In the early 20th century, one of the best-performing stock markets in the world was that of Imperial Russia. For decades, stocks on the St. Petersburg Stock Exchange far outperformed those on the New York Stock Exchange, and it wasn't even close. However, when the Bolsheviks took over in 1918, they shut down the stock market and seized all securities for immediate redistribution to the working class, wiping out many investors' capital overnight, if not their lives as well.
This is obviously an extreme example, but China is going through a fundamental shift in paradigm that is enough to make some raise such comparisons. After decades of free-market reforms, the Chinese Communist Party (CCP) is finally taking some minor steps back toward its core beliefs -- and it all starts with regaining some control over the country's burgeoning private sector.
In two previous articles, I outlined multiple reasons why investors should avoid Chinese stocks right now because of these government actions. There were two new developments earlier this week that illustrate why Chinese stocks' descent into the red zone is picking up speed.
Image source: Getty Images.
A never-ending story of crackdowns
On Tuesday, State Administration for Market Supervision in China announced a draft proposal for more regulations on China's rising tech giants. Among many items, it calls for the prohibition of data analytics on consumers' spending habits, preferences, product impressions, viewing history, etc., on internet platforms. During its second-quarter earnings call, Chinese tech conglomerate Tencent (TCEHY 0.89%) warned its investors that the Chinese government could make fairly substantial changes to its data collection in online advertising.
This is a disastrous development for companies like Alibaba (BABA 2.17%) and JD.com (JD 1.65%), which rely heavily on data analytics to optimize transactions on their e-commerce platforms. But it is even more devastating for companies that depend on advertising revenue, namely Weibo (WB +0.17%), a popular social media platform with 530 million monthly active users, and Baidu (BIDU 1.71%), China's largest search engine. Advertising sales form about 50% to 90% of the two companies' total revenue. The move also has far-reaching effects on companies like Bilibili (BILI 1.50%), a popular multi-purpose video streaming platform. In the second quarter, the company derived 36% of its sales from e-commerce and advertising. It is also at risk of a broad government crackdown on video game addiction.
But such risks, in my opinion, are minuscule compared to the other development announced on Tuesday.
The East is red once more
After the end of the Mao Zedong era of Chinese Communist rule, China as a whole was in shambles economically, with no capital to redistribute to the poor and hungry. So its leader at the time, Deng Xiaoping, took on the Machiavellian goal of using capitalism to better establish communism. His government let a select minority of people get rich first and then it changed the rules to redistribute the wealth they generated. It appears something similar is happening again under President Xi Jinping.
On Tuesday, Xi said there was a need for wealth redistribution and explicitly outlined higher taxes, social welfare adjustments, and government spending as means of achieving his goal. In addition, Xi called for even more government intervention to control how private enterprises can generate their revenue. It would further compound the high tax burden in China and eat away entities' profits, and by proxy, their stock price.
For example, U.S. corporations typically pay a 13.65% Social Security tax (consisting of unemployment, Medicare, and Medicaid) on employees' gross earnings. That tax is a stunning 40.1% for Chinese companies. So the recent requirement to pay mandatory social welfare benefits for Meituan's (MPNG.Y 0.88%) food delivery drivers and possibly DiDi's (DIDI +0.53%) ride-share drivers -- despite their gig worker's status -- could obliterate those companies' bottom lines and devastate investors (for the good of the workers).
What's more, the central government has recently gained interest in establishing direct control over Chinese tech firms. It now owns 1% of ByteDance, the parent company of Tiktok, and Weibo. Don't be fooled by its small stake; for Weibo, that 1% ownership gives the central government the ability to appoint board members, block financing rounds, and veto content rollouts on its platform that are deemed "questionable."
And just because the CCP is now a part of the game doesn't mean it will look out for its fellow investing "comrades." From the CCP's perspective, it's even more profitable to nationalize certain "undesirable" tech giants (either with or without compensation) and add them to the giant pool of state enterprises. In June, the central government already took the first steps to nationalize private companies' data. As a response, countries like the U.K. are calling for a ban on Chinese apps such as DiDi, as the regulation would grant Chinese state intelligence agencies the right to harvest user data over these apps.
Investor takeaway
Overall, Chinese companies are losing their status as high-flying, maverick innovators on their way to eclipsing Silicon Valley. Instead, it appears they are rapidly becoming pawns controlled by the CCP to achieve the latter's political goals. After all, party-affiliated organizations have an executive presence among 70% of "private" Chinese companies.
When you factor in the stricter regulations and the clear suggestion that profits are more likely to end up on the dinner tables of workers' communes, Chinese stocks, especially ones in the tech sector, are a no-go as an investment for the long term.
