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Good relations with the state a double-edged sword

Chinese University of Hong Kong Business School Connect Magazine
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Why are some Chinese firms nearly crippled by scandals, while others seem to shrug them off? Are business and government links beneficial or a poisoned chalice? Pioneering research by leading academics in Hong Kong reveals that an understanding of how the fortunes of Chinese companies are entwined with the state will be critical for the flow of future investment. With three decades of unprecedented economic growth, China exerts a powerful appeal to foreign investors. But as the economy makes its transition from a purely state administered system to one which admits foreign capital and responds to market forces, appreciating how Chinese business operates becomes crucial.

Research undertaken by Prof. T. J. Wong of CUHK Business School and fellow academics1 aims to investigate and explain the sometimes unpredictable results of corporate misconduct including bribery, financial misappropriation, manipulation of accounts and patronage for the benefits of the outside world. The researchers examined the far reaching effects of some 212 Chinese corporate scandals dating from 1997 to 2005, shedding light on the arcane links between business and government. “This type of work is a way of opening up the black box that is China for the rest of the world to see,” says Prof. T. J. Wong.

To date, research on corporate corruption has largely focused on the United States. But prior to this investigation, the longer term effects of business scandals in an emerging economy such as China’s have not been examined in depth. WhenUS firms are hit by scandal, notably manipulating financial information, their share price drops by 38 percent, reflecting the subsequent loss in opportunities for business and growth. US markets rely on laws, regulation and open competition to keep businesses in check. Not so in China, where business operates within a government-led structure and commerce depends upon relationships. When Chinese companies are found guilty of false accounting and manipulating the books something researchers call a “market-based” scandal their stock return drops an average of just 8.8 percent six months later. In China, it appears, professional reputation is simply less important than in the United States.

But this masks a more important story. Only when a scandal damages, or even severs relations between the company and government which researchers refer to as a “relationship based” scandal then stock returns tend to plummet some 30.8 percent. Researchers examined scandals within various time frames these figures refer to performance six months either side of the scandal. Even though suppliers, customers and shareholders may be initially unaffected by news of corruption, the company suffers.

In their research, academics have unearthed some 26 relationship scandals including the case of the Little Swan Co, once the third largest washing machine manufacturer in the world, whose CEO was jailed for 11 years for bribing a provincial government official. “Such scandals may not hurt a firm’s ability to conduct market-based contracting, but they damage the firm’s political networks because the state will lose trust in the firm’s board and may even arrest the government official who previously granted favours,” says Prof. T. J. Wong. “Loss of political networks is more damaging than loss of market credibility.”

“Mixed scandals”, which involve both accounting and relationship scandals say bribing and manipulating earnings, for example, or embezzlement within state-owned companies prompt stock returns to drop 24.5 percent again worse than accounting scandals. “If you take money from minority shareholders, you upset the market, and if you take money from the government you upset the state too,” researchers explain. The graph below illustrates that the change in Cumulative Abnormal Returns (CAR share price worth based) for mixed, relationship and market based scandals from one year before the event date to one year after. The drop of CAR for mixed and relationship scandals is much greater than that of market scandals. Researchers took care to examine share price reactions over periods as long as two or three years to allow for the fact that markets might have already discounted bad news, and to allow for political fallout after cases had come to court.

Corporate Culture in China

To understand why the markets in China care more about how well a company gets on with the state than how open and honest it is ih6 its accounting requires a fundamental change in mindset from a Western business model. Many of China’s listed firms are state-owned enterprises and to these, the government can appoint key executives to control loans and subsidies. Even private companies need to nurture their contacts within the state to win favors. It is estimated that China loses as much as 10 percent of government spending in bribes and corruption. Firms “...just don’t do business based on building a reputation of transparency in China. Corruption is common and ethical standards are very different,” say researchers.

Political ties for Chinese firms are therefore very much a double-edged sword. A relationship-based system can encourage stability and longer term vision and strategies. However, companies which fall out with the state in the wake of a scandal, either locally or on a national level, not only see their stocks plummet; they still tend to bear the brunt of excessive government control and intervention but without the benefits of government favours. Overheads remain high as companies are still expected to provide jobs, roads, schools and hospitals, but they may no longer enjoy favorable taxes, contracts or trading environments.

What Does This Mean For Investors?

Investors should examine a company beyond its accounting performance, which may not reveal the full picture often legislation around company accounts isn’t followed to the letter. Potential shareholders should assess ownership, corporate structure, and crucially the political environment in which the company operates. Knowing how the company is controlled, and by whom, is a crucial indicator of how it might perform in a more market-led environment. Conflicts of interest can arise between shareholders and management when a company is part-owned or controlled by the state and holds responsibilities beyond making profit.

Foreign investors currently hold interests in just a tiny fraction of Chinese businesses, although the government is gradually increasing quotas that foreign institutions can hold in Chinese shares.

Can China Change?

In order to appeal to international markets, Chinese businesses must “clean up” their accounting and adapt to fit international mechanisms. “Modernizing is not just a question of importing different accounting standards or hiring a few accountants,” say researchers, who point out that China already has a respectable regulatory framework. Instead business must confront a substantial problem how to remove the distorted incentives behind state interests.

Traditionally change in China is gradual. Some 60 percent of companies remain under state ownership, and while a watchdog exists, enforcement has still been rather weak. Minority shareholders, many of them day traders, aren’t motivated to be sufficiently vigilant and mechanisms for market monitoring are weak.

Some observers believe market pressures will ultimately bring about change, which will first become evident in China’s coastal regions, specifically within faster-moving and market oriented sectors. “I hope outside pressure will push Chinese firms to reform a bit faster, but I don’t think they’re ready yet,” says Prof. T. J. Wong. “It will take a couple of generations. When you compare China to the United Kingdom or the United States, the stock market is messy the transparency and professionalism is not there. But when you compare it to China 30 years before, it has changed significantly.”

Hong Kong’s Place in China’s Future

And while Chinese markets crawl towards modernization, Hong Kong, which straddles both domestic and international markets, has a role to play as a financial centre more aligned with abroad. While outsiders are barred from investing directly in Shanghai and Shenzhens’ stock markets, they can already invest in companies largely major state enterprises listed on Hong Kong’s exchange, which will remain a vital means of raising capital within mainland China.

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