August 9, 2021 8:00 AM
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3
 min

From China with Love

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The past few weeks have sharply reminded investors of the risks of investing in a dynamic and fast-growing economy run by an authoritarian government. Over the past five months, China has increased pressure on the tech sector, pushing down the stock of the top five tech companies. The decision to carry out tough reforms in the field of online education did provoke a rapid drop in the shares of issuers from this sector by more than two-thirds. As a result of such restrictions, the sector, the volume of which is estimated at $ 100 billion, may come under the risks of being in its current form. In China, virtually all power is in the hands of the Communist Party, so the statements and actions of Chinese regulators have a deeper, and often panic, negative effect on the capitalization of public companies.

For a long time, there was no regulation of the technology sector in China, while the business of technology companies grew at a significant pace, influencing other sectors of the Chinese economy. The lack of regulation has led to the use of unfair practices on the part of the largest players, which have increased the barriers to entry into the market and limiting the conditions for market competition. Previously, the technology sector was positioned as one of the main locomotives of the development of the Chinese economy, therefore the regulation was deliberately softer. Now, the Chinese authorities are ready to carry out a number of structural reforms and impose high fines for non-compliance with the new rules. In addition, the Chinese regulator has given a clear signal that it will welcome investment in the technology manufacturing sector rather than in online consumer services. After nearly two decades of relative freedom, the Chinese internet has come under regulatory scrutiny.

A key turning point occurred a few weeks ago when investor panic spread not only to offshore tech stocks, but to the wider range of A-class stocks traded locally in China. Shanghai CSI 300 lost almost 10% before the securities regulator tried to restore calm through verbal intervention. However, in the short term, regulatory pressure on the tech sector may increase, which will continue to put pressure on the Chinese market. Harsh government measures create tremendous uncertainty in the business of companies and force investors to exit stocks at any price. A week ago, the Ministry of Industrial Information Technology instructed 25 major technology companies in China to address and fix issues ranging from data security to consumer protection. The Ministry of Transport has also promised stricter rules for passenger and freight services. The Politburo has indicated that it may further tighten the rules for Chinese firms that intend to go offshore.

In the long term, the Chinese leadership will clearly strive for more active technological development, in which both private firms and foreign capital will play a significant role. The only question is which path the Chinese authorities will take and whether they will be able to avoid open market conflicts. It is no secret that a more balanced and predictable policy would be perceived positively by investors. Many of the measures taken or discussed to reform the Chinese technology sector look quite logical from an economic point of view, since the largest players have often abused their dominant market position.

Summing up, we can say that currently the shares of Chinese technology companies have fallen in price and look cheap on multiples. Many securities are traded at a significant premium to their Western peers, while their business continues to function as usual. We believe that in the short term, Chinese stocks will remain under pressure, maintaining high levels of volatility. However, we believe that the Chinese authorities will strive for a more harmonious policy of reforming the technology sector, therefore, in the medium term, many investors may reconsider their attitude towards the Chinese stock market.

At present, it would be unwise to consider individual Chinese companies as investment targets, as political risk cannot be predicted and assessed. In our opinion, it is better to bet on the Chinese market through ETF exchange-traded funds, which invest in many companies at once. For example, the MSCI China ETF (MCHI) balanced fund includes more than 600 Chinese companies. The Invesco China Technology ETF (CQQQ) strategy is more focused on the technology sector, with a strategy portfolio of over one hundred positions. KraneShares CSI China Internet Fund (KWEB) invests primarily in Chinese Internet companies (about 50 positions) and is arguably the riskiest fund under current circumstances.




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