Views On China

by Momentum Investment Team

With China now the largest economy in the world (on a PPP measure') and the primary engine of global growth, investors need to think hard about how to gain exposure within global portfolios. The impact of Chinese policy decisions reverberate around the world, whether those are purely domestic or international in scope.

A key challenge is that the Chinese Communist Party (CCP) is relatively opaque, and new policy can be difficult to anticipate. Power is more centralised today than it has been in several years; the Party has removed the two-term limit for sitting presidents and has also enshrined Xi Jinping's name and ideology into the country's constitution, making him the most powerful leader since Mao Zedong.

Over the last year, a raft of new regulations across different industries have been introduced, all with the intention of developing "socialism with Chinese characteristics". It won't be clear exactly how these changes impact the economy for several years to come, but we will consider what these changes mean for global markets and how investors should respond.

Prioritisation of social projects

Perhaps the most unanticipated policy shock from China this year was the clampdown on the education sector, as the government ended private tuition for profit and made it a wholly charitable enterprise. The reasons for this abrupt change were largely ideological; the government wanted to lower the workload for children, reduce the costs for parents, and improve fairness by enabling equal access to education for all citizens. The cost of this change has been to the private sector as a once-$100bn industry is now struggling to survive, with shares of New Oriental, TAL and Gaotu now down 90%-98% from recent highs.

Desire for social change has been the driving force behind other regulation, such as restrictions on gaming where children are now limited to three hours per week, except public holidays. This is something that many parents may have sympathy with, but has the potential to impact growth of companies like Tencent which derives about a third of its revenue from gaming. This isn't the first time the government has stepped into the market, as in 2018 the restriction of new gaming licences caused Tencent to post its first quarterly profit fall in 13 years in Q2 2018 (although revenue still grew 39%). This is another example how the CCP is prepared to put social considerations ahead of economic interests in certain sectors.

Looking forward, the gambling industry in Macau may also be under threat after the secretary for economy and finance announced a review of the industry, just before casinos are due to rebid for their licences next year. Gambling has been illegal on the mainland since the CCP took power in 1949, but has been allowed to operate in the special administrative regions. The industry has been lucrative, with casinos generating $36.5bn in revenue in 2019 before the pandemic struck, but has been a target in the past, most notably in the 2014 anti-corruption drive?.

Reining in the property sector

The property sector has been under regulatory scrutiny for some time and is a source of systemic risk now with the potential default of Evergrande, as well as other names such as Fantasia Holdings which defaulted on October 5th. A catalyst for the sector's current woes was Beijing's "three red lines" policy formulated in August 2020, which mandated that property companies must keep within strict limits on various leverage/coverage ratios (net debt to equity, cash flow to short-term debt and liabilities to assets)3.

The highly indebted property sector has been a source of concern as the government wants to avoid a US-style housing crisis, curtailing price growth to ensure that houses remain within reach of ordinary citizens. Property represents over 70% of Chinese consumer's wealth, and so it is important for economic and social stability to prevent overheating and excessive leverage in the sector. A key consideration for investors is how the CCP will moderate the excesses in the system. A dysfunctional default of a company the size of Evergrande has the potential to cause systemic problems to the wider economy, however we believe the risk of this is low as the government has the willingness, ability and competence required to control the situation.

Clampdown on big tech

The tech giants such as Alibaba, Tencent and Meituan have grown exceptionally fast over the last decade, and the introduction of new regulation in this sector is perhaps the most worrisome for global investors, many of which have direct exposure through US ADRs or similar instruments.

This risk was epitomised with the failed listing of Ant Group, in what was expected to be the world's largest IPO before new online lending rules caused the offering to be suspended just two days before launch. The market value of Ant Group was expected to be $300bn once public, a significant amount for a Fin Tech disruptor when you consider that banks such as Goldman Sachs were valued at less than $80bn at the time. While Ant Group may still yet come to market, its business will have drastically changed and will be much more focused on pure payments rather than broad Fin Tech, likely resulting in a much lower valuation. Undoubtedly this will result in some steep losses for those large institutions such as Blackrock who bought into the company pre-IPO in 2018.

The clampdown on Fin Tech threatens to damage growing industry which has provided a lot of benefit to citizens. China led the way in digital payments in terms of user numbers and penetration rates, even before the pandemic, and that has helped disconnected rural residents and small businesses access financial services, who otherwise may not have had easy access to traditional banking services. Of course the CCP's desire to bring Fin Tech into line with traditional banking regulations is not unreasonable (large unregulated financial products obviously present their own problems) but it is also not conducive to entrepreneurship and innovation in the sector. This can be seen by looking at traditional Chinese banks which are notoriously capital inefficient, and as a result trade on a fraction of their a book value (the largest banks ICBC and CCB are trading at 0.5x and 0.6x respectively as at 06/10/2021), in stark contrast to the multiple Ant Group would likely have achieved.

Another motivation for the clampdown on big tech could be for more centralised Party control. The government does not want to lose control over economically sensitive areas such as payments, giving individuals the power to potentially counter China's system of capital controls. Parallels can also be seen with cryptocurrency regulation; the PBOC and other agencies have banned all crypto trading and mining, causing exchanges to cut off local users. According to the Financial Times, China accounted for 90% of the world's cryptocurrency trading, and so this is a dramatic move which threatens to quash a promising new technology".

Separately to the Ant Group listing, there have also been number of fines newly enforced on the likes of Tencent, Alibaba and Meituan for anti-competitive practices. Alibaba's $2.8bn fine has been the most notable, levied for imposing exclusivity requirements on merchants using their platform, and perhaps not helped by critical comments directed at regulators from Alibaba founder Jack Ma during a now infamous speech in October last year. Admittedly China is not the only country looking to curtail the monopolistic practices of big tech, but unlike the US, technology companies in China lack the same ability to influence and challenge policy as it is being formulated, adding to the opacity of the process. There are clearly limits to the amount of influence the CCP will cede to private enterprise, and that problem is now more acute given the huge scale at which the tech giants now operate.

Economic/Market Impact

Looking at the market impact of these developments, year to date we have seen the onshore CSI 300 index fall just 3.8% in USD terms to the end of September, despite all the above. While that is well below the MSCI World index which is up 13.5% over the same period, it comes off the back of a very strong 2020 for local Chinese markets.

Looking at the offshore market however there has been more weakness, with the MSCI China index down 16.6% this year in dollar terms to the end of September. This index has large weights in the big tech companies most exposed to the change in the regulatory environment. The three largest members (Tencent, Meituan and Alibaba) were worth a combined $2trn at their peak in February, but have since lost over $800bn in value to be worth $1.2trn as at 07/10/21. If we also look at ride-sharing company Didi which completed its IPO in June and has also been affected by the clampdown, its value has more than halved from $79bn to $36bn since listing. These large numbers dwarf the immediate impact of the fines and profitability lost due to the new regulatory measures, but they indicate expectations of future growth that might be lost, either to new competition or a greater regulatory burden.

Another interesting aspect about the discrepancy between onshore and offshore performance this year is around governance. Foreign investors access China via VIE (variable interest entity) structures which don't actually grant them an ownership stake in the underlying company, and have fuzzy legal status. This means that foreign owners have no legal recourse to the underlying assets, and has long been a source of concern for investors. Part of the new regulations in the education sector prohibited companies from raising capital through VIEs, casting renewed doubt on the future of these structures more generally. While we don't expect China to cause needless economic self-harm by outright banning these structures across the board, it creates problems for companies looking to raise external capital. Part of the reasons for the exceptional growth of the big tech companies has been their ability to accesses international capital (e.g. through the US ADR market). If this option is weakened, it may have a negative impact on growth in the private sector.

In terms of the macroeconomic impact, the situation in the property sector has the potential to impact GDP growth materially in China. Real estate is around 13% of GDP, and real estate loans make up around 28% of bank assets6. The industry was constructing 15 million new homes per year, however with the looming failure of Evergrande and others, we could see the sector start to contract. This would likely have an impact on the wider construction supply chain, something that has been a source of decades-long growth as China has opened up and moved its populations into urban areas. The CCP generally has been shifting the focus away from the level of GDP growth, and towards the quality of growth, with additional emphasis on environmental goals such as committing to carbon neutrality by 2060. a Several aspects point to a slower growth trajectory going forward, however that is well within expectations of most economists as China enters the next stage of its economic development.

Exposure to China in portfolios

With all of this uncertainty, how should investors position themselves with regards to China? It is notable that even as expectations of GDP growth fall, there are plenty of exciting prospects in Chinese equities. While Xi Jinping is pursuing the CCP's policy goals with determination, that does not mean he does not value the contribution of private enterprise in general. Indeed, in many areas such as EVs, Al and semiconductors, the government are actively encouraging innovation through capital investment. Recent market weakness, while concerning, is not too unusual; the MSCI China index is volatile and goes through frequent large drawdowns, many of which usually turn out to be good buying opportunities. We think embracing a more active approach in terms of asset allocation and security selection to Chinese equity markets is a sensible option to capitalise on changes in the market, and the growth potential that still exists.

Elsewhere, China's fixed income and hybrid markets are also attractive. Throughout the recent turmoil, the renminbi has remained stable, currency reserves plentiful, yields have remained low and inflation has been contained. All of these aspects point to the local sovereign rates market as a potential area of interest, with yields 1.4% higher (30/09/21) than US treasuries despite much lower headline inflation. It is perhaps not surprising to see large flows into Chinese bonds in recent months, and it is an area we are looking at closely. We have also been invested in the convertible debt market for some time, as Chinese companies have been active issuers in this space and these instruments are a good way of capturing growth opportunities while limiting downside risk.

Conclusion

In summary, we believe the main issues to focus on in China are as follows. Firstly, while the process of policy formulation is somewhat opaque, it is not irrational and many of the issues China is tackling are also issues for Western democracies. Secondly, it is reasonable to expect recent developments to have some negative impact on growth, particularly the property sector, but a slowdown in China has been widely anticipated by economists and is nothing to fear, provided it is handled well. Thirdly, China i of increasing importance in the global economy, and an economic crash would certainly be bearish for risk assets generally. This is currently not our base case, and we are broadly optimistic on China's ability to avoid a hard landing. Finally, we see attractive opportunities across the capital structure, and while China is still a small part of global benchmarks, we expect that to increase over time as the economy continues to open up.