China’s regulatory actions, driven by Beijing’s financial, security and social objectives, have injected volatility into the credit market over the past year. Despite short-term impact on companies’ profitability, there might be a window for the impacted sectors to formulate a more sustainable growth strategy, and eventually to emerge stronger in the long run. For Asian credit investors, being mindful about the dynamic regulatory backdrop while adopting a prudent credit selection can help to navigate through the uncertainties and identify opportunities with superior risk-adjusted return potential.
Social priorities tighten regulatory leash
Prices of some segments of the Chinese corporate dollar bond market have come under strong pressure after Beijing embarked on its campaign of regulatory overhaul. Investors could not help but wonder the direction of government regulatory actions and its ripple effect on the wider Asian credit market. We believe the Chinese government has been supportive of the internet and property sectors for the past two decades, both in terms of favorable regulations and the build-up of infrastructure, as developing these key sectors promoted economic prosperity. The focus has now shifted to achieving more equitable objectives like social stability.
Additional policy steps toward furthering social objectives – such as repositioning housing as living spaces rather than speculative investments, reducing the education cost burden for families, or deriving better value from the big tech firms and promoting greater profit sharing with SME vendors and employees – have the potential to move markets. Asian credit investors should be mindful of how companies in their portfolio are positioned in such a dynamic backdrop.
Ahead of next year’s Party Congress, Beijing’s regulatory crackdown is also aimed at addressing the issue of income inequality, in our view. By removing anti-competitive practices and lowering barriers to entry, some of that gap could be bridged. The new five-year legal development blueprint published by Central Committee of the Communist Party of China and the State Council makes clear that regulatory oversight will remain a persistent theme through 2025 and so should remain top of mind for investors over the medium-term.
Familiar playbook in the previous regulatory cycles
The aftershocks are still being felt as investors study the implications of the recent moves. However, it is worth noting that the regulatory measures in themselves are from a familiar playbook. We think these regulatory pressures have always existed and in themselves are not new.
The move to regulate large internet platform companies that have grown into quasi-monopolistic positions or that have access to large amounts of user data follows a historical pattern. In the past, we have seen companies deploying new technologies and being allowed to grow for many years. But as the technology becomes more mature and other users come to depend on it, regulation steps in, mirroring wider trends globally. We also expect that the government going forward will be mindful about financial market stability following the market volatility seen in July.
Credit selection is the key differentiator
The regulatory actions somehow hit investors’ confidence in the short-term— but there are silver linings for bottom-up credit investors.
The crackdown on the internet sector has not changed our view on our credit picks which we believe have strong balance sheets and solid net cash positions. We believe regulatory changes are unlikely to damage their resilient credit profiles in the short to medium term. Moreover, the divergence in valuations versus their developed market peers has largely been in equities with very little spillover into credit.
The quick responses made by some tech companies have shown their willingness to rein in aggressive growth plans and adhere to a more disciplined financial model. While this may reduce profitability in the face of the likely increase in competition, it also suggests a more sustainable growth trajectory and potentially greater stability in cash flows. These conditions, in our view, are positive for investing in credit markets. The new regulatory changes have also motivated tech companies to rethink their strategies to create value to all stakeholders, not just shareholders, which should improve their ESG standing overtime.
Turning to the property sector, we believe the implementation of Beijing’s three red lines policy targeted at property developers’ leverage would ultimately lead to a healthier sector backdrop and more sustainable balance sheets in the medium-term. Along the way, some accidents may occur and some developers may run into default, which may create some contagion and volatility. At the same time, we don’t expect fundamentally sound Chinese issuers to face sustained credit stress, and they would likely end up with healthier balance sheets in the medium-term.
As long-term credit investor, we can never emphasize too much the importance of fundamental research, downside mitigation and prudent security selection. We believe that diversifying credit exposure across Asia and optimizing allocations within specific markets can help manage volatility during periods of market uncertainties.
Sheldon Chan is portfolio manager, T. Rowe Price’s Asia Credit Bond Strategy
Photo by Road Trip with Raj on Unsplash
