US-China conflict: the pressure intensifies on ADRs

On 20 May, the Senate unanimously passed the ‘Holding Foreign Companies Accountable’ (HFCA) Act. The bill aims to prohibit a company from being listed on any of the US securities exchanges if that company has failed to comply with the Public Company Accounting Oversight Board’s (PCAOB) audits for three years in a row.

The bill also requires all public companies to disclose whether they are owned by a foreign state. There is a three-year grace period on these requirements. The bill now needs to pass the House before reaching the President’s desk to be signed into law. Although the bill covers all listed companies, in practice it will mainly have an impact on Chinese US-listings.

China is the only large country that refuses to allow the PCAOB to inspect audits of companies registered in China and Hong Kong, arguing that Chinese law bars the work of auditors from being transferred out of the country. We expect the House to approve the bill and the President of the US (Republican or Democrat) to sign it, as there is rare but strong bipartisan support for the bill.

China is unlikely to accept the US demand for full PCAOB access as it will consider this a sovereignty issue. Furthermore, the demand by the Senate bill for a full disclosure of state ownership and party membership of senior managers of the ADRs makes any concession by the Chinese government even harder politically.

There are currently 233 Chinese ADRs listed in the US (primary listings only), with an aggregate listed market capitalization of USD 1.03 trillion, representing 3.3% of the total US equity market capitalization and 8% of China’s total market capitalization. On average, these ADRs collectively trade USD 8.1 billion per day, which represents 6% of the average daily turnover in the US. In other words, Chinese ADRs trade twice as much as US stocks.

It has been estimated by Goldman Sachs that US investors currently hold USD 350 billion worth of Chinese ADRs, representing roughly one third of the ADR universe. Goldman Sachs further estimates that 29 of the 233 ADRs, with a total market capitalization of USD 370 billion, are eligible for a second listing in Hong Kong. We would expect many will now opt for a Hong Kong listing.

Beyond the fact that the rising US-China tensions could negatively influence investor sentiment towards Chinese stocks, the implementation of the HFCA Act could also have a negative impact on our Chinese US-listed holdings. Table 1 highlights our exposure to China, including Chinese US-listed holdings. Our US-listed names will be affected by the new ADR rule to varying degrees, depending on the final details of the law and its implementation.

However, as already mentioned, it is likely that the US-listed Chinese companies will move to another exchange. The most likely option would be Hong Kong, though other exchanges, such as London, will also be considered.

Since Alibaba’s successful secondary listing in Hong Kong in 2019, it has been widely expected that other companies would follow suit. JD.com Inc. and NetEase Inc. have both filed for a secondary listing since then. Chinese search engine Baidu is also considering delisting from the US Nasdaq market and moving to an exchange closer to home. Thus, any negative impact on our strategies is expected to be limited in the longer term.

For now, we intend to maintain our current exposure to China. As Table 1 illustrates, Robeco Emerging Stars has a relatively small underweight position in China, while Robeco Emerging Markets Equities has a slight overweight. The Chinese ADRs held in the strategies are performing very well currently. Our base case scenario is for a mild to negative impact for these ADRs, with the potential for companies to move to Hong Kong’s stock exchange.

However, the latest restrictions on US investments in China is a risk factor for the whole Chinese stock market, not just for the ADRs. The US developments notwithstanding, we continue to see other factors as positive for China, such as better control of the coronavirus pandemic, government economic stimulus and positive expected growth in 2020. The HFCA Act is unquestionably a potentially important development that we will continue to monitor closely. A downgrade of the sentiment factor in our country allocation framework is a likely outcome.