The writer is a research associate at Oxford university’s China Centre and author of ‘Red Flags: Why Xi’s China is in Jeopardy’
Investors have been given a clear warning of the decoupling dichotomy between China and the US running through global capital markets.
The sharp sell-off in newly listed shares of ride-hailing group Didi in the US after China launched a security probe into it has illustrated the risks.
Beijing now wants to curb, if not eventually prohibit, Chinese companies’ access to US capital markets where they will increasingly have to submit to normal regulatory and disclosure requirements. Washington is equally hostile to Chinese listings if they refuse. This is just the latest example of a process of financial decoupling, as it is known in Washington, or self-reliance, as it is called in Beijing.
Yet seemingly oblivious to the politics, Wall Street businesses, non-financial companies and investors continue to beat a path to China’s red door, welcomed by Beijing.
Inward direct investment and portfolio capital inflows together registered almost 3 per cent of GDP in the first half of 2021, nearly as high as the trade surplus. Many leading US and some EU financial businesses have put money into their Chinese asset management and investment banking joint ventures or gained approval for majority-owned partnerships. Holdings of Chinese bonds and equities have risen sharply.
Why the surge? One-off factors include familiar themes such as economic recovery, differentials in bond yields between the US and China and exchange rate movements.
Investors also believe China can offer things they want: growing markets and a large pool of largely uncorrelated assets. For foreign banks, China could be a lucrative source of fee income. This year, China has been a sweet spot.
Investors should nevertheless watch out, as Didi’s experience underscored. First, they are directly exposed to the government’s crackdown against many quasi-finance, technology and data-intensive platforms to which their funds have flocked. This campaign stems from China’s angst about financial instability and its determination to keep ambitious private companies and entrepreneurs in check.
However, with capital tamed by party regulation and control, this also means that these innovative businesses, stripped of their growth potential or treated like banks for regulatory purposes, should not command tech-like valuations.
Second, investors are in the crosshairs where assets and valuations are the target of random political initiatives. Numerous US companies are now restricted or barred from commercial engagement with Chinese entities. Investors are under notice to divest holdings in dozens of Chinese companies linked to the repression in Xinjiang and Hong Kong and to the People’s Liberation Army.
Repression, human rights abuses and alleged use of forced labour have triggered concerns, especially in the retail sector and among shareholder activists, about the “S” part of environmental, social and governance investment criteria.
Investors are affected by new legislation that empowers the Securities and Exchange Commission to demand disclosure of shareholder information, board-of-director links to the Chinese Communist party and the release of audit records to a US-authorised audit supervision company.
Failure to do so, which is likely because Chinese regulators prohibit their companies from making such disclosures under state secrecy provisions, would lead to delisting after a proposed two-year period, probably entailing illiquidity and loss risks.
China also has tools to respond. It has passed legislation this year to help its businesses nullify the effect of US export controls and sanctions that apply outside China and it recently approved the Anti-Foreign Sanctions Law, which provides a legal umbrella for companies in China to appeal against sanctions — or face penalties if they comply.
This incremental build-up in decoupling rules and regulations on both sides is going to draw more companies and investors into an awkward space where the contradiction between politics and narrower financial interests will become starker. There is nothing to say that this stand-off cannot continue for some time.
As investors and businesses face more conflicts of interest and decisions about whose rules to obey and whose to flout, politics is likely to win out. Valuations don’t even begin to reflect this yet.