Rising Star

China's CSRC is fast improving disclosure and corporate governance, earning it a worldwide reputation as the rising star of securities regulators. However some deeply rooted corporate practices and structures are hard to change over

When China's Yin Guang Xia was investigated for fraud in August, listed companies really knew the regulatory bodies were taking things seriously. One of Shenzhen's 'big-cap' diversified traders, the company was about to witness the arrest of four of its senior executives - including the former president of a major subsidiary - and face a temporary suspension from trading on the Shenzhen Stock Exchange. This was a company that had last year bandied about the idea it would seek a dual listing in Hong Kong.

Not that long ago and despite the fraudulent circumstances, such a crackdown in the PRC would have been almost impossible. But in 2001, it is a classic example of what the new China is promoting as its attitude towards company disclosure and cronyism within listed companies - and the top dogs have been the ones feeling the heat.

'They are picking on the high profile companies now,' says Merrill Lynch's head of China Research, Lan Xue. 'If you think you can be a major shareholder just because you know someone, then think again.'

There have been crackdowns before, of course, in a bid to send out warnings. But it was smaller, more obscure offenders being picked on. Things have been different this year, with the China Securities Regulatory Commission (CSRC) setting its sights high.

The commission has also outlined plans to protect the rights of shareholders by weeding out corrupt practices and persistently loss-making companies listed on China's major exchanges. The campaign hasn't even balked at going after companies well connected with the People's Liberation Army.

Troubling past

Not so long ago, the government often financially puffed up companies with poor balance sheets and inflated reports. A blind eye was turned to cross-shareholdings designed to protect major stockholders - often from the same family or from within the government itself. This is now changing.

'It looks like the CSRC is taking it much more seriously,' Xue adds. 'If a company does not have proper practices, that company will crash.' This attitude towards transparency and the protection of the minority shareholder has been coming for some time. However the momentum picked up this year and new measures to increase transparency are afoot.

But rather than increase investor confidence, China is seeing many smaller punters turning away from the major Shenzhen and Shanghai exchanges as the extent of the corruption has been filtered out through the mainland's increasingly vocal media outlets.

Still, the Chinese public are great stock market players and while in the past, much of it was pure gamble, the new face of capital markets promises to teach minority shareholders what they can do to ensure they are not left in the dark.

'You can't tell people what to do forever, so you have to educate them,' according to Xue. 'Before, companies were guaranteed by the government. Now, people have to be more careful.'

Work in progress

Despite such positive moves, there are a lot of conflicting reports about investing in China. However, there is one constant theme: the new, stronger and more open PRC is a work in progress - and its capital markets are no exception.

Many pin the changes on China's impending entry to the WTO and the commitment by the PRC government to compete on a global scale by opening up the country for foreign direct investment.

But in reality, China has been slowly on the path to financial expansion for many years now, and particularly since the collapse of communism in Europe back in the early 1990s.

China is not a country that can be overhauled quickly. Roughly 2 bn people and a myriad of complicated family and government-oriented business operations have to be tackled. But the long-awaited WTO entry (14 years in the making) is finally happening. Also, globalization of business has forced China to open up and restructure in order to continue growth. This has resulted in 2001 being marked as a year of drastic change. Some companies may not like it and some investors may be hesitant to get back into the marketplace with the knowledge of such corruption. But either way, corporate governance is moving to the top of these companies' to-do list in the wake of scandals such as Yin Guang Xia's.

'The increasingly globalized capital markets have put China on the map of international finance,' said Laura Cha, vice chairman of the CSRC, in a speech to the China Business Summit earlier this year. 'Last year, Chinese companies raised a total of US$20 bn from foreign equity investors, compared with a combined total of $5 bn for all other Asian countries,' Cha continued. 'Although the potential growth of our domestic economy and the further restructuring of our industries will continue to attract international institutional investors, we must realize that for international investors, the criteria for investment is quality of the companies and quality of the markets. Investor confidence depends on clear and transparent regulations and the quality of the listed companies.'

Bite behind the bark

In August, Guangxia, which listed on the Shenzhen stock exchange in 1994, admitted to gross inaccuracies in its financial reports. An investigation team from the CSRC arrived in Yinchuan and as a result of this examination Guangxia's shares were temporarily suspended. Back in June, foods group Guangdong Kingman - once hailed as one of China's top businesses - was officially stripped of its listing on the Shenzhen exchange, making it the second delisting from the mainland stock markets. Analysts suggested that Guangdong Kingman's delisting showed mainland regulators were continuing to adopt a sober view towards the restructuring of failing companies.

But while the CSRC has been seen to take a tougher stand, there has been criticism from official groups about the CSRC's approach.

It seems that not all have been confident in the CSRC's official operations. Earlier this year, Chinese lawmakers slammed the CSRC for what they said was 'regulatory ineffectiveness' in investigating previous scandals. In a report, the critics accused the CSRC of being slow to respond in the Guangxia case. July's damning report from a team at the National People's Congress revealed details of a dozen cases where the CSRC failed to act properly.

But Merrill Lynch's Xue says the new structure will have its stumbling blocks, as such massive change is a gradual process. 'Before, a lot of people committed fraud because they thought they would not be punished,' she observes. 'But now they think differently. With China, it's a gradual process and it has now gained momentum. The CSRC is determined to do it and certainly, they have more of a free hand. China is changing. There will be more disclosure in the next six months to a year.'

Indeed the CSRC has been quick to point out that it is headed in the right direction. 'The discipline and rewards of the capital markets will incentivize companies to behave in a manner that would benefit shareholders as a whole,' the CSRC's Cha continued in her speech. 'In turn, responsible companies would attract more capital into the markets, resulting in even greater economic growth.'

Tangled webs

One of the problems facing China is unraveling the intricate shareholdings of major listed companies - and doing so without losing the support of the investment-minded Chinese public. There are sometimes unclear splits of assets, management and businesses between the listed companies and their parent companies. Connected transactions between them or controlling shareholders are common, sometimes with severe conflicts of interest that harm minority shareholders.

In essence, this is not dissimilar from many other Asian countries, such as Korea's tightly woven chaebols, where the controlling shareholders are the original founding families of the companies. However, the concept of corporate governance is emerging - a concept that has not been well developed or understood in China.

That's set to change. Dr Zhou Xiaochuan, chairman of the CSRC, has put down corporate governance as one of the commission's major areas of work. 'We are committed to champion the rights of investors and shareholders, and to improve and safeguard the standards of our markets. We will mandate transparency and focus on the behavior and accountability of the board and the management of the listed companies,' Cha stated in her speech.

The CSRC has, among other initiatives, updated the mandatory provisions of the articles of association of listed companies, and it has been drafting guidelines for shareholders' meetings. The regulatory body claimed publicly that it aims to spell out specifically the rights of the shareholders in various corporate actions and in shareholders' meetings. 'Most importantly, we are working on a set of core principles and standards of corporate governance for listed companies in China,' Cha concluded.

The CSRC expects to announce codes of practice for mainland-listed companies by the end of the year, and may make some of the codes mandatory if companies don't voluntarily adhere to them. There are convincing arguments for adherence. According to a recent McKinsey survey of 200 international institutional investors, 80 percent say that when all other factors are equal, they would be willing to pay a premium for a 'well-governed' company. And 75 percent consider corporate governance at least as important as financial indicators. In April, a CLSA Emerging Markets survey of 495 companies found strong links between good corporate governance, earnings and stock price.

Rising star

While there are some dissenters when it comes to praise for the CSRC, others remain confident the regulator will eventually change the face of China's markets.

Morgan Stanley's head of China research, Andy Xie, believes the CSRC's Dr Xiaochuan is a 'rising star'. 'The central government brought him in for a reason,' Xie says. 'This is just the beginning.' For one thing, Xie points out, the CSRC was always aware of the criminal practices going on within major companies in China, but did not have the teeth to make a difference.

Now, the mainland leaders are united in their stand against such corruption for the simple reason that an effective stock market means stronger economic growth - a much-needed certainty as the rest of the world passes through an increasingly severe slowdown. 'The markets are the most obvious areas to increase efficiency,' Xie says. 'Money has been wasted there.'

Among regulators in China, Xie believes the CSRC stands out as being the group that can make the most changes for smaller investors. It is in the process of hiring more staff, including top officials from Hong Kong's securities regulators, and has plenty of senior government support. 'They are leading the charge,' he continues. 'Bank reform is the one area lagging behind.'

Xie, however, concedes enforcement of such changes has not been as sweeping as it could have been. 'In theory, China is moving toward international disclosure standards. However, enforcement has been less impressive... the credibility of the market depends on it.'

On the long road

As far as luring disappointed investors back to the market goes, it seems it will take some time for confidence to re-emerge. Since early July, the two major exchanges of Shanghai and Shenzhen have taken a beating. The Shanghai B-share index (as of the end of the third quarter) declined by 33 percent from its peak on May 31 - after tripling in the preceding four months - following the opening of the dollar-denominated market to local investors with hard currencies to invest. The Shanghai A-share index declined by 9 percent from its peak on June 6. The index had risen by 150 percent since May 1999, when the People's Daily, in front-page editorials, encouraged Chinese households to buy stocks.

Now it is a matter of waiting as the markets face a transitional phase. According to Xie, once the CSRC's serious stance on prosecuting unfair practices becomes more widely known, investors will again pick up where they left off. 'We should not be concerned about investor behavior in-between,' he cautions. 'We need the market to be reformed and companies to ride on fundamentals. Then there will be more people coming in to invest.'

The CSRC also claims that while it is early stages now, the monitoring process will be ongoing. It's working hard to soothe the public's fears that it is merely implementing rules that will not be heeded by Chinese companies hesitant to disclose sensitive information they had previously never been forced to reveal.

Indeed, the resolve of the CSRC is good news for investors - and companies, if they don't mind a bit of hard work. With reform facing historical hurdles such as entrenched family connections and complicated shareholdings, caution will likely prevail for some time.


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