…said the China-Nazis* to a US government pension fund, a jarring statement that seemed to have gotten drowned in the mix of global political cacophony and our abated anxieties on a phase one US China trade truce. But beware, for the uproar could get louder just as many twitters, tweets and cheeps have become screeching realities from trade wars to gun wars! To us it is a reminder of nuke-nations (e.g. North Korea, Pakistan) flexing their muscles when their populace has no food and other basic amenities. Thankfully, our situation is not that dire but could we really afford to be so brazen to the detriment of our firemen, policemen, teachers, nurses and many other servicemen and women to eliminate the world’s second largest economy (and accounting for a third of global growth) from our investing universe when we have a gaping ~$ 4.4 trillion in public pension deficit (Source: Moody’s), with institutional return assumptions seeking everyday new lows in a shaky investing (and negative yielding) world on weakening QE opioids. Leading investors like CalSTRS are quick to point out that “restrictions in investments in specific geographic areas may compromise CalSTRS’ investment strategies, reduce diversification of the fund and negatively affect investment performance”.
Well, the China-hawks argue that Americans would be harmed by channeling money into Chinese firms that are allegedly involved in human-rights violations and at the center of US national security concerns. Hence, they feel justified in restraining financial flows into China by imposing limits on investments in Chinese markets, by putting caps on the value of Chinese companies (especially A-Shares) included in MSCI indexes (estimated by various sources to draw $65-85 billion in inflows from passive investors) and by calling for a delisting of Chinese companies from US exchanges. Just when China is opening up its markets to allow more foreign ownership of A shares i.e. expats working in China and foreign employees with equity incentives working in A-share listed companies abroad, US sentiments are turning sour, setting an odd example for a proponent of free and open markets. Even though most Chinese companies list in the US through ADRs (see below) that require fewer disclosures, one could probably rationalize any delisting (as in the bi-partisan bill introduced in June), if Chinese companies are prevented by their State from complying with American laws and regulations for financial transparency and accountability or handing over audit papers or for that matter not allowing overseas regulators to inspect local accounting firms – including member firms of the Big Four international accounting networks -citing national security concerns. Recall the series of scandals such as that of Longtop Financial, a Chinese software firm whose CFO was found guilty of making untrue statements about its finances (cash and borrowings). Even without delisting the market has its own cleansing mechanism as we have seen with other Chinese firms e.g. Sino-Forest come under attack from American short-sellers on suspicion of fraudulent activity. Nasdaq’s overture to tighten its rules to make it harder for smaller Chinese companies to float on the exchange is likely a reflection of such concerns.
Besides frauds and lack of transparency, with adequate and conclusive proof, one could also probably understand restrictions on Chinese companies associated with the military and makers of surveillance and monitoring equipment like ZTE, Huawei and aircraft and helicopter maker AviChina Industry & Tech that could pose a threat to our national security. One might equate such moves to eliminating “sin” stocks like tobacco, alcohol etc. from portfolios.
However, any blanket ruling (against making Chinese investments) devoid of legitimate concerns, is using economic levers to advance geopolitical objectives by taking advantage of America’s disproportionate financial leverage. Ulterior motives aim to inflict maximum damage, (when China is already struggling with declining exports, sluggish investment, and weak consumption) for currency manipulation, intellectual property theft, forced technology transfer and roadblocking the Made in China 2025 industrial development program targeting key industries (e.g. artificial intelligence, semi-conductors etc.) for domination. Such political motives under the guise of investor concerns could harm the very investors politicians are out to protect.
Hopefuls might dismiss this as tail risk, others like the Peterson Institute for International Economics, place a 30-40% chance of it happening, while still others like Bridgewater wonder if the US is “inching toward bigger moves” that some extremists voice as a precursor to cutting off all Chinese IPOs, and unwinding portfolios of all pension funds and insurance companies in the US that indirectly provide capital to the Chinese Communist Party through state-owned companies. Whether it is a targeted move or whether emergency powers (the 1977 International Emergency Economic Powers Act (IEEPA)) are invoked, to respond to unusual or extraordinary threats by telling pension funds not to buy Chinese shares, or commanding stock exchanges not to list Chinese companies or to delist existing ones, as investors it behooves us to prepare for the worst while hoping (which is not a strategy!) for the best. In preparation, it would also be worth considering some potential ramifications and portfolio actions (based on insights from various sources including China based managers informing ÊMA’s views), beyond knock-on effects on businesses (from Caterpillar, to Tesla to Apple, etc.) should the worst transpire.
As of February this year, 156 Chinese companies with a total market capitalization of $1.2 trillion were listed on the biggest US stock exchanges, according to the US-China Economic and Security Review Commission, with at least 11 of them being state-owned. Almost one-third of the market cap is represented by Alibaba alone (followed by JD.com), and over two-thirds of the market cap is represented by ADRs, which is approx. 2% of the total US market cap. Such firms have raised over $70 billion by selling shares in America since 2000, reckons Refinitiv. A listing in New York once meant higher valuations for Chinese startups than were possible on moribund Chinese exchanges. Western investors, used to Silicon Valley’s profitless (before WeWork era) but promising upstarts, were more inviting. An American listing was also regarded as a stamp of quality, deeper liquidity, and more flexible regulations (e.g. dual class shares). Despite ongoing trade wars, 2018/19 saw over three dozen Chinese companies (e.g. Pinduoduo, an e-commerce company, and iQiyi, a video-streaming service) list in US, an eight-year high (Source: Economist). If delisting ever gained ground, Hong Kong may become the most favored listing destination for Chinese companies (bar any repercussions from recent China-HK tensions), that already has been tested since 2015, when some Chinese companies were taken private by delisting in the US and relisting in HK to fetch higher valuations. Alibaba was recently planning a second listing in HK till it called it off deterred by the HK violence. Some other Chinese companies have chosen to list in Hong Kong and London instead of the US, which partly explains HK’s bid (now suspended) for LSE. It should not surprise us if other foreign companies followed suit unsure when a US stock exchange could delist them at will.
If mistrust of the US and its institutions mount, it could undermine trust among holders of dollar-backed assets as to when those could be frozen or expropriated, a constant fear investing in some frontier markets regarded as banana republics e.g. Democratic Republic of Congo. On the flip side, if Chinese private equity/real estate assets are forced to be divested by the large PE houses in the US or in a retaliatory move frozen by Chinese authorities, US pensioners would see their investments suffer as rightly voiced by the likes of Blackstone, KKR, etc. One also cannot then blame outsiders from viewing this as perhaps first steps toward imposing capital controls, yet another disconcerting feature of investing in some emerging markets including China. If a US dollar-based system of international finance is threatened, China’s push to promote the renminbi (and now digital currency) could gain momentum.
As reported widely, China forbids foreign shareholders in companies operating in “strategically sensitive” industries (including the internet sector). Many (including Alibaba, Baidu) have circumvented this restriction and attracted lots of foreign investors through structures like Variable Interest Entities (VIE) with an offshore parent in places such as the Cayman Islands/BVI and listed on an American exchange, to which the Chinese company (VIE/Opco) routes certain fees and royalties through a Wholly Foreign Owned Entity. While the Chinese government plans to change its foreign-investment laws to close this way around, one might speculate that US investors could, in a reversal of roles, potentially favor and promote the use of such (similar) structures to invest in Chinese companies if they are prevented from investing directly into Chinese entities.
Effects and side-effects of a budding financial war are good to understand but our original thesis, A Chinese Menu for China written in April of 2018 becomes more pertinent and urgent for portfolio action should this nightmare play out for real.
According to Goldman Sachs, US investors currently hold about US$785 billion of Chinese equities in the form of A shares (~ 20% of the total), Hong Kong-listed mainland Chinese stocks and ADRs. It also estimates that on average, US funds hold about 23 per cent in each of the top 20 Chinese companies (skewed towards a few large cap stocks such as Alibaba Group Holding, JD.com) that are listed in the US and Hong Kong. If ADRs were to be delisted it might create negative price action on their Hong Kong equivalents likely to make good short bets. If ADRs and some stocks on US exchanges are delisted or MSCI’s A share percentage is not allowed to assume its full 3.3% of its emerging markets equity index as originally planned for this year, it makes a compelling case for investing in local China stocks driven by domestic themes listed in HK or even mainland. In an extreme situation if US investors are ordered to divest their HK listed shares just as Rusal was on grounds it was controlled by Oleg Deripaska, an oligarch with close connections to the Russian government, it might impact the entire HK market allowing for a good short bet by both equity and macro traders. Cut whichever way, in the ensuing climate local Asia-based China long short managers are much better positioned to straddle-long or short- the entire gamut of ~ 6500 stocks comprising China A stocks, H shares, US listed China ADRs and even tech-heavy Taiwan stocks, remaining equally positioned for China’s NASDAQ-the new science and technology innovation board (STAR Market in Shanghai) . Moreover, in a welcoming move, Chinese regulators are considering introducing more restrictions on stake sale of major shareholders in listed companies after their IPO lock-up periods expire, reducing stock market volatilities and protecting minor shareholders (Source: Caixin). Therefore, investors who were hoping to binge on China A shares inclusion in MSCI could still tap into the breadth and depth of the Chinese economy through Asia based alternative managers in a better risk-controlled (market neutral, variable net) manner. They can also exploit the structural inefficiencies of China’s public markets and avoid succumbing to irrational market gyrations (80% volume driven by retail investors).
Similarly, if Chinese bonds are excluded from indexes (Bloomberg Barclays Global Aggregate index, JP Morgan Government Bond Index etc.) that underpin billions in U.S. investors’ passive investments, investors could be deprived of accessing the world’s third largest bond market. Once again, local Asian relative value bond managers are well-positioned to tap into both onshore and offshore bonds.
With restrictions on China from acquiring US companies, its global acquisitions could pick up pace in its relentless pursuit to lead in technology. From an investor’s perspective, this opens opportunities for merger arbitrage trades. If acquirers’ financing continues to suffer at the hands of banks predisposed to lend only to state-owned companies, private credit could continue to flourish across an array of sectors outside of the more cyclical real estate (prone to rising defaults in a downturn) that is often used to regulate the temperature of the economy.
Valuations aside (though quite the topic du jour), venture investing continues to remain one of the hot spots in the middle kingdom. It assumes special significance (with rising concerns) when the State is backing innovation across the board be it by hailing blockchain technology or by setting up a $29 billion state-owned Integrated Circuit Investment Fund II to accelerate the development of the semiconductor sector. Thus, unless all investing into China is banned, investing through venture funds is an opportunity that cannot be overlooked.
In a report published by Renmin University in September last year, researchers warned that China needed to stay alert and ready for currency, capital and economic warfare, highlighting the possibility that Washington may force its companies to exit their investments in Chinese markets and impose sanctions on Chinese companies through different channels. If the Chinese are bracing themselves for the worst shouldn’t we as investors strapped for opportunities and struggling to meet our portfolio objectives be more proactive and strategic in our thinking by re-positioning our China exposures such that our portfolios are in good stead regardless what the China-Nazis serve or not serve us. There is more to China than its mere 3.6% representation in the MSCI ACWI that we just cannot afford to miss out on!
ÊMA continues to research and conduct independent investment due diligence on local China alternative specialists well-positioned to serve up a rich menu of Chinese opportunities whether or not the China Nazis do. Stay tuned.
Kamal Suppal, CFA
Chief Investment Auditor
October 31, 2019
*For our international readers, reference is taken from the Soup Nazi character in Seinfeld, a very popular American sitcom.
The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.