After years of following US markets as well as emerging markets, there is one type of company I don’t invest in and I advise others not to: state owned companies. The reasons for this are very specific, especially if the public company is majority owned by a government: they don’t have investor capital as a top priority. Usually these entities act as a piggy bank or job creator for the government concerned which leads to weak profits and inefficiencies which can become endemic throughout the organization. In addition to this, as investors have discovered time and time again, the government often will dilute shareholders at the drop of a hat, sending share prices plunging and destroying returns. The US is not immune to these types of entities, case in point being the public shares of Fannie Mae and Freddie Mac.
I thought of the fortunes of state run firms as the Chinese government cracked down last week on particular firms in education and the ride hailing app Didi. On the one hand these are not the type of state run public firms like I described above yet they these firms have a risk in common with state run firms: they are allowed to operate relatively freely until the whims of the government change, especially when that government thinks it knows better for its people than corporations do.
This is not to say that other countries don’t have regulations and government involvement that hurts corporations. The difference is that in open capital markets like the US, the government should be concerned with setting fair playing rules for capital markets, not punishing winners for their product or for their choice in how to fund themselves.
How it Started
The first new stance towards China’s tech companies that we saw was late last year as the $37bn Ant Group IPO in New York was scuttled indefinitely and it’s founder Jack Ma was swiftly whisked off into anonymity. In that particular case, it was surmised by many commentators that the Chinese government was growing too uncomfortable with the business model of Ant. What I think was more likely was that Citigroup and other foreign banks had been providing much of the funding for new loans with Ant as the front man. This provided a back door for US financial firms to eventually become important creditors in the domestic Chinese market. A wave of defaults any time in the future (the government is concerned about private debt levels) would have put the government in the awkward position of having to adjudicate between a foreign creditor and many of its own citizens. It would then be forced into a situation where it either has to abide by fair dealing for foreigners, with a potential backlash from its citizens, or watch foreign capital flee as it becomes apparent creditors have little rights before the law there. Easier to just take a hammer to Ant and force them to hold some of the capital and look more like a bank so they never have to make that choice.
The Chinese government looks at these issues from a power perspective and they have a long history of quashing any group, person or company, that they feel could challenge it’s power down the line. Case in point was the Falun Gong religious movement which was declared illegal and had its leaders arrested in the late 1990’s. It wants to pre-empt any scenario where the government could find itself on the opposite side of public ire.
How it’s Going
When it was announced that ride hailing app Didi was under investigation by the Chinese government for perceived data transgressions, it seemed quite ironic given the data heavy surveillance the government uses on its own citizens. It also came off more as punishment for listing on the New York Stock Exchange in June and added to the suspicion that the Chinese government policy when it comes to capital markets, is unpredictable and fraught with surprise risks for foreign investors.
At the same time the US back and forth policy towards China share listings is not helping either. Continued rumors that Chinese companies will be delisted from US exchanges make the US claim to be a fair and free capital market ring hollow. Although Chinese companies and shares have their problems and their own unique risks, apart from sensitive industries like defense, the US government should leave it up to investors if they want to fund Chinese companies.
The Didi situation may not have been as big of a deal if it wasn’t also announced around the same time as the government unilaterally declaring that for profit education companies must now be non-profits going forward. Tal Education, New Orient and Gaotu all subsequently fell by two thirds on the news, wiping out $18bn of shareholder capital.
Not only are these firms not allowed to take foreign capital but they are banned from teaching foreign curriculums and forbid studying on holidays and weekends, especially on subjects that related to the core curriculums in math, science and history. Many parents had been paying extra for these services to provide their children a leg up over other students.
A number of news outlets have speculated (from where I don’t know) that the government views the cost of extra tutoring as an impediment to maintaining the population in the sense that it increases the cost of raising children. If true, this view is short sighted and will eventually hurt the country in the long run.
Much of the success of fast growing East Asian countries has been built on rigorous education and fierce competition. From Korea to Taiwan to Japan, pupils there produce some of the highest test scores in math and science across the board when compared internationally. This has helped foster not only growth but innovation in manufacturing and tech. From Samsung rivaling Apple for smart phone dominance to Taiwan Semiconductor being an essential part of smartphones, letting people and companies compete has shown that emerging countries can be winners and compete with their western counterparts.
Lowering the cost of tutoring will do little to change the birth rate either. Birth rates across the board, no matter what culture they are in, have been shown to decline as countries develop. This is because kids go from being helpers and farmhands that may help generate income to being investments that require higher income to prepare for skilled work in a modern economy. This shift from children as a resource to cost naturally provides an incentive for families to be smaller. If China wants to be rich, the government will have to accept it can do little to reverse the coming population decline.
In addition, I believe this was also aimed at controlling the curriculum as well. The government prizes stability and maintaining its power. Foreign influenced education could end up being a long term thorn in the government’s side as sneaky foreign ideals or influences make their way early on into the school age population. You could look at education as a “sensitive industry” for China similar to how the US looks at defense.
The Risks for Investors
It is often said that the Chinese government has a 100 year outlook. If that’s the case then the beating down of entrepreneurs and innovative startups is going to be a costly mistake.
With the looming threat of government intervention, startups may choose to remain smaller or fly under the radar, even holding back from having their products become too popular. Parents will find other, perhaps illegal, ways to get their children ahead, sewing contempt for a government policy that thwarts their attempt to achieve the best for their own children.
And it will also raise the cost of capital for Chinese companies across the board. In a world awash in liquidity, it only makes sense for entrepreneurs and growing companies to tap the cheapest sources, right now those sources are in the US and Europe, where slower growth and excess savings is producing a dire need for more foreign risk and yield.
If supplanting the dollar as the global reserve currency is a long term goal for China, this will push that goal further away. Predictably open capital markets and acceptance of foreign capital have been hallmarks of policy underpinning the dollar. Pushing for greater acceptance of the RNMBI while shutting off avenues for foreign capital at home won’t spur willingness to further trade RNMBI.
For investors, it doesn’t mean turning away from China, the innovations and the growth opportunities are too attractive to be left alone. However, I wholeheartedly disagree with Ray Dalio, who writes that the Chinese government is misunderstood and only has the best interests of its unwitting citizens in mind. Investors need to be aware of the risk that a successful Chinese company or business personality could end up catching the ire of a jealous and thin skinned government desperate to cling to power.
With the MSCI Emerging Market Index, by far the most influential index tracking emerging markets, now being made up almost 40% by Chinese shares, it may be time to reclassify China in index terms, to sit on its own to monitor the risk and return in isolation. If the index companies don’t do this, investors can easily do this through ETF’s like one that I own, the iShares Emerging Markets Ex-China (EMXC) which at a 9% return so far this year, is trouncing the return of its counterpart, the iShares MSCI China ETF (MCHI) by almost 20%.
