written_testimonies of Dr. Norman A. Bailey, former Special Assistant to the President and Senior Director of International Economic Affairs at the National Security Council

before the

U.S.-China Economic and Security Review Commission

China’s Presence in Global Capital Markets

SD-138 Dirksen Senate Office Building

April 16, 2004

I’m pleased to have this opportunity to appear before the U.S.-China Economic and Security Review Commission on a topic that is on the cutting-edge of our bilateral concerns with China.  I also wish to applaud the Commission’s leadership on this important national security issue.  Yours is the only organization of the U.S government to be examining this crucial matter on an on-going basis.

Today the Commission is hearing about various dimensions of China’s presence in the U.S. and other international capital markets, including recent examples of Chinese offerings and the woefully inadequate corporate governance practices associated with Chinese debt and equity offerings in this country and abroad.  I’d like to add to the governance equation an issue of great importance to investors and our country, namely the national security htmects and implications of China’s fundraising on U.S. exchanges.

In short, Chinese entities coming to our markets have largely been “black boxes” in terms of full disclosure, minority shareholder rights, the true nature of the activities of these firms domestically and overseas (and their parent, subsidiary and affiliated companies) as well as the material risks that exist for American and other investors.  One category of these “material risks” has periodically surfaced in the security arena. 

For example, the vast majority of Chinese entities tapping the U.S. capital markets are state-owned enterprises.  Each of these companies is often engaged in a wide range of activities from manufacturing refrigerators to the skins of ballistic missiles.  Some Chinese firms listed or traded on U.S exchanges have been identified with arms smuggling, military-related production, and intelligence-related activities.  There is at least a possibility that Chinese firms associated in the past with the proliferation of weapons of mass destruction and ballistic missiles are already in, or headed toward, our markets and the portfolios of unsuspecting American investors.

A central problem is that Chinese companies with these types of security-related ties or involved in the sale of dual-use equipment and technology (with both civilian and military applications) are not inclined to disclose these activities in their SEC filings or prospectuses’.  For their part, the U.S. investment banks bringing these equity and debt offerings to our markets may also not be equipped to ferret out these kinds of associations and activities that can represent a material financial risk to investors and a potential danger to U.S. security interests.

It is for this reason that the Executive Branch should be urged by Congress to institute an and interagency review process of the type that we implemented during the Reagan Administration in dealing with similar commercial financing linkages to security-related concerns.  At that time, the National Security Council assumed the lead role in coordinating the bulk of these activities, including a highly-classified “Follow the Money” initiative on the financial side of U.S.-Soviet relations.  The fact is that it is only when the competent financial agencies of the government (e.g. the Treasury, SEC, the Federal Reserve, etc.) are sharing information and analyses with the security community (e.g. NSC, CIA, and the Departments of Defense and State) that a meaningful result is achieved in the areas of investor protection and broader U.S. security concerns.  To my knowledge, no such interagency process is in place today that is designed to systematically review Chinese entities, particularly state-owned enterprises, listing or traded on U.S. exchanges.

To its credit, the Commission has recommended these kinds of steps to the Congress in the past and should continue to press ahead with such action items now.  The quest for greater disclosure and transparency has been well-served, for example, by the recent establishment of an Office of Global Security Risk at the SEC, but that office is mandated to concentrate on companies doing business in U.S.-sanctioned countries, not China.  This gap in investor awareness and information needs to be addressed as a governance initiative.  China will almost surely ramp up its exposure in the U.S capital markets dramatically over the next two to three years.  In a relatively short time that exposure could total over $150 billion or more.  This would mean that millions of Americans are holding often non-transparent Chinese equities in their public pension systems, mutual funds, 401 (k)’s and other portfolio holdings.  To avoid a future “Chinese Enron” like the kind that could eventuate if a Chinese proliferator were to list successfully, for example, on the New York Stock Exchange, the Executive Branch needs to work in partnership with investment banks and other private sector market players and regulators.

For its part, the Congress needs to insist on the formation of some kind of interagency  capital markets working group concentrating on Chinese debt and equity offerings in our markets and evaluating the true identities and global activities of these enterprises and their senior managers.  This group should also examine Chinese securities listed in Hong Kong on Mainland exchanges that are traded in the U.S. and held by U.S. institutional investors.  Specifically, it is more likely that “security-sensitive” Chinese firms will be purchased by U.S. investors out of Hong Kong or China itself as the disclosure requirements for such entities are generally more lax than those of U.S. exchanges.  This is particularly the case for Chinese companies listed on under-regulated domestic exchanges.  The Congress then needs to conduct oversight of the findings and activities of such an interagency capital markets working group to ensure that investors receive adequate data to make properly informed investment decisions.

Recent examples of Chinese offerings, like the problems that surprised investors in China Life, are instructive with regard to the potential future consequences of the U.S. government playing no role whatsoever in monitoring security-related concerns associated with Chinese entities entering our capital markets.  Although it is clearly not the government’s job to assess risk or perform due diligence for investors, there is little prospect that even the finest commercial due diligence could identify proliferation-related abuses or other covert activities that could later harm the share value of the offending company.  

Mr. Chairman, in closing, I think we can welcome benign, commercial Chinese entities that seek to fund themselves in our capital markets, particularly as the requirements of our markets can help discipline and reform these Chinese enterprises.  Nevertheless, we must not permit the wrong sorts of Chinese enterprises to attract the retirement and other dollars of average American investors to help underwrite the proliferation of weapons of mass destruction, the procurement or development of state of-the-art military systems that could one day be used against U.S. forces, or other malevolent activities within China or abroad that could damage vital U.S. security interests.

Thank you very much.