China is tightening the rules around how Chinese companies access foreign capital, which could create more nervousness – but at the same time, however, it would add legitimacy to what has been a very grey and increasingly dangerous aspect of Chinese investing.
Chinese regulators are drawing up a list that will target Chinese companies, in what it deems sensitive sectors, which will not be able to raise capital in overseas markets.
To date, all Chinese companies that have raised money in foreign public markets have done so through what is known as the VIE or Variable Interest Entity. This is a workaround for the rule that says that only Chinese citizens and entities are allowed to own the shares of Chinese companies and for many years, it has been very widely used.
A VIE is a shell company that through the use of contracts mimics the economic performance of share ownership and it is the shares of these that have been listed on overseas exchanges (NYSE and HKSE mostly). The problem with the VIE structure is that in Chinese law, it is illegal but because China needed foreign capital for its economy to develop, the regulators have turned a blind eye to it for years.
This means that technically, the Chinese government could at any moment declare all of these contracts illegal rendering the shares of the hundreds of VIE companies worthless overnight.
The VIE structure is not limited to technology, as all Chinese companies listed overseas use it, so it is not hard to see that a move of this magnitude would provoke an extreme reaction that could result in a very large increase in economic isolation for China.
This is why I suspect the Chinese government is seeking a middle road where it increases its control and oversight of VIEs but does not banket ban their use in entirety.
Hence for sensitive industries like AI, quantum computing, aerospace, and so on, it looks like it will be very difficult to get access to foreign capital as the use of the VIE will be outlawed for new issues. This is probably why SenseTime eventually listed in Hong Kong – if it waits for better market conditions, it may find that it is no longer able to list.
At the same time, I am pretty sure that this IPO went ahead with the tacit approval of the state, given what the state did to Didi which had the temerity to ignore its concerns.
Consequently, I think that outside of these core sectors, VIEs that already exist will be permitted to continue, but the publication of new regulations is likely to cause some market jitters.
The silver lining to this cloud is that by issuing a regulation related to VIEs, the state will have legitimised the VIEs that it permits to continue. This will remove the uncertainty that has surrounded this structure for years and, in my opinion, greatly de-risk it.
Consequently, for issuers like Alibaba, Tencent, Baidu, the Chinese banks, and so on, there is likely to be no fundamental change other than that investing in their VIEs becomes less risky.
However, what I do expect to see is an increasing focus on Hong Kong listings over time and that eventually most, if not all, Chinese companies delist from the USA. I think that this will be accomplished gradually, with trading volume gradually shifting from American exchanges to Hong Kong followed by delisting when no one cares anymore.
The one big question that remains is the status of Hong Kong. As it stands today, Hong Kong counts as a foreign exchange and it is only VIEs that are listed there. Given the political direction in Hong Kong, it could at some stage become just another province within China which would complicate the status of its financial markets.
Given how large they are and the Chinese government’s requirement to continue delivering improvements in prosperity, I doubt that it will make detrimental changes to the way its markets are run or who can invest in them any time soon. Hence, I am in no hurry to sell my position in Alibaba or the Chinese banks, neither of which have yet performed as I had hoped.