Turmoil in Chinese equity markets

China’s tightening of regulatory measures in the technology sector is not new. In October 2020, Ant Group – affiliate of the Chinese Alibaba Group – was set to raise more than USD 30 billion through a public listing, valuing the company at more than USD 300 billion. On the eve of the IPO, China stopped the process. This year, as we mentioned in our previous market comment (published last week), Chinese authorities interfered in the aftermath of taxi-app Didi’s IPO: only days after Didi’s listing at the New York Stock Exchange, Chinese regulators ordered app stores to remove Didi’s app, citing privacy violations.

Overall, Chinese regulatory tightening seems to be driven by three factors: first, big data is seen as a strategic topic for Chinese policy makers. Behind the targeting of some individual companies appears to be a battle for control over data. Internet platforms see their enormous databases as the foundation of their competitive advantage. Chinese authorities, however, focus on the risks related to big data, as they consider it to be a strategic national asset.

Second, Chinese policymakers are implementing their political agenda, aiming for China to become a ‘great modern socialist nation’. Chinese authorities want to alleviate financial burdens on middle income households by cracking down on the private education sector. By doing so, it would also support China’s demographic ambitions to boost the birth rate.

Third, Chinese authorities want to tighten their grip on financial aspects of domestic businesses. Early July, the Chinese State Council announced that the rules for the overseas listing system for domestic enterprises were to be updated. In addition, private e-payment solutions could be challenged by policymakers if they are seen as a competitor to the digital yuan. We have seen a possible example of this in April, when The Wallstreet Journal reported that Ant Group could be transformed into a financial holding company overseen by China’s state-controlled central bank.

If this analysis proves to be correct, regulatory risks could remain elevated in coming months, due to the long-term nature of these three factors.

With regard to overseas listings of Chinese companies, there is currently a lot of uncertainty. China’s regulatory tightening of its domestic corporate sector also involves new regulation regarding overseas listings of Chinese companies, including a recently proposed rule requiring companies holding data on more than 1 million users to apply for approval from Chinese cybersecurity authorities when seeking overseas listings.

Such requirements could be seen as China’s response to recent measures imposed by the US government on foreign companies listed at US stock exchanges. Many Chinese companies are listed in the US through so-called ADRs (American depositary receipts). Earlier this year, the US Securities and Exchange Commission (SEC) announced it would remove foreign companies, including Chinese ADRs, from American stock exchanges if they fail to comply with American auditing standards. In addition, the SEC demanded that companies need to prove they are not owned or controlled by a foreign government. The SEC also required companies to disclose the names of board members who are Chinese Communist Party officials.

As US auditing would probably involve data deemed sensitive by the Chinese authorities from a national security perspective, the Chinese government is unlikely to agree with the SEC’s demands. As a consequence, most of the Chinese companies with ADRs recently established a secondary listing on the Hong Kong Stock Exchange or were considering to do so.

The situation is highly uncertain and a few scenarios could be considered at this stage:

• The most likely scenario seems to be the one where Chinese policymakers impose tighter rules on Chinese companies for being listed on foreign markets. As a consequence, less IPOs could be done on stock exchanges outside China, in particular US stock exchanges, forcing Chinese companies to raise capital through domestic listings instead.
• The second scenario could be a situation where Chinese companies are increasingly being pressured to end their listings on US stock exchanges and to opt for share buybacks and listings in Hong Kong.

We do not consider the recent sell-off in Chinese equities to represent a buying opportunity for the time being. With a price/earnings ratio of 14 (based on expected earnings in 2021), the valuation of the Chinese equity market remains above its long-term average (11). This valuation level does not provide a sufficient buffer for potential price setbacks stemming from regulatory risks. Further regulatory tightening seems likely in the coming months, as Chinese policymakers will be eager to take sufficient steps ahead of the 20th Party Congress in October 2022.

Overall, our investment strategy remains unchanged. In the first quarter, we suggested investors to reduce their equity positioning in emerging markets from overweight to neutral, considering that potential tightening of monetary policy by the Fed in the coming quarters could be detrimental for emerging markets. Similar to our view on Chinese equities, we do not consider the current significant underperformance of emerging-market equities as an opportunity to increase positions in this region. The price/earnings ratio of MSCI Emerging Market Index stands at 16, above its long-term average. We prefer to remain neutral for the time being.

Regarding the IT sector: in September 2020, we suggested investors to take some profit on technology stocks, moving to a neutral positioning after being overweight IT for a long time. There were several reasons for this shift: rotation towards cyclical sectors, high valuation levels and government regulation. We do not think that the sell-off in the Chinese technology sector constitutes a buying opportunity, as regulatory risks remain elevated in the coming months.

As we mentioned in our previous market comment, volatility around Chinese tech-related equities could remain elevated. We repeat this stance for the coming weeks. Volatility should abate once the regulatory risks decrease, helping investors to focus on the long-term digitalisation trend that is supporting those companies.

Global Equity Team
ABN AMRO Private Banking