Looking back, regulatory pressure has been building incrementally since the beginning of the year on two fronts:
A) A series of investigations into and fines for Chinese companies listed outside of China
In April, Alibaba – the Internet commerce giant – was hit with a record antitrust fine of $2.8 billion. The main issue for the regulator was that Alibaba restricted merchants from doing business or running promotions on rival platforms. The company accepted the fine and stated it would introduce measures to lower entry barriers and business costs faced by merchants on its e-commerce platforms. In July, Alibaba was fined again for not seeking official approval for previous mergers and acquisitions (M&A).
In July, Tencent – a video game and Internet giant – was also fined for not reporting its previous M&A activities to the Chinese authorities.
In July, Didi – the country’s most famous taxi hailing app – was fined by the Cyberspace Administration of China (CAC) for illegally collecting users’ personal data. As a result, Didi’s app was removed from application stores and the firm has since been prevented from acquiring new users until the investigation is completed. However, despite this restriction, Didi has been able to retain its market position and the commercial impact emanating from the development has remained contained.
In August, Meituan – a food delivery giant in China – was hit with a $1 billion fine. As with Alibaba, the regulator took issue with Meituan punishing merchants that sold goods on its platform as well as other platforms, in particular by preventing them from selling on rival platforms.
B) Regulatory clampdown on specific domestic companies and sectors
In July, China issued new regulations on private education companies. The new regulations ban firms that teach the official school curriculum from making a profit, raising capital, or going public. Regulators also said that no new licences will be granted. A possible shift from ADRs to A-shares is expected in the coming years.
The one thing that many of the impacted firms have in common is that these companies are listed outside China as American Depositary Receipts (ADRs) via the variable interest entity (VIE) structure.
A VIE is a special status granted to Chinese companies allowing them to list abroad. However, the structure also enables these companies to avoid traditional Chinese rules on taxation, currency controls and foreign ownership. We believe that Beijing has changed its attitude toward this structure and will now limit its use. Instead, China will likely continue to promote access to the China A-shares onshore market through (i) QFII, which is a program that allows licensed international investors to participate in mainland China’s stock exchanges and (ii) HK Connect, a direct connection between the Shanghai and Hong Kong stock exchanges also allowing for foreign ownership.
The shift away from ADRs towards China A-shares poses another issue for international investors, as it means they must accept China’s accounting standards. About 30% of Chinese domestic companies currently use International Financial Reporting Standards (IFRS), due to their international presence, while the remaining 70% use Chinese accounting standards. That said, it is important to note that Chinese accounting standards have converged significantly with IFRS, with most of IFRS’ recommendations now incorporated into Chinese accounting standards. Whilst this is not a perfect situation, we believe that China is committed to strengthening its accounting standards.
We anticipate more regulatory actions, and it is likely that the authorities could issue further guidelines in areas such as consumer finance, property development and online gaming:
The regulator already requires online lending platforms to feed the consumer data they collect into nationwide credit agencies. The idea is to share the data with banks and lenders, with the objective of clamping down on risky and even potentially fraudulent consumer lending, enabling all involved to evaluate risks more effectively.
Regulators are seeking to curb excessive risk-taking in the property sector and rein in debt levels in the country’s financial system. The government is focused on future economic growth, and excessively high property prices hurts housing affordability.
Restrictions already exist to limit the amount of time students and young adults can spend on online gaming and streaming. However, further rules could be introduced to cap the maximum amount of money that minors can spend on games.
We believe that the heightened level of fear in the market comes from a misunderstanding of the purpose of the Chinese regulator.
Taken in isolation, the government’s desire to ensure fair competition, protect youths from being addicted to online gaming, protect consumer data and reduce the cost burden of education on families seems sensible as the moves contribute to the creation of a more cohesive society.
In the case of foreign-listed companies cited earlier, the regulators’ charges could be valid since these companies had acted to evade existing laws. These perceived market violations are being addressed and we do not believe that the future of these companies will be jeopardised as a result of recent developments.
With regard to education companies, a specific pocket of the sector has become unprofitable but we note that the regulation only applies to official school curriculum. In other words, affected firms can continue to do well by teaching non-school related subjects. As such, we do not think these companies are compromised.
In our view, the regulators are acutely aware that their actions have affected the value of China’s equity market as well as investor sentiment. We expect them to take a more moderate approach and try to assure global investors that China is not closing the door to foreign investment.
However, we do expect the current tide of regulatory changes to continue, which could impact markets further in the short-term.
We acknowledge that sentiment towards Chinese shares has deteriorated but continue to believe that the Chinese market is home to a large number of companies of very high quality and strong future prospects which should not be ignored by investors. In addition, it is highly likely that the currently very depressed sentiment will ease at some point, meaning that today’s valuations will, in time, be seen as too low and may present a buying opportunity for investors.
We believe that negative fund flows out of China may continue in the short-term, but experience tells us that these large pullbacks and associated periods of elevated risk premia for Chinese equities often present investors with excellent opportunities for high future returns.
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