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June 8, 2020

US/CHINA: Financial sanctions on China are (so far) more bark than bite

BY Gabriel Wildau

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( 5 mins)
  • The White House took a step towards delisting US-traded Chinese companies, but this action is widely expected and will have minimal impact on both countries.
  • The “nuclear option” on financial sanctions looks unlikely, but additional financial sanctions with a more modest impact are still possible.
  • Chinese companies now have increasingly diverse and attractive alternatives to US stock markets for raising equity capital.

The White House issued an order on 4 June instructing financial regulators to address the longstanding problem of US-listed Chinese companies that flout US requirements to submit audit records to US regulators. The order follows Trump’s threat on 30 May to impose financial sanctions on China in response to Beijing’s move to impose a national security law on Hong Kong.

No nuclear option (for now)

The White House order instructs a multi-agency task force of US regulators to submit recommendations within 60 days for addressing the issue. The most likely result is that Chinese companies that continue to flout US regulations will be delisted. The action was widely expected and on would have minimal impact on both countries. For US investors and financial service providers, Chinese companies represent a negligible share of total market capitalization and trading volume on US exchanges. For Chinese companies, there are now increasingly attractive alternatives to US equity capital markets.

The Trump administration may still enact additional financial sanctions, but there is no clear sign that further action is pending. The language of Trump’s 30 May statement focused on protecting US investors from risks – which is the focus of the 4 June order – rather than inflicting pain on China’s economy or financial system. At this point the “nuclear option” of Iran-style sanctions that would cut China off from the US dollar-based financial system appears highly unlikely, but the US presidential election remains a significant wildcard. Trump may feel pressure to take tougher measures as the election approaches, especially if US-China relations continue to deteriorate.

What other financial sanctions are possible?

If Trump does want to impose additional financial sanctions, there are several possibilities that would be more impactful than the latest action while still falling short of the nuclear option. For example, the US could ban investment in specific groups of companies, such as: companies with links to China’s military; companies involved in repression (including high-tech surveillance) in Xinjiang; companies implicated in eroding Hong Kong’s autonomy (for example, through sales of police equipment).

Another possibility is that the Securities and Exchange Commission could issue an official warning about risks of investment in the entire universe of Chinese-listed stocks and bonds – in effect, discouraging such investment. Other measures could involve action to discourage or restrict major securities index providers from adding Chinese stocks and bonds to key indices, thereby blocking the flow of passive investment into these assets. An even more impactful action – which is unlikely but can’t be ruled out – is an outright ban on US investment in Chinese onshore and/or Hong Kong capital markets. As previously discussed, yet another possibility is “secondary” sanctions on Chinese banks that service specific officials. That could be done by executive action or through the Hong Kong Autonomy Act now pending in congress.

On 20 May the US Senate passed the Holding Foreign Companies Accountable Act, which would also delist Chinese companies that fail to provide audit records to US regulators. That bill would also require foreign issuers to establish that they are not owned or controlled by a foreign government. The House has not yet scheduled a vote on the bill, and White House action could now render it irrelevant.

Impact of delisting on China

Several hundred US-listed Chinese companies face delisting. As of 1 April, The US Public Companies Accounting Standards Board (PCAOB) had identified 169 non-compliant mainland China-based auditors and an additional 76 with Hong Kong-based auditors, most whom operate primarily on the mainland.

For years, Chinese auditors interpreted Chinese law as prohibiting the disclosure of domestic audit records to foreign entities without explicit Chinese government approval. That prohibition was made more explicit in revisions to China’s Securities Law enacted in December 2019. In principle, it is still possible that US regulators could reach a bilateral agreement with their Chinese counterparts to enable sharing of audit papers, as PCAOB has done with other foreign regulators. The two sides did reach agreement in 2013, but PCAOB says that deal did not lead to adequate Chinese cooperation. Updating the agreement had proven difficult even when US-China relations were in a less perilous state; today an updated agreement appears even less likely.

Even if delisting proceeds, however, the impact on Chinese companies’ ability to raise capital will be minimal. In recent years, China has loosened regulations of its domestic capital markets with the aim of easing the pathway for the kinds of Chinese companies who once sought foreign listings to raise money at home. Last year’s Securities Law revision eliminated the requirement that China’s securities regulator approve all initial public offerings, devolving this authority to stock exchanges. Under the old system, companies often had to wait years for IPO approval, but the new system will speed the process. The legal revisions also eliminated a requirement that companies be profitable before listing, enabling more startup companies to raise funds. These changes were tested on a new stock board created in 2019, which focused on technology companies, before lawmakers enacted similar changes affecing the main boards in Shanghai and Shenzhen.

In 2018, the Hong Kong Stock Exchange changed its rules to allow companies with dual-class shares to list. Chinese companies with dual-class structures had previously sought US listings. Alibaba Group opted for a US IPO in 2014 but completed a secondary listing in Hong Kong in late 2019, with executives praising recent reforms to the Hong Kong market that made the listing possible.

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