China Revises Delisting Rule. But Investors May Want to Sell on the Rally.

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The probability of a mass delisting of Chinese stocks like

Alibaba Group Holding

(BABA),

NetEase

(NTES),

Baidu

(BIDU) from U.S. exchanges may have ticked lower. But the risk remains, adding to the fallout from Covid lockdowns in cities like Shanghai, and geopolitical concerns that could challenge Chinese stocks in the near-term.

The

Invesco Golden Dragon
(PGJ) exchange-traded fund (PGJ), filled with U.S.-listed shares, surged 7% to $32.44 on Monday while the

iShares MSCI China
ETF (MCHI) rose almost 3% to $56.36. But investors may not want to pounce on the latest rally and possibly even lighten up on internet stocks that have been at the center of volatility.

Investors took as good news a proposed rule change by Chinese regulators that could allow non-Chinese government agencies to access audit documents. Regulators have not previously allowed the U.S. full access to Chinese companies’ audit working papers. That’s the issue at the center of the Holding Foreign Companies Accountable Act that has triggered a process to delist Chinese companies unless they are in compliance with U.S. auditing disclosures for three straight years—by 2024.

The removal of a key phrase that on-site inspections must be “dominated” by Chinese regulators was the “first concrete public step” China made to improve the odds of some sort of resolution to keep Chinese companies in compliance, according to a client note from Bernstein analyst Robin Zhu.  

Worth noting, he said, was Chinese regulators’ acknowledgment that the documents and materials provided in audit disclosures “rarely contain state secrets and sensitive information.” according to Zhu.

Also positive: The move wasn’t just from securities regulators but also from China’s Ministry of Finance and State Secrecy Administration, says KraneShares Chief Investment Officer Brendan Ahern. “The probability of a delisting comes down, but it isn’t removed,” he says.

Bernstein’s Zhu also noted that risks remain, writing that much will be left in the details of the rule change.

Here’s one reason the rule change may not be enough: U.S. regulators have stressed they are looking for full compliance or no deal. The Public Company Accounting Oversight Board (PCAOB) said last week in a statement that it continues to engage with Chinese authorities but its requirement for full access to relevant audit documentation, even from companies in sensitive industries, isn’t negotiable.

And China’s rule change doesn’t meet that core U.S. demand. It still requires Chinese companies to get approval from regulators before sharing any audit material, and it also requires approval for transfer of any documents that might “disclose state secrets or harm the state and public interests,” writes Thomas Gatley, a senior analyst at Gavekal Dragonomics, in a note to clients. The most likely outcome, Gatley adds, will be that most Chinese companies will eventually be delisted from U.S. exchanges.

The U.S. has never seen the type of mass delisting that could follow if no agreement is reached, a reason some analysts think some sort of work around could still be reached. That could include companies with sensitive information, like state-owned firms such as

PetroChina

(PTR), or even some internet companies given China’s concerns about data security voluntarily delisting. More Chinese companies are still likely to pursue secondary listings in Hong Kong, with some like

Li Auto

(LI) and

Xpeng

(XPEV) looking to make Hong Kong their primary listing, allowing them to tap mainland Chinese investors through the Stock Connect program.

And these shifts—regardless of what happens with regulators—will bring their own changes as more investors opt for the local shares. The MSCI China index, for example, swapped out the ADRs of

Alibaba
,

JD.com

(JD) and

NetEase

last year for these companies’ Hong Kong listings.

MSCI’s rebalancing in June could see more such swaps for companies who have had their secondary listings in Hong Kong for a while and meet certain liquidity conditions, including

Baidu
,
and possibly

Bilibili

(BILI).  “For big global U.S. asset managers, they are just going to be conservative because the risk is still there,” Ahern says.

The bigger question for investors is if Chinese internet stocks like Alibaba, trading at two standard deviations below five-year historical valuations, are worth pouncing on, especially after myriad reassurances from Chinese officials earlier in the month aimed to calm markets.  

But the delisting risk is just part of the near-term challenges. China’s strict Covid restrictions has pushed cities like Shanghai, a city of 25 million, into an extended lockdown as it grapples with record cases and the changing geopolitical landscape as China tries to stay neutral in the war in Ukraine adds another level of uncertainty. The Biden administration is still shaping its China policy and a China bill is working its way through Congress—both of which could dent investor sentiment about Chinese stocks.

“We see those rebounds as good selling points not good buying opportunities because we think the challenges to those stocks are cyclical and structural,” BCA China Strategist Jing Sima said in a briefing last week about Chinese technology companies. “The business cycle hasn’t hit bottom and it’s likely to have a very choppy bottom with a resurgence in Covid cases and citywide lockdowns.”

Bargain-hunters can probably take their time as the volatility may persist for a while.

Write to Reshma Kapadia at [email protected]