China’s state capitalism is a messy mix of market, plan, and one-party rule. Less than half of the economy is directed by the state; the rest is private and market driven. Except for infrastructure and other nontradables, both Chinese economies operate in the world economy. Although not well known, China’s rapid growth derives primarily from private companies, despite the state policy of “state advance, private sector retreat.” The new leadership that takes command at the end of 2012 must decide whether to liberalize and privatize the state sector as advised by the World Bank’s China 2030 programs or bow to the entrenched interests of the state sector. How they decide will determine China’s long term growth.

China’s battle between plan and market is fought day by day on many fronts. What appears to be a minor dustup between the Ministry of Finance and the Securities Regulatory Commission over accounting practices for publicly traded companies is illustrative of the war between market and plan and between the private and state sector.

Chinese stock markets should be soaring relative to the rest of the world. China appears to have dodged the worst of the global downturn, has low deficits and healthy reserves, and is a natural play for those betting on continued growth. Even more upbeat is the news that China intends to liberalize its stock markets, which have become major players on the world scene.  The  Shanghai Stock Exchange is  now the world’s fifth largest in terms of market capitalization. Liberalization aims to eliminate the difference between A shares denominated in local currency for purchase by locals and B (dollar denominated) shares that can be bought and sold by foreigners. With an impending influx of foreign buyers with liberalization, C Efficient stock markets rely on transparent information produced by independent auditors who use generally accepted accounting standards. In such financial markets, investors buy and sell on the basis of common information which they presume is reliable and has been checked. The audits of Chinese companies, listed either in China or abroad, are among the least transparent and most flawed in the world. Chinese share prices sell at substantial discounts because buyers and sellers lack what they believe to be accurate and reliable information on companies.

hinese stocks should rise, but they have not. Why?

The share prices of Chinese companies have been rocked by a series of accounting scandals both at home and abroad. Chinese companies have claimed assets that do not exist. Major suppliers refuse to supply copies of contracts. Major shareholders quietly  disenfranchise minority shareholders. Yahoo’s Chinese partner transferred the major asset of its joint venture to a company he owned without informing Yahoo, which subsequently withdrew from China. We also know that China’s largest companies are under the control of Prince lings, who use connections and corruption to accumulate billions of personal wealth, often contrary to the interests of the company. No wonder that investors are leery of Chinese stocks.

To make matters worse, China’s Ministry of Finance instructed the Big Four auditors in May of this year to hand over operations to local partners and limit the percentage of partners  who gained their qualifications overseas. Henceforth, audits must be  done by Chinese auditors whose credentials are murky, to say the least. The SEC’s Public Company Oversight Accounting Board has been unable to review the work products of the more than 100 Chinese audit firms that are registered with it.

Even the best of Chinese audit firms operate under severe handicaps. They can be charged with revealing state secrets. Their audits might bring to light unsavory related party transactions between management and state and party officials. Due diligence is a nearly impossible task in an economy run on the basis of relational contracts, where little is put down on paper.

In stock exchanges, investors will try to find ways to substitute for something that is lacking. In the absence of reliable public information, private information is being substituted by short sellers driven by the profit motive.  Short sellers dig deep in companies they suspect of producing false information. If the short seller uncovers negative information, it sells shares short prior to disclosing its investigative reports. Such short sellers have been threatened with jail or worse by Chinese authorities, who complain about their “short and distort” campaigns.

Relying on short sellers to uncover information that should have been publicly disclosed is a miserable substitute for reliable public accounting, but as long as China defies conventional accounting practices, it is, in effect, inviting short sellers to do their work.

The Chinese leadership is liberalizing its stock exchanges hoping that foreign investors will bid up share prices. Higher prices will allow Chinese companies to raise equity capital rather than rely on bank financing. China cannot expect this strategy to succeed if it expels major independent accounting firms. As long as auditing is done by local Chinese accounting firms, buyers will either stay away or make decisions on the basis of short seller investigative reports.

Pity the honest Chinese company. There is little it can do to distinguish itself from the chaff. In the meantime, most investors contemplating buying Chinese stocks understand they are, to use the expression, “buying a pig in a poke.” Few investors want to make such investments.

The simple solution — allow Big Four accounting firms to conduct real audits of Chinese listed companies – is far from simple.  It challenges the foundation of Chinese state capitalism, which is a dense thicket of interrelated companies run in most cases corruptly with the spoils shared among company, state and party officials. Real audits would lift up  the rotting log and reveal the spiders and other frightful creatures as they scatter for cover. Such revelations could challenge the authority of China’s ruling elite. They will be avoided at all costs.

Paul Roderick Gregory’s latest book,  ”Politics, Murder, and Love in Stalin’s Kremlin: The Story of Nikolai Bukharin and Anna Larina, ” can be found at amazon.com.

Web link :
http://www.forbes.com/sites/paulroderickgregory/2012/07/15/command-versus-market-chinese-capital-markets-at-a-crossroad/