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China: The Non-Profit Tantrum

On July 23, China’s State Council released the guidelines for after school tutoring that included making core curriculum tutoring non-profit, and severing this industry from the capital market. This move differed from recent regulations in antitrust, fintech, data security and labor rights, in that it forbade an entire industry from making profit.


This caused the biggest two-day selloff in Chinese equities since 2015 for the MSCI China and CSI 300 indices. For the Hang Seng index, it was the largest two-day selloff since 2008.


Investors worried about other sectors that could face additional regulatory risk, particularly property and healthcare, as these sectors were also named as the three main anchors (mountains) for social stability, along with education. The fear was also elevated to whether China would abandon market based economic development.


Citi analysts believe that regulatory risks remain, such as for property and healthcare, but are likely much less severe than for education. These are much bigger parts of China’s economy, and are too expensive for the government to foot the bill.


There is also evidence that China plans to continue to push forward market oriented development, as Premier Li Keqiang and Vice Premier Liu He both highlighted in recent days. Abandoning capitalism is also inconsistent with stability at this point.


Ultimately, the purpose of all the regulations is sustainability. The measures are likely to support longer term development of consumer and middle class growth by curbing the cost of basic life needs. It would also solidify control of the central leadership.


There are historical parallels. During the 13th Five Year Plan (2015-19), a lot of steel capacity was destroyed in very blunt ways, causing business owners substantial losses. But profitability followed. There were also retail price reform, manufacturing privatization, local government funding for infrastructure, housing privatization, etc. These were cases of major policy changes that created booms and regulation brought busts, followed by more sustainable development.




The initial selloff is fueled by margin deleveraging and fund redemptions, which is likely to be short lived. Between now and sustained recovery, however, there is likely to be a period of volatility, as investors assess impact on earnings.


For longer term investors, Citi analysts believe that Chinese equities already offer potentially attractive 12-month returns at this stage after the panic selling. The education space faces existential risk and may be hard to call. But the internet industry likely offers the most potential for recovery, especially after the most severe underperformance on record relative to US peers. Healthcare and property services have already seen some relief. Meanwhile, tech hardware and green energy industries held up well through the selloff and continue to offer solid long term growth prospects.

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