Bear in A China Shop
A Brief History – China’s Economic Transformation
Before assessing the implications of recent regulations imposed by the CCP (China Communist Party), it may be helpful to examine China’s economic transformation over the last several decades.
Beginning in 1979, under the leadership of Deng Xiaoping, China started to adopt free-market principles, relying less on production from state-owned enterprises (SOEs) and ultimately veering away from the strict maintenance of a centrally planned or state-controlled economy. From 1979 to 2018, China’s annual real GDP averaged roughly 9.5%, translating into the Chinese economy doubling about every eight years. The speed of China’s economic transition from an agrarian society to an industrial powerhouse is arguably one of the greatest achievements in modern history.
In the eyes of the current leadership in China, the problem is that China’s economic gains have not been evenly distributed. In fact, according to the Credit Suisse Research Institute, 31% of the country’s wealth is owned by the top 1%, compared to just 21% in 2000.
China’s Recent Regulatory Surge – “Common Prosperity” Takes Center Stage
Recent Chinese government actions have been geared towards wealth redistribution, narrowing the income gap within the mainland, and more broadly providing social benefits to all members of the population. The term “common prosperity” has received much attention in the investment world as investors digest and speculate what it means and how it will be applied.
Crackdowns and regulatory actions have been front and center over the past year as the Chinese government looks to assert more influence, particularly within companies intertwined with national interests, such as cybersecurity and big data.
Ant Group, The beginning of the government’s forceful actions came last November when Chinese regulators stepped in and suspended the IPO of Ant Group, China’s largest digital payment platform company. This occurred just days before the company was expected to raise a record $37 billion in its stock market debut. Instead, the company was issued a fine of nearly $3 billion for abusing its market dominance.
Tencent Holdings Ltd, one of the largest companies in the world, is also no stranger to large fines. Recent areas under scrutiny have been the company’s WeChat messaging service, and the company’s gaming business. In August, regulations limited the amount of video gaming hours for individuals under the age of eighteen. Interestingly, both companies have set aside $15.5 billion to target towards social and “common prosperity” related projects.
For-Profit Education The $100 billion for-profit education industry was turned upside down when regulators shifted their attention to limiting the industry’s profitability. The government’s goal of making education more affordable has had obvious implications for the industry, and companies such as New Oriental Education, TAL Education Group, and GSX Techedu have seen their market values drop precipitously.
Didi Chuxing, a leading ride-hailing app, found itself in the crosshairs when the company was restricted from signing on new customers. Regulators expressed concerns over data security issues just days after the company debuted its initial IPO this past June.
Government Support, but at a Cost:
As reported by Bloomberg1 in June of 2021, Xi Jinping appointed one of his top lieutenants to “Lead China’s Chip (semiconductor) Battle Against United States.” Chinese domestic innovation policies do not stop at the semiconductor industry, with telecommunications, energy, banking, automobile manufacturers, and many others receiving similar treatment.
However, increased capital investment by the state has another side, which is less conducive to growth and innovation. The rise of State-Owned Enterprises (SOEs) with significant government intervention will likely impede Economic Freedom, a metric compiled by the Heritage Foundation based on four categories: Rule of Law, Government Size, Regulatory Efficiency, and Open Markets. The 2021 Freedom Index found that the standard of living is much higher in economically freer countries with “free” or “mostly free” nations generating incomes more than twice the level of other countries and six times higher in “repressed” countries. If China continues to infringe on economic freedom, we believe that advances in the standard of living, innovation, and productivity may start to slow. Such developments may also prove to be a significant headwind to domestic companies and a deterrent to foreign investors.
Impact on Foreign Investors – Restricting Access and Capital Flows:
Many of China’s largest companies have been able to list on outside stock exchanges through a Variable Interest Entity (VIE) structure. A VIE is a work-around used for the last twenty years to bypass foreign investment regulations in China. With a VIE, a Chinese company will establish an offshore shell company for the purpose of overseas listing that enables foreign investors to purchase shares. The offshore company establishes contracts with the Chinese company to obtain an economic interest in the business. This structure was designed for industries where China will only grant an operating license to Chinese-based firms such as media, technology, and education.2
Recently, media reports indicate the door may be starting to close on the VIE structure as the Chinese government looks to increase regulations for foreign listings. The U.S. Securities and Exchange Commission (SEC) also acknowledges the risks associated with VIEs. In a report issued in November 2020, the SEC warns “China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures”.3 An example of the VIE structure is Alibaba, which set up a Cayman Island-based shell company, ‘Alibaba Group Holding,’ to go public in the United States.4 We believe that there will be a definitive ruling on this structure in the coming years, but the immediate effect it will have on businesses is more ambiguous. For now, it adds an additional layer of uncertainty for investors who have, or hope to get, exposure to Chinese equities via this structure.
Implications for U.S.-Based Companies Doing Business in China
Many U.S.-based companies have been beneficiaries of China’s rise over the past two decades. Few companies exemplify this phenomenon more than Nike. The company’s Greater China sales have increased at a compound annual growth rate (CAGR) of 14.9% between 2010 and 2021. This far exceeds the 7.8% CAGR achieved by the rest-of-world (ex-China) Nike sales. Nike’s exposure to China as a percentage of sales has doubled over this period, with China sales now representing nearly 20% of overall Nike brand sales.
Like Chinese-based companies operating in China, U.S. firms are now facing much greater uncertainty. Although not entirely new, China’s overlap of business and politics, technology transfers, government subsidies, and IP theft have bubbled up to the surface in recent years. These issues have now been exacerbated by China’s public proclamation of a more protectionist posture, one that makes internal production and consumption a priority. Over time, growth rates are likely to trend lower as the “home team” is favored, and the operating environment will become more uncertain for U.S. corporations.
The China and Taiwan relationship further complicates issues for U.S. technology companies, as well as the shipment of goods from the region. During a speech at the 100th anniversary of the CCP, Xi Jinping said China has an “unshakeable commitment” to reunification with Taiwan. The contentious relationship between China and Taiwan presents major risks for U.S. semiconductors, as some of the world’s largest foundries are in Taiwan. Technology companies doing business in China face increasing roadblocks to future growth with rising technology export limitations from U.S. regulations and greater internal R&D spending by the Chinese government to shore up its own country’s capabilities. Within the S&P 500 Index, the technology space, specifically semiconductors and semiconductor equipment, faces the greatest risk as they have the greatest Chinese exposure. Additionally, a China-Taiwan conflict would impact cargo shipments that pass through the surrounding waters – a potentially wide-reaching challenge for global supply chains.5
According to an annual survey conducted by the US-China Business Council, changes within China have already been impacting U.S. company operations. The chart below shows the increased negative impact on U.S. companies since 2019, with the most recent responses citing Chinese consumers are shifting away from American branded products, and U.S. companies are facing stiffer competition from Chinese companies. Much of this shift away from American companies is attributed to a host of government protectionism that includes negative media coverage as well as government pressure on non-government entities to “Buy Chinese.” 6 The focus on internal development was taken further in the “Made in China 2025 Notice” report, which set specific market share targets for advanced industries. For example, it called for Chinese-developed new energy vehicles to achieve an 80% domestic market share by 2025. The potential shift from U.S. product brands to local Chinese brands could be very impactful to large U.S. multinationals that have relied on China for growth in years past.
Hindsight is 20/20 – China Never Planned to “Fully Westernize”
On the surface, it appears that Chinese authorities are looking to take the country along a different economic and cultural path by reigning in decades of progress towards Western-style capitalism. We think the reality is that Western-style capitalism was never the goal, and it was a mistake by many in the West (including us) to believe that was ever the intention.
China was smart – leveraged Western technology to accelerate economic areas critical to national interests but stopped well short of free markets. For example, according to the Section 301 report conducted by the Office of the U.S. Trade Representative (USTR) in March 2018, the Chinese government sought to develop advanced internal technologies and eventually displace imports of technologies through a concept called “IDAR”, or Introducing, Digesting, Absorbing, and Re-innovating, foreign intellectual property, and technology. The concept was to be a combined effort by Chinese Industry and the government to acquire foreign technology, analyze it through government-funded research centers, and eventually “re-innovate” or improve on the foreign technology to develop domestic products that could compete internationally.7 The USTR report highlights that company stakeholders in several industries fear that once China has achieved self-sufficiency in an industry and reduces the technology gap, it will increase investment restrictions on foreign firms. We are now seeing clear evidence that China’s economy will remain centrally controlled. Policies such as levying large fees or requiring that the state has at least a tertiary equity position are being used to ensure compliance with government policies.
Investment Implications and Bryn Mawr Trust’s Approach
How has the risk profile changed for investors thinking about allocations to China? Is China now “un-investable” given the unpredictability of its business regulations?
In the near term:
Investors are shooting first and asking questions later. Thus far, technology stocks have been the biggest target, although we doubt government action will be isolated to the tech sector. The MSCI Chinese Tech Index is down nearly 50% through October 20, since hitting an all-time high on February 16. For this reason alone, immediately pulling the plug on China may not be good timing. As seen in the chart below, Chinese internet stocks (nearly 40% of China’s equity market) are stabilizing around historical price support. At current price levels, we believe materially more downside is unlikely as investors come to terms with the new reality in China.
In the long term:
We believe the risk profile for investors has changed when thinking about investing in China. The uncertainty created by the issues outlined throughout this piece will lead to investors putting a lower valuation multiple on Chinese equities moving forward. Interestingly, even after the recent 25% sell-off in the overall Chinese stock market, the valuation isn’t especially cheap on an absolute basis.
At the same time, we do not believe the Chinese market is completely un-investable. China continues to be a large, rapidly growing, economy. Companies, both U.S. and China-based, will find ways to capitalize on that growth going forward. For that reason, excluding China from portfolios seems short-sighted. For example, China has world-class shipping ports compared to other emerging markets that lack sufficient infrastructure. Also, China may be corrupt, ranking number 78 on the Transparency International Corruption Perceptions Index. However, many other countries fare even worse, with India ranked 86th, Brazil 94th, Vietnam 104th, and Mexico 124th. As a result of the sheer size of the Chinese market, we still expect U.S. firms to continue to invest in China, just at a slower pace. Similarly, U.S.-Chinese relations will likely continue to splinter, but a full decoupling seems less plausible given the interdependency of the two economies.
Our approach going forward must acknowledge the possibility that China will still prove to be fertile ground for investors while also taking steps to reduce our exposure to the most obvious risks. We also believe that maintaining exposure to other emerging market economies makes sense within the context of a diversified portfolio.
Adjustments being considered within Bryn Mawr Trust’s emerging market allocation:
- Our exposure to China is already below the benchmark. Consider reducing that further, given the more challenging environment cited above.
- Favor active managers with an even higher tracking error than the benchmark. Given China’s concentration within emerging markets, which is approximately 49% (as of 9/30/21) when the exposures in China and Taiwan are aggregated, we want to look very different than the market- cap-weighted index.
- Potentially reduce the market cap of our China exposure to reduce the likelihood of the companies we own being directly targeted by the Chinese government.
- Emphasize emerging market economies with higher potential GDP growth to benefit from those countries’ long-term, secular growth.
- Aside from monitoring direct exposure to Chinese stocks, we will also be cognizant of geographic revenue exposure across the strategies we oversee. As of September 30, 2021, the Bryn Mawr Trust Total Return Strategy had less exposure to corporate revenues sourced in China.