Over the last decade, the involvement of Chinese enterprises in American primary markets has aggregated to a combined market capitalisation of $2.1tn. In light of this, the ongoing financial decoupling measures being taken by both countries calls into question the fate of capital movement across the two biggest economies in the world.
These concerns have become more pressing following the decision of the Chinese group Didi Chuxing (second-biggest IPO – $4.4bn – by a Chinese company in New York since Alibaba in 2014) to delist from the New York Stock Exchange and go public in Hong Kong. Although the decision may seem coerced due to intense pressure from Chinese cyber security watchdogs, it opens up the possibility of more companies following suit to avoid legal troubles with the Chinese government. On the other hand, Chinese state-run telecom groups (namely China Telecom, China Mobile, and China Unicorn) were booted from the New York Stock Exchange in early 2021 due to an executive order from the Trump administration that prohibited American investments in businesses with alleged ties to the Chinese military.
These developments are most likely only precursors to further changes:
1) Beijing’s enforcement of rules mandating companies to seek regulatory approval for overseas listing
The idea here being the protection of Chinese citizens’ data held by Chinese cooperation – that they may be required to disclose as a part of tighter auditing standards being planned by the SEC.
Especially Chinese companies that have gone public in the US via ‘variable interest entities’ (a sketchy legal structure in which shareholders only have a traditional stock certificate of a shell company, which is entitled to a percentage of the listed company’s profits via a private contract – instead of actually holding stock of the listed company) which allows them to side-step Chinese laws that prohibit certain disclosure to foreign entities are more vulnerable to this. China plans on banning this practice as a part of tightening capital market governance in the country.
2) SECs enforcement of regulations regarding the delisting of Chinese companies that do not comply with American auditing standards
With US-China relations fraught with tensions, Chinese companies facing accusations of spying for the government, and major default cases like Evergrande, the ‘Holding Foreign Companies Accountable Act’ (passed with rare bipartisan support in the US Congress), mandates Chinese companies to give American regulators access to their audited accounts.
At the same time, China recently passed the Anti-Foreign Sanctions Law providing corporations a legal umbrella to appeal against oversea sanctions or face penalties if they comply.
What does this jargon even mean?
A straightforward analysis of this situation would predict decreasing American capital inflows into Chinese securities, and while some indicators do suggest this, there are others that validate the exact opposite. This raises the question of the near and long-term feasibility of financial decoupling of these economic giants – even with political imperatives overriding business logic for both.
The risks associated with profitable Chinese securities are clear. Firstly, government crackdowns on data-intensive quasi-fintech firms are becoming more and more likely with public funds increasingly concentrated in one place. These crackdowns stem from China’s concerns about the broad financial instability in the country and its nature of keeping corporate ambitions in check. Secondly, assets and their respective valuations have progressively been subjected to predicted implications of volatile political initiatives from both nations. US companies are being restricted arbitrarily from commercial engagements with Chinese entities, investors are being forced to divest their holdings in companies allegedly linked with social repression in Chinese territories, and cyber security watchdogs are forcing data-intensive firms to delist from overseas exchanges sporadically. These actions render the assessed riskiness of previous bulk investments by institutions in Chinese firms worthless and leave finance executives scrambling to manage illiquidity risks due to nationwide sell-offs in recent months.
Despite the above-mentioned risks, empirical data shows that American capital until now has turned a blind eye to political realities with foreign direct investments (FDI) in Chinese securities increasing at record rates. Data from the American Chamber of Commerce found that more than half of existing US multinationals reported increased investment in 2021, up 30.9% compared to 2020. Furthermore, US holdings of Chinese equity and debt securities surged from $765bn in 2017 to $1.2tn in 2020. This process has been greatly aided by index providers who continue to increase Chinese securities in global and regional indices, inevitably increasing the exposure of index funds to Chinese securities.
Additionally, over the last year, yields on Chinese 10-year bonds have outperformed 10-year US treasuries by almost 2% while inflation in China is at a commendable 1.5% at a time when the US is witnessing record inflation rates of 6.2%. Lastly, despite the persistent fragility of the US-China market relations, Morgan Stanley, Goldman Sachs, Blackrock, and most other investment behemoths in the US that started off with asset management and investment banking joint ventures in China have now gained approval for majority ownership of these joint ventures after aggressive biddings in the pursuit of a piece of the Chinese markets. Mostly because China has it all, a) a gigantic market 2) a massive pool of uncorrelated assets 3) ginormous opportunities banking commission fees.
Winners and Losers
This inevitably begs the question of who will come out of this economically worse off (given that business logic has already been trampled over with the battle of sanctions)?
From the perspective of the US, Chinese IPOs have already raised more than $106bn at the Nasdaq and NYSE. Losing this contribution and any future growth rates associated with it, severely hurts the market cap of these stock exchanges especially given that European IPOs will likely not offset the impact they already have on more affordable options in European bourses. In contrast, the Chinese government has multiple options in the form of mainland markets, namely Shanghai, Beijing, and the Shenzhen Stock Exchange, and alternatively the Hong Kong Stock Exchange. All of these contribute directly or indirectly to the Chinese economy, effectively offsetting a better part of the financial implications of the US-led decoupling measures. This certainly makes the US seem worse off.
But is it? By losing out on American stock exchanges, Chinese corporations will miss out on a massive chunk of a market with greater depth and more coverage by equity analysts. Moreover, retail investor activity is much lower in China which may impact the marketability of these companies overseas. Additionally, the Shanghai and Shenzhen stock exchange have plateaued after world-beating performance for a better part of 2020 while the S&P 500 has marched ahead with its current price-to-earnings (P/E) ratio standing at 28 times compared to 14 times for mainland China’s CSI 300. And the Nasdaq Golden Dragon (HCX) index of US-listed Chinese went at an incredible PE ratio of about 100 times during the 2nd and 3rd quarters of 2021.
Furthermore, with a large number of Chinese entities lining up for IPOs in the Chinese stock exchanges already, a mass re-listing of entities booted from the NYSE and Nasdaq will most likely overcrowd Chinese exchanges and lay the foundations for an unsustainable equity market in the near-term.
In conclusion, what we see here are multiple opposing market forces working simultaneously in a politically tumultuous phase of financial decoupling. Whether pure business logic will supersede political imperative or not is the all-important question for institutions (as well as individuals). One cannot say which country is doing better or worse, but popular consensus is that any drastic changes will not take place before 2025 (withstanding status quo) which gives both nations time to resolve the conflict through a trade deal and diplomatic measures. If not, brace yourselves for some financial fireworks!