What lies beneath

Editor's letter

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China's growth statistics are stunning. Since 1979, the country's gross domestic product has increased by 9.7% a year, or some three times the world average, according to government statistics - figures now rarely disputed by economists, in contrast to the days before China joined the World Trade Organization in 2001. Meanwhile, strong exports have bolstered the country's foreign exchange reserves to more than $1 trillion, to now eclipse those of Japan as the largest in the world.

China's stock market indexes have also risen to dizzying heights. The benchmark Shanghai Shenzhen Composite Index, which tracks yuan-denominated A shares listed on China's two main bourses, rose 120% last year and, despite a sharp decline on February 28, was already up by 69% for 2007 in late April.

So everything looks rosy? Well, not exactly. First, the country faces considerable political risk - essentially the risk associated with migrating hundreds of millions of poor Chinese to the middle classes, along with the corruption issues that are inevitably created by such massive wealth generation.

That's not the only danger, however. Risk managers are expressing serious concerns about the business practices deployed at a multitude of Chinese corporations, insurers and banks - despite the frenzy of foreign-Chinese joint ventures and share buy-ins in the past year suggesting the contrary. And, as our cover story explains, new academic research by Zhang Ling, a finance professor at Hunan University, finds that almost half of the 1,400-odd companies listed on the Chinese stock markets are in financial trouble.

The good news is that the Chinese regulators are well aware of the issue. That's one of the reasons for the high-profile public offering of shares in prominent institutions such as Industrial and Commercial Bank of China - the aim is to bolster the overall reputation of Chinese listed companies. And regulators, notably the Chinese Securities Regulatory Commission, are moving to crack down on illegal fundraising and enforce prompt disclosure requirements.

The financial markets will inevitably fail to track perfectly the physical development in China. That means sharp corrections in the financial markets are more than likely. But it also appears that the rise in Chinese equities has not been achieved through the use of borrowed funds, as banks cannot lend money to parties seeking to invest in the stock market. Which is one reason why the delayed listing of derivatives, with their associated use of leverage, on the China Financial Futures Exchange is being watched so keenly, both at home and abroad.

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