Episode 37: China's regulatory reforms: warranted, or a step too far?
18 Aug 2021
Recently, the Chinese government has taken a number of steps to rein in certain industries, including the property and technology sectors. Actions ranging from setting leverage limits and imposing billion-dollar fines to redefining business models have kept investors wondering just how far the regulatory reforms may go.
In episode 37 of The Flip Side, Ajay Rajadhyaksha, Head of Macro Research, and Avanti Save, Asia Credit Strategist, debate the merits of and motivations for this regulatory crackdown. They explore the potential reasons for reform, including anti-trust concerns, systemic risks, consumer protections and levels of foreign investment, which are concerns also held by Western policymakers.
Ajay Rajadhyaksha: Welcome to another episode of The Flipside. I'm Ajay Rajadhyaksha, Head of Macro Research at Barclays. And with me is Avanti Save, our Senior Asia Credit Strategist.
Now, I know this is your first Flip Side, Avanti, so welcome.
Avanti Save: Thank you, Ajay. It's good to be here.
Ajay: In this episode, we are discussing recent developments in China. The government has taken a number of steps to rein in certain industries and both their high-yield market and technology stocks have been pretty hard hit. On the technology side, they’ve imposed billions of dollars in fines, pushed for equity listings to move away from the West, disallowed IPOs in some cases, online edu-tech firms have seen their business models completely change.
And you know, markets have noticed. China has been among the worst performing major equity markets this year.
Avanti: And in the real estate sector, China has introduced its Three Red Lines policy. Now, previously, Ajay, the property developers, their access to credit depended on size, scale and diversification, among various other factors.
But the new policy that imposes a 70 percent ceiling on liabilities to assets, a 100 percent cap on debt to equity and other ratios for liquidity and leverage. This policy caps the firm's ability to borrow depending on how many lines are breached.
This is relevant because China is the second largest bond market and property bonds dominate the high-yield sector. A sector which has been very hard hit over the last six months.
Ajay: Now, in this episode, I will argue that while these actions are abrupt, they're motivated by the same antitrust and macro-prudential concerns that Western policymakers have.
Avanti: Hmm, maybe. But I don’t fully agree with that. Firms held by foreign investors have been disproportionately impacted by these reforms. Property firms have raised hundreds of billions of dollars in debt outside the Mainland and technology companies have raised similar mountain equity capital. And guess what? Those are the main sectors affected.
In fact, I will start with an industry I cover closely. Some of China's biggest property names have seen their bonds fall sharpy this year on concerns about the stress in the sector. China's second largest property developer, the largest dollar bond issuer in Asia high-yield, could enter disorderly default. And the property sector that used to yield seven to eight percent last year is now at 15 percent, reflecting the heightened concerns.
Ajay: All of that is true, Avanti, but is it really the fault of the Three Red Lines policy? Is this really about a change in policy? Because all it does is ask property firms to meet mandated ratios for leverage, for gearing, for liquidity. That’s not a bad thing.
Avanti: The spillover effects are a problem, Ajay. Now, remember, the Chinese property market is very important. Seventy to 75 percent of household wealth is in housing. A quarter of GDP growth comes from property-related sectors and almost a third of bank loans are linked to housing.
So, a disorderly default by a large name could knock the Chinese property sector over, do lasting damage to the economy and, very importantly, change investor perception about the risks of investing in China.
Ajay: OK. I keep repeating myself. But are problems faced by China's property firms this year all due to a change in government policy? I just don’t think so.
Avanti: It's true that many of these firms have high reliance on non-bank financing. Some invest in unprofitable non-property businesses and others have heavy repayment coupons These issues are real, but they all have been exposed at once because of the suddenness of the policy change. And that is the cause of possible contagion.
Ajay: But, Avanti, if there are real issues, it's better to bring them upfront first rather than wait for them to fester. After all, the goal of these reforms is to reduce systemic risks, isn't it?
Avanti: But there is systemic risks in other parts of Chinese economy. Let's look at the state-owned enterprises. So, why focus on the property sector especially when it carries economic risks? Now, given the amount of dollar debt exposure, if property firms keep growing unchecked and get into trouble, foreign creditors will get a say in the solvency process. These policies might well be a way to force all this from happening.
Ajay: I think you overestimate contagion risks. Our China Chief Economist Jian Chang noted recently that housing is still quite resilient. Heck, as someone who lived through the US housing crisis, I'll tell you, I wish the US had put more macro-prudential red lines in our property firms in the 2000s, and maybe the crisis wouldn't have happened.
I realize that it's been a difficult process in China. But the country seems to be moving towards market discipline, not away from it when it comes to housing. And ultimately, I think that is what these new policies are trying to achieve.
Avanti: But then, what about the tech sector? It's harder to argue that the changes there are about making the systems safer. Billion-dollar fines everywhere you look, business models completely changed on the fly, disallowing a very large firm’s IPO.
Ajay: OK. You threw a lot of things in there, so let's take this step-by-step. I assume you are referring to Ant Group's IPO and the government blocking it? China has tried for the last few years to wean its firms away from non-bank financing towards the organized banking sector and it was, arguably, the biggest non-bank financing vehicle out there, so it's not a surprise they wanted to stop it getting bigger.
Think of it as China's version of money market reform and if you remember, the US did money market reform too a few years ago.
Avanti: There is a also the technology firms then. Alibaba, Tencent, Meituan, Kuaoshou – all these are very large firms and all have seen penalties. It's as if the US government decided to go after Amazon, Google, Twitter and Facebook all at once.
Ajay: Well, it's funny you should say that because US politicians from both parties have complained for years that large tech firms have too much power, including access to too much data. Antitrust regulation has been discussed over and over. The US just appointed a new FTC regulator, Lina Khan, who has strongly criticized tech firms in the past.
In that context, are the Chinese moves any different?
Avanti: Well, I will tell you one thing that is different: the impact on stocks. The NASDAQ Golden Dragon China Index, which follows Chinese firms listed in the US, is now down nearly 50 percent from its 2021 high. That’s a pretty big collapse. And this, even as a NASDAQ is close to its all-time high.
Ajay: Yes. That index you mentioned has collapsed but the Shanghai Comp, which is local listed shares, is down only two to three percent from the year’s peak.
Avanti: And what does that tell you, Ajay? I would argue that it shows that these policies primarily affect funds owned by foreign investors. I don’t see how that counts as reform.
Ajay: It tells me that China is not going after all tech firms but after certain consumer tech firms. And, yes, they are mostly listed overseas, but many of these firms also have opaque funding structures and control lots of data.
Once again, look at it through a US prism. Would the US government be comfortable if Chinese or Russian investors owned 75 percent of Google or Facebook with all the data that they control?
Avanti: Look, Ajay, the US does allow companies to list anywhere, so presumably, they will be comfortable. And by the way, how about the online education sector? In a matter of weeks, regulators have basically reshaped the entire business model. They are banned from making profits, banned from raising capital and offering tutoring services on weekends and holidays.
No wonder the largest firms have seen 70 to 90 percent of their equity value wiped out. And once again, these are mostly listed overseas.
Ajay: There has been an explosion of online learning and it has led to too much competition and education inequality within China. That is what these policies are trying to rein in. In general, Avanti, I will emphasize one thing: a lot of new industries are new to regulators as well in China, but also in the West.
And regulators everywhere are finding their way. Sometimes, stumbling along. The US, for example, is looking at how to regulate its fintech and crypto sectors. Regulators don’t have all the answers, but that doesn’t mean that they have ulterior motives.
Avanti: Except, Ajay, US concerns seem mainly focused on protecting the consumer. The recent policy changes seem more about keeping control of data and companies.
Ajay: All right. So you mentioned keeping control. There are parallels in the US there too. What was the consumer concern in US actions around Huawei? One could argue that the US simply did not like the idea of a non-US firm building the backbone of next generation infrastructure, and acted accordingly.
Avanti: Whatever the motivation, an awful lot of companies and industries are now being impacted because of China's action and there are ripple effects. Already, Softbank, the world's largest technology investor, has said it’s holding back on new investments.
Ajay: There have been a lot of changes. I can feel that. I will also acknowledge that they’ve been very sudden. But it's either in areas that are unregulated – consumer-facing tech that controls lots of data – and/or areas that are reliant on shadow financing – like Ant Group's IPO – or foreign funding, or changing social priorities like with online education. That’s it.
Avanti: Perhaps this is where it stops, but the longer this drumbeat of government fines impinging on business models, interfering with capital raises goes on, the more global investors will worry about owning Chinese firms.
Ajay: Avanti, ultimately, I believe that these moves are not to kill business but to prevent monopolistic practices, rent-seeking behavior, reduce antitrust behavior, and move financing to organized banking system and capital markets.
These are all good goals. These are goals that Western regulators also aim for. In that sense, I will argue that China is reforming and that these moves are warranted.
In any case, this is a debate that I suspect will continue for many months if not the years to come, and we will continue to weigh in. Clients can read our views on the Chinese property market as well funding structures in recent Asia Credit Strategy notes, and our views on the recent changes in technology and online education in the latest Global Economics Weekly.
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About the analysts
Ajay Rajadhyaksha is Head of Macro Research at Barclays, based in New York. He oversees the global research and strategy efforts of the economics, rates, FX, commodities, emerging markets, securitised, and asset allocation teams. Since joining Barclays in 2005, Ajay has held various positions, including Co-Head of FICC Research and, before that, Head of US Fixed Income Research and US and European Securitised Research.
Avanti Save is a Director in Barclays Asia with research responsibility for Asia credit strategy, focusing on event-driven situations and relative value trades across the credit spectrum. Avanti joined Barclays in 2006 under the Barclays graduate program and has focused on credit strategy since 2010. Avanti graduated from Nanyang Technological University in Singapore with a Bachelor's degree (Hons) in Computer Engineering and received her CFA charter in 2014.