Every six months or thereabouts comes the latest batch of reports from financial analysts predicting an upturn in the Japanese economy. This has been the pattern over the past 10 years or so with the result that any prediction on the Japanese economy, one even only mildly bullish, hedged around with caveats and full of vague phrases like "light at the end of the tunnel", is simply discarded.

With good reason. Japan’s economic problems are systemic, a part of a greater difficulty affecting the way in which the country is governed. Despite a period of low-to-zero interest rates, a weak but competitive currency, and the old established means used by Japan to keep imports at bay, Japan’s economy continues to flounder.

At heart is a banking and financial system that is bust and has little realistic hope of becoming solvent anytime soon. This, coupled with a government spending programme, much of it on useless ‘pork barrel’ infrastructure projects that have left the government itself running a deficit of frightening proportion.

Hopes were raised last year when Junichiro Koizumi was swept to office as Prime Minister with a mandate to take drastic action to sort things out once and for all. That was then. Today, Koizumi looks like being just another in a long line of Japanese politician who has been hailed, but failed.

The fact is nothing has changed. True, boosted by a weak Yen, Japanese exporters have been doing rather well lately, but it looks precarious. A slightly weaker US dollar has let to a strengthening of the yen. The Japanese central bank is already intervening in an attempt to prevent any further strengthening (much to the annoyance of Washington). The export ‘boomlet’ looks set to falter, especially if the international financial markets are permitted to run their course.

Japan is not Argentina. It says much for the resilience of the world’s second largest economy that it has remained functioning this well, this long, under these circumstances.

But anyone banking on a sustained turnaround in the country’s economic outlook is either privy to information not available to others, or is incurably optimistic.

China, on the face of it has similar problems to those of Japan. By tacit admission of its own government the banking and financial system is bankrupt, and the government runs a massive deficit, caused in large part by huge infrastructure projects. On top of which the financial statistical information available is either of doubtful accuracy or classified a ‘State Secret’, or both.

Yet the perception of China among business and financial circles could not be more different from their judgement on Japan. Partly, it has to be said, is a certain tendency to place hope over experience. Many hopeful foreigners have lost their shirts (or their shareholder’s shirts) in China. Many more will follow.

There are many differences between China’s economy and that of Japan, of course. One is the vast potential domestic market yet to be exploited. Not as easy as it may seem, and certainly not in the short term – but real enough. Then China’s export performance is remarkably healthy and while great swathes of the economy, especially those still owned by the state are probably beyond redemption, another vast sector, mostly privately owned, is booming. China continues to attract foreign investment. And this is investment money, not the short-term foreign loans that prevailed in places like Indonesia and caused such chaos when repayment was demanded back at the start of the Asian Financial Crisis in 1997.

Economists can point to many more distinctions between the Chinese and Japanese economies but one is often overlooked. China, despite its continued shortcomings, is making real changes. To be sure, it’s often a giant step forward followed by a three quarter step shuffle back. The pace might be slower than many would like, but there is progress.

China’s entry into the World Trade Organisation (WTO) is proof. No one knows for sure what the end result will be. Some see the dawning of a whole new era. Others forecast disaster. Who knows? Yet Beijing’s decision to seek WTO membership says a lot about how those in charge see the future of what one day later this century might be the world’s largest economy.  It is that willingness to take chances which characterises the difference between Japan and China in the economic field.

China’s stated intention to maintain the currency, the Renminbi (also, confusingly called the Yen), even though exports will be affected adversely, is a practical differentiation between the two national economies.

Part of China’s stated intention to retain an informal parity of 8.2 Rmb to US$1 (‘informal’ because the Renminbi is not, officially, convertible) is greatly influenced by the country’s desire to be seen as stable during a time of transition – which entry into the WTO surely marks. It is, indeed, a political choice and China has opted not to fudge it.

Another instance of maintaining a link to the US dollar, this time a formal one, is in Hong Kong. There the government, which has just been reinstalled for a second five year term, has stated categorically that the ‘peg’ linking the US dollar to the HK dollar (at a rate of HK$7.8 to US$1) will remain for at least the next five years.

The HK dollar peg has served Hong Kong well in that it gave the economy stability at a time of great uncertainty for the city. Events such as Tiananmen Square in 1989; the return of sovereignty to China in 1997, and the outbreak of the Asian Financial Crisis just one day following the handover ceremonies have all impacted upon Hong Kong. Generally, the administration – which does enjoy a fair degree of freedom from Beijing, especially in the economic field – has met external threats quite well. Their response to speculators betting on a de-linking of the peg was robust, to say the least, and was a major cause for so many speculators getting badly burned.

Yet the Hong Kong economy is floundering. In the view of some, floundering badly. Statistics do not provide an answer. Unemployment at 7 percent and rising, is high, but not a disaster by European standards. The government have begun showing a budget deficit, which is unusual, but seen in the context of Hong Kong’s massive reserves, not yet a cause for alarm.

No, what really ails Hong Kong is a lack of direction. A city that built its reputation on an ethos of hard work and entrepreneurial flair seems to have lost its spirit. The ‘can do’ philosophy of recent times has turned rapidly into one asking, "What is the government going to do?" Hong Kongers seem resigned to being buffered by forces outside their control. The fighting spirit is – well, not gone perhaps, but less prevalent than before.

The declaration that the peg would be retained for the next five years, at least, was necessary to give confidence to outsiders in an economy where the local people themselves appear the least confident.

There are many good reasons to persuade oneself to enter the China market (1.3 billion of them, at last count, and rising) but basic business principles still apply. It is surprising how often this is overlooked.

Two ingredients for a successful financial investment are: an exit route; and a compelling investment case - one that survives the scrutiny of due diligence. 

There are few economies in which due diligence is such an essential part of the appraisal process as in China and gradually is becoming accepted as the norm prior to investment.  This has not always been the case. Even recently a first reaction to a due diligence request from a would-be buyer might have been a flat refusal on the basis that the government's or an individual's integrity were being questioned. 

Business environment.  Certain features of the Chinese business environment reflect a market emerging from decades of total state control.

The mainland tax-driven accounting environment often means that the financial performance of a business is obfuscated in the business' accounts.  It is commonly believed, and with some justification, that every Chinese enterprise maintains three sets of accounts - one for the tax man, one for the shareholders, and another for the general manager.

Whilst the extent to which the financial performance is clouded varies, adjustments to financial statements arising from due diligence are often significant.  As an indication, it would not be uncommon to see adjustments writing down total assets by 50 percent and adjustments so significant to profitability as to render the original figure meaningless. 

Risk management.  Business practices on the mainland have evolved largely without the support of a developed judicial system.  Consequently, there has been little need to create written agreements since these are difficult to enforce.  While this is changing, many core business agreements remain oral and a high proportion of transactions are in cash and difficult to substantiate. 

The same lack of proper enforcement of business deals does however explain (to Westerners especially) the importance Chinese business people attach to personal contact. Personal judgement of the other party’s honesty and integrity assume understandable significance.

Bureaucracy.  As a planned economy, there are many areas where central and local government policy implementation impinge upon business.  For example, constantly evolving employee benefit legislation, business licence requirements, land rights certificates, and tax legislation are sufficiently pervasive and complex that the issue arising from due diligence is not whether a company is in compliance.  Instead it comes down to providing an indication of the level of risk being adopted as a result of the business being non-compliant -- which it almost inevitably will be -- and the extent to which the risk profile changes following investment.

Below are some common due diligence issues.

Initial funding.  One of the features of Chinese culture is a strong, connection-based, network of political, business and social relationships.  Whilst these relationships may be public knowledge, they are rarely documented.  Nearly all private enterprises require start-up capital or expansion funding.  Unless this funding comes from a bank, it is likely that a relationship-based equity funding started the business.  It is quite possible this investment to have originated, without proper authorisation, from state funds. 

All too often there are persons or businesses, undisclosed as equity stakeholders in an enterprise, that exercise significant influence over the enterprise.  This can extend from the composition of the supply chain through key management and on to customer relationships and sales pricing.  Any investment appraisal process should seek to understand the strengths and weaknesses of these arrangements.

Mixing of funds.  In common with many private entrepreneurial businesses across the world, there tends to be an element of mixing of funds between those funds that might strictly be interpreted as those of an enterprise, and those of the equity-holders.  Business sales routed through personal accounts and property transactions are probably the most likely areas where these will arise. 

Government relations.   Private enterprises require support from local officials to survive.  The way in which this support is obtained should be understood as fully as possible by a prospective investor.  Corruption is a recognised problem on the Chinese mainland.

State-controlled entities  

Financial investors typically view state-controlled entities as ‘turnaround’ opportunities. 

Excess employees are a regular feature of state-controlled enterprise due diligence reports.  Ascertaining individual productivity is a key component in the exercise, as is determining the real number of people to whom an enterprise has established a duty of care in terms of pensions, health, education, housing, etc.  

Objective management reporting is often absent.  A blame, rather than reward, orientated management culture can lead to losses being disguised as assets standing idle and understated inventory and receivable provisions.  The lack of objective management reporting may also be an indication that management is not of sufficient calibre to be able to report objectively. 

Gearing can be very high in state-controlled enterprises.  This is usually not a high risk high reward financing strategy, as frequently loans have been advanced over many years, not to fund expansion but instead to meet the cash outflows caused by losses.  Due diligence in this area is probably most fruitful if conducted directly with the lending banks as they may carry interest accounts accruing loan interest due from an enterprise that the enterprise itself may not be aware of.  

Asset appraisals are required where assets are transferred out of state control.  This will usually take place on investment by a financial investor into a state-controlled enterprise.  An asset appraisal that is not handled efficiently can place undue pressure on the deal price, leading to an overpayment, deal postponement or extensive restructuring.  It is preferable to have completed all due diligence before an asset appraisal is conducted.   In general financial investment in China requires more thought, planning and risk mitigation than in other parts of Asia and the world.