Variable interest entities are their weakest link

The Economist article captures the gist of the VIE arguments

  • Investors outside China have about $1trn invested in firms that use them.
  • They are “China’s version of too-big-to-fail”, says one.
  • It is as if Facebook were domiciled in Samoa, listed in Shanghai and its website and brand sat in separate legal entities that were the property of Mark Zuckerberg (but which he had agreed to allow Facebook to run and profit from).
  • American regulators allow VIEs if their dangers are disclosed.
  • For investors, there are two risks. First, the VIEs could be ruled illegal, potentially forcing the firms to wind up or sell vital licenses and intellectual property in China. The second danger is that VIE owners seek to grab the profits or assets held within. If they refuse to co-operate, die, or fall out of political favour, it is far from clear that firms can enforce VIE contracts in Chinese courts.
  • VIEs could even be a diplomatic tool. In the event of a trade war, a quick way to hurt Americans’ economic interests (along with banning Apple, which makes a fifth of its sales in China) would be to void VIEs, although China’s reputation with all investors would suffer.
  • The enduring answer is for China to relax its foreign-ownership restrictions and open its capital account.

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