Chinese equities at risk of more US capital flight
Restrictions on American investment into certain Chinese stocks could drive large withdrawals from index funds and mandates, say industry experts. Even some non-US asset managers are exiting the shares in question to ensure that they do not lose American clients.
This comes amid rising overall demand for mainland equities from both international and mainland investors, which some feel could offset any potential redemptions.
China's CSI 300 benchmark index may have stumbled in its march upwards – having fallen 13% since February 10 – but the overall trend is that money is pouring into A-shares and H-shares. Net institutional flows into China and Hong Kong equity products totalled $16.84 billion last year, up from $4.03 billion in 2019, according to research house eVestment.
This is despite criticism of Beijing as it tightens its grip on Hong Kong and over its treatment of China’s Uighur minorities. It is also despite uncertainty over whether the new US administration will retain restrictions on American investment into mainland stocks. These were introduced on November 12 under former president Donald Trump, and added to in January, just a few days before he left office.
In short, investors are seeking to tune out the political noise and focus on the economic opportunities offered by the world’s second-largest economy.
“There’s definitely been a return in confidence, despite the political unrest,” said Effie Vasilopoulos, Hong Kong-based co-leader of the global investment fund group at US law firm Sidley Austin.
“Following the US’s change of government [in January], the hostility in tone [towards China] has not gone away completely, but it has become more subdued. There’s a feeling that the US fired its worst shot and the market has been resilient to that.”
But there remains the potential for capital withdrawal despite President Joe Biden's less inflammatory approach to China than his predecessor, Vasilopoulos added.
“If the main indices that American investors track remove exposure to [certain] Chinese securities, as is required under US law, there has been market chatter that relevant mandates and index-tracking funds will have to divest those securities.
“Some sources are putting that [potential] pullout at somewhere between $200 billion and $400 billion,” said Vasilopoulos.
In January the US added nine names – including smartphone maker Xiaomi – to the blacklist of Chinese companies that it says have ties with the country’s military. The move brought the total on the list to 44.
But on Friday (March 12) a US judge reportedly issued a preliminary injunction removing Xiaomi from the list. He argued that the US defence and treasury departments had not made a case that there were compelling national security interests for Xiaomi’s inclusion.
On the same day, however, US regulators took a more hawkish stance on five Chinese companies, including telecom giants Huawei and ZTE, designating them national security threats.
If the US continues to exert pressure on Beijing, Vasilopoulos said, it could pass further laws that require American investors to retreat from indices or amend mandates that invest in certain Chinese stocks.
And that could result in more capital withdrawals – even by non-US allocators. AsianInvestor has learned that one UK-based asset manager has ditched the stocks on Washington’s blacklist to ensure that it can retain or attract US clients. The firm asked not to be named.
Admittedly, the fund house's China exposure is small, but the implications are clear: the US restrictions put some asset managers in a bind. If they have American institutions invested in their funds, do they risk making other clients unhappy by dropping certain Chinese names?
One solution is to create share classes or sleeves in their existing fund structures that simply remove exposure to the sanctioned securities, said Vasilopoulos. Some fund houses have already gone down this route.
“As a result of these strategies and some minor restructuring, the effect of the sanctions has not been that jarring [for these managers],” she added. “They have been able to retain their US investors and still comply with the sanctions."
But for smaller firms or fund vehicles, it may not make commercial sense to establish separate share classes.
Another issue for foreign investors is that the prices of several of the blacklisted shares have, against widespread expectations, risen in recent months, said Stewart Aldcroft, Hong Kong-based managing director in Citi’s markets and securities services division.
“There’s clear evidence that some of the [named] companies have been very heavily supported by mainland fund managers," he added.
Bargain-hunting Chinese investors have reportedly piled into stocks that had fallen heavily after Trump signed the executive order in November, taking the view that Biden will reverse the law. Names such as oil producer CNOOC and rolling stock manufacturer CRRC have recovered most, if not all, of their share price losses since then.
This presents asset owners with “a real dichotomy”, Aldcroft said. “If you are a US individual or institutional investor, are you prepared to risk the government’s wrath for holding funds or mandates that invest into some of the stocks [in question]?”
As for asset managers, if they choose to take their funds out of the offending shares, they risk upsetting the remaining investors, he added.
Ultimately, many allocators have delayed their decision on this, Aldcroft noted, as the date for the investment ban to come into force for many of the companies has been delayed until May 27 from January 28.
“The pressure has eased a bit, and many are hoping Biden will cancel [the proposals] before they start to take effect. But he’s shown no indication of that yet,” said Aldcroft. “If he’s smart, he’ll use it as a bargaining chip with China for other things.”
Twinkle Zhou contributed to this article.