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Prevailing Winds

Divest and Delist? The Case Against Exiting China

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

The U.S.-China relationship continues to deteriorate, and China’s actions provoke criticism and outrage across many quarters in the U.S. As a result, many investors are struggling to justify investing in China. Simultaneously, at the highest levels of the U.S. government, there are now efforts underway to limit the ability of Americans to invest in China.

U.S. investors that allocate a portion of their hard-earned savings to Chinese companies do so first and foremost to benefit their portfolios. The China Investment Dilemma – Part I: China’s Financial Rise outlines the investment case for not ignoring China’s massive capital markets and the multitude of companies contained within those markets.

For many investors, however, pure investment return is not the only consideration. While not necessarily adhering to formal environment, society, and governance (ESG) guidelines, investors would like to know that the companies they invest in contribute value to society. For the emerging markets, there is a belief that the engagement between foreign investors and companies can lead to beneficial outcomes for all sides. Pressure from foreign investors can help push companies to improve their governance and operations. These investors might reasonably expect to be rewarded by higher market valuations as these companies improve. The companies, in turn, can contribute to the growth and progress of the countries where they reside, raising living standards and creating a more modern economy.

In an environment where everything linked to China is under a cloud of suspicion, it’s no wonder then that many investors are tempted to reduce exposure or avoid the country altogether, irrespective of the investment opportunities available. However, there are two arguments these investors should consider before exiting their investments in China. First, engagement with foreign investors over the past few decades has been a positive force in improving the transparency, accountability, and social responsibility of Chinese companies. Second, divestment from Chinese companies by foreign investors will likely only accelerate the negative trends in China that many critics condemn.

A Positive Legacy of Engagement

In their modern form, companies in China are a relatively recent occurrence. Until well into the Reform and Opening period, Chinese state-owned enterprises (SOEs) operated as quasi-departments of government bureaucracies. SOEs provided housing and social services to their workers, had budgets directly assigned by the government, and followed government policy dictates as their guiding principle. China’s early private companies were freer from direct government control but were by no means model corporate citizens. Similar to other emerging markets, many of China’s early private companies paid little attention to employee rights, environmental impact, and the protection of minority investors.

With both types, state-owned and private, the engagement with foreign investors has been helpful. Driven by the poor performance of many SOEs, the government pushed these enterprises to adopt a modern corporate structure and list their shares on the stock market. Many of these companies listed on the Hong Kong Exchange and began converging towards international standards of financial reporting and investor protections. The interaction with foreign investors has also pushed SOEs to operate along more market-driven lines, such as adopting formal budgeting processes, setting goals based on market conditions and opportunities, reporting on results, and implementing more meritocratic hiring.

As a result of these changes, SOEs have slowly and fitfully begun to function more like normal companies. Publicly-listed SOEs now have boards of directors with independent members, audit and compensation committees, regular public financial reporting, disclosure of related party transactions and many other hallmarks of modern corporate governance. This is not to ignore the persistent government interference in many SOEs or the setbacks to market reforms during the Xi Jinping era. Nonetheless, it’s undeniable that efforts to transform SOEs, often done with the help of foreign investors, have made the entities more market-driven and transparent. The SOEs of today would be all but unrecognizable to an observer at the start of China’s reform era – even the differences between the early 2000s and today are vast.

The interaction with foreign investors has also been helpful for China’s private companies. Driven by the business acumen of Chinese entrepreneurs, the country has produced many large privately-controlled conglomerates. The weak legal environments in which these companies were established have historically favored ambition and connections over strong corporate governance and social responsibility.

Eventually, these private companies grew to a stage where they desired to tap capital markets to fuel their growth. To do so, they faced the daunting task of meeting market listing requirements: audited financials, reporting on related party transactions, and independent members of the board of directors. These protections for minority investors are far from perfect, but they do provide a basis for helping to level the playing field between the controlling party of a company and outside investors. To access global capital markets, such as those in New York and Hong Kong, China’s private companies have been forced to raise their standards even higher than what was required at home in order to meet regulatory requirements.

Critics will no doubt point to the many ways that China’s SOEs continue to adhere to Beijing’s dictates and the notable corporate governance failures by some of China’s private companies (most recently Luckin Coffee). A related argument is that foreign investors have done all they can to help reform Chinese companies and the shift of money and power eastward means that the demands of foreign investors no longer hold much sway. Yet despite the current pessimism, reforms continue to bring about change: since 2015, the World Bank has noted a marked improvement in protections for minority investors in China,1 the dividend payout ratio for the CSI 300 Index has increased,2 and the China Securities Regulatory Commission (CSRC) has mandated that all domestically listed companies provide ESG disclosures.

The Unintended Consequences of Exit

However, an exodus from Chinese companies by foreign investors will simply remove obstacles to negative trends these critics abhor. If Chinese companies are forced off foreign stock exchanges, the pressure to adhere to international standards for accounting and corporate governance will be severely diminished. If foreign investors, by choice or government fiat, exit China’s domestic exchanges, their ability to advocate for transparency and accountability in Chinese companies will be similarly reduced. Without foreign investors, it is unlikely that there will be many voices within Chinese companies pushing back against overbearing government interference – such as the role of Communist party committees – or advocating for human rights and environmental protection. Individual investors do not bear the burden of responsibility for these efforts, but they should at least be aware that calls to divest from China will be counterproductive.

The argument to stay invested in China despite the current difficulties is based on the belief that it is worth continuing to engage with the country even though the results have not been perfect. A myopic view of the setbacks of the past few years ignores the undeniable changes that Chinese companies have undergone since the start of reform. Along that path, foreign investors have been an important force for pushing Chinese companies to become more professional, market-based, and socially responsible. China may no longer need foreign capital to the same extent it once did, but allure of an international listing remains a powerful attraction for many Chinese companies. The rules and requirements of these listings provide ample opportunities for influence by foreign investors. If this influence can guide companies towards improved governance and efficiency, investors may benefit from the market’s tendency to award well-run companies higher valuations.

While domestically listed Chinese companies are not subject to international standards, the CSRC and the Shanghai and Shenzhen stock exchanges have made significant efforts to modernize the rules for Chinese public companies over the past decade – often in response to pressure from foreign investors. Examples of these reforms include new rules to limit arbitrary stock suspensions, revising existing guidelines to promote share buybacks, standardizing disclosure requirements, and requiring audit committees for all listed companies. Additionally, changes to China’s foreign investment laws now allow majority foreign ownership of banks, securities companies, and asset managers, and for foreign credit ratings agencies to operate directly in the onshore market. Were foreign investors to leave the onshore market in mass, efforts to improve the governance of Chinese companies would undoubtedly be set back.

None of this should rule out investors avoiding or divesting from Chinese companies that egregiously flout international norms, participate in human rights violations, or put the party’s interests ahead of investors. At the individual company level, the ability of investors to vote with their dollars is a powerful tool. Moreover, Chinese companies listed abroad need to conform to rules and requirements of the local market. However, banning investment in China and forcing Chinese companies off foreign exchanges is tantamount to abandoning one of the most important tools for promoting market-based, transparent, and socially responsible Chinese companies. Foreign investors continue to have a role to play in pushing reform and positive change in China.

Nicholas Borst,
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
As of March 31, 2020, the Seafarer Funds did not own shares in the entities referenced in this commentary.
  1. Doing Business Report – Protecting Minority Investors,” World Bank, May 2019.
  2. Bloomberg. Data as of May 2020.