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Corporate Governance and Protection of the Rights of Minority
Shareholders in China
Center for China Financial Research (CCFR)* Faculty of Business
and Economics
The University of Hong Kong
April 2002
Abstract
The issue of corporate governance in China is examined in this
study. We identify several important governance mechanisms for
Chinas publicly listed companies and construct four sets of
variables based on these mechanisms. The variables include measures
of ownership structure, the board, managerial incentives, corporate
control, and financial transparency. We then create a ranking index
for corporate governance (G-index) based on these variables.
Finally, we relate the G- ranking index to measures of corporate
performance. We find that better-governed companies are associated
with higher profitability as measured by ROA and ROE, higher stock
market valuation as measured by the ratio of market value and book
value of the net asset, and lower market turnover ratio. The
results indicate that good corporate governance matters greatly in
Chinas emerging stock market.
Keywords: Corporate governance, Corporate performance, Stock
valuation, Market premium
*Project members: Chongen Bai, Qiao Liu, Joe Lu, Frank M. Song,
and Junxi Zhang. We thank Li Chuntao for his excellent research
support.
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1.Introduction
Corporate governance has always been an important issue of
interest to academics,
businesses, and policy makers. Policy makers in many countries
have been encouraging companies to adopt higher governance
standards. International organizations have also actively
participated in the movement for better corporate governance. For
example, the International Monetary Fund has demanded that
governance improvements should be included in its debt relief
program, especially during the most recent Asia financial crisis.
The World Bank and the Organization for Economic Cooperation and
Development (OECD) have also been working hard towards raising the
standard of corporate governance. Notably, in 1998, OECD issued its
influential OECD Principles of Corporate Governance, which are
intended to assist member and non-member countries in their effort
to evaluate and improve the legal, institutional and regulatory
framework for corporate governance in their economies. In addition,
many private companies, such as Standard & Poor, California
Retirement Pension System, and McKinsey, are calling for sweeping
reforms of corporate governance of companies, especially publicly
listed firms in emerging economies.
Corporate governance has also gained unparalleled importance in
China. Although China
has made remarkable progress in its development since the start
of economic reform in 1978, some obstacles remain that hinder
further economic development and growth. One of the obstacles seems
to be the lack of a sustainable efficient and competitive
market-based economic mechanism. A significant number of
corporations, both state-owned enterprises (SOEs) and corporatized
firms, are often fraught with serious problems of low economic
efficiency, ambiguous property rights, weak corporate governance
and generally poor financial discipline. 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. Corporate China's lackluster performance is believed to
be the direct consequence of ineffective governance. All these
problems point to the crucial role of good corporate governance in
sustaining the growth of the economy.
In this project, we seek to study corporate governance of Chinas
listed companies. It is
believed that Chinas listed companies are among the best
corporations in China. The government gives preferential treatment
to better- managed SOEs to allow them to be listed and raise
capital in the stock market. Over a relatively short period of
time, the market value of China's listed companies has risen to
over 4,000 billion Yuan, or roughly 50% of China's GDP. It is
reported that there are over 60 million registered individual
shareholders, 1/6 of them actively trade and hold stock. Therefore,
the governance and performance of China's listed companies has
enormous economic significance on both the economy as a whole and
the wealth of individuals. Hence, we believe it is important to
have a good understanding of corporate governance structure in
China's listed companies. Our effort also echoes the main policy
goal of the regulatory agency Chinese Securities Regulatory
Commission (CSRC) for this year. Early this year, the CSRC
designated year 2002 as the year for better corporate governance
for Chinas listed companies.
To conduct a test on the proposition that corporate governance
behavior affects the
performance and the market value of Chinese firms, one needs an
objective and reliable dataset on corporate governance rankings for
the publicly listed companies in China. To our best knowledge, such
a dataset is not available. Thus, in this project we devote a
considerable amount of time to construct an index on corporate
governance, dubbed as the G index. In
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constructing the G index, we follow the corporate governance
mechanisms suggested by the theoretical literature and consider
four groups of variables. The first group of variables is related
to the tunneling activities by the controlling shareholder;
Tunneling refers to the diversion of corporate resources from the
corporation (or its minority shareholders) to its controlling
shareholder. The second is related to monitoring, while the third
is related to managerial incentives; Finally, we consider several
measures of financial transparency.
The paper is organized as follows. Section 2 reviews the
theoretical and empirical
literature on corporate governance studies and summarizes major
mechanisms of corporate governance. Section 3 discusses the
variables used in our construction of the ranking of corporate
governance and the methodology of the ranking analysis. Section 4
presents the ranking results and relates the corporate governance
ranking with corporate performance and stock valuations. Section 5
concludes the report.
2. The literature
Over three hundred years ago, in his masterwork The Wealth of
Nations, Adam Smith raised the issue of the separation of ownership
and stewardship in joint-stock corporations. Effective corporate
governance has always been an important issue in market economies.
Modern academic literature on corporate governance stems from the
seminal book by Berle and Means (1932), who argued that, in
practice, managers of a firm pursued their own interests rather
than the interests of shareholders. The contractual nature of the
firm and the principal-agent problem highlighted by Berle and Means
led to the development of the agency approach to corporate finance.
Over the years, in particular in the last quarter of the 20th
century, there has seen rapid growth in both the theoretical and
empirical studies. In this section, we briefly review some of the
main developments in the literature.
The agency approach to corporate governance attempts to provide
answers to the key
question How can shareholders ensure that non-owner managers
pursue their interests? The literature describes seven important
corporate governance mechanisms that encourage managers to act in
the interests of the shareholders. They are, respectively, the
board of directors, executive compensation, the market for
corporate control, concentrated holdings and monitoring by outside
investors, debt, product market competition, and financial
transparency and information disclosure.
Besides, there may also exist a potential conflict among
shareholders. It is well known that
even in developed economies, tunneling the diversion of
corporate resources from the corporation (or its minority
shareholders) to the controlling shareholder can be substantial and
value-destructive. Although some tunneling (especially in emerging
markets) takes the form of theft or fraud, legal tunneling does
take place in developed countries as well. Tunneling usually takes
two forms. First, a controlling shareholder can simply transfer
resources from the firm for his own benefit through self-dealing
transactions. Second, the controlling shareholder can increase his
share of the firm without transferring any assets through dilutive
share issues, minority freezeouts, insider trading, creeping
acquisitions, or other financial transactions that discriminate
against minorities. Thus, a good corporate governance structure
requires directors to follow two broad principles. First, the duty
of care requires a director to act as a reasonable, prudent, or
rational person would act in his position. Second, the duty of
loyalty, or fiduciary duty, requires that insiders do not profit at
the expense
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of shareholders, or of the corporation as the case may be
depending on whom they legally owe loyalty to.
Next, we review each of the seven mechanisms in turn.
(1) The board of directors
In theory at least, the board of directors is the first
instrument through which shareholders
can exert considerable influence on the behavior of managers in
order to ensure that the company is run in their interests.
Empirical studies, however, are complicated by the fact that due to
the well-known historical, political, social, economical, cultural
and legal differences across countries, the structure of boards is
significantly different. Nevertheless, the evidence available
suggests that countries share common features with regard to this
mechanism.
The empirical literature on the relationship between board
composition and firm
performance obtains the following findings: (1) Firms with
boards containing a majority of independent directors do not
perform better than firms without such boards; (2) A moderate
number of inside directors is associated with greater
profitability; (3) In Japan, although the presence of outside
directors on the board has no effect on the sensitivity of CEO
turnover to either earnings or stock-price performance,
concentrated equity ownership and ties to a main bank do have a
positive effect; and (4) There is a strong inverse relationship
between CEO turnover and firm performance in some countries.
(2) Executive compensation
The second method of ensuring that managers pursue the interests
of shareholders is to
structure compensation appropriately, where the measures used to
motivate managers include both stock prices and accounting based
performance measures. Although most of the empirical studies are
constrained by data availability, the limited finding seems to
suggest that there is a positive relationship between executive pay
and performance in the US, Germany and Japan.
(3) The market for corporate control
It is generally believed that the existence of an active market
for corporate control is
essential for the efficient allocation of resources. It allows
inefficient managers to be removed and replaced with able managers
who can gain control of large amounts of resources in a short
period of time. The market for corporate control can operate in
three ways: proxy contests, friendly mergers and hostile
takeovers.
Proxy fights do not usually unseat the existing board of
directors successfully because
share holdings are often spread among many shareholders.
Friendly mergers and takeovers occur in all countries and account
for most of the transaction volume that occur. In some developed
countries, it ranges from 60% to 90%. For hostile takeovers, they
do occur fairly frequently in the US and UK, however, much less so
in Germany, France and Japan. Empirical studies suggest that
takeovers in the past did significantly increase the market value
of target firms, although the increase in value for bidding firms
was zero and possibly even negative. Studies using accounting data
find that changes and improvements in operations can at least
partially explain takeover premia.
(4) Concentrated holdings and monitoring by outside
investors
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It is believed that one of the most important ways through which
a firm maximizes its
value is through concentrated ownership of the firms shares. The
reason is that more wealth commitment by owners encourages
monitoring and thus improves firm performance. Therefore, in
general, concentrated equity ownership is regarded as a positive
mechanism in corporate governance. But, it should also be noted
that there are costs associated with-such monitoring by large
shareholders: it may restrict the misuse of resources ex post but
may also blunt ex ante managerial initiative. Moreover, large
share-blocks result in incentives to monitor but also lead to a
lack of liquidity.
Similar arguments can be made with regard to outside investors,
in particular institutional
investors. In Japan and Germany, because of the lack of a market
for corporate control, financial institutions act as outside
monitors for large corporations. It is generally agreed among
economists, although the main-bank system in Japan has problems, it
is still effective to some degree in achieving good corporate
governance. For Germany, until recently the view has been that
banks provide effective monitoring of firms. Some economists argue
that close relationships between banks and firms in Germany involve
costs as well as benefits for the firm. Nevertheless, widespread
equity ownership should increase firm monitoring and eventually
improve performance.
(5) Debt
It has been argued that debt is a useful force in ensuring
managerial discipline in
corporations. The argument is that default on interest or
principal can be personally costly to managers, therefore legally
required interest payments force managers to focus on generating
positive cash flows and prevent them from squandering
resources.
However, debt can have undesirable effects on managers behavior.
When a firm has
significant debt outstanding, managers would have an unduly
incentive to take risks and may even accept projects that destroy
value. The well-known debt overhang problem in the US in the 1980s
is a good example.
(6) Product market competition
Another powerful force for solving agency problem is competition
in product markets. If
the managers of a firm waste resources, the firm will eventually
fail in product market. Hence, increased competition reduces
managerial slack and may be helpful in limiting efficiency
losses.
(7) Financial transparency and adequate information
disclosure
There is no doubt that financial transparency and adequate
information disclosure are of
ultimate importance in all countries, particularly developing
ones. Managers play a vital role in securing the interests of not
only the existing owners but also potential investors. Honest
managers will attempt to provide sufficient, accurate and timely
information regarding the firms operations, financial status, and
external environment.
In sum, maximizing shareholders' value should be managers'
mission; good corporate
governance helps value-maximization. Hence an interesting
question arises as to whether improved corporate governance
actually pays off. For US firms, evidence that governance
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practices matter is scarce. For example, the proportion of
independent directors on a companys board (or whether the company
has a majority-independent board) has no statistically significant
effect on performance. Similarly, neither overt activism by
institutional investors, nor insider share ownership, nor ownership
by outside blockholders, nor a firms committee structure, has a
measurable effect on performance.
Economists argue that the problem does not lie in the
proposition that firms corporate
governance behavior affects their market values, but lies in the
data. A number of studies are made on countries with weak laws
governing the behavior of firms and their insiders (managers and
large shareholders), and weak norms for insider conduct. It is then
found that good governance is actually rewarded with a higher
market valuation. Shareholders in emerging markets are willing to
pay a premium for good governance standard, averaging around 10% to
12%. For countries like Russia, this premium is even higher.
3. Construction of the G Index In this project, we try to
quantify and evaluate the relative quality of corporate
governance
for each of the listed company in Shanghai and Shenzhen Stock
Exchange. To accomplish this, we construct a corporate governance
index, the G Index, for each of the listed company. We then rank
the companies by the value of the G Index.
In order to construct a quantitative index of corporate
governance for every listed
company, we need to quantify various theoretical aspects of
corporate governance. In this study, we consider several factors
that potentially affect the quality of corporate governance. The
choice of the variables is guided by our understanding of the
corporate governance mechanisms discussed in Section 2. However,
due to data availability, some of the important variables are
missing. In the mean time, we have added a few variables to capture
the uniqueness of Chinas listed companies.
3.A. Definition of variables
The first group of variables is related to tunneling (or
expropriation of small shareholders
by the controlling shareholder). Some of them also affect
governance through other channels.
(1) Shareholding of the largest shareholder top1 This variable
potentially has two conflicting effects on the quality of corporate
governance.
One is related to the monitoring role of the largest
shareholder, who has a stronger incentive to monitor the manager
when his stake in the firm is high. The other effect arises out of
the potential tunneling by the largest shareholder. When he can
control the firm, he may use his control to benefit himself at the
expense of other shareholders. The larger is his shareholding, the
weaker is the threat to his control and hence the worse is his
tunneling.
(2) The firm has a parent company parent dummy
When the largest shareholder is another firm, the scope for
tunneling is wider. There are
many more channels for a company than an individual to tunnel.
The parent company can expropriate other shareholders of the
concerned firm through various business dealings between them, or
connected transactions. The most commonly used tool is transfer
pricing. This is the reason for us to consider the next
variable.
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(3) The number of connected transactions ct_num reported by the
firm in 2000.
(4) Concentration of shareholding in the hands of the second to
the tenth largest shareholders cstr2_10 = sum of squares of the
percentage shareholding by the 2nd to the 10th largest
shareholders
This factor should have a positive effect through three
channels. Firstly, these other large
shareholders are the obstacles to the tunneling activities by
the largest shareholder. Secondly, they enhance the efficiency of
the market for corporate control. When the management
under-performs, these large shareholders can either initiate a
fight for corporate control or help an outsiders fight for control.
Thirdly, these large shareholders also serve as monitors of the
management. The higher the concentration of shareholding in the
hands of these large shareholders, the stronger these roles.
The second group of variables is related to monitoring.
(5) The CEO is the chairman or a vice chairman of the board of
directors ceo_is_top_dir dummy
The board of directors should play a role of a monitor of the
management. When the top
manager, the CEO, controls or partially controls the board, it
is hard for the board to play an active monitoring role.
(6) The proportion of outsider directors out_in_ratio the ratio
of the number of directors without pay with respect to the number
of paid directors.
Paid directors are often members of the management team. If they
dominate the board, the
board is not expected to play an effective monitoring role. The
third group of variables is about managerial incentives.
(7) Shareholding by the top five managers of the firm top5 The
interests of the top managers are better aligned with the interests
of other shareholders
if the former have more stakes in the firm.
(8) Dividend payout ratio div_earning_ratio the ratio of
dividend paid in year 2000 with respect to year 2000 distributable
earnings
When the firm only pays out a small proportion of distributable
earnings, the firm has
more free cash flow a la Jensen. Free cash flow gives the
management room for slack. For example, they may waste the free
cash flow on unprofitable projects or on perks.
The final group of variables concerns financial disclosure.
(9) auditor opinion - audit
Auditors conduct independent examinations of the financial
statements prepared by a
company. An audit report should state whether the financial
statements are prepared in
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accordance with the generally accepted accounting principles. It
should also identify areas in which the generally accepted
accounting principles are not followed. Auditors express an opinion
regarding the financial reports taken as a whole. This variable
represents auditor's opinion on a company's financial reports. It
is a dummy variable that takes the value of
1, if the auditor issues an unqualified or clean opinion; i.e.
the auditor believes that the financial reports are presented
fairly, in all material aspects, in conformity with the generally
accepted accounting principles. 2, if the auditor issues a
qualified opinion; i.e. the auditor believes that the financial
statements are presented fairly, except for the parts that the
qualification relates to. 3, if a disclaimer of an opinion is
issued by the auditor; i.e. the auditor does not have sufficient
information to express an opinion. 4, if an adverse opinion is
expressed by the auditor; i.e. the auditor believes that the
financial statements taken as a whole are not prepared in
accordance with the generally accepted accounting principles. We
notice that most companies in our study received clean opinions
from their auditors. In
recent years, the media and the regulatory agency have exposed
several companies who colluded with their auditors to publish false
and misleading financial statements. We believe that the exposed
cases were the most notorious ones; there could be many more cases.
However, in our opinion, the auditor's opinion still provides
important information regarding a company's corporate governance.
Companies with strong corporate governance are less likely to issue
financial reports that are not in accordance with the generally
accepted accounting principles.
(10) The number of law suits a company involves lawsuits
This variable measures the number of lawsuits a company involves
at the end of the fiscal
year. The lawsuit information is gathered from the Wind
database. We include all lawsuits in which a company involves,
either as the plaintiff or the defendant. In developed economies,
businesses constantly deal with lawsuits. The number of lawsuits a
firm involves in may not provide information on its corporate
governance. However, in China, the legal and business environments
are unique. We believe that generally companies with strong
corporate governance are less likely to entangle in lawsuits. We
notice that there is no database, which comprehensively covers
lawsuits information of Chinas publicly traded companies. Thus,
this variable only serves as a crude measure.
(11) Debt-to-equity ratio d_e
This variable measures a company's debt to equity ratio. Debt is
a company's year-end
total liabilities; equity is its total shareholders' year-end
equity. We employ this measure mainly because the debt-to-equity
ratio captures a company's financial distress. Companies with
strong corporate governance and good management are less likely to
face financial distress.
(12) 1/Accounts payable turnover ratio acc_index
The accounts payable turnover ratio measures how quickly a
company pays trade credit. It
is computed as follows: Cost of goods sold Average accounts
payable
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The ratio proxies a company's liquidity. A high value normally
indicates that a company pays its trade credit timely. Defaults on
trade credits are a serious problem in China. We expect that
better-managed companies are less likely to default. However, this
ratio may not reflect the fact that a company pays some of its
creditors on time but is late with others, which is quite common in
China.
The second set of variables is related to corporate performance.
We use the following two
measures for corporate profitability. (1) Return on asset (ROA)
is measured by the ratio of net profit in year 2000 and the
average asset of year 1999 and 2000. (2) Return on equity (ROE)
is measured by the ratio of net profit and the market value
at the end of year 2000. ROA and ROE are two most used measures
of corporate profitability. In addition, we also use the measure of
market value to book value of companys net asset,
Market/Book, to gauge the market valuation of the company. The
turnover in the trading of companys stock, turnover, is measured by
averaging
monthly turnover rate for the year 2000 where the monthly
turnover rate is approximated by total A shares traded during the
month divided by the total number of A shares.
Finally, we measure the volatility of the stock returns, Std, by
calculating its standard
deviation of the 12 monthly returns in year 2000 and divide the
standard deviation by the mean of monthly returns in year 2000.
3.B. Summary Statistics
Table 1 presents the summary statistics of the variables defined
above. In panel A, we
present the 12 variables used in forming the corporate
governance ranking. The mean for the dummy variable parent is 0.78,
indicating on average, 78% of the sample firms have a parent
company. The mean for the variable audit is 1.08 with lower
standard deviation, indicating most firms received unqualified or
clean opinion from their auditors. The mean of the top largest
shareholder, top1, is 0.43, with highest value equaling 0.88. This
suggests that on average the largest shareholders hold a
significantly large portion of shares in Chinas listed companies.
The mean of the variable ceo_is_top_dir indicates that more than
30% of CEOs in Chinas listed companies are also major directors in
the board. The number of lawsuits in which a company involved,
lawsuits, has a mean of 0.12, with the highest number being 15. The
mean for the variable, ct_num, is 0.38 with the highest number
being 6. The mean and the standard deviation for the concentration
of the second to the tenth largest shareholders, cstr2_10, are
19.23 and 28.34, suggesting a big variation of the concentration
ratio. The mean of top5 variable is 0.0187% with standard deviation
0.0438%, indicating that top managers own very little of their
company. The number of outsider directors in the sample companies
is not low, with mean of 1.19 and standard deviation 2.38. The mean
of dividend/net earnings variable div is 14%, with the minimum
being -7.91 and the maximum 12.755. The negative number indicates
that some companies pay out dividend even in loss while the large
positive number suggests that some companies distribute a lot of
dividend out of their net earnings. In either case, we believe they
are not signs of responsible governance. The mean for the measure
of short-term liquidity, acc_index, is 0.19 with a standard
deviation of 0.58, indicating big
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variation among sample firms. Finally the mean for the
debt/equity ratio d_e has the value of 0.23 and standard deviation
of 0.27. The highest d_e ratio is 4.41.
In panel B, we report summary statistics of several corporate
performance variables. The
mean for the first measure of profitability, ROA, is 3.23% with
a very high standard deviation 9.20%. Another measure of
profitability, ROE, has the mean of 1.03% and a standard deviation
of 4.28%. The mean of market-to-book value of companys asset,
market/book, is 3.56, with the standard deviation being 2.14. The
relatively high mean value for market/book suggests a booming stock
market in the sample period. The mean for the measure of turnover
of trading, turnover, is 0.43 and the standard deviation is 0.12.
Finally, the mean of the volatility measure, std, is 3.42 with a
standard deviation of 10.32.
3.C. Ranking Methodology
According to our theoretical analysis, we divide the variables
used in empirical ranking
analysis into two broad groups. The first group of variables
are: (1) Shareholding of the largest shareholder top1; (2) the firm
has a parent company parent dummy; (3) the CEO is the chairman or a
vice chairman of the board of directors ceo_is_top_dir; (4) the
number of connected transactions ct-num; (5) the number of law
suits a company involves sue-num; (6) auditor opinion audit;(7)
debt-to-equity ratio d_e; (8) the inverse of accounts payable
turnover ratio acc_index. The higher the value of each variable,
the lower the rank of corporate governance. The second group of
variables are: (1) concentration of shareholding in the hands of
the second to the tenth largest shareholders cstr2_10; (2)
shareholding by the top five officials of the firm top5; (3) the
proportion of outside directors out_in_ratio; and (4) dividend
payout ratio div_earning_ratio. The lower the value of each
variable, the lower the rank of corporate governance.
We sort the variables in the first group in descending order,
and the variables in the second
group in ascending order. And the ranking of the companies is
generated accordingly. Specifically, we rank each company according
to each of the 12 variables. After obtaining the ranking according
to each variable, we divide it by the total number of available
observations in the study and multiply the resulting measure to
obtain a normalized value from 0 to 100. Finally, the G index is
constructed in such a way that we summarize the individual rankings
for each company according to the following weighted average
index:
G = i (wi * rank_vi) (1) Where wi is the weight assigned to
variables vi. The detailed description and construction
of the weights are available upon request.
4. Empirical Results on Corporate Governance, Performance and
Valuations We rank all companies according to the G formula (1).
The company with the highest G
index is ranked number one, while the company with the lowest G
is ranked as 788. The details of all the rankings of individual
variables and the ranking according to the total score are
available upon request.
In theory, good corporate governance should be related to good
corporate performance.
A number of empirical studies on emerging markets have found
that investors are willing to
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pay a premium averaging 10% to 12% for good corporate
governance. It is interesting to see whether better-governed
Chinese companies, measured by our measure of corporate G index,
are associated with good corporate performance and whether Chinese
investors reward good corporate governance.
4.A. Regression Results
As mentioned before, we measure corporate performance by using
two popular measures,
ROA and ROE. Market value/book value of net asset of a company
is used as a measure of investors valuation of the company.
Finally, the turnover ratio and stock return volatility is used to
gauge the impact of corporate governance on market performance of
the company.
Table II reports the regression results of ROA, ROE,
Market/Book, turnover, and standard
deviation measures on the corporate rank. First, the two
profitability measures ROA and ROE are both negative, with the
significance level of 1%, related to the corporate governance
ranking. The negative coefficient in the regressions indicate that
highly ranked companies are indeed associated with higher corporate
performance as measured by ROA and ROE. In the regression of
Market/book value on the ranking index, we report a significant (at
1% level) and negative coefficient. This result strongly suggests
that the investors do value companies with good governance. In the
last two regressions, we report the impact of governance on market
performance of a company. In the turnover regression, the
coefficient for the ranking index is positive and significant at 5%
level. The lower turnover for the better-governed companies
suggests that investors tend to hold stocks of better-governed
companies and trade more on companies with weaker corporate
governance. Finally, in the last regression, we report the
relationship between the volatility of stock returns with that of
governance ranking. The relationship seems to be positive but
insignificant.
Overall, the results from Table II suggest that good corporate
governance is associated
with better corporate performance, higher valuation, and lower
turnover of the stock market. Table III reports regression results
of corporate performance and stock valuation variables
on all 12 variables used in forming the ranking. The purpose of
running these regressions is to check if our theoretical prediction
about the effect of the 12 variables on corporate governance is
indeed valid. Of course, running regressions with so many
regressors would encounter the problem of multicolinearity.
However, for illustrative purposes, we still conduct such
regressions but interpret the result with special caution. We
interpret our results as follows.
The first exercise regresses ROA on all 12 variables used in our
ranking analysis. In
addition, we add one variable, top1_sq, which is the square of
top1, to reflect our concern on the nonlinear effect of the
shareholding of largest shareholder on corporate governance. Among
the variables that significantly affect ROA, Audit, top5, d_e, and
acc_index have the expected signs, while ct_num has the opposite
sign as expected. In the second exercise on regression of ROE,
among the statistically significant coefficients, Audit, lawsuits,
top5, and d_e have the expected signs while the sign for ct_num is
the opposite of what we expected. It should not be surprising that
ct_num has the positive sign in both regressions as connected
transactions are mostly used to shore up profitability of the
listed companies. Both regressions of profitability measures have
relatively high R-sqaures, 0.25 and 0.32 respectively.
The third exercise regresses the variable market/book on the
same set of explanatory
variables. Among the statistically significant coefficients, the
variables top1, top1_sq,
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cstr2_10, out_in_ratio, and d_e have the expected signs while
Audit has the opposite sign. The R-square, at 0.27, is again very
high.
The fourth regression regresses Turnover on these same
variables. ct_num has a marginal
positive impact on stock turnover ratio while top5 has the
negative coefficient. The positive coefficient associated with
connected transaction variable may reflect active market trading
over connected transaction news. The R-square for this regression,
however, is quite small.
Finally, in the fifth regression, we regress the volatility
variable, std, on these explanatory
variables. Only Audit has a positive and significant
coefficient. The R-square is again quite small.
Overall, the results from Table III suggest that our corporate
governance variables as a
whole have significant relationship with the corporate
performance and stock market valuation variables.
4.B. Correlation Results Based on Ranking Groups
In the following analysis, we divide all sample firms into
quintiles according to our
governance-ranking index (G). Group 1 indicates the lowest
corporate governance ranking while Group 5 indicates the highest.
In each group we calculate the mean, standard deviation and other
summary statistics of each corporate performance and stock
valuation measures in each group.
Panel A of Table IV reports the summary statistics of ROA for
each group. It is shown that
the lowest ranked companies have an average return to asset of
1.47%, while the highest is 4.92%. Clearly, ROAs rises as corporate
governance index rises. Companies in the highest group have an
average of ROA more than three times higher than those in the
lowest group. Panel B tests whether these differences in ROAs for
each group are statistically significant. Group 1 companies has
statistically significantly different ROAs from their counterparts
in groups of 3, 4, and 5. Similarly, the mean ROA of Group 5 is
significantly different from those of other groups.
Figure I compares the mean of ROA for each group. It is apparent
that there is an
increasing trend in the ROAs of companies from Group 1 to Group
5. Once again, it illustrates the proposition that better-governed
companies tend to have higher profitability.
Table V reports summary statistics and tests for another measure
of corporate profitability,
ROE. Patterns as shown in Table V are similar to those observed
in Table IV, with the former having even more striking magnitude.
For example, the best-ranked companies now have an average of ROE
of 1.49%, more than 7 times higher than the lowest-ranked
companies, (0.2%). The statistics presented in Panel B also suggest
that these discrepancies in ROEs for each group are statistically
significant. In addition, Figure II plots the increasing ROEs as
companys governance ranking index improves.
Table VI reports summary statistics and tests for the variable
Market/book. The average
market/book value of net asset is 4.84 for the best-ranked
companies while it is 2.73 for the lowest group. In other words,
there is a market premium of 77% for the best-governed companies
relative to the worst companies. The differences among the five
groups are again statistically significant as indicated by test
results shown in Panel B. Figure III plots the mean
12
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values of Market/book for the five groups. It is clear that
better-governed companies are rewarded by investors by commanding
high market value relative to the book value.
Table VII presents summary statistics and tests for the market
turnover ratio for the five
different groups of the companies. There is a slightly higher
turnover ratio for the lowest group. Group 2 has significant
difference in turnover from Groups 3,4, and 5. The two lowest
groups, 1 and 2, also have statistically higher turnover than the
higher groups. Figure IV graphically supports the conclusions of
Table VII.
Finally, in Table VIII, we present the summary statistics of the
volatility measure, the
normalized standard deviation std for each group of companies.
There seems to be a slightly higher volatility in the lowest group
than the highest group, but the statistical level is insignificant.
Figure V supports those conclusions.
Overall, the results from the analysis of different ranking
groups of companies suggest
that good corporate governance matters. It improves the
performance of the company, reduces the market turnover, and
investors seem to reward these companies by paying market premium
as high as 77%.
5. Conclusion The paper has studied an important issue of
corporate governance for Chinas publicly
listed companies. The main findings of the study can be
summarized as the following:
(1) We identify several important corporate governance
mechanisms stemming from the agency theory and the more recent
-tunneling- theory of corporate governance. Among others, the
ownership and the board structure, executive compensation, the
market for corporate control, and the financial transparency are
found to be the most important factors in influencing corporate
governance.
(2) Based on our theory and understanding of Chinas capital
market, we construct four different set of variables to explain
corporate governance. The first set of variables is related to
-tunneling- theory. Variables such as whether the company has a
parent company, the number of connected transactions, and
concentration of the largest shareholders are in this set. The
second set is related to monitoring. It includes whether the CEO is
the chairman or a vice chairman of the board of directors and the
proportion of outside directors to inside directors. The third set
is related to managerial incentives, including shareholdings by the
top five officials of the firm and the dividend payout ratio.
Finally, the fourth set includes several measures of financial
transparency. The variables include auditor opinion of the company
and the number of lawsuits the company is involved in.
(3) We rank our sample companies according to the above four
sets of variables. After assigning weights to these variables, we
obtain an index called G index which is a score constructed with
weights based on the above-mentioned four sets of variables. All
sample firms are then divided into five nearly equal groups.
(4) We explore the possible links among corporate governance,
corporate performance
13
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and stock valuations. We find that better-governed companies are
associated with higher profitability as measured by ROA and ROE,
higher stock market valuation as measured by the ratio of market
value and book value of the net asset, and lower market turnover
ratio.
Key Reference:
Berle, Adolf and Gardiner Means, 1932, The modern corporation
and private property, New York: Macmillan.
14
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TABLE I. Summary Statistics
Panel I, Corporate Governance Variables
Variable Obs Mean Std. Dev. Min Max parent
audit top1 ceo_is_top_dir
lawsuits ct_num cstr2_10
top5 out_in_ratio
div acc_index
d_e
788 .7817259 .4133368 0 1 788 1.086294 .3308224 1 4 788 .4358283
.1756202 .0214 .8858 788 .3274112 .4695667 0 1 788 .1281726 .857032
0 15 788 .3718274 .8066233 0 6 788 .0019254 .0028413 1.82e-08
.0160101 788 .0187638 .0438604 0 .696429 788 1.918975 2.386199 0 18
788 .1417363 .6498038 -7.917959 12.7552 788 .1999256 .5877725 0
12.96042 788 .2320619 .2712953 .001076 4.412308
Panel II, Corporate Performance Variables Variable Obs Mean Std.
Dev. Min Max
roaroe
Market/bookTurnover
Std
788 .0317623 .0920067 -.9823067 .3013073 788 .0102282 .0429681
-.5422573 .0955566 787 3.563553 2.14732 .7850426 18.26682 788
.4330608 .1289667 .0747756 1.012688 788 3.421652 10.32081 .7833091
275.7126
TABLE II. Regression of ROA (return on asset), ROE (Return on
equity), market/book value on rank and turnover.
The table reports slop coefficients, t-statistics (in ()), and
adjusted-R2s from regressions of ROA and ROE on rank variable.
Symbols *, ** and *** represents significance level of 10%, 5% and
1% respectively.
Dependent variable Coeff. For rank Intercept r-square
Roa -.00006428*** .05703921*** .0252 (-4.5044473)
(8.7888673)
Roe -.00002295*** .01920814*** .0148 (-3.4286909)
(6.3086368)
Market/book -.00299287*** 4.7440436*** .101 (-9.3425511)
(32.599022)
Turnover .00004064** .41704495*** .0051 (2.0109752)
(45.374526)
Std .0000711 3.39362*** 0.001 (0.04) (4.61)
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TABLE III. Regression of ROA (return on asset), ROE (Return on
equity) and market/book value, turnover and Std on all the index
variables
Independent Variables
ROA ROE Market/Book value Turnover Std
Parent Audit top1 top1_sq ceo_is_top_dir lawsuits ct_num
cstr2_10 top5 out_in_ratio div acc_index d_e Intercept Adj-R2
-.00274759 (-.35729937) -.09769761***(-9.728799) .11360518
(1.335219) -.07497538 (-.81626195) .00027307 (.04321171) -.00532372
(-1.3295972) .00724985** (1.9995152) .20153015 (.18314605)
.20931047***(3.1391634) -.00054193 (-.43202006) .00443151
(.99313942) -.0106489* (-1.7959623) -.0451856***(-3.9364182)
.11361688 (5.0889553) .24872602
-.00509747 (-1.4973933) -.04278098***(-9.6233791) .05684689
(1.5092553) -.03956806 (-.97309948) -.00119213 (-.42614153)
-.00674855***(-3.8072966) .00262318* (1.634272) -.24476957
(-.50247741) .07008874** (2.3745037) -.00044512 (-.801563)
.00259622 (1.3143185) -.00153044 (-.58305645)
-.0406374***(-7.9970304) .05421898***(5.4857846) .32391081
-.23660734 (-1.3381657) .89993988*** (3.892063) -3.2897839*
(-1.6824349) 3.73882* (1.7713862) -.07327104 (-.50454993)
-.06092878 (-.66074514) .11783508 (1.4122735) 106.13864***
(4.1976324) -1.4146798 (-.9217872) .06443697** (2.2351561)
-.13743653 (-1.3398404) .19824058 (1.4535863) -4.4890035***
(-14.898721) 4.0687524*** (7.9071804) .27098412
-.01324649 (-1.077657) .00696248 (.43374972) -.07280318
(-.53530888) .10570971 (.71998831) -.00582362 (-.57652997)
.00838124 (1.3095221) .00975238* (1.6826972) 1.7679405 (1.0051361)
-.31569347***(-2.962022) .00015476 (.07718321) .00192927
(.27049047) -.00445165 (-.4696923) -.00447062 (-.24365128)
.44534039***(12.478937) .02323581
.67183574 (.68376499) 4.2682402***(3.3241718) 10.20978
(.93834074) -10.09852 (-.85970812)-.51235935 (-.63396525)-.15730929
(-.30729036).38922322 (.83909783) 167.21698 (1.1890078) 8.9374409
(1.047899) -.07625423 (-.47521102)-.12200178 (-.21369774)-.62902076
(-.82933398)-1.5939973 (-1.0866867)-3.7477574
(-1.3136971).02154948
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
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TABLE IV. Summary statistics of ROA Panel A, Summary by ranked
grade
grade Obs Mean Std. Dev. Min Max
1
2
3
4
5
total summary
157 .0147253 .0942937 -.9277565 .1803119
157 .0217253 .1022496 -.6086205 .1530019
158 .0341079 .1048396 -.9823067 .3013073
157 .0386514 .0719253 -.2861054 .2787105
158 .0492339 .0794922 -.74604 .2173315
787 .0317141 .0920553 -.9823067 .3013073
Panel B, test if the mean with grade=I is larger than that with
grade=J (where I>J)
I=2 I=3 I=4 I=5
J=1 -.6306 -1.7248** -2.5279*** -3.5125***
J=2 -1.0611 -1.6965** -2.6666***
J=3 -.4482 -1.4451*
J=4 -1.2386*
T-stat.
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
00.010.020.030.040.05
1 2 3 4 5
Grade
Figure I. Mean of ROA for different grades
17
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TABLE V. Summary statistics of ROE (by Grade) Panel A, Summary
by ranked grade
grade Obs Mean Std. Dev. Min Max
1
2
3
4
5
total summary
157 .0021799 .0612847 -.5422573 .0730821
157 .0070278 .0538987 -.5040159 .0714757
158 .0137357 .0411896 -.3855226 .0955566
157 .0129245 .023066 -.0832363 .0683268
158 .0149013 .0166853 -.1121907 .0483589
787 .0101644 .042958 -.5422573 .0955566
Panel B, test if the mean with grade=I is larger than that with
grade=J (where I>J) I=2 I=3 I=4 I=5
J=1 -.7443 -1.9652** -2.0560** -2.5170***
J=2 -1.2415* -1.2603* -1.7536**
J=3 .2155 -.3297
J=4 -.8719
T-stat.
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
0
0.005
0.01
0.015
1 2 3 4 5
Grade
Figure II. Mean of ROE for different grades
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TABLE VI. Summary statistics of Market/book value ratio Panel A,
Summary by ranked grade
grade Obs Mean Std. Dev. Min Max
1
2
3
4
5
total summary
156 2.727927 1.505279 .7850426 10.93403
157 3.291796 2.142839 .9196767 16.50844
158 3.205829 1.916361 .8844014 12.74372
157 3.749819 1.733095 .8943764 12.06264
158 4.84477 2.648729 .8955305 18.26682
786 3.566266 2.147337 .7850426 18.26682
TABLE VI. Panel B, test if the mean with grade=I is larger than
that with grade=J (where I>J)
I=2 I=3 I=4 I=5
J=1 -2.6922*** -2.4553*** -5.5677*** -8.6917***
J=2 .3753 -2.0823** -5.7185***
J=3 -2.6418*** -6.3014***
J=4 -4.3385***
T-stat.
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
012345
1 2 3 4 5
Grade
Figure III. Mean of Market/Book for different grades
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TABLE VII. Panel A, Summary statistics of Turnover rate. Panel
A, Summary by ranked grade
grade Obs Mean Std. Dev. Min Max
1
2
3
4
5
Total summary
157 .4405468 .1357257 .0747756 .9439542
157 .4518506 .1346396 .1789984 1.012688
158 .4225417 .1379524 .1077276 .9735566
157 .4275861 .1105358 .1848791 .7492094
158 .4228914 .1234166 .1398289 .7808484
787 .433057 .1290487 .0747756 1.012688
Panel B, test if the mean with grade=I is larger than that with
grade=J (where I>J) I=2 I=3 I=4 I=5
J=1 -0.6880 1.1232 1.0525 1.0881
J=2 1.8114* 1.8097 * 1.8214*
J=3 -0.1817 -0.1079
J=4 0.0758
T-stat.
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
t-test whether the mean with grade
-
TABLE VIII. Summary statistics of normalized standard deviation
Panel A, Summary by ranked grade*
Grade Obs Mean Std. Dev. Min Max
1
2
3
4
5
Total summary
156 2.903778 2.32542 .7963987 24.75417
156 2.714272 2.101785 .8769898 17.9716
156 3.267451 2.891149 .7833091 26.70377
157 2.977751 2.706345 .8320354 25.35192
158 2.748604 2.024249 .9272213 20.07651
783 2.921998 2.434577 .7833091 26.70377
* We have dropped four extremely large outliers
TABLE VIII. Panel B, test if the mean with grade=I is larger
than that with grade=J (where I>J)
I=2 I=3 I=4 I=5
J=1 0.7374 -1.2153 -0.2273 0.6017
J=2 -1.9100* -0.9145 -0.1577
J=3 0.9394 1.8078
J=4 0.7922
T-stat.
Symbols *, ** and*** represents significance level of 10%, 5%
and 1% respectively.
t-test whether the mean with grade = I is larger than that with
grade = J (where I>J)
0
1
2
3
4
1 2 3 4 5
Grade
Figure V, normalized standard deviation
21