Has China become Un-investable?

The movements last month in China equity markets can be summed up by Lenin’s quote: There are decades where nothing happens; and there are weeks where decades happen

The last week of the month brought double-digit losses in China and Hong Kong equities, as China continued its crackdown on technology companies by focusing on DiDi, causing a -23% fall in a single day, just three days after its IPO. China also cracked down on the music licensing subsidiary of Tencent, causing a similar percentage loss. To top things off, the government announced a severe crackdown on for-profit education companies, banning them from making a profit and almost bankrupting the whole sector, which had been valued at over US$100 billion at the beginning of this year.

All of this wiped out USD170 billion in market cap for Tencent in July. Tencent has been the largest holding in the majority of Asian investors’ portfolios over the last few years. One thing that all these affected stocks had in common is that they were all listed on US stock exchanges.

For decades investors conveniently dismissed the fact that China was run by a communist government, arguing that in reality they were more capitalist than many governments in western countries. This view needs to be completely re-assessed.

China is trying to guide the country and its economy toward its vision of an ideal Marxist society. The education for-profit sector looks to have been permanently marginalised. Many technology companies have suffered as their reach has been heavily curtailed. Many more things will be hit going forward, in the government’s quest to make society more equal.

Witness China’s attempts to persuade couples to get married in order to reverse the country’s terrible demographics, by removing barriers the government perceives, one of them ostensibly being the high cost of tuition fees provided by the for-profit sector. The solution? Ban profits and bankrupt the sector. Elsewhere, in rural provinces where dowries are still paid to the family of the bride-to-be, the government is actively lobbying families to reduce their bride price.

All of this is as misguided as China’s one-child policy, which is the direct self-inflicted cause of the country’s demographic problems today. The reality is that as countries become richer, they automatically end up having fewer children. This has been well documented in every single developed country in the world. Even Bangladesh is now at 2 births per woman, below the replacement rate. Statistical analysis shows that the world population is projected to peak at 10-11 billion by the middle of this century and then stabilise. China thinks it can alter this destiny.

With all these changes in policy, the key question going forward for investors is whether they need to change their outlook on China.

China Portfolio Exposure – the Way Forward?

It is interesting to read the difference in opinions and financial market commentators in China vs. the West on the events of the last week of July. In the West, it is described as an extreme investor unfriendly action which will undermine confidence in China’s equity markets, with some questioning whether China has become ‘un-investable’. In China, it has been described as the government acting to protect its citizen’s interests and has been met with wide approval by the population.

When the market rout spread well beyond the targeted stocks and caused falls of more than -10% in two days in both China and Hong Kong equities, China’s regulator called a hastily arranged meeting with a small number of finance companies to soothe investor fears and reassure them that this was not a wide crackdown on multiple parts of the economy. Either China miscalculated the effect that would spread to its own financial markets, or they made a conscious decision that they will bear the short-term pain.

The affected stocks in the education sector are all -90% year to date, and they may never recover. The ability of China to declare an elimination of profits on an entire sector spooked investors. Which sector is next? How does one tell?

The outlook into two main camps:

China is asserting its control over financial markets in an extreme fashion by arbitrarily choosing sectors/companies as it sees fit. Investors will wonder which sector/company is next, vastly increasing political risk. The prudent thing to do from a risk management point of view is to reduce exposure to China, because these actions, coupled with everything else, show that China has no qualms about hurting investors in ways that hit them the hardest, with no warnings, immediate action, and politically driven according to the government's ideological agenda.

The other view is that the education and tech sector crackdowns are isolated cases and that this may yet be a buying opportunity. Many are taking this stance, especially in Asia. However, publicly criticising the actions of the China government in print can lead to financial institutions being barred. The best justification for holding this view is the analysis that the education sector in China was always supposed to be non-profit according to government regulations, and from legal perspective companies like New Orient and TAL were operating in a gray area. They were structured as offshore entities that charged consultancy and a host of other fees to the mainland operations, thereby making them 'non-profit'. This was a loophole that the government gave warning on in the past but was unheeded, and they decided to finally crackdown on the sector. The government’s reasoning was of the increasing inflation costs of additional tutoring, which increased the cost of having children, leading to a lower birth rate.

The second point that these companies were not operating legally in the first place is a good argument that China is not being as capricious as it first looks. This would hint that the sell-off is a buying opportunity. One big caveat, if China is going after legally dubious sectors, they may put the Variable-Interest-Entities (VIEs) structures in their sights next. VIEs skirt around China regulations on foreign ownership, whereby investors are completely reliant on the goodwill of the company, and the government, to make good on the company’s promise to honor these securities. Cracking down on VIEs would mean that all US-listed China stocks could similarly be banned from earning any profits.

VIEs are similar to Keepwell Deeds which have been used for many Chinese bonds. In the deluge of Chinese defaults over the last three years, Keepwell Deeds were subsequently invoked by bondholders, but repeatedly rejected by both courts in China as well as Hong Kong as not being legally binding. A VIE crackdown would create an even bigger shockwave in China/HK markets. While the risk of this happening is not very high, in this era of rising Sino-US tensions it cannot be dismissed as zero.

There was no official release about the content of the July meeting with Chinese regulators, but some talking points were leaked through social media that Chinese authorities were well aware that China is integrated with global markets and none of the policies were aimed at decoupling China from the rest of the world, particularly the US markets. Regulators are reported to have said that they viewed the VIE structure as a necessary and important one. The question investors need to ask themselves is, how much of their portfolio are they willing to risk on comments like these?

Irrespective of which of the two views an investor takes, a likely outcome is a downgrading of China equity multiples going forward. The main concern is that this may become a permanent downgrade assigned by foreign investors, given China's callousness in hurting them. This is similar to what happened to Russian equities after the government nationalised Yukos, their biggest public company with significant large foreign shareholders - Russia never recovered from that re-rating of P/E multiples.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.