Nicholas Consonery is a China analyst at Eurasia Group.
Last week Chinese regulators asked the Big Four audit firms (PWC, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG) to recheck their work from 2010 and to report any information on Chinese firms that was shared with international regulators. The move comes on the heels of month of fears and recriminations among investors, bankers, and auditors over the veracity of bookkeeping practices at Chinese companies.
These fears were sparked in June by an implosion in the stock value of Toronto-listed Sino-Forest Corporation, following allegations by researchers at Muddy Waters that the company had engaged in a massive fraud (read here for some great journalism on how this fraud went down). Since the Sino-Forest scandal, several other Chinese firms with international listings have come under harsh market scrutiny. The markets are now primed to run down the stock value of any Chinese firm that is accused of fraud (see what happened to Chaoda since Anonymous accused them of fraud in September).
These travails will probably weigh on the stock prices of internationally-listed Chinese firms for years. The problem is much less about the business practices of the Big Four, and much more about a classic “garbage in, garbage out” dilemma. The Big Four could be doing flawless work in China—but the approvals and oversight that they do can only be as good as the data provided to them by Chinese firms. Until China’s regulatory structures change to better guarantee the authenticity of that data, I can’t see how this problem goes away. Considering the opacity surrounding the oversight of corporate auditing by the Chinese government, it is surprising that this issue took as long as it did to pop up.
The Big Four auditors are stuck in the crosshairs on this. Each one of them has a presence in China and works regularly with Chinese firms that seek to list or raise money internationally.
Now the governments are getting involved, and US-China tensions over auditing and fraud are set to deteriorate. Beijing’s entreaties to the Big Four last week suggest that China is seeking to protect its internationally-listed firms from unwelcome disclosures or other scrutiny abroad. Of course Beijing wants to do this—it sees real risk in opening the books of its favored enterprises to global scrutiny. Doing so would raise the chances of further accounting scandals and even bankruptcies by Chinese enterprises. The government also fears that records could ultimately be made public, which could open Beijing up to another level of domestic criticism and political pressure related to the business and spending practices of its own companies.
Given the uncertainty, more market runs on the stock prices of Chinese firms seem all-but-inevitable. Those will raise the temperature surrounding this issue in Beijing, and could precipitate defensive and protective policy reactions.
Yesterday US government officials at the Public Company Accounting Oversight Board (PCAOB) also warned China against unfairly infringing on the business practices of the Big Four, and stated that US-China dialogues surrounding the issue had been delayed. The US government will step up its pressure on China to cooperate with US regulators on coordinating auditing and oversight practices (which Beijing has mostly dismissed so far). The issue is already being elevated on the list of priority topics for bilateral dialogues with China--it could feature in this December’s Joint Commission on Commerce and Trade (JCCT) and certainly in next summer’s Strategic and Economic Dialogues (S&ED).
But there is a real risk that market trouble for Chinese equities accelerates before then. As we’ve seen time and again throughout the financial crisis, markets will eventually seek out and test uncertainties about the soundness of any financial asset. Expect this auditing oversight issue to become a bigger US/China issue as more Chinese stocks are tested.