Red Chips Rising

Investors go wild for China-backed businesses, and the rush of money drives economic reforms on the mainland

Mark S.L. Chen has big plans. For decades his company has had a near-monopoly exporting pigs, goats, beef, and other foodstuffs from China to Hong Kong. Now, as China reforms its economy, Chen will lose his privileged trading position. His response to all of this? Go on a diversification binge that would make even the most daring empire builder take notice.

Chen, who is chairman of Ng Fung Hong Ltd., a former Chinese government company, is angling to buy one of China's largest wineries, and he just hooked an African fishing fleet owned by China's Agriculture Ministry. He rang up the purchase of one of China's largest supermarket chains last December and is considering expanding it. Now, he's talking with foreign partners about getting into specialty meat products. "The long-term goal is for Ng Fung Hong to become an international food empire," says Chen, a former official at China's Ministry of Foreign Trade & Economic Cooperation (MOFTEC), his company's onetime parent.

Money is no object for the urbane Chen, whose previous job was overseeing a massive government-funded real estate project in Bangkok. That's because Ng Fung Hong is a "red chip" company--a corporation controlled by mainland interests but listed in Hong Kong (table). As China reforms its own vast company structure, investors in Hong Kong are eager to provide all the cash the red chips can scoop up.

It is well-connected companies such as Ng Fung Hong that tell the tale of Hong Kong and China in transition. The rise of the red chips reflects both Beijing's efforts to restructure its economy and Hong Kong's moves to establish itself under Beijing's rule as China's international financial center. Indeed, red chips, led by the towering Citic Pacific Ltd.--a huge conglomerate with a market value of more than $12 billion--are emerging as the new pillars of Hong Kong. They are shaking the old order of local property developers and bankers who have long dominated the stock market and the business scene. It's even conceivable that some of the red chips eventually will swallow major Hong Kong companies, just as such Hong Kong entrepreneurs as Li Ka-shing snapped up British-owned hongs in the 1980s.

Investors are giving the red chips a rousing reception. Since the Chinese government spun off Ng Fung Hong and listed it on the Hong Kong Stock Exchange in 1995, its shares have more than tripled, to $1.62 apiece. And the performance of Ng Fung Hong--the name means "fivefold prosperity company"--isn't unique. All told, red-chip stocks have climbed 35% this year alone (chart, page 40). Enthusiasm for red chips has reached such a fever pitch, in fact, that thousands of investors lined up in front of Hong Kong banks on May 21 to apply for the initial private offering of Beijing Enterprises Holdings Ltd., an arm of the capital city's government whose assets include McDonald's fast-food outlets and tourism rights to the Great Wall of China.

Meanwhile, such blue-chip firms as Swire Pacific Ltd., the British-owned hong that ranks among the city's top property developers and controls Cathay Pacific Airways Ltd., have lagged even as the stock market surges into record territory. Investors fear that Swire and other old-line companies won't be connected enough to get the deals they need in the future. But the red chips' backers include a who's who of the mainland Establishment: the Shanghai city and Guangdong provincial governments, powerful agencies such as MOFTEC, the People's Liberation Army, and companies noted mainly for the politically powerful "princelings" who run them.

FAIR DEAL. To be sure, with the exception of Citic, most of the red chips haven't been listed long enough to establish a record of good management and steady profits. In fact, an earlier crop of red chips listed in 1992 and 1993 has so far yielded spotty earnings at best. But there is a lot more at stake than sheer profits. If China is to continue pushing ahead with economic reforms, it will badly need the cash and discipline that international financiers will provide--and Hong Kong is where the big China investors and the red chips come together. To make the red-chip gambit pay off for everyone, Hong Kong will have to make sure investors get a fair deal by not diluting its tough regulatory standards to placate Beijing. Striking that delicate balance "is going to be critical for Hong Kong's and China's success," says Salomon Inc. Chairman Robert E. Denham.

That's all the more true because Hong Kong has emerged in the past five years as the only market capable of raising serious amounts of international money for China. Although the New York Stock Exchange made a push for Chinese listings in the early 1990s, little has come of it, and trading volume has remained low. Despite hopes of recovering past glories, the Shanghai market isn't going to gain international recognition until China's currency is freely convertible, something that is years away. For now, only Hong Kong, with its bevy of internationally recognized lawyers, accountants, analysts, and merchant bankers, can raise the hundreds of billions of dollars that China's companies need to modernize the world's largest emerging economy.

VAST RICHES. Stocks are only part of the story, of course. Hong Kong already is among the world's largest and most active markets in everything from futures to foreign exchange and gold trading. It's the center of Asia's booming venture-capital business, much of it targeted at China, and it wants to be the place where China issues foreign-currency bonds and trades its bank loans and currency. And it has vast wealth, public and private, to make its dreams of a bigger future come true. The city is home to 20 ultrawealthy families worth $3 billion or more each. And the Hong Kong Monetary Authority, the equivalent of the city's central bank, has more than $60 billion in foreign-exchange reserves.

As Hong Kong's riches have mounted, its stock market's capitalization has soared to $500 billion, almost as big as Germany's and nearly one-third the size of the stock market of its soon-to-be-gone colonial overlord, Britain. Last year, Morgan Stanley & Co. figured the market cap would hit $800 billion by the end of the decade. "That's probably conservative," says Morgan Stanley Asia Ltd. head John S. Wadsworth Jr. now.

Red chips, which make up nearly 10% of the market's value, are driving that growth. "Hong Kong is going to become a powerhouse for China," predicts Frank Ning, who heads China Resources Enterprise Ltd., a sister company of Ng Fung Hong and one of the oldest red chips. "Hong Kong can lead the way for China to become a more disciplined, internationally acceptable economy."

DOUBLE DAY. Chinese companies certainly think that's true. A flood of new issues by China-backed companies in Hong Kong has raised $2.4 billion on the Hong Kong Stock Exchange in the past year, estimates Credit Lyonnais Securities (Asia) Ltd. What investors are betting on in red chips is privatization, Chinese-style. To create a red chip, a Chinese state-owned company sets up operations in Hong Kong and gets a stock listing, sometimes via an IPO, but often by purchasing a dormant Hong Kong Stock Exchange-listed company to get onto the bourse with less red tape. Once listed, the red chip buys assets, usually from its parent, paying with a combination of its own stock and cash it has raised in the market. So far, Chinese parent firms have been careful to "inject" assets into red chips at such low values that investors think they're getting assets at a bargain price. Red chips typically buy operations for only 5 to 10 times their earnings. But red-chip shares may sell for 25 times earnings.

Last December, for example, China Resources Holdings handed over a stake in one of Hong Kong's major ports to its publicly listed offspring, China Resources Enterprise. It also sold an ice cream business, its supermarket chain, and a minority stake in its refrigerated-food business to Ng Fung Hong. So far, the deals have worked out--at least on paper. But it will be another year or two before investors will be able to tell if management is up to the task.

Another question is who will regulate the red chips. Hong Kong authorities insist that China will only be able to regulate the way that mainland assets are injected into red chips, and will have to stay out of deciding which companies are actually listed. "They are not coming to interfere with our regulations," says Stock Exchange of Hong Kong Ltd. Chairman Edgar W.K. Cheng. The Hong Kong investment community is cautiously optimistic. If anything, Hong Kong financiers argue, Beijing may even start adopting some of Hong Kong's tough regulatory system as its own.

Still, the possibility of a Beijing backlash against what looks like a giveaway of state assets to foreign investors can't be discounted. And the feverish rush for red chips hints that Hong Kong will increasingly be driven by rumors rather than fundamental stockpicking analysis. For instance, one Hong Kong fund manager confided to a visitor in mid-April that China Merchants Hai Hong Holdings Co., a maker of paint and glass controlled by the Communications Ministry, looked like a buy because asset injections were coming soon. Sure enough, a week later the company announced a massive asset injection. It doubled its outstanding shares and will use the stock to transform itself into a toll-road operator and freight-container maker. Despite the dilution, the company's shares soared 20% in a day, prompting regulators to warn that they will now look more carefully at deals that substantially alter a company.

Indeed, red chips could use tougher regulation. Market pros say corporate insiders routinely stock up on warrants, which give them the right to buy shares cheaply, before deals are announced. "A lot of people coming down here from China are getting very rich," says one longtime market watcher. Others recall a previous surge in red-chip listings in 1992 and 1993 that ended in disappointment in 1994 when investors discovered that executives' mainland political ties didn't translate into good performance.

Stocks took another beating in 1995, when the head of one of the most politically connected red chips, Shougang Corp., was arrested on corruption charges. Analysts wonder what might happen if a China-backed company gets into trouble or collapses. "Many companies' substance is probably a lot less than their reputation suggests," says Robert Broadfoot, who heads Political & Economic Risk Consultancy. "One of the biggest risks Hong Kong faces is how the government and the territory's institutions like the judicial system will respond when one of these red chips is caught up in a scandal or a major business problem."

A red-chip scandal could shake investor confidence in the entire Hong Kong market. That would be bad news for China. China needs Hong Kong to succeed, and Hong Kong has thrived because of its special links with China. If Hong Kong can't maintain its edge, it's likely to shrivel as business moves to Shanghai, Beijing, Guangzhou, and a slew of smaller and cheaper mainland cities. In a city that boasts the world's highest property prices and where manufacturing is increasingly passe, only finance can assure Hong Kong's future. Remaining China's pipeline to the world of global finance will "provide the breakthrough the Hong Kong economy has been looking for," says Anthony K.K. Wong, Hang Seng Bank Ltd.'s general manager for planning. The rise of the red chips is testing that premise daily.