A preliminary agreement to allow audit inspections of US-listed Chinese companies is a step in the right direction for global markets. But any celebration at this point is premature.

Last Friday, the US-China audit dispute made a breakthrough after authorities from both sides came to a preliminary agreement to allow American regulators to inspect audit papers at accounting firms in Hong Kong and the mainland. 

This is a welcome development for global markets which have been experiencing heightened volatility and nearly constant uncertainty. But any celebration at this point is premature.  

There are various signs that indicate there could be more hurdles ahead before US-listed Chinese firms and their investors can breathe a real sigh of relief and dodge a booting from American stock exchanges.  

Statement of Protocol

In a statement by the US Public Company Accounting Oversight Board (PCAOB), chair Erica Williams underlined three key factors that would fulfill the Statement of Protocol signed with the China Securities Regulatory Commission (CSRC) and Ministry of Finance. This includes sole discretion for access, procedures to view documents and direct access to all related personnel.

On discretion for access, the PCAOB notably underlined that it would include the ability to «select the firms, audit engagements and potential violations it inspects and investigates – without consultation with, nor input from, Chinese authorities».

But a statement from Beijing indicated expectations of greater involvement. According to the CSRC, the US «must obtain audit papers and other documents through the Chinese regulatory authority, and conduct interviews and inquiries with the relevant personnel of the accounting firm with the participation and assistance of the Chinese side».

Cautious Language

Even the tone of the PCAOB statement indicated caution about a successful outcome with a strong emphasis on compliance by China.

«On paper, the agreement signed today grants the PCAOB complete access to the audit work papers, audit personnel, and other information we need to inspect and investigate any firm we choose, with no loopholes and no exceptions,» Williams said. «But the real test will be whether the words agreed to on paper translate into complete access in practice. Now we will find out whether those promises hold up.»

The CSRC, too, did not express certainty, stating that delistings in the US can only be avoided if further cooperation can meet the «respective regulatory needs» of both sides.

Goldman: Coin Toss

Markets are approaching the issue warily with investors reportedly hedging positions by swapping their Chinese American Depository Receipts (ADR) for Hong Kong shares.

At Goldman Sachs, its «delisting barometer» – an indicator for the chance of Chinese ADRs to be kicked off US exchanges based on quantitative models – improved significantly from a peak of 95 percent in March but only to 50 percent, according to a note by strategists including Kinger Lau, or the equivalent of a coin toss. 

In the best case scenario of no delistings, Goldman forecasts an 11 percent and 5 percent gain for Chinese ADRs and the MSCI China Index, respectively. And in the event of a forced delisting, the bank estimates a 13 percent and 6 percent fall, respectively. 

Contingency Plans

Chinese authorities have been making efforts to create links to access other markets such as Zurich and London with ambitions for more channels in other European countries, including Germany. Nonetheless, Hong Kong is expected to remain as China’s main offshore market and the prime beneficiary of any US delisting. 

But even in this area, there are concerns that the relatively smaller and more retail-driven market may not have sufficient liquidity to support mass migration of listings.  

And to add to the challenges, 52 out of 261 US-listed Chinese firms – around one-fifth – currently do not qualify to go public in Hong Kong, according to research from CMB Wing Lung Bank, due to insufficient market capitalization, revenue, profit and operating cash flow. If delisted, there will be extra demand for capital to buy back shares from smaller shareholders which could cause liquidity pressures.

PCAOB-China Track Record

If the PCAOB and Chinese authorities do not reach any agreement to avoid delistings, it will not be the first time the two failed to come to terms. In 2013, the accounting regulator negotiated a Memorandum of Understanding with China for audit enforcement but later said that it could not obtain sufficient information access to reach a deal.

«The US Congress sent a strong message with the passage of the Holding Foreign Companies Accountable Act that access to the US capital markets is a privilege, not a right,» Williams added. «Now our work continues, guided by the same mission that guides everything we do at the PCAOB: protecting investors. That is what this is all about.»