China Digital Economy: Expecting a Strong Turnaround In 2022

• Although 2021 was a tough year for Chinese tech stocks, fundamentals remained strong, with continued revenue growth as the pandemic has accelerated the adoption of technology.

• The regulatory crackdown is not intended to deter the growth of tech companies, but rather to safeguard consumer interests and ensure sustainable growth of the sector. 

• There are recent signs that regulatory pressures are easing as most rectifications by internet companies have been implemented. And since 2022 is an important political year, the government will likely prioritise social and economic stability. 

• Most recently, another concern by investors is the delisting of US-listed Chinese stocks. We think it should not be a major concern now as the earliest delisting will not happen till three years later.

• Using a fair PE ratio of 30X on 2023 earnings, we get a target price of HKD 21.50 for the iShares Hang Seng Tech ETF (HKEX: 3067), giving investors an attractive upside potential of 85.0%. 

Over the past year, a series of regulatory crackdowns was imposed by the government on big tech companies, which sent shudders across the stock market. It all began in late 2020 with the cancellation of Ant Group’s IPO, and regulations heightened throughout 2021.

In April 2021, Alibaba (NYSE: BABA) was slapped by regulators with a record fine of USD 2.8 billion for violating antitrust law for its use of the “two choose one (二选一)” exclusivity contracts on merchants. 

In July, the government banned Tencent Music (NYSE: TME) from owning exclusive rights in the online music industry. In the private education sector, sweeping reforms were also announced, including requiring all private education institutions to register as non-profit entities. Such institutions will also not be able to pursue IPOs or take in foreign capital.

These are just some of the many regulations imposed which has weighed on the performance of China’s tech sector. 

Continued penetration and growth of China’s digital economy

While 2021 was a tough year for Chinese tech stocks, fundamentals remained strong, with continued revenue growth as the pandemic accelerated the adoption of technology (Figure 1).

Figure 1: Big Tech companies continued to deliver revenue growth 

In the e-commerce area, sales have continued to grow with the total national online retail sales from January to October 2021 reaching CNY 10,376.5 billion, a year-on-year (yoy) increase of 17.4%. This continued into November, where the Singles’ Day sales were strong with JD.com (HKEX: 9618) and Alibaba (NYSE: BABA) delivering sales growth of +29% yoy and +8.5% yoy respectively.

Despite growing significantly over the years, China’s E-commerce industry still has room for further growth. For example, the Chinese e-commerce grocery market remains at a low penetration rate of 5%, as compared to a 40% penetration rate in the consumer electronics segment, showing that  opportunities still exist.

On cross-border e-commerce opportunities, Chinese e-commerce companies are aggressively gaining market share abroad, where fashion retailer Shein has grown in popularity overseas, surpassing H&M and Zara in sales in the US. 

Companies like Alibaba and JD.com continue to expand their cross-border e-commerce strategies, including building up their global logistics capabilities All these points us to a sustained growth of China’s e-commerce industry.

Besides E-commerce, the cloud industry has also continued to expand throughout 2021, signalling a sustained momentum in the digital shift. In both 1Q21 and 2Q21, cloud infrastructure services spend in China grew strongly by roughly 55% yoy (Figure 2). Compared with other countries, China is the second-largest cloud market globally, and China’s investment in cloud now accounts for 14% of global investment, up from 12% a year ago. 

Figure 2: China cloud demonstrates strong growth

Furthermore, with China’s continued push for artificial intelligence, internet-of-things and autonomous vehicles, the cloud being a crucial foundation of these technologies will benefit. The entire cloud market is expected to grow at a CAGR of 31% till 2023.

Most recently, in early December, Baidu (HKEX: 9888) obtained a permit to collect fares for its Apollo robo-taxi business. This demonstrates to us the trajectory of technological development in China, leading us to believe that as more of such technologies grow in adoption, the cloud industry should stand to benefit.

Regulations set the stage for long-term sustainable growth

Adding to the positivity is the fact that the government has stated multiple times before that the intention behind the regulatory crackdown is not to stifle the growth of tech companies, but rather, to safeguard consumer interests and ensure sustainable growth of the sector.

Firstly, regulations are meant to safeguard consumers and merchants, as well as promote fair market practices which are crucial for the successful long-term sustainable growth of the tech sector. 

Over the past few years, China’s Big Tech companies have grown significantly and gained influence over consumers and businesses, to the point where it is nearly impossible for them to navigate daily life outside of tech ecosystems operated by the likes of Tencent and Alibaba. 

Yet, despite their dominance, little regulation has been imposed on these tech giants, which has allowed for the unfair treatment of customers and merchants. For example, the anti-competitive “two choose one” practice forces online merchants to choose only one platform as their exclusive distribution channel, benefitting the e-commerce platforms at the detriment of merchants.

If left unchecked, power will remain in the hands of these internet platforms, facilitating such market abuses. Furthermore, with the power contained within a handful of Big Tech companies, the lack of competition may impede innovation in the industry. 

As such, a healthy dose of regulation on the sector is perhaps justified and not entirely unreasonable.

Secondly, rather than hindering the growth of the tech sector, the government remains fully committed to digitalisation and innovation, which we see in their ambitious Five Year Plan (FYP). 

The FYP is a grand strategic blueprint of China for the next half-decade, which investors across the world all watch as it is the closest glimpse of what lies ahead. By 2025, the government aims to have the digital economy account for about 10% of China’s newly added economic output and to become a leading innovative country by 2035. 

The government has laid out multiple goals including being technologically self-sufficient, and to be the world’s technology leader as tensions with the United States continue to rise. 

The digital yuan is one of the government initiatives that give us a glimpse of China’s ongoing digitalisation. This digital yuan roll-out will make China the first major economy to introduce a sovereign digital currency, which we expect to further accelerate digitalisation.

The digital yuan will further unlock growth for the digital economy as it opens up access to people without bank accounts, does not need internet access, and will be easily accessible to foreigners. 

It has been a problem getting citizens from China’s rural and lower-tier cities into the digital economy as they lack access to the banking system and the internet. The digital yuan solves these two issues and hence opens the doors to e-commerce and other e-services for the 30% of China’s population who lack internet access. 

Another issue is that foreigners who visit China encounter problems with using their international bank cards. Moreover, many stores and apps do not accept cash but instead accept WeChat Pay or Ali Pay. However, most international bank cards are not accepted on these payment platforms. Here is where the digital currency, which is easily accessible to foreigners will come in handy. 

In both cases, the digital currency opens access to previously cut-off from China’s digital economy consumers, hence expanding the total market opportunity for the digital economy. 

Economic regulation has always been part of healthy functioning markets, and we believe that the government will not hinder the digital economy, but instead, the regulations act as a resetting of the foundations of the industry to poise China for further sustainable long-term growth. 

Regulatory pressures should start to ease

Having said that, there are also recent signs that regulatory pressures are easing with the round-up of investigations for companies as we head into 2022 – a politically important year where the government will likely prioritise social and economic stability.

Most companies have made the necessary rectifications and pending investigations have been given the final verdict. This fits within the timeline given by Ministry of Industry and Information Technology (MIIT) of a six-month review of internet companies which commenced on 23 July 2021, and should end sometime in January 2022. 

Over 68 internet companies including Baidu (HKEX: 9888), Alibaba (NYSE: BABA), Tencent (HKEX: 700), ByteDance (not listed), Sina Weibo (NASDAQ: WB), and iQiyi (NASDAQ: IQ) have completed rectification as required and are now in compliance with the new regulatory framework. 

Moreover, 2022 is an important year where the Chinese Communist Party will host its 20th National Party Congress in November, which will determine whether or not President Xi continues for another presidential term. 

In such a year, Chinese policymakers tend to prefer social and economic stability, and would likely want to demonstrate significant achievements for China’s citizens. Thus it would make perfect sense for the party to wrap up regulatory crackdowns and display how it has benefitted citizens.

Such as the easing of the financial burden of education, which accounted to a high amount of 25% of urban household income. As well as in the case of implementing the minimum wage requirement for China’s 200 million gig-economy workers. 

Hence, with most rectifications done and investigations coming to a close, and 2022 being an important political year, regulatory pressures should start to ease.

Delistings should not be a major concern for now 

Most recently, another concern by investors is the delisting of US-listed Chinese stocks. We think fears have been overblown, as the China Securities Regulation Commission (CSRC) has reinforced their support for US-listings, stating that Chinese companies should be free to choose where to list as long as they abide by the laws of both jurisdictions.

Even in the case of delisting, companies still have plenty of options such as China’s Shanghai Stock Exchange STAR Market and the Hong Kong Stock Exchange to list their shares.

Besides, the first delisting should only take place three years from now, as the US rules state that foreign companies may only be delisted should they fail to comply with audit requirements for three consecutive years. 

In the three years a lot of things can potentially happen, such as a scenario of the US and China reaching a compromise on listing requirements.

Nevertheless, downside risks persist. In the near-term, the delisting news has already and will likely continue to dull investor sentiment, which could affect valuations as investors will probably lower the multiple they would be willing to pay for its shares.

In addition, delisted companies will have to provide an exit option for its US shareholders, such as buying back shares at an agreed upon price. A share buyback means that the company will have to fork out a sum of cash, which could have otherwise be invested back into the business. 

Otherwise, for companies with dual-listings, they can elect to convert its ADRs into HKEX listed shares. However, doing so may give rise to logistical issues such as transfer fees and other associated costs. 

Alternatively, investors who do not wish to be bought out or have their ADRs converted into shares may be able to continue trading on the OTC market, although the liquidity there is expected to be much poorer compared to trading on a stock exchange.

2022 should be a much better year for China Tech

With the continued healthy fundamentals of key big tech companies, the commitment by the government to spur digitalisation, and the easing of regulatory pressures, the outlook for China Tech stocks looks promising.  

We think that the regulatory overhang will eventually fade off as we head into 2022 - a politically important year in which the government tends to prioritise social and economic stability. 

Table 1: China Tech earnings remain robust

Using a fair PE ratio of 30X on 2023 earnings, we arrive at a target price of HKD 21.50 for the iShares Hang Seng TECH ETF (HKEX:3067), which translates to an attractive upside potential of close to 85.0% as of closing price of HKD 11.6 on 28 December 2021. 

Given the steep selloff in Chinese tech stocks, we think that valuations are now too cheap to be ignored. Investors who are positive on the long-term growth prospects of this sector may use this opportunity to add to their positions.