As a result of the deterioration in the U.S.-China relationship, Chinese companies face a growing array of punitive actions by U.S. policymakers.
The breakdown in cooperation between China and the U.S. is increasing volatility in both Chinese and global stock markets.
Multiple efforts by the U.S. federal government are underway to restrict the ability of Americans to invest in China.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

U.S. investors face an unprecedented dilemma: how to grapple with a country that is too large to ignore but locked in an increasingly confrontational relationship with the U.S. The U.S. has had contentious relations with other economic powers, including Germany and Japan before World War II and the Soviet Union during the Cold War. None of those countries matched China’s current size and importance to the global economy, however.

As China grows as a share of the investable universe and occupies a larger portion of investor portfolios, the challenges posed by this dilemma will be increasingly difficult to navigate. Key risks include punitive actions against Chinese companies by U.S. policymakers, market volatility during periods of heightened tensions, political efforts to limit investment in China, and moral quandaries and fear of reputational risks from investing in China.

Punitive Actions against Chinese Firms by the U.S. Government

As a result of the deterioration in the U.S.-China relationship, Chinese companies face a growing array of punitive actions by U.S. policymakers. The most widespread and well-publicized of these restrictions are the tariffs facing Chinese exporters. Tariffs have been imposed on a wide variety of goods, ranging from almonds to aircraft parts, with rates as high as 25%. The two countries recently made some progress in resolving the dispute as part of the Phase I agreement, but significant tariffs will remain in place for the foreseeable future – and Chinese companies remain exposed to the imposition of new tariffs with little notice. In addition, Chinese firms that are part of global supply chains are under pressure, as many multinational companies consider shifting production to other countries to avoid sanctions.

Alongside tariffs, Chinese companies face a broad range of restrictions from U.S. policymakers, including stricter regulations on investments in the U.S. and limitations on their ability to transact with U.S. customers and suppliers:

The Office of Foreign Asset Control (OFAC), housed within the U.S. Treasury, has imposed penalties and restrictions on Chinese companies that violate U.S. and United Nations sanctions. These sanctions range from heavy monetary penalties to full exclusion from transactions with U.S. persons and entities.
The U.S. Department of Justice has launched the China Initiative, a campaign aimed at curtailing China’s acquisition of U.S. technology and trade secrets.¹ FBI Director Christopher Wray has described China as “threatening the U.S. economy – and national security – with its relentless efforts to steal sensitive technology and proprietary information from U.S. companies, academic institutions, and other organizations.”² One prominent example of these efforts is that of Fujian Jinhua, a state-owned semiconductor firm. After being indicted for theft of trade secrets and banned from buying U.S. technology, the firm is reportedly on the verge of halting production altogether.³
The Committee on Foreign Investment in the United States (CFIUS), a government body responsible for screening sensitive foreign investments, has dramatically increased scrutiny over Chinese foreign direct investment into the U.S.⁴ As a result, new Chinese investment into the U.S. has plummeted, falling from about 40 billion USD in 2016 to less than 10 billion USD for the 12-month period ending in June 2019.⁵ CFIUS has also forced Chinese companies to divest from existing U.S. investments due to national security concerns.⁶
The U.S. Commerce Department has placed several Chinese companies on the Entity List, which restricts U.S. suppliers from selling to them. The reasons for addition to the list range from alleged theft of U.S. technology, to violation of U.S. sanctions regimes, and engagement in activities contrary to the foreign policy interests of the U.S.⁷ For companies that rely on U.S. inputs, such as technology firms, being cut off from U.S. suppliers severely hinders their business operations and could even force some companies to shut down.
The U.S. has blocked some Chinese companies from entering the U.S. market or transacting with U.S. firms out of security concerns. The telecom industry has emerged as a focus of these efforts. In May 2019, President Trump issued an executive order invoking the International Emergency Economic Powers Act to allow the secretary of commerce to bar U.S. firms from purchasing information and communications technology (ICT) from Chinese companies.⁸ U.S. regulators also erected barriers to keep Chinese firms from entering the market and selling their products to government agencies and the military.⁹ The Commerce Department recently proposed rules that would institutionalize the powers set out in the executive order to identify, assess, and address risks to the ICT supply chain in the U.S.¹⁰ This new set of powers would grant it broad authority to prohibit transactions involving Chinese companies that were determined to endanger the national interest.

Increased Market Volatility

The more confrontational U.S.-China relationship is increasing market volatility. The stock market in China has reacted to periods of heightened tension with broad sell-offs. Correspondingly, during periods of rapprochement and easing of tensions, China’s markets surge higher. The whipsaw of markets extends beyond just the companies that are most exposed to the U.S.-China conflict. Sectors across the economy face the prospect of significant price movement as a result of developments in the relationship.

Figure 1 shows the weekly movements of the Cboe China ETF Volatility Index, a measure similar to the VIX Index in the U.S. The index aggregates the weighted price of puts and calls over a range of strike prices for the iShares Trust FTSE China 25 Index, which tracks the performance of large-cap Chinese companies. Spikes in the index occur when market participants anticipate price volatility; lower values indicate periods during which market activity is more subdued. Throughout 2018 and 2019, the index showed huge spikes when there were significant developments in the U.S.-China relationship, including escalations of tariffs, the imposition of sanctions on Chinese companies, and the breakdown and resumption of talks between the two countries. Event-driven studies show that negative news related to the trade war was closely linked to market declines on the Shanghai and Shenzhen Stock Exchanges.¹¹

Figure 1. Weekly Movement of Cboe China ETF Volatility Index 1/6/17 – 1/2/20

Covid-19 Shakes Global Markets

Tensions between the U.S. and China are making global problems more difficult to manage and creating significant market volatility in the process. In prior years, it was widely believed that the two countries had a shared interest in resolving important international problems, including climate change, financial stability, global health and transnational terrorism. The current animosity in the relationship makes solving these issues more difficult and increases the possibility they grow into international crises that are damaging to the global economy and financial markets.

A recent example of this trend is the Covid-19 pandemic. After an initial cover-up, the severity of the outbreak of the virus in China became known globally. Infectious disease experts from the U.S. sought access to China to study the disease and better prepare for its possible spread. Reports state that the U.S. Centers for Disease Control (CDC) sought for weeks to send a team of experts to China without receiving approval from the Chinese government.¹² As the number of infections in China grew, senior U.S. officials publicly criticized the response of the Chinese government to the outbreak and the transparency of the figures it was reporting.¹³

Once the virus spread globally, including in the U.S., both sides engaged in bitter accusations over responsibility for the pandemic. An official in the Chinese Ministry of Foreign Affairs alleged that the U.S. military could be responsible for the outbreak, leading to an angry response from the U.S. Secretary of State.¹⁴ Meanwhile, a member of the U.S. Congress compared the outbreak to “Chernobyl” and demanded that China be held accountable for the damage it was causing.¹⁵ President Trump has enraged many in China by frequently referring to the virus as the “China Virus” rather than by its official name, Covid-19.

In March 2020, the virus crippled financial markets and threatened to put the global economy into a recession. As policymakers around the world took actions to tackle financial instability and stimulate their economies, evidence of coordination between the world’s two largest economies (the U.S. and China) was scant. Tellingly, when the Federal Reserve announced coordinated efforts with 14 other central banks to enhance U.S. dollar liquidity and ease strains in global funding markets, the People’s Bank of China was absent from the list.¹⁶

It is likely that the virus would have spread across borders and damaged economies regardless of the state of U.S.-China relations. However, the acrimony between the two countries contributed to a situation where the world was less prepared to deal with the crisis. Instead of openly sharing information, expertise, and coordinating a global economic stimulus, the two countries are mired in recriminations and distrust.

Even if stock markets around the world eventually recover from the Covid-19 pandemic, as they have after other crises throughout history, it’s clear that U.S.-China tensions increasingly represent a barrier to effectively resolving international problems.

Restrictions on the Ability of Americans to Invest in China

Multiple efforts are underway to restrict the ability of Americans to invest in China. At the company level, the U.S. Treasury may impose financial penalties and force divestment by U.S. investors in sanctioned entities. Sanctions on Russian and Venezuelan companies have already forced U.S. investors to divest their stakes.¹⁷¹⁸ U.S. investors are permitted to sell their stakes only to foreigners, and they must typically divest by a prespecified date. These measures often result in a steep decline in the value of the asset being sold.

Similar sanctions have not yet been applied to a major listed Chinese company, but several unlisted Chinese companies have been sanctioned,¹⁹ and several large listed Chinese companies have come dangerously close to having this type of sanction imposed. Subsidiaries of the COSCO Group, a major state-owned shipping company, were sanctioned for their connection to Iran, although they subsequently received limited duration waivers.²⁰ A subsidiary of China National Petroleum Corporation, Bank of Kunlun, was sanctioned and barred from accessing the U.S. financial system.²¹ Chinese telecommunications giant ZTE suspended trading of its shares on the Hong Kong and Shenzhen exchanges for an extended period while it worked out a settlement with the U.S. government over violations of sanctions on Iran.²² A U.S. judge is subpoenaing three major Chinese banks – the Bank of Communications, the China Merchants Bank, and the Shanghai Pudong Development Bank – for their alleged role in helping North Korea bypass U.S. sanctions.²³ It remains a distinct possibility that a major Chinese company will face OFAC sanctions that require divestment by U.S. investors.

In addition to moves targeting individual companies, efforts are underway to restrict investment in Chinese securities at a broader level. The U.S.-China Economic and Security Review Commission, an influential congressional commission, has called for delisting Chinese companies from U.S. stock exchanges if they fail to share audit work papers with U.S. auditors or use a variable interest entity (VIE) structure, a common structure used by China’s technology companies.²⁴ It has also recommended that Chinese companies be required to disclose their connections to the Chinese government and Communist Party before being allowed to issue an IPO in U.S. markets.²⁴ A prominent U.S. senator has called for MSCI, a major index provider, to remove Chinese companies from its indices.²⁵ Doing so would force passive investors that track these indices to exit their China holdings. Officials in the White House have also reportedly considered limiting investment by U.S. investors in China’s domestic capital markets.²⁶ Pensions and other institutional investors have faced pressure to divest from specific Chinese companies or cut China out of their portfolios altogether.²⁷ As the relationship between the two countries continues to deteriorate, these calls for limiting the ability of Americans to invest into China will grow stronger.

Moral Quandaries and Reputational Risks Associated with Investing in China

As tensions between the two countries have increased, policymakers, think tanks, the media, and advocacy groups have increased their scrutiny of China. This scrutiny focuses on many activities, including human rights abuses, privacy infringement, theft of intellectual property, environmental pollution, and potential threats to U.S. interests, particularly in the security realm. Some of the more extreme voices have argued that investing in China is akin to supporting companies that “help suppress human rights, support the Chinese army, and may be spying on the U.S.”²⁸

Investors now face a situation in which specific companies or even whole industries may become classified as nefarious or illegitimate in the court of public opinion. Chinese companies that participate in these activities may be branded as tools of a repressive regime, even if the activity subject to criticism is only tangential to the company’s core business operations. Investors in these companies may be accused of helping to finance and reward these activities, regardless of the original reason for investment.

Equally important, investors that venture into China without conducting due diligence may find themselves connected to companies that violate their own values. Companies may be engaged in activities that investors find morally reprehensible. Although this risk is present when investing anywhere, it is greater in China, given the stark divergence in values between China and the U.S.

Part IV of this paper looks at how U.S. investors can navigate these risks through a better understanding of the new U.S.-China relationship and where the greatest exposure to these risks may lie.

Nicholas Borst, Vice President and Director of China Research

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of March 31, 2020, the Seafarer Funds did not own shares in the entities referenced in this commentary.

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Martin Chorzempa, “New CFIUS Regulations: More Powerful, Transparent, and Complex,” Peterson Institute for International Economics, 10 October 2019.
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Adam Smith, Alison Lee, Christopher Timura, Stephanie Connor, and Courtney Brown, “Trump Administration Imposes Unprecedented Russia Sanctions,” Gibson Dunn, 12 April 2018.
Stephen McNabb, Kimberly Hope Caine, and Katie McDougall, “OFAC Sanctions Venezuela’s PdVSA in Wake of Political Upheaval,” Norton Rose Fulbright, February 2019.
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Aime Williams, Gregory Meyer, and David Sheppard, “US Blacklists Chinese Companies for Shipping Iran Oil,” Financial Times, 25 September 2019.
U.S. Department of Treasury, “Treasury Sanctions Kunlun Bank in China and Elaf Bank in Iraq for Business with Designated Iranian Banks,” 31 July 2012.
Steven Russolillo and Stella Yifan Xie, “ZTE’s Suspended Stock: A Headache for All Market Participants,” Wall Street Journal, 27 May 2018.
Spencer Hsu, “Chinese Bank Involved in Probe on North Korean Sanctions and Money Laundering Faces Financial ‘Death Penalty’,” Washington Post, 24 June 2019.
U.S.-China Economic and Security Review Commission, “2019 Report to Congress,” November 2019.
Office of Senator Marco Rubio, “Rubio Requests Information from MSCI over Controversial Decision to Add Chinese Companies in its Equity Indices,” 13 June 2019.
Jenny Leonard and Shawn Donna, “White House Weighs Limits on U.S. Portfolio Flows Into China,” Bloomberg, 27 September 2019.
John McCrank, “Federal Pension Fund to Include China Investments, Bucking Political Pressure,” Reuters, 13 November, 2019.
Danielle Pletka and Derek Scissors, “Stop Investing in China’s Brutality,” The New York Times, 5 December 2019.

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