A stock crash is just what China
needs By Sheridan Prasso
By all accounts, Chinese companies have
become a lot better at disclosing information and
at running their management operations more
professionally. The Big Four accounting firms do
brisk business in China, auditing many of the
earnings disclosures required of the 1,400 Chinese
companies listed on stock exchanges in Shanghai
and Shenzhen - as well as in Hong Kong, London and
New York.
This newfound market
transparency is such a dramatic evolution from the
old days of state control - in which companies had
production runs and sales
figures officially set by communist bureaucrats
instead of capitalist market forces - that it
might be tempting to believe that international
standards of corporate governance and transparent
management are taking hold in
China.
Perhaps as telling as the
proliferation of taxi-driver day-traders in
predicting the end of the tech stock bubble
earlier this decade, a random man who struck up a
conversation on a New York subway platform
recently revealed that he had sold his US stocks
and invested heavily in Chinese equities. He was
blithely unaware that many analysts believe
Chinese equities to be nearing the end of a bubble
and heading toward a crash. He thought that
Chinese companies are all making money, so they
must be good.
But as the world should have
learned from the Enron scandal in the United
States, audited returns and sky-high share prices
do not good companies make. What matters is
corporate governance: clear and transparent
disclosure of financial information, the
appointment of independent directors to company
boards, shareholder rights, and separation of the
roles of board chairman and chief executive. In
that arena, Chinese companies continue to lag
behind international standards.
When
Chinese share prices come in for their hard
landing, the issue of corporate governance will
take center stage in Asia again, just as it did in
other Asian markets in the wake of the region's
financial crisis in the late 1990s. Back then,
corporate governance took much of the blame for
being the underlying cause of the crisis. But
China, with its closed markets and unconvertible
currency, was largely insulated from the shocks
that hit Thailand, South Korea, Indonesia and
other markets.
Korea has since
dramatically improved governance as well as
shareholder rights, instituting laws to reform its
huge conglomerates and going after the corrupt.
Samsung, Hyundai and LG have been delivering
stellar results since. Many studies show that good
corporate governance boosts share prices. Thailand
and Indonesia, which have not undertaken the same
level of reforms, have not seen the same level of
growth.
Nor has reform yet come to China.
A study released earlier this year by the CFA
Institute Center, which looked at 475 responses
from those with financial stakes in Chinese
companies, found that while the government has put
in place a relatively sound framework for
improving corporate governance, "observable
changes are still not evident in financial
disclosures and transparency".
What does
this mean? "There is a lot of corporate
book-cooking in China; the data is very
unreliable," says Donald Clarke, a law professor
at George Washington University and a leading
expert on Chinese corporate governance. He titled
a recent presentation to legal and China experts
at New York's Council on Foreign Relations
"Corporate Governance in China: All Sizzle, No
Steak?" Of course, China does have an active
regulator. The equivalent of the Securities and
Exchange Commission (SEC) is called the China
Securities Regulatory Commission (CSRC). Since it
was established in 1992 to be the watchdog over
the Shanghai and Shenzhen exchanges, it has
enacted more than 300 laws, regulations,
standards, and guidelines. But there's a
fundamental problem. The CSRC acts "as a
cheerleader, bedeviled by ambiguity as to what
they're supposed to be doing", says Clarke. "It's
pretty clear they have a political role as well.
If markets dive, they're the ones held
responsible."
The CSRC's stick has only
hit a "miniscule percentage" of listed companies,
according to Clarke. In 2003, for example, 11
Chinese companies were punished out of the 1,287
that were listed that year - fewer than 1%. "Of
all the CSRC punishments from 2002 to 2006, not
one was for violation of their substantive
corporate governance rules, such as voting,
calculations of dividends, and so forth," he says.
One reason Chinese companies aren't
responsive to shareholder concerns is that at most
only 5% of their external financing comes from
equity markets. The rest comes from banks. "It's
not clear they need to care about what investors
think," says Clarke. "Clearly management needs to
worry more about what political actors think than
what investors think."
That's partly
because at all companies where the government
maintains a financial stake - despite publicly
listing even a majority of shares on the stock
exchanges - company heads are still appointed by a
party-dominated political process. In one recent
example, the Personnel Ministry named a political
appointee as chairman of a company in which the
government's share was less than 20%.
Jamie Allen of the Hong Kong-based Asian
Corporate Governance Association wrote in
September while releasing the group's Corporate
Governance Watch survey, done in conjunction with
CLSA Asia-Pacific Markets, that regulators may
just feel overwhelmed. He believes that boards are
starting to gain more control, rather than leaving
all the power to a single chairman or chief
executive officer.
Without a tradition of
decision-making in the boardroom, newbie board
members, most of whom have no previous experience,
may be unsure of their responsibilities or
reluctant to carry them out. Indeed, another
survey in 2005, by the International Finance
Corporation, found that "a growing number of
Chinese managers and entrepreneurs have a
willingness and desire to improve corporate
governance. But too often they don't know where to
start."
Appointing independent directors
to boards is one way to start, Clarke says, but
"once you put independent directors on a board of
a Chinese company, there's not a strong
institutional framework for what they can do.
There's [just] a vague hope that they will prevent
insiders from ripping off shareholders."
The courts are of little help. Three
recent rulings of the Supreme People's Court
effectively bar shareholder lawsuits except in
certain limited cases (for misleading disclosures
where there was also a prior criminal conviction
or administrative punishment). "Shareholder rights
are not going to work because courts don't want to
get involved," Clarke says. "The rules are
designed to discourage all multi-plaintiff suits."
In theory, Chinese companies listed on US
stock exchanges become subject to SEC and US rules
- as well as shareholder lawsuits. But that has
not proved effective in improving governance back
in China. "It doesn't make very much difference if
you list abroad," Clarke says. "There is a lack of
a set of institutions that make it necessary to do
something. They're subject in theory to US
lawsuits and SEC rules, but is that something on a
day-to-day basis they need to worry about?"
Clearly the answer is no.
Even if Chinese
courts were more amenable, the legal system is
still too underdeveloped. "Lawyers are not trained
in corporate finance or accounting in law schools,
and the legal profession is still too young for
them to learn these things from senior lawyers as
apprentices," Clarke says.
Nor is the
press a sound watchdog, subject as it is to
government censorship and the official
editor-appointee system itself. Business
publications such as the Beijing-based Caijing
have famously exposed fraudulent practices by
listed companies, but such examples are few and
come at the whim of political mandates.
So what can be done? Clarke
argues that only a bottom-up approach - the
development of civil society institutions - can
work. But for that to happen, political will is
needed at the top. "The approach with the most
potential is the market-monitoring approach in
which civil society institutions develop the role
that shareholders cannot play," he says.
That means bond-rating agencies and stock
market analysts. Even better would be if, as in
Western developed companies, they could count on
support by the courts, shareholder activists and
the financial press - the set of institutions that
help make financial systems elsewhere in the world
more transparent.
So what will make
Beijing more amenable to encouraging the
development of civil society institutions? The
best pressure may be in the form of a stock market
crash.
Although painful, millions of
Chinese shareholders would lose money in such a
crisis and finally demand more transparency of the
companies in which they are investing. These
changes could bring reduced interference in
companies' management by the politically dominated
system and a tougher regulatory bite from the
CSRC.
(Published with permission of the Global Policy Innovations
program at the Carnegie Council for Ethics in
International Affairs.
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