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China—Tech Clamp Down—Why?—How to Invest In China–Now

Date Posted: August 3, 2021

SINO/U.S. TENSIONS CONTINUE TO INCREASE

Our earlier Commentary (10/17/2018)  focused on whether the Sino/U.S. trade war would eventually grow into Cold War II.  For some period now, that concern moved to the  back burner for most investors particularly with the recent lack of  Tweets from the White House. Despite that,  movement to a more confrontational Sino/US relationship continues to grow.  Over the last three years, China’s increasingly aggressive, authoritarian leadership imposed its one-party rule on  Hong Kong by implementing its version of the National Security Law.  Further actions such as developing military infrastructure on the South China Sea Islands and human rights violations increased tensions both in the region and with the United States.

KEY TO UNDERSTANDING SINO/U.S. TENSIONS AND CORPORATE ACTIONS IN  CHINA— CHINESE COMMUNIST PARTY (CCP) PRIORITIES

Looking back can give some understanding to both the current Sino/U.S. confrontation and the recent tech clampdown.  Most important for investors  to understand comes back to  the Chinese Communist Party’s (CCP) top priority—preserve its power and one-party rule—so it can never be challenged.

CCP LONG TERM STRATEGY WITH THE WEST—”HIDE OUR CAPACITY BIDE OUR  TIME”

Since formally establishing diplomatic relations with the United States in 1979, China looked to use its engagement with the U.S. to build itself into a global  power by the PRC’s 2049 centennial anniversary.  An important step to that ambition came in 2001 when it joined the World Trade Organization (WTO.)  At that time, the developed countries believed that opening China’s economy would ultimately liberalize it.  However, according to China-US Relations in the Eyes of the Chinese Communist party—authored by Cai Xia, the CCP hid its true goals with its dictum “hide our capacity to bide our time.”  This strategy guided China’s foreign and global economic engagement policies with developed countries for over thirty years. That dictum helped the CCP to  preserve its power and one-party rule. 

PRESIDENT XI—MORE AGGRESSIVE POSTURE TOWARDS THE WEST

Since President Xi came to power, the time for hiding and biding gradually came to an end.  The new leadership took a more China centric approach, expanded its defense spending, and  after the 2008 Global Financial Crisis saw its economic structure as superior to the West.  This more aggressive posture ultimately changes how businesses and investors must deal with a more confrontational Sino/US relationship. 

U.S. RESPONSE—TARIFFS—LITTLE DENT IN BI-ILATERAL TRADE

The most obvious change to the relationship came with the Trump Administration.  U.S. businesses expressed much frustration with operating in China particularly,  protecting their intellectual property.  The Trump administration attempted to resolve these issues—admittedly with economic threats.  It finally resorted to implementing those threats by imposing trade tariffs.   Those tariffs still remain in place today under the new administration.  Figure 1 shows, however,  tariffs made little dent in Chinese imports to the U.S. particularly after heightened consumer spending during the pandemic.

FIGURE 1

CHINESE TRADE WITH THE U.S. AND EUROPEAN UNION

BI-LATERAL RELATIONSHIP SHIFTS FROM ENAGEMENT TO ADVERSARIAL

With  more aggressive bi-lateral actions, the Sino/U.S. relationship shifted from an engagement to an adversarial one. Recently, President Xi warned that any foreign power trying to stop China “ shall be battered and bloodied from colliding with a great wall of steel.”  Despite that aggressive speech , more likely Cold War II will  prove to be a data and cyber security confrontation rather than a hot war. 

CCP SEES PLATFORM COMPANIES’ BIG DATA GATHERING CAPABILITIES USED TO INCREASE THEIR SURVEILLANCE STATE EFFORTS

The CCP sees the platform companies’  “big data” gathering  capabilities  giving it even greater “tools” to preserve its power and one-party rule.  Therefore, in order to employ those capabilities, the CCP must “control” the gatherers of data.  That effort  leads to regulatory limitations on many of the leading tech platform companies in China (see Figure 2.) In doing so, it both keeps the data within China and limits the use of this data to erode the party’s position. The end goal for the CCP will be to leverage those companies’ capabilities to create a surveillance state  that would make dictators of the past envious.  In my view, these actions suggest the CCP’s  seemingly lack of trust of the Chinese People—if correct, a fundamental flaw in their rule.

FIGURE 2

U.S./ CHINA LARGE INTERNET COMPANIES—ACTIONS BY CHINA


SOURCE: COMPANY REPORTS, GEOPOLITICAL FUTURES

CHINESE COMPANIES USE COMPLEX VARIABLE INTEREST ENTITIES TO WORK AROUND PRC PROHIBITION OF FOREIGN DIRECT INVESTMENTS—CHINESE REGULATORS LOOK THE OTHERWAY

PRC law prohibits foreign direct investment in strategically important industries. This restriction particularly prohibits foreign investments directly in internet and value-added telecommunication services. To work around these restrictions and enable foreign investments, Chinese companies developed the Variable Interest Entity (VIE.} The VIE structure permits Chinese companies to source financing not available locally—to the advantage of the PRC. Therefore, Chinese regulators look the other way as this complex contractual structure permits international investors to accrue profits of Chinese corporations. Roughly 400 U.S. listed ADR’s of Chinese companies use this structure with a total market capitalization of $2 trillion.

VARIABLE INTEREST ENTITY (VIE) NO REAL OWNERSHIP OF CHINESE COMPANIES

The complex VIE structure consists of three entities. First, U.S. investors own an exchange listed offshore shell corporation usually domiciled in the Cayman Islands. That shell corporation—an ADR listed company–consists of the name of the major Chinese corporation and little else. The second step consists of a contractual link from the shell corporation to its Wholly Owned Foreign Entity (WFOE) in China. The WFOE then acts as the bridge between the listed ADR shell corporation and the operating company in China. To bridge the two, the WFOE then arranges a complex set of key contracts. The contracts first enable shell corporation funds to flow to the WFOE. Then, the Chinese operating company receives these funds under a loan agreement with the WFOE. In return, the contracts enable the WFOE to accrue on paper all the profits from the Chinese operating corporation. At the end, the VIE structure enables the ADR shell corporation to establish an accrual claim on the operating company profits. At the same time, neither the shell corporation nor the WFOE legally own the Chinese company’s assets nor control any voting rights. Despite that reality, the Cayman Islands ADR shell corporation can consolidate and accrue both the income and assets of the Chinese operating company in their financial statements under U.S. GAAP .

VARIABLE INTEREST ENTIES THREATENED BY POTENTIAL U.S DELISTING FROM NEWLY INSTITUTED REGULATIONS

Additional uncertainties for owners of Chinese ADR securities occurred when Congress passed The Holding Foreign Companies Accountable Act last December. The S.E.C. then initiated rules that would force Chinese companies, listed in the United States using ADRs, to comply with U.S. regulatory audit and information sharing standards. In effect, it would require Chinese companies to retain auditors whose foreign offices would be fully subject to inspection by the U.S. Public Company Accounting Oversight Board. Three years of non-compliance could then result in delisting at the earliest in 2024.

CHINESE SECURITY LAWS PROHIBIT U.S. REGULATORY ACTIONS—POSING FURTHER THREAT OF DELISTING

This requirement flies directly in the face of China Securities Law which “prohibits foreign regulators from conducting investigations and collecting evidence.” To release such information to foreign regulators would require approval from regulators in China. With a three-year time horizon, some compromises may be reached. Otherwise, U.S investors could face the risk that Chinese companies will be delisted from American markets. Some observers predict very few Chinese companies will remain listed in the United States by the end of the decade. The Hong Kong market will likely prove a major benefactor if this shift occurs.

INVESTMENT CONCLUSIONS—HOW TO INVEST IN CHINA

China Rapid Growth Gives Basis for Investing–China now stands as the second leading global economy with a population more than four times the size of the United States. Its economic growth this decade should substantially exceed that of the United States. Bloomberg Economics forecasts China’s GDP will grow 4-5% annually for the remainder of this decade. This compares to 2% annually for the U.S.–past the recovery– as projected by the Congressional Budget Office. The comparative growth rates should give investors a reason to invest in China despite the concerns outlined in this Commentary—but how?

Avoid Companies likely Under Threat–To deal with those concerns, key will be determining which industries and companies the CCP sees as posing existential threats to their power. Platform companies seemed to represent just that threat in their eyes. In addition, companies that violate guidelines dealing with foreign regulators will also face a similar clamp down.

Look to Companies likely favored–At the same time, companies that contribute to the economic and industrial goals set by the CCP will likely remain in their “good graces.” For example, despite the recent tech crack down, China seeks to accelerate its ability to produce leading edge semi-conductor chips. Therefore, Chinese semi-conductor production equipment and chip producers will likely be looked on with favor. In addition, industries and sectors supplying consumer products and services will likely remain of investment interest as China looks to build up its consumer sectors. Finally, medical, health, and biosciences will likely be looked on in favor by the CCP as its population rapidly ages. Underlying all of the CCP goals will be maintaining domestic stability and that means economic growth leading to better paying jobs—sound familiar.

Look to Companies listed in Hong Kong and China, Not ADRS–With that as overview, investors should focus on the ordinary equities of Chinese companies–those listed in Hong Kong and on the mainland exchanges. In our view, ADR’S of the offshore shell companies domiciled in the Cayman Islands and similar locations could prove problematic particularly as the deadline for filing audit statements to U.S. regulators moves closer.

Look to actively invested funds managed by experienced China “hands”–Practically, investors should look to actively managed funds led by experienced investors in Chinese securities. Those skilled fund managers should be able to selectively seek out those companies that fit within parameters outlined in this Commentary. On the other hand, some index funds may prove problematic if they include major Chinese companies that the CCP could threaten with penalties or regulations to limit their growth.