China credits: observations on China’s shifting regulatory environment

Overall, we view the increased scrutiny on sectors such as real estate, the internet, and education as part of the Chinese government’s initiative to address the concerns of its citizens. Given the notable market movements over the past week, credit spreads moderately widened in some affected sectors.¹  We believe the macro impact of these regulatory moves should be insignificant for China’s second-half 2021 GDP and beneficial to China's long-term socioeconomic development.

First, a look at recent regulatory developments. Recent announcements went beyond the expectations of many market observers but weren’t exactly a complete surprise. We believe that investors should pay close attention moving forward as the regulatory environment may undergo further changes.  

Backdrop for regulatory policy changes

Having said that, we also believe investors need to understand the policy reasons behind these notable changes. Indeed, since 2017 the government has shifted its top economic priority from promoting quantitative growth to encouraging more tangible qualitative outcomes. In other words, economic development should lead to greater benefits in the everyday lives of citizens as opposed to merely chasing impressive headline GDP figures. Building on this framework, a key goal of the recent regulatory changes is to mitigate a shrinking national population by lowering costs related to education and promoting family formation. The government has previously expressed concerns over potentially harmful social consequences in the following areas: 

After-school tutoring

Data from the 2020 population census highlighted the risk of a rapidly aging population and the prohibitive costs of raising a family. Education expenses, particularly after-school tutoring, are a significant factor for many families to consider—particularly those with children. The legal basis of the recently released Double Reduction Education Policy² started in 2018 and involved different stakeholders in the drafting process. The legal framework was finalised three months ago and released in late July.   

Food-delivery riders

Since September 2020, articles on safety risks associated with food-delivery riders circulating on the internet led to a society-wide discussion.³ Almost a year later, on July 26, the State Administration for Market Regulation⁴ and six other departments jointly issued detailed guidelines on protecting food-delivery riders’ rights and interests.

Internet

Since China’s regulators halted an initial public offering last year, they’ve placed internet companies under increased surveillance. In the past two weeks, the regulations on China’s internet sector have escalated significantly.⁵ The areas under scrutiny relate to banking, anti-trust regulation (the nation’s law went into effect in 2008), data security, and social equality. We anticipate that greater oversight of the Chinese internet sector will continue; however, if the companies involved comply with the regulations and work with the government, regulatory overhangs should be manageable. In addition, risks relating to the variable interest entity⁶ structure should be evaluated more on a case-by-case basis instead of being viewed as a  broadly structural issue. 

Real estate speculation

Since 2016, the phrase “houses are for living, not for speculation” has been reiterated at numerous high-ranking government meetings. Since then, policies intended to curb real estate speculation have been introduced (apart from during last year’s COVID-19 pandemic). The Three Red Lines rules as well as other tightening measures would curb speculation (by taking excessive leverage) on the part of investors and property developers.⁷

Policies promote long-term socioeconomic development 

In our view, the short-term impact of the new regulations shouldn’t materially affect China’s second-half economic growth this year. Over the longer term, they could have a positive effect on the social and economic development of the country and key sectors, including: 

Education

While the impact of the regulation update on the after-school tutoring sector is extensive, it represents a relatively small segment of the economy: approximately 0.7% of China’s 2019 GDP.⁸ We think the government will take a gradual approach during the transition period. The sector employs many highly educated tutors, many of whom are recent university graduates. Additionally, front-loaded payments are typical for after-school education, which could lead to extensive financial losses. 

Over the long term, we believe the recently introduced regulatory changes in the sector could help alleviate the high costs of education and child raising for middle-class families, free up more consumption spending power, and foster a more diverse education environment as non-school curriculum tutoring businesses will still be allowed.

Internet

New regulations on the internet sector should have limited macro impact, as they mainly deal with improving employee benefits, cybersecurity, and curbing monopolistic power. Enhancing protection for employees and customers may lower the overall social risks associated with the sector. A reduction in the monopolistic tactics of internet platforms should also foster market competition and spur economic innovation.

From a credit perspective, we expect China’s internet companies to be structurally challenged in terms of medium- to long-term growth and profitability, as they now face additional headwinds to leverage their market dominance and grow across industries. Given the ongoing headline risks, we expect to see higher volatility in bond performance in this sector. 

Real estate

The curbing of speculation in the real estate sector should be manageable for the financial system and could provide greater long-term development prospects. The average mortgage-related loan-to-value ratio in the Chinese banking system is around 50% and the excess leverage from the unofficial banking channel and peer-to-peer lending has reduced in the past few years. In addition, the People’s Bank of China conducted rounds of real estate-related stress testing for the country’s banks in the second half of 2020 to ensure the system can weather a potential correction. 

In a recent outlook, we observed that developers with ample land reserves and access to diversified funding channels in both onshore and offshore markets should be in an advantageous position. 

Conclusion

Recurring volatility in financial markets is no doubt unnerving for investors; however, in this case, we believe that investors should understand the genesis and rationale behind the changes. More importantly, we believe these policies should bolster China’s socioeconomic environment and appeal to investors who are looking for attractive risk-adjusted returns over a longer timeframe. 

1 Manulife Investment Management, as of July 30, 2021. Debt instruments issued by Chinese internet firms have remained relatively steady: benchmark China investment-grade internet bonds widened between 15 to 20 basis points (bps) over the week, with high-beta China investment-grade bonds widening between 50 to 60bps. 2 The General Office of the Communist Party of China Central Committee and the General Office of the State Council issued a set of guidelines to ease the burden of excessive homework and off-campus tutoring for students undergoing compulsory education on July 24, 2021.  3 A study published in the Chinese labor security magazine, Laodong Baozhang Shijie, shows that 84% of delivery staff work more than 10 hours daily. Delivery workers in Beijing, for example, spend on average up to 11.4 hours every day on the job. This increases the risks of these workers suffering from overwork. 4 On July 26, 2021, the State Administration for Market Regulation and six other departments jointly issued detailed guidelines on protecting the rights and interests of food delivery riders. These include rights to mandatory injury protection insurance, flexible employment, and ensuring local minimum income. 5 Other internet-related regulations include: 1) The Data Security Law, set to become effective in September 2021, will have more regulatory oversight on companies that possess a significant amount of personal privacy data, and their businesses are related to critical information infrastructure. 2) The Cyberspace Administration of China announced a cybersecurity inspection on certain ride-hailing platforms in early July shortly after a few companies in the sector went public in the United States. In fact, the Measures for Cybersecurity Review—aimed at ensuring the security of critical information infrastructure and safeguard national security—has already been in effect since June 2020. 6 A holding company structure that enables foreign owners to benefit economically from their stakes in Chinese companies without having operational control. It’s widely used as a way to skirt rules that forbid foreigners from investing in sectors that are deemed to be sensitive by the Chinese government. 7 The People’s Bank of China and the Ministry of Housing announced in 2020 that they had drafted new financing rules for real estate companies. Developers wanting to refinance are being assessed against three thresholds: a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract, a 100% cap on net debt to equity, and a cash-to-short-term borrowing ratio of at least one. 8 Bloomberg, as of July 27, 2021.