The China Story Darkens

Portfolio investors‘ illusions about the "great China growth" story are being stripped away day by day. Instead of the Chinese market looking relatively cheap, at least by comparison with both its past and the nation‘s assumed economic growth rate, it looks seriously over-valued for two very different reasons.

The first is the least remarked, being overshadowed by the recent spate of headlines about bogus accounts and disappearing bosses. It is this. Even if one were to actually believe the published aggregate accounts of major mainland companies listed in Hong Kong and Shanghai, there is scant case for regarding this market as anything other than expensive relative to both developed markets and to some of the currently less fashionable developing countries (such as Thailand).

For sure, Chinese companies can look forward to faster overall top line growth than those in the US. That is a given considering that even under the worst circumstances GDP growth will probably be twice the US level for the next decade, with the consumer and service sectors especially strong. But what about the issue that for equity investors is at least as important: return on capital?

Recent research by McKinsey & Co finds that there is no empirical justification for the fact that Chinese shares, particularly the Hong Kong-listed H-shares, are now trading at higher multiples than their western equivalents. In other words "fear" of poor corporate governance has been superseded among investors by the "greed" prospects of rapid growth. Investors have bought the China story of improving quality and sustained opportunity. But this is more myth than fact.

It turns out that over the past decade returns on investment in China have barely improved. Some sectors are better, some worse, but they remain little more than half those of US and European firms. McKinsey calculates that to justify a current price-to-earnings ratio of 16.9, H-shares would need to raise their rates of return from 6.8 percent to 10.9 percent. The numbers for Shanghai are different but the message is the same.

Combine growth prospects with rates of return and there is no reason why Chinese companies should be more highly rated than US ones. Add in the governance and accounting credibility factors and they should probably be at a discount. Of course, US returns may fall, Chinese ones rise. But there doesn‘t seem to be much prospect of that any time soon. US ones may fall but Chinese ones could well do so as well as the economy slows and debt levels are more evident.

In principle Chinese firms know the importance of increasing efficiency of capital use. However the prospects for improvement appear slim in the foreseeable future. There are several reasons for this:

• The big state firms have the easiest access to capital from the banks and thus the least incentive to use it efficiently. They are often run by party insiders more concerned with size than profits and who respond more to political than to price signals.The cost of capital has been abnormally low, even by Chinese standards, since the 2008 global financial crisis. Real interest rates remain negative. This cannot continue indefinitely. Higher real interest rates will severely squeeze equity returns.

• The post-2008 lending spree led to particularly wasteful, state-driven, investment. This will inevitably lead to a sharp rise in nonperforming loans by banks and probably losses by non-financial companies lending in the informal money market.

• The state sector has tended to increase its grip on key sectors thus reducing the scope for the more dynamic private and semi-private sectors. Companies with ready access to cash have been expanding into unrelated fields. Mergers aimed at improving returns are negligible as companies seek size above all else.

• Urbanization is slowing due to China‘s demographics. This will make ever more apparent the massive overinvestment in infrastructure which in turn will continue to prevent the consumer sector, which can usually offer higher returns to capital and in which the state sector plays a lesser role, from growing as fast as it should.

None of these realities is likely to affect investor sentiment while the China and emerging market stories continue to transfix the foreign media and offer easy money for investment bank myth salesmen.

But focus on fundamentals may follow on from the Chinese corporate shell-shocks that have recently been coming almost daily -- auditors resigning, false accounting being revealed, in some cases the existence of two sets of books, one for the tax man, the other for investors.

The shocks are likely to continue as money becomes tighter in China and hitherto gullible western investors look more closely at the companies now listed on foreign exchanges, let alone at the A shares in Shanghai among which scams and ramps are likely even more prevalent.

Perhaps it is unfair to call investors gullible. They have in most cases been led into this by so-called respectable western investment banks and auditors only too happy to assume that they are being told the truth by mainland so-called professionals.

Worst hit perhaps are the US investors who snapped up shares in US-listed companies which were transformed from small, little traded companies into hot China stocks through the injection of assets of go-go mainland companies. In a whole slew of cases, these assets are now being found to be worth very less than originally claimed, for profits to have been derived from aggressive revaluations rather than actual trading or to have used cash to acquire high-priced assets from related parties. The tricks are all very familiar, particular to investors who remember the "wild east" days of ramps and scams on the Hong Kong and Kuala Lumpur exchanges in the 1980s.

The equivalent mainland racketeering is now being helped by markets such as Hong Kong which should have learned lessons long ago. The US markets may be forgiven a certain naiveté and to have assumed that those responsible for China asset injections had been duly diligent. But Hong Kong has fewer excuses given its proximity and the use, till very recently, of local firms to audit mainland company accounts.

But no, greed has trumped fear for all market operators. Making matters worse has been the inability of the Hong Kong authorities to carry their investigations into China and their unwillingness to ask hard questions of politically-connected companies, let alone prosecute outright illegalities in corporate reporting. The decision now to allow mainland auditors alone to audit Hong Kong-listed mainland stocks can only make matters worse. Indeed the rash of scandals since that was announced demonstrates the combination of greed and irresponsibility shown by the Hong Kong Exchanges and Clearing, the government-controlled monopoly chaired by the property oligopoly‘s former Mr Fixit, Ronald Arculli.

Of course the really big, centrally-controlled Chinese state corporations are unlikely to be caught in the sort of scams unfolding among provincial, municipal or privately controlled entities lower on the totem pole. But that is another worry for investors. It is the state behemoths which have the least regard for return on capital because they find it so easy to borrow and often have to put political priorities ahead of investor interests.

So investors, look out for being further squeezed between honest but low returns and of bogus accounting cancelling out the growth promise of mid-size companies in a fast growing economy.