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1 “SEC Requests Information and Comment on Advisers Act Regulatory Status of Index Providers, Model Portfolio Providers, and Pricing Services,” U.S. Securities and Exchange Commission, June 15, 2022, https://www.sec.gov/news/pressrelease/ 2022-109.
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U.S. Economic and Financial Statecraft in Recent Years
The concept of economic statecraft just isn’t recent. President Roosevelt formed the now-defunct U.S. Board of Economic Warfare in 1941 to coordinate international economic and defense policy, characterizing the agency’s scope as “of commerce and shipping, of barter and buying, of loans and agreements, of blacklist and blockade … It means fighting the tank before it’s a tank, smashing the submarine before it might go to sea. It means stopping the Axis from getting raw materials. It means getting raw materials for our production.”2
And yet the national security community today, with its predilection for conventional armed forces, has been at times reticent to acknowledge the international economic system as a warfighting domain and industrial actors as potential adversaries. Classic economic sanctions and export controls are par for the course, however the Pentagon doesn’t wish to encroach on what it considers to be Wall Street’s territory. Bankers and financiers are bored with the “politicization” of personal markets, and don’t feel compelled by “non-material” U.S. foreign policy objectives to contradict their profit-seeking, fiduciary responsibilities.3
In December 2017, the Trump Administration released its National Security Strategy and declared, “economic security is national security.” The document called for the usage of “economic expertise, markets, and resources” to bolster ties with allies while applying economic and financial pressure on adversaries. It indicated a significant give attention to the economy as a pillar of national security, representing a policy shift towards integrating economic and security policy so as to counter foreign economic aggression in a broader strategic context.4
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2 Tor Egil Forland, “‘Economic Warfare’ and ‘Strategic Goods’: A Conceptual Framework for Analyzing COCOM,” Journal of Peace Research, vol. 28, no. 2, 1991, http://www.jstor.org/stable/424388.
3 The previous chief investment officer of the Employees Retirement System of Texas (ERS) gave an interview where was asked in regards to the “weaponization of policy” by which the U.S. government is stopping pension funds from allocating funds to certain Chinese securities. His response: “I believe there are two complications at any time when governments become involved in dictating on where, how [and] while you get to speculate … At any time when governments become involved it muddies the water.” Iain Bell, “Exclusive Interview with Tom Tull: Be Proactive, but Don’t Feel Pressure to Invest,” Markets Group, October 18, 2022, https://www.marketsgroup.org/news/Exclusive-Tom-Tull.
4 “National Security Strategy of the USA of America,” The White House, December 2017, https://history.defense.gov/Portals/70/Documents/nss/NSS2017.pdf?ver=CnFwURrw09pJ0q5EogFpwg%3d%3d.
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The Biden Administration has carried forward this spirit of great power competition. The brand new National Security Strategy released in October 2022 envisions a strategic competition toolkit incorporating each industrial strategy and economic statecraft, and seeks to galvanize private industry to “protect our core economic and national security interests.”5 Earlier within the 12 months, the USA responded to Russia’s invasion of Ukraine with a sweeping range of economic sanctions, financial restrictions, and export controls intended to isolate Russia from the world economy and legit economic system. The sanctions, imposed in coordination with several U.S. allies and partners, have been characterised in government statements as unprecedented in scope, scale, and speed.6,7
U.S. Investor Response to Russia: Sanctions and Divestment Efforts
Following Russia’s invasion of Ukraine in February 2022, the U.S. government enacted a set of sanctions targeting key sectors of the Russian economy so as to degrade the Russian military’s warfighting capabilities. The sanctions packages have included measures to focus on Russian military production and provide chains, an Executive Order prohibiting all U.S. investment in Russia, and restrictions on Russia’s ability to take part in the worldwide economic system.
Outside of Russia, third party countries resembling China have been targeted by U.S. sanctions authorities for providing support to Russia’s military. In June 2022, the U.S. Department of Commerce’s Bureau of Industry and Security (BIS) added five Chinese firms to the Entity List for providing unspecified support to Russia’s military and/or defense industrial base.8,9 The U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) has also issued guidance indicating willingness to implement its Russia sanctions programs with secondary sanctions, and has subsequently designated a Chinese entity for providing “financial, material, or technology support” for a Russian defense procurement firm.10
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5 “National Security Strategy,” The White House, October 2022, https://www.whitehouse.gov/wpcontent/ uploads/2022/10/Biden-Harris-Administrations-National-Security-Strategy-10.2022.pdf.
6 “FACT SHEET: United States and Allies and Partners Impose Additional Costs on Russia,” The White House, March 24, 2022, https://www.whitehouse.gov/briefing-room/statements-releases/2022/03/24/fact-sheet-united-states-and-allies-andpartnersimpose-additional-costs-on-russia/.
7 “U.S. Treasury Declares Unprecedented & Expansive Sanctions Against Russia, Imposing Swift and Severe Economic Costs,” U.S. Department of the Treasury, February 24, 2022, https://home.treasury.gov/news/press-releases/jy0608.
8 “Commerce Rule Applies Powerful Restrictions Directly on Entities Looking for to Supply Russia’s Military Since Start of Invasion of Ukraine,” U.S. Department of Commerce, Bureau of Industry and Security, June 28, 2022, https://www.bis.doc.gov/index.php/documents/about-bis/newsroom/press-releases/3042-2022-06-28-bis-press-releaserussiabackfill-entity-list/file.
9 “Addition of Entities, Revision and Correction of Entries, and Removal of Entities From the Entity List,” Federal Register, June 30, 2022, https://www.federalregister.gov/documents/2022/06/30/2022-14069/addition-of-entities-revision-andcorrectionof-entries-and-removal-of-entities-from-the-entity-list.
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Russian Stocks, Index Providers, and Financial Risk
On February 28, 4 days after Russian forces invaded Ukraine, each the Recent York Stock Exchange and Nasdaq temporarily halted trading in stocks of Russia-based firms, citing “regulatory concern” in light of U.S. and allied sanctions.11 The stocks weren’t delisted, and U.S. investors are usually not required to divest Russian debt and equity securities in the event that they were acquired prior to the brand new investment prohibitions issued in spring 2022 under a tranche of Executive Orders issued by President Biden.12
Major global index providers began removing Russian equities from their widely tracked indexes throughout the first week of March 2022. Russia was deleted from all FTSE Russell Equity Indexes effective March 7. 13 MSCI and S&P Dow Jones Indices (DJI) followed closely behind and each reclassified Russia from Emerging Markets to Standalone Markets status on March 9, removing Russian securities from any index with global exposure.14,15 All index constituents listed on the Moscow Exchange (MOEX) were affected, including firms involved in key sectors resembling banking, power production, mineral extraction, oil, and military equipment.
This was not an ethical response to Russia’s aggression in Ukraine, a lot as a financial selection. There have been technically no profits forfeited since the Moscow Exchange (MOEX) had suspended trading on all markets. Consequently, Russian stocks became inaccessible, worthless, and effectively uninvestable. Had the index providers divested from Russia back when it invaded and annexed Crimea in 2014, then there is perhaps plausible deniability that the choices were driven by moral principles.
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10 “Sanctions Update: EU and US Impose Recent Sanctions and Export Controls Referring to Russia,” Latham & Watkins, October 11, 2022, https://www.lw.com/admin/upload/SiteAttachments/Alert-3019.pdf.
11 Alexander Osipovich, “NYSE and Nasdaq Halt Trading in Russian Stocks,” The Wall Street Journal, Feburary 28, 2022, https://www.wsj.com/livecoverage/russia-ukraine-latest-news-2022-02-28/card/nyse-and-nasdaq-halt-trading-in-russianstockscTRdEpwhpdUspKwAISo1.
12 “FAQ: Russian Harmful Activities Sanctions,” U.S. Department of the Treasury, updated July 22, 2022, https://home.treasury.gov/policy-issues/financial-sanctions/faqs/1054.
13 “Treatment of Russia in FTSE Russell Equity Indices,” FTSE Russell, March 2, 2022, https://research.ftserussell.com/products/index-notices/home/getnotice/?id=2603553.
14 “MSCI to Reclassify the MSCI Russia Indexes from Emerging Markets to Standalone Markets Status,” MSCI, March 2, 2022, https://ir.msci.com/news-releases/news-release-details/msci-reclassify-msci-russia-indexes-emerging-marketsstandalone.
15 “S&P Dow Jones Indices’ Consultation on Sanctions and Russia Market Accessibility – Results,” S&P Global, March 4, 2022, https://www.spglobal.com/spdji/en/documents/indexnews/announcements/20220304-1450352/1450352_spdjiconsultationonsanctionsandrussiamarketaccessibilityresults3-4-2022.pdf.
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Index providers have already outlined a way for removed Russian securities to rejoin global indexes. Although MOEX partially reopened at the top of March 2022, restrictions that bar foreign investors from offloading stocks still remain in place.16 FTSE Russell has stated that when regular trading resumes on MOEX and “restrictions on non-resident investors have been lifted,” the Russian securities might be re-evaluated for inclusion during an annual classification review.17 MSCI and S&P DJI will even consider potential re-inclusion of Russia into their Emerging Markets indexes during 2023 annual review processes.18,19
Institutional Investors Face Russia Divestment Obstacles
Large public pension plans acted quickly to try to cut back their Russia exposure. Inside every week of the invasion, state legislatures began announcing pledges to divest Russia-linked investments. Leadership at many state retirement and pension funds issued public statements raising the moral imperative for divestment. Connecticut’s state treasurer directed the Connecticut Retirement Plans & Trust Funds to divest its Russian holdings, stating in a news release that: “We cannot stand idly by because the humanitarian crisis unfolds and Russian markets crumble, and I cannot proceed to speculate these pension funds in a way that runs counter to the foreign policy and national interests of the USA.” 20 In March, 36 state treasurers that signed a joint letter advocating for Russia divestment also referenced a financial reason behind their stance: “The present crisis also constitutes a considerable risk for states’ investments and our economic security.”21
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16 Eshe Nelson, “Russia’s stock index reopens and rises with government intervention,” March 24, 2022, https://www.nytimes.com/2022/03/24/business/russian-stock-exchange-moex.html.
17 “Treatment of Russia in FTSE Russell Equity Indices,” FTSE Russell, March 2, 2022, https://research.ftserussell.com/products/index-notices/home/getnotice/?id=2603553.
18 “Q&A: Reclassification of MSCI Russia Indexes to Standalone Markets Status,” MSCI, March 2022, https://www.msci.com/eqb/methodology/meth_docs/QAMSCI_Russia.pdf.
19 “S&P Dow Jones Indices’ Consultation on Sanctions and Russia Market Accessibility – Results,” S&P Global, March 4, 2022, https://www.spglobal.com/spdji/en/documents/indexnews/announcements/20220304-1450352/1450352_spdjiconsultationonsanctionsandrussiamarketaccessibilityresults3-4-2022.pdf.
20 Geoff Mulvihill, “Russia divestment guarantees by US states largely unfulfilled,” August 26, 2022, https://apnews.com/article/russia-ukraine-economy-government-and-politics-78ab15796482b16077baedeb68d354c2.
21 “McRae: Divesting from Russian Investments to Support Ukraine,” State Treasury of Mississippi, March 25, 2022, https://treasury.ms.gov/2022/03/25/mcrae-divesting-from-russian-investments-to-support-ukraine/.
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Although there have been no formal divestment mandates enacted, some state institutions and fund administrators were called on by state governors including Recent York Gov. Kathy Hochul and California Gov. Gavin Newsom in early March to sell their holdings. An Associated Press review present in August 2022 that it had develop into apparent it was very difficult for institutional investors to sell their virtually worthless stocks.22 Most public funds would have lost money whether or not they voted to divest from Russia or not.
The California Public Employees’ Retirement System (CalPERS) didn’t try and sell, and the worth of its Russia investments went from $765 million on the time of the invasion to $194 million by the top of June 2022.23 The MOEX continues to keep up strict capital controls on foreign investors, and a good portion of public funds’ exposure to Russia is tied up in investment vehicles resembling exchange-traded funds (ETFs) and index funds that can’t sell their underlying securities.
Targeting China with Economic and Financial Sanctions
The unprecedented and expansive nature of the economic and financial sanctions imposed on Moscow has raised the specter of the U.S. taking the same approach with Beijing if red lines were to be crossed. Although China and Russia are sometimes mentioned in the identical breath in relation to the U.S. national security landscape and great power competition, they present very different challenges for Washington.
The Russian readout of a June 2022 phone call between General Secretary Xi Jinping and Russian President Vladimir Putin stated that Russia and China agreed to “expand cooperation in energy, finance, the manufacturing industry, transport, and other areas, making an allowance for the worldwide economic situation that has develop into more complicated attributable to the illegitimate sanctions policy pursued by the West.”24 Interestingly, these details weren’t included within the Chinese readout of the decision.25 In some industries, resembling cross-border payments, transport and logistics, and energy, China has stepped in as other countries have shifted away. But typically, Chinese firms appear to have scaled back operations in Russia to avoid exposure to secondary sanctions, despite lip service on the contrary.
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22 Geoff Mulvihill, “Russia divestment guarantees by US states largely unfulfilled,” August 26, 2022, https://apnews.com/article/russia-ukraine-economy-government-and-politics-78ab15796482b16077baedeb68d354c2.
23 Wes Venteicher, “Plummeting stocks and a Moscow shopping center. CalPERS is stuck with its Russia investments,” The Sacremento Bee, July 25, 2022, https://www.sacbee.com/news/politics-government/the-state-worker/article263749188.html.
24 “Telephone conversation with President of China Xi Jinping,” Presidential Executive Office (Kremlin), June 15, 2022, archived at https://web.archive.org/web/20220615171638/http:/en.kremlin.ru/events/president/news/68658.
25 “Summary: China’s Position on Russia’s Invasion of Ukraine,” U.S.-China Economic and Security Review Commission, October 27, 2022, https://www.uscc.gov/research/chinas-position-russias-invasion-ukraine.
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China has a significantly larger economy than Russia, and a more sophisticated financial and monetary system. It’s deeply integrated into global value chains and markets while also endeavoring to construct a parallel system of international economic institutions. By the top of 2021, there have been 26 million registered firms in Russia, in comparison with 48.42 million firms registered in China (not including Chinese firms domiciled in Hong Kong).26 Bloomberg has estimated that Russia’s stock market was valued at $781 billion at first of 2022, compared with the cumulative value of $19 trillion of the mainland China and Hong Kong exchanges.27 And data compiled by CSIS shows that in 2021, “Chinese banks had greater than 30 times as many assets as Russian banks, and cumulative foreign direct and portfolio investment in China was greater than six times the quantity that had flowed into Russia.”28 The size of U.S. economic and financial exposure to China is significantly greater than it’s to Russia, and a few analysts have wondered whether China’s weight in the worldwide economy – despite recent data indicating an incoming recession or economic contraction – insulates it from Western sanctions. Mikael Wigell of the Finnish Institute of International Affairs observed in April 2022 that the U.S. and Europe are more comfortable using financial sanctions attributable to their central role in the worldwide economy’s financial architecture. Whereas China “just isn’t central within the financial world economy, so China doesn’t … use financial sanctions very effectively. But China can use trade sanctions effectively. It has quite a lot of effect when it does.”29 This just isn’t to say that Washington cannot win in an economic or financial war with Beijing, however the stakes are high and the USA’ strategy might be different from what’s being deployed to discourage and punish Russia.
Passive Investment, Exposure to Dangerous Corporate Structures
Variable interest entities (VIEs) are legally ambiguous corporate structures that Chinese firms incessantly employ to list on U.S. exchanges to satisfy the necessities of listing on U.S. and other foreign securities exchanges, allowing Chinese firms to boost funds overseas. The VIE model allows overseas listed entities to manage domestic Chinese business entities through a series of agreements and offshore shell firms. Due to the complex holding structure, U.S. investors don’t have any legal recourse to the underlying assets of VIEstructured Chinese firms. A 2017 report by the Council of Institutional Investors (CII) found that VIE corporate structures had been utilized by 62% of Chinese firms listed on U.S. exchanges on the time.30
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26 Data retrieved from Statista.
27 Sofia Horta e Costa, “China Markets in Turmoil as Russia Ties Add to List of Risks,” March 11, 2022, https://www.bloomberg.com/news/articles/2022-03-11/china-s-markets-in-crisis-as-russia-ties-add-to-list-of-risks.
28 Gerard DiPippo, “Deterrence First: Applying Lessons from Sanctions on Russia to China,” CSIS, May 3, 2022, https://www.csis.org/evaluation/deterrence-first-applying-lessons-sanctions-russia-china.
29 “What are sanctions, and are we in a recent era of economic war? This week’s Radio Davos,” World Economic Forum, April 8, 2022, https://www.weforum.org/agenda/2022/04/what-are-sanctions-radio-davos/.
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The recognition of passive investment strategies, which permit fund managers to delegate their investment decisions to index providers, gives firms using VIE structures a gentle pool of willing buyers that perform no evaluation of company fundamentals to evaluate whether the underlying assets of a Chinese stock, for instance, are real. ETFs and other index products are derivative instruments that mimic the performance of the securities in a goal index created by an index provider like MSCI, FTSE Russell, or S&P DJI, and can’t dump problematic or dangerous holdings without violating fiduciary duty to parallel the returns of the benchmark index as closely as possible. And index providers which can be chargeable for the underlying indexes don’t assess business fundamentals beyond market capitalization, liquidity, and other technical attributes.
Institutional Investors and China Investment Strategy
Public worker pension funds, endowment funds, and other institutional investors put money into diversified portfolios across stocks, fixed-income securities, U.S. and foreign government bonds, alternative investments (private equities, hedge funds), and other asset classes. Fund administrators may employ managers for a portion of their portfolio and depend on passive investment strategies to achieve additional exposure to specific industries or geographic areas. U.S.
investor access to publicly traded Chinese firms has expanded dramatically over the past few years with the rapid inclusion and weighting of China A-shares in major global stock indexes – and consequently, in investment products that benchmark against them.31
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30 Brandon Whitehill, “Buyer Beware,” Council of Institutional Investors, December 2017, https://www.cii.org/files/publications/misc/12_07_17%20Chinese%20Companies%20and%20the%20VIE%20Structure.pdf.
31 A-Shares are mainland Chinese firms that trade on the Shanghai Stock Exchange or the Shenzhen Stock Exchange.
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Prior to the inclusion of A-Shares in 2018, global index providers had exposure only to H-Shares, that are Chinese firms listed on the Hong Kong Exchange.
After the A-Share transition began in 2018, index products with Emerging Markets (EM) and global mandates quickly flooded with Chinese company stocks. Over 1,500 A-shares were available to U.S. retail and institutional investors as of August 2020. As mentioned above, the standards utilized by index providers to choose whether so as to add or remove securities are strictly financial and based on standardized attributes like company size, market capitalization, and liquidity, no matter business fundamentals.32 As a consequence, most of the publicly traded firms included were related to various reputational, regulatory, and provide chain risk aspects including non-proliferation sanctions, advanced weapons manufacturing, and providing surveillance technology utilized in the Chinese government’s detention facilities and prisons.33 U.S. investors were inadvertently supporting Chinese firms involved in activities contrary to the national security and foreign policy interests of the USA.
A few of this risk exposure was neutralized with the Trump Administration’s issuance of Executive Order (E.O.) 13959, which prohibited Americans from holding the securities of Chinese military firms as designated by the U.S. Department of Defense.34 In June 2021, this divestment authority was strengthened when President Biden issued E.O. 14032 to incorporate not only Chinese military-industrial complex firms (CMICs), but in addition Chinese surveillance technology firms and the direct owners and subsidiaries of CMICs. The brand new list of Chinese firms subject to this divestment mandate has been expanded previously 12 months, but just isn’t comprehensive and just isn’t synchronized with other U.S. sanctions authorities. For instance, the China A-Shares that U.S. institutions proceed to have investment exposure to, via index products, include AECC Aviation Power (AVIC) Co., Ltd., which has been designated as a Military End User (MEU) by the U.S. Department of Commerce’s Bureau of Industry and Security, and Avicopter Plc, which has developed helicopters currently in service with the People’s Liberation Army (PLA) Air Force, Navy, and Ground Force Army.35,36,37
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32 “Comparing benchmark providers,” Vanguard, accessed on November 11, 2022, https://institutional.vanguard.com/VGApp/iip/institutional/csa/investments/benchmarks/home.
33 Zhen Wei, “China A Shares: What Have We Learned?,” MSCI, October 30, 2020, https://www.msci.com/www/blogposts/ china-a-shares-what-have-we/02164045217.
34 “Executive Order on Addressing the Threat from Securities Investments that Finance Certain Corporations of the People’s Republic of China,” The White House, June 3, 2021, https://www.whitehouse.gov/briefing-room/presidentialactions/ 2021/06/03/executive-order-on-addressing-the-threat-from-securities-investments-that-finance-certain-companies-ofthepeoples-republic-of-china/.
35 “Commerce Department Will Publish the First Military End User List Naming More Than 100 Chinese and Russian Corporations,” U.S. Department of State, Global Public Affairs, December 21, 2020, https://2017-2021translations.state.gov/2020/12/21/commerce-department-will-publish-the-first-military-end-user-list-naming-more-than-100chinese-and-russian-companies/index.html.
36 “Harbin Z-19 (Black Whirlwind) (WZ-19),” Military Factory, last edited July 6, 2020, https://www.militaryfactory.com/aircraft/detail.php?aircraft_id=992.
37 “CAIC Z-18,” Military Factory, last edited August 12, 2022, https://www.militaryfactory.com/aircraft/detail.php?aircraft_id=2273.
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State and Federal Pension Funds
Some states are more bullish on Chinese markets than others. The California State Teachers’ Retirement System put out a hiring notice in August 2022 for China public equity managers to ascertain three recent investment categories targeting Greater China, China A-share, and MSCI China securities.38 Months earlier, in May, the Massachusetts Pension Reserves Investment Trust’s Management Board (PRIM) approved a $150 million commitment to 4 funds managed by enterprise capital firm Sequoia China.39 PRIM has already hired the partially Chinese state-owned China International Capital Corp. as a pension fund brokerage firms.40 This recent commitment increases PRIM’s China exposure at a time when other public retirement systems are re-evaluating their China investment strategy and considering reducing their holdings to hedge against heightened risks and uncertainty.
One such system is the Florida Retirement System, which entirely stopped funding recent China investments in April 2022 pending a review of “increasing risks” to investors, including volatility in China’s education and tech sectors.41 The Teacher Retirement System of Texas secured approval in September 2022 to halve its China investment exposure from 3% to 1.5%.42 And the Tennessee Consolidated Retirement System (TCRS) manages what is maybe the one state public pension fund with no known exposure to China or Russia, because TCRS actively screens out countries based on levels of democracy by investing in country-focused ETFs.43 On the federal level, the Federal Retirement Thrift Investment Board (FRTIB), which manages retirement savings on behalf of U.S. service members and government employees, is facing pressure to handle concerns in regards to the Thrift Savings Plan (TSP)’s exposure to Chinese military firms.44 The Board introduced a mutual fund window in summer 2022 that gives investors access to 4,728 mutual funds. The choices include international funds, resembling the Vanguard FTSE All World ex U.S. Index Fund and Vanguard Emerging Markets Stock Index Fund – each of which include publicly traded Chinese firms which can be involved with China’s militaryindustrial complex and/or affiliated with Chinese firms which were subject to the Executive Order’s divestment mandate.45 That is the second chapter within the TSP saga, by which the FRTIB had planned to benchmark its International Fund against an index with heavy China exposure, and the White House intervened in May 2020 before the transition took place, citing the “significant and unnecessary risk” of investing federal retirement funds in Chinese firms posing national security risk.46
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38 Rob Kozlowski, “CalSTRS launches first seek for China equity managers,” Pensions & Investments, August 30, 2022, https://www.pionline.com/searches-and-hires/calstrs-launches-first-search-china-equity-managers.
39 “PRIM Board Quarterly Update First Quarter 2022,” MassPRIM, May 2022, https://mtrs.state.ma.us/wpcontent/ uploads/2022/05/Q1-2022-PRIM-Board-Quarterly-Update-FINAL.pdf.
40 “Annual Comprehensive Financial Report, Fiscal 12 months 2021,” MassPRIM, December 2021, https://www.mapension.com/wp-content/uploads/2021/12/ACFR_Fiscal_Year_2021.pdf.
41 Jessica Hamlin, “Florida SBA Halts Funding to Chinese Investments,” Institutional Investor, April 6, 2022, https://www.institutionalinvestor.com/article/b1xhgfxdgt6byc/Florida-SBA-Halts-Funding-to-Chinese-Investments.
42 “Texas Teachers’ Pension to chop China goal allocation,” Reuters, October 14, 2022, https://www.reuters.com/world/us/texas-teachers-pension-cut-china-target-allocation-2022-10-14/.
43 Heather Bell, “Well-Funded TCRS Is Primarily Energetic,” ETF.com, February 12, 2014, https://www.etf.com/publications/journalofindexes/joi-articles/20761-well-funded-tcrs-is-primarily-active.html?nopaging=1.
44 Ralph R. Smith, “TSP Investments in China: No TSP for the CCP?,” FedSmith, August 11, 2022, https://www.fedsmith.com/2022/08/11/tsp-china-investments-mutual-fund-window/.
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University Endowment Funds
Although public universities operate using taxpayer dollars and should be subject to open records acts, only a few have publicly released their endowment portfolios with information on individual debt and equity holdings. In 2016, the Associated Press sent open records requests for investment disclosures from 50 universities, each private and non-private, and was met with refusals from 39 schools and no response from 4. The general public universities that responded provided only limited records, revealing a sampling or aggregate view of their portfolios.
Universities and colleges often employ what has been known as a “stealth investment strategy” in relation to endowment funds.
This aversion to public disclosure will be attributed to reasons including the need to avoid political influence or scrutiny, fiduciary responsibility to maximise returns, concerns about competitive benefits, and confidentiality agreements with external investment managers and consultants.47
A California court ruled in December 2013 that the University of California was not obligated to reveal investment return information for its externally-managed endowment fund, despite previous rulings that the return information was to be considered public record under the California Public Records Act.48
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45 “TSP Mutual Fund Window (MFW) — List of all available funds,” TSP Folio, accessed November 10, 2022, https://www.tspfolio.com/mfw/mutualfundlist.
46 Demetri Sevastopulo, “Trump orders federal pension fund not to speculate in Chinese stocks,” Financial Times, May 12, 2020, https://www.ft.com/content/37ee5097-8ae2-4bc6-9c1f-048a242a4f33.
47 Collin Binkley, “Colleges secretive about endowment investments,” Associated Press via Milwaukee Journal Sentinel, March 17, 2016, http://archive.jsonline.com/news/statepolitics/colleges-secretive-about-endowment-investmentsb99689686z1372399571.html.
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Consequently of the University of Michigan’s lobbying efforts, the State of Michigan enacted the “Confidential Research and Investment Information Act” in April 1994, exempting public universities and colleges from the general public disclosure of certain investment information when provided by a personal external source (for instance, private equity or enterprise capital fund).49 And when asked to reveal its investment portfolio, the University of Virginia has claimed exemption because its endowment resources are housed externally with the University of Virginia Investment Management Company, which was involved within the May 2019 joint filing of a legal transient in opposition to an expansion of the Virginia Freedom of Information Act that may increase transparency and openness in University fundraising and investment activity.50
To a certain extent, we are able to deduce undisclosed but passively managed investment holdings by referencing the investment benchmark indexes attributable to the close replication of their underlying securities. The MSCI All Country World Index (ACWI) created by Morgan Stanley is one of the vital popular options for institutions searching for exposure to a variety of developed and emerging market firms. It has exposure to large swaths of Chinese and (formerly) Russian securities, which include firms which have not been screened for reputational, regulatory, or supply chain risk aspects. As of 2021, all three universities – the University of California, University of Michigan, and University of Virginia – benchmark passive investments against MSCI ACWI or a derivative.51,52,53
In June 2022, Rep. Greg Murphy sent a letter to fifteen private universities with a request for them to divest problematic Chinese firms and “adversarial entities.”54 After receiving what he characterised as “lackluster responses” to the letter, Murphy introduced a bill in July that uses tax incentives to pressure university endowments on the problem of divestment.55 In what appears to be an indirect response, the University of California’s investment arm stated in September 2022 that it was working to taper its China investment exposure, while sources claim that Harvard University’s endowment is considering reducing its holdings in China as well.56.57
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48 Sarah McBride, “University of California needn’t disclose enterprise returns: court,” Reuters, December 19, 2013, https://www.reuters.com/article/us-funds-california-ucal/university-of-california-need-not-disclose-venture-returns-courtidUSBRE9BJ04I20131220.
49 “Confidential Research and Investment Information Act,” Michigan State Legislature, April 5, 1994, accessed November 10, 2022, http://www.legislature.mi.gov/%28S%285gg10rn2wbsibe453kyedb45%29%29/documents/mcl/pdf/mcl-Act-55-of1994.pdf.
50 Ruth Serven Smith, “UVA foundations support donor privacy effort,” The Each day Progress, June 8, 2019, https://www.dailyprogress.com/news/uva/uva-foundations-support-donor-privacy-effort/article_5b3c152c-8a3e-11e9-b3142322ff1b3f6d.html.
51 “Annual Report 2020-2021,” Office of the Chief Investment Officer of the Regents, June 30, 2021, https://www.ucop.edu/investment-office/210924_ucannualreport2021_digital.pdf.
52 “Report of Investments 2021,” University of Michigan, December 6, 2021, https://www.bf.umich.edu/wpcontent/ uploads/2021/12/2021.ROI_.Final_.12.6.2021.pdf.
53 “Annual Report 2020-2021,” University of Virginia Investment Management Company, 2021, https://s3.amazonaws.com/cdn.vssl.io/files/UVIMCO%202021%20Annual%20Report.pdf.
54 Phelim Kline, “Congress targets Harvard, Yale and top universities with China-linked endowments,” June 9, 2022, https://www.politico.com/news/2022/06/09/congress-targets-harvard-yale-and-top-universities-with-china-linkedendowments00038625.
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Alternative Investments: Private Funds
Broadly speaking, the private market consists of other investments resembling hedge funds, private equity funds, and enterprise capital funds that raise capital in private, outside of the general public markets – all while being shielded from SEC registration requirements. Under to the Investment Company Act of 1940, private funds are considered “pooled investment vehicles” somewhat than investment firms and are subsequently exempt from the principles and regulations governing investment company activity. Someone who manages private funds, nonetheless, is required to register as an investment advisor with the SEC.58
Private funds, which represent a good portion of institutional portfolios, essentially function as unregistered investment vehicles that are usually not required to confirm or disclose investors’ identities, source of funds, or other credentials. This presents a perfect environment for Russian oligarchs to park their wealth, and for Chinese state-owned entities to achieve nontransparent access to U.S. businesses and technologies of strategic significance.
Chinese private equity and enterprise capital have an outsized role in financing U.S. high-tech chip innovation. This is especially evident when looking into the origin of the private funds backing artificial intelligence (AI) chip start-ups in Silicon Valley. SambaNova Systems relies in Palo Alto, California and builds AI hardware and systems. It’s primarily backed by major players resembling Google Ventures, Intel Capital, and BlackRock, but has also received funding from Walden International, a San Francisco-based enterprise capital firm with close ties to China, and Redline Capital, a UK enterprise capital firm with close ties to Russia.
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55 “Murphy Introduces Bill to Pressure University Endowments to Divest from Dangerous Chinese Entities,” Congressman Greg Murphy, July 21, 2022, https://gregmurphy.house.gov/media/press-releases/murphy-introduces-bill-pressureuniversityendowments-divest-dangerous-chinese.
56 David G. Barry, “UC Investments Seeks to Reduce China Holdings,” Markets Group, September 22, 2022, https://www.marketsgroup.org/news/UC-Investments-China.
57 Cathy Chan and Janet Lorin, “Investor pullback shows private equity funds’ China struggle,” Bloomberg, April 10, 2022, https://www.bloomberg.com/news/articles/2022-04-10/harvard-endowment-s-debate-shows-private-equity-s-chinastruggle# xj4y7vzkg.
58 “Private Fund,” U.S. Securities and Exchange Commission, accessed November 12, 2022, https://www.sec.gov/education/capitalraising/building-blocks/private-fund.
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* Walden International has offices in Beijing and Shanghai and claims to enjoy “extensive government and industry relationships [in China] that bring critical added value.”59 The firm’s chairman is a founding shareholder of Chinese state-owned Semiconductor Manufacturing International Corporation (SMIC). In July 2011, Walden International partnered with the National Development Reform Commission of China and the Shanghai municipal government to launch a enterprise capital fund to speculate in Chinese semiconductor firms.60
* Before joining Redline, partner Tatiana Evtushenkova was an advisor to the CEO of Sberbank and in addition served as vice chairman at Mobile Telesystems (MTS) – which has been sanctioned by the U.S. under the Foreign Corrupt Practices Act in 2019 and delisted by the NYSE. Tatiana has also headed M&A at Sistema Telecom, where her oligarch father, Vladimir Yevtushenkov, is the chairman. One other Redline partner is Alastair Cookson, who previously worked as a managing director at Russian investment bank Renaissance Capital.
Probably the most distinguished names in American enterprise capital and personal equity is Sequoia Capital. The firm is headquartered in Menlo Park, California but has substantial interests in China, including offices in Beijing and Shanghai, and a subsidiary in Hong Kong referred to as Sequoia Capital China Advisors. In 2016, Sequoia China established a recent enterprise capital fund with a Chinese state-owned enterprise that invests in recent emerging industries and sectors related to national security.61,62 Sequoia has backed controversial firms resembling machinelearning firm Yitu Technology and drone manufacturer DJI Technology, each of which have been sanctioned by the U.S. government and are subject to capital markets restrictions for his or her involvement within the Chinese government’s mass surveillance apparatus in Xinjiang.
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59 “Walden International, China,” Walden International, accessed November 13, 2022, archived at https://archive.ph/nBP8b.
60 “Walden International Declares Recent China Semiconductor Industry Focused Fund,” Walden International, July 6, 2011, http://www.waldenintl.com/docs/ShanghaiWaldenVentureCapitalFund.pdf.
61 “China Reform Holdings Corporation Ltd,” China Each day, December 5, 2018, https://govt.chinadaily.com.cn/s/201812/05/WS5c0744f7498eefb3fe46e2ba/china-reform-holdings-corporation-ltd.html.
62 “Member Overview: China Reform Fund,” Zhongguancun Private Equity & Enterprise Capital Association, accessed on November 12, 2022, archived at https://web.archive.org/web/20210617001821/http://www.zvca.org/enindex.php/a/7367.html.
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The most important private equity investors are pension funds and university endowments.63 Of the 178 U.S. public pension funds that the American Investment Council examined in its annual study, 85% had some level of personal equity fund exposure.64 The quantity of state and native pension funds’ private equity investments has also grown steadily lately, climbing from around $300 billion in 2018 to $480 billion in 2021, in line with investment data provider Preqin.65 As such, U.S. institutional investors which have taken steps to divest problematic or dangerous Chinese and Russian firms may proceed to have high levels of exposure through private equity investments.
Over the past 12 months, federal regulators have rallied around plans to expand oversight of personal markets and increase reporting requirements to handle the dearth of transparency. The SEC has voted twice to propose amendments to the reporting form for SEC-registered investment advisors. The January proposal, which was approved on February 9, will lower the reporting threshold, introduce recent timely reporting requirements, and require advisors to reveal more granular details about their portfolio holdings.66,67 The August proposal, if adopted, would require fund advisors to offer additional identifying details about themselves and their funds, resembling details about helpful ownership, creditors, and operations.68
Recommendations
Establish an interagency committee of the U.S. government to develop programs to strengthen U.S. international economic relations and to coordinate the federal government’s policies and activities in response to varied economic and financial issues related to foreign policy and national security.
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63 Drew Maloney, “America for Sale? An Examination of the Practices of Private Funds,” U.S. Congress, Hearing of the House Financial Services Committee, November 19, 2019, https://financialservices.house.gov/uploadedfiles/hhrg-116-ba00wstate-maloneyd-20191119.pdf.
64 “2021 Public Pension Study,” American Investment Council, July 2021, https://www.investmentcouncil.org/wpcontent/ uploads/2021/07/2021_pension_report.pdf.
65 Heather Gillers, “Retirement Funds Bet Greater on Private Equity,” The Wall Street Journal, January 10, 2022, https://www.wsj.com/articles/retirement-funds-bet-bigger-on-private-equity-11641810604.
66 “SEC Proposes Amendments to Enhance Private Fund Reporting,” U.S. Securities and Exchange Commission, January 26, 2022, https://www.sec.gov/news/press-release/2022-9.
67 Celia Cohen, “US SEC approves proposal to adopt broad disclosure rules for personal investment funds,” Norton Rose Fulbright, February 14, 2022, https://www.nortonrosefulbright.com/en/knowledge/publications/bc84e594/us-sec-approvesproposalto-adopt-broad-disclosure-rules-for-private-investment-funds.
68 “SEC Proposes to Enhance Private Fund Reporting,” U.S. Securities and Exchange Commission, August 10, 2022, https://www.sec.gov/news/press-release/2022-141.
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This committee would coordinate with other departments and agencies as needed to handle issues resembling foreign procurement, critical minerals security, infrastructure investment, supply chain resilience and ally-shoring, and export of strategic materials.
Effective sanctions programs are linked to clear policy objectives, and this committee would work to facilitate alignment between different sanctions programs with shared objectives to stop the inconsistent application of economic and financial penalties. It could also prevent abnormal situations by which U.S. investors are in a position to freely purchase or transact within the securities of an entity that U.S. Departments of Defense, Treasury, or Commerce have determined poses significant risk and placed under economic sanctions or export restrictions.
It could even be charged with engaging with Silicon Valley and Wall Street stakeholders to facilitate close cooperation, communicate guidance on sanctions efforts, and garner support for policies. Lack of clarity around recent sanctions programs has, in some cases, muddled public messaging and made it difficult for U.S. banks and financial institutions to comply.
In April 2022, Sen. Robert Menendez introduced a bill to ascertain the “Countering Economic Coercion Task Force” to “oversee an integrated government strategy to reply to any economic practices by China which can be abusive, arbitrary, and contrary to international rules.” The duty force would engage with U.S. Customs and Border
Protection and Department of State on economic strategy.69 I’d urge support for this bill, and any similar legislative initiatives to introduce a whole-of-government approach to economic and financial statecraft.
Enact divestment requirements on the state and native level to stop U.S. institutional investors from inadvertently providing capital to Russian firms helping to sustain the war in Ukraine, and Chinese firms supporting the federal government’s military modernization efforts.
Congress should complement federal sanctions on certain Chinese and Russian entities by directing state and native governments to enact laws mandating divestment of state and city funds from firms that operate in key Russian business sectors, and within the Chinese military-industrial or surveillance technology sectors.
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69 “S.4112 – Economic Statecraft for the Twenty-First Century Act,” 117th Congress (2021-2022), April 28, 2022, https://www.congress.gov/bill/117th-congress/senate-bill/4112.
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This directive would also require state chief procurement offices to publish an annual list of entities determined to be engaged in activities supporting Russia and China’s defense industrial bases. Concurrently, state and native governments should prohibit stepping into any procurement or contract over a set dollar threshold with an entity on this list.
Congress must also pass laws requiring the identification of firms that operate in key Russian business sectors, including military or defense-industrial firms. This could mirror the Chinese military-industrial firms (CMIC) list administered by the U.S. Treasury Department’s Office of Foreign Assets Control, and supply guidance for states that may not otherwise have the resources to adopt independent screening processes for investments in high-risk Russian and Chinese firms.
These actions would support the efforts of state and native governments, educational institutions, businesses, and investors which have already taken steps to disassociate themselves from firms engaged in activities contrary to U.S. national security and foreign policy interests, but are certain by fiduciary duty to retain such holdings.
Consider strengthening regulatory authorities to stop and even ban the U.S. listings of firms that use corporate structures stopping high-quality disclosure and transparency.
The Securities Exchange Commission (SEC) released a “Sample Letter to Chinese Corporations” in December 2021, which serves as a template for the SEC Division of Corporation Finance’s outreach to China-based firms regarding specific risks, resembling the usage of a variable interest entity (VIE) structure.70 The guidance within the letter doesn’t prevent or ban firms using a VIE structure from listing on U.S. exchanges altogether, but asks for enhanced disclosure and acknowledgment that a Chinese regulatory crackdown on VIEs could lead to material change in the worth of securities.
Three days later, the China Securities Regulatory Commission (CSRC) released draft administrative regulations stating that Chinese firms might be permitted to proceed using variable interest entity (VIE) structures for overseas listings as long as they meet “compliance requirements.”71 This contradicts months of speculation that Chinese regulatory authorities were planning to crack down on Chinese businesses using VIE structures for overseas listings, and appears to be a green light for Chinese firms to proceed using offshore vehicles to perform overseas fundraising plans.72
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70 “Sample Letter to China-Based Corporations,” U.S. Securities and Exchange Commission, December 20, 2021, https://www.sec.gov/corpfin/sample-letter-china-based-companies.
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As a consequence, U.S. retail and institutional investors that use passive investment strategies, and own funds tracking international or emerging markets indexes, will proceed to have exposure to this China-specific category of fabric financial risk.
This testimony was prepared with research support from my colleagues Melissa Ladner and Annie Payson. Thanks.
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71 “The relevant person in control of the China Securities Regulatory Commission answers reporters’ questions, China Securities Regulatory Commission, December 24, 2021, archived at https://web.archive.org/web/20211224134643/http://www.csrc.gov.cn/csrc/c100028/c1662240/content.shtml.
72 “China Puts VIE-Structured Overseas Listings under Regulatory Highlight,” Ropes & Gray, January 24, 2022, https://www.ropesgray.com/en/newsroom/alerts/2022/january/china-puts-vie-structured-overseas-listings-underregulatoryspotlight.
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Original text here: https://financialservices.house.gov/uploadedfiles/hhrg-117-ba16-wstate-chuc-20221115.pdf