Corporate Governance in China

/ Corporate Finance, Corporate Governance, The World Economy / By

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. Moreover, the vast majority of research on corporate governance is on the US. We often assume that these findings will apply throughout the world, but this assumption is unwarranted – the institutional setup is very different across different countries.

I thus sought to educate myself on China, and came across an excellent article by Fuxiu Jiang and Kenneth Kim of the Renmin University of China. In addition to providing a non-technical survey into Chinese corporate governance in its own right, it also introduces a special issue of the Journal of Corporate Finance with many papers on Chinese corporate governance. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu and Kenneth A. Kim (2015): “Corporate Governance in China: A Modern Perspective” Journal of Corporate Finance 32, 190-216). I hope you find this as helpful as I did.

Institutional Background

Capital Markets

  • On December 19, 1990 and July 3, 1991 the Shanghai and Shenzhen Stock Exchanges were launched. Shanghai is analogous to NYSE and Shenzhen to Nasdaq.
  • Regular domestic shares are A-shares, denominated in RMB. A small fraction of firms have B-shares, denominated in foreign currency (US or Hong Kong dollars).
    • B shares have the same cash flow rights as A shares, but were originally restricted to foreign investors.
      • Since 2001, Chinese can own B shares
      • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
    • B shares are less than 0.5% of the total market cap on the two exchanges
  • Regulator is China Securities Regulatory Commission (CSRC), the equivalent of SEC
  • Shares are divided into tradable shares (TS, 1/3) and nontradable shares (NTS, 2/3). Initially, controlling shareholders (often the state or legal persons) held NTS, and domestic individual investors held TS.
  • Individual investors are typically uninformed speculators, leading to stock market volatility. Government has thus promoted institutional investors
    • In April 1998, the first closed-end fund was introduced. Open-end mutual funds and index funds were subsequently introduced.
    • October 27, 1999: insurance companies were approved to own stocks indirectly through a securities investment fund. October 24, 2004: insurance funds were allowed to invest in stocks directly.
    • As above, QFIIs could hold A-shares from 2003
    • Thus, tradable shares became held also by domestic and foreign institutional investors
  • Split share structure was to ensure that the government could retain control of firms. But, government realised that non-tradability is a problem – since NTS holders don’t benefit from stock price appreciation, they had little incentive to pursue shareholder value maximisation. Thus, conflict between TS and NTS
  • April 2005: government initiated the Split Share Reform, to transform all NTS into TS. Since this would dilute the value of TS, NTS holders had to negotiate a compensation plan with TS holders (typically additional shares)
    • Pilot programs conducted in April and June 2005. Reform expanded to all listed firms in August. By end of 2007, almost all firms had established a plan and timetable to convert NTS into TS. Since 2005, NTS are called “restricted shares” to convey the fact that they will eventually become tradable
  • Turnover is high. Even though it’s fallen, it still remains high by international standards. Average holding period of 1 year (4 months) on Shanghai (Shenzhen) Stock Exchange

Corporate Governance

  • For listed firms, a shareholder meeting is required once per year
    • Interim meetings can be called by large shareholders
  • A listed firm must have 5-19 directors
    • Board must meet at least two times per year
    • Since June 30, 2003, at least 1/3 of the board must be independent (can’t be related to the manager, be one of the top 10 shareholders or own 1% of shares, or have a business relationship with the firm).
    • Since China has concentrated ownership, primary duty of independent directors is to monitor large controlling shareholders on behalf of minority shareholders. In countries with dispersed ownership, it’s to monitor management on behalf of all shareholders.
  • Board structure is two-tier: in addition to the board of directors, there is a board of supervisors. Must have at least three supervisors, include representatives of shareholders, and at least 1/3 must be employees
  • Note that it’s the board chair who’s typically in charge of a company, not the CEO or General Manager (GM is often the title given to the CEO)
    • Chairs typically work full-time and go to work every day, unlike in the UK and US

Internal Governance: Stylized Facts and Interpretation

  • Ownership concentration
    • In 2012, largest shareholder owns, on average, 1/3 of the firm; 5 largest own over half of the firm
    • Ownership concentration has declined over time, particularly from 2005 to 2006 since common compensation in the Split Share Reform was to transfer shares from NTS to TS holders
    • Firms where the large shareholder owners > 50% have higher ROE but lower Q than other firms. Thus, even ignoring causality, it’s hard to say whether large shareholders are good or bad for firm value
    • From 2007, firms with multiple large shareholders outperform firms with single large shareholders in ROE. This may be because 2007 is the first year when firms have more TS than NTS, so governance through exit is strong (one large shareholder can threaten to sell if another large shareholder doesn’t cooperate with it)
    • When the government is a large shareholder, it does not tunnel for private benefits (e.g. perks), but it may sacrifice shareholder value for political objectives such as maintaining employment or overinvesting to prop up GDP
  • Managerial ownership
    • SOEs: managers have very little stake, typically because the manager is a government official appointed by the state
    • Non-SOEs: average ownership is 16%, since most non-SOEs are family firms or founded by entrepreneurs. But, median ownership is 0% in most years and 1.1% in 2012. Managers are rarely given shares or options as compensation; managers only become significant shareholders if it’s a family firm or if they buy the shares personally
  • Managerial pay
    • Pay has rapidly increased in a short period of time, but remains modest globally. In 2012, median pay for top manager of SOEs is RMB 470k ($77k)
    • Pay is not an important incentive for SOE managers. They’re government employees, so are incentivized by being promoted to high-level government positions when their term says firm managers has finished. Also, poorly-performing SOE managers are fired. Thus, incentives still matter, but aren’t provided by pay
  • Institutional ownership
    • Has risen over time, largely driven by emergence of mutual funds
    • But, ownership remains small.
      • In 2012, total institutional (mutual fund) ownership averages 17.4% (7.6%).
      • Median ownership of a mutual fund was 0.067% in 2011
    • In 2011, average holding period for a mutual funds is less than 6 months
  • Board structure
    • CEOs are chairs 25% of the time in non-SOEs, 10% of the time in SOEs
  • Capital structure
    • Average leverage in non-financial firms is 1/3. High compared to UK and US
    • Debt is unlikely to discipline managers in China since creditor rights are weak. Thus, bankruptcies are extremely rare
    • Banks don’t appear to monitor. Qian and Yeung (2015: even when controlling shareholders are tunneling from minority shareholders, banks continue to lend, and loan terms aren’t unfavorable.
  • Dividend policy
    • Dividends are very small: around 1%. Potential reasons:
      • Minority shareholders aren’t able to pressure firms to pay out earnings as dividends, since minority shareholder rights are weak.
      • Turnover is high, and so minority shareholders are speculators going after capital gains rather than caring about dividends
    • Dividends are largely driven by regulations.
      • E.g. Number of paying firms more than doubles in 2000 because a CSRC regulation, with effect from March 2001, required a Chinese-listed firm to pay dividends for three consecutive years if it wants to sell new shares

External Governance

  • As China has transitioned from a centrally planned economy to a market-oriented one, China has issued many laws and securities regulations, but China remains internationally weak in its laws, enforcement, and punishment
  • Government recognizes this and is taking steps. 2002 is referred to as the “Year of Corporate Governance of China”
    • Released Code of Corporate Governance
    • CSRC enacted many governance reforms and regulations, e.g. Improving disclosure requirements when large shareholders change
    • CSRC undertook an unprecedented large-scale review of 1,175 listed firms. Found that 30% had significant governance problems. Many CEOs were fired, many firms were fined.
  • Unlike other countries, little governance through managerial labor market, which is nascent
    • SOEs don’t compete among themselves for the best managers, since the government is the only demand-side entity
    • Many non-SOE firms are family firms, so little external hiring historicallly. May change going forwards as firms become more complex, and China’s one-child policy limits number of family candidates
  • Unlike other countries, little governance through corporate control market, which is nascent
    • State won’t sell SOEs to a raider
    • For non-SOEs, ownership is so concentrated that it would be hard for a raider to gain control
    • But, this may change going forwards given that almost all shares are now tradable
  • Like other countries, product market competition is an effective governance mechanism
  • Many Chinese firms engage in CSR to curry favor with the government, since one of the government’s main roles is to promote social welfare (like other countries). Lin et al. (2015): firms that engage in CSR are more likely to receive government subsidies
  • Cross-listings are likely an effective way for Chinese firms to obtain good governance

China’s Corporate Governance Code

  • Like most codes, contains broad and vague language that describes guiding principles rather than explicit regulations. There are eight chapters
  1. Shareholder rights
  2. Rules for controlling shareholders, including advocating a “reasonably balanced shareholding” (multiple sizable blockholders rather than a single large blockholder)
  3. Rules for directors and board of directors
  4. Duties and responsibilities of the supervisory board. Board is accountable to all shareholders and oversees both directors and senior management
  5. Performance assessments for directors, supervisors, and management
  6. Stakeholders. Firms should be good corporate citizens and cooperate with, inform, listen to, and honor the legal rights of stakeholders
  7. Disclosure. Firms must fully and accurately disclose all information required by law
  8. Code comes into effect on the date of issuance