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16 September 2021

Chinese Regulation and Investor Sentiment

A flurry of anti-trust fines and significant shifts in regulation have hit the Chinese market in recent months, all but decimating the private education sector and leaving investors worried that the Communist Party could wield its sharp sword over any of China’s business sectors.

In April of this year, Alibaba was hit with a US$2.8bn fine due to ‘anti-competitive practices against merchants using its e-commerce platform’ sending its stock down over 29% from its late-October highs. While shares initially rallied on a lower-than-expected fine, they have since traded downwards further, alongside other Chinese internet stocks such as Tencent and Meituan, on worries that the government could force a tighter regulatory grip.

Such fears were later confirmed, not across the tech industry but the private education sector, with shares of US-listed TAL Education Group falling over 93% since February this year. The government saw such companies embedding themselves into the Chinese school curriculum and increasing the pressure that children faced at a young age. The new regulations, classifying private education companies as non-profits, shows the power that the Communist Party has over the population and the country’s business environment, again highlighting that they are more than happy to make a splash as a show of force.

Clearly there will be key implications going forward as a direct result of both the regulations and the stark investor response. While China has no plans to stop US listings of Chinese companies, to help shield themselves from potential problems many Chinese companies that were initially looking to list in the US have started to consider a potential pivot over to the Hong Kong market. We would, therefore, expect the vast majority to now choose either Hong Kong or Shanghai as their listing location.

In recent weeks the Chinese securities regulator hosted a meeting with large multi-national banks and financial institutions to stress that the country still wishes to remain open to foreign investment and has no intention to de-couple the China-global capital markets relationship. While investors surely welcomed the news, many will be hoping for substantially improved communication with financial markets. The regulator has realised the importance of better communication, given the shock reaction markets had to the education crackdown and, while policymakers are likely to place foreign investors at the bottom of their priority list, we would hope and expect to see greater prior warning.

As many will know, investing in any emerging market economy carries with it substantially higher risks. The political and economic uncertainties, coupled with a lack of disclosure from companies and a poorer understanding of the local market, exacerbate the risks associated with countries in the growth stage of their economic development cycle. Given such factors, exposure towards China across cautious portfolios should be low, meaning that the specific risks the region presents are limited to a small portion of the portfolio.

However, given the returns within China over the past two years, many had simply forgotten the risks and focused primarily on the impressive performance offered by exciting companies. The recent regulations, then, were a stark reminder and, in many ways, will help investors to better evaluate China’s positioning within their portfolios. Recent events, however, have not been outside the realm of what many might have expected, given the Communist Party’s power and ruthless application of values and regulations. To put it simply, to invest in the China growth story, it has to be done on the strict terms set out by the government, over which individuals have little to no sway. This is something Western investors have not yet experienced, at least to this extent, but it is a key characteristic of investing in the region that they will have to get comfortable with, one way or another.
While the recent regulations have proved frustrating and worth keeping a close eye on, they do not take away from the overall long-term growth story that the country has to offer - there are still a plethora of highly innovative and fast-growing companies ripe for investment.

The regulations were, after all, implemented with good intentions. The private tuition industry in China was placing undue stress on children at a young age and essentially creating an extra hoop within the education system that parents had to jump through if they wanted their children to perform well and attend top universities. Such qualms were raised by the Communist Party last year, but, given that Western investors are predominantly used to either regulation that takes many years to come to fruition or for it to fall through completely (look at big tech regulation in the US), the swift implementation by the government was shocking.

Going forward, regulation analysis will form a key stage in the investment process from the perspective of both fund managers and investors. Fund managers especially will have to both forecast which sectors are prone to governmental regulation and actively manage the regulatory risk within portfolios. Therefore, comprehensive reviews and trust will have to be built over time with active managers to ensure they are effectively implementing procedures to combat regulatory risk and the impact it has on their views and holdings going forward.

This article was taken from the Ausust 2021 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
 
Chinese Regulation and Investor Sentiment

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