7. How can governments help investors manage ESG risks in China?
Key Point Summary
For firms and individuals seeking investments that are in line with Environmental, Social, and Governance (ESG) criteria, investing in China presents significant governance risks. As demonstrated by Beijing’s crackdown on tech firms, the Chinese government is asserting greater control over private companies and blurring the lines between party, state and private enterprise.
The increased presence of Chinese Communist Party cells within company structures also raises serious questions over the ability of Chinese firms to meet the basic levels of transparency and governance standards needed for ESG investors.
Investors that are dependent on China’s markets also face major risks in the event of Beijing taking military action against Taiwan, with the Chinese government likely to place capital controls on assets held by foreign investors and take reciprocal measures to counter Western sanctions.
Governments should encourage investors to manage their China risks by requiring companies to publish country specific risk registers and by stress testing the resilience of financial systems to conflict in Taiwan. Governments must act to protect the taxpayer from any financial fallout from firms which have become over-dependent on Chinese investments.
China’s changing investment environment
Xi Jinping has spent much of his decade in power dismantling what few checks and balances existed within China’s system of governance. Financial markets reeled at the fall-out of a Party Congress that saw Xi Jinping given an unprecedented “third term” and the demoting of so-called reformers. Political rivals and businessmen who step out of line – like Alibaba’s Jack Ma – find themselves the victims of ‘anti-corruption’ purges. Even the likes of BlackRock and Vanguard, the arch-cheerleaders of burgeoning investment in China, now openly concede that there are increasing risks to investing in a country tightly controlled by the personal ideology of one man by ditching new investment funds in China.
Consequently, as China’s economy opens up after three years of restrictive zero-COVID policies, the Chinese government is embarking swiftly on a charm offensive to attract international investors. This has included speeding up the regulatory approval of foreign investment funds to set up in China and an overhaul of the IPO registration system. These measures have had some success. In January 2023 alone, Standard Chartered, JP Morgan, and Schroders were all given the greenlight by the China Securities Regulatory Commission to expand their operations in the country, while investors bought a net 64 billion yuan ($9.5 billion) of Chinese stocks via the Hong Kong-mainland trading link in the first nine trading days of the new year.
Governance risks
For investors who increasingly espouse support for investments that are in line with Environmental, Social, and Governance (ESG) criteria, China should be seen soberly as a risk.
The ‘G’ within ESG refers to the governance standards which guide how companies make decisions. For a responsible investor, it is important to know how decisions in a company are made, and who they are made by. Companies with high standards of corporate governance have rigorous decision making processes, clearly demarcated relationships between shareholders, executives and other stakeholders, and transparent flows of information between key groups.
When it comes to China’s economy, the increasingly blurred lines between state, party and private enterprise make it difficult for Chinese companies to attain these high standards of corporate governance.
China’s crackdown on tech firms
As the crackdown on technology companies within China has demonstrated, few Chinese companies can boast that they are in practice independent from the Chinese state.
In response to the Chinese government’s fears that the sector had grown too powerful, recent years have seen a wave of new regulations seeking to reign back China’s tech firms. These have included restrictions on publishing rules, advertisements, IPOs and the ability of Chinese companies to list overseas. Tech giants Alibana, Meituan and Tencent have paid hundreds of millions of dollars in fines for “abusing their market position”.
The fate of Jack Ma, once the poster boy of a new wave of successful Chinese tech entrepreneurs, is a case in point. Following comments Ma made criticising government regulators in November 2020, authorities halted the IPO of Ma’s Ant Group, forcing its break up and causing Ma to disappear from the public view and flee into exile.
It would be a mistake for investors to consider the pausing of this regulatory crackdown as a return to the previous status quo. Instead, it reflects the success of a campaign designed to bring technology companies firmly under the state’s control. The public destruction of Jack Ma is a warning to other Chinese executives that dissension or a challenge to the party line will not be tolerated.
Increasing Party control
Private enterprises in China are not only subject to the interventions of the Chinese state, they are also increasingly under the influence of its ruling Chinese Communist Party (CCP). Under changes to China’s Company Law introduced by Xi Jinping in 2016, and recently enforced upon foreign companies operating in the country, CCP cells have growing prominence in private sector companies. These cells are consulted regularly by shareholders and have influence over senior recruitment decisions. Rather than the perception of captive companies who are forced into the employ of the CCP apparatus, many of these companies are headed up by executives who are prominent party members helping to draft party policy.
The recent purchasing by the party-state of “special management shares” in Alibaba and Tencent is another layer of control, giving regulators further power over the content these companies put out and placing appointed officials at the heart of business strategy and investment decisions.
National security regime
Chinese firms operate within a legal and regulatory environment increasingly geared towards protecting against what the Chinese government perceives as national security threats. Strict national intelligence laws require private firms to work hand in glove with the state and forbid them from openly disclosing the extent of this collaboration. Such control was on full display in December 2022, when Chinese technology companies TikTok and Tencent were required to help Chinese officials use social media data to identify anti-lockdown protestors, who were later arrested and detained.
New regulations on Variable Interest Entities (VIEs) could present a further avenue for the Chinese government to crack down on private companies on national security grounds. Chinese companies operating overseas often use VIE structures to raise funds abroad while bypassing Chinese regulations on foreign ownership. Investors in VIEs do not hold any direct equities in the Chinese operating company but instead in a non-Chinese holding company. Under the new regulations, regulators will have powers to order Chinese companies with VIE structures to delist if their listing is deemed to harm national security or its controlling shareholder has committed financial crimes against China.
As covered elsewhere in this paper, China’s national security legislation is vaguely defined and broadly interpreted, and is often used as a pretext for a crackdown. These new regulations could put significant levels of investments at risk, including the 240 Chinese VIE companies listed on the US stock exchange, which together had a total market cap of over $2 trillion in 2021.
Geopolitical risks
These governance risks feed into wider geopolitical risks. Xi Jinping has reiterated his commitment to ‘reunifying’ Taiwan with the mainland, and has refused to rule out the use of force. Russia’s war in Ukraine should serve as an example of the likely economic turmoil that would follow if China invades Taiwan. Following Russia’s invasion, large asset managers like BlackRock posted significant losses and major banks and large multinational corporations were forced to leave the country. Putin responded with a ban on investors from “unfriendly countries” selling their shares in certain strategic enterprises.
As of June 2022, foreign investors held over a trillion dollars in Chinese bonds and equities. In the event of conflict in the Taiwan Strait, the Chinese government could mirror Russia’s response to the war in Ukraine by moving quickly to impose capital controls and restricting the movement of Western investors seeking to shed their investments to avoid likely sanctions from the US and other actors.
Conclusion
Investing in China faces extreme challenges from an ESG perspective. Currently the ESG sector is self-regulated without proper regulation or standards. Too often it has geared towards focusing purely on the “E” at the expense of the “S” and the “G”. In China’s case, this has allowed foreign actors to invest heavily in firms compromised by the CCP’s hidden role in governance structures, not to mention the financing of modern slavery abuses in the Uyghur Region addressed elsewhere in this paper.
While private equity investors with a high tolerance for risk should be able to invest freely in Chinese companies if they choose, the onus is on governments to ensure investors fully understand the complex risks of investing in China, while protecting their citizens from the adverse impacts of financial systems being over leveraged on their China investments. No one in good conscience and with good sense can claim the economic warnings and investment risks in China are a mystery.
Recommendations
Governments and banks should work together to stress test their China risks: Central banks should include conflict in Taiwan as a hypothetical scenario in annual stress testing exercises, such as the Federal Reserve Board stress test of US banks and the Bank of England’s Annual Cyclical Scenario for stress testing UK banks. Funds that are overleveraged should enact a plan to reduce their exposure, while governments should regularly share clear guidance on geopolitical risks with financial firms.
Governments must reduce the taxpayer’s China risks: Governments must make it clear that financial firms that are over-exposed to China’s financial markets should not expect a taxpayer funded bailout should the situation deteriorate. The US Dodd-Frank Wall Street Reform and Consumer Protection Act’s ban on federal government bailouts of swap entities could be further applied to investments in Chinese VIE companies.
Governments should cut investment guarantees to China: Investment guarantees provide incentives for firms to increase their investments in China at a time where risks in the country are increasing, while the government, and in turn the taxpayer, takes on a proportion of the risk. These measures are being actively reviewed by the German government, which currently holds 11.3bn euros worth of investment guarantees in China.
Asset managers should be required to publish public country specific risk registers: These measures will help clients better assess their China risks and should take into account corporate governance risks associated with Chinese firms. To reduce the burden on firms, this could be restricted to countries where at least 10% of their overall portfolio is invested.