From the perspective of equity investors in China, 2021 will go down as a year to forget. The period was marked by a number of high profile regulatory interventions, and the related announcement of the Government’s so-called ‘Common Prosperity Agenda’ was interpreted by some as an assault on private capital. Sentiment towards China was further dampened by the slow burning crisis surrounding Evergrande and the broader Chinese real estate sector. Those who had hoped for a softening in the US stance on China following the end of the Trump administration were disappointed, with tensions between the US and China – fueled by Xinjiang and Taiwan – escalating.
We have four key reflections as we look back at the past year, and look ahead to the next decade.
Towards the rule of law
One of the most important but least understood aspect of the Common Prosperity Agenda is that this is a series of initiatives intended to move China away from its traditional model of personal relationship-driven regulation, towards one where the economy is governed by legal certainty.
China’s leadership believe that moving towards a rule-of-law-based society will be necessary if the country is to break through the ‘middle income trap’, a phenomenon which imposes a ceiling on the development of many emerging markets. Clarity in regulation can be a good thing as it provides greater certainty for market participants, in contrast to the prior state of operating in various legal ‘grey areas’.
Naturally, this shift will require a curtailment in the power nexus that has developed over the past few decades between plutocrats and high ranking officials. However, for businesses which do not rely on such relationships for competitive advantage, and which exist by virtue of adding real value to their customers and other stakeholders, we think that this change will be a net benefit.
The Common Prosperity Agenda is good for long term investors
Pursuing this theme further, we think that the objectives of the Common Prosperity Agenda – specifically the creation of a wealthier middle class – are well aligned with those of long term investors in the China development story. The government’s aggressive interventions last year may reflect a more deep-seated anxiety amongst the senior levels of the Chinese Communist Party (CCP) that since the great economic liberalisations of the 1990s China has become a far more unequal society. The CCP leadership may well reason that as growth slows for the overall economy (something which is highly likely given the renewed focus on asset quality) the only way to bolster their legitimacy is through some redistribution of the immense wealth that has been generated over the past few decades. In other words, the objective is high quality, inclusive growth, as opposed to the single-minded focus on quantum of growth which has been the bedrock of official incentivisation and promotion prospects in China for many years now.
The objective of the Common Prosperity Agenda dovetail with another key plank of government strategy: “dual circulation”. This is a response to geopolitical uncertainty and the ongoing initiative amongst many developed countries to repatriate supply chains, a reminder to China’s leadership that it cannot be too dependent upon external demand. Dual circulation essentially means retaining Chinese competitiveness in exports, whilst simultaneously re-directing the country’s massive industrial output to serve domestic demand. These things can only be achieved if China both elevates its middle class but also retains innovation and entrepreneurial vigour. Therefore, the CCP cannot achieve the core objectives of the Common Prosperity Agenda and Dual Circulation if it pushes too hard against some of the world-beating companies at the vanguard of innovation that have grown up in the past few decades. For these reasons, we do not see recent developments as being an assault on private capital, but rather would view the objective of a domestically-focussed, tech-enabled, consumer-driven economy in a more positive light.
The substance of China’s new regulations is rational
There were five major regulatory interventions undertaken by China in the period since late 2020. Although the cadence of these announcements came as a shock to many Western investors (addressed in point 4 below) the actual substance of these initiatives was, we believe, rational. We explain this below in reference to each of the interventions:
a. Ant Group. The cancellation of the Ant Group mega-IPO and subsequent regulatory investigation at first glance looked shocking. However, taking a step back, it is worth remembering that the Ant Group was becoming a systemically important part of China’s credit infrastructure, but was not shouldering a commensurate share of credit risk. The basic thrust of the government intervention here is that Ant should take a greater share of credit risk on its own balance sheet, as opposed to its prior model of being an asset light intermediary. From our perspective, this is sound macro-prudential oversight in response to a potentially destabilizing technological change. China cannot achieve higher quality growth unless it addresses the long-festering and serious issue of asset quality.
b. After school tuition. The effective cancellation of profit in China’s huge after school education sector was another huge shock for foreign investors. The business model essentially is that of using the anxiety of Chinese parent’s to pay expensive fees for evening ‘cram schools’ in order to prepare for the gaokao, China’s infamous ‘all or nothing’ university admission exam. This had two pernicious effects. First, it led to inequalities in access to education, with those unable to afford after school tuition being at a disadvantage. Second, it is thought that the anxiety and cost associated with this situation was reducing the willingness of Chinese parents to have children. Given that the Chinese government is highly concerned about inequality, and possibly even more concerned about the country’s weak demographics, is it any wonder that they intervened?
c. Platform anti-monopoly. An overarching theme of the Common Prosperity agenda is that large enterprises should not abuse the privileges of scale. Alibaba, as by far the biggest ecommerce platform in China, was arguably doing this through the so-called ‘choose one of two’ practice, whereby it is said to have coerced merchants into exclusively selling through its platform alone (the punishment for a merchant’s non-compliance was apparently relegation of their listing to the bottom of search results). If Amazon was found to be doing a similar thing in the US, it would be hard to imagine the authorities there not taking a similarly stern view to their Chinese counterparts, who have made it clear to Alibaba that such practice is unacceptable.
d. Gig economy. Regulation of the so-called gig economy has been implemented in many Western countries. The gig economy in China is on an entirely different scale, with some seven million people working for the food delivery sector alone. The regulator has demanded that these workers are granted insurance by their employers, as well as tightening up on certain health & safety requirements. As with similar Western interventions, none of this is controversial.
e. Data security in ride hailing. Following the IPO of Didi, the government halted downloads of the ride hailing app, and later ordered the company to delist. Whilst this looks harsh, it is worth remembering that Didi has access to some of the most sensitive data in China, including information on the movements of public officials. The fear in Beijing was that US government agencies could request access to these data if Didi was listed in New York, and indeed the Chinese authorities warned Didi not to proceed with the listing until these issues were resolved. As the saying goes “don’t say we didn’t warn you”!
Interventions have moved at ‘China speed’
As argued above, we do not believe that the substance of the government’s interventions over the past year was unreasonable. We think that a big part of the unease amongst foreign investors is down to the fact that these measures were announced in such quick succession, a sort of regulatory ‘shock and awe’ campaign. There are various theories relating to the idea that Xi Jinping wanted to get these measures out of the way in the run-up to his ‘re-election’ in October 2022. We think that the broader issue here is simply that when problems are identified and / or when objectives are set, the Chinese system moves fast and moves decisively.
China is (and arguably has been for most of its recorded history) an authoritarian bureaucracy founded on the tenets of Confucian paternalism. This means that the State will intervene decisively when and where it deems necessary, without having to seek input from competing interest groups in society at large. Indeed, the State believes that it alone has the right and the ability to mediate these conflicts. There are disadvantages associated with such a form of government that do not need to be recounted here. However, one of the clear advantages is the ability to move fast, and this is one of the key explanations as to how China has raised itself from poverty (back in 1980, China’s GDP per capita was the same as that of Ghana) to an economic superpower. As investors, we must remember that progress at ‘China speed’ is one of the reasons for investing in this country – even if it can be at times disconcerting.
Conclusions
As argued above, we believe that the Common Prosperity Agenda is aligned with objectives that present an opportunity for long term investors, namely the promotion of a domestically-focused, innovative economy based on high quality, inclusive growth.
We would further argue that China is simply too big and too important to be ignored by investors. The country is best viewed as a continent in its own right, and is home to the deepest capital markets in the emerging world. The high level of economic complexity, innovation, and dense networks of human capital taken together mean that the bottom-up opportunity set for equity investors is extremely rich.
We therefore believe that China is ‘worth the effort’ for long term minded investors with the capacity to deal with bouts of volatility such as what we saw in 2021.
However, in order to invest successfully, we believe that attention is best focused on ‘masters of their own destiny’ business models which have a clear purpose of creating shared value for multiple stakeholders. Such enterprises are aligned with the objectives of the government, and yet are not reliant on the favour of the State. We think that this is the most repeatable and sustainable process for investing in a China that is building for the long term.
