Corporate Governance in China

Jian Chen

• Publisher: Taylor & Francis
• Year: 2004
• eBook ISBN: 9781134283538
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Based on extensive original economic analysis, Chen examines key questions relating to corporate governance in China, including the relationship between ownership structure and corporate performance, the determinants of capital structure, and the nature of contemporary governance structures. It concludes that corporate performance is positively related to ownership concentration, but negatively related to state ownership, and that contemporary corporate governance structures are heavily dependent on previous structures in the centrally-planned economy and on the path of transition to the market economy.

1 Introduction

What is corporate governance?

This is a study of corporate governance, with particular reference to listed companies in China. The theoretical framework underpinning the book is the incomplete contracts, or property rights, approach which recognises that issues related to firms’ ownership structure, capital structure¹ and corporate control cannot be fully understood if one assumes a world of comprehensive contracts that can define all future contingencies. Rather, contracts are incomplete and economic agents are endowed with rights to specify actions in future contingencies not specified in prior contracts, that is they are endowed with property or ownership rights.

In applying this framework to modern corporations, we find that the combination of the separation of ownership and control, and the incompleteness of contracts, may lead to agency problems: that is, a situation where the management² of the corporations, who are the agents of the shareholders (the principals), may have private interests that conflict with those of some or all of the shareholders. There is thus a need for a sound corporate governance system through which management can be induced to ensure the maximisation of shareholders’ wealth whilst protecting the interests of all parties involved, including the managers, large and small shareholders, and creditors.

Two decades ago, the term ‘corporate governance’ had not been coined (Kay and Silberston, 1995), yet the associated issues date back to the formation of joint stock companies and stock markets. Today, corporate governance is a central political and economic topic, not only in well-developed market economies but also in emerging economies. However, there is still considerable debate as to what corporate governance actually entails, as the following selection of definitions will testify:

• ‘Corporate governance is an institutional arrangement by which suppliers of finance to corporations assure themselves of getting a proper return on their investment’ (Shleifer and Vishny, 1997, p. 737).
• ‘The purpose of corporate governance is to minimise the total cost in aligning managers’ and shareholders’ incentives, and in unavoidable self-interested managerial behaviours’ (Jensen and Meckling, 1976).
• ‘The phrase corporate governance is often applied narrowly to questions about the structure and function of boards of directors to the rights and prerogatives of shareholders in boardroom decision-making. Now this definition has been broadened to refer to the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated’ (Blair, 1995, p. 3).
• ‘Corporate governance is the system or process by which companies are directed and controlled’ (Cadbury, 1992, p. 2).
• ‘Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance’ (OECD, 1999).
• Zingales (1998) defines corporate governance as including anything that affects the ex post bargaining power over the value created in the firm. This definition gives the broadest coverage of corporate governance. It recognises the potential conflicts between involved parties, including the large shareholders, the small shareholders and management, and the institutional arrangements which entitle specific parties with rights when disputes arise which are not foreseen prior to the establishment of contracts.

In drawing upon these definitions, we would like to make the following points:

• All definitions of corporate governance are concerned with the objectives of the corporation: whose interests should the corporation take care of and how? But there are heated debates about which stakeholders (including employees, input suppliers, and customers) should be taken into consideration (Blair, 1995), and the way of putting theory into practice is still unknown.
• In this study, we focus more narrowly on the institutions and mechanisms by which the suppliers of finance to corporations (i.e. the owners) exert control over the managers to ensure satisfactory returns on their investment.
• There is good corporate governance, as well as poor corporate governance. Good corporate governance can improve corporate performance by minimising the total cost of aligning managers’ and shareholders’ incentives, and of unavoidable self-interested managerial behaviour (Jensen and Meckling, 1976). Good corporate governance should provide proper incentives for the Board and management to pursue objectives that are in the interests of the company and its shareholders, and should facilitate effective monitoring thereby encouraging firms to use their resources more efficiently. In contrast, poor corporate governance can damage the interests of the parties involved, either the managers or the shareholders, and may lead to poor performance and the collapse of the corporation.
• Corporate governance is only part of a larger economic context in which firms operate which includes, for example, macroeconomic policies and the degree of competition in product and factor markets. The corporate governance framework also depends on the legal, regulatory, and institutional environment (Roe, 2000). In addition, factors such as business ethics, and corporate awareness of the environmental and societal interests of the communities in which it operates, can also have an impact on the reputation and the long-term success of a company.

Research objectives

The overall aim of this book is to examine the effectiveness of the corporate governance system in China, and to suggest ways of improving it. We take the view that one of the objectives of the reform of Chinese State-owned enterprises (SOEs) is to seek an appropriate mechanism of corporate governance which (a) provides sufficient incentives for management to work hard, (b) prevents management from asset appropriation, and (c) replaces them when they are found to be incompetent. These issues are particularly relevant in the context of the reform of the SOEs and the establishment of a modern enterprise system in China, which are embedded in the whole process of transition from a centrally-planned economy to a market economy. Furthermore, these notions of modern corporations, the corporatisation of SOEs, and corporate governance are closely linked to a perception of superior corporate performance.

We focus on the case of Chinese listed companies using data from the two leading Stock Exchanges, namely, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE). Both Exchanges have been established for 12 years, and list stocks for more than 1,100 corporations. We focus on listed companies for similar reasons to those discussed by Zingales (2000):

• The first is that this book is about corporate governance issues, hence we must consider corporations, and not other types of business organisation. Although there are many corporations that are not public companies, public companies are favourite subjects of theoretical studies (see, e.g. Grossman and Hart (1980) on the free-rider problem in takeovers, La Porta et al. (1998) on small investor protection issues). The investors are dispersed and unable to coordinate, and this is the perfect background within which theories related to corporate governance can be developed.
• The second is the ease of obtaining data, and the possibility of being able to use economic measures of performance such as the market to book ratio (MBR) or Tobin’s Q, instead of having to rely on accounting measures³ such as the return on equity (ROE) or the return on assets (ROA). The data for listed companies are also generally more accurate than for non-listed companies in all economies throughout the world, making listed corporations natural research subjects.
• The third is the importance of listed companies in national economies, in terms of employment, Gross Domestic Product (GDP), technological innovation, tax revenues to the government etc. In the Chinese case, many of the listed companies are among the largest firms in their industries or among the first to have undergone corporatisation from the original SOEs, Township and Village Enterprises (TVEs) or foreign-owned firms. A comprehensive examination of their experience will increase our understanding of the effectiveness of the Chinese reforms.

This study embraces multiple facets of the issue of corporate governance in China, but focuses on four major issues:

• The underpricing of Initial Public Offerings (IPO) of equity – The IPO is the first stage when a company is going public. ‘Traditional’ theories see the IPO as a process for the company to finance its growth, and the value of the stock is simply the present value of all future cash flows. But new theory and empirical findings suggest that going public is a complex process with distinct markets for dispersed shares and controlling blocks, and that the under-pricing of IPOs, which is common throughout the world, is influenced by the ownership structure at the time of the IPO.
• How corporate performance depends upon the ownership structure – On the one hand, the size distribution of shareholders may affect performance because small shareholders may not be able to, or have the incentive to, monitor management to the same degree as large shareholders. On the other hand, large shareholders may monitor management, but more often they may pursue their own interests which do not necessarily correspond to those of other, smaller, shareholders. Furthermore, the nature of the large shareholders (e.g. State, or domestic institutions) may also have an effect.
• How corporate governance may affect the capital structure of a company – Ever since the seminal work of Modigliani and Miller (1958), various explanations about why firms choose one financial instrument over the other have been offered, under different assumptions and in different economic systems. We look here at the effects upon the debt ratios of Chinese firms of a management shareholding and of a large major shareholder.
• The development of corporate governance in the wider context of the transition of the Chinese industrial structure and the move towards a market economy.

These four issues are addressed in four separate chapters, but share a common approach based on a combination of agency theory and the theory of incomplete contracts. The issues are also linked within the whole system of corporate governance. The first issue studies the relationship between the large, initial shareholders and the small, outside shareholders from the perspective of the private gain of corporate control. From a temporal point of view, the IPO is also the stage when a corporation forms or reestablishes its corporate governance mechanism. The second issue looks at how corporate performance is affected by the mechanism of corporate governance after the firms’ IPO. We focus on the relationship between the large shareholders as principals, and the management as agents. The third issue emphasises the role of debt as an instrument to mitigate agency costs. The basic argument is that debt, which is a pre-emptive financial instrument, will trigger financial distress when the management does not work well and does not generate sufficient cash flows to meet the payments required by debt contract. Thus the controlling shareholders may use their influence in deciding the choice of capital structure. We apply theories of debt to explore the possible role of debt as a complementary mechanism of corporate governance. The fourth issue is a study of the Chinese corporate groups, with the perspective at the governance structure since the era of industrial restructuring. The main theme of this chapter is that the division of the government into territorial jurisdictions, and of the division of economic administration by industrial branches, imposes a two-way grid on economic decision-making that has had wide ramifications for the governance structure of large enterprises/corporate groups in China and their evolution. This grid is currently undergoing a radical change because of the abolition of many of the central industrial Ministries and also of industrial bureaux in territorial governments, that may in time have a profound influence on the organisational structure of corporate groups. But the territorial division of the government has been, and will continue to be, of special importance in China because of its geographical expanse and regional diversity.

This book is certainly the first systematic study of corporate governance in China, and the results will provide insights into how well the system is functioning and suggestions as to possible improvements. However, it should be pointed out that the system of corporate governance in China is still in the process of evolution, and it would be premature to recommend the ‘best’ model of corporate governance for China. Furthermore, the book stresses only the micro, particularly finance, aspects of corporate governance rather than the macro aspects, and does not attempt to identify best practices or suggest codes of conduct as in the Cadbury Report (1992) or OECD (1999).

The data and methodology

Data

The dataset used in Chapter 4 covers 467 IPO issues between 1995 and 1999. The other two empirical studies use cross-section data for 1997. 1997 data is used because of the lag in the publication of Annual Reports. Much of the 1997 data only became available in late 1998, or early 1999 for some companies. In 2000, when these studies were being undertaken, the most comprehensive dataset was that based upon 1997 data. But the findings should be fairly robust in that there have not been any fundamental institutional changes since.⁴

The following sources of data were used:

• ‘A Guide for Investment in Shanghai and Shenzhen Securities Exchanges’, published by Securities Times, based at Shenzhen. Securities Times is one of the major news agencies and publishers of financial and economic information in China. The 1996 volume provides information on the corporations listed on both Exchanges in the year 1995. The 1997, 1998, and 1999 volumes do likewise for the years 1996, 1997, and 1998.
• The CD-ROM of Chinese Listed Corporations’ Annual Reports (1997) (Abstract). This CD-ROM contains abstracts of annual reports of all listed companies ending at 27 May 1998. Securities Times is the publisher of the CD-ROM.
• The data on stock prices were taken from the database on the central computer at the SZSE. Prices were available for all listed companies, beginning from the opening days of both Exchanges in December 1990 (SHSE) and July 1991 (SZSE), and ending on 29 March 1999. We extracted the share prices ...

Table of contents

• Cover Page
• RoutledgeCurzon studies on the Chinese economy
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Acknowledgements
• Abbreviations
• 1 Introduction
• 2 Theoretical approaches to corporate governance
• 3 The evolution of corporate governance in China
• 4 The effect of ownership structure on the underpricing of Initial Public Offerings
• 5 Ownership structure as a corporate governance mechanism
• 6 The determinants of capital structure
• 7 Chinese corporate groups: A perspective from governance structure
• 8 General conclusions and future work
• Notes
• References