Introduction
Arguably the increased regulatory pressure can be dated back to the cancellation of the Ant initial public offering in late 2020.
You may remember a flurry of headlines last summer about regulatory developments around various Chinese equities, especially those listed outside the mainland. Ride-hailing group DiDi was one prominent flashpoint, although arguably the increased regulatory pressure can be dated back to the cancellation of the Ant initial public offering in late 2020. Recently, there has been a ramp-up in regulatory uncertainty in various other sectors such as property, education and the internet, which has weighed on Chinese equities, both onshore and offshore. Separately, in the US, the Securities and Exchange Commission (SEC) increased its pressure on US-listed Chinese securities, demanding that they offer more accounting transparency or face the risk of potential delisting.
Other market events since then – such as the recent Covid outbreak in China and geopolitical tensions from Russia’s invasion of Ukraine – have understandably dominated investors’ attention, but that should not lead us to forget the volatility driven by regulatory developments, in our view. Indeed, this is an area that we will be paying close attention to over the next few months.
The Golden Dragon Loses Its Shine
The ongoing effects of these regulatory changes can be clearly seen on asset prices. Figure 1 shows the performance of the Nasdaq Golden Dragon China Index (comprised of securities conducting business in China but listed in the US), the broader Nasdaq Index, and the Shanghai Shenzhen CSI 300 Index (representative of the large-cap China A-share market).
Figure 1. Nasdaq Golden Dragon China Index Has Underperformed Against the CSI 300 and Nasdaq Indices
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Source: Bloomberg; as of 31 March 2022.
Note: Rebased to 0 as of 31 March 2017; data show cumulative performance.
We believe the underperformance of the Golden Dragon relative to the CSI 300 reflects regulatory policy uncertainties.
The prolonged underperformance of the Golden Dragon securities is evident. The offshore index has been in decline since February 2021, while Nasdaq stocks in general – despite their similar growth profile – only began to retreat at the start of this year. In addition, the Golden Dragon’s decline cannot be attributed solely to a China selloff, as the CSI 300 has been more resilient in comparison. Instead, we believe the underperformance of the Golden Dragon relative to the CSI 300 reflects regulatory policy uncertainties from both the US and China (risks such as those around the Variable Interest Entity – ‘VIE’ – structure, accounting transparency and others are detailed later in this paper).
A Risk Model Perspective
The performance of the Golden Dragon Index relative to the CSI 300 Index can thus be used, in our view, as a proxy for these regulatory risks.
Figure 2 displays our statistical risk model, which leverages principal component analysis techniques to dynamically capture drivers of systematic risks in the equity market. The model is agnostic as to the sources of risk: it recognised the escalation of the US-China trade dispute in the summer of 2018 and has started moving higher since January 2021. Most notably, the variance of the return captured by the risk model spiked in March 2022 to 45%, reflecting the significant increase in volatility over the past quarter, a development perhaps missed by investors amid the macro news flow. In particular, volatility jumped on the SEC’s announcement of new securities being added on its watchlist; this was immediately followed by the Chinese government’s pledge to support its economy, triggering a large upswing in asset prices.
Figure 2. Regulatory Risk Captured by Man Numeric Statistical Risk Model
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Source: Man Numeric; as of 31 March 2022.
Distinguishing the Different Regulatory Risks
Despite similar performance over the past five years, VIEs have underperformed non-VIEs in recent months.
Chinese offshore equities are caught in regulatory pincers, and it’s worth understanding the two sides to the pressure.
First, they are subject to regulatory pressures from China on the VIE structure (VIEs are companies conducting their business in China but domiciled outside mainland China or Hong Kong, predominantly in the technology, consumer or real-estate sectors). Despite similar performance over the past five years, VIEs have underperformed non-VIEs in recent months (Figure 3).
Second, the US-listed (i.e. ADRs, or American Depositary Receipts) VIEs also come under US oversight. These ADRs can be further divided into three groups:
- ADRs with a current Hong Kong dual listing;
- ADRs eligible for a Hong Kong dual listing; and
- ADRs not eligible for a Hong Kong listing.
In our view, those in the latter category – ADRs that cannot quickly list in Hong Kong – are the most at risk from delisting in the US, as the first two groups could more easily offset lost US financing through mainland financing via Stock Connect.
Indeed, it is this third group – ADRs not eligible for a Hong Kong listing – that has been punished the most over the past year, a reflection of how the Chinese offshore market has been trading on US regulatory risk (Figure 3).
Figure 3. Performance of Different Categories of Chinese Offshore Equities
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Source: Man Numeric; as of 31 March 2022.
The regulatory risk has been reflected in the other groups too: the specific risk (i.e., the volatility of these assets not driven by their exposure to common risk factors) of VIEs, ADRs in general and ADRs not eligible for a Hong Kong listing has been trending higher (Figure 4).
Figure 4. Specific Risk of Certain Offshore Categories and Broader Emerging Market Equities
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Source: Man Numeric; as of 31 March 2022.
What’s Next?
We believe it is most likely that these securities will remain volatile over the medium term.
Nobody – including us – can predict whether this regulatory pressure will remain, escalate or abate, nor do we think it is feasible to do so.
The most negative scenario could lead to the delisting of these securities from US exchanges as well as further regulatory developments forcing them to adapt their business model. Alternatively, a positive interpretation would see support coming from China and/or a resolution on the US listing side, triggering a sharp rebound of the offshore market. We believe it is most likely that these securities will remain volatile over the medium term and that investors should continue to pay close attention to this area of the market.
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