Article / 26 August 2014 at 14:00 GMT

Foreigners in the firing line as Chinese regulators take aim

Managing Director / Asia-analytica Research
China
    •  The fund management industry could be next in the regulators’ cross-hairs
    •   Liability could ensnare companies exposed via subsidiaries and joint ventures
    •   Market and political risks are the same for China’s investing public

 

By Pauline Loong


China’s aggressive enforcement of its anti-monopoly law in recent months is not some flash-in-the-pan crackdown. The move has all the hallmarks of a wider campaign aimed at establishing the credibility of the Xi Jinping administration’s pledge that the law applies to all — the politically powerful as well as the low-level Party cadre – or "tigers and flies" as China's rulers term them.

 

The anti-corruption drive has already bagged large numbers of Chinese tigers and flies. Attention is now shifting to foreign entities that break the rules. 

 

China crackdown



Tigers and flies alike under are pressure in Chinese regulators' latest crackdown  
Photo: Lintao Zhang \ Getty Images News

International media spotlight has so far focused on the antitrust investigations, which have exploded this summer. More than 30 foreign firms have come under official scrutiny including big names such as Microsoft and Qualcomm. Fines in some cases can go as high as US$1 billion. Adding to corporate anxiety are the dramatic tactics employed by Chinese investigators such as simultaneous multi-city dawn raids on the offices of targeted companies.


But the worst may not be over.


Next in line for regulatory attention could well be players in the trust and fund management industry – particularly those involved in selling high-risk structured funds and investment products to retail investors. A company does not even have to be active in the market. Exposure through a troubled subsidiary or a joint venture could be enough to drag the foreign parent or partner through an investigative nightmare as regulators seek to determine liabilities.

The dreaded D-word amid grassroots anger


The risk of defaults inevitably rises as the economy slows – especially as many of China’s current retail offerings are little more than vehicles to raise funds to lend on to third parties. But while banks can quietly write off non-performing loans, failed investment products can only end in high-profile defaults. 


Public perception has always been that the state does – and should – stand behind retail investment products. Despite government attempts to distance itself from private sector offerings, a failed investment typically brings out large angry crowds demanding that the authorities take responsibility for their losses.


Market and political risks are one and the same for investors in a society where government power is seen as near absolute. The Huaxia Bank protests that made global headlines last year hinged on public perceptions that the bank which distributed the failed investment product should be forced by the government to make good on the default. 

Grassroots anger is Beijing’s worst fear.


Families searching for higher returns than bank deposits have been pouring their savings into structured products. Household exposure is significant. Investment in wealth management products stood at renminbi12.8 trillion (US$2.1tr) at the end of May, according to central bank data. To put this into context, China’s broadest measure of new credit known as aggregate financing came to Rmb 10.5 tr in the first six months of the year. 


The near-collapse in February of the Rmb3bn (US$480bn) product that essentially provided financing for a coal mining venture came even closer to home on the issue of liability. The product was issued by a trust company but sold through the private banking arm of ICBC, China’s biggest bank and state lender and not a mixed-ownership lender as in the case of Huaxia.  Investors demanded that ICBC be held liable. In the end, somebody blinked. Default was averted when an unidentified white knight turned up at the last minute with enough spare cash to finance a bailout.


Liability firewalls, dawn raids and the writing on the wall


Defaults in China go beyond financial market stability. A vice-governor of the central bank made it clear in June that regulation of the wealth management product market is “not only a financial issue, but also a major economic and social issue.” He added that more will be done to regulate the market, to control risks, and to ensure “the value of people's financial assets preserved and increased”.


The regulators already have policy approval for action. The State Council issued a directive – Document #107 – to central and local government agencies at the end of last year to pull free-wheeling trust companies back into line. These companies are to be stopped from engaging in "credit-type" business and restricted to asset management which is their purpose. 


The writing is on the wall. It is only a matter of time before regulators become involved in disputes over payout in the event of product default and be forced to determine liabilities. They do not have to wait until trouble hits. The government has already stepped up the policing of fund management companies and banks involved in the sale of fund management products with firewall rules announced six weeks ago.

The next hot topic in legal consultations could well be liability firewalling – adding to the current rage in dispensing advice on what to do in the event of dawn raids on the company and how to be seen as having a co-operative attitude.

A Shanghai-based consultant is urging clients to review their risks as there is “an often-substantial mismatch” between many foreign owners' evaluation of the risks being taken and the actual potential for liability on the ground. Foreign businesses in China are in for a long hot summer.


china protests

Grassroots anger, such as that seen at Tiananmen Square in 1989,is what Beijing fears most. 
Photo: MN Chen \ Getty Images News 


-- Edited by Clare MacCarthy

 

Pauline Loong is managing director of Asia-analytica Research

 

Important notice: Nothing in this report is intended to be, or should be construed as, an offer to buy or sell, or invitation to subscribe for any securities or as advice relating to legal, technical or investment matters. This report has been prepared on the basis of information that is believed to be correct and from sources believed to be reliable. Asia-analytica makes no express or implied warranty as to the accuracy or completeness of any such information and makes no undertaking to update any such information. Opinions expressed are subject to change without notice.


5y
Juhani Huopainen Juhani Huopainen
Speaking of joint ventures, what's your take on this: "German car parts suppliers asked to form JVs in China" http://www.reuters.com/article/2014/08/25/us-autos-china-partnership-idUSKBN0GP0LV20140825
5y
Juhani Huopainen Juhani Huopainen
If I were a foreign company and in the process of moving production over to Middle Kingdom, such headlines are hardly reassuring (bad for FDI). Or is it so that if you form a JV, you get a preferential treatment policy-wise, as there is a Chinese interest at play as well (good for FDI)?
5y
Pauline Loong Pauline Loong
Preferential treatment, such as tax incentives etc, for foreign companies was put in place in the days when China needed hard currency and the foreign expertise and technology to kick off its fledgling industries. Hard currency is no longer the problem. Its foreign exchange reserves are just shy of US$4trillion. But China still wants and needs foreign expertise. Preferential policy treatment is just one way of obtaining this expertise. Ask Japanese car firms in China. The operating landscape for businesses is changing in China. There is not enough space here to go into details but no one should think of starting production there on the basis of media interpretation of what is happening on the ground. It is possible to make money in financial markets on sentiment and momentum. But investing in bricks and mortar is a whole different game. Information is not freely and easily accessible in China but business groups, say the EU Chamber of Commerce, would be a good place to start.
5y
Juhani Huopainen Juhani Huopainen
Thank you. China is way out of my domain, and I enjoy reading your articles, if only to keep up with the large brush strokes.
5y
Pauline Loong Pauline Loong
I appreciate the feedback. One of the reasons I do what I do and I love what I do is because I believe the China story has not been properly explained to the outside world. The country seems to evoke a black-and-white manic-depressive response even from otherwise solid and sober researchers and analysts. China can look very different depending on whether you are looking at it as a place to bring up your children or as a market with profit opportunities or as a geopolitical power that is a wild card in assessing global risks. I can talk for hours on the topic but I am told by the computer that I am running out of space. Thank you again for your feedback.
5y
Juhani Huopainen Juhani Huopainen
I spent the spring of 2002 in Macau, and devoured what I could. Already back then it was about Gordon Chang's 'coming collapse' vs. Believers in a golden future. People just don't get China, and it's no wonder. Before the reforms it was a black box. For many even today, it remains a black box. My flatmate took a minor in communism. Such details sound alien to most from the Western world.
5y
fxtime fxtime
Pauline your macro overviews are excellent...may I ask what the Chinese populace think of the West? Do they also look at us in a black or white over-view? Are we merely corrupt profiteers as the press suggest here in the west? Sometimes to determine viability of a merger/acquisition it is useful to consider the opposite parties involved but I wonder as you imply whether we are seeing the true picture in the West.
5y
Pauline Loong Pauline Loong
It is a love-hate relationship. Pride and prejudice exist in a curious mix of conflicting emotions in China. The urban young Chinese who proclaims proudly that his ancestors invented gunpowder and paper currency also talks with admiration of western technology and savvy in finance and of societies where widely different views can co-exist. At the same time, he bristles with anger and indignation at his certainty that Westerners ride roughshod over Chinese interests and are trying to stop China from reclaiming its rightful place in the world. As for ideology, Juhani, it has a place in Chinese thinking that is often overlooked. Marxist Leninism and Mao Zedong Thought is enshrined in the constitution. That the Chinese central bank warns of the dangers to the economy of a high ratio of M2 to debt or Shanghai traders talk with savvy about Black-Scholes pricing model means China is pragmatic about capitalist tools. It does not mean they have stopped looking at the world through Marxist eyes.
5y
Pauline Loong Pauline Loong
Oops, trigger fingers. I meant M2 to GDP.
5y
Martin O'Rourke Martin O'Rourke
I lived in Beijing for six months in 2011 and it was possible then to detect an ambivalence towards foreigners. My experience overall was extremely positive and the Chinese are gracious hosts in many ways but there was sometimes an undercurrent of resentment that was barely perceptible but nevertheless there. Of course, the behaviour of some expats leaves a lot to be desired too so this is a two-way street. Still, if you can put up with the pollution and the traffic, I'd certainly not advise anyone against spending time in China.

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