U.S. delisting Chinese companies is 'inevitable': Carson Block

Muddy Waters Capital Founder and CIO Carson Block joins Yahoo Finance Live to discuss the crackdown on U.S.-listed Chinese companies.

Video transcript

- Well, we saw shares of Tencent bouncing back in Hong Kong trade overnight after the stock plummeted on fears of a regulatory crackdown in the gaming space, the gaming sector just the latest in the crosshairs of regulators over in China, and increasingly here in the US, as well. So what is the key risk here for US investors? For more on that, let's bring in Carson Block. He is Muddy Waters Capital founder and CIO.

And Carson, it's great to talk to you today. It feels like we have seen one crackdown after another over the last several weeks. Started with Didi. We talked about the tech companies, then the education sector, now the gaming sector. What do you think is the motive here? Connect the dots for me.

CARSON BLOCK: Sure. So let me preface everything by saying that, when it comes to reading the CCP tea leaves. I mean, who really knows. So I'm just giving you my best assessment. I think you have to look at this in-- really, you have two tracks here. So you have the industry by industry crackdown, whether it's on real estate, such as Evergrande and the leverage there, the cybersecurity with Didi [INAUDIBLE] or the education companies, and also Tencent, as well, gaming, but I think that what actually is more important is this thread that connects them all, which actually is an issue that goes back probably 11, 12 years.

And that is the issue, at least in the United States, with the fraud in the financials of Chinese companies, the US government's increasing demands to be able to inspect the auditors of these companies. And I think what we're seeing now, since most of these moves are against publicly traded companies, especially companies that are public in the US, I think that what this means is-- and understand, I'm reversing myself here. I always thought China would give at the 11th hour on auditor inspections. And the reason I thought that was because so many CCP officials have undisclosed stakes in these US-listed China companies.

So I figured that they would exhaust our political will and give on it, and we'd be able to inspect the auditors and nothing really would be accomplished. But I think Xi Jinping has decided not giving on the auditor inspection. And I think that's because, right now, he has to play to this domestic audience of not being bullied around by the US. And I think he's also assessed, then, that it is inevitable that the US will delist the US-listed Chinese companies, because if you look at this act that was signed into law in December of last year, it passed each house of Congress unanimously, and it requires the SEC to delist these companies.

So I think that, while you can see certain industry-by-industry moves here that are designed to improve things, I suppose, on the domestic front for Chinese citizens, the overall thread is I think Xi Jinping is saying, look, US-listed companies need to understand that they have to find an alternate way of accessing capital markets. Come back to the mainland, come to Hong Kong, but their days in the US are numbered. So that's my best interpretation of what's going on.

- So where does that leave US investors? I mean, it sounds like you're saying that the Chinese side isn't going to give. The US is going to continue to seek additional transparency from these US-listed Chinese companies, which isn't going to actually happen. What about those investors who put their money there?

CARSON BLOCK: Well, so the act that was signed into law, the Holding Foreign Companies Accountable Act, has a pretty long runway on it. I mean, clearly, Congress was not looking to-- this was a bit of a kid gloves approach. But what I think China is doing here-- and actually, this is an important point that I should have made a moment ago-- is by forcing-- by-- with Xi effectively forcing companies to relist or exit the US capital markets over time, if he can-- if Chinese companies get-- largely get out of the US before the mandate to delist kicks in, then it kind of looks to Xi's domestic audience like Chinese companies left the US out of strength, as opposed to being thrown out. So again, this is all, in my view, about playing to domestic politics.

So what is the timeline that Xi Jinping is really imposing here on companies to get out of the US? That's impossible to say. Again, the Holding Foreign Companies Accountable Act, I think it's a three-year runway. So for Xi, it's somewhere inside of that.

Now, some of these companies will be able to relist in Hong Kong and have active markets. And so if you're a US investor holding shares in a company that does that, you should be able to, as we say, funge your shares and trade them over there. But in my view, the Hong Kong market does not have the liquidity to support a wholesale relisting of these companies.

So I think your tier one US-listed China companies will be able to find reasonable markets over in Hong Kong, meaning some liquidity, et cetera. It won't be anything like the liquidity in the US. But your tier two and tier three companies are going to have problems.

Now, the interesting thing here-- and now, this is speculation on top of speculation, but that might mean that China will look to encourage-- and there is precedent for this sort of thing. If you look at these companies that were acquired in 2012 through 2014 with financing provided by state-owned banks, some complete zeros were taken private at real premiums with Chinese government financing, effectively. I think that maybe you can start to see some acquisitions over time of these tier two companies by the tier ones because they just-- there's not enough liquidity in HK.

So speculation on speculation, but there might be an interesting long side play. Not something I'll get involved with. But just putting it out there.

- Yeah, I mean, speculation on speculation, that's where our viewers' ears might perk up here in terms of what they should be doing maybe to play it. And you're talking about risks in some of the bigger guys versus some of the smaller guys. There's also the ETF way to play this, I suppose, if you really wanted to. Fundstrat was out with an interesting note kind of mentioning a potential inflection point on KWEB, kind of the China internet ETF here.

And when you do look at that, I mean, down 54% since March 31, the S&P 6% gain over that time period. I mean, when you're looking at this, obviously you're talking about speculation on speculation here, but it sounds like you're mentioning that there could be less risk to play the bigger guys here that have also been beaten down, but have also seen investors shed them, [INAUDIBLE] among them. I mean, what would your advice be to maybe an investor who does want to take the other side here and maybe jump in now?

CARSON BLOCK: Well, look, I mean, when you say less risk, I suppose it's all relative. I'm of the view and I have long been of the view that substantially all of these companies have problems with their financial statements to at least some extent. So if you look at it through my world view, you're talking about financials that are probably-- you know, have the issues, in many cases.

You're talking about this variable interest entity structure, VIE structure that, we didn't mention this earlier, but the PRC government is putting this up for review, as well. And that's the structure by which almost all of these companies that are listed in the US have gone public in the US. And it applies to, I think, pretty much every internet company. So there are questions around the legality there.

I do think that the end game is to relist these companies in Hong Kong or domestically in China, but that's also a risk right there. If you're thinking, on the US side, hey, I'm going to play this, I want to be able to funge my stock, if the relisting occurs on mainland, then you really have to figure out whether your broker is going to allow for that. So I do think that the government was-- the Chinese government was a bit shocked by the reaction to these moves in the markets, and they're trying to mellow it out. I think they want like a nice glide slope down, as opposed to this. My kind of quip was I think that too many CCP officials lost too much money too quickly when these things dropped.

But it's risky. I-- you know, of course I come from a viewpoint where I've long felt that these are toxic securities, so take what I'm saying with a grain of salt if you want to be on the long side, but I just feel like there are lots of embedded risks here. And there are a number of unknown risks, or unknowable risks, as well.

- Yeah. Well, I mean, let's shift from unknowable risks to maybe known risks, and one name that has been caught and kind of, I guess, shining a light on some of the known risks in the market. We're seeing shares of Robinhood pop quite a bit today. Halted for volatility, and a lot of that-- I mean, we saw kind of short sellers get a lot of flack here in the GameStop meltdown, and now you got Robinhood up 30% and halted well above its IPO price at 38 bucks. I mean, as a man who's played the short side of this, what do you think about the moves there, and what might be looking to do on a move like that?

CARSON BLOCK: Well, I mean, trying to decode moves like that or volatility like that is-- there's no fundamental way to look at that, right? Obviously, Robinhood exists-- its business model is based on payment for order flow. So is there a regulatory risk here? I mean, there is a risk that payment for order flow will be reined in in some way. I'd be surprised if it were eliminated.

The HFTs that provide the payments to Robinhood will tell you that, hey, we must improve price, and we do improve price. But the flip side of that argument is, well, do you improve price as much as you could, or are you making this nice little spread there? And look, it's a very difficult-- you know, I mean, now we're talking US politics, really, and it's a very difficult situation to foresee, especially because there's so little understanding of how this stuff actually works. I mean, it's a little disheartening-- it was a little disheartening watching these GameStop hearings and hearing various Congresspeople try to discuss what happened, and they clearly have no handle on how markets work.

So is there a chance that they go and do something bizarre? I mean, in the absence of people who really know what they're doing? Yeah, there's a chance. So again, I'm going to punt on this one and just say-- you know, state the obvious. Like, there are risks there with Robinhood, but I-- you know, I don't know if PFOF is the wave of the future or if that's something that's going to be reined in.

- Carson, finally, going back to the risk from the Chinese companies, it sounds like you're foreseeing here a potential decoupling, if that's the right word, of financial markets between the US and China. And ultimately, what does that mean for the capital markets here in the US? I mean, sure, there are significant risks involved with these companies, but you've still got dozens of Chinese companies that have come to market in the US this year. What does that ultimately mean for the US exchanges?

CARSON BLOCK: Well, we've heard the word decoupling used for several years with respect to the overall economic relationship between China and the US. And to be clear, it's impossible to completely decouple. So it's degrees of disengagement. I've been making the point for a few years that the capital markets were really the only high ground that had been left unscathed by this broader trade-- trade war or these-- you know, these broader issues, economic, political issues between the two governments. Well, that's no longer the case. It's no longer high ground.

So I think that from the Wall Street perspective, the perspective of the banks and asset managers, they-- they're not liking this because they want to continue to sell the dream to US investors and make the fees associated with that. I do personally think it's healthy if less US retail money and pension money gets-- is put into these things. But on the other hand, capital is mobile. And at least at the institutional level, if there are fewer US-listed China stocks, then large fund managers will beef up their Hong Kong offices and Shanghai offices some more, and they'll be trading from there.

So I don't think this will really scale back the availability of China-based financial products for US investors much. It'll irritate the banks, and the banks tend to get outcompeted in Hong Kong often by local banks, and there's real fee compression there. So for banks who make a lot of money on the IPOs and secondaries of these China names in the US, probably the halcyon days are over.