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The unpredictable nature of politics and government action within individual countries has long been fundamental to institutional investors’ case for disaggregating international exposure. Today’s markets are no different, as recent moves by the Chinese government in balancing social agenda versus growth (implementing anti-monopoly, data security and industry-specific regulations) have caused significant investor reaction, sending the markets into a frenzy. Beijing’s aim is to develop China into a “modernised socialist economy,” which seems to be driving these new regulatory efforts that target common prosperity, green development, and independence in key technologies/industries. While China’s economy is poised to benefit from these efforts in the long run, this latest round of regulation has given investors added pause as they grapple to understand how their current investment in China may be impacted.
As discussed in the latest insights from Franklin Templeton’s Emerging Markets Equity team, one of China’s most notable regulatory “crackdowns” is its new policy banning the use of variable interest entity (VIE) as a way for foreign investors to gain access to the after- school tutoring (AST) industry. This, in turn, has caused renewed interest in assessing vehicle exposure to Chinese companies.
VIE Quick Facts
- The variable interest entity (“VIE”) is a legal structure that has been used extensively to facilitate offshore financing of Chinese businesses, allowing many large well-known Chinese companies—totalling over US$1.7 trillion of market capitalisation—to list in markets outside of China, such as the United States or Hong Kong, in pursuit of capital.
- VIEs rely on contractual arrangements which enable a foreign investor to control (but not directly own) the economic benefits of an operating company. As such, VIEs have opened up foreign investment to companies in industries where China would otherwise restrict it—such as technology sector.
The VIE structure ban in the AST industry has driven investor fear of future unknown actions in other sectors—elevating market volatility in China. The AST industry (which represents < 0.5% of the index) dropped 74% on average for the month of July, while the FTSE China RIC Capped Index dropped 13.4% in three days surrounding the policy announcement before recovering 5.5% in the following three days.1 While it is clear that China is renegotiating the previously ambiguous terms under which it allows foreign investors to participate in the Chinese market, we don’t see this as the death of VIEs nor do we see it as a significant impediment to foreign investment more broadly.
While 61% of the FTSE China RIC Capped Index relies on VIEs and therefore is subject to further potential regulatory changes, another 16% is invested through China A-shares. In comparison, the MSCI China Index consisted of 65% VIE and 14% China A-shares.2 China A-shares, incorporated into many broad market indexes in 2018, are a relatively new share class for US investors and marked a major step into direct foreign investment into Chinese companies. Given the current 25% inclusion of China A-shares in the FTSE indices, we expect that the weight of China A-shares will grow in the future.
While we remain positive on the options for foreign investment in China, we do expect these regulatory cycles to continue as the country aims to increase social fairness and stability. This serves as a prime example of the “country factor,” which we believe underpins the case for disaggregating one’s international equity exposure with single-country investment strategies. Given China’s market capitalisation, it makes up a significant 41% and 37% of the FTSE Emerging Markets Index and MSCI Emerging Markets, respectively.3 However, simply relying on the economic success of the companies in a particular country for determining its weight in an index can be short-sighted.
Macro and geopolitical factors such as regulations, trade, fiscal and social policies all play a part in determining the growth prospects and economic trajectory of a country and competitive positioning in the global markets. Arguably these policies are playing a larger driver in the coming years, requiring investors to adjust its investing lens when balancing risks and returns. It is important for investors to recognize that each country has a distinct set of risks and opportunities that may require disaggregation of broad market exposure into single country to generate a better outcome.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
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1. Source: Bloomberg as at 1/8/2021. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
2. Source: Bloomberg as at 29/7/2021. VIE classification methodology: For either US securities (ADR) or Hong Kong-listed Chinese companies are incorporated in a tax-haven country (Cayman Islands, Bermuda, Virgin Islands, etc.) they were classified as a VIE.
3. Source: Morningstar.