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Prevailing Winds

How Exposed Are U.S. Investors to 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.

American investments in China’s capital markets are attracting increased scrutiny from politicians and the media. A prominent U.S. senator has declared that China’s government “reaps the rewards of American and international capital markets while Chinese companies avoid financial disclosure and basic transparency, and place U.S. investors and pensioners at risk.”1 A recent White House executive order pronounced that China “exploits United States investors to finance the development and modernization of its military,” and prohibited investment in several dozen “Communist Chinese military companies.”2

Given the current controversy around this topic, it is worth investigating the current size of China within U.S. portfolios and the relative importance of American investors for Chinese companies.

Portfolio Investment Outpacing FDI

A recent spate of reforms have led to a considerable opening of China’s capital account. Whether via the Stock Connect, the Bond Connect, the expansion of the Qualified Foreign Institutional Investor (QFII) program, or direct access to the interbank bond market, foreign investors have an unprecedented ability to buy and sell Chinese securities. Consequently, capital inflows into China have increased significantly, even amid the volatilities of its economy and stock markets.

Between the first quarter (Q1) of 2011 and Q2 2020, the value of foreign portfolio investment (FPI) (equity and debt) in China increased 3.1 times. In comparison, the value of foreign direct investment (FDI) increased only 1.8 times.3 While the stock of FDI remains larger, as shown in Figure 1, portfolio investment is rapidly gaining ground.4

Figure 1. Cumulative Foreign Direct and Portfolio Investment into China
Source: Wind Information.

China’s Miniscule Role in the Official Statistics

According to statistics from the U.S. Treasury, as of year-end 2019, American investors held nearly 222 billion U.S. dollars (USD) in Chinese equity and long-term debt.5 That is a substantial amount of money and it is approaching the cumulative value of all U.S. FDI into China.6 However, these statistics do not tell the full story of American investors’ exposure to China.

As shown in Figure 2, China does not loom large as a target destination for American investors in the official data.7 Even with the world’s second-largest economy and stock market, China is not among the top 10 investment destinations for U.S. investors. China appears significantly underweight as an investment destination compared to many other smaller economies. Oddly, the Cayman Islands stands out as the largest source of U.S. foreign holdings. This seems implausible given that the Cayman Islands is a small country with a limited number of industries.

Figure 2. U.S. Residents’ Foreign Securities Holdings, Top 13 Countries USD Billions
Source: U.S. Department of Treasury.

International capital flows are notoriously difficult to track due to the roles of subsidiaries and offshore financial centers. As a result, actual foreign holdings of Chinese securities are significantly higher due to the way residency is treated in the data.

The Cayman Complication

Offshore financial centers, particularly the Cayman Islands, play a large role in distorting the data for China. The first distorting factor is the role of offshore funds. For example, when an offshore fund is set up in the Cayman Islands, investment into that fund by American investors is treated as U.S. holdings of Cayman equity.8 These offshore funds primarily invest outside the Cayman Islands and account for around 25% of that country’s total. The holdings of Chinese securities by these offshore funds are not captured in the official data.

The other factor distorting the data is the misclassification of offshore-registered companies. Many companies set up offshore subsidiaries and affiliates in the Cayman Islands to issue equity and debt. Securities issued by these subsidiaries are counted towards the Cayman Islands’ total, not the true home country of the issuing company. For Chinese companies, this offshore subsidiary activity is often driven by regulatory arbitrage. China’s restrictions on foreign ownership in sectors considered strategic or sensitive are well known.

Despite these restrictions, the lure of foreign capital markets has been irresistible to many Chinese companies seeking to go public. To sell shares to foreign investors while not violating domestic ownership requirements, Chinese firms have made use of a structure called a variable interest entity (VIE). In this case, the VIE is a Chinese-owned entity that enters into a contractual relationship with a foreign-owned company. This contract gives the foreign company the right to the economic benefits of the Chinese company and a degree of effective control. In this manner, the underlying company is still “Chinese” in the eyes of the regulators, while shareholders of the foreign company can receive most of the benefits of ownership.

The VIE structure is not without controversy. The business structure has attracted scrutiny from members of the media, politicians, and academics. A small number of VIE structures have failed and led to significant losses for investors.9 Nonetheless, the VIE structure has allowed foreign investors access to many of China’s most innovative and exciting companies that would normally be barred by Chinese law.

Hundreds of Chinese companies have registered offshore companies in the Cayman Islands that receive the profits from VIEs located in China.10 The offshore Cayman entities then issue depositary receipts in New York, Hong Kong and other locations. The combined market capitalization of these entities is in the trillions of dollars, of which U.S. investors own a substantial portion.11

Chinese companies also issue debt in offshore jurisdictions through subsidiaries that is not counted in the official statistics. The U.S. Treasury estimated that Chinese companies have issued around 34 billion USD-equivalent in offshore jurisdictions as of the end of 2019.

A Substantial Revision

A group of economists at the Federal Reserve recently undertook a detailed effort to correct for the statistical distortions outlined above.12 Matching security-level data back to the ultimate home country of the issuer and adjusting for the role of offshore funds, they produced a significant revision to the official statistics of the foreign holdings of U.S. investors.

The specific adjustment to China was enormous, increasing the estimate to 813 billion USD, more than 3.5 times the official figure. Under this new estimate, visualized in Figure 3, China jumps to the fourth largest foreign exposure for U.S. investors.

Figure 3. U.S. Residents’ Foreign Securities Holdings, Top 10 Countries – Revised USD Billions
Sources: Bertaut, Bressler, and Curcuru (2020), Seafarer.

Figure 4 shows the revised estimate of U.S. holdings of Chinese securities since 2003. The rapid growth during the past few years has been driven by China’s efforts to open its capital markets and the increasing valuation of many of the country’s tech giants.

Figure 4. U.S. Residents’ China Securities Holdings – Revised USD Billions
Sources: Bertaut, Bressler, and Curcuru (2020), Seafarer.

How Important Are U.S. Investors in China?

The revised estimates from the Federal Reserve reveal that American investors own significantly more Chinese securities than the official data indicate. This adjustment complicates our ability to determine the relative importance of American capital as a source of financing for Chinese companies.

As shown in Figure 5, the official statistics show that U.S. investors do not play a significant role in China’s domestic equity market. U.S. investors on average own a much larger portion of advanced economy13 stock markets (18%) compared to emerging markets (4%). However, even compared to other emerging markets, the share of the Chinese market held by U.S. investors is low at around 2%.

Figure 5. U.S. Holdings as a Percentage of Domestic Market Capitalization
Source: U.S. Department of Treasury.

Given the shortcomings in the official statistics highlighted in the section above, several adjustments are required to answer the question more holistically. The first adjustment is for the higher estimate of total U.S. holdings of Chinese securities. Of the 813 billion USD in total China holdings, 764 billion is in the form of equity. The second adjustment is to include the market cap of Chinese companies listed overseas in the denominator, bringing the total to an estimated 11.8 trillion USD-equivalent.14 Under the revised higher estimate of U.S. holdings of Chinese equities and the total market cap of Chinese companies, U.S. investors account for less than 6.5% of the total.

Figure 6 makes clear that U.S. investors own a larger share of China’s total market cap than the official statistics tell us, but still substantially below the role they play in other major markets.

Figure 6. U.S. Holdings as a Percentage of Domestic Market Capitalization – Revised
Source: U.S. Department of Treasury.

The Significance of China in U.S. Investors’ Portfolios

In terms of single country exposure by U.S. investors, China ranks high and is likely to grow significantly over the next few years.

However, at the aggregate level, Chinese securities still do not have a large weighting in the portfolios of American investors. At the end of 2019, U.S. investors owned around 12.6 trillion USD worth of foreign long-term securities. U.S. investors are underweight foreign securities overall – this is referred to as “home bias.” For example, foreign equities account for around 20% of U.S. investors’ portfolios, whereas foreign stocks receive a 50% weighting in global equity indices.15 For fixed income, U.S. investors display even higher levels of home bias.

Assuming 20% of total U.S. portfolio holdings are foreign, Chinese stocks and bonds would account for less than 2% of U.S. portfolio holdings at the aggregate level under the new revised estimates in this post (i.e. including the offshore depositary receipts linked to VIEs and offshore fund shares held by U.S. investors).

As China further opens its capital account and receives a greater weighting in global indices, U.S. investors are likely to invest more in China’s capital markets. This stands in contrast to the negative trend in FDI. Bilateral direct investment has plummeted as relations between the U.S. and China have deteriorated. While scrutiny of U.S. investors’ rising exposure to China seems a bit premature, it is an important trend shaping the economic relationship between the two countries.

Nicholas Borst,
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.
  1. Rubio Requests Information from MSCI Over Controversial Decision to add Chinese Companies in its Equity Indexes,” The Office of Senator Marco Rubio, 13 June 2019.
  2. Executive Order on Addressing the Threat from Securities Investments that Finance Communist Chinese Military Companies,” The White House, 12 November 2020.
  3. Portfolio investment is typically defined as non-controlling ownership interest. It most often takes the form of holdings of publicly listed stocks and bonds. In comparison, direct investment usually entails some degree of control on the part of the investor and often occurs through acquisitions and greenfield investments. For the data referenced in this post, direct investment is defined as “ownership or control, directly or indirectly, by one person or by a group of affiliated persons, of an interest of 10 percent or more of the voting stock of an incorporated business enterprise, or the equivalent in an unincorporated enterprise.” See “U.S. Portfolio Holdings of Foreign Securities,” U.S. Department of Treasury, October 2018.
  4. The gap between FDI and portfolio investment may be even smaller than what these statistics show. A recent working paper argues that investments into variable interest entities (VIE) by foreign investors incorrectly shows up in China’s FDI statistics and is recorded “at cost” rather than as market value. If these statistical irregularities were corrected, China’s stock of FDI would fall and the value of portfolio investment would rise further, until they were roughly equivalent. See Antonio Coppola, Matteo Maggiori, Brent Neiman, and Jesse Schreger, “Redrawing the Map of Global Capital Flows: The Role of Cross-Border Financing and Tax Havens,” National Bureau of Economic Research, April 2020.
  5. Long-term debt is defined as having a maturity of one year or greater.
  6. The U.S.-China Investment Hub,” The Rhodium Group, As of 13 December 2020.
  7. Figure 2 includes both stocks held directly in the target country and depositary receipts (companies incorporated in China whose stock trades in another market).
  8. This is also true for other offshore jurisdictions such as the Bermuda Islands.
  9. For a good explanation of some of the risks associated with VIEs, see Paul Gillis, “Testimony before the U.S.-China Security and Economic Commission,” U.S.-China Economic and Security Review Commission, 28 February 2019.
  10. In the typical VIE structure, there is a wholly foreign-owned enterprise (WFOE) that has a direct contractual relationship with the VIE. That WFOE is owned by the offshore entity which has issued the depositary receipts.
  11. Bloomberg. Data as of 23 November 2020.
  12. Carol C. Bertaut, Beau Bressler, and Stephanie Curcuru, “Globalization and the Geography of Capital Flows,” Board of Governors of the Federal Reserve System, 16 November 2020.
  13. The “U.S. Portfolio Holdings of Foreign Securities,” report by the U.S. Department of the Treasury as of December 2019 defines “advanced economies” as the following: Member States of the European Union that have adopted the Euro as their currency, as well as Australia, Canada, Czech Republic, Denmark, Hong Kong, Iceland, Israel, Japan, New Zealand, Norway, Singapore, South Korea, Sweden, Switzerland, Taiwan, and United Kingdom, including Jersey, Guernsey, and the Isle of Man.
  14. Kinger Lau, Timothy Moe, Jack Wang, and Si Fu, “China Weekly Kickstart,” Goldman Sachs, 4 January 2020.
  15. Brian J. Scott, James Balsamo, Kelly N. McShane, and Christos Tasopoulos, “The global case for strategic asset allocation and an examination of home bias,” Vanguard Research, February 2017.