18 Jun 2020
Michael Lai, CFA
Portfolio Manager, China Equities, Franklin Templeton Emerging Markets Equity
As China’s economy continues to recover from the COVID-19 lockdown, other issues—such as trade tensions—have started to resurface. Portfolio Manager Michael Lai offers his perspective from an investment lens on trade and other issues impacting China today.
It has been about two years since China and the United States became embattled in a trade war which has since expanded into conflicts over a range of areas, including technology, finance, and most recently—the COVID-19 pandemic.
China’s manufacturing supply chains have in fact proven to be highly resilient, getting back up to near full capacity very quickly following the COVID-19 outbreak and ending of the lockdown period. We believe this demonstrates China’s competitive advantage. Concurrently, we also expect pressure for greater localization across global economies to continue given security concerns around health care and technology supplies, although the degree to which end customers are willing to pay more for greater security of supply is something to consider.
Overall, we expect this trade tug-of-war to continue, especially in a US election year where China seems likely to remain a hot topic. In our view, an eventual comprehensive agreement remains in the best interests of both sides.
Another area of US-China tension relates to a bone of contention with regards to the Holding Foreign Companies Accountable Act, which recently passed in the US Senate. If the legislation is enacted, it would prohibit many Chinese companies from listing on US exchanges and delist many existing ones.
The issue is a lack of perceived transparency over audited financials for some Chinese companies. Since Chinese firms are audited locally (in most cases by the “Big Four” international accounting firms), China’s policy has been to prevent overseas regulators access to the audits, citing national security concerns.
This has been a long-running issue between the United States and China, and negotiations have been ongoing for years. The Act states that a company would be delisted if it fails to comply with the Public Company Accounting Oversight Board’s (PCAOB) audits for three consecutive years. If passed by the US House of Representatives and signed by President Donald Trump, it would become law. However, the process could be lengthy and a potential three-year transition period seems to suggest that the liquidity impact on the markets may not be immediate.
However, the potential for tighter regulatory scrutiny on Chinese American Depositary Receipts (ADRs) is likely to accelerate their dual-listing trend into the Hong Kong market. We already saw Alibaba list in Hong Kong in late 2019, and Nasdaq-listed JD.com and Netease are planning to carry out a secondary listing on the Hong Kong exchange in June, which should help broaden their investor base.
In our view, the three-year transition period allows for ample time to resolve differences and put policies in place between the PCAOB and China’s regulators. If that fails, we believe many of these affected companies can list in other markets. As we have already seen, China and Hong Kong would welcome these companies. This would also result in a closer alignment to their stakeholders and customers.
Earlier in May, the Hong Kong exchange announced that companies with weighted voting rights and secondary-listed companies were eligible for inclusion in the Hang Seng and the Hang Seng China Enterprises Indexes. While companies with weighted voting rights are currently included in the southbound trading of the Stock Connect program (via which mainland Chinese investors can invest in Hong Kong-listed stocks), we could see companies with secondary listings also added to their program, which would provide an alternative source of liquidity for companies as China continues to foster capital market development.
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