This article on CORPORATE GOVERNANCE AND CORPORATE CRISIS IN CHINA is written by Chaminda Jayasundara,  pursuing M.A. in business law from NUJS, Kolkata.

Yes. There is a corporate crisis in China….

Introduction

If a company can make the right combination of wants versus needs, it creates an optimum strategy for pricing products for maximum profits. Usually, businesses have policies and procedures to handle expected and unexpected variables in their contextual arena such as low inventory, staff illnesses or introduction of new products etc. Thus, companies are usually in the mindset to pre-identify the triggers that would help them recognize when events start drifting outside of the realm of routine operations. An event outside of its such typical operation expectations begins to escalate and becomes a situation with crisis potential. When this happens to majority of the companies or businesses in the country, it is called “crisis”.

Economic reforms of china during the last decade have mainly fueled to the economic growth of the country. Also,  China has created and developed its policies in the same way of the western countries usually exercise and their corporate governance with the objective of improving public confidence locally and globally in their markets. Despite this progress, the general conception and the reality of corporate governance mechanisms in China is particularly fragile. According to a study carried out in 2003, the World Economic Forum has ranked China as 44th out of the 49 economies surveyed in terms of the quality of corporate governance (Du, 2014). It remains that the corporate governance in china is still weak and fragile compared to other similar economies.

Corporate governance is a concept, whose time seems definitely to have come in China. The concept of corporate governance covers the system regulating affairs among all parties with interests in any business organization, generally explicating shareholders as the most particularly important group (e.g, Liu, 1999; Yin, 1999). However, Chinese corporate governance explicates mainly on agency problems and within only two categories of organizations.

• State-owned enterprises (SOEs), particularly after their transformation into one of the corporate forms provided for under the Company Law

SOEs are nationally or locally owned companies. However, their activities are felt abroad through their involvement in trade, investment and cross-border competition. However, the reform challenges facing the owners of SOEs in China tend to be similar across countries at comparable levels of economic development.

• Listed companies, which must be companies limited by shares (CLS) under the Company Law.

Investment Companies Limited By Shares is one of the most important recent innovations in China invested enterprises law. From 1995, China has granted permission to use of the CLS and, for the first time, it more closely resembles major corporate organizations used by international foreign investors.

In the 1990s, China initiated its first steps to instill modern corporate governance with the introduction of Shanghai and Shenzhen Stock Exchanges and a new regulatory body called “China Securities Regulatory Commission” (CSRC) to regulate its new stock market (Pistor, and Chenggang, 2005).  However, the Chinese government controlled almost complete the economy of China until recently and most businesses were state-owned ventures. The emergence of a modern enterprise was regularised with its first Company Law, setting the rights and responsibilities of corporations (RAND, 2008). Even though they introduced these reforms, it was noted that the stock markets in China flowed during this period. But despite these reforms, state shareholders are still involved in favouritism and partiality over the investors in the country (RAND, 2008). After this period, China implemented some new policies to tackle the continuing power imbalance between state and individual shareholders. However, corporate governance reforms of the country are still more or less driven by endeavors of the regularly body, i.e. the regulatory body’s (China Securities Regulatory Commission (CSRC) to fight for numerous corporate scandals in its short history of stock markets and publicly listed companies.

When we closely look at the corporate governance models in different countries, we can see two types of corporate governance models:

1. the outsider-based model: this can be found in the US and the UK 
2. the insider-based models, which can be seen in Germany and Japan. 

There is an open debate in the industry and academia to ascertain as to which corporate governance model that China is following.  According to Farrar (2001), the Chinese model has been influenced by all models, which means German, Japanese, and US and UK models. It is merely a combination of all styles. It seems that the structure of China falls under a standalone category that may be termed “corporate governance with Chinese characteristics”. However, the current corporate governance model in China can also be categorized as an insider-based model in terms of ownership and control. The reason is that it has been a key feature being a dominant shareholder among the prevailing of businesses in the country.  The dominant shareholder being the state is holding non-tradable shares of which the dominant group is mostly banks. In terms of the characteristics in German model, China is required by law to set up a supervisory board, i.e. which is appointed by shareholders (Dahya et al., 2003). However, there is a rather strong discussion regarding the usability of this supervisory board in China as discussed by Dahya et al. (2003), the functionality of this board as a watchdog could not be implemented in the case of Chinese environment due to its social-political circumstances.  Before 1997, it is noticeable that china has used the Japanese model but this has been throw down due to the concept of market should play a major role as introduced by Premier Zhu Rongji (Brahm, 2003). However, the new view on Chinese corporate governance is characterized as an Anglo-American unitary board rather than the two-tier board as discussed by Tam and Tian (quoted in (Dahya et al., 2003)). The differences in the model lie in the way in which ownership and control are organized or for the contextual benchmark.  As China is still in its transition period of economic reform, the final corporate governance model will depend on how the non-tradable shares are dealt with. If China wants to vend its shares to the market finally, it will either transform to a dispersed ownership structure, as indicated in the outsider-based model, or dominant shareholders holding the majority of shares as indicated in the insider-based model. 

Crisis

The universal economic conditions have been experiencing the strongest recession from 2008, due to financial crisis emerged in the global arena. Many more economies including very large economies have fallen into recession and others have slowed shortly. World trading and financial flows are largely dwindling, while employment and product outputs losses mount. The borrowers in banks are engaged in protracted deleveraging activities and thus the Credit markets still remain frozen. Many banks fight to recover their lost financial health.

The Chinese economy growth rate grasped the peak in 2007 but it twitches to decelerate in the later 2007. Nevertheless, It has kept a healthier growth rate of more than 10%. However, the global crisis in the third quarter of 2008, Chinese economy was declining to 6.8%, and further decreased to 6.1% in the first quarter of 2009. However, the situation was much more better compared to the other economies as Chinese financial market is not completely open to international funds(Li, 2010). Thus, the effect was really small due to the notion that foreign capital is unable to flow into Chinese capital market freely. The banks were not in an urgency to buy subprime debts and foreign reserve mostly is in dollar-valued US government debts. Thus the effect of global crisis to the Chinese market was little and the banking sector was doing well in facing the crisis. However, the impact of crisis on Chinese export industry was extremely substantial. Since October 2008, Chinese export has started to decrease. Chinese exported $1.43 trillion goods and growth rate slowed by 8.6%, in the first season of 2009, china exported $245.5 billion goods, it slowed 19.7% compared with the same season of last year. At the same time, the import is $183.2 billion. It lowered 30.9% than last year (Li, 2010). Due to these effects, Chinese job market lost about 30 million jobs in the first quarter of 2009, as the crisis mainly affected on the export industry.

The strategy of China after the post-Global Financial Crisis was relaying on investment to achieve its economic growth. Thus, the Chinese firms and local government bodies borrowed money from banks and nonbanking organsiations to finance rapid investment growth. Due to this reason, corporate debt was significantly raisen with the outcome of precipitous increase of credit growth from the financial system ((Mali and Lam, 2015). The corporate indebtedness in China is vital to study as growing debts could posture many risks to financial stability and growth of the country. Therefore, the increase in corporate debt in the country is very significant and many people and entities have paid their close attention to this issue. According to S&P (2014), it says that China is one of the largest corporate debtors in the world surpassing the United States since 2013. It also pointed out that the financial position of Chinese corporate borrowers has deteriorated from the time of the global financial crisis, with lower cash flow but a higher leverage relative to other global peers.

The mainly economy of china is always depended on investments in fixed assets such as roads, railways etc. However, as share of exports the economy has collapsed and as household consumption has continued to slide, this investment has become one of the primary drivers of economic growth and employment in China in the past decade. Basically fixed asset investment in China comes from the biggest state-owned banks that they are answerable directly to the government not only focuses its significance as a policy matter but also clarifies why leaders in the country have exercised in a much  laissez-faire way to counterbalance flaws in other areas of the economy (Qin and Song, 2009).

Investments have been financed by debt in the arrangement of loans, bonds or any other formal and informal lending from state banks. Thus the unsettled bank loans in 2015 was 141 percent of GDP and the outstanding bonds was 63 percent of GDP. Thus, it symbolises that the local government debts is the biggest source of systemic financial risk to the country and it has now become a very serious issue. However, once almost all local government debt was borrowed and invested by pseudo corporations known as local government financing vehicles that had no assets or functional management structures whatsoever (Minnich,, 2016).

In 2013, the government started to concentrated effort to reduce inefficient local expenditure by asking pseudo-corporations to stop the provisions (Minnich,, 2016). It has been rolled out fiscal reforms made to reducing local governments’ dependence on debt to pay for the essential basic needs by using this reforms, it was allowed the local governments to switch their debt for commoner, long run municipal bonds. This new platform commenced in mid-2014 and it has somewhat relieved the horror of any upcoming local debt crisis. However, this is not the concrete solution to overcome the crisis issue. Thus, China is still rebalancing, but high credit growth is a big concern. Even though the domestic demand has become a new growth mechanism, it is deeply reliant on credit and the pace of credit growth has remained brisk.

Overall, it can be argued that corporate debt risks in China are generating a larger crisis if the authorities fail to tackle it correctly and promptly. It has been warned by International Monitory Fund too. According to them “Corporate debt remains a serious — and growing — problem [in China] that must be addressed immediately and with a commitment to serious reforms,”. This has been confirmed by the global financial watchdog claiming that China’s huge credit binge has increased the risk of a banking crisis in the world’s second biggest economy in the next three years.  The gap between credit and GDP was hit 30.1 in China in the first quarter of this year as per a report issued from the Bank for International Settlements (BIS).

Debt has played a key role supported by China’s economic growth after the global financial crisis. Outstanding government, corporate and household debt reached 255% of GDP in 2015, fuelled in large part by a surge in company borrowing, up from 220% just two years earlier (Chen, Funke, and Tsang, 2016).

The Chinese corporate sector is vulnerable to a significant slowdown especially in the field of real estate and construction sectors. Especially the business in real estate and construction sectors are facing substantial financial disturbances because of their debt at risk rising severely (Chen, Funke, and Tsang, 2016). On the other hand, the sectors closely related to real estate have also effected. For examples, the sectors like manufacturing and transportation etc.  Altogether, total debt at risk could rise to about a quarter of total debt of listed firms in the event of a 20 percent decline in real estate and construction profit. These private and state-owned real estates and construction businesses seem to have enjoyed lower borrowing costs than the other businesses in other areas, directing for the characteristics of businesses. Thus, the real estate and construction businesses bear a moderate increase of interest rate tremors despite their high leverage (Maliszewski and Zhang, 2015). These things are more sensitive if an interest rate shock were also applied to other liabilities besides loans and bonds. The other important thing that we can see h ere is that private businesses in the field of manufacturing sector are also open to interest rate increase because of their little profit margin while central state-owned enterprises are also experiencing the largest rise in debt at risk with an increase in interest rates.

It is apparent that China believes current growth model as sustainable as investment generates growth and profits. However, it is noticed that capital has been misallocated and the existing growth model is not sustainable. As a result of it seems that China will have to deal with the debt threaten issue. Risks from the rapid credit growth are growing. Basically, credit funded the large upsurge in investment in the corporate sector. At macro level, investment and credit efficiency has significantly dropped. At micro level, financial performance of corporates has declined progressively as per the corporate data.  This is prepared to be the deteriorating asset quality of banks. According to international comparisons, it seems that credit expansion in China has been incredibly rapid. Cross-country experience has put forwarded that the risk of disruptive adjustment has increased and either a banking crisis or sharply slower growth or both may happen. However, the Chinese authorities have diagnosed the issue but they are still struggling to find out better strategy. However, it seems that a strong and comprehensive strategy is needed to liaise with disproportionate corporate debt. They will have to get best practices from developed and other transition countries to deal with this problem. It seems that China must first act fast before the problem becomes more serious. Secondly, both creditors and debtors need to be tacked together. Just cleaning up the banks by moving bad loans off bank balance sheet and recapitalizing the banks, or allowing companies to go bankrupt without recapitalizing banks would not revitalize economic activity. Finally, the problem should be addressed to prevent the re-emergence of a spiteful credit cycle.

Future Prospects and Recommendations

China has taken policies on fiscal and monetary expansionary to face for the crisis of international concern commenced in 2008 and started investing in big infrastructure, reducing taxes for individuals and small businesses, cutting the interest rate in banks. China achieved a growth 9.1% of GDP by 2009, which is a demonstration of effective policies against global recession. The global crisis forced China to reform its economic structure to put emphasis more on local consumption rather than exports, which significantly reduced the dependence on the Chinese economy on foreign money and secure economic. Mainly, China’s economic growth can be classified to two stages.  First, China will be fast as possible due to the people of modernized living standards. Second, China will be a manufacturing centre of modern products.

To overcome the obstacles to better corporate governance, the experts recommended a number of policy options (Wang, Jin, and Yang, 2016). However, due to the corporate crisis happened recently, it can be recompensed some policy options for the good corporate governance in China. These include formal and better definition of the work of supervisory boards allowing investors to sue management easily, and strengthening the punishment system for insider trading

It is particularly noted that there are many reasons to expect China to tighten credit and restructure of Chinese corporations in 2017. Many businesses are dire of fiscal channels and they are much dependent on housing and construction areas even though the legal and institutional infrastructure in their country is still in its embryonic stage. Also, there some other factors which may affect the Chinese economy and economic reforms much more difficult. One example is US elected president Donald Trump informed his voters that he will impose sweeping tariffs on imports of Chinese goods. He further promised that he is to enact a 45 percent tax on all Chinese products. If he implements his promises as stated in the election campaigns, China will have difficulties with their export market in US, for example, a tax on Chinese steel exports to the United States, which account for roughly one-tenth of China’s total steel and steel products exports. Also, the China’s enduring struggle to overhaul and consolidate inefficient businesses in heavy industries such as coal and steel is also a crimp. However, the premier of the country stated that the country will move away from its current model of using the investment to fuel growth, and that assurance depends in part on economic stability in the rest of the world.  Though the biggest challenges in the china come from within different outside developments, they are whether Washington’s policy on china or any unexpected crisis in Europe may bring those internal problems to a head.

References

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