Corporate governance and market valuation in China

Abstract

In this paper, we investigate empirically the relationship between governance mechanisms and the market valuation of publicly listed firms in China. We construct measures of corporate governance and market valuation for all publicly listed firms on the two stock markets in China from the firm's annual reports between 1999 and 2001. Using this three-year panel, we examine the effect of corporate governance variables on market valuation after controlling for factors commonly considered in market-valuation analysis. Our empirical results support several theoretical predictions; for example, we find that both high concentration of non-controlling shareholding and issuing shares to foreign investors have positive effects on market valuation, while a large holding by the largest shareholder, the CEO being the chairman or vice chairman of the board of directors, and the largest shareholder being the government have negative effects. Journal of Comparative Economics 32 (4) (2004) 599–616.

Introduction

The emerging market crisis in 1997 and 1998 rekindled worldwide interest in the issue of corporate governance. In recent years, advocating higher governance standard has become a regular campaign with the participation of an increasing number of parties, namely, academics, media, regulatory authorities, corporations, institutional investors, international organizations, and shareholder rights watchdogs.¹ Numerous initiatives have been proposed and launched by Asian countries to enhance their corporate governance practice, for example, new listing and disclosure rules, mandatory training for board directors, and enforced codes of governance. International organizations are also very keen on governance issues. The International Monetary Fund has demanded that governance improvements be included in its debt relief program. In 1998, the Organization of Economic Cooperation and Development (OECD) issued an influential document OECD, 1999, which is intended to assist member and non-member countries in evaluating and improving the legal, institutional and regulatory framework for better corporate governance. In addition, private companies, e.g., Standard & Poor, California Public Employees' Retirement Pension System (CaLPERS), CLSA, and McKinsey, are also calling for sweeping reforms of governance practice in emerging economies.

Corporate governance is paramount in China. The Chinese government opened stock exchanges in the early 1990s to raise capital and improve the operating performance of state-owned enterprises (SOEs). In less than twelve years, China's stock markets have grown to become the eighth largest in the world with a market capitalization of over $500 billion. Chinese companies, especially SOEs, have benefited substantially from the rapid growth in issuance and the general public's enthusiasm on equity market. Meanwhile, stock market regulations have been evolving to address the tradeoff between growth and control in which a liberal approach fosters fast growth while a controlled approach leads to slower growth. Even though issuance approval, pricing, and placement systems have been liberalized significantly, they are still controlled tightly compared to other Asian markets. Nonetheless, poor governance practices are rampant among the Chinese listed companies. In 2001, the largest shareholder of Meierya, which had been a profitable company, colluded with other related parties and embezzled $44.6 million or 41% of the listed company's total equity. In the same year, the largest shareholder of Sanjiu Pharmacy extracted $301.9 million or 96% of this listed company's total equity.² Although Chinese companies, especially SOEs, obtain considerable capital from the public through either the banking system or the capital market, they remain extremely inefficient. For example, recent official statistics suggest that about one-third of all SOEs are loss-makers, another third either break even or are plagued with implicit losses, while the remaining one-third are marginally profitable. Ineffective governance is widely believed to be the root cause of this lackluster performance so that improving corporate governance should be a crucial objective of China's further economic reform.

To improve corporate governance, the government must strengthen laws that protect shareholder interests and increase enforcement of such laws and regulations. Equally important, firms must also act to improve the situation. Corporate governance must provide the appropriate market incentives. For a firm's corporate governance practice to have a positive effect on its market value, two conditions must be satisfied. First, good governance must increase the returns to firm's shareholders; second, the stock market must be sufficiently efficient so that the share prices reflect fundamental values. These conditions are more likely to be satisfied in mature markets than in emerging markets. In fact, share prices on China's stock markets are often considered to be driven by purely speculative activities and to bear no relationship to fundamentals.

Practitioners believe that good corporate governance does increase the firm's market valuation. Recently, McKinsey conducted a series of surveys with institutional investors and private equity investors focusing on emerging markets McKinsey & Company, 1999–2002. The evidence indicates 80% of these investors are willing to pay a premium to well-governed firms. Black (2001), Black et al. (2002), Gompers et al. (2003), and Joh (2003) find a positive correlation between performance measures and governance level.³ In this paper, we investigate this issue systematically for publicly listed firms in China. We analyze empirically the effects of corporate governance practices on the market valuation of the firms based on a three-year panel data set collected from the firms' annual reports. Rather than rely on survey data, we use the actual corporate governance practices of all publicly listed firms in China between 1999 and 2001. Controlling for a number of variables that are typically included in studies of the firm market valuations, we use various measures of corporate governance to determine Tobin's q values for these firms. In our empirical analysis, we pay particular attention to an important characteristic of Chinese firms, namely the dominance of state-owned shares.

Regarding the literature, Qian (1995) provides a comprehensive discussion of corporate governance issues in China. Groves et al. (1994) and Li (1997) present evidence that improved incentives in the reform process increase the productivity of the firms. On the other hand, Xu (2000) and Shirley and Xu (2001) show empirically that performance contracts are relatively ineffective. Qian (1996) and Che and Qian (1988) emphasize the important role played by the Chinese government in corporate governance. Zheng et al. (1998), Xu and Wang (1999), Zhang et al. (2001), Li and Wu (2002), Sun and Tong (2003), and Tian (2002) investigate the impact of state-ownership on enterprise performance and generally find a negative effect. For example, Sun and Tong (2003) consider the impact of share issuance privatization (SIP) and legal person shares on firm performance. They find that SIP is effective in improving SOEs' earning ability, real sales, and workers' productivity but it does not improve profit returns and leverage. They also find state ownership to have a negative impact and legal-person ownership to have a positive effect on firm performance. Aharony et al. (2000) show how earnings management in the financial packaging of China's SOEs for public listing depends on the firm's relationship with the central government and on where the securities are listed. In this literature, the studies of Xu and Wang (1999), Tian (2002), and Sun and Tong (2003) are related most closely to our work because they are empirical studies using stock market data from China. Our contribution is to consider a comprehensive list of corporate governance mechanisms and to investigate their impacts on the market valuation of the firms. Hence, we assess the relative importance of various governance mechanisms in increasing the market valuation. Furthermore, in contrast to Xu and Wang (1999) and Tian (2002), our study is based on a panel data set, which allows us to mitigate a possible endogeneity problem by estimating fixed-effects models.

Most empirical studies of the relationship between corporate governance and firm performance in other countries focus on a particular aspect of governance, e.g., board characteristics (Millstein and MacAvoy, 1998, and Bhagat and Black, 1999), shareholders' activism (Karpoff et al., 1996, and Carleton et al., 1998), compensation to outside directors Bhagat et al., 1999, anti-takeover provisions Sundaramurthy et al., 1997, and investor protection La Porta et al., 2002. Recently, several papers study the effects of general corporate governance practices on firm value, primarily in emerging markets. Most of these either use a small single-country sample (Black, 2001, and Gompers et al., 2003) or multi-country samples that contain only the largest firms in each country (Durnev and Kim, in press, and Klapper and Love, in press). Our paper is closest to the study by Black et al. (2002) on Korean firms in the sense that all listed firms in the respective market are included. However, these authors use a different method to control for the endogeneity, namely instrumental variables.

Our paper is organized as follows. Section 2 reviews the theoretical literature on corporate governance and summarizes major governance mechanisms. Section 3 discusses the variables used in our empirical study. Section 4 presents the econometric analysis and Section 5 concludes with a summary of the results and policy implications.