Chapter 4

How Much Do We Trust Disclosed Information?

Investment Protection in Relation-Based Markets

In the late 1990s, at a conference on how to invest in China, a senior analyst from Hong Kong lamenting the poor quality of information disclosure among the listed firms in China joked that “reading the annual reports of the Chinese companies is like going to a bikini fashion show—what you see is interesting, but what you don’t see is vital!”

While it is well known that accurate financial information is vital for making investment decisions (such as purchasing shares of a company), what is less known is how people protect their investment when publicly disclosed information is not trustworthy. In this chapter, we will discuss information and investment protection under different governance environments.

Earnings Management in Relation-Based Societies

Earnings management is a managerial accounting practice that manipulates earnings information by either making it appear higher or lower on the books. A firm’s income fluctuates from time to time. The manager of a firm may want to smooth the earnings report over time by using certain accounting measures. For example, if the manager wants to make the earnings look high, he can keep uncollectable (losses) as accounts receivable for a longer period than usual. On the other hand, if he wants to hide profits for “rainy days” or other purposes, then he may set aside a greater amount of reserve for uncollectable accounts. In addition to these practices, which may still be within the legal limit, the manager may also use outright illegal means to manipulate the accounting information, such as what the managers of the now defunct Enron and WorldCom did to mislead their investors.

Indeed, the incentives for earnings management exist for firms in both rule-based and relation-based economies. However, the practice is more prevalent for firms in relation-based countries. One of the reasons for this disparity is government policy in relation-based societies. As we discussed in the introduction, a relation-based political regime is usually authoritarian (or totalitarian) and suppresses opposition and undermines the checks and balances in the political system (if these checks and balances exist at all). This high level of concentration of power usually leads to more abuse of power, which prompts the relation-based government to keep its operations secret. A free press, which spurs competition among the media to publish newsworthy information, would be more likely to expose the corruptions and abuses by the regime. Thus it is necessary for the relation-based government to control the flow of information in the society, a practice that can be called “information manipulation” to parallel earnings manipulation at the firm level.

Information Management by a Relation-Based Government

An example of information management by a relation-based government is the Chinese government’s long history of manipulating public information, going back to Mao Zedong’s era. Mao Zedong ruled China from 1949 to 1976 with a radical communist ideology and totalitarian control over the society. Mao ignored the legal rules he set up and believed that the end justified the means. It was reported that when U. S. President Richard Nixon visited him in 1972, Mao told Nixon, “I don’t obey any laws!”¹ Even Nixon, who did not have much respect for the law either, was shocked. Mao manipulated public information for his benefit. Perhaps the largest information manipulation was the concealment of the great famine from 1959 to 1962, during which tens of millions died of starvation. Even today, the Chinese Communist Party refuses to tell the world how many died in the famine. Estimates run from 27 million to over 40 million.²

Another example of information management in relation-based societies is the government’s alteration of photos to manipulate public opinions. During the Soviet era, Joseph Stalin, the Communist Party head, doctored photos based on the relationship he had with other leaders in the photo. When someone lost his favor, this person would be removed from the picture. Like Stalin, Mao manipulated who should be retained or wiped out from photos taken with other comrades depending on who was in favor with Mao at any given time. Even today, the Chinese Communist Party still practices this technique.³

Local officials in China routinely manipulate economic statistics to serve their agendas: If an official wants to get promoted, he makes the numbers such as the economic growth rate larger; if he wants to get aid, he shrinks the numbers. This practice is jokingly referred to in China as “officials make numbers, numbers make officials.”

Not only does the government suppresses or invent news, it also schedules major, newsworthy projects and chooses when to release the major positive news. Major government-sponsored projects, such as nuclear weapon tests and the space program (e.g., launching a satellite), must be timed to gain the highest impact or to distract the public from major negative news. For instance, in September 2008, a major scandal was exposed in which leading dairy companies in China sold melamine-tainted milk that made tens of thousands of babies sick and caused several deaths. The Chinese government then announced that it would move a space shuttle launch earlier than originally scheduled. Critics suspected that the government used the shuttle launch and the space walk to steer the world’s attention away from the tainted-milk scandal.⁴

As a result of public information management by the government, people in China have not had much faith in official news or statistics. Public information in general is less trustworthy in relation-based societies, and people living in these societies are always seeking reliable information from informal channels, such as rumors and hearsay.

Information Management by Firms

In an environment where the government manipulates public information, there is very little reason why firms should not do the same to their advantage, so they mimic what the government does and manipulate their operating information. According to our interviews with accountants in China, it is common for firms to manipulate their earnings reports.

Private firms tend to lower earnings to avoid taxes. Studies show that tax evasion by firms in China is widespread. Large losses tend to trigger auditing by the tax authorities, so the firms that manipulate earnings in order to avoid taxes only show a small loss.

Managers of state-owned firms report more earnings to get promoted or to simply keep their jobs. In their study of executive compensation and firm performance in China, economists Kato and Long found that “Chinese executives [of state-owned firms] are penalized for making negative profits.”⁵ But they also found that the executives are not further rewarded for profits that are much greater than zero. Their study confirms the existence of a very strong incentive for Chinese state firm executives to engage in earnings management to bring the profit rate into positive territory. But there is also no further incentive to push profits higher.

These two tendencies suggest that firms in China tend to manipulate their profit rate close to zero. To verify this, my colleagues and I did a simple statistical analysis: We created a distribution of all manufacturing firms in China by their profit level as measured by return on assets (ROA),⁶ as shown in Figure 4.1.

In Figure 4.1, the tallest curve is the ROA distribution of Chinese firms, the second tallest curve is the ROA distribution of U.S. firms, whereas the most flat curve is a hypothetical normal distribution curve in the absence of earnings management.

Compared to the ROA distribution of U.S. firms, Chinese firms show a much greater spike around zero on the positive side, which is a strong indication that Chinese firms adjust their ROA to a slightly positive value.

While the purpose of earnings management in China may be tax evasion or promotion seeking, a serious unintended consequence results. Outsiders cannot rely on a firm’s financial report to accurately evaluate the firm, which means that outsiders may not be willing to invest in the firm. This deterrent explains why relation-based firms tend to rely on internal and informal financing.

Figure 4.1. Distributions of return on assets in China, the United States, and normal distribution

Note: China = long dotted line; United States = solid line; normal distribution = short dotted line.

Source: Li, et al. (2008).

Relation-Based Ways of Financing

According to research, the Chinese business community in Thailand relies primarily on informal means to raise capital for their business expansion.⁷ The most common way to raise capital is the chae, which is a rotating credit society in which all members contribute and each member takes his turn to borrow a sum contributed by all members. The key to the functioning of this credit society is careful screening and admitting members who have a good reputation and are trustworthy. Another way to finance their business is to engage in discounting postdated checks, which means to cash a check with a future date with a discount. The risk of receiving a bad check is reduced by the community’s ability to verify and monitor borrower’s business and credit. A third way to raise capital is an equity joint venture in which the fund provider will invest in the fund seeker’s project. All the above financing methods require efficient and accurate monitoring mechanisms that can verify the prospective fund seeker’s credit worthiness (ex ante monitoring), his ability to perform his duty (interim monitoring), and where his assets are in case he fails to deliver (ex post monitoring). If the parties involved are outsiders, such as banks, then this kind of monitoring mechanism would be almost impossible to use, or the cost of doing so would be too high to make business sense.

In such an environment, formal credit risk management does not work efficiently and banks often incur high losses from bad loans. For example, in China, nearly 50% of bank loans to small borrowers cannot be collected, whereas loans arranged privately using the above monitoring mechanism seldom go bad.⁸ As a result, banks charge a very high transaction fee and interest to compensate for the risk associated with the difficulty of evaluating credit in a relation-based market. As commented by a researcher who studied Vietnam’s real estate market, getting loans from banks “was the most expensive option” to finance a project.⁹

Why Foreign Investment Flows to Countries With Poor Legal Systems

In relation-based economies that lack publicly reliable information and effective and efficient public ordering to protect investment, how do foreign investors enter those markets and protect their investment?

The inflows of foreign investment across countries have some interesting patterns, which, as one would expect, are influenced by the governance environment, namely, how investments are protected in a country. Researchers have studied this issue extensively and have accumulated a great deal of knowledge about how a country’s legal system affects the inflow of foreign investment. In general, they have found that a poor legal system deters foreign investment. This finding is hardly surprising: Intuition would tell us that if the legal system does not offer effective and efficient protection of property rights, investors will be reluctant to invest.

However, this argument fails to explain why countries with a poor legal system attract sizable foreign investment. Take the case of China, its legal system is controlled by a single party—the Chinese Communist Party—and judges are political appointees that tend to be corrupt. Despite this, China has been attracting huge amounts of foreign investment.

Of course, one may argue that the huge market in China provides great opportunities for production and consumption. While this is certainly a major factor in attracting foreign investment to China, it does not address the issue of how investment is protected in countries like China, where the rule of law is weak. In order to understand better this question, we need to distinguish two types of foreign investment: direct and indirect investment.

Direct Investment and Indirect (Portfolio) Investment

Capital investment, including both foreign investment and domestic investment, can be classified into two types: direct and indirect. Direct investment refers to an arrangement in which the investor invests and controls (manages) the project or entity in which he or she invests. This is usually the case when the investor invests a large share of the total investment and thus controls the investment. The investor can access all the information about the investment, manage it, and make all the decisions about it. An example of direct investment would be someone investing to build and operate a restaurant or a garment factory.

Indirect investment refers to the type of investment in which the investor cannot directly control (manage) the investment. Usually the investment accounts for a small percentage of the total investment so that the investor cannot directly exercise his control right or management right. In this case, the investor becomes a passive investor; he does not have firsthand, unlimited access to information relative to the investment such as the accounting books or board meeting minutes. He has access to information about the state of the operation he has investment in through annual reports and shareholders meetings. An example of indirect investment would be buying a few shares of stock in a large company such as AT&T. In general, indirect investments include securities offered in the public market, such as stocks or bonds of publicly listed companies. This kind of investment is commonly referred to as “portfolio investment.” We will use “indirect investment” and “portfolio investment” interchangeably in this book.

When we break down the total foreign investment that flows into China, we find an unbalanced distribution. Most investment is direct investment, and portfolio investment accounts for a small proportion. In the 3-year period from 2004 to 2006, China received a net of $181 billion foreign direct investment (FDI) and a net of –$53 billion foreign portfolio investment (FPI). In the same period, the United States received a net of –$71 billion FDI and $1.9 trillion FPI. (Interestingly, most of the foreign portfolio investment in the United States is sent by the Chinese government and other Chinese investors. Obviously, China has faith in the public financial market of the United States.) The popular view that China is the largest recipient of foreign investment is not correct. It is only correct in terms of foreign direct investment. In terms of total foreign investment, the United States is still by far the largest.

Types of Investment and Modes of Governance

The two types of investment require different governance mechanisms for protection.¹⁰ In portfolio investments, since the investors do not have direct access to operational and managerial information or direct control over the managers, they must rely on publicly available information, such as annual reports or company press releases, to aid their investment decisions. For the portfolio investors, the timeliness and accuracy of the public information is vital. If disputes arise between the investors and the management of the investment, they usually resort to public rules, through the courts, to resolve them. The court must rely on publicly verifiable information to make a ruling.

In sum, portfolio investment requires a rule-based governance environment for effective and efficient protection. An anecdote about information distortion and stock price manipulation in China may illustrate this point. In the late 1990s, there was a listed company called Tiange Technology whose products included freshwater snapping turtle, a delicacy in China. In order to manipulate its stock price, management would issue statements such as “due to a flood, our turtles were washed away” to drive the price down; if it wanted to boost the price, it would issue something like “the flood receded and our turtles swam back.”¹¹

When I taught this topic in my international business class, I always asked my students, “What information would you rely on and where would you get it when you evaluate whether to buy a listed company’s stock?” Most American students would start with “studying the prospective company’s annual report and quarterly filings.” My students in Asia, on the other hand, would suggest ways such as “talk with someone with inside information” or “follow someone who is in the know.” In a class in Taiwan, a student said, “Follow A-Chen!” Seeing that I was totally lost, he explained that A-Chen was the nickname for Wu Shu-chen, wife of the former president of Taiwan, Chen Shui-bian, who was charged for corruption. His wife is known for her “ability” to always pick the winning stocks. When I pressed my Asian students further with the question, “What about studying the annual report?” they would always dismiss it by saying, “Most companies cook the numbers. So who would trust their annual reports?”

As for direct investment, there is no separation between investors and management. The investors are the insiders who are also directly involved in managing the investment and share the information about the investment privately among themselves, which substantially reduces the information gap between the investors and the management that exists in portfolio investment. The direct control by owners in direct investment makes it easier for the owners to protect their assets privately than that to protect portfolio investments. In other words, the need for an effective and efficient legal system to protect the investment is not as high for direct investment as for indirect investment.

Now let us consider the type of investment and mode of governance together. Based on the above analysis, we may conjecture that in rule-based societies, foreign investment tends to be in the form of portfolio investment, whereas in the relation-based societies, foreign investment should be in the form of direct investment. Is this pattern supported by evidence? We need to examine the relationship between the mode of governance and the type of investment using data.

If we compare the combination of FDI and FPI in three of the least rule-based countries—China, Azerbaijan, and Pakistan—with three of the most rule-based countries—the United States, Australia, and the Netherlands—we get the following numbers: During the 3-year period from 2004 to 2006, the relation-based group attracted $63 billion FDI per annum, while losing $16 billion in FPI yearly, whereas the rule-based group incurred a loss of $64 billion in FDI, while gaining $701 billion in FPI annually. This pattern suggests that when investors invest in relation-based countries, they prefer direct investment. In order to further confirm this, I plotted foreign direct investment over total foreign investment against the Governance Environment Index (GEI), which was introduced in chapter 2. The pattern is quite clear: The less a country is rule-based, the higher the proportion of the total foreign investment that is direct investment. When foreign investors invest in countries with poor legal systems and unreliable public financial information, they tend to choose direct investment over indirect investment.¹²

Figure 4.2 shows that the less a country is rule-based, the greater the proportion of foreign investment is direct investment.

Figure 4.2. Governance environment and foreign investment

Note: The horizontal axis is the score of GEI, which has been adjusted to a scale of 0 (least rule-based) to 8 (most rule-based). The vertical axis is the proportion of foreign direct investment in the total foreign investment in a country: FDI/FI = (foreign direct investment)/(total foreign investment). Each dot in the chart represents a country.

Source: Li (2005).

This finding helps us to better understand why China attracted so much foreign direct investment and relatively little portfolio investment. Foreign investors choose direct investment in China because of, rather than despite, the absence of the rule-based governance environment. When public ordering is not effective and efficient, direct investment gives them more control and thus better protection through private relationships. This finding also explains why in some of the least rule-based countries, such as Rwanda, Kyrgyzstan, or Armenia, some 99% of foreign investments were in direct investment, whereas the percentage was substantially lower in rule-based countries such as the United States (23%) or Finland (6%).¹³

Implications of Investment Type and Governance Mode

The above discussion on investment type and governance mode has several implications. First, investors must study a country’s governance environment before deciding whether to invest there and what mode of investment is optimal for the protection of the investment. Second, due to the low quality of public financial information, the risk of investing in the public financial market, such as the stock market, is higher. Following the same logic, due to the fact that firm’s accounting information is less reliable (as reflected in the high level of earnings management in Chinese firms), outside investors are reluctant to invest in relation-based firms. These facts suggest that the capital market is limited mostly to relational investment, and the cost of capital in the public capital market is higher in a relation-based economy.

The complexity of property rights differs from industry to industry. In general, the property right structure is relatively simple in manufacturing industries, such as the shoe and the garment industries, where the quality and quantity of the products are easy to verify and thus workers and manufacturers can be paid on a regular basis. Logically, the protection of property rights and investments in those industries is relatively straightforward. On the other hand, in the financial industry, the property right structure can be very complex, such as in initial public offerings of stocks, options, and other complex financial deals. For those products and services, the property rights protection is complicated and requires strong legal protection, which is better in rule-based societies. Thus, in general, for investors who are evaluating different industries in which to invest in a relation-based market, if everything else is equal, the investors should favor industries that have simpler property right structures.