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China's Internet Regulation: Fewer Surprises, Not Zero Surprises

China's internet sector has emerged from its regulatory shakeup. Policymakers are signaling support and seem done with big legal changes or sweeping actions. The period of big surprises is likely in the rear-view mirror.

Yet changes made will not be unmade. S&P Global Ratings believes operating conditions are forever altered. Stricter enforcement of China's anti-monopoly law means that internet companies will need to invest in their core businesses and perhaps selectively in new businesses to ensure they are not disrupted. And social media companies may need to spend more resources on content moderation to control regulatory risks.

We hold to our view that the Chinese government is looking to strike a balance between growth, social stability, and security (see "China Internet: Navigating A New Regulatory Landscape" published on RatingsDirect on Aug. 2, 2021). Some calibrations are likely in offing, one example being this year's government purchases of stakes in large internet firms ("golden shares"). Compared with the turmoil of 2020-2021, regulatory clarity and stability is stronger.

Frequently Asked Questions

Regulators have softened their tone toward the internet sector. What does this mean for the outlook?

It's a sign of support. Such verbal signaling often herald changes in regulatory behavior. For example, at the Chinese People's Political Consultative Conference in early 2022, government leaders committed to supporting the "healthy" development of the internet-platform economy. Fewer negative regulatory surprises have ensued since (see table 1). Furthermore, online game approvals restarted in April 2022, after an eight-month hiatus. The number of approvals per month has notably increased since last December.

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So is the next step regulatory easing?

No. If anything, we expect more regulatory actions well into the foreseeable future, particularly around data security and content moderation. But the scope for surprises should be significantly diminished and they shouldn't result in significant operational challenges, as occurred in 2021.

In our view, companies will adjust their business practices to align with stricter enforcement of anti-competitive rules. Many of the regulatory actions were geared toward such behavior. For example, in July 2021, Tencent Holdings Ltd. was fined for its previous acquisition of China Music Corp., as well as some other old M&A deals. As a result, large internet companies will likely curtail their M&A activity, particular of potential competitors and innovative start-ups that could one day disrupt their market. This has competitive implications for companies such as Tencent or Alibaba Group Holding Ltd.

How does the "golden share" system work, and what's the implication for internet companies?

A golden share grants special voting rights in certain specified circumstances. It is often held by a government or government-related organization, to enforce control over privately owned companies. For China's internet sector, the policy is primarily focused on onshore, media-related operating entities rather than the whole group. The goal is content moderation and not controlling the group's operations or strategy. The enhanced voting rights enable the government to be more directly involved in monitoring content and setting content policies.

The issuance of special shares to the government isn't new. For example, Weibo Corp.'s Weimeng issued 1% of share capital to the government-related entity ZhongWangTou (Beijing) in 2020 (see chart 1). Weimeng is Weibo's onshore variable interest entity (VIE) and holds the company's internet content provision license and online culture operating permit. The special shares granted ZhongWangTou one out of a total of three board seats. It also granted veto rights over matters related to content decision, as well as future financings of Weimeng. We think the latter is most likely related to preventing change of ownership on licenses held by the VIE.

Chart 1

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We expect limited incremental changes for business operators due to golden shares. This is because over the past few years, the leading internet companies have already been allocating more resources to manage content on their platforms. More content control via such stakes might also prevent large fines or penalties to the companies.

In January 2023, reports indicated the government purchased golden shares in a unit of Alibaba and was planning to do the same for Tencent. These entities account for immaterial portions of their group revenue or cash flows. With regard to Alibaba, certain entities under its new Digital Media and Entertainment business group are most likely to be the focus of the government's interest.

Is Alibaba's business reorganization a response to anti-competitive sentiment among China's regulators?

We doubt this was the prevailing motivation. Alibaba's recent reorganization into six independently managed businesses likely stems from a strategy to optimize cash flows, funding, and profitability of its six businesses. There could be an added benefit of addressing some of the government's concern around large internet companies by loosening the control over some business segments.

Other leading Chinese internet issuers already have similar structures, such as JD.com Inc. Such structures can facilitate IPOs, thus deepening financing options. Tencent, for example, has listed some of its business arms, such as Tencent Music Entertainment Group.

In Alibaba's case, setting up boards of directors and increasing the independence for each business unit should in theory drive more efficiencies and cost savings. Businesses that have historically relied on cash flows from the major e-commerce platforms--Taobao and Tmall--will need to work harder to justify loss-making projects. Additionally, incentive programs designed for each business unit (management compensation, share compensation, etc.) could push more of a "eat what you kill" mentality across the individual organizations.

Chart 2

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Nonetheless, we see longer-term risks with this business structure. Such structures could incentive each business unit to be near-term focused on improving profitability and cash flows in pursuit of an IPO, rather than investing for the long term. If not managed well, some innovative businesses could be sacrificed at the margin to shore up profitability. This could lead to a weakening of Alibaba's competitive positioning over the long term.

Is regulation the key driver of changing competitive dynamics?

No. That's only part of the story. Greater competition is coming from two fronts.

The first is a natural occurrence as existing markets get closer to maturity. In the search for new growth drivers, China's internet companies are increasingly getting into each other's domains and exploring new segments. As once example Tencent launched Weixin Video Accounts to compete with short-form video platforms. Multiple platforms are expanding into the community group buying or fresh food delivery.

Chart 3

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On the other hand, the more stringent enforcement of anti-monopoly laws and anti-competitive behavior gives smaller competitors and disruptive startups more room to grow. It's harder now for industry leaders to acquire smaller competitors to strengthen their own market positions and reduce competition. Larger internet companies therefore may need to simultaneously continue investing in their core business, while developing new opportunities organically (as opposed to acquiring potential disruptors once a successful business model has been determined).

Which business segments are most exposed to regulatory risk around content moderation?

We see moderately higher risks for social-media platforms, where user-generated content is more common. This unscripted content is usually delivered in short-form videos or microblogs such as those from Weibo.

We expect authorities will continue to implement rules or measures to censor social media content and manage cybersecurity risks, and communicate closely with the industry. Leading social media companies will stay responsive to new regulatory dynamics. This should help mitigate risks but also entails somewhat higher costs as they exert more effort to monitor and manage the posts and activities on their platforms.

Platforms that rely on professionally generated content--such as long-form video, online games, or online music--face less regulatory risk. These companies have more control over the content and regulators have already established control around such content, as evidenced by the resumption of online game approvals.

In a nutshell, what are credit implications of current internet regulation mood in China?

Incrementally positive. We think greater regulatory clarity outweighs the credit negatives of greater competition and content-related risks.

Rated Companies: A Synopsis Of Their Regulatory Risks And Conditions

Weibo Corp. (BBB/Stable/--)  : The government's tightening control on online content and data privacy will be an ongoing issue for Weibo. This is given the high exposure of micro-blogging platform to user-generated content. That said, incremental risk should be manageable. The company has a track record of adapting to new policies. We do not expect significant fines or penalties on Weibo that could materially hurt the company's operations or dilute its financial buffer. Meanwhile, Weibo's focus on brand advertisements and the intensified competition from other social-media platforms could lead to below-peer recovery in advertising revenue this year.

Tencent (A+/Stable/--)  : Tencent has managed regulatory risks well over the years, with minimal regulatory fines and actions taken against the company despite its size as China's largest online games company.

However, the fast growth of Weixin Video Accounts, Tencent's short-form video platform, and its revived pursuit of fintech-related businesses could create regulatory hurdles. Tencent's online advertising and games business is likely to be a big beneficiary of China's economic rebound in 2023 and the recent normalization of game approvals. This after falls in revenue over 2021-2022, partially affected by regulatory actions taken against online education, insurance, and games sectors.

Alibaba (A+/Stable/--)  : Regulatory risks around Alibaba's e-commerce businesses are likely behind it following the large fines incurred in 2021. This is given already intense competition in e-commerce, particularly from Pinduoduo and JD.com. Moreover, e-commerce is less content-focused. The company's recently announced reorganization could also help address some of the authority's antitrust concerns and somewhat ease regulatory pressure. That said, Alibaba's growing live-streaming revenues could lend itself to more regulatory scrutiny.

JD.com (A-/Stable/--)  : As a retailer, JD.com is less exposed to regulatory risks than peers. JD.com competes with the giant Alibaba in e-commerce and it's unlikely that JD.com can match Alibaba's user base. This would require much larger investments to reach lower-tier cities, which we don't think will be economically productive. Meanwhile, JD's growth could slow in 2023 as offline retailers regain traffic with improved mobility in China.

Meituan (BBB-/Stable/--)  : Regulatory developments in 2023 should be incrementally constructive to China's largest food delivery platform Meituan. New policy directives on fees to merchants and riders' compensation have decelerated in the past 12 months. For example, fee cuts were less severe than widely expected. The company has also been able to delay implementation of paying social security for food delivers.

China's tightened antitrust regulations to restrict unfair competition should reduce cash burn among the major participants in community group buying (vs. Pinduoduo Inc.) and in-stores (vs. Bytedance Ltd.'s Douyin). This could alleviate some pressure on Meituan's margins.

Tencent Music Entertainment (TME; A/Stable/--)  : We believe a further step-up in regulations for online music is unlikely. In 2021, authorities demanded TME stop stalling and the elimination of exclusive music licensing. This has increased competition and reduced TME's music-library advantages. In addition, TME's live streaming business has lost some traction from users due to the rise of short-form video platforms.

TME maintains a large and interactive user base and should be able to manage the risk from competition and defend its market positioning in this highly penetrated online music sector. This could be met through continued investments in music-related content to further enrich its music library, development of new features and products and diversification of its monetization methods by growing its advertising income.

Editor: Cathy Holcombe

Digital design: Tim Hellyer

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Cathy Lai, Hong Kong (852) 2533-3569;
cathy.lai@spglobal.com
Secondary Contacts:Clifford Waits Kurz, CFA, Hong Kong + 852 2533 3534;
clifford.kurz@spglobal.com
Aras Poon, Hong Kong (852) 2532-8069;
aras.poon@spglobal.com

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