Investing in China – A Primer

Investing In China
Investopedia
by Doug McIntyre

International investing can provide attractive returns and diversification for investors. With the advent of various investment products such as international funds, American depositary receipts (ADRs) and index funds, accessing international markets has become easier. However, it is important for individuals investing overseas to get a basic understanding of how these different international markets work. In this article, we’ll tour the Chinese markets and show you how can invest in them.

Chinese Regulatory Bodies

Because China is still a communist country, the rules and regulations for public company trading and reporting are extremely different than they are in the U.S.

For shares traded on the Hong Kong Exchange, the primary regulatory body is the Securities and Futures Commission, which was created in 1989. This body is similar to the U.S. Securities and Exchange Commission. Its major role is to protect public investors and to assist the Hong Kong Finance Secretary in maintaining orderly markets.

The Shanghai Stock Exchange is regulated by the State Council Securities Management Department, which has issued the Securities Law of the People’s Republic of China. The laws determine the listing requirements for public companies traded on this exchange and regulations for continued listing and financial reporting.

Chinese Regulations

Much of the regulation of public stocks in China is done directly by the Hong Kong Stock Exchange and the Shanghai Exchange. Both have listing procedures similar to U.S. exchanges. Companies must report financial results on a timely basis, and audits of company financial results are performed, although the accounting rules are different than they are in the U.S.

In Hong Kong, the Society of Accounts performs the task of setting standards for audits. Most balance sheet, cash flow and profit and loss information is put together in a way that would look familiar to U.S. investors, but the basis of the reporting is different from the generally accepted accounting principles (GAAP) used in the United States.

Based on a January 2004 (the latest data available) report by Lehman Brothers, it appears that the differences in accounting standards between China and the U.S. are still significant. According to the report, “if Chinese authorities can replace the current tax systems with one system for both domestic and foreign enterprises, and continue to reduce the difference between financial statements prepared under Chinese GAAP and those prepared in accordance with international financial reporting standards (IFRS)”, then foreign investors would be better able assess the performance of investments more efficiently in the future.

The IFRS was set up by several countries including the U.S., U.K. and Germany. It was created to try and ensure there was one accounting standard that crossed all major markets.

The Lehman Brothers further point out that in using IFRS, the rule for valuing inventories “can be extended to a maximum of 20 years. Companies using international standards can choose whether to capitalize borrowing costs or not. In China however, costs on project-specific borrowings must be capitalized as part of the cost of acquiring or constructing a tangible fixed asset.” The balance sheet difference between a 20-year valuation and one that is immediate can create a significant difference in asset and liability tables in financial statements.

New Chinese GAAP accounting regulation may make financial activity in China more transparent, but until these procedures conform to those in other major financial markets, the inconsistencies will make Chinese companies more difficult to follow.

An Attempt to Mandate Fairness

According to a February 6, 2007, Business Daily Update article, the China Securities Regulatory Commission (CSRC) mandated that board directors and managers of listed companies cannot speculate on stocks they hold in companies they serve. For a number of years, there have been no rules about timing or the amount of stock sales following an IPO in Chinese markets, which is significantly different from U.S markets. The CSRC also announced a rule to increase the disclosure information public companies must provide.

Company officers still sell shares without disclosing these transactions. New rules encourage the filing of sales, but these requirements do not appear to be policed, unlike U.S. actions that are policed by agencies like the SEC. Furthermore, there appear to be no records of any Chinese public company executive having been fired or prosecuted for violating the CSRC code.

While the Chinese appear to be increasing regulations by adding new rules, there is little evidence of the type of enforcement that is active in the U.S., especially by the Justice Department and SEC.

According to The China Daily, during the first month of 2007, 19 listed companies saw their high-ranking executives and majority shareholders sell off part of their holdings, according to information released by the Shanghai Stock Exchange. Although the sales involved many irregularities, there is no evidence that any of these officials were sanctioned.

High-Risk Speculators

Investors in the Chinese markets often borrow money for stock purchases through lending institutions that are not regulated by the government. The Chinese government has gone so far as to warn banks that they should not make loans for stock purchases, but it is not clear whether those regulations are enforced.

When these loans are called by the banks, investors may have to liquidate positions, leading to sales that are not based on the normal considerations of investing. This can add to market volatility.

Government Involvement

Many Chinese public companies are firms that were once owned by the communist government, such as China Life Insurance Company. Parts of these companies are spun out to public shareholders to raise funds for expansion.

In many cases, only a minority stake is spun out, and the government continues to control the overall operations of the company, leaving shareholders with little say. Also, there is no guarantee that the interests of the government will be aligned with those of shareholders.

A less likely, but still major, risk of investing in China is that the communist government could very well decide that it wishes to own and control 100% of these companies again. The list of governments similar to China’s that have nationalized private companies is fairly long. While there is no evidence that this will happen in China, it should be considered one of the risks.

U.S.-Listed Chinese Companies

Chinese companies listed on U.S. exchanges are required to follow a number of GAAP procedures in their financial reporting and are required to comply with all of the listing requirements of U.S. exchanges. These provide a way for U.S. investors to take a stake in the Chinese markets while benefiting from some of the rules and regulations that govern U.S. stocks.

Conclusion

In recent years, China has boasted a rapidly growing economy. The odds that Chinese companies will continue to do well seem good, but there are a number of pitfalls for the individual investor. Before investing in a Chinese company, be sure to find out how it operates and whether it is likely to act in the best interest of its shareholders.

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One Response to “Investing in China – A Primer”

  1. […] View post: Investing in China – A Primer « China Lawyer […]

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