The financial media is replete with news about a $1.5 trillion selloff in Chinese stocks in recent times. Goldman Sachs, at the end of July, cited “disproportionately high index representation by tech and privately owned companies” for lowering its views on the MSCI China index. Commentators cited Beijing’s crackdown on Chinese tech companies as a significant factor.

This article will seek to give context for what’s happening with Chinese markets.

Root Causes

At the outset, it seems necessary to note that most companies popular with Western investors had no unannounced risk factors as Q2 2021 rolled in. While markets did slow down globally in Q3 2021, the degree of slowdown was nowhere close to such a large selloff. The root cause of it lies within China itself.

Late in October last year, Alibaba founder Jack Ma addressed the Bund Finance Summit in Shanghai as a keynote speaker. Serving as a backdrop to the then-upcoming IPO for his fintech offering Ant Group, Mr. Ma called Chinese regulators an “old boys club” fearful of new ideas and the Chinese banking system as having a “pawnshop mentality”. He went on to pitch the virtues of a digital currency as a solution to future problems and one that can be free of outdated constraints.

Within a week, the Ant Group IPO was suspended and new rules were drafted for regulating internet platforms. Within a month, the Politburo resolved to strengthen antitrust efforts and a probe was launched into Alibaba. Subsequently, a number of companies – predominantly tech – were investigated, prompting many to attribute Mr. Ma’s speech as being the genesis of the crackdown.

It bears noting that Mr. Ma’s speech was not the origin of the crackdown. As early as two years prior to his speech, regulators had been calling for action to address a number of problems: growing “moral corruption” among the youth, increasing familial financial burdens, the brutal work schedule in new companies, and so forth. A key factor underpinning these problems – as per the State – was the ongoing change in “culture”.

When Chairman Deng Xiaoping engineered the liberalization of the Chinese economy 40 years ago – effectively transitioning from a command economy to a mixed-mode economy and permanently cementing the “Sino-Soviet split” – Chinese graduates began to troop into top Western universities and companies. When many of these graduates eventually (and inevitably) went on to build companies, their focus was on the vast untapped Chinese market. With a distinct local advantage and starting out as clones of top Western companies, these companies continually evolved into every niche that the Chinese populace was looking to consume and engendered powerful economic change.

One attribute these companies’ founders imbibed from Western companies was competitiveness – employees worked longer, harder and for far greater reward than they would have within a State-owned enterprise while company management sometimes – possibly/allegedly – didn’t hesitate to take shortcuts to get to the top.

This idea of simply cloning Western ideas for the domestic market was also criticized by Mr. Ma during his speech – which most Western media sources did not transcribe or present to their readers fully. In this regard, Mr. Ma echoed the sentiments of Chairman Deng who, in a conversation with socialist Ghanaian president Jerry Rawlings in 1985, said “Don’t just copy China’s model. You have to walk your own path”.

However, where Mr. Ma and Chairman Deng differ was that while Mr. Ma seemed to be reposing faith in the burgeoning Chinese private sector and its resourcefulness, Chairman Deng’s interest in economic liberalization was rooted in improving China’s economic problems. The country’s political destiny, as per the venerated Chairman, would and must lie with the Party. This idea is shared by current Party General Secretary – and possible President for life – Xi Jinping.

Actions taken on Mr. Ma after his speech had a transformative effect on the magnitude of the State’s punitive actions. Alibaba was fined ¥18.23 billion ($2.8 billion) by the regulators in April for abusing its dominant market position by forcing online merchants to open stores or take part in promotions on its platforms – almost 1% of the company’s market cap. Exclusive contracts tying online merchants to platforms became the root cause for regulators to investigate JD.com and rising rival Meituan – with the latter facing a roughly $1 billion fine.

JD.com, Meituan and several other internet companies are also being investigated by financial watchdogs for practices that include but not limited to irregularities in mergers and acquisitions – a long-valued means of growth in China.

Approval for new games was already problematic to regulators due to the effects of gaming addiction among minors long before Mr. Ma’s speech. Tencent lost $60 billion in market cap (almost 10%) on August 3 after Economic Information Daily – a State-run economics newspaper – called gaming “spiritual opium”, a very loaded term in China. (The article disappeared from the web soon after its effects were felt but reappeared later in the day without said term and some other edits. Tencent closed down 6.1% that day). Loudly-stated concerns by State mouthpieces and think tanks over ongoing “moral corruption” of youth have led to gaming companies, short video platforms and vaping firms feeling the heat from regulators and in the stock market as well.

Tencent was also told that its recently-acquired competitors in music streaming may have to be sold and that its exclusive contracts with music producers must be terminated due to antitrust issues.

Targeted hardest were online education companies – a key (and expensive) means of help for children with the Chinese curriculum. Ostensibly done to ease financial pressures on families that have led to low birth rates, these companies will be barred from raising money through listings or other capital-related activities and must reorganise as non-profits while other listed companies will be barred from investing in them. Duolingo, a popular language-learning app, disappeared from Chinese app stores. TikTok owner ByteDance closed its education division with immediate effect.

Market Effect and View

While the ongoing crackdown might give an impression that the Chinese economy is tanking, a closer view of the market would be in order. For this, we shall compare the performance of the Nasdaq Golden Dragon Index (HXC) and the S&P China A 50 Index (CSSP50) – indexes that tracks U.S.-listed Chinese companies and the top 50 best-performing China-listed companies respectively – versus the CSI300, CSI500 and CSI1000 – which track the large- , mid- and small-cap companies listed in mainland China’s state-run stock exchanges.