricing discrimination, and Tencent's merger of its invested live broadcasting platforms Huya and Douyu has been banned. The Chinese government will review the platforms and the M&As one-by-one. They will come back to Alibaba again after their work on other platforms, and this will be an ongoing and recurring process that last for years.
• Regulation on internet finance: Consumer loan businesses of Ant Financials were in the grey area of the regulatory vacuum - it will be regulated like traditional financial institutions with systematic importance going forward. The establishment of the regulatory framework is still ongoing.
• Regulation on data: Data is regarded as a critical asset and there was no specific regulation previously. The problems brought on by Ant Financials and Didi will accelerate the regulation on ownership and usage. The establishment of the regulatory framework has just started, and it will take time for the regulators to come up with a plan of how to deal with this new and crucial area.
• Preventing capital from expanding in a disorderly fashion has far reaching implications. Killing competition with M&A by platform internet companies is one example. Another example is that private equity investments have focused on online education advertising subsequently creating ‘educational anxiety’ among parents.
4. Common Prosperity
• Common Prosperity as a policy aims at improving welfare of the lower income group. It is a concept derived from Deng Xiaoping’s idea of two steps of economic development: namely, allow a minority of people to get rich first, and then achieve common prosperity for the whole society by helping the lower income group.
• We believe the idea of reducing inequality is really a global theme over the coming decades. Stanford historian Walter Scheidel argued convincingly in his book “The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century”1
• Specifically, for listed companies, common prosperity and improved welfare for lower income groups means structurally higher operating and labour costs for companies that rely heavily on flexible labour, i.e. Meituan and Didi. For years, they have been taking advantage of the grey area of labour law, excluding their drivers from their labour force and underpaying their social welfare. Again, as global investors, we know that this is also the case for shared economy companies in the western countries. We also understand that western country governments also would like to increase their welfare, but the tools they can use are much less than the Chinese government.
The actions of the Chinese government so far can be placed into these four policy areas, which we believe form an important framework and reasons for investing in China in the coming decade.
Why is China governed so differently?
We believe this is fundamental to understanding China and how to invest there.
Historian, Yuval Noah Harari argues that a society functions best when it’s based on a shared common narrative. This is how a nation finds its identity and how its people find meaning. And it is for almost the same reason, that we struggle to understand other culture’s narratives. If it were not the case, we would not have as many arguments, disputes, fights, and wars in our history.
• In his book “21 Lessons for the 21st Century”2, Yuval Noah Harari states “During the twentieth century, the global elites formulated three grand stories that claimed to explain the whole fast and to predict the future of the entire world: the fascist story, the communist story, and the liberal story. The Second World War knocked out the fascist story, and from the late 1940s to the late 1980s the world became a battleground between just two stories: communism and liberalism. Then the communist story collapsed, and the liberal story remained the dominant guide to the human past and the indispensable manual for the future of the world – or so it seemed to the global elite. In the 1900s and 200s this liberal story became a global mantra. However, since the global financial crisis of 2008 people all of the world become increasingly disillusioned with the liberal story. In 1938, humans were offered three global stories to choose from, in 1968 just two, in 1998 a single story seemed to prevail; in 2018, we are down to zero.”
The reason Yuval Noah Harari states that global stories are down to zero is precisely because of some setbacks the liberal story has been experiencing since the global financial crisis: deglobalization, anti-immigration, severe inequality, protectionism, political division, etc.
We would like to borrow Yuval Noah Harari’s framework and argue that what China is experimenting with is an entirely new social model that hasn’t existed before. It is impossible to give the Chinese model a name for this reason. Because it’s new, it’s hard for established global elites to understand. And because it’s hard to understand, it is easy for established opinion leaders in the liberal camp to brand it as “evil”.
However, for people familiar with the Chinese culture and history, the way the Chinese government governs is both logical and coherent.
• Chinese government has been a centralized big government since its first dynastic Qin Dynasty from 221 BC. The specific geography of China allowed frequent invasions from the north throughout its long history. The only way to defend invasion in its massive land is through strong centralized government and large army. In comparison, the US is the safest country in the world with natural barriers provided by oceans, deserts, and forests. A relatively small government was sufficient, especially in early years of the country.
• We believe the best analogy to use for the Chinese government is a “tiger mum”. The government constantly worries about its people and wants to do everything for them. In return, Chinese people also are used to and expect this way of governance. During natural disasters like the Covid pandemic, earthquakes and the recent flooding, Chinese people expected the government to do everything they can to protect them. That’s why we usually see rapid response and action from the Chinese government when it comes to accidents and natural disasters.
• For people living outside of China growing up in a more liberal country, it would be extremely difficult for them to understand why China is run the way it is. And when it is hard to understand, there is misunderstanding. With misunderstanding, there comes hostility. That’s unfortunately how we see the current situation playing out right now.
Putting differing ideologies aside, we would argue that what the Chinese government is trying to achieve is to resolve some of the extremely challenging social issues that almost every government in the world wants to deal with but has failed to do so so far: reducing inequality, regulating data privacy and antitrust issues of internet platforms, increasing birth rates, addressing global warming, reducing healthcare costs, etc. The difference here is that the speed with which the Chinese government can move and the number of tools at their disposal are unparalleled.
In western liberal countries, policy changes take time. Politicians set out their platforms. There is an election. The victor then tries, often with only limited success, to get their pet project approved by parliament, and finally implemented by the administration. This gives markets plenty of time to price in the outcome and therefore is much more manageable from a risk management perspective. For China, or indeed many other emerging markets, we just have to accept cultural differences are a fact and take time to understand the culture, and to analyse the situation in order to make the best investment decision. We believe this is the biggest cognitive barrier when it comes to investing in China, as we believe many have not been diligent enough.
In terms of other concerns caused by simple extrapolations of the experiences of the education sector, we believe these concerns are overdone and again driven by a lack of understanding. For a significant part of history, China was the strongest country in the world. It is the Chinese government’s firm belief that China will eventually return to that status. They know extremely well the importance to remain open, reform focused and innovative for that very reason. There is zero value added by destroying industry after industry through regulation. It is our belief that the Chinese government has no interest in returning to a planning economy, closing capital markets, or getting the country isolated, which many in the media are trying their best to paint this picture of China as.
Maybe a contrarian view, but we believe the recent policies changes are making China’s long-term outlook much more sustainable. We see an up cycle for regulation globally in the coming decades as a universal trend. What the Chinese government is doing is an exploration of a potentially successful path for China, in our view.
Therefore, our bullish stance on China has not changed at all, despite the near-term volatilities.
What's the right way of investing in China?
However, that is not to say we should just buy just any companies in China. Stock selection is extremely important in a market like China.
For many investors, investing in China has historically meant buying large-cap internet names or internet ETFs. Such an overly simplistic strategy worked well in the past decade, but we believe it will work not so well going forward. Since government plays a much bigger role in the Chinese economy, the approach when it comes to investing in China needs to be much more dynamic.
• Our process started with the best long-term themes in China. Although the internet sector is no longer the best long-term theme, we see many other industries and companies that are emerging, just like the internet companies ten years ago. New economy companies in new energy, semiconductors, healthcare and consumption are growing fast and related stocks are doing extremely well. It happens to be that they are mostly listed on ChiNext and STAR Board.
• Therefore, we strongly suggest investors look beyond internet companies, and allocate more capital to these emerging and booming areas like the internet ten years ago, when investing in China. We believe these sectors will be the major drivers for China over the next decade. We have increased exposure to these emerging themes in A share as well as reducing exposure to H-share and ADRs as early as last year at the New Capital China Equity Fund.
1 The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century (The Princeton Economic History of the Western World), Sept. 2018
2 21 Lessons for the 21st Century: Yuval Noah Harari Paperback, Aug. 2019
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