First inspections completed by PCAOB

It's possible that the news about China's drastic change in their "zero Covid" policy was too much for the stock market to absorb. It may also have been overshadowed by the Federal Reserve's decision to increase interest rates by 0.5%. Or, it could be that the stock market adage of "buy when they whisper, sell when they shout" was in effect.

No matter the cause, the investor response was quite different from the one you would anticipate from a US statement that was very positive of the first inspections carried out under the information-sharing accord between the United States and Chinese securities regulators. The announcement reads, " FACT SHEET: PCAOB Secures Complete Access to Inspect, Investigate Chinese Firms for First Time in History."

Thus, investors should have been elated that the stalemate between the US and China might not lead to the compulsory delisting of more than 200 Chinese stocks traded in the US. But unfortunately, the opposite happened, and most of the Chinese stocks and related funds listed in the US ended the day with lowered share prices.

On Thursday, the iShares MSCI China ETF (MCHI.US) dropped by 2.2% in response to the favorable evaluation conducted by the inspection wing of the US Securities and Exchange Commission, the Public Company Accounting Oversight Board (PCAOB).

This appears to lend weight to the idea that people buy stocks when there are rumors about them but sell them when the news is made public. For example, the MSCI China ETF has increased by 30% since late October, when it hit its yearly low. This was around the same time that reports began to circulate that the PCAOB had concluded their trial inspections ahead of schedule and were heading back to the US. Their team of 30-plus inspectors had been in Hong Kong working with the China Securities Regulatory Commission (CSRC).

We must look back at the historical context to better understand the current situation. This particular matter traces back to 2000 when the first Chinese businesses started to be listed in the United States. Unfortunately, most of them were unprofitable private firms that weren't allowed to list in China.

However, the SEC soon realized that it could not check the auditors in China because of the limitations imposed by the Chinese government. As a result, the SEC and the Chinese regulators came to an understanding once in 2013 and once in 2016 to tackle this issue. Eventually, the SEC gave up as it was not receiving the data it asked for.

In late 2020, due to the lack of advancement, the US implemented the Holding Foreign Companies Accountable Act (HFCAA), which gave China three years to provide the SEC with access. If China cannot do that, more than 200 Chinese businesses listed on the US stock exchange may be delisted.

In August of this year, both parties finally came to a consensus, and the PCAOB sent a group to Hong Kong to test the conditions of the arrangement. When the agreement was sealed, the SEC declared that it would issue an update in December to gauge whether they achieved the desired results.

This announcement refers to the PCAOB's involvement in the audits with the CSRC in Hong Kong from September to November. The statement was very complimentary about the collaboration during that period. However, it also included some warnings, mirroring the long-standing American distrust caused by the breakdown of the two previous agreements.

The PCAOB Chair, Erica Williams, declared that the organization had secured total access to audit and looked into registered public accounting firms in China and Hong Kong for the first time ever.

The announcement and its related fact sheet have some highlights that had not been made known before about the examination. A body of over 30 PCAOB examiners concentrated on two auditors during their journey, KPMG's Chinese affiliate KPMG Huazhen LLP in Mainland China and PricewaterhouseCoopers in Hong Kong. It was indicated that the team analyzed eight "engagements" involving those two auditors and stated that neither the CSRC nor the auditors had been warned previously that they would be the targets.

The PCAOB highlighted that the US and China began collaborating as early as April this year before the official agreement was made in August. It noted that this cooperation came following the PCAOB's initiation of investigations into three entities, two Chinese and one from Hong Kong, in March. It added that it started sending out requests about these investigations sometime around then, with the CSRC supplying the requested access as early as April.

The PCAOB identified many potential issues in its most recent inspections, which is an expected outcome for initial inspections globally. Lastly, the organization declared that China is currently honoring the covenant, but if the Chinese regulator does not remain cooperative in the foreseeable future, the PCAOB might alter its assessment.

Investors in Hong Kong responded positively to the agreement, causing the Hang Seng China Enterprises Index to rise at the beginning of the day on Friday. However, at the same time, the Hang Seng Index showed a different trend. It appears the possibility of Chinese companies being delisted from US exchanges is disappearing, which could lead to a surge in new listings in the coming year after a period of no significant initial public offerings.

The newly released report is expected to prolong the current upsurge of Chinese stocks in the US market. The iShares MSCI China ETF consists of stocks whose value-to-earnings ratio is 11, and the price-to-sales ratio is 1.1, which is comparatively lower than the 18 and 3 ratios for the SPDR S&P 500 ETF Trust, indicating that the Chinese stocks are currently trading at a discounted rate when compared to their American counterparts.