China Heads Into Darker Waters

China Heads Into Darker Waters

The near-term investment risks and longer-term implications of heightened interventionism by the Chinese Communist Party (CCP).

Key Takeaways:

  • For-profit education companies are currently in the crosshairs of the Chinese government, as they try to limit the social pressures created by these businesses. 
  • Recent actions by the Chinese Communist Party within the realm of capital markets are further evidence of their efforts to clamp down on free enterprise in favor of statist goals.
  • The Middle Income Trap – the ability to advance economically after the easier elements of modernization are implemented (modern capital equipment tools, telecommunications, etc.) are challenging. The growing pains are very tangible. 
  • China faces a truly unique set of issues due to their communist ideologies contrasting with their gigantic free-wheeling technology and consumer led businesses.
 

 

The epicenter, in July specifically, are Chinese for-profit education companies. These provide intensive tutoring and test prep services for young Chinese students, whose families pay dearly for them to have a better opportunity to excel on standardized exams needed for placement into primary and secondary school tracks. China does not have enough universities for all its young people, and the prospect of not making it into a prestigious school is costly in terms of opportunity lost. The effective cost of education and peripherals has become an increasing form of nuclear family anxiety and a deterrent to having larger families in general. This field had become a full-blown industry, with an aggregate market cap well beyond $100 bn on listed companies such as TAL Education Group (TAL) and New Oriental Education & Tech Group (EDU).  Having met with some of these companies before, pricing power appeared robust due to an endless supply of worried families wanting to give their child the best chance to advance in life. For the kids and their families, the rat race element generates a lot of anxiety and stress, but (seemed) a foregone conclusion.

Cambiar has not owned Chinese tutoring and test prep stocks, or their USA equivalents for that matter, but did own a vocational skills company called China East in our International Small Cap portfolios, which was more focused on training chefs.  We have exited this position given its lesser but adjacent risks.

Generally, we have taken a cautious to outright negative view on businesses such as for-profit education globally. While difficult to encapsulate the negative stance within the context of a Quality, Price, Discipline (QPD) investment evaluation framework, there are substantial questions in China, and the U.S. about the legitimate value of these services and we view the space as somewhat of a “racket” that preys upon lesser human instincts and what amounts to public policy gaps. There are not a lot of vocational education companies to be invested in in the U.S., but these would seem to provide a clearer form of value-added service.

The Chinese Communist Party (CCP) government had been making noises about limiting the scope of the above in the highly active for-profit tutoring space for several months, given the social pressures it creates. Stocks had declined throughout 2021, but the scope of the blow basically nationalizing any profits from for-profit education businesses, as well making meaningful incursions into the curriculum – is a ghastly bit of evidence about the nature of the CCP in general, its agenda in the visible future, and lack of respect for the sanctity of private property/business property rights and values. Some of the main stocks, such as TAL and EDU, which were $20+ bn stocks in January supported by very profitable earnings streams, appear likely to be zeroes but for some residual cash on their balance sheets.

This comes on the heels of several actions by the CCP under Xi Jinping in the last several years that paint a mosaic of what China aims to be as a country. It has become hard to miss the longer term objective. Despite inclusion in the WTO, intended very deliberately to allow China to enjoy the fruits and benefits of the world’s free markets economic system and the eventual and necessary liberalization of business and individual rights that comes along with that, China seems undeterred to use the profits/capital garnered from global access and components of private business success to amplify long term statist goals, and not to become “more free”. China/CCP rather aims to have individuals and businesses closely aligned with whatever goals the CCP establishes for them, with close monitoring of their actions, transactions, intellectual/educational development, and even their recreational frontiers. State-owned businesses will have capital continuously channeled toward them with state-owned banks among the conduits. Free markets will be channeled to conform with statist goals. Capital markets/stock listings will likely move onshore to destinations such as Shanghai and Hong Kong where the CCP has full influence. NYSE listings probably just ended with the Didi listing (the Chinese Uber). NYSE listed ADRs probably become fungible into Hong Kong listings, and then become pink sheet ADRs. As for the treatment of foreign capital in the country, that has not been explicitly marked for prejudicial treatment, though direct foreign investors have long decried being compelled to give up substantial economics of their production/distribution to local companies. I gather this version of things at least continues for a while. 

This does not mean the end of the road for obvious symbols of success and luxury such as foreign cars, apparel, iPhones, etc., as the CCP still does appear to need to permit the Chinese people to enjoy some of the global trappings of success and prosperity, or else what real progress the nation is making will truly become a difficult question to answer to mainland Chinese.

Nevertheless, the shift in direction seems to have come full swing since the end of the Cold War.  This is ideologically very similar to the USSR but for the capacity to spy on people digitally, because that was not a thing in the 1980s and was invalidated by the Communist world’s inability to keep pace with the West or advance its people’s welfare in general. Nonetheless, these seem to be the CCP’s primary objectives: very extensive control, influence, and monitoring of everything they can get their hands on.  

Earlier in Xi Jinping’s rule as head of China, the CCP instituted an “anticorruption drive”. While notionally this has some appeal (who exactly is in favor of unchecked corruption?), the agenda is much darker than first appears. China ranks in the bottom 50 of the world’s 160+ nations in terms of business freedom/ability to start a business. This means that starting something as simple as a hair salon or noodle shop requires a vast array of paperwork and approvals that is so daunting and lengthy to achieve that some inaccuracies in the paperwork are inevitable, as are bribes to just stamp the approvals somewhere. Alas, this means the vast array of small business entrepreneurs in China are all guilty of some form of corruption! In practice, this means that many millions of these folks need to be very afraid of CCP enforcement, which thus in practice means cozying up to local CCP officials and anyone else needed to keep the enforcement arms at bay. If this sounds a lot like a form of mobster capitalism, that it is. The penalties for corruption can be extreme, including steep fines, business forfeiture, re-education camps, etc. The businesses that are less likely to be found at fault are either so large as to be able to set up reasonable defenses, or state affiliated directly.  

As nation-builders, the CCP and the Chinese people managed to pack 150 years of industrial progress into about 32 years, which is amazing and on a scale unseen in human history.

More recently, Ant Financial’s IPO was scuppered at the last minute on financial regulation and antimonopoly grounds. Here too the goals seem benign – with Ant issuing loans, should they not have to hold capital against the loans? Seems fair enough. But the CCP wants more than just this they appear to want to impinge on the private sector to apportion credit in general, and would rather channel credit through “official” channels such as state-owned banks and/or enterprises, and cripple faster moving digital platforms like Ant. The net result is the same less market economics and associated freedoms, more CCP.  

It is also true that private education companies, schools, etc. supply Western enlightened and non-communist fueled dogma to their students as well. That kind of content is now out, replaced by state approved content as we understand it. Thus, there are layers to this evisceration of the sector that go beyond reducing Chinese student and family stresses and is wholly consistent with the drumbeat of “more CCP”, and thus the extreme reactions you are seeing.

The last areas worth direct commentary are the Chinese internets and related technologybased platforms, such as the payment rails that reside in these platforms. Data accumulation/sharing with the CCP is now “a given”, whether for shopping on Alibaba, paying for stuff via WeChat/Tenpay, ride-hailing via Didi, etc. These businesses are being forced to work in close concert with the CCP to monitor the Chinese people closely, whatever it is they do, and if this augments costs, this is the way things are. It remains unclear whether these powerful businesses will be able to invest in obvious adjacent markets freely, with conditions attached, or will be precluded from doing so altogether. We tend to think with conditions attached.

 

 

EMERGING MARKET ECONOMICS

 

MIDDLE INCOME TRAP

 

In the field of Developing Economy economics, there is a well-delineated concept called the “middle income trap”. Middle income countries have per capita GDP ranging between 5% and 40% of that of the U.S., which equates to a ceiling of $25,000 per capita in 2021. In the post World War II time period, only 15 out of 101 middle income countries actually advanced beyond this level. Even among countries that advanced beyond the middle income level, such as South Korea, Taiwan, and Singapore, they spent 23, 27, and 29 years, respectively, “stuck” at a middle income level. Why is this so hard to avoid/grow past?

In simple terms, it is challenging to advance economically after the easier elements of modernization are implemented, such as using modern capital equipment tools, modern telecommunications, etc. The growing pains are very tangible. Countries that have benefited from low wages become less competitive as they move into middle income status. Others with heavy commodity exposure can only go so far digging things out of the ground. One way or the other, nations eventually need to move up the value-added ladder to become richer, and this means Intellectual Property (I.P.) formation.  In turn, I.P. formation requires not only an educated workforce but a commercial and independent legal system that is consistent with supporting/promoting I.P. rights. In addition, as countries move up the income scale, various industries do lose competitiveness and there are natural erosions of relevance, leading to displaced workers and economic losses. The creative-destruction feature of market based economics will rear its head on both the positive and negative sides as countries develop. 

So, what happens when workers are displaced, factories become uncompetitive, and other features of a country’s development strategy begin to backfire? The correct answer is that you need to grind it out and understand that to become an affluent nation, it is more complicated than you might think, that various institutions will need to be fostered carefully, and that some practices that may have gotten your country from zero to where it is presently may not be able to drive it further. And these generally are not the answers that most governments are looking for because they extend beyond most elected governments’ terms, or unelected governments’ expected lifespans. The temptation to resort economically unorthodox forms of intervention are high.  These include blaming scapegoats, blocking certain kinds of imports, stifling  certain kinds of investors, trying to fix their currency to unrealistic valuations, borrow a bunch of money to build irrelevant infrastructure, and/or engage in other forms of populism to quell a population that becomes restive to the lack of progress.

Rather than let the free markets run, governments experiencing aspects of the Middle Income Trap interfere. And that is where things can start to go dark, as interventionist reactions just exacerbate the problem, drive longer-term capital away, cause brain drain, and impede market forces from working. South American countries such as Argentina and Brazil are classic examples of this over the 1960-1990 time period, becoming at first just interventionist, and as their interventions failed quite decisively, military governments eventually came in. At that point, rather than just being trapped, they generally went backwards.

 

 

IS CHINA FALLING INTO
SOME FORM OF REACTIVE INTERVENTIONALISM?

 

 

In their own unique way, but unambiguously, yes.  

China faces a truly unique set of contrasts, by way of its size, cultural longevity, the anecdotal fact that its people are amazingly good capitalist entrepreneurs, and that its government is rooted in a highly antagonistic, Leninist set of dogmatic principles that lie in direct contrast to the normal features of a market-led economy. China has sought, since the end of the Cold War, to grow its productive capacities and economy by opening to the rest of the world. In doing so, it has become the second largest economy in general and second 2nd largest global manufacturer. Technology, internet, and other entrepreneurial businesses have thrived. As nation-builders, the CCP and the Chinese people managed to pack 150 years of industrial progress into about 32 years, which is amazing and on a scale unseen in human history. Maybe now the leadership are overconfident?

The contrast between communist ideology, which features state control over just about everything, and gigantic free-wheeling technology and consumer led businesses is a staggering one. It has been laying in plain sight for years, and observers have generally concluded that in order to advance the country, communist dogma would need to give way to practical reality, namely that the way forward would be through successful private businesses, large and small, that would advance the lives of the Chinese people. As a practical matter, that constructive view ought to be true. But as China’s progress has become more stunted as of late, the same unproductive urges cited above are coming out in force. Whether these prove to be typical reactions to a lack of progress and middle income trap issues, or more extreme ones, exaggerated by communist dogma that China’s leadership actually believes, is hard to parse currently. The signs do point to the CCP doubling down on being a more interventionist state in most respects.  Maybe tripling down after this month…

Brian Barish is the President and CIO at Cambiar Investors and is responsible for the oversight of all investment functions…
This is unfortunate for equities globally, not just in China. Investors will likely assign a much higher risk premium to Chinese stocks (i.e. lower multiples) for some time to come. China has been an immense source of consumer product and industrial growth for 30+ years now. If Chinese growth falls further, and it is reasonable to believe that it will, demand growth for commodities, advanced industrial products, infrastructure, and consumer products/luxuries will also slow given the scope of the nation.  Markets prone to excess global capacity/irrational capacity growth may be particularly at risk.

Offsetting some of this negativity, arms races in technology, and outright military armaments probably continue apace.

Cold War 2.0? Not exactly. At this point, absent some course correction by China that would seem implausible based on recent moves, China ought not to be expected to keep pace with the West, not with these incentives and statism run amok. But the time to see that process run its course will be long.

 

 

Enjoy our content? Please follow.
LinkedIn
Twitter
Follow Me
Facebook
Instagram
Disclosures

Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar.  Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements.  The information provided is not intended to be, and should not be construed as, investment, legal or tax advice.  Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation. 

Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts and other information presented may be based upon third-party sources that are deemed reliable; however, Cambiar does not guarantee its accuracy or completeness.  As with any investments, there are risks to be considered.  Past performance is no indication of future results.  All material is provided for informational purposes only and there is no guarantee that any opinions expressed herein will be valid beyond the date of this communication. 

The specific securities identified and described do not represent all of the securities purchased or held in Cambiar accounts on the date of publication, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. All information is provided for informational purposes only and should not be deemed as a recommendation to buy the securities mentioned.