China's Outreach to Foreign Investors Won't Work Without Reforms
Nov 08, 2002
stratfor.biz
Summary
With foreign direct investment entering China at a record pace, Beijing is turning its sights on global equity investment as a source of fresh funds for struggling companies. But barring serious fundamental reforms, picky foreign investors aren't going to rush into China the way many foreign companies have, putting much more than China's prized economic growth rate at risk.
Analysis
On the eve of China's 16th Communist Party congress, which opened Nov. 8, the Chinese government announced that, for the first time, it would allow qualified foreign banks and funds to invest in locally listed Class A shares beginning Dec. 1. "A" shares, which make up the bulk of the $500 billion capitalization on the Shanghai and Shenzhen stock markets, were previously off-limits to foreign investors.
China desperately needs foreign capital to keep its economy growing at a pace sufficient to generate jobs and manage its ongoing economic transition. However, it lacks the basic financial underpinnings that would allow it to take the necessary next step from being a magnet for foreign direct investment (FDI) to tapping into the vast supply of global equity capital.
Unless the Chinese leadership can address the country's main financial shortcomings -- unreformed companies, immature and poorly regulated markets and strict capital controls -- only a select few Chinese companies listed in Hong Kong and on foreign exchanges will be able to tap into foreign capital. Many of the rest simply will cease to exist.
Foreign investment is an economic necessity in China, and it could be the only means of keeping a worsening unemployment problem from ballooning into a full-blown social crisis. The acute need for fresh capital could push the next group of Chinese leaders to fast-track more fundamental changes to the financial system. Only time will tell, however, whether the necessary changes will come soon enough to avert a social explosion.
Over the last decade, China has experienced one of the greatest rushes of foreign investment in history. Most of this has come in the form of FDI as foreign companies have sunk billions of dollars into China, setting up new manufacturing facilities to take advantage of low-cost labor or buying into joint ventures in sectors like energy and mining.
Despite a global drop in FDI of some 27 percent this year, the boom is still on in China, according to an October report by the U.N. Conference on Trade and Development. With funds pouring into areas like auto manufacturing, petrochemicals and, increasingly, information technology, China might surpass the United States this year to become the top destination for global FDI.
Unfortunately for the country, the FDI boom cannot last forever. There is a limit to how many foreign companies will be able to relocate their manufacturing facilities to China, and there are only so many roads and damns and pipelines that can be built. Sooner rather than later, the direct investment opportunities will begin to dry up and China will have to rely on other kinds of capital to keep its economy growing. That will be difficult for a country that retains strict capital controls and has neither a healthy banking system nor a vibrant stock market.
This dilemma likely sparked the Nov. 7 decision to allow foreign investment in locally listed shares. In theory, the new rules would result in a fresh infusion of foreign capital into a whole new segment of Chinese companies -- including struggling state-owned enterprises (SOEs) -- which would buttress them financially while helping the firms reform in preparation for imminent foreign competition. In reality, however, a simple rules change will do very little for the country.
China is simply too opaque and unpredictable to attract even a tiny fraction of the fast-moving funds controlled by the world's investment-fund managers. Fundamental changes must come about before the massive amounts of foreign capital needed in China will begin to flow.
The problems start at the company level. The manager of one New York-based hedge fund told Stratfor that "corporate valuations are too suspect to get involved in China," and noted that it is "very hard to take Chinese companies seriously."
Chinese accounting standards are lax and companies' financial statements are unreliable. The many listed state-owned companies (SOEs) are top-heavy and inefficient, despite massive layoffs. Moreover, corporate governance is highly suspect, and there is a tremendous lack of transparency in management decision-making, with government interference and regulatory inconsistency acting as wildcards.
Probably most troubling to fund managers is the price of local shares. The return on equity for listed companies in China is low by global standards, with the average price-to-earnings ratio standing at a bloated 53 for A-share companies, according to the Wall Street Journal, compared to P/E ratios in Hong Kong in the single digits.
Rampant corruption is also a concern for investors. Just last month, Gao Yan -- president of State Power Corp., China's largest utility -- disappeared amid a cloud of suspicion. He reportedly is under investigation by the government for corruption, though he also served on the party's high-level Central Committee. Such stories vastly undermine investor confidence in the reliability of Chinese companies.
These are generalizations, but most global fund managers do not have either the time or the resources to separate the wheat from the chaff.
Instead, they can turn to the few large and well-known companies listed on foreign exchanges. The primary outlet for foreign investors interested in China is Hong Kong, which lists two types of Chinese companies: "H" shares (Hong Kong-listed mainland companies) and "red chip" shares (mainland companies incorporated in Hong Kong). The 60-odd companies listed in Hong Kong are the cream of the Chinese crop -- the ones making the money in oil, gas and minerals, power generation and road building. They also include a few of the best-run manufacturers and service companies, including Legend (computers), Jiangling Motors (automobiles) and China Mobil (cellular telephone service).
In addition to having the best Chinese companies, Hong Kong also has stringent listing requirements and a record of sound market regulation not found on the mainland. This represents the second major strike against China. Though domestic capital has flooded into company shares on Chinese exchanges, market regulation is weak and market manipulation (often by the government-controlled media) is rampant.
Finally, China's strict capital controls are a tremendous barrier to foreign capital, which by its very nature is liquid and resists being tied down. Such capital liquidity conflicts directly with Beijing's desire to control the outflow of capital, and so far the government is winning. To trade Chinese equities, one must have Qualified Financial Investor Status, which in turn requires that a fund have $10 billion in assets. This by design immediately locks out many of the moderately sized hedge funds that operate in riskier markets, as Beijing prefers big institutional investors who are more willing to let their investments sit.
And sit they must. Closed-end funds will be allowed to remit their principal only after three years, other institutions will be able to do so after one year, and in all cases repatriations will be allowed only in limited installments. Finally, the lack of currency convertibility creates major headaches for investors interested in the domestic market.
With so many controls and so much risk and uncertainty, foreign investors have little reason to consider China's new offer to jump into the domestic markets. Better to stick to the offerings on foreign exchanges.
But as China is finding out, even a foreign listing is not enough to overcome investor concerns. The government was forced to postpone the initial public offering (IPO) of main landline telecom company China Telecom in Hong Kong and New York on Oct. 31 due to a lack of investor interest. When it was relaunched Nov. 6 at 55 percent of the original offer size, the vastly slimmed-down version met with even weaker investor response than the original aborted IPO, according to the Hong Kong Economic Journal.
While the international portion of the IPO was fully subscribed, one source told Stratfor that Chinese officials might have pressured Asia's richest man, Hong Kong tycoon Li Ka-shing, to participate in the offer to give it a boost. Asia Times reported Nov. 7 that Li indeed purchased HK$400 million (U.S. $51 million) in shares of the offering, while AFX reports the total international tranche of the IPO was only HK$728 million (U.S. $94.64 million).
China Telecom can blame its problems in part on the slump in global markets, particularly in telecoms. But it clearly is also a reflection that new Chinese offerings will be put under a much more powerful microscope. This bodes ill for a string of other IPOs of Chinese companies on the dockets, including telecom company China Netcom Group, Bank of China, Hainan Meilan Airport Co. and China Oilfield Services.
While China certainly can develop a viable domestic stock market, it will take tremendous will and significant time --- and unfortunately, both of those could be in short supply.
The World Bank estimates China will need to generate 100 million jobs over the next decade to absorb laid-off workers and migrants. The less money China can attract to its companies, the more difficult it will be for Beijing to stem the tide of unemployment that could be the greatest threat to social and political stability in the country. |
