By Gordon Orr and Richard Huang
September 27 2006

Governance of Chinese state-owned enterprises (SOEs) has become a much talked about issue, with more and more big SOEs listing in Hong Kong and on international exchanges and foreign strategic investors now allowed to acquire a significant shareholding in SOEs listed on the A-share exchanges in Shanghai and Shenzhen.

Many investors and international independent directors, however, are often unclear on how governance really works in China's SOEs. Outside directors may feel frustrated or simply puzzled as important decisions such as a chief executive appointment, or a big acquisition, seem to be made by an "invisible" force. Decisions are sent to the board for what seems like rubber-stamp approval.

Investors are rightly concerned about how key decisions are made in a company where the majority shareholder is still the government. But by better understanding the Communist party's role, foreign companies should be able to deal with SOEs more effectively.

The Communist Party Committee (CPC) of the group company that owns the listed company plays a critical role in making key decisions on top executive nominations, executive evaluation and compensation, asset acquisitions and disposals, and annual budget-setting. The CPC may even sometimes get involved in operational decisions, such as whether to hire a particular supplier.

The party recognizes that boosting the market value of SOEs is good for the economy, and therefore in the best interests of the party. It also recognizes that conflict between the board and the CPC has a negative impact on the valuation of an SOE because of the "governance discount" that foreign investors apply.

However, while most government and party officials, scholars and company executives all agree with broad best practice principles, few are putting much effort into designing the details necessary for implementation of good governance, because of the apparent sensitivities and complexities involved.

Since it is clear that China's SOEs are not going to reach world-class standards of corporate governance overnight, foreign strategic investors hoping to exercise influence by designating board members will need to take a more measured approach.

By knowing where the CPC draws the line, they can know where to focus their efforts. For instance, on top personnel appointments, at least for the foreseeable future, outside directors can express their views, but eventually the CPC will make the final decision.

However, on issues concerning company strategy or big deals, strategic investors' views are deemed important. So a foreign investor should ensure that its directors join the strategy committee, and participate in meetings by having meaningful and challenging debates.

Gordon Orr is a director in McKinsey & Company's Shanghai Office, and Richard Huang is an associate principal in McKinsey's Beijing office.

This article was originally published in the Financial Times.