Focus on companies in industries that have policy support, profitable tech companies, and risk diversification.
In recent weeks and months, there have been several waves of regulations in China, many of which are fairly broad-ranging.
These affect internet platforms, the after-school tutoring sector, food delivery, music licensing as well as offshore IPOs of emerging platforms.
The continuous and swift rollout of these new policies took the market by surprise. In some cases, directly impacted sectors, such as the after-school tutoring sector saw its market capitalization almost wiped out.
The Hang Seng Tech ETF, which captures 30 largest technology companies in the Greater China area, is down 20% from the beginning of the year, and 40% from the peak in February.
What are the motivations behind the regulations?
It’s hard to generalize because there are several, rather than one unifying motivations.
In the case of the education sector, policymakers wanted to cut down on illicit business practice and reduce the role of profit-maximizing companies in providing K9 education – which is compulsory and generally seen as the responsibility of the public sector.
In other instances, the concerns have been about reducing market dominance of one or two companies, and better protecting workers rights. And there are others, like data security, which is an area that regulations in China are catching up to that of developed markets.
Will there be more regulations?
The simple answer is yes.
The cybersecurity and data security regulations will be officially released in September. Also somewhat related to the tech sector, offshore IPO will now generate more regulatory scrutiny. Macro-prudential policies on the property sector may continue and more tightening for local government financing vehicles are still to come.
Broadly, as China continues to rebalance towards higher quality growth, an emphasis on environmental sustainability as well as economic and social sustainability will only become more important over time.
What are the investment implications?
The market has had a tough time digesting the rapid rollout of the series of regulations. Some investors, particularly those who are not very familiar with policymakers goals or how Chinese regulators operate will likely continue to find Chinese equities, or even Chinese assets hard to understand. That said, many of the China internet and tech companies we like are now at reasonable valuations relative to history, and while regulation is still a concern, the risk/reward is looking more attractive.
In addition, sectors with policy tailwinds, such as semiconductor, clean energy, electric vehicles, automation will likely continue to do well. And last but not least, the domestic A share market is likely to benefit from a more diversified industry composition, more reasonable valuation as well as monetary and fiscal policies that are turning more accommodative. In recent weeks and months, there have been several waves of regulations in China, many of which are fairly broad-ranging.
These affect internet platforms, the after-school tutoring sector, food delivery, music licensing as well as offshore IPOs of emerging platforms.
The continuous and swift rollout of these new policies took the market by surprise. In some cases, directly impacted sectors, such as the after-school tutoring sector saw its market capitalization almost wiped out.
The Hang Seng Tech ETF, which captures 30 largest technology companies in the Greater China area, is down 20% from the beginning of the year, and 40% from the peak in February.
What are the motivations behind the regulations?
It’s hard to generalize because there are several, rather than one unifying motivations.
In the case of the education sector, policymakers wanted to cut down on illicit business practice and reduce the role of profit-maximizing companies in providing K9 education – which is compulsory and generally seen as the responsibility of the public sector.
In other instances, the concerns have been about reducing market dominance of one or two companies, and better protecting workers rights. And there are others, like data security, which is an area that regulations in China are catching up to that of developed markets.
Will there be more regulations?
The simple answer is yes.
The cybersecurity and data security regulations will be officially released in September. Also somewhat related to the tech sector, offshore IPO will now generate more regulatory scrutiny. Macro-prudential policies on the property sector may continue and more tightening for local government financing vehicles are still to come.
Broadly, as China continues to rebalance towards higher quality growth, an emphasis on environmental sustainability as well as economic and social sustainability will only become more important over time.
What are the investment implications?
The market has had a tough time digesting the rapid rollout of the series of regulations. Some investors, particularly those who are not very familiar with policymakers goals or how Chinese regulators operate will likely continue to find Chinese equities, or even Chinese assets hard to understand. That said, many of the China internet and tech companies we like are now at reasonable valuations relative to history, and while regulation is still a concern, the risk/reward is looking more attractive.
In addition, sectors with policy tailwinds, such as semiconductor, clean energy, electric vehicles, automation will likely continue to do well. And last but not least, the domestic A share market is likely to benefit from a more diversified industry composition, more reasonable valuation as well as monetary and fiscal policies that are turning more accommodative.
These affect internet platforms, the after-school tutoring sector, food delivery, music licensing as well as offshore IPOs of emerging platforms.
The continuous and swift rollout of these new policies took the market by surprise. In some cases, directly impacted sectors, such as the after-school tutoring sector saw its market capitalization almost wiped out.
The Hang Seng Tech ETF, which captures 30 largest technology companies in the Greater China area, is down 20% from the beginning of the year, and 40% from the peak in February.
What are the motivations behind the regulations?
It’s hard to generalize because there are several, rather than one unifying motivations.
In the case of the education sector, policymakers wanted to cut down on illicit business practice and reduce the role of profit-maximizing companies in providing K9 education – which is compulsory and generally seen as the responsibility of the public sector.
In other instances, the concerns have been about reducing market dominance of one or two companies, and better protecting workers rights. And there are others, like data security, which is an area that regulations in China are catching up to that of developed markets.
Will there be more regulations?
The simple answer is yes.
The cybersecurity and data security regulations will be officially released in September. Also somewhat related to the tech sector, offshore IPO will now generate more regulatory scrutiny. Macro-prudential policies on the property sector may continue and more tightening for local government financing vehicles are still to come.
Broadly, as China continues to rebalance towards higher quality growth, an emphasis on environmental sustainability as well as economic and social sustainability will only become more important over time.
What are the investment implications?
The market has had a tough time digesting the rapid rollout of the series of regulations. Some investors, particularly those who are not very familiar with policymakers goals or how Chinese regulators operate will likely continue to find Chinese equities, or even Chinese assets hard to understand. That said, many of the China internet and tech companies we like are now at reasonable valuations relative to history, and while regulation is still a concern, the risk/reward is looking more attractive.
In addition, sectors with policy tailwinds, such as semiconductor, clean energy, electric vehicles, automation will likely continue to do well. And last but not least, the domestic A share market is likely to benefit from a more diversified industry composition, more reasonable valuation as well as monetary and fiscal policies that are turning more accommodative. In recent weeks and months, there have been several waves of regulations in China, many of which are fairly broad-ranging.
These affect internet platforms, the after-school tutoring sector, food delivery, music licensing as well as offshore IPOs of emerging platforms.
The continuous and swift rollout of these new policies took the market by surprise. In some cases, directly impacted sectors, such as the after-school tutoring sector saw its market capitalization almost wiped out.
The Hang Seng Tech ETF, which captures 30 largest technology companies in the Greater China area, is down 20% from the beginning of the year, and 40% from the peak in February.
What are the motivations behind the regulations?
It’s hard to generalize because there are several, rather than one unifying motivations.
In the case of the education sector, policymakers wanted to cut down on illicit business practice and reduce the role of profit-maximizing companies in providing K9 education – which is compulsory and generally seen as the responsibility of the public sector.
In other instances, the concerns have been about reducing market dominance of one or two companies, and better protecting workers rights. And there are others, like data security, which is an area that regulations in China are catching up to that of developed markets.
Will there be more regulations?
The simple answer is yes.
The cybersecurity and data security regulations will be officially released in September. Also somewhat related to the tech sector, offshore IPO will now generate more regulatory scrutiny. Macro-prudential policies on the property sector may continue and more tightening for local government financing vehicles are still to come.
Broadly, as China continues to rebalance towards higher quality growth, an emphasis on environmental sustainability as well as economic and social sustainability will only become more important over time.
What are the investment implications?
The market has had a tough time digesting the rapid rollout of the series of regulations. Some investors, particularly those who are not very familiar with policymakers goals or how Chinese regulators operate will likely continue to find Chinese equities, or even Chinese assets hard to understand. That said, many of the China internet and tech companies we like are now at reasonable valuations relative to history, and while regulation is still a concern, the risk/reward is looking more attractive.
In addition, sectors with policy tailwinds, such as semiconductor, clean energy, electric vehicles, automation will likely continue to do well. And last but not least, the domestic A share market is likely to benefit from a more diversified industry composition, more reasonable valuation as well as monetary and fiscal policies that are turning more accommodative.
Over the last year, China has imposed new regulations on fintech, big tech, property developers, for-profit education, cryptocurrencies, and carbon emissions. In this note, we try to interpret this regulatory shift, look at how business models and markets could be impacted, and identify indicators for future regulatory changes.
Shifting government priorities are a driving force. Notably, there is a shift from “growth first” to balancing growth and sustainability – i.e., security, self-sufficiency, and social equality. A common thread among official government statements over recent years has been to emphasize quality over quantity when discussing China’s growth goals. For example, the development emphasis now focuses on “getting rich together” (common prosperity), introducing a new range of goals beyond purely economic growth to include social equality, supply chain self-sufficiency, and data security in the face of rising secular risks – income inequality, U.S. tensions, and aging demographics.
These regulatory shifts are a mere reflection of this reorientation. The anti-trust campaign has mainly aimed to prevent tech giants from obtaining an over-concentration of market share and to protect the welfare of smaller businesses and outsourced employees; fintech regulation serves the purpose of curbing regulatory arbitrage and financial stability risks; increased scrutiny on overseas IPOs and cross-border data flow mainly focuses on reducing security risks amid lingering (or worsening) geopolitical tensions. Similarly, the recent actions against education companies are part of policy efforts to mitigate child-raising costs and ease students’ stress.
These efforts appear to be aimed at rebalancing the economy from a rapid rise in corporate wealth and power towards a greater share of labor compensation. Increasing the household share of wealth aligns with the common prosperity agenda. However, there are potential downsides, particularly for equity investors. Increased corporate social responsibilities, such as the requirement to pay flexible workers higher salaries or provide better benefits, could directly impact future profit margins. Furthermore, uncertainty emanating from the rapid pace of regulatory change could discourage investment and impact innovation, reducing overall productivity. China’s ambitions, as laid out in the 14th Five Year Plan, will require a thriving private sector to drive innovation so we do not think business models would be completely disrupted (except after-school tutoring). For example, online sales have held up well despite the tech regulation campaign starting last year. Meanwhile, many regulatory changes are supportive for sectors such as renewables, advanced manufacturing, semiconductors, and EVs.
Why? And Why Now?
While many of the regulations appear long-overdue and make sense from a domestic perspective, the pace of change has caught the market off guard. It has been taken by many global investors as an arbitrary shift in direction or taken as a signal of the state sector encroaching on the private sector. However, it is important to note we have seen a similar dynamic in past regulatory cycles, particularly when regulations have lagged a period of rapid growth in sectors. In areas such as energy, gaming, and outbound investment, a period of rapid growth has been followed by a period of rapid regulatory changes. The cycles tended to follow a similar pattern: following rapid growth, early warnings emerged whether from public ire or negative policymaker assessment, which would be followed by the formal start of the regulatory cycle usually marked by the release of draft regulations (for example, the draft Cybersecurity law released in June). Eventually, there are signposts of reaching the end of the cycle marked by official proclamations or other official signals.
In some ways, this shift, particularly in the education sector, appears to follow this pattern. However, in other ways, this shift is wider-ranging, more systematic, and covers more issues. Regulations are simultaneously addressing issues around social equality, fertility decline, the environment, national security, and systemic financial risks. In that context, this shift appears to be more fundamental as China more directly pursues a different type of growth.
What might be next?
The shift towards balanced, sustainable growth means regulations will likely continue to realign with the broader goals of social equality and national security. There is potential for new regulations in areas where corporate interests are not aligned with national priorities around the environment, wealth inequality, and national security. That said, these regulations appear to be more about rebalancing between corporate wealth and labor, and not necessarily a dynamic of state versus private. China’s labor (or household) share of wealth remains low by international comparison (see chart). As it attempts to rebalance from a credit-driven investment and export-led growth model (and insulate itself from external pressures), raising the household share of wealth is an important initiative. Therefore, we would expect regulatory pressure to continue on platform companies with significant market share, property developers, and data-heavy tech firms as policymakers continue to push for a balance between corporate, national security, and social interests. On the other hand, sectors in line with China’s new economic agenda should continue to get support, such as green-economy-related companies (EVs and renewables), semiconductors and tech hardware, advanced manufacturing, and innovative agriculture.
What policies or announcements could help us understand where we are in the regulatory cycle?
On average, regulatory waves tend to last for 1-2 years, during which capital markets tend to underperform amid rising risk premiums. Still, the real economy and capital markets eventually adjusted to this new policy framework. As mentioned above, we think it is less about state versus private or revamping entire business models, and more about achieving a balance between corporate interests and household interests. In this sense, given the wide-ranging nature of these regulations, it is unlikely that we will get a conclusive signal, but some signs could include a resumption of offshore IPOs (signaling continued comfort with foreign investment), progress by digital platforms to improve social benefits for flexible workers (to show progress on higher-quality growth), fintech companies complying with regulatory requirements with a potential for going public (to signal clarity around a fast-growing sector), and potentially even clarification from top leadership around the overarching governance framework.
Risks to watch and investment implications
A balance between the private sector and regulation can eventually be achieved, but the process carries potential risks. First, the pace of change and lack of total clarity could stifle private sector confidence and motivation. A perceived unstable operating environment could also discourage foreign investment. Overall, these could undermine productivity growth. Additionally, as companies are required to pursue social goals in addition to profits, it could undermine future margins and revenue growth. Analysis from J.P. Morgan Investment Bank views the long-term margin outlook as at risk given the impact of a more competitive environment, corporate requirements to take social responsibility, and broad uncertainty. In their view, a lower margin outlook argues for a structurally lower valuation range. Lastly, as this shift appears more fundamental and wider-ranging than past regulatory cycles, the impact on valuations and equity risk premiums could be deeper and longer-lasting.
So how should investors position in China?
For now, we would suggest focusing on three specific areas: companies in industries that have policy support, profitable tech companies, and risk diversification.
- As mentioned above, semiconductor manufacturers, clean energy, electric vehicle manufacturers, and companies involved in robotics and automation would be more insulated from regulatory ire given their strategic importance as laid out in China’s Five-Year Plan. Many of these names are also only available in the onshore A-share market, which has received less scrutiny (so far) compared to offshore listed companies.
- Finally, after a dramatic selloff, the valuations of large, profitable tech companies declined indiscriminately amid the broader market decline. The odds could be in the investor’s favor from here with regard to those companies.
- We have long advocated for diversified exposure to China as a means to reduce over-exposure to any particular source of risk. There are many ways to gain China exposure, each of which has different attributes and risks. For example, onshore equities are predominantly domestically owned, retail dominated, and cyclical; whereas MSCI China is primarily foreign-owned, dominated by institutional investors, and heavily tech-focused. Given the many differences in ownership, index composition, currency denomination, and not to mention key drivers, we think it makes sense for investors to take a diversified approach to their China exposure. This can help mitigate the risks often associated with China’s market, such as high volatility in onshore equities, regulatory risk in offshore equities, and the difficulty in assessing credit risks.
All market and economic data as of August 5, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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