China’s Return To U.S. Bond Market Exposes Lack of Security-Minded Diligence
China’s Ministry of Finance is preparing a $2 billion sale of dollar-denominated bonds, with prime investment banks, such as Morgan Stanley and Goldman Sachs, competing to manage the offering. It will be China’s first such sovereign bond offering on the U.S. bond market since 2004, when it raised $1.7 billion from a combined sale of dollar and euro bonds. The move comes amidst a tightening of both formal and informal capital controls in China, leading many analysts to surmise that the Ministry of Finance is arranging the sale to rebuild damaged credibility with international investors. This may well be the case, but it is also an effort to mitigate a worsening in the bilateral relationship in the run-up to the all-important 19th Communist Party Congress in mid-October.
In recent months there has been increasing alarm over the national security and economic security implications of Chinese investment in the United States and Europe. Secretary of Defense James Mattis is among the high-profile voices that have called for an expanded and strengthened mandate for the Committee on Foreign Investment in the United States (CFIUS), a Treasury Department-led interagency group dedicated to security-minded screening of inbound foreign direct investment (FDI). CFIUS, for example, recently denied approval for the takeover of Oregon-based Lattice Semiconductor by a Beijing-linked private equity fund called Canyon Bridge Capital. Regrettably, this positive new awareness of security-related risks does not apply to China’s deepening penetration of the U.S. debt and equity markets.
When considering the upcoming Chinese sovereign bond issuance in the American market, it is important to remember what the essence of a bond offering constitutes. Beijing gives the bond purchaser a piece of paper with an IOU on it along with a repayment date and interest rate, and the purchaser gives the government of China (directly) billions of dollars in cash for its discretionary use. There are no restrictions or underlying purposes for the loan, like a project or trade transaction, just cash. What might that discretionary cash be used for? Perhaps accelerating the Chinese government’s illegal island-building (and militarization of same) in the South China Sea or the continued underwriting the North Korean regime and all that it implies.
We can reasonably expect that this $2 billion-plus Chinese sovereign bond will be sold on the secondary markets of the U.S. to pension funds, mutual funds, Exchange-Traded Funds and other institutional investors who are, in turn, funded by millions of unwitting average Americans. Beijing thereby recruits a sizeable portion of the U.S. working population as investors with a vested financial interest in ensuring that China is not subject to serious U.S. sanctions or penalties in the future that could damage the value of their retirement and other portfolios. It is also an odd time to be rewarding Beijing with this windfall opportunity when the Chinese government is primarily responsible for enabling an existential North Korean nuclear threat to the American homeland, which could lead to considerable controversy.
It will be instructive to determine whether or not the risk section of the prospectus associated with this bond offering will make any reference to Chinese government misdeeds (e.g. officially-sponsored hacking and cyber theft, espionage, technology theft, human rights abuses, environmental degradation, etc.) or the fact that China (through the successor government doctrine) remains in default on now-billions of dollars in sovereign bond obligations to average Americans originally dating back before World War II, which Beijing refuses to settle. In SEC parlance, these should be viewed as “material risks” that an investor should understand before making a purchase decision. Will such risks be outlined in the prospectus? If history is any guide, almost certainly not. It is, therefore, worth looking out for the possibility of a class-action law suit against China and its lead investment banks for what are termed by the SEC “material omissions” which are legally actionable.