How can China attract more foreign investors?

Despite a recent $2 trillion decline in the Shanghai market cap (an amount equivalent to the entire GDP of India), China is still closely linked to the state of the world’s capital markets. This unprecedented influence is being watched closely by global investors. For them, the challenge is the state of corporate governance in China, which causes market participants to assign huge equity-risk premiums to Chinese companies.

The financial reporting and disclosure practices of China’s listed companies have continued to lag behind both developed and developing economies, as a few recent high-profile defaults serve to remind us. In 2013, the China Securities Regulatory Commission proclaimed that China’s existing law provisions were missing the basic disclosure requirements essential to a healthy financial market. Strong institutional forces, the lack of a rigorous judicial system, limited capital-market pressures and prevailing business practices – all have reinforced a lack of transparency and weak financial practices.

China’s cultural and social norms, with its echoes of Confucian conformity, create significant challenges for corporate governance. Majority shareholders have been known to hire independent directors on the basis of personal relationships, leading to biased loyalties (i.e. the new recruit aligning with the majority shareholder despite a regulatory mandate to protect minority shareholders).

This culture means there is little need for costly, high-quality financial reports as business continuity can be ensured through reputation and other social mechanisms. For some Chinese-listed companies, political relationships are more valuable than transparency. Scandals that damage political connections have produced much larger average stock-price declines (a fall of around 35%) compared with pure accounting scandals (roughly 15%). This contrasts sharply with the market reaction for accounting scandals in the United States, where revelations of accounting fraud have pushed down average stock prices by more than 40%.

For Chinese companies listed in Hong Kong, away from the mainland, the situation isn’t much better: most of the companies have failed to embrace the 2012 Hong Kong corporate governance code revisions. Compliance among mainland firms in the Hang Seng Mainland Composite Index fell from a high rate of 80% in 2012, to 58% in 2014. Investment banks in Hong Kong have also done a poor job of keeping rotten stock offerings out of the market. In 2011, the commission reported that out of 100 prospective public offerings submitted for approval, 82 had defects.

Auditors have found it hard to deal with this situation. Large auditing companies tend to assign less-experienced auditors to firms that are listed only in China (as compared to clients cross-listed in Hong Kong). Furthermore, China’s secrecy laws restrict foreign regulators from examining the work of Chinese auditors, making it harder to rely on financial statements and expose fraud among mainland companies.

In conclusion, when evaluating Chinese companies investors must practise extra diligence. They should consider both quantitative and qualitative factors to determine if their financial statements properly reflect economic and financial reality. Careful scrutinizing of financial statements and their footnotes, analysing income statements and balance sheets over time, as well as seeking out independent information about the company – these will all help. In order to help strengthen the corporate core of China, the international community has a responsibility to share its best practices.

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Author: Tan Chin Hwee is Co-Head of Asia-Pacific at Apollo Global Management. He is the author of Asian Financial Statement Analysis: Detecting Financial Irregularities.

Image: An investor smiles as she walks past an electronic board showing stock information at a brokerage house in Fuyang, Anhui province, China, July 17, 2015. REUTERS/Stringer