A US government commission has called for tighter controls on flows to China's capital markets in a move that would have profound implications for asset managers and index providers.
Security concerns raised by the US-China Economic Security Review Commission as a result of a surge in US investment, according to the latest annual report from the US-China Economic Security Review Commission. A surge in US investor participation in China markets is better than the US government's defence against the threats to US national and economic security posed by US investment in some problematic Chinese companies, according to a report to Congress.
Despite ongoing US-China tensions, the US investors, asset managers and mutual funds are increasing their participation in China's financial markets, it added.
It said US positions in Chinese equity and debt securities jumped 57.5 per cent from $765 billion in 2017 to $1.2 tn in 2020.
According to the report, Chinese policymakers are targeting foreign capital and fund managers as they work to make China s capital markets serve as a means to fund the Chinese Communist party's technology development objectives and other policy goals. The commission proposes widening the scope of existing policies to close loopholes, as long as they were not doing so in the US and only involved non-US citizens.
If we are really interested in protecting US national security rather than simply pretending to, this loophole should be closed as the commission recommends, it argued.
The US Office of Foreign Assets Control issued a revised sanctions policy earlier this year that said entities were not prohibited from providing investment management or advisory services to non-US persons, foreign funds or entities in connection with the purchase or sale of securities that would otherwise violate the investment bans.
In June, the announcement seemed to address the concerns of US managers that their onshore business in China and Hong Kong might be impacted by US policies.
The new commission report takes aim at the way the Chinese government has opened its capital markets to foreign investors.
The Chinese government permits the participation of foreign firms and investors in the Chinese market only when it suits its national interests, it said.
The commission said that nominal financial opening in China is a carefully managed process designed to reinforce state control over capital markets and to channel foreign funding toward fulfilling the Chinese government's national development objectives.
One issue identified by the commission's analysis is asset managers allocations to Chinese assets via passively managed funds.
Chinese debt was phasing into its flagship World Government Bond Index, according to FTSE Russell. In three years, Chinese government bonds will comprise 5.25 per cent of the index, and will be included in the gradual inclusion process that started on October 29.
The report said that the inclusion of Chinese securities in investment indices automated US investor allocation to Chinese companies.
It said that index providers have played a pivotal yet unregulated role in guiding foreign portfolio investment towards Chinese companies because passively managed index funds replicate these indices and actively managed funds seek to at least outperform them.
The commission recommended that index providers that include securities issued on mainland Chinese exchanges or the Hong Kong Stock Exchange, securities of China-based companies listed on US exchanges through a variable interest entity or derivative instruments of either of the preceding types of securities be required to be subject to regulation by the SEC.
In early June, the US president Joe Biden imposed an executive order banning Americans from investing in 59 Chinese companies ranging from the surveillance and defence sectors for alleged links to China's military, expanding an earlier order by former president Donald Trump. The restrictions hampered some concerns that US fund groups in Asia could have been hampered by the restrictions, and the order seemed to limit the scope of the policy.
BlackRock, Vanguard and State Street Global Advisors are all heavily invested in China, while many other US managers, including JPMorgan Asset Management and Morgan Stanley, are building onshore businesses in the market.
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