by Luca Ruggeri
China today represents a large economic entity, the second largest economy in the world, but it appears to be characterized by major contradictions in the eyes of Western investors, as also previously reported on this site.
Indeed, some episodes have made investors more cautious, most notably the obstacles placed in 2020 on the public offering of Ant Group, the financial arm of Alibaba Group headed by tycoon Jack Ma, and more generally the activity aimed at downplaying the clout and autonomy of big tech vis-à-vis the Communist Party. A further episode that contributed to doubts and increased country risk perceptions about China was the imposition on after-school tutoring companies of the nonprofit nature, as they were accused of contributing to China's denatality given the heavy costs asked to families for supplementary schooling, which is considered necessary to gain access to the best schools in an extremely competitive educational environment. The Chinese government's decision thus erased with the stroke of a pen a promising sector into which a number of foreign investments had poured. This decision also saw the prohibition of this sector's financing through VIEs (Variable Interest Entities) discussed below.
The Chinese stock market has increased in size and, although much smaller if compared to the importance of the real economy, now makes up more than 43 percent of the MSCI EM Index while Chinese technology stocks have a significant weight in the MSCI ACWI - ESG Leaders Index worldwide. The Chinese bond market is now the second largest bond market in the world, behind only the U.S. bond market.
The Chinese government has taken some initiatives to increase the openness of the financial system in order to attract foreign capital: think, for example, for the stock market of the creation of the Shanghai Stock Connect and the Shenzhen Stock Connect. In the bond sector, the Chinese central bank is expanding market access to selected foreign players. However, the overall environment is still far from being an open financial market.
At this point it is natural to ask, in this setting, what tools Chinese companies are employing to attract financial resources from other countries.
Chinese companies, especially technology companies, extensively use VIEs, typically based in tax havens including the Cayman Islands, to raise foreign capital, including through listing in the U.S. and Hong Kong.
VIEs are companies, controlled by the Chinese parent company, that enter into a series of agreements with the same parent company that give them extensive rights vis-à-vis the latter, sometimes configuring almost a kind of control. The VIEs are then listed and raise capital for the parent company. The VIE scheme, which has been in operation since the early 2000s, allows Chinese companies to avoid the direct entry of foreign shareholders into their capital and at the same time raise ample financial resources as demonstrated by such striking cases as Alibaba, Tencent, and Baidu.
The phenomenon's scale has been quantified by a very recent study (China in Tax Havens by C. Clayton, A. Coppola, A. Dos Santos, M. Maggiori and J. Schreger) published by The Global Capital Allocation Project. The report points out that China-linked companies contribute more than half of the equities and about one-fifth of the bonds to overall issues by tax havens, primarily the Cayman Islands but also Bermuda and the Virgin Islands. The study quantifies, for the Cayman Islands alone, the amount of what has been raised by companies headed by Chinese operators, with reference to both stocks and bonds, at US$1,239 billion as of December 2020. This is a large mass of money that eludes official statistics describing flows and investments between individual countries, with the US as the main source.
This way of using tax havens raises several concerns on different levels; we simply point out a few that seem to us to be of particular importance.
The VIE scheme periodically returns to attention with reference to the risks of the individual investor, as it raises obvious questions about the legal means of recovering one's investment in the event of default of the Chinese parent company. In this respect, developments in the Evergrande real estate group saga are awaited.
More generally, it is questionable whether the use of VIEs is a first step toward opening up China's financial system or just a kind of ploy to prevent the effective entry of international investors into the capital of large domestic enterprises.
On a different level, it seems clear that China's financial ties with the rest of the world, particularly with the U.S., are more prominent than might appear at first glance, and this, among its many consequences, makes it more difficult to weaponize finance as a tool of pressure against China than, for example, has been the case with Russia.
Senior Fellow at the Centro Studi Machiavelli. A graduate in Economics, he worked for over twenty years at a large Italian bank and currently serves as a general manager at an institutional investor.
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