What should you consider before Investing in Chinese Equity
There is a sudden interest among investors, Indian as well as global brokerages, asset management companies about investing in China. Recently, there was consistent selling of equities by FIIs in India and one of the attributed reason is that “global brokerages downgraded India due to valuation concerns & meanwhile, upgraded Chinese equities since the valuations are attractive due to recent correction”. Many people have been considering investing in China due to the sudden interest by global asset management companies. Why the sudden interest in Chinese equity markets? We took a look at those in another article which you may want to look through as well.
But the reasons we are looking at this situation now is very different. Up front there are a lot of pros and cons on reasons to invest in China and some of them are given in the table below.
PROS
- Large internal market, with 1.44 billion potential customers
- Sovereign risk low- public debt mainly domestic and in Yuan
- High Importance given to forex reserves and public debt (mostly owned by government & HNIs)
- A well-developed production sector
- Favorable geographically
- High purchasing power parity thanks to rapid growth of the economy
- Labor costs remain comparatively low for now.
- Development of the western provinces (particularly Sichuan)
- Development of a new export network (Silk Road network)
CONS
- An ever-changing legal environment
- Bureaucratic and administrative complexities
- A lack of transparency and weak IP protection
- Aging population
- High level of corporate indebtedness
- Production overcapacity in several sectors
- A strongly degraded environmental situation in several big cities
- Cultural differences in business practices that may be difficult for foreigners to learn and apply in new business situations
- Underdeveloped middle management and low rate of qualified workers
Apart from the above, there are fundamental risks associated with China and the same is explained below,
Prior to understanding risk, we should be aware of how investments happen in Chinese equities. Globally, there are two ways to invest in Chinese equities.
Invest in Chinese stocks listed in USA (NYSE)
Invest in stocks listed in China itself.
Is it easy to Invest in Chinese Markets?
Foreign investments in many sectors are restricted by the Chinese government. Hence, it is legally/technically difficult/impossible to buy/own Chinese equity directly from the Chinese stock market. Investments through mutual funds/ETFs would be in a portfolio. But the underlying portfolio will not have the stocks listed in China’s market especially those in attractive tech sectors.
Enter Variable Interest Entities (VIEs)
The Chinese corporates along with investment bankers created a corporate structure called 'Variable Interest Entity (VIE)' and only this entity is listed in USA. The real risk of investment is due to this structure.
- At first, one separate company (Shell Company – i.e. it will neither manufacture any products nor offer any services but acts as a holding company) gets incorporated in Cayman Island or British Virgin Island. Global investors & original Chinese company’s promoters are the owners of this shell company.
- This Cayman island company will now set up and own another shell company incorporated in Hong Kong.
- The Shell company in Hong Kong will now set up and own another Shell company incorporated in mainland China (WFOE – wholly Foreign-Owned Enterprise).
- The Shell company in China goes into “Contractual agreement” with “Original Chinese company and its promoters” to offer some services and in return the Shell company will show the profits & revenue of original Chinese companies as its own (entire profit of Chinese company’s profit as a fee for services offered by shell company).
- Later, the shell company incorporated in Cayman Island goes for an IPO in USA, gets listed in USA. It carries the same name as the original Chinese company.
- The money raised through IPO will be channeled through above mentioned shell companies and given as a loan to original Chinese company with promoter stake as a collateral (in some cases)
Live Example of Investment in a VIE
- The above mentioned VIE structure has been prevalent for a few decades and majority of US listing of Chinese stocks are done through this structure.
- Yahoo had invested for a 43% ownership stake in a VIE of Alibaba in 2011. Due to a regulatory requirement in China, Alibaba’s promoter Jack Ma unilaterally severed the VIE structure to get a Payment Processor License for its fintech arm “Alipay” & later demerged Alipay from the VIE.
- Yahoo was not informed about this transaction for more than a year. On discovering it, they complained and the Alibaba promoters settled the case with Yahoo and other VIE shareholders for $6 billion. But the valuation of Alipay was $300 billion.
- Yahoo was powerless to do anything here and its shareholders were furious. Since China does not recognize the VIE structure, Yahoo’s investment into VIE was illegal and there was no remedy for that.
Conclusion
- If you invest in direct equity shares listed in India or USA, the worst possible risk is that the company you invest in, may go bankrupt and as an equity investor, you would lose your entire capital. However, this risk can be well managed through investing in professional fund management i.e through mutual fund route, PMS/AIF route OR if you intend to do only direct equity, the risk can be managed through “position-sizing” i.e. for e.g. If you allocate 3% of your funds to one company out of your 20-stock portfolio, the loss/risk is limited to the extent of 3% of your allocation.
- However, when you invest in China, the risks are very different, much bigger and maybe unaffordable.
- Foreign investment in China is restricted by Chinese Government. It is logically illegal to own their stocks. Therefore, no protection is extended by the PRC government to gullible investors.
- Almost every listed Chinese company we can buy outside of China is listed through a Variable Interest Entities (VIE) structure where investors don’t actually own any part of the actual underlying Chinese company. Investors who buy shares in Chinese stocks such as JD.com, Alibaba, Tencent, etc., do not technically have any ownership of the underlying business whatsoever.
- Even if we invest through mutual funds, the underlying portfolio of the MF may have stocks listed in NYSE. In that case there is a possibility that the entire underlying portfolio of MF is exposed to shell companies which could evaporate at any point.
- Despite facts & a precedence from Alibaba & the Yahoo case, the regulators in USA (SEC) have not taken any action on these VIE structure of Chinese companies.
- Apart from this, corporate governance, accounting standards of all Chinese companies are questionable. The disclosures of Chinese corporates are predominantly in Mandarin again an issue for investors.
- Overall, if you refer all concerns mentioned above, there are not new and every global investors aware of this risk. Still they intend to take such risk with the good faith that Chinese authorities will not harm entire global investors community. Basically, this may be affordable to such risk taking FIIs but not for us at any cost.
- Despite Chinese tech companies looking attractive with their tempting valuations, the risks associated with Chinese stocks are unaffordable. Avoid at any cost.
Bibliography
Chinese VIE Structure: Wall Street Continues to Ignore the Risks, GCI INVESTORS | Variable Interest Entity Structure in China, CHINA LAW INSIGHT | Love China or Hate China, you cannot ignore China, PPFAS MUTUAL FUND | Here’s What Investors Are Most Worried About—Including Meme Stocks And China Real Estate—According To Fed Report, FORBES | China Foreign Investment, SANTANDER TRADE
