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Investors can no longer ignore China-US decoupling threat

The risk that China could decouple from US capital markets can no longer be ignored. That is an important lesson from this week’s 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 $4.4bn initial public offering 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 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 companies and high-profile billionaire 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 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 is that capital has, until now, been blind to political reality. China continues to attract record amounts of foreign direct investment. 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 per cent compared with 2020. Of manufacturers producing in China, 72 per cent had no plans to move any production out of the country in the next three years. So much for deglobalisation.

As for portfolio flows, US holdings of Chinese equity and debt securities surged from $765bn in 2017 to $1.2tn in 2020, helped by the relaxation of rules on foreign access.

This trend has been accelerated by index providers 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 about 3.5 per cent, compared with close to 1.5 per cent on 10-year US Treasuries. With Chinese inflation running at about 1.5 per cent, the real yield is positive, in contrast to US Treasuries, which live under the shadow of an inflation rate in October of 6.2 per cent.

That said, the de facto renminbi peg to the dollar and euro means that Chinese sovereign bonds offer 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 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 all this is that the strategic rivalry between the US and China does not justify analogies with the cold war. China’s economic model has an extraordinary degree of integration into the global system, far greater than what the Soviet Union 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 is the latest annual report of the US-China Economic and Security Review Commission, an independent 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 modernisation, facilitating human rights abuses or subsidising unfair trade practices by US companies.

Does this mean that China is an investment dead end? I would argue that variable interest entities 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 a challenging territory given that the country is the biggest global polluter. There are undeniable human rights concerns. And corporate governance falls notoriously short of developed world standards. But for the rest it is simply a question of whether risk is being realistically priced.

Beijing’s common prosperity agenda, its penchant for random political initiatives and its interventionist behaviour 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 geopolitical risks are becoming more daunting, but a capital exodus is not yet on the cards.

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Robert Armstrong dissects the most important market trends and discusses how Wall Street’s best minds respond to them. Sign up here to get the newsletter sent straight to your inbox every weekday

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