On July 26th, the New York Times reported on satellite photographs that purportedly showed the construction of 110 nuclear silos in Western China. For decades, China has embraced a policy of “minimum deterrence,” which was letting the world know that they had a nuclear capability that could adequately respond to any nuclear attack, but they resisted the temptation to join the nuclear arms race that dominated US/Soviet relations up until the time of the fall of the Berlin Wall. To a trained eye, the images are undoubtedly the first significant expansion in Chinese nuclear capability since Mao Zedong, and Beijing did little to hide the escalation. It appears they were keen to show the world their expanded arsenal, with each missile silo capable of carrying three to four nuclear warheads. This show of strength was worrying, but hardly garnered a mention in the financial media that were laser-focused manically covering technology regulation in China. Weapons of mass destruction were ignored while commentary about the end of capitalism in China frequented our inboxes. Unlike China’s aggressive military expansion, western investors appear to be massively overstating the risk of technology regulation in the Mainland.
Over the past week, I have spoken to dozens of investors about China’s regulatory clampdown. Their response to news ranging from the effective eradication of for-profit education companies to the debacle around Didi has been wide-ranging. While the collapse in market capitalization will scare many investors into borderline hysterical narratives, a calmer assessment of the regulatory framework should deliver a much more optimistic long-term conclusion than most currently have.
It will be challenging to own these companies in the near term. Share price volatility, the early stages of the cybersecurity reviews, and of course, the continued slide toward the inevitable delisting of China-listed shares from US exchanges will provide a level of uncertainty that implies that the more tactically minded cannot participate in the near term. That said, if my assessment of the rationale and scope of the regulatory clampdown is correct, we are on the verge of one of the most compelling investment narratives for the next three to five years.
The following is my rebuttal to a series of hyper-bearish narratives that have been put forward in both the media and the View from the Peak client base.
At the most basic level, I have engaged in several discussions about the stability of the Chinese Government. These have ranged from thoughtful and balance conversations with clients to belittling myself with angry text exchanges on social media. I have seen these debates flourish amongst China Perma-Bears such as Kyle Bass, who has implied that regulation against the technology sector is a sign of the inherent weakness of the Chinese Communist Party. Xi Jinping’s increasingly authoritarian actions towards Hong Kong and Xinjiang exposed his vulnerabilities, and the fragility of the one-party state is coming to the fore. This epitomizes western ignorance towards China.
The Chinese Communist Party has been responsible for many unconscionable acts, past, and present. Uyghur repression is abhorrent, and the western world must hold China to account. My beloved Hong Kong is losing all of its independence, and the notion of the democratic values that were protected in the Sino-British Joint Declaration have evaporated. The collapse of the EU-China Comprehensive Agreement on Investment is a definitive sign that the Chinese refuse to separate mutually beneficial investment from human rights. The West has always known what China is capable of and yet, for two decades, has turned a blind eye to the suppression of values and principles that the US and EU hold dear. For all the criticism of President Trump, his legacy must include attempting to hold China to account for its misdeeds.
However, the internal repression of minorities and industry regulation does not mean that the economic model is destined to fail.
The one mistake that the United States has made ever since Nixon’s first meeting with Chairman Mao was the belief that China could not achieve economic supremacy without political freedom for its citizens. Every US President has made this mistake, which has led to decades of underestimating China’s potential and set in place a framework at the World Trade Organization that China abused to the detriment of tens of millions of developed marker workers.I would argue that the administration of George W Bush, with its focus on spreading democracy to the globe, underestimated China to such an extent that it set the stage for China to come out of the 2008 global financial crisis as the world growth engine.
The United States spent four decades renouncing the involvement of the Government as a source of research, development, and infrastructure. It consistently focused on how much China was wasting rather than conceding that China was building the world’s grandest infrastructure. Successive US administration dismissed the Communist Party’s efforts to be a central part of economic development through a failed Soviet lens. The result is that China’s infrastructure is lightyears ahead of the United States, and frankly, it is China’s great strategic advantage.
What Washington and laissez-faire economists failed to appreciate is the unwritten contract between Beijing and its people. The alliance between the Party and its citizens is one of providing economic prosperity and security, but political freedoms are sacrificed. This equilibrium was forged through a combination of coercion, censorship, and indoctrination, but the reality is that it works. In the past four decades, China has taken 800 million people out of poverty, allowed small businesses to flourish in arguably the most competitive (aka capitalist) environment on the planet, and has provided property rights where there were none two generations ago. The Party has kept its side of the bargain by providing the sort of economic prosperity demanded by citizens who have given up their right to participate politically.
This alliance is evolving. Xi Jinping appreciates that the stability of the Party requires not just the continuation of economic prosperity but also tackling issues such as corruption, pollution, and now, online abuses by technology companies. Some of the biggest scandals in the past decade have not been driven out of a desire to exercise a voice but calling out the Party when they haven’t kept up their end of the deal regarding improving life. Mainland China has not seen a large-scale democracy protest since 1989, but public outrage of issues such as tainted milk, the Sichuan earthquake, corruption scandals involving Bo Xilai led to the Party taking steps to ensure its stability. The Party knows that its long-term survival revolves around making life better for its citizens. While we should not lose sight of the draconian actions that are omnipresent, it is telling that Mainland China could avoid democratic protests of note given moments such as the Arab spring or any fall out from the occupy/democracy movement in Hong Kong. While censorship plays a part, maybe the West has overestimated the importance of democracy to the average Chinese citizen.
I am not being dismissive of the abuses we are witnessing in Xinjiang. However, most Chinese residents have prioritized economic well-being over political choice.
You may not like the model, but it doesn’t mean it is going to fail.
Despite a lack of political choice for its citizens, the Party still takes public opinion seriously. The action against Ant Group, Tencent Gaming, and Meituan focused on consumer abuses, the same sort of regulation that western governments wished they could execute but, for a variety of reasons, cannot.These measures were broadly popular with Chinese citizens as they would be in Europe and the United States. The Chinese Communist Party may be all-powerful but executing on policy that the man on the street supports makes life much easier.
With the people on-side, the ability for the Party to implement regulation is straightforward. How jealous of this is EU President Ursula von der Leyen and President Joe Biden? Where it comes to consumer protection and anti-competitive behavior, the Party can quickly regulate where the political processes in the US and EU make this a lengthy and challenging undertaking.
Would anti-monopolistic claims against Google, Facebook, or Apple’s App store be greedy with charges of a threat to capitalism or that these companies will be uninvestable in the years ahead? My best guess is that even the most ardent free-market investor would accept some regulation that allows for broader competition in search, social, and the ways apps are purchased. Yet, many are greeting China’s measure with such foreboding that there are claims that a bit of regulation will force international investors to give up on the sector entirely. This is completely and utterly irrational.
US and European investors may not like the speed of implementation, but I suspect that the result could well be a model for Western regulators in the years ahead.
On March 30th, 2010, during the height of the drama around healthcare reform, President Obama signed into law the Health Care and Education Reconciliation Act of 2010. Most of us forget that attached to the healthcare reforms were sweeping changes to student loans. It was a dramatic overhaul that ended subsidies to financial institutions for issuing loans. Since that time, students borrowed directly from the Federal Government with artificially suppressed Interest rates.
From July 1, 2010, all new federal student loans were delivered and collected by private companies under performance-based contracts. Private loan origination effectively ended.
According to President Obama at the time:
"By cutting out the middleman, we'll save American taxpayers $68 billion in the coming years," "That's real money -- real savings that we'll reinvest to help improve the quality of higher education and make it more affordable."
The Bill increased the number of Pell Grants offered to low-income students and put a cap on annual loan payments for college graduates -- never exceeding 10 percent of their income.
While I had to look up the dates and details of the legislation, I remember the situation clearly. A dear friend was planning an IPO of his private student loan company at the start of March. By mid-April, he had declared bankruptcy. With an eerie similarity, another friend has seen their net worth plummet in the past week as China announced a ban on for-profit education. This company was also thinking about a public offering, and now, the future is incredibly uncertain.
Both then-Senator Minority Leader Mitch McConnell and House Minority Leader John Boehner were critical of the Bill, but I cannot find anywhere they called it a threat to capitalism. Yet, coverage of China’s efforts to rein in private education has been viewed through a far more sinister lens. Again, the China Perma-Bear contingency is coming out in force to condemn the measures against private education companies as proof that Beijing and the Communist Party cannot be trusted. Given that we have seen equally draconian action against private student loan firms in the United States eleven years prior, it does make these claims a little disingenuous.
While this will open up President Obama to claims that this is nothing but proof that he was a communist all along, the reality is that the previous Republican administration did nothing to reverse this stance. China is not alone in harsh regulations against private education.
Whether it's Variable Interest Entities or the implementation of intellectual property protection, knowing what laws will be enforced is a constant challenge for western investors, corporates, and supply chain managers. Putting the cybersecurity reviews to one side, I would argue that what we are seeing in China is removing much of that ambiguity regarding technology regulation.
On Wednesday, I had a fascinating conversation with a leading authority in energy markets in China. She told me that there is currently a clampdown in the refining industry that revolves around tax avoidance and breaching anti-pollution measures. This got us both thinking about how this applied to the regulation in China technology, and one of the things that is becoming clear is that outside all the push towards cybersecurity reviews, is that there is not a lot of new regulation, and it's more about the implementation of existing laws.
Take Meituan, for example. On Monday, the stock fell 17% after Chinese authorities announced that the delivery company was required to pay their drivers a minimum wage. CNBC commented about more draconian laws on a tech company, but when you put it in the context of a) minimum wage laws already exist and b) how is this different from what the State of California did to Uber, it is much more difficult to argue that this is an aggressive clampdown on an innovative tech company.
Since the cancellation of the Ant Group IPO, I have argued that the measures being adopted by the Chinese Government are designed to protect consumers and equal the playing field between the online and offline world. Many have argued that forcing Ant Group to be a bank holding company is a direct attack on the company itself as the Party tries to rein in Jack Ma. Or you can look at it that every other consumer lender is forced to be a bank holding company, so why should Ant Group be given preferential treatment? Ant Group now has to hold 30% of each loan in reserve, just as China Construction Bank and Bank of China. This sort of regulation is simply creating uniform standards.
Will regulation hurt the profits of many technology companies? Of course, but believing that it is an existential threat to their business models completely misses the point. Alibaba, Ant Group, Tencent, and JD were not dominant businesses because they were under-regulated. They dominate and will continue to dominate because they have superior technology and execution capability and products that modern consumers desire. Tweaking the regulatory environment will not change this scenario.
Over the long haul, this is what makes the China tech story so compelling.
Back in 2016, China initiated a series of reforms targeting Shadow Banking. Concerns over off-balance-sheet leverage, several defaults by peer-to-peer lenders, and concerns over the asset quality at the world’s largest money market fund, Ant Group’s Yu'E Bao, saw a series of measures designed to ensure financial stability ahead of the 2017 Plenum, where Xi Jinping was reconfirmed for another five years and set the stage for his ascendancy to ruler for life.
I believe we are seeing something similar as we head to the 2022 Plenum, where Xi Jinping will be rubber-stamped again as the leader of the Party. Technology regulation should be viewed through a similar prism to shadow banking reform. While I do not believe there is a systemic risk with the technology sector, it does enforce existing rules and will allow President Xi to claim many excesses and unlawful behavior of leading technology firms is now under control.
I appreciate entirely why the loss of one trillion dollars of market capitalization would prompt investors to embrace cataclysmic narratives. The wealth destruction that we have witnessed in recent weeks should challenge all our conventional thinking around the Chinese technology sector and the extraordinary gains in the past decade. Risk management always takes precedence over any investment thesis, and liquidation in such a scenario is utterly justified.
That said, as the Chinese regulatory framework increases scrutiny on Chinese technology firms, home and abroad, you should not lose sight of one obvious point. Companies like Alibaba, Tencent, and even the likes of Didi, may face heightened regulation, but they are still going to dominate their home market of 1.4 billion people. When combined with undeniably cheap valuations, especially against their US peer group, these companies could provide one of the best investment opportunities over the next five years. With cybersecurity reviews in their infancy, it remains too early to own them, but that time is coming.
I have no idea when a bottom is likely to form. The cybersecurity reviews will continue and drag more companies into the mayhem. However, the mayhem is being caused by misconceptions and the speed of implementation, which can be a blessing and a curse for the Party. Beijing has told internet companies that they have six months to get their house in order. While the cybersecurity reviews cover many more sectors than pure technology, it will be tech stocks that will eventually signal that the worst is behind us. One definitive action that I would take as remarkably positive would be an announcement regarding the ByteDance IPO. Allowing a listing of the world’s most valuable private company, with all of its international data issues, would signify that Beijing is comfortable with its checks and balances. I fear this is many months away. A listing of Ant Group would be equally encouraging.
The elephant in the room remains the prospect of delisting Chinese listed shares from US exchanges. While 2024 looks like the most likely date, we need to start thinking about what this process would look like. Will US-listed ADRs start trading at discounts to their dual-listed HongKong shares? What if it gets unruly? I am already having conversations with bearish investors who claim that Beijing will harm US investors by simply abandoning the ADRs. There is no evidence that it will happen, and it joins the long list of hysterical scenarios being put forward.
That said, it will structurally elevate volatility in Chinese tech. The opportunities in the next several years should be remarkable, but it will be a rocky ride in the months and quarters ahead.
Long term, structural investors should start accumulating the likes of Baidu, Alibaba, Tencent and JD on a scale starting down 5% from current levels. I would recommend using volatility to your advantage and adding down 10%, 15%, and 20% from Friday’s close.