The massive Hong Kong IPO last month of The Agricultural Bank of China, coupled with the steady drumbeat of statistics showing the breakneck speed of China’s economic growth, raises the question for the retail investor of whether, and how, to invest in individual Chinese companies. There is no shortage of possibilities. Among the 500 largest companies in the world as ranked by Fortune magazine are 12 Chinese companies, including three in the top ten: #7 China Petroleum and Chemical Corporation or Sinopec (SHP), #8 State Grid Corporation of China, and #10 China National Petroleum Corporation. Other significant companies in the top 500 are #77 China Mobile (CHL), #87 Industrial and Commercial Bank of China, #118 China Life Insurance (LFC), #204 China Telecom Corporation (CHA), and #252 China National Offshore Oil Corporation (CEO), among others. Not all of these companies are publicly traded, and those that are do not always trade on easily accessible New York exchanges. But all the companies listed above, whether traded in Hong Kong, Shanghai, New York, elsewhere in China, or unlisted, share one characteristic: they are state-controlled enterprises.
In China, a state-controlled business is not the same thing as a state-owned company. Since 1978, many enterprises formerly directly controlled by the government have become joint-stock companies, in which the government retains the controlling stake through a public asset administration entity. These joint-stock companies have a board of directors, CEOs, and the rudiments of a corporate structure. Many have initiated public stock offerings. So if an investor wants to buy a Chinese company, should he or she buy stock in a state-controlled enterprise?
Let’s examine the case of China Mobile as an example. China Mobile trades on the New York Stock Exchange (Ticker: CHL) and on the Hong Kong Stock Exchange. Foreigners may invest in both share classes. The company is state-controlled through a series of nested holding companies, which control about 70% of its stock. The remainder is held by the public. As a state-controlled enterprise, and by far the largest provider of mobile telephony in the country, China Mobile enjoys both the privilege of state patronage, but also the obligation to carry out government policies that may not necessarily provide optimal return on equity for shareholders.
For example, the Chinese government has put a high priority on expanding modern services, including mobile telephony, into rural parts of the country. China Mobile is the favored vehicle for implementing this policy. According to the company’s 2009 annual report, “[i]n 2009, complementing state policies for economic development in rural areas, the Group leveraged its large scale to implement an integrated and more efficient sales and marketing approach to expand into the rural market. The offerings […] were broadened in an effort to increase customer loyalty and enhance value for rural customers. We are pleased to see that our presence is increasingly influential and that our competitive edge is strengthening in the rural market.” (Company Annual Report, p. 13)
Even if they can cut through the pablum, investors may well wonder whether their equity is being allocated to the area with the greatest potential for return, or simply subsidizing the Chinese government’s internal infrastructure program. After all, China Mobile is the biggest provider of mobile telephony to rural China already, and thus hardly needs to strengthen its “competitive edge” in an area unlikely to provide substantial returns to shareholders. Ultimately, when considering buying stock in a state-controlled enterprise like China Mobile, investors must weigh the potential benefits of buying an entity favored by government, which may profit from official support and is unlikely to be allowed to fail, against the potential inefficiencies in management, operations, and equity allocation created by that very same patronage. They may also want to consider for how long they think Chinese government intervention in an inefficient publicly traded company can outweigh market forces.
Perhaps nowhere in China is the danger posed by potential government mishandling more acute than in the banking industry. The aforementioned IPO of the Agricultural Bank of China in July completed the public offerings of China’s “Big Four” state-controlled banks; the others are the Bank of China, the Industrial and Commercial Bank of China, and the China Construction Bank. All are global Fortune 500 companies. The sheer size of the offerings should make investors consider the possibility that the banks are overvalued. The 2006 IPO of Industrial and Commercial Bank of China, for example, was the largest in history at $21.9 billion; the recent IPO of the Agricultural Bank of China may yet surpass that, if overallotment options are exercised.
Investors in Chinese financial institutions might be able to overlook the eye-popping IPOs, if only the Chinese banking system as a whole were not throwing money out the door with such alacrity. In 2009, state-controlled Chinese banks extended an astounding 9.6 trillion RMB (U.S. $1.4 trillion) in loans (on top of China’s “official” stimulus of $585 billion). China’s central bank, the People’s Bank of China, then set an official goal of reducing new loans to 7.5 trillion RMB in 2010. A recent and much cited report by Fitch Ratings, however, estimates that Chinese banks have already made 5.9 trillion RMB in new loans in the first half of the year alone, but moved about 28% of those loans off the banks’ balance sheets via elaborate securitization deals (Chinese banking regulators recently required banks to return the loans to their balance sheets). The result, according to Fitch, is “pervasive understatement of credit growth and credit exposure.” This should sound disconcertingly familiar to investors, if not from recent experience in the U.S., then from China’s own experience in the late 1990s, when the Asian currency crisis caused large loan losses in China’s then state-owned “big four” banks. Then the government intervened to take $287 billion of bad loans off the books of the banks and buried it in specially-designed “asset management” companies.
The risk of a sharp increase in non-performing loans and bad debts is probably not spread evenly throughout China’s banking system. The group of institutions classed as “rural commercial banks” by the China Banking Regulatory Commision saw non-performing loans average about 3% of total loans in 2009. That is not so surprising. What may trouble investors more is that other, larger institutions, such as the aforementioned Agricultural Bank of China, with its possibly world-record IPO, has been one of the Chinese government’s favorite conduits for funneling loans to the Chinese countryside (recall the government’s anxiety about rural unrest from the China Mobile example above). How much credit is the Agricultural Bank of China extending to the country’s less creditworthy rural sector? How many of those loans can we see on balance sheets? It is when trying to answer questions like these that the lack of transparency in the Chinese system becomes especially worrying.
Some might conclude that it is best to avoid investing in Chinese companies altogether. But such wisely wary investors should instead consider a different category of Chinese company: the non-state controlled public company. Significant names in this category include Baidu (BIDU), Xinyuan Real Estate (XIN), China Medical Technologies (CMED), China TechFaith Wireless Communication Corporation (CNTF), Netease (NTES), Suntech Power (STP), Trina Solar Limited (TSL), and Yingli Green Energy (YGE). These companies are much smaller than their state-controlled counterparts and are typically involved in the internet, or other technology-, or cutting-edge engineering-dependent sectors.
Let’s examine the Chinese solar industry as an example. Chinese solar companies, Suntech, Trina, Yingli, JA Solar (JASO), LDK Solar (LDK), China Sunergy (CSUN), and the confusingly named Canadian Solar (CSIQ), are some of the largest in the world and compete with the major western photovoltaic companies First Solar (FSLR), Sunpower (SPWRA), BP Solar, a subsidiary of BP plc (BP), Q-Cells, Evergreen Solar (ESLR), and MEMC Electronic Materials (WFR). None of the Chinese companies are state-controlled and although they do receive generous subsidies from the Chinese government (through loans from the government-owned China Development Bank), so does every solar company, on both the supply side via grants and special financing, and on the demand side via feed-in-tariffs and the like. Indeed, China has probably benefitted as much from German, Spanish and U.S. solar subsidies as it has from Chinese aid. The point, despite the embryonic state of the solar industry, is that publicly-traded Chinese solar companies compete with their western counterparts on the strength of their prices and cost profiles and investors can make as informed a decision about buying stock in a Chinese solar company as it can in a German, or U.S., solar company.
Some might argue that China’s state-controlled companies and its non-state controlled companies are not different, that subsidies on the one hand are not substantially different from direct investment on the other. This is wrong. The difference is that in, for example, the Chinese government’s subsidies for the solar industry (or the Spanish or German government’s for that matter), the role of the government as subsidizer, and private companies as free employers of capital are clearly demarcated. Also, the funding levels are public and thus well-known. Investors in (and analysts of) solar companies can calculate how much the government assistance is boosting the companies’ bottom lines, the likelihood of the aid continuing, and, finally, make an informed estimate of the companies’ prospects as investments. No such calculation is possible with, for example, the rural push of China Mobile.
We thus counsel investors interested in buying stock in Chinese companies to do their homework very thoroughly, even in the case of non state controlled businesses. Also, investors ought to keep an eye on China’s macro-economic and political situations. China is growing and evolving rapidly, but it is still not a “normal” economy. Resource nationalism, urban-rural tensions, the desire to stimulate domestic production, currency issues, rigidly demarcated share classes, among other things, can inflate, hide, or too-rapidly pop bubble-like activity in specific sectors or the entire economy. In our view, the greatest risk posed to the Chinese economy now is excessive bank lending, which might lead not only to some kind of financial industry meltdown requiring government bailouts, but also to the building of a lot of excess housing and industrial capacity. Investors in China are well-advised to be mindful of even extreme circumstances, and how their investments would fare in such conditions.