Corporate Governance And Firm . - University Of Florida
Corporate Governance and Firm Efficiency: Evidence fromChina’s Publicly Listed FirmsChen Lin a , Yue Ma a, b, Dongwei Su c,d,aDepartment of Economics, Lingnan University, Hong KongMacroeconomic Research Center, Xiamen University, ChinacDepartment of Finance, Jinan University, Guangzhou 510632, ChinadResearch Institute of Finance, Jinan University, Guangzhou 510632, ChinabAbstractThis paper applies a two-stage, double bootstrapping data envelope analysis (DEA)approach to investigate whether and to what extent various distinctive corporate governancepractices affect productive efficiency in a sample of 461 publicly listed manufacturing firms inChina between 1999 and 2002. We find that firm efficiency is negatively related to stateownership while positively related to public and employee share ownership. The relationshipbetween ownership concentration and firm efficiency is U-shaped, indicating the presence oftunneling activities by the largest shareholder. Among three types of controlling shareholder,state exerts the most negative impact on firm efficiency, followed by state-owned legal entities.These results provide strong evidence that political interferences have reduced firm efficiency.In addition, we find that the proportion of outside directors and the number of board meetingsare positively associated with firm efficiency, suggesting that board of directors can be aneffective internal governance mechanism. Furthermore, we find that provincial marketdevelopment, a proxy for the strength of external governance mechanism, is positively relatedto firm efficiency. Overall, our findings illustrate that restructuring state-owned enterprises viaimprovements in corporate governance has enhanced firm efficiency, but partial privatizationwithout transfer of ownership and control from the state to the public remains a major source ofinefficiency in corporate China.Keywords: Corporate governance, Efficiency, Data envelopment analysis, ChinaJEL classification: D24; G30; P31We thank two anonymous referees, Sanford Berg, Joel Houston, Guohua Jiang, Alan Stent, Lihui Tian,Tracy Wang, and participants at the fifth annual China Economic Conference, the Sixth Annual InternationalConference on Financial Engineering, and the Journal of Banking and Finance 30 th Anniversary InternationalConference for their helpful comments and suggestions. The financial support from Lingnan University(DR07B2) and the RGC of Hong Kong SAR Government (No. LU3110/03H) is gratefully acknowledged. Sualso wishes to acknowledge the financial support from the National Natural Science Foundation of China(Grant No. 70572065), the Ministry of Education of China (Grant No. 200403), the Guangdong Project ofKey Research Institute of Humanities and Social Sciences at Universities (Grant No. 04JDXM79001 and07JDTDXM79005) and the Innovative Research Team Project of Jinan University (Grant No. 04SK2D03).However, we are responsible for all remaining errors of this paper.Corresponding author. Tel.: (852)26167200; fax: (852)28917940.E-mail address: chen.lin@ln.edu.hk1
1. IntroductionCorporate governance is a set of mechanisms, both institutional and market based, designedto mitigate agency problems that arise from the separation of ownership and control in a company,protect the interests of all stakeholders, improve firm performance, and ensure that investors getan adequate return on their investment (Shleifer and Vishny, 1997; La Porta et al, 2000).Governance mechanisms can be classified into internal monitoring mechanisms includingownership structure, board characteristics, outside supervision and executive compensation, andexternal monitoring mechanisms such as legal system, active takeover market and productionmarket competition (Huson et al., 2001; Denis and McConnell, 2003).The effectiveness ofcorporate governance mechanisms has been a subject of academic research for many decades.Although the large majority of corporate governance studies prior to mid 1990s were based ondata from developed market economies such as the U.S., U.K. and Japan, in recent yearsresearchers began looking into corporate governance in transition economies (Dnes, 2005)1.This endeavor is partly motivated by the world-wide surge of enterprise privatization and marketliberalization as governments of all ideological stripes initiated various institutional reforms todecentralize and commercialize their state-owned enterprises (SOEs), and in some cases, tomassively transfer ownership and control of SOEs to the public (Megginson and Netter, 2001).For example, Djankov and Murrell (2002) document that more than 150,000 large SOEs intransition economies have undergone enterprise restructuring and experienced revolutionarychanges in political and economic environments in 1990s, which provides a fertile ground foranalyzing age-old issues such as the relative productivities of state versus private enterprises andthe cost efficiency of diffuse share ownership relative to large shareholder control.Estrin (2002)argues that transition economies make a particularly good laboratory for understanding theevolution of corporate governance structure and for evaluating the impact of alternativegovernance mechanisms and policy frameworks.While researchers have broadened their use ofgovernance data to include privatized former SOEs in their studies, research into the1Dennis and McConnell (2003) provide a good survey of the literature on international corporategovernance.2
effectiveness of corporate governance in transition economies remains limited. The objective ofthis paper is to expand the literature on the corporate governance of transition economies bydisentangling the effects of corporate governance mechanisms on firm efficiency in China, thelargest transition economy in the world.In recent years, there has been a growing interest in corporate governance in China (Liu,2005). Qian (1996) shows that China shares many of the typical institutional characteristics as atransition economy, including poor legal protection of creditors and investors, the absence of aneffective takeover market, an underdeveloped capital market, a relatively inefficient bankingsystem and significant interference of politicians in firm management. Sun and Tong (2003) showthat share issuance privatization (SIP) has improved earnings, sales and workers‘ productivity,but has not increased returns to investors.They also show that state ownership is associatedwith poor SOE performance and that legal entity ownership is tied to better firm performance.Wei et al. (2005) present evidence that Tobin‘s q is negatively related to state and institutionalshares but positively related to foreign ownership for a sample of privatized former SOEs during1991 and 2001. Allen et al. (2005) demonstrate that standard corporate governance mechanismsare weak and ineffective for publicly listed firms while alternative governance mechanisms basedon reputation and relationship have been remarkably effective in the private sector. Aivazian et al.(2005) provide evidence that CEO turnover is tightly linked to firm performance, suggesting thatenterprise restructuring has improved corporate governance in China. However, However, Firthet al. (2006b) find no evidence that firm performance improves following the turnover of theboard chairman, suggesting that internal governance structure may not be effective amongChina‘s listed firms In another study, Firth et al. (2006a) find that CEO pay-performancesensitivity is significantly positive for all publicly listed firms but statistically insignificant forstate controlled firms, suggesting that government weakens corporate governance andpay-performance incentives for CEOs. The reason that China draws so much attention is becauseChina offers a unique environment for analyzing corporate governance and firm performance.First, China‘s SOE reform strategy hinges on the Modern Enterprise System characterized by theseparation of ownership and control (Su, 2005). Ownership of an SOE‘s assets is distributed3
among the government, institutional investors, managers, employees, and private investors.Effective control rights are assigned to management, which generally has a very small, or evennonexistent ownership stake. This distinctive shareholding structure creates conflict of interestnot only between management (insiders) and outside investors but also between largeshareholders and minority investors. Moreover, because Chinese government desires to retainsome control—in part through partial retained ownership of commercialized SOEs, furtherconflicts arise between politicians and firms (Shleifer and Vishny, 1994). Therefore, it is ofinterest to assess whether and to what extent this complex ownership structure affects firmperformance and efficiency in China‘s corporations.Second, board of directors in publiclylisted firms consists mainly of representatives or officials from the government and other stateenterprises, whose interests may not be in line with those of outside investors.Board membersno doubt care more about carrying out the wishes of the government, such as avoiding workerlayoffs and maintaining some level of worker social security than about the concerns ofshareholders.As a result, internal governance mechanisms, such as the number of outsidedirectors on the board and the number of outside supervisors on the supervisory committee, mayinfluence firm performance and efficiency.Third, because of the political nature of theprivatization process itself, typical external governance mechanisms, such as debt (in conjunctionwith appropriate bankruptcy procedures), takeover threats, legal protection of investors, productmarket competition, etc., have not been effective (Su, 2005). Bank loans have traditionally beenviewed as grants from the state designed to bail out failing firms.State-owned banks retain amonopoly in the banking sector and profit is not their overriding objective. If political favor isdeemed appropriate, subsidized loans, rescheduling of overdue debt or even outright transfer offunds can be arranged with SOEs (soft budget constraints).In addition, a market for private,non-bank debt has yet to be established. There is no active merger or takeover activity in stockmarkets to discipline management. Information available in the capital markets is insufficient tokeep at arm‘s length of the corporate decisions. In light of these peculiarities, a proxy for thestrength of provincial market liberalization, economic freedom and legal environment may helpexplain the cross-sectional variation in firm performance and efficiency. Fourth, several social4
reforms (corporatization, privatization and marketization) are ongoing in China. These socialexperiments enable us to find out the most important efficiency driving factors and contribute tothe debate about whether privatization is necessary in improving firm performance (Aivazian etal., 2005).In this paper, we investigate whether and to what extent the aforementioned distinctivecharacteristics of governance mechanisms affect productive efficiency in a sample of 461publicly listed manufacturing firms in China between 1999 and 2002.2 A clear distinctionbetween our paper and the existing literature is that we simultaneously consider a number ofunique corporate governance practices (e.g., complex ownership structure, controllingshareholder identities, and outside directors and supervisors) inherent in the reform of SOEs inChina and include a proxy for the strength of provincial market liberalization and legalenvironment to account for the effects of external governance mechanisms on firm performance.As Boubakri et al., (2005) point out, the ultimate success of privatization depends on theeffectiveness of post-privatization corporate governance mechanisms. Most of the existingstudies omit some aspects of governance practices, which may induce endogeneity problems inregression analyses (Megginson and Netter, 2001; Denis and McConnell, 2003). Moreover,privatizations are often accompanied by massive economy-wide changes such as reduction ingovernment intervention, deregulation of price control, development of product markets andimprovement of legal environment, but the literature usually fails to incorporate these changesinto the empirical models to isolate the impacts of market liberalizations on firm performance. 3Therefore, our paper contributes to the literature on corporate governance of transition economies2Efficient frontier methodologies usually summarize firm performance in a single statistic that controlsfor differences among firms using a sophisticated multidimensional framework. The statistic can beused in a variety of ways to assist managers to evaluate relative firm performance in terms oftechnology, scale, cost minimization and revenue maximization. Chinese stock markets are oftenplagued with speculative activities and earnings management. Thus, measures of productive efficiency(estimated via DEA) are superior to accounting-based performance measures.3As the degree of marketization (adoption of market-based policies) increases, SOEs will be exposed tomore intense competition and managers will more likely be held accountable for poor firm performance,leading to more effective corporate governance practices. Megginson and Netter (2001) assert that―privatization tends to have the greatest positive impact in cases where the role for government inlessening market failure is the weakest‖. Hence, the degree of marketization can be an importantfactor in determining firm performance.5
by providing a more comprehensive test of the relationship between corporate governancemechanisms and firm efficiency in the context of China. By doing so, our study complements thestudy of Liu (2005), which provides a qualitative introduction to corporate governance in China.In addition, our study contributes to the ongoing debate on whether ownership change(privatization) is necessary for improving the efficiency of SOEs 4.In Section 2, we quantify measures for internal versus external governance mechanisms andoutline testable hypotheses on the relationship between corporate governance variables and firmefficiency.In Section 3, we describe the data and characterize the distribution of firmobservations across time and sub-industries, and present summary statistics.In Section 4, wediscuss the DEA methodology for calculating firm efficiency scores and present empirical resultsfrom second-stage regressions with efficiency score as dependent variable and governanceproxies as independent variables. In the last section, we conclude the paper and draw policyimplications from our results.2. Corporate governance variables and hypothesesIn this section, we discuss measures of internal versus external governance mechanisms andoutline testable hypotheses on the relationship between corporate governance variables and firmefficiency.2.1. Ownership structureThe ownership structure of China‘s listed firms can be classified into four main categories:state shares (STATE), legal entity shares (LEGAL), publicly tradable shares (PUBLIC) andemployee shares (EMPLOYEE).5 State shares are retained by the State Assets Management45Boycko et al. (1996), Shleifer (1998) and Shirley and Patrick (2000) assert that because governmentscannot play an active role in corporate governance, ownership change is necessary for any significantperformance improvements of SOEs. On the other hand, Vickers and Yarrow (1991), Allen and Gale(2000) and Aivazian et al. (2005) argue that less radical methods such as managerial incentive contracts,market deregulation, and internal and external governance reform can be effective substitutes to outrightprivatization.The official shareholding classification of state and legal entity is somewhat misleading, in that thegovernment can extend its ownership and control of an SOE through pyramidal shareholding scheme.Liu and Sun (2003) find that 84% of the listed companies in their sample are ultimately controlled bythe state. We find that 86% (1571 out of 1817) of the firms in our sample are ultimately owned by thestate.6
Bureau (SAMB) of the central or local government and are not allowed to be publicly traded,although reforms have been initiated to free up these shares since May 2005. 6For the reasonsoutlined below, we hypothesize that STATE is negatively related to firm efficiency.First, whilein theory publicly listed former SOEs are owned by all investors, they are actually controlled bybureaucrats who have extremely concentrated control right but no significant cash flow rightsince the latter is dispersed amongst the taxpayers of the country (Shleifer and Vishny, 1997). Thebureaucrats‘ main concern is to achieve their political and economic interests, which are oftenquite different from shareholders‘ profit maximization objective (Shleifer and Vishny, 1994;Boycko et al., 1996). Second, SOE managers have weak or sometimes adverse incentives toimprove firm efficiency, because ―as public employees, SOE managers cannot personally reap thebenefits of increasing revenues yet they will bear many of the costs (e.g., angry workers anddisgruntled suppliers) of reducing the firm‘s production costs‖ (Megginson, 2005). Third, softbudget constraint is regarded as another major source of inefficiency of state ownership (Kornai,1986; Lin et al., 1998). When government can indirectly subsidize SOEs to maintain bloatedemployment levels, employee housing, schooling and other political objectives through controlover transfers from the treasury, thus creating a soft budget constraint, SOEs cannot be effectivelydisciplined by the working of the capital market.Legal entity shares are held by domestic institutional investors including securities andinsurance companies, mutual funds and industrial enterprises.Similar to state shares, legalentity shares are not tradable and most of them are ultimately controlled by the state through itscontrol over legal entities.6However, as pointed out by Sun and Tong (2003), there existOn average, the state retains about one third of the shares outstanding and is the largest shareholder inmore than 40% of the listed firms. This phenomenon is quite similar to that in other transitioneconomies. According to Estrin (2002), the state retained a fraction of shares in one out of every fourprivatized firms in 20 of the 23 transition economies. However, beginning in May 2005, shares of amajority of publicly listed firms in China have moved from ―partially tradable‖ to ―fully tradable‖, orhave become the so-called ―G shares‖. During this process, the holders of non-tradable shares haveagreed to provide the holders of tradable shares with free shares, cash, warrants or some other means ofcompensation in exchange for their shares to become tradable. By the end of 2006, 1,139 listed firmsrepresenting 84% of the market capitalization have completed the share reform. However, non-tradableshares are subject to a lock-up period and have not yet become tradable. Specifically, according to theCSRC‘s guidelines, only up to 5% of the non-tradable shares can be floated one year after thecompletion of the reform; another 5% can be traded in the second year following the reform and theremaining non-tradable share can become tradable only after three years following the reform.7
important differences between outright state ownership and legal entity share ownership, whichlead to different implications for corporate governance.In particular, because many legalentities have close business connections with the listed firms in which they have ownership, theyhave incentives to be active in corporate governance.Compared with government officials orindividual shareholders, legal entity shareholders have more expert knowledge of the firm and arebetter equipped with the power to monitor managers through their influence on the board ofdirectors. However, it is also quite possible that legal
1 Corporate Governance and Firm Efficiency: Evidence from China’s Publicly Listed Firms Chen Lin a, Yue Ma a, b, Dongwei Su c,d, a Department of Economics, Lingnan University, Hong Kong b Macroeconomic Research Center, Xiamen University, China c Department of Finance, Jinan University, Guangzhou 510632, China d Research Institute of Finance, Jinan University, Guangzhou 510632, China
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