Dune Lawrence of Bloomberg Business Week published an excellent article that broke no new ground on VIEs, yet has ignited a firestorm in the blogoshere. Check out the China Law Blog, China Hearsay, Digicha, and the China Finance Blog. While they express different and strongly held opinions I think they are all saying the same thing. The VIE structure is unusual, risky, and in trouble. No one expects the Chinese government to suddenly shut down Baidu and Sina over their use of VIEs yet I think all would agree that the days for these structures are numbered. The questions that remain are how quickly will new IPOs of VIE deals be shut down and how are the respective governments going to deal with existing VIEs. On the first issue, I think that lawyers and accountants are going to face incredible pressure from many different directions that may stop new deals in their tracks. I will have a post on this later today.
The second issue is the most important. How does China find a way for its successful entrepreunerial companies to find capital? This is a much broader issue than just VIEs. Today's Wall Street Journal reports on efforts to expand the access to credit for private companies in China. Most of the problems we see today in the China concept stock space, from VIES, to reverse mergers, to fraud, have their roots in the failure of China to provide adequate access to capital for its entrepreunerial companies. At first the problem was ideological, as China's capital markets were initially conceived as a way to reform SOEs, not to support the capitalist roaders. By the time (2001) that Jiang Zemin welcomed entrepreuners to join with workers, farmers, cadres, and PLA officers and men to build socialism with Chinese characteristics, the trail to overseas capital markets had already been blazed.
The current VIE controversy is a small scene in the metanarrative of China's modern development. The bigger story is the increasing importance of the private sector and the need for China to create the institutions that support this development. Nature abhors a vacuum, and Chinese leaders created one when they accepted private business but failed to build the institutions necessary to support their development. International capital flowed in to fill the vacuum, but that has created many of the problems we are trying to sort out today.
The solution lies in reforming and better developing China's capital markets. They need to become more accessible to China's private companies. That is well underway, with the incredible success of ChiNext. But capital does not thrive in captivity, so China's stock markets need to open up before they can effectively compete with overseas markets. The proposed international board in Shanghai was a step in that direction, but it has been derailed by China's slow pace in internationalizing the yuan and relaxing currency and capital controls.
China's capital markets are best placed to serve Chinese companies. Chinese regulators are best positioned to regulate Chinese companies, Chinese auditors are best qualified to audit them, and Chinese investors are best positioned to evaluate these companies. There is likely an important, and continuing role for international capital markets in China. Use of these markets needs to be predicated on the integration of the regulatory systems between China and foreign listing jurisdictions. As we have learned, existing practices have created regulatory holes that have created undue risk for investors.