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Chinese Equity Markets Experienced A Meaningful Decline In Early July Due To Intensifying Regulation Uncertainty

Q: Why people fear China’s regulation overhang?

A: Chinese equity markets experienced a meaningful decline in early July, triggered by a Government ban of a recent market acquisition made by Didi (following the ride-hailing company’s reported breach in cybersecurity laws).

The punishment handed down on Didi is considered to be the another in a series of Government intervention, as efforts to regulate internet platform companies in fintech, e-commerce, food delivery, online education and gaming increase.

Due to this regulation uncertainty, and fundamentally; concerns the Government may no-longer be proponents of growth and tech-innovation, investors have significantly reduced their holdings in China equities.

While we agree that regulation uncertainty is bad news for the market, we strongly disagree with the second notion and continue to have high conviction in the Government being supportive of growth.

Q: What are the nature of these regulations?

A: From our perspective the regulations being introduced are reasonable and fair, reflecting social consensus and in line with Chinese social values.

For instance, there has been regulation overhang on food delivery platform Meituan for some time, speculating the company may be ‘forced’ to provide higher salaries or insurance coverage to its delivery riders.

Meituan was reluctant to resolve the issue earlier, because they think that most riders working on the platform are temporary workers or 3rd party agency hired, meaning that it would not be their direct responsibility.

However, as the company become so large to hire 5 million workers, demand from society has ever grown louder.

From the society perspectives, in our opinion, any regulation to improve workplace conditions is the right decision, as food delivery riders have arguably been working under dangerous and distressing work conditions while pay not enough.

Another example of regulation overhang is in the ’After-School Tutoring (AST)’ sector. AST has become a cause for concern by a vast majority of the middle-class in urban China, due to the increased financial burden on parents and increased mental burden on children. Fast becoming a social problem, the latest rumor is the Government will be forced to act by introducing restrictions on AST operating hours.

Price cutting on generic drugs is an area of recent Government reform. Over the last three years, through six round of group purchasing auctions (nationwide), old generic drug prices have fallen by 50%1 and more on average. Being bad to generic drug makers’ bottom-line, it was an area that needed urgent reform; not only because old generic drugs were too expensive in China, but also because it consumed large portions of public medical insurance. It detracted companies from investing in innovative drug R&D due to the complacency of generating high returns from generic drugs. Due to regulation changes limiting price cutting, we have seen an impressive emergence of innovative drugs from Chinese local companies such as Innovent, Henrui, Junshi, etc.

Malpractice and reducing competition across e-commerce platforms where companies such as Alibaba would typically discourage merchants to sell items on rival platforms, enforcing an exclusivity have been banned. We think this policy is very reasonable and necessary to ensure fairer competition.

In Didi’s case, it is a bit different being a result of the US-China conflict. At the moment, we are not yet clear how Didi breached cybersecurity laws but according to market speculation, the issue stems from the company possibly sharing data with the US SEC, albeit the data could be minor or negligible information for what we know.

The Chinese Government have big concerns about the potential of critical data being leaked to the US via US- listed Chinese companies. Following several years of geopolitical conflict between US and China, a HK exchange listing rather than NY exchange listing has been shown to help avoid these issues.

Further, China is different and outstanding among emerging countries. It’s clearly regulation heavy, but it has a virtue prohibiting any economic interest group or company to yield monopolistic powers over its society.

In summary, we view most of the regulation changes as reasonable and even desirable, reflecting current social values. Based on our vast experience of investing in emerging markets, we often encounter cases where vested interest groups, family businesses and conglomerates hamper innovations and growth in a country. We welcome positive changes that help to ensure a competitive and sustainable economic environment

Q: How we positioned and what we will do?

A: Firstly, we believe there is plenty of untapped growth opportunity in China equities. The powerful and effective way to capture it, is simply to follow the development stage of its economy. China is regulation-heavy but also support-heavy, and the government has a strong track record of supporting businesses to serve China’s social needs. These days, social needs include clean air, energy and technology independence from the US to name a few.

Across Chinese society; appreciation of mercantilism value is high. i.e., The perception that exporters are good for society and any company with export ability is highly regarded. We try to capture innovative opportunities in areas like solar, EV battery, semiconductor, automation, AI, exporters to name a few.

Secondly, we are and should be cautious of mature internet platform companies. If an internet platform already hold a monopolistic position of 60%-plus market share, their business is by its nature a “public utilities” service, comparable to power utility or water utility companies. Key features of “utilities companies” is they should place social service as its first priority, rather than shareholder profit. Hence, these internet platforms don’t deserve a high valuation multiple. We still have an exposure to Alibaba and Tencent, based on their valuation being low relative to the market. In contrast however, there are several internet companies that trade at extremely high valuation multiples that we avoid.

Thirdly, it’s important to note that regulation in China have some characteristics of cyclicality, like a pendulum swinging. Why? Heavy regulations tend to create business disruption and hamper employment markets. For example, operating hour restrictions on AST (which is rumored) may hurt millions of teachers and relevant workers in the AST industry. Heavy regulation periods tend to be followed by a light regulation cycle. Currently, we are undergoing one of the most severe regulatory cycles in a decade, which imply a much easier period down the track.

Lastly, in our view regulation is a short-term pain but a healthy long-term development gain. Despite much discussion on anti-trust action across the world, no other country has successfully reigned in giant corporations. The Chinese Government has at least made good its first step to tackle vested interest groups in its society while creating an environment for further innovation and business start-up’s.

Overall, we are optimistic on China’s innovation trends and trajectory of its growth stocks while paying attention to new and unconventional areas and matters across its market and economy.

Phil S. LEE
Head of AP Research

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1Source: Reuters, as of 28 December 2020.

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