By Connie M. Friesen | Harvard Kennedy School

This article appears in its entirety in the July-August release of The Banking Law Journal from LexisNexis A.S. Pratt. The Journal is available for purchase on the LexisNexis Store.  

U.S./China Financial Relations

Against the backdrop of heightened tensions between China and the United States that is accompanying the Ukraine war, this article considers practical measures that the United States might take to manage the inbound investment activities of certain Chinese financial institutions in the United States more effectively.

It also explores steps that might be taken by U.S. policy makers and regulators to manage outbound investments by U.S. entities and individuals in Chinese financial institutions and securities, including several policy suggestions.

First, regulators need to broaden the concept of national treatment to include a full review of state ownership and political party influence.

Second, U.S. policy makers and regulators should require appropriate disclosure to investors of the risks presented by direct investments in Chinese financial institutions such as asset managers.

Third, the widespread use of variable interest entities and measures to ensure state and CCP influence within Chinese companies merit a more active U.S. government role to protect U.S. investors and markets.

Fourth, resolution of issues related to potential large-scale delisting of Chinese companies from U.S. exchanges should be pursued through continued active discourse between U.S. and Chinese regulatory agencies.

The Ukraine Invasion

The invasion of Ukraine has focused world attention on the high stakes of “weaponized” cross-border economic measures such as sanctions, embargoes and export controls. The threatened use of secondary sanctions has complicated China’s response to the war. Chinese President Xi Jinping has been attempting to uphold principles of state sovereignty and neutrality while supporting China’s strategic relationship with Russia and seeking to avoid irreparable damage to China’s relations with the European Union and the United States. In the first days after the Russian invasion, China adhered to the Russian script of citing Russian security interests and blaming NATO for provoking a crisis.

Then, for a time, China’s strategy emphasized neutrality and a need for diplomatic resolution of the crisis. Subsequently, China seemed determined to support Russia regardless of the consequences. However, despite its shifting diplomatic messaging, China seems to be avoiding actions that would constitute overt noncompliance with Western sanctions or that would directly provoke the imposition of comprehensive secondary sanctions. One reason for China’s caution is that its payments messaging system, the China International Payments System (“CIPS”), is not yet a realistic substitute for the Society for Worldwide Interbank Communications (“SWIFT”) system.

The renminbi is not yet ready to challenge the dollar.

In other words, China is not yet prepared for the economic shock that might be unleashed by secondary sanctions. This presents an opportunity for the United States to employ discrete, pragmatic steps to manage its overall economic relationship with China more effectively. Such steps will not change China’s view that it is “on the right side of history” in supporting Russia, but they may facilitate continued helpful U.S.-China dialogue on cross-border investments and support the role of the U.S. dollar and SWIFT in enabling them. In taking steps based on a strategy of pragmatic containment, the United States also needs to recognize that, just as a policy-driven fear of secondary sanctions stemming from the Ukraine war may temper Chinese attempts to challenge the U.S. dollar and SWIFT, policy-motivated objectives inform China’s approach to managing its inbound and outbound investments with the United States.

Against the backdrop of heightened tensions between China and the United States that is accompanying the Ukraine war, this article explores practical measures that the United States might take to manage the inbound investment activities of certain Chinese financial institutions in the United States more effectively. It also explores practical steps that might be taken by U.S. policymakers and regulators to manage outbound investments by U.S. entities and individuals in Chinese financial institutions and securities. Assuming that the United States will not need to apply comprehensive secondary sanctions against China, such pragmatic measures should serve the United States well in the aftermath of the Ukraine war.

However, if circumstances change in a manner that makes application of comprehensive secondary sanctions inevitable, such measures would need to be adjusted to meet the challenge of hostile competition between the United States and China. Such adjustments would be painful.

Chinese Banks in the United States

Chinese banks have invested in the United States for many years. Each of the major Chinese commercial banks conducts its U.S. operations under a U.S. regulatory regime premised on “national treatment and equality of competitive opportunity” (“national treatment”).

As implemented by U.S. banking regulators, national treatment assumes that the objectives of foreign banking organizations (“FBOs”) will primarily be to conduct commercial banking activities in the United States. The current U.S. bank regulatory concept of national treatment does not explicitly evaluate the consequences of state ownership or the mandate of certain state-owned banks, such as those in China, to support government and dominant political party strategic and economic objectives.

A failure to acknowledge and evaluate publicly the policy mandates of these banks means that U.S. regulators may miss important opportunities to engage them (and indirectly their Chinese regulators) in pragmatic discussions about such important policy matters as U.S. dollar clearing, internationalization of the renminbi, extra territorial jurisdiction and access to documents, use of the SWIFT international payments messaging system and anti-money laundering (“AML”) and sanctions issues.

A revised national treatment paradigm that explicitly addresses how state ownership and dominant political party influence might affect the strategic and business objectives, management and operations of an FBO may result in challenges for U.S. regulators and policy makers. However, it also suggests a way to achieve more effective regulation and opens a pathway for more constructive dialogue on resolution of practical issues. While their current economic footprint is small, the U.S. operations of Chinese commercial banks present one of the few opportunities for direct, ongoing interactions between Chinese enterprises and U.S. regulators that take place on U.S. territory.

This opportunity for dialogue is increasingly difficult to replicate as China and the United States pursue divergent strategies. Chinese nonbank financial institutions (“NBFIs”) such as Ant Financial Services Group, Ltd (“Ant Financial”) have also made significant investments in U.S. business operations. Because they are not “banks,” they face a U.S. regulatory regime based on a broader concept of national treatment as interpreted by state regulatory agencies and the federal Committee on Foreign Investment in the United States (“CFIUS”). Lessons from this approach might be applied more generally to Chinese commercial banks.

Chinese Regulatory Changes

Chinese regulatory changes that commenced in 2018 have dramatically increased opportunities for U.S. investment in specific Chinese financial sectors, such as asset management. U.S. asset managers have been quick to take advantage of the current favorable environment. In addition, individual U.S. investors have increasingly invested in Chinese securities. In contrast to this enthusiasm for investment in China, a countervailing regulatory theme that contemplates potential delisting of Chinese securities from U.S. securities exchanges threatens to undermine the global importance of U.S. securities markets.

These developments present a number of issues for U.S. policy makers and regulators. First, it is possible that the Chinese leadership may favor “opening up” in order to allow Chinese financial and capital markets to benefit from the expertise of U.S. asset management firms to jump start the asset management business in China. It is possible that once significant transfer of knowledge about the asset management business has taken place, the Chinese authorities might find it appropriate to determine that the U.S.-owned firms are engaged in activities that require intervention by the Chinese state. Such intervention might have adverse consequences not only for the China-based U.S.-owned asset manager, but also for numerous U.S. investors in these firms. It could also result in substantial disruptions to U.S. securities markets.

Additionally, even if the Chinese authorities take a more circumspect approach, U.S. fund managers could find it difficult to conduct a China-based business over the longer term. For example, the CCP committees that are active within Chinese commercial banks might obtain access to highly sensitive commercial information because of the role played by these banks in introducing customers. Further, there is a possibility that, unless appropriate safeguards can be put in place, the CCP might seek to influence the day-to-day operations of China-based fund managers in a manner that would adversely affect U.S. interests.

There are also issues with the variable interest entity (“VIE”) structure that seems to be the norm for individual portfolio investments by foreigners in Chinese companies. VIEs may leave U.S. investors without recourse in the event of market problems or political changes because such investors lack a specific, enforceable ownership interest in the underlying Chinese operating company. Another risk is that, because of the complicated structure of many Chinese companies and the many avenues of CCP and state influence, foreign capital invested in Chinese companies may inadvertently fund Chinese government and CCP objectives that are adverse to U.S. interests.

Finally, in the wake of U.S. insistence that Chinese companies (and their auditors) wishing to list their securities on U.S. exchanges must meet certain U.S. accounting standards, some Chinese companies have taken steps to list on non-U.S. exchanges and potentially to “delist” their securities from U.S. exchanges. Such steps might undermine the global importance of U.S. securities markets. Policy Suggestions. Within a framework of pragmatic containment, there are a number of practical steps that could be taken to address these issues. First, regulators need to broaden the concept of national treatment to include a full review of state ownership and dominant political party influence. Second, U.S. policy makers and regulators should require appropriate disclosure to investors of the risks presented by direct investments in Chinese financial institutions such as asset managers.

Third, while portfolio investments by individual investors in foreign companies have traditionally not been subject to U.S. government oversight, the widespread use of VIEs as well as measures to ensure state and CCP influence within Chinese companies may merit a more active U.S. government role to protect U.S. investors and markets. Fourth, resolution of issues related to potential large-scale delisting of Chinese companies from U.S. exchanges should be pursued through continued active discourse between regulatory agencies such as the Securities and Exchange Commission (“SEC”) and China Securities Regulatory Commission (“CSRC”).

The Ukraine war has changed the world.

The threat of nuclear war has made it necessary for the United States to weaponize sanctions against Russia as deterrent measures. In managing its economic relationship with China, the United States should pursue a carefully implemented policy of pragmatic containment. Assuming that the need to deploy comprehensive secondary sanctions against China can be avoided, such a policy should provide a prudent pathway towards better U.S.-China economic relations in the future.

The commentary in this blog is a portion of the full article. Read Rethinking U.S. Policy on Engagement with Chinese Financial Institutions in its entirety in the July-August 2022 release of The Banking Law Journal from LexisNexis A.S. Pratt.

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Connie M. Friesen is a Senior Fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School. Friesen, who previously was a partner in the banking and financial services group at Sidley Austin LLP.