Light at the end of the tunnel

Has the China train wreck arrived?

With each edition of the newspaper, we seemed to have been watching a gigantic Chinese train wreck happening in slow motion, moving toward self-destruction one meter at a time. But with recent stock sell-offs around the world, I wonder if we are already hearing the screech and crunch of steel.

For the past two decades, China has been the 2-ton gorilla in the room that people have selectively recognized. But one aspect about this creature too often overlooked has been the creature’s clay feet.

For centuries, the Chinese have habitually kept double sets of financials - books for external auditors and books for actually running businesses. Matters became even more opaque with the Communist revolution and the establishment of SOEs (State-Owned Enterprises). Initially, the SOEs ran on “revolutionary” rather than business principles, with huge government subsidiaries and monopoly privileges being the order of the day.

Today, SOEs do not keep two sets of books, but they uniquely carry the shadows of “legal person” shareholders who represent the interests of the Chinese Communist Party. These shares are not traded but represent influential if not controlling interests in both SOEs and private Chinese companies. Even private Chinese companies that register in Hong Kong and elsewhere are not beyond the control
one way or the other of “legal person” shareholders.

In any case, as China moved from being something closer to a fascist state than a communist one, the SOEs made some adjustments, but not in as many ways as one may assume. In other words, after decades of never bothering to keep accurate accounts of costs and expenses, the SOEs and their government minders (and perhaps most private Chinese companies’ managers) have rarely gone so far to get a decent handle on their companies’ true values in terms of assets and liabilities.

All of this would be interesting, bordering on quaint, if not for the fact that the Chinese economy has become a major component in both Asian and international financial and manufacturing realms. As such, when the Chinese stock market tanks or soars, one must wonder, based on what? Yes, markets often move on pure speculation, but Chinese stock prices appear to be mostly artificially pegged to mysterious assets.

To a lesser degree, we saw somewhat similar conditions in Korea prior to the foreign exchange crisis at the last turn of the century. One of the most famous case studies took place when a European bank took over one of Seoul’s best-known major retail banks. The new foreign country manager was immediately shocked to discover that the bank lacked an accounting department. Sure, there were bookkeepers, but no genuine accounting. As a result, this huge bank had neither an idea of its cash position and cash flow nor of the liabilities of both performing and non-performing loans. No wonder the operation went bust during tough times!

Looking abroad today, the Chinese economy could be described as a mind-boggling collection of gigantic Ponzi schemes, waiting to implode or to be rescued by the Chinese government. But I cannot help wonder if even the People’s Bank of China knows what its actual cash value is, when taking into account its liabilities.

Ultimately, all “good things must come to an end.” That time of reckoning could well be at hand. Of course, like any good Ponzi scheme, the financial denouement can be postponed, seemingly - but not entirely - indefinitely. The obvious question is “when” and not “if.” We are seeing indicators that “when” could well be coming very soon.

I can only hope we do not see something of the severity of the IMF Crisis, some 15 years ago. We cannot be sure of the size of this Chinese financial tsunami. But it looks like one is already on its way.

As recently retired U.S. State Foreign Officer Stephen Wickman, a well-regarded China economy specialist, recently wrote, “As the U.S. stock market crashes ostensibly because of similar gyrations in the much less-developed economy of China, which also may be sparking a trade war as it tries to wring every ounce of growth out of a faded model of development, it may seem academic to consider once again whether China is truly a market economy.”

As Dr. Derek Scissors of The Heritage Foundation points out, even today, there really is no such thing as a world-class private Chinese company, given the massive invisible class of “legal person” shareholders who operate in China’s non-transparent legal and political system.

Today, China’s world standing is taking a major body check. We have witnessed the incredulous, proclaimed Chinese statistics regarding China’s first half 2015 economic performance followed by the current implosion of the Chinese stock market.

With the apparent inability of Chinese officials to comprehend and take appropriate remedial actions, this is definitely not the time for others to indulge in schadenfreude. The world economy is just too integrated.

All we can do is wait and see. In the meantime, it is up to managers and heads of households to consider what they can do to minimize what appears to be a major international financial crisis on the
horizon.

*The author is a long-term resident of Korea and author of “Doing Business in Korea: An Expanded Guide.”

by Tom Coyner