One problem with measuring China's growth is that the investor is dependent on Chinese official statistics, and many economists openly question the reliability of these. Top Sociétié Général analyst Albert Edwards has suggested that, for all the hyperbole, China is in fact deeply mired in economic problems, and that official data is smoothed to flatter growth. He compares GDP growth, for example, with electricity generation (a proxy for industrial activity), and finds that the correlation broke down completely earlier this year.
Mr Edwards wonders if, while the government was boasting about output recovering, manufacturing was in fact at a standstill. "Personally I believe the bullish group-think on China is just as vulnerable to massive disappointment as any other extreme of bubble nonsense I have seen over the past two decades," he concludes. "The fall to earth will be equally shocking."
Some fund managers agree. Just last week, : "We think China is going to disappoint. The Chinese banking system is pretty rotten. Nobody wants to build new factories."
China's unelectrifying growth
Economic growth isn't profit growth
Setting aside questions about the reliability of China's economic data, there's a more fundamental issue: the assumption that rapid economic growth automatically equates to superior returns for investors. The reality is that is usually does not.
The chart below illustrates this. It shows the performance of Chinese equities versus those of UK and US equities since the start of 1993. As you can see, China's economic growth has left us in the dust. But it's a different story in the markets. Developed capital markets have enriched shareholders to a far greater degree.
Chinese equities vs UK and US equities
Rotten companies
A key reason why China's economic growth hasn't rewarded western investors is the structure of the country's capital markets and its companies (see box below). Even the most die-hard China bull would have to admit that investing in Chinese shares is horribly complicated – as Burton Malkiel observes: "A unique feature of [Chinese] equity financing is the coexistence of an alphabet soup of A shares, B, H, and N shares".
China bulls argue that this confusing array of structures is mainly irrelevant – that buying shares is in reality a bet or option on broader economic growth, and that eventually they will converge anyway. "You cay buy exactly the same share outside of China that you can buy inside it, but at a discount... That discount is going to disappear some day, because some day, you're not going to have all these crazy different classes of shares," said last year.
Maybe so, but the confusing ownership structure does have some material, direct and negative consequences.
One is volatility. As professor Malkiel comments: "The Chinese stock market was more than twice as volatile as the US market during the 1995-2004 period, even though the US market itself went through a spectacular boom-bust cycle."
That's partly because domestic market valuations are influenced largely by short-term speculators (driving prices up), and arbitary changes in market regulation (sending prices crashing down). As Barry Norris remarked: "Lots of money is not going into the real economy... The ratio of the value of the stock market to GDP is higher than anywhere in the world."
| Chinese share classes |
|---|
A shares: incorporated in China and traded in renminbi on domestic A-share markets. Currently available to Chinese citizens only, although selected foreign institutional investors are allowed to trade A shares. B shares: incorporated in China, but traded mostly in dollars on the domestic B-share markets. Used to be reserved for foreign investors, but are now open to Chinese too. H shares: incorporated in China but listed in Hong Kong. N/L shares: as with H-shares, but quoted in New York or London. Red chips: incorporated in Hong Kong and traded there in Hong Kong dollars, but substantially owned by Chinese government entities. |
Corporate governance - don't ask
No matter which class of shares you (or your fund manager) end up buying, the reality is that you are usually buying a company that's majority-owned by one of the world's last remaining Communist governments. That has profound implications. Put simply, Chinese companies are not run for the same reasons as western companies are, especially ones that are in 'strategic' sectors such as energy or telecoms.
As the International Development Corporation (part of the World Bank) stated in a report last year: "They often have complex and opaque corporate ownership structures, overlapping new and traditional bodies of corporate control, and reporting practices that are focused on satisfying the information requirements of the authorities rather than the needs of investors."
Such companies exist primarily to help raise capital for China's broader economic development – if shareholders are rewarded, it's often by coincidence, rather than design.
Some think this is changing for the better, with big overseas-listed companies in particular now increasingly run to deliver value. But the evidence doesn't always confirm this optimism. A survey conducted by CLSA Asia-Pacific Markets, an investment bank, and the Asian Corporate Governance Association, ranked China ninth out of 11, behind only Indonesia and the Philippines.
Although the quality of financial reporting among large companies is now quite high, especially among those listed overseas, the value of non-financial reporting is much lower. The disclosure of director remuneration is often quite vague and misleading, while rules governing disclosure of share transactions by directors and material transactions are not up to international standard. There is little scope for minority shareholders to organise themselves into an independent association to protect their interests against over-mighty majority owners, either.
These issues resonate strongly with David Webb, a former investment banker turned shareholder activist in Hong Kong. He's made himself profoundly unpopular with many leading Chinese businessmen because of his enthusiasm for transparent financial reporting and rigorous observation of the rules. You can read entertaining accounts of some of his battles at www.webb-site.com.
He splits the listed Chinese companies into two categories: the smaller privately-owned enterprises free of government control and the large, mega-cap corporations under the thumb of the party. With the latter, he worries about a "lack of consistency" generated by having senior managers who can be both senior party members and senior managers. With the privately-owned, frequently family enterprises he suggests that investors should "simply worry about them [the bosses] vanishing".
Mr Webb suggests that the vagaries of Chinese power politics mean that simply buying the top companies of today "doesn't mean that they will be the top companies of tomorrow. You need some very specific research and to understand the future growth potential of these companies".
Mr Webb has neatly summarised the challenges facing institutional shareholders in Chinese companies in the table below.
| US/UK investor worries | Emerging Markets investor worries |
|---|---|
| Are the chairman and chief executive separate? | Are the chairman and independent directors separate? |
| Should I force a director to resign? | Do I have any influence at all over the board? |
| Should I accept a bid to take the company private? | How much will be expropriated anyway if I don’t? |
| Will I get enough votes to win a proxy battle? | Will there be a proper vote at all? |
| Will this acquisition enhance value? | Does this acquisition have any value? |
| How much is the company spending on research and development or new product launches? | How much is the company spending on speculating in the stock or property markets? |
Buying outside China won't help
Alarmingly for UK investors, Mr Webb is hugely dismissive of western-listed Chinese companies such as the hordes that have joined the Alternative Investment Market (Aim) in the past few years. He thinks they choose markets such as Nasdaq or Aim to get higher valuations and to prey on "gullible" investors. Numerous investigations in the US have highlighted material shortcomings in corporate governance and financial reporting.
Herb Greenberg, from US news service MarketWatch, has investigated a range of Chinese equities. "The goal of many of these promoters is to help companies avoid regulatory scrutiny," he says, reeling off a long list of failed Chinese-American companies. These include China Energy Savings Technology, which fell apart after just eight months amid concerns about "undisclosed sales of shares by insiders", and Bodisen Biotech, which was delisted in the US in 2007 owing to concerns about its regulatory statements, but which remains traded on Aim.
Mob Rule
It's not the only one. MonsterMob once looked to be one of the most promising companies in the mobile content generation business. Like many of its peers, it soon worked out that the Chinese were avaricious consumers of mobile technology including easy-to-download gambling applications and SMS services. It rushed into the Chinese market, investing millions in a range of Chinese ventures.
Within a few years, these big headline ventures had collapsed. Back in the summer of 2007, MonsterMob announced to a shell-shocked market that it had been "informed by the management of two of its Chinese subsidiaries, M Dream and W Infinity, that these companies will no longer be supplying the company with any further financial or operational information".
Asia calling
London Asia, once backed by City bigwig Sir David Brewer, was destined for great things. It portrayed itself as a fast-emerging London equity investment house that was determined to back a wave of Chinese companies that wanted to list on the London market. This it did – more than half a dozen Chinese small caps floated on the UK markets – but London Asia itself soon ran into problems. Back in 2008, it announced that it was delisting from the market because it had been "unable to prepare and publish audited accounts for the year ended 31 December 2007".
It made a loss that year owing to provisions made to reflect the value of a number of the company's listed holdings, plus losses after one of its biggest investments, UK Plus-listed China Education Group, decided to delist. Problems also emerged with accurate valuations of its holding in a company called LAC Zhongying, which had been one of its largest investments.
Vanishing director syndrome
If you find yourself out of favour in China for any reason, disappearing often looks a good idea. But not for your shareholders. Take ZTC Communications, where Charles Huang, its founder and 74 per cent shareholder, vanished late last year. His disappearance destabilised ZTC's employees and creditors, and may have resulted in the removal of some of the company's assets from its factory.
The company's shares were suspended. He's not the only one. Canton Property Investment, which raised £27m in its Aim flotation in 2008, reported that chief executive Keng Wong had mysteriously become "absent from the company and uncontactable".
In the meantime, various financial issues with the underlying investment in a shopping mall called Comic City in Guangzhou had come to light – including the fact that company assets had been pledged against other debts.
Even those close to the Party are not immune. Zhou Beifang, who ran a Hong Kong-listed subsidiary of the giant Shougang corporation and whose father had close ties with patriarch Deng Xiaoping, was famously banged up in 1995 for "economic crimes".
Extracurricular activites
Chinese managers are good at multi-tasking. Just look at Jetion, which alleged that chief executive Roger Lijin Gai and three senior managers ran a business producing and exporting solar modules in direct competition with Jetion, and that family members were also shareholders in a rival company. All four have since been dismissed, but the shares have not recovered.
