Risks & Trends

by Malcolm Riddell

VIEs
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China: Signals Blinking Red & Oops, We Missed the Risks

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Malcolm Riddell
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Founder of CHINADebate

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July 22, 2021
China: Signals Blinking Red & Oops, We Missed the Risks
China: Signals Blinking Red & Oops, We Missed the Risks
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VIEs

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Note: I had intended to make this issue all about ‘Variable Interest Entities’ (VIEs) and the emerging risks to about $1.8 trillion dollars’ worth of Chinese shares listed on U.S. exchanges – that is, 4% of the capitalization of the U.S. stock markets.

  • Upon reflection, I figured that most readers aren’t as wonky as I am.

Instead, I opted to use institutional investors’ willingness to invest in such a shaky structure as a cautionary tale.

  • This is preceded by the broader cautionary tale of how we should have seen the impact from the U.S.-China collision early on and better factored it into our business and investment decisions.

But, my fellow wonks, never fear. I have included excerpts of articles and links below where you can dig deeper into VIEs.

Wonk or not, how the Chinese regulators decide to handle the legally gray VIEs is going to change markets and give non-financial firms pause to ask what regulations may be impacting their businesses.

  • A heads up for all to keep an eye on how the VIE regulations play out.

1 | A Cautionary Tale?

There’s a cautionary tale or a teaching point or a parable for all business and investment in China somewhere in China’s recent actions in the capital markets.

  • But, with so many contradictory analyses and reports – and even signs of panic – I’ll be darned if I can make it out.

In a July 11 essay, Niall Ferguson of Stanford wrote: ‘David Kotok of Cumberland Advisers said.’

  • “Investors have to rethink the entire China structure.”
  • “ ‘One country, two systems’ in Hong Kong is dead. Alibaba is not a one-off. Neither is Didi.”
  • “Everything China touches must be viewed with suspicion.”

Then this from George Magnus in the FT on July 20:

  • ‘Investors have been given a clear warning of the decoupling dichotomy between China and the US running through global capital markets.’
  • ‘The sharp sell-off in newly listed shares of ride-hailing group Didi in the US after China launched a security probe into it has illustrated the risks.’

‘Beijing now wants to curb, if not eventually prohibit, Chinese companies’ access to US capital markets where they will increasingly have to submit to normal regulatory and disclosure requirements.’

  • ‘Washington is equally hostile to Chinese listings if they refuse.’

‘This is just the latest example of a process of financial decoupling, as it is known in Washington, or self-reliance, as it is called in Beijing.’

  • ‘Yet seemingly oblivious to the politics, Wall Street businesses, non-financial companies and investors continue to beat a path to China’s red door, welcomed by Beijing.’

2 | A Little Breathing Room

So is the lesson, for both investors and businesses, ditch China?

  • Or is it, bet on China’s growth and forge ahead?
  • Or maybe, forge ahead with caution?

To make this even tougher, Mr. Magnus adds:

  • ‘This incremental build-up in decoupling rules and regulations on both sides is going to draw more companies and investors into an awkward space where the contradiction between politics and narrower financial interests will become starker.’
  • ‘As investors and businesses face more conflicts of interest and decisions about whose rules to obey and whose to flout, politics is likely to win out.’

I take ‘incremental’ to mean that more is coming, that is, more unknown stuff.

  • So it may be a while before we know what lesson or lessons to glean from these dustups.

This gives us a little breathing room to understand if we could have seen these issues coming and prepared better.

  • The answer seems to be yes.

3 | Either We Should Have Seen It Coming...

Dr. Ferguson is unsparing in scolding us.

  • ‘For the past three years, I have been trying to persuade anyone who would listen that “Chimerica” — the symbiotic economic relationship between the People’s Republic of China and the United States of America, which I first wrote about in 2007 — is dead.’

‘Even before former President Donald Trump started imposing tariffs on Chinese imports in 2018, the U.S. and China were butting heads over so many issues that cold war began to look like a relatively good outcome, if the most likely alternative was hot war.’

  • ‘Ideological division? Check, as Xi Jinping explicitly prohibited Western ideas in Chinese education and reasserted the relevance of Marxism-Leninism.’
  • ‘Economic competition? Check, as China’s high growth rate continued to narrow the gap between Chinese and U.S. gross domestic product.’
  • ‘A technological race? Check, as China systematically purloined intellectual property to challenge the U.S. in strategic areas such as artificial intelligence.’
  • ‘Geopolitical rivalry? Check, as China brazenly built airbases and other military infrastructure in the South China Sea.’
  • ‘Rewriting history? Check, as the new Chinese Academy of History ensures that the party’s official narrative appears everywhere from textbooks to museums to social media.’
  • ‘Espionage? Propaganda? Check. Arms race? Check.’

‘A classic expression of the cold war atmosphere was provided on July 1 by Xi’s speech to mark the centenary of the Chinese Communist Party:’

  • ‘The Chinese people “will never allow any foreign force to bully, oppress, or enslave us,” he told a large crowd in Beijing’s Tiananmen Square. “Anyone who tries to do so shall be battered and bloodied from colliding with a great wall of steel forged by more than 1.4 billion Chinese people using flesh and blood.” ’
  • ‘This is language the like of which we haven’t heard from a Chinese leader since Mao Zedong.’

As I’ve written before, I don’t subscribe to the Cold War analogy.

  • But that doesn’t mean that, whatever we call the situation between the U.S. and China, Dr. Ferguson is wrong about the signals.

Then, there are the signals from the first six months of the Biden administration:

  • As Steven Lee Myers and Amy Qin of The New York Times write in ‘Biden Has Angered China, and Beijing Is Pushing Back:

‘From China’s perspective, the blows from the United States just keep coming.’

‘The view is that Mr. Biden’s moves reflect an American intention to undercut China’s growing economic and military might.’

  • ‘The strategy to recruit allies in the effort seems to have particularly rankled.’

‘The result has been a deterioration of relations that, to the surprise of many in Beijing, has surpassed even the four tumultuous years of dealing with President Donald J. Trump.’

4 | ...Or We're Just Myopic About China

Okay, maybe we did miss the signals. It complicated. It’s excusable.

  • What is not so excusable is to be just plain ignorant or myopic about what you’re doing.

And the best example I’ve seen lately is ‘Variable Interest Entities’ (VIEs). From Dr. Ferguson:

  • ‘U.S.-listed Chinese firms will face growing regulatory pressure from Beijing’s new rules on ‘variable interest entities’ as well as from U.S. delisting rules.’

‘The stakes are high.

This from ‘Crackdown on US listings: Will China close $1.6tn VIE loophole?' in Nikkei Asia.

  • ‘Variable interest entities are used by businesses in sectors where China limits foreign ownership, including telecommunications and education, to let foreign investors buy in through shell companies based in jurisdictions such as the Cayman Islands.’

More explanation from ‘Tell me lies, tell me sweet little VIEs,’ by Jamie Powell in the FT.

  • ‘Normally when a foreign company lists its shares in the US, it deposits the stock in a US bank, and then receipts for those shares are listed in the States.
  • ‘These are known as American Depositary Receipts, or ADRs.’
  • ‘It’s a neat way for a dollar-denominated investor to buy exposure to say, VW, without any of the faff of German taxes, Euro-exposure or other pesky regulations.

‘But that’s not the case with US-listed Chinese businesses.’

  • ‘There is no share neatly sitting in an American bank somewhere.’
  • ‘In fact, you don’t buy an ownership take in anything when you invest in say, Alibaba, Didi or NIO.’

Or, as Bloombergs’s Mark Levine says:

  • ‘People buy its stock, and they sort of pretend that they’re buying stock in the Chinese company — they sort of pretend that the Chinese company is a subsidiary of the Caymans holding company — even though really they’re only buying an empty shell that has certain contractual relationships with the Chinese company.'
  • The problem with VIEs is that it sort of sounds like you’re kidding.’

‘Before Didi and the rest, investors simply did not care about the problematic nature of the VIE structure.’

  • ‘The situation was very much a “number go up” and “they wouldn’t do that to us anyway” vibe from the institutional investors FT Alphaville talked to (those that were aware of the VIE structure, anyway).’

‘For instance, take this quote from Eric Liu of Ruane, Cunniff & Goldfarb, the firm that runs the famous Sequoia Fund, from 2018:’

  • ‘ “The VIE structure s pretty complicated; we have thought about it and our ultimate conclusion was that the Chinese government is interested in attracting capital to its capital markets and is unlikely to rock the boat there and do something unusual.” ’

5 | Complicated?

  • And you invested anyway without cutting through the complication, understanding what you were buying, and cooly weighing the risks?

Now that complication has become one big potential risk, one that was always there.

‘The China Securities Regulatory Commission is leading efforts to revise rules on overseas listings that have been in effect since 1994 and make no reference to companies registered in places like the Cayman Islands, said the people.’

  • ‘Once amended, the rules would require firms structured using the so-called Variable Interest Entity model to seek approval before going public in Hong Kong or the U.S., the people said.’

‘The proposed change is the first indication of how Beijing plans to implement a crackdown on overseas listings flagged by the country’s State Council on last week.’

  • ‘Closer oversight would plug a gap that’s been used for two decades by technology giants from Alibaba Group Holding Ltd. to Tencent Holdings Ltd. to attract foreign capital and list offshore, potentially thwarting the ambitions of firms like ByteDance Ltd. contemplating going public outside the mainland.’

‘The additional oversight could bestow a level of legitimacy on the VIE structure that’s been a perennial worry for global investors given the shaky legal ground on which it stands.’

  • ‘If the Chinese government decides “VIEs are okay, but you have to get our permission to list them abroad,” that's not a worst-case scenario even if it never grants permission.’

‘That’s not the worst outcome. The worst outcome would be if the ones already listed abroad were just, you know, voided.’

  • ‘The Chinese government could declare “all these VIE contracts are actually a disguised form of foreign ownership, which is not allowed by the rules, so they are all void and your Didi and Alibaba shares are worthless.” ’

This is the so-called ‘Nuclear Option,’ and no one seriously thinks this will happen.

  • Why would Xi Jinping cut off access to western capital when he just has to re-write the regs and then coerce Chinese companies to list in Hong Kong where he seems to believe he will have more control?

That this is the likely outcome doesn’t excuse institutional investors from either not understanding the VIE or ignoring the risks to make a buck (2008 financial crisis, anyone?), or both.

6 | 'It's a Jungle Out There'

All by way of saying, as we await the dropping of more shoes from Beijing and Washington, we should use the time to ask:

  • How is it we missed the impact of the U.S.-China conflict on our businesses and investor?
  • Perhaps, like the investors in VIEs, we just chose to ignore it.

But the risks and the impacts are only going to increase, and we have to do better.

  • As Randy Newman tells us, ‘It’s a jungle out there.’ Be ready.

Bloomberg

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Matt Levine | Bloomberg
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VIEs
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Part 1 | 'Owning Chinese Companies Is Complicated'

‘ “Variable interest entities”(VIEs): The problem with this is that it sort of sounds like you’re kidding. But this is a standard method for mainland Chinese internet companies to go public, and the market has come to accept it.’
7/22/2021

Bloomberg

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Matt Levine | Bloomberg
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VIEs
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Part 2 | The DiDi VIE (as an example)

‘The prospectus has a diagram, above, of the corporate structure, which looks almost normal. But everything below the double arrow — the actual ride-hailing business, etc. — is slightly askew.’
7/22/2021

Bloomberg

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Matt Levine | Bloomberg
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VIEs
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Part 3 | Revising the Rules

‘The Chinese government could declare “all these VIE contracts are actually a disguised form of foreign ownership, which is not allowed by the rules, so they are all void and your Didi and Alibaba shares are worthless.” ’
7/22/2021

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Malcolm Riddell
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VIEs
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China: Signals Blinking Red & Oops, We Missed the Risks

I had intended to make this issue all about ‘Variable Interest Entities’ (VIEs) and the emerging risks to about $1.8 trillion dollars’ worth of Chinese shares listed on U.S. exchanges – that is, 4% of the capitalization of the U.S. stock markets.
7/22/2021

Nikkei Asia

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VIEs
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'Crackdown on US listings: Will China close $1.6tn VIE loophole?'

‘If Chinese authorities start to question “Variable interest entities”(VIEs), amid the crackdown that has already battered ride-hailing company Didi Global -- another VIE user -- the resulting loss of investor trust could send shock waves through global financial markets.’
7/22/2021

Financial Times

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Jamie Powell | Financial Times
7/22/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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1 | 'Wolf Warriors Killed China’s Grand Strategy—and We'll All Come to Miss It'

‘The predominant feature of Chinese conduct today is not grand strategy but a belligerent, defensive nationalism that lashes out without heed of consequences.’ Sometime in 2020, China came unmoored from its grand strategy.
6/3/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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2 | Blame It on Xi

‘In China’s case, the Xi era has seen the accumulation of somewhat counterproductive policies that catalyzed a breakdown.’
6/3/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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3 | Enter the ‘Wolf Warriors’

‘What changed in 2020 was that nationalism for its own sake became the predominant motif of Chinese conduct.’
6/3/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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4 | Why China Abandoned Its Grand Strategy

‘The most persuasive explanation is that China has poisoned itself through its own rhetoric.’
6/3/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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5 | Two Caveats

‘Highlighting the strategic questionability of China’s policies doesn’t mean that Beijing’s fears of the outside world are completely unjustified.’
6/3/2021

Foreign Policy

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Sulmaan Wasif Khan | The Fletcher School of Law & Diplomcy, Tufts University and the author of 'Haunted by Chaos: China’s Grand Strategy from Mao Zedong to Xi Jinping'
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China's Grand Strategy
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6 | The Risks & the Dangers

‘The real danger is that once toxin has spread through the system, there is no knowing where it will end.’
6/3/2021

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Malcolm Riddell
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China's Grand Strategy
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Killing China's Grand Strategy

Trend: Under the Xi Jinping administration, China has amped up abrasive ‘Wolf Warrior’ diplomacy; cracked down within its borders, despite protests and criticisms from other countries; become increasing bellicose in responding to those protests and criticisms, and any other pushback it doesn’t like; and increased its aggressive rhetoric and actions against neighbors. Risks: If this sounds like a problem just for the world’s Ministries of Foreign Affairs, think again – the impact extends deep into business and finance.
6/3/2021

Project Syndicate

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Shang-Jin Wei
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Columbia University

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China's demographic challenges
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'Sex and the Chinese Economy'

‘A rise in China’s male-female ratio may have contributed to between one-third and one-half of the increase in its trade surplus with other countries.’ ‘The sex imbalance thus likely underpins an important source of tension between China and the US. Yet bilateral engagement has paid scant attention to this linkage.’
5/27/2021

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Malcolm Riddell
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China's demographic challenges
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'Demography + Technology is Destiny'

The census showed that the number of births nationwide fell to the lowest level since 1961, following a nationwide, manmade, famine caused by Mao’s “Great Leap Forward” that killed tens of millions of people, and that China’s total population could peak in the next few years.
5/27/2021

Bloomberg

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China's demographic challenges
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'China: Births Falling'

‘China’s total population could peak in the next few years, spurring profound changes for the world’s second-biggest economy.’
5/27/2021

Bloomberg

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China's demographic challenges
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'China Bets on Productivity Over Population to Drive Its Economy'

‘Beijing has a two-pronged approach to maintaining economic growth as its population shrinks.’ ‘First, it intends to slow the decline of the urban workforce by raising the retirement age and encouraging migration of more of the country’s 510 million rural residents to cities.’ ‘Second, it plans to raise productivity -- a measure of economic output per worker -- with the latest five-year plan emphasizing better vocational education and more investment in scientific research, automation and digital infrastructure.’ [see second chart above]
5/27/2021

Financial Times

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Gideon Rachman | Financial Times
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China's demographic challenges
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'Lousy demographics will not stop China’s rise'

‘The old maxim ‘demography is destiny’ no longer holds in the same way that it used to.’ ‘A shrinking and ageing population may not have the same gloomy implications in the 21st century.’
5/27/2021