As more and more major Chinese state-owned enterprises list in Hong Kong and on international exchanges, the governance of those companies has become an increasingly important issue. This trend has been reinforced by the fact that foreign strategic investors are now allowed—for the first time—to acquire a significant shareholding in state-owned enterprises listed on China’s renminbi-denominated A-share exchanges, in Shanghai and Shenzhen.

Too often, however, investors and independent international directors remain unsure how governance really works in China’s state-owned enterprises and how it is changing. Outside directors on boards may be frustrated or simply puzzled by the seemingly invisible forces that make important decisions about, for example, appointments of chief executives or major acquisitions. In China’s state-owned enterprises, the board of directors often seems to have no more than the ability to rubber stamp the big decisions.

Investors are rightly concerned about how key decisions are made in companies in which the majority shareholder is still the government and the Communist Party plays a powerful if shifting role. By better understanding that role in the governance of state-owned enterprises, foreign companies can learn to deal with them more effectively.

China has 70 million party members, and a typical state-owned enterprise...