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The Institutional Risk Analyst

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China Embraces "National Treatment"

July 30, 2021 | For a while now, we have been watching the collapse of the “out of China” trade even as foreign investors have been pouring new money into what they think are Chinese stocks. Now China has taken a page from trade wars of old, imposing a strict regime of "national treatement" on Chinese companies.

The joke, of course, is on foreign investors who think that investing in China is merely about asset allocation and not risk. Foreign investors in China stocks are not really buying stakes in Chinese companies, but rather put cash into indirect vehicles that can be dissolved at the wave of the hand of China’s dictator, Xi Jinping. In China under the Chinese Communist Party, there is no legal protection for private investors or anything else.

China’s Anbang insurance group was sold for $5.2 billion earlier this month, part of the collapse of a cohort of conglomerates, including HNA Group and Dalian Wanda. These firms embodied China’s “going out” policy, which led to aggressive foreign investment and expansion in the mid-2010s. Now this highly leverage surge of investment has collapsed.

This rush of highly leveraged investments from China saw HNA briefly become the largest investor in Deutsche Bank AG (NYSE:DB). Since then, HNA has defaulted on billions in debt and other obligations, including money owed to thousands of employees and retail investors. The scandals pouring from the wreckage of HNA and other Chinese companies and banks seems to be unending, including officials of China’s top government lender, China Development Bank.

Xu Weihua, a former president of the China Development Bank’s branch in the southern island province of Hainan, is now under investigation by the “Central Commission for Discipline Inspection.” Dozens of other officials have been jailed in a growing campaign against “corruption” in response to billions in losses to investors and the Chinese state. In the first half of 2021, China defaulted on a record $18 billion in corporate debt.

In another sign of the unwind of the “out of China” trade, technology distributor Ingram Micro officially closed its $7.2 billion acquisition by private equity firm Platinum Equity. The long-awaited deal frees Ingram Micro from financially troubled HNA Group. In today’s poisonous political environment between Beijing and Washington, such an acquisition as Ingram Micro would be impossible by a Chinese firm.

“The government of President Xi Jinping is placing a priority on reducing excessive debt in the corporate sector,” Nikkei reports. “By doing so, however, it risks pushing a legion of companies into difficulty with financing their businesses. That could then choke the nation's economic growth in the coming years.” But for now, China is awash in dumb money from offshore.

While foreign investors think they have been investing in Chinese stocks, in fact Beijing had created a mechanism – call it “variable interest entities” or VIEs – that have the appearance of allowing foreign investors to invest, but always kept control firmly in the hands of the Chinese Communist Party. These indirect vehicles for gathering foreign investment may now be in jeopardy.

“There has always been this political risk around China,” says Leland Miller, founder of China Beige Book. “For years, foreign investors bought indirect stakes in Chinese firms via what looks like a VIE, but did not actually invest directly. We winked at the lack of audits for Chinese firms listing on US exchanges and other departures from US law. Everything was fine until recently. And now China is having to rethink this arrangement rather considerably. The precipitating issue this time is big data and the national security implications.”

Miller tells The IRA that the recent interventions by Beijing in a number of planned IPOs for Chinese firms in the US marks a larger change in how China will interact with foreign investors and governments. Specifically, Beijing will not allow Chinese firms to list their shares offshore unless they ensure that their business and the related data are protected from the enforcement of US law.

Investors generally don’t care about things like protecting “big data,” but this is topic number one for the Chinese state. The topic is not sexy nor is it conducive to attracting investors, but control over big data is causing a shift in the relationship between Beijing and foreign capital. Bottom line: Beijing wants to ensure that Chinese law trumps US law when it comes to Chinese companies.

Of course, China’s assertion of national treatment for its companies has always been this way, but foreign investors pretended otherwise. Now, says Miller, there is starting to be seriousness on the Chinese side when it comes to protecting mainland companies from the reach of US law – even if it means that smaller Chinese firms lose access to foreign capital.

“China has played the game with foreign investors for a long time,” Miller tells The IRA. “VIEs were not technically illegal as a means of gathering foreign investment, but China played the game. Access to foreign capital is clearly important, but it is not the most important thing to Beijing.”

Miller thinks that Beijing will boost Hong Kong as part of a shift way from dependence upon the US capital markets, even if that means that they must adjust to less access to capital in the near-term. But the biggest implication is for foreign investors in China, who have been unwilling to acknowledge any China risk in the past.

Now that the US has begun to insist that Chinese firms follow US law, Beijing has pushed back, effectively saying that Chinese law is the governing authority. This posture represents a striking confrontation with Washington, which is accustomed to imposing US law around the world unilaterally and often without significant push back.

The implications of this evolving confrontation between the US and China is that global firms seeking to do business in the west and in China must essential bifurcate themselves into separate silos, with data and IP segregated into buckets for the purposes of complying with national legal requirements. After years of listening to the happy nonsense coming from foreign investors, Beijing has now embraced a new policy of national treatment for all Chinese companies.

Under a best-case scenario, the new assertiveness by Beijing implies a major change in how global companies operate and raise capital. There may not be ways for some companies, for example, to adhere to Chinese and US law at the same time. Some companies may not find it possible to do both, creating risk for these enterprises and their investors.

As the US and China adjust to this new reality, the EU is also in the mix, asserting national treatment for companies that do business in the Eurozone. The image of data residing “in the cloud” must now be revised to accept the separation of businesses into clearly defined units that operating under local laws. Forget storing data in the cloud. Those servers used to store company data must be physically located in the nations that exert legal control.

Foreign investors that treated investing in China as merely another asset class choice now face unfamiliar country risk in terms of the political evolution of Beijing’s posture vis-à-vis the US, EU and other states. Now offshore investors must assess whether a given company or industry will become this week’s punching bag in the political battle between Beijing and Washington.

Despite the massive losses accumulating from HNA and other Chinese firms that participated in the out of China investment wave, Beijing has picked an opportune time to rebalance the relationship with the west. Money from credulous foreign investors has been pouring into China. As the situation becomes more clear, however, the surfeit of cash from abroad may gradually turn into an exodus.

“It has always been considered impossible, unthinkable that the Chinese would invalidate a VIE,” says Miller. “Now such an outcome has gone from unlikely to a real concern. Investors need clarity on this issue or they are not going to be able to invest in China as they’ve done in the past.”


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