Jesper Bæk

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Making sense of the Chinese crackdown

Global markets recently took a tumble related to a situation in China - One of their largest real estate developers 'Evergrande' is in serious trouble and at large risk of defaulting on its debt, which is said to be more than $300 billion. This is merely the latest in a long list of concerning developments in Chinese markets and in this post I will dive deeper into what has been going on and why and whether or not it presents an opportunity for me and you as an investor or if we should prepare ourselves for a downturn.

The significance of real estate in China

First of all, it is important to understand why a single entity like Evergrade and its potential for going under could have such profound effects on the market as a whole. Evergrande is the second largest property developer in China and ranked #122 on the global Fortune 500. It is a publicly traded company trading on the Hong Kong stock exchange under the ticker 3333 and managed to become the single most valuable real estate company in the world in 2018. While that certainly makes a massive force in business it does not necessarily explain why it should affect the markets to this degree. It also never had the best reputation, being accused of bribing, investing recklessly, and even being insolvent in the past... So maybe all of this was to be expected?

Besides the very real effects, it can have on people's life once a real estate developer goes under - like the estimated 1.5 million customers expected to lose their deposits on their unbuild homes - China's economy is uniquely reliant on real estate. Not only has real estate prices in China experienced a boom in recent years as people have relocated to cities, but it is also widely considered the preferred and safest type of investment for citizens in China. China was building 5 times as many homes as both Europe and America combined and yet still it was not enough. Individuals bought the property just to hold it without any plans of utilizing it. Societal pressure encourages the purchase of property as a sign of prosperity and at the same time, there are not many good alternatives to be found. For the general population trust in the stock markets of China is low over fears of corruption by the upper class and this is what ultimately has led domestic real estate markets to turn rampant for speculation and create a situation where Evergrande was able to operate as they did and not come under scrutiny sooner. As the Covid-19 pandemic hit operations grinded to a halt and suddenly the company's massive debt caught up with them.

Second home purchases are the majority in China and its citizens are buying nearly as many third homes as first homes. (Source: PolyMatter)

With China being the world's second-largest economy and real estate being such a significant part of it gives good reason for uncertainty in the markets - even outside of China. The country has long bolstered its economy and ever since 2008 the government has been quick to bail out corporations and subsidize industries. We have seen long periods of loose regulations especially within tech, but it seems that we are now finally at a turning point. Throughout the last year, we have seen increased efforts to regulate industries and a significant crackdown in certain areas.

Crackdown in the technology sector

In October last year, 2020, Alibaba Group (9988) Ant Financial was set to IPO. They were set to raise close to $35 billion in what would have been the single largest IPO of all time. But as you may know, it never came to be and this event is considered by many to be the first sign of the Chinese government cracking down and changing its tune in regard to large local corporations. Alipay as a first-party payment platform for Alibaba had grown in importance along with the success of Alibaba's e-commerce business and is now largely considered one of two options available for payments in China (The other being WeChat Pay). The IPO was stopped in the final hour, allegedly by direct command of Communist Party Leader Xi Jinping after a speech by former CEO of the company, Jack Ma criticizing regulations and bureaucracy in the country. It even went so far that following the events the former CEO, disappeared completely from the public eye. It has since been reported by The Wall Street Journal to have been pressured into transforming into a financial holding company overseen by a state-controlled central bank.

Jack Ma reappeared again in January 2021 in a video, although with no mention or regard to his disappearance or the crackdown on his organization.

Following this, the government crackdown has continued. China's largest company Tencent (0700) - is the owner of the social media platform WeChat and one of the largest gaming companies in the world. They received a fine by the state administration in connection with its acquisition of a leading Chinese music streaming company, saying it would enable them to capture too much of the domestic streaming market. WeChat already essentially operates as a monopoly in social media with its more than 1.25 billion users and with its all-in-one approach I know from personal experience that it is largely impossible to live without it when in China. Tencent suspended registrations of new users in July 2021 as they came under scrutiny by regulators for its security and as if this was not enough, in August, the government introduces new rules restricting Chinese citizens under the age of 18 from playing video games to a massive degree. Now users are limited to only three hours of play in specific time slots of the day and biometric security and individual ID registration are there to make sure these rules are upheld.

And if you thought the crackdown on Ant Group/Alibaba was bad then consider the damage done to car-hailing service and Chinese Uber competitor DiDi (DIDI). Its app was removed from Chinese app stores, it too was prohibited from signing up new users and the company had its offices raided by authorities. Accused by the government of violating security rules this happened shortly after the company IPOed in late June. Its market cap is now close to half of what it was when the stock first launched on the New York Stock Exchange. The fact that DiDi chose the US over Hong Kong for its IPO is speculated by some to be the reason for this particular crackdown and done to discourage others from doing the same in the future.

Wealth distribution, education, and crypto

A more general national initiative also came in August 2021 strongly encouraging philanthropist efforts from its companies. Under pressure, Tencent pledged 50 billion yuan for its 'sustainable social values' program. A wealth distribution system in China is now being pushed further. One of my own holdings Xiaomi (1810) also saw its founder and CEO Lei Jun donating $2.2 billion worth of shares to charity. ByteDance, the company behind the social media platform TikTok, had its founder pledge $77 million to an education fund.

Education and tutoring as a business practice have been entirely demolished during this crackdown as well. After-school tutoring has been extremely popular in China in recent years and as the pandemic took effort so has online education in general. All for-profit activities in this field must now seize as they are banned completely. This is done to ease financial pressures on families as expectations for going beyond curriculum are high. Reactions to this, however, have been mixed as thousands of people lost their well-paying jobs and as investors, foreign investors have seen their investments in a growing industry suddenly wiped out overnight. Beijing has mentioned the sector as being 'hijacked by capital' and will entirely stop these types of operations from making profits, raising capital, or going public - As well as licenses no longer being granted.

Finally, we arrive at September in this overview where China regulators announced a blatant ban on all cryptocurrencies outright. We have seen crypto mining slowly being peeled down over the last couple of months but with this latest crackdown comes also a ban on all trading and holding of crypto-related assets. This of course is merely an intensification of China's efforts and their stance on crypto as a whole. It seems every year we hear news of a Bitcoin ban in China - but this time the message seems a little more concise and conjoined.

China's central bank declared all cryptocurrency transactions illegal and even banned overseas crypto exchanges like Coinbase (COIN) from providing services.

Should I be worried as an investor?

There is certainly a reason to be worried as an investor with all this going on. China is dominant in many areas but also happens to be very isolated in the stock market. Should Evergrande fall entirely we will absolutely feel the consequences, but overall I see this entire crackdown as two things:

  1. I see this as China's way of avoiding a bigger more extensive financial crisis.

  2. It is immensely scary for anyone who is invested directly in China, like myself.

China has only been imposing loose regulations for the longest time - all in order to stimulate its economy and growth. They have had a 'we will deal with it later. type of approach - and it has worked in their favor. I think the real estate market in China has been unsustainable and out of control for some time now and a situation like this one was eventually to be expected. It is interesting however to see how it seems everything is being dealt with at once. Other sectors have had their issues of course but not to the same degree. The pandemic may have hastened the communist party's plans for cracking down in these areas. We are not used to seeing such rapid developments and regulations imposed in such a short time frame in my part of the world, but that comes along with the power structure of the country. I think many of these steps have been taken in order to avoid a more serious and longer-lasting financial crisis in China - which in broad terms is a positive development, but that does not make it less scary.

My investment in Xiaomi - Good or bad?

As for my own investment in China - namely Xiaomi, this entire development has also made an impression on me. The stock price has been hit hard and I have had to watch the situation closely in order to figure out in what way they might be affected. Xiaomi still operates on lower margins and does not yet quite command a service comparable to Alibaba or Tencent, which could be considered monopolistic. The China domestic smartphone market is also fiercely competitive and even here Xiaomi is not yet the top dog. I believe Xiaomi's success in the coming years will come from their global markets in both IoT and smartphones and so they are uniquely positioned to avoid the worst of this situation. I do not see a reason why the Chinese government should wish to stifle their competitiveness in other markets and by extension their own influence. That being said, this has all made me painfully aware of exactly why so many investors vow to stay out of Chinese stocks. The right information can be difficult to obtain and the risks imposed by the regime are definitely real.

I will not be selling out of Xiaomi - instead, I will continue to build my position. I now have the opportunity to average down, which I did not foresee when I made my first investment in the company earlier this year. Getting more shares for cheaper is obviously great, but it also does mean that I will try to limit my own capital exposure with it. I am not going to build a larger position than I had planned just because I can now get shares for cheaper - after all, I have been reminded of my risks. What I am however immensely happy with is that I only own shares of Xiaomi listed on the Hong Kong Stock Exchange. That leaves me without fear of a potential delisting unlike their OTC variant on American exchanges - which is an area the crackdown could certainly extend to. Even as I continue to shovel more money into this particular Chinese investment that does not mean I see China as a generally good opportunity now. I would say that unless you are almost certain that the particular investment you intend to make is not likely to be affected by this entire situation, you should probably stay away. China has proven that foreign investors are not a priority and many have been burned in the process.

Disclaimer: I am not a financial advisor, the opinions expressed in this article are entirely my own – always invest at your own risk.