Why Solving U.S.-Listed Chinese Stocks’ VIE Issue Can Get Hong Kong Out of the Doldrums
Original Article Published on Caixin Global
My recent article on whether Hong Kong is ready for Chinese tech stocks exiled from New York has triggered heated debate. This time I’d like to continue the topic about Hong Kong, which involves national security, the city’s stock market, and the variable interest entity (VIE) ownership structure widely used by Chinese tech companies listed in the U.S.
First, let’s look at the logic and general knowledge behind some recent developments.
Sino-U.S. relations and Hong Kong
The outlook for China-U.S. relations in 2022 remains gloomy and Hong Kong will be the first to be affected by any conflict.
On Dec. 19, Joe Manchin, a Democratic senator from the heavily Republican state of West Virginia, announced his veto against the Build Back Better Act, creating a major hurdle for U.S. President Joe Biden’s welfare policy. His switching sides, speculated by the media, would allow the Republican Party to take back the majority in the Senate.
What are its implications for China-U.S. relations? Biden, with his administration facing a bumpy road ahead on domestic issues, would likely seek to make a breakthrough on an issue on which it’s easy to reach bipartisan consensus, in order to avoid losing both the Senate and Congress in the 2022 midterm elections. And this issue might very well be China-U.S. relations.
Hong Kong is the focus and frontier of the current wrestling match between the two countries. It brings challenges to both politics and the capital market of the metropolis.
Political tensions on Hong Kong have been gradually building between China and the U.S. On Dec. 20, the U.S. Department of State submitted its annual review of the “Hong Kong Autonomy Act Report” to Congress, imposing sanctions on five deputy heads of the Liaison Office of the Central People’s Government in Hong Kong. Strongly opposing this action, China’s Ministry of Foreign Affairs immediately announced countermeasures.
At the same time, Hong Kong’s Legislative Council (LegCo) election on Dec. 19 marked the start of the city’s busy political agenda: The chief executive election will take place on March 27; the assembly to commemorate the 25th anniversary of Hong Kong’s return to the motherland and the inauguration ceremony of the new chief executive will be held on July 1. China’s top leaders may be present at those events, as speculated by market participants. From the LegCo election to the chief executive election, it is essential for Beijing to have full control over the governance of Hong Kong to prevent external forces from asserting their influence. Yet, the U.S. will never stay on the sidelines and watch this happen. In this context, Hong Kong, being the center of the China-U.S. geopolitical conflict, is facing increasing risks. Observers’ misgivings about the future of Hong Kong are well-grounded.
Last year, the Hong Kong stock market had the worst performance in the world. While the three major indexes of the market peaked at the beginning of 2021, they declined repeatedly as Chinese tech stocks fell in New York.
China concept stocks and VIEs
China and the U.S. are still seeking cooperation possibilities despite the conflict and competition. Politically, the forward-looking wisdom of both countries’ leadership could well navigate the course.
However, with the Hang Seng Index lingering around its near 21-month low earlier this month, investors in Hong Kong are dissatisfied, pessimistic and angry. These sentiments tend to have a toll on politics.
New York and Hong Kong are seen as essentially one market, a global capital market, with the same institutional investors following the same risk management rules and valuation matrixes in the stock exchanges in both cities. That is to say, any negative impact on China concept stocks in New York always sends the Hong Kong stock market south. With this connection in mind, to address the issue in Hong Kong’s capital market, it is crucial to resolve the VIE issue of Chinese stocks in New York, currently the greatest concern for institutional investors. Essentially, Beijing needs to make it clear how U.S. dollar private equity and venture capital (PE/VC) funds can continue to invest in private Chinese tech companies and how to exit in overseas capital markets, especially in the U.S.
Settling the VIE issue and clarifying ways for U.S. dollar PE/VC funds’ investments and exit would have profound and positive impacts and chain effects, both economically and politically.
U.S. listings would remain a viable option for Chinese tech companies, institutional investors would regain confidence, and the recovery of China concept stocks would lift the Hong Kong stock market, which in turn would help alleviate economic, social and political conflicts in the metropolis. Local residents, with fuller pockets benefiting from the buoyant stock market, could be more supportive of the “One Country, Two Systems” policy and the implementation of the central government’s policies in Hong Kong. Furthermore, with fewer social and economic headaches, China’s leaders would enjoy a better position in their dealings with the U.S. due to less diplomatic pressure. Meanwhile, Wall Street could be more willing to speak in favor of China. In short, the China concept stock and VIE issue is more than an economic one.
Then, how can it be settled?
Essence of the VIE
The VIE structure was created 20 years ago for special reasons. Basically, it is a detour chosen by global investors who intend to invest in China’s tech industry but are restricted by certain policies.
The keen interest among global investors from developed countries to invest in China shows their optimism about and recognition of political stability and prosperity in the country. They can benefit from China’s prosperity and economic growth under the leadership of the Communist Party.
Global investors’ strong interest to invest in China through U.S. dollar PE/VC funds and the VIE structure has revealed developed countries’ recognition of the party and the nation’s political system, political landscape, government, economy, society and development. Essentially, through VIEs, global institutional investors team up with China to foster a community of shared future while pursuing shared interests.
New challenges to China-U.S. relations
The U.S. will not be an onlooker in matters concerning Hong Kong.
That’s clear if we examine the details. There are two levels of sanctions under the U.S.’ Hong Kong Autonomy Act. First, the Secretary of State submits the annual review of the “Hong Kong Autonomy Act Report” to Congress for possible sanctions. Second, within 30 to 60 days following that annual review, the Secretary of the Treasury shall submit a report as well to Congress for possible sanctions on foreign financial institutions with extensive business relations with sanctioned persons. This year’s deadline for the second potential sanctions is Feb. 18, just two days before the closing of the Beijing Olympic Winter Games. If major Chinese banks were to be sanctioned, the two countries would be walking on an even tighter rope as such sanctions could go far beyond what the Trump administration imposed against Hong Kong.
The enormous challenges are waiting for Hong Kong this year.
Against this backdrop, we must be clear that the Hong Kong dollar’s peg to the U.S. dollar underpins the city’s liberal economy and capital market, implying that the role of Hong Kong as a financial center hinges on the U.S., the U.S. dollar and institutional investors. Any possibility of Hong Kong becoming the main battleground and frontier in the China-U.S. conflict would jolt institutional investors and significantly impact the city’s stock market. So, stabilizing Hong Kong requires stabilizing the expectations of Hong Kong institutional investors, who are mostly based in the U.S. To do this, issues regarding China concept stocks and VIEs in New York need to be addressed. In other words, the central government’s effort to address the issue would be a significant and meaningful move to support Hong Kong.
An insight into the global capital market
Over the years, Hong Kong did not appear to be the first choice for Chinese tech companies to seek IPOs. What is the city’s financing role like now? And what will it be like in the future?
The Hong Kong market’s appetite, long favoring profitable companies in traditional industries, is unlikely to change in the foreseeable future. For example, recently, a leading Chinese autonomous driving company, technologically advanced but with little commercial success, was given a cold shoulder when meeting investors to explore a Hong Kong IPO. It was not the kind of traditional IPO candidate that investors favor; and conventional valuation methods, such as the discounted cash flow model, could not be applied to it.
How would American investors treat a similar candidate in the U.S.?
TuSimple Inc., another autonomous driving company, is a vivid counter-example as it had the same commercialization problems when seeking a U.S. listing early last year. Here’s how U.S. investors did the valuation: If the size of the U.S. autonomous freight market could reach $100 billion in five years and TuSimple could account for a market share of 25%, the company would be valued at $25 billion. While the estimate of the market size and the company’s market share may vary among investors, this valuation approach has been universally recognized. Investors believing in this game-changing technology would be willing to take risks, adopt this unconventional way and pay a premium. Only American investors would be willing to do so.
This well explains that New York, rather than Hong Kong, is the favorable and right listing venue for Chinese tech companies. This is an established consensus among all institutional investors, investment banks and fund managers.
Risk of China-U.S. financial decoupling
The capital market is essential to the advancement of technology and innovation. However, both the Chinese mainland A-share market and the Hong Kong stock market are not fully developed to assist the country’s tech industry. If the U.S. were to curb China’s overall tech advancement, it would seek to disconnect Chinese tech companies from the global capital market before they grow too strong. Like it or not, New York is the only favorable listing venue for China’s tech companies. So, we must be fully aware and understand that China needs New York, even though China concept stocks are not essential for the U.S. or institutional investors.
Last year, as the three major U.S. stock indexes consistently reached new highs, investors who placed their bets on China concept stocks suffered a crushing defeat. The defeat drove institutional investors to quickly place allocations to companies in to Europe, Southeast Asia, India and Latin America, which had surprisingly proven to be more lucrative. Investors shying away from China concept stocks ended up recording better performance. The persistence of Chinese tech firms’ sluggish performance would lead more and more investors to abandon Chinese stocks. So, we must be cautious not to fall into such a trap as the U.S. attempts to disconnect China from the global capital market. Maintaining a solid connection to the global capital market is a must.
Domestically, the ongoing tightening regulatory environment has become a new norm fully supported by startups and institutional investors. While regulators are obligated to regulate the business operations of technology companies in the strictest way, they must also be open-minded enough to allow Chinese companies to raise capital by going public in the U.S. This is one way that China could develop its tech industry — by taking full advantage of the U.S.-dominated global capital market. Even if Chinese tech firms have to leave New York someday, they can go to Hong Kong with abundant capital and experience.
Regardless of technical details of the VIE issue, at the macro level, supporting Chinese companies going public in the U.S., as a step to stabilize China concept stocks and the Hong Kong stock market, is the strongest underpinning for China’s governance of Hong Kong, the firmest upholder for “One Country, Two Systems,” and the best gift for the 25th anniversary of Hong Kong’s return to the motherland.
Beyond that, global limited partners of U.S. dollar PE/VC funds, which have maintained close ties with China for years, are well placed to become a strong ally in China’s diplomatic efforts. Common interests create strong binding. Obviously, leveraging these “old friends” in a proactive and prudent way is better than losing their support. This also seems to be an economic issue, but in a broader sense, it relates to diplomacy.
Focus on details with the big picture in mind
Several of the latest policies in China have been greeted with a continuous market decline. As a matter of fact, a radical change may have occurred in the capital market’s expectations toward China. Considering policy risks too high to avert, many institutional investors that have suffered great losses have to technically adjust their China allocations. Such moves, normally completed by the end of January, according to research analysts at investment banks, would significantly reduce the capital allocated to China’s overseas listed companies. Moving forward, the allocations can only be upped if these companies offer years of high returns.
Therefore, the market now needs proactive policies with positive signals. The market has widely expected the termination of the VIE by Chinese regulators. Thus, new rules need to be articulated, including clear definitions and measures, to guide how global investors can invest in China and exit in overseas markets. Ignoring the reactions of capital markets has negatively affected China’s image in the international community. China is a respected major country and needs to fulfill its international obligations and responsibilities.