Responding To China’s Deep Change

The changes in China are coming fast and thick on the ground. A mysterious writer called Li Guangman has written that China is returning “to the essence of socialism.” Li offered a detailed explanation of why it was the correct move to erase several well-known and wealthy entertainers and impede the IPO of Ant Financial on the path to perfected socialism. His piece (here in Chinese) was a classic exercise in “zhengming,” rectifying a discrepancy that has evolved between names and reality, on the terms of the top leaders, of course. What should capitalists do?

The essay claimed that this responds to “ferocious attacks by the United States.” It is probably true that the Trump attacks made Chinese authorities feels less secure in their ability to derive endless growth through export markets and that their access to U.S. capital markets was imperiled. But more saliently, China is responding to its own domestic politics. Any political scientist knows that, as social dissatisfaction grows, the people critically required to prop up top leaders—whether the Imperial Guard of Iran, the North Korean secret police, or top donors to the Republican Party—become fewer in number but ever more important to satisfy. That leads to steadily increasing costs for patronage and ideological alignment. Taking over in 2012, Xi Jinping clearly saw that China would be spinning off less wealth than in the previous decade, and he had to make sure that there was enough to take care of his key supporters. Thus the “anti-corruption campaign,” which reduced the number of hands in government pockets and made sure that abundance would continue to flow to those who really matter.

Now, the door is closing further. China’s asset bubble cannot continue to produce the investment returns that have helped the average Chinese person dream of future wealth and that provided bountiful wealth to the red elite. Losses, as demonstrated by Evergrande (3333 HK), loom so large that the government is trying to distance itself by drawing a bright line between public and private debt. U.S. dollar assets, which can move over the border instantaneously, are under attack, and Renminbi assets—such as those acquired in a Mainland IPO—are encouraged.

The central government has placed a heavy hand on the economy and culture, promising to reduce “excessively high” incomes, stopping some IPOs and interfering with others, and sending police to stop classes at profit-seeking educational institutions. Xi Jinping has been promoting “common prosperity” and attacking monopoly, private control of data, and private finance. The government is “cleaning up” celebrity culture online and making some celebrities disappear. Hostage taking by the legal system is now unapologetic.

Some of China’s bureaucracies clearly worry about killing the golden goose that has been responsible for China’s foreign-sourced wealth. That is why the China Securities Regulatory Commission in July held a conference call with such Wall Street grandees as BlackRock BLK and Goldman Sachs GS . Xinhua News Service in July assured Chinese companies that the government remains supportive of public listings overseas. And the Cyberspace Administration of China, in publishing draconian new rules about data security in August, told foreign investors that they are not targeted—causing shares of U.S.-listed Chinese internet companies to rise.

But the attacks on private and foreign business originate much higher in the government than in these line bureaucracies. How should asset managers respond?

China will likely avoid gross and blatant expropriation but will change regulation either to dilute ownership, reclassify ownership, or null out bond and stock values for heavily indebted companies. Gray-area investment models, such as the Variable Interest Entity or VIE, which underly nearly all overseas-listed tech business, will be eroded to enhance opaque control of cash flows for Chinese partners. 

That means that asset managers who want exposure to China but also want to tell investors they are safe will want to watch regulations coming out of individual ministries. For example, given concerns about geese/golden eggs, it seems unlikely that China will simply outlaw the VIE structure. What will happen is death by a thousand cuts.

In 2006, the Ministry of Industry and Information Technology limited the scope of VIEs in telecommunications and issued a circular saying that China “does not welcome” VIEs in value-added telecom. In 2009, the government limited VIEs in gaming. In 2011, Hebei Province refused to recognize the VIE structure of Baosheng Steel, which wanted to do an IPO. Baosheng had proposed to go public in the U.S. Buddha Steel, its Cayman Islands holding company. Buddha Steel ended up withdrawing its prospectus, terminating the VIE agreements, and Baosheng listed in Shanghai. These curtailments have not really clipped the wings of currently listed internet and gaming companies, but the rules sit there behind the curtain to be deployed as desired.

The biggest risk of all for VIEs is probably in the foreign exchange regime. Already, the State Administration of Foreign Exchange (SAFE) needs to issue a license to transfer money, and these licenses could be withheld. Companies may pay dividends only once a year, and they must reserve for accrued profit and worker welfare. Those accrual amounts could be increased, decreasing payouts. Traditionally, SAFE is a critical choke point for controlling foreign business, because its decision-making is opaque and it provides bank “guidance” without known legislation or regulatory change. SAFE frequently withholds approval to change retained earnings to dollars if the provincial quota for dollars has been met. Watch foreign-exchange reserves, capital flight, and the Renminbi exchange rate to assess the potential for this risk.

Li Guangman appears to be a pseudonym and has attracted some portion of ridicule from Chinese netizens. Republishing his essay on state media can be seen as a trial balloon. But the Chinese system is not particularly concerned with what the average person thinks. China’s political level continues to pull on the slowly tightening noose.