Corporate crackdown: China’s quest for ‘common prosperity’ splits investors

Chinese President Xi Jinping delivered a speech in Shanghai this month where he spoke about his government’s new favourite term: ‘common prosperity’.

“As a Chinese saying goes, ‘Power may win for the time being, but justice will prevail for the long run’,” a translated version of his speech says.

While wealth redistribution resonates with China’s citizens, Xi’s use of blunt tools to rein in its corporate giants has triggered broader market volatility and split Australian investors over the merits in buying Chinese stocks.

The Chinese Communist Party’s (CCP) corporate crackdown started making global headlines in November last year, when celebrity entrepreneur Jack Ma dropped off the radar after the government shut down the initial public offering of Ant Group.

Since then, the CCP has introduced a suite of new rules for its technology giants, prevented private education companies from making profits and imposed limits on how long its citizens can play video games each week, among other widespread changes.

The CCP says these reforms will help achieve common prosperity by fostering greater competition, ensuring children have access to affordable education and weaning the population off what the government sees as an unhealthy addiction to screens.

But the new laws have also spooked investors, reminding them of the limits of a system where profits come second and drastic rules can be implemented overnight, without public consultation or warning.

And this week, China’s volatility took centre stage once more, with its largest property developer, Evergrande, teetering on the brink of collapse that could have ripple effects across China and around the world.

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Amid the chaos, the bulls are increasing their stakes in Chinese tech giants like Alibaba and Tencent, capitalising on an opportunity to buy some of the world’s biggest and most powerful companies for a discount.

Meanwhile, the bears are winding back exposure, with some exiting the market altogether, warning China’s risk profile has totally changed and a lack of transparency means investors are flying blind in an unpredictable market.

‘Really positive’

Mercer’s chief investment officer for the Asia-Pacific region Kylie Willment says long-term investors, including Australian superannuation funds, are increasingly interested in boosting exposure to China equities.

Investors must have the “risk appetite” to invest in China, Willment says, but it’s a great place to seek returns amid historically low interest rates.

“It has spooked investors a little bit, some of that regulatory action,” she says. “But I’m personally not as surprised by it. In China, you’ve got an emerging economy that’s very keen to be part of the global capital markets while coming into tension with the power of corporations versus the power of the state versus the social inequities that can arise.”

Willment says China’s regulatory agenda was inevitable and will “actually contribute to the long-term health of the system”.

This view is informed by Mercer’s market strategist Yaying Dong, who points to China’s status as a developing economy with its gross domestic product per capita around $US10,000 – less than one fifth the size of Australia’s.

“Whilst having grown very rapidly over the past 40 years since initial development, it’s still low,” he says. “The opportunity set in China is still incredibly large.”

Dong says China’s regulatory crackdown is more about restructuring society for its next phase of growth, focused on innovation and domestic consumption, rather than punishing unwieldy corporates.

While Dong says the CCP has historically embraced the liberalisation of markets, it is now intervening after recognising the market is “not the perfect allocator of resources” where monopolies and crippling debt levels have resulted in poor outcomes for its citizens, such as a housing affordability crisis and sky-rocketing tuition fees.

“When you tend to behave like a monopolist, you control prices, limit quality in one way or another. That overall produces a deadweight loss for society.”

Australian investors have typically gained exposure to China through tracking global or emerging markets indices, where China’s size as the world’s most populous country is not accurately reflected.

For this reason, Willment says Australian super funds are now creating specialised asset classes and employing investment managers with local knowledge to build up direct exposure. “It’s a pretty recent phenomenon,” she says.

Smaller investors are also piling into Chinese equities. Holon Global Investments managing director Heath Behncke says one-third of his $10-20 million portfolio is allocated to Chinese stocks and he has steadily increased stakes in Tencent and Alibaba in recent months.

“We don’t think the Chinese are going to suddenly want to dismantle their winners,” he says. “If you start thinking about knee-capping those companies, you’re going to undermine that ability to win that economic outcome.”

Behncke says China’s tech giants have been able to survive previous rounds of regulatory reform, and the CCP’s focus on fostering innovation will only open up more opportunities for investors.

China’s rapid growth through its controlled opening up to the world has taken hundreds of millions of people out of poverty and Behncke says investor fears are misguided.

“When you look at the history of China, they’ve put in so much hard work to pull themselves out of the place they were in. They were in a dark place, why would they dismantle that?

“Investors are pulling out over concerns about what it actually means when the government says they want more than common prosperity. What tends to happen is you look at China through western eyes as opposed to looking through eastern eyes.”

This view is shared by Betashares chief economist David Bassanese, who says China is not going to “kill its golden goose” by over-regulating its tech giants.

Betashares’ ‘Asian Tigers’ exchange traded fund (ETF) has been among the fastest growing since launching in 2018, with now more than $660 million in funds under management – mostly from retail investors.

Bassanese says inflows have slowed in recent months amid the uncertainty, but predicted this would soon start growing again.

“The valuations have come down,” he says. “But the big tech companies in China are similar to the FAANG [Facebook, Amazon, Apple, Netflix, Google] stocks in the US, they have the same market clout as those companies do globally, they still have very strong business outlooks.”

The potential collapse of Evergrande may cause the CCP to launch financial stimulus packages, Bassanese says, which would only further benefit the tech giants. “Consumer spending in China is still relatively low,” he says. “If they do manage to boost consumer spending, that’s going to give them even more earnings capacity.”

‘Painful adjustment’

However, these rosy outlooks are not shared by all. The bears believe China’s endless growth trajectory is going to slow, which will filter through to depressed equities prices.

Like other countries, China’s economic growth has been impacted by COVID-19 but its ageing population, spiralling house prices and mounting debt levels are also starting to bite.

Evergrande, one of China’s largest property developers, rattled global markets this week when it became apparent the company may not be able to repay billions of dollars in loans.

Investment powerhouse Perpetual began reducing its exposure to China in June, after the country’s economic outlook, according to its head of investments Matt Sherwood, became “increasingly opaque”.

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China’s construction industry accounts for more than one quarter of GDP and around 7 per cent of its labour market. Sherwood says the CCP’s handling of Evergrande will send a warning signal to the construction industry that will result in fewer projects, fewer local jobs and further reduced iron ore prices.

Sherwood says China’s economic growth depends on a growing population and endless credit, which have come to an end. “Those two worlds are now colliding,” he says. “The Chinese construction industry is undergoing a very painful adjustment.”

The Chinese government this year added ‘data’ to the fifth factor of production – alongside land, labour, capital and enterprise. Sherwood says the CCP’s obsession with data is bad news for the country’s tech giants, too.

“They have money, and information. And that’s increasingly valuable in today’s world,” he says. “Companies would argue the government’s job is to stand by their side, not ride on their backs. But China might see these sorts of companies, massive tech companies, as something they want to contain and control.”

Bell Asset Management’s chief investment office Ned Bell agrees. His last major exposure to the Chinese market was holding China Mobile in the early 2000s, but he says the CCP put a ceiling on its profits. He predicts other sectors, deemed of importance to the government’s social agenda, could face the same fate.

“As soon as China Mobile started turning into a profitable business, the government came in and regulated the profitability out of it,” he says. “Whether you have businesses like Alibaba or Tencent, they are essentially capitalist organisations operating in a Communist country. It’s inevitable those two things clash.

“Whenever a company starts over-earning and becoming too profitable, you know at some point the hammer is going to come down,” he says. “With the tech sector, they can’t flick the switch but they can keep a lid on growth.”

Bell says the recent volatility has also highlighted pre-existing problems with investing in China, including the lack of transparency in corporate reporting and poor approach to governance among some of its large corporates.

“They overwork their employees. The 9-9-6 culture is right throughout the tech industry,” he says, of the 12-hour day, six-day workweek. “It’s not just tolerated but it’s encouraged from the top.”

Many Chinese companies also operate under a Variable Interest Entity (VIE) structure where investors buy shares in an offshore shell entity to bypass laws that ban foreign capital. While the offshore entities have contractual arrangements with the mainland company, the opaque legal structure, used by China’s major internet companies, creates another layer of risk for investors.

“You don’t own the stock, you own a bit of paper in the Cayman Islands,” Bell says. “Those structures in and of themselves are somewhat scary for us.”

China’s corporate crackdown comes against the backdrop of an increasingly toxic geopolitical landscape, with China making no secret of its plans to ‘re-unify’ democratic Taiwan and expand into contested territory in the South China Sea.

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The Australian government this month responded with the trilateral defence pact, AUKUS, which prompted fury from the Chinese government and set the course for conflict amid what many have described as a new Cold War – an arms race between competing ideologies.

While investors find it difficult to price in geopolitical risk, even Sherwood says “it’s out there and it can occur”.

“I tend to think the peace dividend, which has been a big tailwind for markets the last 30 years, is now pretty much over. There’s going to be more and more stresses from a geopolitical angle, whether that actually leads to conflict is another issue.”

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