How Did Corporate Governance Become Popular?
While China’s stock market has been expanding impressively, it is meanwhile conspicuous that this development has so far been inconsistent with China’s economic success measured by its nominal GDP (see Figure). As the national economy recorded a yearly GDP growth of at least 8% since the 1990s, the stock market capitalization, in spite of increasing listings, fluctuated heavily over the same time period. Especially from 2000 to 2005, albeit the number of listed firms blew up by about one-third and the issued shares doubled, the market capitalization shrank apparently due to collapsing stock prices. In identifying the causes for this conjuncture, the attention of the market regulators and participants was soon directed to the deficiencies of the corporate governance practices in China.
More precisely, it was several unveiled Enron-alike scandals as well as capital tunneling by controlling shareholders that struck the overall investors’ confidence at the Chinese stock market. Two cases illustrate these problems.One involved the one-time top performer, North China-based firm Yinguangxia (YGX), whose stock price leaped by about 440% in 2000. Barely one year later, two journalists called YGX’s brilliant achievements into question and disclosed that YGX had been forging documents and misrepresenting information. The official investigation by the CSRC in 2002 fixed a total fraudulent profit of 770 million RMB by YGX from 1998 to 2001 (Guo 2007). The other example relates to Sanjiu Pharma who inadequately disclosed transactions with related parties, including the controlling shareholder and other subsidiaries of it, and created fictitious transactions in order to raise cash from banks (Chen et al. 2005). The CSRC investigation revealed that Sanjiu Pharma had extracted as much as 2.5 billion RMB, about 96% of the firm’s equity, through related transactions (CSRC 2001).
Although the conception of corporate governance had been introduced to China as early as in the mid-1990s, it did not arouse much interest until during the long lasting bear market from 2000 to 2005. Both the Chinese government and the stock market regulators are now aware of the importance of good corporate governance practices.
Why Is Corporate Governance Important?
The young stock market in China has brought forth a tremendous number of shareholders from individuals over institutional investors to state agencies. According to China Securities Depository and Clearing Corporation, more than 140 million investment accounts (stocks and investment funds totally), overwhelmingly held by small individual investors, had been opened until the end of 2007 (CSDCC 2008). If every account was indeed owned by one person, it would correspond to one tenth of China’s whole population or one fourth of its urban population directly engaging in the stock transactions. As for institutional investors who manage the wealth of individuals, there are more than 350 mutual funds, over 50 QFIIs, several large domestic insurers as well as the National Social Security Fund trading actively on the market. Moreover, an unknown, but large amount of banks loans have been flowing into the stock market through gray or illegal channels (Liu 2006). Notably, the central and local governments who are managing state assets on behalf of Chinese people still maintain the lion’s share in many listed firms through their asset management administrations. The number of directly and indirectly involved small shareholders is so large that a thorough breakdown of the stock market would very likely rock the boat. Therefore, it is not difficult to understand that the central government as well as other state agencies and exchanges warned loudly of an overheated market several times as the stock prices were skyrocketing in 2007.A failed stock market may cause social uncertainty that remains one of the government’s primary concerns.
The more integrated China becomes in the world economy, the more affected will it be by international rules and conventions which have mainly been set down by developed countries. Hoping international investors to buy and hold their shares, Chinese listed firms have to adjust themselves to those corporate governance practices preferred by global investors. The internationalization of the capital markets is nevertheless a two-edged sword for all developing economies: capital can as easily flow out from a market with weak investor protection as into it. The East Asian financial crisis in late 1990s demonstrates that opened capital markets without well developed corporate governance mechanisms can be easily abandoned by capital flows. Even though China’s extraordinary achievements in the last three decades and the internationally broadly recognized prospect for the near future may keep the interest of foreign investors high the list of QFIIs is constantly getting longer and in this way compensate for the negative impacts of its weak corporate governance practices, this is not expected to work in the long run. It is thus in China’s interest to make its corporate governance practices attractive for foreign investors.
China’s economic transition toward a Chinese “socialist market economy” is still ongoing and the current, in 1990s launched round of SOE reforms has not finished yet (see the section “Governance Practices in Chinese SOE's: Content of Change” for more details). Only some of the former SOE's are listed in Shanghai and Shenzhen. The remaining ones are waiting for an initial public offering as a vital channel for their future fund-raising. Hence, the central and local governments who mostly hold claims on SOEs have sufficient incentives to maintain the stock market as a well-functioning platform for financing SOEs. It should also be mentioned that the establishment of a stock market is the first step towards completing the capital markets in China, whereas the stock market itself still needs to complete its functions as well as to diversify its investment product line. The success of the following steps, say, derivative products including stock index futures and a corporate bond market, will depend on the success of the stock market. They could not be executed if the firstly built stock market had already collapsed. China’s further transition and capital markets development cannot afford a failed stock market.
What Has Been Done to Improve Corporate Governance?
In dealing with the deficiencies at the stock market, the Chinese government began to improve its corporate governance framework by enacting and revising a series of governance-related guidelines and laws. After the first corporate governance code for listed companies had been issued by the CSRC in 2002, both the Company Law and the Securities Law were revised by the National People’s Congress (NPC) in 2005. The new regulations address some problems at the stock market, including the independence of the boards of directors, firms’ information disclosure, and expropriation of small shareholders.
With respect to investigation of illegal activities at the capital market, the CSRC did not set up a law enforcement bureau (Bureau I) until 1995. It further established subordinate local enforcement bureaus in several big cities. In 2002, the CSRC instituted another law enforcement bureau (Bureau II) for investigation of market manipulation and insider trading, while Bureau I took the responsibility for investigating fraud in securities issuances, dishonesty in statements, and other offences. In 2003, the Ministry of Public Security established the Securities Crime Investigation Bureau to cooperate with the CSRC for investigation of offences at the securities market. In 2007, the CSRC instituted the Sanction Committee, Chief Enforcement Officer, and the Law Enforcement Task Force in its headquarters to lead the enforcement system. Meanwhile, local enforcement bureaus were reinforced with a larger work force. From 2003 to 2007, the CSRC investigated 736 cases, forwarded 104 of them for criminal charges, imposed sanctions on 212 cases involving 180 entities and 987 individuals, and banned the entry of 165 professionals and executives into the securities market for extended periods (CSRC 2008).
At present, all of the public firms have, in accordance with the CSRC, introduced independent directors as an internal monitoring mechanism into the board, as required by the CSRC. More chairmen are now separated from the CEO function. Listed firms are obliged to make clear statements on their efforts in improving governance structure and revealing information on compensations for the board members and executives. The relations of the board members to the controlling shareholder are defined in annual closures. The regulators and exchanges are making efforts in oversight of affiliated transactions between listed firms and their controlling shareholders among which tunneling of assets had usually taken place. These alterations in corporate governance have let the public firms become more transparent for investors as previously.
How Different Is the Chinese Model?
Corporate governance models vary across countries. Yet researchers tend to identify two prevailing corporate governance models: the Anglo-American market-based shareholder model and the insider models of, say, Germany and Japan (Shleifer and Vishny 1997; La Porta et al. 1998, 1999; Bebchuck and Roe 1999). The preference for one of the two types of models is mainly attributable to each country’s economic success in 1980s and 1990s, respectively (Becht et al. 2002).
In the Anglo-American model, public equity is widely dispersed, while directors make all the decisions or have exclusive power to initiate them (Enriques and Volpin 2007). In spite of several accounting scandals unveiled at the turn of the century in the USA, the listed firms in this model still face strictest legal restrictions and enforcement in respect of minority shareholder protection, and there is a highly competitive product market to boost the firms’ performance. Whilst the external mechanisms for investor protection are strong in this model, the internal governance structure is no more than a principal-agent relation set between shareholders and the board of directors through the general meeting. Both the management and monitoring functions at the corporate level are combined in the board of directors. By contrast, the equity of public firms in the German and Japanese models is more concentrated. Although the market mechanisms are less strong than in the US model, the German and Japanese models have evolved into a more sophisticated internal governance structure that takes in other stakeholders such as labor unions, banks, and employees as co-principals of the firms.
Chinese Model in Comparison
Figure illustrates in a simplified sense the corporate governance models in the USA, Germany, and China. The dot-dash frame symbolizes the external governance-related environments at the national level. A bolder frame indicates that an economy is by and large equipped with more developed capital markets, a stronger legal system with more effective enforcement, and a more competitive product market, whereas a more thinly lined frame matches a weaker governance environment. Compared with the USA and the German models, the Chinese corporate governance model has a weak external environment with regard to market and legal mechanisms. This fact is not surprising in consideration of China’s ongoing process of transition to a market economy and corresponding constructing of its rule of law.
Product market competition drives producers and service suppliers to improve their performance. However, the Chinese product market lacks of competition in some industries: The central government considers industries such as utilities, transportation, telecommunication, banking, oil, and steel to be of strategic importance and keeps the entry of other suppliers under strict control. Therefore, it is big SOE's who dominate in these industries. Another cause of weak competition is local protectionism for the sake of regional economic development. In their procurement process, provincial and municipal governments usually favor local products and encourage local enterprises to purchase locally manufactured materials and products. This is becoming more obvious in dealing with the current world financial crisis since 2007: while planning a huge amount of spending in order to guarantee economic growth, ten provincial governments have issued documents on purchasing local products including electrical appliances, vehicles, and steels (21CBH 2009).
The Chinese stock market is dynamic in terms of a rapidly increasing number of investors and market capitalization. Yet it is so far underdeveloped in other more important aspects. First, the entire financial system in China is dominated by a large, state-controlled bank system, implying that the financing through the Chinese stock market is limited. The limits usually result from the government’s tight control in the number and size of public issuances and in the choice of firms to be listed: the authorities prefer the state sector. Second, the Chinese stock market lacks alternative investment products. Third, the stock market is rather a domestic one than an international one. By now, it is to a limited extent opened to a small number of foreign institutional investors. Similarly, domestic investors barely have any access to overseas stock markets except for a few products of QDII's. Listings of foreign-invested firms have been announced to accelerate the market internationalization. However, no rules or schedule have been made yet.
The legal institutions in China provide an interesting picture. On the one hand, the Chinese legal system represents sufficient shareholder protection. Using the measures of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV) (1998) on legal provisions for publicly traded firms, Allen, Qian, and Qian (2005) compared the shareholder protection in China with that in LLSV countries. They found out that China reaches the average level of all LLSV countries. China’s score falls in between the English-origin countries that have the highest measures of protection and German-origin countries that have the poorest protection. With measures drawn from independent international rating agencies, they further compared the law enforcement in China with that in LLSV countries. This time, they came to a very different result: China’s law enforcement is significantly below the average level of all LLSV countries. The inconsistent results suggest that China’s shareholder protection is relatively strong on paper, but weak in practice. The reasons that the laws are not effectively being enforced in China are (1) lack of qualified legal professionals, and (2) conflict of interest between fair play in practicing law and the monopoly power of the single ruling party (Allen et al. 2005).
As to the internal governance structure, the Chinese model looks, at first appearance, quite similar to the two-tier board system of the German model. In Germany, the public firm is governed by a management board (Vorstand) and a supervisory board (Aufsichtsrat). The managing board is in charge of the daily operations of the firm, while the supervisory board is responsible for appointing, supervising, and advising the management board and directly involved in developing strategies of the firm (Mallin 2007). In the Chinese model, management and monitoring tasks are delegated to the board of directors and the board of supervisors, respectively. The Chinese board of supervisors also takes in employee representatives, which makes it more like the German way of co-determination (Mitbestimmung). However, there is no such hierarchical relationship between the board of directors and the board of supervisors as in the German model. While the German supervisory board has the authority to appoint and, if necessary, even dismiss the members of the management board, the two boards in the Chinese model are run on the same level, and the directors and supervisors are all appointed or dismissed by shareholder action. In view of this structural arrangement, it is doubtful whether the boards of supervisors have enough power to conduct the supervising work effectively.
Overall Ownership Structure
The ownership structure at the Chinese stock market is deeply characterized by the state’s design. Typically, former SOEs were approved to go public, and the share distribution was regulated by the central government. A large proportion of the shares were prevented from being transacted at the exchanges. Until 2005, Chinese shares were divided into two types: non-tradable shares that were not allowed to be publicly traded, and tradable shares that were entitled to transactions at the exchanges. Each type was further divided into different classes, depending on their shareholder or listing location. Non-tradable shares mainly comprised state-owned shares and legal person shares. State-owned shares were in the possession of the central and local governments through their underlying asset management agencies, while legal person shares are those owned by entities with a legal person status. The legal persons referred to domestic sponsors, foreign companies, and other legal entities who had taken part in a non-public offering of the relevant firms. Other untraceable shares were in the hands of employees or private individuals.
Table provides a snapshot of Chinese public firms’ overall share structure in 2005. At the year end, about two-thirds of the shares at the Chinese stock market were non-tradable. Among them, state-owned shares have the dominant proportion of approximately 45%. Since domestic sponsors of public firms are usually former SOE's under control of the state’s agencies, the state indeed controlled more than half of all shares of the listed firms. By contrast, tradable A- and B-shares which were dispersed among private and institutional investors summed up to slightly over 30%. Therefore, the Chinese stock market is state-dominated.
Before 2005, the only legal channel of transacting non-tradable shares was equity transfer between enterprises, provided that the agreement had been approved by relevant authorities and regulators. In 2005, the regulators launched a reform of non-tradable shares in order to make them tradable. Against compensation in cash or stocks, shareholders of the one-time non-tradable shares have gained the right to sell them after certain lockup periods (12–24 months) have expired.
Although the 2005 non-tradable shares reform has enhanced the equity liquidity of the listed firms in China, it has not significantly changed the market’s ownership structure and the state’s dominance. Even though the state’s directly and indirectly controlled shares are now entitled to market transfer, the state and its agencies need not do so. Consequently, the state’s role in the governance structure has not changed.
Why and How Do We Survey the Causality in the Formation?
of the Chinese Model?
Shleifer and Vishny (1997) argued that the Anglo-American and the German/ Japanese corporate governance models are efficient, because they have a good complementarily between the level of legal protection and ownership concentration. Countries with poor investor protection typically exhibit more concentrated control of firms than countries with good investor protection (La Porta et al. 1998, 1999; Claessens et al. 2000).
In reference to these theoretical and empirical works, one may argue that China’s weak legal protection for shareholders has given rise to a concentrated ownership structure. However, this logic does not really match the situation in China. The main reason is that in China, the state has been playing a decisive role in both the formation of the legislation, including legal protection for investors, and the establishment of a corporate governance structure that emerged in the 1990s. Hence, both the general legal protection for investors and the ownership structure at the Chinese stock market rather reflect the will of the central government than build up certain causalities by themselves.
In summary, three features make the corporate governance model at the Chinese stock market different from the classical models: (1) a weak external environment that does not exert sufficient market and legal constraints on listed firms; (2) a simple internal governance structure without a strong supervisory function available; and (3) dominance of the state in the ownership structure. Nevertheless, the causality in the formation of the Chinese model is still unclear, if legal protection for investors is not a drive. How did the Chinese model evolve over the past decades? What backed every big change in its evolution? These questions are crucial for a good understanding of the corporate governance model in China.
Since most listed firms at the Chinese stock market have SOE backgrounds, it makes sense to look back at Chinese SOE's’ development process, and to trace the roots of the Chinese corporate governance model. In doing so, we utilize the distinction between the content of change and process of change in the organizational change studies (van de Ven 2009), and principal-agent relationships as the overall framework of this survey.
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