China Inc. Is Out on a Limb
China's stocks are sky-high. And Chinese companies are huge investors. That means a serious market backslide will send balance sheets into free fall

By now every investor on the planet is trying to handicap what happens when China's scorching-hot stock markets finally start to cool off. The conventional wisdom is that China's greenhorn individual investors will take the hit, while corporate China—the companies that make shirts, build ships, and run utilities—won't feel much at all. The real economy these companies operate in is far too strong to be affected by stock wobbles, goes the argument. The price of corporate shares may fall, but underlying earnings will power on.

That line of argument, though, is looking suspect for the simple reason that companies big and small are now playing the markets with abandon, using corporate funds to invest in each other's initial public offerings and bolster their bottom lines. Although figures are hard to pin down, Morgan Stanley figures a third of reported corporate earnings in China stem from investments outside companies' core businesses—which in almost all cases means plowing money into stocks. "It's quite dangerous for these Chinese companies because these gains have no cash basis," says Ding Yuan, a professor of accounting at China Europe International Business School in Shanghai. "It's really frightening."

Scarier still is what could happen if the stock markets head south. Shanghai is more than 700 points off its all-time high of 6,124, reached on Oct. 16, though as of Nov. 14 it was still up 102% for the year. If and when stock prices start to fall in earnest, companies will have to report these portfolio losses on their income statements, depressing their earnings. That, in turn, could hurt their own stock prices, pushing the market down both further and faster. "It's a replay of what happened in Japan during their bubble," says David Webb, a Hong Kong-based corporate governance expert and non-executive director of Hong Kong Exchanges & Clearing. Japan Inc. gorged on stock and real estate, only to tumble into the red when those markets collapsed.

Professor Ding (It's me - no, just kidding) cites the case of Black Peony, a textile company, as an example of what happens in a hot market. In the first half of this year, Black Peony recorded profits of $5.8 million, almost all of it from gains in shares like Air China, dividends from other stocks, and payouts from affiliates. Meanwhile, its core textile business is struggling. "They're not controlling any costs because life is easy," says Ding. Wang Panda, vice-chairman of Black Peony, admits his business did not do well. But he defends his investments, saying he has put much more money into affiliates than the stock market. "We have diversified," he says.

Until recently banks lent freely at low rates to bankroll companies' investment portfolios. Now regulators are trying to stem the lending by increasing bank reserve requirements. But those tempting IPOs keep coming, and corporate investors are still lining up. No one inside China Inc., it seems, wants to think about what happens when the bubble bursts.