China is Adhering to its Socio-Political Goals
In the last days, and also in the weeks prior, the fund experienced sharp price declines for some Chinese companies. We would like to provide an overview on the reasons behind the market correction, which would offer greater clarity on how the situation might evolve going forward.
China's overarching goals are social stability and sustainable growth. Under this mandate, economic factors including fair competition and fair wages, environmental factors such as addressing pollution, and social factors such as data security and quality of life are taken into account. Developments that jeopardize these goal are scrutinized and decisively addressed.
At the beginning of his term, President Xi Jinping addressed corruption in China. Soon after, environmental protection was included in the constitution. In recent months, topics such as fair competition and Internet data security, systemic credit risk in the FinTech sector, unsustainable competitive pressure facing schoolchildren, and carbon emissions have been tackled.
Against this backdrop, the new policy decisions are understandable and reflect China’s macroeconomic and social goals, even if they do not serve the interests of business owners and investors.
Focus of regulations
The newly introduced regulations affect many industries. Some will be severely negatively impacted, others less so, while still others will benefit significantly from the new reforms. We would like to introduce some examples across these categories. Specifically, the education industry (private tutoring and online education) and the fintech sector (here the Ant Group was the key target) were among the hardest-hit sectors. The Internet platforms (including Alibaba, Tencent and Didi, the Chinese Uber) were moderately negatively affected, while industries such as renewable energies and electric vehicles were among the major beneficiaries of the new policies. Market valuations should have reflected this accordingly, however investor sentiment has indiscriminately soured across Chinese stocks.
In the fintech industry, the new regulations aim to reduce systemic credit risk by no longer allowing fintechs to conduct banking services without banking licenses or holding adequate levels of capital. The government maintains financial control and in parallel develops its own cryptocurrency as an alternative digital payment mechanism.
In the education sector, the new regulations aim to reduce the workload and competitive pressure on schoolchildren. Most Chinese children are enrolled in afterschool classes and study from 08:00 in the morning until 23:00 in the evening, 6 to 7 days a week. The regulations aim to improve the well-being of schoolchildren and relieve the financial burden on parents shouldering the exorbitant costs of afterschool tutoring (often cited as a key contributor to declining birthrates).
In these two areas of private education and FinTech, we believe that the new regulations have dramatically changed industry conditions, upending existing business models. Therefore, the market correction and lowered valuations are justifiable.
In the area of Internet platforms, the government has targeted the "monopolistic" and exploitative practices of the Internet tech titans. In addition, the regulations focus on protecting consumer data. Our belief, with respect to the internet platforms, is that the impact on revenue and profits will be limited and manageable. The capital market is, at the moment, overreacting in most cases.
In the field of "renewable energies", the Chinese government was one of the first to pledge zero emissions by 2060. By the end of this year, China will have installed more capacity from non-fossil fuel sources than from coal-fired sources, in line with government targets. In addition, the government launched the world's largest carbon trading system in July. Accordingly, China is now the world's largest producer of wind, solar and hydropower. Many listed companies in this sector are benefiting significantly from the accelerated industry growth.
In new energy vehicles (NEV), the government has decided to phase out internal combustion engines (ICE). They target to have 20% of new vehicles sold by 2025 to be NEVs (e.g., electric, hybrid), and by 2035, that percentage will increase to 50%. Government directives for developing NEVs include emission quotas for ICE, electric vehicle quotas for manufacturers and importers, subsidies, tax exemptions and aggressive support in building the charging infrastructure. The entire electric vehicle industry, from electric car manufacturers to suppliers, benefits significantly from the new regulatory framework.
From our perspective, we believe that negative price corrections in the two areas of “renewable energy” and “new energy vehicles”” are not justified, based on regulatory support and fundamentals.
Impact on investors
At the present time, we believe that investors should not jump to the conclusion that all other industries will now also be heavily regulated. We do recognize that for many investors, confidence in China has certainly suffered. Nonetheless, we recommend not to generalize.
Excessive market correction: There has been an immediate and sharp decline in valuations across Chinese stocks, even in sectors with strong fundamentals that enjoy broad government support. This could open up potential buying opportunities. Investors should discern between industries that have been permanently “reset” (i.e., fintech and education), sectors that have been temporarily “recalibrated” (i.e., internet platforms), and areas that have been unduly punished (i.e., NEV, alternative energy).
Growing importance of Hong Kong and mainland bourses: There has been a trend in the last year of capital shifting from Chinese companies listed in the US, to companies listed on the Chinese exchanges. Given the escalating US-China tensions and Chinese regulations regarding data security, we anticipate a move by US-listed Chinese companies to “return home” by dual-listing in Hong Kong or in China. Similarly, Chinese companies seeking to IPO will often prefer Hong Kong or China, over the US, as they will be exempt from cybersecurity reviews. International investors seeking to invest in the growth of China will have to increasingly do so through funds that access China through the Stock Connect.
Capital flight to strategic sectors: Investments will continue to flow towards areas aligned with China’s overarching goals of social stability and sustainable growth. Examples of these sectors, many of which are laid out in the 14th 5-year plan, include renewable energy, electric vehicles, semiconductors, frontier technologies such as 5G, AI and quantum computing and select hardware and infrastructure plays. These sectors may potentially be safer bets for international investors as they are aligned with national priorities.
The ACATIS QILIN Marco Polo Fund continues to adjust the portfolio to reflect the changes in China’s regulatory environment and to capture growth opportunities in Asia.
In the medium term, we see 3 adjustments for the portfolio:
Reduction of exposure in industries where the risk of regulation is rather high, such as the aforementioned area of private education
Increase diversification by expanding exposure in industries where the risk of regulation is rather low, such as renewable energies and electric vehicles.
Increase the share of other Asian markets outside China and Hong Kong in the portfolio, such as Vietnam and South Korea.
If you have any remaining questions, please do not hesitate to contact us anytime.