China

SINCE NOVEMBER LAST year, the Chinese govern­ment, through its various organs of State, have announced several regulatory interventions and investigations into companies and industries, some of which are widely held by foreign investors. These regulatory actions have naturally raised the alarm among investors. Questions are being asked about what could be targeted next, and whether these are indicative of a broader attack on capital markets and foreign ownership therein. Given the number of regulatory moves and investigations that have been announced in such a short time period and the impact that these have had on the value of the affected listed businesses, these questions are justified.

PERMANENT HANDICAPPING OF AFTER-SCHOOL TUITION INDUSTRY

In July, widespread intervention in the after-school tuition (AST) industry has most likely permanently handicapped the long-term earnings power of businesses in this sector. Although some form of intervention was expected, the extent was close to the worst possible outcome. On 23 July, Beijing announced that tutoring companies were banned from making profits from classes that cover the core curriculum. In addition, foreign investment and the use of variable interest entity (VIE) struc­tures would not be allowed in this industry going forward. There might be an exception for AST for high school students (years 10 to 12), as these are not ‘compulsory years’ that are attended by all students. For most tutoring businesses, the compul­sory schooling years (pre-school through to the end of middle school/grade 9) represent between 40% and 70% of their revenues. Many of these busi­nesses have announced that they will launch new alternative products, but it is doubtful that classes that do not cover the core curriculum will have the same appeal for parents. This is because their primary anxiety is to ensure that their children are adequately prepared to excel in the grueling univer­sity entrance exam – the gaokao – which determines who gets into the best universities in China.

We believe that the Chinese government has taken the view that this obsession with gaokao exam preparation from such a young age results in a very unhealthy situation for both children and parents, who spend a large proportion of their disposable income on tuition. China faces a demographic crunch, as the population pyramid is skewed heavily away from young people. According to govern­ment forecasts, the working age population is expected to see a net decline of 35 million people over the next five years due to retirement. To put this into sharp perspective, this figure represents more than the UK’s entire current workforce. To address this, China is actively trying to increase the country’s birth rate, as the end of the one-child policy in 2016 did not achieve the desired increase in number of births, and restrictions were subse­quently loosened to allow three children per family.

To this end, lowering the cost of raising a family is seen as an essential step in boosting the birth rate and in China’s drive to promote a ‘common prosperity’. The property and healthcare sectors are also seeing regulatory interventions, as these industries are a large component of the cost of living and, like education, have seen costs rise far in excess of wage growth over the last decade.

INTERVENTION NOT ONLY IN AST

This action against AST came hot on the heels of the announcement of an investigation into ride-hailing service DiDi for inadequate protection of consumers’ personal data and trips taken. Two days after DiDi completed its initial public offering (IPO), it was banned from registering new users and its App was removed from the various appli­cation stores in China. It is our understanding that the company was warned not to go public until the data privacy issues were sorted. DiDi chose to proceed anyway, hence the high-profile nature of the action taken against the company.

Other key events that have taken place since November 2020 include:

• The fintech company Ant’s IPO was blocked in early November and, in February 2021, increased capital requirements were announced for all fintech players.
• In December 2020, customer subsidies were capped and anti-competitive practices in the community group buying^* ecommerce industry were regulated. This affected Alibaba, Tencent, JD.com, Pinduodo, Meituan and DiDi.
• The practice of ‘forced exclusivity’ was also banned in December, which meant that Alibaba can no longer require merchants to sell their wares on only one platform. This was followed by a $2.8 billion fine for anti-competitive practices in April.
• An investigation was launched into anti-competitive practices in food delivery in April, particularly aimed at Meituan’s practices of exclusivity. The investigation is ongoing.
• The merger of the two largest gaming live-streaming platforms in China was blocked in early July.
• Exclusivity in music licensing by Tencent Music (TME) was ended, and a RMB500 000 fine was imposed.

Sources: Coronation, Bernstein

TAKING A STEP BACK TO UNDERSTAND THE CONTEXT

It is impossible to know definitively whether these interventions signal a more intrusive regulatory regime in the future. However, we can draw infer­ences based on what is likely and what is not. It is worth stepping back to get some perspective and asking, first, what is the reason for the flurry of regulatory activity, and secondly, how do these regulations compare to what is happening in other countries?

By and large, the Chinese government has allowed technology to develop without significant regu­latory impediments, with interventions taking place later to correct for any ‘negative external­ities’ that arose. Our view on why so much regula­tory intervention has taken place so quickly is that the government is now playing catch-up after a long period during which its approach was more hands-off.

At present, many of the regulations announced, with the notable exception of those relating to AST, have direct parallels to those that are common­place elsewhere in the world. The protection of privacy and the promotion of competition are regulated and debated in many countries. In most cases, the new regulations imposed by the Chinese government can be managed by the affected companies reasonably smoothly, without materi­ally affecting their long-term earnings prospects or seriously reducing the ‘moat’ around their business.

By and large, all the regulatory actions taken against Alibaba, JD.com, Meituan, Pinduodo, Tencent and TME to date fall into this category. Going forward, there could be further actions taken that change this, but for now, it appears that the objective of the government has been to rein in behavioural excesses. In our view, they are replicating standards that already exist or will be implemented in the EU and the US, albeit with a greater emphasis on national security, given the sensitivity around data. The most prominent example of copying ‘Western’ standards is the protection of ‘Gig Economy’ workers through the provision of social benefits and insurance against injury. This has become commonplace in other jurisdictions. China has an estimated 200 million workers in this sector (almost a quarter of its workforce), so better protections here are a social priority.

Clearly, the manner in which these changes were done damages long-term confidence in the country as an investment destination and we expect that Chinese assets will, all else being equal, trade at a discount to what they used to. This is somewhat reflected already in the sharp decline we’ve seen in share prices, almost across the board.

As a final consideration, the presence of VIE struc­tures to circumvent foreign ownership restrictions has always been an issue for Chinese shares. These structures remain in place and the government has not taken any steps to end them, despite the fact that they have existed for decades. In the case of education shares, they have been banned going forward and not retroactively. Ending VIE structures would largely cut China off from most foreign capital permanently, which is likely the reason why they have been tacitly tolerated so far. The proportion of profits that flow through VIEs varies by company. In the case of JD.com, for example, close to 90% of profits are outside of the VIE structure, as ecommerce is largely exempted from foreign ownership bans. As a final point, the presence of VIE structures in the local A-share market also suggests that they have gained some tacit acceptance.

THE WAY FORWARD

We are not complacent about the risks and contin­ually assess and proactively research potential regulatory actions and how these would affect the stocks we own, and the Chinese market in general. As an example, after an August opinion piece in a State newspaper disparaged the impact that (video) gaming was having on society, particularly its addictive qualities for children, Tencent sold off significantly, as it’s the largest gaming company in China. Subsequent to this, the govern­ment announced tight curbs on when and for what duration children are allowed to play online games.

The short-term impact on Tencent is relatively easy to quantify. Gaming is a material part of Tencent’s earnings (around 45%), but only a small portion (single digits) of the gaming earnings relate to spend by minors. Tencent requires identity recog­nition before one can play games and minors are prohibited from playing content deemed unsuitable. Their game times are also monitored according to the regulated limits (a few hours a week spread over Friday to Sunday). Aside from the protection of minors, recent guidance to game developers has been to avoid ‘misrepresenting history’ and to promote the correct ‘moral and culture’ for China.

We have taken the view that this is all manageable for Tencent (and Netease, which is also owned in our Strategy), but what is more difficult to assess is whether the restrictions on minors playing games fundamentally affect their behaviour into the future. If these restrictions are adhered to by children now – and the technology in place to prevent rule-breaking makes it quite hard to skirt them – will the next generation of children be as prolific gamers as current adults are when they in turn reach the age of majority? These are the tougher questions we constantly debate that will determine whether the selloff turns out to have been a buying opportunity or not.

Not every potential regulation is negative for investment opportunities, as a number of recent regulatory proposals actually promote competi­tion by opening up opportunities for companies that were previously held back from competing effectively with a strong incumbent. JD.com, for example, is a big beneficiary of the prohibition on Alibaba demanding exclusivity. JD.com historically struggled with its apparel offering (among other products) due to Alibaba’s exclusivity demands and levelling of the playing field is a huge positive for the business.

There has been a selloff of Chinese shares since the changes were announced. Where the share price reaction is significant and the probability of the impact of regulatory change is low, this can be, but isn’t always, a potential investment opportunity.

Our portfolios are constructed to take advantage of opportunities while simultaneously managing overall risk to each country, sector and industry. China, as the largest market in emerging markets, with the widest range of investable companies remains, in our view, an attractive invest­ment opportunity for emerging market investors. However, as always, understanding the risks and return opportunities inherent in this market is crucial.+

^* Community group buying: a community or group of consumers coordinating orders to benefit from bulk discounts.