KWEB China Internet Market Volatility FAQ
Updated on August 12, 2022 to include details on SOE voluntary delisting
How might KWEB be affected by the US delisting legislation? Can you convert US-listed shares to Hong Kong shares for companies with dual listings?
Congress passed the Holding Foreign Companies Accountable Act (HFCAA) in December of 2020. The new law requires all US-listed foreign companies to allow the Public Company Accounting Oversight Board (PCAOB) to inspect their audit books, disclose government ownership, if any, or face delisting. The law only applies to listed stocks, not ETFs, so KWEB is not at risk of being delisted under this law.
On March 8th, 2022, the Securities and Exchange Commission (SEC) began to determine which companies are not in compliance with the HFCAA. The SEC has so far named 12 ADRs, reinforcing investors’ concerns about delisting and triggering market volatility in offshore Chinese equities. The China Securities Regulatory Commission (CSRC) has been in talks with the SEC and Public Company Accounting Oversight Board (PCAOB) to resolve this issue, but the two sides have yet to arrive at a solution.
Since the law was passed, we have received questions regarding the US-listed Chinese companies held within KWEB. We believe there are several vital points to consider regarding the potential for delisting.
- KraneShares can convert US-listed KWEB holdings to their Hong Kong-listed equivalents. 70% of KWEB’s holdings by weight are comprised of Hong Kong-listed Chinese companies as of August 12th, 2022.1 The Hong Kong Stock Exchange (HKSE) has a new listing rule that went into effect on January 1st, 2022, allowing almost all US-listed Chinese companies to re-list in Hong Kong. We anticipate that more companies will list in Hong Kong and that the liquidity of Hong Kong shares is expanding as more institutional investors convert ADRs to Hong Kong shares.
- There is a long runway before this becomes an immediate concern. Under the current law, these companies have a three-year window to become compliant. Companies will have the opportunity to comply in their annual reports for fiscal years 2022, 2023, or 2024. The House passed a version of the “America COMPETES Act" that included a provision to reduce the compliance window to just two years. However, the final version that passed both the House and the Senate did not include this provision. As such, there remains a significant window for the companies to come into compliance by 2024, but doing so will require a resolution by regulators.
- On March 11th, the CSRC published a press release on their website saying that they are engaging with the PCAOB and have made positive progress. They believe the two sides will be able to jointly work out cooperation arrangements that comply with both countries' legal and regulatory requirements in an expedited manner. China’s Vice Premier Liu He also said during the State Council meeting on March 16 that “the Chinese and the US regulatory bodies have maintained good communication and made positive progress. The two sides are working on a concrete cooperation plan."2 On March 22, Reuters reported that the CSRC told Alibaba, JD.com, and other private companies that they should prepare their audit disclosures for PCAOB inspections. This would indicate that segmentation between private companies and state-owned enterprises (SOEs) is the path towards a resolution. Allowing the private companies to comply would also provide them time to address the more complicated situation for SOEs.3 However, on March 24, Bloomberg quoted the PCAOB as saying that confidence in a resolution was premature. Nonetheless, the article did confirm that the two sides are engaged in active dialogue.
What is KWEB's current ADR exposure, and what percentage of the portfolio still needs to be converted?
KWEB has converted most of its US holdings to Hong Kong shares.
What does the recent delisting of state-owned enterprises (SOEs) from US Exchanges mean for KWEB and US-listed China stocks?
We have long argued that a solution to the HFCAA was the delisting of State Owned Enterprises (SOEs) as their audit reviews are more likely to contain sensitive information. As the SEC is seeking full compliance across all US-listed Chinese companies, this could open up a window for many of the remaining companies to comply.
Five Chinese SOEs announced their intentions to voluntarily delist from US exchanges on August 12, 2022: China Life Insurance Co., PetroChina Co., China Petroleum & Chemical Corp., Aluminum Corp. of China, and Sinopec Shanghai Petrochemical Co. Of the 273 US-listed Chinese companies, seven are SOEs. The other two SOEs not included in today’s announcement are both Airlines: China Southern Airlines Co Ltd (ticker: ZNH) and China Eastern Airlines Corp. Ltd. (ticker: CEA).
KWEB does not hold any of the seven US-listed SOEs.
What are the potential benefits to companies listing in Hong Kong?
The top reason for the shift to Hong Kong is that the HFCAA does not apply to Hong Kong-listed stocks, so there is no delisting risk there.
A US-listed Chinese company can have a secondary or dual primary listing in Hong Kong. US and Hong Kong share classes are fungible, meaning shares can be freely converted from one listing location to another, as long as your broker allows for such a conversion.
One key benefit of having a dual primary or primary listing in Hong Kong is that having such a listing enables Mainland Chinese investors to access these stocks, often for the first time, via Southbound Stock Connect. This could mean significant inflows to companies like Alibaba, who announced their HK dual primary listing in late July, 2022. For reference, Tencent is listed in Hong Kong and is accessible to Mainland investors via Southbound Stock Connect. Mainland investors now hold 7.5% of shares outstanding and 13.0% of free-float shares outstanding, with a current value of $27.4 billion, which is 7.3% of market capitalization.6
For investors concerned about whether their US-listed Chinese stock positions may be delisted and who cannot convert or do not wish to convert their shares to Hong Kong shares, KWEB may be a solution as we are proactively converting to Hong Kong shares classes ahead of the 2024 HFCAA compliance deadline.
Could China be vulnerable to similar geopolitical risks as Russia?
No. China and Russia are very different from one another economically, culturally, and geographically.
China is an integral part of the global economy, accounting for a far larger share of global GDP, US imports/exports, and US foreign direct investment. China accounted for over 18% of global GDP in 2020 while Russia only accounted for 3%. The US imported $450 billion worth of goods and services from China in 2020 and only $18 billion from Russia, mostly oil and gas.
As the world’s largest trading partner, ensuring that global trade is stable and healthy is a top priority for China. Freezing trade with China could potentially cause a global depression, not just a bout of market volatility.
Both the US and China have entirely too much to lose to fully decouple from one another. As such, we believe the risk that similar economic sanctions are applied to China is low. On March 25th, US Treasury Secretary Janet Yellen told CNBC that she does not believe that sanctions on China are “necessary or appropriate.”4
Despite its neutral official stance, China has expressed its disapproval of the invasion through various soft power measures. China state-backed banks, including the mammoth Asian Infrastructure Investment Bank (AIIB), have suspended Russian activity. Meanwhile, China has urged “constraint” from all parties through multilateral channels.
What are some potential near-term catalysts for KWEB?
- China is currently easing monetary conditions while most of the developed world is tightening. While the cost of capital for US internet firms is rising, the cost of capital for KWEB companies is falling.
- China’s government seeks to achieve an ambitious 2022 GDP Growth target of 5.5% and create 11 million new urban jobs.5 China’s internet giants will play an integral role in achieving these goals.
- KWEB’s long-term growth story remains intact. China’s internet population continues to grow and China’s internet companies continue to grow their revenues.
- As the market is currently pricing in a high degree of uncertainty, any increase in clarity on HFCAA, Ukraine, internet regulations, or the pace of Fed rate hikes could lead to a significant boost in the share prices of KWEB companies.
What about KWEB's fundamentals?
- The 3 & 5-year average revenue growth rates for China internet companies are similar to those of many U.S. internet companies. However, KWEB’s holdings are currently trading at less than one-half of the multiples of their US equivalents.
- Periods of low forward P/Es tend to be associated with higher 12-month returns in the future.
- 13 companies in KWEB now have a price to book (P/B) ratio lower than 1, meaning that they are valued at less than the sum of their assets and cash on hand.
- Of those 13, five have a market value that is less than their cash on hand.
- Data from Bloomberg as of 8/12/2022.
- Xinhua. "China Focus: State Council committee stresses economic, financial stability," Xinhua News. March 16, 2022
- Reuters. "EXCLUSIVE: Chinese regulators ask some U.S.-listed firms to prepare for audit disclosures," Reuters News. March 22, 2022
- Franck, Thomas. “Treasury Secretary Yellen sees no need for China sanctions as US tries to deter aid to Russia,” CNBC. March 25, 2022.
- People’s Republic of China. Government Work Report. March 7, 2022.
- Data from Wind, Hong Kong Exchanges & Clearing as of 8/12/2022