China’s efforts to tighten control over its economy and society have rattled investors and heightened U.S. policymakers’ concerns about China—even as some money managers highlight the risk of avoiding investments in the world’s second-largest economy.
On Wednesday, panelists at a hearing held by the U.S.-China Economic and Security Review Commission outlined the risks to both investors and companies trying to do business there. They stressed that China’s authorities see the economy as a means to the end of a socialist state fully controlled by the Chinese Communist Party, and they voiced concern some U.S. investors are unaware of the risks, especially as U.S.—China relations worsen.
The hearing echoed some of the concerns from others, like George Soros, who warned in an op-ed in the Wall Street Journal that investing in China now “was a tragic mistake” and criticized Blackrock (ticker: BLK), which raised nearly $1 billion from Chinese individuals for a mutual fund in China.
The takeaway was that the risks related to China are on policymakers’ radars, with many commissioners commenting on their reservations about investments in China.
The last couple months have reminded investors of the risks as China has clamped down on its biggest companies, upended business models for the hot after-school tutoring industry and pushed companies and the wealthy to contribute more to society to combat growing inequality.
The crackdown continues, with Xinhua reporting on Wednesday that authorities summoned gaming companies to warn them they would be severely punished if they “inadequately” implement regulations to curb minors’ access to gaming. But the iShares MSCI China exchange-traded fund (MCHI) has gained 9% since its Aug. 19 low as some long-term investors continue to see opportunities in the market.
Bridgewater Associates’ Ray Dalio has described China as a market that investors can’t ignore, and said some have misconstrued China’s crackdown as anti-capitalist. BlackRock Investment Institute recently advocated investors raise their allocations to China. Blackrock is also the first of many asset managers trying to get a foothold in China to target investors domestically, raising about $1 billion for the first mutual fund from a foreign company targeting Chinese individuals, according to the Wall Street Journal.
“China’s market is just too large to ignore for foreign financial firms,” says Rory Green, TS Lombard economist. “From Beijing’s perspective, the Party welcomes foreign investment in areas that it can control and regulate, such as the financial sector.” Green added that “an added benefit is that closer links between Wall Street and Beijing can help offset a wider decline in Sino-U.S. relations. If America’s banks are heavily invested in China it is harder for decoupling to occur.”
It may be harder but that doesn’t mean both countries will back away from recent efforts to reduce their dependence on each other. China has not only been increasing investment in its technological capabilities but stepping up scrutiny of Chinese companies listed in the U.S. in what could be an effort to nudge them back home as U.S. regulators look to delist those that don’t comply with U.S. auditing standards.
While China had viewed U.S. capital markets as a relatively easy source of funds, Shaswat Das, counsel at King & Spalding who was formerly a chief negotiator for the Public Company Accounting Oversight Board, said at the hearing that he expects China to retrench, forcing companies to list on its local markets before they are forced to delist by the U.S.
That highlights the risk to U.S. investors in these Chinese companies, which have used a complex corporate structure known as variable interest entity, or VIE—essentially shell companies with contractual rights to the Chinese company. While disclosures layout the risks related to VIEs, few investors understand that enforcement of those rights could be what Das described as “highly questionable.”
But Das noted that much of the investment in Chinese companies was by larger institutional investors who get the risk but see it as a “proposition of high risk, high reward and so far it’s been high reward.”
While some ADR contracts let investors convert shares into corresponding securities elsewhere, like in Hong Kong—something many fund managers have already started doing for holdings of Alibaba Group Holding (BABA) JD.com (JD), NetEase (NTES), Yum China Holdings (YUMC), and New Oriental Education & Technology Group (EDU)—Das says there’s the risk that other companies are taken private, with insiders buying out U.S. shareholders at a very large valuation and then relist elsewhere at a higher valuation, resulting in “tremendous losses to U.S. investors, particularly retail investors.”
Others closely monitoring China, though, note one big incentive for why China may not go this route: They want foreign capital to build out their own capital markets, crucial for its larger plans to be more independent. And that’s a reason more fund managers are eyeing opportunities in China’s domestic market—and what could happen as more Chinese are encouraged to put their considerable savings in other assets—like stocks.
But that comes with a warning: The risks are rising and merit a good deal of caution.
Write to Reshma Kapadia at firstname.lastname@example.org