From "I Sold BABA" to "How US Could Play $1T Chinese ADRs Card"

trade deficit, tariff, US-China standoff and ADR risk assessment

Background

I recently sold BABA 0.00%↑ and $TCEHY (Tencent), two of my long-held Chinese ADRs (American Depository Receipts). A macro-driven decision to sell two fundamentally sound portfolio companies at a considerable discount to their global peers isn’t easy, particularly since I have weathered past setbacks.

I will outline my thought process to sell, beginning with the trade deficit, then the current tariff / US-China standoff, and how Chinese ADRs fit into these contexts.

I received questions about ADRs’ fungibility (to convert to HK shares), which suggests it could mitigate the delisting risk. I will address them.

I will leave politics out of the article.

Trade Deficit

I will begin with some big numbers (not precise) to orient you to this complex landscape.

Today, the US runs ~$1T annual trade deficit (~$4T imports and ~$3T exports), 90% are from 4 countries/regions: 35%-40% from China (and related), 10%-15% from EU, 25% from East Asia, and 15%-20% from USMCA (Canada/Mexico), with a breakdown below(^):

China and its Rerouting Effect * ~$370Bn (35-40%)
- China $ 270 Bn (27%)
- Rerouted via Vietnam: ~$ 25 Bn
- Rerouted via Mexico: ~$ 30 Bn
- Other regions: ~$ 45 Bn

EU ~130 Bn (10-15%)
- The top 3 are Ireland, Germany, and Italy.

East Asia ~$250Bn (25%)
Taiwan / Japan / South Korea / Vietnam (excluding China rerouting)

North America / USMCA ~$170Bn (15-20%)
- Mexico $ 140 Bn (excluding China rerouting)
- Canada $ 30 Bn

^ The US $1T trade deficit includes $1.2T goods deficit and $0.2T service surplus. The numbers above include both.

* The US trade deficit with China peaked at $ 420 Bn in 2018. It has since decreased by $ 150 billion; however, a large portion was rerouted to Vietnam (US deficit from 2018’s $40 Bn to 2024’s $120 Bn) and Mexico (from 2018’s $80 Bn to 2024’s $ 170 Bn).

Tariff Drama

As we examine the recently announced US reciprocal tariff rate using the data above and the formula provided by WH below, a simplified way to think about it is that if we charge an average 25% tariff on all $4T imports, $1T tariff revenue will offset our $1T trade deficit (actual country-specific tariff rates vary based on deficits at the country level).

The above provides contextual clues why the US first launched a reciprocal tariff with Canada/Mexico (as they are meaningful contributors to the deficit), and why Vietnam's tariff rate tops the list (as China’s primary rerouting partner for US exports).

US-China Tariff Standoff

Trump announced tariff rates on 4/3. While it was unexpectedly high, many countries vowed to respond accordingly, but China was the only one engaged in a tic-for-tac tariff standoff. In the ensuing days, both countries raised tariffs multiple times and are currently at a headline rate of 145% (and 245% as of 4/16) for the US on Chinese imports, and 125% for China on US imports.

Rapidly rising tariffs disrupt international trade, leading to price hikes, job losses, and a slowdown in economies, commonly recognized as a lose-lose situation for the engaged parties. So why are they doing it?

The standoff is a high-stakes brinkmanship game.

Like most conflicts, the objective is to leverage your resources to inflict maximum pain on the counterparty and see who blinks first. This setup has three categories of tools: Tariff, Export Limits, and Special Tools.

Tariff: As tariff rates are 100% + on both sides, any further increase becomes a number game. The tariff as a pressure tool has already been extended to its maximum.

Export Limit: US export limits on advanced chips (e.g., Nvidia’s H2O) and AI-related technology, and China’s export limits on critical minerals/rare earths, both are powerful tools to inflict pain, and we start to see that, and shall expect more on both sides.

Special Tool: US: Chinese ADRs ($1Tn); China: US debts ($700Bn+).

For this article, I won’t discuss how China’s US debt holdings could pose a meaningful threat. Let us focus on $1Tn Chinese ADRs listed in the US Exchanges.

Chinese ADR Risk Assessment

At first glance, delisting Chinese ADRs poses a real threat. It is a sizeable total market cap at over $1T, and the top 5 includes Alibaba, PDD, JD, Netease, and Baidu, all big players in the Chinese market, with a combined market cap of over $ 500 Bn.

However, as we delve into the details, ADRs are fungible, and almost all Chinese ADRs have HK dual listing, thus can be converted to shares in HKEx, and note in 2024 many (e.g., BABA) have upgraded their HK listing to primary to access capital in mainland China, and better prepare for delisting risk.

Some might remember the Sberbank saga in which the US could take extra measures, in addition to delisting, put regulatory restrictions on what broker and depository banks can do, thus trapping its ADRs in the US. The counter to that is if the objective is to inflict pain, only estimated 15-20% ADR holders are Chinese investors, while ~50% are US institutional investors, 10-15% US retail investors, and rest are wealth funds/ETF (sovereign), one could question how much pain it can effectively create to Chinese counterparty.

Not to mention, delisting companies without a compelling, universally accepted cause would damage the reputation of the US capital market.

However, I believe the US could revive the idea of compiling a list of compliance requirements that Chinese ADRs must adhere to (like it did after the Holding Foreign Companies Accountable Act (HFCAA) in 2019-2020), and set a deadline with the objective of inflicting pain. The mere threat would compel many ADR holders to seek an exit, create panic in the ADR market, and likely spread that panic to the HK capital market.

I think the odds of that happening have increased significantly since the US-China standoff, as each side slowly rolls out various tools to exert pressure.

That’s the driving force behind my decision to exit Chinese ADRs.

For readers holding Chinese ADRs and converting to HK shares as a contingency plan, I think the next section could be valuable to you.

How ADR works

For simplicity, I will use BABA as an example.

When you purchase 100 shares of BABA from your broker (e.g., Fidelity, IBKR), your broker relays that to the designated Depository Bank (Citi in BABA’s case), and Citi will allocate 800 shares of BABA’s HK shares (9988.HK) from its pool for you (1 BABA ADR = 8 corresponding HK shares).

When you request a conversion, your broker notifies the depository bank, which facilitates the conversion by cancelling the ADR and delivers the HK shares to your designated receiving Broker (note your receiving broker could be your current broker or a different one).

You shall check with your current broker and ensure it supports the conversion, understand the associated cost, required timeframe, and future tax implications.

Concluding Thoughts

US-China Tariff Standoff, at its core, is a high-stakes brinkmanship game.

Each side leverages its tariff, export limits, and other special tools (e.g., China’s UST holding and the US’ Chinese ADRs) to pressure the other.

Each side seeks optimized strategies to deliver acute pain with long-lasting effects to get the other side to the negotiation table.

With that, imo, an outright delisting of Chinese ADR would be an ineffective strategy; a more likely approach is to construct a framework (new compliance/regulation) with a threat to delist Chinese ADR if they don’t comply in a timeframe that aims to maximize market panic.