US Investors Have Increasing Exposure to Chinese Banks, Bad Loans

Chinese companies’ loyalties often rest with CCP, not their investors
May 31, 2020 Updated: June 2, 2020

Commentary

U.S. investors have an increasing number of reasons to financially decouple from China.

Fraudulent accounting by a number of Chinese companies and a protracted trade dispute between the United States and China have forced U.S. investors to scrutinize their exposure to Chinese stocks. More recently, the Chinese Communist Party (CCP) virus and the Chinese regime’s recent proposal of security legislation in Hong Kong have added fuel to the fire.

And last week, an advisory body to U.S. Congress issued a warning over U.S. investors’ exposure to China’s precarious banking system.

It’s one more reason for investors to reduce their Chinese investment exposure.

Banks

The amount of bad loans on the balance sheets of Chinese banks is worrisome, especially given the growing trend of U.S. savers, pensioners, and retirement accounts owning Chinese stocks, according to a report issued on May 27 by the U.S.–China Economic and Security Review Commission (USCC).

Calling Chinese banks “a source of systemic risk,” the report states that unlike U.S. banks, Chinese banks do not have a fiduciary duty to the interests of their investors (owners).

“They remain beholden to and supported by the state,” the report says. “The Communist Party-state retains the ability to intervene decisively in the banking system to achieve desired outcomes.”

Specifically, the amount of non-performing loans (NPLs) is concerning. NPLs are loans where the borrowers are not financially viable enough to keep paying interest. Already saddled with NPLs before the CCP virus struck, Chinese banks were mobilized by Beijing authorities to provide new capital to struggling companies during the pandemic—even as existing NPL numbers are spiking.

A decade ago, when the Chinese markets were fairly closed off, such issues were irrelevant for American investors. But today, China’s problems have become U.S. investors’ problems. “U.S. investors thus have a growing stake in China’s financial system and all its unattenuated economic and political risks. This is an important issue for policymakers to assess,” the USCC report warned.

Chinese companies—including many of its banks—are part of MSCI and FTSE Russell’s emerging market and global market indices. Chinese domestic onshore bonds also make up a portion of the widely-followed Bloomberg Barclays Global Aggregate Index. And many popular investment funds are mandated to follow the indices by buying up securities issued by Chinese companies.

This development means U.S. investors—through their pension funds, mutual funds, and exchange-traded funds—now own the stocks of Chinese banks and banking system participants. Put differently, U.S. investors are now on the hook for these bad loans.

Investors: Caveat Emptor

The U.S. administration earlier this month directed the Federal Retirement Thrift Investment Board to halt its planned investments into Chinese stocks. The Board’s Thrift Savings Plan, which has about $41 billion of assets, was planning to follow the constituents of certain MSCI indices, which include Chinese stocks.

But that’s only one fund. The government has limited powers to direct individual investors on what to invest in—which is the way it should be in a democratic, capitalistic system. But it behooves every single U.S. investor to reassess his or her portfolio and think twice about investments in Chinese stocks or bonds.

This is not a political consideration—it is a financial and economic consideration.

The USCC’s report on China’s banking system highlights the idiosyncratic risks specific to the Chinese market—risks that a typical investor cannot economically account for.

Chinese companies behave completely differently than their Western counterparts and do not bear the fundamental characteristics of a typical for-profit company.

As the report notes, Chinese companies do not work for their investors (owners) but must ultimately answer to the CCP. The CCP’s directives supersede other priorities, which creates a conflict of interest whereby, in the case of Chinese banks, they could knowingly lose money on loans in order to enact the CCP’s policies and directives—such as lending to unprofitable state-owned enterprises.

And it goes beyond that. Chinese banks and brokerage firms recently pressured their Hong Kong staffers to sign a petition supporting Beijing’s national security legislation imposed on Hong Kong, according to a May 26 Nikkei Asian Review report.

“I had an unexpected task this morning… my boss asked everyone in the team to sign this paper,” an anonymous Hong Kong employee of a Chinese investment bank told Nikkei. The petition also said signatories should support “anti-Hong Kong independence; anti-sedition; anti-terrorism; anti-foreign interference.”

Such policies would be unimaginable in U.S. companies. So how can an investor accurately evaluate the business and economic outlook of Chinese companies? Should U.S. investors really have a stake in such operations?

Investors are used to a certain level of regulatory checks and balances. For the most part, investors should not have to worry about the veracity of a company’s financial reports. Since the early 2000s, when investors lost billions of dollars from the Enron and WorldCom fraud scandals, U.S. capital markets and the Securities and Exchange Commission have tightened regulations by enacting the Sarbanes-Oxley Act, and established industry safeguards such as the Public Company Accounting Oversight Board.

But Chinese companies typically adhere to none of these. There are Chinese rules and regulations in place, but their effectiveness lags behind those of developed markets. Chinese auditors cannot be investigated or examined by U.S. regulators. The number of outright fraudulent companies or companies engaging in fraudulent acts is significantly higher in Chinese markets.

Chinese banks are widely believed by Western economists to underreport their true levels of NPL. A recent investigation by Karlo Kauko, an advisor at the Bank of Finland, found increasing loan quality problems at Chinese banks due to the smoking gun evidence of their diminishing interest income. This is despite the banks’ public reports of stable NPL ratios.

How can a U.S. investor trust the financial disclosures of such Chinese companies?

Investors shouldn’t be kept awake at night by such transgressions. The right call is to divest from Chinese securities.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.