Talk gets tough on China; action far from assured

As the White House continues to discuss clamping down on the flow of capital between the U.S. and China, including tougher oversight of American stock exchanges and limiting investment of federal retirement assets in Chinese companies, few Washington observers are ready to take bets on where it may wind up.

But for now, the prospect of the U.S. doing something, anything, is garnering some bipartisan support and raising hopes.

"I'm glad to see that the Trump administration is finally paying attention," Sen. Chris Van Hollen, D-Md., said in an emailed statement.

Mr. Van Hollen is co-sponsoring a bipartisan bill with Sen. John Kennedy, R-La., the Holding Foreign Companies Accountable Act, "that would make sure that Chinese companies listed on American stock exchanges are held to the same rules as everyone else — and that those who refuse are delisted. Our plan would do so with the least possible disruption to the market and to American shareholders," he said.

The bill would require foreign companies registered with the Securities and Exchange Commission to meet Public Company Accounting Oversight Board standards. Companies refusing the requirement for three years in a row would no longer be listed in U.S. markets.

So far, "China stands alone in its non-compliance" by not even allowing U.S. regulators to see the books, and some Chinese firms escaped initial SEC inspection by merging with American shell companies, said Mr. Van Hollen.

To Jin Zhang, a portfolio manager with Vontobel Asset Management's $34 billion quality growth equity boutique firm in New York, the purpose of the Washington talk is the critical question.

"If it is about protecting U.S. investors, there are some issues that regulators need to work out, but these are not things that are concerning us from a fundamental perspective. We do not think there are significant issues that affect shareholder value.

"If the purpose is to restrain or cut off capital flow, that's a concern," said Mr. Zhang. "We think capital should be left to the capital markets rather than to the politicians. It is important that we let the cooler heads prevail. All this political stuff is just kind of noise."

The subject of Chinese companies posing a risk to U.S. investors is not new. As early as 2014, the U.S.-China Economic and Security Review Commission, which monitors national security issues for Congress, raised alarms about the growing trend of Chinese private internet companies like Alibaba Group Holding, Weibo Corp. and JD.com turning to U.S. stock exchanges to raise more capital. Of particular risk to U.S. investors, the analysts warned, was the use of a complex structure known as variable interest entity, or VIE, that allows Chinese companies to bypass China's restrictions on foreign investment by setting up offshore holding companies to connect with investors.

In addition, commissioners warned, Chinese fraud schemes on U.S. exchanges have cost U.S. investors billions of dollars.

The stakes are even higher now, with 156 Chinese companies listed on the largest U.S. exchanges, with a total market capitalization of $1.2 trillion. At least 11 of them are Chinese state-owned entities.

Now too big to ignore, the Chinese presence in American markets is featuring prominently as the White House on Oct. 11 announced a preliminary deal with China as Pensions & Investments went to press.

Building up to those talks, Trump administration officials, including National Economic Council Director Larry Kudlow, have floated several ideas, including preventing Chinese firms from listing on U.S. exchanges, limiting their inclusion in indexes, and even reversing a plan by the Federal Retirement Thrift Investment Board, Washington, to shift by the middle of 2020 the $590.8 billion Thrift Savings Plan's I Fund benchmark to the MSCI ACWI ex-U.S. Investable Market index, which may include as much as 8% Chinese firms.

White House officials declined to comment on what they said is an ongoing policy process.

One of the harshest critics of FRTIB's plan for the $49.5 billion I Fund is Sen. Marco Rubio, R-Fla., who along with Democratic Sen. Jeanne Shaheen of New Hampshire, warned FRTIB officials in August that the index includes "many firms involved in the Chinese government's military, espionage, human rights abuses and 'Made in China 2025' industrial policy." By failing to consider the national security implications, they said, the decision "poses fundamental questions about the board's statutory and fiduciary responsibilities" to plan participants. FRTIB officials are still reviewing the request, but if they refuse to change their minds, Congress needs to step in to avoid having federal employees underwrite China's Communist Party, Mr. Rubio said.

Mr. Rubio and other members of Congress are also calling for more scrutiny of Chinese companies included in major indexes. As of March 2018, 12 of the top 100 global companies by market cap are based in China, according to PricewaterhouseCoopers LLP.

There is also a growing campaign on Capitol Hill to delist Chinese companies that do not follow securities laws, including audit requirements. Another bill introduced in the House and Senate by Mr. Rubio and others, the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges Act, would prevent the Chinese government from blocking U.S. regulators viewing full audit reports of publicly traded companies headquartered in Hong Kong and mainland China, and delist non-compliant firms.

The increased attention does not easily translate into action, and Washington's options may be limited.

"The SEC, the PCAOB and the stock exchanges all face challenges in overseeing the financial reporting for U.S.-listed companies whose operations are based in China — a market where U.S. investors' interest has increased and is significant," said Jeff Mahoney, general counsel of the Council of Institutional Investors in Washington.

Legal experts doubt that the SEC has the legal authority to delist Chinese companies, even for national security reasons, but the agency at least could get tougher about variable interest entities and make them less attractive to Chinese firms.

The White House could get tougher on its own, through trade negotiations or other unilateral action. One fairly extreme option — declaring an emergency to gain the power to regulate foreign transactions — was used last year to ban the sale of equities in which Venezuela had 50% or more ownership.

As administration officials begin to consider their options, the downside risks are both legal and political.

"The administration's attempts to limit Chinese firms' standings in U.S. financial markets and U.S. investments in China could face significant legal hurdles," said Eswar Prasad, the Tolani senior professor of trade policy at Cornell University and a senior fellow at the Brookings Institution in Washington.

"Such actions also raise the specter that foreign firms' and investors' status in U.S. financial markets is subject to the whims of whatever administration is in power rather than being governed by the rule of law. This would undercut a fundamental element of foreign investors' confidence in U.S. financial markets, which has contributed to the U.S. dollar's status as the dominant global safe haven currency," he said, while forcing U.S. indexes to exclude Chinese markets "would constitute direct intrusion into private-sector operations for political reasons, setting a very unfortunate precedent."

For now, that leaves the spotlight on the exchanges themselves, which declined to comment beyond a statement from Nasdaq that they "provide non-discriminatory and fair access to all eligible companies."

At a September securities traders' conference in Washington, NYSE President Stacey Cunningham warned about driving business away to other countries' markets. "We're lobbying to solve the problem instead of just legislating companies away, and let's make sure that we do have investor protections and audit oversight," said Ms. Cunningham, who held out the prospect of finding some common ground.

Former U.S.-China Economic and Security Review Commission analyst Paul Magnusson, principal of China consulting firm Magnusson Analytics in Chevy Chase, Md., is skeptical. U.S. regulators who may wind up with Wall Street jobs "have no incentive to be more meaningful. The exchanges don't want to lose money, and the Chinese government has no interest in fulfilling promises made through these 'bamboo negotiations,'" that can be more for appearances than substance, he said.