China’s recent crackdown on internet companies has alarmed investors, sending their stock prices tumbling. What is the likely impact of these new regulations? Are Chinese internet companies still investable?
Over the past six months, there has been a major regulatory reset in the Chinese internet sector. Certain events, such as the anti-trust investigation and the subsequent fine of Alibaba, the Cyberspace Administration of China’s probe of ridesharing company Didi Chuxing, and the shutdown of after-school tutoring have triggered a market sell-off. As a result, China’s internet sector has significantly underperformed US big tech since February 2021, with both Hong Kong and Chinese indices seeing sharp falls.
Having allowed the internet sector to innovate and develop in the past decade, China has now started to regulate it. This is not a bad thing. While we are firm believers in the power of digitalisation – one of our five themes – to shape our future and transform our lives, the internet sector has had no shortage of ESG issues.
The transformation to a digital world has brought about a number of societal challenges, such as data privacy, algorithm bias, addiction, platform responsibilities, anti-trust, tax, and unconventional governance. In the US, Amazon, Apple, Facebook and Google have all grappled with these issues amid widespread scrutiny. Chinese internet companies are no different.
In China, companies such as Alibaba, Meituan and JD had used various tactics to ensure merchants stayed exclusively on their platforms, violating China’s anti-trust principles. Netizens have complained about the practice of discretionary pricing, where platform companies (such as Meituan, Alibaba, Ctrip and Didi) allegedly use big data and algorithms to provide different prices to different users.
Another issue is the illegal over-collection and use of personal data, with Chinese regulators calling out a number of apps, developed by Bytedance, Kuaishou, Baidu, Tencent and Alibaba, in May this year. The issue of closed platforms is also a problem in China, with Tencent and Alibaba’s eco-systems closed to each other. Predatory pricing – where platform companies give heavy subsidies to users to drive out competitors, and subsequently put up prices again once the industry is consolidated – is also allegedly common in the Chinese internet space.
We believe the government’s increasing concern over these ESG issues, together with a number of domestic and international events (e.g. Jack Ma’s criticism towards financial regulations, China’s desire for semiconductor localisation following US technology bans and political transition to Xi’s third term in 2022), have unleashed the current regulatory cycle.
What the Chinese government wants to achieve
We believe there are two main driving forces behind the current regulatory cycle in China. Firstly, after declaring victory in eradicating poverty early this year, President Xi has shifted the focus to “common prosperity”, with the aim of closing the gap between the rich and the poor. Secondly, China has declared 2021 to be the year it will “prevent the disorderly expansion of capital”. China’s internet sector has raised billions of dollars in the past decade, and the government is keen to ensure that this capital is not used to power monopoly, promote rent-seeking, harm merchants or abuse users.
The Chinese government has now initiated regulations and investigations in multiple areas. Alibaba and Meituan have faced anti-trust investigations and committed to making changes; Didi, which collected sensitive personal data on trips and travels, is now subject to a cybersecurity review. Tencent and other companies have been asked to rectify their data collection practices.
How do we know when the regulatory cycle will ease?
China’s past regulatory campaigns, such as its crackdown on corruption, which impacted the consumer discretionary sector from 2012 to 2016, and its actions to prohibit gaming addiction among the underage, which saw the gaming industry underperform in 2018, can serve as starting references as to how long this cycle might run for. While these campaigns normally last two to three years, there are plenty of reasons to believe this one might take longer. Not only does the internet sector affect a vast proportion of the economy, but the scope and scale of the changes the government wants to see is unprecedented, a fact that is reflected in the number of agencies involved and issues raised. It is also an unusually high-profile campaign, drawing attention from the most senior of China’s leaders.
Nonetheless, we believe there are a few signposts which give us some idea of progress. There are three key components in a platform company – capital, user data and algorithms. We have seen China already introduce major regulations on the first two. Very recently, a draft regulation was proposed to control the use of algorithms.
In addressing issues around capital, the government has now imposed security checks on overseas listings. While we expect further tightening in this area, pursuing a listing in Hong Kong is now at least a viable option.
The anti-trust regulator has recently introduced measures to prohibit anti-competition behaviours. One measure is to prevent predatory pricing, where a huge amount of capital can be used to drive out competitors by giving excessive user subsidies.
To deal with issues around user data, new regulations on data security and privacy have been introduced, such as the Data Security Law (effective on 1 September) and the Personal Information Protection Law (effective on 1 November). These laws give us some idea as to what the government would like to achieve regarding user data.
Algorithms are an important asset to internet companies as they dictate what kind of products or services a user will receive, which impacts user engagement on a platform and thereby revenue growth. There has been some opinion expressed in the state media that regulations should be introduced to ensure algorithms serve public interests, not corporates’ profit motives. Some anti-trust and data privacy regulations have started to impose restrictions on algorithms. The government has also previously announced that it will strengthen regulations in artificial intelligence and big data in the next five years. On 27 August, the Cyberspace Administration of China (CAC) published the first draft of regulations on algorithms to protect national security and public interests. Apart from prohibiting algorithms from abusing users (e.g. no discriminatory pricing, not causing internet addition to the underage, not using discretionary parameters or attributes and not impairing the labour rights of riders and drivers), the CAC also asks companies to provide the ability to opt-out of any recommendations driven by algorithms and to disclose their basic principles and purpose.
While it remains to be seen how the business models of Chinese internet companies will adapt and change, we believe these regulations now provide an overarching framework of what the government expects of the internet sector.
Is the Chinese internet sector still investable?
It is worth remembering that China has no desire to destroy its internet industry, a sector of which it is particularly proud and which it sees not only as improving the daily lives of its citizens but as a useful tool for the government. The regulations are not designed to totally transform the big internet companies, but to encourage them to adapt and adjust.
In the near term, it is unlikely that earnings will substantially improve in the internet sector. However, we continue to hold Alibaba, Meituan and Tencent in our portfolios. In the long term, we believe the internet sector will ultimately benefit from increased regulation – not only in China but also in the US and Europe. China is now catching up with governments in other major economies who have already taken steps to regulate big technology companies. In some ESG areas such as anti-trust, China is arguably more advanced in dealing with these issues than other countries.
The mega theme of digitalisation in China is not broken, but we believe the sector is right to take a pause to fix its ESG issues. When most of the regulations are in place and market participants are clear on what these regulations would like to achieve, we believe digitalisation in China will still offer attractive long-term investment opportunities.
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