What's happening to China's tech sector?

Below is a commentary I wrote that was published by The Straits Times here.

China's tech sector was a clear winner of the pandemic in 2020 with coffers swelling thanks to the broad shift to digital, propelling share prices to new heights.

But it's been a different story this year.

Although corporate earnings for the fourth quarter were robust, the sector has struggled and leading names are down 15 per cent to 25 per cent from their peaks in mid-February.

The tech sector's weakness has dragged down China's equity market - the tech-heavy offshore MSCI China index has fallen 11 per cent over the past two months.

And Chinese mega tech has under-performed American FAANG stocks (Facebook, Amazon, Apple, Netflix, and Alphabet) by 17 percentage points since mid-February despite China's vibrant economic rebound.

Much of this downward pressure faced by China's tech sector stems from an assertive regulatory drive targeting the country's tech giants and the broader internet industry.

Beijing has grown increasingly uneasy over the industry's unfettered influence on the digital economy, and in recent months has unveiled a slew of new rules and penalties aimed at breaking up a range of monopolistic practices among Chinese internet groups.

Investors have taken flight, concerned that new legislation will stifle the sector's growth.

Data is big business in China - worth US$22.5 billion by 2023, according to market research firm IDC

But with valuations down and some uncertainty clearing, attractive entry points are emerging for long-term positioning into one of the world's most dynamic tech industries.

Beijing's three areas of focus

The regulatory headwinds first intensified last November, and in December Alibaba started facing anti-monopoly investigations.

Since then, several other leading internet players (including Meituan) have come under the regulatory microscope and the implications are far reaching. Beijing, it appears, is focusing on three areas.

First, the Chinese government aims to ban algorithms that restrict competition and discriminate against platform consumers.

Alibaba was fined a record CNY 18.23 billion (USD 2.8 billion) on April 10 for forcing merchants to sell exclusively on its own sites and not those of rivals.

Such online "walled gardens" designed to trap consumers and merchants within an internet ecosystem is a feature of leading Chinese platforms.

Regulators have since warned another 34 internet leaders involved in e-commerce, food delivery, fintech and online travel to fix antitrust practices, including forced exclusivity, discriminatory pricing and excessive subsidies, within one month to avoid a similar penalty.

Second, China's regulators have come down hard on the unsupervised growth of internet finance.

After its initial public offering (IPO) was halted in early November, the Chinese government announced recently that Ant Financial will become a financial holding company to be overseen by the People's Bank of China with regulations similar to those governing commercial banks.

Ant is also required to divest its loan business from its payment system, with its leverage to be capped at about 12 times. Meanwhile, the IPOs of at least two other homegrown fintech firms have been called off as regulations tighten.

Overall, rules now limit internet companies in their provision of financial services, directly addressing excessive leverage and concentration risks in co-lending.

Third, Beijing is seeking to supervise the unfettered collection and use of customer data.

In effect, China is seeking to establish a data governance regime that strikes a balance between stronger government control, protecting personal privacy and encouraging a thriving digital economy where data is fully leveraged as a key factor of production, alongside land, labour and capital.

As China has rapidly digitalised, new legislation is now being drafted that put the onus on big tech firms to protect user data and to curb their excessive collection.

Data is big business in China - worth US$22.5 billion by 2023, according to market research firm IDC - and rampant leaks and underground trading of personal information are increasingly a pressing regulatory challenge.

Regulations aim to protect

These changing regulatory winds in China, while significant, are not out of kilter with the surge in regulatory activism globally as governments around the world propose sweeping regulations to rein in the domination of internet giants.

China's tech legislation has drawn notable interest because of the perceived opacity of Chinese laws and as they mark the first major crackdown on the industry.

Beijing's typical strategy is to grow first and then regulate.

Crucially, China is aiming to prevent market abuse and systemic risks without restraining innovation.

After all, at the heart of United States-China rivalry is technology, and Beijing will be leaning on the domestic tech leaders in its quest to achieve supremacy in the industries of the future.

Indeed, China's latest Five-Year Plan places a strong emphasis on building a "Digital China" through innovations and tech self-sufficiency.

Any further penalties and restructuring orders are therefore expected to be manageable for the affected firms. Although historic, the case against Alibaba was wrapped up in under four months and the fine accounts for just 4 per cent of 2019 revenue versus the 10 per cent maximum allowed under Chinese laws.

This suggests that penalties are meant to dissuade certain behaviour but not cripple the company's prospects. So, while regulatory pressure could loom for some time, action is unlikely to go beyond what is being done globally or to compromise the growth of any individual company or industry.

Better supervision should benefit consumers and hence industries over the long term by creating a more commercially open and competitive digital economy. But in the short term, some pullback in growth for China's leading tech names is likely.

That said, as some certainty has emerged following Alibaba's penalty, investors will likely return their focus to tech's strong fundamentals. Over the medium term, China's tech sector remains well positioned to generate above-average, double-digit earnings growth rates.

Depressed valuations therefore offer attractive entry points for select leading platforms, in our view. In particular, those with strong balance sheets, resilient cashflow and earnings visibility should thrive as the regulatory overhang abates.

Outside of tech, China's cyclical and value segments - construction materials, consumer services, materials and banks - look set to benefit from the global reopening and reflation environment.

Companies delivered solid results for the fourth quarter last year and offered constructive guidance for 2021. With mid-teens returns projected over the remaining months of 2021, China remains one of our preferred equity markets in Asia.

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