By the end of the year, the US Public Company Accounting Oversight Board (PCAOB) will issue a public report determining whether China and Hong Kong are complying with US audit regulations as laid out under the Holding Foreign Companies Accountable Act (HFCAA). If PCAOB determines that China and Hong Kong are compliant – which is 22V’s expectation – it will stop the clock ticking on a process that would otherwise result in all Chinese firms being forcibly delisted from US exchanges starting early next year. Progress on the audit issue is a rare bright spot in the relationship, reducing a major near-term policy risk hanging over Chinese ADRs.
But as we explain here, in a note written jointly with 22V’s head of Washington Policy Research Kim Wallace, broader US-China tensions are set to stay high.
Audit inspections likely to pass the test
US and Chinese regulators have been sparring for years over the requirement in Sarbanes-Oxley that China (like all other foreign jurisdictions) allow the PCAOB to regularly inspect the audit papers of China-based firms listed in the US. The HFCAA, passed in 2020, set a deadline for the two sides to resolve this impasse. Unless China and Hong Kong allow inspections, the SEC must delist China-based firms from these jurisdictions after three consecutive years of non-compliant annual reports – a deadline that would effectively start in early 2024.
That pressure from Congress produced a breakthrough in August, when the two sides agreed on the protocols for a pilot round of inspections. Those inspections, which recently concluded, took place entirely in Hong Kong because of US concerns over travel to mainland China due to Covid quarantine requirements. While there has been some speculation that PCAOB was not able to inspect mainland firms, we do not believe this to be the case: Chinese regulators shipped audit papers of mainland firms to Hong Kong, which is likely sufficient for PCAOB’s purposes, at least for this pilot round.
Media reports have indicated that the pilot inspections went well, but our confidence in a reasonably satisfactory outcome has also been based on the view that the hardest part was reaching the August agreement on the protocols to govern the pilot inspections. That required a detailed understanding between US and Chinese regulators on sensitive issues such as which types of corporate information would be privy to US regulators. We do not think that either side would have agreed to proceed with the pilot inspections if key questions were unresolved.
Delisting risks will be reduced but not gone
It will be important to see the details of the PCAOB’s report once it comes out. There is a possibility that PCAOB will not make a clear conclusion – perhaps saying that more inspections are needed to assess China’s compliance – though again our basecase is a finding that China and Hong Kong are currently compliant with HFCAA.
What would happen next? A finding of compliance would not instantly or permanently remove delisting risks for Chinese ADRs. Our expectation of the process (and we are not lawyers) is that the SEC would begin removing Chinese companies from its delisting watchlist as they file their 2023 annual reports next year – assuming that China and HK stay compliant. This would stop the clock ticking for the purposes of the HFCAA.
In the meantime, the PCAOB is likely to conduct a new round of inspections before firms file their annual reports next calendar year. The recently concluded pilot program inspected the audit work of PwC and KPMG, and the next inspections will likely involve the other main audit firms. The PCAOB may want to travel to mainland China for the next round; while this is unlikely to be a key obstacle it does present a wildcard given the political sensitivities for Beijing of US regulators operating on the ground in China.
Compliance with US audit regulations is determined by jurisdiction and not by company. A future finding that China or Hong Kong is not providing the required access to US regulators would mean that the threat of delisting would again loom for all firms in that jurisdiction. Audit cooperation between the US and China could break down in the future – such as in the event of an investigation into accounting fraud involving a highly sensitive Chinese company. But Beijing has sought to manage this risk by ordering its most sensitive firms – large state-owned enterprises – to preemptively delist from the US.
It will also be important to keep an eye on Congressional dynamics should audit cooperation start to look shaky. The House and Senate each passed separate pieces of legislation earlier this year that would have shortened the deadline for HFCAA compliance from three years to two years, but the item did not make it into a final bill. Such a move seems unlikely for now but could come back in the future. That would accelerate the timeline for delisting should US cooperation with China/HK collapse.
While resolution of the audit impasse will revive the process of some Chinese firms going public in the US, the era of blockbuster Chinese IPOs in the US is effectively over. In geopolitical terms, it no longer makes sense to either Washington or Beijing that high-profile Chinese firms – particularly those with a nexus to strategic tech competition – should go public in the United States. Large tech firms such as Baidu, Alibaba and Tencent also have listings in Hong Kong and will likely keep their US listings for now but be prepared to exit if the political winds shift.
Broader US-China tensions will stay high
President Joe Biden and General Secretary Xi Jinping used their 14 November meeting at the G-20 to establish “guard rails” against a crisis in the relationship, but we noted at the time that this would not alter the key contours of the rivalry or meaningfully lower tensions on economic or technology issues (please see: Biden-Xi meeting suggests constructive effort to lower tail risks, 14 November 2022). Both aspects of this dynamic are visible one month later.
On the “guard rails” side, Assistant Secretary of State Dan Kritenbrink was in China earlier this week to prepare for a visit by Secretary of State Antony Blinken, announced after the Biden-Xi meeting, in early 2023. Readouts from both sides suggest a candid conversation on flashpoints including Taiwan, the Ukraine conflict, and North Korea. Blinken will take these discussions further on his trip.
But the two leaders have limited will and ability to reduce tensions across the board:
- Republican control of the House means stepped up scrutiny of Biden’s China policies, particularly on national security-related issues (including export controls). To gain sufficient votes for the speakership, Kevin McCarthy last week agreed to a Select Committee on China. This would seem little more than a perfunctory but politically salient move. McCarthy has tapped Rep. Mike Gallagher, a leading China hawk, to lead the committee; McCarthy and Gallagher issued an op-ed pledging oversight of policies necessary to “win the new Cold War” against China. (They include efforts to prohibit state and local pension funds from investing in China; binding action in this area is unlikely anytime soon from either Congress or the administration, but the move highlights sustained political pressure on public sector investment in China.) From a practical perspective, the standing Asia/Pacific subcommittee of the House Foreign Affairs Committee will retain legislative jurisdiction. It would seem shaking two fists at China is better than one in the minds of some Members of Congress.
- Xi seeks a broadly stable geopolitical environment to help lift growth and confidence in 2023, but he is hardly moving away from an assertive foreign policy stance or “lying flat” against the US. In the last week alone, China’s border dispute with India has flared up again, while Beijing dispatched a record number of bombers into Taiwan’s airspace as part of a drill that may have been partly in reaction to a visit to Taiwan by the head of Japan’s Liberal Democratic Party.
Specific areas of tension worth monitoring for market implications include:
Taiwan: Taiwan is never far from the surface of tensions in the US-China relationship. As Kevin McCarthy continues to negotiate enough votes to become Speaker of the House of Representatives, he has intimated a trip to the island is part of his 2023 incomplete itinerary. Even if not McCarthy, the next Republican to lead the House Conference will find it politically difficult to stray from the path lain by Speaker Pelosi as the GOP is at least as committed to exhibiting China hawk bona fides as Democrats.
That enmity regarding Taiwan comes through in a few ways this month. The addition of military aid for Taiwan to the pending 2023 National Defense Authorization Act (NDAA) is the most tangible expression of opposition to Xi’s government. The NDAA will likely be sent to President Biden for his signature sometime next week. The actual funding of the NDAA – including the Taiwan aid – would then be left open to the appropriators in this two-step process: (1) authorization and (2) appropriation. FY23 appropriations will be the last important act of the 117th Congress. The main uncertainty is which form of funding Congress legislates. After some progress which began over the weekend, our expectation is that Washington will agree to a nine-month funding bill either in the form of a continuing resolution (CR) or an omnibus package. In either of these scenarios, funding will be included for Taiwan. That decision seems currently on track for December 23rd. If Congress opts for a shorter-term CR into 1Q23, then funding for Taiwan would be at risk.
While we continue to assess a low probability of military conflict over Taiwan anytime soon, to some extent the broader relationship remains hostage to the level of tension on Taiwan.
Semiconductors/export controls. The US continues to tighten the noose on China’s access to advanced semiconductors. The media is reporting that both Japan and the Netherlands are likely to comply with recent US export controls on semiconductor equipment – both countries are key to success of US efforts. The FT is also reporting that the Commerce Department will soon add a flurry of Chinese companies to its entity list, including China’s largest memory chip maker Yangtze Memory Technologies (YMTC). Beijing’s evolving response to US semi controls took two steps this week: a complaint in the WTO (unlikely to have practical consequences for the US), and reports of a large new fund to finance China’s domestic chip industry. These measures highlight China’s lack of attractive choices to retaliate more directly, though there is still the potential for some actions taken against US firms in coming months.
TikTok. On Tuesday, Senator Marc Rubio and others in Congress introduced two bills to ban Tik Tok operations in the US. The related issues of ByteDance’s relationship with the Chinese military and the algorithms that power the app are primary reasons these and other House/Senate lawmakers urge the Biden Administration’s national security review to find Tik Tok a threat. Neither bill is likely to pass this year but generate incremental bipartisan, bicameral opposition to the consent decree negotiations between an interagency and company representatives. META, Facebooks and Instagram’s parent, closed almost 5% higher on Tuesday after the news. It will take years to assess the efficacy of efforts to rebuild US semiconductor manufacturing capacity while constraining China’s ability to meaningfully advance its semiconductor strategy. Chips are an intermediate-term national security consideration but banning Tik Tok is favored by policymakers seeking immediate closure of a long-running national security threat.
Outbound investment. We continue to expect that the administration will implement an executive order that would establish a new regime in Treasury to monitor US investment in sectors of critical technology in China (such as semiconductors), a potential start towards restricting such activity in the future. This program will impact some private equity/VC investment but not portfolio flows to China, which remain more subject to political heat than regulatory action.
