There’s no place like home. The American depository receipts (ADRs) of Chinese firms have suffered massive selloffs this year, as a long-running auditing dispute between the US and China threatens dozens of them with potential delisting, and adds to a confluence of regulatory headwinds, macro concerns, and geopolitical risks spurring volatility in Chinese shares at home and abroad.
But a backup plan for many of these firms - a relisting in Hong Kong, Shanghai, or Shenzhen -may not be the drag on liquidity that some have suggested, and could even bring unexpected silver linings. Here, we look at how prepared China’s markets are to host such returnee listings, and what the various potential outcomes to the current standoff are likely to mean for investors.
The end of the journey to the West
The tides of global capital markets have turned for Chinese tech firms. An era of their westward quest, which started in the late 1990s with China’s most innovative startups beating a path to US exchanges, is slowly coming to an end. Just like the heroes in the classical Chinese novel Journey to the West, the titans of China’s tech industry have reaped rewards from their quest in distant lands. But the case for staying closer to home is looking increasingly attractive. Hong Kong and Shanghai have been overhauling their listing rules in a bid to lure some of the larger and better-known Chinese tech firms listed overseas.
Hong Kong has eased restrictions on profit requirements and weighted voting rights, clearing some roadblocks to Chinese tech firms that previously could only head for the US for such features, while Shanghai has built a listing venue known as the Star Board, where some 400 tech startups have gone public since its 2019 launch.
In the near term, we expect Hong Kong to be the preferred destination of relisting for most Chinese ADRs, given the city’s more internationalised capital market versus Shanghai. In fact, a growing number of Chinese tech firms has sold shares in Hong Kong for dual-listing status over the last few years, such as e-commerce giants Alibaba and JD.com, search engine Baidu and gaming company NetEase. In addition, Shanghai’s market regulators have shown a tendency to favour tech hardware companies, while US-listed Chinese firms tend to focus on consumer tech.
Nevertheless, Shanghai’s ongoing listing reforms will likely add to the city’s long-term appeal, as China plans to gradually open its capital markets to global investors. The Star Board has, on a discretionary basis, allowed some firms with weighted voting rights (WVR) or variable interest entity (VIE) structures to go public. Among them are UCloud Technology, a provider of cloud computing and storage services, Ninebot, a maker of electric scooters, and Jing Jin Electric Technologies, which manufactures electric motors.
In March, both the Shanghai and Shenzhen exchanges unveiled new rules on the issuance of so-called Chinese Depository Receipts, through which some tech firms will be able to go public without unwinding their WVR or VIE structures.
As investors weigh Hong Kong against New York, one disadvantage of the Asian financial hub is its comparatively lower liquidity. For Chinese companies listed in both cities, it’s not unusual to see their daily turnover in Hong Kong at less than half of that in New York. Besides, some global asset managers are not allowed to own Hong Kong shares due to mandate or compliance restrictions.
But when the broader picture is considered, the liquidity impact from institutions being unable to trade in Hong Kong will be limited. Based on Goldman Sachs estimates, while US investors own around US$750 billion of Chinese equities across A shares, H shares, and ADRs, less than 8 per cent of this is likely to be held by investors that cannot trade in Hong Kong.
On the plus side, Hong Kong offers the potential liquidity benefit of listees joining the Stock Connect programme, which allows companies to tap into mainland China’s vast investor base. In effect, liquidity boosts from southbound Chinese traders will help offset any reduction in fund flows from the US. Over time, liquidity will likely improve in Hong Kong with more Chinese tech firms listing there and forming a critical mass of scale.
Move it on over
For Chinese firms that are already listed in both cities, it’s usually not difficult for investors to transfer their shares from New York to Hong Kong. One may make a custodian transfer, which involves no trading costs and typically takes about two days, or conduct a switch through market trading, which may entail positioning risks due to different market hours.
Despite short-term disruptions, the investment case for most Chinese ADRs depends on their fundamentals as well as China’s economic and consumption growth. Delisting threats should have little impact on these fundamental drivers over the longer term. In fact, the recent selloffs have push valuations to rather depressed levels, with some tech names trading at single-digit earnings ratios or near net cash value.
Besides doing fundamental research, ADR investors should also pay attention to how prepared companies are for relisting. The better prepared, the sooner they may remove this overhang.
Still, there is a chance that a solution can be reached and the delisting of ADRs can be avoided if talks between US and Chinese regulators can produce a compromise. At the heart of the issue is China’s reluctance to allow foreign access to the audit work of certain firms on national security grounds, but Chinese regulators have recently shown a willingness to ease access restrictions. In April, the China Securities Regulatory Commission issued draft rules scrapping a requirement that only Chinese officials can conduct on-site audits of Chinese firms listed overseas.
Meanwhile, a watch list of Chinese firms that have been named by US regulators as delisting candidates keeps expanding. The Securities and Exchange Commission has been adding names under the Holding Foreign Companies Accountable Act (HFCAA), which was signed into law in 2020 and amended last year. Chinese companies on the list, including search giant Baidu, online media firm Sohu, video platform iQiyi, and online brokerage Futu, must comply with US auditing standards or face delisting in about three years.
For many if not most Chinese ADRs, the latest developments probably mark the beginning of an end of their journey to the West. While a US-China regulatory rapprochement may still avert forcible delistings, gravity has shifted and now appears to be pulling them in the homeward direction.