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) , Qunar (QUNR) and YY (YY) , and our China-based partners have been involved at the earliest stages of other Chinese tech companies such as Baidu (BIDU) 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.
What’s the impact?
The wealth effect impact of the falling market should be fairly moderate in my opinion. In the U.S., approximately 60% of all equities are owned by institutional investors, in China this figure is only 10%. So, the big losers of this recent market sell off are individuals. Second, while participation in the equity markets had certainly become more popular over the past year as margin debt became available and people were seeing strong gains, the numbers I’ve seen suggest there are less than 100M trading accounts open in China. Relative to the 1.3 billion people in China, this is a small percentage of the population. Third, across the population, equities represent a small percentage of total net worth (much lower than the U.S., for example), so the average person can recover from a shock in equity values. Finally, financial institutions who’ve lent money on margin to these speculators may end up with bad loans on their books, but these seem to represent a very small percentage of their balance sheets, again pointing to a relatively muted impact of this sell-off.
Will it impact the broader economy in China?
Generally there’s a pretty tight linkage between equity markets and underlying macro-economic trends. In this case, similar to the U.S. dotcom bubble, the rally and then fall of Chinese stocks seems de-coupled from the underlying economy. The pain will be felt by a minority of consumers in China and, as a result, I suspect the damage will be fairly muted. This may impact economic growth rates on the margin, especially because consumption is climbing as a component of China’s GDP growth, but I wouldn’t be shocked by government intervention to stimulate consumption. Of course, if consumer sentiment is meaningfully negatively impacted by the equity market swoon, the economic slow-down could be more precipitous, so we should watch this closely over the coming months and quarters.
What’s the impact for Silicon Valley? How about for the new economy companies in China?
Most in Silicon Valley under-estimate the growing convergence between the U.S. and Chinese tech economies. These two markets rely on each other now more than ever. Apple’s (AAPL) biggest market is now China. The same will be true for Uber by the end of this year. Conversely, Alibaba, Tencent and others have been investing and acquiring in the U.S., while Chinese investors have become increasingly active in the U.S. venture capital arena.
I anticipate continued health and rapid growth of China’s new economy. There’s much infrastructure yet to build out, many new consumers entering the ranks of the middle class and huge growth coming in mobile internet users. These factors should conspire to continue to catapult new economy growth in China, overwhelming any negative impacts of wealth declines from the stock market. If I’m correct, I think you’ll see limited impact on Silicon Valley. The best U.S. mobile, Internet, hardware and enterprise companies will continue to eye China as a growth market, and many will follow Apple and Uber’s lead into China, finding strong local competition but a very fruitful, dynamic market. Similarly, the strongest Chinese tech companies and investors will not lose sight of the U.S. as a desired place to do business.
So are we out of the woods?
I’ve argued that the correction in Chinese equities will have a fairly modest impact on China’s new economy and U.S. tech and VC markets. That said, there are still risks. Two that bear watching include the Chinese consumer and Chinese debt levels.
Chinese consumption is a critical and growing part of China’s macro-economic growth machine. If Chinese consumers lose confidence and stop spending money, due to the stock market induced panic, fears of falling home prices, or some other reason, this could ultimately spill over to China’s new economy health. China’s total debt levels, including consumer, corporate and government debt, is at a very high ratio relative to total GDP. While underlying growth has helped finance this debt to date, a slow-down could cause significant challenges as well.
Glenn Solomon (@glennsolomon) is a Managing Partner with GGV Capital. Some of his recent investments include Zendesk, Nimble Storage, Pandora, Successfactors, Isilon, Domo, Square, Opendoor, AlienVault and HashiCorp. This post originally appeared on his blog.