China’s Regulatory Announcements Part I
Understanding the context, goals and ramifications of the recent Chinese regulatory announcements.
What are the reasons behind recent changes in China’s regulatory environment?
I think the most important way to understand what's happening in terms of recent regulatory changes in China is that they are being driven by the same debates and discussions taking place in Washington, London, Brussels and other capitals around the world. The Chinese government has similar concerns about competition, consumer rights, protecting small businesses, anti-monopoly practices, data protection and national security, and also inequality of opportunity. These are all issues that we've been debating in the U.S. a long time—for example, about how to deal with our internet platforms.
But one of the big differences in China is that it's governed by a one party regime, and therefore able to act more quickly. And while the U.S. and Europe have been debating how to handle its online platforms for well over a decade—without doing very much about it—China has acted quickly. China’s fast pace of action has surprised many investors, which has led to market volatility. However I think the objectives of these regulations are pretty similar to what we're looking at here in the West.
What about the recent regulatory announcements related to education?
In the education space, things are a little bit different. There's a real concern in China about the impact that for-profit education is having on family budgets, on inequality of access to education, and that's where the focus is. I think this is all about concerns about inequality—inequality of access to tutoring, which means inequality of access to university spaces, which are limited in China, and the social and economic questions that arise from that.
Another part of it is that the education bureaucracy in China, which is quite powerful, has been complaining for a long time that for-profit education programs are stealing many of their best teachers because they can pay more. So I think they're wrestling with the kinds of things we're wrestling with in education in the U.S., i.e., how do we equalize the opportunity for kids growing up in households that don't have that much money or in towns that don't have enough money to have the same level of schools and teachers that the town down the road has?
Do you think the recent regulatory announcements are a signal that the Chinese government is anti-private company?
I feel very strongly that's not the case—it’s not about the existence or importance of private companies. Let's keep in mind that one of the reasons the Chinese Communist Party has continued to rule China for as long as it has, is that from an economics perspective they've been really pragmatic and increasingly markets oriented. Private companies now drive the Chinese economy, and that's a huge change from the relatively recent past. When I first worked in China in the early 1980s, there were no private companies, you couldn't even find a privately owned restaurant. Today, small entrepreneurial private companies drive the economy, create all of the new jobs, and create all of the innovation and wealth—it's just not possible to wind that back, and I don't see any sign that is what the party is thinking about doing.
Are companies in the A-Share market under the government radar in terms of regulations?
From a macro perspective, from where I sit and look at these things, I don't see any of the regulatory policies that have been announced as targeting companies based on where they're listed. I don't see this as “anti-foreign investors.” I know it feels that way, but I don't think that was the intention behind what's happened recently. I think it's coincidental that a lot of the companies that were caught up in these regulatory changes are listed abroad, because they were recently startups and did not meet the much stricter listing requirements in the Mainland Chinese and Hong Kong markets; so they came to be listed in New York, and that happens to be where the pressure's been felt.
It's worth noting that a Vice Chairman of the CSRC (China Securities Regulatory Commission)—the equities regulator in China—got on an emergency call recently with brokers signaling that they realize that they have really poorly communicated what they're doing, but the Vice Chairman made it very clear that this is not an attack on foreign investors.
Given the growing interconnectivity between the capital markets in New York and in Shanghai and Shenzhen, should investors be concerned that Chinese stocks listed in the U.S, might be de-listed and therefore become uninvestible or face pressure on their share prices as a result?
Let me start with a little bit of background—the PCAOB (Public Company Accounting Oversight Board) which is under the SEC, is required by law to periodically check the workbooks of the accounting firms that are auditing publicly listed companies in the U.S., including foreign companies. It goes back to when Sarbanes Oxley became law, to avoid a repeat of Enron, where the accounting firms were blamed for not keeping proper tabs on what everyone was up to.
Occasionally the U.S. government has had to sign agreements with foreign governments so that they can overcome some of the legal differences in each country so that these audits can be undertaken, but they've been struggling for a number of years to get an agreement like this with China. This came to a head recently because at the end of last year, Congress passed another law, the Holding Foreign Companies Accountable Act, which says that if the PCAOB and a foreign government can't reach agreement on having these audits take place, then a three-year clock starts ticking. And at the end of that time, companies from that country would be delisted.
It sounds like this is a dispute between the U.S. and Chinese governments and not about Chinese companies avoiding being audited or checked.
That’s correct. In fact, Chinese companies have to comply with all of the other SEC regulations to list and stay listed in the U.S. It's not about the auditing firms saying they don't want to do it, it's a government to government issue. So if they don't resolve this issue, then potentially by the summer of 2024, we could see a forced delisting. But I'm hopeful that's not going to happen—it's really in both sides' interest to make this work.
From the U.S. perspective, we want Chinese companies to list here. China is a major source of global IPOs, and if we're going to keep our capital markets the predominant capital markets in the world, we need to have Chinese companies listing here. But it's also really good for investors, because we should want Chinese companies to come here and be subject to SEC and PCAOB scrutiny if Americans are going to be investing in those companies, rather than if they list, say, in Hong Kong or Shenzhen, and Americans continue to invest in them there. So I'm quite hopeful that this is going to get resolved before we have to really worry in the summer of 2024 about a forced de-listing.
Speaking of regulators, SEC Chair Gensler recently made a statement about the use of the variable interest entity (“VIE”) structure, which is a legal structure used by many Chinese-listed ADRs in the U.S. Will the Chinese government continue to allow foreign listings through the VIE structure?
The structure has been in existence for over 20 years, and many Chinese companies listed in markets outside of mainland China use this business structure. These are legal contracts which effectively allow foreigners to invest in a Chinese company without owning shares in the underlying businesses. This structure remains largely tolerated by the Chinese government, which could change, and remains untested in disputes over investor rights even though it has been used by a number of significant Chinese companies.
It's also worth noting that the Vice Chairman of the CSRC, on the recent call with brokers, said that the VIE structure remains necessary and important to the Chinese markets. And that's consistent with my view that while they're going to tinker with how it's implemented, particularly pushing for more disclosure of the underlying shareholders, they're not going to get rid of the VIE structure.
In your view, when will regulation headwinds stop?
Regulatory uncertainty has been a fact of life of investing in emerging markets, including China, for a very long time, and it's likely to continue to be so. The Chinese economy is still evolving, and it's evolving at a really fast pace, and the regulators are constantly struggling to keep up with it. We should also understand that China’s regulatory philosophy is a little bit different than ours in the U.S. They tend to not create the regulations at the very beginning like we like to do, because we're more legally oriented. Instead they say to entrepreneurs, go out and set up businesses, give it a shot, and then we'll intervene where we think it's necessary. I think this is going to be a continuing part of it, and one of the reasons why I believe it’s really important to be an active, rather than a passive ETF-based investor in China.
How does active management mitigate some of the regulatory risks?
With active management you've got somebody who's looking really carefully at the individual companies and their business models and thinking about where regulatory changes are going to go and have an impact on that. But this is in my view going to be a continuing concern for investors.
From an investor’s perspective, I think the focus should not be on what sector will next come under regulatory scrutiny. Most sectors will. Rather, I think the focus should be company specific. Which companies’ business models are likely to be affected by regulations designed to foster competition, protect privacy and national security, and reduce inequality of opportunity? And what impact might that have on valuations? This is where I hope Matthews Asia can add value to investors.
Over the near term, what are the biggest risks to investing in China?
There are two key risks. The first is that the central bank fails to provide enough credit and liquidity to support the final legs of recovery from COVID, but I think this is a modest risk. A recent uptick in the number of Delta variant cases in China means that the recovery in spending on services may take longer than we expected just a month ago, but this may also generate a bit more supportive monetary policy.
The second risk is the political and regulatory environment. Foreign investor sentiment may suffer under the weight of rising political tensions between Washington and Beijing, but this is unlikely to disrupt spending by Chinese consumers, or their investments in their home equities markets. More regulatory changes are expected, especially in sectors which are data-rich, and these have the potential to create near-term volatility if not communicated clearly. But in my view, these regulatory changes are likely to create a supportive environment for quality companies in the long run.
What is your outlook for the Chinese economy?
I am optimistic about China’s medium-term economic prospects as well, within the context of expecting gradually slower year-on-year growth rates. This optimism is based in large part on the continuing evolution of government policy designed to embrace private enterprise and markets. As I mentioned earlier, private firms are the engine of China’s growth and job creation and they are China’s most innovative firms, and the government’s economic growth plans are based on innovation.
Over the near term, the macro picture looks healthy for the coming quarters, including an expectation of a fuller recovery in consumer spending on services, although the rise of the Delta variant means it is difficult to forecast when service sector activity will return to pre-pandemic levels.
Investing in Chinese securities involve risks. Heightened risks related to the regulatory environment and the potential actions by the Chinese government could negatively impact performance.
All investments involve risk. Past performance is no guarantee of future results. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation.