Is China that weird?
In a year that seems to have more than its fair share of sensational financial news, the absolute route in Chinese stocks, especially Chinese tech stocks, will probably have the largest repercussions for investors in the foreseeable future. Before the slight recovery in prices we over the last few days, the crash had cost investors close to a trillion USD. All over the internet (on Twitter, news sites, and blogs), punters instantly became China experts and made several comments about how it’s impossible to have an edge in China as you just don’t know what the government is going to do. There was also further talk about how these actions would never happen in a democratic country. As someone who has been very vocal about how I don’t ever stock pick Chinese companies, I had sympathy for these arguments, as one of the reasons I didn’t (invest in China) was the lack of understanding of policy and products. China has always seemed like a mystical investing land which was always outside my circle of competence, despite having visited several times.
Now, none of the above has changed, and I’m still a long way away from ever making a direct investment in China. However, a conversation with a China investor this week got me thinking if the Chinese government's actions were indeed without precedent. More importantly, it got me asking if it’s possible to try and predict regulatory “tail-risks” that may not actually be so rare. The key here is to understand if other countries have taken similar actions and why they took said actions. Before we get going, I think it would be worth defining what makes for ‘good governance’ when it comes to capitalist markets (or capitalist-communist hybrid markets i.e. China). Without getting into an argument about how ‘free’ markets should be, in general most people, if asked, would say that businesses should be allowed to do what they need to serve customers and turn a profit unless it harms society or the environment (i.e loan sharking/waste dumping), stifles competition (i.e monopoly), or breaks any laws (i.e IP infringement/graft).
Assuming you agree with the above (move along Laissez-faire bros), we can then look at the recent Chinese action through this “framework” rather than an emotional lens that we’ve observed a lot of the recent commentary through.
The Education Issue
One of the most drastic events recently was the news that Chinese authorities have banned the provision of holiday and weekend tutoring and the establishment of new tutoring centres. This, and news that the government was considering making all tutoring firms into non-profits, sent education stocks crashing 95%+ from their all-time highs. Now on the surface, this seems highly draconian, and perhaps it is. But when we dug into the issues, a couple of dots connected in our head. It turns out several of these companies had highly aggressive and predatory practices. A recent blog we read revealed that tutoring companies used incredibly aggressive marketing such as:
“Does your shopping cart contain your child’s future? If you do not enrol, we will be educating your child’s competitors.”
Now, as a parent – can you imagine what this message does to your psyche? You want the best for your kids, and you’re constantly worried that you’re not providing them what they need to succeed in an increasingly competitive world. Layer on top that most families in China only have one child, who has the family’s hope resting on their shoulders. The cost is also enormous and apparently Chinese families spend an average of 120,000 yuan (US$17,400) a year on tutoring[1]. Although this figure makes us a bit skeptical considering the average per capita income per family in China, from what we could gather, a ridiculous amount of net income is being spent on tutoring. A more reasonable number points to 15% of income spent on supplemental education services,[2], and that’s just with one kid! Honestly as a parent, writing this piece gave me a significant amount of anxiety.
I think we’ve barely scratched the surface and you can already see the problem here. Families are stretched thin financially, students are stressed beyond belief (at minimum having 6 hours of tutoring a week), and companies are using unfair practices. On top of this is the huge socioeconomic problem of a collapsing population. As we wrote in this blog post (“The Population Problem”), almost every country in the world is seeing declining birth rates, and China is getting hit particularly hard because of the 1-child policy. But even though the policy is being reversed it won’t make a lick of difference if parents don’t feel like they can afford another child.
If you just take a minute to absorb all this and you go back to the “framework” we presented in the introduction, you can see any government will look at this and see they have a problem. In fact, an eye-opening discovery for us was the discovery that one of China’s neighbours, South Korea, had a very similar problem a decade ago and cracked down hard.
South Korea had a very similar socioeconomic problem in the late 2000s with their “Hagwon” or “Cram schools.” In 2008 there were over 70,000 hagwons in Korea, and with high expectations of students and parents, they flourished. But Hagwons caused very similar problems that we’re seeing in China today. Parents paid through the nose, hagwons kept increasing fees (and used emotional blackmail to get parents to pay), made false promises, and oddly, pushed up real estate prices (as parents would relocate to be close to those tutoring centres). The government eventually decided that enough was enough and put curbs on timings schools could operate (but they still went to 10pm…), cracked down on false advertising, and cancelled several licenses. Now, the Korean response doesn’t seem nearly as harsh as the Chinese one (this is where the argument between a Communist and Democratic styles may have merit), but the pattern was very similar. For-profit business sprouted up to solve a need, the solution became a problem that has severe social and economic implications, the business, in order to compete, competed dirty, and the government eventually had to step in.
We’ve seen this trend around Asia with education. Singapore also has this problem, with 54% of Singaporeans spending more than $500/month per child on tutors (The median income in Singapore is S$5,600/month). Although when the news came out in 2011 about the Hagwon crackdowns, the then-Singapore education minister stated that “We [Singaporeans] are not as bad as the Koreans”[3]. We also see signs of tutoring getting out of hand in India where the current education space darling, Byju’s, has also been accused of aggressive and unscrupulous practices[4].
Given the issues discussed above, it doesn’t seem that the sentiment behind China’s actions is at all unusual or unprecedented. Now, as said, one might argue that their methods are draconian, but I’ll leave that up to readers to decide.
Er Xuan Yi
Several months ago, when Alibaba and Tencent were in trouble for anti-trust activities, I was talking to a friend/fund manager who invests regularly in China. He told me that there was a saying in China where if you were a startup/small business in China you had to “pick one from two” or “er xuan yi”. This typically meant that if you were a merchant you really had to choose to sell through one major marketplace. Quartz had a great piece[5] on this and in it they stated that
“Alibaba had required some merchants to either verbally agree or write in contracts that they would only, or mostly, sell their products on the company’s platforms instead of its rivals.”
My understanding is that it also extended to startups who typically had to either take funding from Alibaba or Tencent and at times were forced to do business with one or the other. Tencent also had several such practices such as blocking links on WeChat that linked to other social platforms[6] as well as forcing music labels to give Tencent Music exclusive rights in China.
Now, one can obviously see how problematic the above practices are and that they are undoubtedly anti-competitive. The question might be why now though, and for that I’ll refer you to this great post about the topic. Basically, China’s laws were a bit slow to evolve with anti-monopoly laws only passing in 2008 (a decade after the formation of Baba and Tencent) and the State Administration of Market Regulation was only established in April 2018.
I assume I don’t need to spell out the dangers of monopolies and anti-competitive practices, and it's wise to try and spot where it is happening in other countries. There are several famous cases in the West about governments fining or breaking up companies due to practices that were seen as anti-competitive (Microsoft/AT&T). Though if my understanding of what occurred in China is correct, I don’t think FAANG stocks have been nearly as egregious. That said there have been dodgy practices such as Amazon selling 3P merchant goods cheaper in-house, or Apple not allowing apps to redirect users to alternate payment sites, and the west does/should investigate these and regulate where necessary.
There is also an argument to be made that perhaps private companies were collecting too much power. In our post about Ant Financial’s IPO we noted how shocked we were that the equivalent of the US GDP flowed through Alipay’s ecosystem every year. In hindsight instead of being amazed, we should have been concerned. Given recent events it's obvious that very few governments would want an unregulated industry to have this kind of power. The west also has a similar issue of consolidated and unregulated power with regards to free speech. While we are investors in Facebook, it never sat well with us that they choose to block a former (democratically elected) US President from operating an account, regardless of who that President was.
Who Watches the Watchers?
Another case that was quite shocking was when DiDi had its app removed from download stores and it was not allowed to register new users. Initially, this seemed heavy handed, but the more I learned about DiDi, the more obvious this sort of became. Turns out, Didi was terrible with its government relations, and could track or was tracking government officials (according to this thread).
This was the impetus for regulators to open a cybersecurity review into the company. This isn’t so different from what happened with Uber’s “Greyball '' tool which tracked the phones of police and hostile local officials. Uber admitted that it had this product and promised to stop using it. So, it’s not surprising that Didi got caught up in the same thing (although they angered the very people you don’t anger in China). We also read a very interesting thread, although we can’t seem to find it anymore, about Didi’s history of shady practices like stealing competitor data, blocking competitors from using local payment options, etc.
But again, if we just focus on the data case, it's obvious that this is not just a China issue. Data privacy is a hot topic all over the world, and Europe has already drafted strict legislation (GDPR) to control what websites and apps can keep and what they can do with it. So, it’s not surprising that if a company, anywhere in the world, commits significant data breaches, that a crackdown is going to occur. Also side note for those in Singapore - recent changes in PDPA laws are making the law very strict, and fines can be up to 10% of a company’s annual turnover or $1MM (whichever is higher).
In Summary
Now in no way is any of the above a defense nor vindication of the CCP/Chinese Government’s actions – I’ll leave it to much better-informed people to discuss the merits of what the government is doing and what it means for long-term investing in China. All this piece is trying to do is highlight that the Chinese government’s recent actions are backed by precedent (with regards to the impetus behind the action, not necessarily the action itself). Further, it helps us think through regulatory risk by looking at what’s happened in other countries and trying to determine what potential outcomes are. Considering we’ve invested in potentially ‘hazardous’ industries such as social media, gambling, and buy now pay later – it’s important that we think through what potential regulatory risk looks like and more importantly identify predatory behaviour before it becomes a problem.
We hope this piece gave you some food for thought. Thanks for reading, and happy investing.
[1] https://www.scmp.com/news/china/society/article/2176377/chinese-parents-spend-us43500-year-after-school-classes-their
[2] https://qz.com/970130/asians-spend-15-of-their-family-income-on-extra-education-and-tutoring-for-kids-americans-spend-it-on-cars-and-gas/
[3] http://content.time.com/time/magazine/article/0,9171,2094427,00.html
[4] https://the-ken.com/story/the-loan-crisis-at-byjus/
[5] https://qz.com/1994879/what-is-erxuanyi-which-led-to-alibabas-2-8-billion-fine/
[6] https://technode.com/2021/06/08/bytedance-rages-against-tencent-over-link-blocking-heres-why/