Corporate governance and market valuation in China
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.
Section snippets
Corporate governance mechanisms
Over three hundred years ago, Adam Smith raised the issue of the separation of ownership and stewardship in joint-stock corporations. Hence, a set of effective mechanisms to resolve the conflict of interests between the firm's owners and its managers is necessary. The seminal work by Berle and Means (1932) argues that, in practice, managers of a firm pursue their own interests rather than the interests of shareholders. The contractual nature of the firm and the principal-agent problem
Quantifying corporate governance mechanisms and market valuation
We begin this section by quantifying some measures of corporate governance. Starting with ownership variables, we denote the stake of the largest shareholder as top1. We use this variable to measure both the largest shareholder's interest in a company and also the largest shareholder's power on the board. As discussed above, we expect the relationship between a firm's market valuation and this variable to be U-shaped, although it should be negative if we restrict the relationship to be linear.
Empirical results on corporate governance and market valuation
In this section, we investigate empirically the effects of the chosen corporate governance mechanisms on the market valuation of the firms. We use three different measures of market valuation, namely Tq, Tq_70, and Tq_80, as dependent variables. The explanatory variables include the eight corporate governance variables, together with size, the leverage ratio, the capital-sales ratio, the operation income-sales ratio, and industry dummies as control variables. We choose control variables that
Conclusion
We analyze empirically the impact of eight corporate governance measures on the market valuation of listed firms in China with standard control variables included. We take Tobin's q, and its adjusted values for the illiquidity of the Chinese market, as measures of market valuation. We use a three-year panel data set and estimate both fixed-effects and random-effects models. Consistent with theoretical predictions, we find that both high concentration of shareholding among the second to the
Acknowledgments
We thank two anonymous referees and especially John Bonin for their valuable comments and suggestions, and Li Chuntao for his excellent research assistance. We acknowledge financial support from the Center for China Financial Research (CCFR) in the Faculty of Business and Economics of the University of Hong Kong.
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