China’s individual and institutional wealth have grown over recent decades, and so has its asset management industry. Total assets under management (AuM), including both traditional and quasi asset managers, grew from a mere US$4 trillion in 2012 to over US$18 trillion in 2017. In June, MSCI made the monumental decision to add over 230 Chinese “A-shares” stocks to its Emerging Markets Index. In parallel, the Chinese government has clamped down on the country’s “shadow banking industry,” has relaxed its rules around foreign investment, and has begun encouraging investors to integrate environmental, social, and governance (ESG) considerations into decision-making.
The evolution of governance means new opportunity in China for domestic and foreign investors alike; a keen understanding of how to navigate them will be increasingly essential.
The evolution of governance means new opportunity in China for domestic and foreign investors alike; a keen understanding of how to navigate them will be increasingly essential. In this context, we sat down with Jamie Allen, Founding Secretary General of the Asian Corporate Governance Association (ACGA), following the recent and timely publication of its report, Awakening Governance: The Evolution of Corporate Governance in China.
Karlyn Adams: How has corporate governance evolved in China in recent years? What are the most exciting or meaningful changes you have seen?
Jamie Allen: Until recently, China was moving quite slowly compared to other markets in Asia. However, in 2018, it revised its Code of Corporate Governance for Listed Companies to now include greater emphasis on ESG disclosure, the role of institutional investors as stewards, the accountability of board directors, and board member skills and diversity.
The Code’s new requirement on formal incorporation of Party committees is also a major development. Party committees have long been a feature of Chinese companies, but they have operated in the shadows. Greater clarity around their role in corporate decision-making is still needed for foreign investors, but formal recognition of their existence hopefully now paves the way for greater transparency in the future.
Adams: What are the top governance-related issues that foreign investors should be aware of when considering investments in China?
Allen: Until the mid-2000s, China’s early corporate governance reform was largely focused on adopting global standards. Following the financial crisis of 2007-9, it became clear that “Western” approaches weren’t a panacea. China has since focused on complementing global standards with locally-appropriate solutions. Today, governance in China is a unique hybrid of global and local, which has implications for how a company operates.
For example, the roles and powers of the board of directors, supervisory board, and Party committee are unique in China. While internationally, an audit committee typically sits under the board of directors, in China, a supervisory board often oversees internal audit as well, which creates an overlap between the audit committees and supervisory boards. Similarly, nomination committees typically have significant influence over appointments of independent directors in the West, but in China, the Party committee usually has greater influence and nomination committees are more of a rubber stamp. The practical implications of these differences vary by company, so investors should conducr their due diligence at that level.
Foreign investors need also be aware of the potential risks associated with Variable Interest Entities—overseas holding companies that effectively bypass Chinese law on foreign direct investment in telecoms and IT, enabling foreign investors to gain an economic benefit from Chinese companies through contractual arrangements between a Chinese firm and an overseas entity. While the government may not shut these Variable Interest Entities down, investors should be aware of that risk.
Adams: Your new report includes several case studies. Which examples are most instructive for Chinese companies?
Allen: Sinopec Corp, a state-owned petrochemical company, is one of the better governed SOEs and is interesting for several reasons. The company has reduced the number of independent directors with government backgrounds on its board, and in 2014, it achieved a successful mixed ownership reform by selling off almost 30 percent of the shares in its retail unit, Sinopec Marketing, to a combination of private and state investors. These minority shareholders were given ample representation on the new entity’s board of directors and supervisory board.
ICBC, one of China’s top banks, is also a positive example. It has one of the more diverse boards for a state-owned enterprise and was one of the first to adopt a board evaluation process. In 2017, ICBC developed a “Green Bond Framework” and invited Norway’s Center for International Climate Research (CICERO) to conduct and publish an assessment of it. Pursuing evaluation by a non-Chinese entity has lent confidence and credibility to both the framework and the firm.
Adams: Is there a relationship between corporate governance and broader sustainability themes? In other words, is there a relationship between governance (good or bad) and likelihood of being committed to or being able to make progress on environmental and social issues?
Allen: Yes. For a company do a good job on “E” and “S” in ESG, they first need good governance (“G”). A strong board of directors can help ensure direction and consistency on sustainability strategy and reporting; it can also help avoid the risk that companies lose focus on “E” and “S” during tight financial times. This should be part of a board’s fiduciary duty. Governance is about creating better long-term performance, so there is a clear relationship between companies that are well governed and those that take sustainability seriously.
Adams: What are the biggest governance-related challenges and opportunities that you see in China going forward—over the next three-five years, for example? How would you recommend that companies, investors, or regulators address these?
Allen: So much of the economy still revolves around the state in China. The government needs to give the private sector greater autonomy. In addition, Chinese corporations, especially SOEs, need to interact more with stakeholders—Sinopec does a good job of this, and others learn from its example, especially as they try to raise capital from overseas.
Ultimately, China needs to create a system that is seen as fairer to minority shareholders. There is tremendous value that can be unlocked through better governance, and companies who pursue this path will see results in their long-term performance.