On the Money Bear in the China Shop

By JOHN ROTHCHILD

As you no doubt have heard, China is the world's biggest emerging market: 1.2 billion potential consumers for cars, TV sets, patio furniture, all the stuff we've already got. This is the era of global investing, it is said, and the sophisticated investor can't afford to ignore China, an exciting economy with a great future, because the most ardent capitalists you'll ever meet are the Chinese communists.

Taking the sophisticated route myself, I bought shares in a China mutual fund in my typical fashion: invest before you investigate. A recent trip to Hong Kong gave me the chance to do the latter, so the first thing I did when I got back home was to sell my China holdings, such as they were. Everybody in Hong Kong thinks China has a great future. It's the Chinese companies you have to worry about.

These beauties were created by U.S. investment bankers, who roam the countryside looking for prospects. They take the old state enterprises and dress them up a little and bring them out as public companies. The ones that trade on the Chinese stock exchange are the diciest, while a slightly better class of company is sold in Hong Kong, and six of the blue chips (they call them red chips) are listed on the New York Stock Exchange.

The first problem is that the new companies have no experience in acting like companies. The idea that they are profit-making operations that owe their allegiance to people known as shareholders hasn't completely sunk in. When they get their hands on the proceeds of a stock sale, they don't necessarily spend it for the intended purpose. Maybe they were in the textile business, but the next thing you know, the management is making a movie or opening dim- sum joints.

A case in point is a chemical company known as Tianjin Bohai, which trades in Hong Kong. I heard about this one from Bill Kaye, who runs the Hong Kong- based Asian Hedge Fund for private clients. According to Kaye, before Tianjin Bohai went public, it produced caustic soda ash, a valuable commodity in China. As soon as the firm got cash, it started lending it to other companies. From what I could gather, Chinese companies maintain a close relationship with the state enterprises from which they came and sometimes can be pressured into making loans and even donations to their old cronies. I'm also told that the Chinese consider it very impolite to turn down a request for financial assistance.

This brings us to problem No. 2: How can the Chinese companies make a profit? In many instances, their biggest customer is the state, which doesn't necessarily pay its bills on time. This leads to the disappointments noted by Fidelity's man in Hong Kong, Bill Ebsworth. "They have a habit of disappearing," he says, referring to the earnings.

Disappearing earnings have already become the bugaboo of China Tire, which was born on the New York Stock Exchange in July 1993 -- a $100 million offering orchestrated by Morgan Stanley. China, tires -- it sounded like a wondrous proposition, but Kaye says it isn't. "All Morgan Stanley did was pull a couple of outmoded bias-ply tire plants off the shelf and repackage them. It's going to take a lot of money to convert those plants to radials. Meanwhile, China Tire isn't being paid for the tires it sells already."

Kaye invests in China, but only in small companies where he can install people on the board who can baby-sit. He predicts that the publicly traded ones that are left to their own devices will come to a bad end. The six China stocks on the N.Y.S.E. have recently headed in the direction he predicts. Brilliance China Automotive has been much less than brilliant, dropping from 29 7/8 at the height of Sinophoria in 1993 to the current 11 78. The once celebrated Shanghai Petrochemical is down as well, along with Shandong Huaneng Power, and its not too distant relative Huaneng Power, brought to New York by Lehman Bros., has been a turkey.

At present there are four China mutual funds trading on the N.Y.S.E.: China, Greater China, Jardine Fleming China and Templeton. The most interesting thing about them is how they've avoided investing in Chinese stocks. Not one of the six China issues listed on the N.Y.S.E. makes the list of the top 25 holdings of any of the four China funds. That tells you something. So far the funds have preferred to buy Hong Kong companies that do business in China but don't live there.

Why is that? Observers in Hong Kong say there are a couple of possible ! unpleasant scenarios. In scenario No. 1, Chinese authorities, who have already tightened credit in a somewhat futile attempt to halt runaway inflation, will tighten it further. This would lead to economic collapse, riots and widespread bankruptcy and would be bad for stocks. In scenario No. 2, the authorities will ease up on credit and resume the merry printing of Chinese renminbi, leading to hyperinflation, which would also be bad for stocks.

The future that everybody says will be great for China is the long-term one. Even Kaye believes China will be the economic success story of the 21st century, the way the U.S. was in the 19th, but that doesn't necessarily help investors now. After all, it was foreign capital (mostly British) that built our canals and railroads back then, but between the scams, panics, recessions and depressions, it was the rare 19th century investor who made any money.

Thought you might like to know all this before you decided to do something sophisticated.