A Time Out to Reassess Chinese Stocks

Beijing’s framework for 'Capitalism with Chinese Characteristics' emerges
August 15, 2021 Updated: August 18, 2021

Commentary

Beijing policymakers have sought to calm financial markets after a period of heavy-handed and unexpected crackdowns on several sectors. Now is a good opportunity for foreign investors to reassess their investments in Chinese companies.

After a period of market volatility, Beijing authorities have unveiled a broad five-year plan to regulate large swaths of China’s economy and industry. The rules should finally give investors a rough idea of how the Chinese Communist Party (CCP) plans to control its private companies, a framework for “Capitalism with Chinese Characteristics.”

Of course, as with all policies issued by the CCP, it’s “caveat emptor” and subject to change without notice.

Let’s quickly recap the regulatory actions that have culminated in the recent volatility of Chinese technology stocks.

  • November 2020: Payments startup Ant Group’s highly anticipated IPO was suddenly canceled.
  • November 2020: China’s market regulator issued draft guidelines to rein in “monopolistic practices” within its internet sector.
  • February 2021: Guidelines to curb “monopolistic practices” finalized; landmark fine issued to Alibaba.
  • June 2021: Beijing pledged to increase welfare and salaries of delivery workers in the “gig economy,” hitting shares of platforms such as Meituan.
  • July 2021: Days after Didi Chuxing’s IPO, China deleted the ride-hailing app from its app stores and opened an investigation into its data security practices.
  • July 2021: Cybersecurity regulator ordered any internet company with more than 1 million users to undergo cybersecurity and data security review and approval prior to listing its stock abroad.
  • July 2021: State Council cracks down on education and tutoring companies, and turns some into nonprofit entities. Shares of a handful of U.S.-listed Chinese tutoring companies tumble.
  • July 2021: Ministry of Industry and Information Technology began a special investigation into the internet industry. Results still to be determined.
  • August 2021: China’s insurance regulator outlined new rules governing online sales and marketing of insurance products.
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Two Meituan food deliverymen ride their scooters in Beijing on June 26, 2018. (Wang Zhao/AFP via Getty Images)

These regulatory measures have sent both U.S.-listed and Hong Kong-listed Chinese companies plummeting and caused consternation among foreign investors.

Beijing’s top policymakers have seen the recent market turmoil and sought to calm investors trying to make sense of the recent regulatory onslaught.

The State Council issued a document on Aug. 11 to strengthen enforcement of antitrust and unfair competition rules, while encouraging “healthy development” of the new economy that respects people’s well-being and data privacy.

In addition, Beijing promised to increase the use of legislation and vowed to not “arbitrarily change or suspend” measures once they have been enacted without going through formal legislative procedures.

In other words, the regime in Beijing is both trying to demystify its recent administrative actions and telling the world to “trust us.”

Set aside for now that the CCP’s track record in carrying out what it promises to do has been dubious. Let’s assume Beijing is serious about these reforms.

This all seems like “nanny-state” at its extreme. Take the for-profit education sector as an example. Beijing cracked down on the $100 billion industry to “reduce the work burden” imposed on students and to make education “more inclusive,” according to a policy statement issued on July 24.

On the surface, it’s a recognition that Chinese grade-school students are under too much stress and the after-school programs favor well-to-do families with the means to pay the high tuition for such tutoring.

But in practice, these measures won’t reverse the trend of after-school tutoring. University acceptance rates aren’t getting any higher. What this means is that more such tutoring will go informal and “off the books.” Such tutoring will just move out from the purview of for-profit institutions—the only losers are the capital providers and investors of such companies.

This has been the modus operandi for CCP leader Xi Jinping, who believes that China must blaze its own trail, and its development must be independent and strong without having to rely on foreign capital and know-how. In many ways, Xi seeks to challenge the West and the West’s established form of development (including the laissez-faire regulatory regimes of the West). And this is a completely different methodology under previous regime bosses Jiang Zemin and Hu Jintao, who favored crony capitalism and making money without ruffling the established world order.

In other words, the Party knows best. And companies must develop, expand, and acquire customers and employees in a manner that is consistent with the vision of the Party (or Xi himself).

Chinese companies and entrepreneurs looking to fashion themselves after Jeff Bezos and Elon Musk have been put on notice. And investors who wish to invest with them should evaluate their positions accordingly. How will their company abide by the CCP going forward, and is it part of a vulnerable industry that could come under the microscope of Beijing?

In hindsight, this development shouldn’t be surprising.

A Chinese stock traded on the New York Stock Exchange acts and behaves just like another stock, right? The answer is no.

U.S. investors’ hubris has left them blind to the fact that their investments in these Chinese companies are nothing but stakes in offshore shell companies that signed paper contracts with the true operating entities in China. These operating companies have nothing to do with the shell companies that foreign investors own, outside of these legal contracts.

But for years, it didn’t matter. Their share prices appreciated. The dividend checks they received didn’t bounce. The companies held quarterly earnings calls and filed some familiar-looking financial statements with the Securities and Exchange Commission. And Beijing didn’t crack down on the offshore variable interest entity (VIE) structures that were technically illegal.

But the faith is wavering now, after all these years.

Many investors decided to pull their money out. Some may decide to wait and see. Others sense an opportunity to buy low. We’re here to help you make smart decisions, not to pontificate. But either way, investors need to look at Chinese stocks differently than before.

Let’s assume the risks of the VIE structure is worth a 20 percent discount in value. And the CCP’s regulatory and political risks, another 20 percent. So the share of a Chinese company should at least be valued at a 40 percent discount than a comparable U.S. company—assuming the economics being equal.

It’s not scientific nor technically precise, but might be a decent starting point if you want to keep both your stock and your sanity.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

Fan Yu
Fan Yu
Fan Yu is an expert in finance and economics and has contributed analyses on China's economy since 2015.