4.2.1 State Ownership
Both China’s central government and local government hold a large portion of state- owned shares in listed companies. State shareholdings are various and complicated.
Shareholders in this category may be government agencies, government representatives, state-owned enterprises (SOE) and even legal persons who have a small property relationship with the government (Chen & Gong, 2000).
A significant stream of research on state-owned organizations has demonstrated that the government is inefficient in monitoring firm performance (Aggarwal & Agmon, 1990; Newbery, 1992). State ownership is argued to lack the basic incentive for closely tracking the performanc e of firms (Andrews & Dowling, 1998). Thus the previous literature has argued that governmental agencies will not be related to diversification strategy. Empirically, Ramaswamy et al., (2002) find no relationship
between state ownership and firm performance in India.
This relationship might hold as well in the China context. First of all, scholars have found that state ownership has been demonstrated to be ineffective in its monitoring role to enhance the performance of China’s listed companies (Xu & Wang, 1997).
Additionally, as I have mentioned above, government ownership is heavily represented in most of the SOEs’boards in China. Thus it is not surprising for managers to be greatly concerned about their relationship with government officials, as it becomes an issue of maintaining management positions (Chen, 1998).
Therefore, the management of an SOE would have an incentive to expropriate the shareholders. Their incentive to expropriate depends on the degree of divergence between ownership and control (Claessens et al., 1999). As I discussed above, the situation in the Chinese listed companies is that managers have high control rights while they have low cashflow rights. In the case of an SOE, the divergence between low cashflow right of the management and high control rights is maximized. Thus, the incentive to expropriate by diversifying the company would be maximum when the state shareholding is distributed. However, as the state shareholding increases its stake, the divergence between cashflow rights and control rights would become smaller. Thus, the management would have less incentive and ability to expropriate so that the diversification level would be decreasing accordingly. Therefore, I raise the following hypothesis:
Hypothesis 2 For China’s listed companies, the proportion of state ownership will be negatively related to firm’s diversification.
4.2.2 Legal Person Shareholdings
Compared to the state shareholder, legal person shareholders do not have to consider political objectives and thus can influence the firm to move in the direction of profit maximization (Xu & Wang, 1999). Thus legal person shareholders are expected to play a positive role in monitoring the management. Legal person shareholders in China are not only motivated to pursue the goal of profit maximization; they also are better equipped than State owners with the power and ability to monitor a firm’s management (Tan, 2002). Unlike the representatives of state ownership who are appointed by the government, ‘representatives of legal person shareholders are elected to the board of directors and the supervisory committee’(Sun et al., 2002).
‘Legal person shareholders have access to corporate inside information, and the right to question chief officers at any time about operations of the firm’(Xu & Wang, 1997).
Although legal person shareholders can provide effective monitoring of managers, when the concentration of legal person shareholding exceeds a moderate level, minority shareholders are exposed to expropriation problems because of weak governance and an under-developed institutional environment in China. Here the expropriation refers to the agency problem between block- holders (legal person) and minority shareholders. The literature has documented both theoretical arguments and
empirical findings in developed countries (Wolfensohn, 1998). Claessens et al. (1999) finds that financial institutions whose shareholdings in firms exceed a certain level disregard the interests of minority shareholders. In emerging economies, the ability to monitor a firms’ management with such an ownership structure is also in question (Khanna & Palepu, 1999). The existing literature shows that high information asymmetry exists in emerging economies, so that it may be more difficult to refrain the block-holders from pursuing their own interests in the cost of minority ones (Brickley, Lease, & Smith, 1988; David, Kochhar, & Levitas, 1998).
Diversification strategy is an important strategy under such circumstances. When the ownership level controlled by legal person is relatively low, legal person shareholders are expected to effectively monitor the management and restrict the firm from over- diversifying. However, as a legal person shareholder controls more ownership in a firm and becomes a block holder, the advantage of expropriating minority shareholders’interest will outweigh the cost of over-diversification. In Southeast Asian countries such as Malaysia and Thailand, scholars find that controlling shareholders transferred resources out of firms for the benefits of themselves (La Porta et al., 2002). La Porta et al (2002) named this type of transfer as tunneling.
Tunneling might cause a seriously negative impact on firm performance. Small shareholders in China also face a similar situation as that of Southeast Asian countries.
As they have disadvantages in information as compared to block-holders, they are vulnerable if block-holders want to expropriate assets and resources through tunneling, especially when the legal protections on the minority sharehold ers are
limited. At that time, if the management team also has the incentive to diversify for the consideration of their own interests as mentioned above, the two would align the interests and take steps for the firm to diversify. Thus I suggest the following hypothesis:
Hypothesis 3 For China’s listed companies, firm’s diversification will be first negatively and then positively related to the proportion of ownership controlled by
legal person.