Editor's letter: China stock scammers driven by lack of alternatives
Amid the storm of accusations, counter-accusations and recriminations that has characterized the developing China overseas-listed stock scandal, much more has been written and said about the question of whether the companies involved are scams than what might have driven these alleged frauds to mislead their investors in the first place.
The obvious answer to that question is greed, as well as a perhaps justified intuition on the part of the company chief executives that remote investors in the US would not have the desire or the wherewithal to investigate the Chinese-language accounting or the offices and factories of the companies in China. But beyond these considerations there is a further motivation that speaks to a broader problem for China.
Access to capital for non-state-owned companies in China, despite huge interest in the country from the global investment community, is limited. Banks prefer to lend to state-owned companies, and are having lending squeezed anyway by a government nervous about inflation. Getting approval for an IPO is a lengthy and uncertain process: one source estimates that as a rough guide tiny Taiwan has 6,000 listed companies compared with China’s 3,000, indicating the pent-up demand on the mainland.
Although the country’s bond markets have loosened up with the introduction of a medium-term note programme, small and medium-sized companies still have very limited access to public debt offerings. Although private equity firms and the growing number of informal investment clubs offer some relief, most small companies in China face the hard choice of going to the black market at usurious rates or trying to look offshore for growth capital.
It is not surprising that foreign promoters have found such success in persuading Chinese companies to float overseas. Listing in the US in particular is seen as prestigious, and doing so via the takeover of an existing shell company as a reverse merger can avoid the hassle and expense of an IPO. As a result of a combination of the exposure of actual frauds, scepticism about the companies’ business models and poor disclosure, Chinese IPOs in the US have been one of the worst performing groups on the market since the crisis. According to a June 20 report from Renaissance Capital, What’s wrong with Chinese IPOs?, if an investor had bought every Chinese IPO since 2008, the average return as of mid June this year would have been a 24% loss as against a 25% gain for the average non-China IPO. Thanks to the efforts of short sellers such as Muddy Waters, Glaucus and Citron, fraud investigations into companies such as Longtop and Duoyuan Global Water, and an increase in the resignations of auditors of Chinese companies, investors are increasingly sceptical of the sector as a whole.
The short sellers attacking these listed Chinese companies are quick to call them frauds but investors on the long side say that many of the difficulties arise from chief executives’ naivety about the differences between US and Chinese accounting, and the obligations of being a public company, rather than from malicious intent.
The truth, of course, is that there is a spectrum of situations ranging from outright fraud to perfectly legitimate businesses that have come unstuck because of some of these misunderstandings or indeed through the attentions of malicious short sellers looking to make a quick buck. Identifying fraudulent parties on both sides of the debate will not solve the underlying problem: that this bubble is driven by many of the factors that have underpinned boom-and-bust situations through the ages. As ever there are companies hungry for money, and investors happy to provide it but separated by gulfs of physical distance and technical understanding from what they are buying. In that sense the US-listed China stock market is an example of the classic bubble-followed-by-fraud model described by Charles Kindleberger in his book Manias, Panics and Crashes.
In the US, investors burnt by the scandal need to look again at their own due diligence and research methods, while in China the problem is likely to persist as long as the country’s fast-growing small companies are starved of ways to raise new money.
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