Dr. P.V. Viswanath

 

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Chinese financial scandals: When it matters

 
 

Aug 20th 2011 | HONG KONG | from the print edition of the Economist

 
 

 

Markets in China are barely fazed by scandal, unless the state is involved

SHORT-SELLERS have been feasting of late on a crop of Chinese companies whose shares have collapsed on foreign markets amid allegations of deceptive accounting. Take Sino Forest, a forestry firm listed in Canada, whose shares slumped from C$25.30 ($26) in March to as low as C$1.99 in June after a research outfit questioned its accounts (Sino Forest has denied the claims and has commissioned a review by an independent committee).

A sharp fall in a company’s share price after allegations of deceptive accounting is hardly unexpected, except perhaps in China. What matters in a scandal there is a little different from in most other places.

A recent study by three academics* looks at several hundred scandals linked to companies traded on the Shanghai and Shenzhen stock exchanges between 1997 and 2005. Their results are striking. Revelations of financial fraud and various other similar crimes, such as embezzlement and kickbacks, are not entirely irrelevant to a company’s share price. But to trigger the sort of collapse in a company’s stock, the loss of short-term financing and the managerial and board changes that occur in America or other developed markets requires another element in China: the involvement of the state.

The study found that companies caught up in mere accounting scandals saw their shares drop by an average of 8.8% over the six months on either side of the incident. In those involving the bribery of government officials or theft of state assets, on the other hand, the stock fell by almost a third.

Collapsing share prices tell only part of the story. Companies caught up in funny business involving the government faced a withdrawal of short-term financing and changes to the board—responses common in Western companies implicated in all sorts of scandal but rare among Chinese companies caught cooking the books.

The reason for the difference is that Western markets rely on contracts being enforced by courts and on investors, suppliers and customers all acting on the basis of audited accounts. In China and other less developed markets, by contrast, business is done on the basis of political and social relationships, not numbers. That changes the dynamic of a scandal.

Staying pals with the government is extraordinarily important: it can lead to cheap financing, land and contracts, along with one other often overlooked (but absolutely critical) benefit. Because China lacks an impartial judicial system, Chinese companies are often at a loss as to whom they can trust when dealing with new customers or suppliers. “Legal” redress for a problem may often hinge on a company’s relationship with officials. If that is compromised and the loss becomes public knowledge—as would happen with the disclosure of a government-related scandal—the company’s ability to operate will be undermined.

It is not just markets that behave this way: officials seem to as well. Reports of prosecutions in China over dodgy accounting in cases where investors or clients are victims remain scarce. But the penalties for financial crimes when the state is the victim can be extreme. A group of people found guilty of counterfeiting money were sentenced to death in July.

It has long been assumed that as China’s market evolved, it would come to look more like the West with the legitimacy of Chinese companies hinging on their own accounts rather than their ties to the government. That assumption may be worth re-examining, not only because China’s vast state apparatus shows little interest in shedding control but also because some Western markets are starting to look a bit more like China’s.

Since the financial crisis governments in America and Britain, to name but two, have become large shareholders (albeit reluctant ones) in financial and industrial companies. The conclusions of the academics’ paper—that the value of a company in developing markets is tied more tightly to its relationship with the government than its investors—may become the new normal elsewhere too.

* “The Value of Relationship-based and Market-based Contracting: Evidence from Corporate Scandals in China”, by Mingyi Hung, T.J. Wong and Fang Zhang.


Issues:

  1. "The study found that companies caught up in mere accounting scandals saw their shares drop by an average of 8.8% over the six months on either side of the incident." Why do you think the share price dropped before and after the incident?
  2. What does the article tell you about the importance of institutions? (And which institutions are important? Click here for related information.)
  3. What does the article impy about proper resource allocation? (Read this article for related issues.)