Corporate Governance in China Current Practices, Economic Effects and Institutional Determinants

CESifo Economic Studies,Vol.52,2/2006,415–453,doi:10.1093/cesifo/ifl001

Advance Access publication24April2006 Corporate Governance in China:Current Practices,

Economic Effects and Institutional Determinants

Qiao Liu*

Abstract

This article provides a preliminary survey of the burgeoning literature on the Chinese listed firms’corporate governance.We structure the existing research around three themes: (1)What are the current corporate governance practices in China?(2)How do these corporate governance practices affect the Chinese listed firms’valuation and various corporate decisions?(3)How does China’s unique institutional setting pre-determine the governance model adopted in China?The evidence indicates that the current governance practice adopted in China can be best described as a control-based model,which contrasts strikingly with the market-oriented model commonly used in the US and UK,and championed by most corporate governance advocates.The evidence also shows that Chinese firms,whose corporate governance practices deviate from the control-based model,demonstrate stronger performance,and tend to make decisions in line with the shareholders’interest.The evidence from the literature also suggests that the control-based model is rooted in the‘administrative governance’approach adopted by the Chinese regulatory authorities,and is tailed to China’s specific institutional setting.(JEL classification:G3)

‘‘China’s stock market is worse than a casino.At least in a casino there are rules.’’

Wu Jinglian,a famous Chinese economist,2001

1Introduction

Corporate governance has received much attention in China in recent years.At the core of such attention is the debate on how China can *Qiao Liu is affiliated to School of Economics and Finance,University of Hong Kong, Pokfulam,Hong Kong,e-mail:qliu@hku.hk

I am grateful to two anonymous referees for many useful comments.An earlier version of

the article was prepared for the CESifo Economic Studies Conference on Understanding the Chinese Economy.I would like to thank Prof.Gerhard Illing for his invitation and suggestion of the topic.I greatly appreciate useful comments from Efraim Sadka,Markus Taube,John Whalley,and conference participants at the CESifo.This article offers a preliminary review of the literature on Chinese corporate governance.I am indebted to numerous researchers,who have been diligently working on the Chinese corporate governance issues,for creating the bulk of materials that appear in this article.This research was also substantially supported by a grant from the University Grants Committee of the Hong Kong Special Administrative Region,China(Project No.AOE/ H-05/99).All errors,of course,remain my own responsibility.

?The Author2006.Published by Oxford University Press

on behalf of Ifo Institute for Economic Research,Munich.All rights reserved.

For permissions,please email:journals.permissions@bbb44672f242336c1eb95e98415

Q.Liu

develop an effective corporate governance system to improve its listed companies’performance and protect the minority shareholders. The Chinese stock market was officially born in late1990.In fewer than15years,it has grown to become the eighth largest in the world.Judged by the number of listed firms,market capitalization, liquidity and fund-raising capability,the Chinese stock market has out-performed the markets in most transition economies(Pistor and Xu2005).

Although the stock market in China is still young and the publicly listed firms only account for a small fraction of all firms in China,1this young market has already generated many stake-holders.According to the statistics released by the China Securities Regulatory Commission (CSRC),more than70million investment accounts have been opened across China;roughly200–300million Chinese people,directly or indirectly,invest in the stock market.A large amount of bank lending has also been shifted into the stock market by interest groups through various channels(most of them are gray or illegal),even though the precise number is difficult to ascertain.An inefficient,resource-draining stock market is a drag on the Chinese economy and may hamper its ability to maintain the7–8percent growth required to keep unemployment in check.Corporate governance thus emerges as a prominent issue in such a context.It is even more urgent now given that a series of corporate scandals have seriously undermined investors’confidence, and the Shanghai and Shenzhen benchmark indexes have both dropped to record lows over the last8years of trading.

Improving the level of the Chinese firms’corporate governance practice is an on-going battle that calls for the participation of many parties, including regulators,market participants and academics.A small but burgeoning literature has been devoted to studying the corporate governance issues in China.Due to data availability,most studies so far have been focused on the listed firms.These studies are inevitably subject to several caveats.First,there is a paucity of empirical evidence on the corporate governance practice of non-listed firms,and it is unclear whether the implications derived from the listed firms can be generalized and applied to the non-listed sector.Second,most of the listed firms are converted from state-owned enterprises(SOEs),and the government still retains majority control of these listed firms through non-tradable shares.Hence,the research on the governance of listed firms really reflects 1For example,the listed firms account for fewer than5percent of total large-and medium-sized firms in China,and a relatively small fraction of total GDP in China(see,e.g.Allen, Qian and Qian2005b;and Liu and Xiao2004).

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the governance for this particular type of firms.2Despite these caveats, we believe the listed firms’corporate governance practice has its roots in the same institutional background as the non-listed firms.Especially, listing SOEs has been,and is still,the most important part of China’s privatization process.The studies based on listed firms therefore still shed light on what kind of best practice corporate China should follow.

The corporate governance research about the Chinese firms so far can be divided into two streams.The first line of research concerns how to identify a set of quantifiable indicators to measure the Chinese firms’corporate governance practices,and how these quantifiable variables affect the listed companies’operation and stock market performance, and the effectiveness of various corporate decisions.The second strand attempts to understand how institutions specific to China shape the Chinese firms’corporate governance system,and how such a system can be improved.

In this article,we provide a preliminary survey of the corporate governance literature on the Chinese listed firms.3We call this survey a preliminary one mainly because the literature on Chinese corporate governance is burgeoning and the papers we survey,likely only capture the tip of the iceberg.Also,while great progress has been made to better understand the corporate governance issues in China,many questions remain unaddressed,and our overall understanding remains limited.We structure this survey around three key questions:(1)What are the dominant corporate governance practices currently adopted by the Chinese listed firms?(2)How do Chinese listed firms’corporate governance practices affect their performance,and the effectiveness of various corporate decisions?(3)What institutional determinants shape Chinese firms’governance practices?And how could these institutional factors be changed to promote better governance practices?

To understand the Chinese firms’corporate governance,one has to bear in mind that China is going through a transition from a planned economy to a market-oriented economy;and that China started its reforms in an environment where most important elements characterizing a sound institutional infrastructure(e.g.well-structured legal system,rigorous law enforcement,well-functioning financial markets,and so on)are missing. These two institutional constraints scope out the various corporate

2We are grateful to a referee for this point.

3See Shleifer and Vishny(1997)for a comprehensive overview of general corporate governance issues.Claessens and Fan(2002)provided an excellent survey of the corporate governance literature on Asia.Although they covered China,papers about China were scant when that survey was prepared.

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governance practices the Chinese firms follow.They also determine the regulatory framework adopted in China.

The main findings of this article can be structured around several themes.First of all,it is found that the corporate governance model adopted in China can be best described as a control-based model, in which the controlling shareholders–in most cases,the state–employ all feasible governance mechanisms to tightly control the listed firms. We find that concentrated ownership structure,management-friendly boards,inadequate financial disclosure and inactive take-over markets have been the standard governance practice commonly observed among the Chinese listed firms.

Second,the control-based governance model,while promoting the fastgrowth of China’s stock market,has demonstrated many built-in weaknesses,which make it less effective in disciplining management/ controlling shareholders,and fostering firms’long-term performance. Most importantly,such a model provides the controlling shareholders with plenty of leeway to engage in self-dealing and expropriate minority shareholders,and eventually undermine the public’s confidence in the stock market.We find evidence that firms whose governance practices deviate from the control-based model,and closely follow the market-oriented governance model,4tend to have better accounting and stock market performance,they also tend to make more efficient corporate decisions that are in the interest of the minority shareholders.The existing research has provided evidence suggesting that the control-based governance model is at most sub-optimal,and is endangering the healthy development of China’s stock market.

We find that the sub-optimal governance model adopted in China is rooted in China’s unique institutional setting.Simply because the initial intention of developing the Chinese stock market is to experiment and find an alternative venue for SOEs to gain additional financing,while at the same time improve their operating efficiency,and the overall legal environment in China is inefficient,the stock market regulations in China have been evolved to address the trade-off between growth and control.The so-called‘administrative governance’approach(Pistor and Xu2005),while fostering the fast growth of the Chinese stock market, seriously thwarts the emergence of a more effective governance model. 4The market-oriented governance model refers to a governance model in which the market-based mechanisms are used to resolve the agency problems,for example,the governance models adopted by most US and UK firms.The market-based mechanisms include dispersed ownership,active take-over market,independent board,high level of information disclosure,institutional-investors,dominant shareholder base,etc.

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Under administrative governance,almost every part of the economy, including the stock market,is heavily regulated.As a consequence, it is difficult to separate business from politics.The quality of public governance thus is of first-order importance in shaping the overall quality of corporate governance(Chen,Fan and Wong2004).Politicians or politician-connected businessmen can easily hijack any governance systems and seek rents for themselves(Clarke2003).As a matter of fact,almost every corporate governance practice in China can trace its origin to a certain deficiency in public governance and is,directly or indirectly,related to politicians’or politician-related businessmen’s rent-seeking incentives.5

Nevertheless,the research on Chinese corporate governance is just emerging.Many important issues remain unaddressed.For example,we still do not know how the control-based governance model will evolve under the current institutional environment.The causality and dynamics between current governance practices and various institutional constraints have yet to be mapped out.We need to further understand what portfolio of governance mechanisms can be better adapted to China’s increasingly challenging institutional setting,and generate the largest benign impact. We also need to understand how China’s governance practices can grow out of the existing institutional constraints.Although the market-oriented governance model has emerged as the consensus(Bai et al.2004),we do not fully understand how Chinese firms can migrate to that model. Specifically,we do not have implementable execution strategies that can help the Chinese firms to overcome various institutional obstacles,and leapfrog their governance practice bbb44672f242336c1eb95e98stly,it is still not clear how various historical legacies could be resolved before China can move towards a market-oriented model.All of those remaining issues pose great challenges to the policy makers and the academia,and call for extensive future research.

The rest of the article is organized as follows.Section2reviews current corporate governance practices in China.We offer a set of quantifiable indicators to measure these practices.We also discuss China’s corporate governance performance in the context of a cross-country comparison.We point out that the governance model practiced by the Chinese listed firms can be best described as a control-based model.Section3discusses in detail the various economic consequences of this control-based model. We discuss its valuation implications and how it affects firms’corporate 5For the literature on rent-seeking behavior in the Chinese economy(Bai et al.2000;

Clarke2003;Chen,Fang and Wong2004).

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decision making.Section4is devoted to understanding how various institutional factors amalgamate to determine the control-based model adopted in China.In particular,we discuss the dynamics between public governance and corporate governance.Section5concludes the article by listing the pending challenges and suggesting the ways forward.

2Corporate governance practices in China

‘‘If I were the only one who lost money,I would blame my poor IQ or wrong decisions;But now everyone has lost money,so it’s a problem with the market.’’

—a Chinese investor

2.1Why is corporate governance such a prominent issue?

While China has experienced very high economic growth over the past two decades(see Table1for the indicators of the Chinese economy),it started to reform its financial system in an attempt to build up an efficient stock market.In1990and1991,China’s two stock exchanges–the Shanghai and Shenzhen Stock Exchanges were Table1The Chinese Economy summary indicators

19992000200120022003 Real GDP growth rate(%)7.18.07.59.19.0 Consumer prices change(%)à1.40.40.7à0.8 1.2

In percent of GDP

Total capital formation37.436.338.540.344.4 Gross national saving39.038.240.043.147.6 External current account 1.6 1.9 1.5 2.8 3.2

Change in percent:end of period

Banking system’s net assets15.010.816.515.319.7

of which:domestic credit15.921.2 6.517.219.6 Broad money14.717.014.416.819.6

2.3 2.3 2.3 2.0 2.0 interest rate

(1year deposits,year end)

Nominal GDP(2003):US$1410billion

Population(2003):1.292billion

GDP per capita(2003):US$1091

Data source:various issues of the Statistical Yearbooks compiled by the National Bureau of Statistics of the People’s Republic of China.

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opened with great fanfare.In slightly over14years,China’s stock market has grown to become one of the largest in Asia(second only to the Japanese market)with market capitalization close to US$500billion. About1400firms have gone initial public offering(IPO)and raised almost 800billion Renminbi(RMB)(around US$100biliion)(see Table2for annual issuance data and an overview of China’s stock market).Corporate China,especially the SOEs has benefited greatly from rapid equity issuance growth and public enthusiasm for the equity market due to a lack of other attractive investment vehicles.China now boasts of1400listed companies,more than130securities firms,over100000practitioners,and over70million investor accounts.(Data source:the CSRC website.) While the growth of China’s stock market has been impressive by any standard,the listed firms’poor corporate governance is becoming a bottleneck of its further development.Chinese investors are quickly losing confidence in the stock market,partly due to their concerns with the listed firms’poor corporate governance practices,and partly due to their concerns with many uncertain policy initiatives which were intended to solve the problem but complicate the matter instead.6During the period from2000to2004,while China’s GDP grew by53percent,the Shanghai and Shenzhen benchmark indexes fell by more than one-third each.

A recent on-line survey of25675Chinese investors conducted by the internet portal firm,bbb44672f242336c1eb95e98,showed that94.28percent of investors claimed that they had lost money in the stock market,67.34percent of whom claimed to have lost more than half of their initial investment (source:bbb44672f242336c1eb95e98,30March,2005).Even more strikingly,after 4years’bear market,the market capitalization of tradable shares in China has dropped from close to RMB1.8trillion yuan to less than RMB0.9 trillion yuan(up to early December of2005).7Nearly1trillion yuan worth of wealth disappeared in just4years.If we only consider the value of tradeable shares,China’s two stock markets are currently valued even lower than Denmark’s stock market.

6In the early2000s,the Chinese government introduced a series of policy initiatives to boost investors’confidence level but met little success.The recent measures include slashing the stamp tax by half,and waiving capital gain tax.More recently(May–June, 2005),the CSRC short-listed scores of firms to experiment with different ways of floating all shares.But the overall market reaction has been lukewarm,even skeptical–the Shanghai benchmark index barely lingers around1000–1100points(it was at one point around2250points in mid-2001).

7Due to special institutional arrangements imposed by the Chinese government,which we will detail later,only about one-third of shares are tradable in China.See Table1for details.

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Table2Summary of China’s Stock Market,1992–2002

Total raised capital through IPOs

(A-and B-shares, RMB bn)Total raised capital

through oversea

issuance(RMB,bn)

Tradable/

total shares

Market Cap.

(RMB bn)

Market cap.

as%of GDP

Tradable

market cap.

(RMB bn)

Tradable

market cap.

as%of GDP

19929.4–0.31104.8 3.986.2 3.2 199323.3 6.10.28353.310.296.9 2.8

19948.818.90.33369.17.996.5 2.1

1995 5.6 3.20.36347.4 5.993.8 1.6 199627.28.40.35984.214.5286.7 4.2 199773.636.00.351752.923.4520.47.0 199846.9 3.80.341950.624.5574.57.2 199957.7 4.70.352647.131.8821.49.9 2000102.156.20.364809.153.81608.818.0 200175.27.00.364352.245.41446.315.1 200268.118.20.353832.937.01248.512.0

The table provides the summary information of China’s stock market over the period1992–2002.The data source is the China Securities Regulatory Commission(CSRC).Q. Liu

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Clearly,the deviations of the stock market performance from the strong performance in the real sectors suggest that something is fundamentally wrong with the Chinese stock market.Not surprisingly,poor corporate governance has been singled out as the usual primary suspect.In order to sustain China’s economic development and improve the SOEs’efficiency, China will continue to privatize its state sector and explore alternative fund-raising venues.Developing a well-functioning stock market is an important part of China’s overall reform strategy.More important,the stock market in China,after almost15years’development,has generated a variety of stake-holders(e.g.listed firms,local governments,financial intermediaries,regulatory authorities,and especially,the investors who own the70million individual accounts).A failing stock market is simply a price the Chinese government is not willing to pay,and cannot, afford.Improving the level of the listed firms’corporate governance thus emerges as the most important and most urgent issue in recouping the Chinese stock market.

To improve the level of corporate governance,one has to first of all understand how it is practiced in the real world.In this section,we discuss in detail the dominant corporate governance practices currently adopted by the Chinese listed firms.In the meantime,we offer a set of quantifiable variables,which characterize the governance model in China. We also discuss how the Chinese governance model can be compared with those adopted in other countries.

2.2Firm-level corporate governance practice

The seminal work by Berle and Means(1932)suggests that,in practice, managers of a firm pursue their own interests rather than the interests of shareholders.In recent years,another set of conflicts of interest has arisen as controlling shareholders take actions to benefit themselves at the expense of minority bbb44672f242336c1eb95e98 Porta,Lopez de Silanes,Shleifer and Vishny(LLSV hereafter)(1998)even assert that the central agency problem in large corporations is to restrict expropriation of minority shareholders by controlling shareholders.8

In this context,our profession’s understanding of corporate governance has been broadened.Taking different sets of conflicts of interest due to the 8This expropriation takes a variety of forms,e.g.excessive executive compensation,loan guarantees for,and transfer pricing between,related companies,and dilution by new share issues.Johnson,La Porta et al.(2000)use the term tunneling to describe the transfer of resources out of firms for the benefit of controlling shareholders.Evidence from the Asian financial crisis indicates that tunneling is a serious agency problem in emerging markets.

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separation of ownership and management into consideration,Denis and McConnell(2003)define corporate governance as a set of mechanisms,both institutional and market based,that induce the self-interested controllers of a company(including both managers and controlling shareholders)to make decisions that maximize the value of the company to its owners.Practitioners share the same view.For example, Teachers Insurance and Annuity Association-College Retirement Equities Fund(TIAA-CREF)defines corporate governance as a set of mechanisms that maintains an appropriate balance between the rights of shareholders and the needs of the board and management to direct and manage the corporation’s affairs.

Becht et al.(2003)provide a relatively more general conceptual framework.They define corporate governance as a set of mechanisms that are necessary for two reasons:‘‘first,to overcome the collective action problem resulting from the dispersion among shareholders,and second,to ensure that the interests of all relevant constituencies besides shareholders face the same basic collective action problem’’(p.17, Becht et al.2003).9

Corporate governance mechanisms employed

by the Chinese listed firms

In essence,good corporate governance comprises a set of mechanisms to ensure that suppliers of finance get an adequate return on their investment.China is no exception.To better describe the current corporate governance practices in China,we focus on a particular set of corporate governance mechanisms,and try to quantify each of them in the Chinese context.10

Broadly speaking,there are two types of mechanisms that resolve the conflicts among different corporate claim-holders,especially,the conflicts between owners and managers,and those between controlling share-holders and minority shareholders.The first type consists of various internal mechanisms,e.g.the ownership structure,executive compensa-tion,the board of directors and financial disclosure.The second are 9Becht et al.(2003)define five ways to mitigate shareholders’collective action problems:

(1)election of a board of directors representing shareholders’interests;(2)a takeover or

proxy fight can be launched when necessary;(3)active and continuous monitoring by a large block-holder;(4)alignment of managerial interests with investors through executive compensation contracts;and(5)clearly defined fiduciary duties for CEOs and the threat of class-action suits that either block corporate decisions that go against investors’interests,or seek compensation for past actions that have harmed their interests(p.18,Becht et al.2003).

10Our description of the corporate governance mechanisms employed in China is based on

a framework proposed in Bai et al.2004.

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external mechanisms,including,e.g.the effective takeover market,legal infrastructure and product market competition.

Among the aforementioned four internal governance mechanisms, ownership structure is crucial to the firm’s value maximization. Concentrated equity ownership gives the largest a shareholders a substantial discretionary power to use the firm’s resources for personal gain at the expense of other shareholders.11To capture the ownership aspect of corporate governance,we compute the stake of the largest shareholder,and use it to measure both the largest shareholder’s interest in a company and also the largest shareholder’s power on the board. The board of directors is a second mechanism through which shareholders can exert influence on the behavior of managers to ensure that the company is run in their interests(Hemailin and Weisbach2003). With respect to the board of directors,we create a dummy variable that equals1if the CEO is the chairman of the board of directors and 0otherwise.The monitoring role of the board of directors is compromised when a CEO controls the board fully or partially.Therefore,we expect this variable to have a negative impact on a firm’s overall corporate governance level.To measure the degree of outside control of the board, we take the ratio of outside directors,who are not members of the management team,to inside directors.If the board is dominated by members of the management team,we do not expect it to play an effective monitoring role.

Providing the executives with incentive-related pay is another powerful mechanism to govern their behavior(Jensen and Murphy1990;Murphy 1999).The interest of the top managers can be better aligned with that of the shareholders if they have a larger stake in the firm.Regarding executive compensation,we note that stock options are rare in China. Furthermore,the information on executive pay is not complete and often inaccessible.Hence,we choose the following alternative variable to capture the alignment of interests between the managers and the shareholders.We first define the top executives of the firm to be its CEO, the executive vice presidents,the chairperson and the vice chairpersons of the board of directors.We take the percentage of shares held by these top executives as a measure of their economic interest in a company.

11Claessens,Djankov and Lang(2000)find that cross-holding and pyramidal ownership are common in Asian economies.This ownership arrangement allows the controlling shareholders to obtain even more control for minimal capital expense,so that tunneling becomes easier.Although in general,cross-holding,pyramidal schemes and deviations from one-share-one-vote are not common in China,Fan,Wong,and Zhang(2005)find that Chinese listed companies’ownership is becoming more and more complicated.

Multi-layer corporate structure is emerging in the Chinese stock market.

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Finally,financial transparency and adequate information disclosure are crucial in developing countries.Sufficient,accurate and timely information regarding the firm’s operations,its financial status and the external environment is important for shareholders to be able to monitor the firm,to make investment decisions affecting the firm,and to exercise control over the firm through other means.12Regarding financial transparency,most listed companies in China are audited by local accounting firms but no reliable information exists to determine which accounting firms are more reputable.However,companies that issue H shares,which are traded on the Hong Kong Stock Exchange or B shares,which are open mainly to foreign investors in domestic stock exchanges,must adopt international accounting standards.We take a dummy variable that equals1if a company has H shares traded in the Hong Kong Stock Exchange or B shares traded in Shanghai or Shenzhen stock exchange and0otherwise.

Now we turn to the external mechanisms.An active market for corporate control is considered to be essential for the efficient allocation of resources.This market allows able managers to gain control of sufficient shares in a short period of time to remove inefficient managers. Proxy fights are not usually successful in deposing the existing management or board of directors because share holdings are often dispersed among small shareholders.Friendly mergers and takeovers occur in all countries and account for most of the transactions in the market for corporate control.In developed countries,the percentage of these activities ranges from60to90percent.Hostile takeovers occur fairly frequently in the US and the UK,but much less so in Germany, France and Japan.Empirical studies suggest that takeovers significantly increase the market value of target firms,although the gain for bidding firms is zero and possibly even negative.Studies using accounting data find that changes and improvements in operations can partially explain takeover premiums(Shleifer and Vishny1997).

However,an active corporate control market does not exist in China. We thus measure the market for corporate control by the concentration of shares in the hands of the second to the tenth-largest shareholders. We take the natural logarithm of the sum of squares of the percentage points of shareholding by the second to the tenth-largest shareholders. This variable should have a positive impact on a firm’s overall corporate governance level for three reasons.First,large shareholders other than the largest one are obstacles to tunneling activities by the largest shareholder 12Bushman and Smith(2001)survey the relationship between financial accounting information and corporate governance.

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because these shareholders have incentives to monitor and restrain the largest shareholder.Second,the efficiency of the market for corporate control is enhanced because these large shareholders can either initiate a fight for corporate control or assist an outsider’s fight for control when the existing management underperforms.Third,these large shareholders have an incentive to monitor the management directly.

Regarding overall legal environment,another important external mechanism,companies that have issued H shares or B shares are subject to stricter legal rules.Hence,the dummy variable we define early can be viewed as a proxy for a better legal environment.

Lastly,we consider one final variable to indicate whether or not the controlling shareholder is the government.We define a dummy variable that equals1if the government is the controlling shareholder and0 otherwise.The government is likely to have goals other than profit maximization,such as maintaining employment and social stability.

A controlling government stakeholder can use the listed company as a vehicle to achieve these other policy goals even though they may conflict with shareholders’interests(Bai et al.2000).

Wang and Xu(2005)suggest that the floating ratio–the proportion of shares that are tradable–capture a firm’s corporate governance level.Based on the data from the CSRC,tradable shares on average accounted for33percent of total shares in2000.The floating ratio has increased slightly since then,but is still below40percent.The size of the floating ratio,while mainly determined by ownership structure,reflects the aggregate impact of various corporate governance mechanisms.However,it is not by itself a corporate governance mechanism.Therefore,we do not include it as a measure.

Are the Chinese listed firms performing well?

We argue that the eight corporate governance variables discussed in section‘‘Corporate governance mechanisms employed by the Chinese listed firms’’,which can be computed based on publicly available information,are able to capture different aspects of the Chinese listed firms’corporate governance practices.We now examine how Chinese firms perform on each of them.Given the data availability,we focus on the1999–2001period,and report the results in Table3.

As shown in Table3,the largest shareholder in China on average holds

44.8percent of shares,indicating a concentrated ownership structure.

A large majority(78.9percent)of the publicly listed firms in China have a parent company.A listed firm within a company group complicates the listed company’s operation and also reduces its transparency.

More than one-third of the CEOs are also the chairmen of the board of directors,which hinders the board from playing an effective CESifo Economic Studies,52,2/2006427

monitoring role.The proportion of outsider directors on the board is surprisingly high,with a mean of 70.6percent and a standard deviation of 18.3%.The evidence suggests that the Chinese listed firms score high on the ‘board of directors’front.

However,the research by Chen,Fan and Wong (2004)argues that although the proportion of outsider directors on the board is high,the level of board independence and professionalism is not necessarily good.They find that in China,politicians and state controlling owners occupy most board seats.They report that almost 50percent of the directors are appointed by state-controlling owners,and another 30percent are affiliated with various layers of governmental agencies.There are few professionals (lawyers,accountants,finance experts)on Chinese boards and almost no representation by minority shareholders.Based on their findings,the evidence in Table 3likely overestimates Chinese firms’performance on the board of directors category.

Top managers typically own little of their companies’shares,on average only 0.1percent.Incentive pay is unlikely to be a primary corporate Table 3Summary Statistics of Corporate Governance Variables in China,1999–2001Variable

Mean

S.D.Minimum Median Maximum Percent of shares by the largest shareholders 44.817.9 1.944.388.6Dummy the listed firm has a parent firm

0.7890.408011Dummy the CEO is also the chair of board

0.3460.476001Ratio of outside directors to inside directors 0.7220.17400.7271Portion of shares held by top management 0.0010.00500.0000.149Dummy a firm has H-and B-shares

0.0990.299001Sum of shares by the second to tenth-large-shareholders 0.16930.1352

0.1357

0.0022

0.6197

The concentration of shares held by top ten shareholders except the largest one à5.975 2.723à14.434à5.416à1.771

Dummy the largest shareholder is the state

0.5560.497011

This table provides the summary statistics of the eight corporate governance variables in China over the period 1999–2001,which capture various aspects of the Chinese listed firms’current corporate governance practices (see Bai et al.2004;and Liu and Lu 2004).

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governance mechanism at work in the Chinese listed companies.However, the managers may be able to extract rents from firms through other channels,e.g.excessive perks not reflected in the salary and bonus,profits from insider trading,etc.The above variable,thus,does not precisely reflect the managers’true incentives,unless we can identify other more reliable proxies to capture those‘gray’incomes.

The mean and the standard deviation for the concentration of the second to the tenth-largest shareholders areà5.98and2.72,respectively. These numbers do not mean much by themselves.However,the sum of the percentage of share-holding held by the second to the tenth largest shareholders has an average of16.93percent and a maximum of 61.97percent.These results,on the one hand,suggest that the ownership structure is highly concentrated among the Chinese listed firms;on the other hand,they suggest that if other large shareholders can act jointly,they can still accumulate a large number of votes to challenge the largest shareholder.But these numbers do not tell us much with regard to how active the takeover market is in China.

Neither dual listing nor multiple listing is common for Chinese firms as the average proportion of companies issuing H or B shares is about 10percent.Finally,over50percent of the companies are controlled by the government.

One of the prominent features of the Chinese listed firms is that only about one-third of shares are tradable(see Table2).Low floating ratios in the Chinese listed firms is one of the consequences of China’s partial share issue privatization.Such a practice leads to the co-existence of several types of shares in the listed firms–state shares,legal person shares and public shares.Only the shares held by the public are tradeable. The transfer of state shares and legal person shares are strictly controlled by the government.The so-called‘gu quan fen zhi’(the same company’s shares having heterogeneous venues of trading,some are tradable and some are nearly non-tradable)has caused much trouble in the Chinese stock market.Floating the state shares and legal person shares may cause a gush of tradable shares in the marketplace,which may further depress the stock prices.

Clearly,the corporate governance system adopted by the Chinese listed firms can be best described as a control-based model,in which the controlling shareholders–in most cases,the state–tightly control the listed firms through concentrated ownership and management friendly boards.As a consequence,there is a lack of timely disclosure of accounting information.The overall transparency in operations is low. Table4also shows that the ultimate controlling shareholders for more than80percent of the Chinese firms are the central or local governments. The state has the incentive to keep enough equity interest so that it can CESifo Economic Studies,52,2/2006429

Table4The different ownership types of China’s publicly listed companies

Year Number of

listed companies Local

government

(%)

Central

government

(%)

Privately-

controlled

firms(%)

Collective

(%)

Widely-

held(%)

Miscellaneous

(%)

Unidentified

(%)

199316677.71 6.63 3.01 3.01 1.81 3.61 4.22 199428575.44 6.32 3.86 4.21 1.05 4.56 4.56

199530975.737.12 3.88 3.880.97 3.88 4.53 199648673.059.67 4.94 3.910.41 4.32 3.70 199771970.9311.68 5.29 4.450.14 4.45 3.06 199882568.9712.737.15 4.120.12 4.48 2.42 199992365.4413.768.99 4.330.22 4.88 2.38 2000106063.1114.6210.85 3.870.19 5.66 1.70 2001113461.3815.2612.79 3.440.09 5.82 1.23

Total590767.3912.568.38 3.960.30 4.94 2.51

The table presents the ownership types of China’s publicly listed company over the period from1993to2001.The data source is Fan and Wong(2004) and Fan,Wong,and Zhang(2005).Here the ownership is judged based on the status of the controlling shareholders.Q. Liu

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achieve other policy goals easily through the listed firm vehicles.It is interesting to gain an understanding on how such a control-based control model emerged and now prevails in China.We will discuss how the control-based model emerged in China in Section4.What is worth noting is that the effectiveness of varied corporate governance mechanisms crucially hinges on the level of the overall institutional environment. When the legal system is incomplete and law enforcement is weak,and when business is closely connected to politics,the effectiveness of the conventional governance mechanisms,even though they are squarely in place,might also be greatly compromised.

2.3Where is China?A cross-country comparison

The firm level evidence clearly demonstrates the‘control’nature of the corporate governance practices commonly observed in China. However,it does not tell us how good the Chinese firms’corporate governance practices are,compared with other countries/economies. Especially,given the‘transitional nature’of the Chinese economy,it is informative to compare the Chinese listed firms’corporate governance practices with those employed by firms in other transition economies. We consider China’s corporate governance level in a cross-country comparison setting in this sub-section.

The Asian financial crisis and the recent corporate scandals in the USA (i.e.Worldcom,Enron,etc.)have greatly intensified worldwide interest in corporate governance issues.Numerous initiatives have been proposed by international organizations,academics and the private sector to better understand and frame corporate governance practices in the world, which provide an opportunity for us to understand China’s corporate governance practice in the context of cross-country comparison.

The International Institute for Management Development(IMD)in Switzerland surveyed60economies in the world in2004,and provided a country-level corporate governance ranking.When examining a country’s overall corporate governance performance,the IMD emphasizes its per-formance on the following four categories:corporate board,shareholder value,insider trading and shareholder right(Panel A of Table5).13Among60 13There are numerous corporate governance principles,or corporate governance‘codes’that have been issued since the early1990s.The prominent ones include the Cadbury Report and Recommendations,1992;the OECD Principles of Corporate Governance, 1999;and the Asian Development Bank Corporate Governance Report,2000,to name just a few.Most of these recommendations emphasize the importance of governance mechanisms including board of directors,ownership structure,shareholder right, information disclosure,and external governance mechanisms such as legal system,law enforcement and the degree of financial deepening.

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economies surveyed,China ranks 25th on the corporate board category,40th on shareholder value,57th on insider trading and 44th on shareholder right.Its overall ranking,not surprisingly,appears very low on the list.Panel B of Table 5provides another economy-level corporate governance ranking provided by the World Economic Forum in 2003,Table 5Corporate Governance ranking -international comparison

Average rank

Corporate board

Shareholder value

Insider trading Shareholder right Panel A:IMD 2004,60economies surveyed Singapore 7.551339Hong Kong 16.0982225Malaysia 16.310122518Sweden 18.83814176UK

22.522301622Germany 23.54431712USA 23.535172913Taiwan 23.812213428India 37.029354935Thailand 37.327285539China 41.525405744Japan

45.350591359Philippines 45.837425450Korea 50.553534155Indonesia 55.35652

59

54

Rank

Economy

Score

Panel B:World Economic Forum 2003,49economies surveyed

1United Kingdom 6.346Sweden 5.987USA 5.948Singapore 5.919Germany 5.7813Hong Kong 5.5921Malaysia 5.2723Taiwan 4.9628Thailand 4.7231Japan 4.5932India 4.5933Korea 4.5943Philippines 3.8944China 3.8046Indonesia 3.62

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when49economies were surveyed.The results in Panel B provide a message very similar to that in Panel A.That is,China under-performs most countries/economies surveyed–among the49economies surveyed, China’s overall ranking is only the44th,slightly better than Indonesia, but worse than other Asian economies such as Taiwan,Malaysia, Thailand and India.

We now revisit the four categories specified in Panel A of Table5. China ranks25th on corporate board,which is higher than Japan (50th)and Korea(53th),and surprisingly,the US(35th)and Germany(44th).Obviously,a series of policy initiatives introduced by the Chinese government,aimed at improving the independence of corporate boards,have been acknowledged by the rating agencies. However,apart from those low-hanging fruits,China’s scores on other governance categories are quite low.14The protection of shareholder rights is poor,insider trading is rampant,and the listed companies do not take shareholder value maximization as their primary goal,in practice.15

2.4Comparison of China with other former socialist countries

Since most of China’s listed firms are former SOEs,it is probably most appropriate to compare governance of these firms with that of privatized firms in former socialist countries such as Russia,Eastern European Countries and Vietnam.The largest obstacle to this analysis,however, is that firm-level evidence in former socialist economies is lacking. For the few studies conducted at firm level,16the methodologies used to assess corporate governance are not consistent.Fortunately, the literature so far provides some country-level evidence,which make the comparison of governance in China with that of other transition economies possible.

14Arguably,the efforts to improve corporate board are tangible–increasing the portion of outside directors,and having a variety of sub-committees to formalize board decision making can be implemented easily and generate quick impact.

15Besides the two rankings we discuss in this article,other organizations such as Standard &Poor’s(S&P),Credit Agricole’s Asian Investment banking arm,CLSA and the Asian Development Bank,have also provided corporate governance ranking at country/ economy level.Most of them position China at the low end of those lists.

16See,for example,Bai et al.2004;Black et al.2000;Coffee1999;and Megginson and Netter2001.

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Using comparative data on the quality of the law on the books and indicators for the effectiveness of law enforcement,17China performs below the average of other transition economies in both,formal law and legal enforcement categories.For example,on the widely used LLSV indicators for shareholder rights protection(LLSV1998),China’s score is only3,compared with an average of 3.61for all other transition economies.Although shareholder rights protection only reflects one particular aspect of corporate governance practice,it arguably is the most representative indicator,and China is not any better than other transition economies.

To better understand the Chinese listed firm’s corporate governance practice,it is important to keep in mind that the Chinese stock market was established to support the privatization of SOEs.However,privatization in China is very different from the rapid and mass privatization of SOEs in Russia and other former Soviet Union countries.Black et al.(2000)argue that rapid and mass privatization is likely to lead to massive self-dealing by managers and controlling shareholders unless a country has a good institutional infrastructure.In China,the government chose the staged privatization strategy.While implementing partial privatization,the government makes an effort to retain the control of the SOEs.By no means does such a scheme imply that self-dealing by managers and controlling shareholders is less pervasive in China.But it does help explain the‘control’nature of the corporate governance practice widely adopted among the Chinese listed firms.

3Economic effects of corporate governance in China

How does the current corporate governance system,which can be best described as a control-based model,affect Chinese firms’performance and various corporate decisions?A growing literature has been devoted to examining the economic effects of those governance mechanisms in China.While we focus this section on discussing corporate governance’s impact on the Chinese firms’valuation,profit reporting decisions and tunneling incentives,we also discuss in detail how different governance mechanisms interact and amalgamate to impact on corporate China.

17See,LLSV(1998);La Porta et al.(1999);Pistor and Xu(2005);Allen,Qian and Qian (2005a);and the World Bank corporate governance indicator available at: bbb44672f242336c1eb95e98/wbi/governance.

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3.1Corporate governance and firm valuation

A firm’s various corporate governance practices shape its behavior and eventually affect its stock market performance and accounting perfor-mance.18Earlier research on the Chinese firms focuses on examining the relation between state ownership and firm performance.Xu and Wang (1999)report that Chinese firms’accounting performance is negatively related to the level of state ownership.Sun and Tong(2003)find that share issue privatization–a reduction in state ownership–is associated with improved corporate performance.Tian(2002)studies the relation between the ownership structure and the Chinese listed firms’stock market valuation.He finds that government ownership’s impact of stock market valuation is non-linear–it worsens a firm’s performance when government ownership is small,but improves a firm’s performance when government ownership gets significantly larger.Tian(2002)attributes the non-linearity of government ownership to stock market valuation and the state’s varying interest alignment with other shareholders when state ownership increases.

Several other studies examine the impact of other governance mechanisms on Chinese listed firms’performance.Ning and Zhou (2005)find that employee stock ownership does not improve firm performance significantly in China,suggesting that a negligible fractional ownership does not provide a meaningful employee incentive.Kato and Long(2005)find evidence that CEO turnover-firm performance sensitivities are larger for privately controlled listed firms than for state controlled firms,indicating the inefficiency of state ownership from the CEO turnover perspective.

Bai et al.(2004)offer a comprehensive analysis of the impact of various governance mechanisms on firm market valuation.They examine how the same eight different corporate governance variables as those discussed in section‘‘Corporate governance mechanisms employed by the Chinese listed firms’’,which are designed to capture the control-based governance model adopted among the Chinese listed firms,affect the Chinese listed firms’market valuation.They find that the effect of the share-holding of the largest shareholder is non-linear.There is a U-shaped relationship between a firm’s market valuation and the proportion of shares held by the largest shareholder.They find evidence that the degree of concentra-tion of shares held by other large shareholders,excluding the largest one, positively affects firms’market valuation.It is argued that when shares are concentrated in the hands of other large shareholders,they are more likely to monitor the largest shareholder and prevent him from tunneling 18See Gompers,Ishii and Metrick(2003)for evidence from the US firms.

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