China’s business plutocrats have lost billions of dollars during Beijing’s months-long campaign to bring the technology sector to heel. For foreign investors, the regulatory blitz has been just as troubling.
The offensive has throttled the outsized returns that China’s technology titans, such as Alibaba, Tencent and Baidu, have garnered for their foreign backers. It also has shone a light on the precarious structures underpinning Chinese tech stocks listed in New York.
Investors who buy shares in, say, Didi Chuxing, the cab-hailing app, do not get a direct equity stake in its Chinese operation. Instead, they are buying shares in a holding company based in the Cayman Islands with management contracts with the operating assets inside China. It’s a convoluted arrangement designed to circumvent restrictions on overseas investment in key industries. The model hinges on variable interest entities, or VIEs — conduits that allow the holding company to exercise control over and receive economic benefits from a Chinese operation. The VIE structures give shareholders the illusion of ownership. In reality, all investors get is exposure to the onshore businesses through contracts whose legal validity could be removed at the whim of the politburo.
Shareholders in US-listed Chinese technology stocks have known about these pitfalls for years. Since listing in the United States in 2014, Alibaba has warned repeatedly that it could have to “relinquish” its claim over the ecommerce business if VIEs were outlawed. Yet investors have turned a blind eye because of their hunger to ride China’s booming digital economy.
Beijing’s authorities have been willing to overlook the legal subterfuge. Chinese tech companies have raised hundreds of billions of dollars on the US market through VIEs. Mutual dependence has bred complacency, yet the “techlash” is a reminder that policymaking in Beijing can be brutal and swift. In November the government torpedoed the float of Alibaba’s payments offshoot and in April it handed the internet retailer a record fine for breaking anti-monopoly rules. Last month it crashed Didi’s share price — days after its float — by ordering it to stop accepting new users, citing security grounds.
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Beijing has reserved its most brutal retribution for online education. Two weekends ago it banned companies offering after-hours tutoring from making a profit, wiping billions off the value of US-listed providers such as TAL Education, New Oriental and Gaotu. It specifically prohibited companies that teach schoolchildren from receiving investment through offshore registered entities. Many concluded that the VIE racket was under attack.
Banning offshore funding structures has always been seen as a nuclear option. It would require a shift in China’s industrial strategy, inflict huge losses on external investors and cut the country off from international capital markets. Why would Beijing press a button marked “mutually assured destruction”?
Since taking aim at the education industry, China has adopted a more emollient tone. The head of its securities regulators met some of the big Wall Street banks last week and told them that recent shifts were aimed at tackling specific problems in certain industries. The message was clear: China has no intention of withdrawing from global markets.
Still, the crackdown continues. Tencent’s shares tumbled this week after a state-owned newspaper denounced online gaming as “opium for the mind”.
China’s tech crusade has brought unpredictable shifts in regulation, but the attacks are far from indiscriminate. This is a capitalist economy run by an authoritarian state whose sole interest is to preserve power. Plutocrats who forget their subordinate status do so at their peril.
