In August 2021, the Chinese government published the “14th Five-Year Plan” – a project for the country’s socio-economic development from 2021 to 2025. The project provides for strengthening regulation in the field of financial and educational services, which have been recognized as vital for the future of the country.
But in fact, the implementation of state plans began in 2020. So, in November 2020, the Chinese regulator launched an antitrust investigation against the largest company Alibaba. As a result, the founder of the holding, Jack Ma, was unable to launch Alibaba’s subsidiary, the Ant Group payment platform, for an IPO. The Ant Group’s share offering could have been the largest IPO in history: the company expected to raise $37 billion.
Next, the Chinese authorities took up the educational business: in mid-June 2021, the state banned companies that work in the field of school education from making a profit and raising capital on stock exchanges. The three largest education companies in the country – TAL Education, Gaotu Techedu and New Oriental Education – lost about $16 billion in total, more than half of their market value. According to CNN Business estimates , as a result of tightening China’s regulatory policy, Chinese businesses lost about $1 trillion over the year.
Exchange to support competition
Already in the fall, after the presentation of a new development plan, the Chinese President announced the creation of a stock exchange in Beijing – “the third new platform.” Prior to that, there were two main exchanges in China: Shanghai and Hong Kong. According to the plan of the state, the Beijing Exchange will be focused on small and medium-sized businesses in the field of technology.
According to Alexei Debelov, HSE and NES lecturer and partner at FP Wealth Solutions, the new platform is being created on the basis of the Chinese National Stock and Quotation Exchange (NEEQ), which has been in existence since 2021. The exchange is being reformed as part of a program to develop and support competition from large Internet conglomerates such as Tencent and Alibaba.
The new exchange will be able to list Chinese companies listed in the US as part of the government’s strategy to develop its own financial markets. In addition, foreign legal entities will be allowed to trade.
The measures, along with tighter regulation of the high-tech sector that scared investors so much, are part of the implementation of the strategy of shared prosperity announced by Chinese President Xi Jinping in August, adds Debelov. According to him, the goal of the new policy is to increase the share of the middle class and fight poverty in order to ensure political stability. “It is proposed to pay for these measures through taxes on the rich, just like in the United States,” the analyst concludes.
Now Chinese companies cannot list their shares on Chinese stock exchanges and abroad, this is prohibited by the regulator. A business that wants to conduct an initial public offering needs to choose only one of the options. Therefore, large Chinese companies that want to attract foreign capital create Variable Interest Entities and place American Depositary Receipts (ADRs) on them, explains Capital Lab partner, investment manager Evgeny Shatov.
It differs from standard ADR shares on VIE by an important condition: by acquiring a standard share, the investor acquires ownership of a part of the company and becomes its minority owner. A depositary receipt on VIE does not give the investor the right to a part of the company whose securities he has acquired. Instead, the investor owns a part of another company that has an agreement to receive a percentage of the profits of the entity listed in the ADR.
This is exactly what Alibaba did: the company registered Alibaba Group Holding Limited in the Cayman Islands, then this new structure entered into an agreement with Alibaba to receive a percentage of the profits. Alibaba Group Holding Limited then listed its depositary receipts on the New York Stock Exchange under the ticker symbol BABA. These securities are bought by investors from all over the world, including Russian ones – there are no shares of the parent company Alibaba on foreign exchanges.
According to Shatov, the main risk of owning an ADR on VIE for an investor is that he does not receive rights to any of the company’s assets. In the event of a force majeure situation, such as a sanctions war between the US and China, an investor could suddenly become the owner of a shell company, and this would not even be considered a confiscation, Shatov explains. At the same time, as a rule, it will be useless even to sue: in developing countries, the courts are rather weak, which are not able to protect foreign investors from the arbitrariness of the authorities or local players with connections, the analyst adds.
What changes await foreign investors with the advent of the Beijing Stock Exchange?
The Chinese government can easily ban its companies from listing on foreign exchanges with a stroke of the pen, says Evgeny Shatov, partner at Capital Lab. At the end of December, the country’s authorities tightened the rules for the IPO of their companies abroad.
Now, before conducting an IPO on an overseas stock exchange, a company must register with the China Securities Regulatory Commission (CSRC). There it will be checked for reliability. If an organization may pose a threat to China’s national security, it will not be allowed to conduct transactions abroad. This rule applies to all Chinese companies, whether they place depositary receipts or shares themselves. The first case of delisting has already happened: the Chinese taxi aggregator DiDi was forced to remove its depositary receipts from the New York Stock Exchange at the request of the regulator.
However, according to Shatov, the story of Didi’s delisting is not indicative, the reason for the company’s withdrawal from the stock exchange was the failure to comply with the requirements of the Chinese regulator, which were presented to the company even before the IPO. Now the Chinese government does not create obstacles for the listing of Chinese companies on foreign exchanges, if they comply with the instructions of the regulator. Placing on the new exchange is more of a choice for the companies themselves, if they have a desire to remain public, they can list on any Chinese exchange.
However, the authorities are aware of the danger, for example, of restrictions by the United States or a complete ban on the listing / trading of shares of Chinese companies at home. This may limit the ability of Chinese companies to raise private capital, so they decided to play it safe and create a new exchange.
The BSE (Beijing Stock Exchange) will target medium and small technology enterprises that already trade stocks but are on the OTC market and want to go public. The registration procedure on the Beijing Stock Exchange will be the same as on the Shanghai Stock Exchange (analogous to the American Nasdaq), but with one exception: companies with less capital will be able to register on the new stock exchange. In addition, the rules of the new exchange are safer for private investors. According to the rules exchanges, only private Chinese investors with a capital of at least 500,000 yuan and at least two years of experience in financial exchanges can trade on it. Foreign investors are also allowed to take part in the auction, but only institutional (legal entities) – the capital threshold for them is not set. Also, according to the rules of the exchange, trading can be suspended if the index rises or falls by more than 30% during the day.
The Chinese government continues to talk about the need to attract foreign capital and plans to pursue an easy monetary policy next year, this should help restore the Chinese stock market, says Shatov (Capital Lab). But, on the other hand, the expert reminds that a number of serious risks remain. The main one is regulatory, which can affect any industry. Tensions between the US and China remain another important risk, and we cannot expect them to improve in the near future. The planned tightening of monetary policy in the US may provoke an outflow of investment capital from the markets of countries, including the Chinese market.
Along with increasing regulatory pressure on technology giants, China is creating conditions for the development of small and medium-sized IT businesses in China. The opening of the Beijing Stock Exchange will allow small and medium-sized companies to directly attract foreign investment. In turn, the opportunity to gain access to the domestic Chinese market attracts foreign institutional investors. They get the opportunity to avoid the regulatory risks of Alibaba and Tencent through a wider diversification of the country portfolio.