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Thursday, 5 April 2012

An economy falling short?

The 4 billion dollar question
Like other emerging markets China is affected by significant levels of corruption and fraud across government and private enterprise.  Many different misdeeds have been reported in recent times, including endemic seizures of land from farmers and individual owners and theft of funds by government officials and employees from ministry coffers and state-owned enterprises (to the tune of $123 billion since the 1990s and more recently an alleged $2.8 billion from the Railways Ministry).  Premier Wen Jiabao recently told the State Council that corruption was the greatest danger facing the ruling party, while in his piece on land seizures for the BBC Damian Grammaticas pointed out that the combined wealth of delegates at last month's National People's Congress was ten times that of the US Congress.

Last year saw the rise of the China short sellers, a group of analysts mostly based in the US, who successfully targeted Chinese companies with overseas share listings - publicising evidence of fraud and/or inaccurate accounting and then profiting from short positions when the prices of the respective companies' shares fell.  One of the most notorious China short sellers, Carson Block (through reports of his company Muddy Waters Research) helped trigger the collapse in share prices of a number of Chinese companies, most notoriously with Sino-Forest Corp., which filed for bankruptcy last week.  Not giving up without a fight, Sino-Forest sued Block and his research outfit for defamation seeking $4 billion in damages and costs, questioning Block's tactics.

Block, confident the defamation action will fail took time out with CNN to announce that he had turned his focus closer to China - to Chinese companies listed in Hong Kong rather than in the US or Canada.  There appear to be similar signs of concern as was for the short sellers' first round, including  auditor resignations, so expect more of the same.  Interestingly there were also a few soundbites on the general state of the Chinese economy which Block called a "fixed asset bubble".

A solid foundation...on the world's newest and highest suspension bridge in Hunan
What is concerning about the short selling episode is there seem to be many of the same factors as were present in the US housing crisis of 2007-8, including failures in regulatory oversight, manipulation of obscure legal structures, failures by professional advisers, greedy investors, outright fraud and, in the end, significant value destruction.  An investigative report by Bloomberg last year illustrated the rise of the short sellers -  starting at least as early as 2009 when they started to scrutinise  the public accounts of certain Chinese companies which had been able to list their shares in the US and Canada without preparing a full disclosure.   

The trick the Chinese companies had used to list in the US was the process of a "reverse merger" (or reverse takeover), pioneered back in the early 2000's, involving the Chinese company acquiring an empty US shell company which had a small sharemarket listing enabling the combined US-Chinese entity to sell further shares.  It was cheaper than the Chinese company listing itself and involved less scrutiny.  And as detailed in this Reuters special report, a whole industry of advisers arose to facilitate the Chinese companies' speedy entry into the US capital markets:
...That industry hinges on a handful of leading "shell brokers" such as Halter who purvey paper companies; investment banks who specialize in financing a firm after a reverse merger; and auditors, usually small shops, who are lightly regulated in the U.S.--and not at all in China and Hong Kong...
While the regulators have clamped down on the use of structures like the reverse merger, the advisers, including the auditors remain liable to accusations of negligence and even fraud.  One key adviser, Benjamin Wei, whose firm New York Global Group structured a number of such deals was reported to be the subject of an investigation by the FBI in January, while auditors Deloitte, KPMG and Ernst & Young have faced scrutiny for their signing off of the accounts, in Deloittle's case, in respect of Hong Kong listed companies aswell.  An interesting piece in FTAlphaville gave some details of current attempts to deal with management conflicts at one company as outlined in letters to the shareholders.  Meanwhile regulators struggle for other solutions to protect investors.

Getting the numbers wrong
A few news reports appeared towards the end of this week suggesting other people looking at the China market are also making miscalculations in their assessments of certain companies and industries.  Reports of oversupply (in whole or in part related to the Chinese market) appeared in relation to various commodities including alumina, logs, coal, iron ore and goods and services like hotel rooms in the resort city of Sanya and automobiles.
Looking for growth (Qilai Shen/Bloomberg)
It will be interesting to see what the second quarter will bring.

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