Great wall of China finance

While the west frets about the future of the eurozone and rising debt levels, China is quietly spreading its trade tentacles, honing its influence with no-strings trade agreements, buying up land and resources – all fortified by a huge (and accumulating) great wall of cash. It is worth examining why China is investing in places where it previously had little interest or muscle, for these actions reveal much about the country’s long- term industrial motives.

Trade winners

The Chinese have long used the tactic of picking up troubled assets at bargain prices – Zhejiang Geely’s acquisition of Volvo is a good example. But while China is flexing its new financial muscle, it does not want to challenge Russia in the geopolitical sense says James Lee, regional director for Greater China at ICAEW. “So it’s more about improving trade. That means logistics, infrastructure and technology.

“Look to Germany and Japan. They did not win the Second World War so they were not allowed to re-arm or militarise – they focused their efforts on the economy. Overall, the Chinese approach is to go where western nations haven’t been focusing because of their own domestic issues. China is also more in tune with the aspirations of many developing nations.”

The majority of their interest comes from Chinese state-owned enterprises (SOEs), corporatised entities controlled by the Chinese state through majority equity ownership or other state- controlled businesses. Because they have a close relationship with the Chinese government, these SOE operators may also have very low borrowing costs.

“Oil, gas, extraction, anything that ticks those boxes will be a priority industry, encouraged either through sovereign wealth funds or through SOEs. That’s where the oomph is coming from,” says Jeremy Clegg, director of the Centre for International Business at the University of Leeds. “China’s five-year plan sets out several objectives. Deeper international co-operation around energy, for instance.”

Despite huge investment strides by the Chinese in several sectors, the total amount of investment is relatively modest, coming from Beijing, the eastern seaboard and in the south-east, such as Guangdong province, says Clegg. “But once most cities and provinces start switching to outside investment, you’ve got the equivalent of several Japans coming on-stream. That’s why much of the world is so excited. It’s a no-brainer – China is going to be a major investor.”

Investing abroad also allows the Chinese to raise their skill and aptitude levels. Competing in a foreign market is a very good way to go about learning the rules of the game, especially when they have access to large reserves of cash. “Or they may acquire a business,” says Clegg. “A lot of investment under the radar is from private firms. We interviewed a Chinese lighting firm which bought NVC and is now based in Longbridge in the UK. They’re number two in the market, second only to Thorn Lighting. And that’s just within three years.

"They’re trying to build the brand, be reliable, and they’re putting plenty of thought into the things that matter. It’s remarkable how these new Chinese investors are so productive. And there’s a whole cohort of similar firms in other industries bubbling up ready to invest in Europe.”

As a sign of its economic maturity, China is now switching its accounting rules to favour home-grown businesses. These new accounting rules carry huge implications for the way the Big Four operate on the Chinese mainland. Big Four players need to limit the number of foreign-certified partners to no more than 40%. By 2017 this cap drops to just 20%, and all senior partners will need to be Chinese nationals.

The changes move China further along the road to global norms where local partners own their practices. The move, however, could offer significant opportunities to some players.

Old China hands

On the Chinese mainland, time pressure on the Big Four auditors is building. KPMG, Deloitte Touche Tohmatsu, Ernst & Young and PwC will all form special partnerships once their joint-venture arrangements with Chinese companies come to an end. KPMG’s deadline was 17 August, Ernst & Young has until this month, Deloitte will make good its adjustments by February 2013, while PwC’s contract comes to an end in March 2018. Under the new proposals, a local partner is anyone who can pass the Chinese Institute of Certified Public Accountants (CICPA) exam. (You don’t have to be a Chinese national, although you do have to sit the exam in Mandarin – the pass rate is just 10%.)

Long term, the Chinese clearly feel the dominance of the Big Four is suffocating; there’s also concern that the Big Four simply aren’t, well, big enough. It makes sense to encourage home-grown players, even though the home market is barely three decades old, while also looking more closely at risk and longer-term strategy offerings.

Paul Gillis, accounting professor at Peking University’s Guanghua School of Management, says the Big Four have done well in China, landing most of the big state-owned enterprises as clients, from finance to utilities to communications, as well as getting access to extensive foreign investment opportunities. Could the changes spell opportunities for mid-tier operators also?

“The second tier firms are doing very well. They have hooked up with some of the leading local Chinese accounting firms that have enjoyed favourable treatment from the government,” says Gillis. “RSM is now the fifth largest CPA firm in China and passed RMB 1bn (£99.7m) in revenue last year. It is rapidly closing the distance between it and KPMG, the smallest of the Big Four. In China, RSM is 55% of the size of KPMG. Globally, it is 18% of the size of KPMG.”

Many of the second-tier firms are also punching above their weight class in China. PKF, says Gillis, has 4.1% of its global revenue in China compared to PwC, which earns only 1.7% of its global revenue in China.

Risk issues

How will cross-border co-operation and PCAOB/Sarbanes Oxley strictures be affected by the Chinese changes? Hundreds of Chinese companies have listed in the US, but the Chinese have not allowed American regulators to come and regulate the companies or their auditors, says Gillis. “One of the Big Four [Deloitte in Shanghai] is facing charges that it has violated US securities laws by not providing working papers to the SEC. In order to audit US listed companies, auditors must be registered with the PCAOB and subject to their inspections.

"The inability to inspect Chinese auditors, including the Big Four in China, could lead to the SEC and the PCAOB deciding to de-register the audit firms,” he says.

Chinese companies could be kicked off the US market as a result. The problem will have to be solved through diplomacy, yet neither side seems able to make the necessary compromises yet.

Alternatively, voices in China would like US-listed Chinese companies to come home, keeping Chinese money in China – a nationalistic view with roots deep in the wounds of 19th century western colonialism, the policies of the long-lasting Qing Dynasty, and Marxism.

Much of the arguing is about basic transparency, says Russell Brown, from a local advisory firm. “The accounting industry in China should be opening up, not becoming restrictive, if there is a desire for greater trust in the financials. The recent scandals are probably not the end, and though these scandals represent only a small percentage of companies in China, they unfortunately reduce any trust that anyone had or tried to have with financial companies.”

Big 10?

The jury is out on how profoundly the Chinese – given the massive growth in the country’s economy – will re-shape the international audit market. CICPA wants local firms to triple 2010 revenues by 2020.

London School of Economics emeritus professor of accounting Richard Macve thinks the Chinese government has a vision of a super league of 10-plus indigenous accounting and audit firms.

Just as Chinese industrial and commercial firms increasingly muscle in on international markets, professional firms may follow suit, possibly taking over a current international network – or even a current Big Four operator, Macve says. In a recent paper, he and Shuwen Deng from the Shanghai University of Finance and Economics wrote: “The view from the London offices of the firms... and the majority of others we have interviewed is... there is some way to go before this challenge can succeed. Deng’s (2011) research indicates that indigenous firm mergers may be achieving growth in the size of firms but it is not clear that there has been improvement in risk control. Risk may have increased with the taking on of new, rapidly growing clients.”

ICAEW’s Lee is, however, encouraged by the professionalisation of China’s audit players. With Chinese companies expanding aggressively overseas, the pressure is on. “We [ICAEW] would like to help the profession develop in China and globally. Local Chinese firms don’t have much choice to internationalise their practice and it’s a matter of which international body they want to align themselves [to]. I’ve been to see the top 10 firms’ managing partners. Even before the regulations come out, they needed to follow their own Chinese clients overseas. Some are begging to take up that challenge.”

Mandatory audit rotation for state- owned enterprises would also likely reshape the competitive landscape. And as Chinese companies expand globally, they will probably use the same accounting firm that serves them at home. That, says Gillis, could shake up the entire global accounting market in the decades to come.

 

Adrian Holliday