Relative Regulatory Risk: A-Shares vs. H-Shares vs. ADRs

RESEARCH NOTE

China’s recent market decline is the investment topic du jour. Less discussed are the different ways this decline is manifesting across various China listings. Depending on the source of an investor’s China exposure, their experience of the recent decline may vary widely.

Consider the following for the period June 30 to July 27:

• CSI 300, which includes onshore large cap China A-shares, fell 9.3%.
• HSCEI, which includes Hong Kong-listed H-shares, fell 14.5%.
• S&P / BNY Mellon China ADR Index, which includes US-listed ADRs, fell 23%.

Source: Rayliant Research, iShares. Data as of July 27, 2021. Onshore A shares represented by CSI 300 Index; Offshore Hong Kong represented by Hang Seng China Enterprise Index; Offshore ADRs represented by S&P/BNY Mellon China ADR Index.

What is driving the divergence among Chinese A-shares, H-shares, and ADRs?

Answering this question starts with understanding the catalyst for the current sell off: regulatory risk. Over the past year – but particularly over the past month – China’s regulators have taken an aggressive stance on a broad range of issues affecting Chinese businesses, from data privacy to education to monopolistic practices. Collectively, this regulatory action has spooked investors who have not already priced in that regulatory risk.

And if regulatory risk is driving the recent sell-off, then it follows that the greatest mispricing of China stocks was in U.S.-listed ADRs (23% decline), followed by Hong Kong listed H-shares (14.5% decline), and finally A-shares (9.3% decline). This data reflects the market’s view–which I share–that onshore-listed A-shares present less regulatory risk than their offshore counterparts.

This is not surprising. China’s regulatory scrutiny over the past year has disproportionately affected firms listed outside of mainland China. For example, big technology firms–which represent the largest category of China ADRs– have been hit particularly hard. So have those companies that listed in Hong Kong or the U.S. to benefit from bloated valuations or to avoid China’s difficult listing process. It would appear the Chinese government may be pressuring firms listed abroad to return to Chinese exchanges or, at a minimum, to ensure offshore-listed firms receive some of the of same scrutiny that their onshore counterparts receive prior to listing.

Based on recent signaling from Beijing, it appears we may be approaching the end of the current burst of regulatory activity. We may also be seeing the end of the corresponding volatility. The reaction we have seen in the market is simply the pricing of regulatory risk into Chinese securities–including the current pricing of potential future regulatory pressures. (For example, we’ve seen volatility in certain industries, like brewing, that are not yet the subject of regulatory scrutiny but may be in the future.) That said, from a fundamental perspective, it’s hard to understand how regulatory punishments will end up equaling 10% of market value, so the steep decline we’re seeing is likely an overreaction.

Moreover, as explained above, China’s regulatory pressure has been primarily directed outside of A-shares–H-shares and ADRs are taking the brunt of the regulatory scrutiny. The decline we’ve seen in A-shares is probably driven by international investors pulling capital out of China A and a general fear of a regulatory crackdown. While understandable, this is again likely an overreaction. It is reasonable to expect the A-shares market to stabilize and for values to revert.

In short, offshore stocks of Chinese companies may well be oversold. But in the long run, it’s clear where the regulatory winds are blowing. Gradually, Chinese firms will begin responding to the positive and negative incentives of China’s government and regulators. New firms will increasingly look to IPO in Shanghai and Shenzhen, and firms listed as ADRs will try to find their way back to mainland China or Hong Kong. The change will not be overnight, but it’s coming. The future of China lives onshore – and for China investors seeking to accurately price regulatory risk, that’s probably a good thing.

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