Playing A Risky Game With `Red Chips'

Investors bid up stocks with Chinese government ties

In mid-March, Gitic Enterprises, a Guangdong-based construction materials and property company, put up for sale 100 milion of its shares at 13 cents apiece,

to be traded on the Hong Kong stock exchange, starting Mar. 26. The offer touched off a storm. In a frenzy, buyers oversubscribed the shares by 892 times. They borrowed so much to plunk down as deposits on their bids--a total of $13 billion--that they sent Hong Kong interbank interest rates soaring by nearly one and a half percentage points. The buying spree added to the mix of euphoria and apprehension in the crown colony as the July 1 date of its reversion to China approaches.

Gitic Enterprises, owned by provincial holding company Guangdong International Trust & Investment Corp., is one of Hong Kong's "red chips"--companies owned by Chinese state ministries or provincial or local governments that are traded in Hong Kong. Since last summer, red chips have been the highest of highfliers. From 170 in late August, ING Baring Ltd.'s Red Chip Index rocketed to 310 by mid-March before easing back to 280 on Mar. 24. Some individual red chips have soared to dizzying heights: industrial conglomerate China Everbright International is trading at 500 times its 1995 earnings.

WINDFALLS. Buyers of Gitic Enterprises are hoping the company's stock will benefit from a process that has boosted the price of other red chips. Chinese parent companies often sell choice subsidiaries to Hong Kong red chips on favorable terms. The deals often boost the value of the listed company and produce stock-option windfalls to managers--who are usually the same in both the parent and the red chip.

There are dangers, too. Investors in Gitic Enterprises are making a risky bet on such asset transfers, argues Peter Churchouse, research director at Morgan Stanley & Co. in Hong Kong. Given the opaque nature of much of China's business practice, "they can have no idea what those assets may be, or what comes with them." His concern: If a company is transferred to the red chip complete with liabilities for the package known as the iron rice bowl of Chinese worker benefits, it could be a burden on the red chip's earnings.

Foreign individual investors and institutions may have participated in the initial runup of red chips, but that has changed. "We're noticing that a huge part of the volume has been coming from local brokerages, which suggests it's retail or China-related," says Churchouse. Speculators hope that signals even more gasoline on the fire since it could mean the Chinese government is encouraging state enterprises to invest in Hong Kong prior to the takeover.

A more likely explanation is offered by ING Baring Securities Inc. analyst Alan Butler-Henderson. "I think that red chips to a certain extent have taken over the role of A-shares and B-shares," he says, referring to the shares in Chinese companies that Chinese citizens and foreigners, respectively, are allowed to trade on the Shanghai and Shenzhen stock exchanges. "I think Chinese investors have the notion that red chips are less susceptible to central government manipulation."

Some analysts warn that red chips may be due for a market correction of 20% to 30%. But not everyone is so skittish. Peter Perkins, a regional strategist at Daiwa Securities Co., argues: "You can't look at red chips as a sector." Instead, he suggests that each company is a separate story, and that it is Chinese politics--national, regional, and local--that will determine the quality of any asset transfers. Indeed, the range of p-e ratios of red-chip companies is enormous. China Everbright International, buoyed by rumors of asset injections, is at one extreme. At the other are Guangzhou Investments, a building materials and property company, with a p-e of 23, and food distributor Guangnan Holdings, with a p-e of 20.

The correction could hit the red chips soon, some analysts say, or after Hong Kong's reversion, others believe. Either way, it seems certain that with the handover, these companies will become an increasingly important part of the Hong Kong stock market. Still, playing with red chips is a risky game. "These companies are so diversified there aren't any analysts or investors who have a firm grasp of what the underlying businesses are," Perkins says. Such talk should scare speculators. But as the Gitic listing shows, there are record numbers willing to keep the game going.

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