China Tech Stocks: Shifting Investor Sentiment

China's Tech Regulation Landscape in 2021

Throughout 2021, a series of stringent regulatory actions have significantly impacted the Chinese technology sector. Keeping abreast of the evolving regulations, the responsible authorities, and the specifics of these rules has proven challenging.

These changes span multiple areas, including financial technology, data governance, and the education industry. A diverse set of governmental bodies are actively revising the operational framework for businesses.

The Rise of SAMR

In the realm of antitrust regulation, the State Administration of Market Regulation (SAMR) is signaling a substantial and ongoing restructuring of interactions between Chinese internet companies, their customers, suppliers, and the government.

Established just three years ago through the consolidation of pre-existing agencies, SAMR has rapidly gained prominence. It is now fundamentally altering corporate risk assessment and opportunity evaluation within the world’s largest internet market.

Following substantial penalties imposed on major companies like Alibaba and Meituan, indications suggest that SAMR’s regulatory efforts are far from complete.

Potential Upgrade to National Antimonopoly Bureau

Recent reports, as highlighted by Reuters on October 13, indicate that China is contemplating elevating the antitrust division within SAMR to a deputy-ministerial level. This new entity would be known as the National Antimonopoly Bureau.

This proposed upgrade is expected to provide antitrust investigators with increased resources for reviewing mergers and acquisitions.

Furthermore, it aims to bolster SAMR’s internal research capabilities, reducing its reliance on external consultants – a move consistent with plans for significant workforce expansion.

Implications for Tech Companies and Investors

These developments suggest continued challenges for China’s leading technology firms and their competitors. The evolving regulatory environment is also prompting a reassessment of investment strategies and company valuations.

The changing landscape is rapidly influencing how investors determine the worth of some of the world’s most rapidly expanding businesses.

Key takeaways include increased scrutiny of mergers, stronger enforcement of antitrust laws, and a more proactive approach to regulating the tech sector.

Trusts and the Antitrust Response

Regulatory repercussions of this nature are not uncommon throughout history. The “Gilded Age,” following the American Civil War, was characterized by significant wealth disparity and lavish displays of affluence. This era witnessed the United States emerge as a leading industrial and economic power.

A defining feature of the time was a limited role for the federal government, alongside the increasing influence of powerful corporate entities and industrialists – figures like Rockefeller, Carnegie, and Morgan – who established dominant monopolies across the economic, political, and social landscapes.

Despite fostering substantial innovation and economic vitality, the period’s excesses ultimately prompted corrective actions during Theodore Roosevelt’s Progressive Era. This involved implementing regulations to safeguard natural resources, protect consumers, and dismantle corporate monopolies.

Several commentators have drawn parallels between contemporary China and the United States during its transition from the Gilded Age to the Progressive Era. Both nations experienced social inequality, environmental concerns, and the rise of massive corporate interests.

In both cases, the national leader – Roosevelt and now Xi Jinping – has strengthened state control and is working to address the imbalances created by prolonged periods of rapid growth. Xi Jinping is actively attempting to mitigate the consequences of decades of transformative economic expansion.

Similar to Roosevelt’s approach, Xi Jinping appears to consider the nation’s most prominent corporations as excessively large entities. Their dominance is perceived as a potential threat to the sustained well-being of the economy and society.

However, while Roosevelt targeted oil and railroad monopolies, Xi Jinping’s focus is primarily on China’s globally prominent internet companies.

Historical Context and Current Actions

The actions taken by Xi Jinping reflect a broader concern about the concentration of power within the technology sector. This mirrors the historical concerns that led to antitrust legislation in the United States.

The goal is to foster a more balanced and sustainable economic environment, preventing any single entity from wielding undue influence. This approach aims to ensure long-term economic stability and societal harmony.

• The Gilded Age saw the rise of industrial giants like Rockefeller and Carnegie.
• Theodore Roosevelt’s Progressive Era implemented regulations to curb monopolies.
• Present-day China faces similar challenges of inequality and corporate dominance.
• Xi Jinping is taking steps to regulate China’s leading internet companies.

Antitrust measures are being implemented to address these concerns and promote fair competition.

Re-evaluating “Monopoly” in the Context of Platform Economies

As Chinese authorities aim to address the economic imbalances of the recent past through updated antitrust measures in the digital sphere, a re-evaluation of the definition of a monopoly is also underway. This necessitates the development of regulations that specifically address the unique dynamics of market dominance within the digital economy, not just for China, but globally.

Michael Norris, a Shanghai-based analyst at AgencyChina, highlights the complexity: “Given that many large internet platforms operate as two-sided markets, regulation must account for the interests of both consumers and merchants.” He emphasizes the need for a balanced approach that protects consumers, supports merchant viability, and acknowledges the underlying economics of these platforms.

A Shift from the Consumer Welfare Standard

This approach contrasts with the long-held Consumer Welfare Standard prevalent in the U.S. This standard primarily directs regulators and courts to assess the impact of business practices on consumers, rather than focusing on potential harm to competitors.

However, an increasing number of policymakers argue that this standard is inadequate for the digital economy. Companies like Alibaba and Amazon, functioning as intermediaries between buyers and sellers, leverage their substantial scale to surpass competitors. The traditional standard may not fully capture the complexities of this dynamic.

SAMR’s Enforcement Actions

China’s State Administration for Market Regulation (SAMR) appears to be adopting a broader perspective, as evidenced by its recent investigations and penalties. Both Alibaba and Meituan have been fined 3%-4% of their annual revenue for implementing “choose one from two (er xuan yi 二选一)” practices.

This involved pressuring merchants to exclusively utilize their platforms. While sometimes explicitly stated, this practice was often implemented through subtle and deceptive tactics, exploiting data analytics and recommendation algorithms to influence merchant success. Details of these tactics were outlined in SAMR’s conclusion of the Meituan investigation.

Breaking Down “Walled Gardens”

The Ministry of Industry and Information Technology (MIIT) has also instructed internet companies to dismantle their “walled gardens.” This means ending the practice of blocking links to competitor platforms.

Despite potential complications for some businesses, this move has been generally well-received by Chinese consumers. The previous inability to share Alibaba links on Tencent’s WeChat platform was a frequent source of frustration.

Addressing Exclusive Content Deals

SAMR has also taken action against Tencent Music Entertainment, ordering the cessation of exclusive agreements with record labels. A fine of 500,000 RMB (approximately $77,000) was levied, and the viability of business models reliant on exclusive content deals across other platforms is now being questioned.

Current Challenges Facing Investors

Investment companies are facing increased attention regarding mergers and acquisitions. In July, the planned $5.3 billion combination of Huya and Douyu, two prominent Chinese game-streaming services, was cancelled just two days after the State Administration for Market Regulation (SAMR) issued a prohibition. This marked the first instance of SAMR, or its predecessor, blocking a deal that did not involve foreign entities.

China’s strengthened antitrust enforcement, alongside a wider range of new regulations, is prompting investors to reassess their strategies within the country. A source at a well-known venture capital firm reported significantly greater difficulties in securing approval for a recent merger. The screening process conducted by SAMR was considerably more detailed than anticipated, encompassing inquiries into business models, operational practices, and even matters of national security. Ultimately, the firm chose to abandon the transaction.

Significant uncertainty also surrounds companies that were previously considered leading investments in China. Achieving consistent profitability has proven difficult for many large, platform-based businesses. Their high valuations and share prices were largely based on expectations of continued expansion and the potential for future profits derived from market dominance. Sectors like e-commerce and food delivery, where Alibaba and Meituan operate, are known for high sales volumes but relatively low profit margins.

The recent fines, equivalent to 3%-4% of revenue, are particularly damaging to these already narrow profit margins. Investors are increasingly concerned about the limited opportunities to realize returns on their investments in China.

Beyond the increased scrutiny of mergers and acquisitions, regulatory obstacles to initial public offerings (IPOs) are emerging. While the abrupt suspension of Ant Group’s planned late-2020 listing caused considerable disruption, it was initially viewed as an isolated event. That offering, had it proceeded, would have been the largest in history.

The intervention to halt it was reportedly directed by Xi Jinping and carried out by China’s central bank. However, a broader trend is now apparent. A growing number of regulatory bodies, operating within the bureaucratic structure, now possess both the authority and the directive to intervene in IPOs if they deem it necessary.

The China Securities Regulatory Commission (CSRC), comparable to the U.S. Securities and Exchange Commission, has established a new inter-agency task force to combat illegal activities in the country’s capital markets. This action coincides with corruption charges against several of the regulator’s former officials.

The Cyberspace Administration of China (CAC), the nation’s primary cybersecurity agency, has demonstrated its willingness to take decisive action. Following ride-hailing company Didi Chuxing’s decision to proceed with a U.S. IPO despite warnings to delay until a comprehensive network security review was completed, the CAC removed Didi’s apps from app stores and cast doubt on the company’s future and the positions of its leaders.

Furthermore, with SAMR’s increasing prominence, it is anticipated that the agency will also gain the power to influence whether and how a company can become publicly listed. The path to an IPO for investors is now fraught with a growing number of regulatory hurdles, and the criteria for approval appear to be becoming increasingly stringent.

The Expanding Scope of China’s Antitrust Enforcement

China’s antitrust efforts are undergoing a significant shift, driven by a strengthened regulatory body and a broad mandate. This evolution potentially extends the reach of enforcement into previously uncharted territories. Given the nature of China’s political system, companies face limited avenues for resistance.

Compliance and cultivating positive relationships with authorities are often the most viable strategies, as opposing investigations carries substantial risks. The consequences of falling out of favor with Beijing can be severe.

Reputational Risks and Financial Impact

“Chinese authorities are highly skilled in utilizing reputational penalties,” notes Angela Huyue Zhang, a law professor at the University of Hong Kong, as discussed on my podcast regarding her book “Chinese Antitrust Exceptionalism.” She highlights their proficiency in strategically releasing information through state media to influence public perception.

The announcement of an antitrust investigation into Alibaba in December 2020, for example, resulted in a $90 billion decrease in the company’s market capitalization. As Didi is currently experiencing, the damage to a company’s reputation from being perceived as acting against the government’s interests can be as detrimental as any official penalty.

Current Focus and Future Targets

With investigations involving Alibaba and Meituan now resolved, the scrutiny surrounding “choose one from two” practices may be diminishing. However, uncertainty prevails, as the newly empowered and expanded SAMR (State Administration for Market Regulation) likely has a substantial workload.

A prevailing theory suggests SAMR will increasingly focus on subsidized group-buying practices. These practices fueled the growth of social e-commerce platforms like Pinduoduo, but simultaneously exerted downward pressure on prices, potentially harming smaller vendors.

In March, SAMR issued modest fines to five companies for violations related to group-buying. Given the widespread prevalence of such practices among Chinese internet platforms, further investigations and potentially more substantial penalties could follow.

The Deterrent Effect of Stronger Penalties

“Prior SAMR fines and official statements demonstrate a strict stance against subsidies used to sell products and services below cost,” observes Norris. “A more robust penalty system is essential for SAMR to establish an effective deterrent against growth driven by subsidies.”

Antitrust as a Countermeasure to Sanctions

The extraterritorial application of antitrust law is also noteworthy, particularly as a response to U.S. sanctions. Zhang explains, “The imposition of sanctions on Huawei, ZTE, and other Chinese tech companies in 2018 served as a wake-up call for the Chinese government, highlighting the significant extraterritorial sanctioning power of the U.S.”

Antitrust emerged as a potential tool for China to exert similar jurisdiction over foreign businesses. This was evident in mid-2018 when Qualcomm abandoned its proposed $44 billion acquisition of NXP Semiconductors due to difficulties in securing SAMR approval.

Despite a potential easing of tensions compared to the Trump administration, China clearly views extraterritorial antitrust measures as a valuable strategic asset.

A New Era for Business in China

For both domestic and international companies, the period of rapid, largely unregulated growth in China is drawing to a close. Antitrust enforcement is proving to be a powerful instrument in driving this transition, ushering in a new era of increased regulatory oversight.