The Changing Investment Climate

Changing political circumstances impact investment climates.

As we write this, the horrific images of desperate people clinging to the wheels of a U.S. Air Force plane, frantic to escape Afghanistan, are on our minds. The world has changed.

As a country, we are turning inward. The withdrawal from Afghanistan is just one example. The previously inalienable belief in free trade continues to erode across the globe. Manufacturing goods in the cheapest possible location is giving way to manufacturing goods in places where supply chains are more reliable.

This shift from "just-in-time" manufacturing to "just-in-case" manufacturing is likely to be inflationary.

Many Americans attributed rising tensions with China to former President Trump's policies. In reality, the issue runs much deeper. The loss of well-paying manufacturing jobs created a class of disaffected workers and increased awareness of the unintended consequences that can accompany free trade.

While relations between the United States and China continue to deteriorate under President Biden, a more significant development is occurring within China itself.

China has moved from promoting the growth of Chinese companies on the world stage to regulating those companies in pursuit of what it calls "common prosperity."

In 1979, China implemented free-market reforms, opening its economy to foreign trade and investment. The Chinese government encouraged economic expansion to reduce poverty, but those policies also created enormous corporations and powerful billionaires with influence extending throughout Chinese society.

Today, in the name of social fairness, China is pursuing wealth redistribution and common prosperity, targeting individuals and companies that the government believes have become too wealthy and influential.

As President Xi Jinping stated, common prosperity is critical for maintaining the Communist Party's authority and transforming China into a "fully developed, rich, and powerful nation by 2049," the 100th anniversary of the People's Republic of China.^1

From Beijing to Wall Street

The Financial Fallout of China's New Social Policy

Recently, the Chinese government has intervened in capital markets to advance a variety of policy goals, including:

• Maintaining financial stability
• Reducing the influence of powerful individuals
• Protecting consumer privacy
• Lowering the cost of raising children to encourage population growth
• Restricting online gaming for minors

The broad scope of these actions demonstrates the Communist Party's increasing control over the private sector.

Major Regulatory Actions

Ant Group IPO Cancellation

In November 2020, Chinese regulators halted the IPO of Ant Group, a financial technology company one-third owned by Alibaba, just two days before it was scheduled to launch. It would have been one of the largest IPOs in history.

The Disappearance of Jack Ma

After publicly criticizing Chinese regulators, Alibaba co-founder Jack Ma disappeared from public view for several months.

In 2017, Fortune ranked Ma among the world's 50 greatest leaders. By 2021, with a net worth of approximately $51.5 billion, he was China's third-richest individual and the 26th richest person in the world.^2

DIDI's Troubled IPO

In July 2021, ride-hailing giant DIDI completed one of the largest U.S. IPOs of the decade.

Just days later, China's cyberspace regulator ordered app stores to remove DIDI from their platforms, preventing the company from acquiring new users. The stock ultimately fell approximately 50% from its IPO price.

Education Industry Crackdown

Later in July 2021, China eliminated the for-profit status of education and tutoring companies.

The new regulations restricted foreign capital investment and were intended to reduce the financial burden of tutoring on Chinese families.

Government Stake in ByteDance

In August 2021, reports surfaced that the Chinese government had acquired a 1% stake in ByteDance, the parent company of TikTok, and had secured a seat on the company's board of directors.

Algorithm Regulations

On August 27, regulators published draft rules governing recommendation algorithms used by technology companies to personalize content and services.

Restrictions on Online Gaming

On August 30, China introduced new regulations dramatically restricting online gaming for minors.

Market Consequences

The impact on Chinese equities was significant:

• The broad China ETF (MCHI) declined approximately 28% from its February highs.
• The China Internet ETF (KWEB) declined approximately 52% from its highs.

Investors quickly realized that political risk had become a major factor in valuing Chinese companies.

U.S. Regulatory Response

The United States has also increased scrutiny of Chinese companies listed on U.S. exchanges.

According to SEC Chairman Gary Gensler, many American investors may not fully understand the risks associated with Chinese ADRs (American Depositary Receipts).

Many Chinese companies use a structure known as a Variable Interest Entity (VIE), which allows them to circumvent Chinese restrictions on foreign ownership. Under this arrangement, U.S. investors often own shares in an offshore shell company that has contractual rights to the Chinese operating business rather than direct ownership of the business itself.

As a result, the SEC has explored measures that could eventually lead to the delisting of Chinese companies that fail to comply with U.S. auditing and disclosure standards.

Conclusion

China's pursuit of common prosperity represents a significant shift in economic policy. While these actions may advance domestic political objectives, they also introduce new risks for investors.

The events of 2020 and 2021 demonstrate that government policy can have a profound impact on markets, corporate profitability, and shareholder returns. For investors, understanding these political and regulatory risks is becoming just as important as analyzing financial statements and economic data.

Sources

1. Laura He, CNN Business, August 18, 2021
2. Forbes Billionaires List, 2021
3. Statements from SEC Chairman Gary Gensler regarding Chinese ADRs and VIE structures