Over the past year, the Chinese government has started cracking down on its domestic tech monopolies. In late 2020, regulators blocked the $37 billion IPO of Ant Financial, one of the biggest fintech companies in the country. Then in July, right after Chinese ride-hailing company Didi went public, the government banned them from the app stores for supposed data privacy violations. Didi IPO had a valuation of $70 billion but has subsequently fell by over 40%. More recently, it was reported that the Chinese government will be banning the $100 billion for-profit education market. This has cost stocks such as TAL Education to lose close to 90% of their value in just the past few months.

These recent actions are destroying the stock market with the Invesco China Technology ETF down more than 40% from its recent highs. The tanking share prices will have an unambiguous negative impact on economic growth but none of this is happening by accident. The Chinese Communist Party (or CCP) is enacting a carefully calculated plan to tighten their political control over the country.

Since China’s economy surpassed Japan as the world’s second largest economy in 2010, one of the most genius pieces of China’s economic policy was the establishment of the so-called ‘Great Firewall’ which effectively banned western internet companies such as Google and Facebook. While censorship was one motivation for this, the economic aspect was arguably even more important. The market vacuum allowed domestic Chinese companies to develop their own product offerings such as the search engine Baidu, the social media platform QQ and the messaging WeChat app which today boasts more than 1.2 billion active users. These companies have experienced disproportionate growth over the years, indirectly creating millions of jobs and turning China into a global force in the internet and technology sectors. But not everything seems to be proceeding to plan.

The CCP has two main policy objectives. Firstly, they want to promote economic growth and raise living standards, just like any other country. But secondly, they also want to maintain their eye and grip on political power. If the tech companies become too powerful, they can eventually fund opposition to the government and lobby for looser regulations. This will slowly erode the communist party’s hold on power and eventually the powerful business interest will demand a transition to democracy. This is why the CCP did not take lightly a speech undertaken last year by Jack Ma, Alibaba’s co- founder and one of the richest and culturally important figures in China. Ma had originally criticized Chinese regulators as being too restrictive and referred to the country’s state-run banks as inefficient. The CCP made an example out of Ma, blocking his $37 billion IPO of Ant Financial and the charismatic character himself disappeared from the public eye for three months. The communist party wanted to send a clear message to the business community – anyone that speaks out against the government, will have to face consequences.

In 2021, the government has gotten even more aggressive in cracking down on the powerful tech companies. They levied massive antitrust fines against Alibaba and WeChat’s parent company Tencent. They blocked Tencent’s proposed merger of the top two live streaming companies and more recently they cracked down on the ride hailing company Didi. As China’s crackdown is suppressing these companies’ share prices, they won’t have as much money to invest in new innovation. Also, the regulatory uncertainty will dampen foreign direct investment which has been the backbone of China’s growth historically. So why is the government taking these self-defeating actions?

Ever since China opened up in the eighties they have struck a delicate balance between liberal economic reforms and maintaining the party’s control. If the state’s control of the economy becomes too tight they will end up with an inefficient system, closed off from the outside world. But if they go too far with the liberal reforms they will eventually be forced to turn into a democracy.

Over the past decades, China has gradually moved toward democracy on this spectrum. Now they finally decided that enough is enough and are turning back towards more state control. So, what does this mean for the economy going forward? With large private tech companies becoming less powerful and foreign capital markets being less friendly to Chinese listings, it is now a strategic priority to become self-sufficient in strategic industries. In this respect, we are likely to see state run companies in the areas of semiconductors and electric vehicle batteries, for example, receiving significantly increased funding over the next few years. They will also spend tens of billions of dollars to fund domestic AI startups.

As such, state-owned or state funded enterprises will make up a greater share of China’s economic outlook going forward. State-owned enterprises are inherently less innovative than private companies. Private companies in high tech industries face cut-throat competition and most of them fail. Through a process of natural selection only the best companies survive and are able to access funding in competitive capital markets. State-owned enterprises on the other hand enjoy either explicit or implicit monopolies. As long as the government continues funding them, they can survive indefinitely without making any profits. This lack of urgency makes it very difficult for them to foster a culture of creativity and innovation.

In the near term, it looks like the Communist party is willing to give up some economic efficiency to gain greater control over the economy. The effect this will have on growth remains to be seen.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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