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Education Series: Single-Stock ETPs

Why Are Chinese Markets Falling?

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Websim is the retail division of Intermonte, the primary intermediary of the Italian stock exchange for institutional investors. Leverage Shares often features in its speculative analysis based on macros/fundamentals. However, the information is published in Italian. To provide better information for our non-Italian investors, we bring to you a quick translation of the analysis they present to Italian retail investors. To ensure rapid delivery, text in the charts will not be translated. The views expressed here are of Websim. Leverage Shares in no way endorses these views. If you are unsure about the suitability of an investment, please seek financial advice. View the original at

The financial media is replete with news about a $1.5 trillion selloff in Chinese stocks in recent times. Goldman Sachs, at the end of July, cited “disproportionately high index representation by tech and privately owned companies” for lowering its views on the MSCI China index. Commentators cited Beijing’s crackdown on Chinese tech companies as a significant factor.

This article will seek to give context for what’s happening with Chinese markets.

 

Root Causes

At the outset, it seems necessary to note that most companies popular with Western investors had no unannounced risk factors as Q2 2021 rolled in. While markets did slow down globally in Q3 2021, the degree of slowdown was nowhere close to such a large selloff. The root cause of it lies within China itself.

Late in October last year, Alibaba founder Jack Ma addressed the Bund Finance Summit in Shanghai as a keynote speaker. Serving as a backdrop to the then-upcoming IPO for his fintech offering Ant Group, Mr. Ma called Chinese regulators an “old boys club” fearful of new ideas and the Chinese banking system as having a “pawnshop mentality”. He went on to pitch the virtues of a digital currency as a solution to future problems and one that can be free of outdated constraints.

Within a week, the Ant Group IPO was suspended and new rules were drafted for regulating internet platforms. Within a month, the Politburo resolved to strengthen antitrust efforts and a probe was launched into Alibaba. Subsequently, a number of companies – predominantly tech – were investigated, prompting many to attribute Mr. Ma’s speech as being the genesis of the crackdown.

It bears noting that Mr. Ma’s speech was not the origin of the crackdown. As early as two years prior to his speech, regulators had been calling for action to address a number of problems: growing “moral corruption” among the youth, increasing familial financial burdens, the brutal work schedule in new companies, and so forth. A key factor underpinning these problems – as per the State – was the ongoing change in “culture”.

When Chairman Deng Xiaoping engineered the liberalization of the Chinese economy 40 years ago – effectively transitioning from a command economy to a mixed-mode economy and permanently cementing the “Sino-Soviet split” – Chinese graduates began to troop into top Western universities and companies. When many of these graduates eventually (and inevitably) went on to build companies, their focus was on the vast untapped Chinese market. With a distinct local advantage and starting out as clones of top Western companies, these companies continually evolved into every niche that the Chinese populace was looking to consume and engendered powerful economic change.

One attribute these companies’ founders imbibed from Western companies was competitiveness – employees worked longer, harder and for far greater reward than they would have within a State-owned enterprise while company management sometimes – possibly/allegedly – didn’t hesitate to take shortcuts to get to the top.

This idea of simply cloning Western ideas for the domestic market was also criticized by Mr. Ma during his speech – which most Western media sources did not transcribe or present to their readers fully. In this regard, Mr. Ma echoed the sentiments of Chairman Deng who, in a conversation with socialist Ghanaian president Jerry Rawlings in 1985, said “Don’t just copy China’s model. You have to walk your own path”.

However, where Mr. Ma and Chairman Deng differ was that while Mr. Ma seemed to be reposing faith in the burgeoning Chinese private sector and its resourcefulness, Chairman Deng’s interest in economic liberalization was rooted in improving China’s economic problems. The country’s political destiny, as per the venerated Chairman, would and must lie with the Party. This idea is shared by current Party General Secretary – and possible President for life – Xi Jinping.

Actions taken on Mr. Ma after his speech had a transformative effect on the magnitude of the State’s punitive actions. Alibaba was fined ¥18.23 billion ($2.8 billion) by the regulators in April for abusing its dominant market position by forcing online merchants to open stores or take part in promotions on its platforms – almost 1% of the company’s market cap. Exclusive contracts tying online merchants to platforms became the root cause for regulators to investigate JD.com and rising rival Meituan – with the latter facing a roughly $1 billion fine.

JD.com, Meituan and several other internet companies are also being investigated by financial watchdogs for practices that include but not limited to irregularities in mergers and acquisitions – a long-valued means of growth in China.

Approval for new games was already problematic to regulators due to the effects of gaming addiction among minors long before Mr. Ma’s speech. Tencent lost $60 billion in market cap (almost 10%) on August 3 after Economic Information Daily – a State-run economics newspaper – called gaming “spiritual opium”, a very loaded term in China. (The article disappeared from the web soon after its effects were felt but reappeared later in the day without said term and some other edits. Tencent closed down 6.1% that day). Loudly-stated concerns by State mouthpieces and think tanks over ongoing “moral corruption” of youth have led to gaming companies, short video platforms and vaping firms feeling the heat from regulators and in the stock market as well.

Tencent was also told that its recently-acquired competitors in music streaming may have to be sold and that its exclusive contracts with music producers must be terminated due to antitrust issues.

Targeted hardest were online education companies – a key (and expensive) means of help for children with the Chinese curriculum. Ostensibly done to ease financial pressures on families that have led to low birth rates, these companies will be barred from raising money through listings or other capital-related activities and must reorganise as non-profits while other listed companies will be barred from investing in them. Duolingo, a popular language-learning app, disappeared from Chinese app stores. TikTok owner ByteDance closed its education division with immediate effect.

 

Market Effect and View

While the ongoing crackdown might give an impression that the Chinese economy is tanking, a closer view of the market would be in order. For this, we shall compare the performance of the Nasdaq Golden Dragon Index (HXC) and the S&P China A 50 Index (CSSP50) – indexes that tracks U.S.-listed Chinese companies and the top 50 best-performing China-listed companies respectively – versus the CSI300, CSI500 and CSI1000 – which track the large- , mid- and small-cap companies listed in mainland China’s state-run stock exchanges.

Over a trailing 1-year period, virtually all indices were either recovering from the pandemic or attaining giddy heights midway through Q2 2021 before State actions began in earnest. The hardest-hit were the U.S.-listed companies with the next lot being the top 50 China-listed companies, with nearly matching underperformance. However, drawing up par with their performance as of last year are the state-run exchanges’ indices.

This is a clear indicator of two facts:

  1. The hardest-hit companies were the “blue-eyed” investor favourite tech giants with aggressive growth trajectories in high-consumption “consumer” segments;

  2. The larger Chinese economy is far more diversified and relatively unaffected.

This underlines what Goldman Sachs had highlighted: “tech” companies are too large a component of China-centric investments while the broader economy had been chugging along quite reasonably, largely unnoticed by Western eyes, all this time. China’s crackdown is simultaneously a lesson for investors to broaden their focus beyond “tech” and a warning to the nouveau riche to not dream of being above the nation-state.

Interestingly, as per the reported Put/Call Ratio over the past year, the global trading community seem to have faith that at least some top Chinese companies have largely internalized the lessons learned.

Using “China’s Google” Baidu – which has not been seriously censured till date – as a baseline for comparison versus the recently-chastised Alibaba and the currently-being-chastised JD.com, it can be seen that Alibaba’s ratio indicates that the market expects the worst to have passed for Mr. Ma while JD.com’s fortunes are still being considered a little tenuous. Such a scenario can be seen being played out on almost all the listed companies under fire.

 

In Conclusion

Given their wealth and power, the global tech nouveau riche might be accustomed to a certain leeway and deference from the Western populace and its political class. This is a key difference between the West and the East: in the East, the nation-state is the supreme embodiment of an ancient “culture” older than Christ and Moses which radiates beyond mere lines on a map. And by no means will this type of crackdown be likely limited to China.

In May of last year, the Indian government tabled a bill in Parliament mandating the localisation and protection of all Indian citizens’ data collected and monetised by tech giants. Expected to become law later this year, China – which typically doesn’t require a specific law be in place for a regulator to take action – has already demanded the same of tech companies as well.

Under fire by Indian parliamentarians over the company’s repeated failure to remove inflammatory fake news under amended laws, Twitter CEO Jack Dorsey stated that the company operates under its own rules. IT Minister Ravi Shankar Prasad replied that the laws of India are supreme in every case and that the country doesn’t need a lecture on freedom and democracy from the likes of Twitter. The company dilly-dallied to the brink of having its local management behind held personally responsible for spreading hate speech and the company’s expulsion before capitulating. All other tech giants – including Google and Facebook – had long affirmed their compliance by then. Antitrust actions by Indian regulators against the business practices of Amazon and Walmart-owned Flipkart – which were dismissed by U.S. Supreme Court – have been admitted by the Indian Supreme Court, despite these companies’ pleas, and legal proceedings are due to begin soon.

China and India hold a remarkably similar view in this case: the political class and teeming indigenous masses’ aspirations rank far higher than the supranational ambitions of a select few among the global tech nouveau riche – be they indigenous or not. Of course, how it works out for investors rests squarely on how deeply the principals that investors pin their fortunes on understand the ideas of “culture” and national boundaries, especially when it comes to these two behemoths representative of the East.

Your capital is at risk if you invest. You could lose all your investment. Please see the full risk warning here.

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