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China’s new normal and the impact on fraud, corruption and financial integrity issues
Over the past three decades China has grown to become the world’s leading economy by many measures, and in the low-growth world of recent years China has provided the only significant source of global economic growth, making it arguably the most influential economy in the world. As such, China has become a top-priority market for multinationals seeking revenues as well as a primary destination for strategic and financial investors. In addition to China moving up to become the world’s leading economy, it also continues to hold the lead in some not-so-flattering areas such as:
• leading country for investigations related to the FCPA, fraud and other accounting irregularity matters;
• largest issuer of debt to the extent that China’s total debt is now estimated to be around 300 per cent of GDP, and still rising; and
• leading country in terms of the arrest and conviction of government officials for corruption within China as well as the pursuit of those who have fled the country.
After many years of high growth China’s economy has reached a major inflection point and is now slowing down. As China’s highly controlled economy continues to slow and meaningful structural reform remains elusive, China will remain a leader in the areas noted above. China may well stand out even further in the years ahead as the significant structural economic and social forces in play at this moment greatly increase the risk and occurrences of fraud and corruption issues for entities operating and investing in the country.
The pressure builds: a sobering macroeconomic perspective of China’s new normal
China’s economy is unmistakably slowing and the underlying trends point to more challenges ahead. The double-digit GDP growth of the last decade is over, and even the currently declared annual growth rate of 7 per cent is largely supported by increasingly unsustainable levels of debt to fund inefficient and unproductive state-backed companies.
China’s shift from a high-growth economy to a low-growth one constitutes the most significant change to its developmental trajectory over the past two decades; however, as with most major watersheds, the magnitude and impact of the shift often initially goes unnoticed or unacknowledged for some time. For example, there was still debate in the early 1990s as to whether or not Japan’s economy actually experienced a fundamental shift before it was eventually recognised to have entered its famous ‘Lost Decade’. Likewise, the magnitude and impact of China’s changing economy has yet to be fully comprehended, and the recent market turmoil and disruption in China carries a warning of more challenging issues to come. Understanding the significance of these challenges requires looking at the critical drivers of China’s economic slowdown and placing them in historical context.
Although China’s emergence as an economic powerhouse has been a dramatic success story, growth has come at a cost. Even as early as 2007, China’s (then) premier Wen Jiabao warned, ‘China’s economy is unstable, unbalanced, uncoordinated and unsustainable.’ Since the global financial crisis in 2008 when the rest of the world experienced a sharp downturn, China fuelled its continued high levels of economic growth with an unprecedented increase in debt, which now stands at nearly 300 per cent of GDP. To put this into perspective, on the eve of the global financial crisis the US debt to GDP ratio was around 250 per cent, and in 1990 when Japan entered its ‘Lost Decade’, Japan’s total debt to GDP ratio was around 240 per cent. China is heading off the charts in comparison.
China’s debt continues to grow, and the increase in debt is outpacing GDP growth. This disparity is fundamentally unsustainable over time as the economy increasingly falls behind its ability to relieve its historically high and rising debt burden. Furthermore, this disparity looks to continue as indicated by recent policy actions in China effectively constituting a bailout of local governments, reversing earlier attempts to control their debt. Although China has substantial capacity to continue supporting its economy, the extent of its mandating ‘extend and pretend’ funding policies are unprecedented in an economy of this size. China’s non-performing loan ratio is also telling as it indicates that an unprecedented amount of new debt is being used to service old debt. Such ‘evergreening’ is a classic early-warning symptom of economic downturns.
Given that increasing debt levels are unsustainable over time, a key question then revolves around growth. Will China be able to maintain its relatively high level of economic growth to help alleviate its growing debt burden? Probably not, as there are significant trends pushing toward decreasing economic growth rates for the foreseeable future.
There are three fundamental sources of economic growth: an increase in labour, an increase in capital or an increase in productivity. Demographics drive labour supply. After decades of reaping the rewards of a relatively young and growing population, China’s working age population has started to decrease and the overall population is projected to peak around 2020. The head of China’s National Bureau of Statistics recognises this major shift: ‘The demographic dividend that has driven growth in China for many years is now coming to an end.’ China is fast becoming an ageing nation before it becomes a fully developed nation.
So, what about increases in capital? The term, ‘capital’, in economics refers to non-financial assets used in creation or production of goods or services. China is now one of the world’s major manufacturing economies, but it is plagued with chronic overcapacity that indicates significant misallocations of capital. China has also been on a prolonged infrastructure and real estate building spree, driven largely by goals to maintain high GDP growth levels rather than by actual demand. Stories of China’s ‘ghost cities’ have been well publicised. From a historical perspective, China is an outlier in terms of fixed investment (capital) as a percentage of GDP growth. Since 2008 China’s level in this regard has been just under 50 per cent. This far exceeds that of Japan’s economy in 1990, which at its high point was around 35 per cent.
The final source of growth is productivity. Given the above considerations, this area is really the only option left for China to effect sustainable growth. However, this area also faces some severe headwinds as well as a fundamental contradiction arising from current economic policies. In a shrinking labour market, all other things being equal, productivity gains can be achieved through greater automation (across all types of businesses). However, given chronic overcapacity across nearly all industrial sectors, shifting toward greater automation will likely proceed slowly and incrementally. In addition, China faces a contradictory scenario in its prospects of improving productivity as it continues to misallocate limited capital to inefficient and unproductive assets.
As another indicator linked with productivity, urbanisation has been held up by some analysts as a major source for China’s continued economic growth into the future. According to China’s statistics, only approximately 50 per cent of the population is currently urbanised. Developed economies have urbanised populations upwards of 80 to 90 per cent, so the assumption is that China has a long way to go before it hits the limits of urbanisation. However, when we break down the assumptions, a different picture appears. China defines an ‘urban area’ as having at least 1,500 people per square kilometre. By this standard, the US cities of Atlanta, Dallas and Houston do not qualify as urban areas. This indicates that the urbanisation process in China has most likely progressed much farther than commonly recognised and calls into question China’s ability to meet its projected growth rates.
Finally, comparisons have been made above contrasting China’s current situation with Japan’s in 1990 when its economic bubble burst, and a few more are worth considering. In the decade leading up to 1990 the Japanese economy saw a dramatic increase in debt and real estate prices, much as we have seen in China over recent years. Furthermore, contemporaneous with Japan’s stock market collapse of 1990, Japan’s population demographics encountered a major shift with a turn in its inverse-dependency ratio as the number of people in the workforce relative to the non-working population started to decrease. This same demographic shift is occurring in 2015 in China, ironically in the same period as a collapse in stock market share prices.
Although China will always remain one of the world’s leading economies, the days of high growth are rapidly fading and obstacles to even a moderate level of economic growth lie ahead. China’s leadership has even adopted the term, the ‘new normal’, reflecting their recognition that the economy has shifted towards lower levels of growth. If policymakers can make the right moves, China may yet avoid a deep, prolonged recession (though even a slowing economy creates sufficient problems of its own). However, as long as the increase in debt continues to outpace economic growth the risks of a deeper correction and longer recession loom ever larger. The recent turmoil in China’s stock markets is simply an indicator of more to come.
An environment conducive to corruption and fraud
As China’s economic situation continues to decline, operating and liquidity pressures will build and this will produce a continued high volume of fraud and corruption issues, even despite the government’s ongoing crackdown. We have already evidenced the increased business and operating pressures that owners and managers in China (both foreign and domestic) are facing from the impact of the slowing economy. Despite the debt-fuelled growth (which disproportionately benefits the state-backed sector), there is actually a contraction of access to liquidity and capital for many participants in the Chinese economy. Furthermore, there is an growing realisation that certain transaction exits are narrowing or even closing, and that banks may be rationing available borrowings. Meanwhile, managers in China face continued and increasing market pressures to deliver results. Due to this combination of factors, fraud and corruption issues will increasingly emerge.
Perception also plays into the pressure on managers to deliver results. Despite the readily apparent trends described above, recognition of China’s evolving economic situation lags behind reality. The widening disconnect between expectations for a company’s business prospects in the China market and the reality of the economic shift underway put pressure on management teams to meet increasingly unrealistic expectations. Managers in China will need to address gaps in meeting projections and forecasts, while at the same time needing to address access to liquidity and broader strategic corporate issues pertaining to closing exit windows (via mergers and acquisitions, and capital markets). As China’s slowing economy widens the gap between perception and reality, there will be ever more pressure for managers to do whatever it takes to close that gap in order to meet forecasts, obtain liquidity, and pursue corporate development objectives.
In any case, simply being under pressure (or having the desire or intent) to commit an act of fraud is not enough; one also needs the opportunity to act, as well as a rationalisation for such acts. Weak corporate governance practices and underdeveloped internal controls continue to be common among companies in China (including foreign-invested ones), and these open the door for opportunities to commit fraudulent acts. Furthermore, the rationalisation factor is exacerbated and made more complicated by the evolving nature of ethics in contemporary China. Although this appears to be gradually changing in Chinese society, actions can be typically perceived as acceptable as long as one does not get caught.
A perfect storm for corruption
According to a study earlier this year, approximately half of all pending Foreign Corrupt Practices Act (FCPA) investigations were in Asia, more than two-and-a-half times the number in the next highest region, Africa. As China’s economy dominates others in Asia by size, China likewise stands out as a leading source of corruption cases. There are several key factors that have combined to make the perfect storm for corruption in China: the importance of China for global business, China’s chronic corruption problem, increased enforcement by regulatory authorities, and now, China’s slowing economy (as discussed above).
It’s no secret that China has been a priority market for multinationals and global private equity firms for many years. Coming in various waves over the past two decades, foreign investment helped drive China’s dramatic economic development, and at times China has even rivalled the United States as the world’s top foreign direct investment destination. With the sheer volume of foreign investment there is much more exposure to risks from China’s chronic corruption problems as multinationals enter and try to navigate the Chinese market.
China is not unique in being a developing economy with corruption issues; however, what is unique is the sheer size of its economy combined with the pervasive direct role the state plays in it. Despite reforms, approximately half of GDP remains state-owned or controlled. Even ostensibly private domestic companies may actually be state-owned or controlled (in full or in part) through state ownership in their group organisation structure (for example, from local-level holding companies of the State-Owned Assets Supervision and Administration Commission). In addition, truly private companies with no state-ownership are often also heavily influenced by local government. Following major reforms in the 1990s there have been no major moves since then towards the widespread removal of the state’s direct role in the economy. Essentially, China’s economy remains stuck in transition, and this is the root cause of China’s chronic corruption problem.
Increased anti-corruption enforcement by regulatory authorities has been a general global trend following the 1997 OECD Anti-Bribery Convention and aggressive initiatives by the US SEC and DoJ over the past decade or so. China initially lagged behind in joining this trend; however, China plunged into its own aggressive and well-publicised anti-corruption crackdown two years ago when President Xi Jinping came into office. Although China’s crackdown on corruption continues to make daily headlines as to the arrest and trial of Chinese government officials and businesspersons, it has not actually resulted in a decrease or even a projected decrease of investigative matters. As China’s economy continues to slow and banks continue to lend to under-performing companies, China not only faces greater risks of creating a hoard of ‘zombie companies’ and ‘ghost cities’, but the massive misallocation of capital creates an environment conducive to corruption.
Evolving corruption schemes
Around 10 years ago when China-related FCPA cases first started to emerge, conducting investigations was relatively straightforward. Personnel in China were typically naive about anti-corruption compliance. In combination with this, the business culture has also long been characterised as one of excessive gift-giving and entertainment. As such, relevant transactions were often readily transparent in a company’s books and records. For example, it was common to see transactions clearly recorded in the general ledger with descriptions such as, ‘gifts of alcohol and tobacco to the Association of Industry and Commerce director’.
As corruption cases became more frequent and visible, multinationals started to require anti-corruption due diligence as part of any prospective deal. Concurrently, compliance programmes evolved from a simple ethics statement to a fully fledged package of detailed policies and supporting procedures. Through this evolution, awareness of anti-corruption issues grew among employees in Chinese operations. As awareness of bribery and corruption issues increased, the methods for making and disguising corrupt payments evolved as well.
Early FCPA matters in China drew attention to gifts, entertainment and travel provided to government officials. Compliance programmes now typically contain provisions asserting controls and company guidelines for these types of activities, and in rolling out FCPA compliance programmes these constitute the low-hanging fruit. However, with the increased awareness of corruption issues in China, there has been a general shift in corruption-related schemes from relatively higher-volume and lower-dollar-value schemes (excessive meals, gifts and travel), to relatively lower-volume and higher-dollar-value schemes involving more creative, non-transparent approaches (such as increased use of third parties and schemes similar to embezzlement methods).
One example of this involves the creative use of third-party consultants in response to greater scrutiny of fictitious supporting documentation (in the form of fapiao, or official tax invoices). Fictitious receipts can be a common occurrence in China, and it was common to find fake invoices available for sale from street vendors. However, in recent years the Chinese tax authorities have cracked down on the use of fake invoices by implementing online databases that allow one to check their validity. We have noted an approach developed in response to this stricter environment utilising a series of different third-party consultants over brief durations for the same scope of work. A consultant would be hired by a high-risk function in the company for a high-risk scope of work, such as interfacing with government officials. The consultant would issue valid, officially registered invoices, so from an initial examination of the company’s books and records no red flags would appear in the form of fictitious receipts. However, the consultant would then depart after a brief duration (less than a year) and would be replaced by another consultant with the same function and scope. In addition, these series of consultants would essentially be start-ups with no history, track record, or recognisable brand in the market; highlighting the need for substantive due diligence on intermediaries and third parties.
The resurgence of financial integrity and quality of earnings issues
In the ‘Wild West’ of China’s development the spectre of financial fraud has always loomed near. The issues have tended to come in waves, from the early days of private equity investment in China and the related war stories, to the more recent wave of fraud allegations pertaining to Chinese reverse-merger companies. However, with China’s economy at a turning point we can expect to see a resurgence of financial integrity and quality of earnings issues, and these may eventually take centrestage over corruption.
As discussed above, appreciation of the magnitude and potential impact of China’s structural economic shift has been slow in coming, and this sets the stage for a potentially increasing disconnect between business plan expectations and the evolving market situation on the ground. As this disconnect increases, some management personnel will feel increasing pressure to do whatever it takes to close the gap. In this regard, as economic pressures mount one can expect to see a re-emergence of classic financial statement fraud issues as well as more sophisticated schemes designed to pacify regulators, attract and retain investment, and maintain access to liquidity. Managed earnings as well as aggressive and fraudulent accounting practices are likely to be an increasing reality in China.
Fraud methods in China have historically tended to be relatively simple. In order to inflate revenue or overstate assets, perpetrators simply fabricated transactions. However, as with corruption matters, the methods related to financial integrity issues are likely to evolve as well, involving more complicated business patterns with harder-to-detect fraud schemes and creative accounting methods (such as using third parties to inflate revenues and hide liabilities).
Common issues in China-related fraud cases include:
• fabricating transactions;
• inventing non-existent customers;
• recording fictitious or inflated revenue;
• overstated or non-existent assets;
• side letters with customers;
• fabricating cash records to cover bogus sales;
• use of related parties to manipulate profits or record fictitious revenue; and
• collusion with, and corruption of, banking officials.
China has always been an interesting yet challenging place to do business. However, despite the ups and downs over the past 20 years (the era of foreign investment in China), the challenges of doing business will reach a new level of magnitude in the years ahead. There will be much work for investigative professionals to help our clients navigate China’s new normal.