Why is China’s Xi targeting domestic tech firms despite limping COVID-19 recovery?

• Beijing’s falling out with Jack Ma of Alibaba signals establishment’s growing unease with digital economy

• Jack Ma’s demand of more economic liberalization may have upset Beijing

The billion-dollar question of US investors is why China’s Xi Jinping is cracking down on the domestic technology sector now? Seldom do they realise that political exigencies easily trump economic priorities in the Asian nation even when the world is in the thick of battling the COVID-19 pandemic.

Over the past two decades, Chinese internet companies have grown exponentially and returned considerable profits to investors, which helped attract major international Venture Capital (VC) firms like Sequoia Capital and SoftBank.

The VC firms also greatly expanded their portfolio basket with stakes in Chinese firms.

Jack Ma’s gaffe

Although the two-way capital flow between the U.S. and China started fading before the COVID-19 pandemic, the suspension of the public debut of Ant Group, the financial arm of Jack Ma’s Alibaba, in late 2020, destroyed an astronomical amount of wealth and forced the investors to reconsider their investment decision.

The Chinese crackdown on the tech sector started when the richest man in China, Ma, in October last year, asked the country’s political establishment to consider the need for reform of the financial system and indirectly blamed Chinese regulators for stifling innovation.

Many thought Ma got off on the wrong foot with the President of the People’s Republic of China, Xi Jinping, by questioning the establishment.

The Chinese regulators halted the Ant’s dual IPO in Shanghai and Hong Kong stock exchanges two days before the debut in November, after meeting Ma, which planned to raise $37 billion for a post-IPO valuation of $300 billion and was on track to be the world’s biggest public offering.

Cybersecurity probe

China even fined Alibaba $2.75 billion for abusing its market dominance.

Although DiDi, the Uber of China, was lucky and managed to get its overseas IPO out the door, raised $4.4 billion, and reached an intraday peak valuation of $87 billion on the debut day, its success did not last long.

Days after the Nasdaq listing, China launched a cybersecurity probe and asked the company to stop registering new users and removed its ride-sharing app from domestic app stores.

The Nasdaq Golden Dragon Index, which includes 98 Chinese companies listed in New York, dropped almost 50% since February, and its return on investment went to negative territory, wiping out trillions of dollars from the market.

On top of that, China is currently framing a legislature to ban domestic companies from overseas listings, and experts are predicting the move to restrict cross-border data flows and security, especially to the United States.

The new legislation will help the Chinese government to exert more control over corporations using business structures like Variable Interest Entity (VIE) that China’s biggest tech companies used for years to sidestep oversight from Beijing as the country does not allow direct foreign ownership in most cases.

Controlling interest

A VIE is a type of legal business structure created so that even if an investor does not hold a majority of the voting rights, they can exercise a controlling interest in it to protect a business from legal action by its creditors, allowing Chinese companies to establish offshore shell companies in a foreign jurisdiction and issue stocks to public shareholders.

There are many theories revolving around why China is cracking down on internet companies. However, the most prominent among them is the government’s hesitancy to let outside investors access Chinese company data.

When the new legislation will be implemented, the companies seeking for overseas listing will have to obtain formal approval from a cross-ministry committee, which would include CSRC, Cyberspace Administration of China (CAC), and other ministries, to review data flow from sensitive sectors like the internet, telecom and education because of geopolitical and national-security concerns.

Moreover, China realized its dependence on foreign technology after the U.S. government banned Huawei in 2018, citing the Asian nation could use the Chinese telecom conglomerate for spying with the help of its 5G equipment.

Largest equipment supplier

Following the ban, the Trump administration revoked some licenses forcing all the U.S. tech firms to stop supplying to Huawei, including Qualcomm that sells semiconductors for smartphones, Intel that provides technology for high-end chips, and Google, the licensor for Android.

Although Huawei is still the world’s largest telecom equipment supplier, its enterprise business, with a 31% revenue share of the total market as of the last year, but its consumer business fell 47% in the first half of 2021, hurt by its smartphone and semiconductor and other businesses.

The fall of the largest telecom company forced China to reconsider its strategies around the technology sector, and last year, President Xi unveiled a plan to achieve technology superiority by 2025 and intended to invest an estimated 10 trillion yuan (US$1.4 trillion) over six years.

To independent itself from foreign technology and achieve tech supremacy, Beijing had to cut its enormous internet companies down to size to redirect capital flow toward higher-priority technologies, which are strategically important like quantum computers, semiconductors, and satellites that many believe will determine China’s future.

Longstanding distrust

The Communist Party in China has a longstanding distrust of the internet, a somewhat decentralized mass communication tool that cannot be controlled entirely. Moreover, China feared the massive size of the digital economy and its shady business practices could result in economic fallout if left unchecked.

To put the  situation into perspective, the Chinese digital economy accounted for nearly 40% of the country’s gross domestic product (GDP), according to Digital Economy Development in China (2021), a whitepaper published by the China Academy of Information and Communication Technology (CAICT), a think tank affiliated to the Ministry of Industry and Information Technology. In comparison, in the U.S., the latest data by the Bureau of Economic Analysis, published this year, shows this figure was just around 10% for 2019.

Regardless of the motives that played a role in China’s recent crackdown on its big domestic tech companies, the sector has become too big to fail, and the steps by the government of the world’s second-largest economy evidently made it neither surprising nor unprecedented.

Picture Credit: Bloomberg