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China's equity markets: Buyer
beware
By YongYan Li
BEIJING
- Overseas money is now theoretically free to be poured
into China's equity markets, hitherto closed to foreign
direct investment. Toward the end of last year, the
Chinese government allowed "qualified foreign
institutional investors" to set up portfolios investing
in China's stock exchanges. Before charging into the
most liquid form of investments in this emerging market,
be forewarned, however, that one may end up with more
than one bargained for.
It is said that no matter
whether you are a bull or a bear, you can make money as
long as you get the stock-market movements right. But
that assumes the market behaves, for the most part, as
an approximate proxy for the underlying economy and
within a sound legal framework. In other words, an
investor has only to worry about the market fluctuations
in a well-regulated stock exchange. The more regulated a
market is, the more attractive it becomes.
What
is perverse is that while some investors lament the
recent decline of moral standards in Wall Street houses,
they rush to the emerging markets that are subject to
much poorer controls and recourse. They convince
themselves that owning a piece of Chinese companies is
like owning a part of the one of the fastest-growing
economies in the world. Rather than get embroiled in the
bureaucratic, corrupt corporate nightmares, the foreign
investors now have a way of taking a stake that is
highly liquid. No more lost sleep over a redundant,
unskilled workforce or an obscure tax system. No more
wringing of hands about production hiccups, inventory
pileups, or foreign-exchange controls. But there is one
question that sticks out like a sore thumb: how can the
stock market be immune from the ills that plague the
whole of China's economy?
The biggest peril
associated with investing in China's stocks lies in
fraud, the kind that is widespread, deep-rooted and
incurable.
There is no telling the extent to
which the listed companies resort to cheating. But the
dozens of cases that have been made public are alarming
in their sheer contempt for laws. From financial reports
to accounts books, and from bank statements to related
transactions, everything can be falsified. From
management to auditors, and from law firms to securities
brokers, everybody can be a paid co-conspirator.
Non-existent sales are recorded, imaginary profits are
announced, while in reality the companies are insolvent
even before they get listed. After they lock in and
squander away the subscription money from an
unsuspecting investing public, they suddenly become
truthful and disclose a horrendous loss.
The
first reported fraud case in the stock market involved a
cathode-ray-tube (CRT) maker in Sichuan province. In the
year before it went public, the company ran up a loss of
53 million yuan, making it ineligible for the induction
in the stock exchange. The rules require that a
prospective firm must have shown a certain profit growth
for three consecutive years immediately before the
listing. So the company, with help from auditors and
lawyers, forged a financial statement showing a 54
million yuan profit in 1996, a magic 108 million yuan
swing from the red to black. The regulatory authorities
may well be kept in the dark, but the market continued
to be unkind. Within 10 months after going public, the
tube maker stunned the market with a loss of 200 million
yuan. All the shareholders' equity was lost and then
some. There was no money even to pay the million-yuan
fine levied by a red-faced Regulatory Commission.
Worse yet, courts simply refused to take up
stock-related lawsuits, denying investors, institutions
and individuals legal remedy. That changed in January
2002 when China's Supreme Court issued a notice allowing
suits to be filed. This appalling failure in justice
should not come as a surprise, given the fact that a
Securities Law was not promulgated until eight years
after the stock market reopened in 1990.
China's
stock exchange is an abnormality. Forty years after the
communist government abolished the Shanghai Stock
Exchange to the dustbin of history, it was
re-established in 1990, primarily as a tool to take over
the financing of state-owned enterprises (SOEs). In
China's socialist economy, everything was owned by the
state. So it followed that the Treasury funded all
companies. Because socialism never works out nor
produces efficiency, the government coffers were sucked
dry soon enough. Then the state-owned banks - there was
no other kind - were ordered to take over as the
lifeline, until they, too, were near collapse under the
bad debts thus accumulated, threatening to bring down
the whole financial system. The next bag of blood
transfusion was found in the stock market, of course.
That is the root cause of the pervasive frauds:
the government is directly responsible for and has an
active part in the cheating. A company in the northeast
province of Heilongjiang went public on false accounts
fabricated jointly by the local government and
Commerce/Industry Administration, an agency whose job it
is to make sure all business activities comply with
rules and regulations.
That also explains why it
is nearly impossible to go after the thieves one way or
the other. Civil litigations are next to impossible for
a variety of reasons, every one of which is rigged
against the wronged party:
1) Chain reaction:
One victory for the plaintiff may very well open the
floodgates for pent-up anger among the Chinese
investors. Countless smaller punters have been hurt bad
but have no legal recourse.
2) Creditor banks
are unwilling to write off the bad debts owed by the
cheating companies. Once a company is forced into
bankruptcy, not a single cent will be salvaged. On the
other hand, bad debts sound better than dead debts. So
everybody will go on pretending that the debts are still
collectable as long as the debtor is still breathing.
3) Local governments will do everything possible
to keep bankruptcies from happening on their watch. It
will look bad.
4) More important, Beijing has
always stressed that stability prevails over anything
else, economics included. What is a few billion dollars
when it comes to keeping in power? Bankruptcy means
unemployed workers, and that in turn means instability.
The courts, of course, are worried about the health of a
government, because the government owns the courts.
Then there are other, technical considerations
that may give would-be investors pause: the stock in
circulation accounts for about 32 percent market cap of
the listed companies. The balance majority stake is held
by the state. Nobody knows when the government will
decide to cash in on the holdings, or how. And it is
scary to think what will happen when that big chunk of
equity hits the market. Also, public companies are not
known to be generous with dividends, supposing there is
any money left.
More baffling is the fact that
many companies issue not one, but three categories of
shares, A, B and H. A category is the ordinary share
just opened to foreign investors. B shares are
purchasable only in hard currency other than yuan, and H
shares are traded on Hong Kong's stock exchange. Last
but not least, given the poor management and backward
technology, the fact that the stock market sports an
average price-to-equity ratio of 40 is beyond any
reasonable explanation.
The only positive thing
about the coming influx of foreign funds is that, when
more international pressure is brought to bear on China,
the system just may change for the better. Until then,
it's caveat emptor.
YongYan
Li is an analyst of Chinese business.
(©2003 Asia Times
Online Co, Ltd. All rights reserved. Please contact content@atimes.com for
information on our sales and syndication policies.)
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