Here’s One Way Chinese Retaliation Could Really Hurt Investors

April 12, 2018

Here’s One Way Chinese Retaliation Could Really Hurt Investors

  • You don’t own Alibaba, and you can’t own it.
  • Today, we’ll discuss how Chinese companies list on U.S. markets and 10 risks that go alongside that.
  • Do you trust Jack Ma?



Introduction

Many of the stories out right now are about tariffs, trade wars, and the negotiations between the U.S. and China on trade. President Trump is playing hard ball as the U.S. trade deficit with China is huge and getting bigger.

Figure 1: The U.S. trade deficit with China has been growing on a monthly basis. Source: FRED.

The deficit was $566.0 billion in 2017, the highest since 2008, which represented 2.9% of GDP, up from 2.7 percent in 2016.

2.9% of GDP per year is huge and something definitely needs to be done about it. President Trump has addressed the issue by putting tariffs on Chinese imports and China has retaliated in a similar fashion.

Figure 2: U.S. China tariffs. Source: Wall Street Journal.

I’m not going to go deeper into tariff theory, but I want to point out something that some investors are unaware of but is extremely important and in case the trade war continues, this might escalate in an actual risk.

You Don’t & Can’t Own Businesses In China

Perhaps you’re an Alibaba (NYSE: BABA) or Baidu (NASDAQ: BIDU) shareholder or own some other Chinese stock, and you might think your portfolio is exposed to the Chinese growth story as you own parts of the fastest growing and largest businesses in China. Well, you don’t own anything because China doesn’t allow foreign ownership.

Let me show you what I mean by discussing Alibaba and what’s actually traded on the U.S. stock exchange.

Alibaba Is A VIE Structure

In a variable interest entity (VIE) structure, you don’t own shares directly in the Chinese company, but you own shares in an intermediary that provides capital through a loan to the Chinese company with various contractual agreements.

Figure 3: Alibaba’s corporate structure. Source: BABA.



A VIE is where foreign investors don’t buy shares of Alibaba China, but of a Cayman Island based company called Alibaba Group Holding Limited which has contractual rights to the profits of Alibaba China but absolutely no economic interest.

The VIE structure is currently the only way that foreigners may have an economic interest in businesses in Chinese restricted industries like telecommunications, e-commerce, mining, banking, private education, and online games.

Do You Trust Jack Ma?

The key behind the VIE structure is to circumvent the Chinese government’s restrictions on foreign investment which is something of a grey area. However, in 2012, Jack Ma decided to transfer the assets of Alibaba’s online payment platform to a company owned by him. At the time, Yahoo and Softbank, which owned 44% and 30% of Alibaba respectively, complained and the case was settled but still shows how much of a grey area this is both on the conflict of interest side and regulatory side.

Minsheng Bank VIE

At any point in time, China can declare those contractual rights on foreign ownership illegal and what you would then own is squat. Further, all the contractual agreements are governed by PRC law and therefore, all your holdings are held to what a communist government can decide. This probably won’t materialize as a risk, only if all hell breaks loose, but it’s something to be aware of because you never know.

In 2012, China’s Supreme Court broke up one form of a VIE when it invalidated contracts made between Minsheng Bank of Hong Kong and its mainland proxy cutting off foreign investors from future profits.

You Don’t Own Ant Financial

Another interesting thing to elaborate on is that if you own stocks—or better to say, have a contractual agreement with Alibaba China—you don’t have a contractual agreement with Ant Financial. Further, the licenses and domain names used by Alibaba in China are owned by Jack Ma and Simon Xie who have just agreed to allow Alibaba to use them and profit on them.

So, there is the risk that the owners of those assets refuse to collaborate with the VIE. Perhaps Jack Ma will collaborate, but what if he dies? Will those who get his inheritance agree with what is there now on paper? And whose side will Chinese courts take in the case of a dispute?

Another point is that there can be no activist intervention there. Chinese owners don’t like when investors make the calls and might do whatever they want.

Alibaba Owned Ant Financial Before Ma Spun It Off To His Own Company

Established in October 2014, Ant Financial’s businesses include Alipay, online bank MYBank, credit scoring service Sesame Credit, lending marketplace Zhao Cai Bao, mass-market investment vehicle Ant Fortune, and Yu’e Bao, China’s largest money market fund.

Alibaba once controlled Alipay, but spun off the ownership in 2011 to a separate entity controlled by Ma and evolved into Ant Financial.

Ma & Xin Are Using BABA’s Money To Buy Companies

Jack Ma and Simon Xie have taken a loan of $1.05 billion renminbi to buy 20% of Wasu.

What kind of company gives a loan to its owners so that they can invest in another company? Why wouldn’t the company itself invest? Well, that’s what you get for doing business in China. Investors are blinded by the exorbitant growth shown in their financial numbers which is questionable but let’s leave that for another article.



Chinese People Can’t Invest In The Hottest Chinese Companies

If you’re a high school student in Salt Lake City, Utah, or a college graduate in Berlin, you can easily buy stocks in Alibaba and the other Chinese tech giants. If you are a student in Beijing, or another Chinese city, you can’t.

How long will the Chinese government allow this if there is more pressure put on them in relation to trade?

Conclusion

It isn’t all growth when it comes to investing in China, and what seems like it’s one way on the surface looks a lot different when you dig a bit deeper. However, the points touched on in this article are mostly just corporate governance issues, but things happen that would be severely punished in more transparent markets.

Why isn’t Alibaba punished? Well, if you’re in trouble as a foreign investor, you can quickly lose your shirt just as Yahoo and Softbank did when they settled with BABA and only got 33% of Ant Financial, not 100% as would be normal in the western world.

This is just the tip of the iceberg. I’m investigating whether or not the growth numbers shown by Chinese companies are truthful or if these companies are cooking the books a bit to make things look better.

Stay tuned as I’ll keep you posted on what I find out.



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