Fall of the red capitalists

Zhang Yin was once worth US$10 billion but now has a fortune of loess than US$1 billion. Photo / Bloomberg

If China's richest man knew he was about to become the most prominent casualty of the country's love-hate relationship with capitalism, he didn't show it this past August.

Huang Guangyu, a peasant's son who became a billionaire by building Gome Electrical Appliances from scratch, outlined plans for continued expansion of the 800-store appliance chain.

He told the board members gathered in the company's mauve-carpeted executive offices 61 floors above Hong Kong's Victoria Harbour that Gome's profit had tripled in the first half of 2008 from a year earlier.

The directors lunched on Cantonese dishes ordered in from Man Wah, one of the city's ritziest restaurants.

"It was a very pleasant, chatty meeting," says Mark Greaves, 51, chief executive officer of London investment bank Hanson Capital and one of the company's two non-Chinese directors. "Mr Huang talked about his crusade to take Gome to all corners of China."

Greaves has not seen or spoken to the 39-year-old Huang since. One morning in November the dapper, baby-faced tycoon failed to turn up, along with his Maybach limousine, at Gome's Beijing headquarters, where he normally worked such long hours that he had installed a double bed in the office next to his own.

On November 24 the company halted trading in its shares on the Hong Kong exchange. Three days later Beijing police disclosed that one of China's most celebrated entrepreneurs was under investigation for share manipulation.

Three months later, Huang and his wife and former co-director, Lisa Du Juan, remain incommunicado, along with Zhou Yafei, Gome's former chief financial officer, somewhere in China's penal system, leaving Greaves and his remaining co-directors scrambling to avert the company's collapse.

Gome's investors - which include Capital Research & Management, a unit of Capital Group, the largest US manager of stock and bond mutual funds; Warburg Pincus; and clients of JPMorgan Chase and Morgan Stanley - still cannot trade the suspended stock. All four fund managers declined to comment.

During China's 30-year boom, foreign investors bet heavily on the so-called red capitalists: emerging billionaires who symbolised the nation's new wealth. But as of February 23, Chinese stocks listed in Hong Kong had plunged more than 60 per cent from their peak in October 2007 compared with a 50 per cent fall in the US Standard & Poor's 500 index.

Some of the companies that have crashed hardest are those built by billionaire highflyers such as Huang, whose 34 per cent stake in Gome is now worth less than a quarter of the US$2.8 billion ($5.6 billion) at which it was valued on September 1.

Even in the good times China's new rich thrived only at the whim of an autocratic and still nominally communist regime. Now, collapsing global demand for its exports has plunged the world's fastest-growing
major economy into crisis, causing thousands of factory closings.

More than 20 million workers have lost their jobs, the Government disclosed last month. A record six million students will leave universities this year unable to walk straight into the high-paying jobs that their predecessors took for granted. Strikes and mass protests occur daily.

Only corruption continues to flourish - at a cost of US$86 billion a year, according to the Carnegie Endowment for International Peace in Washington.

And China's embattled leaders are seeking somewhere to place the blame. "Maybe people are lashing out as a defence mechanism," Greaves says. "There seems to be some tension between business and politicians."

The economy will not improve any time soon. China's breakneck growth plunged to 9 per cent last year from 13 per cent in 2007. This year bearish economists predict it will fall to a pitiful - by Chinese standards - range of zero to 5.5 per cent. That is despite the announcement in November of a US$585 billion Government stimulus package. "We must urgently reverse sliding growth," Premier Wen Jiabao said in January. China is targeting 8 per cent growth
this year.

China's corporate carnage has surprised investors even more than the mayhem taking place elsewhere in the world, says Nick Toovey, who oversees US$80 billion, including Chinese stocks, at ING Investment Management in Singapore.

"In the West there are still those who remember what happened in 1987 and even 1974," Toovey says of earlier Wall Street plunges. "But this is the first generation of investors to have experienced a bear market in China in conjunction with a serious slowdown in global growth."

Some of Huang's fellow billionaires have also had precipitous falls. Citic Pacific, run by Larry Yung, lost as much as US$2.4 billion last year by betting wrong on the Australian dollar.

The company was bailed out by the Chinese Government and now faces an unspecified investigation by the Hong Kong Securities and Futures Commission, according to a statement released by the stockmarket regulator.

Under the 2003 Securities and Futures Ordinance, making a false and misleading statement can result in a prison sentence, according to a Government website.

On the mainland, Zhang Wenzhong, founder of Hong Kong-listed Wumart Stores, was sentenced to 18 years in prison in October for bribery, embezzlement and fraud, according to the website of the Chinese Supreme People's Court.

Scandal-free entrepreneurs are suffering, too, as their fortunes evaporate along with a weakening economy.

Li Ning, the former gymnastics gold medallist who lit the Olympic flame, Spiderman-style, at the 2008 Beijing Games, has watched a plunge in shares of his sporting goods retailer whittle away his wealth by almost two-thirds since October last year.

And the stock price has plummeted more than 90 per cent at the company owned by Zhang Yin, who became a billionaire recycling used paper into cardboard boxes to pack China's exports.

"Like Warren Buffett says, when the tide goes out, you find out who's swimming naked," says David Webb, a Hong Kong investor, shareholder activist and website publisher.

It has been more than 30 years since Deng Xiaoping cast off communist orthodoxy and told his countrymen that to get rich was "glorious". Since then the country has become fascinated with the newly wealthy class created as the economy boomed.

Last year China had 415,000 millionaires, according to a Merrill Lynch/Capgemini report. The country also has more than 100 billionaires, says Rupert Hoogewerf, CEO of Hurun, a research firm that tracks China's new rich.

That was fine with China's leadership, which subscribed to a form of trickle down economics. "Deng's view was that some people would get rich first and the momentum would pull along the rest," says Laurence Brahm, an American author and investor who owns hotels and restaurants in China.

In the 1980s those waiting to be swept up by that wave envied the wanyuan hu, households with savings of 10,000 yuan - about US$3500 at the time. By the end of the next decade newspaper and magazine readers were poring over rich lists of multimillionaires.

So were the authorities, who were on the lookout for those who failed to pay taxes or obtained their wealth as a result of some blatant criminal activity.

The rich lists became wanted lists, Brahm says. Some of China's wealthiest went to jail. They included Yang Bin, 43, a Dutch-educated orchid and tulip entrepreneur with a fortune of US$940 million, who was imprisoned for 18 years in 2003 for defrauding shareholders in his Hong Kong-listed company, Euro-Asia Agricultural, by inflating profits. Others were murdered by business rivals or committed suicide to avoid public embarrassment.

While to get rich remained glorious, those who became too wealthy were sometimes made into scapegoats, especially in a country where 200 million people still subsist on just US$1.25 a day. "There's a Chinese saying that you kill the chicken to scare the monkey," Brahm says.

Even businessmen the Government once lauded can wind up in jail. "China's reforms are full of contradictions and juxtapositions," he says.

China isn't retreating from capitalism, says Tao Dong, Hong Kong-based chief regional economist at Credit Suisse. "There's no new policy targeting the private sector."

In fact, China will have to rely heavily on private companies to boost its economy. "The good entrepreneurs are symbols of the success of 30 years of reform," says Christian Jiang Weisong, a Hong Kong-based analyst at Bocom International Holdings, part of Bank of Communications, China's fifth-largest lender. "It's important for China that they don't fail." The role of entrepreneurs in the economy is more than symbolic. Private companies accounted for
70 per cent of the country's gross domestic product last year compared with 17 per cent in 1990, according to CLSA, the Asian investment banking arm of France's Credit Agricole SA.

Entrepreneurs have also created 50 million jobs in the past decade, according to Liu Yang, who helps to manage US$2 billion in Hong Kong for London-based Atlantis Investment Management. That's more than the 46 million who were fired when China began closing its inefficient state-owned enterprises in the late 1990s.

But entrepreneurs still have to navigate a hybrid economic system. The Communist Party retains a firm grip on the world's third-largest economy. Many companies have a party secretary serving on their board of directors, and all but one of China's 130 banks are still Government-controlled.

"When times get tough, those state-owned banks lend to the state-owned enterprises and not to the entrepreneurs," says Chris Ruffle, who helps to manage US$14 billion at Edinburgh-based Martin Currie Investments' China unit in Shanghai.

The red capitalists are also vulnerable when their political connections - known as guanxi - change because leaders retire, are transferred to other jobs or are purged.

"Entrepreneurs have to constantly watch the political winds and waves," says Albert Louie, founder of Beijing risk consulting firm A. Louie Associates.

The departure in 2007 of high-profile Commerce Minister Bo Xilai, who moved out of Beijing to become party chief of Chongqing municipality in southwest China, may have contributed to the downfall of Gome's Huang, Louie says.

"Huang was an obvious target and a victim of political wrangling," he says. "Without the support of people in the Commerce Ministry, he couldn't have gotten so far so fast."

Even the Government acknowledges the importance of guanxi. "Most entrepreneurs fail because of the country's political/business relationships," said a January editorial in Xiaokang/Caizhi magazine, which is owned by the central committee of the Communist Party. "While this enmeshment between politics and business in China has allowed a whole group of entrepreneurs to rise, it has also hindered their progress and may lead to potentially explosive consequences."

Few have used guanxi better than suave, silver-haired Yung, chairman of Citic Pacific. The 66-year-old Yung is the son of a former Vice-President of China and grandson of Rong Desheng, who made his fortune in freewheeling prewar Shanghai. When most tycoons, including members of the Rong clan, fled abroad before Mao Zedong's 1949 communist revolution, Yung's father, Rong Yiren, stayed and handed the family's mainland businesses over to the state.

After China embraced free markets, Rong Yiren was rewarded in 1979 with the task of setting up China's first state-owned investment corporation, today known as Citic Group.

Rong was appointed Vice-President of China in 1993. When Citic set up a publicly traded unit in Hong Kong in 1990, Rong's son, Yung (Yung is the Cantonese pronunciation of the Mandarin Rong), was named chairman.

Yung lived the capitalist lifestyle: he raced horses and became a steward of the Hong Kong Jockey Club. He bought a British estate, once the home of former Prime Minister Harold Macmillan, where he built a private golf course and hunted.

"Yung demonstrated a lifestyle that's compatible with Hong Kong and was a tremendous force for confidence," Brahm says.

Not any more. In October Yung disclosed to investors that Citic Pacific could lose up to US$2.4 billion - the equivalent of its combined 2006 and 2007 profit - from betting that the Australian dollar would rise against the US dollar.

In July, when the Australian dollar was trading near a 25-year high against its US counterpart, Citic Pacific bet it would keep rising.

Using derivatives contracts known as accumulators, the company wanted to minimise its currency exposure resulting from an A$1.6 billion investment in an iron ore mine in Australia. Three months later, the aussie had lost almost 40 per cent of its value against the greenback and Citic Pacific's losses from the accumulators - so notorious in Hong Kong that investors refer to them as "I kill you laters" - had soared.

The currency loss would be the biggest ever by a Chinese company, about four times the US$550 million China Aviation Oil lost on jet fuel trades in 2004. Yung fired financial director Leslie Chang and financial controller Chau Chi Yin because they made the contracts without proper authorisation, Yung said in October.

Yung's daughter Frances, 36, who was described in Citic Pacific's 2007 annual report as director, group finance, escaped the axe because, according to the company, she was less culpable and reported to Chang.

Citic Pacific shares plunged to HK$8.68 on February 23, down 79 per cent from a year earlier.

But Yung's connections helped to save Citic Pacific, which makes steel and develops property. He flew to Beijing to persuade the company's state-owned parent to cover the losses in exchange for convertible bonds. Ratings agencies in February upgraded Citic Pacific debt because they said the deal showed the strength of support the company has from Citic Group, which now owns 57.6 per cent of its Hong Kong unit.

Yung, who owned 19 per cent of the company, lost more than a third of his stake when Citic Group converted the bonds to stock.

Albert Ho, chairman of Hong Kong's opposition Democratic Party, says he wants to know why Yung and his fellow directors waited six weeks before disclosing the losses.

Citic said in October that the company learned of the losses on September 7 - five days before it issued a circular announcing a connected transaction that said "directors are not aware of any material adverse change in the financial or trading position of the group since December 31, 2007".

Hong Kong's Securities and Futures Commission said in October that it was investigating the company.

The Securities and Futures Ordinance allows civil or criminal action against anyone for market misconduct. The maximum penalty is 10 years in prison and a fine of HK$10 million ($2.6 million).

Though she has political connections, Zhang Yin, who founded Nine Dragons Paper, has no state-owned parent to bail her out.

The daughter of an Army lieutenant who quit the military to become general manager of a metallurgical company in Guangdong province, Zhang, 51, started a scrap paper business in the 1970s with US$3800 in capital.

In 1990 she moved to Los Angeles, where she ran a paper collection company out of her apartment. After moving back to China, Zhang and her husband, Liu Ming Chung, set up Nine Dragons. Business boomed as China's exports soared, increasing demand for cardboard boxes to pack toys, shoes and computers that the country was selling abroad.

Zhang and her husband made US$400 million selling a 30 per cent stake in Nine Dragons on the Hong Kong stock exchange in 2006. By September of that year Zhang's shares were valued at US$10 billion, making her China's richest person, according to Hurun.

Zhang's success also earned her a seat on the Chinese People's Political Consultative Conference, an advisory body to the Chinese Government. There, Zhang was criticised by fellow conference members for proposing tax cuts for the rich and amendments to a new labour contract law that increases benefits for workers, the official news agency Xinhua reported last year. Zhang sought an exemption for labour-intensive industries such as her own.

"By opposing China's new labour laws so conspicuously, she has made enemies, and that has hurt her business," Louie says.

China's slowing export growth didn't help either. Zhang's customers began using fewer of her company's boxes. Thousands of factories closed last year, including 4000 toymakers.

In December Nine Dragons issued a statement denying Chinese news reports that it was facing bankruptcy. Last month Nine Dragons said it planned to buy back US$284 million of five-year notes at a deep discount to their face value. Investors who accept the offer for the notes, which were issued less than 10 months ago, will get back only 53c in the dollar plus interest.

Later that month the company said profit fell 69 per cent in the second half of last year, compared with the previous year. Zhang said the global financial crisis and fluctuating raw material prices had resulted in "unprecedented challenges and difficulties".

By February 23 the share price had fallen 91 per cent from its peak in September 2007 to HK$2.38. That leaves Zhang, once worth US$10 billion, with a fortune of less than US$1 billion.

Real estate developer Yang Huiyan, 28, also found her paper billions evaporating as the market shifted. In April 2007 investors bought shares valued at US$1.9 billion in Yang's Country Garden, a property developer based in Guangdong province, where home sales had grown at the rate of 22 per cent annually for a decade.

Within five months Yang's 60 per cent stake in Country Garden was valued at US$16.2 billion. Then China's property bubble burst. By February 23 Country Garden stock had plunged 88 per cent to HK$1.60.

Some entrepreneurs stand to lose more than just a paper fortune.

On the windswept grasslands of Inner Mongolia, far from the boom-and-bust property markets of China's great cities, Niu Gensheng made his fortune betting that China's population would acquire the Western taste for milk and dairy products.

In September Niu lost a chunk of his wealth when the Chinese Government disclosed that 22 dairy companies, including his, had been selling products containing melamine, an industrial chemical that can boost the protein levels of watered-down milk.

At least six babies died and 294,000 suffered kidney ailments and urinary problems after drinking infant formula tainted with melamine, said the Ministry of Health.

In 1999 Niu founded China Mengniu Dairy, now the biggest player in the country's dairy industry, which had US$20 billion of sales in 2007. In June 2004 he sold US$200 million of stock on the Hong Kong exchange. As the price surged sixfold by the end of 2007, Niu became a billionaire.

He sponsored China's first astronaut and the Chinese version of the American Idol TV show, as well as giving away US$92 million to charities, making him China's fourth-biggest philanthropist, according to Hurun.

He was not so successful in ensuring that all the milk he bought from independent suppliers was of high quality. In September, China's General Administration of Quality Supervision, Inspection and Quarantine said melamine had been found in infant formula made by Mengniu and 21 other companies.

That day shares in Niu's company plunged 60 per cent. On February 23 the shares were trading at HK$9.88, down 72 per cent from their September 2007 peak. In December the company said it expected to post a US$121 million loss for 2008 compared with a US$136 million profit a year earlier. Niu cut his 990,000 yuan salary in half to atone for the error.

In January lawyers for 213 families filed lawsuits against Mengniu and the other companies. Six days later China sentenced two men to death for their involvement and gave a life sentence to another company chief - Tian Wenhua of Sanlu, partly owned by Fonterra. Chinese media have not reported any charges against Niu or other Mengniu executives. Niu declined to be interviewed for this article.

At least Niu still has his freedom - unlike Huang. In January, Huang resigned from Gome's board, according to Greaves and Gome spokesman Tim Payne. Huang's wife, Du, 38, who is under house arrest, resigned in December.

Huang and Du built Gome into a national chain selling everything from flat-screen televisions to rice cookers.

To bring international experience to the board, Huang recruited Chang Sun, who runs the China business of New York-based Warburg Pincus, which owns about 1 per cent of Gome stock; American Tom Manning, a former Bain & Co managing director; and Greaves of Hanson Capital.

As they prospered, Huang and Du embraced some of the trappings of wealth. Though his teeth were nicotine stained from chain-smoking, Huang dressed in well-tailored striped shirts and suits and owned a BMW 6 Series car, while Du wore Dior. With their three children they moved into a 300sq m condominium in a development owned by Huang's real estate company.

After Huang disappeared Xinhua reported that he was suspected of having manipulated trading in shares of two other companies, Beijing Centergate Technologies and Sanlian Commercial. Xinhua also reported in January that two investigators from China's Public Security Ministry had been detained for allegedly taking bribes during the investigation into Huang.

Alarmed that Gome could collapse without its founders, the remaining directors set up an action committee headed by Sun. They also called in a forensic auditing team from Ernst & Young to investigate any irregular transactions.

Greaves says nothing has been found so far. "When people do get taken in for questioning, they sometimes disappear for months or even years. That creates uncertainty, which is the worst thing for institutional shareholders, especially when the rest of their world is crumbling around them."

The company has appointed a new chairman to replace Huang and begun preliminary talks about selling a stake in the company to private equity funds, according to Greaves and a Hong Kong-based company spokesman, Tim Payne. As much as 20 per cent of the company is up for grabs, people familiar with the plan say.

Greaves says he believes Gome can be saved, and outsiders agree.

"The word we are hearing from Beijing is that even if they take out the individual, the company will be allowed to survive," says Steve Vickers, chief executive of International Risk, based in Hong Kong.

The outlook for Huang himself is bleaker. "The chances of Huang Guangyu coming out of captivity are pretty small," Xiaokang/Caizhi, the party central committee magazine, wrote in its January issue.

As the new rich become the newly poor in China's seesawing economy, the one thing that seems constant is the power of the state.

- BLOOMBERG