What to make of the regulatory risks in China?
- China’s new regulations are a part of structural reforms required to achieve “common prosperity”
- Structural reforms, though painful in the short term, are necessary for the next phase of growth
- Evergrande’s potential default is a part of the deleveraging process in the property sector We see opportunities in sectors enjoying regulatory tailwinds
- China is now a stock-pickers’ world and favors an active strategy
“Common Prosperity” is the new buzz phrase in China. In essence, China aims to move towards a more egalitarian society by addressing income disparity and redistributing wealth. China’s richest 20% earns 10 times more than the poorest 20%. Many policies have been rolled out under this pursuit, including regulatory crackdowns that have upended markets. Indeed, the Chinese market has witnessed significant volatility with its technology stocks losing a trillion dollars in market capitalization since February this year.
Figure 1: MSCI China Price Index and Announcements of New Regulations
Source: Bloomberg (30 September 2021), Goldman Sachs Research (10 September 2021)
Tracking its timeline broadly, it started when Ant Financial’s highly-anticipated Initial Public Offering was halted in November 2020 by the Chinese authorities, an event that had no doubt shocked investors globally. After which, there was a deluge of new regulations that hit across various sectors. To draw a couple of significant examples – in July alone this year, there was a complete banning of private tuition for core school subjects, while ride-hailing giant Didi was banned from signing on new customers. To this end, there was heightened alarm in the market as investors were worried that more sectors would be under fire with increasing regulatory risks.
In addition to the regulatory crackdowns, there have also been massive efforts to deleverage its property sector. As a result, many heavily indebted property developers were put under pressure. The latest headlines about China Evergrande Group (3333 HK)’s potential default in September 2021 sent markets on a wild swing, with many investors debating if this was China’s “Lehman’s Moment”.
With all that said, the million dollar question now – “Is China Still Investible?”
Is the “common prosperity” policy a crackdown on private ownership?
We do not think that the ongoing regulation is a crackdown on private ownership but an attempt to restructure the economy to achieve more equitable and sustainable growth. Painful structural reforms are required if China wants to overcome challenges like the middle-income trap, demographic headwinds as well as slowing productivity growth.
In the 14th Five-Year Plan, China plans to upgrade the Chinese economy through technological advancements instead of resource intensive investments. The “common prosperity” agenda to create greater income equality and greater total wealth for the population is consistent with the 14th Five-Year Plan. China is now more focused on productivity growth instead of job creation as its population growth has slowed. Part of the restructuring requires regulations to correct some of the imbalances in the system, like preventing monopolistic behaviors and over-leverage in resource intensive industries such as the property sector.
Striking a balance between protecting the market and encouraging innovation
A healthy dose of regulation at the Fintech and ecommerce sectors is required to return the balance between protecting the market and encouraging innovation. China has, like other countries, allowed unfettered innovation in these sectors and many of the fintech and ecommerce platform companies have grown to become systemically important companies with increasing control over other sectors through acquisitions. Basic regulations to protect consumer rights, prevent over-leverage and monopolistic behaviors are required and would ultimately be positive for the development of these industries. We expect the regulatory overhang to ease once more clarity is given that the authorities are satisfied with their revised business models.
Shifting away from capital intensive and unproductive investments
China no longer relies on the property sector to generate economic growth. The “three red lines” policy was introduced in September 2020 to bring down leverage at property developers and restore the financial health of these companies. This has inevitably led to liquidity issues with some developers like Evergrande. Despite the negative headlines, the potential bond default at Evergrande is generally not considered China’s Lehman moment as the amount owed is small compared to the total banking loans outstanding. While we expect deleveraging to continue for a couple more years, we maintain the view that its contagion will be limited to the weaker developers and we do not see systemic risk to the Chinese property sector.
Some sectors face unclear regulatory risks
The regulations at the private education sector may sound draconian but the intentions are to benefit society in the long-run. Education is taken very seriously in China and private tuition is seen as necessary for students to do well in the central examinations. Aggressive advertisement campaigns by private tuition companies leads to unhealthy social pressure and the high cost of education is seen as a cause of the low fertility rate in China. Unfortunately, there are no good alternatives to this problem. It is unclear if the new regulations introduced are effective to achieve their goals. As such, there is uncertainty on further regulations and the prospects of such sectors remain bleak.
Opportunities in sectors enjoying regulatory tailwinds
As discussed above, there are many sectors that will continue to face regulatory headwinds in the foreseeable future. However, we also see investment opportunities in many sectors that are aligned with the government’s policies – sectors that the Chinese government sees as essential to the upgrading of their economy like semiconductors, industrials, Artificial Intelligence, robotics, medical technology, renewable energy and clean technology. To this end, we remain positive on the Chinese equities market in the long-term but see short-term volatility as regulatory risks persist. This investment environment favors stock-picking and active investing due to cyclical opportunities as investors rebalance across sectors.
Lion Global Investors’ funds with exposure to China
Asia benefits from a growing China and investors could gain exposure through our LionGlobal Asia Pacific Fund which aims to achieve long-term capital appreciation by investing primarily in the equity markets of the Asia Pacific (excluding Japan) region. Investors who want a more focused investment into China may consider our LionGlobal China Growth Fund.
Both funds are actively managed to position for long-term trends as well as short-term opportunities. Macro themes drive our sector allocations, while our bottom-up stock picks reflect the analysis of our team.