In a late summer surprise, “China” emerged as the scariest word in capitalism.

As investors now know too well, a surprise devaluation in the yuan brought into high focus long-standing questions over the quality of the country’s financial data, as well as the ability of Beijing to manage tensions between Communist Party control and freer markets. The result was a vertiginous plunge in share prices.

Add worries over systemic corruption, excessive debt, social unrest, and an aggressive foreign policy, and the Chinese market’s crash seems—at least in hindsight—not only understandable, but inevitable. Global consequences are profound because of the country’s importance as an economic powerhouse. But one contributor to its tumble has so far largely escaped media scrutiny: the state of corporate governance in China. Recovery, as it affects both China and world markets, may hinge in part on that.

So how does Chinese corporate governance stack up? On a superficial level, the country deserves high marks. The peek public watchdog, the China Securities Regulatory Commission (CSRC), has long monitored international corporate governance trends. As far back as 2001, and later in 2004 and 2012, the CSRC installed standards that then compared favorably with many other jurisdictions.

Independent directors, for instance, must usually comprise at least one-quarter of the board of directors of a listed company. Even at state-controlled listed firms, one-third of the directors must be independent. An independent outsider must chair the audit committee. Strict risk management controls must be in place. Outside directors must direct approvals of related-party transactions. The Ministry of Finance tried to press further improvements, convincing a World Bank inquiry in 2009 that it was aligning national accounting standards with IFRS and policing audit quality in line with international standards on auditing.

Still, a 2006 World Economic Forum survey, looking not just at standards but at implementation, ranked China near bottom, 44 out of 49 larger markets, in corporate governance. And indeed, sometime around then, progress began to stall—possibly when it became clear that effective application of new rules threatened entrenched interests of the state, the party, or controlling families. Regulators at the CSRC most identified with reforms lost clout in corporate governance oversight. By the time the Millstein Center, then at Yale School of Management, held its April 2010 “Capital Markets and Corporate Governance” conference in Shanghai, concerns had mounted that parties were largely paying lip service to the issue.

In fact, one takeaway from the Yale event was that if governance was working at all, it was largely as a mechanism to align state-controlled enterprises more firmly with their major shareholder: Beijing. In particular, SASAC, the government’s main “owner,” had learned professional tactics on how to pull levers of corporate governance to exercise its political will, regardless of the interests of minority investors. State-controlled corporations account for about two-thirds of all listed companies in China.

Another conference takeaway: guanxi, or the invisible networks of tycoons, Communist Party, and social connections, can prove far mightier than neat governance architecture.

Our bottom line: So long as China puts political stability above all else, corporate governance will pose high risk in that market. The irony, of course, is that many of China’s actions are designed to produce stability.

Signs increasingly exposed the gap between rules on paper and the way they worked in practice. One large U.S. institutional investor, for instance, contacted us a few years ago about a problem it had encountered. It had chosen to vote against management on one resolution at a midcap Chinese company. As per usual practice, the fund had instructed its Hong Kong-based custodian to file paperwork with the mainland firm. Within 48 hours the custodian had forwarded a response from the midcap. Thank you for the vote, the company wrote, but it had decided not accept any ballots cast against management.

Other warnings of resistance to accountability were more public, and more colorful. “China is to stock fraud as Silicon Valley is to technology,” short-seller Carson Block told a college audience last year. His firm Muddy Waters Research is among an intrepid group of investors patrolling Chinese-listed companies for any allegedly running on deception. His most infamous target was Sino Forest, which went bankrupt following Block’s public assault. Since then short-sellers have accused a long string of Chinese firms, many listed on Western exchanges, of fraud.

Even online retailer Alibaba, whose $25 billion initial public offering was the largest ever, has been brushed by its association with Chinese practices. CEO Jack Ma approved IPO arrangements that protect him against investor influence and create complexity while reducing accountability. As Block noted, “If Alibaba wanted to defraud investors, it absolutely could.”

If the quality of financial reporting by companies is suspect, and governance rules are often window dressing, who can market players count on to build business credibility in China?

What about government? That’s doubtful. Remember China’s commitment to audit quality? In 2012, Chinese regulators refused to allow the Securities and Exchange Commission and the Public Company Accounting Oversight Board to inspect the working papers of the Chinese auditors of companies listed on United States stock exchanges. That resulted in an SEC enforcement action against the affiliates of the big four U.S. accounting firms, who were caught in the crossfire between Chinese and American regulators.

Even today, after a much-ballyhooed settlement, the CSRC still can deny U.S. regulators access to working papers of auditors of U.S. firms for a variety of reasons, including “applicable privileges under Chinese law.” We understand China is a sovereign country and its government deserves respect. Given the role of the state in China, however, those privileges are broad. In China, politics still trumps markets.

And forget conventional media doing the job. Controlled by the Communist Party, they put a virtual cone of silence around the August crash. But social media is an emerging, less-constrained source. Sina Weibo, the Facebook-like microblogging site, has been a platform for whistleblowers and corporate critics. For instance, it hosted grassroots stories about Foxconn’s controversial labor practices that eventually triggered investigations and reform. Investor David Webb pioneered a related approach in Hong Kong through www.webb-site.com. As use of such tools expands, corporate secrecy will almost certainly erode.

Finally, what about investor scrutiny and pressure? Access to domestic Chinese shares remains limited, so it is perhaps understandable that foreign institutions (other than short-sellers) have been relatively quiet. By contrast, an international group of funds led by F&C, LGIM, and Standard Life have kept a close eye on Japan’s corporate governance developments, and served as a sounding board for change there.

Investors have yet to establish a similar group focused on China. They should, and urgently. Meanwhile, they keep a weather eye through the Hong Kong-based Asian Corporate Governance Association (www.acga-asia.org), the 16-year-old multi-stakeholder group. You can bet that the Association’s November 3-4 annual conference in Kuala Lumpur will be dominated by a focus on the role of corporate governance in the China crisis.

Our bottom line: So long as China puts political stability above all else, corporate governance will pose high risk in that market. The irony, of course, is that many of China’s actions are designed to produce stability. But though tactics such as limiting short-selling, temporarily banning initial public offerings, hindering the ability of U.S. regulators to investigate fraud, and refusing to allow votes against management may extinguish the immediate fire occupying Beijing’s attention, they build up fuel for the next crisis. As long as that is the case, “China” is likely to remain a scary word for years to come.

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