There was much excitement when the Shanghai-Hong Kong Stock Connect trading link finally launched on 17 November. It opened the Chinese mainland’s A- share-market to foreign investors without a special licence. There were hopes for significant flows of foreign investment into listed companies on the mainland and – perhaps more fancifully – related corporate governance improvements. However, since a lively start on the first day of the Stock Connect’s operation, little cash has been flowing towards Shanghai stocks.
There are a number of reasons why much of the daily Shanghai stock quotas have remained unused since then. Little notice of the launch date of the platform was given, questions about capital gains tax remained unanswered until the last minute and investors continue to be concerned about ownership mechanisms. Moreover, operational complexities relating to the short settlement cycle of trades exist. More fundamentally, investors may already have exposure, or it could simply be down to valuations and the fact that some of the most attractive Chinese stocks are listed in Shenzhen rather than Shanghai.
Could the corporate governance of Shanghai-listed companies, specifically state-owned enterprises which make up the majority of the market capitalisation of the mainland’s A-share market, have played a role?
Two recent studies, one by the Asian Corporate Governance Association (ACGA) and broker CLSA (September 2014) and another by Institutional Shareholder Services (ISS) (November 2014), suggest that for the Stock Connect to live up to its expectations corporate transparency and disclosures need to be improved in China and – more fundamentally – the way state-owned enterprises (SOE) are run needs to be reformed.
The ACGA study scored 11 Asian markets based on their corporate governance framework and practices. China, with a score of 45 out of a possible 100, was ranked ninth followed only by the Philippines and Indonesia. In spite of slight improvements, China’s score slipped in some categories relative to other markets, highlighting that it remains a market with weak corporate governance. In comparison, Hong Kong and Singapore ranked joint first in the study, scoring 65 and 64 respectively.
The ISS study, which included a survey of institutional investors, confirmed the results of the ACGA study and demonstrated the practical impact of China’s poor corporate governance. Indeed, one of its key findings is that concerns about corporate governance are the main reason for not investing in China. While corporate governance may have been widely interpreted in the study, according to the research, investors are clearly worried about the lack of transparency, related-party transactions (RPTs) and share issuances without pre-emption rights.
Need for reforms
What needs to happen? First and foremost, there needs to be a push for more corporate transparency and better disclosures as well as improved communications between companies and investors. This is particularly important with regard to RPTs and capital measures.
Secondly, the government has to push on with reforms of SOEs. The high-level announcements following the third plenum of the 18th National Congress of the Communist Party of China in November 2013 were encouraging. The overall ambition seems to be to reduce the role of the government in listed entities. The role of the State-owned Assets Supervision and Administration Commission is expected to change from one of a close supervisor of SOEs to more of a manager of capital. However, progress on the reforms appears slow. The sluggish start of the Stock Connect may send a powerful message to the government that more momentum is required.
It will take more than a trading link between Shanghai and Hong Kong to boost the attraction of the mainland’s A-share market and improve corporate governance practices. However, the new link presents a crucial part of the infrastructure required to facilitate change over time.