A pause or aplunge?
Chinese IPO

Source： Economist on July 9th, 2011

OWNERSHIP is rarely straightforward in China. After Mao Zedong died andland was opened up for commercial development, each plot came with only a50-year government lease. No one knows what will happen when those leasesexpire. Yet building projects continue apace.

Foreign investors face a similar conundrum. Several Chinese industries,such as mining, steel, education, telecommunications and the internet, are bothcapital-hungry and politically sensitive. They need foreign investment, but thelaw bans foreigners from owning stakes in them.

Eager investors and canny locals have found ways around the rules. Perhapsthe most important is the creation of a complex investment vehicle called a“variable interest entity” (VIE). It works like this: valuable Chinese assetsare placed in a Chinese company. This entity, the VIE, must be run by a Chinesecitizen. A series of contracts are then arranged, shifting the returns from theVIE first to a foreign-owned company registered in China and then to anoffshore company, perhaps in the Cayman Islands.

This structure—a Chinese-owned company in China, a foreign-owned companyin China and an offshore parent—is known as the “Sina” model, after the firstChinese internet company to be listed overseas. It is used by about half of theChinese companies listed in America, says Paul Gillis, a professor at PekingUniversity. Numerous other unlisted companies use it as well. It allows Westerncompanies to invest in China without breaking local ownership restrictions.

There are signs, however, that the Chinese government has begun to frownon VIEs. In 2006 the Ministry of Information, which regulates internet firms,said it was taking a look at them. In 2009 three other ministries announcedthat VIEs were banned for companies involved in internet games.

Berating Buddha

In March, says Thomas Shoesmith, an attorney with Pillsbury, a global lawfirm, a $38m bond offering in America for a company called Buddha Steel waswithdrawn after authorities in Hebei province blocked its VIE with a localsteel plant. Officials said that the very existence of a VIE contravenedChinese management and public policies. An anxious debate followed: was thisthe random act of a single region, or a wake-up call from Beijing?

A dispute between Alibaba, a Chinese internet group, and Yahoo!, anAmerican firm that owns 43% of Alibaba through a VIE, suggests the latter. TheAlibaba VIE recently transferred a valuable asset (Alipay, an online-paymentsfirm) to a local Chinese company controlled by Jack Ma, Alibaba’s chairman.Yahoo! was outraged. Alibaba claims it had no choice. It says it was warned byChina’s central bank that Alipay would not be allowed to operate if it was, ineffect, partly foreign-owned.

In theory, the same problem could afflict the rest of the Alibaba Group.But Alibaba says its other operations will be unaffected because they fallunder a less fussy regulator, the Ministry of Information.

Perhaps so, but Mr Gillis, who has long blogged about the potentialpitfalls of VIEs, is suddenly getting lots of attention. Alibaba is not unique.Other firms with VIE structures are also involved in electronic payments. Atleast one has a foreign partner. Now that the issue is in the news, China isunder pressure to spell out what is permissible, and what is not. The risk thatbig foreign firms will suddenly find that their investments in China areillegal or worthless is surely remote. Or is it?