Jonathan Marriott, Chief Investment Officer
The growth in the Chinese economy has provided huge opportunities for investors. With a population of 1.4 billion, over 4 times that of the United States, China is likely to be the largest economy in the world in the next decade. Some investors had begun to treat China as a developed market, but the actions of the ruling Communist Party reminds us that it still carries many of the risks associated with emerging markets. There have been a number of actions to regulate company activities more closely and to align companies more closely with the long-term objectives of the party. The initial actions have been particularly targeted at the technology sector. The Hang Seng Tech Index which was up 78% last year and nearly 30% in the first seven weeks of the year has fallen back 38% from its peak.
Earlier this week, it was the education sector’s turn to be targeted by the party. China has a long tradition of progress through examination going back over 1000 years. The Song Dynasty (960-1279 AD) introduced an exam system, that was open to all from almost any background, for entry to the Imperial Civil Service. This mandarin selection process survived through many dynasties until 1905. Today entry to the top universities is based on a national examination (Gaokao). Many see this as key to success in life and over 10million Chinese students sit the exam each year. There is immense pressure to do well in these exams; as a result, parents were willing to pay dearly for extra tuition. The private sector sniffed this out early on and took advantage of this opportunity.
The Communist Party of China (CPC) has several possible reasons to be unhappy about this situation. They want the system to be an even playing field for all, and do not want the rich to gain advantage. They have woken up to the risks of a low birth rate and ageing population; the cost of education was cited by many parents as a reason for having only one child. It should be noted that the CPC had recently announced a three-child policy to help boost the birth rate. The CPC may also be concerned that any political messaging included in education will be diluted if foreigners are involved. The recent policy statement issued by the CPC clearly refers to the pressures put on children by excessive work outside of school hours and aims to protect young people's eyesight whilst ensuring they go to bed on time. According to Xinhua, the official government news agency, two of the highlights are:
In other words, the CPC are cutting foreign involvement, and are making it such that no money can be made out of education. It does appear to leave open some foreign involvement in non-core areas of education, but nevertheless severely curtails any potential activity. This came as a massive shock to the market. For example, TAL Education American Depository Receipts (ADRs) which had risen 168% in 2019/20, fell over 70% on Monday, and are now down 91% year-to-date!
This attack on education companies came after a stream of other regulatory activities hit many technology companies over the last few months. These include the blocking of the listing of ANT financial, Didi being punished for not getting cybersecurity clearance before listing, and Meituan being told to improve pay and conditions for its delivery workers. Clearly, the CPC is flexing its muscles to rein in the large technology companies and exert its authority.
The extent of the action on the education sector spooked the market, causing a sharp sell-off at the start of the week which eventually spread to wider financial markets. Later, the Chinese authorities were reported by Bloomberg as having called in a number of investment banks to calm market sentiment and to communicate that these actions are limited in nature. This seemed to provide some short-term stability in the market. Clearly the risk of government intervention will mean that investors should demand higher expected rewards for the higher perceived risk. It may also mean that investors look for investment in less prominent companies that are less likely to attract the attention of the authorities.
The investment opportunities in China remain enormous, but returns to investors may be tempered by the need to keep the CPC happy. Enormous wealth has accumulated in the hands of entrepreneurs particularly in the technology sector. Meanwhile, there are huge numbers of Chinese people who have failed to benefit from the economic boom. The CPC, similar to the UK Government, is looking to level up and spread the benefits. The CPC is also keen to ensure opportunities are open for all and make a fairer society. Its other priorities include investment in Artificial Intelligence, semi-conductor manufacturing, electric vehicles, and solar panels. Companies that contribute to these aims may be less likely to see government intervention for now.
When investing in China we need to remember that its version of capitalism is not the same as the western model. The CPC grip on power depends on keeping the masses happy rather than a few entrepreneurs. The potential for investors in China remains huge and Chinese companies may still look for foreign capital. However, this comes at the price of keeping the administration happy. The market tends to be more volatile with many individual investors who actively trade their portfolios and often have leveraged positions. This means that the market is likely to be volatile and react quickly to policy changes. This week we have seen this in action. Investors should continue to see the opportunities in China but given the volatility positions should be sized to reflect the risks.
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