2012-03-19 12:03:25
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