China is in the midst of a tightening regulatory cycle, implementing anti-monopoly, data security and industry-specific regulations. Increased regulatory scrutiny, especially the new policy governing the After School Tutoring (AST) industry announced on July 24, has elevated market volatility and investor fears of policy risks in China.
The underlying thread that ties the intense regulatory activities across many industries lies in Beijing’s determination to develop China into a “modernized socialist economy,” including objectives of common prosperity, green development and independence in key technologies/industries. Geopolitics also plays a key role. It is critical to evaluate the alignment of companies with China’s long-term strategic goals.
Regulatory cycles are not uncommon in China—policy and regulatory scrutiny should be seen as ongoing risks when it comes to investing in China, to be carefully monitored and integrated in company research and portfolio management.
Given the role of innovation as a driver of productivity and gross domestic product (GDP) growth, we don’t believe government regulatory efforts aim to curtail digital sector growth as a whole. Rather, similar to many regulators globally, key objectives include curtailing monopolistic behavior, enhancing data privacy/security and improved outcomes for a broader range of stakeholders. More recent efforts by the securities regulator to ease market concerns offer evidence of this, and the takeaway was that recent actions were targeted and intended to be limited in scope.
Regulatory Actions by Industry
In the broader internet sector, we have seen extensive anti-monopoly actions, driven by concerns regarding the rapid growth of large internet platforms with strong bargaining power versus their stakeholders. This had resulted in rent-seeking behavior such as burning excessive cash in sales and marketing to gain market share and exploiting the scale benefits and information asymmetry between the platform and customers.
In the fintech sector, regulatory scrutiny on the consumer finance co-lending model (that resulted in the suspension of the ANT initial public offering) was driven by government concerns about the rapid growth of consumer leverage, as well as limited oversight into online facilitated lending. In the previous regulatory cycle, the government also cracked down on peer-to-peer (P2P) loans for similar reasons.
With rail-hailing app Didi, Beijing’s concerns have centered on national security due to the company’s vast amount of consumer data, and fears this may be accessible through audits to the US government.
There have been new regulatory developments that have caught investors’ attention in recent days.
In the education sector, on July 24, a new policy governing the After School Tutoring (AST) industry was released. The purpose of this policy is to reduce the educational burden on children and parents, in the context of government concerns regarding the country’s slowing birth rate. The policy stipulated:
- AST companies will be limited by licensing and operating hours restrictions, requiring them to scale down their subject-based tutoring programs and pivot from traditional subjects toward enrichment topic, and from tutoring towards content or pre-recording.
- AST companies must be “not-for-profit” entities, in which case all profits and cashflows must be reinvested into the business and sponsors (shareholders) cannot lay claim to profits.
- Foreign investors can no longer invest in AST via Variable Interest Entity (VIE), which will likely result in company de-listings. The VIE structure ban in the AST industry has driven investor fear of similar future actions in other sectors. However, this was in large part due to AST companies being classified as not-for-profit organizations, hence preventing them from raising funds through the VIE structure.
China’s securities regulator hosted a virtual meeting on July 28 to ease market concerns following the announcement of the new policy governing the AST industry. The key takeaway from the call was the education policies were targeted and not intended to hurt companies in other industries.
We disseminated a more detailed update on the AST industry, which can be accessed here.
In the music sector, on July 24, the regulator issued its final ruling on Tencent Music Corporation, addressing the issue of unfair market competition in a highly concentrated market. The key rulings included: 1) all exclusive licensing agreement must end within 30 days, 2) new song exclusive release window should be shorter than 30 days and 3) independent artists exclusive contracts should last shorter than three years.
In the food delivery sector, on July 26, guidelines were issued on protecting food delivery riders’ rights and interests. The guidelines cover the 1) evaluation of rider performance, 2) lowering labor intensity and loosening the delivery time of each order and 3) social security coverage for riders.
Why Regulatory Scrutiny Has Increased
The underlying thread that ties the current intense regulatory activities across many industries lies in the government’s determination to develop China into a “modernized socialist economy” and achieve the “great revival of the Chinese nation.” In particular, three developmental features seem to be key:
- Common prosperity
- Green development
- Independence in key technologies/industries
Past and future regulatory actions need to be interpreted through these lenses. Furthermore, the role of private capital will be under greater scrutiny in order to ensure “orderly expansion” and to prevent risks to the economy.
Escalating geopolitical tension is an additional factor in the current regulatory cycle. Sensitivity around data is becoming an important geopolitical issue. This is particularly relevant to the internet sector given the prevalence of American Depositary Receipt (ADR) listings of companies that possess a significant amount of data. Chinese ADRs will be required to allow US regulators to audit their financials otherwise risk eventual delisting, raising Chinese government concerns that sensitive data could be shared with the US government. This accordingly favors domestic internet plays with local China listings (including Hong Kong).
Regulatory cycles are not uncommon in China. For example, in 2018, internet, AST and fintech (specifically peer-to-peer lending) industries also faced regulatory headwinds.
In the internet sector, the regulatory body stopped approving games in March 2018 as it underwent a major reshuffle of the approval process on fears that video games were causing addiction and impacting the productivity of the country’s youth, and concerns over inappropriate content. After a nine-month time out, license approvals resumed with 80 video game titles in the first batch, though some games had to go through modifications before release.
While regulatory changes raised investor concerns on sector headwinds and therefore heightened share price volatility in names operating in affected industries, well-managed companies were able to adapt and subsequently thrive.
The regulatory approach is becoming more “principle-based” rather than “rule-based,” as rules can be modified/compromised to accommodate long-term strategic goals. The result is higher political risks than previously expected, though it will take more time to fully understand the implications. Investors need to be confident that companies’ primary business activities are aligned with the government’s long term strategic goals, while minimizing exposures detrimental to broader stakeholders.
The principles relevant to recent regulatory actions would include “common prosperity” and “independence of key technologies.” Specifically:
- Internet giants cannot restrict the development of millions of businesses/workers utilizing their platforms by imposing unduly onerous rules (e.g., exclusivity).
- Workers/riders/drivers in flexible employment cannot be excluded from existing social welfare systems.
- User/transaction data management cannot lead to potential security risks, as perceived by Beijing.
- Private businesses cannot place undue burdens on broader society (such as the costs to parents and pressures on children of AST).
In some respects, this is analogous to the increased attention to environmental, social and governance (ESG) and stakeholder capitalism that we are seeing politicians, companies and investors embrace globally. This can cause friction and share price volatility—the ongoing debates over whether, for example, Uber drivers are employees entitled to benefits is just one of many such examples.
Given the role of innovation as a driver of productivity and GDP growth, we don’t believe government regulatory efforts aim to curtail digital sector growth as a whole. Rather, similar to many regulators globally, key objectives include:
- Curtailing monopolistic behavior
- Data privacy/security
- Improved outcomes for a broader range of stakeholders, including employees, consumers and society in general
From a bottom-up perspective, this will have an operational impact, implying higher costs (including employee welfare, management of personal data, increased competition, etc.). We expect short-term earnings to come under pressure and risk premia to rise, reducing valuations. However, this is balanced by recent severe share-price corrections and the continued long-term growth runway for these businesses.
Our Investment Thesis for the Broader Digital Economy
The internet sector contributes positively to strategic goals by improving digitalization, efficiency and independence of key technologies. We view the investment thesis as remaining largely intact:
- These companies create value by offering higher efficiency or better user experiences, while aligned to the principles discussed above.
- Headwinds facing internet companies are largely operational, not existential, as they imply changes in cost structure and business practices, not challenges to the business model.
- There is no obvious alternative to the existing digital economy, which generates substantial value in support of “common prosperity.”
- Beijing is incentivized to encourage the digital sector, as this enables greater management/control of society and the economy (e.g., digital payments/social networks/enterprise infrastructure).
After this period of intense regulatory action, we expect the sector to resume its growth albeit at a slower pace than before, as the problems Beijing perceives are rectified.
Ultimately, Chinese internet companies contribute to a significant proportion of economic growth and employment and play a pivotal role in the government’s technological goals. We believe China’s government remains committed to fostering innovation, despite the regulatory crackdown. We focus on bottom-up stock selection to ensure we hold companies that can sustain their earnings power through regulatory cycles.
As in the past, we can expect to see future cycles of government intervention to ensure a level playing field for all segments of society. While the short-term volatility is painful for investors, these cycles have historically not unduly impeded the long-term structural growth of the digital or indeed broader economy.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
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