China’s continued rise as a global economic powerhouse has been a double-edged sword for leader Xi Jinping and the ruling Chinese Communist Party (CCP). On one hand, state-sanctioned capitalism and entrepreneurship have been crucial to China’s growth, spawning such global companies as Alibaba (e-commerce), Tencent (video gaming) and NIO (electric cars). On the other, the power and influence that these companies and their owners have accumulated also threatens the authority of the CCP and has led to great disparities in wealth and opportunity within Chinese society. In response, Beijing has shown an increasing willingness of late to use aggressive regulation to target some of the country’s largest companies. These actions have not been well-received by the market – through October 31, 2021, the MSCI China Index returned -13.95% year-to-date, while the broader MSCI Emerging Markets Index has been flat (see Figure 1).
Figure 1: China stocks have fallen sharply in 2021 while emerging markets stocks more broadly have remained flat. Global stocks have risen. Source: MSCI
The uncertainty surrounding future government action makes for a challenging environment for investors in the nearer term; however, it is our belief that these challenges can be overcome, and that the continued growth of the middle-class warrants a long-term allocation to China as part of a global portfolio. Because the difficulty in investing in China stems from the inherent conflict between the ruling communist party and successful free enterprise, having some knowledge of the stated policy goals of the CCP, and understanding which sectors of the economy are the most likely to be the target of government regulation, is key to determining where the best (and safest) opportunities lie.
“Common Prosperity.” In October 2020, Xi Jinping led the development of the 14th Five-Year Plan of the CCP. Released in March 2021 (in the CCP’s centennial year), the plan lays out several initiatives under a broad theme of working toward “common prosperity.” While this concept has its roots in the Mao era as a rallying call for socialism, the steady increase of private enterprise in China caused an evolution in the meaning of the term. Beginning in the 1970s, as the economy liberalized and free enterprise blossomed, “common prosperity” came to signify a tolerance of capitalism, so that a few may get rich to the shared benefit of the masses.
Fast forward to the present day and, like in the U.S., Chinese society has seen a widening of the wealth gap – a study from the Credit Suisse Research Institute estimates that China’s top 1% owned 21% of the country’s wealth in 2000, but now own nearly 31% (the report estimates that the top 1% in the U.S. own 35% of the wealth). Ryan Hass, Senior Fellow at the Brookings Institute, observes that in China, nearly twice the population of the U.S. lives off a monthly income of $154 or less, while another much smaller group consumes about half of all luxury goods sold worldwide – such disparity has put significant domestic pressure on the CCP to live up to its stated egalitarian ideals. In response, Mr. Xi has sought to reclaim the original spirt of “common prosperity,” by cracking down on companies that the government perceives as a threat to society and reigning in the excess of certain segments of the Chinese economy.
A Very Public Crackdown. The CCP’s first regulatory target was very high-profile – Alibaba and its billionaire founder, Jack Ma. In October 2020, Ant Group, an e-payments company and Alibaba affiliate, was to become the biggest IPO in history, surpassing the previous recordholder (Alibaba itself) by 40%. Following a rare public rebuke by Jack Ma of the heavy regulatory hand of the Chinese government, the IPO was cancelled at the last minute, reportedly at the order of Xi Jinping himself. Alibaba was subsequently fined $2.75 billion for monopolistic behavior and Jack Ma was compelled to donate billions of his own money to charity to further the goal “common prosperity.”
Another prominent regulatory action has targeted for-profit education. In July 2021, Beijing issued new rules requiring all private tutoring companies to become nonprofits, with the stated goal of addressing disparities in educational access between wealthy urban and poorer rural Chinese. Since then, these companies have seen their market values plummet. The largest such company, New Oriental Education & Technology Group, saw a decline of approximately $7.4 billion in its U.S.-listed shares from July to September.
Other targets have included Tencent, DiDi (ride-hailing) and Meituan (food delivery). The targeted companies have several things in common – they are high-profile, consumer-facing, technology-based service businesses with a predominately Chinese user base. The Chinese government has closely observed the rise of U.S. internet-platform giants such as Facebook, Google and Amazon into monopolies that not only dominate the U.S. economy, but also have an outsized influence on American culture. The “internet platform” business model, where a service is provided at little or no upfront cost to the consumer in exchange for personal data that is then exploited and monetized, does not align with the long-term economic and societal goals of the CCP. Thus, much of the regulatory crackdown in China has been in the guise of consumer privacy laws mean to prevent companies with business models like Facebook or Google from becoming too powerful. Targeting highly visible companies has the added benefit of demonstrating to its domestic audience that the CCP means business and reinforces Beijing’s desire to focus talent and capital on the strategic sectors laid out in the Five-Year Plan, such as electric vehicles, semiconductor production and other high-end manufacturing.
The Excess of Evergrande. China’s “top-down” approach to managing capitalism can result in unintended entanglements within Chinese society. The recent plight of the Chinese real estate behemoth Evergrande is an illustration of the complex relationship between business and the Chinese state. Founded in 1996, Evergrande became a key part of China’s economic, political, and social fabric as the country’s largest real estate developer. Because local governments in China have a near-monopoly on land ownership, regional projects and services are largely funded by the sale of rural land to Chinese developers. In 2020 alone, local government revenue from land sales were over $1.3 trillion. These deals have kept the coffers of regional governments full and made some Chinese investors fabulously wealthy, while creating an environment rife with corruption and graft. This arrangement also encouraged overdevelopment and loose lending practices leading to an enormous amount of debt. In fact, Evergrande has the distinction of being the most indebted real estate developer in the world with more than $300 billion outstanding. Because China is such a large part of the world economy, and the fact that foreign bondholders are owed $7.4 billion in payments in 2022 alone, global investors have a close eye on the government for signs of a bailout. So far, however, Beijing has stood back as the company teeters on the brink of default, content to allow this bubble to burst. Because nearly 75% of household wealth in China is tied to real estate, it’s likely that the government will ultimately step in to rescue Evergrande’s customers, while letting investors and lenders face the consequences as the company’s debt is unwound.
Choosing Active Managers with Local Knowledge is Key. Despite the complexity, we conclude that long-term case for investment in China is strong. For one, there are diversification benefits, as Chinese stocks have historically had a very low correlation with U.S. stocks. Additionally, China’s influence as a global economic leader will continue to grow and the emerging Chinese middle-class provides a powerful consumer base. However, the mechanics of the Chinese economy are quite complicated – the ever-present oversight and influence of Beijing intertwines with local governments, wealthy business leaders (who are often well-connected politically), rural and urban segments of Chinese society, and other constituents in a way that makes it difficult to understand from an outsider’s perspective. The CCP seeks a delicate balance between keeping Chinese society as much of a closed system as possible, while still allowing and encouraging foreign investment as a driver of growth. An in-depth knowledge of the nuances of Chinese business and politics is required to successfully navigate this dichotomy. For these reasons, our investment research has focused on identifying active, locally based managers who know the culture, understand the vagaries of Chinese politics, and can uncover the most attractive opportunities.
As always, we welcome your questions and conversation – please reach out to us anytime you would like to chat.
Joel Streeter and the Mangham Associates Team
About the Author. Joel Streeter is a Director at Mangham Associates with over 15 years’ experience in the investment industry. Prior to joining Mangham in 2018, he served as Vice President, Investor Relations at Trian Fund Management, as Assistant Vice President at BNY Mellon Investment Management, and as an Analyst at Wells Capital Management. Joel received a B.A. in Government from Wesleyan University in Middletown, Connecticut.