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Update on China August 2021


‘In China the Party’s just like God- he’s everywhere you just can’t see him.’ Richard McGregor former Beijing correspondent of the FT and author of ‘The Party’.

The overriding factor driving policy of the CCP is to maintain unchallenged control of the country. This has always meant avoiding policies which could potentially create social unrest and therefore weaken the popularity of the Party. In the post crisis period China has delivered real wage growth to the bulk of its workforce, especially in the ‘blue collar’ sector each calendar year. When thinking about changes in policy, investors should always first ask how this will impact on the Party’s hold on power, and therefore the recent regulatory scrutiny is not a bottom up issue. Investing in China has always required the ability for a fund manager to avoid holding any business which is on the wrong side of Party policy. This has been re-emphasised over recent weeks (Didi and the education sector, together with some technology names), although became apparent with the cancellation of the planned IPO of Alibaba’s financial subsidiary and ANT last year at very late notice.

The Chinese government have become more socialist and interventionist in recent years. It is focused on consumer rights, employees’ rights, whether parents have too high burdens, whether students have too high burdens, whether kids are playing too many (internet) games, whether property prices are too high, whether pharmaceutical drugs (especially generics) are too expensive, and whether banks are making too much money. This is a risk the market awoke too rather belatedly. Xi is a populist politician and this is now being seen.

The confirmed education regulation has caused huge uncertainties for the sector, with analysts extrapolating to think about whether cash could be repatriated from China (US listed VIE structures) and whether these companies will be de-listed. Analysts are also adjusting down net cash to adjust for tuition prepayments and lease liabilities. The surprise regulation on education (a not-for-profit sector isn’t going to generate great earnings!) has also raised investor’s concern about regulatory risks in China and what could be the next sector hit resulting in a rise in the risk premium for Chinese stocks. Concerns are for internet companies which had already seen more regulation, including on the US listed subsidiary of Tencent-Tencent Music and before this generic drug makers through price controls with a similar comment applying to medical device manufacturers. The government in China has been cutting drug prices aggressively through its Group Purchasing Organisation.

The regulatory environment in China has turned less stable and China has been increasingly becoming more socialist under President Xi with stronger State control. The government under Xi is very different from that in the post-Deng period when there was a collective approach amongst the Politburo Standing Committee (PBSC) with a consensus on economic and social policy sought. This was continuously demonstrated under President Hu and Premier Wen, in the administration which handed power over to Xi. There is no doubt risk in Chinese stocks has grown under Xi who would appear to view himself as appointed for life, rather than serving what had become the norm of two terms as President, and more importantly Party General Secretary and leader of the military. Questions have now been raised about the US listed VIE structures as the government has the potential to use the legal loop holes in these to their advantage at any time.

President Xi and the Party have been focused on the “Three Mountains” that make life difficult for people. These are: costs of property, healthcare, and education. Xi has commented that property is for living in, not investing in, and around three months ago made comments about the excessive cost of education. The Chinese Census results were delayed and showed a population either down or only seeing a small increase in size and the Party is very concerned about a shrinking population and so have moved to a 3-Child Policy. Unfortunately, the cost of education has counted against couples having larger families. Many couples believe they also have elderly parents and possibly grandparents to look after and the cost of education was going up and up which is why Xi had warned earlier this year something was coming on this front. In Healthcare the government policy has forced generic drug prices down year by year. China has also been concerned about data security and it appears that Didi was told not to list in the US as this would have resulted in the United States being supplied with data on the Chinese population detailing things such as what hours were worked and wages. In China the tightening of anti-trust and anti-competitive regulations will continue as there are concerns the big internet companies now have too much power. There are now around nine government agencies in China looking at what has been going wrong. The authorities are also putting in place protections for gig economy workers.

It can be argued the regulatory cycle was not unexpected or unannounced having been clearly flagged last October/November when the ANT IPO was pulled at the last minute. The education sector was one where rising costs were leading to even greater levels of inequality in the country. Successful investment in China needs to be focused on companies which solve China’s issues and problems rather than compounding them. Avoiding social unrest is at the core of policy decisions in China. Looking at broad sectors AI companies advancing medical technology domestic semi-conductor stocks and companies focused on green energy/lower emissions themes will all have favourable tailwinds and likely support from the government.

At this stage, the internet giants Tencent and Alibaba have both seen significant price corrections and have in effect become consumer companies, so growth rates will be slower than delivered previously, although still strong compared to the market average. An example of the type of issue fund managers need to watch involves Meituan where there have been concerns about the effect of community group buying schemes on Mom & Pop stores which has not pleased the government as it could adversely affect social stability. Both software and healthcare alike remain favoured areas in China on the right side of policy change. China’s software as a service sector is at an early growth stage compared to the developed world and should benefit from not only homegrown talent but a returning talent pool from overseas. The shift to cloud has helped companies and there are technological innovations in areas like AI making software more efficacious. Software as a service is very under developed compared to the States. Technology orientated companies in China are likely to also benefit from the trend towards localisation.

In summary, China can still provide strong returns for investors as long as the companies held are beneficiaries of Chinese policy goals and not operating in areas with policy headwinds. Sectors important to the country such as national security over its supply chain and ensuring China is not vulnerable to any escalation in trade war tensions should see tailwinds. Many would argue the changes being see in China by the authorities are good for society over the longer term. It is in the interests of the CCP to grow the economy and employment, along with real disposable incomes and there remains a high reliance on the private sector to achieve this as state owned businesses are now relatively small employers compared to history. Over the long-term, China will remain a strong consumption story as highlighted by the Dual Circulation Strategy. Thus, China can remain a rewarding option over the medium term for investors, with successful fund managers in the region focused on companies benefitting from Party policy as well as bottom-up fundamental analysis.



G O’Neill 18.08.21