Commentary: Does China's tech crackdown spell the end of the Chinese ADR market?

Beijing's ongoing crackdown on technology companies has left many investors wondering if the days of Chinese firms listing on U.S. stock exchanges through the American Depository Receipt market are over. If so, how to adjust portfolios to reflect the new reality?

China's actions to date suggest that Beijing's long-term plan is to create a regulatory environment designed, in essence, to discourage Chinese listings on U.S. exchanges. Instead, Beijing appears to want those companies to list in Hong Kong or other domestic markets.

If so, investors allocating to Chinese equities should consider a holistic approach that expands the investible universe from the likely-to-remain-volatile ADR market to Chinese equities traded in Hong Kong (as H shares) and on domestic exchanges (as A shares.) This more comprehensive approach should enable investors to continue to gain exposure to China's growth potential while potentially mitigating volatility.

Over the past year, Chinese policy toward financial markets has grown more restrictive. Late last year, China suspended Ant Group's initial public offering, set to be the largest-ever IPO. This summer, just two days after ride-sharing firm Didi Global Inc.'s IPO, the Cyberspace Administration of China announced it was investigating the firm over national security concerns. And as financial supervisors are making it increasingly difficult to maintain overseas share listings, a number of Chinese tech firms have pulled plans to list in New York as ADRs. Significant regulatory action in July against for-profit, private tutoring companies added to growing investor anxiety that Beijing may be embarking on an extended period of corporate regulatory interference that could broaden beyond the tech sector.

Amid market turmoil, Beijing has sought to reassure international investors that regulators want stability in capital markets. Nevertheless, investors, remembering China's 45% stock sell-off in 2015, are unsettled by the swift, broad crackdown. So, what are investors to do? In China, finding the path forward often starts with taking a step back, in this case understanding China's various equity listing venues.

Chinese stocks list in three main venues — as ADRs in New York, as H shares in Hong Kong or as A shares in Shanghai or Shenzhen — with each offering exposure to different aspects of the China opportunity.

ADRs are dominated by megacap tech firms such as Baidu Inc., Alibaba Group Holding Ltd. and Tencent Holdings Ltd. H shares are dominated by state-owned enterprises such as banks. Together, ADRs and H shares are called China "offshore." As a result of dual listings between U.S. ADRs and H shares, the H share market also suffered recently, but was spared the worst of the selloff. For example, in July, the MSCI China H index fell 5.2% vs. the MSCI Overseas China index's (USD) 20.4% drop.

A shares ("onshore" China) reflect broad exposure to fast-growing sectors of China's economy, from tech and hospitality to electric vehicle makers and medical innovators. These firms typically draw more than 90% of their revenues domestically, thereby offering investors meaningful portfolio diversification. They also encompass more fast-growing mid- and small-cap firms.

Beijing's long-term goal is probably to discourage Chinese firms from listing in U.S. markets while also encouraging greater participation in IPOs and secondary listings within domestic exchanges by promoting the A shares market broadly and specialized exchanges such as the Nasdaq-like STAR Market launched in 2019 to make it easier for tech firms to go public. China's moves to discourage ADR listings is just the latest twist in deteriorating relations with Washington, a tit-for-tat response to a U.S. law mandating that Chinese firms listed on U.S. exchanges open their audited financials (currently performed by domestic Chinese firms) to review by U.S. authorities. Since Beijing views that as impinging on its sovereignty, it is unlikely Beijing will ever agree to what it views as an intrusion.

While the latest crackdown squarely targets offshore-listed firms, it could be a net positive for H shares and especially for A shares. H shares will benefit if a growing number of companies now listed as ADRs start to dual list in Hong Kong, a trend that is already well underway. We have recently seen a wide range of Chinese firms, from home services to electric vehicle makers to logistics firms, shelve their U.S. listing plans and list, or explore listing, in the H-share market. The improving breadth of Chinese firms listing on A-share and H-share markets will create more opportunities for investors and improve liquidity in domestic equity markets over the long term, potentially reducing volatility.

While some fear that the crackdown could restrain innovation, private advances in such areas as health care and Beijing's commitment to investing in such things as artificial intelligence and 5G/6G suggest that the world's second-largest economy — already home to the most unicorns, or private firms valued at more than $1 billion — still represents an attractive, long-term investment opportunity.

Some investors had hoped that U.S.-China trade tensions might thaw under a new U.S. administration, but President Joe Biden has kept tariffs, bans on investing in Chinese firms seen as strategic threats and bans on technology transfer for certain firms. While these tensions remain a risk for both China and the U.S., this risk is far greater for Chinese firms with deep ties to the U.S. — those listed as ADRs. At the same time, active investors should be able to identify attractive investment opportunities in companies less intertwined with the global economy — firms typically trading as A shares.

For example, there will be areas where China and the U.S. will likely cooperate, such as the production of renewable energy products; perhaps more than any other country, China stands to benefit most from any large-scale U.S. spending on renewables and sustainability.

The latest crackdown shines a light on a serious problem many investors already faced. Specifically, investors tracking the weightings of popular indexes (such as the MSCI Emerging Market index or the MSCI All Country World index) were already overexposed to a handful of megacap "offshore" firms — ADRs and H shares — while having negligible exposure to the thousands of faster-growing, domestic Chinese firms trading as A shares. Investors have a number of ways to tackle this problem. For example, an investor could keep current emerging market allocations while adding an additional China A-shares allocation to better balance the offshore/onshore opportunity, or they could add an all-China allocation.

The latest crackdown has left many investors asking, "Is this the end of the ADR market for Chinese companies?" The answer, for now, is looking like a clear "yes." The good news, however, is that investors have an opportunity to optimize their China allocations to better reflect the long-term investment opportunity across all of the country's equity markets.

Christian McCormick is a senior product specialist covering China equity at Allianz Global Investors. He is based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.