Few ways of getting around China are more harrowing than a nighttime taxi ride through the countryside. Invariably, such trips are taken at high speed. With one hand on the steering wheel, the cabbie will accelerate past villages, swerve around ox carts, and honk at each pedestrian and cyclist passing by. There are no streetlights. Farmers walking home from the fields suddenly loom in the dim headlights, causing the driver to slam on the brakes. There's little a passenger can do but hope for the best — there are no seat belts.

Anyone investing in China's stock markets these days knows how such a wild ride feels. But the unruliness — and anxiety — accompanying white-hot growth is also disturbing the country's CFOs. They worry that their companies, like the Chinese stock market itself, may be growing beyond control and could be headed for disaster.

A recent survey of Chinese financial executives conducted by CFO China (one of CFO magazine's sister publications) shows how pervasive that anxiety has become. Just over half of the survey's 359 respondents say that growth isn't under control in their companies. In particular, the CFOs worry about their ability to respond to any problems that crop up. "Risk management is not done well at most Chinese companies," says Louis T. Hsieh, CFO of New Oriental Education & Technology Group, a Beijing-based private education services company, and a board member at several Chinese listed companies. "That's because they haven't faced [risk] yet. These companies are expanding like crazy, and everything they make they can sell."

A growing chorus of market observers is warning that China's market boom won't end well. How damaging a crash would be to China's economy remains to be seen; the Shenzhen and Shanghai markets remain small relative to the country's overall economy. For listed companies, however, any downturn could have severe effects.

True, in interviews and at conferences, China's CFOs display an infectious enthusiasm about their businesses. Most can rattle off IPO details and cite today's percentage rise in their company's stock price. But they see problems, too. Finance executives worry about their rudimentary financial-reporting systems, complain about business managers who focus solely on topline growth, and wonder whether they can achieve the level of financial transparency required of listed companies.

The survey confirmed many of these worries. For CFOs of listed companies, the number-one growth-related concern is that the development of internal controls isn't keeping up with corporate growth, with nearly two-thirds saying this is a problem. Other worries include the lack of attention given to the quality of growth (53 percent), managers who don't understand business risk (46 percent), and a failure to properly analyze investment decisions (41 percent).

The survey also shows that financial executives see weaknesses within their own functions. For example, only 39 percent of listed-company CFOs think they can manage risk well, and just 41 percent say they are happy with the quality of internal financial reporting.

You don't have to look far for problems that can arise under these conditions. Consider Hunan Xiangquan Group, which went bankrupt last year. From its start in the spirits business (the company's flagship business was Jiugui Liquor) Hunan Xiangquan diversified widely. It got involved in tea, ceramics, leasing, printing, workforce training, museums, medicine, animal feeds, five-star hotels, and other businesses. Analysts blamed the failure on bad investment decisions — the hotel business, for one, created a heavy debt load. The CEO had partly funded the expansion by pulling capital out of Jiugui, causing losses in the core business.

Rampant Speculation
Difficult times for other Chinese companies may not be far off. Jerry Lou, Morgan Stanley's China equities strategist, sees trouble ahead. "We think that the A-share market is producing not only a multiples bubble, but an earnings bubble as well," he says. (So-called A shares are issued for domestic investors by companies listed on the Shanghai or Shenzhen stock exchanges, while B shares are available to domestic and foreign investors alike.)

Lou cites speculative investments as a particular cause for concern. The survey of CFOs found that corporate speculation is indeed rampant. Among A-share companies, 66 percent invest in either the stock market or in real estate (other than property used in company operations). According to a Morgan Stanley analysis of the most recent financials of Chinese listed companies (excluding insurers), investment income is 17 percent of absolute market earnings per share. That's possible because of an accounting rule change in 2007 permitting companies to reflect the change in the value of assets on their income statements (see "The Great Experiment," CFO Asia, May 2007).

More startling is that investment gains account for a disproportionate part of earnings growth — 36 percent. Core earnings, meanwhile, account for just 54 percent of overall growth.

Some companies are even taking out bank loans to invest. Last year, regulators cited China Nuclear Engineering & Construction and China Shipping for diverting loan money into the stock markets. China Shipping, for example, received $356 million in loans from six banks and used $324 million of it to participate in IPOs.

The trouble, says Lou, is that as stock-price gains begin to slow (as they have recently), earnings growth will brake sharply. That's what happened on the Tokyo Stock Exchange in 1989, he points out. "[Investors] had included a lot of investment income in their forecasts. So when the market started coming down, the earnings cut was moving faster than the market, which created a snowball effect."

Submerged Risks
Urging caution during a time of euphoria isn't easy. And the kinds of changes advocated by consultants require a determination that's hard to muster in the absence of an immediate threat. "It's the classic problem," says Nigel Knight, a managing partner with IBM Business Consulting Services in Shanghai. "Until things go wrong, it's hard to change. You need a 'burning platform,' and in many of these companies that may be a major problem resulting from not managing risk effectively."

But when revenues are rising, the threats to a business aren't obvious. "In some ways, China is like the U.S. in the 1990s; when economies are booming, the risks are submerged," says Chris Low, head of China operations for Protiviti, an internal-audit and risk-management consultancy. "But what happens if some of the variables change?"

For A-share companies, at least, there isn't much pressure for financial improvements coming from the retail investors that currently dominate the domestic stock markets. "The average investor is poorly educated," says Lou. Instead of doing careful analysis investors typically trade on themes, and do so quickly and often. Lou has seen some investors suggest in online discussions that it makes sense to buy stocks that are "cheap" — in other words, a 5-yuan stock would be a better deal than a 10-yuan stock.

Indeed, the survey shows that China's CFOs feel relatively little pressure from retail investors, and only slightly more from institutional investors. Just 15 percent of listed-company CFOs claim to feel significant pressure for change from individual investors, while 32 percent feel such pressure from institutional investors. That shouldn't come as a surprise. In many of the recent instances where listed companies were punished by Chinese regulators, their share prices actually rose, buoyed by overall optimism about the market.

Limited Authority
If investor pressure on Chinese CFOs is low, other pressures more than compensate. "[Running finance] is a massive challenge during the first year after an IPO," says Hsieh of New Oriental Education, which listed on the New York Stock Exchange in 2006. "You are setting up the finance function, setting up employee share plans, investors are calling you, and you have to comply with Sarbanes-Oxley."

This article was excerpted from CFO Magazine. Read the full article here.

Don Durfee, Yang Jian, and Wu Chen write for CFO in Hong Kong and Shanghai.

© CFO Publishing Corporation 2008. All rights reserved.