Wednesday, September 14, 2005

Beware the sting in the dragon’s tail

By Debbie Harrison

It’s no wonder that the “China story” has been dominating the press lately. Economic growth is pushing 10 per cent a year, per annum, double or treble the rates currently achieved by most western economies. Labour costs are one-twent-ieth of US and UK rates, and with its vast , cheap labour force China has justly earned its reputation as the factory – as well as the fake – centre of the world.

China enthusiasts also point to the modest 2 per cent appreciation in July this month of the renminbi, the local currency, which may begin to ease strained trade relations with the US and could signal further rises against the US dollar. The 2008 Olympic games will be held in Beijing, triggering a massive investment in infrastructure, while the country’s membership of the World Trade Organisation (WTO)and its move towards a western-style free market economy are all promising signs for foreign investors.

Chinese companies are certainly eager to secure inward investment. But for most companies, their main source of capital is bank loans, where interest rates are centrally controlled and where substantial bad loans can lurk in the background. The need for reform is an urgent issue.

China’s largest state banks are being prepared for stock market listings over the next few years and foreign institutions are expressing interest but need to see a clean balance sheet. This is particularly important for investors in China given the prevalence of bank debt.

The debt-equity balance here is very different from the UK,” says says Katherine Tsang, chief executive of officer for Standard Chartered Bank in China, speaking at a Shanghai conference organised by Cass Business School for MBA students. “Over 80 per cent of business funding comes from the banks – there is no equivalent to the UK corporate bond market.”

Liu Mingkang, the chairman of the China Banking Regulatory Commission, is also keen to introduce western-style regulation and draconian heavy penalties for financial fraud. Scandals have included theft and arranging loans without due diligence – for example, to personal acquaintances – and also in return for large commissions.

Liu is planning to introduce new offences for financial crimes and bank fraud. “The cost of doing evil things is too low in China,” he says. By contrast, economic crime, such as bribery and other forms of corruption, is already a capital offence. According to local press reports and official announcements, tens of millions of dollars have been stolen from Chinese banks over the past year.

Yet foreign capital is continuing to pour into China. There is clearly the potential for substantial gains but China investment specialists recommend that would-be investors also hear the alternative China story, as it this is less enchanting.

The move to a market economy is painfully slow. China is still an authoritarian country where the government controls everything from what the press say to the official starting date for the summer’s hot season, when factories are forced to switch to unsociable hours in order to conserve energy expended on air conditioning.

There is widespread evidence of poor disclosure and financial reporting; weak corporate governance is a serious problem and many companies maintain the dual role of chief executive officer and chairman, a system discredited in the UK. Investors seeking professional business plans from company management will be disappointed.

The mainland exchanges – Shanghai and Shenzhen – suffer from ragged regulation and may be flooded with government-owned stock at any moment, diluting the value of privately- owned shares. Figures are not reliable and debts and assets can get shifted around a group of companies. Figures quoted for profits may also be unreliable or, in the case of multinationals, worldwide figures may be used quoted but the profits for the Chinese enterprise may not be disclosed.

Paul French, publishing director of the Shanghai-based business and economic analyst AccessAsia, says: “The Shanghai exchange has a long way to go to meet international standards. At present it is mostly composed of non-tradable shares – 65 per cent are owned by state holders. The government seems reticent to move to a completely tradable share system, and the overhang makes it difficult for companies to come to market.”

As a result many foreign investors gain exposure to China via the Hong Kongexchange, which is where most privatisations take place and where governance and regulation are up to international standards. And But even when where the company is listed on the HK exchange, post IPO the group might inject some undesirable assets that will affect the future profitability after the initial public offering.

HoweverThe usual fundamentals on which fund managers base stock selections are not always available even if the company is launched in Hong Kong. on the Hong Kong exchange. State-owned companies tend to sell only a small part of the group to the public and, while the IPOinitial public offering (IPO) might look attractive, investors have no idea what lies behind the scenes. Due to foreign demand, many IPOs have been sell-outs, so companies don’t tell prospective investors any more than they have to.

As all the fund managers want in on China, IPOs almost without exception are oversubscribed,” French says. “This makes it a seller’s rather than a buyer’s market and since it is so difficult to pierce the corporate veil it also makes the investment process far more speculative than it might appear. Given pitiful dividends and hazy results, most investors are betting on China’s future rather than company fundamentals.”

Henrietta Luk runs Dalton Strategic Partnership’s Melchior Greater China Opportunities Fund from Hong Kong and generally prefers companies that can benefit from China’s economic growth rather than companies in mainland China.

The big issue for investors is not so much outright fraud, which can happen anywhere, as we have seen with WorldCom and Enron, but rather it is the problem of poor management and transparency,” Luk says. “Where the IPO is part of a very big company there may be some undesirable assets and businesses inherited by the group long ago. At the time of the Hong Kong listing the company will be clean but you need to monitor it very carefully afterwards to make sure the group does not inject something into the company that you don’t like. If I spot any warning signs I pay the company a visit.”

Local experts say that corporate governance is beginning to improving, but clearly this is something investors need to check carefully. Amy Sommers, a partner in the Shanghai office of international law firm Squire, Sanders Dempsey, says: “In the changing regulatory environment, thriving companies will toe the governance and legal line and will not rely too heavily on ‘guanxi’ – relationships with people in the right places – which is the traditional way of doing business and is still prevalent.”

But company blow-ups are not uncommon in China funds. Luk says that to withstand competition companies need to have critical mass and a clear niche. “I look for companies that have a high barrier to entry so that it would be difficult for new competitors to represent a major threat. The company needs to be able to demonstrate specialist knowledge and expertise, and have a strong brand.”

Greg Kuhnert, joint fund manager for Investec’s Asian equity fund, says: “We are looking for profit growth in the energy, oil and mineral resources sector rather than in manufacturing, where there is rapid margin erosion and over-supply, leading to profit warnings. It is important to recognise that the economic growth in the Chinese economy does not reflect an homogenous picture across all sectors.”

Some investors in China have seen startling gains. But this market also holds the potential for sizeable losses. Advisers therefore recommend that private investors who are attracted by the neon lights of Shanghai seek out the services of a specialist fund manager.


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