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Investing In China

July 23 2009 | Filed Under Economics , Financial Theory , Futures , Insurance

, International Markets

International investing can provide attractive returns and diversification for

investors. With the advent of various investment products such as international

funds, American depositary receipts (ADRs) and index funds, accessing

international markets has become easier. However, it is important for

individuals investing overseas to get a basic understanding of how these

different international markets work. In this article, we'll tour the Chinese

markets and show you how can invest in them. (For related reading, see

Broadening The Borders Of Your Portfolio.)

Chinese Regulatory Bodies

Because China is still a communist country, the rules and regulations for

public company trading and reporting are extremely different than they are in

the U.S.

For shares traded on the Hong Kong Exchange, the primary regulatory body is the

Securities and Futures Commission, which was created in 1989. This body is

similar to the U.S. Securities and Exchange Commission. Its major role is to

protect public investors and to assist the Hong Kong Finance Secretary in

maintaining orderly markets.

The Shanghai Stock Exchange is regulated by the State Council Securities

Management Department, which has issued the Securities Law of the People's

Republic of China. The laws determine the listing requirements for public

companies traded on this exchange and regulations for continued listing and

financial reporting.

Chinese Regulations

Much of the regulation of public stocks in China is done directly by the Hong

Kong Stock Exchange and the Shanghai Exchange. Both have listing procedures

similar to U.S. exchanges. Companies must report financial results on a timely

basis, and audits of company financial results are performed, although the

accounting rules are different than they are in the U.S. (To learn more about

listing requirements in the U.S., read The Dirt On Delisting and Getting To

Know Stock Exchanges.)

In Hong Kong, the Society of Accounts performs the task of setting standards

for audits. Most balance sheet, cash flow and profit and loss information is

put together in a way that would look familiar to U.S. investors, but the basis

of the reporting is different from the generally accepted accounting principles

(GAAP) used in the United States.

Based on a January 2004 (the latest data available) report by Lehman Brothers,

it appears that the differences in accounting standards between China and the

U.S. are still significant. According to the report, "if Chinese authorities

can replace the current tax systems with one system for both domestic and

foreign enterprises, and continue to reduce the difference between financial

statements prepared under Chinese GAAP and those prepared in accordance with

international financial reporting standards (IFRS)", then foreign investors

would be better able assess the performance of investments more efficiently in

the future.

The IFRS was set up by several countries including the U.S., U.K. and Germany.

It was created to try and ensure there was one accounting standard that crossed

all major markets.

The Lehman Brothers further point out that in using IFRS, the rule for valuing

inventories "can be extended to a maximum of 20 years. Companies using

international standards can choose whether to capitalize borrowing costs or

not. In China however, costs on project-specific borrowings must be capitalized

as part of the cost of acquiring or constructing a tangible fixed asset." The

balance sheet difference between a 20-year valuation and one that is immediate

can create a significant difference in asset and liability tables in financial

statements.

New Chinese GAAP accounting regulation may make financial activity in China

more transparent, but until these procedures conform to those in other major

financial markets, the inconsistencies will make Chinese companies more

difficult to follow.

An Attempt to Mandate Fairness

According to a February 6, 2007, Business Daily Update article, the China

Securities Regulatory Commission (CSRC) mandated that board directors and

managers of listed companies cannot speculate on stocks they hold in companies

they serve. For a number of years, there have been no rules about timing or the

amount of stock sales following an IPO in Chinese markets, which is

significantly different from U.S markets. The CSRC also announced a rule to

increase the disclosure information public companies must provide. (For related

reading, see IPO Lockups Stop Insider Selling.)

Company officers still sell shares without disclosing these transactions. New

rules encourage the filing of sales, but these requirements do not appear to be

policed, unlike U.S. actions that are policed by agencies like the SEC.

Furthermore, there appear to be no records of any Chinese public company

executive having been fired or prosecuted for violating the CSRC code.

While the Chinese appear to be increasing regulations by adding new rules,

there is little evidence of the type of enforcement that is active in the U.S.,

especially by the Justice Department and SEC.

According to The China Daily, during the first month of 2007, 19 listed

companies saw their high-ranking executives and majority shareholders sell off

part of their holdings, according to information released by the Shanghai Stock

Exchange. Although the sales involved many irregularities, there is no evidence

that any of these officials were sanctioned. (For related reading, see Defining

Illegal Insider Trading.)

High-Risk Speculators

Investors in the Chinese markets often borrow money for stock purchases through

lending institutions that are not regulated by the government. The Chinese

government has gone so far as to warn banks that they should not make loans for

stock purchases, but it is not clear whether those regulations are enforced.

When these loans are called by the banks, investors may have to liquidate

positions, leading to sales that are not based on the normal considerations of

investing. This can add to market volatility.

Government Involvement

Many Chinese public companies are firms that were once owned by the communist

government, such as China Life Insurance Company. Parts of these companies are

spun out to public shareholders to raise funds for expansion. (For more

insight, see State-Run Economies: From Public To Private.)

In many cases, only a minority stake is spun out, and the government continues

to control the overall operations of the company, leaving shareholders with

little say. Also, there is no guarantee that the interests of the government

will be aligned with those of shareholders. (To learn about U.S. shareholder

rights, see Knowing Your Rights As A Shareholder.)

A less likely, but still major, risk of investing in China is that the

communist government could very well decide that it wishes to own and control

100% of these companies again. The list of governments similar to China's that

have nationalized private companies is fairly long. While there is no evidence

that this will happen in China, it should be considered one of the risks.

U.S.-Listed Chinese Companies

Chinese companies listed on U.S. exchanges are required to follow a number of

GAAP procedures in their financial reporting and are required to comply with

all of the listing requirements of U.S. exchanges. These provide a way for U.S.

investors to take a stake in the Chinese markets while benefiting from some of

the rules and regulations that govern U.S. stocks.

Conclusion

In recent years, China has boasted a rapidly growing economy. The odds that

Chinese companies will continue to do well seem good, but there are a number of

pitfalls for the individual investor. Before investing in a Chinese company, be

sure to find out how it operates and whether it is likely to act in the best

interest of its shareholders.

To learn more about the risks of foreign investing, see Why Country Funds Are

So Risky.

by Doug McIntyre