Red-Hot Stock Connections to China Go Stone Cold

The Asian financial crisis has taken its toll on markets throughout the region but perhaps nowhere more than among Hong Kong shares once considered a near sure thing.

The "red chips" have grown cold, plunging as much as 40 percent compared with a 17 percent decline for the broader Hong Kong market this year.

Red chips, companies with direct connections to the mainland Chinese government, were the biggest gainers during the summer's rally. Market players believed the mainland connections would bring lucrative business contracts. They also believed that the best returns would come from projects on the mainland, with economic growth projected at 10 percent.

Shares in Beijing Enterprises, the investment arm of the Beijing city government, for example, traded in October at $65 (Hong Kong, $8.33 US) a share. They now trade around $10.

What triggered the the red-chip rejection was a seemingly innocuous property deal. A company called Xin Hua Estates last month defaulted on an expensive deal to buy 11 stories in a Hong Kong office tower.

Xin Hua Estates was regarded as a shell company for China's news agency Xinhua. (Before Hong Kong's return to China in July, Xinhua was China's defacto embassy there.) The news agency denies the connection, but investors are skeptical and now worry that firms with supposedly good guanxi, or personal relations, with China are not what they appear to be.

Stocks like Beijing Enterprises are also being hit by fears that China's money may soon be worth less. The PRC competes directly with countries like Indonesia, whose currency has lost 75 percent of its purchasing power since July. Indonesian products, and labor, are suddenly much cheaper than China's.

China says it has no intention of devaluing its currency, the renmenbi, but investors worry that regional pressures will force Beijing's hand, leaving investments there worth a lot less.

Beijing meanwhile is signaling that it wants to stem the flow of capital from the mainland into Hong Kong. The Xinhua incident spurred a local Beijing-backed newspaper to editorialize that China wants business and politics kept separate.

While that might sound normal in America, it's hard to believe in a country where government agencies from the supreme State Council down to the municipal level are all running businesses. And it's certainly not good news for a market that has been spurred on by mainland money.