Accounting and ownership issues could shut doors to capital markets

SINGAPORE - Nine Dragons Paper Holdings Ltd, GCL-Poly Energy Holdings Ltd and China Medical Technologies Inc are among some 35 Chinese companies that might find capital markets closed to them due to escalating corporate governance concerns, according to Fitch Ratings Ltd.

High levels of cash and external valuations of reserves that can mask accounting issues, teamed with concentrated private ownership and independent directors who stay on boards for longer than five years, are traits investors should be alert to, the ratings company said in a report released on Monday.

"International investor interest in Chinese companies driven by the search for yield is coinciding with limited access to information at key issuing entities," said John Hatton, Asia-Pacific corporates group credit officer at Fitch. Companies with a "blemished reputation" can't raise funds, especially if there's an accompanying deterioration in investor sentiment.

China's reputation among investors has been strained after short sellers said companies from Longtop Financial Technologies Ltd to Sino-Forest Corp were exaggerating operations. Moody's Investors Service last week cited five Chinese companies as having more "red flags" on corporate governance than others, sending shares of West China Cement Ltd to a record decline.

High cash balances at companies could indicate trapped funds in offshore accounts, for example, which are not available to repay debt, while exponential year-on-year growth and the rapid addition of new businesses can enlarge the scope for financial misstatement, Fitch said.

"Many Chinese companies have raised debt ahead of growth-led capital expenditure requirements and in anticipation of Chinese banks reducing their lending capacity," said Hatton, who is based in London. "Higher-than-normal profit margins could also be an indicator of governance issues."

Chinese developers have sold $10.2 billion of dollar bonds alone in the past 12 months, compared with $1.6 billion for real estate companies in the rest of Asia, according to data compiled by Bloomberg. Fitch said it would examine the capital controls that can impede Chinese companies transferring US dollars onshore in an upcoming report.

The yield investors demand to own the 8 percent bonds due December 2016 of Shimao Property Holdings Ltd, a Chinese developer highlighted by Fitch for its ownership concentration and long-serving independent directors, has increased 190 basis points this year to 10.22 percent, Royal Bank of Scotland Group Plc prices show. That's 8.62 percentage points more than the yield on similar-maturity Treasuries, a gap that's widened from 6 percent at the start of the year.

"One of the unusual things about China is that you have a very high-rated sovereign with very bad systemic issues in terms of clarity of regulation, rule of law and transparency of information," Andrew Steel, Fitch's Singapore-based head of corporate ratings, told Bloomberg Television on Monday.

"There's a huge differential between the strength of the state and the environment in which companies are operating and that tends to make investors less cautious than they ought to be."

China is rated A+ by Fitch, its fifth-highest investment grade. The cost to insure China's government debt against default has risen 23 basis points this year to 91 basis points, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market.

A pool of professional independent directors with corporate experience has also yet to develop in China and founders of companies with concentrated ownership probably regard such forms of objective shareholder representation as an "unnecessary expense," Fitch said.

In the case of Nine Dragons, a paper products company whose debt ratings were withdrawn last month by Standard & Poor's Financial Services LLC, the current independent directors have served on the board since 2006, Fitch said.

Chairwoman Zhang Yin, China's richest woman, boosted her stake in the company last month and said on June 27 that debt is expected to peak this year. Nine Dragons said on July 4 it agreed on a 3.1 billion yuan ($480 million) loan facility with China Development Bank Corp in June. Steel said it was "difficult to say" whether corporate governance standards in China are improving. "Clearly there are intentions to improve the framework in which companies operate but we're still at very early stages."

Bloomberg News

(China Daily 07/19/2011 page17)