Report

Missing Link: Corporate Governance in China’s State Sector

MOUNTING RISKS IN CHINA’S ECONOMY AND GROWING INTERNATIONAL EXPOSURE TO STATE-OWNED ENTERPRISES (SOEs) make improving corporate governance at these firms essential. China’s leaders have called for strengthening SOE corporate governance at all levels of owner- ship, but Beijing has not empowered boards of directors to carry out key governance functions. Chinese Communist Party (CCP) influence on enterprise decision-making persists through multiple mechanisms. As the market-oriented reforms pledged at the 2013 Third Plenum meeting remain stalled after five years, President Xi Jinping’s administration is acting to institutionalize the Party’s leadership role in SOE gover- nance. Yet steps forward can be made even in the current political environment. Taking action to improve SOE corporate governance can boost performance and valuation and foster broader growth. The goal of this report is to provide a full, contextual understanding of the state of corporate governance in SOEs today so that these outcomes can be achieved.

Five trends and conclusions derive from this analysis, each of which is worth highlighting at the outset:

1. Rising domestic risks and expanding international stakes make improving SOE corporate governance imperative. SOEs are absorbing more credit in China’s economy even as their performance lags behind private firms. The June 2018 inclusion of mainland China-listed A shares—65% of which are SOEs—in the MSCI emerging markets index directly exposes international institutional investors to SOE performance and the risks associated with their governance. Today, SOEs’ corporate governance and potential CCP influence on commercial decision-making now impact their foreign joint venture (JV) partners and governments worldwide.

2. State and private investor incentives remain misaligned, and loosely-defined Party influence persists. Senior SOE executives are typically also government officials. This incentivizes them to pursue state goals from industrial policy to social stability, distinct from – or even at odds with – maximizing profit and shareholder value. The Party state continues to appoint, assess, promote, and remove top SOE leaders—board chairmen, Party secretaries, and general managers or presidents—who in turn select the leadership of listed subsidiaries. Joint managerial and Party appointments, in which a single individual serves as both board chairman and Party secretary, are now a policy priority and widespread at the group company level (a company’s top administrative layer, which controls all subsidiaries below it and has no commercial function). Significant overlap between the membership of boards and Party committees is also common.

3. The Xi administration is institutionalizing the Party’s leadership role in SOE governance in a manner that concerns some potential investors. Pledges at the 2013 Third Plenum for market-oriented reform to the state sector have been largely unfulfilled. Instead, the Xi administration is institutionalizing the Party’s “leadership role” in SOE governance, most recently by legalizing the long-standing practice of Party committees discussing “major decisions” before they go to boards of directors for final determination. The Xi administration revised the Party constitution to enshrine this principle and is requiring SOEs to do the same in their articles of association. China’s current leadership argues that a stronger Party will improve, not impede, SOE performance and valuation by boosting oversight and accountability.

4. Better corporate governance could boost SOE performance and valuation and foster broader growth. The current political climate makes far-reaching reforms to SOE corporate governance unlikely. However, steps forward can still be made. An important first move is reducing the structural overlap between the board and the Party committee by limiting Party-managerial joint appointments to top SOE leaders. Another critical measure is clearly delineating the Party’s role in commercial decision-making. Yet another key step is increasing the transparency of SOE corporate governance activities at the group company level. Further prioritizing the appointment of external and independent directors with private sector and international experience could also help. These moves could boost SOE efficiency and better align board members’ incentives and decision-making with the market. They could also foster broader growth by attracting inbound foreign capital, bolstering existing and prospective JV partnerships, and facilitating SOE overseas direct investment and acquisitions in increasingly politicized world markets.

5. Improved corporate governance is critical for other, related reforms to succeed. Such reforms include financial reforms to restrain the expansion of credit growth, fiscal reforms to reconcile the responsibilities of government (central and local), competition policy reform to break local protectionism and level the playing field, and labor market reforms. These and other policy reforms are needed to reshape the competitive environment in China that all companies—and national growth in the aggregate—depend on. It is essential to have proper corporate governance in place to make sure that SOEs make responsible decisions with adequate discussion, supervision, and consideration for all stakeholders.

This report leverages original data and new sources to illuminate how China’s national champions— opaque and poorly-understood—are governed. Chinese SOE corporate governance has made important advances over the past four decades. Yet serious concerns remain about transparency, the effectiveness of internal monitoring, and Party influence on enterprise affairs. The stakes involved in improving SOE corporate governance are high not only for China, but also for international investors, JV partners, and the growing number of foreign countries where Chinese SOEs operate.

Renewed efforts to improve SOE corporate governance offer positive potential but will face formidable obstacles. Despite these potential benefits, improving SOE governance faces formidable obstacles. Most fundamentally, the Xi administration does not see a contradiction between strengthening the Party’s role in SOE corporate governance and improving firm performance and valuation. On the contrary, leaders believe that institutionalizing a stronger role for the Party will benefit SOEs by improving supervision and accountability—top priorities in Xi’s anti-corruption campaign. This prioritization of Party leadership makes it unlikely that boards of directors will be empowered to perform key governance functions like selecting corporate leaders or determining their compensation anytime soon. And SOE leaders’ continued status as officials in the Party’s personnel system means that they are unlikely to share private investors’ unitary objective of maximizing profit and shareholder value. These constraints have existed for a long time and are unlikely to change. But improvements are still possible. After all, despite their differences, both the Chinese government and private investors share an interest in improving SOE oversight, efficiency, and long-term value.

Full report available here.

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