Blue Haven

How a new SEC law and DIDI’s IPO spurred a sell-off in China

By July 29, 2021 No Comments

In the continuation of a long-running theme, China has once again become a source of friction in the financial markets for companies based in the mainland. Since the beginning of June this friction has dampened investor sentiment across Asia, even as other major global stock markets kept rising. Investors fear that China’s recent moves may be part of a broader effort to reduce its exposure to Washington, D.C., its stock markets, and its regulators.

A new SEC law was the catalyst

Back in March, the U.S. SEC adopted a law called the Holding Foreign Companies Accountable Act, which was initially passed by the previous Trump Administration. This act will allow for the SEC to identify certain foreign-listed companies as requiring auditing from a U.S. watchdog. The process will require documentation and other proof that a company is not controlled or owned by a governmental entity.

Chinese companies specifically would have to identify any board members that are Chinese Communist Party (CCP) officials. Companies that fail to submit to the auditing could be de-listed by U.S.-based stock exchanges. Being listed in the United States is a big deal and financial haven for Chinese growth stocks. However, these listings often find themselves on the front lines of diplomatic battles between China and the U.S., as well as Europe.

There have been plenty of U.S.-China machinations in the past decade. Fears over the de-listing of certain China-based equities from U.S. exchanges is nothing new – they have been at the forefront of analyst discussions for several years, and were a common threat dispensed by the Trump Administration during the multi-year trade shenanigans.

Let’s take a quick look at some of the recent disruptions to the Chinese stock complex, and discuss why investors should still be seeking exposure to the largest population and fastest-growing economy of the past 20 years.

Didi Crackdown Renews Fears

The most recent event sparking concern was the sharp selloff in shares of Didi Chuxing (DIDI), China’s largest ride-sharing app (think Uber for China). The Didi selloff happened after the Chinese government banned downloads of the Didi app in the mainland. The suddenness of the ban was jarring, as it was just one week after Didi’s splashy, upsized IPO in the United States that valued the company at more than $70 billion. This marked the largest IPO of a China-based firm since e-commerce giant Alibaba went public here in 2014.

The Didi app ban was ostensibly so that China could conduct a “cybersecurity review” of Didi’s user data and to review for monopolistic practices. But these seem to be a thin veil for a broader clamp down on Chinese companies that trade on exchanges in the United States, or have simply grown too fast for the CCP’s liking.

The CCP seems to be taking a hard line on oversight of companies that have overseas listings as tensions between the U.S. and China continue to be strained with the new Biden Administration. At the core, China is dealing with the same issues that we face here – namely, the rise of technology giants that threaten to corner market leadership, and all the privacy and security issues that rise creates. Obviously though, China has much more aggressive tactics when it comes to interfering with how any company in its borders is running things.

One need look no further than the aforementioned Alibaba on this. Last Fall, Alibaba’s chairman Jack Ma – the Jeff Bezos of China – was making a speech just weeks before Alibaba’s massive financial tech/services division Ant Financial was set to go public on both the Shanghai and Hang Seng index. He lobbed some criticism at Chinese regulators in that speech, and just days before the dual IPO was set to go, the CCP just shut the whole thing down – and fined Alibaba $2.8 billion in an anti-monopoly probe.

Recent Stock Performance,Warning from Biden

China-based stocks responded to the Didi clampdown by broadly heading lower on both the mainland Shanghai index, and more importantly, the Hang Seng, based in Hong Kong and the most popular and liquid avenue for foreign investors to gain access to the Chinese economy.

The Hang Seng is down over 15% in the past few weeks, despite a rising tide for equities in most other markets around the world. And the Nasdaq Golden Dragon China Index, which track U.S.-listed Chinese stocks, is down over 20% in the month of July. These U.S. listed Chinese stocks are currently trading at their biggest discount to general U.S. stocks in nearly 10 years.

Emerging Market ETFs like VWO, which have large allocations to China & Hong Kong, have fallenn about 9% since the beginning of June, compared to gains across Europe and the U.S. during that span.

The Biden Administration has kept the pressure on Beijing, for having too much melding between its military, government, and nationalized corporations, as well as for human rights violations. Last month, Biden signed an executive order prohibiting U.S. investors from investing in 59 Chinese companies, saying they were too closely tied to the Chinese military. And just last week, the U.S. added 23 more companies to the investing blacklist. Chinese telecom giant China Mobile and a few other stocks have already been delisted from American exchanges.

Reasons to stick with China

All of this sounds scary, but we feel that having exposure to China and to Asia is a prudent philosophy for long-term investors. The largest investment banks in the U.S. agree, as Goldman, J.P. Morgan, Merrill, et all continue to back deals and underwrite offerings. And through all the trade war melee of the 2016-2020 period, the Hang Seng index and VWO were still up over 25%.

Treasury Secretary Janet Yellen recently criticized the tariffs we put on China during the previous Administration. She rightly notes that the trade spat did nothing to improve the fundamental issues surrounding the economic relations between the U.S. and China. But, those tariffs are currently still in place. The Biden trade delegation’s first attempts to meet with Chinese officials and cool tensions went sour. And there’s bipartisan support for taking action against what is objective fact – that China commits trade violations around the world with advanced economies.

Through all of that, a simple logic flow makes the best case for having some stock exposure to China. China needs the rest of the world – just as the rest of the world needs China. Advanced economies need the Chinese consumer market to sell into. The CCP needs to introduce enough capitalist goodies to its people to keep them happy – in order to keep up with the charade of communism as they try to transition into something that resembles a sustainable government.

China simply wants to become the largest economy in the world – something they won’t be able to accomplish without having solid relations with major trading partners.

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