Early December, the U.S. Securities and Exchange Commission (SEC) adopted final amendments to its rules implementing the Holding Foreign Companies Accountable Act, a law enacted in December ’20, subjecting the auditors of securities listed on a U.S. securities exchange to inspection by the American regulators
In a seemingly choreographed mirror effect, China’s regulators have engaged in a number of announcements constraining access of private Chinese business to U.S. investors
Disconnected at first blush, occurring in slow motion, the Chinese laws, the new rules and updated interpretations of current regulations seem to redefine the settings of foreign investment in China in a profound way
…which raises the question what is driving the reversal and what goals the Chinese leadership expects to achieve
The full picture may remain difficult to apprehend
It seems all but certain that the U.S. markets, early on a financial supporter of China’s growth, and Chinese finance are growing apart, much faster than the bleakest prognosis could anticipate
The international banking system is seeking to adjust to the new realities, but the right to operate in China may come at a very high cost, putting the banks in the crosshairs of the U.S. government
Hard choices which the American giant banks have been loath to confront… until now
The prohibition of foreign investment in Chinese companies, for 'national security' reasons, has been ignored for years in a round-about way with so-called Variable interest Entities (VIEs), creative accounting constructs tolerated (but never endorsed) by the Chinese authorities
The understanding that VIEs guaranteed foreign, and especially American, investors was flimsy at best, as the founding shareholders of Alibaba
Foreign investors in Chinese listed entities were buying shares in an offshore holding company
- which owns a subsidiary in China,
- which, in turn, contracts with one or more VIEs,
- which actually own some of the underlying assets, such as intellectual property, of the Chinese business and which are controlled by the firm’s top management or founders
The American regulator – by way of a FASB regulation – choose to assume “ownership” because the holding company will, by contract, “absorb a majority of the entity’s expected losses, or receives a majority of its expected residual returns…”
A stretch....
The U.S. and China have upset the apple cart early December '21...
...the U.S. by approving the Public Company Accounting Oversight Board’s (PCAOB) Rule 6100 — Board Determinations Under the Holding Foreign Companies Accountable Act Securities
Securities listed on a U.S. exchange must, according to the Securities Exchange Act of 1934, comply with registration and reporting provisions, filing audited financial statements annually
- The auditors of those financial statements are subject to inspection by the PCAOB, and more than 50 countries have permitted controls
- The new rule determines a framework when the American regulator is unable to inspect registered public accounting firms located in a foreign jurisdiction, because of a position taken by authorities in that jurisdiction
China and Hong Kong stand out in their rejection, on the basis of national security, of these legal obligations, and by the number of firms listed in the U.S. – estimated at 250 companies headquartered in China and 110 in Hong Kong…
Listing prohibition will hit the securities if the PCAOB is unable to inspect the financial statements, and their auditor, for three consecutive years, leading presumably to mass delisting's of Chinese firms sooner rather than later
The U.S. exchanges will lose a potential $2.1 trillion in market cap, according to the U.S.-China Economic and Security Review Commission (April 2021 estimate) and the Wall Street banks a profitable line of business (raising $82 billion for Chinese companies through first-time share sales in the U.S. over the past decade)
...China by floating a ban on the VIE structures, which, while probably not universal, will bring new foreign listings by Chinese firms to a halt
The ban is expected to be included in a review of China's overseas listing rules, under the guise of 'data security'
Though denied by the China Securities Regulatory Commission, a partial (or total) ban of VIEs, used extensively by China's tech firms to raise capital in the U.S., will inevitably be triggered by tighter reviews, strict implementation of sectors "off-limits" for foreign investments and the like...
The future status of the 250 Chinese firms listed on American exchanges has not been settled but, when VIEs are involved, as is the case precisely in those tech-oriented industry segments deemed 'strategic' by Chinese authorities, and collecting vast reams of data in China, a reversal is all but certain
The financial tide is truly ebbing for Chinese securities on U.S. markets
The delisting of ridesharing company Didi Chuxing Invalid tag asset, 6 months after its June IPO valued the firm at $60 billion, signals a policy overhaul, not a one-shot regulatory backlash, as has been suggested
From a Chinese perspective, the implications are profound
- The uncoupling from America's vast, and liquid, financial markets is a vote of confidence in China's ability to go it alone
- Foreign investment will undoubtedly still be encouraged, by way of Hong Kong...that is, on China's terms
- Casting its net even wider, China's regulators intend to support the development of leading futures derivatives companies, with a focus on commodity markets
- Foreign banks and foreign traders are encouraged to participate in domestic markets, contributing by their expertise to revamp and to broaden China's financial institutions
A leading article of the Economist, December 11, '21, draws a similar conclusion
Many Wall Street firms are being given new licences and are expanding their operations in China. JPMorgan Chase’s cross-border exposure to the country has risen by 9% since 2019. Foreign portfolio investors’ holdings of stocks and bonds have almost doubled over the past three years, to $1.1trn. Even as Xi Jinping, China’s president, unleashed a war on big tech and tycoons under the banner of “common prosperity”, more than $100bn flowed into mainland markets in the first nine months of 2021.
However, the trillion dollar question could - and probably should - be worded differently
Political decisions of China's leadership will preempt economic considerations for the foreseeable future
- The decision to withdraw the IPO of Alibaba's financial juggernaut Ant in November 2020 had everything to do with control over credit allocation - and next to nothing with Mr. Ma provocative statements
- The decision to cut down private education outfits, such as TAL Education
or New Oriental - at great cost for foreign investors - was commanded by considerations of social fairness, on the Communist Party's terms - Concern about data security, pressed by the Chinese regulator, had in all likelihood been assuaged by the various tech platforms but foreign shareholding itself proved to be undesirable
Even though they are the tools of very different trades, credit allocation, education and data management channel control, either on behalf of private enterprise...or for the benefit of central command
Striking at the heart of the social contract from which each nation derives its identity, solutions of compromise are not meaningful
The international banks - caught in the middle and still hankering for the globalization of old - may find themselves on the losing end
The onus will be on the third most powerful financial center in the world, the switch between two systems, amid deepening antagonism....
"Hong Kong, America's Trump Card"... as we hope to discuss shortly