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Fraser Howie: Financial 'engineering' is all too common in corporate China

Expect more companies to follow Huishan Dairy's troubled footsteps

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An independent dairy farm in China's Liaoning Province, home to troubled Huishan Dairy   © Reuters

The trials and tribulations of China Huishan Dairy Holdings over the last 10 days of March read like a Chinese financial thriller. With new stresses appearing in China's corporate financing system, investors should be on alert for sequels.

Despite being targeted in a negative report by American short-seller Muddy Waters in December, Huishan's shares were initially unruffled. Then suddenly on March 24, the stock posted a record fall on the Hong Kong stock exchange, plunging from 2.80 Hong Kong dollars to 42 cents, or 85% over the space of an hour and a half. The stock has since been suspended from trade, pending further disclosures. Muddy Waters had said in its report that it thought the stock worthless, but even it was surprised by the sudden turn of events.

A subsequent company statement to the Hong Kong exchange only confirmed what had already been said in the media and was clearly known by some a number of days before the stock's collapse. Huishan, China's largest dairy farm operator, denied Muddy Waters' allegation that it had forged invoices but confirmed that it had failed to make some bank payments on time. It said that it had been unable to reach Ge Kun, an executive director with responsibility for treasury and cash operations and bank relations, since March 21 when she had sent notice that would take a leave of absence because of work stress and did not want to be contacted.

The failure to pay bank creditors forced Yang Kai, Huishan's chairman and controlling shareholder, to reach out to the provincial government in Liaoning, where the company is based, to help organize a meeting with 23 banks on March 23. The government urged the banks to provide additional support to Huishan, which employs over 11,000 people, with the bulk in Liaoning.

If this wasn't enough, it also came to light that Yang had pledged most of his shares to Ping An Bank, a subsidiary of Ping An Insurance Group, for a loan to purchase another company. Huishan said Yang did not believe a share sale by Ping An had touched off the price plunge.

Further details have since emerged of how Huishan has funded itself -- not only with bank loans but via various wealth management products on which it was paying interest rates of up to 13.5%. This company seems to tick almost every box of financial risk and regulatory concern in Hong Kong and China.

Hong Kong authorities have waged war against short-sellers and those who raise red flags against Chinese companies. A mixture of disclosure requirements far stricter on holders of short positions than long ones and unreasonable actions brought against those who issue reports raising concerns has done little to protect investors. Yet there is a growing list of Chinese shares that are suspended from trading after collapsing.

The behavior of Huishan should really surprise no one. For years, there have been growing concerns about the opaque nature of Chinese financial engineering as banks and companies become more desperate to access funds regardless of the cost. The disappearance of company executives in China is so common now that it barely warrants news reports. Insistence that official documents are fraudulent may well turn out to be true in this case, but the picture is still developing. More bad news is likely to come out.

The pledging of shares to fund other businesses is also common practice in China and it all holds together until it suddenly doesn't. Whether Huishan's problem was cash-flow stress or malfeasance is almost secondary to the tale; the financial plumbing of this company was bound for failure.

HELP LINES One interesting element was the chairman's call to the provincial government for help. Liaoning is suffering more than most provinces in China's economic slowdown and it has recently been exposed as having falsified economic data. It definitely does not want any more bad news, and its call for banks to continue to support Huishan is hardly shocking.

The case reflects the cozy relationship between the public and private sectors in China or, perhaps more accurately, between the Communist Party and the private sector. The party has often called on business tycoons to do its bidding, so who else would they call on in times of need?

Such connections make reform and the total embrace of the market all the more difficult. Nearly two weeks after Huishan's share collapse, there seems little appetite to let market forces run their course. Once again, there is likely to be a bailout and another instance of "too big to fail" in China.

The dairy sector has been booming in China on rising demand for its products. Disorderly stock falls in a strong sector is not what the authorities want.

It is ironic that China's largest banks have just been reporting better-than-expected profits. That combined with positive purchasing managers' index readings and other economic indicators have given comfort to many investors that China will be just fine and that it can handle its problems.

A broad economic collapse does indeed seem unlikely but it is hard to look across the Chinese corporate landscape and not think that Huishan Dairy is in fact representative of many domestic companies that hold everything together in complex financial transactions at high interest rates until at some point the cards come crashing down.

Huishan's debt-to-equity ratio had doubled over the past few years and it would be interesting to know, especially after the Muddy Waters report, whether any of its creditors had started to mark down its debt, at least internally. Were they as caught by surprise as the poor average Hong Kong retail investor?

Since the stock fall, all four independent directors of the company have resigned. There is still much to come out in this story, but it has all the hallmarks of becoming a Chinese classic.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise."He has worked in China's capital markets since 1992.

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