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A US government commission has called for tighter controls on flows to China’s capital markets in a move that, if approved, would have profound implications for asset managers and index providers.
The latest annual report from the US-China Economic Security Review Commission highlighted security concerns from a huge rise in US investment. “A surge of US investor participation in China’s markets is outpacing the US government’s defence against the diverse threats to US national and economic security posed by US investment in some problematic Chinese companies,” the report to Congress said.
“Despite ongoing US-China tensions, US investors, asset managers and mutual funds are increasing their participation in China’s financial markets,” it added.
It said that US positions in Chinese equity and debt securities jumped 57.5 per cent from $765bn in 2017 to $1.2tn in 2020.
According to the report, “Chinese policymakers are courting foreign capital and fund managers as they work to make China’s capital markets serve as a vehicle to fund the [Chinese Communist party’s] technology development objectives and other policy goals”.
The commission proposes widening the scope of existing policies to close “loopholes”, pointing out that US institutional investors could still buy, sell and profit off of Chinese-military related companies as long as they were not doing so in the US and only involved non-US citizens.
“If we are really interested in protecting US national security rather than simply appearing to, this loophole should be closed as the commission recommends,” it argued.
Early this year, updated sanctions policies issued by the US Office of Foreign Assets Control had indicated that entities were “not prohibited” from providing investment management or advisory services to non-US persons, foreign funds or entities in connection with the purchase or sale of securities that would otherwise violate the investment bans.
This announcement in June appeared to alleviate some of the concerns of US managers that their onshore business in China and Hong Kong might be severely impacted by US government policies.
The new commission report also takes aim at the way the Chinese government has opened up its capital markets to foreign investors.
“The Chinese government permits the participation of foreign firms and investors in the Chinese market only when it suits its national interest,” it said.
“As a result, nominal financial ‘opening’ in China in reality is a carefully managed process designed to reinforce state control over capital markets and channel foreign funding toward fulfilling the Chinese government’s national development objectives,” the commission said.
One particular issue identified by the commission’s analysis is asset managers’ allocations to Chinese assets via passively managed funds.
Most recently, FTSE Russell began phasing Chinese debt into its flagship World Government Bond Index. The gradual inclusion process, which kicked off on October 29, will in three years see Chinese government bonds comprise a total of 5.25 per cent of the index.
The report said the substantial increase in the inclusion of Chinese securities in investment indices automated US investor allocation toward Chinese companies.
“Because passively managed index funds replicate these indices and actively managed funds seek to at least outperform them, index providers have played a pivotal yet unregulated role in guiding foreign portfolio investment toward Chinese companies,” it added.
The commission recommended “requiring index providers that include within their indices securities issued on mainland Chinese exchanges or the Hong Kong Stock Exchange, securities of China-headquartered companies listed on US exchanges through a [variable interest entity], or derivative instruments of either of the preceding types of securities, be subject to regulation by the SEC”.
The commission also advises that Congress mandate from the US Treasury an annual update of the accurate US portfolio investment position in China since 2008, including money routed through offshore centres such as the Cayman Islands.
US president Joe Biden signed an executive order in early June banning Americans from investing in 59 Chinese companies ranging from the surveillance and defence sectors for alleged links to China’s military, expanding an earlier order by former president Donald Trump. However, the order also appeared to limit the policy scope, alleviating some concerns that US fund groups in Asia could have been severely hampered by the restrictions.
BlackRock, Vanguard and State Street Global Advisors are all heavily invested in China, while many other US managers, including JPMorgan Asset Management and Morgan Stanley, are also quickly building onshore businesses in the market.
Additional reporting by Echo Huang
*Ignites Asia is a news service published by FT Specialist for professionals working in the asset management industry. It covers everything from new product launches to regulations and industry trends. Trials and subscriptions are available at ignitesasia.com.