As a broader decoupling between the U.S. and China is underway, terms from the military have entered the financial lexicon, signaling a widening rift between both nations.
“Weaponizing financial networks,” referring to the imposition of financial sanctions by the U.S. to take hold of critical chokepoints in the financial architecture, to allusions of the “nuclear option” that threaten excommunication from the U.S. dollar-dominated SWIFT messaging system, are now frequently bantered about. The hardening rhetoric marks a notable shift for the financial sector, which up to this point has stood as a haven of cooperation, fostering meaningful collaboration rather than accentuating a broader systemic rivalry.
Although many point to China’s gradual weening off the dollar and development of the Cross-border Interbank Payment System (CIPS), a homegrown alternative to the SWIFT network, as signs of financial decoupling, the reality is that China, throughout its enduring history, has always and will always continue to chart a distinct and separate course.
What would a broader financial decoupling look like? The looming danger of the decoupling narrative stems from legislative proposals and regulatory mandates that pose a threat to unmooring one of the remaining bastions of bilateral financial cooperation, and setting it adrift into unchartered waters.
In the U.S., a growing chorus of lawmakers is calling for greater scrutiny over inbound investment by China into the U.S. and outbound American investment into Chinese enterprises. At the beginning of 2021, American investors held about $1.2 trillion in Chinese stocks and bonds, while Chinese entities had invested $2.1 trillion in public U.S. debt and equity securities, according to the U.S. China Investment Project.
Caught in the crosshairs is a review of certain state pension vehicles with hundreds of billions of dollars at their disposal that have allocated funds to Chinese public equity investments. And while the stock market grabs virtually all the spotlight, Chinese debt markets have been nearly as active and adept in luring U.S. capital from investors seeking higher yield.
Currently, there is no disclosure requirement for private equity and venture capital funds to reveal their stock of Chinese assets. But if the steady drumbeat of proposals from China hawks find a receptive audience on Capitol Hill, it is not unfathomable to envision future disclosure from private investment vehicles under the guise of national security.
Decoupling, left unchecked, could crescendo in a nightmare scenario where in the sale of half of the U.S. foreign direct investment (FDI) in China, U.S. investors would lose $25 billion per year in capital gains, and a one-time GDP loss of up to $500 billion, according to a joint report issued by the U.S. Chamber of Commerce and the Rhodium Group.
For its part, the Securities and Exchange Commission (SEC) has stepped up vigilance of Chinese firms seeking to list in the U.S. Bulked up registration statements that expand and accentuate the risks of investing in China — is now the norm. Last year, SEC Chairman Gary Gensler temporarily shut off the valve on the steady flow of Chinese cross-border IPOs, to permit a thorough review of the listing process. These days, any entity that drafts a registration statement as a precursor to a public listing will notice heavier scrutiny on risks related to variable interest entity (VIE) structures and regulations subject to doing business in China.
A long running dispute in the Sino-U.S. relationship has straddled Beijing’s audit secrecy rules pushing back on Washington’s bid for access to those audits. Since last summer, officials at the SEC and their counterparts at the China Securities Regulatory Commission (CSRC) have attempted to hammer out an audit cooperation model that would be amenable to both governments, all in a dash to stop the winding shot clock on the first wave of Chinese companies subject to delisting in 2024. A lone ray of hope burst through the impasse recently when Beijing announced a revision of its audit secrecy laws that had become outdated and no longer serve today’s dynamic listing environment.
Common sense regulation is clearly understandable. But for Chinese firms, alternate investment channels are still available. Local firms can tap into indigenous markets in Shanghai, Shenzhen, Hong Kong and the newly launched Beijing Stock Exchange that acts as a launching pad for small and medium-sized enterprises. As the chorus for delisting has grown louder, so has the steady march of secondary listings back to Greater China.
Assume the doomsday scenario where a large cluster of Chinese firms are systematically bumped off U.S. exchanges, knocking them back to the mainland. Barring additional restrictions, U.S. investors would still be able to invest in these firms in their home exchange. Investor portfolios would merely swap out ADRs (American Depository Receipts) trading in New York for ORDs (ordinary shares) trading in the local Chinese market. The larger argument is that restricting Chinese firms from American capital markets does not block them from accessing U.S. capital. Capital is global.
Another route may take Chinese firms on a trip to international liquidity venues, such as those in London or continental Europe to seek a listing. If all else fails, companies can take themselves off exchange. Private equity firms would be all too eager to facilitate a “going private” transaction, where existing shareholders of the publicly listed entity are bought out, likely at a premium, as the firm is converted into a private enterprise.
Within this context, Beijing has taken measures to slow down the quickening pace of companies listing overseas. New regulations, including a multi-step review from the Cyberspace Administration of China (CAC) for companies in sensitive sectors adds to an already lengthy approval process. Highly publicized regulatory measures taken against Didi and other tech high-flyers, together with concerns over hidden risks in the real estate sector has dampened foreign investor appetite. These tributary actions wash up against an opposing tide of reform and opening of the financial sector, where incremental progress has been made to liberalize the capital account and ease foreign financial institutional ownership limits in domestic enterprises. These competing forces have resulted in a dizzying whiplash of sentiment — investors are attracted to the long-term investment thesis, while simultaneously repelled by arbitrary regulatory enforcement.
Policy actions that sever financial linkages bring great costs to both nations. The scant but continued hint of a disruption to bilateral portfolio flows is enough to raise the cost of capital and divert those flows to other recipients. Some investors may even voluntarily divest themselves of Chinese assets in order to sidestep political landmines. A reversal of portfolio investment into China may over time amplify knock-on effects on the exchange rate, weakening it, and adding to imbalances in bilateral trade flow. Ultimately, a steady hand is needed to guard against the patina of legitimacy given to proposals that until recently have been on the fringe. Doing so will ensure that in the future, Sino-U.S. financial engagement is rock solid and securely moored.
Joel A. Gallo is CFO at ETAO International Group and Adjunct Faculty at New York University Shanghai.
The views and opinions expressed in this opinion section are those of the authors and do not necessarily reflect the editorial positions of Caixin Media.
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