China Slowdown Pushes Chinese Internet Stocks and VIEs Off a Cliff

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Markets sold off sharply Thursday with every Dow (NYSE:DIA) component closing lower.  Although the Federal Reserve’s announcement of Operation Twist obviously disappointed investors, developments from China (NYSE:FXI) weighed on the market as well.

In addition to the HSBC (NYSE:HBC) preliminary PMI survey that predicts a Chinese manufacturing contraction for a third month, internet stocks in the world’s number two economy are tanking.  China’s biggest internet company by market value, Baidu (NASDAQ:BIDU), sank nearly 11% during Thursday’s selloff.  Sina Corp (NASDAQ:SINA), which is the equivalence of Twitter in China, closed 9% lower.  Fears of new Chinese regulations are hitting internet companies hard. The Wall Street Journal reports, “China’s government is considering new regulations to govern a corporate structure that has enabled a wave of Chinese firms to list overseas by circumventing rules against foreign investment in sectors like the Internet.”

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Currently, there are no regulations on variable-interest entities, also known as VIE.  The VIE corporate investment structure was created in the 1990s, and allows foreign investors to access cash flows from Chinese companies where foreign investment is restricted.  Ministry spokesman, Shen Danyang said, “There are currently no laws or regulations to regulate VIE. Ministry of Commerce and other related government agencies are studying ways to regulate such investment.”  The Ministry of Commerce does not hesitate to regulate something it does not approve.  The Ministry blocked Coca-Cola’s (NYSE:KO) bid to buy Chinese juice maker Huiyuan, and frequently spars with Google (NASDAQ:GOOG) over regulations. The announcement of new Chinese regulations should concern U.S. markets as they may loose more access to the growing Chinese economy.

Other Chinese internet companies such as Sohu.com (NASDAQ:SOHU), Youku.com (NYSE:YOKU), and Tudou Holdings (TUDO) also closed sharply lower.  SOHU is the operator of China’s most visited website.  While the new regulations may not seem like a game changer now, investors should realize that at least 42% of Chinese companies listed on the Nasdaq or NYSE use the VIE structure, including Baidu and Sina.

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