China’s stock markets have been in free-fall for the past several weeks, reversing tremendous gains over the prior twelve months. The Chinese version of the SEC (CSRC) has intervened, attempting to staunch the fall, but so far, efforts have proven ineffectual. The management teams of many local Chinese companies have unilaterally halted trading in their own stocks, adding to the panic that currently prevails. Additionally, the ADRs (American Depository Receipts) of the shares in Chinese tech companies that trade in the US on the NYSE and Nasdaq have also fallen pretty sharply over the past month.
At my firm, GGV Capital, we’ve been actively investing in China with a strong local presence for the past 15 years. We’ve backed some of the strongest new-economy Chinese companies that have emerged including Alibaba, Qunar and YY, and our Chinese-based Partners have been involved at the earliest stages of other leading Chinese tech companies such as Baidu and Xiaomi. We’re heavily invested in China and are on the ground to see developments first-hand. We’ve lived through the internet bubble, SARS and the global financial crisis, to name a few. As a result, I’ve gotten lots of questions recently about what’s going on in China, the prospects for the Chinese economy, and what the impacts might be on the US tech & VC markets. I’ve summarized some of the key elements of the story and my perspective on these questions below.
The Chinese stock market sell off in context
China has several local exchanges. The Shanghai and Shenzhen exchanges (which include “A-Share, Renminbi denominated stocks) are the most developed and include many low growth, offline-economy, state owned enterprises (SOEs) with minority stakes that trade publicly. SOEs are often local monopolies. There are also three Nasdaq styled exchanges – the Shenzhen-based Chinext (aka “3rd board), the Beijing based “New Third Board” and the very new “Special Shanghai Board.” These three exchanges have less stringent listing criteria, and include other local companies, many of which are offline-economy focused or niche players with slowing growth. Chinese stocks on all of these exchanges fell steadily for roughly the four years leading up to summertime of last year (2014). Meanwhile, the Chinese economy kept growing and many publicly listed companies exhibited solid financial performance. As a result, Chinese stocks got cheaper on a multiple basis during this period and started to look more attractive. Eventually a rally ensued, initially based on fundamentals. Subsequently, more liberal government policies, including the enhanced ability for individuals (retail investors) to buy on margin, began to fuel further stock appreciation as investors had access to more capital and a thirst to bet on appreciating equities. This spiraled on itself until roughly one month ago when Chinese stocks began their nose-dive. The surge was meaningful – for example, A-Shares were up on average approximately 140% in the 12 months before the fall of the past 3-4 weeks.
What is the government doing and why?
The government has a priority to build flourishing, open capital markets in China. One important step for this to occur is to have some of the highest quality Chinese companies trade locally. As local Chinese stocks rallied up until a month ago, an arbitrage window began to open up. Chinese companies trading in the US with ADRs looked like they’d have much higher valuations on Chinese exchanges. As a result, several take-private transactions were announced, where local Chinese funds partnered with management teams and local financial institutions to announce buy-out offers of ADR, US-listed Chinese companies, with the ultimate plan of restructuring these companies as on-shore Chinese entities and taking them public locally. Given the government’s priority of building out the local Chinese stock markets, I believe there’s tacit support for these types of deals, and many of the US-listed ADRs rallied on rumors of more take-private offers coming.
Now with the local markets in free fall, the Chinese government is more focused in the short term on trying to calm the markets, similar to the moves we’ve seen the US government make in times of local market strife. To date, these moves seem pretty draconian (eg, unilaterally locking up insiders from selling stock for a long while, closing the IPO window, etc.) and have been ineffective reversing the slide. Making matters worse, many companies have halted trading in their own stocks, further stoking panic fears among investors who are getting margin calls and needing to find liquidity urgently.
What’s the impact of this?
The wealth effect impact of the falling market should be fairly moderate in my opinion. First, while in the US approximately 60% of all equities are owned by institutional investors, in China this figure is only 10%. Hence, retail investors own a far greater percentage of the equity markets in China. So, the big losers of this recent market sell off are individuals. Second, while participation in the equity markets had certainly become more popular over the past year as margin debt became available and people were seeing strong gains, the numbers I’ve seen suggest there are less than 100M trading accounts open in China. Relative to the 1.3 billion people in China, this is a small percentage of the population. Third, across the population, equities represent a small percentage of total net worth (much lower than the US, for example), so the average person can recover from a shock in equity values. Finally, financial institutions who’ve lent money on margin to these speculators may end up with bad loans on their books, but these seem to represent a very small percentage of their balance sheets, again pointing to a relatively muted impact of this sell-off.
Will it impact the broader economy in China?
Generally there’s a pretty tight linkage between equity markets and underlying macro-economic trends. In this case, similar to the internet bubble of ’00 in the US, the rally and then fall of Chinese stocks seems de-coupled from the underlying economy. The pain will be felt by a minority of consumers in China, and as a result, I suspect the damage will be fairly muted. This may impact economic growth rates on the margin, especially because consumption is growing as a component of China’s GDP growth, but I wouldn’t be shocked by government intervention to attempt to stimulate consumption to counter-act any softness. Of course, if consumer sentiment is meaningfully negatively impacted by the equity market swoon, the economic slow-down could be more precipitous, so we should watch this closely over the coming months and quarters.
What’s the impact for Silicon Valley? How about for the new economy companies in China?
Most in Silicon Valley under-estimate the growing convergence between the US and Chinese tech economies. These two markets rely on each other now more than ever. Apple’s biggest market is now China. The same will be true for Uber by the end of this year. Conversely, Alibaba, Tencent and others have been investing and acquiring in the US. Chinese investors have also become increasingly active in the US venture capital arena.
I anticipate continued health and rapid growth of China’s new economy. There’s much infrastructure yet to build out, many new consumers entering the ranks of the middle class and huge growth coming in mobile internet users. These factors should conspire to continue to catapult new economy growth in China, overwhelming any negative impacts of wealth declines from the stock market. If I’m correct, I think you’ll see limited impact on Silicon Valley. The best US mobile, internet, hardware and enterprise companies will continue to eye China as a growth market, and many will follow Apple and Uber’s lead into China, finding strong local competition but a very fruitful, dynamic market. Similarly, the strongest Chinese tech companies and investors will not lose sight of the US as a desired place to do business.
So are we out of the woods?
I’ve argued that the correction in Chinese equities will have a fairly modest impact on China’s new economy and US tech and VC markets. That said, there are still risks. Two of these risks that bear watching include the Chinese consumer and Chinese debt levels. Chinese consumption is a critical and growing part of China’s macro-economic growth machine. If Chinese consumers lose confidence and stop spending money, due to the stock market induced panic, fears of falling home prices, or some other reason, this could ultimately spill over to China’s new economy health. China’s total debt levels, including consumer, corporate and government debt, is at a very high ratio relative to total GDP. While underlying growth has helped finance this debt to date, a slow-down could cause significant challenges as well.
At GGV Capital, we’ve bet our business on the convergence of the US and China. We fully expect China to continue to have ups and downs, but we believe strongly in the long term prospects for its new economy. The best tech companies of the next decade will go global much more quickly than ever before. We’re continuing to invest in great entrepreneurs in China and the US, and we’re focused on building out capabilities to help our companies go global as part of their genetic code. The past 15 years have been amazing. The next 15 will be even better.