China Required More Funds to Complete an Aircraft Carrier; U.S. Investors May Have Helped

It is no secret that China is focused intently on developing aircraft carrier capabilities to project power well beyond its borders. It has been doing so since the mid-1980s, with the country making major strides and recently starting sea trials on what state media describe as China’s third and most advanced aircraft carrier, with a fourth under construction.

But what is less well known is that U.S. investment money may have helped bankroll China’s aircraft carrier program by providing financial liquidity in 2018 and 2019 to complete its second flattop, Shandong, giving the country a capability that can be used to further threaten Taiwan and its neighbors.

The ship is now a major component of China’s naval power. In a report to Congress last year on China’s growing military threat, the Department of Defense said, “the Shandong conducted its first training exercise in the Philippine Sea with J-15 aircraft entering Taiwan’s air defense identification zone for the first time, demonstrating the People’s Liberation Army’s increased capabilities further from China’s borders.”

At issue is a $1 billion bond issued by a company named Poseidon Finance 1 Ltd., incorporated in the Cayman Islands in 2017. With just one share and just one dollar in capital, the special purpose vehicle raised $1 billion for China’s state-owned China Shipbuilding Industry Corporation (CSIC), the Shandong’s shipbuilder.

Poseidon’s 341-page “Offering Circular dated 25 January 2018” said that CSIC would use cash raised by the fund for “general corporate purposes and refinancing existing debts,” in other words, to build ships.

Poseidon likely sold a material percentage of its bonds to American investors, who were on the hunt at the time to invest abroad –U.S. investors increased their ownership of foreign securities by more than $1 trillion in 2018. American investment made the bond offering more likely to succeed by flooding the wider Chinese market with cash.

At the same time, it’s unlikely U.S. investors were unaware of the connection between CSIC and China’s military. Poseidon’s Offering Circular is replete with references to CSIC’s extensive military shipbuilding efforts. CSIC’s corporate symbol prominently features a warship, leaving no doubt as to the company’s primary mission. What’s more, China’s shipyards are dual use, building both commercial and military ships, a common practice within the state-owned Chinese shipbuilding industry.

The bond issuance and completion of the flattop

While there is no direct “smoking gun” that ties the Poseidon bond specifically to the construction of Shandong, there are indications that the two are well connected.

First is CSIC’s own financial information. Poseidon’s Offering Circular revealed that CSIC “had recorded negative net operating cash flow for the year ended 31 December 2016.” Even in China, with its low labor costs, building warships requires cash. CSIC’s defense-related revenues grew 17% from 2018-2019 alone before its merger with another Chinese shipbuilder, suggesting a surge in its warship production capacity once the bond was issued.

Second, China’s communist government was able to take advantage of a loophole in the escalating trade war with the United States. In 2018, when the bond was issued, the U.S. was more focused on the direct transfer of technology with military implications rather than pure investment. The Poseidon bond is just an investment and not technology transfer.

Third, Poseidon took several steps that created a degree of opacity about the bond issuance. It promised either to exchange the bond investments for shares of the Postal Savings Bank of China (PSBC) or to pay back 107.23% of the bond purchase amount in seven years. In addition, Poseidon was formed in the Cayman Islands, used the Frankfurt Stock Exchange for a trading platform and routed cash from the bond proceeds through the British Virgin Islands, a decision noted in the bond offering.

To better frame the context, consider the unlikelihood of a U.S. shipbuilder raising money through a bond offering and securing that offering with shares of an unrelated company. While the offer to exchange bond proceeds for shares of PSBC may not surprise China watchers, the unusual structure reflects the unitary command by, and subordination of all entities to, the state communist party and the high priority the government would place on completion of the aircraft carrier. The Offering Circular, p. 100, even includes an organizational chart that identifies the State Council of China, the chief administrative authority in the government, as its top corporate authority.

Lastly, the company’s suggesting the importance of that ship to the firm.

A wider problem than just an aircraft carrier

The possible funding of the carrier Shandong is not the only time that U.S. investors may have bankrolled  a weapon used by China’s military. A U.S. House panel investigation in February found that over the course of more than two decades, five U.S. venture capital companies had invested “at least $3 billion in, and provided expertise and other benefits to, the People’s Republic of China critical technology companies, including many aiding the Chinese military, surveillance state, or the Communist Party’s genocide in Xinjiang” against the Uyghur minority population. And that’s only a sample of five such companies.

Much has changed since the bond issue for CSIC, with the U.S. government curtailing investment into China that could benefit the military. Both CSIC and CSSC, the shipbuilder with which it merged in 2019, have since been added to the list of companies banned from U.S. investment, a process begun by the Trump administration and expanded under President Biden. And a 2023 executive order from the Biden administration continues the ban on technology trade with China.

A strategy for shutting down the flow of funds

But the U.S. needs to move beyond prohibitions and sanctions. It can more quickly, more potently and more dynamically squeeze cash flows to China’s government-controlled companies with a few minor changes to investment incentives.

Across the nation, U.S. communities add costs for buying alcohol and tobacco. Similarly, and for good reason, U.S. regulations could add a surcharge on investments supporting the China’s capabilities, call it a “security fee.”  Deposit, say, just 4% of such an investment with the U.S. Treasury. Companies like TikTok and Huawei could attract this treatment.

Raising the exposure of advisors for their investment decisions can quickly change behavior. U.S. pension funds could require investment managers to represent that they are not funding development China’s military capabilities. Another, more obvious method is to warn investors that China will use all elements of its power, including its economy, to build military capability.

It is time to spread the word — loose, unclear investment tips may help build more Chinese warships.

 

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