House Financial Services Subcommittee Issues Testimony From Janes Group Senior China Analyst Chu
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I'm a senior
Last year, I testified before the Subcommittee on the risks to investors posed by Chinese issuers in the
Today, I have been asked to speak on
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1 "SEC Requests Information and Comment on Advisers Act Regulatory Status of Index Providers, Model Portfolio Providers, and Pricing Services,"
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The concept of economic statecraft is not new.
And yet the national security community today, with its predilection for conventional armed forces, has been at times reticent to recognize the international financial system as a warfighting domain and commercial actors as potential adversaries. Classic economic sanctions and export controls are par for the course, but the Pentagon does not want to encroach on what it considers to be
In
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2
3 The former chief investment officer of the
4 "National Security Strategy of
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Following
Outside of
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5 "National Security Strategy," The
6 "FACT SHEET:
7 "
8 "Commerce Rule Applies Powerful Restrictions Directly on Entities Seeking to Supply Russia's Military Since Start of Invasion of
9 "Addition of Entities, Revision and Correction of Entries, and Removal of Entities From the Entity List,"
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Russian Stocks, Index Providers, and Financial Risk
On
Major global index providers began removing Russian equities from their widely tracked indexes during the first week of
This was not an ethical response to
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10 "Sanctions Update: EU and US Impose New Sanctions and Export Controls Relating to
11
12 "FAQ: Russian Harmful Activities Sanctions,"
13 "Treatment of
14 "MSCI to Reclassify the MSCI Russia Indexes from Emerging Markets to Standalone Markets Status," MSCI,
15 "
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Index providers have already outlined a way for removed Russian securities to rejoin global indexes. Although
Institutional Investors Face Russia Divestment Obstacles
Large public pension plans acted quickly to try to reduce their
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16
17 "Treatment of
18 "Q&A: Reclassification of MSCI Russia Indexes to Standalone Markets Status," MSCI,
19 "
20
21 "McRae: Divesting from Russian Investments to Support Ukraine," State Treasury of
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Although there were no formal divestment mandates enacted, some state institutions and fund administrators were called on by state governors including
The
Targeting
The unprecedented and expansive nature of the economic and financial sanctions imposed on
The Russian readout of a
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22
23
24 "Telephone conversation with President of China
25 "Summary:
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Variable interest entities (VIEs) are legally ambiguous corporate structures that Chinese companies frequently employ to list on
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26 Data retrieved from Statista.
27
28
29 "What are sanctions, and are we in a new era of economic war? This week's Radio Davos,"
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The popularity of passive investment strategies, which allow fund managers to delegate their investment decisions to index providers, gives companies using VIE structures a steady pool of willing buyers that perform no analysis of company fundamentals to assess whether the underlying assets of a Chinese stock, for example, are real. ETFs and other index products are derivative instruments that mimic the performance of the securities in a target index created by an index provider like MSCI, FTSE Russell, or S&P DJI, and cannot sell off problematic or risky holdings without violating fiduciary duty to parallel the returns of the benchmark index as closely as possible. And index providers that are responsible for the underlying indexes do not assess business fundamentals beyond market capitalization, liquidity, and other technical attributes.
Public employee pension funds, endowment funds, and other institutional investors invest in diversified portfolios across stocks, fixed-income securities,
investor access to publicly traded Chinese companies has expanded dramatically over the past few years with the rapid inclusion and weighting of China A-shares in major global stock indexes - and consequently, in investment products that benchmark against them.31
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30
31 A-Shares are mainland Chinese companies that trade on the
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Prior to the inclusion of A-Shares in 2018, global index providers had exposure only to H-Shares, which are Chinese companies listed on the Hong Kong Exchange.
After the A-Share transition began in 2018, index products with Emerging Markets (EM) and global mandates quickly flooded with Chinese company stocks. Over 1,500 A-shares were available to
Some of this risk exposure was neutralized with the
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32 "Comparing benchmark providers," Vanguard, accessed on
33
34 "Executive Order on Addressing the Threat from Securities Investments that Finance Certain Companies of
35 "Commerce Department Will Publish the First Military End User List Naming More Than 100 Chinese and Russian Companies,"
36 "Harbin Z-19 (Black Whirlwind) (WZ-19),"
37 "CAIC Z-18,"
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State and Federal Pension Funds
Some states are more bullish on Chinese markets than others. The
One such system is the Florida Retirement System, which entirely stopped funding new
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38
39 "PRIM Board Quarterly Update First Quarter 2022," MassPRIM,
40 "Annual Comprehensive Financial Report, Fiscal Year 2021," MassPRIM,
41
42 "Texas Teachers' Pension to cut
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44
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University Endowment Funds
Although public universities operate using taxpayer dollars and ought to be subject to open records acts, very few have publicly released their endowment portfolios with information on individual debt and equity holdings. In 2016, the
Universities and colleges often employ what has been referred to as a "stealth investment strategy" when it comes to endowment funds.
This aversion to public disclosure can be attributed to reasons including the desire to avoid political influence or scrutiny, fiduciary responsibility to maximize returns, concerns about competitive advantages, and confidentiality agreements with external investment managers and consultants.47
A
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45 "TSP Mutual Fund Window (MFW) -- List of all available funds," TSP Folio, accessed
46 Demetri Sevastopulo, "Trump orders federal pension fund not to invest in Chinese stocks,"
47
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As a result of the
To a certain extent, we can deduce undisclosed but passively managed investment holdings by referencing the investment benchmark indexes due to the close replication of their underlying securities. The MSCI All Country World Index (ACWI) created by Morgan Stanley is one of the most popular options for institutions seeking exposure to a range of developed and emerging market companies. It has exposure to large swaths of Chinese and (formerly) Russian securities, which include companies that have not been screened for reputational, regulatory, or supply chain risk factors. As of 2021, all three universities - the
In
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48
49 "
50
51 "Annual Report 2020-2021,"
52 "Report of Investments 2021,"
53 "Annual Report 2020-2021,"
54
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Alternative Investments: Private Funds
Broadly speaking, the private market consists of alternative investments such as hedge funds, private equity funds, and venture capital funds that raise capital in private, outside of the public markets - all while being shielded from
Private funds, which represent a significant portion of institutional portfolios, essentially function as unregistered investment vehicles that are not required to verify or disclose investors' identities, source of funds, or other credentials. This presents an ideal environment for Russian oligarchs to park their wealth, and for Chinese state-owned entities to gain nontransparent access to
Chinese private equity and venture capital have an outsized role in financing
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55 "Murphy Introduces Bill to Pressure University Endowments to Divest from Dangerous Chinese Entities," Congressman
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57
58 "
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* Before joining Redline, partner Tatiana Evtushenkova was an advisor to the CEO of
One of the most prominent names in American venture capital and private equity is
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59 "
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61 "
62 "Member Overview:
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The biggest private equity investors are pension funds and university endowments.63 Of the 178 U.S. public pension funds that the
Over the past year, federal regulators have rallied around plans to expand oversight of private markets and increase reporting requirements to address the lack of transparency. The
Recommendations
Establish an interagency committee of the
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63
64 "2021 Public Pension Study,"
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66 "SEC Proposes Amendments to Enhance Private Fund Reporting,"
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68 "SEC Proposes to Enhance Private Fund Reporting,"
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This committee would coordinate with other departments and agencies as needed to address issues such as foreign procurement, critical minerals security, infrastructure investment, supply chain resilience and ally-shoring, and export of strategic materials.
Effective sanctions programs are linked to clear policy objectives, and this committee would work to facilitate alignment between different sanctions programs with shared objectives to prevent the inconsistent application of economic and financial penalties. It would also prevent abnormal situations in which U.S. investors are able to freely purchase or transact in the securities of an entity that
It would also be charged with engaging with Silicon Valley and
In
Enact divestment requirements at the state and local level to prevent
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69 "S.4112 - Economic Statecraft for the Twenty-First Century Act," 117th
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This directive would also require state chief procurement offices to publish an annual list of entities determined to be engaged in activities supporting
These actions would support the efforts of state and local governments, educational institutions, businesses, and investors that have already taken steps to disassociate themselves from companies engaged in activities contrary to
Consider strengthening regulatory authorities to prevent or even ban the
Three days later, the
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70 "Sample Letter to China-Based Companies,"
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As a consequence,
This testimony was prepared with research support from my colleagues
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71 "The relevant person in charge of the
72 "China Puts VIE-Structured Overseas Listings under Regulatory Spotlight," Ropes & Gray,
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Original text here: https://financialservices.house.gov/uploadedfiles/hhrg-117-ba16-wstate-chuc-20221115.pdf
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