‘In China the Party’s just like God- he’s everywhere you just can’t see him.’: Richard McGregor, former Beijing correspondent of the FT and author of ‘The Party’.
The overriding factor driving policy of the Chinese Communist Party is to maintain unchallenged control of the country. This has always meant avoiding policies which could potentially create social unrest and, therefore, weaken the popularity of the Party. In the post-crisis period, China has delivered real wage growth each calendar year to the bulk of its workforce, especially in the ‘blue collar’ sector. When thinking about changes in policy, investors should always first ask how this will impact on the Party’s hold on power, meaning that the recent regulatory scrutiny is not a bottom-up issue. Investing in China has always meant that the fund manager needs to be able to avoid holding any business that is on the wrong side of Party policy. This has been re-emphasised recently (Didi and the education sector, together with some technology names), although there were previous indicators last year with the late cancellation of the planned IPO of Alibaba's financial subsidiary and ANT.
The Chinese government has become more socialist and interventionist in recent years with a focus on: consumer rights, employees’ rights, burdens for parents, burdens for students, children’s exposure to internet games, property prices, the expense of pharmaceutical drugs (especially generics) and profits made by banks. This intervention is a risk that the market awoke to rather belatedly given that Xi is a populist politician.
The confirmed education regulation has caused huge uncertainties for the sector, with analysts extrapolating to consider whether cash could be repatriated from China (US listed VIE structures) and whether these companies will be de-listed. Analysts are also adjusting down net cash to account for tuition prepayments and lease liabilities. The surprise regulation on education (a not-for-profit sector isn’t going to generate great earnings!) has also raised investor concern about regulatory risks in China and what could be the next sector hit, resulting in a rise in the risk premium for Chinese stocks. Concerns are for internet companies that have already seen more regulation, including the US listed subsidiary of Tencent-Tencent Music and previously, generic drug makers and medical device manufacturers, regarding price controls, since the Chinese government has been cutting drug prices aggressively through its Group Purchasing Organisation.
The regulatory environment in China has turned less stable and China has been becoming increasingly socialist under President Xi with stronger state control, very different from the post-Deng period when there was a collective approach among the Politburo Standing Committee (PBSC) with consensus sought on economic and social policy. This was continuously demonstrated under President Hu and Premier Wen, in the administration that handed power over to Xi. There is no doubt that risk in Chinese stocks has grown under Xi who appears to view himself as appointed for life, rather than serving what has become the norm of two terms as President and, more importantly, Party General Secretary and leader of the military. Questions have now been raised about the US listed VIE structures as the government has the potential to use the associated legal loopholes to their advantage at any time.
President Xi and the Party have been focused on the “Three Mountains” that make life difficult for people: cost of property, healthcare, and education. Xi has commented that property is for living in, not investing in, and recently made a statement about the excessive cost of education. The delayed Chinese census results showed a stagnant population and as the Party are concerned about a shrinking population, they have now adopted a 3-Child Policy. Unfortunately, the cost of education has meant that couples are reluctant to have larger families. Many couples consider that they also have elderly parents and possibly grandparents to look after which also has an impact. In healthcare, the government policy has forced generic drug prices down year on year. China has also felt uneasy about data security and it appears that Didi was told not to list in the US as this would have resulted in data being supplied on the Chinese population detailing working hours and wages. Tightening of anti-trust and anti-competitive regulations will continue in China as there is concern that the big internet companies have too much power. There are now around nine government agencies in China looking at what has been going wrong and the authorities are also putting in place protection for gig economy workers.
It could be argued that the regulatory cycle was not unexpected or unannounced having been clearly flagged last October/November when the ANT IPO was pulled at the last minute. Rising costs in the education sector were leading to even greater levels of inequality in the country. Successful investment in China should be focused on companies that help to solve China’s issues and problems rather than compounding them and avoiding social unrest is at the core of policy decisions. Looking at broad sectors, AI companies advancing medical technology, domestic semi-conductor stocks and companies focused on green energy/lower emissions will all have favourable tailwinds and will likely be supported by the government.
At this stage, the internet giants Tencent and Alibaba have both seen significant price corrections and have, in effect, become consumer companies, so growth rates will be slower than delivered previously, although still strong compared to the market average. Fund managers need to be mindful of potential issues; an example would be Meituan and concerns about the effect of community group buying schemes on Mom & Pop stores. This could adversely affect social stability and has not gone down well with the government. Both software and healthcare are on the right side of policy change and remain favoured areas. Software as a service sector is at an early growth stage in China compared to the developed world and should benefit not only from homegrown talent but also from a returning overseas talent pool. The shift to cloud has been beneficial and there are technological innovations in areas like AI making software more efficacious but software as a service is very under- developed compared to the US. Technology-orientated companies in China are likely to also benefit from the trend towards localisation.
China can still provide strong returns for investors, as long as the companies held are beneficiaries of Chinese policy goals and not operating in areas with policy headwinds. National security over its supply chain and reduced vulnerability to any escalation in trade war tensions should produce tailwinds and many would argue that the changes made by the authorities in China are good for society over the longer-term. It is in the interests of the CCP to grow the economy and employment, along with real disposable incomes and there remains high reliance on the private sector to achieve this as state owned businesses are now relatively small employers compared to in the past. Over the long-term, China will remain a strong consumption story as highlighted by the Dual Circulation Strategy. China is still a rewarding option over the medium term for investors, with successful fund managers in the region focused on companies benefitting from Party policy as well as bottom-up fundamental analysis.
Graham O'Neill, Senior Investment Manager, RSMR
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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