Globalization, Competition and Growth in China

Jian Chen, Shujie Yao

• Publisher: Taylor & Francis
• Year: 2006
• Print ISBN: 9780415351973
• eBook ISBN: 9781134264001
• Edition: 1
• Topic: Economics
• Subtopic: Economic Conditions
• Index: Economics

Presenting original work and new thinking on a wide range of important issues, the book explores the current state of globalization, competition and growth in China.

China has produced an economic miracle since the late 1970s in its transition from a planned to a market economy. This remarkable economic performance was brought about by an open-door policy and gradual integration with the world economy, culminating in China's admission into the World Trade Organisation in 2001.

Studies included in this book focus on issues such as foreign direct investment, international trade, reforms in the financial sector, the development of rural township and village enterprises, the investment strategies of multinational corporations, and economic growth.

Part I
Financial Sector Reforms

1 Board characteristics as corporate governance mechanisms

Evidence from China’s real estate stock companies

Jian Chen, Qiulin Ke and David Isaac

Introduction

The monitoring role of corporate boards in public corporations has become a central issue in both the financial and academic press. Berle and Means’s (1932) seminal work suggested that managers did not have sufficient equity in the firms they managed to give them the incentive to turn their full attention to profit maximization. As a result, managers may pursue self-interested initiatives at the expense of shareholders. One monitoring mechanism that may temper that tendency is the oversight of the board of directors: this oversight, or control, function of a board is often described as the most critical of directors’ roles (Fama, 1980; Mizruchi, 1983; Zahra and Pearce, 1989).

Three characteristics that affect the monitoring potential of a board are board size, board composition and board leadership structure (Jenson, 1993). The research that has examined the association between board characteristics and firm performance has produced mixed results. There has been no consensus regarding the direction of the relationship of firm performance and board size. For example, Yermack’s (1996) study of Fortune 500 industrial firms, partly confirmed by Bhagat and Black (1996), verifies the predictions of Jensen (1993) and others of a negative correlation between firm value and the size of a firm’s board of directors. Yermack’s sample is dominated by firms with large boards and finds no consistent association between board size and firm value for board size below six board members. Eisenberg et al. (1998) use a randomly selected sample of approximately 900 small Finnish firms. The effect, confirming Yermack’s findings, shows a negative correlation between firms’ profitability, as measured by industry-adjusted return on assets, and board size.

When a single individual wears the ‘hats’ of both the CEO and chairman of the board (unitary leadership structure), managerial dominance is greatly enhanced since that individual is more aligned with management than with stockholders. Having separate persons holding the CEO and chairman positions (dual leadership structure) enhances the monitoring ability of the board (Jensen, 1993). Therefore, a board that is effective for monitoring has relatively more outside directors, a dual leadership structure and is small (Jensen, 1993).

So far, most studies on corporate governance in China have focused on the ownership structure, the behaviour of different types of controlling shareholders (see Xu and Wang, 1997, which suggests that the company owned by legal person shares outperformed those controlled by state shares), ownership concentration and the behaviour of the controlling shareholder, for example the expropriation by the controlling shareholder via related party transactions, the diversion of funds from the listed companies and so on. Very little research addresses the relationship between board characteristics and firm performance. To start the research in this direction, we take one sector – the real estate sector – for tentative analysis.

This chapter focuses on a study of board characteristics and their effects on the corporate performance of listed real estate companies in China. The corporate governance environment in China is different from Yermack’s study sample. The ownership of listed real estate companies of China is highly concentrated by state or family. Approximately 61 per cent of all shares in this sector comprise nontransferable state and legal person shares, making the threat of takeover ineffective as a form of governance mechanism. Holding large amounts of non-transferable stocks, managers are not worried about being taken over as a result of share price falls resulting from inappropriate operation of the business. The boards are dominated by insiders. Highly concentrated ownership structure leads to smaller board size. Thus, increasing board size implies an increase in the numbers of outside directors. Our study finds a positive relationship between board size and corporate performance, inconsistent with the studies of Yermack (1996) and Eisenberg et al. (1998).

In the following sections of this chapter, we first review previous studies on the advantages and disadvantages of large board size. We then discuss the board structure of China’s listed companies and continue our study by defining the variables. The outcomes of regression analysis are presented in the regression analysis section and we end by drawing some conclusions.

Why board characteristics matter

Why board size matters

Researchers have not achieved a consensus on the optimal size of the board. Jensen, for example, suggested that ‘when boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control’ (1993, p. 865). This view is consistent with that of Firstenberg and Malkiel, who argued that a board with eight or fewer members ‘engenders greater focus, participation, and genuine interaction and debate’ (1994, p. 34). Lipton and Lorsch (1992) suggest an optimal board size between seven and nine directors, while Yermack (1996, Fig. 1.1) suggests that the greatest loss in value occurs for board sizes in the range of five to ten members, the small end of his board size.

Advantages of larger board size

The literature addressing the advantages associated with larger boards involves a range of perspectives. These include:

• Resource dependence theory which has been the primary foundation for the perspective that larger boards will be associated with higher levels of firm performance (e.g. Alexander et al., 1993; Goodstein et al., 1994, etc.). In this view, board size may be a measure of an organization’s ability to form environmental links to secure critical resources (Goodstein et al., 1994). According to Pfeffer and Salancik, ‘The greater the need for effective external linkage, the larger the board should be’ (1978, p. 172). Consistent with the tenets of resource dependence, Birnbaum (1984) reported that environmental uncertainty (lack of information and volatility) led to increased board size.
• The view that board interlocks may also provide a rationale for expecting larger boards to be associated with positive corporate outcomes. There is some evidence, for example, that board interlocks are associated with effective capital acquisition (e.g. Mizruchi and Stearns, 1988; Stearns and Mizruchi, 1993). It may be that larger boards provide more possibilities for such interactions.
• The expertise-counsel account of board service which suggests that directors may provide CEOs with advice of a quality unobtainable from other corporate staff (e.g. Zahra and Pearce, 1989). Lorsch and MacIver reported that many directors are themselves CEOs: ‘CEOs have the most relevant experience and expertise to be effective directors. CEOs understand the complex problems of running a major enterprise and, it is argued, provide the best counsel and advice’ (1989, p. 174).
• The question of board composition. The proportion of outside directors is likely to be positively correlated with board size (Yermack, 1996) and outside directors generally own negligible equity shares in firms. Outside directors thus bear a reputation cost if projects fail and the firm encounters financial difficulties while their share of the gains is limited. This asymmetry suggests that outside directors have a bias against projects with high variance which increase the probability of bankruptcy, even when the net present value of the projects is positive. Bhagat and Black (1996) find that the median outside director stock ownership is only 1 per cent for a sample of 780 public US companies, suggesting that outside directors often want to avoid risk.

Disadvantages of larger board size

The discussion of the disadvantages of larger board size or the advantages associated with smaller boards is focused on:

• Increased problems of communication and coordination as group size increases, and decreased ability of the board to control management, thereby leading to agency problems stemming from the separation of management and control (Jensen, 1993; Yermack, 1996). Jensen suggests that larger boards lead to less candid discussion of managerial performance and to greater control by the CEO. Thus larger board size can reduce the board’s ability to resist CEO control. Yermack (1996, p. 210) suggests that ‘CEO performance incentives provided by the board through compensation and the threat of dismissal operate less strongly as board size increases’. And he concludes that whatever benefits may be associated with large board size may be overwhelmed by poor communication and decision-making processes.
• Group cohesiveness, another construct that may have application for boards of directors. Cohesiveness, which may be facilitated by having fewer group members, has been related to performance. Evens and Dion (1991), for example, relying on a meta-analysis, reported a positive association between group cohesion and performance. Arguably, smaller boards would, on average, have more group cohesiveness (Lipton and Lorsch, 1992; Jensen, 1993).
• Mintzberg (1983) suggests that board members’ assessments of top management are more easily manipulated when boards are larger and diverse. It might be reasonably expected that large boards would tend to be more diverse, more contentious and more fragmented than small boards. In such cases, CEOs may gain advantage in power relations with board members through tactics like ‘coalition building, selective channelling of information, and dividing and conquering’ (Alexander et al., 1993).

However, there are other alternative opinions on the likely power relationship between CEOs and large boards. For example, Zahra and Pearce (1989, p. 309) concluded that ‘larger boards are not as susceptible to managerial domination as their smaller counterpart’. Ocasio (1994, p. 291) suggested that ‘the stability and cohesiveness of the governing coalition under the CEO can best be contested when the number of directors on the board is large. A large board is more likely than a small one to generate alternative political coalitions that challenge the CEO and take control over the firm. A large board also limits the possibility of the CEO exerting social influence to maintain his power.’

A large amount of theory-driven rationale thus suggests a relationship between board size and firm performance but the literature provides no consensus about the direction of that relationship.

Board composition and corporate performance

The association between board composition and firm performance has been the subject of many studies. The composition of a firm’s board is typically a surrogate for the extent to which the board is independent of the firm’s CEO (e.g., Daily et al., 1999; Dalton et al., 1998 and Seward and Walsh, 1996). Although more than 20 measurements of board composition can be found in relevant research – for example, the proportion of inside directors, outside directors, affiliated directors or interdependent directors (Daily et al., 1999) – these measures are all designed to capture some aspect of board independence. The relevant research concerning firm performance and board composition includes Hermalin and Weisbach (1991), Klein (1998) and Mayers et al. (1997). Klein’s study demonstrates a linkage between firm performance and board composition by examining the committee structure of boards and directors’ roles within these committees. He finds little association between firm performance and overall board composition. But by going into the inner workings of the board via board committee composition, he finds significant ties between firm performance and how the board is structured. A positive relation is found between the percentage of inside directors on finance and investment committees and accounting and stock market performance measures.

A board comprising members with dependent relationships with a firm (that is, inside directors, affiliated directors and/or interdependent directors) is less likely to provide a dispassionate assessment of the firm’s CEO. Mayers et al. (1997) investigate the role of outside directors in the corporate-control process by examining variations in ownership structure within the insurance industry. In mutuals, ownership rights are not transferable. This inalienability restricts the effectiveness of control mechanisms like external takeovers, thus increasing the importance of monitoring by outside directors. Consistent with this hypothesis, they find that mutuals employ more outsider directors than public joint-stock companies and firms that switch between the two forms make corresponding changes in board composition. Laws affecting mutuals frequently stipulate participation by outside directors and mutuals with more outside directors making lower expenditure on salaries, wages and rent. Dalton et al. (1999) investigated the relationship between the board of directors and the firm’s financial performance. Moderating variables included firm size, board composition (external vs internal members), and performance indicators (market-based vs accounting-based indicators). The results for the overall meta-analysis of the association between board size and financial performance strongly suggests a non-zero, positive relationship. Also these relationships are consistent for market-based and accounting-based firm performance measures. Likewise, board composition does not moderate the board size–financial performance relationship.

The board structure of China’s listed companies

The directors are the r...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• List of Figures
• List of Tables
• Preface
• Notes on the Contributors
• Abbreviations
• Introduction
• Part I Financial Sector Reforms
• Part II FDI and Globalization
• Part III Economic Development and Policy