China: Red Flags Rising.

Updated: May 24, 2020

A combination of international and domestic pressures has elevated the risks to foreign investment in the Chinese market

China - Red Flags Rising

China’s economy is caught in a perfect storm of events—the ongoing trade conflict with the United States, a slowing domestic economy, the transition from an export-led to consumer-driven economy and increasing corporate debt—that is slowing growth to rates not seen since the last century.

The culmination of these events has set the scene for increased issues affecting foreign investments in China especially related to fraud, bribery and corruption. Therefore, the need for companies to review their exposure to China and monitor and assess risks related to fraud, bribery and corruption is now, more than ever, paramount.

Trade War and Economic Slowdown

China’s economic contraction is widely projected to carry over into 2020 and is expected to slip below the 6% growth recorded in the third quarter of 2019, itself a 27-year low[i]. The country’s GDP expanded by 6.6% in 2018, down from 6.8% the previous year, and is on track to decrease for a third consecutive year in 2019 to 6.1%.[ii]

The effect of the trade dispute with the US on the Chinese economy has been substantial, with exports to the country’s largest trading partner falling inexorably since Washington first introduced tariffs in July 2018. The Sino–US trade war has weakened China’s manufacturing and export[iii] sectors, while also undermining consumer confidence. Companies can expect increasing instances of fraud and corruption as many struggle to remain viable. Instances related to revenue inflation and overstatement, bribery schemes to win new business or secure existing business, kick-back arrangements with customers and suppliers and other fraudulent methods to shore up the balance sheet and income statement are expected to escalate significantly.

While US and Chinese officials announced on December 13, 2019, that the two countries had settled on a phase one agreement after a contentious 18 months, details regarding exactly what has been agreed upon are still murky and do not seem to resolve the deeper underlying disagreements between the two countries. Indications are that this interim agreement will include suspending pending tariffs and reducing some already in place, although they will not be discontinued entirely. This means the Chinese economy will continue to be affected by many of the fundamentals that have led to the downturn. While not deepening the slowdown, the phase one agreement will by no means abate it.

Supply Chain Decoupling

As a result of the protracted trade issues, and in many instances in an effort to avoid US tariffs and minimise risks associated with their supply chains, businesses, both private and public, have begun moving their operations beyond China or, at the least, to assess the feasibility in doing so. In July 2019, more than 50 multinational and Chinese companies were reportedly investigating the relocation of manufacturing operations to Southeast Asia or, in some cases, repatriating their operations and supply chains.[iv] China’s Goertek, for example, is understood to have started trial production of Apple’s AirPods at its plant in northern Vietnam.[v]

During this downsizing and rationalisation process in China, risks related to asset misappropriation, siphoning of funds and employee malfeasance become much more elevated. It is imperative for firms that intend to move, or are undertaking the feasibility of moving, operations and supply chains to non-Chinese jurisdictions to monitor asset movements (both disposals and acquisitions) and major changes to working capital and cash flows.

Debt Crisis

At the same time, corporate debt levels have continued to increase. China’s corporate debt-to-GDP ratio climbed by 65 percentage points[vi] in the decade ending 2017 to 160.3% of GDP[vii].

Increased oversight on credit growth has squeezed liquidity and has driven onshore bond defaults to record levels. The value of defaults in the first 11 months of 2019 climbed to 120.4bn yuan (US$17.12bn), just short of 2018’s record 121.9bn yuan (US$17.33bn), according to data compiled by Bloomberg[viii]. Fitch Ratings has reported that the default rate for bonds issued by non-state Chinese companies increased to a record 4.5% in the first 10 months of 2019.[ix]

While this number is still small in size compared to China’s US$4.4tn onshore corporate bond market, there is growing unease amongst investors. Defaults, rather than being limited to a single sector, instead have spread across a diverse array of industries from property development to steelmakers to software development.

With ever-increasing debt levels, more companies are finding themselves unable to meet their repayments, opting instead for insolvency. The number of corporate bankruptcy cases settled by Chinese courts in 2017 climbed by 73.7% year on year to 6,257, according to the Supreme People’s Court[x]. Some estimates a further 20% increase in 2019.[xi]

In the face of tightened liquidity and potential insolvency, instances of fraud and corruption are amplified. Risks ranging from financial statement fraud to improper financing and utilisation of funds to asset misappropriation become more frequent. It is critical that companies understand and monitor major changes to their financial statements, cash flow and working capital with major changes signifying potential red flags. Financial statements from Chinese business partners should be scrutinised in greater detail.

Red flags rising

These issues have left local government financing vehicles (LGFVs), privately owned companies, foreign-Chinese joint ventures (JVs) and Wholly-Owned Foreign Enterprises (WOFEs) striving to increase revenues while slashing costs and minimising capital expenditures. In this perfect storm of events, all warning signs continue to flash “red” as the risk of instances related to fraud, bribery and corruption increases exponentially. Financial statement fraud, asset misappropriation, bribery, kick-back schemes with customers and suppliers, and siphoning of funds are just a few of many issues that arise during challenging economi