From the eye of the storm: African fixed income
Thys Louw reflects on recent market turmoil and assesses relative strength across this increasingly diverse investment universe.
28 Jul 2021
Since we published the article below, the Chinese authorities have made clarifying statements, resulting in a recovery in much of the technology sector. In particular, the Chinese Securities Regulator convened a virtual meeting with senior executives of major international investment banks to provide more clarity. While the details of that meeting are private, most bankers left the meeting with the message that the education policies were targeted and not intended to hurt companies in other industries. Among other statements made in official Chinese media outlets such as Xinhua, this concerted messaging provides reassurance that the tutoring industry decision is specific and unique, and does not form part of a wider intention to attack private enterprise in the Chinese economy.
The market has welcomed the news, with both bond and equity markets rallying in Asia, led by the tech sector. While this is a positive development, it is important to note that we expect the high degree of regulatory scrutiny in China’s technology sector to continue over the medium term, just as tech sector regulation is being pursued in other key markets such as the US and Europe. The point is that Chinese regulators, like their developed markets counterparts, may be late to the party, but they have every intention of ensuring that the largely unregulated but fast-growing tech sector in their home economy receives adequate supervision and regulation, in accordance with their specific policy objectives.
The State Council of China has announced aggressive reforms on the country’s private education sector, focusing on the providers of after-school tuition. In effect, the move will force existing companies in the sector to convert to non-profit institutions while imposing a general ban on the foreign ownership of such firms under the Variable Interest Entity framework (details at the end of this piece), with the latter potentially having wider implications for the Chinese technology sector. Here are five key takeaways.
The release of the opinion paper announcing the reforms initially caused an isolated sell-off in the listed equities of the affected companies operating in the sector. However, given the wider backdrop of China’s policy moves in other sectors – such as the ongoing deleveraging push in the property sector – the sell-off then spread to other sectors.
As the opinion bore the stamp of the State Council (one of the highest authorities in China), investors began to question if the policy might be extended to other sectors, particularly those that also rely heavily on VIEs. As a result, the Chinese tech sector began to suffer. Finally, as some of the affected VIEs are also issuers of corporate bonds, fixed income markets were also impacted.
We think the market has perhaps been somewhat hasty in extrapolating what is a very narrow opinion statement on a specific sector into a broader generalisation about the wider constellation of Chinese companies.
In our view, there is not yet enough clarity or detail in the opinion to draw the kind of strong conclusion that the recent market moves would imply – namely, that it amounts to a large-scale change in underlying economic arrangements.
To give credence to such fears, we would need to see clear evidence that the Chinese authorities are planning to expand the implementation of these measures more broadly across other sectors. Equally, as has been convention, we expect to see clarifying statements and remarks in the coming days and weeks that will provide details about the scope and likely timeframe for the implementation of this policy. This should help to reduce uncertainty and quell fears.
While it is important not to overreact to developments, the opinion paper does reveal changing priorities at the highest levels of the Chinese administration that merit closer study and attention. Policy shifts of the kind being discussed currently have become an increasingly prominent part of the new fabric of Chinese policy, especially in the context of rising Sino-US tensions. Therefore, investors are right to be cautious.
However, it is hard to imagine that the Chinese authorities intend to indelibly undermine on a wholesale basis the business models of internationally competitive companies that are in many ways national champions and important vectors of Chinese growth and development. Yes, China may well be fine-tuning its approach to a market-based socialist economy in a way that allows more influence by the State, especially in the context of rising nationalism globally. But it seems unlikely that it is about to needlessly abandon the hard-won gains of the last few decades since it joined the WTO and global trading order.
It is also important to consider Beijing’s motivations here, with concerns over social inequality (reforms relate to privately funded after-school tutoring) and a declining birth rate (based on the theory that education costs act as a deterrent) viewed as likely drivers.
Investors should also expect the affected companies to respond quickly to the changing regulatory landscape – in fact a few of the stronger players in the space have demonstrated an adroit ability to do just this in the past. In recent episodes, companies have been quick to embrace proposed changes to show their willingness to comply with and adhere to the changing regulatory landscape – this has tended to result in day-to-day implementation of policy that has ended up being less draconian than first thought.
Equally, the sector at the heart of the opinion paper (the K9 after-school tuition sector) has been under regulatory scrutiny for the last two to three years now, with many of the attendant risks well noted in offering prospectuses. So as ever, prudent investors should heed the motto of caveat emptor as they make their investment decisions.
We have no direct exposure to China’s private education sector in our corporate debt strategies.
The policy shift will have different implications for equity markets than for fixed income investors – most of the bond issuers in this space are investment-grade rated and have robust balance sheets that should be able to absorb shocks.
It is also important for investors to differentiate the impact these policy changes might have on the equity narrative compared with the fixed income narrative of the affected companies. Policies that might have an outsized impact on growth or profits could have a meaningful impact on the prospects for equity valuations, but could yet leave the company with a resilient credit profile that is now more attractively priced.
That said, we would not be surprised to see further negative spill-over into China’s corporate bond market as investors digest these recent developments. Against this backdrop, we will continue to do what we always do – even when headlines cause a sense of panic in segments of the market: carefully assess risk and underlying company fundamentals while looking for mispricing opportunities arising from any market dislocation.
Variable Interest Entities (VIEs) work by keeping the ownership of businesses with Chinese investors who in turn agree to contractually pass on substantially all the economic benefits of the underlying business to the offshore entity, which then in turn raises the equity capital. It is a common legal structure used by foreign-listed Chinese companies to circumvent the prohibition of foreign ownership in protected sectors under Chinese law.
The opinion paper relates to K-9 schools (teaching children between 15 and 16 years old). It stated that VIEs are a forbidden form of foreign ownership for companies operating in this sector.
The opinion further states that those who are already in violation with this prohibition must rectify the situation, but it is vague on the exact mechanism by which this can be carried out. In addition, the opinion states that foreign capital is banned from the ownership and acquisition of ownership of companies in the sector and that companies operating in the sector will be forced to convert to non-profit institutions.
Following on from his recent article on China’s education sector reforms, PM Alan Siow shares insights to help investors make sense of recent developments. Alan sheds light on the economic, cultural and geopolitical considerations for investors as China navigates the internet age.
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