Navigating China's regulatory tsunami

It is an unusual sight to have two bellwether education stocks plunging by over 50% in a single day.

When news broke late last month that Chinese regulators require K-12 private tutoring firms to be converted into non-profit institutions, the share prices of the two largest Chinese private education services (New Oriental Education & Technology Group and TAL Education Group) subsequently corrected 65% and 73% respectively.

The sharp plunge in the Chinese education sector sparked a sell-off in Chinese technology stocks - which were already under pressure for much of this year due to regulatory curbs – and triggered a broader correction in Chinese stocks.

Clearly, mounting uncertainties over wide-ranging regulations in China is leading to significant volatility in Chinese stocks.

The question investors are asking now is: How should I navigate this environment?

For a start, let us examine the Chinese government’s goals. China seeks to fulfil its ambitions as a world-leading economic and technology superpower, and to transition from an export-led growth model to achieving more sustainable and high-quality growth. To do so, the government is aggressively addressing a mix of critical challenges related to excesses and weaknesses in various markets and sectors, an aging workforce, and tensions with the United States.

On the one hand, in addressing these challenges, the broad direction of China’s policies has been fairly sound and consistent.

For example, in the fast-growing technology sector, where network and scale effects often accrue overwhelming market power to the leading players, regulations against monopolistic practices and to protect consumers are sensible.

China’s efforts in this area are not dissimilar to the US and European Union’s antitrust efforts to keep Google, Facebook, Amazon and other tech giants in check. The key difference is that under the China model, we can see results in months instead of years of litigation.

China is also taking a well thought out approach in addressing tensions with the US in the arenas of capital markets and technology. The recent market attention on the tighter requirements for overseas listings for Chinese companies in the aftermath of China’s punitive actions on Didi Chuxing created a common misperception that these were a knee-jerk reaction to Didi’s US IPO.

The reality is that these rules formed part of a set of capital market regulations approved at a top-level government meeting last year which also focused to a large extent on domestic capital market infrastructure development. This speaks to China’s structured approach to capital market development governed by clear rules and regulations, including clarity around data security and cross border data flow, and to alleviate long-term funding risks for overseas-listed Chinese firms.

On the other hand, we need to recognise the consequential trade-offs and risks posed by China’s regulatory actions.

Investors value a steady operating environment underpinned by market-oriented policies. The sharp hit to private education businesses has raised doubts over the role of private capital, in terms of the balance between the profit incentive and social equality, as viewed by China’s policy makers, and whether this equilibrium is subtly shifting. In the extreme scenario of prolonged investor uncertainty, it could increase risk premiums, depress asset prices, and hurt the ability of Chinese companies to raise funds for growth.

In the education sector, while the goals of removing the profit motive in private education centres are to reduce childcare costs, alleviate the wealth gap, and to boost the birth rate, history tells us that policies can have unintended effects.

The UK Labour Party’s campaign against Grammar Schools in 1960s and 1970s, for instance, were driven by egalitarianism ideals and resulted in an unintended deterioration of education standards.

In China’s case, the risk is that removing the profit motive in the private education sector might ironically result in less innovation, lower quality, and higher cost to consumers.

Overall, the good news is that the ongoing volatility in Chinese stocks is unlikely to impact China’s macro-economic outlook significantly. Past stock routs have not hurt economic growth. Low levels of margin debt in the Chinese stock market will limit contagion to the financial sector. China’s central bank has also recently begun to inject system liquidity by cutting the reserve requirement ratio for banks, and has more dry powder to shore up growth if needed.

Regulatory uncertainty, however, is likely to weigh on investor sentiment over the near to medium term, and investors will need a new roadmap for investing in Chinese stocks in the months ahead.

Within the Chinese equity universe, we have a relative preference for the onshore A-shares market, which yields less exposure to the sectors receiving regulatory scrutiny.

We are cautious that Chinese stocks listed in the US (also known as ADRs), especially those in sensitive technology and data-intensive sectors, could see further volatility as both US and Chinese regulatory pressures continue to loom large.

As for the Chinese technology sector, we believe its long-term prospects remain sound, but it is premature to call a bottom for the sector considering the latest move by the government to set up a special task force to regulate the internet sector and the risk of further earnings uncertainty.

In contrast, we favour sectors that are key to Beijing’s long term strategic goals as highlighted in its 14th Five-Year Plan, such as AI, 5G, renewables, infrastructure, and new energy vehicles as they are slated to receive increased government support.

The semiconductor and telecom sectors will also benefit from Beijing’s support of 5G technologies and strong demand for chips. The outlook for the domestic consumption sector is also buoyant as China prioritises the expansion of the middle class.

This article was first published by Bank of Singapore on August 2, 2021. The Opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of Bank OCBC NISP Private Banking Tbk. or its affiliates.

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