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  • Faculty & Research

    Knowledge creation on China, from proven China experts.

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  • Faculty & Research

    Knowledge creation on China, from proven China experts.

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Thursday, March 4, 2021

Industrial integration, mind-set overhaul key to China’s development

By Huang Sheng

Due to changes in the China’s capital market ecosystem, Chinese companies, especially listed companies, are facing risks as well as opportunities in business operations and issues relating to corporate governance at the micro level.

With the launch of the registration-based IPO system on the country’s Nasdaq-style ChiNext board in Shenzhen and Shanghai’s tech-focused STAR Market, the number of listed companies has increased rapidly of late, and this trend will likely continue for a while.

During the same period, however, the number of financial institutions that have a professional nature may not rise in the same proportion, nor will their capabilities improve quickly.

Therefore, industry leaders will be tracked by a growing number of analysts. They will find that shares of such industry leaders will be held by an increasing number of institutions, leading to higher transaction volumes and better liquidity, whereas other companies will turn the other way.

These changes are worth noticing for both listed companies and those waiting to get listed, as well as those considering listing in the future.

An IPO is not the end of a corporation’s development. Instead, it is only one step in the process. So, how can organisations grow rapidly and stand out amongst an increasing number of listed companies in the same industry without seeing their valuation drop quickly after an IPO? That question will reflect the highest risk faced by many listed companies.

Risks are also reflected by companies’ leverage ratios, debt repayment capabilities and debt structures.

Although the leverage ratios of companies listed on the main board of the A-share market have not changed much, the average leverage ratio of companies listed on the ChiNext board increased from 10% to about 35%. This phenomenon should be taken seriously.

If we look at corporate debt structures, we will see that while the overall level of long-term debt is increasing, the proportion of current liabilities (i.e. companies’ short-term financial obligations that are due within one year or within a normal operating cycle) is declining. That said, the drop is not big enough. Companies are still under relatively high pressure of debt in the short term.

Currently, the debt repayment capacity of the companies listed on the ChiNext board is at an historic low. A fairly large number of them carried out mergers and acquisitions by raising their level of financial leverage and became sensitive to risks which will be influenced by economic development and changes in business conditions in the future.

For quite a long time, many companies entered diversified areas that were not related to their primary businesses by using high leverage, and the risks brought by such activities deserve our attention.

During China’s 13th Five-Year Plan period (2016-2020), the central government stated that the country should endeavour to develop new energy, new technology and new material sectors. Many companies entered these sectors through high-leverage practices although they were unrelated to these areas of business. Some of them later faced liquidity problems when China ramped up measures for corporate deleveraging.

China is now promoting the development of strategic industries such as 5G, biomedicine, artificial intelligence and integrated circuits. Many companies that are not specialised in these businesses are eager to try. We should be particularly cautious against such moves so as not to follow the same disastrous road to ruin taken earlier by previous buccaneering corporates.

In addition, we must realise that the integration of industries with finance in a real sense is to let finance play a better role in promoting industrial development.

At the same time, business, consumer and credit information collected by enterprises through business activities with their counterparts or partners will serve as a foundation for financial services. In this way, financial activities that are combined with industries will help enterprises control financial risks effectively.

Having said that, the financial business activities of many companies are completely independent of their primary businesses. These kinds of financial services may bring relatively high returns to the companies temporarily and can be regarded as part of their diversification.

However, high-leverage financial business with high volatility will significantly increase the risks faced by such companies and even have a negative effect on their primary businesses, as this type of financial business is separate from a specific industry and lacks an advantage in industry information.

In the meantime, the complexity and connectivity of financial business may also lead to the rapid spread of risks from a company or a financial institution to others. It may eventually evolve into systemic risk for the whole market.

Recently, the central government stepped up regulation of the phenomenon where finance is not yet integrated into industries that state-owned enterprises specialise in. Therefore, companies should have a clear understanding of the attitudes of regulators on this matter.

In the future, value creation will be realised by Chinese enterprises through industrial integration and the improvement of efficiency.

How can companies achieve rapid economic growth by optimising the combination of factors of production and increasing their efficiency? That challenge has become key to the transformation of China’s growth model.

To realise better economic development, China should rely more on industrial integration and the improvement of efficiency of the existing companies and industries.

In the foreseeable future, listed companies will either merge or be merged with other companies. Apart from the trend of companies getting listed under the registration-based IPO system, another hot trend we may see is that unlisted companies will exit the market after being acquired by listed companies.

For Chinese enterprises, there is still a lot of room for improvement in terms of their operational capabilities. Those companies that can offer cost-effective products and services still have a number of opportunities to do business internationally.

Companies also need to improve the integration of supply chains to better satisfy the needs of younger generations of consumers, which raise higher requirements on product design and the speed of iterative product development.

Besides, in the next five to 10 years, traditional companies have a lot to do in terms of digitalisation in areas such as purchasing, production, sales, logistics, human resources and organisation to enhance corporate efficiency.

By using new technologies including 5G, AI and blockchain, traditional companies can better match consumer goods with consumer needs, ensure smoother logistics, and realise smarter and more automated production.

With capital market reforms set to continue, Chinese companies will no longer find it difficult to obtain external financing for innovative business.

As a result, an increasing number of companies will make the transition from adopting diversification strategies to adopting professional development strategies by managing their non-primary businesses separately from their primary businesses.

To put it simply, Chinese companies are in urgent need of changing their traditional modes of operation and mind-sets, as well as making full use of new technologies, to improve efficiency and create value.

This article originally appeared on China Daily here. Huang Sheng is an Associate Professor of Finance at CEIBS. For more on his teaching and research interests, please visit his faculty profile here.

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