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China Inc. Is Out on a Limb


By now every investor on the planet is trying to handicap what happens when China's scorching-hot stock markets finally start to cool off. The conventional wisdom is that China's greenhorn individual investors will take the hit, while corporate China—the companies that make shirts, build ships, and run utilities—won't feel much at all. The real economy these companies operate in is far too strong to be affected by stock wobbles, goes the argument. The price of corporate shares may fall, but underlying earnings will power on.

That line of argument, though, is looking suspect for the simple reason that companies big and small are now playing the markets with abandon, using corporate funds to invest in each other's initial public offerings and bolster their bottom lines. Although figures are hard to pin down, Morgan Stanley figures a third of reported corporate earnings in China stem from investments outside companies' core businesses—which in almost all cases means plowing money into stocks. "It's quite dangerous for these Chinese companies because these gains have no cash basis," says Ding Yuan, a professor of accounting at China Europe International Business School in Shanghai. "It's really frightening."

Scarier still is what could happen if the stock markets head south. Shanghai is more than 700 points off its all-time high of 6,124, reached on Oct. 16, though as of Nov. 14 it was still up 102% for the year. If and when stock prices start to fall in earnest, companies will have to report these portfolio losses on their income statements, depressing their earnings. That, in turn, could hurt their own stock prices, pushing the market down both further and faster. "It's a replay of what happened in Japan during their bubble," says David Webb, a Hong Kong-based corporate governance expert and non-executive director of Hong Kong Exchanges & Clearing. Japan Inc. gorged on stock and real estate, only to tumble into the red when those markets collapsed.

To see how big an impact investment income can have on earnings, consider the Youngor Group, which has some $800 million in annual sales. Since the garment maker was founded in 1979, Ningbo-based Youngor has grown into one of China's top-selling apparel brands. But these days those operations pale in significance beside its stock portfolio. Youngor's holdings include shares in China Life (LFC), Bank of Ningbo, and Citic Securities, the country's largest broker and a red-hot stock in its own right. Gains on these shares helped Youngor book $223.6 million in investment income for the first nine months of the year, accounting for 98.5% of overall earnings.

HOOKED ON EQUITIES

Is Youngor concerned about its dependence on Citic shares and other equities? A member of Youngor's investment department, who requested anonymity, downplays the investments as "just a supplement." The company continues to load up on shares, though. Hoping for a repeat of its hit with Citic, Youngor has even applied to regulators to participate in a secondary offering of Haitong Securities, whose shares have rocketed 885% since its IPO.

By increasing the number of available shares, IPOs like Haitong's have amplified the role that stock investments now play in companies' income statements. Wind Info of Shanghai, which provides financial data on listed companies in China, estimates that as of June 30, 494 listed companies had stock market holdings worth $45.6 billion, vs. $2.3 billion held by 163 companies a year earlier. Morgan Stanley figures "noncore" earnings from stock, real estate, and other ventures accounted for 54.1% of profits in China's health-care sector and 64.6% in the consumer goods sector.

In China, few investors possess the ability to comb through financial statements and distinguish a company's operating earnings from its stock plays. "People overestimate Chinese investors' sophistication," says Jerry Lou, head of China research at Morgan Stanley (MS). "Somebody needs to point out that the emperor has no clothes."

Professor Ding cites the case of Black Peony, a textile company, as an example of what happens in a hot market. In the first half of this year, Black Peony recorded profits of $5.8 million, almost all of it from gains in shares like Air China, dividends from other stocks, and payouts from affiliates. Meanwhile, its core textile business is struggling. "They're not controlling any costs because life is easy," says Ding. Wang Panda, vice-chairman of Black Peony, admits his business did not do well. But he defends his investments, saying he has put much more money into affiliates than the stock market. "We have diversified," he says.

Until recently banks lent freely at low rates to bankroll companies' investment portfolios. Now regulators are trying to stem the lending by increasing bank reserve requirements. But those tempting IPOs keep coming, and corporate investors are still lining up. No one inside China Inc., it seems, wants to think about what happens when the bubble bursts.

By Frederik Balfour and Chi-Chu Tschang


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