Don't F*ck with the CCP

Collapse of Chinese Stocks Highlights Regulation Fears

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Anytime something gets too big and too powerful, the government will mess it up.

In a democratic capitalist-based system, the primary focus is the protection of free competition - the equal opportunity for enterprising individuals to improve their situation based on merit and GRIT. 

Monopolistic pricing behaviour where a few people dictate prices to all negatively impacts the entire system. Monopolies and cartels extract a disproportionate amount of value from each transaction, turning price-takers into bag-holders. 

In a frictionless system, a meritocracy makes a lot of sense. You get out what you put in. However, this system is far from perfect due to the unequal distribution of the opportunity to provide utility. 

While it is not my suggestion that this system is perfect, I simply want to acknowledge that to me, it seems like one of our best options. 

But we need to better understand systems that are in place across the world.

What about in a communist regime? The goal shifts from the importance of free competition to the idea that all property is publicly owned and each person works and is paid according to their abilities and needs. 

China, ruled by the Chinese Communist Party (CCP), employs a drastically different political system vs. those found in North America. Nor is China a traditional communist regime, adapting its own form of capitalism over the past 40+ years (‘China’s third way’), leading it to become the world’s leading export nation and the world’s second largest economy, all of which has lifted more people out of poverty than any time in the history of the world.

But challenges abound, especially for investors. Current issues around regulating large companies have rightfully dominated headlines over the last couple weeks, as the entire Chinese Stock market has been decimated. 

I waited for a bit of the dust to settle to try to deepen my understanding surrounding these issues.

China has been of great importance to many investors, as it has one of the fastest growth rates for GDP and a huge population. It’s a country of massive opportunity, but not without heavy regulation risks. 

We don’t dive into the political realm here – there are far smarter people in that space than me. What we will focus on, is trying to understand the political and regulatory risk as an outside investor, and why this matters. 

This week, in <5 minutes, we’ll cover What’s Going on in China:

  • A Brief History of the CCP 👉 Origin & Ideology

  • What is Happening Now? 👉 FinTech, Ride-Sharing, EdTech, Gaming

  • How Might it Shake out? 👉 Historical Precedents & Buy the Dip? Or “Wait and See”?

  • What Instruments Are Used To Invest Here? 👉 American Depositary Receipts (ADRs)

Let’s get started!

1. A Brief History of the CCP 👉 Origin & Ideology

The CCP claims its origins around 1919 when ideologies like anarchism and Marxism gained traction in China. This movement was heavily influenced by the Russian Communist Party (Bolsheviks) which sent their foreign affairs division to develop Marxism in China, Korea and Japan. 

The Russian influence would continue to persist as they wanted to foster pro-Russian forces in the Far East to fight against anti-communist countries, especially Japan.  

The CCP was officially founded in 1921 during the 1st Nation Congress of the CCP (which occurs every 5 years) whereby the resolution of the congress called for the establishment of a communist party with Chen Duxiu elected as the leader. 

The Chinese Civil war followed (1927-1949) during which Mao Zedong became the Chairman of the CCP in 1945. In October 1949, Chairman Mao formally proclaimed the establishment of the People’s Republic of China (PRC).

Since the CCP controls the country’s armed forces – the People’s Liberation Army (PLA) – ties between the political and military leaders dominate civil-military relations. This resulted in an overlap of leaders amongst the PLA and CCP.

Mao adopted extreme leftist policies. Instead of the ‘Great Leap Forward,’ his regime resulted in gross violations of human rights on his way to effectively turning the country into a one-party state at the hands of the socialist republic.

Following Mao’s death in 1976, a power struggle emerged between Hua Guofeng and Deng Xiaoping, in which Deng would become the “paramount leader” in 1978.

It was Deng that argued a socialist state could use the market economy, without itself being a capitalist society. This ushered in a new era of economic growth. 

Jian Zemin succeeded Deng as paramount leader in the 1990s and continued most of his policies to “advance productive forces, the progressive course of China’s culture, and the fundamental interest of people.”

Hu Jinatao, Zemin’s successor, laid an emphasis of collective leadership as opposed to a one-man dominance of the political system. Xi Jinping would succeed him in 2012 to implement a heavy anti-corruption campaign that ousted many high ranking officials and consolidated power around himself.

“Xi Jinping Thought” is China’s new official political doctrine, and it is distributed across China in schools, newspapers, TV, the internet, billboards, and banners. 

After the country abolished the presidential term limit (used to be 10 years), it is pretty clear that this doctrine and Mr. Xi aren’t going anywhere any time soon. 

To understand decision-making at the CCP, here are some of the key principals out of the 14-point basic policy:

  • Ensuring Chinese Communist Party leadership over all forms of work in China

  • The Chinese Communist Party should take a people-centric approach for the public interest.

  • Following "socialism with Chinese characteristics" with "people as the masters of the country."

  • "Improving people's livelihood and well-being is the primary goal of development."

People first.

2. What is Happening Now? 👉 FinTech, Ride-Sharing, EdTech, Gaming

The retreat of regulatory headlines has resulted in major Chinese stocks losing over ONE TRILLION DOLLARS in market cap. 

We saw the most recent slew of regulatory crackdowns start when famed Entrepreneur Jack Ma, of Alibaba, tried to take his micro-lending company Ant Group public. 

We’ve all had that moment, whether blinded by rage, after a couple too many cold ones at the bar, or where we were not in the right headspace when we opened our mouth to speak before thinking through the ramifications. But few of us have said a speech that costs us hundreds of billions of dollars. 

On October 24 2020, at the Bund Summit in Shanghai, Jack Ma launched a not-so subtle attack against the Chinese Government. Common dude, you know better. During his speech, he challenged the “outdated supervision” of financial regulation for stifling innovation and said its global banking rules were like an “old people’s club.”

He called for urgent change and said that Chinese banks had a “pawnshop mentality (that) is severe, and it also affects many entrepreneurs.” Ma called the people who run the banks “old men” and inferred they were out of touch. 

There could not be a better way to top-tick your businesses than attacking the Chinese government… The trading day before his speech is the exact peak of this chart. 

The market cap of Alibaba at this peak was USD$858B, and is now $533B. Losing $325B market cap in under one year is one helluva hangover. 

This speech was his way of introducing the Ant Group IPO as a viable alternative. Most of us are familiar with the headlines that followed:

Shortly after this, the CCP went after Alibaba itself. They brought an antitrust case against Alibaba, arguing that they behaved like a monopoly. The timing is not a coincidence. By April 2021, the CCP slapped Alibaba with a $2.8B fine. The turnover in the regulatory proceedings was 4 months. This would take years and years to happen in the US, but not in China… 

The following actions taken by the government further hindered Chinese Tech stocks:

  • On June 30, Didi Chuxing, the world’s largest ride-sharing service, IPO’d on the New York Stock Exchange. Apparently, they learned absolutely nothing from the Jack Ma saga, because they IPO’d against the wishes of China’s cybersecurity watchdog. By July 2nd, Chinese regulators put Didi under a cybersecurity review, banned it from accepting new users, then instructed app stores to stop offering Didi’s app.

  • On July 23rd, China knocked out an entire industry: Tutoring companies. Following a report that China may ask companies that offer school curriculum tutoring to become non-profit, stocks tanked: Tal Education group (-55%), New Oriental Education & Technology group (-62%), GSX Techedu (-59%).

  • On July 24, China ordered Tencent to give up exclusive music licensing rights and followed up with a fine for anti-competitive behavior. 

  • On August 2, Tencent was hit with their second double whammy, as a state-owned news outlet Xinhua called video games “spiritual opium,” which prompted discussion of limiting play time for kids to one hour per day. 

3. So What? 👉 Implications of the Crackdown

The reason that I started this article with the origins of the CCP is to highlight that policy will always reflect the greater interests of the people rather than freewheeling enterprise. China puts social interests ahead of economic ones. 

If we look at Chinese technology companies, they essentially started out as copy cat versions “____ is ____ for China”. 

Now, however, these apps have grown into super-apps that are pervasive across all aspects of life and are incredibly innovative

Examples of this are Tencent’s WeChat and Alibaba’s Alipay. Through WeChat you can message, shop, pay a utility bill, order from a restaurant, or hail a cab.

“Super-apps” in China are at the forefront of social interaction and engrained in so many lives, which is why it makes sense for a totalitarian regime to monitor them. 

The growth strategy for these companies have been to acquire the capabilities to fill in the gaps, or to acquire competitors to absorb them or shut this down. 

Sound familiar? It’s the exact same in the US.

I think this crackdown reflects on the overall impact of modern monopolies. If we look in the US, the DOJ and SEC firing small salvos at Megacap tech which has grown pretty much unchecked. The recent focus on Apple and Google in regards to their App stores being monopolies should’ve happened a long time ago. 

Is China onto something here, and they can just do it more efficiently? Is this stifling innovation or encouraging competition? How big is too big for these tech companies?

All fascinating questions with broad ranging implications for the overall ecosystem.


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4. How Might it Shake out? 👉  Catch Falling Knife? Buy the Dip? Or “Wait and See”?

“History doesn’t repeat itself, but it often rhymes.” – Mark Twain

To better understand the current and future environment, I find it useful to study history to identify patterns. 

You have to consider the nascent nature of the stock exchanges in China. The Shanghai and Shenzhen stock exchanges were launched in 1990 and 1991 respectively. 

China’s stock market has long been complicated by the existence of state-owned non-tradable shares. This meant that majority ownership in many firms remained with the state. However, there have been recent developments, like the gradual sell-down of non-tradable shares within the market. 

As I wrote in a previous piece that you can find here, you need to have democratization through institutional and retail investors in order to provide a better liquidity picture. 

For now, after this recent crackdown, I am in “wait and see” mode watching for additional regulations that may come down the pipe.

But eventually the risk has to become priced in and the innovation that is present in the Chinese technology square has to provide a risk/return profile where the returns outweigh the risk.

Now, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!

5. What Instruments are used to invest here? 👉  American depositary receipts (ADRs)

So you understand the risks and still want to get exposure to more global themes in other markets. How exactly do you do this? Through purchasing an American Depositary Receipt (ADR).

A depository receipt is a financial security that is usually traded on a local exchange and represents equity issued by a foreign publicly-listed company. 

The DR is issued by a U.S. depositary bank, such as The Bank of New York, where the underlying shares are deposited in a local custodian bank, usually by a broker who has purchased the shares in the open market.

Once issued, these certificates may be freely traded in the U.S. over-the-counter market or on a national stock exchange. When the DR holder sells, the DR can either be sold to another U.S. investor or it can be canceled and the underlying shares can be sold to a non-U.S. investor.

Although these instruments grant access to foreign markets that are tricky to navigate, the downside is accounting transparency, which Chinese companies specifically have been flagged on. 

For example, a company that trades as a Sponsored level I DR does not need to comply with GAAP accounting principles and does not require full SEC disclosure. This creates many risks where investors are unable to do proper deep dives due to the skirting of rules. Caveat emptor. 

In addition to the opacity of results, shareholders of ADRs also have limited rights as opposed to straight out equity ownership, thus resulting in alot of governing issues. 

It is up to each investor to make a decision to purchase the ADRs if the potential rewards outweigh the risk of lack of transparency.

Wrapping Up…

Although the recent crackdown is alarming, I believe keeping actors in a system in check can be conducive to the overall health of an industry. As we can see through both the pandemic’s K-shaped recovery, and the widening wealth gap in America, people’s self-interest can prevail in a negative way through an unfettered capitalism-dominated society. 

Will be one helluva ride… buckle up.

Until next time. Always Yours. Incessantly Chasing ROI,

-Genevieve Roch-Decter, CFA

P.S Find someone who holds you the way I held bitcoin over the last six months.


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Sources:
https://en.wikipedia.org/wiki/Chinese_Communist_Party
https://entrepreneurshandbook.co/the-speech-that-cost-jack-ma-37-billion-dollars-5ad42393c9ba
https://www.hg.org/legal-articles/china-s-securities-regulation-a-historical-perspective-5164
https://www.ukessays.com/essays/finance/history-and-definition-of-depository-receipts-finance-essay.php
https://markets.businessinsider.com/news/stocks/tal-edu-gotu-stock-price-tutoring-companies-non-profit-baba-2021-7

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