Global Perspective – Forceful regulations on Chinese companies spooks investors – too early to bottom feed

Global Perspective

July 27, 2021

Read how the pattern of forceful regulations on Chinese companies are spooking foreign investors.

Summary

Last October, the Chinese regulatory crackdown embarked on a new journey when the Ant Group’s (Alibaba’s offshoot) initial public offering (IPO) was abruptly canceled due to a regulatory change implemented at the last minute—resulting in heavy losses for pre-IPO investors. Then, more news headlines came in when the ridesharing company Didi’s apps were removed from mobile app stores due to a cybersecurity review. The final straw came in the form of a crackdown on private education firms, with regulators asking them to be converted to non-profit and limiting their scope of business. There's no question the opaque and forceful regulations will hit investor sentiment for Chinese stocks, leading to the depressed valuation of currently listed firms.

Our take

In the past, Chinese state-owned entities (SOEs) were the companies international investors avoided due to the heavy hand of the government. With a whiff of a regulatory change, privately owned entities may now seem like the new SOEs.

The real reason for the tutoring firm crackdown is that policymakers in China are in a difficult situation with the country’s dire population dynamics. According to the latest census data, the country’s fertility rate dropped to 1.3 children per woman, well below the 2.1 ratio needed to keep the population at constant levels. The problem is so severe that the fertility rate already is close to Japan’s or Italy’s level, where the shrinking population problem is much more visible. The drop in fertility rate is mainly connected to the one-child policy introduced in the 1970s. Still, another important reason is the cost of education and how competitive it became with wealthy upper and middle class families pouring money into tutoring to gain an edge in highly competitive middle school and university entrance examinations.  Something needed to be done quickly. The tutoring industry was an excellent starting point from a long-term policy-making angle but had a disastrous outcome for investors, especially overseas investors. These firms have public listings only in the U.S.

The recent regulatory moves also resurfaced the earlier questions for variable interest entities. These offshore vehicles are used to allow foreign investors to invest in Chinese companies like Alibaba, Meituan, and Baidu. The Chinese government is signaling that changes for these structures may come as well. The current arrangements will probably stay in place, but any future ones could be in jeopardy.

Bottom line

Regardless of the new rulings, spooked foreign investors are asking the right questions that should have been asked many years ago, such as; “Who really owns a Chinese company, a private entity or the state?” In short, regulatory risk has become one of the most critical factors for any Chinese company, state-owned or not. Unfortunately, this risk is unpredictable and probably impossible to mitigate or navigate through. While some of these pullbacks may create longer-term opportunities, we continue to recommend underweight positioning in Emerging Market equities where Chinese names dominate the index until the fog clears.

To read the publication in its entirety, including our comprehensive view on what this means for global investors and consumers, please select the "Download PDF" button, below.

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