Net Investment Ban in China is Murky –

BEIJING – The flurry of contradictory headlines in September concerning China’s ban on foreign Internet investments were as perplexing as they were numerous.

The confusion began when Minister of Information Industry Wu Jichuan announced that an existing government ban would be enforced on overseas investments in mainland Internet companies, which would affect Internet Service Providers and Internet Content Providers.

Shortly after Wu’s statement, however, U.S.-based Internet portal company Yahoo Inc. announced plans for a joint venture in China to develop an on-line directory called Yahoo! China. And the press immediately pounced on inconsistencies in the situation. “Yahoo! evades ban on Net deals,” the South China Morning Post proclaimed Sept. 25, followed by an Associated Press headline two days later reading: “Official: China welcomes high-tech investment, but not Internet.” Meanwhile, the Sydney Morning Herald Sept. 28 said “China Warns Off Foreign Telecom Investors,” but that was immediately followed the next day by the South China Morning Post firmly proclaiming “Beijing to open up Internet market.”

The confusion over China’s investment policy was set against the backdrop of Beijing’s ongoing attempt to gain support, mainly from the United States, to enter the World Trade Organization (WTO). Membership into the international body would grant China many privileges, including allowing more of its exports into the huge U.S market. It is unclear, however, that the WTO, which plans to meet in November in Seattle, will admit China until it promises to open its own markets and makes improvements to its human rights record. In the meantime, however, China market-watchers are not panicking.

As Richard Margolis, first vice president of equity research at Merill Lynch [Asia Pacific] Ltd. explains, Wu’s comment and the ensuing confusion is characteristic of how the Chinese market economy has developed and the way in which Chinese public policy is formulated.

The Chinese public tends to improvise business practices and what they create often ends up gaining official sanction, Margolis said. Improvisation is what led to the formation of China’s capital markets, and eventually, they got “tidied up” and regulated, he added, noting that the Securities and Exchange Commission was created after Wall Street, not before.

Further, Chinese policy makers often float trial balloons in the form of public statements to elicit a response. What usually follows is confusion, some exchange of dialogue between government bodies and various interests, and then a policy is adopted, Margolis explained.

“There has been precedent that China has oscillated in their orders or laws,” said Ta-Lin Hsu, chairman of H&Q Asia Pacific, adding that he did not think the Internet ban would be a sustainable policy or that the government was serious about it, as illustrated by Yahoo!’s recent announcement of a joint venture to create a portal site in China.

As an example of China’s vacillation, Hsu noted that the government cracked down on domestic direct-sales businesses about a year ago, banning all forms of fraud and pyramid schemes. Shortly after the pronouncement, however, Beijing relented, allowing respected players such as cosmetics seller Avon to continue operating in China.

The Chinese embassy’s spokesman in Washington, D.C. was unable to elaborate on Wu’s announcement.

Margolis does not see much evidence that Wu’s announcement banning outside investments in ICPs and ISPs is representative of the overall policy of the Chinese government. With China’s membership in the WTO still under negotiation, Margolis speculated that in preparing to eventually open the “front door” to foreign investments, China would want to first get rid of foreign investors who came in quasi-legally through the “back door.” That way, foreign backers who got in before overseas investment in the Internet sector was formally welcome would not have an advantage over those who were waiting until it became legal.

If taken literally, Wu’s pronouncement would mean ISPs and ICPs with foreign investors would have to close their doors or buy out their foreign investors. Margolis views that possibility as “deeply improbable,” however. He acknowledged that China remains very rough terrain for would-be U.S. investors, and that it is necessary for American venture capitalists to find Chinese partners who can steer them around the pitfalls of investing there.

“The wise thing to do is not to take any irreversible decisions until the picture becomes clearer,” Margolis said, advising investors to hold tight until the Chinese government makes a definitive statement about foreign investments.

Hambrecht & Quist’s Hsu looks at the situation in a domestic political context: “I think it’s no secret that for the last two years China has been trying to stop the proliferation of the Internet because that runs counter to their fundamental control of information.”

While China is uncomfortable with foreign investments in ISPs and ICPs, it has opened it its doors to outside backers in other industries. That said, Hsu does not think the government is committed to the ban, and he continues to have interest in investing there.

“This has certainly caused us to wonder a little bit [about] what’s going on, but it certainly hasn’t stopped us from looking for opportunities,” Hsu said. H&Q Asia Pacific has invested a little more than $100 million in China since 1993, he said, although not much of that was in Internet companies.

The firm is raising H&Q Asia Pacific Growth Fund III L.P., a private equity fund targeting $750 million, which is expected to wrap in this month, Hsu said.