CPA’s chief economist Jeff Ferry was one of four witnesses to provide testimony to the House Financial Services Committee’s Investor Protection Subcommittee on November 15. The hearing was entitled, “Investing in our Rivals: Examining U.S. Capital Flows to Foreign Rivals and Adversaries Around the World”, which could only really mean one country – China.
“U.S. investors are inadvertently subsidizing Chinese companies involved in activities that are contrary to the national security, economic security, and foreign policy interests of the United States,” Ferry said in his opening statement on Monday. “We’re also subsidizing the economic growth of our top global adversary. (Chinese) companies are oftentimes non-compliant with U.S. securities laws and financial reporting norms and, in some cases, have been sanctioned by the U.S. government for egregious human rights and national security abuses. If the financial industry will not lead. Congress must do so.”
Chairman Brad Sherman (D-CA-30) noted that some 262 Chinese companies are listed on the NYSE, Nasdaq, or available through over-the-counter investing, either through the SEC-regulated over-the-counter bulletin board, or through direct broker-dealer private trades known as “the pink sheets” in Wall Street lingo. Pink sheet-listed companies do not need to report any information to the SEC.
Mutual funds and exchange-traded funds also buy China stocks listed in Shanghai and Shenzhen, known as A-shares, or in Hong Kong, which are called H-shares. Sherman said U.S. capital flow into Chinese companies could raise national and economic security issues. For the last 12 months, the Thrift Savings Plan (TSP) – a government employee savings plan – has been under pressure to remove Chinese stocks from their investment options. The Biden administration has banned numerous Chinese military companies from accessing American capital via stock purchases, but there are many companies who are listed on the Commerce Departments Entity List – a black list of sorts – or face other import sanctions due to forced labor, and are still allowed access to U.S. capital markets.
“We send a $1.2 trillion of capital to China. Some would say, well, why don’t we just stop? Well, China’s provides $2.1 trillion to the U.S. economy. But not all capital is equal,” Sherman said.
In June this year, the Thrift Savings Plan administrators enabled TSP participants to invest up to 25% of their savings in more than 5,000 mutual funds via a new platform called the “Mutual Fund Window.” CPA research found that five of the largest investment funds in the Window had an average weight of 22% toward Chinese companies, and all five funds held companies listed on the U.S. Department of Treasury’s list of Chinese Military-Industrial Companies, the Department of Commerce Entity List, the Department of Commerce’s Unverified list, or the Defense Department’s Chinese Military Companies list. We would like to see all these lists harmonized and enable American investors to know and to avoid investing in Chinese companies that are involved in Chinese civil-military fusion and other activities harmful to the United States. – Jeff Ferry, opening remarks, November 15, House Financial Services Committee.
Here are some excerpts from Jeff’s remarks in the Q&A session.
Rep. Maxine Waters (D-CA-43): I’d first like to say to Jeff Ferry, the senior economist at the Coalition for Prosperous America, I certainly thank you for your testimony. You were absolutely descriptive in the harm and solutions. And I am sitting here a bit unnerved by the fact that we have not moved more aggressively in dealing with the issues of our adversaries that we allow to invest and to seek investments here in our country. I don’t know whether or not you went through all of the solutions and some that you would like to share with us. If you did not, I’d like you to share with us some solutions.
Ferry: One would be sanctions harmonization. The Department of Commerce’s Entity List includes over 1,100 Chinese companies which are engaged in activities that are either a threat to our national security or through taking advantage of oppression in the Uyghur regions of Xinjiang, a violation of basic human rights. On the other hand, the Treasury list contains a couple of dozen companies. It’s a tiny list, and we need to harmonize both of these lists so all arms of the government are operating together. We’re not doing that today. They should be extended to private investment vehicles, including private equity, and venture capital.
Waters: Wow, thank you very much. This is very timely. The harmonization that you refer to is absolutely necessary for us to move forward.
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Rep. David Scott (D-GA): How are Wall Street’s investments in China a threat to national security?
Ferry: The civil-military crossover is widespread, it spreads across many industries. So, I could give you an example of CSSC, which is a Chinese shipbuilding company, which is building military ships. China, as you may know, has the world’s largest Navy, the United States is now number two. CSSC takes in investment funds through these indexes and international exchange-traded funds. It’s building ships, ports, and it’s building naval equipment as a defense contractor and we’re helping to fund that. I think that’s a situation that should change.
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Rep. Jim Himes (D-CT-4): What should be our strategy with respect to these financial and capital markets entanglements with China? Should we be looking for less because of what that might imply for growth? Or should we be looking for more because commercial entanglement will them might actually create interests that go against the possibility of kinetic antagonism?
Ferry: Congressman, I believe we are to decouple this economy from China, not immediately, but over time. I believe that will benefit the U.S. economy. You say there are commercial gains on both sides. Well, right now we are importing from China $600 billion worth of goods each year, and exporting around $150 billion worth of goods. If we can reduce that level of imports and redirect that demand towards American production, you will see the American economy grow, you will see employment, good paying jobs grow in this country. On the capital market side, I think the same thing will follow. We do not need them to buy $1 trillion worth of our Treasury debt. And they are buying it partly in order to keep the dollar high so that they can continue to keep Chinese people employed because the one thing President Xi fears more than anything else, is a revolt in a revolution of the Chinese people against the oppressive system he has put in place. Instead, our capital should be funding investments in U.S. industry and investing in friendly nations…. As far as capital markets go, I always fall back on the quote of Paul Volcker, who was chairman of the Fed many years ago, and I believe the best Chairman the Federal Reserve ever had, he said, every time I have a meeting with financial professionals, they tell me that free open capital markets are making the U.S. economy more efficient. And I asked them for an example. And in 30 years, they’ve never been able to give me one.
Himes: Should Congress reopen talks about the Trans-Pacific Partnership trade agreement?
Ferry: No. Free trade agreements will not benefit us in this endeavor and are not helpful to the U.S. overall.
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Rep. Bill Foster (D-IL): There are two general classes of disclosures for cross-border investment flows. There are disclosures to regulators and disclosures to the public. And can you say something about the relative merits of either one in terms of accomplishing what we want to accomplish here?
Ferry: I spent an earlier part of my life reading 10-Q’s and 10-K’s. Those public disclosures are a great benefit to investors. Think of a guy like Bernie Madoff and the way in which he evaded disclosure to the public and got billions of dollars of funds…China is full of literally hundreds of them. Who are these people, using non-transparency to attract millions and billions of dollars? I’d hate for that to be American money that finds out the hard way.
Foster: But what sort of efficiency hit would the global economy take from such a radical transparency requirement for all cross-border investment flows? If you have to know the beneficial owner of the capital, and if you have to know where the money’s actually going?
Ferry: Well, efficiency, in quotes, always benefits when you strip away regulations. You know, if in — if in the Democratic Republic of the Congo, there are 10-year-olds mining cobalt boys and girls, would you call it more efficient because the Cobalt is cheaper than if we mined it in a country that respected laws and regulations? So, I think efficiency is an overused and overrated word. And with that, I’ll yield …
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Rep. Sean Casten (D-IL-6): If the PCAOB* is not allowed to review these Chinese auditors, then those China companies are going to be delisted here within three years of enactment, which is about a year from now. Are you optimistic we come to an agreement with the Chinese regulators to get through that? Or are the some 200 listed firms going to be delisted by the end of the year? Can you handicap where your view is, where this sits right now?
Ferry: Agreements are possible. Enforcement of the agreement is going to be very difficult. Also, their interest is in keeping our investors’ pockets open to help prop up their economy.
Casten: We’ve also seen the rise in the exempt offerings market, which would be totally outside of these PCAOB rules. Should we be concerned that we’re just going to create a venue for China’s companies to move over to the exempt offerings market? Because I think the latest number I was able to find was $2.7 trillion was raised on those markets in 2019, which I think would be totally outside of this PCAOB agreement, is that right?
Ferry: I think so, yes, because they are not on the stock exchange. But I haven’t studied that issue in detail. If your point is that the money that was invested in these Chinese companies will just find a way to be domiciled in the Cayman Islands…then, yes, all of these leakages are possible because capital is fungible. We have to go step by step and protect American investors each step of the way. Then you plug up the holes one by one, like the proverbial human in the Dutch Dike. The first thing is to enforce the Holding Foreign Companies Accountable Act. And the next thing is to require all arms of the federal government to harmonize their restriction lists, like the Commerce Entity List, which all told have hundreds of Chinese companies that U.S. investors should not be invested in.
*The PCAOB is the Public Company Accounting Oversight Board, a nonprofit corporation created by the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies traded on the NYSE and Nasdaq to avoid Enron-like accounting scandals.
Chairman Sherman said the Holding Foreign Companies Accountable Act, which became law on December 18, 2020, is what lit the fire under PCAOB to finally act. Officials from the PCAOB were in Hong Kong last week to discuss audited financial requirements for listings on U.S. exchanges. China has, once again, agreed in principle.
“We will know more about that by year’s end,” Sherman said.
Chairman Sherman also highlighted China’s variable interest entities (VIE) – which are like holding companies that are open to American investors. American investors invest in these holding companies that then invest in Chinese publicly traded firms. However, the problem there is that investors own shares in the holding company, and not in the actual company the holding company is invested in. These VIEs have come under scrutiny over the last two to three years. China tech giants that are heavily purchased by U.S. investors – Alibaba and JD.com have added secondary listings in China just in case they get kicked off U.S. exchanges.
Does this suggest that Alibaba and JD.com are not going to abide by the PCAOB rules, the same rules that Russian companies (now delisted), and Brazilian companies, including state-owned ones, have had to abide by for years?
“You think you’re buying Alibaba stock, but you’re not really,” said Sherman. “You’re buying Alibaba Cayman Islands, which then has a contractual relationship with a shell company in China, which then has a contractual relationship with Alibaba. We’ve got to see what risks that poses for investors, and we have to particularly question whether there are any funds that are invested in VIEs instead of the actual company. It’s also questionable whether index funds should be allowed to invest in the Shanghai or Hong Kong-listed stocks of any Chinese company that has avoided the PCAOB rules by delisting from the United States,” he said.
