China - Unpacking the recent regulatory interventions

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 amongst 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. These questions are justified, 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 of the value of affected listed businesses.

PERMANENT HANDICAPPING OF THE AFTER-SCHOOL TUITION INDUSTRY

Most recently, widespread intervention in the after-school tuition (AST) industry has most likely destroyed 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 are banned from making profits from classes that do not cover the core curriculum. In addition, foreign investment and the use of variable interest entity (VIE) structures will not be allowed in this industry going forward. For most tutoring businesses, this represents between 40% to 70% of their revenue which disappeared overnight – probably for good, at least on a for-profit basis. 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. Their primary anxiety is to ensure that their kids are adequately prepared to excel in the grueling university entrance exam, called 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 has resulted 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 and is actively trying to increase the country’s birth rate. To this end, lowering the cost of raising a family is seen as very important in their drive to promote a “common prosperity”. The property and healthcare sectors are also seeing intervention, as these industries are a large component of the cost of living.

INTERVENTION NOT ONLY IN AST

This action against AST came hot on the heels of the announcement of an investigation into the ride hailing service DiDi for inadequate protection of consumer personal data and trips taken. Two days after DiDi completed its initial public offering (IPO), it was banned from registering new users and their 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. They chose to proceed anyway, hence the high-profile nature of the action taken against them.

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 greater capital requirements for all fintech players were announced.
• 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, Meiutan 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 $2.8bn 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, together with a RMB500 000 fine.

(Additional source: 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 firstly, 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 intervention taking place later to correct for any “negative externalities” that arise. 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 where their 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 earning 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. Of course, there could be further actions taken that change this. For now, however, it appears that the objective of the government has been to rein in excesses and implement something akin to standards implemented or planned to be imple­mented in the European Union and the United States. The most prominent example would be the protection of “gig economy” workers, through the provision of social benefits and insurance against injury which has become a commonplace provision 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 before. 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 stocks. These structures remain in place and the government has not taken any steps to end these, despite them having existed for decades. In the case of the education stocks, 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. 

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. There has been some speculation that the gaming sector (desktop and mobile video games) will come under regulatory scrutiny soon. This is based on an opinion piece in a state newspaper which disparaged the impact that gaming was having on society, particularly its addictive qualities for children. Gaming is a material part of Tencent’s earnings (around 45%) and there are several other listed gaming stocks in China. We cannot predict with any certainty whether draconian regulations will emerge. However, it is useful to bear in mind that it is primarily the protection of minors that the Chinese government seems to be focused on. In 2018, this sector was addressed and, in addition to game approvals being delayed, there were also significant curbs put in place to limit time spent on games by minors. Tencent, for example, requires identity recognition before one can play games, and minors are prohibited from playing content deemed unsuitable and their gaming times are monitored according to the regulated limits. 

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, as they have historically struggled with their apparel offering (amongst other products) due to Alibaba’s exclusivity demands. 

There has been a sell-off 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. +

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