Chairman Mike Gallagher’s (R-WI) House Select Committee on the CCP continues to be must-watch TV for anyone looking to check the pulse on Congress’s views of China. On July 13, in a hearing titled “Risky Business: Growing Peril for American Companies in China”, Gallagher hinted he would propose legislation banning certain China investments from listing on the NYSE and Nasdaq, calling variable interest entities (VIE) “a CCP-run casino.” While other Committee members said they supported making it harder for Silicon Valley and Manhattan private equity firms to invest in China, adding the Committee should drag leaders of venture capital firms to Washington for a little chat.
At the heart of the debate was the inability to decipher what was happening on the ground in China, and that companies faced never-before-seen headwinds that should turn more of them off to China even as Bloomberg tries promoting a “thaw” in relations.
Here are some takeaways from that hearing.
Chairman Gallagher said Beijing policies were leading to a newfound unfriendliness towards American companies, in what some have blamed as retaliation for the “trade war” started in 2017 with Section 301 tariffs.
“A raft of legislation, like the updated counter-espionage law, the data security law, the anti-foreign sanctions law, has codified what was always true: Beijing reserves the right to swipe any data, seize any assets, and steal any IP that it wishes,” Gallagher said. “The government often mandates the creation of CCP cells inside firms, and China’s military-civil fusion policy means any private company can effectively be turned into an arm of the PLA or communist intelligence apparatus. In just the last few months, three firms — Mintz, Bain, and Capvision — have been raided, reportedly for engaging in routine due diligence and corporate research.”
“It’s time for American corporate executives to take off the golden blindfolds and stare with clear eyes at the growing peril of doing business in China.” – Rep. Mike Gallagher, Chairman, House Select Committee on the CCP, July 13, 2023.
In a video presentation at the start of the hearing, China researcher Peter Humphrey talked about his and his wife’s arrest in Shanghai in 2013. He ran a due diligence company.
“Today’s situation is ten times worse than in 2013,” he said. “Due diligence has become impossible so that most businesses now have to fly blind or tiptoe through minefields. I used to advise my clients how to avoid the land mines, but then one day in 2013 I stepped on one myself and was arbitrarily in prison for two years with medical treatment refused to me and I developed cancer.
“Every American business today must understand that nobody and no company is safe in China,” Humphrey said. “This means that business decisions cannot be made with any certainty about the integrity of your counterparties and the state of the playing field. Whether it is an M&A project, national statistical data, or day-to-day business operations requiring market research, none of these things can now be done safely in China. Businesses must walk away. The fiduciary duties of American companies simply cannot be fulfilled in China today.”
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Piper Lounsbury, Chief Research and Development Officer at Strategy Risks. Ex-Director of United Technologies and in leadership roles at Boeing and the U.S.-China Business Council, was one of three witnesses. She said the CCP “creates a dangerous business risk environment for U.S. companies, their customers, and frankly the entire U.S. population.”
The party’s goals are structured to promote Beijing’s stated objectives to eventually replace American firms and businesses while using them or subjugating them in the near term, Lounsbury told the Committee.
“To achieve their goal, the parties created a set of national development strategies which rely on theft, coercion, merger-enabled access to U.S. technologies, intellectual property and data. And also shareholders and investors remain unaware or choose not to look at the extent of which these practices exist,” she said. “Since China is now the second largest country in the world by nominal GDP, I think American CEOs are increasingly concerned about the risk now more than ever before.”
Lounsbury gave three examples of souring relations and economic coercion:
- A provincial mayor of a high-profile mega city demanded a Fortune 100 American CEO release its latest tech to its Chinese partner, or the American firm would lose market access for its other businesses in China.
- A U.S. company’s local joint venture partner stole intellectual property (IP) from its U.S. partner to establish a local state-funded competitor factory right across the street, taking not only the IP but also the U.S. firm’s marketing and distribution networks and making it difficult for the U.S. company to exit the joint venture.
- A wrongful death claim leads to extortion. One China company blamed a U.S. firm for the death of a worker in exchange for a payoff to stop talking about it.
“I think one thing I’m concerned with and hope that you will consider is the identity technology service providers that we are using here in this country have supply chain or manufacturing components or partners that are affiliated with the Chinese Communist Party,” she said about facial recognition software, a favorite investment tool of Silicon Valley and often used by the U.S. military and government agencies. “I would highly recommend that we look at how we manage due diligence on making sure that our personal information and biometrics are safely secured,” she said, recommending a reshoring of those technologies.
“You need to create some incentives for the U.S. manufacturer to bring about American supply chain reshoring. Not only with tax incentives, but also consider some purchase credits, or any incentive to promote supply chain resilience here.” — Piper Lounsbury, senior executive at Strategy Risks, in testimony to the House Select Committee on the CCP, July 13, 2023.
Shehzad Qazi, COO and Managing Director of China Beige Book International, a macro investor information service.
He said China’s economy is a black box and that it was harder to get a read on what’s happening today. He said it was harder to know what is happening with the Chinese economy now, than it was 10 years ago.
“China’s statistical authorities created this illusion of strength by simply deflating baseline 2019 numbers, nearly 7 trillion yuan, about $1 trillion worth of economic activity was just erased from 2019 statistics to show growth in 2020,” he said of China’s economic miracles.
“The challenge of separating truth from fiction in China is made tougher by yet another entity, Wall Street, whose China economic analysis is based almost exclusively on official data, making it a loudspeaker for Beijing’s economic and often political propaganda.” – Shehzad Qazi, Managing Director, China Beige Book International, July 13, 2023.
Qazi talked about how Wall Street titans bend over backward for Beijing.
“The most damaging publicly known instance of such a practice came last year, when it was revealed that JP Morgan had censored an analyst’s reports where he referred to a basket of Chinese technology stocks as uninvestable,” Qazi said. “Turned out this rating was only seen by the outside world as a result of a copy-editing error, because the bank’s content reviewers simply missed it in a few places. In the aftermath, JP Morgan was swiftly removed from an upcoming IPO deal. And then, after what can only be described as a naked instance of pay-to-play, a mere two months later, the bank decided to upgrade the very stocks it had just called uninvestable.”
Wall Street does not have any reliable information on its China holdings. Congress has no visibility on what U.S. investment banks own in China outside of publicly traded stocks and bonds.
Fund managers are having a harder time assessing investment risk.
Some 60,000 economic indicators once published by the Chinese government have been discontinued. This list includes the Guangdong Purchasing Managers Index, which the central government banned in 2018 once the gauge began showing that U.S. trade tariffs were hurting China.
“China’s clampdown on foreigners’ access to information on its economy and its policies reached a crescendo this year when it shut off access to Wind Financial, a financial markets platform, considered to be China’s version of the Bloomberg terminal, shut it off to foreigners,” Qazi said. “China is more of an information black hole today than at any point since its accession to the World Trade Organization (WTO) in 2001.”
Although not mentioned by Qazi, Hong Kong is part of the Government Procurement Agreement of the WTO, meaning Hong Kong can submit bids for U.S. government contract work as if it is just another American city.
Standouts from the Q&A Session
Wall Street: A Wall of Worry?
Chairman Gallagher: If we cannot trust China data, can that pose a systemic risk on our financial system and economy?
Qazi: It absolutely can. You see what happened over the last few years where Chinese equities got hammered because of the tech crackdowns. Most of the stories coming out of the (U.S.) investment banks were always rosy: ‘Beijing’s about to become pragmatic. Tech crackdowns are about to come to an end. Don’t worry, there’s going to be a stimulus. The economy’s looking really great.’ You name it. It’s all based on just guesswork and really bad data.
Rep. Blaine Luetkemeyer (R-MO): US investment firms should disclose all of their China holdings so investors and account holders can understand just how caught up these companies are in the Chinese economy.
Qazi: We don’t know what exposure American banks have domestically. Forget knowing sectors, forget knowing specific industries. We just don’t have data on even overall information, and I have asked around for it. So I think we need tools to the right bodies here, whether it be the SEC or another body, so that they can start collecting that information. Because before we can figure out which companies are getting American money that perhaps is a national security concern, let’s at least start by figuring out just how big the problem is.
Rep. Andy Barr (R-KY): How can the Congress or the government communicate the risks to Americans of investing in Chinese firms that use this VIE structure that limits recourse for U.S. investors due to the uncertain legal status of VIEs under Chinese law?
Qazi: We need to warn investors, especially the average American now that we’re talking about, about the risk in a very simple way, but making sure that they fully understand it. Most people do not.
Rep. Barr: We should ban VIEs. We shouldn’t deny Americans access to emerging growth investment opportunities but certainly when it comes to these national security risks, we need to protect U.S. investors.
Chairman Gallagher: I’m going to assume the banned VIE proposal has the full support of the House Financial Services Committee and I’m going to run with it.
What about trying reshoring…
Rep. Ritchie Torres (D- NY): The CCP’s lawlessness creates the economic equivalent of asymmetric warfare. China benefits from a rules-based international order without following the rules. It benefits from an open global market without opening its own domestic market. And when it opens the market, it does so deceptively to expropriate the intellectual property and technology of others. How do we win a competition in which we follow the rules and the other side wholly disregards them?
Lounsbury: I don’t know what to do other than try to find some incentives for our own companies to really allow for the market to change on its own through some pricing rebates, some tax credits. There’s got to be other ways to incentivize our own companies to make that decision to add some supply chain or resilience and/or reshore to the degree that will make that asymmetry less and less palpable.
Silicon Valley and Private Equity in the crosshairs…
Rep. Kathy Castor (D-FL): We already prohibit U.S. companies from directly selling certain advanced technology to China. But we are now talking about private equity and venture capital investment in highly strategic sectors and this would be a first and unprecedented. It looks like the White House wants to prohibit investments in sensitive military and surveillance technologies and require greater transparency reporting of different private investments in China. How will China react? What can we anticipate from the private equity companies?
Lounsbury: Private equity companies who don’t have the same disclosure requirements because they’re private. We don’t know what they’re investing in. And also, there are lots of Chinese state-owned funds that these private equity investments are going into, which are investing in state-owned enterprises, especially in the high-tech sectors where there is a mission to replace American competitiveness. Some larger scrutiny on private equity firms is not a bad thing.
Qazi: There’s always going to be industry pushback, but the job of Congress needs to be to increasingly specify what the red lines are and to increasingly specify what the threats are. That clarity in the long run is actually a good thing.
Witness Desmund Shum, a China expat from Shanghai and Hong Kong, and author of “Red Roulette: An Insider’s Story of Wealth, Power, Corruption and Vengeance in China”, said direct investment into China was “collapsing”.
“This first quarter, China raised, foreign investment to China of $20 million. Last year, the first quarter was “100 million. So it’s a drop of 80% compared to COVID year,” Shum said. “While the U.S. is looking into restrictions, China is doing the same thing. They are restricting foreign companies from investing in their own high-tech companies because of their view of national security. There is a push on both sides on this issue. And to illustrate that, you have Sequoia Capital, which is the biggest venture capital investor in China by far, has now separated — they separate into a China unit and an American and India unit.”
China vs the West. Who is Winning?
Rep. Haley Stevens (D-MI): Who is winning the strategic competition?
Qazi: I think what I would say is that free and open societies can lead to the kind of problem we have right now where we say, look, it’s free market capitalism for everybody and you have a bunch of companies that respond to that and then relocate to China. As a result, we have very serious and complicated supply chain dependencies that hurt us. There’s no guarantee that free and open societies can win.
Rep. Stevens: What does resilience look like then… It might be supply chain resilience. And that might mean lessening reliance abroad. Certainly coming from the industrial Midwest, I care a lot about that.
Rep. Jim Banks (R-IN): To what degree are U.S. financial investments powering China’s military civil fusion strategy?
Qazi: We don’t know where American financial companies are investing their money so we don’t know which companies they’re invested in, or even broadly what sectors they’re invested in.
Lounsbury was asked if big business, long enmeshed in the Chinese economy, had any remorse for turning China into the U.S. manufacturing center.
“I started working on U.S.-China business when I was in my 20s and was very much a proponent of permanent normal trade relations with them,” she said. “I wanted to have China be part of the World Trade Organization. I wanted to see the trade negotiators have some successes, ticking off the checklist of all of the commitments China made, but still have not been done. That progress just wasn’t happening. Shame? Maybe regret, I think. We aren’t where we need to be.”