In recent weeks there has been increased volatility within the Chinese equity market, specifically within the internet names related to the ‘new economy’. In short, the regulatory crackdown that started late last year has intensified, targeting virtually every sub-sector from e-commerce, ride-sharing, online gaming and internet advertising. This has several important implications for the sector and China as a whole.
Regulatory tightening cycles are relatively common in China. ‘Supply side reform’ was a catch-cry that started back in 2015, with authorities initially seeking to clean up the coal and steel industries. Peer-to-peer lending (as well as the wider shadow banking system) was more heavily regulated from 2018 while reform (and greater regulation) of the healthcare industry has been an ongoing priority of the government for several years. The online gaming industry underwent a regulatory overhaul in 2018, where the game approval process was tightened while also placing additional restrictions on children’s playing time.
What makes this different?
The key event in this latest episode was the reform of the after school tutoring industry. Announced late July and known as the ‘double reduction’ policy, it sought to reduce the burden on children as well as reduce the cost of after school tutoring. It is widely considered that the government wanted the private sector out of providing education services for mandatory education (kindergarten to year 9). As part of this policy, they sought to close all potential loop holes and banned foreign investment, including via Variable Interest Entities (VIE)(1). This led to fears that all foreign investment would be banned in the wider internet sector. Recognising this risk of contagion, the Chinese securities regulator quickly clarified that US listings (and foreign investment) would remain open to Chinese companies, though approval from various authorities would be required first.
More recently, there has been a number of opinion pieces in state-run media calling for greater regulation of the online gaming sector, regarding protecting teenagers and the cessation of various tax breaks. The fact that it led to such a violent sell-off in gaming companies speaks volumes about the sentiment towards the sector.
(1) Variable Interest Entities are a 20-year-old legal construct that enables foreign investment into restricted sectors in China.
Ultimately, we think education is a special case and foreign investment (and VIE structure) in the broader internet sector is not under threat. Regulatory action has been focused far more on exerting greater control on particular industries, as opposed to changing ownership. Education costs have been rising quickly in China, and the government has been acutely aware of China’s falling birth rate and has recently announced a raft of measures to reverse this trend, including addressing the cost of raising children.
The recent anti-monopoly crackdown by authorities which sought to regulate internet-related companies that use VIE structures, while not definitive, supports this view. Authorities have moved towards recognising the VIE structure over the past decade, though progress has been frustratingly slow. Meanwhile, the Chinese government needs these companies to support their broader policy objectives. Self-sufficiency in key technologies including semiconductors, artificial intelligence and the digitisation of industry will be greatly assisted by the significant R&D budgets of these companies. China’s efforts to open its markets to foreign capital via Stock Connect and Bond Connect also demonstrate its desire for foreign investment.
The market sell-off in recent weeks has resulted in valuations for a number of companies reaching levels not seen in over a decade. In time, we believe that the current period will prove to be a buying opportunity and we have been selectively adding weight to the sector as it has sold off.
The regulatory path from here
Investor confidence has been undoubtedly shaken in the sector as well as China as an investment destination itself, and it will take some time for this to be repaired. ‘Sell now, ask questions later’ has been the approach that many investors have taken in recent weeks. Yet we believe a far more nuanced (and longer-term) approach is required. Many of these companies have created a huge amount of value and are examples of the innovative economy that policy makers wish to foster. Regulation is and always has been a part of this equation.
While further regulatory action over the coming months is considered likely, we expect the market impact of this news flow to be more modest. Given recent share price moves, many of these companies are already reflecting a particularly negative outcome in their prevailing valuations. Like other cycles in the past, this one will also fade in its intensity.
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