Market uncertainty created by short sellers targeting Chinese companies is likely to outweigh the benefits of improving corporate governance and transparency, says Fitch Ratings.

In a new report released Friday, the rating agency argues that reports alleging fraud at Chinese firms by ‘whistleblowing’ short sellers, such as Muddy Waters LLC, are likely to do more harm than good. It notes that Chinese companies, “provide relatively easy targets for these tactics”, as the domestic analytical investor base is less developed than in the West, the country has poor rankings on corruption indices, and companies have concentrated ownership structures. “Combined with strong growth expectations and a desire by local and foreign capital to participate in this growth process this increases the potential for unusual practices and sometimes fraud,” it says.

The upside of short sellers alleging fraud, it says, is that it may focus management and directors on ensuring they understand and are able to explain their companies’ operations and procedures. However, Fitch maintains that the scope for these sorts of improvements should not be overestimated. “The entrepreneurial and equity focused high growth business environment in China has not generally resulted in management teams developing a debt-focused business mentality and as such leaves many of them poorly prepared to face such challenges,” it says.

“For the companies involved, even if they succeed in raising standards and refuting allegations, these potential benefits come at a price,” it says, noting that even in cases where the allegations are found to be unjustified, they are likely to wreak significant reputational damage, at least in the short run. “This can severely influence debt and equity prices, and tackling such untimely headlines absorbs management time, disrupts customer and supplier relationships and reduces access to sources of funding,” it says.

Fitch says that on its recent tour of emerging market investors in the US and UK, one of the main concerns raised by investors was the short-seller research report risk. “The advent of a few of these reports has been enough to ‘stall the market’, but if it transpires that they can be used indiscriminately, then ‘innocent’ companies may suffer the consequences, and investors will look elsewhere,” it says.

Ultimately, it concludes that the added market volatility and uncertainty generated by these sorts of reports is likely to outweigh any positives for investors from improved corporate governance and transparency.

IE