The Lowdown │ Post-Lockdown Chinese Tech Crackdown

The Lowdown │ Post-Lockdown Chinese Tech Crackdown

Published September 3, 2021

Japan, make way for China

Remember the days when Japan was synonymous with high-tech and innovation? Remember when we oo-ed and ahh-ed at the release of a new JVC, Sony or Sanyo video recorder? Remember when Japan was the second-largest economy in the world?
Japan is still very much a leading technological power, but having recovered from its “Lost Decade” that started in the mid-90s, it has changed tack slightly, and now focuses its efforts more on infrastructure, automation and robotics (rather than hi-fi and entertainment). This shift coincided with the start of China’s vertiginous rise.
Nowadays, Huawei and Lenovo have overtaken the likes of Sony and Sanyo in public consciousness. And by a number of metrics, Alibaba is twice the size of Amazon. You think WhatsApp is in a class of its own? Tencent’s WeChat became the world’s largest stand-alone mobile app in 2018 with over a billion monthly active users.
China’s long-term economic prospects have been given a huge boost by its homegrown tech revolution. The days when it was just the world’s factory are over: innovation has helped free it from the constraints of mere manufacturing and it is breaking new ground in digital healthcare, AI and a plethora of other fields.

Why decimate the tech sector?

So what is President Xi Jinping playing at? China’s tech industry is worth some US$4 trillion. So why does he appear hellbent on dismantling it? The past few months have seen dozens of regulatory actions brought against companies for a baffling array of alleged transgressions – everything from anti-trust to data breaches. This has sent share prices tumbling, costing investors dearly, and leaving them wondering if China is still a good bet.
Xi Jinping’s short-term aim may simply be to rein in business tycoons and give regulators more control over disorderly digital markets. But the main issue for him is that this kind of capitalistic techno explosion is incompatible with the principles of Communism. If the Communist Party has its way, the country will indeed become a techno-utopia… but one based on its own design. There will still be cloud computing, AI and self-driving cars, but the likes of Alibaba and Tencent will have a little less dominance. What Xi Jinping wants is policies to curb these mega-cap companies’ market (and political) power so as to redistribute some their profits in a way that boosts competition and benefits consumers.

It’s getting geopolitical

Relations with the US are also playing a role. Things are not much more cordial between Xi Jinping and Biden than they were with his predecessor. The resulting difficulties in procuring components made with US tech are encouraging China to become more self-reliant when it comes to chips and semiconductors. This kind of “hard tech” could actually benefit if the crackdown on education, social media and games developers pushes talented programmers and engineers in its direction. But this crackdown is also a huge gamble. Indeed, it could well end up doing major long-term damage to innovation, economic growth and Chinese entrepreneurship.

China’s unregulated Silicon Valley

A decade ago, China was widely perceived as an imitator. Not an innovator. Companies like Alibaba were dismissed as mere copycats. But then they overtook their US counterparts. Currently, nearly a hundred Chinese companies are valued at more than US$10 billion. Many of them are based in the Pearl River Delta – the country’s most economically dynamic region that Beijing wants to turn into China’s Silicon Valley. And thanks to this dynamic and varied ecosystem, new stars are emerging on a regular basis, operating in fields such as artificial intelligence, big data and robotics.
Xi Jinping’s crackdown has much in common with the preoccupations that motivate regulators and politicians in the US: concerns that digital markets are tending towards monopolies and that tech companies accumulate mountains of data, exploit suppliers and workers and undermine public trust.
It was somewhat inevitable that the tech sector was going to be more stringently policed. When China started to open up to the outside world, the Communist Party kept energy, finance and telecoms under its control. Tech, on other hand, was allowed to explode unbridled. Its staggering growth is due to the sector being almost completely unregulated. App-based vehicle-hire company DiDi, for example, currently has more than 550 million users. That’s more than the population of the US.

An end to behemoths riding roughshod…

But these digital behemoths also took advantage of this lack of regulation to annihilate smaller companies. Amazon allows its merchants to pick and mix the platforms via which they sell their wares. Alibaba extends no such privileges. Deliveroo cyclists get free rider insurance and other benefits. Gig workers in China are denied such luxuries. Xi Jinping wants to end these aberrations. And this is a commitment that many ESG-aware investors have enthusiastically embraced.
But can these aberrations be brought under control? Basically, an unaccountable state is doing battle with its biggest tech companies for control of increasingly essential infrastructure and demanding ownership of certain categories of data. Platform interoperability could become a legal obligation (so that, for example, instant messaging platforms cannot block competitors). Addictive algorithms – algorithms that prevent you from leaving a particular platform or closing an app – may become more stringently regulated. All of this would make a dent in profits, but it might make the markets work more fluidly. A number of companies – such as Tencent – are already opting for compliance and adapting to this new landscape.

All-powerful, brazen Chinese communism

The crackdown on China’s unfettered tech sector is also evidence of the party’s unbridled power. Previously it was constrained by its need to go after foreign capital and generate employment. Under Xi Jinping, Chinese Communism is more brazen, and the party is passing new laws at breakneck pace and fervently enforcing them. Although China’s regulatory immaturity is very much in evidence (only around 50 people are employed by its anti-monopoly agency), it can decimate business models with one email. Due process has not yet been established, so companies have little choice but to comply.
Xi Jinping sees his party’s crackdown on tech as a refinement of its Communist policy – a way to combine prosperity and control in order to maintain stability and stay in power… forever. And as China’s population starts to fall, he wants to increase productivity by automating factories and developing huge urban agglomerations.
But these endeavours to bring tech under control could go wrong, wiping billions off the stock market. This crackdown has already raised suspicions abroad, interfering with China’s attempts to sell services and introduce global tech standards. And as we have seen in recent weeks, attempts to put a brake on growth are felt well beyond the country borders.
A bigger risk is that increased regulation will negatively impact entrepreneurship. As China transitions from making things to delivering services, entrepreneurship and taking risks will become more important. A number of China’s leading tech leaders have already given up and started to retreat. People thinking about emulating them will now think again – particularly since the crackdown has increased the cost of capital.

A post-crackdown slowdown?

In recent days, Chinese electric carmaker BYD’s plans to sell shares in its computer chip making unit have been suspended – the latest share offering to be hit by Beijing’s crackdown on businesses. Start-ups – tiny companies taking ride-hailing business away from DiDi, for example, with their mapping apps – have been nibbling away at the government’s main target. Instead of being emboldened by the crackdown, they are likely to feel vulnerable. Economic development is often all about creative destruction. Xi Jinping has demonstrated that he is quite good at the destruction part of that equation. But there is still a question mark hanging over whether this crackdown will ultimately foster creativity.
Political uncertainty – combined with economic volatility – complicates the risk-return equation for investors… and not just in relation to portfolios with direct exposure to the Chinese market. For IQ’s Chief Investment Officer Peter Lowman and his team, all of this highlights the importance of allocating funds to active fund managers with expertise and a significant presence in the region (rather than to passive index funds).
With so much blood on the floor, now appears to be a good time to invest – assuming, of course, that companies are through the worst of these regulatory crackdowns. “I’m still enthusiastic about the wider prospects for the region”, says Peter Lowman, “particularly since we make absolutely sure that we select the best active managers with a preference for companies with strong balance sheets, experienced management teams and compelling business outlooks”.