After weeks in correction territory, global stock markets rebounded strongly on March 16 as the US Federal Reserve raised interest rates for the first time since the pandemic started, and laid out a clear path to 10 more hikes over the next 21 months. The biggest gainers of the day were beaten-down Chinese stocks, particularly those facing delisting from US exchanges and had nothing to do with the US Fed or interest rate hikes. KraneShares CSI China Internet Index ETF, better known by its ticker symbol KWEB and which represents a broad swath of tech stocks, was up 39.7%, while video gaming giant Tencent Holdings shares surged 33.4%, e-commerce player JD.com 39.4%, search engine operator Baidu 39.2% and Internet giant Alibaba Group Holding was up 36.7%.
Having plunged between 50% and 70% over the past 15 months, Chinese tech stocks were headed for a steeper and more slippery slope as regulators in Beijing and Washington DC tightened listing rules and as the US distanced itself from China, which had not condemned Russian leader Vladimir Putin’s decision to attack Ukraine last month. Wall Street firms had rushed to dramatically downgrade China tech stocks to “hold” or “sell”.
JP Morgan, in a report on March 14, essentially called Chinese stocks “un-investible”. The US investment bank said that “broad-based concern about China’s geopolitical risks has triggered investors with a global mandate to sharply reduce their exposures” to the Chinese tech sector as the Russia-Ukraine conflict continues. It advised investors to “avoid China Internet” stocks on a six to 12-month view.
The ‘great decoupling’
Wall Street soured on the Chinese tech sector after the US Securities and Exchange Commission (SEC) identified five US-listed American Depository Receipts (ADRs) of Chinese companies because they were not adhering to the Holding Foreign Companies Accountable Act (HFCAA) earlier this month. There are 278 Chinese ADRs listed in the US with a combined market capitalisation of over US$1.8 trillion ($2.4 trillion). HFCAA has ruled that if the US Public Company Accounting Oversight Board (PCAOB), which oversees the audits of all companies listed in America, is unable to review a company’s audits for three years in a row, it can be delisted from US exchanges by the SEC.
Here’s the problem: Almost all Chinese companies whose shares are traded in the US as ADRs are legally unable to comply because under Chinese law, local companies cannot answer to auditors of another country. That means they will eventually be delisted unless Beijing and Washington can reach a compromise to amend their laws.
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US regulators claim they are only protecting the interests of American shareholders who have been burnt over the years in all sorts of scandals and corporate shenanigans, most recently Luckin Coffee, a rival of Starbucks in China, which was forced to delist following a blatant accounting fraud.
To be sure, listed Chinese companies have been preparing for the “great decoupling” from US markets. E-commerce giant Alibaba, restaurant chain owner Yum China, search engine giant Baidu, and others have all obtained secondary listings in Hong Kong and made their US ADRs fungible. That means if you own an ADR of Alibaba or Yum, you can exchange it for Hong Kong-listed shares and trade them in the former British colony.
Until recently, Beijing had indicated that it was happy that its companies were shifting their listings away from the US and relisting in Hong Kong. Yet as the delisting threats became real this past week, Beijing’s top officials stepped in and said they were willing to talk to US officials to strike a compromise. Chinese tech stocks then rallied on hints of government support.
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Vice-premier Liu He, who is President Xi Jin Ping’s top economic advisor, or the No.3 man in China behind him and Premier Li Keqiang, sparked the rebound rally when he revealed that Beijing and Washington had made “good progress” on regulatory issues and were trying to “come up with concrete solutions”. Russia’s invasion of Ukraine, says Edison Lee, a tech analyst for Jefferies & Co in Hong Kong, “could hasten a potential deal between CSRC [China Securities Regulatory Commission] and the US SEC”.
The main reason behind the huge selloff of Chinese ADRs was not merely the threat of delisting of the five companies identified by SEC for non-compliance, but also geopolitics. Investors were concerned that China could potentially be subject to the same sanctions as Russia if Beijing was seen to be supportive of Moscow.
“China has little incentive to provide financial or military support to Russia”, says the Jefferies analyst, because Putin’s action against Ukraine is inconsistent with China’s view that other countries should not meddle with another country’s internal affairs. Moreover, China recognises Ukraine as an independent country, as does the UN.
Secondly, Lee believes Beijing understands that if China were to be subject to the same sanctions that Russia is, there would be potential economic and social fallout.
“China is looking to integrate into the global economy and community, not staying away,” notes Lee. At the Chinese State Council’s Financial Stability and Development Committee meeting on March 16, Liu stressed four key tasks: economic development; continued opening up of China; market-oriented and rule-based reform; and protection of property rights. Liu also said Chinese officials should be quick to “respond to issues that draw attention from the market”.
As for Chinese Internet companies, China’s goal is to develop predictable and transparent regulations to promote stable and healthy growth, and enhance their international competitiveness. As such, “investor concerns of much tighter Internet regulations or potential sanctions against China appear overdone”, the Jefferies analyst says.
China’s No.3 official also said relevant government departments will steadily advance and complete the rectification work on large Internet platform companies soon “through standard, transparent, and predictable regulation”. The government, he directed, “should promote the steady and healthy development of China’s platform economy and improve its international competitiveness.”
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The Beijing-Washington spat over tech delistings has been seen by investors as a part of the ongoing decoupling of the world’s two largest economies. The US and China are among each other’s largest trading partners. American consumers buy Chinese goods which helps China grow and prosper. The US exported US$151 billion worth of goods to China and imported US$506 billion worth of goods from China last year. China has been a key cog in the global supply chain of an array of raw materials, components and finished goods. In recent years, the US and China have disagreed on the imbalance in their trade relationship and how China could open its markets to allow more US goods and services to achieve a better balance.
Liu’s statement was a clear indication that China is willing to resolve the issues to avoid delisting of all Chinese ADRs. The proposals put forward by China, Lee notes, include joint audits and joint investigations into potential fraud. Liu said Beijing was willing to make concessions on a case-by-case basis to allow companies with China-listed ADRs to comply with PCAOB rules. Liu also stressed continued government support for Chinese companies to seek overseas stock market listings.
While Liu did not comment on the controversial variable interest entity (VIE) structure, which enables a Chinese company to set up an offshore entity for overseas listing purposes that allows foreign investors to buy its stock, Jefferies analyst Lee believes it has been made clear by other government officials that it is no longer being viewed as an illegal structure. The VIE arrangement was originally designed by global investment bankers to help tech companies to skirt Chinese government rules restricting foreign investment in sensitive industries such as Internet, media and telecommunications.
Bargain prices?
So, is it time for investors to buy tech stocks? For a year now, Chinese tech firms have become a doomsday trade. Having fallen between 50% and 75%, Chinese tech stocks looked inviting to bargain hunters. Berkshire Hathaway vice-chairman Charlie Munger, a confidant of billionaire investor Warren Buffett, began buying Alibaba shares last year after it had plunged 40% from its peak. In a way, it looked like a classic Berkshire-type investment — swooping on an undervalued company at bargain prices. Munger was still down over 25% on his Alibaba investment last week.
There is a reason why stocks like Alibaba are as cheap as they are. Although their business fundamentals are likely to improve over time, it is unclear whether they will ever be able to have similar 50% to 60% annual growth rates, or high margins, or command the sort of premium valuations they once did, given increased competition, tighter regulations and sluggish economic growth in China.
Still, investment banks like Jefferies & Co argue that value is emerging in China’s Internet sector, with companies trading at about 14 times this year’s estimated earnings or far lower than their overseas peers. Jefferies notes that at its trough on March 15, Alibaba’s net cash was 26% of its total market capitalisation, while Baidu and JD’s net cash were 40% of their market value. While it is true that big tech companies in China have a lot of cash, Chinese regulators have not said they are done punishing them with fines. Alibaba, Tencent and their peers have already paid billions in fines over the past year.
Even after the recent huge rebound, Chinese tech stocks are still in deep bear market territory. Despite its 39.7% surge on March 16, KWEB is down 70% from its peak 13 months ago. S&P/BNY Mellon China Select ADR Index, a proxy for top US-listed China ADRs, is still down 63% from its February 2021 peak. Alibaba, despite its 36.7% one-day surge on March 16, is still down 68% from its October 2020 peak.
Indeed, investors with exposure to China have little to show for over the past five years. The Shanghai Shenzhen CSI 300 Index, which replicates the performance of the top 300 A-shares traded on the Shanghai and Shenzhen, is up 25.6% since January 2017. In comparison, if you had invested in tech-heavy Nasdaq 100 Index, you would be up 182% over the same period, while the broader US stock market gauge, S&P500 index, is up 93%. Singapore’s Straits Times Index is up 11% and Kuala Lumpur Composite Index is down 6% since January 2017.
China’s tech sector got to its late 2020 peak because it was seen by global investors as a proxy for growth in what was then the fastest-growing consumer markets in the world. Regulation, slower growth and geopolitics, particularly China’s stance on Ukraine, have helped contribute to its slide. Ironically, the global slowdown and slower growth in China might eventually help resurrect the sector as long as innovative tech companies create new products and services. In a sluggish environment, investors are often willing to pay a premium for growth wherever they can find it.
Assif Shameen is a technology and business writer based in North America
