Market Crash May Burst Chinese Bubble Mentality
By Sheridan Prasso | December 7, 2007
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 U.S. 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 Asian financial crisis of 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 Centre, which looked at 475 responses from those with financial stakes in Chinese companies, found that while the Chinese 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 percent. "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, etc.," he says.
One reason Chinese companies aren't responsive to shareholder concerns is that at most only 5 percent 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, China's Personnel Ministry named a political appointee as chairman of a company in which the government's share was less than 20 percent.
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 CEO.
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 China's 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 U.S. stock exchanges become subject to SEC and U.S. 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 U.S. 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 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 they, like in Western developed companies, 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, in such a crisis, millions of Chinese shareholders would lose money 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.
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