Feb. 24 (Bloomberg) -- If China’s richest man knew he was about to become the most prominent casualty of the country’s love-hate relationship with capitalism, he didn’t show it this past August.

Huang Guangyu, a peasant’s son who became a billionaire by building Gome Electrical Appliances Holding Ltd. from scratch, outlined plans for continued expansion of the 800-store appliance chain.

He told the board members gathered in the company’s mauve- carpeted executive offices 61 floors above Hong Kong’s Victoria Harbor that Gome’s profit had tripled in the first half of 2008 from a year earlier.

The directors lunched on Cantonese dishes ordered in from Man Wah, one of the city’s ritziest restaurants. “It was a very pleasant, chatty meeting,” says Mark Greaves, 51, chief executive officer of London-based investment bank Hanson Capital, who is one of the company’s two non-Chinese directors. “Mr. Huang talked about his crusade to take Gome to all corners of China.”

Greaves hasn’t seen or spoken to Huang, 39, since. One morning in November, the dapper, baby-faced tycoon failed to turn up, along with his Maybach limousine, at Gome’s Beijing headquarters, where he normally worked such long hours that he had installed a double bed in the office adjacent to his own.

Under Investigation

On Nov. 24, the company halted trading in its shares on the Hong Kong exchange. Three days later, Beijing police disclosed that one of China’s most celebrated entrepreneurs was under investigation for share manipulation.

Three months later, Huang and his wife and former co- director, Lisa Du Juan, remain incommunicado, along with Zhou Yafei, Gome’s former chief financial officer, somewhere in China’s penal system, leaving Greaves and his remaining co- directors scrambling to avert the company’s collapse.

Gome’s investors -- which include Capital Research & Management, a unit of Capital Group Cos., the largest U.S. manager of stock and bond mutual funds; Warburg Pincus LLC; and clients of JPMorgan Chase & Co. and Morgan Stanley -- still can’t trade the suspended stock. All four fund managers declined to comment.

During China’s 30-year boom, foreign investors bet heavily on the so-called red capitalists: emerging billionaires who symbolized the nation’s new wealth.

Stake’s Value Plunges

As of Feb. 23, Chinese stocks listed in Hong Kong had plunged more than 60 percent from their peak in October 2007 compared with a 50 percent fall in the Standard & Poor’s 500 Index. Some of the companies that have crashed the hardest are those built by billionaire highfliers such as Huang, whose 34 percent stake in Gome is now worth less than one fourth of the $2.8 billion it was valued at on Sept. 1.

Even in the good times, China’s new rich thrived only at the whim of an autocratic and still nominally communist regime. Now, collapsing global demand for its exports has plunged the world’s fastest-growing major economy into crisis, causing thousands of factory closings.

More than 20 million workers have lost their jobs, the government disclosed in February. A record 6 million students will leave universities this year unable to walk straight into the high-paying jobs that their predecessors took for granted. Strikes and mass protests occur daily.

Only corruption continues to flourish -- at a cost of $86 billion a year, according to the Washington-based Carnegie Endowment for International Peace.

‘Defense Mechanism’

And China’s embattled leaders are seeking somewhere to place the blame. “Maybe people are lashing out as a defense mechanism,” Greaves says. “There seems to be some tension between business and politicians.”

The economy won’t improve anytime soon. China’s breakneck growth plunged to 9 percent in 2008 from 13 percent in ’07. This year, bearish economists predict it will fall to a pitiful -- by Chinese standards -- range of zero to 5.5 percent. That’s despite the announcement in November of a $585 billion government stimulus package. “We must urgently reverse sliding growth,” Premier Wen Jiabao said on Jan. 19. China is targeting 8 percent growth this year.

China’s corporate carnage has surprised investors even more than the mayhem that’s taking place elsewhere in the world, says Nick Toovey, who oversees $80 billion, including Chinese stocks, at ING Investment Management Ltd. in Singapore.

First Bear Market

“In the West, there are still those who remember what happened in 1987 and even 1974,” Toovey says of earlier Wall Street plunges. “But this is the first generation of investors to have experienced a bear market in China in conjunction with a serious slowdown in global growth.”

Some of Huang’s fellow billionaires have also had precipitous falls. Citic Pacific Ltd., run by Larry Yung, lost as much as $2.4 billion last year by betting wrong on the Australian dollar.

The company was bailed out by the Chinese government and now faces an unspecified investigation by the Hong Kong Securities and Futures Commission, according to a statement released by the stock market regulator.

Under the 2003 Securities and Futures Ordinance, making a false and misleading statement can result in a prison sentence, according to a government Web site.

Jailed for 18 Years

On the mainland, Zhang Wenzhong, founder of Hong Kong- listed Wumart Stores Inc., was sentenced to 18 years in prison in October for bribery, embezzlement and fraud, according to the Web site of the Chinese Supreme People’s Court.

Scandal-free entrepreneurs are suffering, too, as their fortunes evaporate along with a weakening economy.

Li Ning, the former gymnastics gold medalist who lit the Olympic flame, Spider-Man style, at the 2008 Beijing games, has watched a plunge in shares of his sporting goods retailer whittle his wealth by almost two-thirds since October 2007.

The stock price has plummeted more than 90 percent at the company owned by Zhang Yin, who became a billionaire recycling used paper into cardboard boxes to pack China’s exports.

“Like Warren Buffett says, when the tide goes out, you find out who’s swimming naked,” says David Webb, a Hong Kong-based investor, shareholder activist and publisher of Webb-site.com.

It’s been more than 30 years since Deng Xiaoping cast off communist orthodoxy and told his countrymen, “To get rich is glorious.” Since then, the country has become fascinated with the newly wealthy class created as the country’s economy boomed.

415,000 Millionaires

Last year, China had 415,000 millionaires, according to a Merrill Lynch & Co./Capgemini report. The country also has more than 100 billionaires, says Rupert Hoogewerf, CEO of Hurun Inc., a research firm that tracks China’s new rich.

That was all right with China’s leadership, which subscribed to a form of trickledown economics. “Deng’s view was that some people would get rich first and the momentum would pull along the rest,” says Laurence Brahm, an American author and investor who owns hotels and restaurants in China.

In the 1980s, those waiting to be swept up by that wave envied the wanyuan hu, households with savings of 10,000 yuan -- about $3,500 at the time. By the end of the next decade, newspaper and magazine readers were poring over rich lists of multimillionaires.

So were the authorities, who were on the lookout for those who failed to pay taxes or obtained their wealth as a result of some blatant criminal activity.

The rich lists became wanted lists, Brahm says. Some of China’s wealthiest went to jail. They included Yang Bin, 43, a Dutch-educated orchid and tulip entrepreneur with a fortune of $940 million, who was imprisoned for 18 years in 2003 for defrauding shareholders in his Hong Kong-listed company, Euro- Asia Agricultural (Holdings) Co., by inflating profits. Others were murdered by business rivals or committed suicide to avoid public embarrassment.

Scaring the Monkey

While to get rich remained glorious, those who became too wealthy were sometimes made into scapegoats, especially in a country where some 200 million people still subsist on just $1.25 a day. “There’s a Chinese saying that you kill the chicken to scare the monkey,” Brahm says.

Even businessmen the government once lauded can wind up in jail. “China’s reforms are full of contradictions and juxtapositions,” he says.

China isn’t retreating from capitalism, says Tao Dong, Hong Kong-based chief regional economist at Credit Suisse Group AG. “There’s no new policy targeting the private sector,” he says.

Private Companies’ Role

In fact, China will have to rely heavily on private companies to boost its economy. “The good entrepreneurs are symbols of the success of 30 years of reform,” says Christian Jiang Weisong, a Hong Kong-based analyst at Bocom International Holdings, a unit of Bank of Communications Ltd. The bank, China’s fifth-largest lender, is 20 percent owned by HSBC Holdings Plc. “It’s important for China that they don’t fail,” he says.

The role of entrepreneurs in the economy is more than symbolic. Private companies accounted for 70 percent of the country’s gross domestic product last year compared with 17 percent in 1990, according to CLSA Ltd., the Asian investment banking arm of France’s Credit Agricole SA.

Entrepreneurs have also created 50 million jobs in the past decade, according to Liu Yang, who helps manage $2 billion in Hong Kong for London-based Atlantis Investment Management. That’s more than the 46 million who were fired when China began closing its inefficient state-owned enterprises in the late 1990s.

Party’s Firm Grip

Entrepreneurs still have to navigate a hybrid economic system. The Communist Party retains a firm grip on the world’s third-largest economy. Many companies have a party secretary serving on their board of directors, and all but one of China’s 130 banks are still government controlled.

“When times get tough, those state-owned banks lend to the state-owned enterprises and not to the entrepreneurs,” says Chris Ruffle, who helps manage $14 billion at Edinburgh-based Martin Currie Investments Ltd.’s China unit in Shanghai.

The red capitalists are also vulnerable when their political connections -- known as guanxi -- change because leaders retire, are transferred to other jobs or are purged.

“Entrepreneurs have to constantly watch the political winds and waves,” says Albert Louie, founder of Beijing-based risk consulting firm A. Louie Associates Corp.

The departure in 2007 of high-profile Commerce Minister Bo Xilai, who moved out of Beijing to become party chief of Chongqing municipality in Southwest China, may have contributed to the downfall of Gome’s Huang, Louie says.

‘Political Wrangling’

“Huang was an obvious target and a victim of political wrangling,” he says. “Without the support of people in the Commerce Ministry, he couldn’t have gotten so far so fast.”

Even the government acknowledges the importance of guanxi. “Most entrepreneurs fail because of the country’s political/business relationships,” said a January editorial in Xiaokang/Caizhi magazine, which is owned by the Central Committee of the Communist Party. “While this enmeshment between politics and business in China has allowed a whole group of entrepreneurs to rise, it has also hindered their progress and may lead to potentially explosive consequences.”

Few have used guanxi better than suave, silver-haired Yung, chairman of Citic Pacific. Yung, 66, is the son of a former vice president of China and grandson of Rong Desheng, who made his fortune in freewheeling prewar Shanghai.

Citic’s History

When most tycoons, including members of the Rong clan, fled abroad before Mao Zedong’s 1949 communist revolution, Yung’s father, Rong Yiren, stayed and handed the family’s mainland businesses over to the state.

After China embraced free markets, Rong Yiren was rewarded in 1979 with the task of setting up China’s first state-owned investment corporation, today known as Citic Group.

Rong was appointed vice president of China in 1993. When Citic set up a publicly traded unit in Hong Kong in 1990, Rong’s son, Yung (Yung is the Cantonese pronunciation of the Mandarin Rong) was named chairman.

Yung lived the capitalist lifestyle: He raced horses and became a steward of the Hong Kong Jockey Club. He bought a U.K. estate, once the home of former British Prime Minister Harold Macmillan, where he built a private golf course and hunted.

“Yung demonstrated a lifestyle that’s compatible with Hong Kong and was a tremendous force for confidence,” Brahm says.

Not anymore. In October, Yung disclosed to investors in a statement that Citic Pacific could lose up to $2.4 billion -- the equivalent of its combined 2006 and ’07 profit -- from betting that the Australian dollar, one of the world’s more volatile currencies, would rise against the U.S. dollar.

‘I Kill You Laters’

In July, when the Australian dollar was trading near a 25- year high against the U.S. currency, Citic Pacific bet it would continue to rise.

Using derivatives contracts known as accumulators, the company wanted to minimize its currency exposure resulting from a A$1.6 billion (US$1.07 billion) investment in an iron ore mine in Australia. Three months later, the Aussie had lost almost 40 percent of its value against the greenback, and Citic Pacific’s losses from the accumulators -- so notorious in Hong Kong that investors refer to them as “I kill you laters” -- had soared.

The currency loss would be the biggest ever by a Chinese company, about four times the $550 million loss China Aviation Oil (Singapore) Corp. incurred on jet fuel trades in 2004. Yung fired financial director Leslie Chang, 54, and financial controller Chau Chi Yin, 52, because they made the contracts without proper authorization, Yung said in a statement in October.

Demoted

Yung’s daughter, Frances, 36, who was described in Citic Pacific’s 2007 annual report as director, group finance, escaped the ax because, according to the company, she was less culpable and reported to Chang. Frances Yung was demoted and will take a pay cut, the company said.

Citic Pacific’s shares plunged to 8.68 Hong Kong dollars on Feb. 23, down 79 percent from a year earlier.

Yung’s connections helped save Citic Pacific, which makes steel and develops property. He flew to Beijing to persuade the company’s state-owned parent to cover the losses in exchange for convertible bonds. Ratings agencies in February upgraded Citic Pacific debt because they said the deal showed the strength of support the company has from Citic Group, which now owns 57.6 percent of its Hong Kong unit.

Yung’s Stake Plunges

Yung, who owned 19 percent of the company, lost more than a third of his stake when Citic Group converted the bonds to stock. Other investors include Montreal-based Power Corp., which owns 4.35 percent of Citic Pacific, according to Bloomberg data. Andre Desmarais, a member of the billionaire family that controls Power Corp. and a Citic Pacific director, declined to comment on the losses. Yung and other directors also declined to comment.

Albert Ho, chairman of Hong Kong’s opposition Democratic Party, says he wants to know why Yung and his fellow directors waited six weeks before disclosing the losses.

Citic said in October that the company learned of the losses on Sept. 7 -- five days before it issued a circular announcing a connected transaction that said “directors are not aware of any material adverse change in the financial or trading position of the group since 31 Dec. 2007.”

Hong Kong’s Securities and Futures Commission said on Oct. 22 that it’s investigating the company. Citic Pacific directors including Managing Director Henry Fan, Yung and his son Carl, 39, the company’s deputy managing director, are being investigated as part of that probe, the company said in January.

Criminal Penalty

The Securities and Futures Ordinance allows civil or criminal action against anyone for market misconduct. The maximum penalty is 10 years in prison and a fine of HK$10 million (US$1.29 million).

Fan, 60, and other directors declined to be interviewed pending the result of the inquiry, Fan said in an e-mail to Bloomberg News. SFC spokesman Ernest Kong declined to comment.

Though she has political connections, Zhang Yin, who founded Nine Dragons Paper Holdings Ltd., has no state-owned parent to bail her out.

The daughter of an army lieutenant who quit the military to become general manager of a metallurgical company in Guangdong province, Zhang, 51, started a scrap paper business in the 1970s with $3,800 in capital.

In 1990, she moved to Los Angeles, where she ran a paper collection company out of her apartment. After moving back to China, Zhang and her husband, Liu Ming Chung, set up Nine Dragons. Business boomed as China’s exports soared, increasing demand for cardboard boxes to pack toys, shoes and computers that the country was selling abroad.

Tax Cuts for Rich?

Zhang and her husband made $400 million selling a 30 percent stake in Nine Dragons on the Hong Kong stock exchange in 2006. By September of that year, Zhang’s shares were valued at $10 billion, making her China’s richest person, according to Hurun.

Zhang’s success also earned her a seat on the Chinese People’s Political Consultative Conference, an advisory body to the Chinese government. There, Zhang was criticized by fellow conference members for proposing tax cuts for the rich and amendments to a new labor contract law that increases benefits for workers, the official news agency, Xinhua, reported in March 2008. Zhang sought an exemption for labor-intensive industries such as her own. “By opposing China’s new labor laws so conspicuously, she has made enemies, and that has hurt her business,” Louie says.

Fewer Boxes Used

China’s slowing export growth didn’t help either. Zhang’s customers began using fewer of her company’s boxes. Thousands of factories closed last year, including 4,000 toymakers.

In December, Nine Dragons issued a statement denying Chinese media reports that it was facing bankruptcy. “Our position remains healthy,” Zhang said at the time. On Feb. 9, Nine Dragons said it plans to buy back $284 million worth of five-year notes at a discount of at least 47 percent to face value. Investors who accept the offer for the notes, which were issued less than 10 months ago, will get back only 53 cents on the dollar plus interest.

On Feb. 18, the company said profit fell 69 percent in the six months ended Dec. 31 from a year earlier. In a statement, Zhang said the global financial crisis and fluctuating raw material prices had resulted in “unprecedented challenges and difficulties.” On Feb 23, the share price had fallen 91 percent from its peak in Sept. 2007 to HK$2.38. That leaves Zhang, once worth $10 billion, with a fortune of less than $1 billion.

Real Estate Slump

Real estate developer Yang Huiyan, 28, also found her paper billions evaporating as the market shifted. In April 2007, investors bought shares valued at $1.9 billion in Yang’s Country Garden Holdings Co., a property developer based in Guangdong province, where home sales had grown at the rate of 22 percent annually for a decade. Within five months, Yang’s 60 percent stake in Country Garden was valued at $16.2 billion. Then, China’s property bubble burst. By Feb. 23, Country Garden stock had plunged 88 percent to HK$1.60.

Some entrepreneurs stand to lose more than just a paper fortune. On the windswept grasslands of Inner Mongolia, far from the boom-and-bust property markets of China’s great cities, Niu Gensheng made his fortune betting that China’s population would acquire the Western taste for milk and dairy products.

In September, Niu, 50, lost a chunk of his wealth when the Chinese government disclosed that 22 dairy companies, including Niu’s, had been selling products containing melamine, an industrial chemical that can boost the protein levels of watered-down milk.

Babies Killed

At least six babies died and 294,000 suffered kidney ailments and urinary problems after drinking infant formula tainted with melamine, the Ministry of Health said in a series of statements from October through January.

In 1999, Niu founded China Mengniu Dairy Co., now the biggest player in the country’s dairy industry, which had $20 billion of sales in 2007. In June ’04, he sold $200 million of stock on the Hong Kong exchange. As the price surged sixfold by the end of ’07, Niu became a billionaire.

He sponsored China’s first astronaut and the Chinese version of the American Idol TV show, as well as giving away $92 million to charities, making him China’s fourth-biggest philanthropist, according to Hurun.

Melamine Found

He was not so successful in ensuring that all of the milk he bought from independent suppliers was of high quality. On Sept. 23, China’s General Administration of Quality Supervision, Inspection and Quarantine said that melamine had been found in infant formula made by Mengniu and 21 other companies.

That day, shares in Niu’s company plunged 60 percent. On Feb. 23, the shares were trading at HK$9.88, down 72 percent from their September 2007 peak. In December, the company said it expected to post a $121 million loss for 2008 compared with a $136 million profit a year earlier. Niu cut his 990,000 yuan ($145,000) salary in half to atone for the error.

On Jan. 16, lawyers for 213 families filed lawsuits against Mengniu and the other companies. Six days later, China sentenced two men to death for their involvement and gave a life sentence to another company chief. Chinese media have not reported any charges against Niu or other Mengniu executives. Niu declined to be interviewed for this article.

At least Niu still has his freedom -- unlike Huang, the imprisoned founder of appliance retailer Gome. In January, Huang resigned from Gome’s board, according to Greaves and Gome spokesman Tim Payne. Huang’s wife, Du, 38, who’s under house arrest, resigned in December.

Gome’s Rise

Huang and Du, a former employee of Bank of China Ltd., built Gome into a national chain selling everything from flat- screen televisions to rice cookers.

To bring international experience to the board, Huang recruited Chang Sun, who runs the China business of New York- based Warburg Pincus, which owns about 1 percent of Gome stock; American Tom Manning, a former Bain & Co. managing director; and Greaves of Hanson Capital.

As they prospered, Huang and Du embraced some of the trappings of wealth. Though his teeth were nicotine stained from chain-smoking, Huang dressed in well-tailored striped shirts and suits and owned a BMW 6 Series car, while Du wore Dior. With their three children, they moved into a 300-square-meter (3,200- square-foot) condominium in a development owned by Huang’s real estate company.

Share Manipulation Suspected

After Huang disappeared, Xinhua reported that he was suspected of having manipulated trading in shares of two other companies, Beijing Centergate Technologies (Holding) Co. and Sanlian Commercial Co.

Xinhua also reported in January that two investigators from China’s public security ministry had been detained for allegedly taking bribes during the investigation into Huang.

Other than that, Chinese authorities have released no details of the allegations against him.

Alarmed that Gome could collapse without its founders, the remaining directors set up an action committee headed by Sun. They also called in a forensic auditing team from Ernst & Young LLP to investigate any irregular transactions.

Greaves says nothing has been found so far. “When people do get taken in for questioning, they sometimes disappear for months or even years,” Greaves says. “That creates uncertainty, which is the worst thing for institutional shareholders, especially when the rest of their world is crumbling around them.”

Private Equity Talks

The company has appointed a new chairman to replace Huang, and begun preliminary talks about selling a stake in the company to private equity funds, according to Greaves and a Hong Kong- based company spokesman, Tim Payne. As much as 20 percent of the company is up for grabs, people familiar with the plan told Bloomberg News.

Greaves says he believes Gome can be saved, and outsiders agree. “The word we are hearing from Beijing is that even if they take out the individual, the company will be allowed to survive,” says Steve Vickers, CEO of International Risk Ltd., a Hong Kong-based unit of FTI Consulting Inc. of West Palm Beach, Florida.

The outlook for Huang himself is bleaker. “The chances of Huang Guangyu coming out of captivity are pretty small,” Xiaokang/Caizhi, the party central committee magazine, wrote in its January issue. As the new rich become the newly poor in China’s seesawing economy, the one thing that seems constant is the power of the state.

-- With reporting by John Liu in Shanghai and Cathy Chan in Hong Kong. Editor: Laura Colby

To contact the reporter on this story: William Mellor in Hong Kong at wmellor@bloomberg.net.

Last Updated: February 23, 2009 17:49 EST