Four years ago the word privatization was taboo in China. “When I came here in 1992 nobody would talk about it,” recalls one investment banker, “and we had to be very careful about mentioning that kind of thing.”
Now there is even a sign outside the building where China Eastern Airlines is working on the company’s long-awaited New York listing indicating the “China Eastern Privatization Office”.
With nearly 40 Chinese companies already listed on international exchanges, or authorized to list, and two official domestic stock markets plus a further 17 informal ones scattered across the country, the adoption by the Chinese of privatization as an acceptable part of the language should not come as much of a surprise.
Add to that the fact that in 1993 the non-state sector already accounted for nearly 60% of industrial output and that China’s state statistical bureau expects the state’s share to shrink to 25% by the end of the century, and there can be little doubt that a dynamic process of privatization is going on.
But surprise is exactly what it does cause. “Even I was taken aback,” says CS First Boston’s chief representative in China, Carl Walter, on seeing the sign at China Eastern’s headquarters in Shanghai, a view shared by other bankers who warn that even today privatization is a word that is discouraged in China.
It is a candid admission of the terms on which investment banks have been prepared to get involved in listing Chinese companies – that is, without assurances that a wide-ranging sell-off of state assets would take place and, perhaps more importantly, without any explicit commitment to private ownership.
Neither of these terms are likely to change in the foreseeable future. When the proposals for the ninth five-year plan (1996-2000) were published after the meeting of the Chinese Communist Party’s central committee last September, they included adherence “to the principle of maintaining public ownership” as reforms of state-owned enterprises are “deepened with a view to building up a modern enterprise system”.
With the macroeconomic situation improving and inflation once more at manageable levels, improving the performance of state-owned enterprises is now a high priority for the government. Hardly a day passes without some discussion in the official media about what can be done to improve the situation. The question has attracted a spate of official speeches and government-sponsored conferences.
But there has been no indication that a drastic solution is at hand. If there is any overall plan in Beijing for bringing vitality to state-owned enterprises it is that there should be no plan: the piecemeal, experimental approach is the way forward.
“The Chinese don’t have grand unifying theories like the eastern Europeans,” says John Crossman, chief representative at Jardine Fleming in Shanghai. “The Chinese have: ‘We’re going to try this, we’re going to try that, we’re going to muddle through, don’t worry’. They say: ‘Look where it got the eastern Europeans, they went out and bought some Harvard Business School or McKinsey study, and they went all out and shot themselves in the foot – in fact they blew their foot clean off.’ And they laugh at them. They think they’ve done it poorly. They don’t believe that they have done a good job by their people.”
Ironically, the use of the former Soviet Union’s experience as a blueprint by the Chinese for what to avoid has acted as a catalyst in opening up China’s capital markets. “I never in my life thought that there would ever be anything like what happened – overseas listing of Chinese companies or even development of stock markets domestically,” says CS First Boston’s Walter. “And the only reason I think it did happen was because of what happened to the Soviet Union: it disappeared in three days. And I think Deng Xiaoping understood what happened very clearly, and that if they didn’t really try to make a qualitative push, beyond what I call the eastern European-style revisionism of the 1980s – which was basically joint ventures and very much at the margins in special economic zones – then China was going to ultimately experience problems.”
Room for improvement
Enter the stock market “experiment”, as it is still called by Chinese officials. Experiment it may be but because of China’s size it has been a headline-catching initiative. And, even without a formal privatization programme, there has been a steady flow of Chinese companies listing on domestic exchanges and becoming available to foreigners (the “B” shares), and gaining approval to list on international exchanges.
These approvals are announced in batches by the Chinese Securities Regulatory Commission (CSRC). In 1993 nine companies were given the green light, in 1994 22 companies and in 1995 a further seven. So far 21 of those have been listed.
For international investment banks, parti-cipation in the experiment has meant a massive boom followed by bust; enormous enthusiasm and a China binge to begin with, followed by the inevitable hangover; and excitement at being able to participate in an economy with the size and growth rates of China’s, followed by a realization that even after 20 years of reform, it is very much a planned economy.
Bankers, brokers and investors are at best deflated. Personnel have been redeployed, efforts focused elsewhere in the region. “A lot of bankers are somewhat discouraged,” says one. “Chinese companies have performed well below expectations and there’s a lot of disappointment. And I don’t see any dramatic change in the offing that would make them perform a lot better.”
True, underwriters have few complaints about the number of companies on offer for private-sector participation. On international exchanges alone “they’ve got 19 companies that have been approved to list, but that haven’t listed yet”, points out one banker. “Of what other country around the region can you say there are 19 companies trying to go to the market?”
Nor, as might have been expected to happen, have many sectors been put out of bounds by the government because they are viewed as too sensitive for foreign investment. The 22 companies given permission to list in 1994 included not only four electricity-generating companies but also two large airlines. The only areas where foreign investment has specifically been barred are telecoms operations and media.
Bankers are not surprised at these priorities. “They don’t want to lose control of their ability to monitor what’s on the airwaves,” points out Crossman. “Some of that goes into the telephones as well – they want to be able to maintain control of what’s being said over the telephone – it’s more of a dissident thing. Now if dissidents are going to travel on China Eastern Airlines, they can catch them at the check-in lounge, it’s not a big deal. And they’ve got lots of other airlines that they own – so they’re not particularly worried about that.”
Telecoms are obviously attractive. As one Beijing investment banker points out: “With a low penetration rate of a few lines per 100 people, bringing that up to anywhere near Third World standards would imply a tremendous amount of growth for any telecoms company.”
However, blanket sectoral restrictions have not been the greatest cause of frustration. With 10 of the companies approved in 1994 still not listed, it is clear that there have been difficulties in bringing to market even companies whose listings are approved.
There is no single cause. In the case of the two power companies – Shandong International and North China Power – negotiation of a tariff has been the stumbling block. For the airlines, rumours circulate about a variety of issues that are as yet unsettled, such as land-use rights, tax issues and dividend pay-out ratios.
The poor reception of Chinese companies in the international markets has led to a loss of impetus to resolve those issues. In 1994, Chinese companies were selling at price/earnings ratios of over 20. Now it would be an impressive achievement to reach a P/E ratio of 10.
Like most governments engaged in privatization, the Chinese are extremely concerned that state assets should not be sold off cheaply. The only specific constraint, though, is that companies are not sold off below net asset value. But the sums that Chinese companies can attract now are fairly close to that cut-off.
That, bankers say, is probably the main present problem on the Chinese side with issuing equity. “Of course there is ideological resistance,” says one underwriter, “but much more important than that is what I call rent-seeking resistance. It’s a major operation for these companies to repackage themselves, to get their accounts in order, to handle the triangular debt issue and so on. And they get all that resolved and they say: ‘Wait! I used to be able to keep all the money I made. Now I have to give it to the investors. And not only that, but I have to write all these damn reports. I went through all that nonsense, and I sold the assets at almost net asset value anyway – so how much money have I made?’ So people are asking themselves do we really want to do this? Is it worth it? Is it worth all the trouble?”
Blaming market performance
After seeing the money their assets could attract in the heady days of 1993 and 1994, a not uncommon attitude on the Chinese side is to blame the markets alone for low valuation of their assets. On this outlook, all they really have to do is to wait for the markets to improve again or hunt around for new markets to try out: if companies with New York and Hong Kong listings have not performed so well, it could be worth trying other exchanges. In 1995 agreements were signed with both the Tokyo and Singapore stock exchanges, and discussions with Australia and London were undertaken.
In the meantime, there is not much incentive to approve more substantial companies for listing. When the 1995 batch of seven was announced, underwriters let out a veritable groan. “We’re just left here twiddling our thumbs,” says one. “There’s just nothing to do. These companies are too small, they’re in the wrong sectors. There’s really not a lot major banks can do with them.” The inclusion of a Chinese traditional medicine company was symptomatic. “Give me a break!” exclaims one underwriter. “You’re not going to get any western investor for that. It doesn’t seem to me to be a logical company to go out and list.”
Here the method of selecting companies for listing – not according to what investors want but according to quotas allocated to localities – may explain the choice of these specific companies. Once they receive their allocations, it is the provinces and municipalities that decide which companies should be sent up to the CSRC to receive final approval for listing. “The really big filtering-out is at the level of the regional governments,” says Anjali Kumar at the World Bank, which conducted a study of the screening of applications for listing in the period up to 1994.
But if the selection process has left a lot of room for political manoeuvring and just plain ignorance about what investors are interested in, few bankers argue that improving the process would release a batch of model Chinese companies that have just been waiting on the sidelines to dazzle international investors.
From planned to market economy
As analysts have discovered, the problems with Chinese issuers are rather more endemic. Even darlings of the international investment community like Tsingtao Brewery have fallen from favour. The truth is that, after 40 years of a planned economy, it will take time for Chinese issuers even to understand what it means to be listed on an international exchange.
The government’s ambivalent attitude towards privatization has not helped this. It retains a controlling stake in all companies and, in most cases, the stake available to foreigners has not even been close to 50%. This is not a problem in itself. But it is a problem when investors feel that they have had absolutely no influence on the behaviour of a company. “A lot of investors feel they have been taken for a ride,” says one banker. “They feel that the Chinese have issued enough shares to attract a lot of money but not so much that they cede control to anybody. And the Chinese still see the company as their own little fiefdom, and public investors don’t have to be taken into consideration when they make decisions.”
More cynical bankers will raise a common accusation heard in emerging markets – that all they have done by participating in listings is to help companies raise cash. “It’s a cash-raising exercise,” says one. “They’re not really privatizations. They’re doing it to raise cash for these companies so they can modernize.”
To back up this view, they point out that in most cases listing has not led to a radically different approach to that which prevailed when the companies were fully state-owned. “Haixing Shipping is a classic example,” says Jardine Fleming’s Crossman. “They thought of themselves as a utility and they kept shipping coal, even though they weren’t getting paid for it, because they thought their responsibility wasn’t to their shareholders but primarily to their customers who weren’t paying them. And basically they acted like the old state-owned enterprises they always were. So you ask yourself what was the point? And they took the money and they went and bought some new ships – but there hasn’t been a radical change in the enterprises, except maybe that once a year they’ve got to put out statements.”
The interim earnings announced by Chinese companies last August were the last straw for some. The worst offender was Hong Kong-listed Maanshan Iron & Steel which reported a massive 93% drop in half-on-half profits. Across the board, earnings were well below analysts’ expectations.
It was not only the companies that were to blame. In a planned economy, government policies have strong repercussions on company performance. The austerity measures imposed by the government in 1993 in an attempt to cool down the economy played a big role in reducing earnings. Even with the best will in the world, Chinese companies are far from independent players.
Communication problems
Austerity measures imposed from above played an important role in Maanshan Iron & Steel’s poor results. As a Baring Securities report points out, drops in sales reflected “weak demand from the credit-tight construction sector”.
What annoys analysts more is that companies did not properly inform them of what was happening. A comparison by Baring Securities of market-consensus, full-year forecasts with actual first-half interim results, shows the enormous discrepancies. For Maanshan Iron & Steel, the consensus forecast of Rmb770 million ($93 million) was confounded by paltry actual first-half earnings of Rmb40 million.
The Baring Securities report says that “in isolated cases, company managements were suspected of withholding information from the market, as in the case of one company which went on an around-the-world roadshow near the end of 1995, telling investors that everything was as smooth as can be.”
Others in the market share that view. “Analysts are fed up. We have really had enough,” says the head of research at one Shanghai brokerage. “These companies have been lying to analysts. Somebody has got to take responsibility, heads have got to roll.”
Unfortunately, the CSRC, which might perhaps be charged with the responsibility of cutting off those heads, does not hold out much hope of radical action. The CSRC has a staff of only 120 people and its officials say there is little they can do except in the most blatant cases of abuse. Generally, they say, that has not been the problem.
“When we go down to investigate we find very few companies that are actually trying to lie, to deceive the public,” says a CSRC source. “Most people just don’t know what they’re doing. It takes time for them eventually to learn how to do it, how to be responsible to the shareholders – because they have been responsible only to their superiors in the government for the past 40 years – and then all off a sudden the whole thing has changed. So the mentality has to be changed.”
Holding back on the big ones
The new year for Chinese equity is kicking off much as last year ended – with small issues. Two roadshows are in progress, one for the Jingwei Textile Machinery company (a $27 million deal) and one for noodle manufacturer Tingyi. Foshan Ceramics, also relatively small at $50 million, is likely to be the next in line.
Nor are deals likely to dazzle with their pricing. Fund managers expect Jingwei to list at a 20% discount to the current market, “a realistic level” according to Ching Ju Yeh, a fund manager at HSBC Asset Management. Ching predicts that over this year the average price/earnings ratio for Chinese issues will be a meagre six.
Investors are in a cautious mood. Unless market sentiment towards China improves dramatically, 1996 is unlikely to be the year of the flashy deal. As one fund manager points out, investors are not in any rush to get involved in primary offerings. “For over 70% of Chinese shares, the current market price is still below the IPO price,” he says. “So I think investors will be very cautious about taking up new issues. They’ll tend to think that you can always buy them cheaper in the secondary market.”
That pessimistic mood will inhibit the arrival in the market of the larger, more strategic companies that the Chinese are not keen to see sold off cheaply to foreigners. The most eagerly awaited of these issues are regional airlines China Eastern and China Southern, which had been expected to list on the New York Stock Exchange (NYSE) last year but failed to do so.
Fund managers are uncharacteristically upbeat on China when it comes to discussing the prospects of airlines as a sector. According to Billy Chan, who manages the GT PRC Fund: “In each geographical area the airlines have a strict monopoly. So given the huge growth in flights in China over recent years, which will probably extend into the future, this is probably a very good business to go into.”
Still, investors are withholding final judgement until they see what kind of a deal is thrashed out between the airlines and the government on issues ranging from division of airspace to fuel supply. “Conceptually they sound good,” says Chan, “but I haven’t yet seen a prospectus or talked to the management.”
Dealing with those issues may take some time. “I don’t expect them to finish all the due diligence until the second half of 1996,” says one fund manager. If one airline comes to market then the other is unlikely to be offered until later – possibly even as late as 1997.
Other large deals in the batch of 22 companies approved for listing in 1994 may not receive so enthusiastic a response. This is particularly true of the two power companies that remain to be listed, Shandong International and Datang Power. After the poor performances of the two other power companies in the batch of 22, both of which were listed on the NYSE in 1994, investors are justly cautious about the remaining two. Shandong International in particular may suffer from the troubles of its predecessor: it is in the same province as the New York-listed Shandong Huaneng, whose share slumped after the government refused to allow the company to go ahead with capital expansion. Electricity tariff rises have also proved difficult to negotiate with the authorities.
Still, with inflation now at manageable levels, the market for power operators and other infrastructure companies dependent on government-regulated tariffs may improve as price increases and investments become less contentious issues. That could work in favour of the listing of the Guangzhou Shenzhen Railway – approximately a $400 million deal. That, according to Nicole Yuen, a director at SBC Warburg, could be “one of the most notable issues for the first half of this year, if not the whole year”.
In the meantime, the smaller, less contentious issues will go ahead. As one underwriter explains: “Generally the more political an organization is, the more political an industry is and the more difficulties you have with all these bureaucracies. And it also depends how complicated the company is. Some companies have subsidiaries, they have factories and facilities all over China, and then you have a hell of a time doing the accounting, legal due diligence and things like that – it just prolongs the time it takes to bring an issue to market.”
The deal not to look out for this year? Apparently First Automotive – which is likely to be an issue of more than $500 million. According to one banker: “That’s a sort of a headline enterprise of China, so that will probably take a long time, because it’s so big, it’s so well-known, so everybody in China will try to get their hands on it and get a share of the glory. It’s expected to come out, but I don’t think it will until 1997.”
Still, a shortage of big-ticket deals may not be a bad thing. As SBC Warburg’s Yuen points out: “You need to have a variety of industries and companies that try to list and come to the market. And the biggest may not be best.” – SR
