China credits on-the-ground: Observations on China’s shifting regulatory environment

4 August, 2021

Fiona Cheung, Head of Global Emerging Markets Fixed Income Research

China’s financial markets have recently experienced heightened volatility on the back of regulatory changes in several key sectors, such as real estate, the internet and education. In this investment note, Fiona Cheung, Head of Global Emerging Markets Fixed Income Research, details the genesis of these changes and highlights key issues that investors should be aware of moving forward. With access to both onshore and offshore insights, Fiona and her team also believe the government’s implementation should be viewed as a positive for China’s long-term socio-economic development.

Overall, we view the increased scrutiny on sectors such as real estate, the internet, and education as part of the Chinese government’s initiative to address the concerns of its citizens. With notable market movements over the past week, credit spreads moderately widened in some impacted sectorsⁱ. We believe the macro impact of these regulatory moves should be insignificant for China’s second-half 2021 GDP and beneficial for China’s long-term socio-economic development.

First, a look at recent regulatory developments. Recent announcements went beyond the expectations of many market observers but were not a complete surprise. We believe that investors should pay close attention moving forward, as the regulatory environment may experience further changes.

Backdrop for regulatory policy changes

Having said that, we also believe investors need to understand the policy reasons behind these notable changes. Indeed, since 2017 the government has shifted its top economic priority from promoting quantitative growth to encouraging more tangible qualitative outcomes. That is, economic development should result in greater benefits for the every-day lives of citizens as opposed to merely chasing impressive headline GDP figures. Building off this framework a key goal of the recent regulatory changes is to mitigate a now shrinking national population through decreasing costs related to education, promoting family formation. The government has previously expressed concerns over potentially harmful social consequences in the following areas:

After-school tutoring: Data from the 2020 population census highlighted the risk of a rapidly ageing population and the prohibitive costs of raising a family. Education expenses, particularly after-school tutoring, is a significant factor for many families to consider when having children. The legal basis of the recently released Double Reduction education policyⁱⁱ started in 2018 and involved different stakeholders in the drafting process. The legal framework was finalised three months ago and released in late July.
Food-delivery riders: Since September 2020, articles on the safety risks associated with food-delivery riders circulating on the internet led to a society-wide discussionⁱⁱⁱ. Almost a year later, on 26^th July, the State Administration for Market Regulation (SAMR)^iv and six other departments jointly issued detailed guidelines on protecting food-delivery riders’ rights and interests.
Internet: Since China’s regulators halted an IPO last year, China’s regulators have placed internet names under increased surveillance. In the past two weeks, the regulations on China’s internet sector have significantly escalated^v. The areas under scrutiny relate to banking, anti-trust regulation (the nation’s law went into effect in 2008), data security, and social equality. We anticipate that greater oversight of the Chinese internet sector will continue; however, if the companies involved comply and work with the government, regulatory overhangs should be manageable. Also, risks relating to the variable interest entity (VIE)^vi structure should be more on a case-by-case basis than broadly structural.
Real estate speculation: Starting in 2016, “Houses are for living, not for speculation” has been reiterated at numerous high-ranking government meetings. Since then, policies intended to curb real-estate speculation have been introduced (except due to the COVID-19 pandemic last year). The “Three Red Lines” rules, as well as other tightening measures would curb speculation (by taking excessive leverage) on both the physical market and property developers’ side^vii.

Policies promote long-term socio-economic development

In our view, the short-term impact of the new regulations shouldn’t materially affect China’s second-half economic growth trend this year. Over the longer term, it could have a positive effect on the social and economic development of the country and key sectors:

Education: While the regulation update on the after-school tutoring sector is extensive, this is believed to be a relatively small segment of the economy: approximately 0.7% of China’s 2019 GDP^viii. We think the government will take a gradual approach during the transition period. The sector employs many highly educated tutors, many of whom are recent university graduates. Additionally, front-loaded payments are typical for after-school education, which could lead to extensive financial losses. Over the long-term, we believe the regulatory changes in the sector could help alleviate the high costs of education and raising kids for the middle class, free-up more consumption spending power, and foster a more diverse education environment, as non-school curriculum tutoring businesses will still be allowed.
Internet: New regulations on the internet sector should have limited macro impact, as they mainly deal with improving employee benefits, cybersecurity, and curbing monopolistic power. Enhancing protection for employees and customers may lower the overall social risks associated with the sector. A reduction in the monopolistic tactics of internet platforms should also foster market competition and spur economic innovation. From a credit perspective, China’s internet names will be structurally challenged in terms of medium-to-long-term growth and profitability, as they now face additional headwinds to leverage their market dominance and grow across industries. Given the ongoing headline risks, we expect to see higher volatility in bond performance in the China internet sector.
Real estate: The curbing of speculation in the real estate sector should be manageable for the financial system, providing greater long-term development prospects. The average mortgage-related loan-to-value ratio (LTV) in the Chinese banking system is around 50%, and the excess leverage from shadow banking and P2P lending has reduced in the past few years. In addition, the People’s Bank of China conducted rounds of real estate-related stress testing for the banks in the second half of 2020 to ensure the system can weather a potential correction.

In a recent outlook, we observed that developers with ample land reserves and access to diversified funding channels in both onshore and offshore markets should be in an advantageous position.

Conclusion: Recurrent volatility in financial markets is always unnerving for investors. However, in this case, we believe that investors should understand the genesis and reasoning behind the changes. More importantly, we believe these policies should bolster China’s socio-economic environment and help investors looking for attractive risk-adjusted returns over a longer time frame.

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ⁱAs of 30 July 2021, Manulife Investment Management. Chinese internet credits have been relatively well-behaved: benchmark China IG internet bonds widened around 15-20 basis points over the week, with high-beta China IG widened around 50-60 basis points.

ⁱⁱ 24 July 2021, a set of guidelines to ease the burden of excessive homework and off-campus tutoring for students undergoing compulsory education was jointly issued by the General Office of the Communist Party of China Central Committee and the General Office of the State Council.

ⁱⁱⁱA study published in the Chinese labor security magazine, Laodong Baozhang Shijie, shows that 84 percent of delivery staff work more than 10 hours daily. Delivery workers in Beijing, for example, spend on average up to 11.4 hours every day on the job. This piles up risks of them suffering from overwork.

^iv On July 26, 2021, the State Administration for Market Regulation (SAMR) and six other departments jointly issued detailed guidelines on protecting food delivery riders’ rights and interests, such as mandatory injury protection insurance, flexible employment, and ensuring local minimum income.

^vOther internet-related regulations include: 1) The Data Security Law, set to become effective on September 2021, will have more regulatory oversight on companies that possess a significant amount of personal privacy data, and their businesses are related to Critical Information Infrastructure. 2)The Cyberspace Administration of China (CAC) announced a cybersecurity inspection on certain ride-hailing platforms in early July soon after the IPOs of a few concerned companies in the US. In fact, the “Measures for Cybersecurity Review” – aim to ensure the security of critical information infrastructure and safeguard national security, has already been in effect since June 2020.

^viHolding companies entitling foreign owners to the economic benefits flowing from Chinese companies but limiting their control of the business.

^vii The People’s Bank of China and the Ministry of Housing announced in 2020 that they’d drafted new financing rules for real estate companies. Developers wanting to refinance are being assessed against three thresholds: a 70% ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract, a 100% cap on net debt to equity, a cash to short-term borrowing ratio of at least one.

^viiiBloomberg, 27 July 2021.

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Some funds may invest in emerging economies or markets, where special risks, including liquidity, volatility, government policies, taxation, currency, currency repatriation, political and regulatory risks, may be substantially higher than the risks normally associated with more developed economies or markets.
Some funds may invest in securities of small and/or medium sized companies in the relevant markets. This can involve greater risk than is customarily associated with investments in larger and more established companies.
Some funds may invest in a single country/region and/or a particular industry sector which may be concentrated and subject to greater risks than diversified investments in several countries and/or regions and across sectors.
Some funds may invest directly in certain China A shares via the Stock Connect, which may involve risks related to investments via the Stock Connect and Mainland China investment.
Some funds may have significant exposure to Renminbi ("RMB") bonds/equity/assets or emerging markets, which will be subject to debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with more established markets.
Some funds with significant exposure to RMB bonds/equity/assets may hold a significant portion of assets in deposits if there are not sufficient RMB instruments to invest in. This may adversely affect the funds’ return and performance.
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Some funds’ performance will be closely tied to the economic, political, regulatory, geopolitical, market, currency or other conditions in the European Economic Area and may be subject to increased liquidity, price, and foreign exchange risk.
Some funds may invest in Russia and some investments in Russian securities may be unlisted securities not dealt on a regulated market. The Russian market presents specific risks in relation to the settlement and safekeeping of securities.
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Manulife Global Fund is an umbrella fund comprising a number of sub-funds investing in equity and/or fixed income securities, each of which has a different investment objective and risk profile and may involve equity market, geographical concentration, sovereign debt, liquidity, volatility, credit downgrade, interest rate, counterparty risks. Certain investors may also be subject to the risk relating to RMB hedged share class.
The relevant distributing class of the sub-funds does not guarantee distribution of dividends, the frequency of distribution and the amount/rate of dividends. Dividends may be paid out of income, realized capital gains and/or out of capital of certain sub-funds in respect of Inc share class(es). Dividends may be paid out of realized capital gains, capital and/or gross income while charging all or part of their fees and expenses to capital (i.e. payment of fees and expenses out of capital) in respect of MDIST (G), R MDIST (G) and F MDIST (G) share class(es). Dividends paid out of capital of these sub-funds amounts to a return or withdrawal of part of the amount of an investor’s original investment or from any capital gains attributable to that original investment and may result in an immediate decrease in the net asset value per share in respect of such class(es) of the sub-funds. Fixed yield share classes pay out a pre-determined annualized fixed percentage of their NAV, which can be adjusted by the Directors with at least one month’s prior notice, do not entirely reflect the actual or expected income or performance of the Fund. These distributions may exceed the actual income, leading to capital erosion, especially during negative returns or losses, and may reduce future capital growth. A positive distribution yield does not guarantee a positive return, and the absolute distributions vary with the NAV, resulting in fluctuating monthly payouts for investors.
Certain sub-funds invest in emerging economies or markets, where special risks, including liquidity, volatility, government policies, taxation, currency, currency repatriation, political and regulatory risks, may be substantially higher than the risks normally associated with more developed economies or markets.
Certain sub-funds invest in securities of small and medium sized companies in the relevant markets. This can involve greater risk than is customarily associated with investments in larger and more established companies.
Certain sub-funds concentrate their investments in a single country and/or a particular industry sector are subject to greater risks than diversified investments in several countries and/or regions and across sectors.
Certain sub-funds may invest directly in certain China A shares via Stock Connect, which may involve in risk related to Investments via Stock Connect and Mainland China investment.
Investment involves risk. The sub-funds may expose their investors to capital loss. Investors should not invest solely based on this material and should read the offering document for details including the risk factors, charges and features of the sub-funds and their share classes.
Each sub-fund intends to use financial derivative instruments (“FDIs”) for investment, efficient portfolio management and/or hedging purposes. The use of FDIs exposes the Fund to additional risks, including counterparty/credit risk, liquidity risk, valuation risk, volatility risk and over-the-counter transaction risk.
Given RMB is currently not a freely convertible currency, payment of redemptions and/or dividend payment in RMB may be delayed due to the exchange controls and restrictions applicable to RMB. As offshore RMB (CNH) will be used for the valuation of RMB denominated Class(es), CNH rate may be at a premium or discount to the exchange rate for onshore RMB (CNY) and there may be significant bid and offer spreads and thus the value of the RMB denominated Class(es) will be subject to fluctuation. Any devaluation of RMB could adversely affect the value of investors’ investments in the RMB denominated Class(es) of certain sub-funds.

Manulife Advanced Fund SPC

Manulife Advanced Fund SPC is an umbrella fund comprising a number of sub-funds investing primarily in equity and bond securities, each of which has a different investment objective and risk level.
The sub-funds do not guarantee distribution of dividends, the frequency of distribution, and the amount/rate of dividends. A sub-fund may at its discretion pay dividend out of capital or gross income while charging / paying all or part of its fees and expenses out of its capital. This amounts to a return or withdrawal of part of an investor’s original investment or from any capital gains attributable to that original investment, and may result in an immediate reduction of the net asset value per share of the respective share classes after the distribution date.
Certain sub-funds with significant exposure to Renminbi (“RMB”) bonds/equity/assets or emerging markets, may involve debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with the world's more established markets.
A bond sub-fund may hold a significant portion of assets in deposits if there are not sufficient RMB instruments for it to invest in. This may adversely affect its return and performance.
Certain sub-funds using invest directly in debt instruments/shares via QFII regime, the Bond Connect and/or the Foreign Access Regime are subject to various requirements and restrictions under the laws of Mainland China related to investment in QFII and/or China Interbank Bond Market and custodial risks.
RMB is not freely convertible and is subject to exchange controls and restrictions.
Certain sub-funds may have significant concentrated exposures to particular industry sectors and geography's, which subjects investors to concentration and equity market risk.
Certain sub-funds may invest in equities of small- and mid-capitalization companies, which can expose investors to liquidity and volatility risks, and is subject to greater risk than is customarily associated with investments in larger capitalization companies.
Investment involves risk. The sub-funds may expose to a high risk of capital loss. Investors should not invest solely based on this material and should read the offering document for details including the risk factors, charges and features of the sub-funds.

Manulife Hong Kong Series

Manulife Hong Kong Series (“the Series”) is an open-ended unit trust comprising a number of funds primarily investing in equities, debt securities, exchange-traded funds and/or collective investment schemes, each of which has a different investment objective and risk level.
The funds do not guarantee distribution of dividends, the frequency of distribution, and the amount/rate of dividends. Dividends may be paid out of capital and/or out of gross income of certain funds in respect of Inc classes, while charging/paying all or part of certain funds’ fees and expenses to/out of capital of certain funds. This represents a return or a withdrawal of part of an investor's original investment amount or capital gain attributable to that amount. Distributions will result in an immediate decrease in the net asset value of the relevant units. Class AA (RMB) Inc Hedged Unit of certain funds is subject to higher distribution risks than other non-hedged unit classes.
Certain funds may involve equity market, emerging markets, Dim Sum bond market, concentration, volatility, liquidity, credit, credit ratings, below investment grade and unrated securities, credit rating downgrading, interest rates, valuation, sovereign debt, unlisted debt securities, political and regulatory, currency, foreign exchange, derivative and structured product, hedging, and distribution risks. Certain investors may also be subject to the risk relating to RMB hedged share class..
Certain funds are subject to the risks of investing in other funds and the risks relating to asset allocation strategy and/or downside risk management process.
Certain fund is subject to the risks relating to investment in exchange traded funds, Strategic and Tactical Asset Rebalancing Strategy (“STARS”), small- and mid-capped companies, convertible bonds and the risks associated with securitised debt instruments and investments in loss-absorption features. Certain fund is a feeder fund that invests all or substantially all of its assets in another collective investment scheme (the “master fund”) and is therefore subject to the risks of investing in the master fund.
Certain fund will not have direct investments other than cash, cash equivalents and financial derivative instruments (such as futures, options and forwards).
Investment involves risk. The funds may expose its investors to capital loss. Investors should not make investment decisions based on this material alone but should read the offering document for details, including the risk factors, charges and features of the Fund and its unit classes.