中国公司海外上市系列:CHINA’S PRESENCE IN GLOBAL CAPITAL MARKETS IMPLIC

http://www.uscc.gov/hearings/2004hearings/written_testimonies/04_04_16wrts/gamble.htm

           

CHINA’S PRESENCE IN GLOBAL CAPITAL MARKETS

IMPLICATIONS FOR U.S. ECONOMIC AND SECURITY INTERESTS

HEARING

BEFORE THE

U.S.-CHINA ECONOMIC AND SECURITY

REVIEW COMMISSION

ONE HUNDRED EIGHTH CONGRESS

April 16, 2004

 

 

Written Statement of William Gamble

Emerging Market Strategies

281 Olney Street

Providence, RI 02906

401-272-8906

[email protected]

 

 

Economics is not just about capital and technological constraints. It is also about political‑legal institutions, such as the protection of property rights and the enforcement of contracts that are critical determinants of sustainable economic growth and investment opportunities. The problems of the Chinese economy are systemic. The Chinese Communist Party has chosen power over the law. In the process they have created a dysfunctional legal infrastructure. Without an economically efficient legal system, the economy relies instead on second or third party social norms (guanxi/connections) to function. Such a system not only prevents sustainable economic growth. It fails to protect the property rights of foreign investors.

 

 

 

PART I

SIZE OF THE US DIRECT INVESTMENT IN CHINA

 

 

 

1. What has been the amount raised by Chinese firms in the U.S. Capital markets for the years 2001, 2002 and 2003?

 

Commercial paper, corporate bonds and convertible paper are just beginning to be issued by Chinese firms on their domestic markets. The government has $280 bn. of Chinese Treasuries outstanding. Chinese firms get over 90% of their financing from the state banks. They have no reason to raise money on the bond market, because the bank loans are cheaper. Companies do not have to pay market rates. They pay the rate fixed by the government regardless of the risk. State Owned Enterprises (SOEs) are almost guaranteed loans that are almost automatically rolled over at maturity. Therefore, my response refers only to equity raised by Chinese firms in US Capital markets:

 

2001 Two listings $ 1,720,700,000

 

2002 One Listing $ 1,434,200,000

 

2003 Two listings $ 3,098,000,000

 

There are other Chinese ADR’s listed on American stock exchanges. The total number is about 51 firms. Companies that do not list their initial public offerings (IPOs) on American exchanges, will do their IPOs in Hong Kong and then list their Hong Kong shares on US markets as ADRs.

 

The Chinese have a large incentive to maintain their image as a preferred destination for foreign capital. The government is very careful in choosing companies to list on US exchanges. They pick large SOEs with the greatest appeal and potential. The so-called national champions are usually companies in traditionally blue chip sectors like oil, telecommunications, cars, shipping, pharmaceuticals, petrochemicals, insurance and utilities.

 

Despite the careful selection by the Chinese and the hype by the American financial community, Chinese stocks generally lose money.  “According to Barron’s magazine, a sister publication of the Wall Street Journal, of 208 offshore open‑ended mutual funds focused on China in the five years to April 1st 2003, the average China fund lost 4.2% a year. A US$1,000 investment in these funds in 1998 would be worth US$807 today ‑ not the story China wants people to hear. The five‑year return for 23 US‑based China funds was only a slightly less miserable negative 3.7% a year, reducing an original US$1,000 investment to US$828.” China Economic Review, April 12, 2004, available at http://www.chinaeconomicreview.com/index.php.

 

This should surprise no one. As we all should know by now, socialism does not work. Government owned companies in every country are badly managed. They end up patronage dumps with political rather than profit objectives.

 

 

 

2. How much U.S. portfolio investment goes toward Chinese firm listing on the Hong Kong stock exchange? What have been the characteristics of such firms, as compared with to those listing in the U.S.?

 

Almost all U.S. portfolio investment goes toward Chinese firm listing on the Hong Kong stock exchange. An American investor, who wishes to purchase a Chinese stock, can purchase four types of investments: ADRs, H shares, Red Chips and B shares. The problem is that these stocks are generally issued by only one type of Chinese firm, a SOEs.

 

American Depositary Receipts or ADRs were first introduced onto American capital markets in 1927. It is a share of stock trading on an US exchange, which represents an investment in shares of a non-US corporation, which trade on a non-US exchange. ADRs trade in dollars. ADRs in Chinese firms represent shares of stock listed on the Hong Kong Stock exchange. Sometimes the ADRs will be sold directly on US exchanges as part of an IPO. Other times the company will package shares already listed on the Hong Kong stock exchange as ADRs and begin to sell them in the US. Since an ADR sold in the US is a “security” it is subject to US jurisdiction and regulation by the SEC.

 

H shares and Red Chips are stocks of mainland Chinese companies traded on the Hong Kong stock exchange. The majority of their shareholders and business are in the People’s Republic of China (PRC). The distinction has to do with the place of incorporation. Red Chips are incorporated in Hong Kong and are subject to Hong Kong corporate jurisdiction. Generally, Red Chips were companies that floated shares on the Hong Kong Stock exchange several years ago. When mainland companies first started listing their shares on the Hong Kong stock exchange, they probably incorporated subsidiaries in Hong Kong to increase investor comfort levels. Companies issuing H shares are incorporated in the PRC.

 

A shares and B shares are shares of stock of companies incorporated and doing the majority of their business in the PRC. Both types of shares are traded exclusively on one of China’s two stock exchanges, Shenzhen or Shanghai. In theory, A shares can be purchased only by Chinese nationals and B shares are available only for foreigners. In practice both A shares are owned by foreigners and B shares are owned by Chinese nationals.

 

There are 1287 companies listed on the Chinese exchanges. With a few exceptions, they are all SOEs, even the ones that are ostensibly private. The beneficial ownership of Chinese companies can be opaque. It is usually hidden behind corporate shells, which invariably lead to a government entity. The government entity in turn is often controlled by a relative of a Chinese leader. The children of Deng Xiaoping, Li Peng, and Jiang Zemin always seem to turn up on the boards of many large companies or their beneficial owners.

Usually Chinese companies list both A shares and B shares. Chinese companies that list shares on the Hong Kong stock exchange almost always have shares listed as A shares and B shares. The B shares are the only way that an American investor can own the stock of a Chinese company that is not listed on the Hong Kong exchange. Historically B shares have traded at a huge discount to A shares, so no one owns them until recently when there have been proposals to get rid of the distinction.

 

Last year in order to boost the performance of the local stock markets, the  central government approved the so-called Qualified Financial Institutional Investor (QFII) scheme. This scheme allows certain qualified foreign managed funds to invest more than $1bn directly into the A share market. It has not helped. Despite the growth of the Chinese economy, stock prices did not increase and remain stuck in a 30 month-long slump.

 

Investors do not want to invest in these stocks, because as the name implies about 50% of an SOE is owned by a government entity. At some point in the future the government entity can dump their shares onto the market and send prices plunging.

 

 

 

3. What proportion of total funds raised by Chinese companies in international capital markets is raised in the U.S.?

 

I do not know the exact number. During recent IPOs, 5% of the new listings have been reserved for the Hong Kong exchange. The other 95% has been raised in the US. If you are trying to raise a couple billion dollars, obviously the largest markets are your best bet. I would guess that between 80 and 90 percent of the total funds raised by Chinese companies are raised in the US. Of course, this does not mean that these securities are purchased by only Americans. Investors from around the world use our markets.

 

To guarantee success of an offering, often a large share is purchased by a multinational as a strategic partner. For example, the American Insurance Group paid about $300 million for a 10% stake in PICC, China’s largest non-life insurer before its $800 million Hong Kong IPO last year. Only ten percent of the offering was available to retail investors and the rest went to institutions. AIG also bought a 10% stake in the recent China Life listing. Alcoa purchased 8% of the Aluminum Corporation of China prior to its IPO in 2001. Royal Dutch Shell bought 20% or the CNOOC $1.2 bn. IPO, which was also brought out in 2001.

 

 

 

4. What are the funds being raised by Chinese companies in international capital markets being used for?

                                                                                               

No one knows. The problem has to do with the poor transparency and corporate governance, which I will discuss in part II. According to their prospectuses the money is used to pay long term debt, funding pension expansion, capital and streamlining production. My favorite is “general corporate purposes.”

 

Recently, some of China’s largest firms have been making acquisitions abroad. Most of these acquisitions are in the commodities areas to secure access to strategic materials like iron ore and oil. Undoubtedly, some of the money raised on international capital markets has been used to fund these acquisitions.

 

It is also true that large sums are simply stolen. For example, two months after a $3.5 bn. IPO by China Life, the Chinese Audit Office uncovered illegal or irregular conduct at China Life involving Rmb5.4bn (US$652m) in funds. Exactly what was taken by whom from what company when, is at this time unknown. What is interesting is simply the size of the number quoted. Although huge, the amount is not unknown. Similar frauds that have been discovered at the “Big Four” state banks have run into the hundreds of millions.

 

 

5. What are the most significant expected future listings of Chinese firms in the near term, in the US markets and elsewhere?

 

In the past year IPOs of Chinese stocks have done very well. They have been oversubscribed. Their prices have increased. The last time this happened was in 2000. With the economy growing at over 10%, at least for now, there are great expectations. Many commentators project that 2004 will be a good year for Chinese companies to float their shares. Estimates range from $15 bn. to $30 bn. They include all sorts of companies.

 

Companies that have been specifically mentioned include a Hebei steel maker, owned by China Oriental Group, Kingsoft, a government supported software house, Ping An, life insurance, airlines, telecommunications and specifically banks.

 

Banking in China is dominated by four huge state owned banks. Together they account for 70% of China’s savings. Banks account for 90% of the capital for Chinese businesses. Virtually all of their loans go to State Owned Enterprises (SOEs). It is this huge volume of lending that is the principal source of China’s economic boom.

 

The banks include China Construction Bank, Bank of China, Industrial and Commercial Bank and Agricultural Bank and they are all insolvent. Nevertheless, to restructure these banks, the government is trying to clean them up in preparation for listings. China Construction is slated for 2004 and Bank of China for 2005. Industrial and Commercial Bank will be marketed in 2006 and Agricultural Bank in 2007. The amounts they expect to raise are immense. China Construction Bank alone is hoping for $ 6 bn.

 



 

 

Part II

Corporate Governance and Transparency in China

 

 

Neither the common law nor game theory trusts agents. Agents have a bad habit. Given the opportunity, they will act in their own best interest ahead of the interests of their principals. Management, employees, bureaucrats, and other agents, unless limited by law, might steal anything that is not nailed down, as any shareholder of Enron, Worldcom, or Parmalat will tell you.

 

The problem with corporate governance is that the agents, the management, the employees, who are supposed to be making money for their investors, have enormous economic incentives to keep the money for themselves. It is only the existence of economic and legal disincentives that discourage the agents from acting only in their own interest.

 

There are basically five categories of disincentives. One derives from the marketplace and the others are based in law. The market disincentive is competition for corporate control. If management cannot run the firm efficiently, it will be bought out by someone who can.

 

The obvious legal disincentive is the legal duty of management (and all agents) to act with the highest care. This is generally referred to as a fiduciary duty. If management gets greedy, they can be prosecuted both civilly and criminally (e.g., Fastow, Ebbers, Stewart)

 

Two other legal disincentives are derived from corporate codes. Corporate oversight is one. The board of directors, especially independent directors, is authorized to rein in rogue executives (e.g., Hollinger International). The other is shareholder empowerment (e.g., Disney, Calpers). Shareholders vote to oust the board.

 

Finally the penultimate discipline is business failure. In market economies, incompetent executives drive their companies under. The creditors can use the law to put the company into bankruptcy and get rid of the management.

 

The other necessary ingredient to good corporate governance is transparency. Transparency is all about the easy of getting accurate information. It requires the fundamental legal right of free speech. Markets are about choice. Efficient choices require accurate information. Accurate information requires free speech. The financial press must have the freedom to get and publish the information. Regulators must have the power and the incentive to force managers to disclose.

 

Potential investments for indirect investors in China are fundamentally limited to SOEs. There are almost no legal or economic disincentives that restrict an SOE’s management. There is no market for corporate control, so they don’t have to worry about a take over. The regulator, China Securities Regulatory Commission (CSRC) has a conflict. It is a government agency regulating businesses owned by the same government. If the CSRC is too diligent, the government loses money. Neither the CSRC nor the courts are independent or coequal. Other government entities can and often do ignore their orders.

 

The management and the board are appointed by the main shareholder, the state or more accurately, the Communist party. Foreign investors never own more than 20 or 30%. Not enough to make a difference. SOEs are not necessarily run for profit. They are run for the goals of their principal shareholder. These goals are the political and economic goals of the Communist Party.

 

SOEs cannot even be closed down. The 1987 bankruptcy law is ineffective and almost never used. A new one has been “in the works” for almost ten years. These zombies are kept alive by loans from state banks.

 

Finally, there is no way to get accurate information about these firms. There are no legal disincentives for management to make full and fair disclosures and very large economic incentives to lie. The press is allowed to go only so far. Usually they are allowed to find a few scape goats to give the impression of effective regulation and that is all.

 

 

6. How transparent are the assets or loan portfolios of Chinese state owned banks listed in Hong Kong or looking to list in the US?

 

With the exception of the Minsheng Bank, which is partially owned by the International Finance Corporation, there is no transparency. The reality is that the banks themselves probably do not know. According to the Chinese, the Bank of China cut its nonperforming loan (NPL) ratio to less than 16 per cent and the Construction Bank reduced its NPL ratio to under 12 per cent. Regulators say the NPL ratio for China’s overall banking sector fell by 5.32 percentage points to 17.8 per cent. Last year the number was appreciably higher at 24% and the year before that it was more than 30%.

 

Private economists have estimated that the real ratio is between 35 and 40% or between $374bn and$749bn. I would go with the higher number. The $45 bn. “bail out” that the Chinese just took from their currency reserves to give to the banks is a drop in the bucket. It is also the second bailout. There was a massive restructuring in 2000, which in theory, turned bad loans into good bonds. These bonds are still on the banks’ books as capital.

 

In Game Theory in the absence of a legal disincentive, a debtor’s best move is to refuse to pay back a loan. Since the Chinese legal system does not have sufficient legal disincentives, the loans do not get paid back.

 

In China the vast amounts of bad loans are due to people, policy and practice. Loan decisions are based on connections or guanxi or rather than on credit analysis. State banks lend to state companies based on state policy. National champions get cheap money. Efficient profitable private firms get nothing. If the reason for the loan is not based on the probability of getting it back, banking practice can be ignored. Documentation is shotty. title to collateral is ignored if it exists. Local branches lend to local SOEs often contrary to directives from central management. No one really knows who owes what to whom.

 

To reduce the percentage of bad loans, the banks use three methods. They transferred the loans to Asset Management Companies in exchange for bonds at the face value of the loans. They exchanged the debts for equity in the debtor. They made more loans. The size of the new loans can be determined by the growth of the economy in the last two years. Most of these loans were probably made to the same SOEs. Like their honored ancestors, these loans will not be paid back.

 

The Chinese government has encouraged banks to make more loans to consumers. The problem with consumer loans is best illustrated by the example of Korea. Excess consumer lending in Korea resulted in bad debts of 1.3% of GDP and a billion-dollar bailout of a credit card company. Without credit bureaus, secured property laws and repossession infrastructure, consumer loans can be as disastrous as loans to SOEs.

 

The reality regarding the NPLs of China’s banks is that their true size is probably not known even to banks’ management. It is a reasonable assumption that they have grown appreciably over the past two years. Eventually they will threaten the viability of the Chinese economy and any Chinese investment.

 

 

 

7. How thorough are the transparency and corporate governance standards of Chinese firms accessing firms accessing U.S. and international capital markets?

 

For the reasons I described above, they are non existent. We invest in China like we invested in the dotcoms.  We do not apply the same standards that we would use for other companies. As an illustration, there is the following anecdote from the Financial Times (4/12/04) China Mantou Fund, a Hong Kong based hedge fund tried to get some basic information from Qioa Xing a mobile head set manufacturer. They asked management the projected sales for the coming year. “We told them we were international investors and they were a listed company, and we had a right to know this information. At that point they just kind of laughed."

 

 

 

8. Do the Chinese firms listed in international capital markets adequately disclose their true financial situation and the full scope of their activities?

 

In my opinion, they do not. If there is one thing that we should have learned from the recent corporate scandals like Enron, Worldcom, and Parmalat, it is that even with the best legal system, free press, good corporate governance, honest auditors, determined well-funded independent, state and federal regulators, prosecutors and courts, fraud can still occur. Companies in China either do not adequately disclose, spin the disclosures or simply lie.

 

If you do not have a legal system, a free press, good corporate governance, qualified and honest accountants, and if your regulators and courts are not independent, well funded and subject to conflicting governmental policy, the probability that corporate disclosures will be full and accurate falls to almost nothing.

 

If the legal and economic disincentives within the system are insufficient to prevent management, agents and majority shareholders (Chinese governmental units) from taking advantage of huge economic opportunities, game theory correctly predicts that they will. 

 

The other problem that is unique to many Chinese listed companies is that most of them are subsidiaries. They have been carved out of much larger companies. In order to “clean them up” for listing, many of the losses, money losing enterprises or obligations are left behind in the parent company. Without adequate definitions of property or adequate documentation, it is impossible to really know who owns what. There are no audited consolidated balance sheets.  The listed company may or may not find itself liable for the losses and obligations of the parent. Even if they do not, there is enormous pressure on the profitable listed company to divert funds to the parent, always the majority shareholder.

 

 

 

9. How important have international capital markets been to China’s economic growth and development?

 

The big ‘so what’ question. The reality is at this point in time, not much. It has been estimated that from the first listing in 1993 up to 2002, the total capital raised from international equity markets for Chinese companies was $ 43 bn. While not an insignificant sum, it does not even equal the $ 50 bn that is invested in China annually.

 

The main drivers of the Chinese economy are the people of China, who save an estimated 40% of their income. In addition, it is estimated, that a majority of the billions of dollars directly invested in China annually, comes from the Chinese dihtmora. They are principally located in Taiwan and Hong Kong, but they also live throughout South East Asia, US, Canada and Europe.

 

The problem is that without a legal system, the capital allocation has become grossly inefficient. For most of the Chinese people, state banks are the only place to put money other than under the floor. Over a trillion dollars have been saved and then lent to the least efficient, most corrupt sectors of the economy. The odds of getting the money back are exceptionally small. A rare and not to be repeated example of a bankruptcy occurred several years ago. The total amount recovered after the GITIC failure was about 2% on the dollar.  

 

The enormous hole in the banks’ balance sheet is not the only problem. The Chinese leadership desperately needs money to solve two other problems. Even though the SOEs have squandered the bank loans, they are still losing money. Yet since they still employ about 35% of the urban work force, they can’t be closed down. The third problem is pensions. Like many other countries, China’s pension system is almost entirely unfunded. The work units of the SOEs, who had this responsibility, do not have either the inclination or the ability to fund this liability.

 

To solve these three problems, the Chinese leaders are counting on continued formidable economic growth. Since they are running out of their own funds, they are counting on the continued attraction of the “China Play” in international capital markets. Just the fact that they are hoping to attract almost as much capital in one year as in the first ten gives you some idea of the reliance that the Chinese leadership will place on international equity markets in the future.

 

It has often been observed that the Chinese Communist Party’s only source of legitimacy is China’s spectacular economic growth. There are costs for everything. The Communist leadership has the power to get things done. The problem is that what they have done is often wrong and incredibly wasteful. This profligacy cannot go on forever. To keep it going they will increasingly rely on international capital markets. The problem is that information is the enemy. The money tide could be stemmed by corporate fraud and scandals. To prevent this from happening, the government will rely on its ability to restrict transparency and corporate governance when ever possible.

 

A good analogy occurred during the SARs epidemic last spring. One of the country’s most adventurous and liberal newspapers, Southern Weekend, tried to break the story about a plague in Guangdong. The government tried to suppress the news to prevent social and more importantly economic instability. Nevertheless, the story got out with detrimental consequences. For his courage, the editor in chief of Southern Weekend was fired. He was replaced by the official who enforced the suppression of news about the SARs. The editors of Southern Metropolitan have been jailed. Their paper was known for its coverage of social issues, official corruption and SARS.

 

International capital markets will become increasingly more important to the Chinese leadership as time goes on. It is the only deep pocket that they have yet to pick. If they are willing to cover up a modern plague to protect their power, what else will be suppressed?


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One Response to “中国公司海外上市系列:CHINA’S PRESENCE IN GLOBAL CAPITAL MARKETS IMPLIC”

  1. youhighness Says:

    标题:Read it all over after three years, the author’s opinion

    and resentful feeling were obviously wrong. Though I partially agree with the smart GS guy, but history has showed us there is always an alternative you may choose from.

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