Investing in China: do you know what you’re getting into?

For some investors, Fitch’s warning this week that shareholders in Chinese companies lack ‘quality information’ may have come a little late.

Even the best investors have been burnt by making investments in Chinese firms that, it turned out, had cooked the books. In an interview with the Financial Times last week, Fidelity's Anthony Bolton said he had underestimated the risks of investing in China and was now spending more time on due diligence.

The scandals have been coming thick and fast: Bolton made his losses on London-listed Chinese small company fund Vision Opportunity China and US-listed China Integrated Energy. But higher profile cases have included US-listed Chinese IT firm Longtop, accused by its auditors of ‘very serious defects’, including faking its bank statements; and Toronto-listed Chinese tree plantation owner Sino-Forest Corp which was accused of faking land holdings (with hedge fund manager John Paulson reportedly among those making losses).

It’s not just accounting standards that befuddle even the canniest investors – both institutional and private – in the world’s fastest growing major economy.

Accounting standards: dodgy

Many of the investments that have turned ugly have been made in Chinese firms listing abroad, particularly in the US, but also in London as with Vision Opportunity China. Using a process called a ‘reverse merger’, whereby a private company acquires a public shell company in order to become listed themselves, Chinese companies don’t even have to meet the standards expected in mainland China.

James Roy, senior analyst with Shanghai-based China Market Research Group, gives the example of Youku, the Chinese equivalent of YouTube. ‘Listed Shanghai stocks must show three years of profits, but Youku listed in New York after just one year. I don’t believe it’s had a single profit making year yet,’ Roy says.

Companies listed in China itself pose their own accounting risks. Compared with UK or US stock markets, it’s ‘a lot harder to see the real picture,’ says Roy. And you can’t necessarily rely on a professional to get it right for you. ‘You could go through an institution that is able to do its own research. But still there’s a risk – there are still things that are missed,’ Roy added. ‘Even for institutions it’s very difficult to understand what companies are up to – even if their books check out they still might not be doing well’.

For some investors, this lack of reliable information is good reason to steer clear. Hugh Young, fund manager at Aberdeen Asset Management, said last week that accounting scandals justified his Asia Pacific fund’s underweight to China: ‘We are wary of this kind of thing in China and have seen it before. A lot of hot money has gone into the Chinese stock market and people did not necessarily know what they were doing or abide by the rules.’

There are also, as Exclusive Analysis puts it, ‘well-founded’ concerns regarding fraud and accounting manipulation in the Chinese banking sector in particular.

Monetary policy: who calls the shots?

China’s approach to interest rates and other tools of monetary policy provides a clear example of the information chasm investors must somehow bypass. For a start it’s not as simple as keeping an eye on interest rates. The authorities use a complex array of tools to control inflation, and base rates (of which there are several) aren’t even necessarily the most important of these; In fact the International Monetary Fund this week urged the Chinese authorities to stick to interest rates and rely less on their various other measures.

And again here the experts lack all of the information they need. Economists versed in the minutiae of Chinese policy making will admit that few people know who calls the shots – it’s hard to gauge how much of a say the central bank has.

Economic data: trustworthy?

With each release of official Chinese data comes accompanying accusations of inaccuracy or falsification for political purposes, but how true is this? Several years ago, researchers attempted to clarify the issue. One study found that ‘long-run growth trends are approximately correct’ but that the margins of error might be ‘uncomfortably large’. Another concluded that ‘official data are by and large reliable’. So no help there.

Roy says that a wide margin of error is needed: ‘It’s hard to understand how accurate government figures are. It’s not just manipulation by people at the top…. issues arise from the way that data is collected.’ He explains that the National Bureau of Statistics sends out staff to conduct surveys who don’t have the relevant skills. ‘On the other side’, Roy adds, ‘businesses are not willing to give them accurate information so they can get lower taxes’.

Then, there is a very large unreported underground economy. This has been estimated at 10-20% of the total economy, but the figure could be much higher.

Stock markets: complicated

Confused by A, B and H shares, or red chips? You won’t be alone: see the table below (remember there are also the reverse merger shares in New York and elsewhere). And note that there often wide disparities between the different share classes of the same company.

How much investor cash would be flowing into China if everyone abided by that most simple of investment’s tenets: don’t invest in something you don’t understand?