Chinese Markets: Rising, Complexifying and Differentiating
Part 1 of the "Great Delink" Series that highlights the increasing distance between the West and the East
Near the end of July last year, Goldman Sachs cited “disproportionately high index representation by tech and privately owned companies” for lowering its views on the MSCI China index. In the following month, there was a reported $1.5 trillion selloff in Chinese stocks. While there is some imputation of falling U.S. market exuberance having an impact on these stocks, the root causes aren't solely related to trading classical metrics.
But first a clarification: for the most part, Western-favoured Chinese stocks aren’t really stocks in the typical sense.
Basic Market Terms
A "stock certificate" is a unit of ownership in a company. An “American Depositary Receipt” (or “ADR”) is a certificate issued by a U.S. bank representing a specified number of shares - usually one - of a foreign company's stock that is held in an overseas branch of the bank operating in said foreign country. Given the bank is a U.S. institution and this certificate is guaranteed to be based on physically-held stock approved by said foreign country's regulators, it can be traded just like any U.S.-listed share and derives the same meaning of ownership.
An over-the-counter (OTC) stock trades outside of the stock exchange via a network connecting a foreign country's dealer with, say, a U.S.-based dealer and denotes ownership to the holder as well. However, both parties can take part in this transaction subject to their respective countries' rules. Prominent OTC stocks in the U.S. include the likes of Tencent, Nestle and Bayer.
A Language Problem (Sort of)
China's stock markets are embedded with an intricate web of share classes to help manage the Government's need to both attract foreign investment and guide its citizens' investments. U.S.-listed Chinese companies with $-denominated stocks are termed "N-Shares" with some ostensible limits on investment by Chinese citizens while shares of China-listed companies with ¥ -denominated stocks are denoted "A-Shares" with some ostensible limits on investments by foreign entities. The stocks of Hong Kong-listed Chinese companies are denoted as “H-Shares” and are denominated in Hong Kong dollars.
However, the Government also mandates that no foreigner can own a stake in any Chinese company. So how are foreign investors holding an interest in Chinese companies? Answer: they typically aren't.
For decades now, any Chinese company hungry for foreign capital would establish a shell corporation - in, say, the Caymans - known as a Variable Interest Entity (VIE), which establishes a series of contracts with the Chinese company granting the former rights to the latter's profits but not a claim on its assets. The VIE goes on to list in a U.S. exchange with the company's name. Foreign shareholders have no voting rights in or legal recourse against the Chinese company. Meanwhile, the Government’s requirement that the company be 100% owned by citizens is satisfied. The VIE structure looks quite similar to (and is often conflated with) an International Depositary Receipt (IDR) – except there is no guarantee of ownership underlying the arrangement as in the latter, merely a series of promises to hand over profits.
While said "stocks" tend to label themselves as "American Depositary Shares", "Class A Shares", "Class F Shares" et cetera, the difference between them versus shares is obvious. On a practical note, however, ownership of a company is a passing concern for most Western investors (even institutional): asset performance is key. On the question of the difference in terms, U.S. regulators, for example, have long been satisfied with the terminology: "caveat emptor" has been street law in Western stock markets since the Amsterdam Stock Exchange was established in 1602.
The State vs Outsiders
The Government has always recognized that foreign companies contribute to the "quality growth" of its indigenous industry but has always required the former to be aligned with an indigenous company to spur this transfer of competence. Take the vehicle industry as an example: Guangzhou Automobile Group Co., Ltd (GAC) is in a partnership with Fiat, Honda, Isuzu, Mitsubishi, and Toyota that produces foreign-branded products for sale in China. Huachen Automotive Group Holdings Co. Ltd. - better known as Brilliance Auto Group - operates joint ventures with both BMW and Renault to manufacture their China-oriented products. BMW also operates under a joint venture with Great Wall Motors Company to produce electric vehicles (EVs). Similarly, Toyota has recently entered into a partnership with BYD Company to produce EVs.
Asian market followers will be aware that GAC is dual-listed in the Shanghai Stock Exchange (SSE) and the Hong Kong Stock Exchange (SEHK), BYD is dual-listed in the Shenzhen Stock Exchange (SZSE) and SEHK while Brilliance and Great Wall Motors are listed in SEHK. The dual-listing is made possible through SEHK's “Stock Connect” program with both exchanges through which Chinese companies can offer their shares to an investor base that includes all overseas investors through the SEHK. Chinese non-HK investors who meet certain eligibility requirements can participate as well. It bears noting that "A-Shares" have an interesting dynamic relative to their "H-Shares" counterparts: although both valuations tend to be more conservative as opposed to the hyperbole seen in the U.S.-listed "stocks", the former tends to trade at a premium relative to the latter.
There is an interesting phenomenon with regard to foreign-listed Chinese companies: the companies weren't considered materially significant to the larger economy at the outset. For instance, consider total EV sales estimated for 2020 versus in the YTD till October 2021:
Investor favourite NIO barely figures in the list while the Wuling HongGuang is produced by the SAIC-GM-Wuling (SGMW) - a triumvirate comprising of state-owned SSE-listed SAIC Motor (50.1%), General Motors' China venture (44%) and SEHK-listed Wuling Motors. BYD's various offerings collectively comprise around 16% of total EV market share in China.
Given that some companies that sought foreign investor interest left as minnows with potential and grew to be whales, it is possible that the Government will impress upon these champions the need to pursue a dual-listing down the line instead of solely listing in SEHK. This is not necessarily a detriment: both H-Shares and A-Shares denote an equal meaning in terms of ownership in the company; the distinction lies in apportioning distribution in line with the Government's mandate.
In the event that this happens and the investor is to rely on the "Stock Connect" facility, SEHK rules that rising foreign ownership is to be handled thus:
A single foreign investor's shareholding in a listed company is not allowed to exceed 10% of the company's total issued shares, while all foreign investors' shareholding in the A-Shares of a listed company is not allowed to exceed 30% of its total issued shares.
If the aggregate foreign shareholding exceeds the 30% threshold, the foreign investors concerned will be requested to sell the shares on a last-in-first-out basis within five trading days.
Once SSE/SZSE informs SEHK that the aggregate foreign shareholding of an SSE/SZSE Security reaches 28%, further Northbound buy orders in that SSE/SZSE Security will not be allowed, until the aggregate foreign shareholding of that SSE/SZSE Security is sold down to 26%.
The 10%/26% number is the red line for foreign investors in any company whose stock eventually pursues dual-listing within the State and the apportioning of dual-listed assets will be designed with this in mind, with SEHK's relative market liberalism (as compared to the Mainland exchanges) maintained.
Warren Buffett's Berkshire Hathaway owns, as of FY21, 7.7% of all of BYD's stock.
A Shell Game (of Sorts)
On the question of "Chinese stocks" vs classical stocks, Tencent is an interesting study. Despite being traded on the SEHK, it has the same Cayman-registered structure issuing stock as with U.S.-listed "stocks". There are one of three reasons for putting in place such a structure (or perhaps all three apply in some cases):
The Government’s requirements are satisfied if the company were to raise capital overseas via a VIE arrangement.
Company leadership can’t be replaced even if majority shareholder opinion turns against them.
If debt raised overseas goes sour, the company's management can't be held accountable and the company's assets in China can't be seized by any court of law outside of China. The only collateral lost, if at all, would be quantities of the VIE’s stock deposited.
However, news purportedly from insiders late last year claims that this feature might be banned, which might thus default/reset these companies to a "vanilla" listing on the SEHK, which would work out best for investors everywhere.
The Crackdown: More Than What It Seems
Late in October 2020, Alibaba Group founder Jack Ma addressed the Bund Finance Summit in Shanghai as a keynote speaker. Serving as a backdrop to the then-upcoming IPO for his fintech offering Ant Group, Mr. Ma called Chinese regulators an “old boys club” fearful of new ideas and the Chinese banking system as having a “pawnshop mentality”. He went on to pitch the virtues of a digital currency as a solution to future problems and one that can be free of outdated constraints.
Within a week, the Ant Group IPO was suspended and new rules were drafted for regulating “internet platforms”. Within a month, the Politburo resolved to strengthen antitrust efforts and a probe was launched into Alibaba. Subsequently, a number of tech companies were investigated, prompting many to attribute Mr. Ma’s speech as being the genesis of the crackdown.
It bears noting that Mr. Ma’s speech was not the origin of the crackdown. As early as two years prior to the speech, State organs have called for action on a number of problems: growing “moral corruption” among the youth, increasing familial financial burden, the brutal work schedule in new companies, and so forth. A key factor underpinning these problems – as per the State – was the ongoing change in “culture”.
When Chairman Deng Xiaoping engineered the liberalization of the Chinese economy 40 years ago – effectively transitioning from a command economy to a mixed-mode economy and permanently cementing the “Sino-Soviet split” despite Soviet premier Mikhail Gorbachev’s best efforts – Chinese graduates began to troop into top Western universities and corporations. Many of this new generation went on to build companies in the vast untapped Chinese market.
This idea of simply cloning Western ideas for the domestic market was also criticized by Mr. Ma during his speech. In this regard, Mr. Ma echoed the sentiments of Chairman Deng who, in a conversation with socialist Ghanaian president Jerry Rawlings in 1985 said, “Don’t just copy China’s model. You have to walk your own path”.
However, where Mr. Ma and Chairman Deng differed was that while Mr. Ma reposed faith in the private sector and its resourcefulness, Chairman Deng’s interest in liberalization was aimed at improving China’s economic problems and no further. The country’s political destiny, as per the venerated Chairman, must always lie with the Party. Mr. Ma, in his speech, seemed to imply that the State was failing in its duties.
Actions taken by the State after Mr. Ma's speech were transformative, to say the least: the practice of "er xuan yi" (二选一; "pick one from two") - wherein a merchant is persuaded by an e-commerce platform into an exclusive distribution channel - subsequently has ended. Several tech companies are also being investigated by financial watchdogs for practices that include but not limited to irregularities in mergers and acquisitions – a long-valued means of growth in China. Tencent’s exclusive contracts with music producers were directed to be terminated due to antitrust issues.
On the social end of the spectrum, a number of employees at many of China’s tech giants have been championing a popular online campaign against the “996” work culture (“9am to 9pm, 6 days per week”) over the past few years - a practice that was hitherto celebrated by tech titans as a cornerstone of their success.
The corporate part of the spectrum hasn’t exactly been pristine, either: Chinese accounting firms are often accused of being rather… creative… in their reporting. This has been a persistent public problem that has blown up from time to time. Even Deloitte's China branch was accused of auditing violations this past year. In another example, NIO was accused earlier this week by a research firm specializing in ground research in China of inflating its revenue and net income by a series of actions involving an Battery-as-a-Service (BaaS) investee - which the company denies.
A U.S. bill requiring that N-Share companies comply with U.S. auditing requirements was passed with unanimous support and made into law in December 2020 and operationalized by the SEC the following year. Past attempts to audit Chinese companies have notably failed, which creates an existential problem for N-Shares. Unsurprisingly, most companies offering these U.S.-listed "stocks" are now either “dual-listed” or in the queue for listing at SEHK. Interestingly, in the U.S. State Department's Investment Climate Statement released in June last year, economic officers reported that that Hong Kong (HK) doesn't discriminate against operations being set up by foreign companies while SEHK maintains that foreign individuals are free to invest in almost any HK-listed stock through a registered broker-dealer. In addition to HK-born broker-dealers - of which there are legion and include the likes of HSBC Holdings plc (HSBC) - U.S.-based brokers with a local office such as Fidelity also enable U.S.-based investors to purchase these stocks.
Now, let's compare the performance of the Nasdaq Golden Dragon Index (HXC) and the S&P China A 50 Index (CSSP50) – indices that track N-Share companies and the top 50 best-performing China-listed companies respectively – versus the CSI300, CSI500 and CSI1000 – which track the large-, mid- and small-cap companies listed in mainland China’s state-run stock exchanges respectively.
In the period from August 2018 to August 2020, the performance of N-Share companies are lockstep in trend but lagging behind the A-Share companies until 2020 saw them beginning to catch up. Predictably, the 50 largest A-Share companies led the pack.
Over the period from August 2020 till Q3 2021, all the indices were either recovering from the pandemic or attaining giddy heights midway through Q2 2021 before State actions began in earnest. In the present day, the A-Share companies are drawing a little above par relative to their market value last year while the N-Share companies are just beginning to recover.
This suggested that:
The hardest-hit companies were “blue-eyed” investor favorite tech giants
The larger Chinese economy was more diversified and less affected.
In the Year Till Date (YTD) however, the wild divergence - hitherto unseen - between N-Shares/”top-line” companies and the rest of the Chinese market becomes even more stark:
While Western investor appetites might have arguably had a big hand in divorcing the N-Share stocks’ performance from that of the companies themselves by ascribing heavy overvaluation, trends in market performance of stocks of companies with a more curated investor demographic - indigenous investors and qualified overseas institutions - have been showing a steady divergence.
Thus, the risks inherent within N-Shares as a whole could rather broadly defined as “idiosyncratic and focused” that is less reflective on the Chinese stock market as a whole. This is, of course, attributable to a number of factors:
China’s pegged currency theoretically enables a more efficient form of State control on valuations.
On a broader economic basis, traditional companies continue to be more robust than Chinese “tech” favourites.
There is also an interesting argument as to why the “onshoring” of Western tech favourites to HK or mainland exchanges would be in the Government’s interest: State entities already run an army of funds (colloquially referred to as the "national team" by Chinese traders) help in staunching market routs and propping up private equity investments. Once these companies become "vanilla" publicly-traded entities, these entities could empower the State to enable directions to its champions' leadership via a seat on the board through stock ownership - a form of State activism, if you will. With harmonization between State and the private sector, there is potential for synergies that are less predicated on Western investor appetites and outlook.
At this point, all of this is conjecture. In the present, overall trends indicate a rising mismatch between Western and Chinese markets and respective fortunes. As it turns out, the other rising global powerhouse/rival - India - has its own set of interesting patterns that the delinking argument isn’t just limited to the 人民共和国 (“People’s Republic”).
More on that in Part 2 (coming soon).
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