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In the past two years, Chinese equities have become a must have asset in any emerging market portfolio. However, investors believe Chinese markets have been held back by a weak corporate governance framework. Progress is being made, albeit slowly. Western as well as home grown investors are leading the charge in the hope of reaping the benefits of the country's economic success story.

A new report by the Institutional Shareholder Service, the US based provider of proxy voting and corporate governance services, shows that the development of Chinese capital markets have lagged behind the country's explosive growth. "In macro economic terms, we have seen the market value of all listed companies in China fall by half over the four years ending June 2005 even though the economy grew by 9%. The question is where has this growth gone and at whose expense? One possible explanation is that the bulk was captured by the majority shareholders at the expense of the others," says Jean-Nicolas Caprasse, Belgium based managing director of ISS Europe.

The 2006 ISS Global Institutional Investor Study, which collected responses from 320 institutional
investors in 18 countries, conducted
a separate study on Chinese investor attitudes.

About half of those questioned cited corporate governance risks as the greatest threat to their investments. Share ownership structures topped their concerns followed by the lack of independent directors, transparency and disclosure. There were also calls for more regulation and enforcement to stop abuses and protect the rights of minority shareholders.

One of the main hurdles has been that central and local and quasi-governmental bodies such as state owned enterprises have had a firm grip on public companies through ownership of non-tradeable shares. They represent around 64% of outstanding common stock which has meant slim pickings for institutional and retail investors.

According to the ISS report, minority shareholders have only two avenues of recourse - independent boards
and government regulations - both of which were deemed to be ineffective. Chinese investors complained about the lack of independence of the directors and their close ties with the companies they were meant to be overseeing.

Moreover, the dearth of stringent rules and regulations meant that insider trading and market abuses were left unpunished. This can be attributed to the fact that the regulators and insider traders are all working on the same team for the same government.

As Caprasse points out, "There is a predominance of majority shareholders which creates huge gaps and inequalities with the minority shareholders. They also have access to internal information and can influence management, which leaves the other investors in the dark."

In order to unearth information, Chinese investors often go straight to the main source - the companies themselves - although this too can create its own set of problems. The information stays behind closed doors and can lead to a stock market driven by speculation rather than the economic fundamentals of the underlying companies.

The tide, though, is definitely
turning and corporate governance has become an increasingly important issue on the Chinese government's agenda. The country has already embarked on the road to reform, the most important one being The China Securities Regulatory Commission (CSRC), the country's capital markets regulator's, new rule - Measures for the Administration of Share Capital Segregation Reform of Listed Companies. This is seen as the most significant step in China's stock market history since the creation of the Shanghai and Shenzhen markets in 1990.

The aim is to convert the non-tradeable shares - estimated at roughly 2.2 trillion yuan - into tradeable shares. So far, the plan is rated as a success with more than 70% of the 1,400 companies listed on mainland stock markets agreeing to implement plans for the conversion. This is, however, not the CSRC's first attempt. It tried in 1999 and again in 2001, but had to pull out due to panic selling. Other reforms include measures to strengthen disclosure rules, increase the authority of independent directors as well as introduce equity based pay which will help align a manager's incentives with investor interests. Until now, managers received a fixed salary plus a cash bonus.

Although the road to corporate governance is expected to be bumpy, Caprasse is optimistic that things will improve. After all a shareholder culture and corporate governance structure did not happen overnight in continental Europe. "The results of our survey reminded me of the situation in some continental European countries such as France and Italy after the wave of privatisation of state companies in the late 1980s and early 1990s. It took 10 to 15 years for them to develop their own corporate governance systems but I think it will take less time in China due to regulatory and investor pressures being placed on the government," he adds.

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