An investigation of the information content of the financial policies of chinas listed companies

By comparing the institutions of China’s stock market with those of the stylized markets in matured capitalist economies, it reveals that the chief problem of China’s stock market is its

AN INVESTIGATION OF THE INFORMATION CONTENT OF THE FINANCIAL POLICIES OF

CHINA’S LISTED COMPANIES

(MA, Nankai University)

A THESIS SUBMITTED FOR THE DEGREE OF DOCTOR OF PHILOSOPHY

DEPARTMENT OF ECONOMICS NATIONAL UNIVERSITY OF SINGAPORE

2004

The ceaseless love, encouragement, and support that I received from my family, especially my parents and my husband, are the sources of my spirit, without which, it

is unimaginable for me to finish this thesis finally I also wish to say thank you to people who helped me and to my friends who shared the pains and happiness with me

I will bear all of these in my mind forever

Chapter 2 Institutional Feature of China’s Stock Market 11

2.1.1 A Unique Feature of China’s Stock Market 11 2.1.2 Comparison with the Insider-based Model 14 2.1.3 Comparison with the Outsider-based Model 18

3.3.3 Institutions of Rights Issues in China 65

Summary

The thesis attempts to find out the reasons that caused the deteriorating share price performance and the unusual financial behavior of China’ listed companies By comparing the institutions of China’s stock market with those of the stylized markets

in matured capitalist economies, it reveals that the chief problem of China’s stock market is its failure to protect the interests of public minority shareholders and this is caused by the share structure of the stock market where most shares are state-owned

or state-controlled which are non-tradable The possible solution to the problems of weak corporate governance without changing the share structure is to connect the firm’s performance with shareholders’ wealth by enforcing regular cash dividend payment

Based on data collected for financial events of China’s listed companies over 1994-2003, the thesis investigated the information content of cash dividends, stock dividends, transferred capital stocks, and rights issues using event study and regression analysis under the framework of information signaling The empirical results did not support the main hypotheses implied by the information signaling theory, suggesting that these hypotheses may not be applicable to China’s case due to the institutional differences, which are discussed in light of our test results A series of regulatory policies associating the cash dividend distributions with the equity issues were released since 2000 The empirical findings indicate that the new policies,

associating the equity issues with cash dividends, have impacts on the managerial behavior to a certain extent These findings have brought optimism to the effect of the cash-dividend-enforcement policy on improving corporate governance

This study has implications for the relationship between corporate governance and corporate finance On one hand, the thesis provides evidence about the influence of corporate governance on corporate finance by investigating the information content of various financial policies in a stock market with unique institutions On the other hand,

it provides evidence about the how corporate finance can affect corporate governance

by examining the impact of the cash-dividend-enforcement policy on the managerial behavior of listed companies

List of Tables

Page

Table 1-2 Features of All A-share Firms (1993-2004) 137Table 1-3 China’s Stock Market in the National Economy (1992-2004) 138Table 2-1 Share Structure of All Listed Firms (1992-2004) 139Table 2-2 Ownership Structure of Listed Companies (1993-2001) 139Table 2-3 Ownership concentration in terms of a single shareholder 140Table 2-4 Overall Performance of Listed Companies (1992-2001) 140Table 2-5 Losing Firms in China’s Stock Market (1995-2003) 140Table 2-6 Changes of Capital Structure of Listed Companies (1992-

Table 2-7 A summary of A-share Firms Issuing New Shares

(1994-2003

142Table 2-8 A summary of A-share Firms Paying Dividends (1994-2003) 142Table 2-9 Turnover Rates of China’s Stock Market and Major World

Markets

143Table 2-10 Number of A-share Investors (1990-2001) 144Table 4-1-1 Sample Description of Cash Dividend Events (1994-2003) 145Table 4-1-2 Sample Description of Pure Cash Dividend Events (1994-

2003)

145Table 4-1-3 Expected Results of Regression Models of Cash Dividends 146Table 4-2-1 Sample Description of Stock Dividend Events (1994-2003) 147Table 4-2-2 Sample Description of Pure Stock Dividend Events (1994-

Table 5-1-2 Announcement Effect of Cash Dividends Changes

(1994-2003)

153

Table 5-1-3 Announcement Effect of Cash Dividends Initiations and

Table 5-1-4 Announcement Effect of cash dividends by Year 155Table 5-1-5 Announcement Effect of cash dividends by Period 156Table 5-1-6 Statistical Description of Explanatory Variables in

Regression Models of Cash Dividends

157

Table 5-1-7 Cross-sectional Regressions of Cumulative Abnormal Return

Table 5-1-8 Cross-sectional Regressions of Percentage Change in Cash

Table 5-1-9 Cross-sectional Regressions of Cash Dividend Distribution

Size

160Table 5-2-1 Announcement Effect of Stock Dividends (1994-2003) 161Table 5-2-2 Announcement Effect of Stock Dividends by Year 162Table 5-2-3 Announcement of Stock Dividends by Period 163Table 5-2-4 Statistical Description of Explanatory Variables in

Regression Models of Stock Distributions

Period

169

Table 5-3-4 Statistical Description of Explanatory Variables in

Regression Models of Transferred Capital Stocks 170Table 5-3-5 Cross-sectional Regressions of Cumulative Abnormal Return

of Transferred Capital Stocks

171

Table 5-3-6 Cross-sectional Regressions of Distribution Size of

Transferred Capital Stocks

172

Table 5-4-1 Announcement Effect of Rights Issues (1994-2003) 173Table 5-4-2 Announcement Effect of Rights Issues by Year 174Table 5-4-3 Announcement Effect of Rights Issues by Period 175Table 5-4-4 Statistical Description of Explanatory Variables in

Table 5-4-5 Cross-sectional Regressions of Cumulative Abnormal Return

of Rights Issues

177

in 1993 to 1099.8 billion in 2004 (see Table 1-2) As a result, the stock market has played a very important role in China’s economy According to Table 1-3, the market capitalization as a percentage of GDP has been increasing until it reached the peak in

2000 which is 53.79 percent, after that, it began to decrease and reached 27.14 percent

in 2004

The stock market was established due to practical needs of improving state-owned enterprises Although the enterprise reform, which began in mid 1980s, had made many trials to replace the old management system administered by bureaucrats with more effective management system, including the Director Responsibility System, and the Contract System, the efficiency of State Owned Enterprises (SOEs) was not

greatly improved The SOE sector which employed over 70% of the urban workforce still occupied a predominant status in the economy, but the overall performance of SOEs was unsatisfactory because over one thirds of SOEs were in chronic financial distress and being supported by the state budget grants and government-directed bank credits It was getting worse because the state treasury and the state-owned banks themselves were facing financial difficulties, the former of which had a constantly decreasing income since the taxation reform, and the latter of which had already been implicated by the huge amount of bad debts How to solve the financing problems and

to improve the efficiency of SOE became urgent issues of Chinese government at the early 1990s

The development of stock market was regarded as a remedy for the above issues and was thus greatly supported by the Chinese government Undoubtedly, by directing the huge amount of personal savings and even the foreign funds to the investment needs, stock market can solve the financing problem faced by many enterprises including both state-owned enterprises and many non-SOEs, and to relieve the burden of state budget and state-owned banking sector as well Moreover, it was believed that stock market can function as a governance system that would help establish a truly competitive corporate sector in China as argued by some economists Firstly, companies going public have to be transformed to shareholding companies In this process, the company’s ownership would become clearer based on the shareholdings that the ownership was not clear was considered as a key factor leading to the inefficiency of SOEs; secondly, by issuing shares to the public, the ownership of shares will be diversified It helps improve the performance of SOEs and the public shareholders can directly or indirectly participate in the corporate management through the stock market

There are two characteristics in the building of the Chinese stock market One is that the Chinese stock market was patterned after the US stock market in many legislations of the stock market1 The reason that the China’s stock market emulated the US stock market is because the latter is regarded as one of the most active and efficient markets for corporate control which helps the US maintain a leading role in the world economy The other characteristic is that most of the listed companies are SOEs or dominated by state-owned shares The government hoped that a shareholding system together with an active stock market can help develop an effective management system of SOEs to restructure their inefficient management system Under the direct control of the government, the construction of stock market has become a program of reforming the SOEs

After more than one decade’s development, it is still uncertain whether the reform on the stock market is successful It is no doubt that China’s stock market absorbed a great amount of public funds and began to exert an important influence on the China’s economy There were also concerns about over-speculation making the share prices greatly volatile and the stock market highly risky However, the concern of this thesis

is whether the US-like stock market established in China has worked well in improving the corporate efficiency The following phenomena, which were observed

in China’s stock market, intrigued my research interests

In contrast to what was expected, the overall performance of the listed companies has been deteriorating although the trend was reversed in recent two years Indicated in the Table 1-4, the average return on equity decreases from 14.28 percent in 1992 to as low as 5.35 percent in 2001 The average earnings per share decreased from 0.35

1 Tam, On Kit (1999)

Yuan in 1992 to 0.13 Yuan in 2001 Since 1994, more and more listed companies became money-losers The proportion of firms losing money increased from 5.1 percent in 1995 to 12.51 percent in 2003 (see Table 1-5)

It was also observed that the financial behavior of China’s listed companies differed

in significant ways from that of their counterparts in mature economies such as the US For example, China’s listed companies paid little and irregular cash dividends; the seasoned equity offerings were very popular in China, and the rights issue which was rare in the US stock market has been the only form of seasoned stock issues before

1999 Furthermore, investors’ reactions towards these financial decisions were also different from their US counterparts China’s investors prefer stock dividends and transferred capital stocks to cash dividends whereas investors in the US prefer cash dividends; while in the US the market reaction towards rights issues is generally negative, China’s stock market reacts favorably to rights issues

The above facts show that, despite the similarities in many institutions, the operations

of China’s stock market and the US stock market are different It also suggests that the objective of creating an effective system for corporate control and improving the Hence, exploring the reasons behind the differences between China’s stock market and the US stock market becomes the motivation of this thesis

1.2 Objectives

The unique financial behavior of China’s listed companies has also drawn the attention of many researchers It can be seen from the existing studies that at least some of the results are not consistent with those of the US stock market The limitations of these studies are that they studied the market response to the news of a

financial decision either without reasonable explanations or, even if there are any, they are not empirically supported Therefore, the questions about why there was such

an announcement effect towards a specific financial decision and why the firm took this financial policy remain inconclusive In addition to study the market reaction to certain business financial decisions, this thesis attempts to examine the managerial incentives of financial policies by testing a number of hypotheses derived from the information signaling theory or other theories

Miller and Modigliani (1961) are the first ones to propose signaling-based explanations for the positive stock price response to dividend increases They suggested that managers may announce such dividend changes in an effort to move market expectations closer to those of the management about future earnings prospects From this information proposition an information signaling model was eventually derived and many researchers2 have contributed to the signaling theory by providing a rigorous logical structure They developed models of financial policy under the assumption of asymmetric information showing that the financial decision was relevant to the shareholders’ wealth

The theoretical construct of the information signaling approach were developed by Spence (1974), and were expanded into the areas of financial and dividend signaling

by Ross (1977), Leland and Pyle (1977) and Bhattacharya (1979) Spence (1974)

observes that buyers may use an imperfect proxy to predict product quality ex ante

market transactions Because there is a negative correlation between the marginal cost

of improving the proxy and the actual product’s quality, the level of the proxy is a signal to potential buyers Ross (1977) applied this signaling mechanism in

2 Bhattacharya, (1979); John and Williams, (1985); Miller and Rock, (1985); Myers and Majluf, (1984); Leland and Pyle, (1977); Brennan and Kraus, (1987); and Ambarish, John & Williams, (1987)

investigating the effect of financial leverage The change in the financial structure can alter the market’s perception of a risk without actually altering the actual risk An implication is that in a cross-section sample, the value of firms will rise as the leverage increases because the increasing leverage raises the market’s perception of value Leland and Pyle (1977) also investigate the signaling implications of financial structure in a world of information asymmetries They show that the willingness of insiders to invest in their own projects is a signal of the project’s quality They found that the value of the firm increases with the shares of the firm held by insiders

The main idea of information signaling theory is that, due to information asymmetry, financial instruments can be used by the management to convey inside information to outside investors This theory is applied to explain the changes in share prices on the announcement of certain financial policy, a phenomenon well-documented in the literature For the management to convey any inside information about the firm’s prospect to the outside shareholders through certain policy, two assumptions must be met according to the information signaling theory that (i) the share price is changed with the shareholders’ assessment about the firm’s value; and (ii) the falling share price tends to oblige managers to maximize the shareholders’ wealth

It is not certain whether these assumptions hold in China, because the shareholder relationship in China’s listed companies is complicated The public minority shareholders are the weakest group among all the parties, as they do not receive enough protection from the regulatory framework Although they hold almost all the tradable shares, they have hardly any control over the company Things are more complicated in the state-owned enterprises, which account for a large proportion

manager-of the listed companies In these companies, the controlling shareholders are not

shareholders in a conventional sense Such a shareholder-manager relationship certainly will affect the corporate finance Those agents of state-owned shares with controlling power may pursue the interests of their own instead of the interests of the company and other shareholders By colluding with the major shareholders, they may also pursue their common interests at the cost of minor shareholders

Therefore, the objectives of this thesis are as follows It is hypothesized that the financial behavior and the overall performance of China’s listed companies are the outcome of the institutional arrangements, which shape the relationship between shareholders and managers, and thus shape the behavior of shareholders and managers

A financial decision is not only a decision made by the managers, but is also a reflection of the relationship between shareholders and managers Therefore, the first objective is to find out what are the differences in the institutional settings between China and other countries, especially the US

It is also expected that the conventional information signaling theory may not be able

to explain some empirical tests for China’s case because, in addition to the information asymmetry, there also exists more complicated agency relationship in China’s listed companies The second objective is to verify whether the behavior of the shareholders and management in China’s listed companies are consistent with the predictions of conventional information signaling theory The investigation of the information content of the financial policies is conducted through the following steps

Firstly, the market reaction of the announcement of a particular financial decision will

be examined If the financial decision does contain some information not known to the shareholders, the announcement of this decision will change the shareholders’ expectation about the firm’s performance and reevaluate the firm’s shares Therefore,

the announcement effect of a particular policy on share price can verify (1) whether there is any information conveyed by this policy; and (2) if any, whether it is good news or bad news from the shareholders’ viewpoint

Secondly, the thesis attempts to find out whether the market behavior in China is consistent with the information signaling theory According to the information signaling theory, the shareholders can perceive whether a certain action is value-added from the announcement, and the management has to avoid those actions which may be perceived by the shareholders as value-reduced Therefore, the information signaling to some extent helps reduce the cost of asymmetric information However, provided in China the shareholders are lack of corporate control power, the management is likely to take actions not in the interests of shareholders

The last objective is to explore whether the cash-dividend-enforcement policy has some impacts on the financial polices It is noteworthy that the policy makers of China gradually realized that the insufficient legal protection provided for the public minority shareholders and the weak corporate governance are the dysfunctions of the stock market A series of regulatory polices about the corporate governance were enacted by the China Securities and Regulatory Commission (CSRC), such as the

“Directives on the Reinforcement of the Supervision for Listed Companies” in June

2000, the “Directives on the Establishment of the Institution of Independent Board of Directors” in August 2000, the “Code of the Corporate Governance for Listed Companies” in January 2002, and the ‘Seven Measures to Promote the Corporate Governance’ in January 2003 Among these regulatory policies, some policies are relevant to the corporate finance For example, the release of “Supplementary Notice

on the Rights Issues of Listed Companies” in March 2000, the Directive on the

Management of New Share Issues of Listed Companies” in February 2001 and “The regulations of Reinforcement of the Social Public Shareholders’ Rights Protection” in year 2004 It is supposed that these policies would have some impacts on the financial policies of the listed companies Therefore, the third objective of this thesis is to confirm whether the new policies have impacts on the corporate finance

1.3 Methodology

Event study and regression analysis are the primary tools adopted in this thesis to achieve the above three objectives This thesis conducts event study to examine the market reaction towards the announcement of specific financial decisions made by the listed companies Regression models are then used to investigate the possible factors that cause the announcement effect of a specific event and the managerial incentives

There are some features of the empirical tests of this thesis in comparison to those in the literature of the information content theory Firstly, the aim of the thesis is to find out the nature of the information that can be used to interpret the market reactions and the managerial incentives, no matter whether it is suggested by the information signaling theory or any other theories

Secondly, the thesis concerns whether the market reaction towards and the managerial incentives of a specific policy are consistent The empirical studies of information content in the literature usually omit the examination of the managerial incentives and make conjectures on whether the event signals good or bad news for the firm’s prospect based on the market reaction only These studies assume that the shareholders concern about the firm’s value and actively involve in monitoring the corporate management When a financial policy reflects the management’s confidence

in the future, the shareholders will revise their expectation upward and cause the share prices to increase; when a financial policy signals the management’s pessimism about the future, the shareholders will revise their expectations down and cause the share prices to decrease The institutional features of China’s stock market, however, suggest that the public shareholders’ wealth in China may not be linked to the firms’ value due to insufficient legal protection Therefore the investor’s reaction may be different from that suggested by the information signaling theory Even if the investors do care about the firm’s value, it may still be problematic whether they are able to correctly interpret the information conveyed by a certain corporate decision especially in an emerging market with ever-changing institutions, incomplete information disclosure, and immature listed companies Therefore, both the market reaction and the managerial incentives are to be examined for any type of events

The remainder of the thesis is organized as follows Chapter 2 examines the institutional settings of China’s stock market, the problems of China’s stock market, and the possible solution Chapter 3 reviews all the relevant literature about the market reaction towards and the managerial incentives of the announcement of cash dividends, stock distributions and rights issues of listed companies over 1994 to 2003 Chapter 4 presents the data used and methodologies applied The results and findings are presented in Chapter 5 and Chapter 6 is about the conclusions

CHAPTER 2

INSTITUTIONAL FEATURES OF CHINA’S STOCK MARKET

Institutional features and the problems related to China’s stock market are two subjects discussed in this chapter, which comprises three sections Section 2.1 analyzes the institutional arrangements in China in comparison to two stylized markets, the insider-based market and the outsider-based market; Section 2.2 discusses the problems of China’s stock market; with possible solutions to these problems discussed in Section 2.3

2.1 Features of China’s Stock Market

2.1.1 A Unique Feature of China’s Stock Market

In China, the shares are classified as A-shares the ownership of which is confined to only local citizens, and B-shares were allowed to be held initially by foreigners only, and now are open to domestic citizen, but are traded in foreign currency A-shares and B-shares are shares of companies registered in China and listed in China’s stock exchanges H-shares are shares of companies registered in China but listed in stock exchanges of Hong Kong A company can issue A-shares and B-shares together and can be listed in a domestic stock exchange and a foreign stock exchange simultaneously

The classification of shares above-mentioned is not unique as it is a common practice

to classify shares as domestic shares and foreign shares The uniqueness is that the shares of a company are classified according to the ownership property of the shareholders, and are categorized as State-owned Shares, Legal person’s shares, Staff

Shares and Public shares Before the reform and opening, there are only two types of enterprises, state-owned enterprises which dominated the economy and collective-owned enterprises In the transformation from state-owned enterprises to shareholding companies, the state assets were converted to state-owned shares, the assets belong to the state-owned enterprises were converted to Legal person’s shares, and shares issued to employees were converted to Staff Shares Once the transformed shareholding company is listed in either stock exchange, the shares issued to other enterprises belong to the Legal person’s shares; and shares issued to the public are called public shares

The aim of such classification is to separate tradable shares with non-tradable shares State-owned shares, Legal person’s shares, Staff Shares are not allowed to be traded

in the stock market, only public A-shares and B-shares are traded in the stock exchanges The policy-makers are afraid that the state might lose the control rights on the state-owned shareholding companies with the reduction in the proportion of the state ownership when it can be freely transferred While prohibiting the state-owned shares and Legal person’s shares to be transferred in the stock market, the dominant status of state’s ownership can remain Since most of the legal person’s shares are also the assets owned by the state-owned enterprises, legal person’s shares are treated

as state-owned shares and not allowed to be traded in the stock market As a result, most of the shares are non-tradable and most of the companies are controlled by the state or legal persons The unique share structure of the listed company has substantial impact on China’s stock market

The ownership of non-tradable shares can be transferred outside the stock exchanges The ownership is generally transferred through agreements signed by both parties

concerned The ownership transfer of state-shares and state-owned legal person’s shares has to be conducted within state-owned enterprises or organizations, and approved by the state assets management organizations The transfer is helpful to some extent to mobilize the capital, but a large proportion of the transfer of state-owned enterprises were proposed and organized by the government or state-authorized organizations rather than a free market transaction organized by firms This government behavior greatly reduced the effects that ownership transfer would have in mobilizing the funds and improving the management efficiency

Table 2-1 gives a general picture of share structure in China’s stock market through years 1992 to 2004 The figures are the numbers of each type of shares as percentage

of total shares It shows that on average the state-owned share accounts for 41.31 percent of the total shares, while the legal person’s share accounts for 23.04 percent, and the public A-share accounts for 23.30 percent During 1992-2004, there has been

a decrease in the proportion of legal person’s shares from 26.60 percent to 16.40 percent, but the proportion of state-owned shares increased from 42.10 percent to 46.78 percent, and the proportion of public A-shares increased from 15.90 percent to 27.87 percent But the number of total non-tradable shares remains almost a double of that of total tradable shares as the percentage of the non-tradable shares to the total shares is 66.02 percent and the percentage of tradable shares to the total shares is only 34.03 percent

The ownership structure is further described by Table 2-2 On average, in about 49%

of the companies, the state-owned share accounts for the largest proportion; in about

32 percent of firms, the legal person’s share accounts for the largest proportion, public A-share dominates in only about 19 percent of the firms Therefore, in about 86.7

percent of the firms, non-tradable shares dominate the ownership structure As mentioned before, part of the legal person’s shares is also state-owned Although the proportion of the state-owned legal person’s shares in the total Legal person’s shares

is not known, one thing can be sure is that the state control is more than what is reflected in the proportion of state-owned shares where the proportion of state-owned Legal person’s shares is not included

Based on Table 2-1 and Table 2-2, the following conclusions can be drawn upon the share structure of China’s stock market: a) on average most of the shares (66.02%) in the stock market are not tradable in the stock exchanges A vast majority of the listed firms (86.70%) whose ownership is dominated by non-tradable shares; b) state-owned shares, which on average account for 41.31 percent of the total shares, dominate the scene in the stock market The state ownership has the absolute control rights in about 48.89 percent of the total firms; c) Public shareholders holding tradable shares are the weakest shareholders because on average they hold about only 23.30 percent of the total shares, and the A-share ownership dominates in only about 19.90 percent of the total firms; d) The status of legal person’s shares is in between the state-owned shares and public tradable shares

2.1.2 Comparison with the Insider-based Model

The insider-based model is also called bank-based corporate governance model because this model puts emphasis on the role of the banks in the corporate governance Germany is often cited as an example of a country in which the relationship between bank and industry is not burdened at all by regulatory constraints The institutional structure of the German financial system centers on the principle of universal banking Universal banks can hold as many of equities as they like in any non-financial firm In

Japan, financial institutions are subject to few regulations regarding the holding of corporate stock or the use of the stock they own for corporate control Japanese commercial banks are not prohibited from owning corporate stock, although they are subject to anti-monopoly regulations

Interlock shareholding is another feature of Germany-Japan model The large shares

of a company are often held by other companies – a cross-holding of shares – or by holding companies for families In smaller German companies, the family exerts control through majority ownership, in which the owner controls 51% of a company, which in turn controls 51 percent of its subsidiaries and so on (Franks and Mayer, 2001) In Japan, many companies are organized around a major bank and form a network group called “keiretsu.” There are long standing business relationships between the group companies The banks and other financial institutions own shares

in most of the group companies and those companies may in turn hold the bank’s shares or each other’ shares The power in Keiretsu is split among the main bank, the largest companies, and the group as a whole

In this model, banks end up holding equity as well as debt of the firms they invest in,

or alternatively vote the equity of other investors (OECD 1995) The power of the banks’ control on the companies is very significant because banks vote significant blocks of shares, sit on boards of directors, play a dominant role in lending, and operate in a legal environment favorable to creditors As a consequence, the share ownership is concentrated on the small portion of the inside shareholders In Germany, large commercial banks through proxy voting arrangements often control over a quarter of the votes in major companies, and also have smaller but significant cash flow stakes as direct shareholders or creditors (Frank and Mayer 1994, OECD 1995)

In Japan, though ownership is not nearly as concentrated as in Germany, large holdings as well as shareholdings by major banks are very common (Prowse 1992, Berglof and Perotti 1994, OECD 1995)

cross-Germany firms own a two-tier board structure comprised of a supervisory board and

an executive board The employees of a firm have a right to participate directly in the governance of the company through representation in the company’s supervisory board with half of the board membership The supervisory board supervises the activities, and can scrutinize and veto the management’s investment plans, appoints or removes members of the executive board Members of the executive board cannot sit

on the supervisory board Board members are required to represent the interest of the company, not of the group they represent

The advantage of Germany-Japan model is that, the banks and other large shareholders can, with the majority shares they hold of a company, take their advantageous position in the board of directors and shareholders’ meeting, and exert their influence directly on the corporate control through the internal governance system That is the reason that the model is also called insider-based market However, the disadvantage of such an insider-controlled governance system is that, the interests

of the numerous minority shareholders was neglected and might be impaired by the majority shareholders That is also the reason that an active stock market is absent under this model

China’s ownership structure is more like the Japan-German model with share ownership highly concentrated in a few insiders In a study of 530 listed companies in

1996, He (1998) gives evidence about the ownership concentration in terms of an individual shareholder One of his results is presented in the Table 2-3 which

classifies the companies into groups by the percentage of shares owned by the largest shareholder It shows that in 38.3 percent of the 530 companies, the largest shareholder holds more than 50 percent of the total shares of a firm which means he has the absolute rights on the firm In about three quarters of the sample companies,

an individual shareholder holds more than 30 percent of the total shares of a firm The degree of ownership concentration is comparable to that of the Germany and Japan

Although the ownership structure is highly concentrated, the governance system of the China’s public companies was not similar to that of the Germany-Japan model which is bank-centered Banks in China cannot control the firms by acting as active large shareholders because they are not allowed to invest in equity markets According to the Article 133 of the “Securities Law of China”, capital of banks is prohibited from entering into securities exchanges Even if the bank can be a large creditor, the banks’ role on the management of the firm is limited In principle, banks can impose financial discipline on firm primarily by requiring them to make regular payments on loans Banks also have rights to access to fairly detailed information on the financial condition of a borrowing firm, and exert corporate management But most of the listed companies are former state-owned enterprises; their short-term external financing relies on the loans from the state-owned banks State-owned banks are not likely to play an effective role in the management when they have only limited rights to choose between carrying a bad loan on their books and force bankruptcy and closure of the state-owned firms

China’s listed companies have a similar supervisory board as in Germany, which is comprised of employees and representatives of shareholders It is supposed to supervise the illegal behavior or misconduct of directors and managers that would

impair the interests of the companies The main function is to balance the interests among the executives, shareholders and the employees The supervisory board in China did not exert their active supervisory duty because the board members are all insiders of the company Employees are also shareholders but, when confronted with conflicts in interests, they would consider themselves as employees rather than shareholders and support decisions favored to employees at the cost of the shareholders Neither can the China’s governance rely on the interlock shareholding Although there is no legal prohibition of interlocking shareholding among public companies, the constraints of the ownership transfer for the state-owned firms hinders

the development of a cross-shareholding network to reinforce their interactions

2.1.3 Comparison with the Outsider-based Model

In contrast to the insider-based Japan-German model, the most distinct feature of the

US model is that the ownership is highly dispersed among a large number of outside individuals and institutional investors

This is because that the banks and financial institutions face significant constraints on their ability to take large stock positions in firms and use them for corporate control purposes3 The US banks are prohibited from owning any stock on their own account

by the Glass-Steagall Act of 19334 Other financial institutions also face strict rules governing their equity investments There are also impediments to non-financial firms taking large stakes in firms US antitrust laws have historically been hostile to the inter-corporate ties that would be implied by large inter-corporate shareholdings In addition, the US dividend tax rules discourage inter-corporate holdings of stocks

3 Roe (1990) and Prowse (1990)

4 The Glass-Steagall Act of 1933 was repealed with the passage of the Financial Services Modernization Act of 1999 Commercial and investment banks have been drawing closer to universal banking

The dispersed ownership structure of the US constraints the control power of major shareholders determines that the corporate control relies more on the stock market, which is also called the market for corporate control This distinguished feature of US model is to give more protection for the outsiders by restricting the control power of insiders This function of stock market depends on active takeover market and active institutional investors

The takeover market is widely recognized as a potentially important mechanism for corporate governance in the US where large shareholders are less common.5 In a typical hostile takeover, a bidder makes a tender offer to the dispersed shareholders of the target firm, and if they accept this offer, acquires control of the target firm and so can replace, or at least control, the management The most important form of corporate control in the US is the takeover either by another public company or a private investment partnership Takeovers allow poorly-performed management to be replaced by superior management and resources to be redirected from low to high value activities According to Prowse (1994), the average annual volume of completed domestic mergers and corporate transactions with disclosed values during

1985 to 1989 in US is 1,070 billion which is as 41.1% of total market capital capitalization

Hostile takeovers are rare in Germany and Japan because of legal and regulatory impediments For example, in Germany, the presence of employee representatives on the supervisory board means that he board will tend to support existing management against any takeovers The ability of German firms to restrict the number of votes that

5 Jensen and Ruback (1983); Franks and Mayer (2001)

can be exercised by a single shareholder may also be an impediment to takeovers, while the US firms are discouraged from doing this by Stock Exchange regulations

As an emerging control element, institutional investors in the US are being recognized

as active, value-maximizing shareholders (Black, 1990) In the US, the share of institutional investors’ holding of equity assets has risen from 6 percent after the Second World War to over 50 percent by 1996 while the share of banks and insurers

in institutional financial assets has fallen from 80 percent to 45 percent and the share

of pension funds rose from 3 percent to 25% (Prowse, 1994) It is believed that institutional investors and financial intermediaries are able to accumulate larger amounts of funds than private investors They are in a privileged position to acquire large equity stakes and exercise substantial control over listed corporations

There are limitations for the hostile takeover and institutional investors to play an important role on corporate control Takeover is a very large action involving huge costs, and is unlikely to be used to discipline all the companies at all the time when the firms are undervalued The ability of institutional investors on the corporate governance is also limited by the strict rules governing their equity investments that any institutional investors cannot invest more than 10 percent on a single company Therefore, in most cases, the management discipline still has to rely on the internal control system – incentive contract and board effectiveness

Incentive contract is an important internal control device, which associates the management’s reward with the firm’s performance, thereby tying management’s welfare to shareholder wealth, provides an incentive for the management to maximize shareholder value (Fama, 1980) Incentive contracts can take a variety of forms, including performance-based cash bonuses and salary revisions, share ownership,

stock options, and performance-based dismissal decisions (Jensen and Meckling, 1976; Fama, 1980)

An effective Board of Director is another internal device There is a host of evidence

of the weakness of boards in the US (see Mace, 1971; Weisbach, 1988; and Jensen, 1989) The outside independent directors, who owe their appointment to the board or

to the CEO, and who may often have a financial interest in the continuity of the current management team, are regarded as a primary controlling element to improve the accountability and independence of the board In the US, boards, especially those dominated by outside directors, sometimes remove top managers after poor performance (Weisbach, 1988)

Although the takeover market is believed to be an effective way of corporate control

in the US model, a takeover market does not exist in the China’s market as a dominant proportion of the shares are non-tradable

China’s policy makers have been aware of the importance of the institutional investors and the independent outside directors In year 2002, China’s stock market introduced the system of Qualified Foreign Institutional Investors (QFII) hoping that

it can improve the governance by educating the domestic institutional shareholders who are immature and inexperienced in exercising control over corporation However, the effect of the QFII has yet not been seen in the China’s stock market The Corporate Governance Guideline given by the CSRC tends to emphasize a larger percentage of outside independent directors in the executive board While actually these independent directors receive salaries from the company, they are not real

“independent”

2.2 Problems of China’s Stock Market

The essential problem of China’s stock market is that it fails to protect the interests of real shareholders although many regulations and rules of China’s stock market are patterned after the US market The cause of the problem is the ownership property of the firms because most listed companies are dominated by the State-owned Shares or State-owned Legal Person’s Shares which are non-tradable The state-owned listed companies dominate the stock market, and therefore the state-owned shares dominate the ownership structure of the listed companies The ownership dominance of state-owned shares has been strengthened since 1998 after several years’ weakening

The state ownership property of the listed firms makes the conflicts between shareholder and management more complicated than in other firms In addition to the common agency relationship between the shareholder and management, the state-owned listed companies have more complicated agency relationships than other types

of companies – the relationships between the state and various levels of state asset representatives, and the relationship between the state asset representatives and the managers they nominate to operate the state-owned listed companies Because the state assets can not be managed by the state directly, they are managed by the various levels of state assets management organizations authorized by the state These state assets management organizations then authorize holding companies, investment companies, industrial groups, or other departments, all state-owned or state-controlled, which function as the state assets representatives to be the directors to directly manage the state-owned companies And certainly these directors on behalf of the state will nominate some managers to undertake the routine management of the companies

But these directors of the state-owned companies are the actual “agents” of the state in charge of the state-owned shares and state-owned legal person’s shares Therefore, in

a state-owned company, there is not much difference in the status between the directors and managers as both are in nature the ‘agents’ of the state Moreover, the directors and the managers are not only the “agents” of the state; they are at the same time the “agents” of the minority shareholders of the company The outside shareholders cannot exert any direct control on the corporation, and have to rely on the directors and managers to manage their wealth

The above discussion indicates that there are many-layer agency relationships within

a state-owned listed company, i.e., the relationship between the state and the state asset management representative, the relationship between the state asset management representative and the company directors, the relationship between the directors and the managers, and the relationship between the managers and the public shareholders The principal-agent relationship determines that the agents may not act in the interests

of the principals Among all of the layers, the agency conflict between managers and public shareholders is the most acute than that of all the other layers This is because not any individual or institution is the real owner of the state assets, so all those who manage the state assets on behalf of the state including the company directors and managers are “agents” with interest different from that of “principals” Among all the relationships, the relationship between the management and the public shareholders is

a true “agent-principal” relationship as the public shareholders are real owners of public shares Because both company directors and company managers do not have conflicting interests and both are insiders who are in an advantageous position to acquire information and exert corporate control, it also leads to the possibility that both of them may collude to pursue their common interests at the cost of the real

shareholders and make the real shareholders difficult to exert control on the corporate management That is the reason why public shareholders in China do not receive enough protection under the current system

First of all, the voting rights on important corporate matters, such as the elections of boards of directors, or mergers and liquidation, are undoubtedly the most important legal right of the shareholders (Manne, 1965; Easterbrook and Fischel, 1983) In China, the power of the voting right is determined by the number of shares held by the shareholders according to the rule of “one vote per share” In a typical company where a huge number of public shareholders hold only one thirds of the total shares, it

is not difficult to imagine how trivial the influence of the public shareholders, especially the public individual shareholders After learning about the influence they could have on the firm’s management, the public individual shareholders would not bother to vote in the shareholders’ meeting, especially when they have to show up and cannot vote by mail

Secondly, institutional investors may serve as a good device to protect the interests of individual shareholders As observed in the US, the institutional investors are playing

a more and more active role in the corporate management The existence of riders” problem makes it hard for an individual to monitor and supervise the management of a firm when the benefit of doing so is less than the cost of collecting and analyzing the necessary information The cost of monitoring will be borne by the individual himself, but the benefit will be shared by all the shareholders Therefore, it

“free-is more appropriate for an institutional investor to undertake the task of monitoring because conducting activities such as information gathering and analysis is more cost-effective by an institution

Realizing the importance of the institutional investors in disciplining the corporate management, the China’s policy-makers are trying to foster a good environment for the institutional investors including attracting foreign institutional investors to enter the stock market However, the influence of institutional investors on the corporate control may not be as good as expected The institutional investor may exert influence

on the management of a company either through internal mechanism such as voting in the shareholders’ meeting or through the market control But this ability is limited by certain restrictions on the equity investment of institutional investors as in the US, and

is limited further due to the inferior position of the tradable shares which on average account for only one-thirds of the total outstanding shares, and the huge number of individual investors accounting for over 99 percent of the A-share investors (See Table 2-10) The influence of institutional investors on China’s corporate control is still awaiting a longer period’s examination

Thirdly, the Chinese minority shareholders cannot rely on a takeover market The takeover is likely only in about 19.90 percent (See Table 2-2) of the companies where tradable A-shares are more than the state-owned shares and legal person’s shares Following the same rule as in the US, the Law of Securities requires that any shareholder who has acquired 5 percent of the issued shares of a limited stock company should report to the company within three days after 5 percent of the shares

is acquired, and report the case to the securities supervision administration of the State Council within three days upon receiving the report While it is helpful in protecting minority shareholders in the US by restricting the ownership concentration, it works

in the opposition direction in China to further weakening the rights of minority shareholders by decreasing the feasibility of a takeover Even if a company has most

of its shares tradable, it is difficult for a hostile takeover to succeed For example, a

recent case of hostile takeover targeted at Guangfa Securities Limited Company (Guangfa) indicates that the insiders’ attitudes toward the hostile takeover can be the key to the success of a takeover The failure of this takeover by the China International Trust and Investment Securities Limited Company (Zhongxin) worths thinking as Guangfa successfully made three of his largest shareholders to collect nearly two-thirds of its total shares by offering price less than the tender offer price given by Zhongxin6

Finally, “voting by feet” is also considered as a controlling device that minority shareholder can resort to They can protect themselves by selling the shares they held

if they are unsatisfied with the performance of a listed company But “voting by feet” can be an effective controlling device only if the falling of share prices is unwanted

by the managers In this case, the managers’ interests should be closely related to the share price The management may concern about the falling of share prices if their salaries are associated with the market performance of the company under the incentive contract The management concerns about the share price may also because their status or the reputation would be threatened if the undervalued company becomes a target of takeover It means the “voting by feet” works through Incentive Contract or takeover It is uncertain whether the enforcement of incentive contract is enough for the managerial behavior to be disciplined by the “voting by feet”, but at least the takeover is unlikely to be a threat of current management because it rarely happens in China

The above discussions indicate that corporate governance is non-exist in China’s stock market as most of the firms are state-owned or state-controlled On one hand,

6 Details refer to the article of the following website: http://www.cs.com.cn/02/02/200410150281.htm

the rights of public shareholders in China are not well protected in a US-like stock market through either the internal governance mechanism or the external governance mechanism On the other hand, no one is the real owner of state-owned shares who is acting in the interests of “the state” Thus, the company insiders can take advantage of their controlling position to pursue their personal interests at the cost of public shareholders, and this situation can have a profound influence on the listed companies and the stock market

The above arguments are supported by the following facts One fact is that the overall performance of the companies kept falling until 2001, and more and more firms began

to suffer losses (see Table 2-4 and 2-5) While the chief objective for a shareholding company is to maximize the shareholders’ wealth, the decrease of firms’ value is undoubtedly the most convincing proof for the poor corporate control

This poor corporate control is also be reflected in the financial behavior of the listed companies The listed company treated the stock market as a cheap or free ATM (Automatic Teller Machine) because kept raising funds from the public without repaying the cash dividends to the shareholders Table 2-6 shows the changes of capital structure through 1992 to 2002 classified by the share ownership During this period, the listed companies raised 5.807 billion Yuan of funds from the stock market The total capital expanded from 68.87 million shares to 5.875 billion shares The capital changes owed to the IPOs, stock dividends, seasoned equity issues The change of IPOs accounted for 70.11 percent, the change of stock dividends accounted for 22.64 percent, the change of rights issues accounted for 5.21 percent, and the change of public issues accounted for 2.17 percent On average, there are 13.85 percent of firms issuing seasoned shares during 1994-2003, among which 86.86

percent of firms issuing rights (See Table 2-7) But this trend was reversed since 2001 when the number of firms issuing seasoned shares fell to half of that in 2000, and kept falling

Although the listed companies were enthusiastic in raising funds, they were scant in paying dividends to the shareholders According to Table 2-9, on average there are 57.76 percent of companies paid dividends to the shareholders during 1994-2003, among which 42.28 percent of firms paid stock dividends instead of cash dividends The proportion of firms paying stock dividends remained above 45 percent of all dividend-paying firms until the end of 1999 Furthermore, the cash payment is often trivial compared to its price as the average dividend yield for listed companies is about 0.86 percent, which is lower than the three-month fixed deposit rate which is about 1.7 percent7

The pool corporate governance also results in a risky stock market with highly volatile prices Since shareholders cannot get fair returns through cash dividends, a shareholder who invested in the stock market can only rely on capital gains to take back his return In addition, capital gains have tax advantageous over cash dividends, the latter of which is subject to 20 percent taxation It is not easy for the shareholders

to capture capital gains in a market where stock prices are relatively stable The larger the volatility of the share prices, the larger the chances for the shareholders to capture the price appreciations Shareholders’ favor with the capital gains also motivated some institutional investors to manipulate the market prices, resulting in a highly volatile stock market According to the “Securities Law of China”, no one is allowed

to obtain illegal benefits or impute the risks to other people through manipulating the

7 Shanghai Securities News (Aug 14, 2004)

trading price of the securities individually or collectively However, the violation of this regulation was very common Because the stock price reflected only the transactions for the tradable shares, which on average account for only one third of the total shares, and also because more than 99 percent of investors are individuals, the share price was easily to be affected Some institutional investors then took the advantage of their huge number of shares to manipulate the stock prices, accompanied with fabricating and spreading of rumors in the market which was absolutely prohibited This is one reason that China’s stock market presented persistent high levels of volatility compared with that of other countries

According to Table 2-9, the turnover rate in either Shanghai Securities Exchange (SHSE) or Shenzhen Securities Exchange (SZSE) was on average 479.59 and 519.94 respectively through 1992 to 2004 The turnover ratio was even as high as 1350.35 in Shenzhen in 1996 In contrast, the average turnover rates were 57.08, 61.15 and 27.39

in New York, London and Tokyo It can be seen from the table that the turnover ratio

in the Japanese market was relatively lower than that in the US market or UK market The inactive trading activities in Japan might be partly explained by the dominance of large block shareholders in the listed companies On one hand, the controlling shareholders concerning long-term development of the firms tend to keep the stability

of the shareholding and are unlikely to trade the shares frequently On the other hand, the outside individual shareholders are precluded from entering the stock market due

to the lack of information and corporate control power This can be further supported

by the fact that Japanese individuals hold only about 10%8 of the total shares

8 Global Equity Market (1990)

As the turnover ratios for China’s stock market reflected only the trading activities of tradable shares, the active trading in the stock market cannot be explained by the behavior of managing shareholders The figures show that, although the ownership is highly concentrated in China as in Japan, the individual investors in China were willing to invest in the stock market, and trade the stocks This phenomenon is inconsistent with the conventional idea that investors tend to actively invest in a capital market where their rights are well protected The shareholders invest in the stock market in exchange for some extent of control rights on the firm, without which the shareholders will be involved in high risks It is commonly believed that the legal and regulatory protection towards the public individual shareholders makes the US market one of the most active stock markets in the world However, the legal protection cannot be used to explain why so many individual shareholders in China were enthusiastic in investing in the stock market because they were not well protected Table 2-10 shows that the number of A-share investors has kept increasing all the years till 2001 and the percentage of individual investors over the total investors remained above 99 percent each year Therefore, there arises a problem that why there were so many investors in China were willing to invest in the stock market with high risks What are the motivations that they were willing to invest in a stock market without any control rights?

Probably the rapid growth of China’s stock market can be attributed to the following two explanations At the early stage, when people had no idea about the stock market, they probably had misconceptions that, as the stock market is encouraged and supported by the government and most of the listed companies are state-owned, there should be of little risk involved in investing in this market But the most important reason that so many people invested in the stock market is that they could not resist

the temptation of the large appreciation of the stock prices in very near term Large volatility of the China’s stock market at the early stage has been recorded The typical non-payment of cash dividends by the listed firms implies that the only way for an outside shareholder to realize his investment return is to capture the capital gains rather than to receive the cash dividends The high volatility of the stock prices was not only expected by the outside investors but also partly caused by some institutional investors who take their advantages to disseminate new information about firms or about government policies to manipulate the market

The persistence of large IPO underpricing was another important reason that so more investors were willing to invest in such a risky stock market Now that the new shares were issued through a lottery process, as there was always excess demand for the new shares The investors put as much as money they have to subscribe new shares because they will surely earn capital gains as long as they win the allocation at the lottery The process of the new share subscription is completely without any risk except that their subscription funds will be frozen for several days or several weeks The above explanations are supported by the arguments of Shleifer and Vishny (1996) that, in order to come to the capital market and raises funds in the future, the firms and managers need to establish a reputation by repaying investors so as to convince future investors to give them money But they also pointed that the reputation was probably not the whole explanation An alternative explanation is excessive investor optimism “If investors are sufficiently optimistic about short term capital gains and are prepared to part with their money without regard for how the firm will ultimately

pay investors back, then external finance can be sustained without effective governance.”9

In summary, due to the weakness of corporate control, many companies did not care about their performance, but tried their best to raise money from the shareholders by continuously issuing new stocks They do not worry about how to repay the shareholders because they do not need to promise anything when they collect money from the shareholders If they have to pay dividends, they can choose to pay stocks instead of cash, or pay very little cash The minority shareholders can do nothing to change it because they have hardly any control over the company Gradually, since other companies did not pay cash dividends, some good-quality firms also chose not

to pay or pay little cash While more and more shareholders become speculators and

no longer care about the firm’s long-run performance, the firms not subjecting to monitoring and disciplining will become even worse It becomes a vicious cycle as the poor corporate control leads to poor performance, poor management, and bad financial policies, and then leads to even worse corporate management It also teaches

us a lesson that just borrowing some institutions from a good governance model, either the insider-based model or the outsider-based model, is not enough to ensure an effective corporate control system Finding out what should be the key elements of an effective market for corporate control is more important for the improvement of the corporate governance in China’s stock market

9 Shleifer and Vishny (1996), p 20