China Daily (Hong Kong)

Industrial integratio­n, mindset overhaul key to value creation, developmen­t

- By Huang Sheng The writer is an associate professor of finance at the China Europe Internatio­nal Business School (CEIBS). The views don’t necessaril­y reflect those of China Daily.

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 due to changes in the country’s capital market ecosystem.

With the launch of the registrati­on-based IPO system on China’s Nasdaq-style ChiNext board in Shenzhen and Shanghai’s tech-focused STAR Market, the number of listed companies increased rapidly, 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.

The IPO is not the end of corporate developmen­t. Instead, it is only one step during the process. How to grow rapidly and stand out among an increasing number of listed companies in the same industry, rather than 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 the 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 percent to about 35 percent. This phenomenon should be taken seriously.

If we look at corporate debt structures, we will find that while the overall level of long-term debt is increasing, the proportion of current liabilitie­s — a company’s shortterm financial obligation­s that are due within one year or within a normal operating cycle — is declining, but the drop is not big enough. Companies are still under relatively high pressure of debt in the short term.

Currently, debt repayment capacity of the companies listed on the ChiNext board is at a historic low. A fairly large number of them carried out mergers and acquisitio­ns by raising the level of financial leverage and became sensitive to risks, which will be affected 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 business by using high leverage, and the risks brought by such activities deserve our attention.

During the 13th Five-Year Plan period (2016-20), the central government said China should endeavor 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 the fifth generation of wireless technology, biomedicin­e, artificial intelligen­ce and integrated circuits. Many companies that are not specialize­d 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 similar buccaneeri­ng corporates.

In addition, we must realize 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 the foundation of financial services. In this way, financial activities that are combined with industries will help enterprise­s control financial risks effectivel­y.

Having said that, we also found that the financial business activities of many companies are completely independen­t of their primary businesses. This kind of financial services may bring relatively high returns to the companies temporaril­y and can be regarded as part of its 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 separated 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 the industries that some State-owned enterprise­s specialize in. Therefore, companies should have a clear understand­ing of the attitudes of regulators on this matter.

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

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

To realize better economic developmen­t, the country 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 other companies with themselves or get merged with others. Apart from the trend of companies to get 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 digitaliza­tion in such areas as purchasing, production, sales, logistics, human resources and organizati­on to enhance corporate efficiency.

By using new technologi­es including 5G, artificial intelligen­ce and blockchain, traditiona­l companies can better match consumer goods with consumer needs, ensure smoother logistics, and realize smarter and more automatic production.

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

As a result, an increasing number of companies will make a 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 mindsets, as well as making full use of new technologi­es, to improve efficiency and create value.

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