Market Update - China’s latest regulatory crackdown
China’s latest regulatory crackdown
Ever since the West started to engage with China in the 1980s there have been questions over China’s integration into the global economy. Optimists thought these questions had been answered after the country gained admittance to the World Trade Organisation in 2001. It was believed that China would play by the rules and reciprocate by opening its economy to other countries. But it has become increasingly apparent that to do business in China, you do it on Chinese terms - a form of capitalism strictly controlled by the Chinese Communist Party.
Big tech too big
The Chinese authorities decided some time ago that certain companies, particularly in tech, were getting too big for their boots. This became apparent after Alibaba’s billionaire founder, Jack Ma, went missing in November last year, just ahead of the planned IPO of his financial services company, Ant Group. The IPO was pulled soon after Mr Ma criticised the regulations surrounding China’s banking system. Ant was supposed to shake things up. Fortunately, Jack Ma reappeared in January. But he is rather more subdued than before, suggesting that his wings have been clipped. Beijing went on to levy hefty fines on several high-profile Chinese tech companies, such as Tencent and Baidu, for various infringements including violating anti-monopoly rules.
DiDi’s US listing
But the authorities really upped the stakes in June this year when a ride-sharing company called DiDi Global Inc., often referred to as China’s Uber, went public on the New York Stock Exchange. The company raised $4.4 billion, valuing it at over $70 billion. Two days later the Cyberspace Administration of China (CAC) announced a data-security review of the company. It accused DiDi of misusing its customers' personal information, and subsequently ordered the removal of DiDi from app stores. DiDi was unable to sign up new customers and the stock slumped by around 25%.
Since then, the Chinese authorities have widened their targets, taking aim at companies involved in education and gaming. First there was the threat to turn tutoring firms into non-profit organizations. The reason given was to reduce inequality in education by cutting the costs for parents unable to afford these services, but desperate for their children to have access to extra tuition. Some of these companies are US-listed, such as TAL Education, Gaotu Techedu, and New Oriental Education & Technology Group. They saw their share prices slump 70%, 61% and 52% respectively on the news. Then there was the recent statement about online gaming. Economic Information Daily, an affiliate of the state-backed Xinhua newspaper, charged the sector with providing "spiritual opium" and "electronic drugs". The article also flagged "widespread gaming addiction" among children, which could "negatively impact their growth." Shares in Tencent, which also has a US listing, fell 11% in Hong Kong, wiping close to $60 billion off its market capitalization. Other gaming companies such as NetEase and XD Inc. also took a hit. Tencent was quick to impose restrictions on children’s accounts to avoid further harsh criticism.
Owning Chinese stocks
There could be many parents in the West who wish their own governments would take such a stand to protect children from social media and gaming sites. And who can object to widening the availability of education, other than shareholders in a tuition company that has just been targeted? But there are suspicions that these crackdowns on Chinese tech companies have little to do with data security, at least within China. The country’s citizens already have little privacy or data security. It’s more likely that these issues relate to market access, and the Chinese authorities’ involvement in what we understand to be public limited companies. Under Chinese law foreigners aren’t allowed to own shares in certain Chinese companies. In addition, the US-listings of Chinese companies are not listings in the normal sense. When you buy a share of DiDi on the New York exchange, you’re not buying a piece of DiDi. You’re buying a bit of a Variable Interest Entity, or VIE, registered in the Caymans, which is contracted to the parent company. There’s no secret about this. It’s all there in the prospectus. The VIE is great for Chinese companies as they receive capital in the form of foreign investment without surrendering any ownership of the company. Now it’s even possible that this structure itself is illegal under Chinese law. But it’s unlikely anyone would bother trying to fight that in court. So, China gets the money and keeps control. Capitalism communist style. US and other non-Chinese investors have been happy with the arrangement as it gave them a way to profit from growth in China’s giant tech corporations. But now that investors have seen the effects of heavy-handed state intervention, many are getting nervous. It’s not good news for Chinese companies either as they are being put off from raising capital on Wall Street. And this is a big market. In the first half of this year, thirty-four Chinese companies raised $12.4 billion listing in the US. This was very profitable for Wall Street’s investment banks who made around $460 million in fees on the business. But that business is now threatened. ByteDance, the owner of social media giant TikTok, has already postponed its proposed US IPO due to China’s ‘data security’ concerns.
Tit for tat
There’s another reason to question China’s motivations for their regulatory clampdown. At the end of last year, Congress passed a law authorizing the delisting of Chinese companies from US stock exchanges if they fail to meet US auditing standards for three years. China responded by saying that their own regulators would carry out all audits and submit their conclusions to US regulators. This was firmly rejected by the US Securities and Exchange Commission. According to the US-China Economic and Security Review Commission, there are around 250 Chinese companies with a combined market capitalisation of over $2 trillion listed on US exchanges. None of these are open to US auditors. That should be a worry for investors, and it does raise concerns over how long these companies will be allowed to keep a US listing. This would also be a blow for Chinese companies wanting to list in the US. Not only do they benefit from foreign ‘investment’, but they also have access to the financial knowledge and expertise that is not currently available in China.
There are currently no signs of any let-up in the regulatory crackdown from Beijing, despite the cost for investors. China’s main stock market index, the Shanghai Composite, dropped 6% between 22nd and 28th July. Losses on US-listed Chinese stocks in general are estimated as being in excess of $760 billion over the past five months. Now many people may prefer to avoid investing in Chinese companies all together. Certainly, if you have any interest in confining yourself to ethical investing then you have good reason to give China a miss. But it appears that the recent clampdowns have done nothing to put off large investment houses from extending their presence in China. BlackRock, Fidelity Investments, Amundi, Schroders, Goldman Sachs and JP Morgan are all looking to build asset management operations there. This is understandable, as this business has enormous potential given the economic growth of the middle class. It’s certainly appears to be significant enough to put aside any concerns about dealing with a country run by the Chinese Communist Party, whose attitude towards its own citizens, those of Hong Kong, Taiwan, Tibet, and the Uighurs is woeful. It also pays lip service to climate change, one of the great passions of the West’s wealthy elite. But if previous experience is anything to go by, once China has extracted the necessary knowledge and intellectual property from these banks and institutions, it will keep their customers and boot them out. Time will tell.