Author: Eric (Tianli) Wen, Head of Research

For past Pilgrimage publications, please contact BLRI sales (sales@blue-lotus.cn).

Stocks mentioned in this email

WUBA, EDU, TAL, BIDU, BILI, BABA, JD. PDD, VIPS

Dear all:

Over the past few weeks I have been traveling with clients, corporates and experts. The picture I got was not positive, even for us. While we recognize the need to transform the Chinese economy into more sustainable path of growth, the current handling of the situation, meddled by administrative measures,  has alienated many important factors of the Chinese economy. President Xi’s leadership and his approach are being questioned. We believe the Xi Reform has gotten off to a bumpy start. But how it will progress depends on the ability of the Chinese bureaucrat to self-correct and self-calibrate. We are optimistic this will be the case.
 

Mess around and conspiracy theory

We heard that: (1) In the kindergarten industry, the state is taking over in many cities to realize the goal of 80% of total kindergartens being affordable and inclusive (普惠) by 2019. However, no definition has been given on what constitutes “affordable”. Therefore in most cities the tender price was set too low so that no bidder showed up. Coupled with a cap on high priced kindergartens this has led to a net reduction in the number of kindergartens, contrary to the expectation of the policy directives;  (2) In the real estate brokerage industry, the state mandate of registering property listing with unique ID’s has made listings of many commercial real estate impossible in Beijing due to the myriad of complicated ownership structures behind. We notice Anjuke’s traffic matrices declining in the month of November (please see our December Chartbook for detail). We believe registration of property listing might play a role;
 

We noticed that: (1) In the express delivery and food takeout industry, the implementation of social security tax based on real income will kick into effect next year. Our channel check found three different responses: Some have pre-emptively converted to the new regulation, some has figured out a way to circumvent the new regulation and still some is looking out for ways to circumvent the new regulation. Our current assumption is that initial implementation will be lenient, meaning non-compliance will not be punished at least in 2019; (2) In the e-commerce industry, adoption of e-commerce law will pressue on pure online brands and unauthorized distributors of offline brands. Our current assumption is also that initial implementation will be lenient; (3) In the online game industry, game approval has been suspended for six months now. However, the lifting of the suspension is on its way.
 

Conspiracy theory runs wild. Many believes President Xi has a secret agenda to roll back to the Maoist-era policies. We disagree. Our disagreement is based on two observations: (1) the Chinese Communist Party (CCP) is a complex organization with many different factions, agendas and political inclinations. Xi’s anti-corruption campaign has helped him consolidate power, but we doubt it sufficient to silence all oppositions. The fact that Xi’s policy has not met any visible opposition probably means it has achieved some kind of party-wide consensus, which means it probably has deeper thought process under the surface, (2) Xi doesn’t appear to have a strong staff team, which appears to be hindering the effectiveness of his reform, which could explain the chaos we have witnessed.
 

The Xi-Reform hit a bumpy start

If we divide the timeline of Xi’s reform measures, we can group them into three categories and list 8 different measures that affected our sectors:

-          Structural reform aimed at debottlenecking China’s long term economic growth problem. Among this, declining birth rate is a particularly perilous problem because (1) China doesn’t yet have a self-funding social security and medical care infrastructure, which will become a time bomb in due time; (2) China’s GDP per capita has not yet reached developed country levels, yet the contributors to social security and medical care are already dwindling. The root cause of the crisis is the one-child policy adopted some forty years ago. CTRP CEO James Liang wrote a series of thesis working towards his PhD in Stanford on this subject and has gradually gained attention within China. Declining birth rate is a universal problem resulted from urbanization and economic growth, in China it was believed that high property price, high education cost and high medical cost are partially to blame. Besides birth rate, overcapacity has been a persistent problem of the Chinese economy. This problem arose because of the “super corporation” model, i.e., zaibatsu-like government-industry complex that has been successfully supporting China’s early economy growth but now is increasingly becoming a liability. Last, it has been widely recognized that China’s education industry, famed at producing spectacled test takers but not physically adept problem solvers, needs reform to support Chinese economy stepping upward. Measures in this category include (1) environmental protection (smog control in Beijing which

backfired), (2) social security tax, (3) e-commerce law, (4) education reform, (5) game approval control;
-          Measures to enlarge China’s oversea influence. This includes (1) Road and Belt, (2) South China Sea;
-          Measure that tightens state’s ideological control. This includes party cell in private enterprise, including MNC’s.
 

The majority is in the first category. Ordinary Chinese has no objections to measures that enlarge China’s influence. But why has the Xi-Reform received such poor feedback? We believe it is because (1) Ideological control was universally disliked, (2) Road and Belt initiative is rumoured to have, or might have already produced a wide range of corruption, (3) In the past months impacts of structural reform fell disproportionately onto private enterprises. The reasons are multifaceted. Lack of adequate financing option is one reason. Many private enterprises belongs to the “capacity” within the overcapacity is another reason. To put in another way, M&A is the expected outcome for the reduction in overcapacity, so why M&A surprises so many only because SOE is the acquirer?  
 

This sensitive subject, coupled with the strong ideological push, distorted public opinion, leading to the perception of the Xi-Reform as a rollback to the Stalinist-era economy. This is our interpretation of what happened.
 

The economic aspect of the Xi-Reform is to raise the cost of doing business

While it appears to be counter-intuitive to talk about raise the cost of doing business when the economy is going to a cyclical downturn, we believe it is the right remedy for the Chinese economy from a structural perspective.
 

Over capacity, cut throat price competition, environmental pollution, food poisoning, migrant worker exploitation and intellectual property theft are the persistent illnesses of the Chinese economy. The reason for their existence is the very low cost of offense, because (1) China doesn’t have a class action tort infrastructure and is probably a long way to have one, (2) local government-industry complex with the local government functioning as the controlling bank in a Zaibatsu structure.
 

Some argue China already has a very high cost of doing business, as local bureaucrats cooked up a myriad of fees and charges. True, but it only means that raising the cost by rule of law and reducing the cost by implementation of law must happen at the same time. One cannot negating another. The cost of doing business in China has so far poorly aligned with public interests. To correct, the inefficient cost of doing business must go, the efficient one must come, after which the right incentive can be in place.
 

The consequence of higher cost of doing business is that corporations must raise their prices. Some can and some can’t. Those who can’t will be bought or vanish. M&A will be a bonanza for investment banking in the years to come.
 

How to interpret Xi-Reform’s ideological push?

Xi’s left-leaning ideological inclination has been the most criticized of its reform. But to understand it is also very simple.
 

“Make China Great Again” has been the source of legitimacy for CCP for decades, long before Donald Trump’s “Make America Great Again”. To make China great again certainly means both economically and culturally. China wants to possess its soft power but Xi believes in the cultural arena, laisse faire is not the way leading to soft power so the state must exercise some guidance.
 

It is for this reason we believe the regulatory pressure on the game industry will not lessen even after the lifting of the game approval ban. In the eye of the government, China has the largest game market in the world, employing the most workforce and has flagship companies like Tencent and NetEase, yet its cultural statue in the world pales in comparison. This certainly does not comport with the goal of making China great again. Going forward the administration of game will bear resemblance to the administration of movies, with increasing censorship on the political correctness of the game content, in our view. This will force more Chinese game developers to go overseas.
 

We believe another reason for Xi’s ideological push is his unfamiliarity with the party’s propaganda apparatus. Xi’s career has been heavily along the provincial governing track, spending 17 years in Fujian Province, 5 years in Zhejiang and 3 in Hebei. This CV is very different from his predecessors like Hu Jintao (who rose through the rank of party affairs track), Wen Jiabao (who rose through the state council track) and Jiang Zemin (who was in charge of China’s biggest city). Xi’s political experience in the past probably makes him a good candidate to align the relationship between central and local governments, but Xi doesn’t have adequate exposure in central economic planning, trade and commerce, party affairs, investigative or one of the urban centres (Beijing/Shanghai/Guangzhou). Similarly, Premier Li Keqiang doesn’t have complementary experience either. His inclusion in the top leadership is an exchange made with outgoing president Hu Jintao in a horse-trading deal. Many pointed to President Xi doesn’t have a capable staff and we agree.
 

The outcome of the Xi-Reform depends on the ability of Chinese government to self-correct and self-calibrate

Unfortunately, to implement the ambitious structural reform requires knowhows in central economic planning, party affairs and urban centre governorship. With US-China trade war erupting, trade and commerce knowledge must add to the menu.  But China’s economic bureaucrats clearly lack a voice in the central leadership, in our view. Premier Li’s CV includes stings in the Communist Party Youth League (party affairs) and provincial governs in Henan and Liaoning. But he has never commanded the state council before.
 

From our observation, different departments of Chinese government are devising their own policies towards the overall goal of structural reform. Some, like the Ministry of Education, appears to be overly eager, causing upheaval in the capital market. Others might be more moderate. We believe there are still more government ministries quietly adjusting their policies to make them more realistic.
 

In our last Pilgrimage, we pointed out Taiwan’s mid-term election might pave a way for China to adopt more conciliatory tone towards the US in the trade negotiation. It appeared it was exactly what had happened. But the arrest of Huawei’s CFO further complicated the matter. It has become increasingly obvious that the Trump Administration does not intend to reach an agreement, as long as China’s public opinion is on the verge of demoralization. We believe demoralization of China’s public opinion has become a bigger obstacle to reaching a trade deal. A key reason for the demoralization is the public interpretation of the Xi-Reform, which we believe is overdone.
 

Stock market saves the world

Rightly or wrongly, stock market has honestly predicted what was about to happen. When the trade war erupted, Chinese stock market first succumbed, predicting, largely correct, what was about to happen next. Recently, the US stock indices experienced sharp corrections. While the reason might be related to Fed, it probably chastened the Trump Administration, making his “Make America Great Again” less appealing than before.
 

Now neither US nor China will be able to make their countries great again, perhaps we can all rest in peace and live happily thereafter.

How to trade?