Good evening.

I'm William D. Cohan, the author of six books and a former M&A banker. Welcome back to Dry Powder, my private email about what's really happening on Wall Street.

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In the meantime, please enjoy this free preview of Dry Powder, regarding my conversations with China experts about how Wall Street is responding to Xi's sweeping "regulatory crackdown" in China—and what Washington gets wrong about Beijing.

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“The Unknown Unknowns Have Increased”: Wall Street Ponders the China Conundrum

Serious China watchers fear that businesses have underestimated the gravity of Xi’s “regulatory crackdown”—but privately worry that Washington isn’t responding with nearly enough nuance. “It's impossible to decouple,” warns one China expert. “[You] can't afford to not be there.”

In a September research report, the mighty Goldman Sachs asked the important question: “Is China Investable?” By this, Goldman wasn’t necessarily thinking about retail investors. Instead, the firm was hypothesizing about the risk tolerance for the companies that it specializes in advising, and raising capital for, around the globe. Should they still feel comfortable doing business in the country?

It’s a question that many on Wall Street are pondering these days. “The known unknowns and the unknown unknowns have increased,” explained one very senior Wall Street executive, echoing the late Donald Rumsfeld’s famous expression. We were speaking soon after the United States, Britain, and Australia agreed to a nuclear submarine deal designed to countermand China’s increasing military presence in the South China Sea (and one that also pissed off France). “That’s sort of a direct acknowledgement that  portions of the Western world [believe], ‘You know what, we have to begin to counteract China’s intrusion into Southeast Asia, the Middle East and Africa, put aside Taiwan,’” he continued. (We spoke just before China buzzed Taiwan with some 56 fighter jets during a fraught couple days.)

The problems that companies face in China these days go well beyond whether Evergrande, the Chinese real-estate giant, defaults on its $300 billion in debt. What is more worrisome, those on Wall Street seem to agree, is the “regulatory crackdown,” as one investor put it in the Goldman report, upon which the government of China’s supreme leader, Xi Jinping, has recently embarked. “This isn’t business as usual,” George Magnus, an associate at the China Center at Oxford University, told the Goldman Sachs researchers. 

Magnus, who is also the author of Red Flags: Why Xi’s China is in Jeopardy, cited a variety of recent events for his growing concerns. Since Xi was “heralded as a closet reformer” at the 18th National Party Congress, in 2013, he said, “real and market-oriented reform in most areas has ground to a halt.” Recently, there has been the cancellation of the Ant Financial I.P.O. and the post-I.P.O. investigation of Didi, the Chinese ride-sharing company, which has caused its stock to fall nearly 50 percent since it went public in the United States at the end of June. Many have interpreted the post-I.P.O. investigation of Didi as a form of retribution against the company for listing on the New York Stock Exchange. And we’re not even talking about factoring in the fate of the million or so Uyghers that China has been busy disenfranchising. (“We care [about the Uyghers],” the senior Wall Street executive said.)

Chinese regulators have targeted certain sectors of their economy for reform, including internet platforms, education, gaming and real-estate. “In recent months, the Chinese government has embarked upon a regulatory tightening cycle unprecedented in terms of its duration, intensity, and scope,” the Goldman researchers noted. Since February, Chinese stocks have lost more than $1 trillion of value, and now have a total valuation of around $7.5 trillion, down from around $10 trillion a year ago. According to an estimate by Siblis Research, the total value of the publicly traded companies in the U.S. was nearly $47 trillion at the end of June.

Close observers of China, such as Magnus, are worried. In the report, he said Xi’s recent initiatives “reflect a discrete break from the last 20 to 30 years, and—if anything— suggest that China is turning back the clock to a more Marxist-Leninist system of governance with conservative morals that we thought it had left behind a long time ago.” The moves, he suggested, represent a return to the Chinese Communist Party’s “centrality” in the country. “North, south, east, west, the party leads everything,” as Xi once said. Magnus suggested that Xi is at the beginning of “a broad campaign” to bring China’s private sector “to heel” and to reinsert the Party at the “vanguard of leadership” in “all realms of economic, social and political life” and “people and firms need to align their interests with it.” 

In the report, Magnus noted that he has dismissed the argument that China’s “regulatory crackdown” is overblown—a refrain generally made by those who point out that it appears to have ensnared merely “frivolous technologies” (such as video gaming, ride-sharing, and streaming services) and spared high-tech innovation, such as artificial intelligence and quantum computing. “I’m not sure that regulating consumer technology won’t be harmful,” he continued in the report. “Things like Apple watches and Xiaomi telephones fulfill a very important role not just as products, but through the processes companies use to produce them, which creates spillovers for technological adoption in areas like retail, wholesaling, and transportation. Jettisoning these technologies understates their significance and risks stifling innovation. So, the regulatory rollout won’t be uniform. But the drift toward more intervention and political control will win out, in the end, because that’s the government’s raison d’etre.” 

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After reading this report, I called a few serious China watchers on Wall Street to get their read on the evolving situation. One of them, a longtime China expert and respected Wall Street player, said that Xi’s recent moves were largely an “evolution” of the president’s concept of capitalism...

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