China's New Investment Law

China's New Investment Law

There will be much writing and fanfare about new laws proposed and passed in China last week. While I am sanguine at the long-term prospects of China’s opening-up and reform, I also feel that the optimism in this particular case might be a bit overblown. I’ll give a quick background here about: 1) the history of the law, 2) what some of the key changes are, 3) why I feel this law was passed with more haste than others in the past, and 4) how the new law might affect our work at LearningLeaders, if at all. In short: there’s not much change for us, though I think it’s still worth everyone understanding.

[Please note: I’m not a lawyer nor a long-term domain expert. I’m just incredibly interested in this because it affects the life of everyone at LearningLeaders greatly. I feel it’s my duty to learn about this because it affects all of your lives too! I’m sharing ideas that I have read about, that have been shared with me by lawyers, or those that are my own. Anything in here may or may not be on the mark or way off base. It’s only based on the information I have at the moment.]

Background: A quick and hopefully not too dry history of relevant business laws in China.

Deng Xiaoping kick-started China’s opening-up in ~1978, depending on who you ask and what action they define as the start of the Gaige Kaifang (reform and opening-up).

In 1979, the first law that directly addressed foreign business in China was codified. The Equity Joint Venture law allowed foreign businesses to invest in China and set up Joint Ventures based on the amount of capital each party invested in the business. Basically this means if a foreign company invested 40 RMB and the Chinese company invested 60 RMB, then the company would be owned 40% by the foreign entity and 60% by the Chinese company. Pretty straight forward.

In 1986, for the first time a Wholly Foreign Owned Enterprise (WFOE - often pronounced ‘Woof-fee’) was possible. This means that the company would be 100% owned by a foreign shareholder. Quite a big departure from the 1979 law, for the first time, foreigners could invest in China without needing a local partner. Currently, the legal structure of LearningLeaders is a WFOE. Not many changes to this law have transpired since ’86.

In 1988, another form of Joint Venture was created - a Contractual Joint Venture. This is basically putting some sprinkles and toppings on the vanilla Joint Venture, with one fundamental difference: the shareholding percentages do not need to reflect the equity invested. This means that if the foreign company invested 40 RMB and the Chinese company invested 60 RMB, then they still needed to negotiate on the percentage of ownership. The 40/60 investment might result in a 10/90 ownership or a 90/10 ownership or anything in between, depending on that negotiation and what each party brought to the table. Note that a significant minority of businesses operate like this in China, but it can make sense when dealing with larger investment projects in infrastructure or energy, for instance.

So what happened next? Lots of companies entered the China market. The law firm TaylorWessing estimates that one million (!) foreign-invested companies operate in China today. Note that also includes Hong Kong or Taiwan-invested companies. Over the last 30 years, the balance in corporate structures have shifted from majority JVs to now a majority WFOEs. Approximately 80% of newly-registered foreign-invested companies are WFOEs and 20 are JVs. Of those, 99% are EJVs and 1% are CJVs. As said above, CJVs represents a significant minority.

There are plenty of other smaller laws or changes that have been passed, though this new law, the Foreign Investment Law, to be passed this year, is the biggest change in many years.

Key Changes with the Foreign Investment Law: Cool Idea, but Implementable?

The changes in the new law range from Market Access Systems to National Security and Antitrust, to Special Economic Zones. While being hailed by Xinhua, the Chinese government’s mouthpiece media organ, as “creating a a stable, transparent and predictable market environment for fair competition,” there are still many unclear parts. (Lack of Oxford comma is theirs, not mine.)

The draft of the law in 2015 was originally published with 170 articles and was operational and detailed, while the newer drafts in December 2018, January 2019, and ultimately what was ratified last week have far fewer details, with only 39 and 41 articles in December and January. It is far more general and political than the previous version, including many sweeping statements that may be no more than propaganda.

For example, there is a statement of protecting property rights of companies, which is in direct response to other countries, most notably the U.S., pressing China to address forced technology transfer. The law states that foreign technology transfer is prohibited. This may be true, legally. Yet if you want to do business with a Chinese company or Chinese mayor of a city, they can simply make the technology transfer as part of the negotiation agreement. So, in my opinion (note again: I’m not a lawyer!), this seems to constitute more rhetoric than anything else. Tech transfers are not legally required, but they may be required in order to do business. No real change here, but it may play well in the headlines.

The biggest changes that will actually be enforced are changes to the internal workings of companies. For JVs, the shareholding structure has changed so that board members do not have veto power. In the past, one board member could veto a decision, which has killed deals, re- capitalizations, or investment partnerships in the past. Now, 2/3rds majority is all that is needed to proceed to modify the articles of association. This is massive and will give foreign businesses more confidence to enter JVs. Overall, there is far more flexibility for foreign investors and businesses due to this law.

Why the Hurry?

In speaking with lawyers and some other entrepreneurs in Shanghai, they pose the thesis that this law wasn’t passed in a hurry, but was more overdue than anything else. After all, there haven’t been many changes in the last 30 years and the new draft was proposed in 2015.

"We’ve seen this coming for a long time,” is the refrain.

Looking at this with a beginner’s mind, I’m not so sure. Or maybe I’m just being overly skeptical.

I personally feel a little bit of a disconnect with what is being said and what is being done right now from certain actors in the government. There is pressure on the RMB to fall, China currently has a negative capital account, and the government seems to me to be centralizing and consolidating influence, rather than letting go of oversight on private business. The passing of the law in a hurry seems to me to be more of an advertisement for foreign capital rather than true reform.

Not to bore you, dear reader, but a quick background of the above paragraph: It’s recognized that China’s economy is slowing. Depending on who you ask or where your data (forget the reliability of the data) is coming from, we’re looking at between 1-6.5% GDP growth in 2019 (Still better than nearly everywhere). Most of that is coming from the services and tertiary market segment, rather than from agriculture or manufacturing. As the economy has developed, we’ve crossed into a higher-value-add economy rather than the ‘World’s Factory’ economy of the 80s and 90s. Since the GFC in 2008, we’ve seen an acceleration in this transition, largely backed on private-sector debt.

Despite having a dysfunctional zoo of senior politicians, global trust in the U.S. government is still high. Look no further than the USD strengthening right now compared to the RMB to play that out. However much China wants the RMB to be a global reserve currency, only ~1% of all SWIFT exchanges are actually happening in RMB. If fewer than one in a hundred exchanges are occurring in your currency, you are far from reaching the status of reserve currency. (Big nod to Kyle Bass of Hayman Capital Management for noting that metric.) Further, China is exporting less and importing more - the net imports have never been greater, leading to a negative capital account. Add to this what is noted above that the economy is changing away from manufacturing and more towards services and domestic consumption, further restricting outbound capital flows. This all puts pressure on the RMB and makes it less valuable for currency traders or businessmen wanting to get involved in cross-border business. The money to be made in China is by staying within China. And the money to be made with China is due to inflows, not outflows.

This is important because it may indicate that foreign capital is basically underwriting the growth of the Chinese economy. To keep the music playing, China just relaxed laws on foreigners investing in the local stock markets. This only allows for more capital to flow in to prop up these equities. So to bring us back to the topic at hand, in my opinion, this Foreign Investment Law isn’t so different from the aforementioned relaxation in equity trading laws: it is an advertisement and an encouragement to foreign businesses to enter the market.

It’s a billboard saying, “Open for Business!”

So why the hurry? Because I think the Chinese government knows more than we do. Actually, for sure they know more than we do. Unless the capital flows continue to be net positive into China, then the local domestic consumption alone can’t keep up with the projected growth rates and the protracted economic expansion. When Chinese companies go public on U.S. exchanges, it's the same thing. American retail investors fork over dollars to finance the growth of Chinese firms. Make no mistake - China is conscientiously using USD to underwrite the growth of the Chinese economy, just like they have been doing for the last thirty years. In the sands of time, the U.S.’s role as a tributary state to China will have been to supply China with USD.

Bottom line here is that I think the law was pushed through so that in the next 6-18 months, we will see more foreign investment in China. It’s a good time to be a lawyer, accountant, or banker who speaks both English and Chinese. It’s also a good time to be involved in the domestic Chinese economy, of which LearningLeaders is a participant. I’m always afraid to gaze into the crystal ball, but I’d guess that 12-18 months from now, holding long positions in Chinese manufacturing or ag stocks is going to be the wrong move.

TL; DR - So, how does this all affect LearningLeaders?

It really doesn’t that much at this moment. Because we are registered as a WFOE and not a JV, we don’t need to renegotiate any deals with our local partners (as we don’t have them). In the future as we look to register a new education company or henceforth technology companies to hold IP, this may change the procedure slightly and the shareholding structure. Even then, the change won’t be so great, but on the positive side, we will have more flexibility in terms of organizing the Board so that no one person has veto rights. This is definitely a positive change to the new law.

The Chinese government is among the cleverest decision-making bodies in the entire world. They are keeping their options open while still promoting foreign investment in China to keep their economy humming. The new law refers to other laws, including the Negative List and National Security Law, essentially keeping back doors open so that to the central government is able to make any changes to other laws necessary to achieve the desired outcome for the Investment Law.

At LearningLeaders, we will continue to keep our legal structure as simple as possible to maintain flexibility. There’s no change for us on a daily basis, despite the potential far-reaching impact on China’s overall economy. Whatever the headlines may say, for us it’s generally business as usual. Sorry for the boring punchline!

We are so well-positioned to lead our sector and become the undisputed market leader in providing public speaking and debate training and learning experiences. I’m confident that over the next 10-15 years, this upwards macro-cycle will lift our business even further and we will be able to attract enough capital and supporters to help us to achieve our longer-term goals.