Joint Seminar of the ICAC and Shanghai People's Procuratorate 13 June 2002

The Effect of China's Accession to WTO on Corporate Governance

By Andrew Sheng Chairman, Securities and Futures Commission Mr Alan Lai, Ladies and Gentlemen,

Thank you for inviting me to speak at this luncheon on this most timely topic.

The topic of Chinas accession into WTO has been discussed so thoroughly that I do not need to repeat what is involved. I wish to share with you my own thoughts on the implications of Chinas accession in the area of corporate governance and the role of securities markets in this transition. Even before accession to the WTO, institutional and other reforms in China have been evolving hard and fast.

Soon after accession, China announced new regulations to encourage foreign investors to take stakes in key State-owned enterprises 1 . Last week 2, the Peoples Bank of China issued new guidelines on corporate

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February 2002 4 June 2002

governance for banks. As part of its WTO obligations China will also allow foreign stakes in securities firms and fund management companies.

The main implication of Chinas accession to the WTO is that China is telling the world, that in joining the WTO, China will play by global rules and global standards. There are huge implications: -

(1)

Unprecedented foreign competition will force the pace of ongoing fundamental reforms in the Chinese economy, including the reform of ownership structures in Chinese enterprises.

(2)

By absorbing the market discipline provided by external competition, China's economy will become more efficient and competitive, raising the standard of living for both China and her trading partners.

Because the whole range of Chinese institutions - SOEs, minyin enterprises, regulatory authorities, judiciary and other social bodies must change as a result of external competition, an effective corporate governance framework lies at the heart of the reform process. The

Chairman of the UK Financial Services Authority, Sir Howard Davies, recently made a key observation on developing an effective corporate governance regime in a speech in Beijing. To do so, he said, one of the principles to remember is that People are more important than processes3. Allow me to elaborate.

Howard Davies, Chairman, Financial Services Authority Corporate Governance and the Development of Global Markets, China Securities Regulatory Commission, Beijing, 22 nd April 2002

Background

Given the profound changes in technology, globalization and innovation, we tend to forget that institutional reform is a competitive necessity. And the market is an institution. Therefore, changing market institutions, comprising enterprises, exchanges, and the regulatory structure, is crucial to the well functioning of markets and therefore our standard of living. In this competitive world, not to change is to be left behind.

But changing people is even more difficult than changing processes. As the old saying goes, it takes ten years to grow trees, but a century to change people.

In this long march to reforms to meet global standards, even before accession to the WTO, China had already initiated a slew of reforms for the health of its financial system. In the securities area, the CSRC has undertaken many bold and significant market-oriented reforms to develop corporate governance. One has only to surf the CSRC website to see the enormous amount of effort that have gone into improving governance practices 4.

Even the Mainland courts are beginning to allow investors to take civil action for compensation in relation to listed companies charged with providing false information. A Shanghai-listed company, after being fined about USD $70,000 by the CSRC on May 14, is presently being sued by 1,000 stockholders.
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The Future of China's Capital Markets and the Role of Corporate Governance, by Laura M. Cha Vice Chairman, China Securities Regulatory Commission, Luncheon Speech at China Business Summit, April 18, 2001

The Three Disciplines

Good corporate governance is like a three-legged stool of discipline. First of all, we rely on the management or controlling shareholders to exercise self-discipline. This works when the controlling shareholders or management are highly ethical and treat minority shareholders fairly. We have already witnessed the fact that in slightly more than a decade of listed companies, a number of Mainland enterprises listed in Hong Kong are already being regarded as world class in terms of business strategy and corporate governance 5.

But if the morality and ethics are lacking, and when the internal checks and balances, such as independent board committees, internal and external audits, and the transparency of disclosure do not function well, then you need outside forms of discipline.

This is where regulatory discipline comes in. The Mainland authorities have already strengthened this area considerably and commendably.

But self-discipline and regulatory discipline are not enough, without market discipline. Companies, when protected from competition, may develop cartels or monopolistic tendencies that do not treat consumers or investors fairly. These may deter foreign or minority investors from entering the market when they perceive that they are not treated equally.

Survey by Asset Benchmark Research, The Asset (January 2002), representing the views of estimated 750 CIOs, fund managers, buy side analysts in the leading 120 international institutions investing in Asian equities

Mainland management and shareholders may be familiar with domestic rules of the game, which are still evolving, but so far they have not been subject to international rules of the game. This is where accession to the WTO will have the most significant impact in bringing market discipline to the fore.

Market discipline comes from two inter-related forces, market competition and global standards -

(1)

To compete globally, the market demands professionalism and more effective management models. Previously protected

industries will have to meet challenges from international competition and have to meet global standards of quality, code of conduct and accounting and disclosure rules.

(2)

Greater transparency to global standards will force the enterprises and their management to greater accountability. In well-

functioning markets, the market's assessment of corporate performance is reflected in the prices of equities and bonds. Corporations that fail the test could find difficulty in raising new capital, and eventually be competed out of the market.

Good corporate governance requires all three disciplines to keep the checks and balances for healthy companies.

I want to analyze the WTO issues by dividing them into seven factors, what I call the six Is and one R of financial markets. Let me quickly elaborate on these.

The first I is information. Accurate, timely and accessible information is a market fundamental. To have good information, you need to have international accounting standards (IAS) and good auditing standards. Enron, which is currently the largest corporate failure in history, has demonstrated clearly that without good information and good checks and balances, large companies can fail even in the best of regulated markets. China has accepted the need for IAS, but building the infrastructure of accountants and quality accounting will take time. The second I is incentives. Currently, one of the greatest obstacles to rapid institutional change is that salaries of SOE staff are not yet commensurate with the risk-reward structure of markets. For markets to function well, the incentive structure must be evenly matched. If the risks and rewards are imbalanced, the markets will be distorted by greed without the fear of the risks of failure. As Hong Kong experience has shown, staff who is entrusted with huge powers or resources and who is grossly underpaid may be tempted by corruption or theft. Addressing the incentive structure in the Mainland is one of the most challenging of tasks in the reform process. The third I is the Investor. The investor will be the first to benefit from the opening up of China under WTO because he or she will have greater investment choice, in terms of products, services and service providers. But of course, ignorant and uneducated investors can easily be cheated or be persuaded to invest in risky or bad asset by poor quality intermediaries. Investor education is clearly very high priority for promoting investor protection.

As many of us are aware, shareholder activism in terms of legal suits against Mainland companies for false advertising and securities violation is beginning to happen 6. This must be good for the Mainland securities markets as it imposes greater market discipline on companies and protects minority interests. The fourth I is intermediaries. Mainland financial intermediaries will undergo a profound and qualitative change with WTO, as more and more foreigners are allowed to enter into the services sector. Qualitative

changes will arise from the emergence of a greater pool of investment bankers, fund managers, lawyers, accountants and other service providers. Investment bankers act on behalf of issuers, advising and underwriting IPOs and mergers and acquisitions. They are supported by accountants and legal advisers who play a key role in due diligence of information disclosure to professional standards. The higher the quality of

intermediaries, the more the financial regulators can rely on the market to exercise discipline on the market participants.

With the WTO, foreign fund managers will also be allowed to manage part of China's US$6 billion pool of social security funds7. As markets open up, institutional investors would be able to provide oversight and improve the corporate governance of companies8. The fifth I is issuer. The quality of a market is determined by the quality of the companies that raise capital from the public. At the end of the day, they have to provide an appropriate risk-adjusted rate of return to investors. The first and foremost persons responsible for the quality of a
Corporate Governance Development in The Greater China: A Taiwan Perspective, by Lawrence Liu, November 2-3, International Conference at Hong Kong University Law School. 7 PRNews Asia at http://prnewsasia.com/china 8 Ownership Structure, Corporate Governance, and Firms Performance, the Case of Chinese St ock Companies, Xiaonian Xu and Yang Wang (Amherst College and the World Bank) May 1997
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company are its management and controlling shareholders. They set the standards of ethics and performance that the company is judged by.

WTO will force the pace of change, as Mainland enterprises will be able to import both foreign shareholders as well as foreign managers in order to compete globally. As Chinese enterprises compete globally, they will be able to have global reach and also tap global capital. But to do so, they have to learn to play by global rules of conduct, including standards of transparency and corporate governance.

The sixth I is infrastructure. The financial infrastructure comprises the platform and processes to ensure that markets function in an orderly and robust manner. It must also have a legal framework and efficient and fair judiciary that protects property rights of market participants. Being a

latecomer, China has very high quality financial infrastructure, with a centralized and unified registration and clearing of securities nationwide with a clearing risk fund for operational and other risks.

The quality of the infrastructure determines the size of the operational risks. It can also determine the quality and efficiency of financial

services, since important checks and balances are normally built into a world-class trading, payment and settlement system. September 11 has shown so dramatically the importance of good back-up systems and contingency planning.

Last but not least, the quality of markets must depend on the quality of R, the regulatory framework. The Mainland has made considerable progress since the creation of the CSRC in 1994. But the markets are
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growing so fast, that putting the full range of codes, rules and regulations, as well as experienced regulators, into the field is no easy task.

It all depends on people, and trained and skilled people are scarce everywhere.

Conclusion What I was trying to say is that all three disciplines self-discipline, regulatory discipline and market discipline ultimately boil down to people. It is the conduct of all market participants, bound or unbound by the disciplines, that determine the quality of markets. In the end, it is the quality of people that determine the quality of markets, and markets are all about confidence and trust.

China is changing very fast, but I am confident, with such a wealth of people talent, and the three disciplines brought by the opening of WTO, the Mainland market will grow to its rightful place as one of the largest capital markets in the world in the 21st century.

Thank you.

Andrew Sheng 13 June 2002