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Today’s post is from Peter Roberto, investment research analyst on our Investment Management and Research team.
In 2020, we saw strong foreign capital flows into the U.S., as foreign holdings of mainland China stocks increased 62 percent over 2019, according to Bloomberg. The Chinese bond market saw a similar trend, with a 47 percent increase in foreign-held flows—and for good reason. China was the only major global economy to report positive economic growth during the year. This growth was largely due to the swift and firm measures taken by the country’s singular party to battle the pandemic. Even if you were too caught up in the chaos of 2020 to check your statements, the contrast between the images of large New Year’s Eve crowds in Wuhan releasing balloons and a barren Times Square in New York City illustrated that the world saw dramatically different results for the year.
Regulators, Mount Up
The year also gave way to numerous actions by regulatory officials within the country. The most notable action occurred on November 5, 2020, when regulators changed the rules around online microlending. Coincidentally, this rule change occurred just days after Jack Ma, founder of Alibaba, made his comments about banking regulations being enforced by an “old person’s club.”
As a result of these new rules, the dual listing (in the U.S. and Hong Kong) of the financial technology firm Ant Group, which offers online microlending, was halted. The resulting regulation also forced Ant to carry higher amounts of capital on its books for its nearly $255 billion in consumer loans and took away much of its operational advantage over traditional banks. While this action appears to limit credit risk within the financial system in China, it is part of a larger group of objectives for the country.
Different Perspectives, Yet Again
China and the rest of the world have taken different economic policy stances post-pandemic. Europe and the U.S. have seen their central banks and governments offer support for recovery following the decline seen at the onset of the pandemic in 2020. China, on the other hand, has taken a much more cautious approach, with the lessons of the financial crisis remaining fresh in its memory.
One of the key tenets in President Xi Jinping’s centenary speech was “promote high-quality development and build up our country’s strength in science and technology.” The country and regulators have followed this pledge by focusing on credit expansion and driving technology through competition.
Same Scrutiny, New Methods
This focus on competition grabbed headlines when regulators placed antitrust fines against tech giants Tencent and Alibaba. The fines, estimated to be $1.5 billion and $2.8 billion, respectively, were due to nondisclosure of acquisitions and anticompetitive e-commerce merchant practices. While driving technology through innovation and credit was the focus of these regulatory actions, we have seen regulators scrutinize other areas of the party’s interest in the past. For example, actions have been taken against the gaming and cryptocurrency areas for their influence on children and their lack of oversight.
More recently, the focus of regulatory actions has fanned out into other areas, including cybersecurity and education. The first cybersecurity action took place against ride-hailing company Didi (DIDI). The company, which underwent its IPO on June 30, had its app removed from a number of outlets, as Chinese regulators indicated the company was illegally obtaining customer data. ByteDance, the company that created the social media app TikTok, delayed its listing after government officials told the company to focus on data security risks.
Further action against for-profit education companies was particularly jarring, as the country barred for-profit tutoring for core school subjects to reduce the financial burden on families who have children. The move drastically reduced the earnings capabilities of names such as TAL Education Group (TAL), New Oriental Education & Technology (EDU), and Gaotu Techedu Inc. (GOTU), as their stocks fell by more than 50 percent on the news. The sell-off was not contained to these firms, as areas that had been previously hit by regulatory actions sold off heavily as well. The MSCI China Index has sold off by nearly 19 percent this month (as of July 28, 2021), with areas such as technology faring slightly worse.
Takeaways for Emerging Market Investors
With much uncertainty surrounding future regulatory actions, there are a few key takeaways for emerging market investors to keep in mind:
Know what you own. The MSCI Emerging Markets Index, one of the most common benchmarks, had 37.5 percent exposure to China as of June 30. But we have seen both retail investors and active managers take bets on China and specific industries within the country. If your portfolio does not match your risk tolerance and objectives, it should be adjusted accordingly.
Exposure to regulators can be difficult to predict, but financial strength is easier to observe. Alibaba (BABA) has been hit with the largest fine thus far ($2.8 billion). But this fine represents just 4 percent of the firm’s balance sheet. The financial impact, however, is not the only one, as we have seen in the case of the education industry. Is your exposure diversified from an operational perspective?
Recent regulatory actions are not without reason and not something that occurs consistently over time. Many of these actions in China were done to create competition as the country faces challenges of an aging population, changes in social equality, and the shift toward a service economy. These challenges, in addition to the ongoing competition between China and the U.S. as they vie for the top global economic spot, lead us to believe that regulation is here to stay—and now is as good a time as ever to make sure your portfolio is allocated properly for the next round of regulatory action.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI China Index is a free float-adjusted market capitalization-weighted index designed to measure the performance of equity securities in the top 85 percent of market capitalization of the Chinese equity securities markets as represented by H shares and B shares.
