The Chinese government’s crackdown on privately owned companies and entrepreneurs has captured the world’s attention and dismayed many portfolio investors.
Beijing is compounding investors’ concerns by also putting a new emphasis on a longstanding political slogan — known as “common prosperity” — to focus attention on the country’s deep inequality, and put some socialism back into the term “socialism with Chinese characteristics”.
With Beijing drawing on national, economic and financial security policies, China experts are trying to decipher what this all means in the context of Xi Jinping’s authoritarian regime, ahead of the important 20th Congress of the Chinese Communist party next year.
After decades in which domestic private businesses were encouraged, Xi is performing a sort of handbrake turn, moving the party sharply leftward and reconnecting with its Marxist roots. He is leading a campaign against private entrepreneurs and companies that he previously courted in his early years in power. Now he wants them to serve the party, and harness their technologies for its political ends.
Hardly surprisingly, the campaign has triggered a precipitous fall in the stock market valuations of tech, digital and other companies. For example, the shares of Didi, the ride-hailing app listed in New York in June, are down more than 40 per cent since its initial public offering.
All this is of huge significance to foreign investors, who own more than $800bn of financial assets in China’s onshore markets, and to those people who own and trade the stocks of more than 230 Chinese companies listed on US exchanges and capitalised at more than $2tn.
As well as investors holding individual Chinese stocks, these include many retail savers who have put money into China funds, Asia funds and many tech and growth-orientated funds. We need to decide whether investing more cash in China right now, or even retaining the holdings we bought in the past, is a good idea. I have no definitive answers but the prospects do not look good.
Since I first went to China in 1993 there have been times when, like elsewhere, Chinese assets were both absurdly dear and ridiculously cheap, and subject to normal risk assessment. Yet I cannot remember a time when the issue about investing was dominated by unpredictable politics and governance as it is now.
After such a hefty decline in key stock prices, including in well-known companies such as Alibaba, Tencent and Didi, investors are often tempted to buy, hoping for a bounceback.
Yet, siren voices can be heard, warning about elevated risk surrounding many Chinese stocks. Billionaire investor George Soros, for example, recently said that investors buying into any rally in China were in for a rude awakening.
It is an important moment to ask what is going on, and how that should shape the way we think about investing in China.
Investors have been fed for years with a marketing pitch about the virtues of investing in China. The reasons for investing include risk diversification from Europe and North America, the low correlation of the Chinese market’s performance with other major markets, the country’s economic size and sophistication, the surge in its huge middle class and the development of “made-in-China” science and technology.
These arguments have weight. In the current turmoil they seem, for now at least, to have helped broadly based onshore markets, such as Shanghai, hold up better than the tech- and digital-heavy offshore markets in Hong Kong and New York. The latter feature many more companies affected by the new regulatory blitz and political risk.
The investment kaleidoscope, however, is in flux. Bullish strategists regularly predict that the typical modest 5 per cent allocation to China in global portfolios should double or triple to match the country’s 16 per cent share of world gross domestic product, a figure that is widely expected, though far from certain, to go even higher in the next decade.
But far from rising, that typical allocation has dropped recently to 4 per cent. I suspect that, in the entire debate for and against higher allocations, they will stay low relative to expectations because of weak governance and unpredictability.
Given Xi’s assault on private capital, investing in China remains a risky proposition, requiring a major leap of faith about Chinese politics and totalitarian governance, and its long-term economic future.
Investors’ behaviour will be important to watch. The money they put to work in stock markets may have little bearing on the cyclical economic outlook for China but the valuations they ascribe to companies tells us something, untainted by bias or politics, about the prospects for earnings, productive growth and innovation.
In this sense, it does not really matter if China becomes the biggest economy in the world, which it might not. What matters is whether Chinese companies can prosper, be productive and thrive in an enabling and well-regulated governance system.
But now they face the challenge of the 2021 regulatory crackdown and the “common prosperity” agenda.
The party gets a grip
The abrupt cancellation in November last year of the mega IPO of Ant Financial, an arm of Alibaba, and the orchestrated deposition of its celebrity founder, Jack Ma, heralded the start of Xi’s campaign.
This marked a major intensification in a campaign to assert control over the private sector, and, in a way, take over the private sector from the inside, so to speak.
The practice of having party committees involved in the operational management of companies with more than three party members was already well-established when Xi addressed a symposium of entrepreneurs in July 2020, appealing to business leaders to try harder to fulfil both economic and also social and moral responsibilities.
He urged the private sector to align with the party’s political leadership, and cultivate compliance with and obedience to its goals. Party officials were encouraged to lead staffing and recruitment, monitor corporate behaviour, implement compliance and management systems and improve party-led union activities.
The regulatory assault that followed has embraced ecommerce, social media, fintech, data, private tutoring, ride-sharing, gaming and video-streaming platforms and activities. Companies that want to list in the US, or that make extensive use of algorithms, or have large cloud computing capacity or pool large volumes of customer data have also been targeted.
Some analysts have advanced case-by-case justifications in support of stronger regulation applied to data privacy and security, the use of algorithms, minimum standards for gig workers, private education and the proliferation of “frivolous” technologies such as gaming. Some of this might even make sense in many countries.
Yet, taken together in the context in which all these things are happening in China, it is hard not to see that the government is waging an overtly political campaign. Investors should try to evaluate where the regulators might look next in their pursuit of greater control and lowering inequality. The real estate sector, medical services and healthcare companies as well as pension and social welfare arrangements would seem likely targets.
One highly significant measure is the rumoured plan to introduce a long-discussed national property tax. Limited pilot projects were launched in Shanghai and Chongqing in 2011, but progress stalled because of strong opposition from vested interests in local and provincial governments, which rely heavily on land sales for revenues, and from urban property owners. For these groups, the threat of a fall in property prices is anathema.
With the party’s focus on “common prosperity” though, investors should recognise that this time “it might be different”. Real estate is the most important form of wealth ownership in China, bigger even than bank deposits.
A meaningful property tax, however, would undermine an already soft real estate sector, probably generating a serious drop in real estate prices. This suggests a property tax might not come before the 2022 party congress, especially in view of the financial crisis enveloping China’s second-largest property developer, Evergrande, with more than $300bn in liabilities.
Whether or not a tax comes, the government would prefer political and “extend and pretend” debt solutions for companies such as Evergrande, though foreign creditors might still be hit with losses.
Real estate is just one important contributor to the wide proliferation of debt and financial stress across the economy, in local governments, state enterprises and even among households, as mortgage debt has been growing particularly rapidly. Household debt as a share of disposable income has doubled to more than 130 per cent since 2010, and is now far higher than the 75 per cent ratio in the US.
Investors should, therefore, monitor debt developments in real estate and in the wider economy carefully. Over-indebtedness in China is a cauldron that is never far from boiling over; deflation in real estate would have profoundly adverse implications both directly and via its impact on lending collateral. There is no orderly and trusted system for writing off bad debt in a timely way.
Other “common prosperity” features should be monitored too. Taxation of property and capital is not in itself a bad thing, but politically driven financial punishment is different from a spreading of the tax burden in the interests of fairness, while preserving incentives.
The government has stated that high-income earners will be targeted, along with those with illegal and “unreasonable” income. The economic impact will be in the messaging and the measures.
Investors should also recognise the insidious ways in which the party pushes private companies to align with its objectives. Rhetoric and the simple threat of punishment or restraint are often enough to force compliance.
This is happening now with so-called “tertiary distribution”, best described as a form of corporate giving. Dozens of companies eager to please the government, including many of the biggest such as Alibaba, ByteDance, Pinduoduo, Tencent and Xiaomi, have pledged billions of dollars of donations over the next few years to help advance or fund “common prosperity” programmes. Coercive state directed philanthropy is not the same as unforced enthusiasm for transparent, private charitable giving in accordance with proper governance procedures.
What is to be done?
As a more restrictive regulatory and governance system is brought to bear on everything from Chinese schools and universities to companies, media and entertainment, and often abruptly and without recourse to appeal, investors in Chinese assets will have to weigh the risks more carefully.
It is more important than ever to be able to trust and verify financial advice, and understand the nature of assets owned or intended for purchase. Savers should look to companies that are less likely to be drawn into the regulatory crosshairs, and pay prices that properly discount political, economic and regulatory risks.
These could be companies that fall into line with government policies to avoid punishment, and those in less politically contentious areas such as manufacturing, advanced technologies and consumer products.
Valuations that have taken a beating may not all revert to where they were if, for example, growth companies are heavily regulated and come to trade more like conventional stocks, even utilities. Low transparency and openness, which has often been a weakness of Chinese company reporting, may get worse. Liquidity in certain companies could diminish.
China could prohibit foreign IPOs altogether, or retract the “variable interest entity” business structure which has allowed Chinese companies to list abroad bypassing domestic regulations, and investors to buy into Chinese companies in ways that would not be permitted in China. Regulators may look next to real estate and healthcare pricing. Foreign investors could yet be blamed for domestic financial or economic volatility, possibly leading to limits on access to US dollars for Chinese entities and tighter restrictions on outward movements of capital.
In the medium term, the key issue is the sustainability of China’s economic development model. With rising headwinds from indebtedness, poor demographics, stalled productivity and the harshest external environment since the Mao era, Beijing urgently needs to make economic reforms that would help re-energise productivity, private sector expansion and innovation.
But will Xi’s governance and regulatory regime help or hinder? It’s a rhetorical question. The immediate cause of the president’s political and ideological campaign, hastened by the faltering relationship with the US and the pandemic, may be to cement his own enduring authority ahead of the 2022 congress.
In trying to consolidate power, he wants to pull China sharply leftward and address what he sees as the capitalist excesses in the country’s development model. He may also be trying to divert attention away from an economy with a multitude of underlying economic troubles, and from a political system with no provision now for an orderly transfer of power. For investors, it is caveat emptor.
George Magnus is the author of ‘Red Flags: Why Xi’s China is in Jeopardy’ (Yale University Press)