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Close political bonds won’t guarantee a healthy share price

CUHK Business School Connect Magazine
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Investors beware contrary to expectations, a close relationship betweenbusiness and government won’t guarantee good returns for investors, say researchers at Hong-Kong-based universities. While good links with government seemingly offer a host of benefits for businesses, such as favorable taxes, monopoly rights and even subsidies, the cost of such a relationship can be high, especially as firms embark upon privatization.

How well a company’s stock performs during the first period of privatization depends on who sits at the helm and directly beneath. Businesses led by managers with close political ties actually perform 18 percent worse than their professionally-led counterparts during the three years after initial privatization on China’s exchanges, research published by the China University of Hong Kong (CUHK) and City University of Hong Kong shows.

Nowhere is this clearer than among China’s largest four banks (Bank of China, China Construction Bank, Industrial and Commercial Bank of China, Agricultural Bank of China) which have all made an IPO within the last few years. Yet, despite healthy fiscal performance - each institution has only seen a return on equity of around 14 percent - shares have stagnated since their initial offering. “In every case, the (share) price does not go up,” says Anthony Neoh, formerly chief adviser to the China Securities Regulatory Commission (CSRC) and board member since 2006 on one of the institutions, Bank of China. “These banks are owned 60 to 70 percent by the Chinese government,” he says. “So the lingering question in the market is this: to what extent are these banks carrying out a government function?” Would these institutions bend to government pressure to improve credit in a particular sector, for instance?

“Our main message is that partially-privatized state enterprises do not run professionally if they have ex-government officials as CEOs and on the boards they still have political obligations,” says Prof. T. J. Wong of CUHK, who collaborated withprofessors Joseph P. H. Fan and Tianyu Zhang to complete the research. China’s former central control still extends a strong legacy the government retains the power to appoint CEOs to listed companies and large state-owned enterprises (SOEs) are prominent, especially in vital infrastructure industries. “In the past we’ve believed in countries such as China, political connections are a good thing because they provide support and favors,” says Prof. T.J. Wong.

Data from the research below based upon 790 partially privatized firms in China shows the difference in CAR (Cumulative Abnormal Returns) over a three year period. The pink line represents the firms which have a CEO who is a current or former government official after 35 months an 18 percent gap in CAR is evidenced.

Over the last three decades, China has moved away from a centrally-controlled economy to allow private enterprise and some foreign investment. Some 790 companies that have been partially privatized on China’s stock exchanges between 1993 and 2001 were examined during the three years after their initial public offering (IPO). Of those companies, almost 27 percent of CEOs were former or current government officials perpetuating state control on a significant slice of Chinese commerce with greatest hold in strategic sectors such as natural resources and utilities, while finance and real-estate retain the lowest state presence. Companies with a politically connected CEO also tend to have more bureaucrats and fewer professionals on the board, with older directors who are more likely to be men, researchers found.

Investors immediately anticipated effects of political connections, research shows. This was reflected in initial low returns on stocks after two months, which remained lower in the longer term. This graph below shows a 4.4 percent difference in CAR after 60 days, with the red line representing the firms which have a CEO who is a current or former government official.

These findings might have implications for potential investors. Knowing how the company is controlled, and by whom, is a crucial indicator of how it might perform after an IPO, both in the short term and longer term. Additionally, the pricing of IPO shares varies according to the level of state control: companies with no political ties tended to under-price IPO shares more so than politically connected firms - a signal of their greater freedom from state intervention, research suggests. A lack of separation between state and business creates a conflict of interest. “The overall evidence is consistent with the ‘grabbing hand’ argument that bureaucrats and politicians extract resources from listed SOEs under their control to fulfil objectives...not consistent with firm value maximisation,” researchers said in the report. Company owners and managers also have social objectives that don’t sit well with their commercial responsibilities. “In China, social stability is very important,” says Prof. T.J. Wong. “And the government needs to retain tight control despite pursuing economic reform and these (state-controlled) firms do provide stability. In some cases, they own the entire city. They provide schools, hospitals, day care, and infrastructure. These responsibilities remain after privatization, and conflicts are even greater if CEOs are ex-government.”

However critical this social role, this is likely to be challenged by ensuing generations. Competition for China’s vast domestic market will inevitably grow more intense and if national firms are to compete, they will need to modernize, says Prof. T.J. Wong. Sectors such as retail and technology might move faster than typically strategic industries, and eventually become completely privatized. “If China wants to promote domestic consumption these sectors need to be more competitive but I hope it will open up the car industry and manufacturing eventually. China needs to be careful otherwise its domestic market will be taken over by competitors.”

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