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 slide. 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 U.S. have also fallen pretty sharply.
At my venture capital 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 BABA 1.21% , Qunar QUNR 0.36% and YY YY 0.08% , and our China-based partners have been involved at the earliest stages of other Chinese tech companies such as Baidu BIDU 0.10% 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 and 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 last summer.
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 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 buyout offers for ADR, U.S.-listed Chinese companies, with the ultimate plan of restructuring these companies as onshore 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 U.S.-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 U.S. government make in times of local market strife. To date, these moves seem pretty draconian (e.g., unilaterally locking up insiders from selling stock for a long while, closing the IPO window, etc.) and have been ineffective in 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.