China - A New Beginning or More of the Same

Taking financial markets by surprise, Chinese authorities announced that the ride-hailing platform, Didi, was to be banned from app stores in China. This effectively severed the company’s ability to add new users within the country. Didi, the Chinese equivalent to Uber, received this unwelcome news just two days after going public on the New York Stock Exchange, in what was the largest US initial public offering by a Chinese company since Alibaba went public in 2014. Unsurprisingly, the announcement sent Didi’s stock price tumbling. The Cyberspace Administration of China (CAC) justified the action saying the company was illegally collecting and using personal information. However, skeptics of the communist regime believe that this action was taken as part of a newly emerging effort by China to reign in the power of some of the country’s most influential companies. Whatever the reasons, the Chinese government’s recent series of regulatory actions have rippled through the Chinese stock market and left many investors unsure of what to expect. Before we attempt to estimate the future implications of these actions, we must first discuss the events that have unfolded over the last few months and take a brief look to the past to gain historical context.

Yesterday, Today & Tomorrow

Over the past few months, China has taken concrete action to crack down on Chinese companies listed on foreign stock exchanges, particularly those within the technology sector. While the list of new regulations continues to grow, the ones that have had the greatest impact on market sentiment are provided in the following table.

The increasing uncertainty within the market has resulted in a precipitous drop in the stock price of many of these firms. Rationalizing their decision to rewrite the law, China has cited the need to dismantle monopolistic companies, protect consumers, and promote equality. There are others who believe this is part of a larger effort by the Chinese Communist Party to solidify its position of power. To date, the technology sector has been the hardest hit, however a report released by Chinese officials on August 11 detailed plans to increase the scrutiny of all companies within “important fields” such as education, science, and technology among others. These events have caused the S&P/BNY Mellon China Select ADR Index (an index that tracks the performance of nearly all Chinese companies listed on American stock exchanges) in July of 2021 to experience the largest single month drop in over five years. Given investors’ disdain for uncertainty, it comes as no surprise that financial markets reacted in this manner. However, this lack of regulatory clarity is unlikely to persist in the long run. So, to understand what may occur once the dust settles, we will now turn our attention to past experiences to see what lessons we can glean.

By Western standards, this recent upheaval of the regulatory environment is inconceivable, however within the context of developing nations such as China this degree of regulatory uncertainty is anything but uncommon. To gain perspective on the events unfolding in China, we have to look no further than the crackdown on the banking industry that occurred in the years leading up to 2010. In this instance, the Chinese government implemented a series of regulatory changes with the stated goal of protecting fair competition and promoting sound banking practices within the nation. Much like the changes being implemented today, there appeared to be other factors influencing these policy changes, namely weakening the standing of foreign competitors to prop up Chinese banks. While the abrupt regulatory changes resulted in a period of market turmoil and a reshaping of how banks could operate within the country, once the changes were fully implemented financial markets normalized and the investors that were able to ride out the storm were rewarded with higher returns. A similar series of events unfolded in the early 2000s when China reformed the laws governing financial institutions, resulting in a period of poor equity performance that was followed by a rally in stock prices. Whether or not these past experiences are directly transferrable to today’s situation is unclear. As we will discuss next, what is clear is that China did not go into this with its eyes shut, and if history is to repeat itself investors may be able to unlock value by simply riding out the storm.

Up to this point, we have discussed the events surrounding the current market volatility and deepened our understanding of how today’s events compare to those of the past. So, naturally we must now contemplate what lies ahead. To accomplish this, it is paramount to first make it clear that China has benefited immensely from adopting free-market policies. The progress China has made in raising its population out of poverty is unmatched and is largely attributable to the opening of its economy and adopting free-market principles. Given the benefits realized by China it is hard to believe that it would be willing to kill the “golden goose.” Provided that Chinese officials do not have a proclivity for self-harm, it is safe to assume that high-ranking officials weighed the pros and cons of these actions and concluded that the long-term benefits from reshaping the regulatory framework outweighed any short-term consequences. Due to this, we believe the reshuffling of regulations taking place within China will be inconsequential in the long run. This may even present opportunities for strategic investment in the short run. Warren Buffett, Chairman and CEO of Berkshire Hathaway and regarded by many as one of the greatest investors of all time, highlighted the potential benefits of uncertainty when he said “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.” We tend to subscribe to this long-term investment orientation and believe that our client portfolios are well positioned for the unfolding events.

Into the Unknown

The actions undertaken by the Chinese government have shaken the confidence of many investors and the uneasiness may not be ending any time soon. As of this writing, the scope of China’s efforts to revamp the laws governing publicly traded companies is unclear. While this uncertainty persists, we expect heightened volatility to remain. That said, we believe that client portfolios are well positioned to take advantage of this disruption through the actively managed mutual fund managers we employ. In addition, the temporary market aberrations should be muted at the portfolio level as the typical client’s balanced portfolio (i.e. 60% stocks and 40% bonds) has less than 2.5% of their portfolio invested in Chinese securities. Given the above, we believe the best course of action is to sit back and, in this rare instance, hope that history repeats itself. In the meantime, we will continue to monitor the events unfolding in China and as always, we will keep clients abreast of future developments.