Red Chip Revelry

How long can the runup in mainland stocks last?

Gary Greenberg used to be dismissive of red chips, the murky companies controlled by mainland Chinese interests that are listed on the Hong Kong stock exchange. While other investors wildly bid up new red-chip offerings, the deputy managing director for Peregrine Asset Management (Hong Kong) Ltd. feared they were far too risky--and prone to a crackdown by Chinese regulators.

But in mid-May, Greenberg says he "underwent a conversion." That's when he attended a Hong Kong road show to promote the initial offering of Beijing Enterprises Holdings Ltd., which owns a hodgepodge of businesses controlled by Beijing's municipal government. Among the luminaries on the dais was the Communist Party secretary for Beijing. To Greenberg, the powerful official's presence proved China's leadership is solidly behind the red chips and will ensure they have access to juicy deals on the mainland. Thanks largely to Hong Kong stocks such as Beijing Enterprises, which has quadrupled, to $6.28, since May 29, Peregrine's Asia Pacific Growth Fund is up 10% over the past month.

Now the fear is that too many people have bought that seductive story. Since early 1993, red-chip prices have risen nearly fourfold, far outpacing the rise in the Hang Seng Index of blue chips (chart). Most of those gains have come in recent months, thanks to buying by mainland Chinese, who carry suitcases of cash over the border. No matter that few China-backed companies have track records as reliable performers. They still trade at phenomenal levels--78 times projected 1997 earnings in the case of Beijing Enterprises. Even after Beijing sent the market tumbling with a crackdown on insider trading, red chips bounced back on June 16, jumping 7.3%.

With just days remaining before Hong Kong's July 1 handover to China, investors are wondering how long the party can last. Regulators in Beijing and Hong Kong are determined to curb trading abuses. But they face a dilemma. If they move too aggressively now, they risk triggering a confidence-shattering sell-off just as China takes over. And doing nothing poses its own dangers. When it comes to red chips, "we're very worried about the potential for insider trading and market manipulation," says Anthony Francis Neoh, chairman of Hong Kong's Securities & Futures Commission (SFC). Beijing is worried, too. If Hong Kong loses its reputation as one of Asia's cleanest capital markets, it could be tougher and more costly to use the city to raise funds for China's heavily indebted state enterprises.

FIRINGS. For now, authorities on both sides of the border are relying on tactical strikes to keep the rogue traders off balance. Hong Kong regulators have moved quickly to suspend trading in stocks that appear to be manipulated. In China, retribution has been harsher. On June 12, Beijing announced that senior executives at some of the country's largest banks and securities houses were fired. The president of Industrial & Commercial Bank of China's Shanghai branch, for instance, was ousted after authorities found the branch illegally lent more than $1 billion to three major securities firms last year. Earlier, the head of the China Securities Regulatory Commission (CSRC), the country's top watchdog, was replaced. And on June 11, the chairman and chief accountant of Hong Kong-listed Guangshen (Guangzhou-Shenzhen) Railway Co. were fired after it was learned that they had used $36 million raised through unauthorized stock offerings for their own trading.

The shakeup drove down prices of Hong Kong's red chips by 11%. But within four days, prices shot up by 18% as word spread that the purge was over. Such exuberance shows how difficult it will be for regulators to cool the fever. Helping fuel the rise: billions in capital sloshing around the Chinese economy after three years of tight monetary policies. Hong Kong Chinese investors also are becoming more adventurous.

Investors are betting that after the red chips list in Hong Kong, their parent companies in China will sell assets to them at cut-rate prices. Mainland managers and party officials own stock in Hong Kong-listed vehicles, and such asset injections will make their holdings more valuable. But there are big risks. There's no guarantee businesses sold to Hong Kong holding companies will be profitable. And Beijing leaders, fearing state property is being sold on the cheap, may suddenly halt such transfers.

BOUND TO SLIP. The good news is that oversight agencies in both Hong Kong and China are starting to cooperate. Chinese regulators rounded up witnesses and documents from China for the Hong Kong SFC's largest-ever trading fraud case, against Paragon Holdings Ltd., where insiders allegedly pocketed $13 million in ill-gotten gains. Says the SFC's Neoh: The Chinese "understand that if our market suffers, the whole nation suffers." But the SFC has 280 staff to police 614 public companies. Beijing's CSRC is even more understaffed. Given the poor disclosure by Chinese companies, says Peter Churchouse, Morgan Stanley Asia Ltd.'s co-director of Far East research, Hong Kong oversight is bound to slip.

So should investors dump Hong Kong stocks after July 1? Not necessarily. Except for a handful of companies, such as Hongkong Telecommunications and Hongkong & Shanghai Banking Corp., the Hang Seng Index has been flat all year. Many analysts believe that other blue chips are overdue for a runup. But for investors who are gambling on Hong Kong's red chips, the coming months are likely to remain a wild ride.