23 October 2018
A tourist poses in front of a sculpture of a bull in Shanghai, a replica of the one on Wall Street. Photo: CNSA
A tourist poses in front of a sculpture of a bull in Shanghai, a replica of the one on Wall Street. Photo: CNSA

Dear China: Here’s why Americans aren’t buying your stocks

China’s A shares have long been the realm of domestic retail investors. The result has been markedly higher volatility than other major stock markets and a disconcerting tendency for stock prices to depart from their business fundamentals. Worse, China’s retail investors don’t provide the steady, long-term capital Chinese businesses need to thrive.

The opportunity to improve this situation has not gone unnoticed by Chinese officials. Last November, China unfurled the Shanghai-Hong Kong Stock Connect, granting foreign investors their first unqualified access to Chinese-listed stocks. Remove the barriers, China believed, and institutional capital would flood the market.

But China found something surprising: American investors don’t want to come.

After a promising opening day, flows into Chinese stocks have tapered off and remained tepid — at a time when the Shanghai stock market was soaring. Investors who worried about the 13 billion yuan daily quota found their fears misplaced: To date, investors have filled only 14.4 percent of that limit on average.

Even more disappointing are the investors who are entering. The newcomers are largely foreign retail investors and short-term focused funds — the same fleeting capital China is attempting to replace.

It’s not liquidity that’s keeping American investors at bay. The combined Shanghai-Hong Kong exchange represents US$7 trillion of market capitalization, ranking it the world’s third largest after only the New York Stock Exchange (US$19 trillion) and the Nasdaq (US$7.3 trillion), both in the United States. If China ropes in the Shenzhen stock exchange, the scheme will move past Nasdaq into second place.

The problem isn’t fears about the Chinese economy, either. China’s GDP growth may be slowing, but its GDP growth rate is still twice that of the US. Nor is the problem lack of knowledge: China’s economic news is plastered in every major American business publication daily.

Rather, the problem is lack of trust. We know this from years of experience working with institutional and individual US investors. American investors fear several specific things about China and need to feel comfortable in their resolution before opening their wallets to provide the long-term capital that could drive China’s next economic miracle. Here’s what those things are:

Problem 1: Reverse Merger Fraud. It sounds strange that the wrongdoings of 40-50 firms between 2010 and 2012 can influence a nation’s perception, but even today, mention a Chinese stock to the average American and the first question he or she will ask is: Is it a fraud?

The Chinese companies that snuck onto American exchanges by “merging” with empty US shell companies that had already gone through the IPO process defrauded investors of tens of billions of US dollars before watchful American short sellers — and eventually, surprised American regulators — curtailed the practice.

Fraud happens everywhere. But US perpetrators on this scale are sent to prison and considered psychopaths. Americans were horrified that Chinese authorities took no action to investigate or punish the alleged fraudsters within China.

What it will take to change: Investors need evidence that Chinese authorities and regulators are willing to be on the side of what’s right — instead of just on the side of China.

Problem 2: Americans don’t trust the motivations of Chinese accounting regulators: Not only did China refuse to actively investigate its citizens for defrauding US investors, but it refused to passively cooperate by providing information to the US Securities and Exchange Commission (SEC), or for use in arbitration.

In fact, the US Public Company Accounting Oversight Board (PCAOB), a private-sector agency, has petitioned China for years for access to audit documents for US-traded Chinese companies, but China has refused to provide them.

The SEC and the Chinese branches of the Big Four recently reached a token settlement for failing to provide data, but China still won’t allow the PCAOB to inspect its auditors. Americans — to whom these issues reek of a one-sided Chinese mindset — are left wondering what exactly is being hidden and why.

What it will take to change: Crime is crime, regardless of the victim. American investors won’t feel safe until China shows interest in preventing its citizens from committing crimes against foreign investors and its domestic investors alike.

Problem 3: Americans don’t understand — or trust — the Chinese legal system: The US has one lawyer for every 265 people. China has one lawyer for every 6,250. The US uses common law, which considers prior court decisions and follows the language of the law closely. Chinese civil law doesn’t.

Civil law has some practical advantages — such as less need for lawyers — but Chinese laws tend to change often, and selective enforcement is common. If Americans perceive the Chinese legal system to be intentionally vague so that Chinese authorities can choose whom to favor, they’ll stay away. Americans have a strong sense of fairness. America was founded by rebellion, so Americans detest accepting an unfair system simply because it’s the norm.

What it will take to change: China has more than 120 investment treaties, but not one with the US, so US investors must rely on Chinese courts’ willingness to enforce international arbitration awards. Americans know that Chinese courts have been improving enforcement, but won’t feel comfortable until Chinese regulators show that protecting foreign investors is a priority.

Problem 4: What Americans are buying, Chinese stocks aren’t offering.

Not all deterrents depend on some national policy to change. Stocks like Alibaba, Sina and China Mobile have proven that it is possible to garner American investors’ support — but few of the 568 stocks traded in Shanghai have taken a page from these companies’ playbooks.

Take dividends. American wealth is concentrated in older generations seeking income and stability. Many pension funds aren’t even permitted to buy stocks that don’t pay a dividend. Though plenty of Chinese stocks are payors, their yields look anemic to US investors who can easily lock in 3 percent, 4 percent or higher at home.

Dividends are not just about income. In a market regarded with suspicion, they imply a level of financial discipline. A company that commits to paying a substantial dividend must have real, valuable assets and is less likely to take on risky projects.

Those 40-50 alleged reverse merger frauds? Not a single one paid a dividend.

Today’s Chinese companies successfully cross-listed in the US offer a 2.3 percent average yield — over 70 percent above the CSI 300 average. The more Chinese companies that follow in their footsteps, the more comfortable American investors will become.

Also ripe for improvement is manager compensation. Reward managers with stock — preferably with restrictions on selling for many years — and US investors will have more reason to believe management is looking out for shareholders. Engaging an international auditing firm would further allay skeptics. The auditor doesn’t need to be American (just one of the Big Four audit firms is US-based), but it does need to signal independence and legitimacy.

What it will take to change: Surprisingly little. Decisions to up dividends, revamp executive compensation, or swap auditors are made in boardrooms, not courts. Nor would these changes merely appease US investors — they should improve performance all around.

Problem 5: The Chinese fiduciary standard is nebulous and unenforced.

A CEO turns down a generous acquisition offer because he’d lose his job in the deal. A director champions switching suppliers to his brother’s company. A management team consistently misses its earnings targets because it can’t keep costs under control.

In the US, repercussions for such behavior are predictable. At best, these executives can expect to lose their jobs. At worst, they’ll find themselves in a lawsuit, their misdeeds and punishment splashed across newspapers.

Even managers who color within the lines of the law are not protected if they are bad at their jobs. Activist investors, specializing in turning around underperforming companies, can swoop in, mount a proxy fight, and kick out management.

Disincentives to value-destroying behavior exist in China — but only on paper. China adopted “fiduciary duties” for directors and supervisors in 2005, but the law does not elaborate on what exactly those duties are. Even if they were clear, enforcement — by both the market and the courts — is lax.

Nor is it easy for shareholders to take action when a breach of duty takes place. An array of conditions must be met to file an investor lawsuit, including that the investor owned at least 1 percent of the company’s stock for 180 consecutive days. Minority shareholders find legal action nearly impossible.

There’s more than a legal barrier to overcome here. While US investors are comfortable with confrontation, Chinese value harmony. It’s no surprise that the China Securities Regulatory Commission has seen only a handful of lawsuits since they became a possibility ten years ago.

What it will take to change: When Americans plunk their hard-earned dollars into a stock, they expect management and directors to act as stewards of their capital. China needs strong disincentives to self-dealing, incompetence, and neglect — and when they do crop up, US investors much be confident they have legal recourse.


The Hong Kong-Shanghai Connect is unpopular for a reason — a reason that’s tied to China’s future success.

The Chinese economy is growing at its slowest rate in 24 years. China’s debt is now 250 percent of GDP, and much borrowing is connected to the softening real estate market. Manufacturing wages have nearly doubled in the past five years, enriching workers but rendering China less competitive on costs. A crash isn’t likely, but Japan-style stagnation could be. Fair rules and fair enforcement may be the best way to avoid stagnation — and to attract capital and reward good corporate practices that will propel China’s next wave of growth.

Americans study China closely, and are excited to participate in its long-term economic growth. But they want trust. They want transparency. They want long-term win-win relationships amongst themselves, Chinese companies, and Chinese regulators. The more Americans feel that Chinese companies want the same thing, the more capital they’ll provide.

The Hong Kong-Shanghai interconnect still has the potential to provide everything Chinese regulators hoped it would — if they allow international standards to accompany international capital.

The article first appeared in the March issue of Hong Kong Economic Journal Monthly. [Chinese version中文版] [HKEJ Monthly IPhone/iPad App] [email protected] 

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James Early is chief executive of Iwaitou. Alex Pape is Chief Investment Officer of the firm.

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