Really interesting interview below from Stratechery about China generally and Tech crackdown specifically.  I've worked a lot in China over the years but have never felt particularly insightful about the decision-making of the Party.  Some useful insights here I thought.

An Interview with Dan Wang About China’s Tech Crackdown (Stratechery Daily Update 9-20-2021)

Monday, September 20, 2021

Good morning,

Tomorrow is the Mid-Autumn Festival holiday in Taiwan; the country is actually on holiday both today and tomorrow. I’m going to take tomorrow off, but today I have an interview, appropriately enough, about China, and what has been happening in the Chinese tech industry in particular.

My guest is Dan Wang, who as I note below, has appeared on Stratechery twice previously; I’ve also cited him in disagreement in a couple of recent pieces, so it seemed a particulary good time to have him on.

On to the interview:

An Interview with Dan Wang About China’s Tech Crackdown

Dan Wang is a China-based analyst for Gavekal Dragonomics, a global macro research firm based in Hong Kong and Beijing; that noted, relying on his employer to characterize Wang does him a disservice: he is one of the deepest thinkers and most careful observers of the world that I know. He is also the first person I have interviewed three times on Stratechery — I think all have been well-worth the time. Dan and I don’t agree about everything, but that is a big reason why I think you will find this conversation interesting.

Please note: there is a brief amount of construction noise at the beginning of the interview; it does not last.

Dan, you are the first ever, I think, three time interviewee on Stratechery, so congratulations on that.

DW: Has it already been three?

It has. We talked at the beginning of the coronavirus pandemic, and then we talked in April of this year. But there’s been a tremendous amount of news and upheaval in China in the tech industry, and I think it’s a great time to check in on that. There has been a ton of questions I hear from my readers all the time, about what’s going on. I’ve always said, the one lesson you learn the longer you observe China is how little you know, and so to some extent I’m very excited to defer to you. But then also I’ve been citing you a couple of times recently, and disagreeing with you on a couple of points, so I think it’s a good time for us to bounce some arguments off of each other and see how it goes. But thanks for joining me again.

DW: I love being a trailblazer, Ben, and this is always great fun.

So it’s a bummer because we haven’t seen each other in person for a very long time, and it feels like that might not happen any time soon. When do you think China is going to open up to foreigners again? Even those that go have a significant quarantine, a specific reason to be there — tourism, no way. When do you think this is going to change?

DW: Years, is my current expectation, at the very least. I think China will not broadly loosen its borders before the Beijing Olympics, which takes place in January-February, 2022, so a couple of months from this point. Before we were all optimistic that China will significantly relax by then, now our minimum expectation is that China probably will not open up before the 20th Party Congress, which takes place in October-November 2022, when President Xi Jinping will probably have a third term. Why should he let a bunch of foreigners derail his third coronation? So at the minimum, I think, it probably won’t relax before the beginning of 2023, but it could well be years from now, just given how much of a mess the world looks from the Chinese perspective.

So here’s my question then. Is this all about COVID, or is COVID also a bit of a convenient excuse for something that central leadership is taking advantage of? You mentioned this Xi Jinping third term, Party Congress, obviously a momentous event. What’s the balance there between what’s driving this closedown?

DW: I think the main reason is that 99% of Chinese don’t want to go abroad at the present moment, and so there is very strong political support to have a pretty much shut down border. The Chinese people perceive the rest of the world to be mostly a mess. Partly that’s true, but probably that is also significantly exaggerated, and the Chinese economy, in our view, is not suffering a great deal from having mostly shut down borders. Businesses are mostly functioning, the rest of the world needs Chinese manufacturing to produce all of the goods that are currently in shortage right now. Most people don’t want to go abroad, they’re keeping their spending at home, so it hardly looks like an economic disaster from the Chinese perspective. So why should they open up and let this virus that the leadership terrorized the people about, for quite a few months, ravage much more of the population?

Is there any sense in China that zero-COVID may not be sustainable in the very long run, or is that the prevailing sentiment? You mentioned the economy, and I think of this report came out that third-quarter growth may actually have slowed down quite a bit, in part because a lot of the lockdowns that happened in response to breakouts over the last few months. Is there any evolution on that, or is it still zero-COVID or bust?

DW: I think it is zero-COVID for a very long time. There have been some prominent voices in the health establishment that said, “Look, what we are doing cannot be sustainable. Are we just going to lock down for decades from now?” Then they were slapped down by both the central leadership as well as online trolls, for even suggesting that the virus should rampage throughout China. So I think there is quite a bit of economic uncertainty here. Nobody knows when the next city would be to shut down, there’s a lot of port blockages here, and I think they’ve accepted that is the price to pay for having a mostly shutdown border, which doesn’t let the virus come in.

Is there any connection between COVID and the so-called China tech crackdown? Jack Ma’s speech in Shanghai appeared to be the precipitating event, which was in, I believe, October 2020? So at that point COVID had been going on for about a year; the dates are obviously up in the air a little bit. But is there any sort of connection there, or is it a mere coincidence that both are happening at the same time?

DW: I think there is a pretty big connection. So last year during COVID, the leadership saw how much people were using online web services, in all sorts of ways. First of all, everybody had to use a lot more online learning. The online education firms stepped up in a big way, and the government perceived what was going on there. The delivery firms did a very good job in doing deliveries of groceries, as well as prepared foods. A lot of the maps, a lot of the payment platforms, created their own contact-tracing app. I was using a contact-tracing app in Beijing in March of 2020. So they stepped up in a very big way, and the government mostly appreciated that. We have a line from Xi Jinping, from last November, saying digitization was very helpful during COVID.

But the leadership saw that a lot of people were using a lot of services that had been pretty unregulated, and I think this is one of the big things about Chinese tech. Relative to other sectors of the Chinese economy, and relative to the tech sector in the US, the Chinese tech sector had not broadly been regulated. There have been minimal application of antitrust against these platforms, there have been minimal regulation of privacy and data issues, and that’s when they decided we can’t let these essential services that people have been using this extensively during the pandemic, be mostly unregulated at this stage.

This is a question I was going to ask you later on, but it leads right into it, which there is an acknowledgement, okay, these companies really stepped up in a major way, in a very rapid way, arguably in a way even more quickly and rapidly than happened in the US. Is there any sense of a connection between the lack of regulation and the speed of response, or is it assumed that you can get one without the other?

DW: That’s my view, that they were able to react so quickly because they had not been so extensively regulated. But there is a more sinister view that you can take of this, which is that, well, well, we don’t know the details of how well these companies really work with the government, but it is possible that these companies responded very well to government directives, that when the government said “Jump,” they asked, “How high? How can we help? How can we create all these interfaces that would be very extensively useful for you?” So I see it, at least, that one can tell a story in which these firms are much more symbiotically linked with the government, in which they innovated on top of government directives to figure out exactly how they can help.

So, for example, all of the mapping services from Tencent, Baidu, etc. putting in place very easily where the fever clinics are for people who may be sick, is that how much of that is exactly private initiative? How much of that is government support? It’s probably both, but it’s hard to disentangle where the line is.

Well, I guess… So, that’s the question. If they did work very well with government and they did respond very well, then why the sudden need to do more? And you were just on Odd Lots previously, and you’ve talked about that there’s lots of different things going on. It’s not necessarily one thing. The educational establishment is one thing. Video games are another thing, which may be connected to an extent, as far as family values go and whatnot. But then there’s also being on the board seat of Bytedance and on Weibo, and what happened with DiDi, and there’s all different stories that are explanatory to these, but the fact it all happened all at the same time, I think is what’s been very jarring to people on the outside.

And I think it’s understandable. You could be looking in or be an investor saying, “Okay, there’s too much of this.” Yes… I don’t want to parse every one of these explanations in isolation. What I see is this mass shift against the industry broadly, and why so much all at once, if things particularly were working rather well?

DW: That’s really the ultimate question. Why are they cracking down on so many things right now? Why did one of the biggest actresses in China disappear from the internet? Why is Beijing concurrently cracking down on men who like to dress as women? It’s kind of all very mysterious, and I would be the first person, always, to put up my hand and say, “I have no idea what’s going on in the mind of Beijing.”

But I think it is useful to try to figure out what we can explain and acknowledge what we cannot explain. And in terms of what we are able to understand here, I think I would say there are some things which the Chinese government had to be very reactive to, and there were some things that were much better planned.

So in the beginning, when all we had to work with were, first, the cancellation, or the delay of, Ant’s IPO in November 2020, and then the punishment after DiDi did IPO in June 2021, these were targeted actions against particular companies, and we had all been very nervous. Is this just about the entrepreneurs? Is it just about the companies? But paradoxically, I think, after a lot more regulations came out in July and August, I think we can be a little bit better assuaged that there is a bit more of a coherent program, even though we can’t understand all of it.

And so I think there are basically four big slogans that we have to keep in mind in terms of Beijing’s thinking. The first one I would cite is “Common Prosperity.” This is the big thing from the party leadership this year, to say that China should have an olive-shaped income distribution. According to Deng Xiaoping, it is okay for some people to get rich first, but socialism means prosperity for the entire people, and they’ve moved on to the second clause that there should be much less inequality in China.

Second slogan is building rule of law, which is something that Xi Jinping talks extensively about. That doesn’t mean that there will be Western-style rule of law, but it means that governments and agencies have to follow the central party leadership’s directives.

A third thing has to do with dual circulation, which is a very weird Chinese term. It means that they will have to still try to export as much as they can, but internally they really have to build up a functioning and competitive domestic market. And then there is something going on with family values and promoting population, because they realize they’re reading the same stories as everyone else, that China faces a looming demographic crisis, and they really have to encourage families to have a much more willingness to have more children.

So you have all of these things going on there. Each of them implicate the tech companies. This is sort of the political backdrop to what’s going on. And so I think that is something that we can identify a bit more of a coherent program that isn’t just about targeting particular entrepreneurs and particular firms.

The other part of what we can not yet explain are part of the social crackdown on actresses and men who prefer to look like women. One of the big uncertainties in my mind that I would cite is that we now a major new regulator to contend with. This is the Cyberspace Administration of China, the CAC, which has now asserted powers to block IPOs, to regulate financial media, to scrutinize algorithms, and this is kind of a new agency that is also a party institution. So it is both a state institution, as well as a party institution. Its director is a vice director at the propaganda department, which is one of the key party institutions, not just a government institution. And to what extent will we have to contend with a party directly regulating firms instead of state institutions, which everyone is more familiar with? That is a major uncertainty.

Your point that concerns are assuaged a bit that it’s not necessarily targeted, it’s more sort of widespread, I get what you’re saying on one hand. On the other, doesn’t that seem to be far more uncertainty? How would we know when an equilibrium has been reached? “Okay, now going forward, this space is investible, or is going to be stable,” or is that still unknown? We don’t know when that’s going to happen?

DW: It probably should trigger a broad re-rating of the entire sector, and I think that the question should be the depth of this rerating and not whether there is a re-rating. So yes, I agree that it’s not exactly assuaging everyone. To what extent this has really settled down to an equilibrium, no-one’s very sure, but I think at least our view is that people are prepared for new regulations now. They may be broadly too reactive, but everyone is thinking extensively about this.

My personal view is that there will probably not be actions like that which Beijing took against the online education firms, which decapitated the entire sector and said, “None of you can make profits anymore.” So I think the ferocity with which the Chinese government brought to bear on that particular sector, I suspect is unique. And it is unique because the Ministry of Education announced that it surveyed 17,000 firms, 500,000 children, 700,000 parents before it did something like this. It was a very well-extensively studied action, and I think that was a unique in terms of the scale. But now the question is a broad re-rating of the entire so-called tech sector in China, not so much, I think, on these actions that are completely unpredictable.

So one of the things that we’ve gone back and forth on, you’ve talked about this distinction between hard tech and consumer tech. And I think the first time we met was four or five years ago, I think we had this discussion even that at the time where you’ve been fairly skeptical of “Is consumer tech really on the cutting edge, as opposed to something like semiconductor manufacturing, or design, or whatever it might be?”

And I’m curious, because this obviously comes to bear in the combination of this crackdown, which by-and-large, or large parts of it, are on this end-user side of things. And obviously China, very famously, and in part in response to US sanctions is a heavy, heavy push towards, quote unquote, “Hard tech.” I’m curious to what extent is China getting it right because it’s the right thing to do, versus, is there a sense of like, “Yes, this is the way it ought to have been all along”? I’m just curious what your personal response has been. Is it gratifying, like, “This is the way they should have figured it out all along,” I’m just curious your personal response to that.

DW: Delight. I think that they are now focusing-

See, I knew it! I knew it!

DW: I think they’re focusing on the important technologies, and I’ve always been skeptical that consumer internet represents the very best of what our technologically accelerating civilization can do. I think one can make a better case for that in the US context, in which you have Google and Facebook leading TensorFlow and PyTorch, which are really doing the most in machine learning right now. You have Apple, which has become a major semiconductor company in its own right. You have Amazon, which has measurably improved the productivity of US retail, as well as having a cloud, which has enabled productivity improvements in a lot of other sectors.

I think there’s a weaker case to be made that Chinese consumer tech firms are actually doing a lot of technology. First of all, I would say that, if you take a look at just their annual reports, the Chinese firms, mostly Alibaba and Tencent, are spending quite a bit less on R&D as a percentage of revenue relative to Facebook and Google. So they’re just not spending quite as much. In its announcement that Alibaba would give away about $16 billion US dollars to contribute to government initiatives, the first of its five priorities is technology innovation, and I see that as a sign of acknowledgement that it has not done everything that it’s needed to do to actually do real technology. In my view, the case is weakest for firms like Tencent and Pinduoduo; having group buying of fruits and making a lot of video games, these are not to me, the peak of technological improvement. In my view, technology is still the hardest science-based endeavors like semiconductors, like going to space, in terms of aviation and chemicals. I love heavy industry, the heavier, the better.

You sort of neutered my response, I’m kind of annoyed at you, which was because I think you look back at technology over the last 15 years and you look forward to the next 15 years, and in the US sector, you see how mobile in particular has driven tremendous amounts of innovation in the hard tech sciences: miniaturization and sensors and processor improvements. And you look forward with AI and ML, because you, you reached this point with Moore’s law where the cost curve flipped — it used to be every time you went down to size, it got cheaper, but it’s gotten more expensive as of late, and that’s why, more and more foundries have dropped out, but what’s pushing it is Apple on one side, and then you have this tremendous need for processing density when it comes to artificial intelligence, machine learning on the other, and all of those are driven by and large by the US consumer tech companies.

And so maybe the way to square our points of view, because I think you just sort of acknowledged that is, is this more a factor where China is relatively-speaking in its technological evolution, because the US is sort of on the cutting edge, and so you need that forcing function of sort of consumer tech to drive these very expensive investments in things like three nanometers and whatever it might be. Whereas China still can’t make processors that are even remotely that complicated. And so on that side, because the path is known, they just need better direction along that path. Is that a fair way to sort of balance our two points of view?

DW: I love how well you’ve reconciled our views, and I think that’s a very good. So when you’ve cited me that in two or three posts in Stratechery the last couple of weeks that, these entrepreneurial firms which, I wrote in Foreign Affairs will be driving a lot of China’s tech progress going forward, I still haven’t seen that much of the tech crackdown, which has focused overwhelmingly on these internet platforms, they have not been ever in my view, the most crucial drivers for China’s progress. They’ll still buy a lot of servers, but a lot of the semiconductor development is going along with other firms.

I think one other angle to consider on this hard-tech versus consumer-Internet, is that I think when I was graduating from college, this has been true for quite a few years, a lot of the best and brightest from a lot of the most elite schools still want to go into consumer Internet as well as Finance. These are still the two most glamorous sectors. And I think, one of these things I perceive that the Chinese leadership has decided is that these are not where our very best and brightest ought to be going. Finance, which is very significantly zero sum in a lot of ways, consumer internet prompting, better noodle delivery, as well as video games, this is not where the best from Peking and Tsinghua Universities really ought to be going.

So I think sending these signals, crushing online education on the one hand, and then with the other hand dispensing favor to semiconductor firms, I see very much a real economy talent question here. And it is saying that we are not going to be quite like the US which has allowed its best and brightest into these fields that China rightly or wrongly believes to be fruitless, but it should really be pushing them into technologies that we consider important for salvation and national greatness instead.

So basically, the scarcity issue is not capital. There’s always been enough capital for every industry, especially in today’s world, the scarcity is talent. And that to your mind is the bigger concern of China’s leadership in steering as it were.

DW: That’s right. Steering is a very good word. And maybe you can consider the cryptocurrency crackdown in China as part of that path as well. Whatever your views about crypto, there are a lot of smart people that have jumped into that field now, and maybe the Chinese leadership has looked with horror as so many smart people are working on a technology that it doesn’t consider to be very useful. It wants them to move into aviation and chemicals and semiconductors instead.

Is it a problem for China that, and I don’t know how much this is connected, actually I’d love your view on how much this is connected, but that unicorn generation has sort of slowed dramatically. I think it was in 2018, china had nearly matched the US in sort of the number of startups that were achieving that status. But it’s absolutely plunged in the last few years, and I think over the last year it’s been something like only like 10 or 11, quite a low number. Is that purposeful? Is that an accident? Is that a good thing? Is that a problem? What’s your view on that?

DW: I suspect that they don’t consider it to be a huge problem. And I don’t know, to what extent this is.

Oh, is there a reporting issue too? Maybe people don’t want to be known as being big.

DW: Right. Well, if we take the data at face value, let’s say it’s correct. Maybe the argument could be that for a long while people have been saying in China that there’s no room for another internet platform. It is split between Alibaba, Tencent, Bytedance. Maybe you want to throw a Baidu in there as well, but it’s too much of a mature space. And so, maybe the best slant on this effort is that they’re very serious now about antitrust. And so what they want to do is to unblock some of these unicorns from being founded. I don’t have much of a view on that, but I think the argument can cut both ways.

Do you think that China undervalues founders, I think one of the things that concerns, and this perhaps is my American perspective from the outside, is the exit of someone like Zhang Yiming from Bytedance or Colin Huang from Pinduoduo. Maybe they’re not the most technologically savvy sort of company — although I would argue Bytedance is pretty compelling — but is there a sense where a few out the door, that’s okay. Not as many unicorns, that’s fine. I mean, I guess the reason I think about this, you sort of go back philosophically, you think about a sort of materialist view of history, a Marxist view is history, doesn’t seem to leave much room for the sort of founder sort of ideal. Is this just a fundamental philosophical incompatibility? Or am I sort of overthinking it here?

DW: Well, I believe last time we chatted, I accused you of being a Marxist. I’m really glad that I have the opportunity to do it again.

Now I have to flip to the other side!

DW: I think the big risk is that in this blunt, reshuffling of innovation and technological priorities, actually crushes a lot of entrepreneurial dynamism in the country. And that is absolutely a risk. I think we won’t know for maybe 10 or 20 years, when we actually see no Jack Ma’s on the horizon. And I wonder if this will be the case.

Now, I suspect that for the most part, I don’t think that this is going to stop everyone from wanting to be entrepreneurs, but certainly the Chinese government has been sort of spooked about that. It sent the vice premier in charge of the economy out to say we love private firms still. So the fact that it had to do that, is an acknowledgement that it has spooked too many people in the country, but I think the other way to look at this is that it’s possible that the crackdown on the entrepreneurs right now resembles something like the American attempt to reign in its robber barons during the gilded age, which failed to stuff out entrepreneurial dynamism in the following century.

At least so far, when I talk to entrepreneurial friends like mine, I ask them, “Well, does Jack Ma’s fate spook you?” They tell me they would love to have Jack Ma’s problems. The guy is spending most of his time playing golf and I think doing calligraphy, he’s still one of the richest people in China, one of the richest people in the world. I think a lot of this is about setting the rule so the political road. It’s absolutely a shame that entrepreneurs like Jack Ma can’t speak out in the way that they wish to, and I think this crackdown does reign in a lot of people who want to say things that as they see it, but I’m not sure that this actually crush entrepreneurial dynamism over a very long.

I guess I think about that scene from Arrested Development where they’re saying it didn’t work for them, how silly were they? But it might work for us! Is it really reasonable to think that China is actually going to strike the balance just right? I think even if you want to call back to various US crackdowns or whatever it might be, there was still, the rule of law. There was a constraint that was independent and separate from the entity doing the crackdown, whereas in China, the entity doing the crackdown is also the one making the law. What confidence do you have that China can actually strike this balance without this spiraling and going too far?

DW: It is a pretty material risk that they go too far, especially with the big guy in charge. I mean, he has tended to overreact more often than not. I think the other model that I take is that the Chinese have known how to make money for thousands of years.

Yes.

DW: And they are very good at least being petty entrepreneurs and figuring it out.

It’s well-known throughout Asia. It’s I think an underappreciated cultural reality that is well-known in this part of the world, but I think is less known in the US.

DW: I live in Shanghai and I previously used to live in Beijing, and one of the characteristics I find of Chinese is that they’re absolutely irrepressible. You can impose 1,000 rules on them and they’ll figure out 1,001 ways to get around them, and this big guy is trying to teach them, “You actually have to listen to what I say.” But still, I think there is too much dynamism and this society to really rule out by diktat.

One of the things that’s been very weird for me over the last, I would say year or so, is I’ve lived in Taiwan for a very long time. The sense of a Chinese threat has been omnipresent. It’s one of those things that’s just in the water, as it were. It’s always been a threat. I’ve always been much more cognizant of it than any of my friends in the US who thought Taiwan was Thailand. And then suddenly, over the last six to 12 months, the people in the US have gone from zero to 100 on the issue. It’s like, “Oh, China is actually invading tomorrow.” Now I feel like I’m the opposite side where I’m like, “Whoa, let’s put the brakes on a little bit here.” And I feel that here, where people in Taiwan are just so used to it, the water could very well be boiling around them, they don’t even realize it because they’ve already grown accustomed to the threat and are actually undervaluing the increase. I don’t know the answers to these.

I’m curious, your perspective. How much of a threat is there, do you perceive? Is it something where people in America just look at a map and overreact? Or do you think there’s been a material change in circumstances?

DW: I think DC tends to overreact to all sorts of things. And I think it has also been a bit of a material change in circumstances.

Yeah. That’s what I think.

DW: I guess what I don’t see is a trigger that reunification needs to take place anytime soon, right at this moment. I think this is a long-term issue for the party to solve, but I don’t think that’s how they need to do it in the next six to 12 months.

Well, in six to 12 months, I don’t think so either. What is the timeline, if any? And what do you think are the deterrents? Is it a lack of Chinese capability? Is it US military capability? Or is it economic sanctions? I think one of the interesting takeaways from the Trump-era sanctions is that the US barely felt them. And I think they were felt much more strongly in China. Was that a little bit of a wake up call about the relative sting that could happen if something like that were to go down?

DW: I think that’s part of it. Now, I’m not a military analyst, but I think one of the things that I do think about a lot are semiconductors. One of the most common questions I’ve had in the last couple of months is, will Beijing attack Taiwan to seize TSMC? And this has always been one of the silliest points to me. I think certainly not, because these $15 billion dollar fabs are highly sensitive in a conflagration, I think there’s no way to actually keep them safe. The Taiwanese, can just credibly threatened to sabotage these fabs, and then fly out only one plane load of engineers, and these fabs cannot function. I think that China knows that if it ever attempted on such a thing, neither Taiwan nor China actually manufactures the semiconductor production equipment like Lam Research, Applied Materials, ASML. And China would be facing sanctions six ways to Sunday if it actually tried to make this type of attempt. So rather than advancing China’s interests in the least, at least when it comes to semiconductors, this would set back China in a huge way. Again, since I don’t see that semiconductors are not really the trigger here, I’m not sure I can identify why anything needs to happen in any sort of a truncated timeline.

I don’t know if it makes me feel better or worse that I basically completely agree with you on those points. I mean, maybe we both have a blind spot, but I’m with you I think, on the TSMC point in particular. What is a reason for optimism, particularly in the US-China relationship? Everything seems pretty dour. If you were in charge of this relationship, particularly from a US perspective, what would your approach be? And the good thing is there doesn’t seem to be an approach right now. So there’s an opportunity just to plant some seeds here. I mean how would you deal with this situation going forward?

DW: I spend most of my time thinking about the US-China relationship now, Ben. My conclusion is the future is bad. Bad and weird. And I just don’t…

I tried. I tried to pull something out.

DW: How do I get very optimistic about this? It is pretty difficult. At least in the short term, what I feel is that neither side wants things to get much worse. But at the same time, neither side is able to do the hard work to make anything better. Maybe the only plausible area of cooperation is something like climate, but it doesn’t seem to be going particularly well on that front. And so, just in general, everyone that I talk with, in terms of people who think about US-China, it’s always, “We’ve gotten more gloomy than in the past.” And so, it’s a never ending pit of horrors.

Does that make any difference really, to US tech? I mean, is it more, just, oh, look at what’s happening over there? And because the great firewall never allowed a significant level of integration, that it’s almost weird. Because the US-China relationship is so weird, because unlike the US and USSR, we weren’t building stuff in the USSR. The manufacturing integration makes this relationship really weird.

But on the tech side, it’s like the USSR situation where there’s just two different worlds. There is literally just completely different ecosystems, not really much integration. And so, in the long run from a tech perspective, does it really make a difference either way?

DW: Well, Ben, that’s very biased towards consumer tech in the areas that I’m mostly thinking about.

I set you up for that. Yes.

DW: First of all, Apple, I think is one of the big exceptions that employees millions in China at its peak to manufacturerall sorts of products. But if you take a look at the semiconductor companies for Qualcomm and firms like Broadcom, almost two thirds of their revenues are generated in China. A lot of that is put into products and then we export it. But still, China is a very big end market for Nvidia, AMD and Intel. It’s about 20 to 30% of their revenues are generated in China. And for the equipment makers, it’s around 20 to about 40% of their revenues are generated in China.

And so for everything outside of consumer internet, the relationship between China and the US are enormous. The US directly exports around $200 billion of goods to China every single year. But that’s actually really dwarfed by the amount of sales that US multinationals make in China. If a Nike shoe is manufactured in China and then sold to a Chinese consumer, that’s booked as a sale. And the figure there, according to the bureau of economic analysis, is $600 billion. $600 billion of sales by US multinationals in China, plus $200 billion of US direct exports to China, it’s close to a trillion dollasr of economic relationship every year. And that’s what’s at stake for a lot of the US economy. It’s just the consumer tech field that is relatively insulated.

All right. Fair enough. You got one over on me at the end. And fairly so, fairly so. It was good to talk, Dan. If things keep evolving at the rate they are, you might be on even sooner for episode number four.

DW: Looking forward to it, Ben. Thanks.

All right. It sounds good. Talk to you later.

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From the Economist this morning...

The share price of Tencent, one of China’s tech behemoths, plunged after a state-run newspaper lambasted computer gaming as “spiritual opium”. The Economic Information Daily later deleted its story, but investors worry that gaming could become the latest front in the Chinese Communist Party’s crackdown against China’s big tech firms, which it fears are becoming too influential.

I've been a long-term holder of ASIA and have bought a little more as the price has come off due to the Chinese government interventions.  I think we may continue to see unpredictability from the Chinese government but long-term see these companies generating value - and the ETF is also balanced outside of China.

I found this an interesting read from livewire... https://www.livewiremarkets.com/wires/a-rare-buying-opportunity?utm_source=bell_direct&utm_campaign=Trending%20on%20Livewire

For those unaware there was a market storm in China over the last week or so which brought the usual mix of challenges and opportunities in what was the steepest sell-off for these names since September 2008.

A regulatory crackdown that began with the chastening of Jack Ma and the cancellation of Ant Financial's IPO broadened to include many of the technology companies favoured by international investors.

Alibaba and Tencent will need to open up their closed ecosystems to both each other and competitors. Didi (Chinese Uber) had its app pulled from app stores shortly after IPO, landing major shareholder Softbank and its new US investors an immediate bloody nose. Internet monopolies are under attack across the board, and on-demand/delivery/ride-sharing firms will have to provide minimum wages, working conditions and social security, and 

And most dramatically, Chinese tutoring companies will henceforth be non-profit, which came as something of a shock to shareholders (though not to management, who was briefed well in advance). 

One US-listed company has gone from $38 billion value to <$1b in equity value in the space of a few months, quite a shift in fortune.

The US has announced a freeze on Chinese IPOs and capital raisings until risk disclosure improves, which means venture capital sunk into China relying on such an exit is now effectively frozen. 

Amidst the chaos, confusion, and changing rule-book, we believe last Wednesday marked something of a bottom in these stocks and presented a rare buying opportunity.

We always like to buy into panics, and startling though these moves are, there’s a certain kind of social logic which suggests they’re not nearly as scary as they seem at first. 

Tutoring

Let’s take tutoring first. This was one of the hottest sectors in global venture capital, with valuations topping $100 billion in aggregate with over $10 billion committed in the last year: 

This is a large amount, even by modern VC standards.

The tutoring companies focused on the Gaokao, the end of school examinations offering a small percentage of students access to the country’s leading universities - a merit-based tradition going back millennia. 

In a country where most children are only children, this puts immense pressure on children... and their parents, a situation ripe for advertising, which apparently is ubiquitous in Beijing and is a major social issue.

Foreign investors profiting from the situation clearly did not sit well with Chinese officials hoping to increase the birth rate. And so Xi struck back. 

As it turns out, all these moves were flagged well in advance in President Xi Jinping’s own speeches, though it’s a lot easier with the benefit of hindsight to see the signal amongst the noise (we missed this):

From a speech by Xi Jinping

My guess is this won’t change the real issue causing so much angst, namely, an ultra-competitive academic system that rests on one deterministic set of exams. But this kind of system is as much a strength as a weakness as anyone who’s competed against the Chinese academically can attest. 

The boldness of converting an industry into non-profit is impressive, but I do have a certain kind of sympathy for the idea that society shouldn’t outsource a major component of what should be social welfare to the corporate sector. 

Antitrust

A second issue is antitrust, for reasons highlighted in state media:

Existing valuation models have indeed been refashioned!

This is actually quite reasonable stuff. 

Alibaba and Tencent operate separate ecosystems and, with some exceptions, lock out both each other and any non-aligned startups, who are typically forced to choose between one or the other. This will now end, and both firms, as well as new ones, will be able to compete on each other’s platforms.

Alibaba was also in the habit of forcing manufacturers to sign exclusive agreements, blocking them from selling on competing platforms. No more.

These changes represent a significant opportunity for both, but a more competitive environment will clearly be less profitable in total, certainly compared to the current duopoly. In the long term, the benefits of increased competition and innovation will likely create more value, though not necessarily for the same companies. 

Coincidentally, Australian industry structures often end in duopolies though for different reasons, namely we have a small market that can only support so many large businesses (let me know if you have a better explanation). Think Woolworths and Coles, Qantas and Virgin, Rio and BHP, etc.

The crackdown on monopolistic behaviour is broad, and also targets companies running at losses to gain monopolies, only to turn around and abuse that power, which is the modus operandi of much of the venture capital industry: win the market first then raise prices later.

Again, it's hard not to have a certain amount of sympathy for these regulatory moves. 

The winners from breaking up the dual monopoly structure of Tencent and Alibaba are consumers and the broader ecosystem. 

VC is taking the brunt of the hit, firstly by direct losses in education and firms like Didi, and secondly for the likely freeze in capital markets. But long term, this will create more, not less, opportunity for the kinds of startups they like to back.

There are plenty in the West that think Google should split from YouTube, Amazon from AWS, and Facebook should be forced to open up its social graph to new competitors which would foster a new round of startups and innovation and leave us all better off. 

The power of China is that when they say they will do something, they can just, like, do it. In the West, there are strict legal limits on how far regulators can go (for very good reason). 

Without going deeper along that tangent, it’s clear that when you dig into these changes, they are surprisingly reasonable. 

Didi

The attack on Didi right after its IPO seemed outrageous. But as the facts came out, the real surprising thing is that the IPO went ahead at all.

Didi is particularly guilty of that monopolistic behaviour, and has seriously irked Chinese consumers by charging higher rates to the elderly. As far as I know, even Uber hasn’t stooped that low.

Curiously, Didi’s Chinese shareholders, Alibaba and Tencent, reportedly warned Didi not to list, which suggests the pressure came from Softbank and Masayoshi Son, who has sunk $12 billion into the business and lost maybe five. 

And what a strange investor he is, amassing an immense fortune by being ultra and unwaveringly bullish about technology, so much so that he gets away with mistake after mistake. One can only imagine what he would have achieved if his boldness and optimism were matched by other talents… 

Despite nearly 90% market share, Didi is still loss-making. 

We generally shy away from companies that are loss-making after reaching user saturation which is why we consistently avoided investing in Spotify, which listed too late in its life cycle to be interesting to us. It is a case study in customer love, but has no explosive growth… and we need both. 

A company milking an existing, locked-in customer base, is not really what we want to see. 

And neither, apparently, do the Chinese regulators. 

Pinduoduo

Pinduoduo does look like a loser here. Its success is one of the reasons it is now under pressure (the shorts were negative on the company for very different reasons, so those of you reading this don’t gloat!)

One of the many aspects of the story missed by offshore investors was the relationship with Tencent. 

Pinduoduo used WeChat’s user graph to virally sign up hundreds of millions of customers in a few short years. But now WeChat will now be opened up to Alibaba’s copycat version of Pinduoduo, which will no doubt be a fierce - likely loss-making - competitor. 

Before this, the company was going from strength to strength. Their focus on primary produce is unique and they are expanding this model to South America. The stock has repriced, but from here the risk/reward seems good. This is still, after all, a company which just posted 161% revenue growth.

Analyst estimates for Pinduoduo have been rapidly revised upwards over the last year.

Interestingly, after one of the worst periods on record for Chinese stocks, Pinduoduo is still up ~4x from when we first started buying, which shows the power of an ultra-high growth strategy: a lot can go wrong, but if you hold for 2-3 years, you can still make money. 

With companies growing this fast, every day that goes by works in the fund’s favour.

So where are we now? 

We increased our exposure to Chinese technology companies (they are mostly <3% positions) in the middle of last week for a few reasons. 

Firstly, market sentiment reached levels in line with the panic of September 2008 and March 2020. 

I’m always impressed by the market’s ability to throw up new sets of circumstances that rattle everyone, and make the ardent long-term investors panicked sellers. 

This time was different and has its own set of calculations. Politics trumps markets and the Chinese regulators displayed their power to wipe out industries with no recourse. Sensible people running multibillion dollar funds have publicly questioned the very nature of equity investments in the country and whether they are investable at all. Valuations will likely carry a regulatory discount for quite some time. 

Nevertheless, we will always instinctively look to buy when we see panics and steep sell-offs like this. But this alone is not enough. 

Secondly, and more importantly, there are clearly articulated reasons for the crackdown, the majority of which we have a lot of sympathy for. 

Extra competition and fostering innovation at the grass-roots is good. Mega tech companies can and do stifle competition and innovation. Until the details came out, it was not clear whether these moves marked a complete change of political direction. 

As far as I can tell, they seem to have both public support and be in the public interest. 

Tencent and Alibaba should compete, ridesharing companies should pay minimum wages and offer more to workers, and education should probably be in the hands of the state. 

While there is method to the madness, we don’t seem to be as scared as everyone else. 

Thirdly, market prices stabilised quickly in industries that were not targeted by the crackdown, fitting this view. Most of these firms are still largely owned by Chinese, who have early warning of trouble. Price action in tutoring companies was horrific over the last six months. 

Beigene, the leading Chinese biotech company wtih a number of best-in-class cancer treatments, and electric vehicle makers like Nio and Li Auto, have traded extremely well throughout this period. These sectors are in line for more support, rather than less. 

Beigene stock has been resilient in the sell-off

There is a fashionable line in Western circles that China wants less value accruing to internet platforms and more to hard-tech industries associated with manufacturing and defence. 

There’s almost certainly truth to this, but some of the leading commentators we follow on the ground see this take as an oversimplification. Supporting the consumer is still a key plank of the Chinese strategy.

Another reason for optimism, taken again from market price action, is that the US announced a freeze on Chinese listings and capital raisings. Markets reacted with a shrug, and many Chinese equities rallied. 

A couple of weeks ago such a move would have triggered a severe sell-off. So this marks a clear change in market reaction to bad news, one of the more reliable indicators of market turning points.

Fourthly, valuations have come right down to where they were the last time the Chinese cracked down. It’s worth noting Alibaba increased several fold from those lows in January 2016. The last five years flew, didn’t they?

This chart, put together by Goldman Sachs shows PE bands, ie what PE is indicated by certain prices. The idea is to buy at historic PE lows, and lighten up at the highs.

The multiple compression in Alibaba has been significant over a period of strong execution. At some point in our lifetimes, we suspect a similar fate for richly valued tech companies in other parts of the world:

Nevertheless, even after a dramatic sell-off returns to long term investors have been solid, even after the drawdown, which is another indication of the risk-mitigating power of a multi-year outlook:

Alibaba share price

Finally, and perhaps most importantly, on Wednesday before we added to our positions, editorials in leading state media gave strong signals of support for markets and companies that list in offshore jurisdictions. 

The regulator summoned leading foreign investors to give soothing messages of support which were backed by state owned media.

As another example, as I was writing this editorial came out a few hours ago (edit: Sunday 1 August 2021) from Xinhua:

This about-turn by the regulators was the final signal we needed to increase our positions. 

Political risk is not solely in the hands of the Chinese. US tech companies also come with their own set of political issues which wax and wane. 

Think of the handful of social media tycoons, who abetted Trump’s rise in 2016, then more recently, silenced him, giving cause for those of all political stripes to ponder: how much power exactly should rest in the hands of our internet overlords? 

The Chinese have given their answer, and also, coincidentally, a buying opportunity for foreign investors. 

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