The Shaky Legal Vehicles That Could Bring Down The Chinese Stock Market

The Shaky Legal Vehicles That Could Bring Down The Chinese Stock Market
Andrew Rummer

over 2 years ago9 mins

The Chinese stock market – and Chinese shares listed overseas – have been having a tough time lately. 

Back in November, Chinese authorities pulled the plug on Ant Group’s initial public offering at the 11th hour – halting what would have been the biggest ever IPO. In April, regulators hit e-commerce giant Alibaba with a $2.8 billion antitrust fine before complaining that ride hailing firm Didi’s June IPO in New York had gone ahead without their blessing. 

Most recently, a government crackdown sent private education stocks plummeting and WeChat owner Tencent dropped the most in a decade after state-backed media described online games as "spiritual opium". 

It’s all fueling the perception that China is happy to see investors take a hit as long as it can achieve domestic political aims like reducing the cost of housing and healthcare for regular Chinese people.

To unpack this story, and discover where Chinese markets – and US-listed Chinese firms like Alibaba and Didi – might go from here, we’re very pleased to be joined by Oliver Brennan, head of research at TS Lombard

Oliver began by explaining to Finimize analyst Andrew Rummer whether this crackdown from China’s government will remain just a Chinese story or whether it could spill over to affect sentiment in other markets. 

Oliver Brennan: I think this is just a Chinese story. It helps that the renminbi is on the rich side compared to his trade-weighted basket, as well as compared to the dollar. So that there could be a period of renminbi weakness without it having global macro consequences. But it's the typical unstable equilibrium problem. There could well be a path whether the renminbi weakens in a relatively orderly fashion. But whenever this kind of move does happen, there is the risk that it tips over into something more disorderly. And it also depends on the sequence of events. So you could have a situation where there's another crackdown on another domestic sector. And another – let's say, for sake of argument – 50% write down in certain stock values. Well, what that means is: any investors with exposure to those sectors, they may have to cover their losses elsewhere. And that's how contagion really starts: you've lost some money in Country X and then you have to reduce risk in Country Y to manage your P&L and to manage your stop loss. Now, we certainly don't think that the crackdowns are the start of something major. That is not that the Chinese government wants to socialize the entire stock market. The crackdowns are very much targeted in sectors where there may be egregious profiteering or which don't fit well with the five-year plan policies. But it's the unstable equilibrium risk that some people may be looking to disinvest. But why would it be only contained to China in the central case? Well, if you're disinvesting from China and you're an emerging market investor, you're not going to sit in cash and you're probably not going to sit in the US. So you have to reinvest somewhere. So you could well get the situation where this is a rotation story rather than a risk-off story. You can see a situation where Chinese stocks get hurt, but Indian stocks or Korean or Taiwanese – the next big EM countries – actually see more inflows.

Andrew Rummer: This whole saga has focused attention on the concept of the variable interest entity, or VIE, which is the legal structure by which firms like Alibaba have listed in the US. It’s one of those things that's been hiding in plain sight for a lot of people, I think. So could you explain what a VIE is and why investors should care about them?

Oliver: A VIE is actually quite a clever company structure. And what it does is it separates the risk of an investment. So if you're an oil exploration company and you wanted to start digging in Texas, but you weren't sure if you're going to find any oil, you may create a VIE, which is wholly owned by the parent company and capitalized by the parent company. But if it all fails, the failure is contained. And the variable interest is the interest that the daughter company has in the parent – effectively how much influence the parent company and the daughter company have on each other. So there's a reason for these structures to exist, and it's a perfectly rational reason. The problem is that for Chinese companies wishing to attract foreign capital, there were a lot of hurdles to jump over. And, as ever in finance, the shortcut is far more attractive than jumping over all the hurdles. So if you're a Chinese company who wants to – let's say – list in the US, then you go to the State Council to get approval. And the approval could be forthcoming. And it certainly is forthcoming for large domestic companies like PetroChina, but – perhaps rightly – smaller, privately owned Chinese companies decided that approval may not be forthcoming, or it may take a long time to arrive. So instead of going the official route, they restructure their companies such that the onshore Chinese company is a related daughter to a wholly owned foreign company. And then the foreign company lists in the Cayman Islands or in another low-tax jurisdiction. And then the foreign company issues American Depository Receipts in New York. So foreign investors buying American Depository Receipts in New York get exposure to the company listed in the Cayman Islands or elsewhere. And then the relationship between the foreign company and the Chinese company is a contract. And that's the important part here. There's no equity share. And there's no watertight legal relationship between the foreign company and the Chinese VIE. And that's why it's a VIE. And that's why this is a risk.

These entities have been going at least 10 years, probably longer. I was reading before we started speaking about the the Alibaba settlement 10 years ago. The relationship between the foreign company and the Chinese company is effectively a contract between all of the foreign shareholders and nominee shareholders of the Chinese company. Now, the nominees will usually be the founders or the majority shareholders, or the archetypal Chinese billionaire. The question is whether that arrangement holds legal sway in China. And what we've seen over the last couple of weeks is you have to question whether that's really the case: this relationship has never been tested. And, in fact, the only test that there ever was was when Jack Ma had to restructure the ownership of Alibaba and effectively executed a reverse takeover to make his previous investors – SoftBank and Yahoo – take a loss. And he was persuaded by those external investors to restructure back so that the loss was was lower. But that's the problem: if there's no Yahoo or SoftBank, the American investor doesn't have any legal sway over what the Chinese company will do in the end. And that's why the risk in the VIE arises.

Andrew: How does the Chinese government see these VIEs? What's their approach to them?

Oliver: I think the kindest way to say it is they've looked the other way. So there's not been a formal approval and – at the same time – there's not been a formal disapproval of the process. Now, this is where it gets quite complicated, and you do have to start thinking about the motivation of all the parties involved. So the motivation of the Chinese government is to attract foreign capital: it's far easier, far less risky for foreign capital to take the loss of any speculative investment than it is for domestic Chinese investors – whether they be local governments or Chinese retail investors. So the Chinese government likes foreign investment. Therefore, it should like the structure of the VIEs, because private companies have found a way to get a lot of foreign investment into China without going through all the kerfuffle of having a formal ownership arrangement. The problem now is: well, if this foreign investment begins to reconsider his value proposition, they may have the opposite problem of there being outflow from China.

Andrew: So after the sell-off we’ve had, are Chinese stocks attractive at current valuations? Or best left alone for now?

Oliver: Some are, and some aren't. And we did get reassurance from policymakers, effectively telling banks that this isn't the start of a crackdown. And we saw some liquidity injections to ease financial conditions. So you would draw from that that there is no intention from policymakers to trigger a large sell-off. But China was always a policy-led market. One of the phases I like is that policymakers care about policy, not prices. So you'll always have that risk hanging over you. And that risk, we think you can relate it directly to the policy goals of the administration. So then you have demographic, social security, data security, financial risk control. What else might we have? Well, there's decarbonization – so electric vehicles, battery stocks may do well, while old, old car manufacturers may do poorly. And deleveraging is also a priority. So there's probably some risk around housing. So I think you need to go on a sector-specific basis, or maybe even a stock-specific basis. There will absolutely be some stocks which are good value – especially after a 15% sell off, you can certainly do some bottom fishing. 

I think the top line is: what's your risk premium? Now, Chinese stocks in aggregate are pretty rich: they're trading at 15x P/E ratio, which isn't high compared to the US but it is high for an emerging market. And when we start to think about risk premium and political risk and the risk of politics or the government capturing your share of profits, well, it makes sense to think about Russia, because there is a history of political risks there 10 or 20 years ago, nearly now, when Yukos was nationalized. Russia trades at about 7x P/E. So there's an enormous difference. And now I'm not sitting here saying Chinese stocks have to halve in value. But Chinese stocks certainly shouldn't be trading at the same value that they were before the government started to crack down on Didi and on the education sector. So you have to take a good look at the exposure that you have in China and decide if it’s at the right price. And I would suspect somebody taking a long, hard stare at that exposure, the answer would be: it's not at the right price.

You have to assess policy risk now as one of the major inputs to your decision making. And if Russian investors have decided that the policy risk is worth a valuation below 10x on a P/E ratio, then you want to have valuation much more on your side than it currently is. So there will be some opportunities, probably not in the education sector, probably not in the big tech sector – simply because when these companies get too big, they attract regulatory scrutiny and then you're more likely to be on the wrong side of that – but there will be some opportunities in smaller caps, in tech, manufacturing, semiconductors and so on. And then in the new energy space.

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