One of China’s biggest drugmakers recently said that it overstated its assets by $4.4 billion, calling into question the quality and standard of accounting at Chinese listed companies.
Kangmei Pharmaceutical Co., a producer of traditional Chinese medicines, disclosed in an April 30 regulatory filing that it had made an accounting error, leading to an overstatement of cash by 30 billion yuan ($4.4 billion) on its 2017 financial statements. The company also revised downward its 2017 revenues by 8.9 billion yuan ($1.3 billion).
Investors fled from Kangmei’s stock, which tumbled by the 10 percent daily limit on April 30. Its bonds also fell by 20 percent, as creditors doubted the company’s ability to repay its debt.
The sheer size and type of the misstatement are alarming, given that cash is one of the most readily identifiable assets on the balance sheet. The revelation comes about four months after Kangmei told investors that it was being investigated by regulators for potential financial disclosure issues.
The China Securities Regulatory Commission (CSRC) has recently stepped up efforts to delist companies whose accounting disclosures aren’t up to par. If the CSRC deems Kangmei’s accounting error as a “major violation,” the company faces possible delisting from the Shanghai Stock Exchange.
This isn’t the first time Kangmei’s financial position has been questioned. Earlier this year, Kangmei came close to defaulting on $300 million of bonds. It was saved in the 11th hour, when the Guangdong provincial government stepped in and told all regional hospitals that owed money to Kangmei to pay up (or their leaders would face disciplinary action), allowing Kangmei to raise the funds necessary to repay the debt.
According to Caixin, a China-based financial magazine, Kangmei was implicated in several bribery cases involving government officials during 2018. Court documents showed the company “bribed Cai Ming, the former director of the drug safety supervision department at the Guangdong Province Food and Drug Administration, to the tune of 300,000 yuan [about $44,500] from 2014 to 2015,” Caixin reported.
Inflow of Foreign Cash
The Guangdong Province-based Kangmei is one of the Chinese companies that index provider MSCI Inc. added to its emerging markets index, a benchmark tracked by many global mutual funds and exchange-traded funds (ETFs).
MSCI’s emerging markets benchmark is tracked by funds with $1.9 trillion in total assets under management, according to the Financial Times. As a result, about $100 billion of foreign capital is expected to flow into China’s stock markets—including shares of Kangmei—by the end of 2019.
Several institutional investors already own substantial shares of the Chinese pharmaceutical company. As of August 2018, BlackRock’s iShares MSCI Emerging Markets ETF and iShares Currency Hedged MSCI Emerging Markets ETF jointly held 1.1 million units of Kangmei stock, according to its annual report.
Norges Bank Investment Management, investment adviser to the Norway Government Pension Fund, owned 6.1 million shares of Kangmei, as of December 2018.
A Risky Bet for Investors
Kangmei’s financial indiscretions underscore the risk foreign investors are taking when investing in Chinese listed companies.
Chinese companies are defaulting at a record pace. Last year was the biggest on record for onshore bond defaults, and 2019 will test regulators’ wills as Chinese corporations face a wall of bond maturities later this year. Reuters data shows Chinese issuers defaulted on bonds with a total face value of 23.3 billion yuan ($3.5 billion) during the first four months of 2019, a 70 percent increase from 2018.
The 2018 defaults were mostly from small, unknown companies with little economic significance for China. But this year, some of the most well-known Chinese enterprises have been tied to bond defaults. In early April, CWT International, a Hong Kong-listed subsidiary of Chinese conglomerate HNA Group, defaulted on a loan it had taken out just months earlier.
China Minsheng Investment Group (CMIG), one of the country’s biggest financial firms, missed a bond interest payment in February. The influential financial giant was said to be favored by Chinese premier Li Keqiang. CMIG is showing various signs of financial distress—which are complicated and beyond the scope of this report—and Bloomberg reported in April that the company had hired law firm Kirkland & Ellis as a legal advisor, possibly as a precursor to restructuring.
“Investors have to be more careful about Chinese firms’ reporting,” Andrew Lam, a director at accounting firm BDO, told Bloomberg following the Kangmei disclosure.
“They will have to do real homework, examining closely companies’ financial reporting for any potential irregularities.”
That’s obvious. But to independently examine Chinese companies’ accounts is mission impossible for most investors.
China has its own credit rating agencies and its own rating standards. There are almost zero companies rated below investment grade, making it difficult for investors to decipher a company’s true credit-worthiness. On Wall Street, it’s widely believed that Chinese rating agencies’ standards are vastly inferior to the “big three” U.S. rating agencies Standard & Poor’s, Fitch Ratings, and Moody’s.
In addition, Chinese auditors charged with signing off on companies’ books don’t abide by the same standards as those of the United States and are not subject to U.S. regulatory oversight, even if their clients are listed on U.S. exchanges.
The U.S. Securities and Exchange Commission and the Public Company Accounting Oversight Board have failed for almost a decade to reach a resolution with Beijing to examine Chinese auditors’ work. Despite bipartisan support for more oversight of auditors who examine U.S.-listed Chinese companies, the China trade deal currently under consideration by the Trump administration doesn’t mandate a resolution to this issue.
It should be noted that the lack of oversight or transparency presents an opportunity for some sophisticated investors—such as Muddy Waters—to bet against certain Chinese companies based on proprietary research and investigation. But fundamentally, these are significant drawbacks for the ordinary investor.
It’s time for fund managers, U.S. regulators, and financial firms to be more transparent and educate their clients about the additional risks of investing in China.