Eye on China: Safeguards of little relevance

Any investor interested in China has several choices. He could go via the select number of huge global institutions that have been permitted to invest in China via the qualified foreign institutional investor system, or he could invest directly into the Hong Kong or Singapore markets.

Whichever route he goes, he will be confronted with the problem of corporate governance. Chinese companies are especially prone to corporate governance lapses because of two factors: ownership is concentrated and the Communist Party still retains a role.

The idea of the communist bogeyman apart, it would be fair to ask why the party should be a danger. After all, many European firms are government-owned and have government representatives on their boards. Just like the Communist Party, these agents might not be focused on shareholder value to the detriment of everything else. They might be equally interested in other stakeholders, such as the communities in which the factories are based, social stability or international relations.

The special anxiety reserved for the party's influence is related to its existence as a parallel structure alongside that of the Government. That adds one more layer of complexity to investors keen to find out what the majority shareholder's plans are. From a personnel viewpoint, given that the party structure and the Government structure are parallel, one might ask who is responsible for running the company? What is the role of the party over the Government? To what extent can it intervene?

The answer is simple: the party is the ultimate arbiter of everything in China. Such a position of undisputed power rightfully disturbs investors.

Take the example of Zhang Enzhao, the former chairman of China Construction Bank who was recently put under house arrest for taking bribes. His position as chairman of the company came with the position of party secretary. Combining the two roles might foster administrative clarity but it has a disastrous effect on the system of checks and balances. Opposing the party, unlike opposing the Government, can be construed as treason in China. That made it unlikely anybody would oppose Zhang, however much they might disapprove of his conduct.

The other aspect relates to the concentration of ownership. A high concentration might seem desirable, since the fortunes of the firm are closely tied to the fortunes of the management. Therefore, you would expect management to be keen on maximising the firm's earnings.

That argument usually works for unlisted companies owned by their founders. When a closely held company is listed, however, a new constellation emerges.

When investors buy such a company during its initial public offering, they buy a minority stake.

But selling a small portion of itself, say 30 per cent, creates a special dynamic, and one in which abuses may easily arise. The parent company could sell over-valued assets to the listed company. It could meet little opposition, since the parent will be the strongest element on the board of the listed company thanks to its large share ownership.

This problem is especially prevalent in China, since share ownership via the Government, unlike in developed economies, is highly concentrated. In the West, millions of shareholders own the biggest firms, with effective power concentrated with the management. This can also lead to corporate governance abuses of another kind.

The future model of China's system is still being worked out. Although the US model gets the most attention, some believe the German model corresponds more to China's realities. This system has the board of directors paralleled by a second, supervisory board manned partly by employees. Many Chinese firms listing abroad have introduced this.

Another reason for using the German model is that traditionally its firms have been bank-debt financed, meaning banks are the main guardians of the debtor companies.

The situation is similar in China, where the sharemarkets have played a very small role in the financing of state-owned enterprises.

But an obvious problem is that, unlike in Germany, the officials of the SOEs and the banks are appointed by the Government. Their loyalty to one another as fellow civil servants and party members could overrule the duty of the bank official to rein in SOE managers.

Here, the case of Singapore-listed China Aviation Oil is interesting. The company is in dire straits after scoring derivatives losses of more than US$500 million. Most shocking for investors was the connivance of the parent company in the sale of 15 per cent of the listed company to Deutsche Bank, with the proceeds being funnelled back to the very managers who caused the situation in order to pay margin calls.

Shortly beforehand, CAO had been voted the best company for corporate governance. But it's clear that paper safeguards were of little relevance to the tight personal bonds that existed between Chen Jiulin, CAO's boss, and his Government cronies back in mainland China.

* The writer remains anonymous to protect his position in China.