China is now in open conflict with many of its most prominent entrepreneurs, a battle that is rattling markets as investors question how far Beijing will go in bringing its superstar companies to heel.
Over the past month, the country has launched a rapid-fire series of assaults against fast-growing industries ranging from ride hailing to private tutoring. The crackdown has hammered the stock prices of many of its flagship companies trading in the United States. The Nasdaq Golden Dragon China Index, which tracks Chinese companies listed on U.S. stock exchanges, plunged 22 per cent in July.
Chinese regulators reportedly reached out to reassure international investors in a private phone conference on Wednesday. However, the ferocity of Beijing’s recent actions underlined doubts about Chinese President Xi Jinping’s commitment to open markets and private enterprise.
“This is an attempt by the state to rein in control of big tech companies, which are growing very powerful because of the sheer amount of data that they possess,” said Lynette Ong, an expert on China and an associate professor of political science at the University of Toronto.
China’s booming digital economy accounts for about 40 per cent of the country’s economic output, so Beijing is presumably not intent on destroying these industries. But analysts say what has radically shifted is the degree of freedom these companies will be allowed, especially when it comes to tapping foreign capital at a time of growing tension with the United States.
“What is clear to us – and unnerving for investors – is that compliance and regulatory costs will increase for e-commerce and internet names,” Zhikai Chen, a fund manager at BNP Paribas, wrote in a note.
The opening salvo in Beijing’s crackdown on digital entrepreneurs took place last November when Chinese authorities abruptly cancelled the initial public offering of Ant Group, the payments company spun out of online giant Alibaba Group Holding Ltd. The cancellation occurred just two days before Ant’s enormous US$37-billion debut was scheduled to take place.
Jack Ma, the colourful founder of Alibaba and a critic of Chinese regulators, disappeared from public view for three months and has resurfaced only sporadically since then. His company was fined US$2.8-billion for violating anti-monopoly rules.
Since that episode, Chinese authorities have swung their regulatory cudgels against many of the country’s other best-known digital brands.
Didi Global Inc., the Uber of China, is nursing some of the biggest bruises. The ride-hailing giant debuted on the New York Stock Exchange on June 30, raising US$4.4-billion in the biggest U.S. share sale by a Chinese company since Alibaba listed on the NYSE in 2014.
Within days, Chinese regulators launched a data-security probe into the company, blocked Didi’s China business from adding new users and ordered app stores to take down several of the company’s apps. Didi is now pondering going private in a bid to placate authorities, according to The Wall Street Journal, although the company has denied any such plans.
Beijing’s ire has found other targets as well. A week ago, it devastated China’s US$100-billion after-school tutoring industry by announcing that most tutoring services must now be operated as a non-profit business. “The move could spell the end of the sector,” warned Mr. Chen at BNP Paribas.
Chinese policy makers also took a swipe at Meituan, the huge food-delivery company, by imposing new rules to protect overworked drivers. And they ordered the country’s online giants – Alibaba and Tencent Holdings Ltd., most prominently – to fix anti-competitive practices such as blocking access to each other’s websites.
Chinese leaders offered no catch-all explanation for the sudden crackdowns, but two potential motivations stand out – the Chinese Communist Party’s desire to hobble potential rivals and its determination to wean its tech companies off U.S. capital.
The single biggest rationale is likely Mr. Xi’s concern about the growing clout of China’s tech giants and their ability to act as potential counterweights to the state, Prof. Ong said.
“The fundamental purpose here is to rein in potential rivals, to increase state control at the expense of the market,” she said.
She acknowledged that the speed of the recent moves has sent “a lot of jittery signals” to financial markets, but predicted that Mr. Xi would not be deterred by squeamish investors. “In Xi Jinping’s mind, politics trumps everything.”
China signalled its desire to follow its own economic path, rather than one set by global capital markets, when it unveiled a new “dual circulation” strategy more than a year ago, Prof. Ong noted. The strategy aims to gradually reduce China’s reliance on export-oriented development – “external circulation” in the jargon – and increase the importance of domestic consumption, or “internal circulation.”
A key part of that strategy involves reducing China’s dependence on foreign capital, said Colin Robertson, vice-president at the Canadian Global Affairs Institute and former Canadian consul in Hong Kong. It is no accident, he added, that Beijing’s recent crackdown has been directed largely at Chinese companies that have chosen to list in New York.
“Beijing wants to ensure it continues to call the shots on anything to do with the economy,” he said. Mr. Xi appears determined to prevent powerful Chinese companies, flush with foreign capital, from upsetting the Chinese Communist Party’s ability to set the agenda.
Investors should not expect Beijing to back down, according to Carson Block, the famed short seller who rose to fame a decade ago by exposing fraud at Sino-Forest Corp., a Toronto-listed company with operations in China.
Mr. Block, who previously worked as a lawyer in China, told Institutional Investor, a publication for money managers, that he thinks Beijing’s primary motivation is to get ahead of a law passed by the U.S. Congress last year that would eventually require Chinese companies listed on U.S. stock exchanges to open their audit records to inspection by a U.S. regulator.
Beijing is not prepared to allow foreigners that degree of oversight, Mr. Block argued. Its recent regulatory assaults may be a face-saving move designed to prod Chinese companies out of the U.S. before the regulation kicks in.
“I think that this really all relates to the auditor inspection issue and the trajectory of the relationship between China and the U.S.,” Mr. Block said.
To be sure, Beijing’s recent regulatory zeal could have multiple roots. Its crackdown on for-profit tutoring, for instance, could be related to China’s desire to boost its birth rate. Anything that reduces the hefty cost of preparing a child for the country’s notoriously competitive school exams would make it easier for Chinese families to afford more children.
Yet another factor in the assault on digital companies could be a desire to deflect attention away from troubled China Evergrande Group, one of the country’s largest property developers. Its bonds and shares are sinking in value as concern grows about its financial condition and more generally about China’s frothy real estate sector.
Whatever the exact message Beijing is delivering, it is doing so with bare knuckles. Its recent actions have spawned enormous uncertainty about what rules Chinese companies will operate under, especially when it comes to the variable interest entity (VIE) structure that most use to skirt China’s restrictions on foreign ownership and gain access to U.S. markets. The VIE structure is a piece of accounting legerdemain that allows foreign investors to participate in sectors of the Chinese economy nominally off limits to foreign investors. The basic notion is that foreign investors put their money into a shell company, typically located in the Cayman Islands, that stands to benefit from contracts linked to the performance of the Chinese operating company.
The problem with this deal, from the foreign investors’ point of view, is that there is little recourse if something goes wrong. The problem, from China’s point of view, is that it encourages Chinese companies to list overseas and depend on foreign capital.
This arrangement is now rankling both countries. The U.S. Securities and Exchange Commission said on Friday it would require Chinese companies to make additional disclosures about the potential risk of these structures before allowing them to list shares in the United States. Also Friday, the Chinese Communist Party leadership announced its determination to “improve” the regulatory framework for companies listing overseas, which may foreshadow a review of VIE arrangements.
Anyone tempted to bargain hunt Chinese shares after their recent beat down should not assume that such uncertainties will ease any time soon.
“The regulatory crackdown on many private sector enterprises seems to be increasing in scope and severity, notwithstanding some official efforts to reassure foreign investors in the past couple of days,” Oliver Jones, senior markets economist at Capital Economics, wrote in a note this week. He expects returns on the Chinese market to “be little better than zero over the next couple of years.”
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