Executive summary
In recent months, Chinese stocks have been roiled by a series of government regulations. Global investor confidence has been shaken with many believing that regulators are indiscriminately and haphazardly targeting private sector. This has created a climate of uncertainty causing volatility and value erosion as investors attempt to make sense of what has happened.
We believe it is important to view the recent regulations in a broader context. Specifically, it is necessary to understand the Chinese government’s overall vision on how it would like China to develop. To do that, it is useful to frame the government’s priorities through the two lenses of 3S’s and Dual Circulation. These twin objectives outline how the Chinese regulators are dealing with issues facing most governments worldwide (i.e., dominance of Big Tech, data privacy, income inequality), and in a balancing act, promoting industries to meet aggressive growth targets and aspirations laid out in the 14th Five Year Plan. As a result, we believe that the regulations will continue to have impact in the near term, however the medium to long-term growth prospects of the economy, and specifically the private sector and Internet remains promising.
The 3S’s - Stability, Sustainability, Security
In the last fifty years, China has undergone significant economic liberalization by allowing private sector to flourish. These reforms catapulted China from being one of the poorest countries to the second largest economy in the world. While incomes have risen for the nation overall, the gap between the wealthy and poor has increased dramatically as well. China has more billionaires than any other country in the world, yet it is also home to 600 million people (42% of the population) that earn less than US$150 per month. This growing inequality threatens social stability, challenges the principles of China’s socialist model and the legitimacy of the Communist party. As a result, the government under Xi Jinping, ahead of his third term, has focused its sociopolitical agenda on the 3S’s or maintaining stability, sustainability, and security.
Stability
The government is focused on social stability in areas of 1) People with the objective of maintaining the support of the masses, 2) Systems by reducing systemic risk, and 3) Businesses by reining in the excesses of private enterprises.
People: Xi has repeatedly used the phrase “common prosperity” to promote greater income equality. As a result, regulators have focused on tackling the spiraling costs of housing, healthcare and education (“Three Mountains”), increasing wage levels and improving working conditions. Recent regulations include capping housing prices, banning tutoring companies from making profits and lowering the costs of drugs and medical services at public hospitals.
Systems: The government has focused primarily on reducing leverage across the economy and minimizing systemic risks in the financial sector. Specific regulations include capping the amount of mortgage loans and raising borrowing rates, requiring property developers to deleverage and mandating fintech companies to obtain banking licenses and meet capital requirements.
Businesses: The regulators have targeted the Chinese Internet titans, who have driven much of China’s recent growth but have also accumulated a disproportionate amount of market power and capital. The key regulations in this space include curbing monopolistic practices of the platform players and improving working hours and wages.
Sustainability
The Chinese government has shifted gears from promoting rapid growth to sustainable development. For the first time in its planned economy, the government did not put specific GDP number targets in its most recent Five Year Plan, instead opting for the phrase “quality development”.
The government is also focusing on environmental sustainability and has pledged to become carbon neutral by 2060, a tall order given that it is currently the world’s largest emitter of carbon dioxide. It has recently established the largest carbon trading market in the world and is promoting a home-grown electric vehicle industry.
Finally, it has relaxed restrictions on its one-child policy to a three-child policy to prevent a potential shortfall in labor force. Part of the crackdown on the tutoring industry was attributed to the growing burden of education costs for middle-class families, who cannot afford to have more children.
Security
Data security is the third part of the 3S. Last year, State Council published a paper, naming data as the fifth factor of production, alongside capital, labor, land and technology. As such, all companies including overseas listed companies (e.g., Didi) must submit to a cybersecurity review, and data collection and usage rules are now being established and implemented. Data privacy and security are not new issues, however Europe (GDPR) and US (i.e., probes against Tiktok, Google, Facebook) have been farther along in implementing data regulations. China is now catching up.
Overall, the issues laid out in the 3S (e.g., Big Tech, growing income inequality and data security) are similar to what governments around the world are grappling with. China is now ahead of the curve in implementing measures to address abuse of market power, promote consumer welfare and worker rights, and to ensure compliance with data privacy. This has and will continue to result in corrections in the valuations of targeted private sector, and in particular internet businesses. However, we believe this is a short-term correction because of the government’s focus on “Dual Circulation”.
Dual Circulation
Dual circulation is the core strategy underlying China’s 14th Five Year Plan. In a nutshell, China seeks to build self-reliance which is dubbed Internal Circulation. This is done by promoting domestic consumption (not just export-led growth) and ensuring supply chain self-sufficiency (by supporting home-grown industries and not relying solely on imported technologies e.g., semiconductors).
The second part of dual circulation is International Circulation which focuses on further opening up trade and capital flows with the rest of the world and establishing global leadership in select areas. China has pursued free trade agreements like RCEP and CAI and continues investments in Belt-Road Initiative. China is also aggressively promoting its national digital currency ahead of the upcoming winter Olympics.
In order to meet the aggressive targets laid out in the 14th Five Year Plan and to achieve ”Dual Circulation” objectives, private enterprises will be key (especially in areas of digital, green and frontier technologies). In fact, the 14th Five Year Plan has increased the percent contribution by the digital economy to overall GDP. Maintaining high growth rates will absolutely require the leadership of private enterprises. To date, private sector has accounted for 60% of China’s economic growth and 80% of urban jobs. Big Tech is China’s best hope for global leadership and innovation. As such, regulators are unlikely to continue to over-regulate these sectors in the long-term.
The ACATIS QILIN Marco Polo Fund remains overweight on China based on the mid-term and long-term outlook for the economy. We continue to invest in select Big Tech opportunities during this period of price correction. However, we also rebalance our portfolio to align with Chinese government priorities. We exit and reduce exposure to the industries hardest hit by regulation. We invest or raise our exposure to government supported industries like renewable energies and home-grown technology leaders and in particular, the semiconductor and electronics spaces.
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