China Stock Meltdown Magnified by Poor Governance and Lack of Transparency

February 27, 2007

hang-seng-cp-2592060.jpgChinese stocks are taking quite a tumble today. There appears to be no official or definitive explanation as to why. Getting to why in China is never easy, especially when it comes to business. Rampant corruption and lack of transparency make truth and accuracy elusive commodities in that country. The poor corporate governance practices that have been ignored by many analysts and accepted by most investors in return for soaring numbers will not assist in stabilizing flagging market confidence as the gains shift in reverse. Many investors will now begin to ask how much they really know about China and its companies. Others will conclude that the lure of short-term gains is not worth the risk of dealing in a financial market that undervalues western practices of truthfulness, transparency and disclosure. A regime that places little value on human rights, after all, is unlikely to care too much about investor rights.

I have for some time suspected that these conditions, along with widespread corruption in China, were creating a serious distortion in that country’s true financial picture and that recent stock gains may well be, in part at least, the result of heavily jiggered figures. Any hint of a government crackdown or effort to bring genuine transparency to the market might well reveal China’s own Enron equivalents, and on a much larger scale. Most of China’s corporate economy and publicly traded companies are owned and controlled by the state. Many investors appear to have forgotten that this is a communist regime where accountability and openness are observed as the exception rather than the rule. Proper disclosure, meaningful certification of financial results and insider trading laws don’t exist in the Chinese markets for all practical purposes. Their absence may not be forgiven very long by western investors if a major slide is in the works and there is a contagion influence upon North American and European markets.

China is not a country whose capital markets infrastructure, regulatory apparatus, securities law enforcement or corporate governance practices were ever prepared for the huge run up in valuations that has taken place in the past 20 months or so. It certainly won’t be eqipped to deal with that other —and often forgotten by investors— part of Newton’s first law of physics.

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