A logistical nightmare?

In response to Nancy Pelosi’s visit to Taiwan last month, the House Speaker and her immediate family members went straight onto a Beijing blacklist that blocks business activity with Chinese companies.

The retaliation went beyond targeting Pelosi herself: Beijing announced eight further measures that curtail cooperation with Washington in a number of areas. One way of looking at the sanctions – which are supposed to bring “real and lasting pain” as China’s state-run media put it – is that they will harm Washington’s interests more than that of Beijing.

Suspending dialogue on climate change, for example, will hamper Joe Biden’s election pledge to lead the international effort at tackling global warming.

Beijing’s cancellation of cooperation on drug control policy was significant too: it was also high on Washington’s priority list during recent trade talks as American officials urged China to crack down on opioids such as fentanyl produced in China and sold illicitly in the US causing crime and social harm.

By the same token, the areas of ‘dialogue’ that have been left unrestricted also speak to China’s main areas of concern, or at least where it wants to make progress in discussion with the Americans. Negotiations between the two teams of trade representatives to lift tariffs imposed by Trump on Chinese imports have not been stopped, for instance. Nor has the interaction between the two governments on the joint effort to contain Covid-19 or discussions over a range of imminent diplomatic engagements, including preparations for a potential in-person summit between Biden and Chinese President Xi Jinping on the sidelines of the G20 gathering in Indonesia in November (though it remains unconfirmed whether Xi will attend in person).

Yet given the extent of the bad feeling generated by Pelosi’s trip to Taiwan and the Chinese reaction to it, observers were pleasantly surprised last week when it was revealed that the Chinese were willing to move forward in the longrunning row over audit oversight of China’s 200 or so firms listed in the US.

On August 26, both governments announced that the China Securities Regulatory Commission (CSRC) and the Ministry of Finance had signed an agreement with the US Public Company Accounting Oversight Board (PCAOB).

The American regulator described the deal as “a statement of protocol” and “the first step” taken by the Chinese towards allowing open access for the PCAOB to inspect and investigate public accounting firms headquartered in China and Hong Kong in accordance with US laws.

The agreement includes provisions for the PCAOB to initiate investigations into potential violations of American audit rules without consultation of Chinese authorities. It also allows the inspectors to view audit work papers and retain the information if required, as well as take testimony from personnel associated with areas of dispute.

The “real test” ahead, as the PCAOB has put it, will come next month as American inspectors begin on-site inspections of firms headquartered in China, including Hong Kong.

“Whether the PCAOB can make a determination that China is no longer obstructing access depends on whether China abides by this agreement and allows for full and timely access to information,” the PCAOB warned.

The new agreement seems to indicate that the Chinese have given the most ground in a bid to reach a compromise – perhaps because of reluctance to countenance a wave of forced delistings from American bourses. US lawmakers passed legislation two years ago that threatens to expel hundreds of Chinese firms (many of which are known locally as ‘China concept stocks’) unless they complied with PCAOB rules.

Still, the CSRC said the agreement was in line with common practice in global capital markets and that the cooperation with US regulators will help to improve audit quality and protect investors. Moreover, the Chinese government has emphasised the reciprocal nature of the agreement, which is binding on both sides. The message is that the Chinese government is entitled to inspect relevant audit firms in the American jurisdiction too.

As events have played out, the Chinese government still seems to be trying to ringfence certain companies – especially the largest of the state-owned heavyweights – from the PCAOB’s long-arm jurisdiction. But the deal could soon become a major headache for the auditing firms, especially for their compliance officers, who are now required to manage relationships with regulators from both countries.

Nevertheless, the news has been largely welcomed by anxious investors. Just a week ago few expected such a breakthrough, after five state-controlled heavyweights including China Life, PetroChina and Chalco all said they would be voluntarily delisting from New York. Internet giant Alibaba also seemed to be preparing for the worst as it applied earlier this month to the Hong Kong Stock Exchange to upgrade its locally-listed shares to a “primary listing” from their current secondary status.

Already this week there was speculation that internet giant Alibaba and Yum China (the operator of popular restaurant franchises such as KFC) have been chosen as two of the first group of companies likely to get a visit from the PCAOB’s audit inspectors when the officials arrive in Hong Kong in a couple of weeks.

Of course, many commentators have needed convincing that last Friday’s audit deal isn’t going to unravel as the two sides try to make it work in practice. “My advice is don’t count the chickens before they hatch. This is a positive development. However, the devil is in the details,” cautioned Clement Chan, head of assurance at accounting firm BDO in Hong Kong, to the Financial Times.

Yet two months ago some analysts had been assigning a 95% probability that the ‘China concept stocks’ would be delisted in the US, the newspaper acknowledged. Last Friday’s deal had reduced that risk to a 50% chance, by Goldman Sachs’ estimation.

In fact, following a seven-hour meeting in Rome between China’s top diplomat Yang Jiechi and US National Security Advisor Jake Sullivan in March, China’s powerful regulator Financial Stability and Development Committee (FSDC) had published a statement signalling new willingness to cooperate on arrangements that boost market stability.

“The Chinese and the US regulatory bodies have maintained good communication and made positive progress,” it noted, adding that the Chinese government would continue to support Chinese firms seeking listings in overseas markets.

However, last week’s announcement also raises as many questions as it answers, especially in respect to process. Here’s a few queries that still need to be resolved. How many of the 200 Chinese companies in question will the PCAOB vet? Would a random sample of 10 firms (along with their various auditors) suffice? What about the human resources element: how many PCAOB staff will be sent to Hong Kong and for how long? How many people at the PCAOB are fluent in Mandarin and conversant in the language’s fast-changing financial and technical jargon? Will they be able to pore over local documents and cross-examine the Chinese auditors? And how adept will the PCAOB accountants prove at understanding the differences between Chinese and US business practices (these differences often reflect divergent cultural approaches to doing business and not necessarily wrongdoing)?

Another obvious question is how the new process is going to be funded. Will it trigger a ramped-up budget for the PCAOB, for instance, which may need to set up a permanent office in Hong Kong to monitor the 200-plus Chinese firms on an ongoing basis? Some estimate this would require at least 50 staff, presumably all transferred from the US.

All of the questions above point to the procedural and logistical challenges ahead, particularly as lots of sensitive documents will need transferring from the mainland to Hong Kong. And beyond that, there is the scope for deeper disagreement over how the audit information is interpreted. In short: expect plenty of road bumps ahead as the PCAOB begins the process of scrutinising the figures.

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