Ali Baba - Too big not to comply

Anyone with interest in China needs to read Richard McGregor's book, The Party.

While it is a little dated, as it was published pre-Xi Jinping, it remains the most insightful look at the inner workings of the Chinese Communist Party. I re-read it every couple of years as it forms the foundation of many of my thoughts on investing in the region.

While my mantra of "The Number One Goal of the Communist Party, is the Preservation of the Party" is not a direct quote, it is a central thread of the book and keeping this statement in mind when looking at every facet of the Chinese political economy should prevent you from making the ideological mistakes than many governments and investors repeatedly make.

The Party is the orb in the center of Chinese life that everything revolves around. While there have been organizations and sectors of the economy that rose to prominence, none were ever too big not to comply with the Party.

No individual, no organization is bigger than the Party, and established interests have been challenged continuously and reformed to strengthen the core.

The Steel and Railway Ministries fought reforms as many thought Deng Xiaoping's efficiency drive and the removal of the iron rice bowl (guaranteed employment) would lead to social upheaval. Reforms to the People's Liberation Army were not feasible yet managed. Urbanization had its challenges, as did tackling corruption and pollution.

While no one should claim any of these efforts for change occurred without consequence, reforms in the last four decades have left the Party stronger than ever.

Even the greatest threat to the Party in the near 100 years of its existence, the 1989 student uprisings, was met with the most extreme action with one priority in mind: the Party's safeguarding.

Every policy, every action executed by the CCP, is designed to strengthen China economically, socially, militarily, diplomatically with the Party at the helm.

China continues to evolve, and the Party meets every challenge. China may be methodical in its approaches, but it cannot ever be accused of inertia. While control has been a central ethos, post-Maoist China embraced facets of the market economy to drive prosperity and innovation.

For four decades, China has permitted markets to flourish, with differing degrees of state involvement. Embracing outside expertise in some sectors and altogether rejecting it in others this allowed State-Owned Enterprises to reform and the private sector to blossom. Nowhere has this been more pronounced than in e-commerce and payments.

For the past decade, technology giants such as Alibaba, Tencent, Baidu, and JD.com have become omnipresent in the lives of the Chinese populous.

The technological leaps that these companies have enabled are extraordinary, with China now having the most sophisticated messaging, online shopping, and payment model on the planet. Alibaba and Tencent dominate the financial system and have exposed the traditional Chinese banking system as backward and unable to innovate to keep up with consumer trends.

The banks are commercially subservient to Wechat and Alipay, and the dominance of these upstarts is reflected in the fact that Ant Group was planning the largest IPO on record as of two weeks ago. This was achieved through relatively limited regulations by banking authorities that struggled to keep up as well.

Jack Ma has historically done an outstanding job of maneuvering around the CCP. This goes back to the early days of Alibaba when he gave out stock to the princelings, the offspring of revolutionary elites, to ensure he was always on the right side of Beijing. Cronie capitalism, combined with extraordinary innovation, saw Alibaba and Tencent given free rein to grow as they saw fit.

A theme amongst senior executives at large technology companies is that they have avoided criticism of the Party. It is ok to be rich in China, but it isn't ok to engage in conduct that bites the hand that feeds them. For all the wealth that has been created in the past decade and through the most draconian anti-corruption campaign in the early years of XI Jinping, technology founders and CEOs by enlarging avoided controversy.

From the private sector to senior party members, everyone involved knew how the game was played.

Jack Ma's recent critical comments about the financial regulators were hardly egregious, but what appears clear is that they came at a time when the Party was reconsidering the laissez-faire approach they were taking towards e-commerce and payments.

It appears that Mr. Ma has flown too close to the sun, but this has become so much bigger than China's most high profile individual outside of Xi Jinping, making comments to anger the regulators.

The suspension of the Ant Group IPO and the moves by regulators to rein in the dominance of the technology giants must be viewed as more than just a technical event that can be fixed with a little more disclosure. While this is not a Bo Xilai moment, a Kordokovsky moment and the comparison to Mohammad bin Salman's extortion of his relatives don't apply either, it is a turning point for Jack Ma, Ma Huateng, and China's tech behemoths.

It is proof that both Tencent and Alibaba have become so strategically important in the new era of payments that they have to toe the line. This could well include being intertwined with the digital RMB, which puts the two companies into an inimitable position because digital RMB transactions will be monitored by the PBOC (they call it controllable anonymity).

If the digital RMB goes onto the WeChat pay or Alipay networks, the companies are endorsing monitoring, which they have historically been meticulous to avoid.

In the Ant Group report we published in late October, we discussed nationalization risk, and frankly, I think it is underestimated over the medium term. These companies are now too big to fail, which in Chinese parlance, means they are too big not to comply. The banking system is one of three segments of any society that can derail the prevailing order.

The other two being the military and healthcare. Putting it in these terms, Beijing's response to the dominance of Alibaba and Tencent specifically is hardly surprising. With the necessity of the Chinese Communist Party to control every facet of daily life in China, why would they hand over dominance of a systemically important sector of the economy, i.e., the banking system, to two technology companies that are only tangentially controlled by the Party? It is incredible in this context that it took this long for a clampdown to be initiated.

What does this mean for the IPO and mega-cap tech stocks in China? They should continue to trade at a discount to Western peers, even with market positioning that is more dominant in China. This is old stale thinking, but the Chinese economic model does contain risks that the likes of Google, Facebook, and Amazon are not exposed to.

As such, this does limit the companies' ability to re-rate, and while few doubt their future profitability, there are limits. The days of heady growth for Alibaba and Tencent are behind us.

Alibaba and Tencent will face the sort of regulations that any other strategically important sector would face, including interference by the Party on how they run their businesses. The private sector plays no role in the military and a minor role in healthcare that was sideswiped by the government response to COVID-19.

The banking system, including the extraordinary innovation that has vault China to pre-eminence in digital payments, will also face much stricter scrutiny. The result will be share prices that will struggle to outperform in 2021 and beyond, even with a remarkably constructive framework for emerging market equities and risky assets as a whole.

Be careful when comparing regulation in China with that of the US and Europe. China doesn't have lobbyists. China won't go through years of congressional hearings to get to where they need to be, if at all. Jack Ma won't be publicly placed in front of partisan hearings to defend his actions.

It doesn't work that way.

The Party will make a decision and implement it. Stringent regulation is coming and coming quickly.

Regulation threats in China should be taken much more seriously and a sign that the days of unfettered growth are coming to an end. There is only one organization that can dominate the banking system, and that is the Party. Investors will have to come to grips with this and value the firms accordingly.

By Paul Krake