China’s regulatory crackdown on education and tech companies led early this week to a dramatic sell-off that started in Chinese stocks and extended into offshore Chinese currency and credit markets. While investor concerns about unpredictable government intervention are understandable, we see a silver lining to today’s dark clouds.
First, Chinese companies that paid attention to government warnings have been bracing for closer scrutiny and tighter regulation for some time. Second, while companies that ignore Beijing’s signals can face dire consequences, those that heed the government’s warnings and align their practices with government goals will likely thrive in a tighter and more predictable regulatory environment—one conducive to lower margins but more stable cash flow. That’s a healthy environment for credit investing.
China’s Regulations: Further, Stricter, Faster
The dramatic sell-off was triggered by new regulations in China’s booming private education industry. Chinese regulators banned for-profits business in after-school tutoring, prompting a collapse in shares of private education companies that sent shockwaves through the market.
These moves came on the heels of regulatory crackdowns in other industries, especially for companies in high-growth sectors such as e-commerce, food delivery and ride hailing. These new sectors thrived in recent decades, thanks to lax regulations, technological progress, lifestyle changes and evolving demographics, and have overtaken the more traditional Chinese sectors of property, financial services and infrastructure.
To investors, the speed and stringency of China’s new regulations may seem surprising. But regulators’ underlying concerns aren’t unique to China. Indeed, they’re very similar to those of politicians and regulators in the US and Europe.
Big tech companies, for example, are under the microscope everywhere because of their huge size, anti-competitive practices, control of consumer data and potential to create financial risk. The difference between the government response in China and the government response in the rest of the world is that China’s system of governance allows it to act faster and more forcefully.
Identifying Key Regulatory Risks
We divide China’s regulatory risks into four major categories:
1) Antitrust. To protect consumers and underprivileged employees, the government is cracking down on anti-competitive practices. This particularly affects sectors such as e-commerce, food delivery and local logistic/courier services, which are dominated by just two or three players. Usually, companies pay a one-off fine. High ongoing compliance costs can eat up their margins. Nonetheless, these businesses remain viable and are considered essential in improving people’s lives, creating jobs and cultivating a harmonious society.
2) Content regulation. Beijing controls public expression of opinion, with video streaming, content providers, social media and even gaming all focal points of China’s content regulators. The problem for companies is that the government’s definition of acceptable expression has been evolving, making it more difficult for these companies to conform.
3) Higher reforms. China’s government has an ambitious reform agenda driven by both structural factors and far-reaching social, environmental and political goals. This can be especially challenging for companies at the epicenter of such reform, such as the education and fintech sectors, for two reasons.
First, at the signaling stage, the government often sets broad guidelines intended to reshape the acceptable scope of business, rather than curbing specific practices. As a result, companies may not fully heed the warnings and may even worsen existing problems. Second, the government is willing to pay a high economic price to attain its social and political goals. This creates uncertainty about whether a company’s business model will be viable.
4) Individual disruptors. Companies that are very big and that refuse to listen to regulatory signals can wind up in deeper trouble. The ride-hailing app Didi, for example, was initially subject only to antitrust regulatory risk because it dominated its market. But because it ignored government warnings about national security concerns, it faced even heavier scrutiny for misuse of customer data. China’s government can accept disruptive technologies, but disruptive companies are another matter.
Diverging Paths for Chinese Companies
Having celebrated its 100th anniversary on July 1, the Chinese Communist Party is more confident than ever in its ability to take the Chinese economy and society to the next level. Its goal has already shifted from simple, number-based GDP growth to a multifaceted objective combining political, social, economic and environmental targets.
Chinese companies must choose a path forward. Those that adapt the same mentality as Beijing are likely to be rewarded, while companies that insist on the “old ways” of growth may face deeper crisis.
The bottom line? Chinese companies should think twice about taking on excessive capex or unnecessary regulatory risks to drive incremental topline growth. Instead, they should focus on generating stable cash flow, improving transparency and compliance, and promoting environmental, social and governance awareness.
And with this framework in mind, investors can more readily identify which companies will be most likely to thrive in China’s stricter regulatory environment.
Jenny Zeng is Co-Head of Asia Pacific Fixed Income at AllianceBernstein (AB).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.