Wednesday, January 9, 2013

China's Impending Foreign Direct Investment Armageddon, Part 2

Shifting the financial center of gravity from west to east

Last time, I bought you up to speed on what's been going on with the brouhaha between China and the US over Chinese companies that are listed on US markets. It's clear that we're on the verge of what could be a pretty major confrontation that could shift the focus of China's capital markets from the US back to China.

There are other, smaller legal skirmishes going on, like the dust-up between VisionChina Media and the Supreme Court of New York. The court has entered a judgment against them for $60 million, but VisionChina refuses to transfer any funds from China to pay the fine, saying that Chinese law does not allow it to. The court has now held them in contempt. Will warrants be issued for the arrest of executives? Will they be kicked out of the market? It's hard to say.

Nobody is quite sure what's coming next in this fight. Both sides have legitimate claims against the other. The US says that if you're going to use our markets to raise capital, then you've got to play by our accounting and disclosure rules. China says that you can’t send US government officials into China to impose US law on Chinese citizens. So who's right?

Well, both sides are right, and both sides are wrong… which is why we're at loggerheads.

I'm pretty pessimistic about all of this in the short term. I heard a great point brought up on a recent Sinica podcast about this issue. Basically, both sides are kind of spoiling for a fight. And since they can’t safely engage with each other in any other area without risking serious hostilities or dramatic diplomatic consequences, they may be willing to refuse to come to any kind of agreement here.

If that happens, you'll see a full-on retreat from the US by Chinese companies, which will result in billions of dollars of value being wiped off of the ledgers of US markets. That's not a good thing. Those companies will then start looking for new places to trade their shares. Where will they go? Reputable companies like Baidu don’t want anything to do with the Shanghai or Shenzhen stock exchanges. They're so corrupt as to be laughable. And places like London and Singapore will have the same kind of sovereignty issues to deal with. The logical thing for China to do is to facilitate the move of companies from US markets to Hong Kong.

But that's not really as easy as it sounds. There are currently questions in Hong Kong about the accounting practices of some of the mainland China-based companies that are already listed there. Hong Kong has a brand to protect, too. They certainly don't want to ruin the good thing that they've got going by infecting their markets with a bunch of unreliable companies whose numbers can’t be trusted.

If the Hong Kong markets were to develop an acceptable processes for handling mainland China-based companies, you could see an avalanche of IPOs there. There is a huge backlog of companies on the mainland who would love to go public, but the corrupt and inefficient processes in China mean that only a fraction of them get to list. And after they do, trading is severely suspect and there isn’t much capital to be had. If they could be given a roadmap to follow that would let them access international capital markets through Hong Kong they'd jump at the chance.

If you saw more companies make the leap to Hong Kong, it could put even more pressure on China to float its currency, or at least ease their controls and provide some more outlets for moving it across borders. This would be an unequivocally good thing for the US. The Yuan would rise, more Chinese would be able to buy US exports and there would be less incentive for US-based companies to move their manufacturing here. (Though that process is already well in motion for other reasons.)

As pessimistic as I am about the short term prospects for a deal between the US and China, in the long term I think that this confrontation will end up being a good thing. As I first said 18 months ago, the US forcing Chinese companies to adopt western accounting practices, and China better policing its markets, can only be a positive for the world's economy. Giving more people access to investment opportunities in China will help to not only open the market even further, but it will also help to develop China's business community in ways that will be very beneficial to the burgeoning middle class here. Who knows, maybe a mass of Hong Kong listings from Chinese companies might even lead to some truly public, accessible investment vehicles that middle class Chinese could take advantage of. That would have a tremendously positive effect on housing pricess, upward mobility and inflationary pressures.

Time will tell. Stay tuned!