Illiberal Governance and the Rise of China’s Public Firms

Against the backdrop of current U.S.-China relations and the various pressures in favor of an “economic decoupling” from China, policymakers in the United States are trying to comprehend the various implications of China’s rising power while considering appropriate foreign policy and regulatory responses. As part of this process, the U.S. government is rethinking its approach to global financial integration.

The risks of investing in Chinese firms that participate in U.S. financial markets have attracted most of the attention in this space. Recently, however, U.S. portfolio investing in Chinese firms that trade outside the U.S. market, whether in China or through other global exchanges, entered the debate as well.

Somewhat ironically, most efforts taken so far seem to turn away from principles of free-market capitalism towards investment restrictions and isolationism. “Economic security as national security,” an approach that was advanced in recent years in the global trade and investments space, is now spilling over to global portfolio investing, pressuring institutional investors, index providers, and asset managers to shoulder geopolitical views in their overseas investment strategies.

In my paper, Illiberal Governance and the Rise of China’s Public Firms, forthcoming in the University of Pennsylvania Journal of International Law, I elaborate on China’s growing integration with global financial markets and examine the implications for U.S. portfolio investors in Chinese firms in the context of these recent policy debates.

Law & policy developments in the U.S. reflect, at the same time, both an oversimplified and an alarmist view of China’s corporate governance landscape. The enactment of the Holding Foreign Companies Accountable Act, which in effect directs the SEC to prohibit the securities of China-based U.S. issuers that are non-compliant with the Public Company Accounting Oversight Board’s audit inspection processes from being traded in the U.S. market (see HFCA Act for terms and conditions); as well as recent Executive Orders (#13959, #13974 and clarifications), which prohibit transactions in publicly-traded securities (in any jurisdiction) of firms identified by the Department of Defense as “Communist Chinese Military Companies” and their subsidiaries, rely on outdated notions of state ownership and control and their impact on investors’ sentiments.

As I discuss in my Testimony before the U.S.-China Economic and Security Review Commission as part of a “Hearing on U.S. Investments in China’s Capital Markets and Military-Industrial Complex,” the above steps taken to limit the effect of China’s growing global financial integration on U.S. market participants reflect an orthodox, overgeneralized view of state ownership, control, and political influence on the governance of Chinese firms. This view fails to capture the intricacies of China’s Party-state’s role in corporate governance and has led to misconceptions about the full impact of these attributes on investors, firms, and the markets in which they trade.

Understanding the full array of China’s corporate governance mechanisms and their potential implications requires us to break loose of prior conceptions of what mechanisms belong, or should belong, in the corporate governance landscape.

Similarly, understanding the source of investors’ confidence in Chinese firms and the Chinese market at large is crucial to any contemplated law or policy, whether aimed at increasing investor protection or at securing other national interests. My paper takes an important step in these directions by revealing the inner governance structures of Chinese listed firms and by challenging conventional assumptions about investors sentiments.

The demand for public finance is clear; Chinese firms need external finance to grow. Financial integration with global markets gives firms access to a broader base of capital, and the Chinese government is gradually accommodating such needs by relaxing prior access limitations.

Yet, the supply side is more puzzling. What attracts suppliers of finance to Chinese firms? What sustains the allure of Chinese firms to foreign investors given shared perceptions of the risks involved? Such allure is puzzling especially considering fundamental assumptions underlying development orthodoxies and prevailing corporate governance theories.

Indeed, the growing availability of external finance to Chinese firms challenges many fundamental assumptions underlying modern law and development theories and notions of corporate governance best practices. For example, scholars have long understood private ownership and liberal governance as engines for growth and global expansion. Yet many large Chinese firms with global presence feature forms of state control, and almost all globally prominent Chinese firms—whether they are private, or state-controlled—are potentially subject to the political clout of the Chinese Communist Party. The orthodox approach also holds robust legal institutions as a necessary precondition for external finance. Yet China’s capital markets continue to expand and attract new firms and investors without many of the qualities of a well-functioning legal system. Chinese public firms are thus able to raise capital in the absence of many of the attributes assumed necessary under widespread notions of corporate capitalism.

What can explain this puzzle?

Perhaps surprisingly, my paper finds answers to the puzzling allure of Chinese public firms in the functions of China’s il–liberal corporate governance system. Side by side with the embrace of conventional corporate governance mechanisms, a parallel and much stronger governance system operates in China. Through both the State and the Communist Party’s capacities, this system employs carrots and sticks that ensure market regularity and support the growth of Chinese public firms and China’s economy more generally. Alongside its many obstructions, therefore, China’s illiberal corporate governance system plays an important role in providing investors with the assurances necessary to secure the flow of external finance.

At the same time, however, this illiberal corporate governance system has blurred the lines between public and private firms and made the risks from investments—particularly non-financial risks—harder to isolate and resolve. Similarly, China’s illiberal corporate governance system also makes dissociations between ownership and control ever so potent and highlights the need to reconceptualize “corporate control” in the context of foreign companies more generally.

Given China’s rising global financial integration, efforts to rethink global investors’ interests, protections, and their potential (mis)alignment within broader national interests are worthy. Notwithstanding, such rethinking cannot be fulfilled without deeply engaging with China’s corporate governance landscape, understanding what attracts investors to Chinese firms and what keeps them invested in these firms despite the risks involved.

As I argued elsewhere, any remaining expectations that growing global integration would bring greater congruence with American corporate governance notions and best practices have been irrevocably shattered with China’s recent politicization of corporate governance. Yet now, in its disenchantment, the U.S. administration is deploying the same governance characteristics that antagonized U.S. policymakers against China all along—the politicization and advancement of national interests through the market at the expense of investors and free trade.

The impact of corporate governance no longer flows in one direction. The system of global finance is reactively being pushed further and further away from market liberalism.

The complete paper is available here, and the USCC Hearing on the subject including my testimony is available here.