From the US and China Trade War to Decoupling Risks in Financial Markets

The risk that China could decouple from US capital markets can in our opinion no longer be ignored. That is an important lesson from this month decision by the Chinese ride-hailing group Didi Chuxing, under pressure from China’s cyber security watchdog, to delist from the New York Stock Exchange and go public in Hong Kong.

The stakes here were not small. Didi’s 4.4-billion-dollar initial public offering (IPO) in June was the biggest listing by a Chinese company in New York since Alibaba in 2014. The move came after reports that China is planning to ban companies from going public on foreign stock markets via variable interest entities, the flimsy legal structures based in tax havens that have underpinned the flotations in the US of such companies as Alibaba, and Pinduodo.

Beijing’s clear desire to have Chinese companies list closer to home could inflict in our opinion losses on western investors as more Chinese companies delist or go private. Much portfolio damage has already been incurred as a result of Beijing’s assault on Big Tech and high-profile entrepreneurs, while the plight of overstretched property developers such as Evergrande has added to the pain. At the same time, the US Securities and Exchange Commission (SEC) is set to force Chinese companies to delist if they fail to disclose more information about audits and government control over their operations.

The curious thing in our opinion is that capital has, until now, been almost blind to political reality. China continues to attract record amounts of foreign direct investment (FDI). A recent survey by the American Chamber of commerce found that in 2021, 59.5 per cent of US multinationals reported increased investment, up 30.9 percent compared with 2020 of manufacturers producing in China, 72 percent had no plans to move any production out of China in the next three years.

So much for deglobalization.

As for portfolio flows, US holdings of Chinese equity and debt securities surged from 705 billion dollar in 2017 to 1.2 trillion dollar in 2020, helped by the relaxation of rules on foreign access.

This trend has been accelerated by index provides including more Chinese securities in global and regional indices causing passive funds automatically to increase their exposure to China. In effect, the Chinese government bond market offers the ultimate happy hunting ground for searchers after yield. Over the past year, 10-year bonds have offered an income of around 3.5 percent, compared with close to 1.5 percent on 10-year US Treasuries. With Chinese inflation running at about 1.5 percent, real yield is positive, in contrast to US Treasuries which live under the shadow of an inflation rate in October of 6.2 percent. That said, the de facto renminbi peg to the dollar and euro means that Chinese sovereign bonds after little or no diversification to the official reserve managers who are the main foreign buyers, since dollars and euros are the mainstays of their portfolios. And there must be in our opinion a question about the durability of the peg. Given the deep-seated problems in the housing market, China is heavily dependent on exports to propel growth, which could make it tempting to aim for a more competitive exchange rate.

What emerges from al this is that the rivalry between the US and China in our opinion does not justify analogies with the cold war. China’s model has an extraordinary degree of integration into the global system, for greater than the Soviet Union ever had. To the extent that there is a war in the capital markets, it is largely confined to the primary market in equities. There is nonetheless a strong likelihood that political pressure will build in the US for curbs on investment in China. One clear indication in our opinion is the latest annual report of the US agency. It points out that nominal financial “opening” in China is in reality a carefully managed process, designed to reinforce state control over capital markets and channel foreign funding towards fulfilling national objectives. The commissioners further worried that US capital could be helping advance China’s military modernization, facilitating human rights abuses or subsiding unfair trade by US groups.

Does this mean that China is an investment dead end?

We at Calvin•Farel would argue that variable interest are a “no-no” because they do not offer investors real ownership rights and carry no voting power. For environmental, social and governance funds, China is also challenging territory given that it is the biggest polluter by far. There are undeniable human rights concerns. And corporate governance falls notoriously short of developed world standards. But for the rest it is in our opinion simply a question at whether risk is being realistically priced.

Beijing’s common prosperity agenda, its penchant for random political initiatives and its interventionist behavior in markets obviously call for a discount relative to the US, Europe, and Japan. Many investors take the view that the discount is adequate. The geographical risks in our opinion are becoming more daunting, but a capital exodus is not yet on the cards.