May 11, 2017 3:30 pm JST
Minxin Pei

Why Western dealmakers should worry about China's entrepreneurial upstarts

Disclosures about Anbang Insurance hint at a looming crisis in corporate sector

The recent, lengthy expose about Anbang Insurance by Caixin, the China's most respected business publication, is among the most explosive investigative reports ever seen in China.

In the magazine's cover story published on April 29, Guo Tinbing, a Caixin special correspondent who is also a registered financial analyst, detailed evidence that raises questions about the financial health and corporate ownership structure of China's third-largest insurer by assets.

Although Anbang immediately denied the allegations made in Caixin's report and threatened to sue, even disinterested observers should start worrying about the financial conditions of some of China's most aggressive corporate giants and the potential fallout of their questionable business practices.

Even before Caixin's bombshell report, Anbang had attracted attention for its aggressive big-ticket investment projects overseas. The insurer made its debut as an acquirer of trophy property in 2014 by paying a record $1.95 billion for the Waldorf Astoria Hotel in New York. Anbang also struck deals totaling $6.5 billion for such luxury hotels as the Essex House in New York and several Four Seasons hotels in the U.S.

Its more recent attempts to add to its overseas portfolio have fared less well. Last year, Anbang engaged in a bidding war with Marriott for Starwood Hotels. It offered - and then quickly withdrew -- a jaw-dropping $14 billion bid after Chinese insurance regulators raised concerns about the proposed acquisition. Anbang's latest setback was its failure to seal a $400 million deal to invest in a Manhattan property owned by the family of Jared Kushner, U.S. President Donald Trump's son-in-law and senior adviser.

Besides its high-profile deal-making, Anbang is known for its political connections. Its chairman, Wu Xiaohui, who owns the firm along with other family members, is married to the granddaughter of Deng Xiaoping, the late paramount leader who launched China's capitalist revolution in the last 1970s.

Anbang's prominence, rapid ascent and opaque corporate ownership structure have intrigued both Chinese and Western journalists. Most of the media coverage about this financial behemoth has centered on its mystifying ownership structure. An investigation by the New York Times last September found several oddities, including that some obscure Chinese companies were listed as Anbang's shareholders.

The address of one of them turned out to be the empty floor of a Beijing office building, while two others listed Beijing post office boxes as their registered corporate address. A villager in Zhejiang, Mr. Wu's home province, and two relatives owned stakes in Anbang representing $19 billion in assets.

Financial questions

Caixin's expose of Anbang has raised more questions because its detailed financial analysis casts doubts on the financial health of the insurer, which has about $300 billion in assets. Caixin's analysis suggests that the insurance company may not be as well-capitalized as it claims.

Additionally, the company's eye-popping growth in life insurance premium income in recent years seems to have been implausibly fast. For example, in 2013, Anbang collected only 1.37 billion yuan in premium income from its life insurance business that year, but it reported 52.9 billion yuan in life insurance premium income for 2014, a whopping 39-fold rise.

Even though it is too early to tell whether Anbang has engaged in any illegalities, Western investors and corporate executives should take Caixin's story seriously because the publication has a strong record in uncovering corporate fraud and corruption in China. The story of Anbang also merits scrutiny because of its wider implications.

Caixin's allegations about Anbang are being aired when the level of financial distress in China is rising amid warnings that companies rely on questionable -- if not outright fraudulent -- methods to stay alive are heading for a reckoning. In the first quarter of 2017, data compiled by Bloomberg show that the default rate in China's lower-rated corporate bond market hit a record high, indicating that many highly leveraged firms will go bust as China's credit bubble deflates.

Another recent high-profile story in China concerns financial fraud at China Mingsheng Bank, in which Anbang is the largest shareholder. A bank executive was implicated in the sale of fraudulent "wealth management products" worth about 3 billion yuan ($420 million), according to Chinese authorities. WMPs are among the riskiest funding instruments in China's poorly regulated financial sector. Part of China's "shadow banking system," WMPs are estimated to total nearly $4 trillion, or roughly 40% of gross domestic product, at the end of 2016.

These high-interest short-term investment instruments are sold by banks and used to fund companies and local governments that are seen as poor credit risks by Chinese banks. Anbang generated about 90% of its life insurance premium income through Chinese banks, a possible indication that Anbang's business is closely tied to the WMPs peddled by the banks.

Those familiar with the carnage left behind by credit bubbles throughout history would have no trouble recognizing these apparently unconnected stories as omens of an impending financial tsunami. Since 2008, China has created the largest credit bubble in history. Its debt-to-GDP ratio more than doubled -- from 125% to nearly 280%, according to estimates from private research groups including McKinsey and official institutions such as Bank for International Settlements. Based on such estimates, the net increase of debt is about $25 trillion, roughly 1.5 times the U.S. GDP.

History shows that credit bubbles of such magnitude unavoidably lead to a proliferation of wasteful investments and financial fraud. Although it is impossible to know how much of the $25 trillion in net credit has gone into the pockets of fraudsters, even a tiny share could be a shockingly large amount (1% of $25 trillion is $250 billion).

Curbing credit

Worried by the unsustainability of its debt-driven growth model, the Chinese government has finally, although belatedly, begun to tighten bank lending and financial regulations. This development is not good news for Chinese companies relying on the shadow banking system to maintain their liquidity.

If Caixin's analysis is correct, Anbang could be vulnerable when China's tide of credit recedes and exposes the naked corporate swimmers that have nose-bleeding leverage and depend heavily on short-term financing. The possible collapse of a systemically important financial institution such as Anbang would send shock waves around the world.

If companies such as Anbang had confined their aggressive business activities to China, foreign investors and corporate executives would not worry much about the spillover effects if they failed. But privately owned Chinese conglomerates have been on a debt-fueled buying spree of assets in developed economies in recent years. As a result, any financial scandal involving these companies will have far-reaching repercussions.

Anbang had purchased or attempted to acquire more than $30 billion in overseas assets as of late 2016, according to the New York Times. China's HNA Group has just become the largest shareholder in Deutsche Bank, one of the world's biggest banks. Like Anbang, HNA is a Chinese corporate upstart with secretive corporate ownership and high leverage (HNA's outstanding corporate bonds are at least $9.7 billion).

The Hainan-based conglomerate, which started as an airline, has gained global fame as a voracious acquirer of Western assets. In 2016, it paid $6 billion for Ingram Micro, an American technology distributor, and another $6.5 billion for a 25% stake in Hilton Worldwide Holdings. In March this year, HNA spent $2.2 billion on a building on New York's Park Avenue. Its 10% stake in Deutsche Bank is worth about $3.8 billion.

Even though it is impossible to forecast whether firms such as Anbang and HNA can sustain their acquisition binge or stay afloat when China's credit bubble bursts, Western companies should start worrying about conducting deals with these firms.

They should be aware that these Chinese companies will have great difficulty obtaining financing in the future since Beijing has tightened capital controls. Western executives should also be wary when they receive offers of rock-bottom prices given that many Chinese corporate buyers have high leverage, an opaque shareholder structure and unverifiable financial statements. Even for deals that are concluded, the collapse of a Chinese investor could cause many types of disruptions.

Western companies that have already unloaded overpriced assets to Chinese firms may breathe a sigh of relief and toast their good luck. For those contemplating doing similar deals, they should call a time out. Everybody else, meanwhile, should gird for the coming financial tsunami in China.

Minxin Pei is a professor of government at Claremont McKenna College and author of China's Crony Capitalism (2016)

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