Friday, 2 January 2015

Moody and its Chinese red flags

From Reuters: "China developer Kaisa says fails to repay $51 mln loan, may default on others"

Chinese property developer Kaisa Group Holdings said it had failed to repay a HK$400 million ($51.3 million) loan and warned it may default on more debt, the latest problem to hit the firm amid a downturn in the real estate sector. In a stock market filing late on Thursday, the company said the payment of the loan and its interest became compulsory on Dec. 31, following the resignation of its chairman Kwok Ying Shing. The failure to repay the HSBC term loan may trigger default on other loan facilities, debt and equity securities, co-chairman Sun Yuenan said in the filing to the Hong Kong exchange.

China observers are most likely not surprised, the Chines property market appeared to be red hot, and the balance sheets of many developers stretched, Kaisa was one of them.

As so often, with 20/20 hindsight we are all experts. But there was one company which did stick out its neck, namely Moody, in 2011. Its report "Red Flags for Emerging Market companies: A Focus on China" can be found here.

Kaisa does indeed feature on the list of Chinese property issuers, with seven possible red flags being tripped and a negative outlook on its bond rating:

We know now that Kaisa is indeed in big troubles, so it appears to be a job well done by Moody's.

But quite soon after publishing the report drew the attention of the Hong Kong regulators, according to this article from Reuters:

"The report caused a sharp fall in the stock and debt prices of some Hong Kong-listed companies it flagged, including West China Cement (2233.HK) whose shares slumped 17 percent before rebounding. That prompted stinging criticism from some market analysts who debated the agency's risk framework, especially since at least one of the so-called "red flags" was publicly denied by one of the companies. The Moody's note also grabbed the attention of the city's market regulator, the Securities and Futures Commission."

David Webb wrote "SFC actions risk chilling critics" about this issue:

.... let's look at the total returns on the stocks since the day before the report (8-Jul-2011) up to the end of 2014 to see whether Moody's scoring system was broadly right. Kaisa's stock is down 42.07% , but it wasn't one of the top 5 companies singled out by the report, which tested 61 companies with 20 possible red flags. The top 5 were: West China Cement Ltd (2233), down 69.76%, Winsway Enterprises Holdings Ltd (1733), down 92.14%, China Lumena New Materials Corp (0067) down 56.86% (and suspended), Hidili Industry International Development Ltd (1393), down 89.07% (source: Webb-site Total Returns) and last but not least, LDK Solar, which was US-listed and is  now bankrupt. We'd say that's a pretty good hit rate, even though industry factors are involved in some of the declines. For all HK-listed stocks, the median (718th) stock in that period returned 0.32%.

One can of course argue with Moody's methodology, but that kind of debate on which factors matter for future performance is what makes a market.

The Moody's appeal has yet to be heard, and the SFC's Decision Notice is not yet a public document, so we don't know what the precise allegations are, the arguments in their favour are or what Moody's full appeal will be, but we hope that the SFC has more grounds for complaint than a few errors in a report covering numerous companies, because it would be unreasonable to expect that a report on 61 companies with 20 different flag-tests would be correct on all of the 1220 tests.

And further down the article:

The risk of a chilling effect

Free markets depend on free speech and the open exchange of opinions and analysis, whether it turns out to be right or wrong. The SFC will need to tread very carefully in this area and show good grounds for their actions in the SFAT and MMT, otherwise they are likely to have a chilling effect on critical research. That would be very bad for the market, for at least three reasons:
  1. There is a systemic skew in investment bank/broker research which produces far more "buy" or "hold" (don't sell) notes than actual "sell" recommendations, because banks face conflicts of interest in seeking business with companies and in maintaining open doors for their analysts. Often the diplomatic way out is just to quietly drop coverage rather than put out a "sell" note. So we need investors, short or long, to express their opinions freely.
  2. In China, as with other emerging markets, there are vast problems with corporate governance, fraud and corruption, and these need to be exposed, partly to improve market efficiency and partly to deter such behaviour by reducing the chance that it will remain unnoticed.
  3. One of Hong Kong's core competitive advantages over mainland China is supposed to be the ability to speak freely.

I can't agree more with that.

Wishing all readers a Happy and Healthy 2015!

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