Ringing the ceremonial bell on an American stock exchange is a career highlight for many Chinese entrepreneurs. But those stocks haven’t always panned out for US investors, and fewer of them may be listed on America’s iconic markets in the future.
Chinese companies are under increasing scrutiny from US politicians as well as regulators. US president Donald Trump said he’s debating whether to tighten restrictions on these firms as a way to punish Beijing for its handling of the Covid-19 pandemic, and the White House is also pushing the Thrift Savings Plan, which covers the retirement savings of around 5 million American civil servants, to avoid investing in Chinese companies. Last month the chairman of the SEC warned that disclosures in emerging markets, including China, are more likely to be “incomplete or misleading.”
While the White House and the SEC may have different objectives, they’re right to be worried about these securities. At the core of their concerns are incomplete financial disclosures by some Chinese enterprises. For years, American regulators haven’t been able to inspect Chinese firms’ accounting audits, which is in accordance with directives from Beijing.
Unlike at US companies, Chinese executives are able to avoid having their audits reviewed by the Public Company Accounting Oversight Board (PCAOB), the nonprofit created in the US in 2002 after the accounting scandals of WorldCom and Enron. The US Senate passed a bill this week that would prohibit companies from listing on US exchanges if they’ve failed to comply with PCAOB audits for three years in a row, and would also require them to disclose whether they are owned or controlled by a foreign government.
“The utility of an auditor’s report depends upon the veracity of the underlying data, which is precisely the source of the current dispute,” said Brock Silvers, the chief investment officer at Adamas Asset Management, which focuses on investing in growth companies in Asia. “The PCAOB demands access to underlying audit data of Chinese companies as per US law, while Chinese regulators forbid the sharing of such data as per Chinese law. The US regulators have been partially enabling such fraud by allowing Chinese firms to adhere to their own local laws.”
Investors tend to lose out when companies can hide information. To sum up the SEC’s analysis of the penny stock market in 2016, just about everything seems to get worse when companies avoid disclosures: liquidity (the ease of trading) declines and the likelihood of a stock increasing in value sinks. The research suggests that a lack of disclosures can attract fraudsters.
A lack of transparency may partly explain the lackluster performance from Chinese companies in the US market. More than 270 of them went public on American exchanges between 1991 and 2018, according to University of Florida professor Jay Ritter, an IPO expert. Those offerings jumped an average of 19% on the first day of trading (a pop similar to US companies), but their returns, on average, later sagged: Chinese IPOs underperformed against the broader market by about 7% in the three years after they were listed.
Nasdaq, meanwhile, is preparing to tighten up its listing requirements in a way that would probably prevent smaller Chinese stocks from getting on the exchange. Chinese coffee chain Luckin Coffee listed there in 2019 and then quickly ran into trouble. The company said this week that it’s at risk of being delisted after it disclosed fabricated transactions.
“The door will not be shut completely”
Even so, it’s probably too late for US investors to fully “decouple” from Chinese companies, as money managers are invested heavily in Chinese enterprises, some of which are among the world’s biggest and most valuable companies. When Jack Ma’s Alibaba listed on the New York Stock Exchange in 2014, it was the biggest IPO ever, and the stock has soared more than 130% since it went public in the US. (Alibaba also issued shares in Hong Kong last year in a secondary listing.)
The entrenched tie-ups make it unlikely that the US could completely turn its back on Chinese companies. “Politicians are going to be politicians, it is natural for them to launch attacks on Chinese companies to get votes,” said a US-based lawyer who has handled IPOs for Chinese companies. “As long as China remains the second-largest economy worldwide, and those big companies keep performing well, the US would not shut the door to the firms completely.” The lawyer declined to be identified because he was not authorized to speak to media.
For their part, Chinese executives are likely to continue seeking out US investors even if they face more scrutiny. US markets are deep, meaning companies can raise more money there, and the iconic American exchanges carry prestige.
A severe tightening of restrictions in the US would also push some Chinese listings to other exchanges, making venues in Hong Kong and London the most likely beneficiaries. (That’s a possibility the US president has acknowledged.) That could crimp the bragging rights for US exchanges when it comes to the number of listings they oversee and the amount of trading they handle. Wall Street investments bankers, who provide lucrative services for those listings, could also lose out. And while regulators have good reasons to push for greater transparency, American investors also benefit from access to a diverse market.
That all suggests that even though fewer Chinese companies may have access to America’s exchanges in the future, they’re unlikely to be barred completely.