By Jingchao (Diana) Gong
China has been attracting global investors for its growth in recent years. According to data from the International Monetary Fund (IMF) in 2016, China made up “28 percent of global GDP growth – a greater share of global growth than the US, Europe and Japan combined.” Meanwhile, many risks exist when investing in China. For instance, China is now facing an escalating trade war with the U.S. and stocks of some of the biggest Chinese tech companies, such as Alibaba, and JD.com have recently performed poorly. Despite these risks, China remains the largest internal market in the world with 1.3 billion potential customers and 700 to 800 million internet users. , Meanwhile, it is keeping momentum on innovation in artificial intelligence, electronic cars, pharmaceuticals, and many other areas. Therefore, investors are encouraged to take a closer look at these markets and weigh its benefits and risks for every investment decision. This article aims to assist this process by pointing out three risks that investors need to evaluate carefully when investing in China.
Compared to the New York or Hong Kong exchange, the corporate governance rules and regulations for China’s domestic exchanges are considerably weaker. Additionally, one great risk of investing in China’s stock market is a common, but controversial corporate structure called a “variable interest entity (VIE).” A VIE is a shell company established in a country outside the jurisdiction of Chinese government (generally the Cayman Islands) where it only owns a few “structure contracts” with underlying operating Chinese companies. Through this arrangement, the shell company is entitled to all or a portion of the company’s profits without owning any of its assets. First appearing in 2000, the VIE structure was invented to circumvent foreign ownership restrictions under Chinese laws, which used to forbid foreign ownership of Chinese companies in many industries, including mining, steel, and telecommunications. The most well-known Chinese tech giants – “BAT” (Baidu, Alibaba and Tencent) – have all adopted this structure.
In the meantime, despite the wide use of this structure in practice, Chinese authorities have never specifically addressed whether VIEs are legal. Tencent disclosed in its Directors’ report that “the Company’s legal advisors believe the Structure Contracts do not violate PRC laws and regulations but that there are substantial uncertainties regarding the interpretation and application of the currently applicable PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities and PRC courts may in the future take a view that is contrary to the position of the Company’s PRC legal advisers concerning the structure contracts.”  Thus, it does seem that the Chinese government could potentially declare the VIE structure illegal someday, and investors would pay the price. Yet on a more positive note, in early 2017, the Chinese Supreme Court upheld a lower court’s ruling that a framework agreement, quite similar to a VIE, was valid. Although not specifically addressing VIEs, it seems that the state would likely review it favorably. Additionally, given the ongoing international tensions between China and other parts of the world, banning such a structure is likely to reflect negatively on the Chinese market and thus damage its economy. The Chinese authorities will likely avoid this situation. Therefore, even though the VIE structure remains a high risk for many Chinese companies, investors need not to be too alarmed. Investors should be particularly mindful of this risk when making investment decisions and conduct more research on target Chinese companies, as it is hard for outsiders to understand.
Investors should be particularly mindful of this risk when making investment decisions and conduct more research on target Chinese companies, as it is hard for outsiders to understand.
The Debt Problem
For years, China has been building up its debt load rapidly, to the point where some estimate it may run as high as 262 percent of China’s GDP. This number is expected to continue climbing. Chinese government started increasing its debt in the 2008 financial crisis, during which Beijing ordered local governments to build roads and other public works projects to employ workers. Later, state banks continued to fuel the Chinese economy through prolonged loose credit conditions. One Bloomberg article compared this “borrowing binge” to Japan’s debt bubble in the 1980s.
To make matters worse, there is another debt issue that China faces, and has been largely ignored. For many years, China has been lending money overseas to fund infrastructure and bailing out foreign governments (many through the Belt and Road Initiative). Some of these debtors may be incapable of repaying their debts to China. For instance, from 2007 to 2014, Beijing loaned Venezuela more than $60 million, and Venezuela is now in a state of economic collapse. This may just be the tip of the iceberg. Thus, due to both massive borrowing and imminent defaults, China is likely to face an intensifying economic slowdown with any small negative trigger. This could be bad news for global investors interested in Chinese companies.
Tariffs and the Trade War
The ongoing trade tensions between the U.S. and China have shown few signs of slowing down. On September 19, 2018, both countries exchanged a new round of tariffs that will affect billions of dollars’ worth of goods and products. Amid trade tensions, Chinese mainland stocks are down almost 30 percent since their peak in January. However, some experts reason that “on a medium- to long-term horizon, the A-share still looks attractive,”  and may present good entry points. Some further argue that macroeconomic implications for the U.S. and China may be surprisingly small given that bilateral trade only represents a small portion of either country’s total GDP.
However, the intensified trade war could go far beyond tariffs and directly disrupt global supply chains. In an integrated global economy as we are in today, any disruption to supply and distribution chains could have a lasting impact. For instance, some U.S. companies with factories or distribution centers in China may have to relocate, and this may result in increased unemployment rates and prices for many consumer goods. In turn, market confidence is likely to drop as people may think that the economy cools down as the number of unemployed workers increase and goods become more expensive. These effects could then lead to less spending by the Chinese consumer, which could potentially have other economic consequences. Thus, if these are in fact the economic impact, the risk of the current trade war is a systematic one, which may eventually result in negative economic consequences for Chinese companies and stocks.
In short, high-return investments are usually associated with high risks. China remains a promising and lucrative market in the foreseeable future. But investors should understand and carefully evaluate these risks before making investment decisions in China.
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 “A-share” refers to domestic Chinese equities that are dominated in Yuan (the Chinese currency) and traded in Shanghai and Shenzhen stock exchanges.
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