The formation of the China Securities Regulatory Commission nearly ten years ago was a landmark in the process of capital market reform in China, laying the foundations for subsequent impressive growth of the financial markets by streamlining the regulatory structure. The further reforms implemented in the December 1999 Securities Law continued this work. The latest steps came just last month [ie August] with the announcement of changes to the law governing wholly-owned foreign enterprises and equity joint ventures.

All these steps have been beneficial in themselves, and are also highly welcome moves towards implementation of the World Trade Organization’s fundamental principles for integrated market economies. Still, it is clear that China’s accession to the WTO is going to require further evolution in the corporate governance framework and regulatory structure. However, before referring in more detail to the specific issue of corporate governance I would like to reiterate what I have said in the past – but with even greater emphasis – China’s accession to the WTO should take place forthwith.

Indeed it now seems that China will accede to the World Trade Organization before the end of the year. In just three days from now the WTO accession working party should agree a complete package including its own report, a protocol of accession and the schedules of concessions on goods and services. It is then expected that the Members will adopt the package at the Ministerial Meeting of Doha in early November. If China were able to sign the protocol during that same meeting, then it would become a Member 30 days later.

When it comes, it will be a momentous event – not just for China and the WTO but also for the future of multilateralism. The WTO has been, for too long, a global institution without potentially the largest global player. It needs China every bit as much as China needs the WTO. The cause of multilateralism needs a China fully integrated into the trading system and playing a role which befits its status as a global economic power.

It has been a long road, over 15 years. But these have not been wasted years. One could get the impression that they have simply been filled with endless squabbling over the details of membership terms in Geneva. Quite the contrary: the GATT and, since 1995, the WTO have provided a framework, a foundation and a target for the process of reform in China. It has taken a long time since China has had a long way to come. But it is an object lesson in the value of the multilateral trading system to countries emerging from different economic backgrounds seeking to integrate themselves on a secure and predictable basis in the global economy. It is very much the background to the use now being made by the Russian leadership in fashioning new laws, regulations and practices to complete a long and difficult transition to a market-based economy.

It is not an easy or painless path to tread. But China’s leadership has been wise enough to understand that it is the only path to tread. In many respects, this is still a developing country facing many difficulties and challenges in the adjustment process. These will continue. Other Members will want assurance that the provisions agreed through the 43 bilateral agreements and China’s general terms of accession in the protocol and working party report are being observed. It is not impossible that China will find itself frequently in dispute settlement cases in the WTO. All that will be a reflection of China’s economic importance. And it will not be alone. China is already one of the world’s biggest markets and one of the most competitive exporters. As with the United States and the European Union, that means it will always be a centre of attention in the WTO. It is unavoidable, but I have no doubt that China will rise to the challenges of membership.

Indeed, I believe China will be expected to accept a leadership role in the WTO. Given the nation’s economic power and potential, this is an unavoidable element of membership. I have every confidence that this will not mean a partisan leadership but a leadership which reinforces and promotes the ideals and principles which underlie the multilateral system. That is what is needed. Yes, there are always domestic interests to be fought for in Geneva. But there are also overriding ideals which make the WTO one of the best hopes for global governance in an increasingly integrated global economy. These must always be protected and reinforced. Membership of the WTO is more than just a bargain on market access. It entails a wider contract of rights and obligations: a contract to make multilaterism work in an interdependent world.

In fact, I already sense signs of an emerging leadership role by China in the WTO. I understand that China wants to see a new global trade round launched at Doha. That is a correct and far-sighted judgement in my view. The system now has to move forward if the WTO is to continue to be part of the answer to the challenges posed by globalisation. Despite the protesters, the institution never was the problem; it has always been a solution. Acceptance of China’s accession by Ministers at Doha will be a great victory, that is for sure. But the simultaneous launch of a new trade round would make it a sweeter and more meaningful victory still.

Membership holds out tremendous promise in addition to trade, in terms of economic growth and access to international capital markets. The chief benefits of access to a large and liquid capital market are that it reduces the cost of raising finance for investment and provides a means of channelling savings to the most economically efficient uses.

It is hard to overstate the beneficial effects an increasingly open multilateral system of trade and investment have had on the leading economies over the decades.

Already there has been a dramatic extension of China’s engagement in world trade and investment, with a recent boost gained from the prospect of WTO membership. By 1999 it had become the world’s 9th biggest exporter, just behind the G7 countries and the 10th biggest importer. With the economy expected to grow by about 7% a year for the foreseeable future, in contrast to the 3% or so likely for the G7 economies, China’s importance in the world trading system can only grow.

The global financial markets have grown even faster than world trade. The value of equities and international bonds and loans outstanding has expanded from the equivalent of 40% of world GDP in 1980 to more than 80% of GDP by the end of the 1990s. Annual net international financial transactions are now worth five times the value of world trade.

Within the world totals, private investment flows to emerging markets have expanded dramatically. The net flow of foreign private capital to emerging markets climbed from $44bn in 1990 to a peak of approaching $300bn in 1997. The financial crisis in 1997-98 took that total back down sharply in 1998 but the latest forecasts from the Institute of International Finance suggest the peak figure will be matched once again either this year or next.

The financial crisis in the late 1990s was a good lesson in the risks as well as the rewards of access to the international capital markets. We have a better sense, with hindsight, of how to be prepared for the possibility of financial turmoil in future.

There are some obvious conclusions to be drawn:

For example, there is a need for adequate foreign exchange reserves in the early stages of a crisis, especially when a country hopes to defend a fixed exchange rate or manage its decline. This is a lesson that China has certainly taken to heart;

domestic regulators need to monitor better cross-border financial flows and especially their maturity and currency composition. They should perhaps also ensure the availability of contingent lines of credit that can be drawn quickly in case of urgent need, and there may be a case for some controls on short-term capital inflows;

it is also important to ensure the domestic financial system is robust enough to handle large flows, in and out, of overseas investment. The crisis revealed many emerging market banking systems to be under-capitalized, poorly supervised and burdened with non-performing loans. Working out the non-performing debt burden is an urgent task. In the Chinese context this puts a high priority on addressing the debts of loss-making state-owned enterprises and on the privatization programme.

Another important lesson was that many emerging markets had actually been putting up obstacles to the most stable kind of inward investment, namely direct investment, because of a reluctance to allow majority foreign ownership and control of domestic enterprises. In fact, the easiest way in for overseas capital has been precisely the route of short-term bank lending, followed by portfolio investment in equities and bonds and financial derivatives.

In fact, direct investment has now proven its value in many ways. It is in general stable and long-term, much less likely than other categories of investment to be reversed. It increases competition, the life-blood of a healthy market economy. It transfers management expertise and technical know-how. And of course it creates substantial new assets and employment in the recipient country.

Compared to other developing economies, China has fared extremely well in attracting foreign investment, especially direct investment. It’s estimated that inward direct investment in this rapidly growing market will within a reasonable period be of the order of $100bn a year. The prospect of WTO membership has already encouraged a surge in direct investment commitments. The Institute of International Finance expects direct investment in China to reach $43bn this year, compared to $9bn for the rest of Asia.

There is also every reason to expect a rapid evolution in Chinese financial markets and increasing portfolio investment. In addition to China’s improving access to the global capital market, increasing prosperity is also creating a big pool of domestic savings available to fund investment. The level of domestic savings is up eightfold since 1990, reaching $724bn.

Some of these savings are funding more and more home-buying. The trend towards private home ownership, and the privatization of the public housing stock, has led investment banks like Goldman Sachs to identify the mortgage securities market as an untapped potential resource likely to grow in importance.

Mutual funds and asset management are also seen as highly promising growth areas in financial services. The spread of shareholding has a long way to go still. There’s no doubt that a number of prominent global fund managers are keen to enter the Chinese market through joint ventures as soon as they are able.

However, there are some barriers to further expansion, despite the dramatic growth of the Shanghai and Shenzhen stock exchanges from a market capitalization of $2bn a decade ago to more than $500bn.

One indication of the unrealized scope for growth is the fact that total stock market capitalization remains low relative to GDP at under 30%. For most OECD countries a figure closer to 50% of GDP is typical, and in the case of the biggest equity markets, like the US, UK, Switzerland, Sweden or the Netherlands, it is close to or even above 100%.

The small and illiquid bond market in China is one factor holding back the further development of the equity market. Another is the existence of the separate categories of A and B shares. While the domestic market for A shares has performed spectacularly well, the B shares have underperformed substantially in the past. The surge in the Shanghai B index this year following the decision to allow Chinese residents to purchase shares formerly reserved for foreigners is an indication of how big a distortion the existence of separate share categories has been. Such restrictions have prevented the equity market developing the depth and liquidity that can most effectively cut the cost of investment capital.

This is one specific example illustrating the point that continuing capital market and investment growth will depend on making Chinese companies more attractive to investors.

The foundations for many of the encouraging trends in the financial markets pre-date China’s WTO accession negotiations, but the decision to join has certainly extended the financial and corporate reform agenda. To list just the obvious measures, there will need to be improved financial reporting, moves to bring competition policy in line with international standards, a determination that the legal system that will enforce commercial contracts and that regulators ensure banks and companies carry out their fiduciary duties, and the opening up of service sector industries including financial services to foreign competition.

Simply implementing all these changes will be challenging enough. Once in place, there will be further ramifications. Equal market access will be challenging. It would be naive to imagine the process will be straightforward. For those affected, it is little consolation to know that their pain is the source of future economic gains, no matter how large these promise to be. So it’s as well to be clear about the benefits of reform.

What benefits will enterprises gain from the adoption of more demanding standards of corporate governance in particular?

Surveys of institutional investors, carried out by McKinsey’s, indicate they are willing to pay a big premium for shares in companies they deem to practice good governance. The premium is all the greater for well-performing companies in markets where the average standard of corporate governance is low. In Asia, for example, the survey reported a share price premium ranging from about 20% in Japan to 28% in Indonesia. By contrast, the low premium of under 20% reported for the US and UK reflected investors’ satisfaction with corporate governance standards in the Anglo-Saxon markets.

The implication is that moving early towards adopting the best international standards will bring a large reward in terms of share price and shareholder value.

So for individual enterprises that’s a clear enough advantage. The economy as a whole will benefit too. A recent survey by the World Bank of empirical research found consistent evidence that good corporate governance is linked to faster economic growth.

For example, there is clear evidence that administrative corruption reduces business investment. Similarly with company boards that are not independent from political influence or the distortion of business decisions in the interests of corporate elites rather than the wider interests of companies and their shareholders. A majority of truly independent Board members whose interest is solely shareholder interests is vitally important.

The World Bank concluded that strong corporate governance and ethics, along with reform of the audit process and appropriately strengthened financial regulation are going to prove crucial weapons for many countries in their national economic development strategies.

Globalization and corporate governance

There are, though, limits to what external standards can or should be imposed on individual countries. One aspect of the process of globalization has been the pressure for greater ‘corporate social responsibility’ being applied by non-governmental organisations, by international agencies, and increasingly by some investing institutions in response to concerns amongst their customers.

This is not an issue for corporations alone, as the question is how the rights of their owners, the shareholders, need to be weighed against the rights of other constituencies, such as employees, local residents, suppliers or society as a whole.

To judge from some of the campaigners’ rhetoric, corporations ought to be responsible for setting the whole world to rights, a burden any company would find a little heavy. Nevertheless, it is true that corporations are important economic and social institutions. Part of the fall-out from globalization is that public confidence in corporations’ exercise of their responsibilities has waned. The protestors resorting to violence at international summits are an extreme and ugly manifestation of a genuine underlying concern.

But to pose an apparent trade-off in terms of corporate governance between a narrow focus on shareholder rights and a broader set of social responsibilities is somewhat misleading. While any company will face lots of uncomfortable trade-offs from day to day, long-term shareholder value will depend on the consequences of corporate decisions for health and safety, or the environment, or society. If they have a genuine commitment to the long-term promotion of their owners’ interests, companies simply cannot be cavalier about any fall-out from any decision.

This is not to say there is nothing problematic about the idea of corporate social responsibility. As with any motherhood and apple pie ideal, its operational content is what matters. Or to put it another way, the devil is in the detail. It is possible in the current climate that this emphasis in the public debate on companies’ wider responsibilities simply risks the re-emergence of costly and burdensome regulation.

What’s more, the demand by some campaign groups based in the OECD countries for higher environmental standards or labour standards may be a vehicle for protectionism. If imposed on companies operating in developing economies, standards of this sort could easily reduce levels of investment and market access.

It is because of the de facto process of convergence in standards of corporate governance that the Organisation for Economic Co-operation and Development has been able to issue, in 1999, the first universal statement of ideal corporate governance standards. Globalization has therefore brought to prominence the question of how companies ought to be run and in whose interests, and how what ought to be compares with current practice.

Thus we have seen some unwinding of the cross-shareholdings and powerful minority shareholdings that have been common in the past in some countries. There has been large-scale privatization in both OECD and non-member countries. In many countries compliance structures have moved in the direction of the so-called ‘Anglo-Saxon’ model – with companies, for example, shrinking the size of their boards, tilting the composition in favour of non-executive directors, increasing the frequency of board meetings and making more use of board committees.

At the same time, there has been some convergence in the other direction on the part of the market-driven or Anglo-Saxon systems. In these countries there has been tremendous growth in private equity investment, typically more patient than shareholders in a publicly-quoted company. Private investors are often deeply involved with the companies concerned. Many of the fast-growing high-technology companies like many listed on America’s NASDAQ exchange have been quite closely held, with large minority stakes evidently acceptable to outside investors. There has also been a vigorous debate about the relevance and role of other ‘stakeholders’ apart from the shareholders.

The OECD’s statement of principles identifies five basic aspects of good corporate governance.

The protection of the rights of all shareholders

Equitable treatment of shareholders including foreign investors as well as minority investors

Recognition of the legal rights of other stakeholders and co-operation with stakeholders

Timely and accurate disclosure, and transparency with regard to corporate performance and governance

A clear framework for corporate governance to ensure the company has clear strategic guidelines and effective monitoring of its management.

These are broad enough to encompass a very wide range of institutional outcomes.

The extremes typically painted of the varying models of corporate governance are caricatures of the reality. It has never been as easy as myth would have it to win a hostile takeover bid in the US, nor as difficult as it’s supposed to be to modify corporate strategy in Continental Europe. Yet despite the fact that some convergence has taken place, it is definitely not the case that one size fits all.

Even amongst the members of the European Union, all prosperous market economies with more similarities than differences, there is far from complete consensus on questions of corporate governance.

In the United States about half of the outstanding corporate equity is held by individual investors, compared with 40% held by investment funds, although the share held by the latter is growing. In the United Kingdom, on the face of it a country with a capital market structure similar to America’s, pension funds and other institutions own 58% of the outstanding issues. In Germany and Japan it is banks and non-financial corporations that account for about half. In other countries, especially Australia, France and Sweden, foreign investors form a large category, holding a quarter to a third of the total.

Obviously these varied patterns have led, absolutely appropriately, to the development over time of distinctive governance structures. While in many countries recent years have brought a fresh emphasis on shareholder value as the over-riding corporate purpose, this should not be expected to lead to uniformity in governance structures.

There are several ways investors can in principle exercise control over the companies they own, and the mix will be a bit different in every case. In principle, the conventional mechanisms of accountability have been strong protection for minority shareholders; majorities of non-executive directors on corporate boards; the use of performance-related incentive structures for executives; and the requirement for a high level of disclosure of information by the board.

As far as many investors in the highly market-driven or Anglo-Saxon capital markets are concerned, these mechanisms have been too weak not only in most emerging markets but also in Continental Europe and Japan.

It would be hard to argue in principle with any measures to improve accountability, although they haven’t all worked equally well in practice. The academic research on the UK and US, where all of these mechanisms tend to be applied, suggests that strong non-executive directors prove the most consistently effective means of keeping the boards of enterprises accountable to investors.

Non-executives in particular need to focus on the promotion of shareholders’ interests and on ensuring there is an honest and constructive debate of corporate strategy internally.

There are typically far fewer independent non-executives on the boards of Continental European or Japanese companies, and indeed companies outside the OECD. This is perhaps the one Anglo-Saxon characteristic that hasn’t really started to catch on elsewhere, and yet could do much to improve corporate governance standards.

So the fact that the context in which enterprises operate differs everywhere and changes constantly means it is sometimes difficult to generalize about the specifics of good governance.

Nevertheless there are some universal underlying principles.

The boards of companies must be able to act independently in the best interests of the business and its shareholders, free from outside influence of any kind and unburdened by corruption. Independence needs to be guaranteed by effective channels of accountability from shareholders to their boards, although precisely what those channels are might well differ from case to case. It is a fair presumption, though, that they will include a minimum level of protection for minority shareholders and representation on the board by individuals who are not part of the company’s inner circle.

Secondly, transparency is essential. The honest disclosure of all relevant information means the specific details of the corporate structure matter less because investors can make an informed choice. Indeed, diversity of choice rather than uniformity is usually thought by economists to be highly desirable. Transparency is a basic principle of good corporate governance. It is always better for the company too: business disasters are all the worse when they come as a nasty surprise to investors.

Finally, and fundamentally, good corporate governance demands adherence to the highest ethical standards of the wider society in which the company operates. It is this which ensures that corporations act responsibly and meet the obligations that come with their importance as economic and social institutions. Globalization is making the ethical framework in which businesses operate much more complex, however. It is no longer at all clear where the relevant geographical boundaries of a corporation’s constituency lie, and therefore which standards apply. This is a question about which opinions are highly likely to differ. Businesses the world over are struggling with the challenges of globalization.

China’s full engagement in the market-based world trading system and capital markets through membership of the WTO holds out the promise of even greater strides in economic progress than the past 20 years have brought, impressive as these have already been. Achieving this economic promise will depend on building support for a challenging process of change that will inevitably be disruptive and uncomfortable at times.

That in the end is not just a technical matter of regulatory and governance structures, but a question also of political leadership and vision.

This is the text of a speech first delivered by Peter Sutherland at the China Securities Regulatory Commission Conference