Capital crisis

The decision taken at last September's Communist Party congress to speed up the reform of China's state enterprises came at an unfortunate time. The reform process complete with stock market listings and costly restructurings ?has been complicated by the subsequent financial crisis in Southeast Asia. Stock markets in Asia have been falling, bankers are more leery of lending to projects and direct investment growth is forecast to fall further as countries such as, japan and South Korea pull the plug.

Private equity could also take a breather as investors consider opportunities thrown up by reversing economies in Thailand and other parts of Asia. The World Bank, which counts China as its biggest borrower, is keen to see Beijing's dependence on its loans reduced in favour of private sector loans, especially in the area of infrastructure.

Meantime, Beijing itself is having to weigh up conflicting aims, such as how to attract capital into the country without selling off assets cheaply or surrendering watertight control of its strategic industries. It is also putting the squeeze on domestic bank loans in a bid to improve the quality of loans. are often of poor quality.

While share trading is nominally restricted to foreigners, brokers estimate around half the market is held by domes-tic players who are finding it ever easier to get hold of US dollars. Beijing's attempts to stamp down on this practice earlier this year had one net result: share prices tumbled. Without local players, brokers said, liquidity would evaporate.

The stock market performance of Chinese listed companies has been marred by the overall poor quality of the companies themselves. Selected by the central government mostly for political rather than business reasons, the companies are frequently managed by the same officials that were in place when they were totally state-owned enterprises. Even today, the listed companies remain only partially privatised, with the result that there has been limited progress in changing corporate culture and promoting transparency.

injections were, and are, the appeal of red chips: listings were typically followed by reasonably-priced deals that saw assets transferred from the mainland parent company.

The immediate impact of Beijing's guidelines was minimal, but once the market started tumbling, red chips were among the most severely hit. China Telecom was heralded as the cream of red chips, giving foreigners their first ever entry into China's tightly controlled telecoms sector. Yet in October 1997 the stock sunk 10 per cent on its debut, leading many to call it curtains for the red chips.

In the wake of China Telecom, two Chinese companies ?China National Aviation Corporation and Yangzhou Coal Mining (which was to issue H-shares) ?pulled their flotation plans.

The waters were re-tested for the first time since China Telecom earlier last month when Tianjin Development Company, the investment arm of the Tianjin municipal government, began trading. The company which raised HK$1.2bn (US$155m) saw its share price jump 24 per cent over the HK$6.60 issue on its debut. Bankers say this strong performance stands to expedite the listings of red chips which are in the pipeline ?as well as secondary cash-raising exercises.

Asset injections and listings are also back to the fore, albeit on a more modest scale. This follows speculation that Beijing would allow a revival of red chip asset injections, albeit in a controlled manner, to shore up their share prices.

Equity placements

China currently has three main structures for raising equity from overseas: listing state enterprises in Hong Kong and other international financial centres, floating on either of the domestic bourses through hard-currency B-shares rather than yuan-denominated A-shares, or listing the Hong Kong-incorporated arms of mainland companies in the territory.

The first method ?known as H-shares for those companies listed in Hong Kong, N-shares for those in New York, L-shares for London, etc ?was hatched by regulators in Beijing and Hong Kong in 1992. The pioneering H-share, Tsingtao Brewery, came to market in a blaze of glory in July 1993. Subsequent issues, especially latterly, have been barely subscribed.

B-shares, for their part, have failed to respond to Beijing's endeavours to stimulate demand. Brokers complain frequently that trading is illiquid, market capitalisations small and that companies

Tighter regulation

Last November Guangdong Investment (GDI), one of the biggest red chips, entered into a shares-for-assets deal worth about US$142m with its parent. The deal came just one day after fellow red chip China Merchants Holdings International completed a US$543m share placement to finance asset acquisitions from its parent, China Merchants (Holdings). GDI, the listed flagship of the Guangdong provincial government, bought its parent's entire interest in the Guangdong Regency Hotel in Zhuhai for US$84m along with Guangdong Finance for US$58m.

But brokers say interest in red chips continues to wane. Expectations that Vice-Premier Zhu Rongji would clarify the regulatory framework surrounding the sector at November's National Financial Conference in Beijing failed to materialise, adding to the negative sentiment.

Asset injections have slowed down No red chip revival

Since the pace of listings is controlled by the government, several Chinese institutions which have not found themselves on the quota of equity placements have taken the 'red chip' route. Red chips looked like the snappiest option earlier this year. These mainland-backed Hong Kong-incorporated companies now account for around 15 per cent of the Hong Kong stock market and have their own dedicated index, the Hang Seng China-Affiliated Corporations Index.

In the last months of British rule of Hong Kong red chip prices doubled and trebled. The typical red chip, usually one or two levels removed from state control, was commanding a price earnings multiple of around 40 times.

The frenzy reached fever pitch in May with the listing of Beijing Enterprises, the investment arm of the Beijing municipal government. An odd assortment of assets, ranging from a McDonald's franchise to tourism rights on the Great Wall of China, were packaged together. Some 1m people, or one in six of Hong Kong's population, subscribed for shares.

But barely a month later Beijing was pulling in the reins on red chips, issuing guidelines to tighten up on listings and, more significantly, asset injections. Asset since the issue of red chip guidelines in June, in part due to the new rules but also because Beijing gave a clear signal it would not tolerate any violations of its securities regulation.

Shortly after the guidelines were issued, China regulators confirmed that a group of financial institutions and listed companies would be punished for stock market violations, the first time Beijing made the clean-up official after months of speculation. Beijing said it would fine, suspend from proprietary trading and seize ill-gotten gains from Shenzhen Development Bank, the Shanghai branch of the Industrial and Commercial Bank of China, Shenyin & Wanguo Securities, Haitong Securities, Guangdong Guangfa Securities, J&A Securities and Guangshen Railway.

The Shenzhen-listed Shenzhen Development Bank, China's only listed bank, was the most severely punished. It was found to have used Yn3llm (about US$37m) of its own stocks between March 1996 and April this year, illegally netting Yn90m.

Its punishment was all-embracing: company president He Yun was removed and banned from the financial and securities industry for five years, the bank fined and its illegal profits confiscated. It has also been ordered to sell its holdings of its own stocks.

Lending exposure

To prove its determination, Beijing said it would in future dismiss officials at financial institutions speculating in stocks and deny market access to anyone using bank credits for speculative purposes. LaC Culprits could end up in the scrvi courts.
husii On top of the clean-up, People's Daily called in a recent commentary for more rigid law enforcement on the stock market, a move which mirrors a stern warning it issued in December 1996 that kick-started a spate of market-dampening measures. LaC Beijing realises it is not cons immune to the financial turmoil sweeping across Asia.

In to p1 November, official media For I warned of 'hidden dangers' in your':. the banking system. Pulling no punches, Economic Daily said Tele bad debts were mounting and Tele possible defaults and bankrupt- Emscies among underground lend- Weting institutions posed 'tremendous financial risk'. It continued: 'The problem of huge bad loans and economic structure commonto Southeast Asia also exists to varying degrees in our country.'

The People's Bank of China officially estimates that non-performing loans stand at 13-14 per cent of total outstanding loans. This compares with 14 per cent for South Korea and under five per cent for Malaysia, Indonesia, Philippines and Hong Kong (in 1996). However, Standard & Poor's, the US credit rating agency, puts non-performing loans as high as US$200bn, or 24 per cent of outstanding loans. Other foreign analysts reckon the proportion could be as much as 40 per cent.

Awareness of its vulnerability to the Asian financial crises has prompted Beijing to step up its monitoring procedures. Last month it announced plans to set up a banking watchdog to super-vise quality of loans, asset management and personnel of the big four state banks. The big four ?the Bank of China, the Industrial and Commercial Bank of China, the Agricultural Bank of China and the China Construction Bank ?dominate the state-owned commercial bank sector, accounting for some 80 per cent of total loans.

Xinhua said the board of supervisors would be charged with reviewing the financial reports of those banks as well as supervising and evaluating the quality of credit assets and asset-to-liquidity ratios.

Analysts said the move showed Beijing, wary of the turmoil, was bolstering its lines of defence against thefinancial risks in the banking system, and could also be the instrument for overseeing the transformation of the big four banks into commercial entities.

Loans gone bad are at the heart of rotting banking and financial systems in parts of Southeast Asia, as well as Japan and South Korea where the problem is exacerbated by cross-holdings and government-dictated lending. Yet bad debts in these countries are dwarfed by those in China, where lending is also frequently made at the state's behest and aided by its ownership of the banks.

Improving controls

Bad debts themselves were often the result of easy money ?from which China has been insulated during its period of credit tightening. Now, however, interest rates are inching down and Beijing has hinted that a further relaxation of credit may be forthcoming, either in the form of another cut or lower bank reserve levels, which require commercial banks to keep 13 per cent of their deposits with the central bank.

A front page commentary in Financial News, published by the central bank last November, said: 'Maintaining appropriately tight monetary policies and improving macro controls over the financial system are beneficial to the prevention and elimination of financial risk. But, based on the actual conditions of economic development, our monetary policy must make slight adjustments at the appropriate time and at the appropriate levels.'

It also said mainland banks were faced with mounting bad loans because of reckless expansion and wrong policies: 'Quite a lot of bank loans are disappearing like a stone dropped into the sea. Principal and interest are hardly being repaid, sharply fuelling the proportion of unhealthy assets at some banks.'

By looking to clean up its own errs banks' balance sheets, and realis Itionsing that it can no longer be guaranteed indiscriminate access to international equity markets, celop Beijing is witnessing an environment where funds will be harder
to access.

In the long run, however, this may be no bad thing as it will mean funds are restricted to the quality companies. Those which fail to woo investors or secure loans will very possibly be the sort of companies which should not be funded in the first place.