China revises delisting rule. But investors may want to sell on the rally.

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The likelihood of a mass delisting of Chinese stocks like Alibaba may have diminished with revised rules from Chinese regulators.

Greg Baker/AFP via Getty Images

The likelihood of a massive redemption of Chinese stocks like


Alibaba Holding Group

(BABA),


NetEase

(NTES),


Baidu

(BIDU) of US 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 Gold Dragon

(PGJ) exchange-traded fund (PGJ), filled with U.S.-listed stocks, jumped 7% to $32.44 on Monday while the


iShares MSCI China

The ETF (MCHI) rose nearly 3% to $56.36. But investors may not want to pounce on the latest rally and perhaps even lighten 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 access to audit documents. Previously, regulators had not allowed the United States full access to Chinese companies’ audit working papers. It’s the issue at the center of the Foreign Company Liability Act that has sparked a process of delisting Chinese companies unless they comply with US audit disclosures for three consecutive years, by 2024.

Removing a key phrase that on-site inspections must be “dominated” by Chinese regulators was the “first concrete public step” China has taken to improve the chances of some kind of resolution to maintain the Chinese companies in compliance, according to a client note from Bernstein analyst Robin Zhu.

Of note, he said, Chinese regulators have acknowledged that documents and material provided in audit disclosures “rarely contain state secrets and sensitive information.” according to Zhu.

Also positive: The decision not only came from securities regulators, but also from China’s Ministry of Finance and the State Secrets Administration, said Brendan Ahern, Chief Investment Officer of KraneShares. “The likelihood of a write-off is decreasing, but it’s not being removed,” he says.

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

Here’s one reason the rule change might not be enough: US regulators have stressed they’re looking for full compliance or no deal. The Public Company Accounting Oversight Board (PCAOB) said in a statement last week that it continues to engage with Chinese authorities, but that its demand for full access to relevant audit documentation, even for companies in the sensitive sectors, is not negotiable.

And China’s rule change fails to meet that basic US demand. It still requires Chinese companies to get approval from regulators before sharing any audit material, and it also requires approval for the transfer of any material that could “leak state secrets or harm the state and to the public interest,” writes Thomas Gatley, principal analyst at Gavekal. Dragonomics, in a note to customers. The most likely outcome, Gatley adds, will be that most Chinese companies will eventually be delisted from US stock exchanges.

The United States has never seen the kind of mass delisting that could follow if no deal is struck, which is why some analysts believe some sort of workaround could still be found. This could include companies holding sensitive information, such as public companies such as


PetroChina

(PTR), or even some Internet companies given China’s data security concerns, voluntary delisting. More and more Chinese companies are still likely to seek secondary listings in Hong Kong, some like


Li-Auto

(LI) and


Xpeng

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

And these changes, regardless of what happens with regulators, will bring their own changes as more and more investors opt for local equities. The MSCI China index, for example, traded the ADRs of


Ali Baba
,


JD.com

(JD) and


NetEase

last year for these companies’ listings in Hong Kong.

MSCI’s rebalancing in June could see more such swaps for companies that have had their secondary listing in Hong Kong for some time and meet certain liquidity conditions, including


Baidu
,

and eventually


bilibili

(BILI). “For the big global US asset managers, they’re just going to be cautious because the risk is still there,” Ahern says.

The biggest question for investors is whether Chinese internet stocks like Alibaba, which are trading at two standard deviations below five-year historical valuations, are worth trading, especially after multiple assurances from Chinese officials earlier this month aimed to calm the markets.

But the risk of radiation is only part of the short-term challenges. China’s tough Covid restrictions have 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 attempts to remain neutral in the war in Ukraine adds another level of uncertainty. The Biden administration continues to shape its China policy, and a Chinese bill is pending in Congress that could shake investor sentiment toward Chinese stocks.

“We view these rallies as good sells and not good buying opportunities, as we believe the challenges for these stocks are cyclical and structural,” BCA China strategist Jing Sima said during a briefing. a briefing last week on Chinese tech companies. “The economic cycle hasn’t bottomed out and is likely to have a very choppy bottom with a resurgence in Covid cases and city-wide shutdowns.”

Bargain hunters can probably take their time as volatility can linger for a while.

Write to Reshma Kapadia at [email protected]

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