China has a plan to lure back Big Tech. Having lost a string of internet champions to exchanges abroad, the People’s Republic recently announced a pilot scheme to let firms sell shares at home using depositary receipts. Giants like Alibaba and Tencent could see their market values rise yet further.
What are Chinese depositary receipts?
A variant on the American depositary receipt, basically. That means traded certificates tied to underlying shares, which are often based abroad. Some $3.4 trillion of ADRs and similar instruments, such as London’s global depositary receipts, changed hands in 2017, Citigroup says.
Alibaba is the world’s most-traded ADR by value, for example. It is incorporated in the Cayman Islands. Investors buy and sell its stock via receipts in New York, which are backed by unlisted ordinary shares. Yuan-based CDRs will be issued by a Chinese financial institution and traded on mainland exchanges.
How would CDRS work?
They would probably mostly preserve the status quo. Companies should be able to keep “variable interest entity” structures, a legal workaround that lets foreigners invest in sensitive sectors. Same goes for weighted voting rights, a system which give founders outsized control compared to economic stakes. In each case firms will simply have to disclose this clearly in their prospectuses. Neither of these things is normally allowed for listed firms in China.
But bankers don’t expect them to be fungible, or legally interchangeable with a company’s other shares, since that would open a hole in China’s strict capital controls.
Why does Beijing want this?
It is embarrassed by the exodus of national champions to foreign exchanges. And it wants to give domestic investors access to hot stocks.
There were many reasons for the original rush abroad: from strict rules on profitability and corporate structures in China, to the prestige of listing in New York. When pioneers like Baidu floated in 2005, there was vastly more capital available in the United States than at home.
How big a deal will CDRS be?
Probably small at first. Five firms -- Alibaba, Baidu, JD.com, NetEase and Tencent -- would qualify to issue CDRs, given they have market values of more than 200 billion yuan ($31.8 billion).
These securities could represent 2.5 to 5 per cent of existing shares outstanding, Morgan Stanley analysts reckon, based on Hong Kong-listed stocks that have US ADRs. That implies at most roughly $56 billion of CDRs, or 0.6 per cent of China’s equity market, the bank estimates. This total could grow over time, given Beijing will want this to be more than just a token gesture.
Will investors benefit?
Yes. Chinese outfits who buy the CDRs when they are issued are particularly likely to do well. The new instruments might either be priced in line with the foreign shares, or offered at a price range, as in a flotation. Either way, the securities are likely to trade up sharply, given these are household names in China and tech firms that have swapped New York for the mainland, like Qihoo 360, have soared in value.
Aside from these lucky few, international shareholders might reap gains, too. The CDR plan should soothe worries that Beijing could outlaw VIEs, helping boost valuations, Morgan Stanley’s analysts reckon.
More broadly, an epic rally in China could prompt a wider reassessment of a company’s value. And as they issue CDRs, firms might buy back ADRs to keep their overall share count steady. That would tend to push up the price of their US- or Hong Kong-listed stock.
What about private companies?
They can join in, too. At present Chinese tech companies cannot list at home if they are unprofitable or incorporated overseas. That rules out promising candidates such as smartphone-maker Xiaomi and ride-hailing giant Didi Chuxing.
The new guidelines will let businesses valued at 20 billion yuan or more float in Shanghai or Shenzhen, wherever they are incorporated, provided they meet minimum sales requirements. Others could be approved at the regulator’s discretion, provided they are fast-growing and leaders in their field. However, controlling shareholders and senior management of loss-making companies cannot sell shares until the business turns a profit.
Aren't there drawbacks?
Definitely. While Chinese companies generally score badly on corporate governance, at least they are barred from using things like super-voting stock. Some of those safeguards will fall away. And the small band of tech stocks already listed in China could fall in value, as money flows out into the sexier CDRs.
Corporate bosses will have some new headaches, too. They might need to report results under two different sets of accounting standards, for example. One senior executive says firms could be forced to publish board minutes, which would be an uncomfortable new level of disclosure. On balance, though, this will be a trade worth doing for Alibaba et al.