Questions remain as countdown begins on depositary receipts with Chinese characteristics
As the clock starts ticking down on the July debut of Xiaomi’s Chinese depositary receipts (CDRs) on the Shanghai Stock Exchange, a raft of questions remain unanswered on some of the most basic aspects of how the new financial instrument would function.
The ability of CDRs to be converted into their underlying stocks; the channels by which retail investors can trade them; the choice of the bourses for hosting them; down to the accounting treatment to reconcile global accounting standards with Chinese rules; and contradictory governance regulations - are all adding up to make Xiaomi’s debut a closely watched case study in the evolution of China’s financial system.
The stakes are high. Poised to celebrate four decades of taking China’s communist system of governance down the road of capitalist market reforms, the government is keen to showcase CDRs as a way for the country’s investors to partake in their largest - and most highly valued - corporate successes.
“The CDR pilot programme is introduced to make China’s financial system more inclusive and competitive, to make preparations and explore new measure for more systematic changes in China,” said Li Chao, vice-chairman of the China Securities Regulatory Commission, during a June 10 forum in Shenzhen.
At least another five Chinese technology companies are in the queue to raise a combined US$60 billion through CDRs, according to an Goldman Sachs estimate.
The first question concerns the fungibility of the depositary receipts. CDRs are based on the American Depositary Receipts (ADRs), first sold in the late 1920s for non-US domiciled companies to raise funds onshore. ADRs including those sold by Baidu, NetEase or this newspaper’s parent Alibaba Group Holdings, can be converted into their underlying stocks.
The ability of CDRs to be interchangeable with the stocks of New York-listed Baidu, or Hong Kong-listed Xiaomi, is still under question, because of China’s capital controls that prevent yuan-denominated assets from being converted into hard currency.
Sources close to China’s State Administration of Foreign Exchange (SAFE), the currency watchdog agency, said the chance for free conversion of CDRs is almost zero, because the interchangeability would break China’s capital control.
“Even if CDRs could be legally interchangeable with the basic securities issued, there will be a quota or strict restrictions for conversion” to deter capital flight, Guosen Securities said in a report last week.
It might as well be called a depositary receipt with Chinese characteristics, as any restriction on its convertibility would make it “pointless” as a receipt, making it more like a secondary listing, said Ba Shusong, chief economist of the Hong Kong Exchanges and Clearing (HKEX), during a forum.
“Without fungibility, it cannot be called a depositary receipt,” he said.
More important than the definition is the pace of issuance, and the liquidity available in China’s US$8.5 trillion capital market to absorb the CDRs.
Six of China’s largest tech companies - Alibaba, Tencent, Xiaomi, JD.com, NetEase, Baidu - could raise US$60 billion between them through the issuance of CDRs, Goldman Sachs said, assuming each company would raise the equivalent of 5 per cent of its market value.
Add the fundraising plans of China’s164 unicorns - tech companies valued at more than US$1 billion, including Didi Chuxing - as much as US$700 billion could be drained from the markets, the report said.
They also noted red chips, “unicorns”, and unlisted “new economy” companies, representing the new growth engine like artificial intelligence, may form an aggregate market capitalisation of US$7 trillion in a “blue-sky scenario.”
To absorb the impending listings, China’s regulator approved in record time the establishment of six mutual funds, dubbed the unicorn funds, and authorised them to invest in these depositary receipts for at least three years to stabilise the market. With a total 300 billion yuan (US$15 billion), their combined financial war chest is larger than the funds raised in the entire A-share market last year.
And there is more. US-listed and Hong Kong-traded stocks and depositary receipts operate under different accounting standards that must be reconciled with mainland Chinese companies. The CSRC and China’s finance ministry are yet to rule on how the different sets of figures can be comparable.
China’s retail investors had been pulling their capital out of the stock market, whether in flight or in preparation for the impending blockbuster CDRs. The Shanghai Composite Index, the benchmark gauge on the larger of two Chinese stock exchanges, fell for the third day on Friday to a year low of 3,037.9.
“The logic of China’s A-share market operates on the principle of who the next fool is,” said Gao Xiqing, the former chief investment officer of China’s sovereign wealth fund, known as the country’s “godfather of capital markets” for his role as a former regulatory vice-chairman speaking with the South China Morning Post during the Caixin conference in Hong Kong. “As long as the crowd of fools is large enough, they would not care much about the clarity or fairness of the rules.”
