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Prevailing Winds

The China Investment Dilemma – Part III

Risks for U.S. Investors 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:

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
Past performance does not guarantee future results.
Sources: Bloomberg, Seafarer.

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,
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.
  1. U.S. Department of Justice, “Information about the Department of Justice’s Attorney General China Initiative, AAG Demers Bio and a Compilation of China Related Criminal Cases since Jan. 2018,” 2 July 2019.
  2. Federal Bureau of Investigation, “Confronting the China Threat: Director Wray Says Whole-of-Society Response Is Needed to Protect U.S. Economic and National Security,” 6 February 2020.
  3. Kathrin Hille, “Trade War Forces Chinese Chipmaker Fujian Jinhua to Halt Output,” Financial Times, 28 January 2019.
  4. Martin Chorzempa, “New CFIUS Regulations: More Powerful, Transparent, and Complex,” Peterson Institute for International Economics, 10 October 2019.
  5. Thilo Hanemann, Cassie Gao, Adam Lysenko, and Daniel H. Rosen, “Sidelined: US-China Investment in 1H 2019,” Rhodium Group, July 2019.
  6. Yuan Yang, “Grindr Sold by Chinese Owner after US national Security Concerns,” Financial Times, 3 March 2020.
  7. U.S. Department of Commerce, “U.S. Department of Commerce Adds 28 Chinese Organizations to its Entity List,” 7 October 2019.
  8. The White House, “Executive Order on Securing the Information and Communications Technology and Services Supply Chain,” 15 May 2019.
  9. Cecilia Kang, “F.C.C. Chair Plans to Block China Mobile from U.S. Market,” The New York Times, 17 April 2019.
  10. U.S. Department of Commerce, “U.S. Department of Commerce Proposes Rule for Securing the Nation’s Information and Communications Technology and Services Supply Chain,” 26 November 2019.
  11. Francesca de Nicola, Martin Kessler, and Ha Nguyen, “The Financial Costs of the U.S.-China Trade Tensions: Evidence from East Asian Stock Markets,” Policy Research Working Paper, World Bank, November 2019.
  12. Donald G. McNeil Jr, Zolan Kanno-Youngs, “C.D.C. and W.H.O. Offers to Help China Have Been Ignored for Weeks,” The New York Times, 7 February 2020.
  13. Manas Mishra, Daniel Trotta, Jeff Mason and Susan Heavy, “U.S. reports 15th coronavirus case; White House bashes China's response,” Reuters, 13 February 2020.
  14. U.S. Department of State, “Secretary Pompeo’s Call with People’s Republic of China Politburo Member Yang Jiechi,” 16 March 2020.
  15. Rep. Jim Banks, “With Coronavirus, the Chinese Repeat the Soviets’ Chernobyl Failure,” The Daily Signal, 12 March 2020.
  16. Federal Reserve announces the establishment of temporary U.S. dollar liquidity arrangements with other central banks,” Board of Governors of the Federal Reserve System, 19 March 2020.
  17. Adam Smith, Alison Lee, Christopher Timura, Stephanie Connor, and Courtney Brown, “Trump Administration Imposes Unprecedented Russia Sanctions,” Gibson Dunn, 12 April 2018.
  18. Stephen McNabb, Kimberly Hope Caine, and Katie McDougall, “OFAC Sanctions Venezuela’s PdVSA in Wake of Political Upheaval,” Norton Rose Fulbright, February 2019.
  19. U.S. Department of Treasury, “OFAC Sanctions List,” accessed 5 February 2020.
  20. Aime Williams, Gregory Meyer, and David Sheppard, “US Blacklists Chinese Companies for Shipping Iran Oil,” Financial Times, 25 September 2019.
  21. 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.
  22. Steven Russolillo and Stella Yifan Xie, “ZTE’s Suspended Stock: A Headache for All Market Participants,” Wall Street Journal, 27 May 2018.
  23. Spencer Hsu, “Chinese Bank Involved in Probe on North Korean Sanctions and Money Laundering Faces Financial ‘Death Penalty’,” Washington Post, 24 June 2019.
  24. U.S.-China Economic and Security Review Commission, “2019 Report to Congress,” November 2019.
  25. Office of Senator Marco Rubio, “Rubio Requests Information from MSCI over Controversial Decision to Add Chinese Companies in its Equity Indices,” 13 June 2019.
  26. Jenny Leonard and Shawn Donna, “White House Weighs Limits on U.S. Portfolio Flows Into China,” Bloomberg, 27 September 2019.
  27. John McCrank, “Federal Pension Fund to Include China Investments, Bucking Political Pressure,” Reuters, 13 November, 2019.
  28. Danielle Pletka and Derek Scissors, “Stop Investing in China’s Brutality,” The New York Times, 5 December 2019.