We are embarking on a new era in global markets — likely one that has at its core China’s increasing integration into the global financial system. As the country rebalances its economy, internationalizes its currency and allows greater foreign participation in its capital markets, decisions made in Beijing will have a greater impact on investors’ portfolios. Despite recent market volatility, we at Investec Asset Management believe that now is the time for investors to understand the global effects of China’s economic transformation and the possible long-term implications for their portfolios.
For international investors, the liberalization of China’s onshore capital markets provides exciting opportunities, as well as many challenges, particularly when it comes to understanding local corporate governance practices. But unfamiliar local legal and cultural contexts often present hurdles to investors entering new markets, and China is no exception.
Chinese corporate governance practices are going through a period of change. Beijing has focused on enforcing market-abuse regulations and improving business integrity. After a recent visit to the Shenzhen Stock Exchange, it became clear to us that Beijing is keen to improve the governance reputation of domestic companies to attract overseas capital. Local institutional investors are also showing signs of a more active approach to ownership and have started to engage with Chinese companies, including state-owned enterprises. What will these changes mean, for companies and investors?
By reforming China’s SOEs, Beijing is seeking to reduce government involvement in listed entities and replace state supervision with a more managerial approach. The government hopes to encourage a more diverse board structure, with increased representation by independent directors via selling equity to private and institutional investment funds. We believe that international investors are eager to see this progress.
China’s two main stock exchanges, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, also need to be included when assessing governance issues. There are plans to make the Shenzhen exchange itself a listed company and extend the Shanghai–Hong Kong Stock Connect program to this bourse to attract and facilitate further foreign investment in mainland China. The Shanghai exchange has already conducted some basic due diligence on prospective initial public offerings, as well as promoted governance training and electronic voting. The ability to vote electronically is particularly important, as the vast majority of shareholders on the exchange are retail investors. Electronic voting would help overcome some of the geographical challenges in a market of this scale and encourage shareholders to exercise their rights. The number of electronic voting sessions in China has grown more than tenfold since 2005. The Shanghai exchange has also focused on “open day” activities, in which investors can meet with companies.
Another key area of focus is the reform of auditing practices. In March the State-Owned Asset Supervision and Administration Commission of the State Council, China’s top regulator for state-owned enterprises, announced plans to launch a bidding process for independent accounting firms to conduct audits of SOEs’ overseas units. The so-called Big Four accounting firms — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers — are likely to be excluded from this procedure as they will already have audited state-owned enterprises and overseas subsidiaries in the past three years. This reform should be well received by those who have concerns over financial management of state-owned enterprises both in general and with regard to their foreign assets. According to the Asian Corporate Governance Association, an industry body, as of the end of 2013, SOEs had accumulated more than 4.3 trillion yuan ($676 billion) of overseas assets. The challenge with this initiative may be that the stakes of state-owned enterprises in foreign businesses are sometimes small, and foreign governments might not allow third-party audits.
The corporate governance space has an interesting time ahead in China, in our view. As the government enforces higher governance standards, and domestic shareholders push for more accountability from boards, new models are likely to evolve that can provide investors with better transparency and greater interaction between management and shareholders. These changes will also entail a learning curve for investors. China’s unique legal and cultural environments are likely to precipitate governance norms that will be unfamiliar to foreign shareholders but fit for the companies that adopt them.
As we have experienced in other markets, however, fundamental changes to board structures — such as including independent directors to add value, representing external stakeholders including minority shareholders, and providing the right function in terms of oversight and control of Chinese boards — is a long process. It is to be hoped that China will continue to crack down on corruption and open its financial markets to foreign investment, which should provide an opportunity to review and update fundamental principles around good governance, including transparency, shareholder rights and structures that support the accountability of management, effective oversight and control.
Therese Niklasson is global head of environmental, social and governance at Investec Asset Management in London and a contributor to its Investment Institute’s latest China research.
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