The Certainty of Change: Evolution of Investor Access to China

The unpredictable nature of politics and government action within individual countries can make a case for disaggregating international exposure, according to our Dina Ting. With support from members of the Global Index Portfolio Management Team, she outlines some recent regulatory developments in China within the lens of exchange-traded funds (ETFs).

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 “modernized 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—totaling over US$1.7 trillion of market capitalization—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.