China market sell-off: Why I am holding on

If you have investments in the Chinese market, the recent sell-off has likely done a number on your portfolio. This sell-off comes after a series of actions by the Chinese Communist Party (CCP) as they tighten the regulation on Chinese companies.

What exactly are these events which led to this panic selling? Is the selling justified, or is this an opportunity for us to buy? Let’s have a look at it!

What happened?!

All of this began with Didi’s initial public offering (IPO), which was one of the largest IPO to hit the US market this year.

The Cyberspace Administration of China (CAC) launched an inquiry into Didi just days after its IPO, citing concerns about its users’ data being mismanaged. During this time, Didi was ordered to be removed from app stores while investigations were ongoing. While Didi took centre stage in the latest crackdown, it wasn’t the only victim. The CAC began investigating other companies concurrently, some companies include Full Truck Alliance Co. and Kanzhun Ltd. Both of which were recently listed in the US due to data security concerns.

To end off the eventful week, news outlets started to pick up rumours on the CCP’s intention to close the VIE structure loophole.

All of this news instilled fear in investors, resulting in the current sell-off.

Let’s take a closer look at these developments.

Cyberspace Administration of China’s (CAC) investigation on Didi

The CAC was established in 2014 by President Xi JinPing, which enforces online censorship and promotes Beijing’s ‘internet sovereignty’ policy. Days after Didi’s massive IPO, the CAC launched an investigation on Didi over the concern of their collection and usage of personal data.

It was also ordered to remove its app from the Chinese app store and was prohibited from enrolling new customers.

This announcement came as a complete surprise to investors and triggered a sell-off. Didi’s stock dropping by more than 20% after the information came to light.

The question now is, did Didi violate any use of personal data?

According to specific reports, Didi received warnings before its IPO. However, the CAC did not reveal the issues it had discovered with Didi’s data security measures, making this move suspicious.

We do not know the true intention. But I believe one of the reasons would be that the Chinese regulators are getting increasingly concerned about Chinese data falling into foreign hands.

Didi has more than 377 million users in China. It has the addresses these users frequent, their phone contacts and even audio recordings of car rides (Yes, rides are recorded after a series of passenger murders in 2018).

While Didi took the spotlight, the CAC has also begun investigations into two other companies, Full Truck Alliance Co, a truck hailing platform, and Kanzhun Ltd, an online hiring service, on data security grounds.

Both of these companies were recently listed, which is interesting. Is it purely coincidental? I find it hard to believe it.

Following the announcement, the stock prices of Full Truck Alliance Co. and Kanzhun Ltd plunged 6.6 per cent and 16 per cent, respectively.

What is “VIE”? (and how it has been ‘exploited’)

On top of that, rumours of a Chinese regulator scrutinising the VIE structure has appeared just days after the crackdown on Didi and other enterprises.

For those unfamiliar with the acronym, a Variable Interest Entity (VIE) is a type of legal entity that allows investors to profit from a company’s economic activity without really owning it. 

This structure was established to get around the Chinese government’s restrictions on foreign investment in sensitive industries, allowing Chinese companies to acquire funds without seeking permission from the authorities.

Prior to the latest rumors, the Chinese government had never interfered. Many Chinese tech giants, including Alibaba and Tencent, were listed with this structure.

However, with the fear of sensitive information going to foreign countries, the Chinese Securities Regulatory Commission (CSRC) is now finding ways to close this loophole. Moving forward, companies looking to list overseas via the VIE structure may have to obtain approval from the relevant authorities.

On the other hand, companies that have already been listed via the VIE structure will be required to obtain additional approval should they need additional funding from the market.

According to Dealogic statistics, 36 Chinese companies went public in the US market in the first half of 2021, the same amount as in the entire year of 2020. This decision will undoubtedly make listing overseas less appealing than before, and we may witness a decrease in Chinese listings abroad.

What do these actions mean?

These regulatory efforts are part of the Chinese government’s ongoing effort to put Chinese companies on the ‘right’ track. In a negative sense, we can call it coercion; in a positive sense, we can call it nudging.

In the short run, we can expect Chinese companies to cancel any ideas for a foreign IPO.

In fact, three companies had pulled out recently. Namely Keep (a popular fitness app in China), LinkDoc Technology (A Chinese medical data solution provider) and Ximalaya (China’s largest podcasting platform). To go one step further, Ximalaya has also stated its intention to list on Hong Kong instead.

Why is the Chinese communist party doing this?

Your guess is as good as mine. There are many reasons, from data protection to telling the Chinese companies who is in charge.

To me, the Chinese government’s activities in clamping down on tech companies are no different than the western governments battling big tech firms’ anti-monopolistic behaviours. Well, except that the Chinese government are much more effective, given the power it has.

Moving forward, I believe the regulation will be tightened, and companies like Alibaba and Tencent would likely not have that much freedom as they used to.

However, I think this is the best way forward for the countries before these firms become too big to be controlled, as in the case of many big western companies.

I do not think the Chinese government is out there to kill their homegrown brand. Although profit margin may be slightly affected, healthy competition would allow these companies to continue innovating and competing globally.

With that, I still believe the market is overreacting, and we should not lose hope in China stocks.

Why am I still holding onto Chinese stocks

Need more assurance?

Well, here are some reasons why I had looked into China in the first place.

Firstly, China has a vast economy that is growing very fast. A study by the Japan Center for Economic Research shows that China gross domestic product would soon surpass that of the US in 2028 or 2029. (Well, it could even be earlier)

China’s population of 1.5 billion people is five times that of the United States, which has a population of 330 million.

Economic 101: With more people, there will undoubtedly be more economic activities in China that will help businesses grow.

Furthermore, China’s per capita GDP is estimated to be approximately $11,000 in 2020, far lower than the US’s $63,200. This implies that there is still a lot of room for household income to increase. As China’s economy develops, rising disposable income will increase consumption, bolstering the country’s economy.

Finally, I’d want to bring up China’s technological advancements and innovation.

Most are used to dismissing Chinese technology as a carbon copy of Western technology. However, the tide is turning. In several sectors, China has already surpassed the United States.

With nearly 58,990 patent applications filed with the World Intellectual Property Organisation last year, it even surpassed the United States, which filed 57,840 and came in as the country with the most applications. Patent ownership is commonly regarded as a sign of a country’s economic strength and technological know-how. If there’s one thing to take away from this statistic, it’s that there will be plenty of opportunities for those wishing to invest in China.

This can take the form of technological advancements such as 5G, Blockchain, the Internet of Things, and self-driving cars.

For a complete picture of why China is attractive, do take a look at this guide created by the team.

3 Ways to Invest in China

If you don’t have time to research individual companies, an exchange-traded fund is the most convenient option. By purchasing an ETF, you can rapidly diversify your China portfolio while also reducing the chance of investing in a fraudulent company.

1 – MSCI China ETF (HKG: 2801, NASDAQ: MCHI)

If you are looking for an ETF that focuses on technology companies, you can consider MSCI China ETF.

The MSCI China ETF contains a mixture of mid to large capitalisation stocks across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). In total, it has 736 stocks in its holding, which covers 85% of all China equity.

Here are the performances from 2006 till now. You can see its annual performance has outperformed MSCI Emerging Market and MSCI ACWI. In terms of annualised return, MSCI China ETF returned an average of 7.93% annually for the past 10 years.

2 – Hang Seng Tech ETF (HKG: 3067)

Another alternative for exposure to China technology companies is iShares Hang Seng Tech ETF. The ETFs comprises 30 Hong Kong listed companies in the technology sector or with tech-enabled businesses. As such, if you are bullish on Chinese tech companies, this would be the stock to choose.

As the ETF was recently launched, there isn’t much data to analyse for Hang Seng Tech ETF.

3 – CSI 300 ETF (300 largest and most liquid A-share stocks) (HKG: 3188, NYSE: ASHR)

Lastly, if you are banking on the growing domestic consumption that comes with the rising income and large population, you can choose the CSI 300 ETF.

This ETF comprises 300 mid to large capitalisation stocks traded on the Shanghai and Shenzhen stock exchanges. Drilling down to its top 10 holdings, you can see how these companies would do well when domestic consumption increases.

In terms of annual return, this portfolio has generated an annualised return of 12% over the last five years,

There you go, these are the 3 ETFs you can consider adding to your portfolio. For more ETF recommendations, we have compiled a list of China ETFs you can consider.

If ETFs aren’t for you, you’re probably more interested in picking specific equities. For starters, you can start by looking at the top holdings of the ETFs listed above. Alternatively, you can learn how to choose like Yaonan, our China investment trainer, by attending his next webinar.

Key risk for China Investors: One Party System

China’s one-party system has resulted in fast economic growth, with an average annual GDP growth rate of more than 9% from 1979 to 2010. This one-party system has allowed the Chinese government to pass policies considerably faster than a democratic country like the United States.

With a great leader at the helm, China would be capable of adapting and progress considerably faster than others. At the same time, without adequate checks and balances, China may easily fall apart under poor leadership, which could spell disaster for any investments in the Chinese market.

For now, the Chinese people are content to let the CCP run the country because of the country’s economic prosperity and rising level of living.

When economic growth slows, though, the problem will start to creep in. That would be the true test for the CCP, given the issue of income inequality and other social ills that many developing countries face. Will they be able to keep their grip on power? Well, since this is still a long way off, there aren’t many concerns for now.

Will I Invest? (Author’s Opinion)

Chinese companies are currently trading at a significant discount as a result of the recent sell-off. I have personally added Hang Seng Tech ETF (3067) and Ping An Insurance to my portfolio during the sell-off.

Of course, I have no idea how long this will persist.

Is it possible that China’s businesses would be subjected to more regulations? Possibly. As a result, having a mixture of equities from several countries is advantageous. My other positions are in the United States and Singapore.

Finally, keep in mind that the Chinese market is dominated by retail investors rather than institutional investors. As a result, increased volatility is to be expected, as most market movements are driven by emotion rather than fundamentals.