How do we know when the regulatory cycle will ease?
China’s past regulatory campaigns, such as its crackdown on corruption, which impacted the consumer discretionary sector from 2012 to 2016, and its actions to prohibit gaming addiction among the underage, which saw the gaming industry underperform in 2018, can serve as starting references as to how long this cycle might run for. While these campaigns normally last two to three years, there are plenty of reasons to believe this one might take longer. Not only does the internet sector affect a vast proportion of the economy, but the scope and scale of the changes the government wants to see is unprecedented, a fact that is reflected in the number of agencies involved and issues raised. It is also an unusually high-profile campaign, drawing attention from the most senior of China’s leaders.
Nonetheless, we believe there are a few signposts which give us some idea of progress. There are three key components in a platform company – capital, user data and algorithms. We have seen China already introduce major regulations on the first two. Very recently, a draft regulation was proposed to control the use of algorithms.
Capital
In addressing issues around capital, the government has now imposed security checks on overseas listings. While we expect further tightening in this area, pursuing a listing in Hong Kong is now at least a viable option.
The anti-trust regulator has recently introduced measures to prohibit anti-competition behaviours. One measure is to prevent predatory pricing, where a huge amount of capital can be used to drive out competitors by giving excessive user subsidies.
User data
To deal with issues around user data, new regulations on data security and privacy have been introduced, such as the Data Security Law (effective on 1 September) and the Personal Information Protection Law (effective on 1 November). These laws give us some idea as to what the government would like to achieve regarding user data.
Algorithms
Algorithms are an important asset to internet companies as they dictate what kind of products or services a user will receive, which impacts user engagement on a platform and thereby revenue growth. There has been some opinion expressed in the state media that regulations should be introduced to ensure algorithms serve public interests, not corporates’ profit motives. Some anti-trust and data privacy regulations have started to impose restrictions on algorithms. The government has also previously announced that it will strengthen regulations in artificial intelligence and big data in the next five years. On 27 August, the Cyberspace Administration of China (CAC) published the first draft of regulations on algorithms to protect national security and public interests. Apart from prohibiting algorithms from abusing users (e.g. no discriminatory pricing, not causing internet addition to the underage, not using discretionary parameters or attributes and not impairing the labour rights of riders and drivers), the CAC also asks companies to provide the ability to opt-out of any recommendations driven by algorithms and to disclose their basic principles and purpose.
While it remains to be seen how the business models of Chinese internet companies will adapt and change, we believe these regulations now provide an overarching framework of what the government expects of the internet sector.
Is the Chinese internet sector still investable?
It is worth remembering that China has no desire to destroy its internet industry, a sector of which it is particularly proud and which it sees not only as improving the daily lives of its citizens but as a useful tool for the government. The regulations are not designed to totally transform the big internet companies, but to encourage them to adapt and adjust.
In the near term, it is unlikely that earnings will substantially improve in the internet sector. However, we continue to hold Alibaba, Meituan and Tencent in our portfolios. In the long term, we believe the internet sector will ultimately benefit from increased regulation – not only in China but also in the US and Europe. China is now catching up with governments in other major economies who have already taken steps to regulate big technology companies. In some ESG areas such as anti-trust, China is arguably more advanced in dealing with these issues than other countries.
The mega theme of digitalisation in China is not broken, but we believe the sector is right to take a pause to fix its ESG issues. When most of the regulations are in place and market participants are clear on what these regulations would like to achieve, we believe digitalisation in China will still offer attractive long-term investment opportunities.
