This article follows a previous article by the author on Chinese capital markets.
What are US lawmakers trying to accomplish by discussing whether some 150 Chinese companies listed on US stock exchanges set to be delisted? Is their objective US-China financial decoupling? Although discussions of Chinese listings in the United States are technically about accounting rules, they must be understood in a larger geopolitical context.
One of the key questions for the future world order is how Western capital markets will be connected to Chinese capital markets. The level of integration between Chinese and Western capital markets affects China’s economic growth. The stronger the ties, the better the prospects for Chinese growth.
If China continues to have increased access to Western capital, China may soon be in a better economic position to challenge the Western liberal capitalist model. However, the increased integration of Sino-Western capital markets is only one scenario among many, depending on many political and geopolitical factors. Instead of the increased integration we are currently seeing, a “strong decoupling” or “scrambling” may prove more likely, depending on how perceptions of China and Chinese financial markets in the United States and in West.
For several decades, major Wall Street institutions have worked successfully on US-China financial integration and the opening up of Chinese markets. The January 2020 U.S.-China Phase One Agreement was a milestone for U.S. banks, which gained the ability to become majority owners of Chinese financial institutions. US private equity and venture capital have been actively investing in China for a long time. Despite recent lockdowns and geopolitical uncertainty, Western banks continue to expand their presence in China.
Importantly, since 2016, there has been a significant increase in the number of US and European investors in China’s public equity, bond and derivatives markets. This flow of Western institutional investment capital to China took off after stock and bond index providers like MSCIFTSE Russell and Bloomberg-Barclays decided to include mainland Chinese assets in their indices. Their decision caused hundreds of billions more dollars to flow from the United States and Europe into Chinese stocks and bonds. In the summer of 2021, Western holdings of Chinese financial assets would amount to US$1.1 trillion. At the beginning of July 2022, the Chinese authorities announced “swap connect”, giving international investors access to China’s €3.1 trillion swap market.
However, geopolitical tensions or “strategic competition” between Washington and Beijing may well hamper further US-China financial integration. American decision-makers increasingly perceive that national security is about economic security, which makes international finance a key element of geopolitical dynamics. Thus, institutional investors, as well as international banks, private equity and venture capital are increasingly involved in US national security affairs.
This trend was marked by the Trump administration’s expansion of the Committee on Foreign Investment in the United States (CFIUS) with the Foreign Investment Risk Review Modernization Act Where FIRMMA, which has significantly limited Chinese investment in the United States. Concerned that American companies are contributing to China’s military-tech rise, the Biden administration may soon complement FIRRMA with new legislation to screen outbound foreign direct investment.
Beyond private markets, there is an emerging pattern of US-China competition for global banking dominance and potential conflict in banking markets. As a further sign of US-China tensions in banking markets, US banks in China have very recently began to publicly express differences of opinion with the Chinese financial authorities.
Regarding portfolio investment in China, the Trump and Biden administrations have released executive orders to prevent US investment in China’s military-industrial complex. In the White House Biden still careful languageit “signals that the administration will not hesitate to prevent American capital from flowing into the defense and related materiel sector of the People’s Republic of China (PRC), including companies that support military programs, intelligence and other security research and development programs of the PRC; or in Chinese companies that develop or use Chinese surveillance technology to facilitate repression or serious human rights abuses. important between the military, security and civilian components of the Chinese economy, a wide range of Western portfolio investments in China could ultimately be subject to exit restrictions.
The debate now is whether, and to what extent, US institutional investors should be banned from holding Chinese financial assets. In the financial sector, there are those who are strongly in favor of deepening the integration of US-China capital markets. The asset manager Blackrock called for a new treble Western capital flows to China. Similarly, Ray Dalio of Bridgewater argued that China is on the right track and is highly investable, despite the inevitable risks. Voices in favor of expanding US-China financial integration seem less concerned about the geopolitical consequences of their investments in China.
On the other hand, several opinions of influential voices that portfolio investments in China are bad for US national security. In late 2021, the US-China Economic and Security Review Commission (USCC) pointed out that Western portfolio inflows into Chinese stock and bond markets undermine US national security in several ways. First, Western money is used to directly finance Chinese military and national security enterprises. Second, outside investment can flow into Chinese conglomerates that include both military and civilian parts. Third, ostensibly civilian companies are still contributing to Chinese military and security technology through China’s military-civilian fusion programs, as well as through business ecosystems that facilitate financial and technological know-how, as well as than other transfers between civilian and military companies. Fourth, Western investment in Chinese stock and bond markets makes China richer overall and thus allows the CCP to increase its military budget.
Geopolitical motivations are likely to trump commercial instincts. The overall US relationship with China is dominated by strategic considerations, and finance is increasingly seen as an integral part of the equation.
One can only speculate on the consequences as the US moves to further separate US and Chinese capital markets. The structure of international capital markets can become bifurcated, one centered on China and the other centered on the US dollar. A partiel financial decoupling, with the effect of trillions of dollars being sucked or locked up in China at once, can cause global contagion and financial instability. How China will react or seek to deter any US financial decoupling remains a relevant question.
To prevent Western institutional investors from entering the Chinese market, the United States will also have to ensure that European portfolio investors end their exposure to China. This could cause a transatlantic imbroglio, which will be discussed in a future article.
As the official U.S. position on portfolio investment in China continues to evolve, international policymakers, market participants, and observers should adapt accordingly. The most important thing that the three groups can do now is to carefully observe the American debate on geopolitical competition with China and be aware that this debate is likely to affect the future of Chinese capital markets and the structure of global finance. More importantly, this era of financial geopolitics demands that international financial institutions learn to consider national security at all times.
Dr. Elmar Hellendoorn is a Nonresident Principal Investigator at the GeoEconomics Center and the Europe Center.
At the crossroads of economics, finance and foreign policy, the Geoeconomics Center is a translation center whose goal is to help shape a better global economic future.