China's crackdown: Time to sell?

James Gard, senior editor for Morningstar UK, examines whether investors should steer clear of China, or not.
By Morningstar |  26-08-21 | 
 

After a stunning performance in 2020, China has been one of the weakest stock markets in the world this year as a number of political interventions have unsettled investors. From computer games to education, Beijing’s tough new regulations have had a material impact on the share prices of listed companies. But does this hardline approach mean that investors should steer clear of China, or is it just part of the risk associated with buying into the world’s second largest economy?

What's Happening in China?

China’s rulers are currently concerned about the nation’s youth, describing computer games as “spiritual opium” and insisting they cut down on screen time. They are also cracking down on online tutors, which have flourished amid rising anxiety about results among students and parents. Now these companies can’t make profits or receive foreign investment and the whole sector has been wrongfooted. Shares in the likes of New Oriental Education & Technology, TAL Education, China East Education Holdings, Wisdom Education and China Maple Leaf have crumbled. Morningstar analysts have placed some of these companies’ ratings under review until the situation becomes clearer.

Why does this matter to overseas investors? The computer games element of this crackdown is perhaps most concerning, as the industry is a huge part of the growth potential of EM giants like Tencent, and the second biggest company in the MSCI Emerging Markets Index. Tencent’s blockbuster game Honour of Kings was singled out as an example for causing a detrimental impact to the country’s youth.

Let's look at the reasons for and against holding Chinese equities after this latest regulatory squeeze, and how fund managers have reacted.

Reasons to Hold

1) Investing in emerging Asia has always been fraught with political risk. Last year, Beijing squashed Ant’s IPO and earlier in 2021, authorities changed the goalposts for Uber rival DiDi just as it floated in New York. “There are clearly a whole series of risks you take on implicitly when you allocate money to this part of the world,” says FSSA Asia Pacific fund manager Richard Jones. Investors should not be surprised when Beijing flexes its muscles, he adds. “China has always been an interventionist economy,” says Shore Financial Planning’s Ben Yearsley.

2) Regulatory changes are nothing new in China, but this time they’ve hit sectors owned by foreign investors so people have taken more notice. “We think the market has overreacted to China’s recent regulations,” says Jimmy Chen, manager of the Comgest Growth China fund, which has a Morningstar Analyst Rating of Bronze.

3) Investors may face volatility in the short term, but the Chinese market hasn’t collapsed this year despite the biggest intervention in the economy since the markets opened to foreign investors 1990s. The Shanghai Composite Index is actually up in the year to date, although by less than 1%. In a world starved of genuine growth opportunities, China will always boast dynamic companies whatever the political climate. “That’s why everyone comes back to China, there’s secular growth, there’s innovation,” Jones adds.

Reasons to Sell

1) China investors are being too complacent, say the managers of the Ruffer Investment Trust, and not fully pricing in political risk. This threatens global stock markets too, they say: “This will not be the last barrage in the burgeoning capital markets war, nor the last nasty surprise for financial markets.”

2) No sector is safe because the government has given itself a very wide remit to interfere in anything affecting “common prosperity”, says Somerset Asia Income manager Mark Williams. He believes this latest bout of interventionism is an escalation rather than “more of the same”. He adds: “The all-encompassing nature of such a policy is far greater than we have seen to date and heightens ongoing concerns that any profitable entity may fall under Beijing’s scrutiny."

3) Share price collapses this year show that foreign investors come way down the list of important stakeholders for Chinese authorities in their pursuit of reform. “Combined with the disregard recently paid to minority shareholders of both Didi and the education companies, this raises the concern that we are left with greater risks in China,” Williams adds.

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