News Analysis
The Trump administration is mulling various restrictions on U.S. investments into Chinese companies, according to several media reports that cite anonymous officials.
Such restrictions could include potential delisting of Chinese companies from U.S. stock markets as well as blocking U.S. pension funds from investing in Chinese companies. A U.S. Treasury statement later denied that the administration was considering delisting Chinese stocks.
Looking at a more likely scenario—restricting pension flows into Chinese equities—the strategy is sensible and aligns with President Donald Trump’s foreign policy on dealing with the Chinese Communist regime.
Today, the United States is mired in a trade war, technology war, financial war, and a potential cold war with China and its sphere of influence. The challenges go far beyond trade and economics—the world is at an inflection point where China is looking to export and influence foreign nations with its communist ideology, agenda, and world view.
Pension funds are pools of money held to fund the future retirements of public employees such as teachers, firefighters, and government administrators. While the federal government shouldn’t interfere with the investment decisions of private funds, there’s an argument that at minimum, public pensions should not fund the operations of companies which are directly or indirectly hurting U.S. interests.
One such example is Hikvision Digital Technology, the Chinese surveillance technology group that was put on a Department of Commerce blacklist on Oct. 7 and barred from doing business with U.S. enterprises. Hikvision is a prominent supplier to Chinese detention centers and apparatuses monitoring Uyghur Muslims in the northwestern region of Xinjiang.
The California State Teachers’ Retirement System (CalSTRS), the nation’s second-largest pension fund with $227 billion of assets, owned 4.4 million shares worth $24.4 million as of its June 30, 2018 disclosure of its assets.
Many pension funds have investments in Chinese equities, driven by widely accepted asset allocation models which recommend between 5 to 15 percent capital to emerging markets securities. The biggest capitalization within the emerging markets category is China, the world’s No. 2 economy.
Earlier this year, The Epoch Times reported that the chief investment officer at the $350 billion California Public Employees Retirement System—which holds a sizable allocation to Chinese stocks and real estate—has close ties to China.
However, the motive of most pension funds are more benign. In recent years, several leading stock and bond indices—which many investment funds track and benchmark themselves against—have added Chinese stocks and bonds to their index.
Global index provider MSCI earlier this year lifted the weight of China A shares from 0.7 percent to 3.3 percent of its emerging markets equity index by November.
In April, the benchmark Bloomberg Barclays Global Aggregate Bond Index began including certain Chinese yuan-denominated government and policy bank bonds. In October, Chinese bond names were added to J.P. Morgan’s Government Bond Index-Emerging Markets.
The Federal Retirement Thrift Investment Board (FRTIB) announced two years ago that by mid-2020 its global fund offered to many federal government employees would track the MSCI All Country World Index, which has an allocation in China. Some U.S. lawmakers, including Senator Marco Rubio (R-Fla.), have pushed FRTIB to reverse the decision.
China Investments Pose Inherent Risks
Predictably some pension funds, including the $238 billion California State Teachers’ Retirement System (CalSTRS), are pushing back against potential investment restrictions. “CalSTRS follows an investment strategy of diversification and passive index management that does not systematically include or exclude any investments in companies, industries or geographic areas,” Vanessa Garcia recently told Pensions & Investments magazine.
Ignoring the difficulties of enforcement, there will be short term disruptions if all pension funds decide to divest their Chinese holdings. Pensions will need to sell assets, presumably over a period of time, which will attract short sellers and undoubtedly push prices down. Investment methodologies will have to be rewritten and there will be governance changes. Some pensions, already underperforming, may face tough questions from their constituents.
But over the long term, weaning U.S. funds off of China isn’t very disruptive and could de-risk American retirement portfolios. Over the last five years, Chinese stock market performance has trailed U.S. markets (Shanghai Composite Index is up 27 percent while the S&P 500 is up 57 percent), while returns on Chinese and U.S. corporate bonds have been comparable.
Chinese firms listed in the United States have enjoyed better returns but the risk is even greater. Well-known Chinese companies such as internet giants Alibaba, Baidu, and JD.com all utilize some form of a VIE (variable interest entity) structure to list in the United States, circumventing Chinese restrictions on foreign investment in “sensitive” industries.
Astute investors know that ownership in these VIEs do not actually represent economic or legal ownership in the Chinese company or its assets. And no voting power is granted. These VIEs, usually offshore companies set up in a tax-advantaged jurisdiction, mimic the economic relationship of ownership through a series of contractual agreements between the VIEs and the Chinese companies where actual assets and revenues reside.
For institutional investors who usually demand transparency and a say on governance from their U.S.-owned companies, investing in these Chinese firms is akin to closing one’s eyes and hoping for the best.
Additionally, Beijing does not allow the Securities and Exchange Commission or U.S. regulators to examine audit work papers of Chinese companies. China claims that the books present “national secrets” which cannot be shared with outside parties.
In essence, these U.S.-listed Chinese companies have long had it both ways—circumventing Chinese laws while raising capital abroad. And Beijing regulators so far have looked the other way; it’s an implicit acknowledgement that foreign investors in fact do not have legal ownership in Chinese companies.
U.S. institutional investors are major holders of U.S.-listed Chinese companies. BlackRock owns $13.6 billion worth of Alibaba shares and $1.6 billion worth of Baidu shares as of June 30. Vanguard Group owns $7.6 billion of Alibaba shares and $1.1 billion of Baidu shares. Among the top ten institutional investors holding Alibaba shares are BlackRock, T. Rowe Price, Vanguard, Invesco Funds, and State Street. These firms manage money for millions of U.S. retail investors.
Think about this: what if one day Beijing decides that all of these VIE structures are illegal? If China decides to pull the plug and force companies to renege on these paper contracts, billions of dollars of wealth from American pensioners and retail investors would be wiped out.
It’s far more advantageous for the United States to withdraw capital—on its terms—than waiting for China to push the nuclear button.
