Is capitalism just a phase? China struggles with the math

Global investors are shocked to have discovered that China is run by Communists. Shares of online education companies collapsed last week after the government all but outlawed the industry, and internet behemoth Tencent Holdings Ltd. shed more than $50 billion of value at one point on Tuesday after state media declared electronic games to be "spiritual opium." China's leaders are making abundantly clear where they stand on the tension between private profits and social wellbeing. These sudden regulatory shifts have thrown asset managers across the world into a frenzy of effort to understand and explain how prospects for investors in the second-largest economy have changed.

The most lucid and logically coherent explanation also happens to be the simplest: Take China's Communist Party at its word. For decades, foreign investors have told themselves a comforting story. China was no longer truly Communist, after late paramount leader Deng Xiaoping embraced markets in the late 1970s and kicked off the country's spectacular economic rise. The wealth and growth generated by capitalist techniques had converted the government and people. While the ruling party continued to wrap itself in the rhetoric of Communism, its members knew they were paying lip service to a bankrupt ideology, or so the thinking ran. The era of such creative ambiguity is over. With a true believer holding the reins of power, there can be no doubt that China's rulers mean what they say.

How much does this matter? Communist or not, China has no intention of abandoning capital markets. Having helped to bring the country to the level of a "moderately prosperous" society, markets will play an important role in driving development forward to higher levels of affluence and technological achievement. And that inevitably implies opportunities for investors. The difference will be a greater willingness than in avowedly capitalist countries to intervene to secure socially desirable outcomes, such as steering parents away from a wealth-and-energy-sapping educational rat race or discouraging children from playing Honor of Kings for eight hours a day.

Is this really so dissimilar to market regulation in Western democracies? Capitalism is subject to constraints everywhere. And the Chinese government's declaration that training institutions teaching the school curriculum should be non-profit mirrors a perennial debate in capitalist countries over the appropriate division between the state and private economies. Take healthcare, where commitment to free-market principles has seen the U.S. keep provision mainly in private hands while most developed countries have opted for state-provided universal systems.

Then again, regulators in developed democracies don't generally abolish a $100 billion industry overnight. The contrast probably seems quite stark to shareholders in U.S.-listed New Oriental Education & Technology Group or TAL Education Group, which both had lost more than 90% of their peak market value by last week's trough, following the government edict. Investors may reasonably have considered that companies allowed to sell shares overseas and operate for years unmolested (New Oriental was listed in New York in 2006) were legitimate businesses in good standing with the state. Tencent, whose shares pared losses Tuesday after an online link to the gaming critique was removed, has waved goodbye to almost $400 billion of value this year amid a wider regulatory crackdown on China's technology industry.

It's not simply a matter of China's autocratic system giving officials more sway to enact draconian regulations at short notice — a capacity that some Western consumers may actually envy when it comes to cutting back the overweening dominance of internet titans (besides Tencent, Alibaba Group Holding Ltd. has lost more than $300 billion of market value from its peak). The distinction exists at a deeper, philosophical level.

Matthew Brooker. Illustration: TBS

Chinese Communist ideology declares that capitalism is a stage human society will pass through, to be replaced by socialism and ultimately communism. This idea goes back to the writings of Karl Marx, who claimed to have discovered the universal laws governing human history. Having been relatively poor and backward prior to Deng's "reform and opening up" era, the Communist Party decided it had been wrong to try to leap straight into the stage of communism, and needed to pass through capitalism first. But, crucially, capitalism is still only a stage. The party's leaders are the architects of the future, there to look beyond this phase.

Markets, viewed through this metaphysical lens, are mere tools to be deployed as needed by the shapers of history. That's a contrast with capitalist countries where markets and the laws that govern them are regarded, often with reverence, as something outside of ourselves, to which participants have no choice but to conform. "You can't buck the market," in the words of the U.K.'s free-market priestess, Margaret Thatcher.

This dichotomy implies some differences in behavior by China — such as, dare we say, unilaterally declaring that successful industries employing tens of thousands of people shouldn't exist, at least as for-profit entities listed on foreign stock markets. And then hastily convening talks with investment banks and fund managers to try to limit the damage once the fallout has spread to the rest of the market.

The market reaction was entirely rational, and predictable. Equity value can be viewed as a function of dividends (or cash flows), growth and the required rate of return. The higher the return that investors demand, the lower the value. The "equity risk premium" is a nebulous concept to pin down numerically, but the logic is clear. The higher the risk of a company or market, the higher the return that investors should demand to compensate them. A market that suddenly erases an entire industry's profits is, ipso facto, riskier than one that doesn't. In that light, investors were right to mark down Chinese equities relative to other markets.

Marx's universal laws of history may have the last laugh; it's too early to tell, as Zhou Enlai is reputed (wrongly) to have said about the French Revolution. In the meantime, the laws of mathematics are proving quite immutable, too.