January Insight-Wither the bloom on Chinese companies listed off-shore?

With low growth in Western economies, there is a perception that the relatively healthy GDP growth in China makes China-focused equities attractive. But investors need to consider a number of short-term governance issues for companies already listed, as well as some long-term market risks. 

The most immediate red alert impacting Chinese equities listed in the United States is the current battle between the Securities Exchange Commission and the big five U.S accounting firms.

The U.S. Securities Exchange Commission claims the China affiliates of the big five U.S. accounting firms broke securities laws by failing to provide documents from their audits of nine U.S.-listed Chinese firms under scrutiny. However, to be objective Chinese regulations currently prohibit the removal offshore of audit papers and the auditors are between two hard rocks until this is resolved on a bi-lateral basis.  If this and other issues around SEC scrutiny of Chinese stocks are not resolved, some experts predict the SEC will go the extreme route of delisting a majority of firms with significant operations in China.

Intercedent is confident that smarter heads will prevail. A solution to this impasse will develop because of the strategic importance of healthy bilateral relations, the long-term benefits of better market practices in China, China’s globalization goals for the RMB and the matter of divesting state assets through public markets. However, until all this is resolved, it will dampen market prices for investors.

Marshall McLuhan’s vision of a global village refers to our ability to communicate globally, but not our ability to know what is happening locally around the world. A village market functions on the principle that local villagers never get scammed in a market they frequent daily.  This was also the founding principle of Silicon Valley’s venture capital marketplace before the first tech bubble — invest with people whom you know can execute the business plan.

At a bare minimum, institutional and public investors should be wary of Chinese public equities that were underwritten by firms with no office in China, audited by firms that do not have offices in China and do not have strong independent directors on the Boards of the listed companies that are based in China. 

Investors should also make sure that the technical consultants, such as engineering firms, valuation firms and key suppliers of goods and services to these listed companies, have offices in China.

Also of concern, in Intercedent’s view, is reporting of an enthusiastic nature by the Western financial media this quarter as it looks for a silver lining in a cloudy global economy. China is facing, under its new leadership starting in April, 2013, a negative impact on growth as a result of the fiscal discipline and restructuring required over the next one to three quarters after the National People’s Congress formalizes Xi Jinping and Li Keqiang as leaders. 

It is unlikely that growth will fall to Western levels, but the perpetual blossom that is China’s economy will wilt around the edges during the restructuring period.

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