China recently implemented sudden, draconian regulations on private education companies, leaving investors reeling. This, coupled with some increased tech regulations for certain new chat app users and music licensing, has sparked a full-blooded sell‐off across China’s various equity markets. Since July 22, the MSCI China Index has fallen ‐8.18% and the Shanghai Shenzen 300 Index has fallen ‐7.62%.1
What regulatory changes have been announced?
In the education sector, the Chinese authorities effectively transformed the landscape in one fell swoop. They announced that companies providing after‐school tuition (AST) cannot make profits or accept foreign capital. They also imposed a blanket ban on all weekend and holiday tutoring. These policy changes went far beyond the worst-case scenarios that we and the market had anticipated for this $100 billion industry. Shares of Chinese AST providers have fallen sharply as a result.
What are Chinese authorities trying to achieve with these regulatory changes?
Behind these changes is more than just capriciousness. Chinese authorities are addressing strategic obstacles impeding China’s advance toward “common prosperity.” This ideal essentially represents a greater focus on the social welfare of average households, requires public and private enterprises to have greater social equality and responsibility. Common prosperity is a pillar of economic strategy that aims to establish a fairer Chinese economy focused on domestic consumption, digitization, modern industry and services, underpinned by a successful green transition.
For the most part, changes have been focused on new economy sectors. Indeed, China’s internet sector has been so successful and grown so rapidly the government has had to engage in various rounds of “catch-up” regulation. Regulatory change in previous cycles included the rollout of anti‐trust policies to stop forced e‐commerce exclusivity practices, limits on fintech to control their growth into a regulated sector, opening platforms to peers and raising requirements on wages and social security of delivery riders.
We saw elevated regulatory cycles in 2015-16, 2018-19. Starting in November 2020 and into 2021, we observed curbs on consumer lending and monopolistic practices, notably with the failed IPO of Ant Financial. In the second half of 2021 we are entering a new round of regulatory tightening.
Will this mark a turning point for a new, heavy-handed approach to policy?
The clamp down on education marks a departure from previous regulatory cycles. The sector faces a complete overhaul, far more than a requirement to re‐fine regulatory compliance. However, the severity of the intervention reflects the importance of the sector to China’s social fabric. Intensive schooling is a burden for students and parents alike, and the cost of private tutoring was becoming a barrier to social mobility and, therefore, common prosperity. The cost of education for a single child has also reduced the number of families having multiple children. Since the government is anxious to address demographic decline, this sector was doubly misaligned.
Investors need to reassess the level of China risk factored into valuations going forward. For investors who thought China risk was a thing of the past, this has provided a stark reminder that the hand of the government is both strong and visible in all aspects of the Chinese economy and society.
Which areas are most at risk of additional intervention?
Property and healthcare standout as sectors that may face increased regulation in the near future:
- Property: stabilizing property prices through tax changes, which may impact some developers
- Healthcare: reducing the prices for medicine, equipment and in the future, services, while encouraging innovation
Conversely, we see consumer sectors as more aligned to party strategy. While monopolistic behavior may come under scrutiny, the importance of domestic consumption should offer investors a degree of insulation. As ever, in all sectors, understanding company fundamentals will be crucial. So will staying up to date on government priorities and deploying that information wisely.
What is our outlook?
We remain constructive on the long-term prospects for Chinese equities. Despite these recent events, we believe that the private sector retains a critical role in ensuring that the Chinese economy continues to innovate and prosper and that China reaches its goal of being a moderately prosperous nation by 2035.
China still needs well-functioning capital markets to help propel growth. We think the outlook will continue to be bright for companies that can adapt to emerging regulatory frameworks and align with policy objectives such as:
- Digital innovation
- Green technology
- Access to affordable healthcare
- Improved livelihoods
Per China’s 14th five-year plan, innovation remains a key policy priority. Ensuring innovation is able to continue and thrive requires a balanced approach to regulation. We China to be able to strike expect a good balance between promoting innovation and achieving regulatory purpose.
More broadly, actions against sectors like technology carry some risks. If they go too far, they could damage business confidence. But if they fail to address anti-competitive practices, they could also hold back business innovation and dynamism.
While regulations may appear swiftly enforced or even heavy handed, they do need to be seen in context. China has moved swiftly up the innovation curve. But, as has been in the case in other countries, regulation has failed to keep pace. Our view is that Chinese regulators are effectively playing catch-up with the considerable innovation that has taken place in recent years in sectors like technology. Tighter regulation appears to be priced in near term.
We believe China remains pro-innovation. A broad, heavy-handed clampdown on private new economy sectors seems unlikely, given their role in underpinning China’s economic vision for a modern, productive, consumption-led economy.
In terms of navigating regulatory developments, environmental, social and governance (ESG) analysis is critical. At a high level, government policy objectives focus on areas like social, economic and financial stability, as well as national security. Within these broader policy goals, more granular objectives have emerged and have been expressed in the regulatory developments. These include access to:
- Low-cost healthcare
- A good livelihood
When researching companies, we view regulations that aim to protect client data and privacy, tackle monopolistic practices, lower costs of basic goods and ensure basic labor rights through an ESG lens. Companies that don’t understand or address these risks will have a weakened investment case, while those that do understand and address these risks will have a stronger one.
In the internet sector, we see good alignment between the government’s interests in digitizing the economy and bringing costs down for consumers. However, intervention in the education sector may be seen as a “line-in-the-sand” moment, increasing ESG risk for any sectors that fall foul of domestic consumer interests or policy.
Looking forward, we remain watchful of regulatory developments and the risks and opportunities that emerge. It’s clear that regulatory focus will continue in areas such as the internet, education, real estate and healthcare. This doesn’t necessarily mean that investors should avoid these sectors. It can pay to be selective and take advantage of mispricing opportunities. In our eyes, investors who have indiscriminately sold off the broader market and extrapolated potential effects unnecessarily could be missing an opportunity.
We have a preference for high-quality companies that have a strong link to consumption, particularly domestic consumption. This sector has a reasonable alignment with the strategic aims of Chinese authorities. As a consequence, it should be better positioned to withstand regulatory headwinds and may continue to prosper.
1 Bloomberg, July 27, 15:50 PM GMT
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