Beijing's crackdown on corporate China has laid bare the shortcomings of investing in a command economy. One command that goes the wrong way in your industry and you're finished.
The Communist Party warned last Friday that the property industry has three years to "restore order." Chinese property stocks have been the worst performers in the world by a long stretch, and it doesn't matter the time frame: worst over the past month, worst over the past quarter, worst over the past year.
It's yet another target on a long list. Beijing's actions this past weekend essentially eliminated for-profit tutoring as an industry, as I explained on Monday. These are far, far tougher controls than investors ever saw coming.
Tencent was ordered not to sign exclusive music deals; food delivery also took a beating as app providers were ordered to ensure that pay for their delivery drivers meets the legal minimum. Delivery drivers aren't employees, much like ride-hailing drivers, but at least when it comes to pay Chinese companies will need to treat them as such.
The property curbs are subtler, but the massive industry taps a nerve in China. Anyone with any money thinks about buying property above all else in terms of investment. And that makes sense. We can see how arbitrary and sudden the market-moving regulatory changes can be if you put your money in the stock market.
Developers will face greater constraints on how they use the money that they raise from "presales" -- selling apartments before they're built. Rent charges and rental housing loans will face tougher scrutiny and rules on property marketing are being toughened to prevent misleading ads.
The Chinese stock market stabilized here on Wednesday after a torrid few days. The CSI 300 index of the largest companies in Shanghai and Shenzhen edged ahead 0.2% on Wednesday. However, the index is down 9.4% in the last month and 7.6% in the last week alone.
The Hong Kong benchmark, the Hang Seng, posted a 1.5% gain Wednesday. However, it has fared even worse recently, down 13% in the last month and 8.1% in the last week.
The makeup of the Hong Kong market has shifted dramatically toward tech over the course of the last decade. Hong Kong is also the venue of choice for "local" listings of Chinese companies looking to tap international investors. It's exactly these kinds of companies that have been most dramatically affected by Beijing's sudden shift to bring the corporate world to heel.
It is not clear how long China will put up with a structure that has allowed Chinese companies to skirt ownership restrictions for overseas capital. Foreign investment has been banned in the tutoring industry, with the Communist Party knowing full well that several of the largest tutor centers such as TAL Education (TAL) and New Oriental Education & Technology Group (EDU) have listed in the United States. In 2020, the industry as a whole raised C¥116.4 billion (US$17.9 billion) in financing home and abroad, according to the consulting company iResearch.
Even the domestic money no longer has anywhere to go, and overseas education listings no longer seem viable. Investors in U.S.-listed Chinese stocks would do well to worry which sector is next. Chinese President Xi Jinping himself chaired a meeting in May that started the review of tutoring centers, and it seems his muscular view of the place of the Communist Party will result in other industries being strong-armed into the shape he would like to see.
A dim view of VIEs
Around 600 Chinese companies are listed in the United States with a total of US$2 trillion in market capitalization. Of that total, 80% are listed using a Variable Interest Entity, or VIE, structure that sets up a Cayman Islands or other offshore company for foreign investors. Under this arrangement, the offshore company has a contractual agreement to receive the business proceeds, or the "economic benefits," of the Chinese company, but it does not actually own the Chinese company.
Chinese management and overseas investors have been pretending this distinction doesn't really matter. It is becoming highly relevant. Investors will have no recourse if the Communist Party rules that any industry can no longer take in foreign capital or that VIEs are no longer allowed. And that appears to be the direction in which we are headed.
China bulls say the rules may become clearer. They cite a new requirement that companies with the data on more than 1 million customers in China must receive cybersecurity clearance to list overseas. Perhaps that will essentially mean the Communist Party can clear which VIEs are allowed to list and which are not. It may give the Beijing leaders greater comfort that they do have control. But we really don't know.
Allison Lee, a commissioner at the Securities and Exchange Commission, said on Monday that Chinese companies listed in the United States must disclose the risk of interference by the Chinese government in their businesses as part of their regular reporting. But that is likely to lead to a whole load of corporate boilerplate. And do the companies actually know? There's no public consultation by the Communist Party, no open discussion of proposed changes before they're suddenly slapped in place.
It's clear from the fiasco surrounding the listing of ride-hailing app Didi Global (DIDI) that the Communist Party is not always clear on what companies are required to do. It was "suggested" by the cybersecurity agency that the company not list. But Didi also fulfilled the expectations of market regulators and the well-established procedure for listing overseas that had worked for so many years before. Didi shares, after the party's surprising ban on signing new customers, have flatlined, down nearly 43% from the US$14 offer price.
Method behind the madness
The changes the Communist Party is mandating all have social goals in mind. Runaway prices in the property industry are a constant worry for the party. Providing jobs and homes are vital in maintaining social stability, and social unrest that could morph into anti-government sentiment is the unelected government's worst fear.
We've reached a confusing moment in the evolution of the Chinese economy, though. The party had been happy since China began opening up in the 1970s to allow private industry to flourish. "Socialism with Chinese characteristics" looks a lot like a for-profit capitalist economy with a dictatorship above it.
China's leadership under Xi is intent on forcing change. While social goals are cited, there's always the suspicion that sectors and companies get targeted when they threaten to rival the Communist Party's power.
The decision to force tutoring centers to register as non-profits and stop taking outside investment is intended to give a break to beleaguered parents. China Daily, the state-run mouthpiece, gave the industry a stern talking-to, like a strict parent admonishing a child.
"Seeking as much profit as possible has turned out to be the sole purpose of tutoring agencies," the newspaper insists in an editorial. "Those teachers moonlighting take it for granted that they can muddle along with their teaching at school since they can teach the kids at tutoring institutions and make good money doing so."
Is that really the case? It seems highly unlikely. The industry has become very much for-profit. Tutors do have their faces plastered on the back of buses here in Hong Kong, "stars" who promise to get your kids results. But no teacher that I know enters the profession purely to get rich. Any who do would certainly not take a government school job.
"When good teachers are invited to moonlight as tutors at such agencies and earn big rewards for doing so, they will hardly whole-heartedly devote themselves to their teaching in classrooms," the newspaper also asserts. "Then students have to have such extra-school training. It has become a vicious circle."
Bad tutoring centers would be forced out of business if the industry is allowed to function openly and properly. Outlawing tutors hardly seems likely to make the issues in Chinese education to go away. To accomplish this balanced life for students, there needs to be a societal shift away from the intense pressure that parents in Asia place on their children academically. In China, South Korea and Japan the pressure for the university entrance exams is crushing.
We do not know which industries will require social correction to "rectify" their ways or when the VIE structure may come under full attack. And that should be very scary for those who invest into China.