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Lihui TianGovernment, governance and finance: some corporate finance issues in China’s emerging stockmarketThesis

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Tian, Lihui

(2003)

Government, governance and finance: some corporate finance issues in China’s emerging stockmarket.

Doctoral thesis, University of London: London Business School.

DOI: https://doi.org/10.35065/NUWQ5163

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GOVERNMENT, GOVERNANCE, AND FINANCE

-Some Corporate Finance Issues in China's Emerging Stock Market

Lihui Tian

Thesis submitted in fulfillment of The requirements for the degree of

PhD at the

London Business School University of London

Program Authorized to Offer Degree:

PhD Programme at the London Business School

October 2002

Lon

London Business School University of London

Abstract

GOVERNMENT, GOVERNANCE, AND FINANCE -Some Corporate Finance Issues in China's Emerging Stock Market

Lihui Tian

This thesis documents the ownership and control, capital structures and initial public offerings of China's modem firms listed on its burgeoning stock market. I find that there is a U-shaped relation with a higher left end between the values of firms and the sizes of government shareholdings; managerial agency costs increase with the sizes of bank loans; and that governmental interests-centered financial regulations and China-specific investments risks bring about China's IPO underpricing as severe as 267%. Three main findings show the profound impacts of the government on corporate governance and financial development. There are two hands of the government influencing the firms: a grabbing hand and a helping hand. The Chinese government is intelligent and sophisticated, but some social elites - both the managers and the bureaucrats -benefit from the widespread businesses of the government at the expense of corporate wealth.

TABLE OF CONTENTS

List of Figures .............................................................................................................................................. ii List of Tables ............................................................................................................................................... iii Acknowledgement

....................................................................................................................................... v Abbreviations

............................................................................................................................................. vi

Introduction ................................................................................................................................................. i

Chapter 1: Government Shareholding and the Value of China's Modem Firms ........................... 6 1. Introduction ...................................................................................................................................... 7 2. Modern Firms in China and the Emerging Stock Market ...................................................... 10 3. Ultimate Shareholding Structure and the Government Shareholder ................................... 20 4. Government Shareholder and the Determinants of Corporate Value ................................ 28 5. The Overall Impact of Government Shareholding is Detrimental ...................................... 35 6. The Two Hands of the Chinese Government Shareholder .................................................. 42 7. Conclusion ....................................................................................................................................... 60 Appendix 1. Data Sources

................................................................................................................ 62 Appendix 2. Shanghai State Asset Management System ............................................................ 63

Chapter 2: Debt Governance, Bank Capture and Soft Budget Constraints .................................. 64 1. Introduction .................................................................................................................................... 65 2. China's Modem Firms and Financial Institutions ................................................................... 67 3. Capital Structure and Soft Budget Constraints ........................................................................ 74 4. Data Samples, Proxies and Univatiate Analysis ....................................................................... 81 5. Multivariate Regressions ............................................................................................................... 94 6. Further Discussion ..................................................................................................................... 111 7. Conclusion .................................................................................................................................... 114 Appendix 1: Data Sample: Sources and Data Selection ........................................................... 116 Appendix 2: Multivariate Regressions: Models, Control Variables and Methods .............. 118 Appendix 3: Scatterplot Matrices of Debt and Managerial Exploitation ............................. 121

Chapter 3: Financial Institutions, Investment Risks and Detemiinants of the Chinese IPO Underpricing ............................................................................................................................................ 123

1. Introduction ................................................................................................................................. 124 2. China's Primary Market ............................................................................................................. 128 3. Detertninants of the Chinese IPO Underpricing .................................................................. 139 4. Data, Empirical Methods and Tests ........................................................................................ 150 5. Further Discussion ..................................................................................................................... 177 6. Conclusion .................................................................................................................................... 178

Condusion ............................................................................................................................................... 180

BibRography ............................................................................................................................................ 185

LIST OF FIGURES

1. Illustration of Chapter 1: Ownership and Control 3

2. Illustration of Chapter 2: Capital Structure 4

3. Illustration of Chapter 3: Initial Public Offerings 5

4. State Shareholding and Corporate Value (U-shaped Curve) 45

5. Rationalization of the U-shaped Relation 53

6. Simplified Financial Structure of China's Modem Firms 68

7. Theoretical Framework and Development of Contradictory Hypotheses 76

8. Scatterplot Matrices of Debt and Managerial Exploitation 121

9. IPO Underpricing around the World 124

10. P/E Comparison 137

11. Analytical Framework of IPO Underpricing in China 141

ii

LIST OF TABLES

Chapter I

I. I. Simplified Balance Sheets of Chinese Public Listed Companies 15

1.2. Chinese Stock Market 17

1.3. Official Share Classes 20

1.4. Shareholding Structures of Chinese Quoted Firms 23

1.5. Corporate Performance along the State Shareholding Spectrum 31

1.6. Definition and Signs of Variables 33

1.7. Comparing the Value and Characteristics of Firms 36

1.8. Corporate Value in Different Enterprises 38

1.9. Corporate Value and Government Shareholding: 1 43

1.10. Corporate Value and dovernment Shareholding: 11 47

1.11. Helping Hand of the Government 57

Chapter 2

2.1. Financial Leverages 69

2.2. Bad Loans 73

2.3. Administration Cost 85

2.4. Cash Retention 87

2.5. Board-member Turnover 89

2.6. Spectrum of Managerial Agency Costs on Financial Leverage 93

2.7. Regressions of Administration Cost 96

iii

2.8. Regressions of Investment Ratio 99

2.9. Regressions of Board-member Turnover 103

2.10. Regressions of Managerial Exploitation 105

Chapter 3

3.1. China's Stock Market Development from 1992 to 2000 130

3.2. Share Classes on China's Stock Market 132

3.3. Underwriters and Underwriting Methods in China 134

3.4. Literature Survey of China's Initial Public Offerings 140

3.5. Descriptive Statistics and Univariate Analyses 152

3.6. Ownership Types of Issuers 160

3.7. Time Gap between Offering Date and Flotation Date 162

3.8. Determinants of Listing Time Lags

3.9. Determinants of Initial Returns

166

172

iv

ACKNOWLEDGEMENT

The emotional support from my parents and my sister is essential to the completion of this thesis. The author wishes to express sincere appreciation to Professor Saul Estrin and Professor Julian Franks for their guidance, encouragement, and time spent during the last five years.

Chapter 1 benefits from the comments of James Ang, Alun Bevan, Ken Charman, Saul Estrin, Julian Franks, William Megginson, JP Mei, Larry Lang, Mario Nuti, Enrico Perotd, Lawrence Rose, Henri Servaes, Oren Sussman, Eli Talmor, Paolo Volpin and participants of the seminars at the London Business School, Cardiff Business School, Columbia Business School, Brunel University and Lancaster University, the Fords International Finance Conference (2000) and the 2 nd Asian Corporate Governance Conference (2002). Ile working paper of this chapter won the best-papet award from the Global Finance Conference (Beijing, 2002).

Chapter 2 benefits from the comments of Saul Estrin, Julian Franks, David Li, Mario Nuti, Jan Svejnar, TJ Wong and the participants of the seminars at INSEAD, Lancaster University, London Business School, the University of Michigan and the CES/HKUST Annual Meeting (2002). This chapter was nominated for the GFA best- paper award and it has been invited to be presented in Financial Management Association Annual Meeting (2002) and the American Social Science Association Annual Meetings (2003).

Chapter 3 benefits from the discussions with Sumon Bhaumik, Saul Estrin, Julian Franks, Jevons Lee, William Megginson, Enrico Petotti and the participants of the ESRC/CEA Finance and Accounting Meeting in Cardiff (2002) and the EU/FEEM Conference on Privatization, Corporate Governance and Financial Development in Milan (2002).

Data collection for my thesis would not have been possible without the help of Tianguang Wang and Dr. Yaping Xu from the China Securities Regulatory Commission, President Yun Xia from the Hairong Co., and Dr Houqi Zhang from the Hua Xia Securities Co. The Center for New and Emerging Markets at the London Business School also sponsored the one-year subscription of the Taiwan Economic journal data set. The core data set was provided by Hui Gong, the former Vice President of Genius Company.

The core financial support of the Centre for the New and Emerging Markets at the London Business School is gratefully acknowledged. The PhD programme, Department of Finance and Department of Economics at the London Business School also support my research and conference activities. I received further support from the following institutes: the China Securities Regulation Commission, the Chinese Economic Association (UKý, the Chinese Economist Society (North America), the Darden Business School, the European Union TMR Project, the Financial Service Exchange, the London Goodenough Trust, the Peking University, the Review of Economic Studies, the Royal Economic Society, the Tinbergen Institute (Visiting PhD Researcher hosted by Professor Enrico Perotti, from December 1999 to January 2000) and the William Davidson Institute at the University of Michigan Business School (William Davidson Visiting Fellow hosted by Professor Jan Svejnar, from September 2001 to June 2002). Besides the names mentioned above, Tim Ambler, Simon Commander, Cheol Eun, Judith Fry, Kenneth Liberthal, Paul Geroski, David Goldreich, Richard Portes, Andrew Scott and other members of the London Business School also provided their support.

V

GLOSSARY AND ABBREVIATIONS

CF Corporate Finance

COE Collective-Owned Enterprise

CSRC China Securities Regulation Commission

IPO, Initial Public Offering

NSE Non-State Owned Enterprise

PLC Public Usted Company

POE Private-Owned Enterprise

SBC Soft Budget Constraints

SEO Seasoned Equity Offering

SIP Share Issue Privatization

SOE State-Owned Enterptise

SSE Shanghai Stock Exchange

SZSE Shenzhen Stock Exchange

vi

Introduction: Government, Governance, and Finance

The role of the government is usually recognized as a topic of political economy, but

is at the center of the study of corporate finance in some new and emerging markets,

particularly China. Using a newly assembled data set from the firms listed on China's

stock market, this thesis documents the profound impacts of the government on

corporate governance and financial development in China.

In Chapter 1,1 examine the ownership and control of 826 corporations listed

on China's stock market, and find that government shareholding therein is notably

large. Its effect on corporate value is negative, but non-monotonic. Up to a certain

threshold, corporate value decreases as govenunent shareholding stakes increase, but

beyond this threshold, as government shareholding stakes continue to increase,

corporate value also begins to do so. I develop a view of the goverment shareholder

as an entity that can be both detrimental and beneficial to the companies in which it

holds shares.

I examine the governance role of debt under soft budget constraints in Chapter

2. Using a sample of modem firms listed on China's burgeoning stock market, I find

that in contrast to standard finance theories, debt facilitates managerial exploitation of

corporate wealth. An increase in bank loans increases the size of managerial perks by

and free cash flows, or it decreases corporate value. The failure of debt governance is

attributable to the institutional setting of China, where the government owns large

banks and firms.

Documenting an average first-day IPO return of 267% in Chapter 3,1 question

the rationale of such severe underpricing in the primary market. I find that financial

regulations and investment risks bring about severe IPO underpricing. The

government regulator sets a cap on pricing IPO shares and stipulates the IPO quotas to

I

control the supply of IPO shares. Regulatory underpricing is a unique feature of

China's primary market. Furthermore, besides the asymmetric information about the

quality of IPO firms, there are some Chinese-specific investment risks. There is a long

time gap between going public and going for flotation. Lockup risks come with the

illiquidity of IPO subscribers' investment. The investors in China's primary market

further discount the IPO shares with tunneling risks and grabbing risks. These

Chinese financial institutions rationalize the severe Chinese EPO underpricing. In

addition, the length of the listing time lag is endogenizied on insider shareholdings

and underwriting costs, which shows some faint traces of rent-seeking activities in

China's primary market. This chapter suggests that the complex web of the Chinese

government's political and financial interests and private benefits of some social elites

underlies the Chinese financial institutions.

From three different issues on China's emerging stock market, I conclude that

the Chinese government is sophisticated in its widespread business empire, but that

some social elites can exploit the conflict of governmental interests in business and

extract private benefits.

The impacts of the Chinese government on corporate governance and financial

development are specified to several empirical research questions and examined in the

three chapters of this thesis. As each of them discusses a particular topic in corporate

finance, they are self-contained, with an introduction, literature review, hypotheses,

methodology, empirical findings, interpretations and conclusions. To aid the

understanding of my arguments, I present summary charts of the three chapters in the

following pages. '

1 The literature reviews of corporate governance and the institutional description of modem Chinese firms on the stock market, given in my M. Phil. Thesis, are not fully incorporated here due to the space, although it would assist a newcomer to this topic in understanding this thesis. These writings, of more than two hundred pages, are available upon request.

2

Figure I

Illustration of Chapter 1

Pyramids Cross- Reciprocal-

shareholding shareholding

Ultimate Shareholding Structure of China's Stock Market

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(1) r

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mixed enterprises are valued lower than the enterprises without any government shares

Government Shareholder in Control

Key to Understanding\ y China's Modern Firm

& "s Stock M arketý to

firrns under control of the govt shareholder are valued lower than those under control of the a non- govern. shareholder

Grabbing Hand of Govt. Shareholder

I U-shaped relationship

Regression between the size of

___I ____ government shareholding

stakes and corporate value

Helping Hand of Govt. Shareholder

Interpretation the U-shape with Graphs

Statelmsecl C, ), p,,,, t,

Total Effect

Shareholding Structure State Shareholding and Corporate Value Linder Method of La Porta et al 1999

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C), "'Pt've statistics distributions, difference of means and medians, cluster comparison spectrum distributions etc Econometric regressions cross-sectiontil drd panel methodologies, univanate and multivanate analyses, Hadi methods of outliers control etc.

Summary of Enipir, al Fir fi, j,

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Debt is not an effective instrument of corporate governance under soft budget constraints:

The cash-hard-out hypothesis is supportedý Budget constraints needs to be hardened to reduce managerial exploitation and avoid a financial crisis,

The source of soft budget constraints is the business role of the government,

Privatization reduces the problem of soft budget constraints and competition helps to reinstate the governance role of

debt

4

Figure 3

Illustration of Chapter 3

Anýflytical Framework

P Auluig. Up. - ........ ........................... ....... ..... ------ ....

Offering S Investor Subscription ! 1ýý T

(Q

Exlenwx) Govemmem-A Imarests

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61

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>

5

Chapter 1:

Government Shareholding and the Value of China's Modern Firms

i. Introduction

A new corporate China is emerging. Different from the well-known Chinese state-

owned enterprises (SOEs), China's modem firms have modem corporate governance

structures and strong cash flows. Some of them are publicly listed on stock exchanges

and China's stock market has become second to Japan in Asia. Since China is coming

to be among the most influential players on the world economic stage, it is essential to

understand China's modem firms. In this chapter, I document the features of these

Chinese public listed companies (PLCs) and show the profound impact of government

shareholding on corporate performance.

Using the method of La Porta, Lopez-de-Silanes and Shleifer (LLS, 1999) and

Franks and Mayer (2001), 1 reveal the ultimate shareholding structures of firms listed

on the Chinese stock market. The separation of cash flow rights and voting rights

through pyramids and cross-shareholdings is found to be marginal, but the control is

highly concentrated. The government is the majority shareholder of 31.4% of Chinese

PLCs. It holds stakes greater than 10% in 41.2% of PLCs. Government shareholding

on China's stock market is significantly higher than in developed economies and other

emerging markets, documented by Claessens et al. (2000), and Faccio and Lang

(2002). For example, there are only 5% of French PLCs having a large government

shareholder with over 10% shareholding stakes, although France is known for its

large state-owned sector. I argue that the key to understanding the new corporate

China is the role of the government shareholder.

Mainstream economists generally view the government as a detrimental

7

determinant of corporate performance. 2 Shleifer and Vishny (1998) suggest that

private ownership should be preferred to public ownership, because the government

has a "grabbing hand" that extorts firms for the benefit of politicians and bureaucrats

at the expense of corporate wealth. Examining this hypothesis within the context of

China's modem firms, I demonstrate the profound impact of government

shareholding on corporate value. The overall impact of state shareholding on the

corporate value of China's PLCs is negative: mixed enterprises 3 are valued lower than

enterprises without any government shareholding, and enterprises under the control of

a -government shareholder are valued lower than enterprises under the control of a

non-government shareholder. However, this relation between corporate value and the

size of government shareholding stakes is not monotonic. As shown when graphed

corporate value on government shareholding, it is a U-shaped curve, rising higher on

the left than on the right. 4 When the government is a relatively small shareholder-up

to a certain threshold between 30% and 40%, corporate values decrease as

government shareholding stakes increase. This finding supports the hypothesis that

the Chinese government shareholder has a grabbing hand. However, as government

shareholding stakes increase beyond this threshold and become relatively large,

corporate value begins to increase. This finding suggests that the government

shareholder has another hand that helps the firms under its control.

'For example, analyzing enterprises fully-owncd by the state (SOEs) and surnmarizing the theoretical literature, Vickers and Yarrow (1988) argue that state ownership is inefficient. Megginson and Netter (2001) conclude that "[the weight of empirical research] is now decisively in favor of the proposition that private owned firms are more efficient and more profitable than otherwise comparable state-owned firms. 99

3 Mixed enterprises are firms whose ownerships consist of a mix of both government and private owners. For example, the PLCs in my sample are partially owned by the government. Firms with no overnment shareholding may be loosely termed as private enterprises. This chapter follows the research approach of Morck, Shleifer and Vishny (1988) and McConnell and

Servaes (1990). Morck et al. (1988) document the non-monotonic relation between management ownership and market value of the firm; McConnell and Servaes (1990) document the concave relation between insider ownership and Tobin's Q. These studies take the ownership variables as being cross- sectionally continuous and find the relation between corporate value and the size of the shareholding stakes of a certain type of owners in a large sample of firms.

8

That the government's relation with the companies in which it holds shares

can be both detrimental and beneficial is due to the fact that the government acts with

a combination of political and financial interests. Based on government shareholding

stakes, political interference in corporate operation has a negative impact on firms, but,

as I argue in this chapter, there is a limit to the extent to which a government can take

advantage of a company and its corporate wealth. Damaging actions are balanced by

the benefits that the government can provide. To maximize its financial gains based

on corporate cash flows, the government shareholder provides a company in which it

holds high stakes with preferential treatments-for example, a tax rebate or a

favorable ordering contract.

Concentrating on the study of the impact of government shareholding on

corporate value, I make the following contributions: First, by describing the

shareholding structure of Chinese firms, this chapter enriches the map of ownership

structures around the world (LLS 1999, Claessens et al. 2000, and Faccio and Lang

2000). Second, by focusing the study on a particular shareholder-the government-

this chapter contributes to the knowledge of the impact of shareholding structures on

corporate value (Shleifer and Vishny 1997). It is the first work to develop a view of a

two-handed government. Third, with evidence from China of the overall detrimental

effect of government ownership, this chapter complements the mixed-enterprise

literature (e. g., Boardman and Vining 1989) and privatization literature (e. g.,

Megginson et al. 1994). Fourth, by examining the effects of government shareholding

and statistically documenting other corporate finance factors, this chapter contributes

towards a better understanding of the firms emerging on the Chinese stock market

today. However, the data availability refrains me from extending the discussion to

social welfares.

This chapter proceeds as follows: Section 2 describes institutional settings of

9

China's public listed companies. Section 3 documents the shareholding structures. I

present the research hypothesis, proxies and regression models in Section 4. Section 5

finds that the overall impact of government shareholding on corporate value is

negative. Section 6, however, shows that there are also some incremental positive

impacts when the government is a large shareholder. The conclusion is given in

Section 7.

2. Modern Firms in China and the Emerging Stock

Market

China has undertaken a grand reform to restructure its corporate sector and modernize

corporate governance structures. The features of modem firms are presented here.

Some of the best modem firms are listed on China's stock market. I also introduce the

emerging stock market in this section.

2.1 Enterprise Reform

Under the Communist Party and the austere repression it engineered through

the Cultural Revolution, very few private enterprises existed. Most large-sized

enterprises were either fully owned by the state (SOEs) or collectively owned by a

community (COEs). In 1978, SOEs provided 77.6% and COEs 22.4% of the industrial

GDP. Property rights of firms are ambiguous. SOEs were usually controlled by a

multitude of bureaucrats both in central and local government, and thus depended

heavily on the Communist Party for corporate governance. Every community had a

controlling center that was normally a branch of the Communist Party. COEs are also

controlled by the communist government. Enterprises in China before the advent of

10

reform were virtually sub-units of society rather than commercial entities in their own

right. For example, all financing was paid out of the state budget, the prices of

production factors and products were fixed, and the government set production targets.

Furthermore, enterprises were required to provide their employees with housing,

schooling, and even a funeral service when they died. Under the egalitarian policies of

the government, managerial pay was not much higher than the wages given to

workers. The core problem of firms was lack of incentives.

The economic enviromnent began to change when enterprises in China began

to be restructured through the clarification of property rights, changes in corporate

governance, and the use of commercial modes of operation.

The owner of an SOE is specified as either the central government or local

governments. Specifically, the ministers or the local governors control these SOEs, on

behalf of the prime minister. The clarification of property rights often involves

5 recapitalization and partial privatization. Some SOEs and most COEs have been

restructured to joint stock companies that have more than one owner to contribute the

equity capital. One-share-one-vote is law in these joint stock companies. Clarifying

property rights and pairing control rights with residual returns would provide an

incentive to maximize the value of these enterprises (Li, 1997). According to figures

produced by the National Bureau of Statistics in China in 1999, joint stock companies

made up 3.3% of the total number of firms in China, but provided 7.3% of the total

industrial GDP and 14.6% of total profits. Although the number of joint stock

companies grew 28% per year between 1994 and 1998, their contribution to the GDP

grew 36% per year over the same period.

Political control of firms has been significantly reduced. In the past, managers

5 As a matter of fact, the Chinese govermnent does not recognize the term "privatization", because the diversification of ownership and the dilution of the control rights do not directly sell out the state assets.

11

were monitored through employee associations and the enterprise branches of the

Communist Party, but since 1993 the law has explicitly forbidden the secretaries of

the various branches of the Communist Party to interfere with corporate management.

According to the 1988 Enterprise Law, the secretaries shall "guarantee and supervise

the implementation of the guiding principles and policies of the Party and the State in

the enterprises". Although the Communist Party nevertheless continues to be

ideologically influential 6 it deprives the Communist Party of decision-making rights

in the firms. The managerial responsibility system was introduced under which power

was fully delegated to the managers. However, managerial exploitation of corporate

wealth became a core problem. In 1994, a set of modem governance structures was

introduced by the Company Law. 7 It regulates China's modem firms and includes

some good practices of western firms.

The firms have to be commercially operated under the rule of market

competition, since China has evolved from a "command" economy to a market-

oriented economy, after two decades of reform. The more competitive conditions of

supply and demand decide the levels of prices. Finances are now raised through banks

and other creditors. Firms now have to pay out dividends to their shareholders, pay

back interest and principal to their creditors, and pay tax to the government. They

have become true commercial entities, although China's new economy is still

characterized by, widespread government ownership coupled with weak legal

enforcement of the new legislation that governs the economy.

6 The ideological influence in question mainly influences personnel matters rather than daily corporate operation. According to the results of questionnaires, a paper under the review of the Journal of Financial Quantitative Analysis finds that the Communist party is still influential, but that the magnitude of the influence does not depend on whether it is a firm with or without government ownership, nor on the size of government shareholding. This finding implies that the Communist party is rather a macro factor of corporate performance in this country under a communist government. My chapter on the micro factors of corporate performance therefore reasonably leaves aside the direct influence of the Communist party. 7 The Company Law was revised in 1999, but follows the same spirit of the 1994 Company Law.

12

2.2 Corporate Governance

Together with depriving the Communist Party secretaries of their role in

corporate governance, the 1994 Company Law stipulates that the board of directors

monitors the managers. Under the one-share-one-vote system, directors are elected at

a general meeting of shareholders. The board of directors is usually composed of the

delegates of the large shareholders. The large shareholders may nominate managers to

be members of the board. When the government is a large shareholder, the former

party secretary or some retired bureaucrat is assigned as the chairman of the board.

Since March 1999, regulatory authorities have been able to promote external directors

to the board.

Once elected, the duties of directors include approving annual reports and

corporate strategy, appointing a general manager, and monitoring corporate

management. The directors have the power to intervene in corporate management

when necessary. There is also a so-called supervisory board whose members are

mainly employees of the firm. Supervisory boards have inherited the employee

associations from the former planned economy and play an advisory role. In essence,

the governance structure of China's modem firms is the one-tier board system. This

model of Chinese corporate governance is fundamentally different from the German-

Japanese bank-based model and the East-Asian family-based model.

Monitored by the board of directors, the general manager is in charge of the

daily operation of the enterprise. Both his and the other managers' bonuses are tied to

corporate performance. The top management team can be shareholders of the

company, but these shares cannot be transferred during their tenure and securities

laws require that managerial shareholdings be disclosed to the public. My data set

shows that managers hold, on average, only 0.005% of the total shares in public listed

13

companies. The trivial extent of their shareholding stakes partly comes from the fact

that the incentive scheme of stock options is seldom used in China. However,

managers can benefit from a number of perquisites such as corporate cars, housing

benefits, and entertainment bills.

2.3 Financial Features ofPublic Listed Companies

The typical balance sheet of Chinese PLCs is significantly different from

SOEs, but similar to the firms in developed countries.

Table I in the following page reports that the ratio of total liability to total

assets is 49% and the ratio of debt to total assets is 21%. Since there is no corporate

bond market in China, debt finance in PLCs is mainly in the form of bank loans.

Overall, China's PLCs are not heavily in debt. The average current ratio of quoted

companies is 2.0 and the quick ratio is 1.5, indicating that their liquidity is generally

adequate. These modem firms are different from the financial situation of highly

leveraged SOEs.

The average total assets of China's PLCs come to US$180 million. Of total

assets, 53% are current assets and 36% fixed assets. In 1998, the average net asset per

share was US$ 0.31 and the average earning per share was US$ 0.025. The largest

industrial quoted company, Shanghai Petrochemical Company Limited, has total

assets of US$2.7 billion, fixed assets of US$1.4 billion and an income of US$1.26

billion. The total assets of the smallest Chinese PLC Xiamen Xfongzhen are only

US$14.3 million, with an income of US$4.4 million. Chinese PLCs have an average

age of 14 years and a median age of seven years. Most of these PLCs are either newly

formed or were older companies that were restructured during the period of reform in

China. SOEs differ from most PLCs because they were founded under the former

central planning system.

14

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2.4 The Emerging Stock Market

The Chinese stock market comprises the Shanghai Securities Exchange (SSE)

and the Shenzhen Stock Exchange (SZSE), which began to operate in December 1990

and July 1991, respectively. There is no fundamental difference between the two

stock exchanges in terms of legislation and regulations. The purpose of separating the

stock market into two stock exchanges is to encourage competition between them.

The Chinese regulatory authority is the China Securities Regulation Commission

(CSRC), founded in October 1992. The CSRC stipulates disclosure rules and

governance regulations.

The Chinese stock market has grown rapidly. Table 2 shows that between

1992 and 1998, market capitalization increased at an average rate of 84.7% per year.

At the end of 1998, total market capitalization was about a quarter of China's GDP.

The number of listed companies grew by 62% annually, from 53 PLCs in 1992 to 851

PLCs in 1998.

However, this market is still in its early stages of development, as reflected by

its high volatility, unfair trading, and the frequency with which policy talks take place.

By the end of 1998, the turnover rate of share transactions was as high as 291% and

price/earnings ratios were as high as 33.4. Second, as an emerging market with the

features of a transitional economy, the legal enforcement of the necessary legislation

in China is relatively weak and illegal activities such as insider trading and market

manipulation are widespread. Third, to control the risks of the stock market and

establish a mature market, the government frequently holds policy talks. For example,

16

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a policy commentary talk on the high P/E ratios of the stock market at the end of 1996

brought down the stock index by 10%. The policy talks may disturb the natural

evolution of the stock market. Fourth, the market is segmented: about 60.8% of shares

are restricted in tenns of their tradability; only 4.9% of shares are allowed to be

invested in a foreign currency, yet the Chinese currency is not freely exchangeable.

Foreign investors are not allowed to invest in tradable A shares, but only in the thin

B-share market.

Ultimate Shareholding Structure and the

Government Shareholder

With the data sample from the Chinese stock market, I document the shareholding

structures of the PLCs and discuss some of their other characteristics. I find that the

main characteristic of Chinese PLCs is the presence of a government shareholder in

control.

3.1 Data Sample

My data is based on audited annual reports from the PLCs and share price data

from the stock exchanges. Taiwan Economic Journal (TEJ) is a leading data vendor

on Chinese PLCs, but the TO database has a large number of missing values.

Domestic investment bankers and security analysts tend to use the Genius database.

Therefore, I have constructed a new data set based on both these databases and

several other complementary sources (see Appendix 1). This newly assembled data

set covers accounting information, the holding stakes of large shareholders, and daily

share prices from 1994 to 1998. During this period the regulatory framework was

18

relatively consistent8 . The description of corporate features and mapping of ownership

structures are based on 1988 data, which is the most recent data available.

My data sample excludes fund management companies, since their operations

are distinctly different from those of industrial firms, 9 and also firms that do not issue

shares to domestic investors. 10 The sample I use to examine the relation between state

shareholding and corporate value includes 287 companies in 1994,311 in 1995,517

in 1996,719 in 1997, and 826 in 1998. Altogether, my main data set has 2660 firm-

year observations.

3.2 Shareholding Structures of Chinese Quoted Firms

Chinese PLCs are generally organized and operated along the same lines as

successful western firms. However, the shareholding structures of Chinese PLCs are

unique.

In the Chinese stock market, share ownership is officially classified into state,

legal-person, employee, tradable-A shares, and shares denominated in a foreign

currency. Although these various classifications of stock exist, all Chinese PLCs

follow the one-share-one-vote rule with all shares. However, the classification system

cited above was originally designed to facilitate the regulation of trading activities,

8 The 1994 Company Law formally legislates and governs joint-stock companies. In the same year, the China Securities Regulatory Commission introduced a series of six rules called Contents and Form of The Information Release by PLCs, which formatted the annual reports. In 1999, a new version of the Company Law based on the 1993 Company Law was introduced. 9 Furthermore, due to regulations, the government is not allowed to own fund management companies. '0 Otherwise, I would have had to use the share prices from the foreign investors' market. However, the market values may not be comparable, for example, as a result of the home bias problem (Cooper and Kaplanis, 1994).

19

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rather than to actually classify different ownership types, and the boundaries between

the various categories are not clear cut. For instance, institutional shareholders do not

necessarily own only legal-person shares, and foreign shareholders can own shares

other than those denominated in foreign currency. However, most of the cuffent

research about the impact of shareholding structures on corporate value in China's

quoted companies (for example, Xu and Wang 1999, Qi et al. 2000) uses this

classification system.

In this chapter, I use the cut-off method of LLS (1999) and Franks and Mayer

(2001) to document the ultimate shareholding structures of these Chinese firms, which

is a method that detennines the ultimate shareholder whose holding is larger than a

certain threshold. " It does so by examining pyramids, cross-shareholdings, and

reciprocal shareholdings. For example, a 10% threshold traces only the ultimate

shareholders who hold more than 10% of a company. 12

The method defines a pyramid as an entity that has a shareholding in one

public listed company, which in turn owns another corporation, and so on. That is, if

A holds a substantial part of B and B holds a substantial part of C, the relation

between A and C is a pyramid. Cross-shareholding is defined as a condition that

exists when a company has a controlling shareholder and owns shares in a firm that

belongs to its chain of control. That is, if A holds part of B, and B holds part of A, the

relation is a cross-shareholding. Reciprocal shareholding occurs when a company

owns part of itself. The calculations of ultimate shareholding rights are based on the

lowest holding rights in the chain tracing back to the ultimate shareholders.

In China, the law requires that the size of the shareholding stakes of the largest

ten shareholders be released to the public. Among 846 PLCs, 167 companies reported

11 Aggregating the shares of these individual shareholders is not very meaningful because they usually do not exert their voting powers collaboratively. 12 Ile weakest-link concept (LLS 1999) is adopted here. If company A holds x% of company B, and company B holds yO/o of company C, it follows that company A holds min(x%, yo/o) of company C.

21

another PLC among the ten largest shareholders in 1998. These shareholders had an

average holding size of 1.5%. However, even using the minimal threshold of 10%,

only 19 firms involve pyramids or cross-shareholdings. That is, there are 19 cases in

which an ultimate shareholder holds more than 10% of a company through another

quoted company. In a sense, this finding reflects the youth of the Chinese stock

market. I also find, according to the 10% cut-off level, the ratio of cash flow rights to

voting rights is 99%. Thus, the separation of ownership and control is marginal 13 .

Panel A in table 4 summarizes the shareholding fractions of the largest

shareholders (and therefore ultimate owners) of the 846 quoted companies in my

sample who own more than 50%, 30%, or 10% of the voting equity. The government

shareholdei is the largest shareholder of 44%, and the majority shareholder of 31%, of

these sampled PLCs.

The reasoning behind the choice of these three thresholds is as follows:

holding more than 50%, the majority shareholder has absolute control; the CSRC

takes 30% as the relative control threshold; and Claessens et aL (2000) and Faccio

and Lang (2002) take 10% as a controlling threshold.

If I take 30% of voting shares as the threshold for control, I find that the

government controls 38% of the sampled PLCs. If I use 10% of voting shares as the

threshold for control, then the government controls 44% of the sampled PLCs.

Compared with findings in developed economies and emerging market, 14 a

government shareholder in control is at least quantitatively a salient feature of public

13 Tlds fact reduces the difficulty of examining the impact of the government shareholder in the following sections. 14 It contrasts distinctly with other countries (Claessens el aL 2000, and Faccio and Lang 2000). LLS (1999) admit that the high government shareholding in their report is due to a bias in the sample selection towards very large firms.

22

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listed Chinese companies. 15 Therefore, to understand modem firms in China today, it

is necessary to understand the impact of government shareholding.

There is no individual or family in China owning more than 10% of the shares

in a PLC, because it is actually stipulated by the government that no single individual

investment account is allowed to hold more than 0.5% of one PLC. Thus, a rich

Chinese family must present itself as a private joint-stock company. Only in this guise

will the family be able to hold a large block of shares in a PLC.

For example, the largest shareholder of Orient PLC is the Orient Group,

which, although actually an entrepreneur-owned finn, is registered as a joint-stock

company. 16 The entrepreneur, Zhang Hongwei, holds directly only 4.85% of this PLC

and sits as the president of Orient PLC, yet there is no question that Mr. Zhang is the

largest shareholder of the Orient Group. However, the ownership structure of an

unlisted joint stock company is not released to the public. In this way, presenting

themselves as an unlisted firm, rich families can circumvent the 5% limitation.

However, before 1998, known cases of these "disguised" large family-shareholders

were very few.

Panel B in table 4 shows a highly concentrated ownership structure. On

average, the five largest shareholders account for 60.6% of the total outstanding

shares, compared with 25.4% in the United States and 33.1% in Japan (Prowse 1998).

More strikingly, the largest shareholder holds more than 40% of the equity in these

Chinese PLCs.

15 A significant proportion of PLCs are under the control of another domestic company. Having encountered the same problem as other researchers, I could not trace the ultimate shareholder of a company not listed on the stock market. Thus, there is, admittedly, a bias towards revealing the ultimate shareholding structures under the methodology of LLS (1999). However, this bias only strengthens my argument in this chapter, that the government shareholder in the China's PLCs is highly influential. 16 The LLS method cannot trace the owners of unlisted firms. My data set does not allow me to improve the LLS method. That is, some of the domestic unlisted companies are disguised family owners. Despite this fact, it does not bias my study on the impact of government shareholding on corporate value.

24

3.3 Government Shareholding in Chinese Firms

I calculate government shareholding as the proportion of state-owned shares to

total shares. I define state-owned shares as those shares directly owned by the

government or its economic institutions. The government itself is composed of the

central government and local governments 17 . China is a politically centralized country

and the heads of local communist governments are usually assigned by the central

communist government rather than elected by the local community. Thus the central

government is essentially the owner of any state-owned shares and local governments

execute the order of the central government. For example, Appendix 2 shows the

organizational structure of the regional state-shareholding management system in

Shanghai City in a PLC. The structure shows that the State Council ultimately takes

responsibility for the government shares in PLCs. Although I argue that both the local

government ownership and the central government ownership are government

ownership and they are not different on handling the firms they hold in Chinese

communist system, it would be nicer to empirically present the non-significant

difference between central government ownership and local government ownership.

However, my data set does not allow me to do so.

Given that government shares are managed and controlled by functionaries

working in the government bureaucracy, government shares are, in effect, managed

by bureaucrats. In contrast, indirect government shareholding is not the bureaucracy

shareholding, because the intermediate joint stock company stands in the way of the

influence of government officials, and a joint-stock company is not a government

17 In China, the government ownership of firms is at or above the administration level of county or city. The collective ownership of small towns or villages is taken as collective ownership of the community. A local Chinese government may govern a population as large as a small country.

25

agent but acts in its own corporate interests. 's

Government functionaries treat the government shareholder differently from

other shareholders, and serve governmental interests by collecting the revenues of

corporate operations and reallocating resources for political purposes. For example,

the government holds 88.6% of shares in the firm Qinggong Machinery. This holding

is the largest share stake of the government in any PLC. The other shareholders in

Qinggong Machinery are family investors and some township-village enterprises. The

government agent that controls the government's shareholding is the Shanghai

Electronics Group (an SOE), which is fully owned by the state and operated like a

department of the Shanghai Municipal Government. The mayor of the Shanghai

Municipal Government and his management committee, the members of which are

assigned by the central government in Beijing, decide who will be appointed general

manager of the Shanghai Electronics Group and who will be the board members of

the Shanghai Light Industry Machinery Company Limited. There are 15 directors on

the board. 19 Mr. Zhao Dingzhai was assigned by the government shareholder to be

both the President and the General Manager. Communist Party secretaries, one deputy

general manager, the chainnan of the labor union, the chief accountant, and the chief

engineer sit on the board, as do six managers of other SOEs who are the

representatives of the government shareholder. The other directors are the managers

of other joint-stock companies who hold legal-person shares. There were no external

directors or directors from these small family-shareholders on the board.

18 Technically, the traceable pyramids and cross-shareholding of the government shareholder is marginal and a change of around 1% in state shares does not change my empirical results. 19 http: //www. cninfo. corrLcri/finalpage/1988-01-07/148346. htnil

26

3.4 Non-Government Shareholders

All othcr shareholdcrs, that is, thosc not designatcd as govcniment

shareholders, are generally referred to as non-govermnent shareholders. These

shareholders include both institutional and individual shareholders. As described in

Section 3.2, the shareholdings of individual shareholders are dispersed. Institutional

shareholders can be financial companies, foreign companies, collective holding

entities, or other domestic industrial companies.

The category of "other domestic industrial company" includes the group

company that has the PLC as its flagship. These companies include collective

enterprises, township-village enterprises, joint stock companies, companies with

foreign ownership, and entrepreneur-led firms. Since the detailed ownership

structures of these companies are not available to the public, my data sets do not allow

me to give a statistical count of these companies, but a description in the following.

Collective enterprises are owned by a small community, for instance a

residential district of a city. Township-village enterprises are also collective

enterprises, but are located in rural areas. These small local communities require

financial returns on their investments. Different from the government, these owners

are very limited in their ability to provide support to their PLCs, which are large-sized

enterprises that have expanded extensively beyond local communities.

Joint-stock companies and companies with foreign ownership may have

government ownership, but they are not the SOEs and they pursue their own financial

interests. The government may exert pressure on these firms to make them pursue its

political interests, but the extent to which it can do so is quite limited compared with

that of the direct government ownership in some PLCs.

Banks are forbidden to purchase and trade in PLCs, although in the past banks

27

have held some PLC shares. Investment trusts, mutual funds, and securities

companies may have some government ownership, but they are fully commercialized

and pursue profits rather than social welfare.

Thus, in a PLC, there is a marked difference between the nature of the

government shareholder and its activities and that of the non-government shareholders.

This difference is characterized by the government's pursuit of its own political

interests and its capability of helping or harming the firm in the process. In China,

non-government shareholders are obviously greatly affected by the government

shareholder, but there are at least some limits on how far the government may affect

the other shareholders in its efforts to realize its political interests.

4. Government Ownership and Determinants of

Corporate Value

In this section, I briefly review the literature on the detrimental government

shareholder, describe our proxies of corporate performance, and present a multivariate

model specification.

4.1 Hypothesis of the Detrimental Government Owner

The general consensus is that government ownership negatively influences

corporate performance. Among large and publicly financed joint stock companies, the

detrimental role of the partial government ownership is mainly due to the

government's interference in corporate activity in the name of its political interests,

which is based on its voting rights from its shareholdings (Shleifer and Vishny 1994).

Political interference is nonnally at the expense of corporate profitability (Boycko et

28

aL 1996). For example, politicians, through the control rights of state shareholding,

may deliberately transfer resources of firms to their political supporters (Shleifer and

Vishny 1998). Therefore, the government is viewed as a grabbing hand that snatches

at corporate wealth, which is called the detrimental hypothesis in this thesis.

Much of the empirical literature supports this theoretical view that state

ownership is detrimental to corporate value. These studies can be classified as either

dynwnic or static in approach.

Comparing corporate performance before and after privatization, the dynamic

approach finds that reducing or eliminating state ownership improves corporate

performance. Such comparisons indicate that therefore, government ownership is

generally detrimental (e. g., Megginson et al. 1994).

Most studies that have used the static approach to compare fully-state-owned

enterprises, mixed enterprises, and private enterprises find that private enterprises

outperform both mixed enterprises and SOEs (e. g., Boardman and Vining 1989),

although their samples of mixed enterprises are small. Thus, both static and dynamic

researches suggest that government shareholding is detrimental to corporate

profitability. The 1990s wave of privatizations around the world is a reflection of the

consensus of the detrimental government ownership.

However, there have been instances of government actions in corporate

activity that have been beneficial. Blanchard and Shleifer (1998) observe that the

Chinese government provides a helping hand to various types of firms. 20 For example,

the Shenzhen Municipal Government has a special committee to assist associated

PLCs in financial distress. These methods include making it easier for a firm to obtain

bank credit and the promotion of a firm's products. In light of these facts, this chapter

20 Again, the paper under the review of JFQA proposes that the Communist Party in enterprises poses a negative performance, but the authors admit that their study is not closely related to government shareholding.

29

investigates whether or not the detrimental view of government ownership still holds

in China's modem firms.

4.2 Measures of Corporate Value

An effective and efficient way of investigating the role of the govenunent in

modem firms is to examine the impact of government shareholding on corporate

performance and profitability. I use both a market-value measure and an accounting-

value measure to approximate corporate value in the reported tables.

Tobin's Q is an adjusted measure of the market value of the firm. I calculate

the Q as the sum of market value of equity and book value of debt all over book value

of total assets. This simplified Q is a good substitute for the actual Tobin's Q and has

been widely adopted in the recent empirical corporate finance literature. For instance,

Chung and Pruitt's study (1994) shows the explanatory power of simplified Q is at

least 96.6% of Lindenberg and Ross's forraulation of Tobin's Q (1981). More

important, the simplified Q avoids arbitrary assumptions about depreciation and

inflation rates. Some researchers argue that share prices may not reflect the intrinsic

value of the firms in China because it is an emerging market. To be cautious, I use an

accounting measure of corporate performance that complements Q, as the value of a

finn is decided by its profitability. Following the conventions of corporate finance

literature, I use the return on assets (ROA) as my proxy for profitability.

4.3 Spectrum Distribution of Corporate Value

To understand the relation between state shareholding and corporate value,

table 5 presents Q and ROA under the ten percentile distribution of the size of

government shareholding stakes. About one third of companies have no state

shareholding, and their profitability is significantly higher than other companies. Then,

30

as the stake of state shareholding increases, corporate value appears to decrease. This

trend reverses when state shareholding reaches about 40%. Finally, when state

shareholding is in the 80% to 90% range, corporate value again seems to decrease.

However, there are few firms in this range and outliers may have a big influence. This

observed pattern requires examination by rigorous econometric investigations.

4.4 A Regression Model

Any investigation of the relation between two economic variables requires

regression methods. Although univariate regressions are not subject to the multi-

collinearity problem, they suffer from spurious correlations due to missing control

variables. Multivariate regressions are preferred.

31

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My multivariate regression model is specified as follows:

Value =C+a* State +A* Ownership +, 82 * Asset +, 83 * Capital +, 84 * Traits +, fl5 * Time +e

where Value is corporate value; State represents of the percentage of government

shares among total shares; Ownership is the control of other types of owners,

including ownership concentration, non-govermnent shareholder's holding, and

managerial shareholding; Asset accounts for the characteristics of corporate size,

including the size, structure and growth; Capital represents the capital structure of the

firm; and Traits covers other characteristics of the firm, including firm age, industrial

classification and whether trading in SSE or SZSE. I also control the effect of time on

the relation between corporate value and government shareholding, which captures

rapid institutional changes and macroeconomic shocks in different years.

I introduce the dependent variable State in Section 2.3 and my independent

variable of Value in Section 4. L The specification of control variables is based on the

current literature in empirical corporate finance, the availability of related data for

China's PLCs, and the seriousness of multi-collinearity problems.

Table 6 presents the definitions, calculation methods, and the predicated signs

of the variables used in this chapter. It also provides some selected supporting

references for each control variable. 21

21 Due to lack of space and the author's concentration on the main research question, this version only briefly describes the control variables. Interested readers can require a copy of detailed discussions on the selection of the control variables.

33

Table 6

Definition and Signs of Variables Variables Definitions Supporting literature Predicated Empirical

QA proxy of Tobin's Q as the adjusted market value of the firm. It is calculated as the Chung & Pruitt 94 FM, summary of market value of equity and book value of debt over book value of assets. Shin & Stulz 98 WE

ROA A proxy of corporate accounting profitability. It is calculated as the net profit over total assets.

Private A dummy variable of ownership. If the government is a shareholder of an enterprise, Boardman & Vining ++ it is 0; otherwise, 1.89 J. Law & Eco.

Private A dummy variable of ownership. If the government is the largest shareholder of an + + Large enterprise, it is 0; otherwise, 1.

State The cash flow rights of the government as well as approximately the voting rights of U the government. It is calculated as state-owned shares over total common shares. State2 is the squared form of State. State 0-30% is calculated as min(State, 30%); State 300/o-50% as max(min(State, 50%), 30%)-30%; State 50-90% as max(State, 500/o)-50%.

Herrindahl jA An indicator of ownership concentration. Calculated as F(S 2)/10 where Si is the + +

large shareholders' holding fraction, i is from I to 10.

Second A dummy variable of ownership. If the second largest shareholder has more than Gomes & Novaes 99 + 0 10% voting rights, it is 1; otherwise, 0. Wharton

Manager Managerial shareholding. It is calculated as the total shares held by senior managers Morck et al. 88 JFE + 0 for Q; over total common shares. + for

ROA

Size Corporate size. It is calculated as the log form of total assets as for Q and Market-to- Chh1bber & Majumdar + - for Q; Book value; log form of sales as for ROA and other accounting profit measures. 99 J. Law & Eco. + for

ROA

Tangible An indicator of the asset structure or the capital intensity. It is calculated as fixed Demsetz & Lehn 85 assets over total assets. RE

Gear An indicator of the capital structure. It is calculated as total liability over the book Titman & Wessels 88 + value of total assets. JF

Age Firm age. It is calculated as the number of years a firm has existed since it was founded.

Exchange Stock exchange. It is I if the firms are listed on Shanghai Stock Exchange; 0 if they ?0 for are listed on Shenzhen Stock Exchange. ROA: +

for Q

Industry The industries in which a firm mainly operates. The 21-industry classification is Montgomery& used, including agriculture, chemical industry, conglomerate, construction, electricity Werneffelt 88 AER; equipment, information technology, electronics, finance, food & wine, machinery, Schmalensee 85 AER metal, motor, papers, petrochemicals, pharmaceuticals, real estate, shopping and travel, textile, transport, utility and others.

Year The effect of time. Four dummy variables represent the data in different years. It covers the years 1994,1995,1996,1997 and 1998.

34

5. The Overall Impact of Government

Shareholding Is Detrimental

Based on the hypothesis of a detrimental government shareholder, here I examine 1)

whether the companies with partial state ownership are valued lower than those

without any state ownership, 2) whether the companies in which the government is

the controlling shareholder are valued lower than those with a non-goverrunent

controlling shareholder, and 3) whether corporate value is a negative function of the

size of government shareholding stake. These are the three specifications of the

hypothesis of government shareholding being detrimental.

5.1 Classification ofModern Firms

To examine my hypothesis of the government shareholder as having a

negative effect on corporate performance, I classify the modem firms on the Chinese

stock market as mixed enterprises (ME) and private enterprises (NSE)22 ; enterprises

whose largest shareholder is the government (SL) and those with a non-government

shareholder as the largest shareholder (NSL); enterprises in which the majority

shareholder is the government (Smaj) and those where a non-govemment entity is the

majority shareholder (NSmaj).

The classical approach in examining the efficiency of government ownership

is to compare state-owned enterprises, mixed enterprises, and private enterprises (e. g.,

Boardman and Vining 1989). Although there are no SOEs in my data set of PLCs and

22 NSEs represent Non-State-owned-Enterprises, in which there are no state shares. The "private enterprises" here include the companies owned by many individuals and institutes. The abbreviation of NSEs avoids the confusion with the private enterprises fully owned by one entrepreneur.

35

the so-called private enterprises here are joint stock companies, this approach still

makes sense. However, the impact of government ownership on corporate value

depends not only on whether there exists government shareholding in a PLC, but also

on whether that government shareholder is in control.

5.2 Comparison

The so-called "private" enterprises on the stock market are actually enterprises

without state shares (NSEs). As described in Section 3.4, the owners of these

enterprises include both institutions and families. Enterprises with a state shareholding

of more than zero but less than 100% arc known as mixed enterprises (MEs).

Table 7 finds that NSEs perform significantly better than MEs. The mean of

the Q in NSEs is 19% higher than in MEs, and the ROA is 18% higher. This finding

supports Specification I of the detrimental hypothesis that firms with partial

government ownership perform worse.

Another way to examine the overall influence of the government shareholder

is to categorize firms into those with the govemment as the largest shareholder and

those with a non-government shareholder as the largest shareholder. The shareholder

who holds the largest stake is often the controlling shareholder, as there are few

instances in China of collaboration between other shareholders to counter the largest

shareholder. 23

23 Although the law allows proxies of voting rights, proxy rights are seldom used in China. The first proxy war occurred in 2000 when Tong Baihui collected proxies to control Shenli Gufen.

36

Table 7

Comparing the Value and Characteristics of Firms 11iis table presents some firm characteristics and compares them among different ownership types of enterprises. NSEs are enterprises with no state shareholding, also called private enterprises. NSLs are firms whose largest shareholder is not the state (non-state largest shareholder) and SLs are firms where the State is the largest shareholder. A NSmaj is an enterprise in which the major shareholder is a non- government entity. A Smaj is an enterprise in which the government holds more than 50% of shares. The comparison of means is based on Student T statistics. It is significantly different, except for the ROE. Under the whole data set, without ruling out outliers, the Mann-Whitney U test compares the medians of the two samples with the null hypothesis that median(ME)=median(NSE), if taking the

MEs and NSEs as an example. The statistics are Unse = nnsenme +n nse (n

nsee +

Snse 2

Ume = nnsenme + nme (nme + Sme

- It indicates whether there are significant differences by 2

asterisks against the latter column of the compared variables; *** as p or z -value: 5 I %, ** p or z- value:! ý 5%, *p or z -value: 5 10%.

Items NSEs MEs NSL SL NSmaj Smaj All Q Mean 2.935 2.467*** 2.817 2.457*** 2.995 2.547*** 2.604

Median 2.547 2.197*** 2.450 2.190*** 2.603 2.303*** 2.291

ROA Mean 0.059 0.050*** 0.056 0.050*** 0.074 0.054*** 0.053 Median 0.063 0.054*** 0.063 0.054*** 0.074 0.056*** 0.058

SECOND Mean 0.276 0.385*** 0.199 0.465*** 0.324 0,870*** 0.199 Median 0 0*** 0 0*** 0 1 *** 0.000

MANAGER Mean 0.006% 0.004%*** 0.006% 0.004%*** 0.032% 0.008%*** 0.005% Median 0.002% 0.001 %*** 0.002% 0.001 %*** 0.000% 0.000%*** 0.001%

SIZE Mean 8.470 8.555*** 8.471 8.571*** 8.563 8.676*** 8.530 Median 8.412 8.540*** 8.413 8.559*** 8.509 8.645 8.501

TANGIBLE Mean 0.248 0.246 0.247 0.246 0.248 0.251 0.246 Median 0.215 0.222 0.216 0.223 0.219 0.225 0.219

GEAR Mean 0.398 0.441 0.407 0.443*** 0.370 0.477*** 0.429 Median 0.393 0.440*** 0.400 0.448*** 0.373 0.459*** 0.424

AGE Mean 11.764 17.497*** 13.372 17.517*** 12.089 15.545** 15.820 Median 7 8*** 7 8"* 7 7 8

Observabons 778 1882 1089 1571 348 1028 2660

37

Table 7 finds that enterprises that have the government as the largest shareholder

have a significantly lower value and profitability than do those in which a non-

government shareholder holds the largest share of equity. If the government is the largest

shareholder, simplified Tobin's Q decreases by 14% and ROA decreases by 12%.

1 further group firms by whether the majority shareholder is the government.

Table 7 finds that Q is 2.5 and ROA 5.4% where the majority shareholder is the

government, and Q is 3.0 and ROA 7.4% where the majority shareholder is not the

government. This finding is consistent with Specification 2 that the firms under the

control of the government are valued lower than the firms under the control of a

commercial entity.

5.3 Regression

Table 7 also compares the corporate features of Chinese firms. There is certainly a

concern that state shareholding and corporate value of the firms may be correlated

through other factors. Thus, taking the different types of enterprises as dummy variables,

multivariate regressions are required to examine the hypothesis of detrimental

government shareholding.

Table 8 presents the OLS and MLP multivariate regressions. This table confirms

that enterprises without a government shareholder perform better than enterprises with a

government shareholder. It also confirms that enterprises in which the government is the

largest shareholder perform better than those in which a non-government entity is the

largest shareholder. The highly significant coefficient of the Herfindhal index also

suggests that ownership concentration creates value in Chinese firms.

38

Table 8

Corporate Value in Different Enterprises This table reports the regressions of Q and ROA on whether the government is a shareholder and whether the government is the largest shareholder. After excluding the firms issuing foreign shares, the table comprises 2168 firm-year observations. Private is the dummy variable that is zero when the government is not a shareholder. Panel I reports the robust pooled OLS regression (OLS) and Panel 2 the maximum log- likelihood regressions (MLP). In Panel 2, MLP models estimate the cross-sectional time series data. The MLP model provides the random-effects estimator, which counts for both individual-specific effects and time-specific effects. The panel-data model has been used to resolve or reduce the magnitude of a potential econometric problem that omitted variables are correlated with explanatory variables. More importantly, the MLP model uses both the within and the between information and captures the over-time information. Mundlak (1978) argues that individual effects should always be treated as random. Moreover, ranging from 287 firms in 1994 to 826 firms in 1998, the unbalanced panel data set is wide and longitudinal. In addition, the results of Baltagi-Li LM tests also support the assumption of random effects. The maximum log- likelihood estimation of the MLP model is consistent and asymptotically efficient for my data. Standard deviations are given in brackets. The asterisks behind the coefficient show the range of P-values: *** as p- value: 5 I %, ** p-value: 5 5%, * p-value_-, ý 10%.

39

Panel 1: OLS regressions

Q ROA Pdvate 0.221ý 0.006"

(0.035) (0.003)

Private Large 0.171*** 0.006- (0.058) (0.003)

Second 0.105* 0.089 -0.006 -0.004 (0.052) (0.072) (0.004) (0.003)

Manager 0.181 0.410 0.303' 0.318' (1.399) (1.866) (0.064) (0.075)

Herl'indahl 6.455' 6.511 ' 0.194' 0.191ý (1.614) (2.016) (0.061) (0.068)

Size -0.573" -0.591ý 0.025ý 0.032ý (0.061) (0.082) (0.004) (0.005)

Tangible -0.490 -0.498 -0.028 -0.028** (0.371) (0.231) (0.016) (0.010)

Gear -1.711 ý -1.728ý -0.161ý -0.166ý (0.435) (0.369) (0.022) (0.026)

Age -0.004ý -0.005ý -0.0002ý -0.0002" (0,001) (0-001) (0-0001) (0-0001)

Exchange -0.179" -0.178" -0.004 -0.004 (0.052) (0.051) (0.003) (0.002)

Industry Yes. Yes. Yes. Yes.

Year Yes. Yes. Yes. Yes.

Constant 8.231' 8.110ý -0.115' -0.110ý (0.549) (0.531) (0.027) (0.028)

R-squared 0.489 0.501 0.410 0.436 F statistic 34.93 34.81 14.80 14.01 Significance 0.000 0.000 0.000 0.000

40

Panel 2: MLP regressions

Q ROA Pdvate 0.228- 0.006"*

(0.063) (0.002)

Private Large 0.163' 0.005" (0.061) (0.002)

Second 0.113* 0.180 -0.004 -0.004 (0.065) (0.124) (0.003) (0.004)

Manager 0.601 0.824 0.291" 0.297" (2.845) (2.823) (0.141) (0.123)

Heffindahl 9.363ý 9.232ý 0.297ý 0.295ý (2.035) (2041) (0.081) (0.090)

Size -0.606' -0.601*" 0.031"* 0.039' (0.068) (0.062) (0-001) (0.004)

Tangible -0.431 -0.428 -0.029 -0.029 (0.210) (0.206) (0.007) (0.005)

Gear -1.422' -1.431' -0.153' -0.157' (0.172) (0.165) (0.005) (0.006)

Age -0.004 -0.005 -0.0002* -0.0003" (0.002) (0.002) (0-000) (0-000)

Exchange -0.120 -0.118 -0.001 -0.002 (0.070) (0-091) (0.005) (0.003)

Industry Yes. Yes. Yes. Yes.

Year Yes. Yes. Yes. Yes.

Constant 8.359' 8.351 ' -0.138*** -0.142' (0.625) (0.634) (0.014) (0.026)

Log-likelihood -4361.5 -4371.1 4013.5 4211.2 ChiA2 statistics 409.12 412.61 767.34 756.36 Significance 0.000 0.000 0.000 0.000

41

Taken together, tables 7 and 8 confirm the hypothesis of government shareholding as

detrimental. Ceteris paribus, non-government shareholders are more efficient than a

government shareholder. These findings lead to the conclusion that with corporate value,

government shareholding does matter and is largely detrimental.

With the first large sample of mixed enterprises, 24 this chapter finds that private

enterprises perform better than mixed enterprises. This conclusion is consistent with the

empirical finding of Boardman and Vining (1989). Furthermore, the evidence from China

corroborates the dynamic privatization studies.

Adopting the approach of Megginson et al. (1994), Chen et al. (2000) find that

there is no significant improvement in value after share privatization. Their findings

support the argument that state ownership is irrelevant to corporate performance. An

alternative interpretation could argue that the gradual shift from a seller's market to a

buyer's market, and the intensified competition, explain the empirical findings of Chen et

al. (2000). Nevertheless, finding the overall impact of state ownership to be detrimental,

our study shows that China is not an exception from that government ownership is

generally detrimental.

6. The Two Hands of the Chinese Government

Shareholder

In this section, I examine the regression relations between corporate value and the size of

goverment shareholding. In contrast to the straightforward view of government

shareholding as being simply detrimental to the performance of a firm, I find a U-shaped

24 The findings of Vining and Boardman (1990) include as mixed enterprises those partly owned by a special fund.

42

relation, which I interpret as illustrative of a view of the government as having two hands

- one grabbing and the other helping.

6.1 Further Development of the View of Government Shareholding as

Detrimental

In joint-stock companies, the greater the shareholding stake of a shareholder, the

greater is the shareholder's influence and the greater the fraction of residual cash flow

that accrues to the shareholder. The nature and type of the shareholder will naturally

affect the relation between it and corporate value, which will change as the influence of

the particular shareholder in question increases. Morck et aL (1988) show that there is

non-monotonic relation between corporate value and the size of managerial shareholding

in which the elements increase, decrease, and then increase again. McConnell and

Servaes (1990) show that there is an inverted-U shaped relation between the value of the

finn and the size of insider ownership. Under the hypothesis of the government as

shareholder being detrimental to a firm, corporate value decreases with increased

government shareholding.

To examine Specification 3 that corporate value is a negative function of the size

of the government shareholding stake, I regress corporate value on the simple form of

state shareholding in mixed enterprises. However, whether the analysis is univariate or

multivariate, table 9 shows that the coefficients of State are not significant. The influence

of the government as shareholder does not grow more detrimental as the size of its

shareholding stakes grows larger. Thus, in the Chinese context, an assessment of the

influence of the government shareholder is not fully consistent with that of the classical

view that it is purely and simply detrimental.

43

Table 9

Corporate Value and Government Shareholding: I

This table reports the regressions of Q and ROA on the fraction of government shareholding. The table comprises 2168 firm-year observations, after ruling out the firms with B shares. Panel I presents the results of the robust pooled OLS regression (OLS) and Panel 2 the maximum likelihood random effect panel model regression (MLP). Standard deviations are given in brackets. The asterisks behind the coefficient show the range of P-values: *** as p-value: 5 I p-value:! ý 5%, * p-value:! ý 10%.

Panel 1: OLS Regressions

Q ROA State -0.343 -0.358 0.006 0.005

(0.222) (0.821) (0.015) (0.007)

Second -0.082 -0.005** (-2.041) (0.002)

Manager -0.986 1.203 (-1.976) (-1.765)

Large Private -0.361*** 0.007** (0.064) (0.003)

Size -0.597*** 0.027*** (0.063) (0.007)

Tangible -0.507** -0.023*** (0.223) (0.007)

Gear -1.722*** -0.163*** (0.360) (0.023)

Age -0.005*** -0.025*** (0.001) (0.007)

Exchange -0.166*** -0.004 (0.051) (0.002)

Industry Yes. Yes. Yes. Yes.

Year Yes. Yes. Yes. Yes.

Constant 2.612*** 8.005*** 0.076*** -0.115*** (0.243) (0.538) (0-009) (0.025)

R-squared ---------

0.112 ......... ..

0.216 ---- - ----- 0.065

----- - ----- 0.277

F statistic 25.83 34.48 7.40 13.68 Significance 0.000 0.000 0.000 0.000

44

Panel B: MLP Regressions

ROA State -0.365 0.205 -0.012 0.003

(0.312) (0.182) (0.013) (0.007)

Second 0.075 -0.005 (0.066) (0.004)

Manager 1.062 0.287** (2.943) (0.101)

Large Private 0.232** 0.007 (0.087) (0.004)

Size -0.623*** 0.035*** (0.067) (0.004)

Tangible -0.437** -0.031*** (0.212) (0.007)

Gear -1.428*** -0.165*** (0.172) (0-008)

Age -0.005** -0.039*** (0.002) (0.010)

Exchange -0.106* -0.001 (0.059) (0.002)

Industry Yes. Yes. Yes. Yes.

Year Yes. Yes. Yes. Yes.

Constant 2.884*** 8.234*** 0.113*** -0.141*** (0.214) (0.527) (0-009) (0.036)

Log-likelihood -4453 -4345 3913 4134 ChiA2 statistics 224.8 423.3 223.6 734.5 Significance 0.000 0.000 0.000 0.000

45

6.2 A U-shaped Relation

Using descriptive statistics, table 5 suggests that there is indeed a relation between

state shareholding and corporate value, which may not be monotonic. In this section I use

polynomial regressions to examine this relation.

Table 10 finds that the coefficient of State is significant and negative and that of

StateA2 is significant and positive. This regression result means that the statistical relation

between state shareholding and corporate value resembles the following stimulated chart:

State Shareholding and Corporate Value

2.7 2.6- 2.5- AP

0 2.41 '00001" 2.3 2.2 2.1

2 0 10 20 30 40 50 60 70 80

State Shareholding

Up to a certain threshold, a finn's value decreases as the shareholding stake of the

government increases, but beyond this threshold corporate value begins to increase with

increased sizes in the government's shareholding stakes. The turning points are relatively

stable in the 301/o-40% range of government shareholding, depending on the model

specification. It is a U-shaped pattern with a higher left end than right end. With the

institutional backgrounds and the related regression method (see Appendix 3), 1 confirm

that the size of government shareholdings causes the distribution of corporate values.

46

Table 10

Corporate Value and Government Shareholding: H This table reports the regressions of Q and ROA on the fraction of government shareholding, using 2168 firm-year observations -after ruling out the firms with B shares-. State2 is the squared form of state shareholding (State). Panel I presents the results of the robust pooled OLS regression (OLS) and Panel 2 the maximum likelihood random effect panel model regression (MLP). Standard deviations are given in brackets. The asterisks behind the coefficient show the range of P-values: *** as p-value-< I %, ** p-value:! ý 5%, * p-value: 5 10%. Panel A: OLS Reeressions

Q ROA State -2.296- -1.694- -0.069ý -0.034"

(0.346) (0.337) (0.015) (0.018)

State2 2.823ý 2.563ý 0.086"* 0.044** (0.448) (0.416) (0.027) (0.020)

Second 0.208' -0.006 (0.075) (0.003)

Manager 1.208 0.343ý (1.773) (0.080)

Private Large 0.415** 0.015' (0.186) (0.004)

Size -0.644ý 0.014ý (0.062) (0.004)

Tangible -0.527" -0.031 ý (0.223) (0.007)

Gear -1.665ý -0.166' (0.358) (0.025)

Age -0.005ý -0.0002ý (0.001) (0-0001)

Exchange 0.161*** -0.002 (0.041) (0.002)

Industry Yes. Yes. Yes. Yes. Year Yes. Yes. Yes. Yes. Constant 2.685ý 8.456ý 0.085ý -0.099"*

(0.217) (0.525) (0.011) (0.030)

R-squared 0.131 0.238 0.087 0.296 F statistic 27.09 35.23 8.34 12.62 Significance 0.000 0.000 0.000 0.000 Turning point 0.408 0.291 0.385 0.389

47

Panel B: MLP Regressions

ROA State -1.820ý -1.367ý -0.048ý -0.036-

(0.413) (0.409) (0.015) (0.015)

State2 2.212"* 2.318' 0.057" 0.047" (0.616) (0.574) (0.028) (0.024)

Second 0.187ý -0.004 (0.068) (0.003)

Manager 1.489 0.295" (2576) (0.127)

Private Large 0.434ý 0.014ý (0.112) (0.006)

Size -0.656ý 0.012ý (0.071) (0.002)

Tangible -0.475" -0.086' (0.201) (0.018)

Gear -1.397ý -0.260"* (0.154) (0-008)

Age -0.005" -0.0003*** (0.002) (0.0001)

Exchange -0.100 -0.002 (0.068) (0.003)

Industry Yes. Yes. Yes. Yes.

Year Yes. Yes. Yes. Yes.

Constant 2.929ý 8.656' 0.035ý -0.125"* (0.263) (0.620) (0-008) (0.028)

Log-likelihood -4438.3 -4436.8 3886.6 3675.9 ChiA2 statistics 267.75 436.43 279.98 787.89 Significance 0.000 0.000 0.000 0.000 Turning point 0.410 0.295 0.408 0.378

48

Although the aggregated impact of government ownership is negative, as proved

in Section 5, the above finding challenges the theory that state ownership leads to

inefficiency, because my results show that the impact of government shareholding on a

firm is not necessarily detrimental. It is incrementally detrimental when the government's

shareholding stakes are relatively small. The relation becomes positive and incrementally

beneficial to the firm when, after a certain threshold has been crossed, government

shareholding stakes are relatively large.

This U shape implies that a shareholding structure with a large non-government

shareholder is preferable, followed by a shareholding structure with a large government

shareholder. A dispersed shareholding structure is least preferable.

6.3 Endogeneity and Robustness of the UShape

Section 6.2 finds that there is a U-shaped pattern between state shareholding and

corporate value. The reason may be that the government bases its decision on the amount

of shares to buy in a given firm on the corporate profitability and value of the firm in

question. If there is some causality from corporate value to state shareholding, it could

happen through three channels. The first is initial public offerings. The government

shareholder may sell more shares in enterprises that have higher profitability. The second

is SEOs or seasoned equity offerings. After the IPOs, the government may increase its

shareholding based on the firm's profitability. The third is the market for partial-stake

transfers, since the government is forbidden by law from participation in the open market.

The change of state shareholding in these three processes may be based on corporate

value.

49

Timely ordering is a necessary condition of causality. I tested whether the past

distribution of corporate profitability correlates to the change of state shareholding stakes.

The signs of ROA-, remain insignificant when the model specifications are changed with

more control variables. Statistically, if there is no correlation, there cannot be any

causality. That is, historical corporate performance does not decide the distribution of

state shareholding. It is consistent with the situation in China that liquidation of the

government's equity stake in a company does not aim at raising fiscal revenue25. The

ideology of the Communist Party dominates the financial interest of the government in

the IPOs. The goal of selling part of state ownership is to restructure enterprises 26 .

With regard to SEOs, the central government encourages its agents that directly

hold state shares to maintain its former position in corporate control. However, it does not

allocate a sufficient budget for the seasoned equities. Therefore, the purchase of SEOs is

decided not by corporate profitability, but by the budgetary constraints of the agents

holding state shares. In practice, the controlling rights of the government shareholder are

normally diluted during SEOs.

As for the block transfer of state shares, it is also targeted at enterprise

restructuring. There are a number of cases in which the government grants its shares to

strategic investors. 27 For example, the government gave away its shares in Tianjin Meilun

to Tianjin Taida Group Co. in 1997. The Securities Times found that state-share transfers,

including both grant transfers and negotiated transfers, usually aim at injecting new

25 Since 2000, the government has been discussing redirecting their focus on selling shares under the financial need to build a social security. system. 26 "Measures on the Shareholding Experimenf', issued by the State Council, 15 May 1992. 27 According to China Security Daily in 2000, about one third of state-share transfers were free grants in 1998.

so

capital into a company and updating its technology, rather than raising revenue for the

govermnent. 28

Thus, corporate value does not decide the distribution of state shareholding. The

significant non-monotonic relation between state shareholding and corporate performance

is caused by impacts that derive from the equity stakes of the govermnent.

Another potential problem is the accuracy of the proxies of corporate value. To be

cautious, I tested other measures of corporate performance, including excess value 29 11

return on sales, return on equity, net margin and return on capital employed. The results

support the findings based on Tobin's Q and ROA.

In specifying the model with control variables, I followed corporate finance

literature. I performed more sensitivity tests by adjusting the set of control variables; for

example, by adding the sales-growth ratio and removing the tangibility ratio. The results

are consistent with the reported tables.

I also examined the potential nonlinearity of the control variables and included

their squared forms or cubic forms during sensitivity analyses. However, I found that

most nonlinear forms of control variables tend to have insignificant coefficients. The

signs for the independent variables remained the same with different sets of control

variables.

My analyses crosschecked for the potentially undue influence of outliers on the

empirical results. The median regressions performed are consistent with the results

reported in the tables. The results in the tables are robust if the Hadi dummies are added

28 http: //www. p5w. net/company/200009/09/ýsyj2OOOO9O9Ol 10. html 29 Excess value is the premium of Tobin's Q, based on the industrial medians.

51

to capture the multiple outliers in the multivariate analysis. The DFITS test suggests that

the regressions reported are generally robust.

I applied different regression methods to confirm the results. In my analysis of

categorized enterprises, I performed the discriminant analyses and logit analyses with the

artificial setting, using the types of the enterprises as success rates. I found results similar

to those of the comparison statistics and dummy-variable regressions. I also performed

the piecewise regressions for table 9 and table 10. The results are consistent with my

arguments. Therefore, I report only the nested tables.

6.4 Rationalization of the UShape

While this U-shaped empirical result is of interest of and in itself, it provides

supports the political economy of the government shareholder. That is, the government

has both political interests and financial interests, which consequently brings about the

two hands of the government, -one is to gab and the other is to help. With the

interpretations in the subsections, the following chart summarizes my interpretation of

this U-shaped finding.

52

0 01

Govemment ParOality.

..........

0 State-based CorDorate Governance State Shari

Total Effect

Political Interference *-------------------------

6.4.1 The Grabbing Hand of Political Interference

The hypothesis of the government shareholder as having a detrimental effect on

corporate value is based on the view that the government has a grabbing hand that

interferes in corporate operation as it pursues its political interests. For example, the

Sinopec Shanghai Petrochemical Company Limited, which has the govemment as

majority shareholder, hired 38,000 employees for its core operation even though it could

have gotten by with far fewer people. Although it tried to lay off 17,000 employees, its

government shareholder did not allow it to do so. Further, this firm was forced to find

jobs for its employees. It only succeeded in doing so for 13,000 of the employees it had

originally planned to lay off, yet it must continue to pay the wages for the remaining

4,000. Although this satisfies the government shareholder's political interests and

benefits society, it is at the expense of corporate wealth.

In the context of a joint stock company, the extent to which the government

shareholder may interfere in corporate activity in the pursuit of its political interests

53

depends on the extent of its voting rights. Generally, as its voting rights increase so does

the extent of its interference. However, the likelihood and magnitude of political

interference stops increasing once the shareholding stakes of the government have

reached a certain size and have become relatively large.

All else being equal, the influence of the government on a finn in which the

government shareholder owns 51% of shares is the same as that in a firm in which the

government owns 85%. That is, after the controlling stake threshold, which varies with

the specific shareholding structure of a company, has been passed, the probability and

magnitude of political interference reach their maximum.

aB -

av Assigning the threshold as 01, there are >0 and-<O if a<01 where Vis

ad aB

corporate value, B is the private benefits from political interference and a is the fraction

aB of voting rights. When a> 01 )-=0, which partly explains why the coefficient of State

ea

is insignificant in table 9.

6.4.2 The Helping Hand of the Government on Corporate Governance

The government shareholder can be helpful. For example, to reduce managerial

agency costs, a government-dominated shareholding structure is more effective than a

3 dispersed shareholding structure under a weak legal enforcement. 0 This point can be

illustrated by the case of Monkey King Co. With no large shareholder to monitor its

" Black (2000) outlines five institutions for the dispersed shareholding structure to be effective on corporate governance: 1) effective regulation of the securities market; 2) accounting rules, independent audits and extensive financial disclosure; 3) a sophisticated accounting and banking profession; 4) a stock exchange with meaningful listing standards; and 5) company and insider liability for false and or misleading information. Chinese stock market, so far, has not reached these five conditions. I therefore have the sequence of effectiveness of corporate governance: the firms with a large commercial shareholder, the firms with a large government shareholder and the firms without a large shareholder-dispersed shareholding structure.

54

activities, this firm squandered its cash flows and manipulated the accounting reports. It

might have been prevented from happening had the firm had a large government

shareholder to oversee management activities, provide corporate governance, and protect

the cash flow rights of the company to which its own financial interests would have been

closely linked. Corporate governance of the government shareholder may not be as strong

as that of the governance of a commercial shareholder, but it exists. For example, the

Chinese State Council has issued an explicit policy guideline to remove the managers

from firms under government control if those managers have been responsible for losses

for three years running. The government-controlled shareholding structure is not most

effective as for corporate governance, but it is better than a dispersed shareholding

structure.

If there is to be state-based corporate governance within a firm, the shareholding

stake of the government must be sufficiently large, because if its voting rights are small,

it is difficult for the government to control the managers. In addition, small voting rights

mean cash flow rights are also small, and since monitoring managers is costly, 31 a

government shareholder with small voting rights has little incentives to do so. Naturally,

as the size of the government's shareholding stakes increases and the proportion of cash

flow received by the government shareholder starts to outweigh the monitoring cost of

the managers, the government shareholder has more incentive to provide corporate

governance.

If I denote G the cost of corporate governance and 02 as a threshold, there are

31 Costs lie in the allocation of good bureaucrats, time loss, and the effort of monitoring. In addition, it should be noted that with regard to incentives for providing corporate governance, there is not much difference between the case of a government shareholder and other shareholders.

55

OG >0 and

av >0 when a>02;

aG =0 when a< 02.

aa aG aa

If using the board-member turnover as a proxy of corporate governance, there is

no significant relation between the frequency of board-member turnovers and the size of

government shareholding when the government is a small shareholder. When the

government is a controlling shareholder, the board-member turnovers increase with

increasing the size of government shareholding. Panel A in table 11 supports this

interpretation.

6.4.3 The Helping Hand of the Government on Preferential Treatment

A particular characteristic of the government shareholder that makes it markedly

different from other shareholders is its ability to provide a wide range of preferential

treatment. The partiality includes biased regulations when the government is a regulator,

preferential loans when the government is a creditor, a large order for products when the

government is a consumer, and discounted sales of production factors when the

government is a producer. For example, Fu-Jian Expressway PLC received direct

subsidies from the government to a sum of US$18 million, which represented 58% of its

profits.

56

Table 11: Helping Hands of the Government

This table examines whether a large government shareholder has a helping hand. Based on Table 10,40% is chosen to classify the whole sample into Sample A where the government shareholder holds less than 40%; and Sample B where the government shareholder holds more than 40%. This table reports the robust regression results after adjusting the outliers with Hadi procedure in 1998, because my dataset only records the subsidies in 1998, sourced from Securities Times. The frequency of board-member turnover approximates the governance role of a shareholder, which is the dependent variable in Panel A. Panel B uses the government subsidies as the dependent variable, which approximates the preferential treatment of the government shareholder.

Panel A: Board-member Turnovers and Government Sbareboldin Sample A Sample B

State 0.055 0.406*** (0.118) (0.173)

Debt 0.196 0.254 (0.164) (0.160)

Size -0.054*** -0.037** (0.017) (0.019)

Tangible -0.024 0.038 (0.069) (0.080)

Herfindhal 2.244** -0.582 (0.913) (1.583)

Age -0.002** -0.002** (0.001) (0.001)

Industry Yes Yes

Constant 1.537*** 1.058*** (0.350) (0.381)

F test 8.07 8.28 Significance 0.000 0.000 R-squared 0.027 0.037

Panel 13: Subsidies and Govemment Shareholding Sample A Sample B

State 0.892 0.325** (0.278) (0.158)

Size 6.310** 5.254*** (2.908) (1.260)

Debt -1.941 0.839 (2.470) (0.686)

Industry Yes Yes

Constant -1.530*** 1.083*** (0.450) (0.315)

F test 6.69 8.28 Significance 0.000 0.000 R-squared 0.194 0.274

57

However, government partiality comes at the expense of the financial interests or

even political interests of the government. Therefore, the government has no incentive to

provide such costly partiality to a firm in which its cash flow rights are small. Thus, the

extent of preferential treatment provided by the government is correlated to its cash flow

rights.

There are cis >0 and av

>0 when a>03 , where S denotes the cost of aa as

government partiality; av

=0 when a<03. aa

If using the subsidies from the government as a proxy of government partiality,

there is no significant relation between the size of subsidies and the size of government

shareholding when the government is a small shareholder. When the government is a

controlling shareholder, the subsidies increase with increasing the size of government

shareholding. Panel B in table II supports this interpretation.

Table 11 shows that the beneficial effects of a large government shareholder

comes from two channels-corporate governance and preferential treatments, which are

not in conflict.

6.4.4 Synergy of the Grabbing Hand and the Helping Hand

Based on the behaviors of political predation, corporate governance, and

preferential treatment, the utility function of the government shareholder is as

follows:

58

U=a*V+B-G-S

Subject to:

0: 5 a <1

V=v G+v O+v S -VB

where VO is corporate value independent of a, VG is value changed by G, Vs by S, VjB by B.

Therefore

Set ýp<O, and (p<03, when V< 01, we have av

0; ea

Set V/ > 02 and V/ > 03, when V/ > 01,

where (p < V.

we have av 2a

Thus, the relation between the shareholding stakes of the government

shareholder 32 and corporate value is negative until a certain threshold and positive

beyond this threshold. The U-shaped empirical relation is a result of the aggregated

impact of the government shareholder's different goals, i. e., its political and financial

interests. Its political interests bringing about the reallocation of corporate resources are

detrimental to a firm. But when it is pursuing its financial interests, which lie in its cash

flow rights and thus the size of its shareholding, the government provides corporate

governance and acts with benevolence and partiality. If corporate value is the main

" The simplified descriptive model here does not differentiate between voting rights and cash flow rights because the one-share-one-vote system makes the separation of voting rights and cash flow rights in China marginal.

59

consideration, the balance between the government's pursuit of these two main interests

must be firmly tipped towards the financial and not the political. This bent explains why

the value of a finn decreases as government shareholding stakes increase until a certain

threshold, since when the government is a small shareholder it has no incentive to

provide the preferential treatment and benevolence that would outweigh the

disadvantages of its political interference. 33 If the presence of a government shareholder

is to be beneficial to a firm, its shareholding stakes must be relatively large. In this way,

both the government shareholder and non-government shareholders work towards the

common goal of corporate value.

Conclusion

Government shareholding is a particularly characteristic feature of Chinese PLCs, and

this shareholder plays a significantly large role in the shareholding structures of public

listed companies in China. According to the findings in this chapter, the overall impact of

government shareholding appears to be detrimental to a firm's corporate value. This

finding supports the new evidence from China and contributes to the existing empirical

literature on the inefficiency of state ownership.

However, the detrimental impact of state shareholding is not monotonic, and

companies where the government shareholder has high voting rights are not necessarily

always valued lower. The relation between the size of the government's shareholding

33 It also implies that solely-state-owned-enterprises (SOEs) are theoretically more profitable than mixed enterprises, all else being equal. However, in reality, SOEs are not monitored by the stock market and most Chinese SOEs have not yet built up modem corporate governance structures.

60

stakes and corporate value is, on the contrary, U-shaped, caused by the tension between

the activities and political interests of the government on the one hand, and on the other,

its financial interests. Up to a certain threshold, as government shareholding stakes

increase but remain relatively small, the government's financial incentives are not

sufficient for its helping hand to provide the costly benevolent treatment that would

compensate for the negative effects of its grabbing hand, which pursues political interests

beneficial to society but detrimental to corporate value. When government shareholding

stakes increase beyond this threshold and become relatively large, state shareholding can

have a positive impact on a firm. Only then does the government have enough of a

financial interest in a company to provide it with the preferential treatment that the firm

would be hard put to find elsewhere.

Clearly, if corporate value is the main consideration and state shareholding is a

feature of a company's shareholding structure, the size of the government's shareholding

must be large enough for it to pursue its financial rather than political interests. Thus,

both government and non-government shareholders would be working in harmony.

However, given that the overall impact of government shareholding is negative, I believe

full privatization to be preferable for the profitability of a firm. On the other hand, the

optimal business strategy would be to buy out state shares in one shot and require that the

government fully retreat from a firm.

Having documented the features of China's PLCs and having found the role of the

government shareholder in them to be so significant, in this chapter I propose that the role

of the government shareholder be a new topic of study in financial institutions.

61

Appendix 1:

Data Sources Data Source Reliability

Share price data Datastrearn Inc. Established International Renown Data Specialist

Accountancy data before Taiwan Economic Journal The leading data specialist company in NO Taiwan and the major Chinese data vendor

to Reuters, Datastream, etc.

Accountancy data after Genius Inc. More than 80% of Chinese investment TPO bankers and security analysts rely on the

data provided by this company.

State ownership Genius Inc.

Board of directors Taiwan Economic Journal

Large shareholders Beijing Hairong Inc. The major financial data specialist company in Beijing.

Industrial classification China Securities Daily The leading newspaper on finance and securities in China

Block transfer China Securities Daily

State-share transfer Securities Times A major newspaper on securities in China

With regards to accountancy and ownership data, the validity of the data sets has been crosschecked and missingpoints were made up based on annual reportsfrom the website managed by the Shenzhen Stock Exchange http: //ýww. cnplýý. com. cnl.

62

Appendix 2

Shanghai State Asset Management System

This chart illustrates the organizational form of the Shanghai State Asset Management System.

The arrows represent the control, which can be implemented by nominating or appointing the

crucial official in this pyramid. The state asset management system also covers state

shareholdings. As a general rule, agencies with direct control responsible for specific public listed

companies can be numerous, but this organizational chart shows that the control of the

government and ultimately the Communist Party on these numerous agencies is considerable.

I Shanghai Municipal Government Mayor I

State Asset Committee Mayor+ >30 Heads of Municipal Agencies

I Central Government I

I State Asset Management Office I

State Asset Operating Companies (Holding Companies)

State Asset Group Companies (Fortner Bureau)

State Shares

I Operating Entities I I Operating Entities I

State Shares

I Operating Entities I

63

Chapter 2:

Debt Governance, Bank Capture, and Soft Budget Constraints

64

iL. Introduction

Corporate capital structure is an instrument of corporate governance, and financial

disciplines are crucial to corporate performance. 34 Jensen and Meckling (1976) and

Dewatripont and Tirole (1994) argue that debt keeps a tight rein on managerial agency

costs. The governance role of debt comes from the threat of bankruptcy (Aghion and

Bolton 1992), the reduction of free cash flows (Jensen 1986), and due diligence

monitoring by creditors (Diamond 1984).

Finance theories are developed in the western economies. In the former

communist economies, Kornai (1980) observes the stylized fact of soft budget constraints,

under which the lack of bankruptcy enforcement brings about the problem of bad loans.

This phenomenon also exists in other new and emerging markets. However, so far, this

essential economic institution is largely ignored by the mainstream finance literature. It

remains a question what role debt serves in corporate governance under soft budget

constraints.

The public listed companies (PLCs) in China provide a laboratory in which to

study this question. Moving towards a mixed economy, the Chinese government

restructures state-owned enterprises into joint stock companies that have more than one

owner and lists the "star" companies on its emerging stock market. Meanwhile, the

government ownership of firms and banks is widespread. As political interests intervene

34 This view is accepted by practitioners. For instance, Financial Times quoted Jonathan Meggs, a partner of JP Morgan, "... leverage is a financial discipline" on June 10,2001.

65

with commercial decisions, government ownership holds back the enforcement of

bankruptcy and the budget constraints of China's modem firms are soft.

There are some theoretically surprising but institutionally intuitional findings

within my Chinese PLCs' panel data set. An increase in financial leverage increases the

size of managerial perquisites and free cash flows. The relation between debt levels and

board-member turnovers is not statistically significant. These findings suggest that debt

governance does not function in China; on the contrary, debt encourages managerial

agency costs. Bank loans expand the resources under the control of the managers and so

facilitate managerial agency costs. I further find that the facilitator role of debt on

managerial agency costs is more significant in the government-controlled companies, but

it becomes much less serious in the commercial-entity-controlled companies. Debt does

provide a role of governance in cntrepreneurs-controlled firms. The source of

dysfunctional debt governance is the soft budget constraints that arise from government

ownership.

Soft budget constraints are intrinsic in the businesses of the state. When the

government plays a major role in the business, the budget constraints become soft and

consequently, debt governance stops functioning. Because the Chinese government has a

widespread business empire, the Chinese corporate governance problem is more

profound than that of East Asian firms before crisis, although the closed Chinese capital

market escaped the brunt of the 1997 Asia financial meltdown. With integration into the

global market, the peculiar relation between debt and managerial agency costs

documented in this chapter could eventually engulf China in a financial crisis. There is a

Sword of Damocles looming over the future of this emerging economy.

66

I organize this chapter as follows. Section 2 describes the institutional background

of China's modem firms and reviews the literature on capital structure and soft budget

constraints. Section 3 develops the conceptual framework and presents the competing

hypotheses. Section 4 describes the data and presents the univariate analysis. Section 5

presents the empirical findings of the multivariate regressions. Section 6 discusses the

relation between debt and managerial agency costs. I conclude this chapter in Section 7.

2. China's Modern Firms and Financial Institutions

China has a bank-dominated financial system, 35 but the stock market has been growing

very fast in the last decade. This section introduces China's modem firms, its stock

market and its banking sector. The institution of soft budget constraints, which causes the

problem of bad loans, has not changed fundamentally.

2.1 China's Modem Firrns

Since 1978, China has gradually transformed from the centrally planned system to

a market oriented economy, as well as having undergone a massive corporate

restructuring. Starting from 1993, the government promoted the "modem enterprise

system" to restructure the state-owned enterprises to be joint stock companies. 36 The

financial structure of these modem firms is illustrated in the following chart.

35 Total loans reached US$ 1.1 trillion and the ratio of loans to GDP exceeds 100% (Merrill Lynch, 2000). 36 According to China's Communist Party Congress in 1993, the modem enterprises are defined as "clarified property rights, clearly defined responsibility and authority, separation of enterprises from the government administration and scientific internal managernent".

67

Simplified Financial Structure of China's Modern Firms

Assets Liabilities

Productive capital Debt owed to the government- controlled banks

Equity in the firms owned by the government, institutions and households

The ownership of these firms is clarified. They have more than one owner. The

government is a large block shareholder, but there arc no golden shares. 37 The

government asset management companies and other agents of the government hold the

shares and report to a special branch of the government-the Bureau of State Asset

Administration. The controlling rights of the government shareholder are dependent on

the sizes of government shareholding.

These companies also use debt financing. So far, there is no domestic market for

corporate bonds in China yet. Except for temporary financing from enterprise arrears or

trade credits, the major liabilities of these companies are bank loans. The banks are

forbidden to own shares of a company. 38

" Golden shares are shares with control restrictions, normally the veto right to major strategic decisions. 3g This rule came into effect in 1995, but it does not require a bank to sell out its shares in a firm purchased before 1995.

68

Table 1: Financial Leverages

The table reports the means, standard deviations, and medians of the proxies of capital structures for my sample of companies listed on either the Shanghai Securities Exchange or the Shenzhen Stock Exchange. The leverage ratios are based on the accounting reports. Panel 1 reports the leverage ratios of two samples: total firms and the firm listed in the year 1992 that excluding the noise brought by newly-listed firms each year. Panel B reports the aggregated numbers compared with other countries. The figures for the United States, United Kingdom, Japan, and Germany are from Rajan and Zingales (1995). The figures for South Korea, India, Turkey, Brazil, and Mexico are from Booth et aL (200 1).

Panel 1: Leveraae Ratios In China's PLCs from 1994 to 1998 1994 1995 1996 1997 1998 Total

Liability to Total Assets All Firms 287 311 517 719 826

mean 0.413 0.461 0.445 0.417 0.422 0.429 median 0.412 0.458 0.455 0.415 0.416 0.424

Firms Listed in the Same Year 1992 39 39 39 39 39 mean 0.437 0.477 0.482 0.495 0.546 0.487 median 0.445 0.489 0.494 0.497 0.503 0.484

Bank Loans to Total Assets All Firms 287 311 517 719 826

mean 0.205 0.225 0.224 0.212 0.215 0.216 median 0.193 0.212 0.216 0.201 0.206 0.206

Firms Listed in the Same Year 1992 39 39 39 39 39 mean 0.211 0.239 0.252 0.268 0.287 0.251 median 0.233 0.235 0.243 0.261 0.265 0.243

Bank Loans to Capital All Firms 287 311 517 719 826

mean 0.457 0.481 0.475 0.454 0.453 0.461 median 0.471 0.499 0.498 0.475 0.467 0.479

Firms Listed in the Same Year 1992 39 39 39 39 39 mean 0.610 0.615 0.634 0.649 0.675 0.636 median 0.641 0.633 0.630 0.651 0.652 0.640

Observations 287 311 517 719 826 2660

Panel 2: International Comparison

No. of Firms Time Period Nonequity Liabilities to Total Assets

Debt to Total Assets

Debt to Capital

China 287-826 1994-1998 0.43 0.22 0.46 United States 2580 1991 0.58 0.27 0.37 United Kingdom 608 1991 0.56 0.24 0.34 Germany 191 1991 0.76 0.16 0.39 Japan 514 1991 0.75 0.42 0.63 South Korea 49 1985-1991 0.30 India 99 1980-1990 0.67 Turkey 45 1983-1990 0.59 Brazil 49 1985-1991 0.30 Mexico 99 1984-1990 0.34

69

Panel A in tablel reports that the public listed firms are not heavily indebted. The

total liabilities are 42.9% of total assets, and the bank loans are 21.6% of total assets. If

excluding the newly listed firms, the financial leverages seem to keep increasing with

time, which shows in the sample of the firms listed in 1992. It casts the doubt whether

there is an optimal capital structure in an emerging economy. It also demands an

explanation why the firms gradually increase debt financing after listing on the stock

market. Panel B shows that the financial structure of these Chinese firms, -different from

the State-Owned Enterprises-, is similar to that of the firms in western economies, but the

question remains whether the standard corporate governance theories can be applied to

China's modem firms.

2.2 Emerging Stock Market

These joint stock companies are encouraged to list on stock markets. As a result,

the stock market has grown very rapidly. Between 1992 and 1998, the market

capitalization increased at the average rate of 84.7% per year. At the end of 1998, the

total market capitalization was about a quarter of China's GDP. The number of listed

companies grew 62.0% annually, from 53 PLCs in 1992 to 851 PLCs in 1998.

The rule of one-share-one-vote is widely used in these modem firms. Large

shareholders control the management team. The voting rights of the large shareholders

can decide the fate of top manages. For instance, the controlling shareholder of Founder

Tech dismissed the CEO, Zhu Jianqiu, when Mr Zhu attempted to control the board of

directors.

70

There are frequent mergers and acquisitions in SSE and SZSE. The Boston

Consultancy Group ranked China the third largest merger and acquisition market in

Asia, 39 although the hostile takeovers are relatively rare. The transfer of state shares and

legal person shares is undertaken as block transfers over the counter. After a merger or an

acquisition, the shareholders often reshuffle the directors and top managers.

The internal governance of the board of directors and the external governance of

the market for corporate control function in China. However, there is still no formal code

of bankruptcy. There is only reluctant enforcement of the trial code of Bankruptcy Law. 40

This incomplete legal infrastructure is due to the social pressures of unemployment and

the ideology of communisms. Very few large firms have been liquidated and no PLCs

have gone into bankruptcy until very recently. 41 The budget constraints on these modem

firms are soft.

2.3 Banking Sector and Non-Performing Loans

Debt finance for China's modem firms comes from 40,000 financial institutions

in China. However, the banking industry is dominated by the four fully state-owned

commercial banks (the "Big Four"), which provide more than 80% of all corporate loans.

Under the Commercial Banking Law of 1995, these banks should manage credit risks and

"' The Southern Metropolitan Newspaper quoted Jim Hemerling, a Vice President of Boston Consultancy Group, on September 7h, 2001. ' The Enterprises Bankruptcy Law was legislated in 1986, which is only a trial version and the formal version is still under discussion. It entitles the government owner to the right of a two-year restructuring period for enterprises that are in default before liquidation. It assigns top priority to pension and other welfare obligations. Employees' claims on their salaries and other welfares receive priority over debt creditors during liquidation. 41 In 2001, the Huarong Asset Management Company and other two creditors requested the Hubei Supreme Court to liquidate the Monkey King PLC. It is expected to be the first bankruptcy case of a public listed company.

71

pursue profits, but Lardy (1998) argues that reform in China has so far done little to

improve the allocation and use of bank capital.

Because the government is the sole owner of these four banks, it still exerts great

influence over the commercial banking sector through its ownership rights. Under the

administration of the government, the central bank also attempts to compel commercial

banks to issue the policy loans. 42 For example, in 1998 the central bank issued a guideline

to commercial banks indicating that they should guarantee reasonable funds to state-

owned enterprises (Hanli Consultancy Ltd, 1998). Because of the career concerns of

bankers, the government-owned commercial banks closely follow the direction of the

central bank and the government. And because of unemployment pressure, the

government has few incentives to see its loss-making firms liquidated. However, the

government can ensure that its firms have a steady source of capital through the banks

owned by the government. It thus reduces the incentives for the banks to monitor the

firms. On the other hand, firm managers can hold up the government's political interests

to force the banks to lend as much as the banks can afford. When a loan is due, the firms

make new loans, thus rolling over the old loans. Soft budget constraints inevitably induce

badloans.

42 Compared with central banks in western economies, PBC is assigned a larger power in regulating financial institutions. For example, it sets the lending rate. Commercial banks are allowed to vary the centrally governed rates by only 10% for lending to large-sized enterprises, and up to 30% for other enterprises.

72

Table 2: Bad Loans

This table describes the severity of problem loans in China. Part A summarizes some studies to estimate the size of bad loans among total loans, and the cost to clean up the bad loans. Part B cites a research report by UBS Warburg and presents the table of total bad loans (in billions of Chinese RMB). Part C cites a research report from Merrill Lynch and compares the problem of China with the rest of the Asian countries.

Part A: Summary of Studies on Problem Loans in China Study Period Estimate

Problem loans (as percentage of outstanding loans) LI (1998) End of 1996 24.4%

Mid-1997 29.2% CCER (1998) 1997 24.0% Fan (1999) 1997 26.1%

1998 28.3% Dal Xianglong (2001, interview with FT) 2001 28.0%

Clean up costs (as percentage of GDP) Moody 1999 18.8% Dornbusch and Givazzi (1999) 1999 25.0% Standard and Poor 2001 50.0%

Part B: UBS Warburg Estimation of Non-Performing Loans of Individual Banks (2001)

Rrnb bn CC13 ICBC ABC Wars Total Total loans 1,386.3 1,543.1 958A 1,238.5 5,124.3 Estimated Gmis NPL 443.6 540.1 383.4 356.1 1,723.2 Gron NPL ratio (%) 32% 35% 40% 28A% 34%

ChIrtaConstruclion Bank (CCBY, InclushialMmmercial Bank of China (ICBCý Agriculure Bank of China (ABC) Source: One dat&awned bank's 20DO annual report UBS Warburg esft*, s

Part C: Merrill Lynch Estimation of the Cleaning Up Cost (2001) 609L -

49% -

30%.

2VJL -

los-

V%. ' ains kda Indonesia Ablayis Phdippines Soulh Kare s Thailmnd

73

Table 2 of Chapter 2 in the following page provides an overview of the severity of

the bad-loan problem in China. In an interview with the Financial Times, the governor of

China's central bank admits that nonperforming loans at the Big Four come to about 25%

of total loans. Some academic papers estimate the rate at about 40% and Standard & Poor

provides a figure of 50%. Some banks are technically insolvent, since the nonperforming

loans are even larger than net assets, but with the ultimate backing of the government, the

trust of depositors remains.

These bad loans are not a legacy of the former planned economy, but they started

to accumulate during the reform period. That is, there is a momentum to increase the size

of bad loans, which could eventually lead to a collapse of China's economy. 43

3- Capital Structure and Soft Budget Constraints

Surveying classical corporate finance literature, I define the term managerial agency costs,

present the three dimensions of debt governance, clarify the concept of soft budget

constraints, and develop theoretical hypotheses for empirical testing. My framework of

the role of debt in managerial agency costs is presented in the chart of the following page.

43 In fact, the Chinese economy suffers from many of the same debilitating structural problems that long plagued to Korea, Thailand, Malaysia, and Indonesia, including the fragile bank-dominated financial systems, poor prudential surveillance, weak central bank regulation, and a largely state-owned financial sector that is almost insolvent. China emerged unscathed from the Asian financial crisis because of its control of foreign exchanges on capital accounts. However, this Pandora's Box has to be opened with the deepening reform and as China integrates into the world economy. This study of debt governance sheds lights on whether China is sliding into a financial crisis (Lardy 1998) and on how China can avoid a potential crisis.

74

3.1 Managerial Agency Cost

In a joint stock company where ownership and control are separate, agency costs

arise. The agents behave so as to maximize their own interests rather than the interests of

their principals. Agency costs induced by the managers include managerial slackness,

risk aversion, and exploitation of the firm. This chapter discusses managerial agency

costs with three dimensions: excessive perks, empire building, and entrenchment.

3.2 Debt Govemance

Corporate governance is a set of mechanisms designed to control managerial

agency costs. Debt is an instrument of corporate governance. Debt governance functions

by acting as a threat to sack incumbent managers under financial distress. As for going

concerns, debt forces out free cash flows and encourages due diligence monitoring

activities.

75

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E Ln a E (D (a M

CO

46

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:3E CIS (D = > 0

0

co it:: .0 0

CL

co = E LU

(1). s m LL z (D

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a a- (a CL x CD -ý3 m

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(D CL

rn

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tl--" t0

First, a high financial leverage is associated with a high probability of financial

distress which causes managerial replacement. Aghion and Bolton (1992) model the shift

of control to debt holders when profits are low. Gilson (1990) shows that creditors take

over the dominant role in disciplining the managers when firms are in financial distress.

The empowered creditors tend to replace incumbent managers that were assigned by the

shareholders. 44 On the other hand, debt plays a role in pre-committing the shareholders to

penalize the managers for their value destroying exploitation, because the shift of control

to creditors drives out the private benefits of the controlling shareholder. Debt also has an

incentive effect on shareholders' monitoring efforts. With a sample of British firms,

Franks et aL (2002) find that the turnovers of board-members is higher when the financial

leverages are higher. 45

Secondly, Grossman and Hart (1982) and Jensen (1986) argues that debt carves

out free cash flows and reduces managerial agency costs. Free cash flow is cash flow that

remains after the firm has completed its positive net present value (NPV) projects. Under

the separation of ownership and control, the managers are reluctant to pay out cash flows

to shareholders, but prone to overexpanding corporate operations and to "empire-

building". Debt functions to force out cash flows to repay interest and loan principal.

Moreover, debt holders can impose rules and restrictions on management through an

indenture and the availability of remedies for breach thereunder. The debenture caveats

44 If laid off due to exploiting corporate wealth, the managers are punished with the reputation effect in the managerial labor market (Fama and Jensen 1983a, b). 45 Harris and Raviv (1988) and Stulz (1988) argue that with an increase of leverages, the voting rights of outsiders are reduced and the voting rights of the insiders increase. The managers are therefore prone to entrenchment. However, the average voting rights of the management teams in China's PLCs were as small as 0.005% of the total shares. The Stulz leverage impact is not expected to be influential in the Chinese context. Therefore, the classical corporate finance theory should follow the governance hypothesis. Friend and Lang (1988) and Berger et A (1997) provide empirical evidence that financial leverages are negatively correlated to managerial entrenchment in developed economies.

77

of loans restrict the over expansion of corporate operation. By containing the propensity

for overinvestment, debt improves corporate value. McConnell and Servaes (1995) find

that firm leverage is positively correlated with firm value when a firm's growth

opportunities are scarce.

Thirdly, the theory of financial intennediation argues that banks have incentives

to collect information and monitor firms to ensure the returns to the depositors (e. g.,

Diamond 1984). Bankers' specialized knowledge helps to reduce asymmetric information.

Moreover, typical bank loans are short tenn. When bank loans are renewed, the bank

actively investigates corporate quality and evaluates the investment risk (Shleifer and

Vishny 1997). If there are excessive managerial perks, banks tend to reject additional

funding. Consequently, it signals to the market the quality of firm management and may

trigger a disciplinary action from equity holders on the managers. Harris and Raviv (1990)

model the informational role of debt. Debt financing therefore improves corporate

performance by inducing due diligence monitoring by creditors.

In summary, classical corporate finance theories argue that high leverages reduce

managerial agency costs and strengthen corporate governance (e. g., Jensen and Meckling

1976, and Harris and Raviv 1991). Kaplan (1989) find that a high financial leverage

coming with leveraged buyouts has a positive effect on corporate performance.

3.3 Soft Budget Constraints

Ile classical corporate finance theories on debt governance take hard budget

constraints as granted. However, Kornai (1980) observes that the finns in fonner planned

78

economies face the soft budget constraints. 46 1 define the soft budget constraints as the

perceived re-negotiability of debts under political interference. This concept of soft

budget constraints is a strong form of the Dewatripont-Maskin concept (1995). Political

benefits are also a rationale for refinancing loss-makers. Under soft budget constraints,

the firms in default expect refinancing instead of bankruptcy. Contract fulfillment is

therefore dependent on bargaining. Political pressures from the government also soften

the budget constraints imposed by banks.

Under soft budget constraints, debt governance becomes weak. The shift of

control from shareholders to creditors is blocked by political interference. If the

government is the controlling shareholder, it tends to retain its control by exerting

pressure on creditors. Without the threat of the shift of control dejure, the managers in de

facto control are not concerned with the dissatisfaction of the creditors. The agent who

represents the government has little concern for the loss of private benefits, since there is

no shift of control from shareholders to creditors. Bankers' disapproval does not trigger

the disciplinary action from shareholders in this setting.

A going concern normally pays back its interest and loan principal, but it does not

necessarily lead to the conclusion that debt forces out the cash flows. On the flip side,

bank lending injects capital into firms. If the credit is soft, the firm keeps making new

loans to pay back old loans. Meanwhile, the managers can use bank capital to expand

corporate operations. Empire building is thus promoted by debt under soft budget

46 Dewatripont and Maskin (1995) show that when creditors have limited information on the future return of an investment and cannot commit to terminating ex post unprofitable projects, there is a soft-budget- constraint problem. The sunk costs of initial financing provide creditors the incentive to continue their finance, even when the firm cannot pay back some interest and loans. This holdup problem is universal.

79

constraints. Bankers actually hand out cash to the managers without the governance

implication

The creditors pressured by the government have no incentive to monitor debtors

and how the credit is used. It is the pressure of the government that imposes the soft

budget constraints on creditors. The bankers' incentive to undertake due diligence

monitoring on corporate business operations is diminished under bureaucratic

coordination of economic activities.

The theory of soft budget constraints therefore predicts that debt cannot reduce

managerial agency costs. On the contrary, it may facilitate managerial exploitation. When

banks renegotiate with firms and allow the rollover under political pressure, managerial

agency costs are exacerbated. This argument is consistent with the theory of politicians

and the firm (Shleifer and Vishny 1994). In fact, World Bank (2000) argues that the East

Asian financial crisis in 1997 partly comes from dysfunctional debt governance.

3.4 Hypotheses

Based on the framework presented in Chart 2 and the above discussion, the

following contradictory hypotheses are developed:

Hypothesis CF. - Higher leverage constrains managerial agency costs.

This corporate finance hypothesis of debt governance can be stated as being that

there is a negative relation between financial leverage and the scale of managerial perks,

a positive relation between financial leverage and the possibility of an over-investment

problem, and a negative relation between financial leverage and the magnitude of a

managerial entrenchment problem. All else equal, managerial agency costs result in low

80

efficiency and drives down the value of the firm. 47 Tben, it should be projected that

higher leverage is associated with higher efficiency and higher corporate value.

Hypothesis SBC. - Higher leveragefacilitates managerial agency costs.

In contrast to classical corporate finance theories, the theory of soft budget

constraints suggests that bank loans do not constrain managerial agency costs, which is

the alternative hypothesis to Hypothesis CF. A higher leverage is associated with larger

managerial perks and a more serious problem of over-investment. Since the soft budget

constraints come from political pressures, Hypothesis SBC further suggests that the

facilitator role of debt is stronger if the firms are more closely affiliated with the

govemment.

4. Data Samples, Proxies and Univariate AnalYsis

Based on the 1994-1998 annual reports and share performance of all Chinese PLCs, a

new data set is assembled (Appendix 1). This section describes the data and provides the

univariate analysis of the governance role of debt.

47 Managerial exploitation damages corporate value. That is, in a large sample of firms in a semi-strong efficient stock market, corporate value carries information on the magnitude of managerial exploitation. If debt provides governance, a highly leveraged firm should be valued high, cewls paribus, as a higher financial leverage reduces further the magnitude of managerial exploitation. In addition, Ang el aL (2000) suggest that corporate efficiency also reflects the scale of agency costs within a firm.

81

4.1 Ownership Cluster

Tian (2000) argues that state shareholding is a main feature of China's public

listed companies. Kornai (1992) argues that the softness of budget constraints depends on

ownership, and state ownership is a fundamental cause of soft budget constraints.

Relatively speaking, state owned enterprises face the softest budget constraints; the

collective enterprises face less soft budget constraints and the private enterprises face

hard budget constraints. Therefore clustering samples by ownership is a way to examine

the relation between soft budget constraints and debt governance.

In descriptive statistics, I group the firms into four clusters: 1) the dispersed

shareholding structure in which the largest shareholder holds less than 30% of total

shares; 2) the state-controlled shareholding structure in which the government

shareholder holds more than 30%; 3) the institutional-shareholder-controlled

shareholding structure in which the non-government institutional shareholder holds more

than 30%; and 4) the entrepreneur-led shareholding structure in which an entrepreneur

founds and leads the firm. The 30% cut-off threshold is based on a CSRC regulation that

names 30% as the relative control threshold. Whilst this threshold is arbitrary, my results

do not change when I try other cut-off points.

In the regression analysis of Section 5,1 further group the finns into three clusters

to compare the coefficients of the independent variable: 1) firms under the control of the

government shareholder, 2) firms that the government has a significant shareholding

stake but not stays in control, and 3) firms under the control of an entrepreneur. In the

reported tables, I adopt 40% as the controlling stake, which is based on the turning point

of the U-shaped relation between the size of government shareholding and corporate

82

value, documented in Chapter 1. When the government holds more than 10%, the

government is a significant shareholder. This further classification of the firms with

government ownership is to examine the consistence of this chapter with chapter 1. My

qualitative conclusions derived from the quantitative findings do not vary on the choice

of thresholds. This classification helps to examine the effect of government ownership in

the relation between agency costs and bank loans.

4.2 Financial Leverages

Since there is not an active domestic corporate bond market in China and trade

credits for transaction purposes do not contribute significantly to corporate governance,

debt governance is the governance based on bank loans. My main measure of financial

leverage is therefore the ratio of the amount of bank loans to total assets. This ratio shows

the liability of the firm, suggests the probability of financial distress, and approximates

the influence of bankers in corporate management. A high gearing ratio in the firm

should trigger a prudent lending policy by its banks and a stronger governance effect of

bank monitoring. I also examined other forrns of gearing ratios, but my basic conclusion

does not vary with different forms of gearing ratios.

To examine whether there is a distribution pattern of managerial agency costs on

financial leverage, I group the firms into three clusters: low-debt firms whose financial

leverage is below 10%; middle-debt firms with the leverage between 10% and 30%; and

high-debt firms with leverage above 30%.

83

4.3 Managerial Perks

Managerial perks are the hidden income for management teams. In fact, such

perks represent the main income for Chinese managers, since the average nominal annual

salary of the general managers is only $4,667.48 It is a normal practice for a firm to pay

for the phone, taxi and dinner bills of the senior managers' family members.

Most perquisites for managers are not explicitly reported in the annual reports

formulated by the CSRC, but they inflate the accounting item of administration cost.

Administration cost records the administration expenditure in organizing and managing

corporate operation. It includes the expenses of the top management team and the

administrative staff and the cost that should be born by the company as a whole, such as

corporate cars, traveling expenses, entertainment expenses and other service bills. Among

the data reported in the annual report, the item of administration cost serves as the best

indicator of managerial perks. I normalize the administration costs by sales, which

controls for both size and operation effects. The quantitative difference among the

administration cost ratios in different firms approximates the degree of perks taken by the

managers.

48 Wang (1998) shows the annual income of the general managers of 146 PLCs on the Shanghai Stock Exchange was only RMB 38,650 in 1997, although there are some cases of high bonuses for management teams.

84

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Table 3 presents the distribution of perks by ownership and leverage clusters. The

average ratio of administration cost to total sales is 9.1%. The firms with a dispersed

shareholding structure spend $0.111 on administration for each dollar of the sales; state-

controlled firms $0.090; institutional-shareholder-controlled firms $0.086; and

entrepreneur-led firms $0.081. Perks vary among firms with different ownership types

and ownership affects corporate governance. With increasing financial leverage, it is

striking to find that the ratio of administration expense to sales increases. When the firms

have a low debt burden, the average administration ratio is 8.7%; a debt burden in the

middle range, 8.8%; above 30%, 10.2%. In the cluster of state-controlled firms, the

increasing pattern of administration ratio with the debt levels is most significant.

4.4 Free Cash Flows

Free cash flow is cash flow left over after the firm has exhausted its projects of

positive NPV. It has a significant positive correlation with the cash retention ratio, which

is also called the plowback ratio. The retention ratio is calculated as one minus the payout

ratio, which is the dividends per share over the earnings per share. This ratio measures

the proportion of earnings retained after paying out dividends to shareholders, and it

serves as a proxy of free cash flow. It is the fraction of distributable cash flows that a

company invests in new projects.

86

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,' *g v9g'- .E-ý .4- (L) '0't; 5 >,

21 .. 0 ,j u0

121 eu

0 rn =

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9) 0 Ici - g; '0 ýroýO -0 mi

r 4 -Z. t -5 e> LM 2 En ei

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-t; g) - -2 r- "y .2Zm gl (D C) Zi. 0-0 *ýr- *i-- gme eij

-0 4) 0 .-- t) ýi r. 0u-

e 0. -= =5- .- IL) ;Zu. - ýo c)

ýD 62 *E -2 -e. E-, a) ;ý >c ZQ ei 0SMß.

jz 0u

k. 4. lu .4. , EI, -4 1-1 0eZ 00 C> -4 Z=

0 (L) iz 0E-. 1--: =9

LA

u04Z rZ = *5 2Z 'Z t) Eý -0 ce W 9 -. A -2 -- ;ý92 im ý, : ýi 4) >. 0M -rj

.2 -ci gE0 -ý3 -j 14 tr. -a 4. ) g 2 -ci 4) 0 W00 ce u 4. )

JJ r, r. c2 0 -ýJ ' ý: 1 4-, oý -=

00 -0 '-K, 0U00 (D = rn (U 14. M9Q

GOI

gDý., 0 00 q> rn -0 ý3 -14 2Z0

3. - - 'Eb 00 40A. (4 0 li 9 ti. -

ei, Ici . 5.9 - . ý: IS2 s.

9u ;5E>0. Q-00'

0 (Y) C) C14 U)

U) m U') I- (D

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LO

- co

i C) 0 C) CC)

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co co <> Cý

0 - <>

Lf) CC)

I- <> 'o t*ý < cq "':

0

CD CY)

Cl C) 44

+ 44 CD 4 rl-

44C; C)

44 C)

44V.: C)

4 V.: (D

CL r- .t>>

CO C') > <>

co C3) go, <>

r- " C

Lf) c w

r- <> CR CR R co

LD 44

0 U) ** 0 0

++ a. t- 4 rl-

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44 ci 0

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(: ) C, ) >> -

CD 0) >> ce)

co <> < *

co r-

t,. 0) 0 . r - 0 <> t": 00 ,: .1 1 : (D

C; 0 C)

10.0.0 It S, 0

C) 30 Q C)

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co 44 44

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CO (0 0>>

co r- >

U) ý <> 0

ýt t-

C) CIO

rl- <> "% < cq r": 6 C) 0 CD

C, C) w 10, C)

C) **

CD W it.

C) C)

4 0

44ý: 0

44 ** 4 4 V (D

C L U)

i5 U) 0 o)

Cl 0) r- >>

CC) co 00

0) T- 00

CN cr)

ci C5 I

c; ci U)

II

0 U) 0

.0 0 .0 CD ca

?: ýo ýD _r_ 0)

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(D V)

- 0

I 0 I-

wo Ml

r- 00

Table 4 shows that, by increasing bank loans, the finns have a higher retention

ratio. On average, firms with a high financial leverage retain distributable earnings 6%

higher than those with a low financial leverage. This increasing pattern of plowback

ratios is significant in the government-controlled and the entrepreneur-led firins. Table 4

also shows that a low-leveraged firin with a dispersed shareholding structure has the

highest retention ratio, 90.5%. A dispersed shareholding structure has the worst equity

govemance.

Due to the inaccuracy of the plowback ratios as an approximation of free cash

flows, I also used the ratio of capital expenditureý9 normalized by sales to examine the

magnitude of investment. I find a similar pattern of distribution to that in table 4.

4.5 Managerial Entrenchment

Board member tumovers are a measure that approximates the problem of

managerial entrenchment. Taiwan Economic Journal data set reports the names of

directors on an annual basis. Board member turnover is calculated as the number of exits

from the board over the total number of corporate directors.

49 Capital expenditure is the sum of China's GAAP items of short-term investment, long-term investment and construction in place.

88

C)

ci 0 b. N. E- t! ýý -0 5 Q "C (U

0 00 J-- 0

(L) u04. IC 0u "0

v 10

0 1. CI, o r- 0 c> en 0 -1-. , *Z S �, - e Wý to öz -0

:s 4-- V r. 0 cu 94-. r. 0 >u4,

A rA U= 0-

0- = "CJ 0

- go, g3tE,, = 22 eZ*0e

,0G; 9) -0 $ý -CJ «)

gE ci 0 ý. 0u- -ci

00 m > 0 CU 0 rA rU, -- 1) j3 w--4

U 1- :j -Z'- 0--: 9) ;a02 U) -ý0

ýo 0 4'- (n 2 4ý .0

"- ti- .2 r- -i-- e00 - -- =0- -= u ýc , 12 m0ý: -, M M "ö = "0 uU

41 J :i

= -, i Z3, r- 0, -. e ,bm S- eý>, ce 2 &) En r- 'ZJ , g--

.Q0 0 c2.2 1., cn - .

111 0= 1-, In = i-. Z '15 J. - = >, 02, 'n 00 M', 0 ý.

ö20 0 -oa -

,w 4) b, CU > ý2 '0

2 b) '-

ß. .-ZU .- Cd (U N- ýýj-- 2 1-- M>' 0) 9)

.e (A 0U cl 2-=., Z

> 0- 0 "0

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to E-- lý - 0

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1-- to 'A n :s . -

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U to 0. -0 EI 6 . 2: ö 0--u

jl, cz cýe WAo0 110 = (U

e) t2 -, -,, 0U2 No-

10 1-- 4) tu < -0

e- 9ý t) -rc ti. -

-0 ZI 0 ý. -: 00nw- g r_ A -r, e0Zb. 0M`, 00-ZZ0- CA

2 ý-b rn i-- - . -

,0u0. -. = Z= CU ý. 0 k) tun 9 14n) OU

EI2 b. >, rz &) ý3

.- c) j -. . 35 &)

-2 in 0- ýa .-0 -0 .. - :S -0 0- -5 w, 0Q JL)

60,

Q) :ß05

C, 2 ö0 "0 92 ý: E1 l>I 0 ci, 2 ýo0 rr, . 42 ý. b4 C 4) .

, ce S- 4- ý: e3 t) eE90=-e .2 ; '. '- -, 4

21 e ý. 9 -. e 4-. -C2i n . 1*DI

it (D 0 CY)

C, 4 C) cli

(0 LC)

U) LD r, - (0

n Li)

0) a) 00

U) r1- (0

LO

- ce)

c5 CY) Cl

ci (D C'4

a 0 F- (1 (» >

m LO (0

(0

(0 <>

,0 C) : (» C%4 , r-

ýý >(O -4 ce,

c5 ci

ci (1) "

(0 Ln >> V) Co > > 00 C> -0 Llý <

Lf) ý Ilý Lin OD

w CD C: )

C: ) Ci C: )

Ci CD

= (» CO > <>

M 00

> <> Le) e0 C: )

C: )

c5 CD

N>> eý

C, 4 >< :4 CI) (0 <> < <

C)

00 C)

< C) (D

CY e2 6> Mt

C> +*

ci 4d 4 -4 m a)

Ci . U) i5

" (D >>

C: )

<< rl_ LO Ill

N Co

ci ý (D LO

m c 0 (D

(D T) A)

- 1 .j

c

ON 00

Table 5 does not show that there is a significant distribution pattern when there is

a change in debt levels. However, the firms with dispersed shareholding structures have

the lowest annual turnover of board members, 45.7%. Board member turnovers increase

in the sequence: the government-controlled firms, institutional-shareholder-controlled

firms, and entrepreneur-led firms. This finding is consistent with the governance

hierarchy of ownership: private ownership, state ownership and dispersed shareholding

structure. Table 5 also shows that the firms with a low leverage and with a dispersed

shareholding structure have the lowest turnover ratio, 40.1%. The firms with a high

leverage and with the entrepreneur-led shareholding structure have the highest frequency

of board-member turnovers at 54.7%. However, in contrast to Franks et al. (2002), the

frequency of management turnovers is not significantly higher when the debt is higher in

Chinese PLCs, except for the firms under the control of an entrepreneur.

4.6 Comprehensive Proxies

The above sections examine managerial agency costs from three aspects and this

section introduces the index of managerial agency costs to present the general relation

between managerial agency costs and debt financing. The index of managerial agency

costs is generated through factor-analysis of administration costs, capital expenditures

and board-member turnovers. The procedure of factor analysis is reported in appendix 3.

The regression on these three dimensions of managerial agency costs explains about 90%

90

of the principal factor-the index of managerial agency costs. Factor analysis tests whether

my three proxies have a common underlying factor, provides a support for the goodness

of my proxies and for the empirical robustness of my conceptual framework of

managerial agency costs. In addition, it generates a parsimony index of managerial

agency costs and assists in the articulation of the relation between managerial agency

costs and debt.

Ang et al. (2000) uses the expense ratio to approximate agency costs in the firm.

This ratio is operating expense scaled by annual sales. As a measure of efficiency, it

indicates how effectively or ineffectively the managers operate the firm. Ang et al. (2000)

compare the expense ratios in firms with many shareholders and then in owner-manager

firms that theoretically have no managerial agency costs. Using American data, they find

that there is an insignificant negative relation between financial leverage and expense

ratio. From their argument, I can conclude that a firm with a high expense ratio has a

relatively high agency cost. Even without the control sample of the owner-manager firm,

the variance of expense ratios shows the variance of the magnitude of agency costs in

different firms. This efficiency ratio provides an auxiliary measure of managerial agency

costs.

Managerial agency costs damage the intrinsic value of the firm. The most often

used value measure is Tobin's Q. Following Perfect and Wiles (1994) and Chung and

Pruitt (1994), 1 use the simplified Tobin's Q, which is measured as the sum of market

value of equity plus book value of debt all over book value of total assets. This simplified

Tobin's Q is widely adopted in the literature to avoid arbitrary assumptions about

depreciation and inflation rates (e. g., Shin and Stulz, 1998). Tobin's Q is driven by

91

market valuation of the firm. 50 A firm that has excessive managerial agency costs should

be valued low. Solely based on the governance arguments, Hypothesis CF argues that

there is a positive correlation between debt and Q. However, besides the effect of

managerial agency costs, the cost of financial distress, tax shield and the market

perception of debt affect the relation between financial leverage and corporate value. In

an economy with hard budget constraints, debt makes multiple contributions to corporate

value (e. g., McConnell and Servaes, 1995). Soft budget constraints further complicate the

relation between corporate value and debt. By excluding the cost of financial distress, the

market still attempts to assess the quality of the firms by their financial leverage. Both of

my hypotheses do not clearly predict the relation between corporate value and debt in the

real world, since debt is not just an instrument of corporate governance. However, the

relation between Tobin's Q and leverage is itself an interesting empirical question and I

provide a test in following sessions, with some caveats.

Table 6 presents the distribution of the proxies of managerial agency costs on the

10% quantiles of the bank loans to total assets. Some patterns of the data distribution are

visible, but it demands rigorous econometric investigation.

50 Share prices in China are a highly controversial measure. Some journalists regard this stock market as the castle in the air. However, except for some notorious stories of share price manipulations, I find that there is a strong correlation between share price and ROA among 826 firms.

92

t') ; Z)

rjý Q

u

t: i E4

"U 9

(V) OD (9 (3) OD C) m r, - Lf) 0 cu cli cli m r, - (0 G) CY) r, - (0

(D ýt C) 00ý 0) 0 CD OD (0 E cý cý cli cý cý 0

CY 10 2 rm- 0 r

(0 CO n CO CM (0 00 CO ý- (M 0 e (0 OD ýt r, - C, 4 LO CO

. a) 00 cý 17 .

0ý cý cý r1: r1.: (C!

E C, 4 C'4

t- U') C%J ce) C) LO '

A ) LO 00 't r- m C, 4 (Y) C) MU 0 (0 (0 (0 r, - r- r- r, - r, - r_ r- E ci öö ci cs ö c5 ci ö ci

0 r_ . (D

r- (0 (n to C C: ) ci e2 cq -e ' ) (0 r- r, - OD CD CD C, 4 LO r- U

> 0 E C) C) CD 00 C) C: ) C: ) CD CD

(D r- e LD nt C) C) N ' rz ) (» (D (C) rý LO c9 (0 U

> 0 LD le le le le le

Eä 0 E ci öäöööö6 c5 ä 0

0 Zr - 13

, LD M ce (» LO C) LD M00 LC) e (A

0 . CD

M 0

C) C: ) ) (0 (N r- CD LO 1- c C, 3 cr) m Igt ei l; r ce) m xt le

m0 re 0 E CD oö6 c5 6ö

cli (0 U) NN cq r-- Co cq i <O «) C-4 t (0 C: ) co (D 0

P. r- CO 0 r1- ý r1- el C'4 -I: E ö c5 öö4 ci :ý9 CD

�; u 0 75

c: (D

.

l , 4 00 e 0 CD C) N C, 4 C r- rl_ r- CC) r- r- Co

E 0 (D C: ) öö ci ö c; c; 6

> r m ce N (1 Ne r- ý (0 r- 0 _ 00 CO (D CI, 1 C: )

, 4 ce 9 (: ý c4 cý cý C CD 0 CD CD 00000 CD

90 Z- Im- N LD r_ 0) m a) ei le 0 (D ' >

* : . ) (0 (D (0 r_ (0 r- r, - Co Co U

000 CD CD CD (D 0 Z 0 - « cu CD (D ..... :j o C) 00 CD CD (D C) ci c; ä

0 - r- (0 CD (0 ei -e Co ý» - c: ä 1: Z Cj ii H cn Co CD q, r, - N (» m , % j ce co Co NC 4c

0 1

te 0 1 0 le A, - r- (0 0 (0 ei to

.......... (D to (3i ce (0 C) e r- C, 1 m (N C, 4 C%4 m ci

e .0 C, 4 (V) e tn (0 r- CO (D - 92 "

rn 011

5. Multivariate Regressions

In this section, I present the empirical findings of multivariatc regressions. A positive

relation is found between debt levels and the magnitude of managerial agency costs in the

full sample, but not in the cntrepreneur-controllcd firms. Government ownership is a

necessary condition for bank lending to facilitate managerial agency costs, although the

government shareholder can provide some kind of corporate governance when it is in

control. This conclusion is based on the empirical findings with a number of econometric

methods. In the following sessions, I report the findings with the fixed-effect panel

regressions, GMM Arellano-Bond regressions and the instrumental variable regressions.

The GMM regressions and instrumental variable regressions theoretically help to control

for the usual caveat of endogeneity problem in empirical corporate finance literature,

although testing the hypotheses CF and SBC only requests to show the directions of

correlations between debt and managerial agency costs. 51

5.1 Administration Cost and Debt

Table 7 shows that the administration cost ratio rises when the financial leverage

increases. In the fixed-effect regressions, 1% higher financial leverage is associated with

51 This chapter attempts to establish the role of debt as a facilitator of managerial agency costs under soft budget constraints, which only needs to prove the positive correlation between managerial agency costs and debt financing. The positive correlations documented in previous tables support the soft budget constraints hypothesis and reject the application of the corporate finance hypothesis into Chinese firms. This causality problem isn't a big concern of this chapter, but I control it with the instrumental variable regressions that allow a feedback system between managerial agency costs and financial leverages. I instrument the financial leverages on the proxies of managerial agency costs lagged one year and other deten-ninants of capital structure to report the CIV regression results in the previous tables. The regression results are also examined with the Arellano-Bond GMM method, which arguably handles the endogenity problem.

94

2.4% higher of administration costs. In the GMM regressions, it increases the ratio of

administration costs by 2.2%. This effect becomes more significant when the financial

leverages are endogenized 52 in the robust instrumental variable regressions clustering on

years. 1% financial leverage increases the ratio of administration cost by 3.7%. This

increase indicates that managers in a highly leveraged finn enjoy large expense accounts.

Debt does not prevent managers from squandering corporate wealth, which contradicts

Hypothesis CF. On the contrary, bank lending increases the resources under the

managers' control and promotes a large expense account of administration. This finding

supports Hypothesis SBC.

Columns 4,5 and 6 presents the clustering robust IV regressions in the

subsamples: 1) firms under the control of the government shareholder, 2) firms that the

government has a significant shareholding stake but not stays in control, and 3) finns

under the control of an entrepreneur. The testing of our hypotheses should focus on the

comparison of column 4 with column 6. The comparison of column 5 with column 6

checks the robustness of the findings on the effect of government ownership. The

comparison of column 4 with column 5 checks whether the government controlling

shareholder has a helping hand, as argued in Chapter 1.

52 Following Booth et aL (2001), 1 use tax rates, risk, tangible, size, ROA and MBV as the determinants of financial leverages. I also test the managerial agency costs as the determinants of financial leverages, which builds a feedback system similar to the instrumental variable regressions. Because the focus of this chapter on testing the governance effect of debt, these tables on another paper about the determinants of capital structure are not reported in this chapter, although they are available upon requests.

95

Table 7. Regressions ofAdministration Cost

The table reports the regression results of administration cost ratios on debt. The dependent variable, the ratio of administration costs is measured by the administration expense normalized by total sales, adjusted by industries and years. The control variables are introduced in Appendix 3. The Hadi method is followed to remove the outliers. Column I reports the fixed effect panel regressions (FEP) with the subsample of the firms listed before 1994. Column 2 reports the Arellano-Bond GMM regressions (DPD), which controls for the endogeneity problem of financial leverages. Based on Booth et aL (2001), column 3 further instruments the financial leverages on tax rate, risk, tangible, size, ROA and MBV. If adding managerial agency cost as one more instrument of financial leverages, the results remain the same. Columns 3,4,5 and 6 then reports the robust two stage regressions with clustering by years (CIV). With the CIV methods, Column 4 examines the subsample that the government shareholder in total control of the firms, Column 5 examines the subsample that the government shareholding is larger than 10% but below 40%, and Column 6 examines the subsample that an entrepreneur is in control of the firms. The standard deviations are reported in parentheses. *** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.

(1) (2) (3) (4) (5) (6) FEP DPD Civ State- State- Entrepreneur-

Control Significant Control

Debt 2.403*** 2.156*** 3.688*** 2.722** 4.722*** -1.251 (0.226) (0.253) (1.357) (0.729) (1.035) (1.263)

Lagged Admin 0.461 *** (0.123)

Size -0.222*** -0.491 *** -0.308*** -0.207*** -0.496*** -0.324 (0.059) (0.084) (0.044) (0.044) (0.106) (0.221)

Tangible 0.904*** 0.432** 0.. 691 *** 0.103 1.384*** 0.948*** (0.200) (0.221) (0.138) (0.218) (0.368) (0.184)

Herfindhal -6.448** -4.866* -0.821 1.930 -11.156 -12.502** (3.227) (3.557) (1.295) (2.852) (6.335) (3.680)

Age 0.002** 0.003*** 0.002* 0.002 (0.001) (0.001) (0.001) (0.002)

State -0.149 -0.161 -0.080 -0.835** 0.355 0.417 (0.111) (0.152) (0.186) (0.270) (0.640) (0.593)

Constant 4.599*** 0.112*** 3.967*** 4.556*** 9.691*** 6.256 (1.238) (0.024) (0.441) (0.761) (2.051) (4.609)

Observations 1243 943 2214 942 541 85 Significance 0.000 0.000 0.000 0.000 0.000 0.000

96

Column 6 reports that there is not a significant relation between the size of bank

loans and administration costs in the firms under the control of an entrepreneur, although

the sign of debt coefficient is negative. Under the control of an entrepreneur, the relative

size of administration cost does not increase with the size of bank loans, but has an

insignificant tendency to decrease. The distribution of administration cost does not

correspond with the distribution of debt. It is sharply in contrast to columns 4 and 5,

which report a significant positive relation between debt and administration cost. The

positive signs of column 1,2 and 3 for the full sample come from the firins with a

significant government shareholder. Comparing column 4 with column 5,1 find that,

when the government is a large shareholder but has no controlling position,

administration costs increases 4.7 times with a larger size of bank loans. When the

government shareholder is in control, bank loans still facilitates administration costs, but

with a smaller magnitude. The coefficient of debt ratio is 2.7 in the subsample with a

controlling government shareholder. It suggests that with a significant but not controlling

government shareholder, the manager has a free hand to use bank loans for perks. When

there is a controlling shareholder, even which is the government, managerial exploitation

of bank loans is somehow contained. When the controlling shareholder is a private

investor, the manager cannot make use of bank loans to increase his luxuries. That is,

debt does not facilitate managerial perks in those firms that are under the control of a

commercial entity.

I use the log form of total assets in this regression, in order to approximate the

size to reduce the multi-collinearity with this ratio of administration cost to sales. I find

that large firms have a low administration ratio. This finding implies that they benefit

97

from economies of scale. Furthermore, a large firm draws the attention of the media and

faces better monitoring. The monitoring helps to reduce the managerial perks. I further

find that the firms whose assets are more specific and more tangible have a higher

administration cost ratio. These firms involve more administration staff to manage these

assets. Consistent with the governance effect of large shareholders, I find that ownership

concentration helps to reduce administration cost in the fixed-effect panel regressions and

GMM regressions. Although all the coefficients of state are negative, they are not

significant in the full sample. In the subsample of a controlling government shareholder, I

find that, with increasing the size of government shareholding, the ratio of administration

cost decreases. Chapter I argues that the government can provide monitoring efforts and

tend to provide better governance to the firms it holds a larger shareholding stake. The

finding in table 7 is consistent with this argument.

5.2 Capital Expenditure and Debt

Table 8 reports a strongly positive relation between the ratio of capital

expenditure and financial leverage. A 1% increase in financial leverage increases the

ratio of capital expenditure over total sales 2% or 3%. A positive relation between cash

retention and bank loans is also found, which is not reported here. Other things being

equal, a firm that has a higher ratio of earnings retention has a larger proportion of free

cash flow and a larger propensity towards over-investment. The findings with either the

investment ratio or the cash retention ratio show that, on the contrary to Jensen (1986)s

argument that debt shall push out free cash flows in the firms, bank loans in China

encourages the managers to retain more cash to squander and overexpand the firms with

inefficient investment projects. Hypothesis SBC is supported.

98

Table 8: Regressions of Investment Ratio

The table reports the regression results of capital expenditure ratio on debt. The investment ratio is measured by one minus the dividend ratio, adjusted by industries and years. The control variables are introduced in Appendix 3. The Hadi method is followed to remove the outliers. Column I reports the fixed effect panel regressions (FEP) with the subsample of the firms listed before 1994. Column 2 reports the Arellano-Bond GMM regressions (DPD), which controls for the endogeneity problem of financial leverages. Based on Booth et aL (2001), column 3 further instruments the financial leverages on tax rate, risk, tangible, size, ROA and MBV. If adding managerial agency cost as one more instrument of financial leverages, the results remain the same. Columns 3,4,5 and 6 then reports the robust two stage regressions with clustering by years (CIV). With the CIV methods, Column 4 examines the subsample that the government shareholder in total control of the firms, Column 5 examines the subsample that the government shareholding is larger than 10% but below 40%, and Column 6 examines the subsample that an entrepreneur is in control of the firms. The standard deviations are reported in parentheses. *** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with p- value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.

(1) (2) (3) (4) (5) (6) FEP DPD CIV State- State- Entrepreneur-

Control Significant Control

Debt 1.875** 3.377*** 2.783*** 0.957** 7.218** 5.568 (0.426) (1.062) (0.348) (0.345) (1.594) (5.353)

Lagged Invest -0.501 *** (0.135)

Size -0.093 -0.298* -0.128** -0.052 -0.426* -0.494 (0.114) (0.114) (0.037) (0.026) (0.177) (0.479)

Tangible -4.180*** -1.432*** -0.958*** -0.744*** -1.010* -0.247* (0.387) (0.421) (0.169) (0.110) (0.445) (0.189)

Herfndhal -1.800 -2.897 -3.582 -8.315 -1.420 -8.137 (6.254) (3.561) (1.317) (7.852) (10.259) (10.378)

Age 0.002* 0.003*** -0.001 0.038 (0.001) (0-001) (0-001) (0.023)

State -0.450 -0.371 -0.223*** 0.705** 0.969** 0.812 (0.219) (0.126) (0.035) (0.199) (0.322) (1.247)

Constant 3.334 3.329*** 3.208** 1.201 9.413* 10.129*** (2.416) (0.244) (0.799) (0.566) (3.758) (2.854)

Observations 1243 943 2217 939 530 85 Significance 0.000 0.000 0.000 0.000 0.000 0.000

99

Column 4 in table 8 shows that there is a highly significant positive relation

between financial leverage and investment ratios in the government-controlled companies.

The positive effect of debt on investment is much larger when the government

shareholder is not in control of the firm. It suggests that the controlling government

shareholder may discourage the firm managers to misuse bank loans and overexpend the

firms, to some extent. A manager in a firm with some government ownership but without

the control of a government shareholder may have a free hand to use debt financing to

overinvest to build a managerial empire.

However, when an entrepreneur-controlled firm has a higher ratio of bank loans,

it tends to have less free cash flows and reduce its investment scope. Jensen (1986) is

supported in this subsample of entrepreneur-controlled firms. Government ownership of

the firms not only dysfunction the governance role of debt, but turns bank loans to be a

facilitator of managerial agency costs.

I find that the tangible ratio-fixed assets to total assets-has a negative impact

on the investment ratio. The firms with a large proportion of intangible assets tend to

invest more. For instance, the IT sector requires intensive investment. I do not find a

significant impact of ownership concentration on the investment ratio. A large

shareholder does not seem to influence the management team for paying out larger

dividends. However, this finding does not necessarily invalidate the governance argument

of large shareholders, supported in table 7 and 9. In addition to the governance effect on

the management team, a large shareholder also tends to take advantage of small

shareholders. Instead of paying out the dividends to all shareholders, a large shareholder

100

may cash out with transfer pricing at the expense of small shareholders. The anecdotes on

China's stock market support this interpretation on the insignificant Herfindhal

coefficient on cash retention.

5-3 Board-member Turnover and Debt

Table 9 investigates whether debt has an impact on managerial entrenchment.

Board member turnover is the converse of managerial entrenchment. In the regressions

presented in table 9, the coefficients of debt are negative, which suggests that a firm with

a higher debt ratio may have a low frequency of board-member turnovers. However, in

the full sample, the negative coefficients in the fixed effect regressions and GMM

regressions are not significant. In the IV regressions, it is only marginally significant.

Although it cannot be concluded that debt encourages managerial entrenchment, I find

that debt financing does not provide a governance role in China, on the contrary to the

argument of Franks et al (2001).

In columns 4,5 and 6, the coefficient of debt turns to be positive in the

entrepreneur-controlled firms, although it is not significant. Due to missing points of

board-member turnovers, the sample size of entrepreneur-controlled firms is small, which

can be a reason of the insignificant results. Debt financing, however, has a negative effect

in reducing managerial entrenchment in columns 4 and 5. Under government ownership,

debt financing is correlated to an entrenched management team. This effect is not

significant when the government becomes a controlling shareholder. When the

government has the control of firms, managers may not be able to use their connections

with creditors to play around shareholders and entrench themselves in the offices.

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Actually, a larger sized state ownership increase the turnover of board-members, which

suggests that the government provides a better quality of corporate governance in the

firms it has larger cash flow rights.

I further decompose my sampled firms into going concerns and loss makers. The

coefficient of bank loans remains insignificant. 53 Therefore, there is no evidence to

support the view that debt affects managerial entrenchment, even in the finn in financial

distress where the Aghion-Bolton shift of corporate control (1992) from shareholders to

creditors is expected. Hypothesis CIF is rejected by the Chinese data, but this finding fits

the broad framework of Hypothesis SBC. In fact, there are very few cases where bankers

have succeeded in removing incumbent management teams.

Whether the firms are under the control of the government or a commercial entity

does not change the ineffectiveness of financial leverage on managerial entrenchment, as

reported in column 4 and 5. Bankers generally have no significant impact on managerial

replacement, since the Aghion-Bolton shift of corporate control seldom happens in

Chinese PLCs under the weak enforcement of the trial code of bankruptcy.

53 To be concise, I do not present the regression tables in the decomposition format.

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Table 9: Regressions of Board-member Turnover

The table reports the regression results of board-member turnover frequency on debt. The dependent variable, the ratio of board-member turnover is by the annual number of resigning directors in the board over the total number of directors. The control variables are introduced in Appendix 3. The Hadi method is followed to remove the outliers. Column I reports the fixed effect panel regressions (FEP) with the subsample of the firms listed before 1994. Column 2 reports the Arellano-Bond GMM regressions (DPD), which controls for the endogeneity problem of financial leverages. Based on Booth et aL (2001), Column 3 further instruments the financial leverages on tax rate, risk, tangible, size, and MBV. If adding managerial agency cost as one more instrument of financial leverages, the results remain the same. Columns 3,4,5 and 6 then reports the robust two stage regressions with clustering by years (CIV). With the CIV methods, Column 4 examines the subsample that the government shareholder in total control of the firms, Column 5 examines the subsample that the government shareholding is larger than 10% but below 40%, and Column 6 examines the subsample that an entrepreneur is in control of the firms. The standard deviations are reported in parentheses. *** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.

(1) (2) (3) (4) (5) (6)

FEP DPD Civ State- State- Entrepreneur- Control Significant Control

Debt -1.182 -1.251 -2.695* -2.966 -2.681* -2.144

(1.123) (1.267) (1.258) (1.983) (1.212) (1.722)

Lagged Board -0.064 (0.057)

Lagged ROA -0.299** 0.087 -0.701* 0.217 -1.225* -5.693* (0.054) (0.186) (0.392) (0.517) (0.662) (3.310)

Size 0.013 0.179** -0.101 -0.004 0.426* 0.003 (0.009) (0.077) (0.123) (0.030) (0.177) (0.124)

Tangible -0.038*** -0.034** -0.007 -0.096 -0.356 -0.311 (0.004) (0.019) (0.392) (0.131) (0.210) (0.491)

Herfindhal -0.040 0.434 1.936* -1.327 1.875 2.611 ** (0.200) (1.981) (1.072) (2.326) (4.581) (1.257)

Age -0.0004 -0.002*** -0.003** -0.002 0.012* (0.0004) (0.001) (0.001) (0.002) (0.007)

State 0.103 0.109 0.125* 0.073* 0.281 0.252 (0.057) (0.086) (0.073) (0.022) (0.423) (0.334)

Constant 0.093 0.267*** 0.255 0.245 1.106 0.526 (0.274) (0.021) (0.472) (0.593) (0.997) (2.500)

Observations 651 229 1116 506 268 35 Significance 0.000 0.000 0.000 0.001 0.047 0.098

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Column 6 in table 9, however, shows that a concentrated shareholding structure

significantly increases the frequency of board member turnovers and reduces managerial

entrenchment. The change of managers depends on the controlling shareholder. A

sufficiently large shareholding stake is necessary for the success in removing a manager.

The ratio of ownership concentration is not significant in the samples of a significant but

not controlling government shareholder and a controlling government. The size variable

is negatively associated with board member turnovers. Merger and acquisition happens in

small sized companies more frequently than in large sized companies. I further find that

firm age has a positive impact on managerial entrenchment. The reshuffling of a board of

directors is a selection process. Having selected the right people, the firms with a longer

history tend to have a more stable board of directors.

5.4 General Effects ofFinancial Leverage

Table 10 in the following pages further examines the general effect of financial

leverage on managerial agency costs, corporate efficiency and corporate value.

5.4.1 Managerial Agency costs

Panel A in table 10 finds that there is a significantly positive relation between the

indexes of managerial agency costs and debt financing. This index rises 13.7% when the

financial leverage increases by 1%. Debt financing significantly encourages managerial

agency costs.

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Table 10: Regressions of Managerial Agency costs

The table reports regression results of three comprehensive proxies of managerial agency costs on debt are reported. Panel I reports the results taking the managerial agency cost ratio as dependent variable that is loaded by the factors of administration cost, cash retention, and board-member turnover. Following Ang et A (2000), panel 2 reports the results taking the corporate efficiency ratio as a dependent variable that is measured as operating expense scaled by annual sales. The control variables are introduced in appendix 3. The Hadi method is followed to remove the outliers. Based on Booth et aL (2001), this table instruments the financial leverages on tax rate, risk, tangible, size, ROA and MBV. If adding managerial agency cost as one more instrument of financial leverages, the results remain the same. The reported results are based on the robust two stage regressions with clustering by years (CIV). With the CIV methods, colurrin I examines the full sample, column 2 examines the subsample that the government shareholder in total control of the firms, column 3 examines the subsample that the government shareholding is larger than 10% but below 40%, and column 4 examines the subsample that an entrepreneur is in control of the firms. The standard deviations are reported in parentheses. *** indicates being highly significant with p-value smaller than 0.01, ** indicates being significant with p-value smaller than 0.05 and * indicates being marginally significant with p-value smaller than 0.10.

Panel A: Factor-loaded Index of Managerial Agency Cost

(1) (2) (3) (4) Total State- State- Entrepreneur-

Control Significant Control

Debt 13.692** 3.079*** 14.003*** -6.625* (4.615) (0.249) (2.846) (2.815)

Size -0.111 -0.420 -0.307 -0.155 (0.129) (0.253) (0.219) (0.193)

Tangibfe 0.197 -1.903 1.257 0.618 (0.293) (0.992) (0.984) (0.955)

Age 0.003* 0.003** -0.009 0.004 (0.001) (0.001) (0.005) (0.019)

Herfindhal -6.975* 1.902 -8.995** (2.607) (1.719) (2.634)

State -0.637 -1.411* 0.204 0.619 (0.292) (0.582) (1.367) (0.954)

Constant 2.555 -7.291 5.860 3.281 (2.762) (5.167) (4.514) (3.827)

Observations 1573 678 370 49 Significance 0.000 0.000 0.000 0.000

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Panel B: Expense Ratio as Proxy of Managerial Agency Costs

(1) (2) (3) (4) Total State- State- Entrepreneur-

Control Significant Control

Debt 1.362** 1.532* 2.559*** -0.279 (0.297) (0.646) (0.224) (0.209)

Size -0.026* -0.053*** 0.037 -0.048* (0.012) (0.013) (0.027) (0.022)

Tangible 0.034 0.028 0.014 0.038 (0.028) (0.048) (0.051) (0.067)

Age -0.0002 -0.0002 -0.001 0.001 (0.0002) (0.0003) (0.001)) (0.002)

Herfindhal -0.0002 1.902 0.004 (0.0002) (1.719) (0.019)

State -0.067 0.033 0.116 0.054

(0.042) (0.151) (0.146) (0.073)

Constant 0.512* 1.440*** 0.530 0.987*

(0.239) (0.290) (0.600) (0.444)

Observations 2350 982 558 102 Significance 0.000 0.000 0.000 0.000

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Panel C: Corporate Value and Financial Leverage

(1) (2) (3) (4)

Total State- State- Entrepreneur- Control Significant Control

Debt -1.115** -0.972** -1.296** -0.475 (0.318) (0.292) (0.403) (0.297)

Size -0.190 -0.044 -0.240** -0.662*** (0.110) (0.078) (0.086) (0.128)

Tangible 0.030 -0.055 -0.160 -0.014 (0.124) (0.256) (0.120) (0.517)

Age -0.003** 0.003 -0.002** -0.009 (0.001) (0.002) (0.001) (0.004)

Herfindhal 3.391 ** 13.077* -2.402 (1.520) (6.122) (3.083)

State -0.081 ** 0.595*** -0.945* 0.095 (0.027) (0.122) (0.412) (0.390)

State2 1 . 091* (0.472)

Constant 4.192 0.919 5.222 13.791

(2.289) (1.624) (3.879) (10.554)

Observations 2356 984 559 102

Significance 0.000 0.000 0.000 0.000

107

The relation between managerial agency costs and debt financing is, however,

negative in the entrepreneur-controlled firms. The loans from state-owned banks reduce

the index of managerial agency costs by 6.7%, which is marginally significant.

Hypothesis CF is supported here. Private ownership allows debt financing to provide a

governance role on managerial behaviors. Consisting with hypothesis SBC, columns 4

and 5 find that debt financing turns to be a facilitator of managerial agency costs when

the firm has a significant proportion of government ownership. With increasing 1% bank

loans, the index of managerial agency costs increases 14.0% when the government holds

more than 10% and less than 40% of ownership in the firm, or 5.1% when the

government holds more than 40%. This finding is consistent with Tian (2000) that argues

government-based corporate governance is worse than governance provided by a large

private shareholder, but better than the governance vacuum with a dispersed shareholding

structure. Comparing with column 4, the firms in column 5 has a relatively dispersed

structure. When the government is a large shareholder, its voting rights crowd out the

governance from private shareholders. If the cash flow rights of the government

shareholder is not large enough and the government is not in a firmly controlling position,

the mangers may have a free hand to exploit corporate wealth. The managers can also

maneuver to dysfunction the monitoring from the government-owned banks. The

managers in government-controlled firms take advantages of bank loans at a smaller

magnitude than these in the column-5 firms.

Panel A also shows that a more established firm with a longer history tends to be

associated with higher managerial agency costs. The management team in a newly

founded firm takes less advantage of corporate wealth. This finding suggests a

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deteriorated quality of corporate governance after listing, which is driven by the fimis

under the control of the government. The concentration of ownership decreases the index

of managerial agency costs. It suggests that equity governance functions in China, even

where the budget constraints are soft. The equity governance is stronger in the firms

controlled by an entrepreneur. In the firms controlled by the government, the government

shareholder provides the governance rather than other large shareholders and the

reduction of managerial agency costs by state ownership has a significantly smaller

magnitude than the ownership concentration in the firms controlled by the entrepreneurs.

1, however, cannot find a significant relation between managerial agency costs and debt

financing. A large government shareholder without a controlling position may

dysfunction equity governance, as well as debt governance.

5.4.2 Corporate Efficiency

Ang et aL (2000) suggests that the ratio of operating expense to total assets is a

proxy for agency costs, although it is essentially an indicator of corporate inefficiency. I

find that it conforms to the argument of last section. There is a positive relation between

the expense ratio and debt ratio. If the ratio of bank loans to total assets increases by 1%,

the ratio of operating expense to total assets rises by 1.4%. When the firm is highly

leveraged, corporate efficiency is low and so vice versa. Debt cannot push the managers

to reduce costs or improve efficiency. On the contrary, the efficiency of the government-

controlled firms is even lower with a larger size of banking loans. If managers can access

the low-risk bank credit and have more free money, the firm is under less pressure to

survive and has less incentive to be efficient.

109

I found that a large-sized firm has a lower expense ratio in the full sample. A

large listed firm can be run more efficient. It also suggests that Chinese firms shall pursue

the economy of scales. However, in column 3, the sign of the coefficient of company size

becomes insignificantly positive.

5.4.3 Corporate Value

In table 10, panel 3 presents the significant negative relation between Tobin's Q

and debt ratio. The increase of leverage decreases market value of the firms. Although

there are other interpretations on this relation, my finding provides the support to

Hypothesis SBC. 54 When bank loans are large, the market perceives the problem of

managerial exploitation and devalues these firms, since large loans are associated with a

high probability of tunneling and empire building. When the firms under the controlling

shareholder as the government, corporate values decreases 1.0% with a 1% larger ratio of

bank loans to total assets. When the government has no controlling position, corporate

value decreases 1.3%. When an entrepreneur stays in control, the market does not

perceive bank loans as a negative signal.

In my set of control variables, I find that corporate value is high when the firm

has a concentrated shareholding structure, supporting Shleifer and Vishny (1986) and

Shleifer and Vishny (1997). However, I cannot find a significant relation between

corporate value and ownership concentrations in the firms under the control of

54 As suggested in Section 3, there is no clear predication of Hypothesis CF on the relation between financial leverage and corporate value. Titman and Wessels (1988) and Rajan and Zingales (1995) find that there is a negative relation between the market-to-book value and debt ratios in developed markets. Their findings may be driven by the risk of financial distress (Fama and French 1992) and by the tendency for firms to issue SEOs when P/E Tatios are high, which decreases the leverage ratios (Rajan and Zingales 1995).

110

entrepreneurs. With instrumentalizing capital structures on its determinants, column I

confirms the U-shaped relation between corporate value and the sizes of government

shareholding. It is further confinned with the negative relation when the government is

not a controlling shareholder and the positive relation when the government holds more

than 40%.

I also find that a firm with a longer history has a lower value in column 3. A

larger-sized finn has lower corporate value in the state-significant firms and

entrepreneur-controlled firms, but I cannot find a significant relation between value and

size in the govemment-controlled firms.

6. Further Discussions

This section discusses whether these two hypotheses are contradictory. I argue that banks

are not only snared by the firm managers but also trapped by the government owner.

6.1 Are Hypothesis CF and Hypothesis SBC Contradictory?

I set up the two competing hypotheses to highlight an implicit assumption of

classical finance theory that firms operate under hard budget constraints. When soft

budget constraints are the institutional reality in an emerging market economy, such as

China, debt governance fails to function. Debt then plays a facilitator role for managerial

agency costs. Under soft budget constraints, the theory of debt governance collapses.

That is, soft budget constraints are a blind spot in corporate finance theories so far. The

debt governance theory is correct in its implicit assumptions for well-established markets,

III

but it should not be applied to emerging markets. Put another way, these two hypotheses

are contradictory with their predictions, but the logic is intrinsically consistent.

6.2 Whose Fault, Firm Managers or Bankers?

Managerial agency costs of bank loans require at least two cooperative players:

firm managers and bankers. Under the principal-agent theory, effective corporate

governance is necessary to control managerial agency costs. Managers in government-

controlled firms are subject to the government-based corporate governance, which is

better than the corporate governance with dispersed shareholding structures, but the

distortion exists. The government shareholder not only pursues cash flows from the firm,

but also promotes social welfare. The private interests of bureaucrats further complicate

the role of the government shareholder. Within the government's business "empire", the

career promotion of a firm manager not only depends on corporate performance, but also

on how well the managers follow the wills of the government and bureaucrats.

On the other hand, firm managers can hold up the political concerns of the

government on social problems from shutting down a government-controlled firm and

keep borrowing from the banks to expand the resources under their control and exploit

corporate wealth for personal benefits. The magnitude of managerial agency costs

increases with the size of bank loans.

This moral hazard also exists for the bankers of govemment-owned banks. La

Porta et A (2000) argues that the banks under the control of the government are

politicized. Because of government ownership, typical Chinese bankers perceive

themselves as the financial agents of the government. The bankers follow the orders of

112

the government to providing the government-controlled firms capital rather than take care

of the profitability of their own banks. The blame for a low profitability in the banking

sector is often shifted to the policy loans that take place under the direction of the

government. Because of the ultimate backing of the government, these banks have no

fear of bankruptcy. The classical incentive problem of SOEs also exists in these

government-owned banks. Relying on the government owner, the banks are not strongly

motivated to provide due-diligence monitoring. On the contrary, such bankers may tend

to lend to a firm with a high managerial agency costs, since a corrupted firm manager

will share the private benefits with some individual bankers.

In the process to shifting capital from government-owned banks to government-

controlled firms, the firrn managers put some money into their own pockets and squander

other money for personal purposes. There are some cases that some Chinese managers

with a nominal annual salary of $4,667 bought real estate in London or lose millions in a

Las Vegas casino. This corruption problem is so extensive that the cleaning-up cost of

bad loans may reach half the Chinese GDP.

The moral blame of managerial exploitation of bank loans should be attributed to

both firm managers and bankers, but the fundamental cause is the institutional

arrangement of government ownership. When the government becomes a businessman,

its own complex interests provide the opportunity for some individuals to capture

personal benefits. Dual government ownership of banks and firms inevitably causes soft

budget constraints and the failure of debt governance.

113

Conclusion

The traditional corporate finance theory argues that debt governance is "harder" than

equity governance (Williamson 1988). Debt governance functions by threatening to sack

incumbent managers whose firms are under financial distress, forcing out free cash flows

in going concerns and encouraging due diligence monitoring activities. Using the data of

the companies on China's stock market, I find that financial leverages are associated with

decreasing Tobin's Q, increasing expense ratios and increasing administration

expenditures. There is a failure of debt governance. Furthermore, I find that firms under

the control of a government shareholder have a higher integration of debts and

managerial agency costs. The softness of budget constraints influences the magnitude of

the correlation between bank loans and managerial agency costs.

I argue that soft budget constraints fundamentally change the governance role of

debt. Under soft budget constraints, debt is a catalyst for managerial agency costs. That is,

debt gives the managers a free hand over a larger pool of capital. Over-investmcnt and

tunneling destroy shareholder value. The problem of debt governance in China is even

more profound and deep-rooted than that of pre-crisis East Asian countries. The

facilitator role of debt in managerial agency costs could one day bring down the Chinese

economic giant.

Soft budget constraints result from the widespread businesses of the government.

The dual government owne rship of the banks and enterprises inevitably results in

114

bureaucratic coordination of economic activities. 55 Due to the political benefits of social

stability, this coordination rationally obstructs bankruptcies. Firm managers can snare the

financial institutions of banks. Surveying competition and corporate governance literature

on central and eastern European economies, Estrin (2002) argues that privatization alone

is not enough, enterprise reform also requires effective corporate governance and hard

budget constraints. However, this chapter suggests that privatization is a pre-condition for

hard budget constraints. The fundamental correction of the failure of debt governance

requires the government to desist from owning and conducting business.

55 My findings concerning the governance vacuum in government-control firms, with the major creditors as the government-owned banks, provides new evidence to support the inefficiency of government ownership of banks (La Porta, Lopez-de-Silanes and Shleifer 2000). The argument of governance failure enriches their "political" theories.

115

Appendix i: Data Sample: Sources and Data Selection

There are three main electronic databases of annual reports. Internationally, the leading data vendor is the Taiwan Economic Journal (TEJ), but the TEJ database has a large number of missing values. The domestic investment bankers and securities analysts tend to use the Genius database. The Hairong database provides information on the large

shareholders' holding stakes. My data set also combines some information from other

sources. In 1994, the Company Law that formally legislates the organizational form of the

joint stock companies with the Anglo-American featured corporate governance structures

took effect. In the same year, the China Securities Regulatory Commission introduced a

series of six rules called the Contents and Forms of the Information Release by PLO,

which fortriatted the annual reports. My data sample therefore starts from 1994.

Describing corporate features and mapping of the ownership structures are based on the

most recent data of 1998.

This chapter imposed two restrictions on my sample. It excluded fund

management companies, as their operations are distinctly different from industrial

firms. 56 It also excluded the firms that do not issue shares for domestic investors; 57

otherwise, I would have had to use the share prices from the markets of foreign investors,

but such market values are not comparable. After these restrictions, the sample used to

examine the relation between state shareholding and corporate value includes 287

companies in 1994,311 in 1995,517 in 1996,719 in 1997 and 826 in 1998. Altogether,

the main data set used in this chapter has 2660 firm-year observations. The following table reports the sources of my database. The main data source is

the Genius database, but I complement it using a number of other databases. With regards

to accountancy and ownership data, the validity of the data sets is crosschecked, and

missing points were made up, based on annual reports from a website of the Shenzhen

Stock Exchange http: //www. cninfo. com. cn/.

56 Furthermore, due toregulations, fund management companies are excluded the government shareholder. 57 A-shares are the shares denominated in Chinese currency and traded on either the SSE or the SZSE. There are also so-called B-shares, H-shares and N-shares, which are mainly for foreign investors.

116

Data Sources Reliability

Share price data Datastrearn Inc. Established International Renown Data Specialist

Accountancy data Taiwan Economic Journal The leading data specialist company in before IPO Taiwan and the major Chinese data

vendor to Reuters, Datastream etc.

Accountancy data after Genius Inc. More than 80% Chinese investment IPO bankers and security analysts rely on

the data provided by this company.

State ownership Genius Inc.

Board of directors Taiwan Economic Journal

Large shareholders Beijing Hairong Inc. The major financial data specialist company in Beijing.

Industrial classification Securities Times A leading newspaper on finance and securities in China

117

AppendiX 2: Multivariate Regressions: Models, Control Variables and Methods

Here, I introduce the basic setting of my econometric model and its variations. The

definitions of variables are presented.

Model Set-up

Examining the relation between financial leverage and managerial agency costs,

the basic model to estimate is:

Managerial Agency Costs= C+a* Debt +B* FirmCharacters +6

Following the conceptual framework in Section 2, the dependent variables of

managerial agency costs are perks, entrenchment and empire building. I use factor

analysis to load the principal components and construct the variable of managerial agency

costs. The independent variable of debt is mainly reported with the ratios of total bank

loans to total capital, but other gearing ratios are also tested. Based on the available data,

I control for a range of firm-specific shocks. It includes shareholding structure,

managerial shareholding, firm size, firm age, asset specificity and profitability.

Following Berger and Ofek (1995), 1 control for the industry-specific shocks by 58

normalizing dependent variables on their medians for the same industry. I also control

for the time-specific shocks by nornializing dependent variables on the five-year medians

of the same firm, since the macro environment keeps changing with time in China.

Discussing the influence of soft budget constraints, I not only test the interaction

term of debt and budget constraints, but also examine the impact of debt on managerial

agency costs within different groups that face different budget constraints. I then compare

the regression coefficients in different groups to show the differences in the impact of

debt on managerial agency costs.

58 There are two kinds of industrial classifications for Chinese PLCs. One is the five-industry code: manufacturing, trade, utility, real estate and conglomerates. It is used by most studies on Chinese PLCs (for example, Xu and Wang 1999), but the industry effects cannot be well captured by this over-simplified industry classification (Chen and Jiang 2000). The other is a two digit standard industrial classification as 21-industry-code, which is used in this chapter. Adopting this two-digit industrial classification is a significant technical feature of this study.

118

Factor Loading Analysis ofManagerial Agency costs

This table shows our construction of the artificial managerial agency cost ratios. Based on eigenvalues, Panel I shows that the three principal components of

administration-cost ratio, board-member-turnover ratio and investment ratio demand a

main common factor as Factor 1, which is the index of managerial agency costs. Panel 2

reports the influences of these three components on the index of managerial agency costs.

Panel 1: Principal Factors of Admin. Cost, Board Turnover and Investment Ratio

Factor Eigenvalue Difference Proportion Cumulative

1 0.320 0.321 2.473 2.473 2 -0.001 0.188 -0.011 2.461 3 -0.189 -1.461 1.000

Panel 2: Factor Loading for Managerial Agency costs Variable Exploitation Uniqueness Bartlett Score

Admin Cost 0.399 0.841 1.187 Board Turnover -0.047 0.998 -1.139 nvestment Ratio 0.398 0.842 1.187

Control Variables

The factors of size, tangibility, age, ownership and profitability can induce

spurious correlations between proxies of managerial agency costs and financial leverages.

Size With regard to economic fundamentals, large-sized firms have scale

economies and better access to bank credits (Chhibber and Majumdar 1999). On the other hand, corporate size affects governance. For instance, a large-sized firin draws the

attentions of the media and therefore closer monitoring. I control for size effect in my

multivariate analysis. Tangibility The asset structure or the assets' tangibility influences firms'

growth and corporate valuation (Vilasuso and Minkler, 2001). The scales of managerial agency costs probably systematically vary with the structure of corporate assets.

119

Mortgage borrowing depends on the tangibility of assets and so asset structure influences

capital structure. A spurious correlation between managerial agency costs and financial

leverage is therefore induced by tangibility. In addition, the tangibility ratio also helps to

identify the growth potential of a company. Age A firm with a long history can establish its reputation in the debt market

and so firm age influences debt ratios. On the other hand, managerial agency costs, such

as the entrenchment problem, is expected to vary with firm age. Finn age needs to be

controlled for.

Shareholding structure Corporate governance literature (Shleifer and Vishny 1997) argues that a concentrated shareholding structure improves' corporate

governance and therefore reduces managerial agency costs. The creditors decide their lending policies and scales with reference to the shareholding structures. Herfindhal

index is a proxy of the shareholding concentration by calculating the weight of the ten largest shareholders' holding stakes.

120

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Chapter 3:

Financial Institutions, Investment Risks, and Determinants of the Chinese IPO Underpricing

123

1. Introduction

China's new stock market has grown rapidly. Starting from scratch in 1991, this market

has become the second largest stock market in Asia within about a decade. One unique

feature of this stock market is severe IPO underpricing. The average first-day returns are

267% with the median as 13 1%, which is higher than other countries around the world.

300%-fT - ___ IM

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Comparing with industrialized countries, why are the Chinese IPO underpricings

so severe? This chapter addresses this question by documenting the deterrnmants of

initial returns of the Chinese IPO shares.

China Securities Regulatory Commission (CSRC) requires to price IPO shares

with net earnings per share multiplying by a fixed multiplier. The issuers choose the

specific multiplier, but the regulator sets the cap. Although the average price/earning

ratios in the Chinese secondary market were over 30 most of the time, the multiplier was

124

set as between 15 and 20 from 1992 to 1999. It is binding for most firms. At least 100%

of underpricing comes from this regulation. Econometric investigations show that the

pricing cap contributes to 134% underpricing, although it interprets only 24% of the

variance of initial returns. Besides the pricing cap, the government also imposes the "IPO

quotas", which restrict the quantity of TO supplies and enlarge the scales of underpricing.

From 1991 to 2000, the total equity capital raised in the primary market is RMB Y656

billion and the TO shares count for 22% of total shares in the public listed firms.

Empirically, the sizes of offerings significantly decrease initial returns, which interpret

4% of the variance of initial returns. Financial regulations are a main determinant of

China's TO underpricing.

The investment risks coming from asymmetric information about the value of TO

firms can interpret the universal TO underpricing around the world. Besides it, there are

some particular investment risks of the Chinese primary market, including lockup risks,

tunneling risks and grabbing risks. Investment risks capture about a half of variance of

initial returns.

After making public offerings, the firms need wait in a queue to be floated, which

produces a long listing time lag with the average as 305 days and the median as 34 days.

During this period, IPO subscribers' investment is locked up. Illiquidity of equity

investment shall be compensated with discounts of share pricing. I find that one day's

delay of the flotation increases the initial returns by 0.4% in China, which captures 38%

of the variance of initial returns in the univariate analyses. I further find that, the length of

the lag is not exogenous, but depends on insider shareholdings and underwriting costs. It

125

suggests that there are some faint traces of rent-seeking activities in China's primary

market.

During a long lockup period, managerial agency costs can keep reducing

corporate value. Before going for trading on the stock exchanges, there are no signal from

share prices and no market for corporate control. Insider control and weak corporate

governance, however, are featured with China's unlisted firms. Stealing of corporate

assets is a big concern of IPO subscribers, who inject new capital into the firms. IPO

shares need to be discounted with tunneling risks. I find that the sizes of insider

shareholdings are a negative determinant of initial returns. With a larger sized insider

shareholding, insiders are less inclined to destroy corporate values by tunneling and IPO

underpricing becomes less severe. It shows corporate governance plays a role in the

Chinese IPO underpricing.

Being another feature of Chinese 1POs, the largest issuer is the government. In my

sample, 66% IPOs are share issue privatizations (SIPs), in which the government sells

part of ownership in State-owned enterprises (SOEs) to the public. Shleifer and Vishny

(1998) argue that the government owner has a grabbing hand, which ensnares corporate

wealth to maximize social welfare. The grabbing risks in former SOEs shall compensate

the locked-up IPO subscribers with a discount of SIP shares. However, my data shows

that there is no pricing differential between SOEs and private-owned enterprises. The

sizes of state shares do not significantly influence initial returns, either. The government

shareholder may not only have a grabbing hand but also have a helping hand, which

disguise the direct effect of issuers' ownerships on initial returns (Tian 2000). On the

supply side, this insignificant effect of issuers' ownerships suggests that SOEs go public

126

for new capital and therefore price IPO shares as high as private issuers (Dewcnter and

Malatesta 1997). This chapter suggests that, different from Biais and Perotti (2002), the

political interests of the Chinese government are pursued through financial regulations

rather than through deliberate underpricing of SlPs, which would further sacrifice the

financial interests of the government.

Financial institutions do matter (Allen 2001). This chapter concludes that the

Chinese financial institutions, including both financial regulations and investment risks,

bring about severe IPO underpricings.

This chapter makes the following contributions to the IPO literature. First, by

providing a novel analytical framework and concrete empirical evidences, this chapter

contributes to rationalizing the Chinese IPO underpricings. Second, with systematically

documenting China's primary market and econometrically examining the determinants of

initial returns, this chapter contributes to investment strategies in China's emerging stock

market, which is opening to foreign investors. Third, this chapter casts some light on

understanding the role of the Chinese government and therefore adds a political

dimension to the financial phenomenon.

This article is organized as follows: Section 2 describes China's enterprises

reform and its primary market. In section 3,1 review the IPO and SIP literatures and

present my hypotheses of investment risks and financial regulations. Section 4 examines

the determinants of initial returns with univariate and multivariate analyses. Section 5

further discusses the underlying motivation of regulatory underpricing. Section 6

concludes this chapter.

127

2. China's Primary Market

This section illustrates the features of China's stock markets and provides the institutional

backgrounds of share issue privatizations. This young stock market is a complex web of

the government's political and financial interests as well as of private benefits.

2.1 China's Emerging Stockmarket

There are two stock exchanges on the Chinese stock market, the Shanghai

Securities Exchange (SSE) and the Shenzhen Stock Exchange (SZSE), founded in

December 1990 and April 1991 respectively. The regulatory authority is the China

Securities Regulation Commission (CSRC), founded in October 1992. With the legal

origin of socialist laws, China's financial institutions featured with interventionism of the

government into market places. Under the direct administration of the Chinese central

government, China Securities Regulatory Commission (CSRQ functions as an

authorized ministry governing the stock market. Although legal enforcements are

typically weak in emerging markets, CSRC regulations are effectively implemented with

their high publicities.

The government sets two main objectives to develop this stock market: 1) to tap

domestic savings; and 2) to reform unprofitable, inefficient state-owned enterprises. 59 As

a symbol of capitalism, the stock market was one of the most controversial issues in

China. With the voting rights based on their investment, shareholders decide corporate

59 The stock market mainly serves to raise capital for enterprises and to reform the SOEs, according to the speeches of Liu Hongru, the then CSRC chairman in January 1994 and Li Peng, the then Prime Minister in September 1997. In contrast, the British government under the Thatcher administration sets the privatization goals as 1) raise new revenue for the state; 2) promote economic efficiency; 3) reduce government interference in the economy; 4) promote wider share-ownership; 5) provide the opportunity to introduce competition; and 6) develop the nation's capital market.

128

strategic matters. The rule of one-share-one-vote is the law in Chinese PLCs. It implies

that capital employs labor in these firms and in the firms modeled after PLCs in China,

but such a capital-labor relationship is taken as exploitations in the Marxist theories. The

conservative wing of the government opposed the development of a stock market, which

was initially founded as an experiment in 199 1. The then paramount political leader made

the clear pledge to close it down if this experiment turned out to be against the interests

of the people. 60 However, under the leadership of the reformists and the management of

the CSRC, the stock market has become an indispensable part of Chinese economic life

in only eleven years.

In table 1,1 report the rapid development of the Chinese stock market. Between

1992 and 2000, the market capitalization increased at the average rate of 57.5% per year.

At the end of 2000, the total market capitalization was over half of China's GDP. The

number of listed companies grew 62.0% annually, from 53 PLCs in 1992 to 1088 PLCs

in 2000. Increasing by 26 times from 1992, there were 58-million investment accounts by

2000. If one family has one investment account, there are 16.7% of households invested

in stocks. Given that most of investors live in a city, a rough estimate is that nearly a half

of urban families participated in the stock market in 2000. Still under the leadership of

Communist Party, China has been significantly transformed into a society of investors.

This expanding stock market also provides a platform for large-scale privatization. With

attracting equity investors, severe IPO underpricings contribute to the development of

China's stock market and the transition of the society.

60 In a talk during his famous tour of south China (January 22 nd , 1992), Deng Xiaoping said "whether securities and stock markets are good, whether they are dangerous, whether they only belong to capitalism, and whether they can be used in socialism are allowed to keep observing, but we should do the experiment. Trying for a couple of years, if correct, open it up; if wrong, close it down. "

129

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On the other hand, the Chinese stock market is still in the early stage of

development. 61 Firstly, there are many anecdotes of corruptions in the primary market

and insider trading in the secondary market. Rent-seeking activities are reportedly

rampant. Secondly, the government frequently intervenes in the market. For instance, a

policy commentary on the high P/E ratios of the stock market at the end of 1996 brought

down the stock index 32% in two weeks. 62 The government also uses other methods to

influence this market to achieve its policy targets, including IPO quotas documented in

this chapter. Thirdly, the market is segmented. Table 2 in the following page presents the

official classification of shares. About 60.8% shares are restricted in tradability. Only

4.9% shares are denominated in foreign currency, whereas the Chinese currency is not

freely exchangeable. On the other hand, foreign investors were only allowed to invest in

the thin B-share market till very recently. 63 It separates domestic investors from

international investors and severe 1PO underpricing happens only in the domestic stock

market.

61 Wu Jinglian, a preeminent Chinese economist, compared the Chinese stock market to a casino when be discussed some illegal activities of some traders. However, the investors continue investing in this stock market and most economists argue that the problems within the Chinese stock market are on the track to be corrected, although they are relatively more severe than these in developed economies. 62 On December I Ph, 1996, when the stock index was 1258, CSRC announced twelve measures to strictly regulate the stock market and People Daily published a commentary article. The stock market immediately crashed. On December 25h, 1996, the index was 855. 63 The qualified financial institutional investors were implemented at the end of 2002, which allows the very large investors, like Morgan Stanley, to invest in China's A-share market.

131

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More importantly, the government is not only the regulator, but also a major

investor on the stock market. Based on the method of La Porta et al. (1999), Tian (2000)

shows the ultimate shareholding structures of these PLCs. Although pyramids, cross

shareholdings, and reciprocal shareholdings are not widely used in China, the

government directly owns 28% of all the shares of China's public listed companies and

ultimately controls 44% of China's public listed companies. There are huge financial

interests of the government in the stock market.

The heavy weight of government shareholding comes from the history of China's

PLCs. Share issue privatizations are a significant feature of China's emerging markets.

Tracing down the antecedents of 771 listed companies, I find that there are 63.8% of SIN

among total IPOs. The other issuers are joint-stock companies, township-village firms

and entrepreneur-led firms.

2.2 Underwriting and Share Allocations

Company Law (1994,1999) stipulates the following conditions for a company to

apply for listing on the stock market: 1) it has share capital of at least RMB Y50 million

(US$6 million); 2) it is newly-formed under the 1994 Company Law or has a three-year

track record; 3) it has more than 1000 shareholders who each hold shares with a nominal

value of over RMB YIOOO; 4) it has offered at least 25 percent of its shares to the public

or at least 15 percent if the share capital of the company is more than RMB Y400 million

(US$46 million); 5) it has not committed any serious violations of government

regulations in the last three years. These PLCs are therefore large-sized profitable modem

firms. In fact, the rest of China's enterprises take the PLCs as role models.

133

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During the initial public offerings of these companies, the investment bankers

mostly work as brokers and lead the selling of shares to the public. The issuers often have

the responsibility for unsold shares, although the shares are usually oversubscribed.

Underwriters, in this chapter, broadly mean the sale managers of offering shares.

Table 3 reports that the top ten underwriters have 64.8% of the IPO market. Most

of them are associated with the government and are very well connected to the regulation

authority. For instance, the top three national brokers, Huaxia, Guotai and Nanfang, were

directly founded by the central bank and the managers were former high-profile

bureaucrats.

Although there are as many as 129 underwriters in this competitive market, most

of them make substantial profits. The average net profitability of investment bankers is

24.45%, whereas the PLCs' profitability was 9.03% in 2000. As discussed in the

following section, the P/E gap between the primary market and the secondary market

gives these investment bankers an easy life. In China, underwriting of equity shares is

called "the profession that makes big money even when they take naps all the day". 64

The underwriting methods consist of online offering, 65 certificate application, and

saving-deposit lottery, besides some issues that occurred before formulating the

underwriting procedures. Panel B in table 4 reports these allocation methods. The

tradable-A shares for the public to purchase are normally oversubscribed and all the three

64 Quoted from China Securities Daily (December 27h, 2001). 65 With utilizing the trading system of the SSE or the SZSE, the main underwriter works as the sole seller of the offered shares of one company and the investors apply to purchase at the offer price during the offer period. The main underwriter organizes the lottery of the application for initial offered shares and the winners of the lottery become the shareholders at the offer price. This method of online offering has been frequently used during the recent years.

135

methods use some lottery systems to allocate them to the applicants. In the lottery

mechanism, the probability of receiving hugely underpriced IPO shares depends on the

amount of applicant capital. A large investor has a better opportunity to be allocated with

some TO shares.

2-3 Pricing Methods and IPO quotas

As an emerging market and a transition economy, China is featured with the

frequent changes of regulations. Before founding the stock exchanges, there was no

regulation on pricing of shares issued to the public. There were 90 PLCs issued shares in

1980s' and face values of shares were often taken as issuing prices. Since 1991, it was

stipulated that issuing shares have to be authorized by the government regulator and the

allocation method of IPO shares shall use the lottery method. The disclosure requirements

of IPO firms were specified in 1994.

The CSRC ruled out of the auctioning method, including book building, since it

puts the offering prices out of the control of the regulator. The pricing method was

stipulated as the multiplier method until 1999. The offering price is required to be the

product of net earnings per shares and a chosen multiplier. 66 An issuer sets a ratio as the

offering multiplier with references to the price-earning ratios of similar firms on the stock

market. However, the offer price, particularly the multiplier, has to be validated by the

CSRC. In several internal guidelines issued during different periods, the CSRC sets the

ceiling of the multiplier as 15 to 20 times earnings, which is the pricing cap of IPO shares.

66 In most periods, the CSRC requests the firms to use predicated corporate earnings after authorized by charted accounts. However, from end of 1996 to September 1997, the CSRC requires the IPO firms to use predicated earnings as a main determinant of IPO prices.

136

As following chart, there is a gap between the average P/E ratio in the secondary

market and the IPO pricing multipliers. Since the P/E ratios in the secondary market are

usually more than 30, the government regulator intentionally brings about severe

underpricing with the multiplier cap.

P/E Comparison

90.00

80.00 70.00

60.00

jjj 50.00

40.00

30.00 t

20.00 - 10.00

0.00 1993

0 IPO Pricing Multiplier 0 Secondary Market P/E

Before 2000, the CSRC also exercised a strict quota control of public offerings

and flotation. 67 The CSRC only allows a certain amount of new shares to be public

offered and be floated on the stock exchanges and rations the quotas to each of the 29

central government ministries that oversee various industries, and the 32 provinces,

municipalities, and autonomous regions. In essence, it is a licensing mechanism that

promotes rent-seeking activities. The enterprises desiring for going public have to devote

67 The system of quota control and restricted applying has been replaced by the model of recommending by the local government or tile ministries and examining and authorizing by the CSRC in 200 1.

137

1994 1995 1996 1997 1998 1999 2000

resources to competing for the quota. After being allowed to make initial offerings, the

firms still need apply for a date to be floated onto the stock exchanges. Because of the

urgent need of capital, many firms make public offerings and collect IPO proceeds before

knowing a date of flotation. There is consequently a time gap between going public and

going for listing. With a median of 34 days, this listing time lag can range from three

days to 12 years.

Controlling the pricing, stipulating the IPO quotas and assigning a waiting period

for flotation in a strong seller's market, the CSRC creates severe IPO underpricing in a

China. This chapter devotes to understanding the determinants of IPO underpricing

before 1999.

At the end of 1998, the Security Law was stipulated, which allows that the issuers

and underwriters decide the prices of IPOs, but it shall be still authorized by the

regulator. 68 The pricing cap is then gradually phrased out. The Guotaian database reports

the initial returns of the firms listed till end of 2000. The average initial returns of the

firms listed in 2000 are 151%. As the average initial returns of the firms listed before

2000 are 284%, it can be taken that the regulation of pricing caps brings about 133% IPO

underpricing. The effect of pricing caps on initial returns is econometrically investigated

in section 4.

68 In March 2001, the CSRC abolishes the IPO quota and pricing of 1POs depends on the demand and supply in the market. There are some firms still having high initial return. Baodao Gufen (600130) uses the P/E multiplier as 49.71 and achieved the first-day returns as 119.06%, but Chengming B (2488) seasoned A-shares with the P/E multiplier as 30 and only has the first-day return as 6.97%. Book building begins to be popular in China.

138

3. Determinants of the Chinese IPO Underpricing

This section reviews the literature of initial public offerings and share issue privatizations

and proposes the hypotheses of financial regulations and investment risks to interpret

severe Chinese underpricing.

3.1 Analytical Framework

There are some papers documenting the extraordinarily high underpricing of

Chinese IPOs. A comprehensive survey is provided in table 4.

Using different data sets from different data sources, these papers report that the

average initial returns range from 142% to 949%, the median range from 119% to 24 1 %.

All of them find the fact of severe IPO underpricing in China. With some problematic

econometric methodology, 69 they make the attempt to investigate the determinants of

underpricings, including listing time lags, offering sizes, non-tradable shares, offering

proceeds etc. Some papers further make the attempts to rationalize the Chinese

underpricing with the classical theories of asymmetric information. In contrast, some of

them argue that China's institutional features bring about this extraordinary underpricing,

particularly the long listing time lags. The rationale of Chinese IPO extraordinary

underpricing has not been concluded or articulated yet. New research is needed.

69 Comparing the means and medians in these papers, the distribution of all the used samples in existing research is highly skewed. I use the Shapiro-Wilk W test to confirm the non-bell-shape distribution of initial returns in China, but the regression methods of the existing papers on China's TO underpricing adopted the regressions-mainly OLS-with the assumption of normality.

139

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The scarcity of capital is a common feature of emerging markets. Although going

public is costly, many firms compete for IPO quotas. Because of the restriction of capital

flows, if not being an entrepreneur, China's domestic institutions and households can

either deposit their money in banks or invest in shares. Given the bad-loan problem of

China's banks (Tian 2001) and the low interests of deposits, there is a high demand for

equity investments. IPO shares in China are rather like a good, which is different from

industrialized countries. The analysis of demands and supplies fits the Chinese situation.

My analytical framework of IPO pricing is formulated as the following chart.

P

pa 1

pa ...............

Pf pf-I PIE

'' .... 11 ........... T), t4r-onc, ran Al

Offering Shares Investor Subscription

QL QC QF.

D.. -

The demand curve of the investors is BE and the supply curve of the issuers is OD.

In a competitive primary market, the equilibrium of demand and supply, point E, prices

the IPO shares at PEwith issuing QE amount of shares. The demands of investors are

actually depressed at this stage, which is because of the asymmetric information about the

intrinsic values of the IPO firms. The process of public offerings disseminates

information. After knowing better the quality of IPO firms, the demand of shares

increases and the demand curve shifts from BE to GH on the first day of trading. Since

141

the quantity of IPO shares cannot be changed immediately, there is a temporary rigidity

of supplies. The supply curve is OEF. On the first day of public trading, the share price

therefore increases from PE to PF. This IPO investment risk is rather universal, which

may also induce Chinese underpricing. 70

The Chinese regulator uses IPO quotas to restrict the amount of issuing shares and

the supply curve of IPOs consequently becomes the line OTG. The market equilibrium

shifts from E to B. Furthermore, the government regulator stipulates a pricing gap as the

line ACD, which requires that the pricing of issuing shares must be below P.. Because

of the high demand for equity investments, most of issuing shares shall be priced at Pm.

The partial equilibrium of the primary market is consequently becomes A. Investors

purchase QL amount of issuing shares at price P.. Financial regulations of pricing caps

and IPO quotas consequently induce a shortage of issuing shares as AC. On the first

trading day in the secondary market, the regulatory pricing cap is demolished; whereas,

the immediate supply of issuing shares remains the same. Because of the supply shortage

AC, the prices of IPO shares shift from Pm to PB and the market reaches the new

equilibrium at point B. The gap of AB is the regulatory underpricing. I hypothesize that

financial regulations bring about Chinese underpricing.

Similar to the rationale for the change from PE to P., the share prices further

shift from PB to PGwhen the repressions of demand by IPO investment risks are relieved.

I further hypothesize that investment risks are another main determinant of China's IPO

underpricings.

70 The so-called investment risks are to capture the depressed demands. To some extent, the investment risks may include the risks originally generated from Chinese particular financial regulations.

142

3.2 Investment Risks

IPO underpricing is a universal phenomenon. There is 18% of money left on the

table in Anglo-American primary markets during the last two decades (Loughran, Ritter

and Rydqvist 1994, updated in 2001). The theory of asymmetric information is so far the

most recognized interpretation of underpricing rationales. It argues that the investors are

afraid of the winners'curse (Rock 1986) or a negative information cascade (Welch 1992).

IPO subscribers' worries mean that there are investment risks of primary market. The

IPO-specific investment risks depress the demand of investors, which is relieved after

flotation. It provides a theoretical foundation of the shift of demand curves from BE to

GH in the above chart.

This shift of EPO demand curves and the consequent change of equilibrium prices

also exists in the Chinese primary market. Furthermore, it shall be larger in China than

the Anglo-American economy; not only because the information is more asymmetric in

an emerging market, but also because there are some Chinese-specific investment risks.

High IPO investment risks are compensated with high returns on the first-day trading.

The following sections specify the Chinese IPO investment risks. My sub-hypotheses of

investment risks may not cover all of the risks in Chinese primary markets, but it can

provide a good test of the demand shift from BE to GH in the above chart.

3.2.1 Infonnational Risk

Beatty and Rock (1986) argue that the expected underpricing is an increasing

function of uncertainty. IPO underpricing of a better-known firm is lower. A larger-sized

143

firm is better known than a smaller-sized firm. A firm with a longer history is better

known than one with a shorter history.

Following the universal theory of asymmetric information, some IPO investment

risks can be examined by:

Hypothesis 1.1: Initial returns of IPOs are a negative function of corporate size;

Hypothesis 1.2: Initial returns of IPOs are a negative function of corporate history.

3.2.2 Lockup Risk

There is normally no liquidity in primary markets and the subscribers have to hold

the shares till flotation. Different from Anglo-American markets, the listing time lag in

China is unusually long. The average listing time lag is 305 days with a median as 34

days. For instance, the Chengdu Hoist Ltd issued shares to the public at RMB YI in

January 1990, but was floated on the Shenzhen Stock Exchange in March 1998. During

more than eight years, there is no liquidity for TO subscribers of the Chengdu Hoist Ltd.

In another extreme case, a firm even needs wait for twelve years to go for public trading.

The long listing time lag means the problem of illiquidity, which is the lockup risk.

Similar to informational risks, this Chinese specific investment risk depresses demands in

the primary market. If the lockup risk of a firm is higher, investors shall require a higher

compensation by discounting its IPO shares further.

Hypothesis 1.3: Initial returns of IPOs are a positive function of listing time lags.

3.2.3 Tunneling Risk

If the shares of a firm are listed on the stock exchanges, the change of share prices

may promote the board of directors or the market for corporate control to discipline bad

144

managers. However, during the lockup period, the IPO subscribers cannot sell out the

shares. Share prices cannot change and there is no signal to prevent from some moral

hazards that destroy the value of the firm. With the long listing time lag in China, weak

corporate governance is more costly to investors in primary market than these in

secondary market. Johnson et aL (2000) terms expropriations of corporate assets by

insiders as tunneling. The investment risks of weak corporate governance during a long

lockup period are called as tunneling risks in this chapter.

Moral hazards of corporate insiders may happen by cheap-selling of IPO shares,

which tunnels corporate wealth at the expense of the owners. Shleifer and Vishny (1986)

and Kaplan and Minton (1994) argue that a firm with a larger block shareholder has

better governance. Large shareholding blocks improve corporate governance as large

shareholders exert great influence and remove managers who do not maximize

stockholders' wealth. As discussed in section 2, share blocks in China are non-tradable

shares, including the legal-person shares and state shares.

Hypothesis 1.4: Initial returns of IPOs are a negative function of the size of non-

tradable shares.

Jensen and Meckling (1976) argue that managerial ownership aligns the interests

of managers with the owners. McConnell and Servaes (1990) show that, up to a certain

point, corporate value increases with insider ownership. By the Chinese share

classifications, employee ownership is insider ownership, which provides the incentives

for managers and employees to protect corporate wealth. When a firm has high employee

ownership, insiders shall be reluctant to underprice the firms in the primary market.

Hypothesis 1.5: The size of insider ownership is a determinant of initial returns.

145

Another stream of IPO theories argues that underwriters may take advantage of

their superior knowledge of market conditions to intentionally underprice offerings.

Taranto (2001) shows IPO underpricing maximizes underwriters' profits. With

underpricing, the underwriters create excess demand and make the offering an "event" to

induce buyers (Shiller 1990). Underpricing therefore saves the marketing effort of

underwriters and also ingratiates underwriters with buy-side clients (Baron and

Holmstrom 1980 and Baron 1982). When they allocate shares to their favored clients,

underwriters profit from collateral business (Fulghieri and Spiegel 1993). Underwriters

further profit from underpricing when they act as post-IPO market makers (Ellis et aL

2000). Underwriters have incentives to tunnel corporate assets by underpricing at the

expense of the issuers. With a higher payment on underwriting fees, the issuers may

persuade the underwriters to refrain from internationally underpricing IPO shares.

Underwriting fees can reduce the tunneling risks of underwriters.

On the other hand, the underwriting costs are directly deducted from corporate

values. The demand of IPO shares can be depressed when there is no knowledge about

the specific underwriting costs. It is relieved after reporting the actual underwriting costs

after finishing IPOs. When the underwriting costs are high, the after-listing returns shall

be lower.

Hypothesis 1.6: Underwriting costs are a determinant of initial returns.

3.2.4 Grabbing Risk

Shleifer and Vishny (1998) argue that the government has a grabbing hand. As

Chinese laws have protected property rights, the firms with government ownership are

more likely to be ensnared by the government than private enterprises. Ensnaring

146

corporate assets is a process rather than a sudden act. A long lockup period brings about

this grabbing risk in the primary market. After listing on the stock market, the publicity

of corporate matters is largely improved and the government shareholder is relatively less

inclined to take advantage of corporate wealth at the expense of other shareholders.

Furthermore, investors in the secondary market have the option to exit before the value of

the firms decreases too much. Investors in the secondary market are less worried about

the grabbing hand than these in the primary market. Therefore, grabbing risks depress the

demand of shares during IPOs.

The literature of share issue privatizations argues that IPO underpricing of State-

owned enterprises is different from private enterprises. Assuming that the government

pursues privatization revenues, Perotti (1995) argues that the investors still remain

uncertain about the commitment of the govemment towards privatization. The

govemment may renationalize the SIP firms or grab corporate wealth for social welfares.

It implies that share issue privatizations have this particular grabbing risk.

Schmidt (2000) and Biais and Perotti (2002) show that, to ensure political power,

a market-oriented government should underprice IPO shares of SOEs in fixed-price

offers and then ration the shares to median-class voters. This Machiavellian strategic

underpricing builds up political supports for the reformist government. Jones et aL (1999)

show privatized firms are often dramatically underpriced. Corporate wealth is taken for

the political usage through IPO underpricings.

Share issue privatizations may lead to severe underpricing. The above arguments

differentiate share issue privatizations that the government is the owner of the issuers

147

from other initial public offerings where a non-government shareholder is an owner. If

there are grabbing risks in the primary market, ownership of the issuers matters.

Hypothesis 1.7: Ownership types of the issuers are a determinant of underpricing.

3.3 Financial Regulations

In the American Finance Association 2001 presidential speech, Allen (2001)

argues that finance theories have to take proper account of the role of financial

institutions. Regulatory framework is centered of financial institutions. These Chinese

IPOs are not issued in a competitive market, but arranged by an administrative plan. The

above analytical chart shows that the financial regulations of the fixed-pricing method

and IPO quotas bring about extraordinary IPO underpricing in China.

3.3.1 Earning Multiplier

The Chinese IPOs is priced under the eaming-multiplier method and the

multipliers are normally capped between 15 and 20 in different periods. The price cap in

competitive industries is set to promote the interests of the Chinese government, although

the pricing-cap literature argues it helps to improve corporate efficiency in privatized

monopoly industries (Beesley and Littlechild 1989). The CSRC stipulates the multiplier

caps with its internal guidelines. In most cases, the final choice of a specific earning

multiplier is apparently the bargaining result between the issuer and the regulator.

However, due to the scarcity of capitals in China, the firms wishing to go public to raise

capital are too many for the newly emerged stock market to take. The regulator has to

work as a doorkeeper of IPOs. In order to be allowed to make public offerings, an issuer

has to follow the regulator's opinion. The regulator has the dominant bargaining position.

148

The IPO pricing cap is literally mandatory. I suggest that earning multipliers play a role

in IPO underpricing.

Hypothesis 2.1: IPO multiplier is a determinant of initial returns.

3.3.2 IPO Quotas

The Chinese regulation authority not only restricts the prices of the IPO shares,

but also controls the supplies amount. Consulting with other ministries of the central

government, CSRC sets a periodic plan how many shares shall be allowed to be publicly

issued and rations this plan to local governmental authorities. The total supply of IPO

shares is periodically fixed and the issuing amount of each firm is controlled by CSRC.

As shown in the above, if the issuing size of a finn is larger than another firm, the line of

GT moves towards the right and the immediate after-listing price should be lower.

Hypothesis 2.2: Initial returns are a negative function of issuing sizes.

3.3.3 Oversubscription Rate

Under the offering quotas, the investors in the primary market are not ensured to

get the shares they subscribe. The underwriters allocate the shares by lotteries with

various specific methods. The lottery success rate of IPO applications reflects the

interaction of controlled supplies and depressed demands in the primary market. I use the

inverse of lottery rate as the rate of oversubscriptions.

Hypothesis 2.3: Oversubscription rates of IPO applications are a determinant of

initial returns.

149

4. Data, Empirical Methods, and Tests

This section describes my data samples, discusses the testing of hypotheses, and reports

the empirical findings. The measures of variables and econometric methods are presented

in the related tables.

4.1 Data Sources

This chapter combines the IPO, accounting and ownership data from the

databases of Guotaian, the Taiwan Economic Journal (TEJ), the Genius, the Hairong and

the SDC. These data are based on the company reports, audited by charted accountants.

The Thomas Financial International provides the share price data. My IPO sample

consists of 1124 firms going public from 1991 to 2000. Based on the IPO prospectuses

from 1990 to 1996,1 further collected data on the ownership types of issuers by hand.

4.2 Empirical Methods

Table 5 presents the descriptive statistics of hypothesized determinants of initial

returns. The spectrum of initial returns is grouped to six groups. The overpriced IPOs

with negative initial returns and the superstar IPOs with initial returns over 1000% are the

two ends of the spectrum. I then equally divide the rest of the firms into four groups by

the 25% percentiles of initial returns between 0% and 1000%.

Row I reports the means and medians of initial returns in its own category. The

average initial returns of 1124 firms are 267% with the median as 13 1 %. The Kurtosis of

initial returns is 26.7 and skewness 4.3. The Kernel density of initial returns is graphed as

bellow, which is not a bell-shaped distribution. The Shapiro-Wilk test strongly rejects the

normality of initial retuns. This data sample is highly skewed.

ISO

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One shall not estimate a highly skewed data sample with the ordinary least square

regressions, but, as in table 4, most of the Chinese IPOs papers have not taken much care

of the data structure. I'his chapter handles the highly skewed IPO data sample with the

bootstrap methods for both the means and medians. The Tobit method is also used when

regressing with earning multipliers, given that the data is naturally censored with the

pricing cap.

I report the univariate regression coefficients in table 5 and the multivariate in

table 9.

151

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4.3 Univariate Analysis

Although row 3 in table 5 does not show an obvious distribution pattern of

corporate assets on the spectrum of initial returns, the coefficient of logarithm of

corporate assets is highly significant in column 8. A firm with a larger corporate size has

lower initial returns. It is consistent with the argument that a large-sized firm is better

known to the public and better information reduces underpricing. Hypothesis 1.1 is

supported.

A firm with a longer corporate history shall also be relatively better known and

therefore it should be less underpriced. However, row 4 shows an elder firm tends to have

higher underpricing. Hypothesis 1.2 is not supported. Row 3 and row 4 seem to have

contradictory results.

The listing time lag is incredibly long. On the average, a firm going public has to

wait for 10 months before listing. As for the median, a firm also needs wait for more than

a month. In the overpriced category, there are 74% of the firms issuing shares before

1994 when the regulations were not well established. In the regressions, one day delay of

listing increases initial returns by 0.4%. The R-squared is 38% in the mean regressions

and 34% in the median regressions. Being locked up in IPO investments, IPO subscribers

require a discount of IPO shares. Hypothesis 1.3 of lockup risks is supported. Given the

significance of the lockup risk, a further analysis is given in section 4.5.

The listing time lag may help to interpret why the univariate relation between

initial returns and corporate ages is positive. The correlation between the listing lags and

corporate ages is 48.3%, which is significant at 99% level. Hypothesis 1.2 shall be further

tested with the multivariate regressions that control the listing time lags.

154

Row 6 shows that the firms with large block shareholdings are less underpriced.

During a long lockup period, IPO subscribers are reasonably concerned on managerial

exploitation and a price discount of tunneling risks is demanded. By theory, the risk

decreases with an increased size of block shareholdings. Consequently, initial returns

become lower. Hypothesis 1.4 is supported. As a long listing time lag is a condition for

the existence of the particular governance risk in primary markets, the test of hypothesis

1.4 also needs control for the lockup durations.

There is not a distribution pattern of managerial shareholding or a significant

relation between initial returns and the sizes of managerial shareholdings. Row 7,

however, shows how marginal the sizes of managerial shareholdings are. On the average,

the Chinese managers only hold 0.5% of total shares. The median is as small as 0.1%.

Managerial shareholdings have to be reported to the public every half a year and it is

locked-up during the whole tenure of the managers. It possibly cannot send the after-

listing market a clear signal on the alignment of managerial interests and corporate

interests on the first-day trading.

I, however, find a decreasing distribution pattern of insider shareholdings on

initial returns. Insider shareholdings are approximated by employee shares. The average

size of employee shares is as high as 12% of total shares. These shares are distributed to

managers, employees and friends of the firm at the offering price. Except for managerial

shareholdings, employee shares are freely tradable after the authorization of CSRC. This

authorization may take half a year to be made after flotation. Given the size of employee

shares, outsiders shall perceive it as the alignment of insider interests with corporate

interests. The insiders with their own shareholdings have smaller incentives to tunnel

155

corporate assets and destroy corporate values. When the size of insider shareholdings

rises, the discount of tunneling risks becomes smaller and the IPO underpricing is lower.

Different from row 7, hypothesis 1.6 is supported by row 8.

Hypothesis 1.7 suggests that underwriters can take advantage of the firms during

public offerings. Issuers may pay a high fee to buy off the underwriters, but the

underwriting costs depress the demand of IPO shares. After floating, the risk of

underwriters' ensnaring is relieved. Since the final costs of underwriting are deducted out

of corporate values, the upward shift of the demand curve is at a smaller magnitude when

underwriting costs are larger. Row 9 provides the supporting evidence of this hypothesis.

For unclear reasons, the data of underwriting costs is missing in all the firms with initial

returns above 1000% in the Genius IPO database; whereas, the Guotaian database has

even more missing values of underwriting costs.

The possibility of political intervention is called as the grabbing risk. However,

the sizes of government shareholdings do not provide a good proxy of this risk. As

argued in Tian (2000), the government shareholder has double faces. With large-sized

government shareholding, the grabbing risk increases till a maximum point, but the

tunneling risk decreases with a better corporate monitoring than the dispersed

shareholding structure. The government may even provide some preferential treatments

to its closely held firms to increase corporate value, like tax rebates. Besides the grabbing

hand, the government also has a helping hand. Row 10 confirms that there is not a

monotonic relation between initial returns and the size of government shareholding. The

univariate analysis of grabbing risks will be further discussed in the following section.

156

In a short summary, my hypothesis of investment risks is generally supported in

the univariate analyses.

Row 11 shows a clearly decreasing distribution pattern of issuing sizes on initial

returns. Issuing sizes measure the supplies of IPO shares, which are a determinant of

initial returns. With increasing the issuing size, underpricing becomes smaller. The

superstar firms that achieves above 1000% have the average issuing size of RMB 24

million, much smaller than other firms. Hypothesis 2.1 is strongly supported.

Row 12 shows that the eaming multiplier is a positive determinant of initial

returns. Earning multipliers are chosen by the issuing firms, but they have to be set below

the pricing caps, which follow the internal periodic guidelines of CSRC. If there were no

pricing caps, the initial returns of an IPO on the secondary market shall have been

relatively lower with a higher multiplier decided by the high demands. Under the pricing

caps, I find that the earning multiplier is a positive determinant of initial returns. When

the multiplier gets close to the pricing cap, the decision-makers of this issuer shows the

care of corporate wealth and a good bargaining capability with the regulator. Ile market

may take it a positive signal of the quality of corporate management. Hidden behind the

earning multipliers, pricing caps influence initial returns. Hypothesis 2.2 is supported.

Table 5 also investigatges the interaction of controlled supplies and demands.

Row 13 shows that the after-listing market valuation increases with an increased

oversubscription rate. Supporting hypothesis 2.3, it confirms that initial returns are a

result of the interaction of demands and supplies in the primary market. My analytical

framework of China's IPO underpricings is empirically grounded.

157

4.4 Types of Issuers

Except for the grabbing risk, table 5 presents a clear picture of the hypothesized

determinants of IPO underpricing in China. To investigate the grabbing risk, I use

ownership types to classify the issuers into State-Owned Enterprises (SOEs), Collective-

Owned Enterprises (COEs), Joint-Stock Companies (JSCs), Township-Village

Enterprises (TVEs) and Entrepreneur-Owned Enterprises (EOEs). SOEs are fully owned

by the government and directly controlled by the government. Public offerings of the

SOEs are share issue privatizations. COEs are the firms owned by a local community.

Although the government has a big influence on most of local communities, the

government does not own COEs. The influence of politicians on COEs is significantly

less than SOEs. JSCs are the firms having more than one owner. Both the SOEs and

COEs can be one of the owners of a JSC. The politicians can also influence JSCs, but the

probability and the magnitude of political intervention in JSCs are much less than in

SOEs. As both the COEs and JSCs have more than one owner, I group them together and

name them as institution-owned enterprises (IOEs). TVEs should be the enterprises

owned by a village or a small town, but many private enterprises are disguised as TVEs.

More importantly, the TVEs are often under the control of a "strong man" and they are

operated as a family-owned enterprise. EOEs are typically private owned enterprises. I

therefore group the TVEs and COEs together and call them private-owned enterprises

(POEs).

Table 6 presents the distributions of key variables of different types of issuers. In

my sample, 63.8% of listing firms were state-owned enterprises, 31.4% institutions-

owned enterprises, and 4.8% private-owned enterprises.

158

The average first-day returns of the SOE issuers are 255%, IOEs 264%, and POEs

327%, although the medians are much smaller. The significance of the mean difference is

examined with the Johnson corrected T test. This test shows the initial returns of SOEs

and IOEs are significantly less than the size of POEs. The Mann-Whitney U test on the

medians confirms that the POEs have a significantly higher first-day return. It is

consistent with the empirical findings in firms from Canada, Japan and Malaysia

(Dewenter and Malatesta 1997). It seems to support the argument that IPO subscribers

are worried about the grabbing hand of the government, but the hypothesis of grabbing

risks need further investigations with control variables.

There is no significant difference among the offering multipliers due to the large

variance. The SOE issuers are not priced significantly higher than the IOEs or POEs. The

issuing proceeds are also homogenously distributed among these three types of issuers.

The government-owned enterprises pursue the issuing proceeds as much as the private

owned enterprises. It implies that the significant differences of initial returns between

SOEs and POEs may result from some missing variables.

159

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4.5 Listing Time Lags

Before reporting the multivariate analysis of determinants of initial returns, this

section further examines the lockup risk. As discussed in section 4.3, the listing time lag

is a main factor of IPO underpricing, counting for 50% variance in the univariate analysis.

Interestingly, similar to China, there is also a long listing time lag in Malaysia, where EPO

underpricing is 104%.

4.5.1 Endogeneity and Gamesmanship

In China, the length of the listing time lag is not a choice of issuing firms, but a

decision of the government regulator. The issuers have no idea when the flotation can

happen after going public, but it remains a question whether they can influence on

decision-makings of the regulator.

Because the holders of employee shares are not allowed to trade their shares

immediately after listing, these insiders cannot gain from high initial returns. The insiders,

however, can benefit from reduced lockup risks if the shares are listed earlier. After

listing, the insider shares can then be traded in half a year and it soon provides liquidity.

The advertisement effect and the probability of season equity offerings also add value to

the firm. Insiders therefore prefer to shorten the listing time lag. Can they manage the

listing time lag?

161

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4.5.2 Descriptive Statistics

To better present my data, I separate my sample into four groups of firms. Finns

are floated onto the stock exchange for public trading 1) in less than one trading month, 2)

between one month and half a trading year, 3) between half a year and one year, and 4)

more than a year. I use actual trading days to measure the months and years.

Panel I in table 7 reconfirms the results reported in row 5 of table 5. There is no

significant difference between the initial returns when the gap is less than half a year.

Initial returns increase with the length of the listing time lag after half a year. Most of

Chinese PLCs publish semi-annual company reports, which are not required by charted

accountants.

Row 3 shows that there is a larger variance of listing time lags for private-owned

firms to get listed. Of these, 36% begin to be publicly traded on the stock exchange

within one month, but 32% of them need to wait for more than one year. The percentages

of POEs in both the left tail and the right tail of the distribution are higher than SOEs and

COEs. There is perhaps a game between the CSRC and the private-owned firms. Some

POEs may lobby skillfully for a timely flotation and they succeed in gaining favors from

some officials in the regulation authority. Some POEs, however, are not good at lobbying

and the CSRC puts them to the end of the flotation waiting list. In contrast, the

distribution of the number of SOEs by time to flotation is concentrated in the range up to

less than half a year and it is higher than the percentage of institutions-owned enterprises

in that range. Ile evidences of the favoritism by the CSRC are not strong in this

statistical investigation, though.

163

Panel 3 in table 8 investigates the distribution of insider shares in the categories of

listing time lags. The insider shares are standardized on the total shares. On the average,

insider shares count for 6.5% of total shares with a lag of less than a month, 4.2% in these

of half a year and 2% in these of one year. There seems to be a declining pattern of listing

time lags on the size of insider shares, in which there is a shorter lag when there are a

larger proportion of insider shares.

With severe IPO underpricings, the shareholders of insider shares normally make

handsome gains, although they have to wait longer to trade the shares and pocket the

money. Considering the controlled supplies, the listing lag cannot bring about such a

sharply decreasing pattern for insider shares. In addition, the insiders have no idea about

the length of the listing time lag when they subscribe the IPO shares. It is the sizes of

insider shareholdings that cause the change of listing time lags.

Allocating insider shares to influential bureaucrats is bribery, but the firm

managers can legally pay a middleman to handle the flotation process. The middleman is

normally the broker. The fee paid to the broker is recorded as underwriting costs. Row 7

further examines whether underwriting costs have some pattern in relation to the length

of listing lag. 71 Tle general pattern is that, with increasing underwriting costs per share,

the firms get listed earlier. It seems to be a buyoff of the listing time lags.

71 The average underwriting cost per share for the firms to be floated in more than one year is RMB V0.06 per share and the median is RMB V0.00, since some firms did not use a broker to make the public offerings and they issue the shares themselves. The cost is recorded as part of the administration cost. It is consistent with an administration cost per share as high as 0.74 in this category.

164

4.5.3 Regression Analysis

The variable of listing time lags is transformed with the logarithm in table 8.1

then examine the effects of issuers' types, insider ownership, lobbying costs as well as

the market cycles on the listing time lags.

4.5.3.1 Ownership Types

When I regress upon the listing lag only with the dummies of POE and IOE, the

coefficients are insignificant. In fact, column I is not a valid econometric model, since

the F-statistic is not significant.

Column 2 shows that, when controlling for insider shares, the coefficients of POE

and IOE are significantly positive. That is, if all the firms have the same proportion of

insider shares, an SOE issuer has a shorter time gap between the offering date and the

flotation date. There is a sequence of listing time lags: POEs the longest, IOEs the second

longest, and SOEs the shortest. The proportion of insider shares in SOEs is significantly

less than in POEs and IOEs, which interprets the indifferent finding without controlling

the insider-shares effect.

165

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Column 3 presents the effect of insider ownership without the influence of

issuers' types. The significantly negative coefficient of insider shares suggests that

insider shares clearly play a role in reducing the listing time lags. With a larger

proportion of shareholdings, the insiders are better motivated to push through the

flotation process.

No data is available on the allocation of insider shares, but some insider shares are

illegally allocated to some bureaucrats and they help to reduce the listing time lag. Some

sense of the whole can be gained from individual cases. For instance, Daqing Lianyi

Petroleum arranged 941,500 shares at the offer price to 17 top local officials and to 44

deputy local officials in the city of Daqing. The shares of Daqing Lianyi were

underpriced by 15 1%. Mr Na Fengqi, the head of the tax bureau of Daqing, gained profits

of RMB Y740,000 after selling out the offering shares. The flotation waiting time Daqing

Lianyi was less than 3 weeks, among the shortest 10% time gaps to float on the stock

exchange.

For another example, the firm Kangsal Group issued shares to the public without

employee shares in February 1990. The firm did not push through the flotation till the

employee shares were issued in 1996. Wu Wenying, a former state advisory counselor

and Xu Penghan, a former vice minister helped the firm Kangsai Group to get the quota

from CSRC to go public in the same year, since the Kangsai Group specially arranged

the sale of the employee shares to their relatives at the offer price, to which they were not

entitled. The wife of Xu Penghan bought 40,000 shares at the offer price of RMB VI and

received 43,600 shares for free. She profited by RMB Y796,000 when the Kangsai Group

repurchased these shares at the price of RMB YlO. The son of Wu Wenying bought

167

100,000 shares at the offer price and profited RMB =Y890,000 when the employee shares

became tradable. The IPO shares of Kangsai were underpriced by 905%. This extreme

case is taken as an outlier in my regressions, but it shows a widespread problem about

insider shares.

The above two cases of IPO bribes became known only after the investigation of

the prosecutors, which show the tip of the iceberg. Some social elites, including some

firm managers, some investment bankers, and some governmental officials, profit from

buying the insider shares at the offer price and selling out after the lockup period. The

listing time lags are influenced by a special interest group, including employees of the

firm, privileged business associates and targeted influential bureaucrats.

4.5.3.3 Underwriting Costs

Column 5 looks at the isolated effect of underwriting costs on the length of lockup

periods. I find that by increasing one unit of payment to the broker, the waiting time is

reduced by nearly 7 days. The underwriting cost accounts for 33% of listing time lags. If

excluding the historical cases, where the issuers issued shares themselves instead of

going through a brokerage house, the sign of the underwriting cost remains significantly

negative.

All else equal, the underwriting costs approximate the lobbying costs.

Underwriting costs are a kind of "ransom" to shorten the long lockup period, which is set

by the regulator. Since the Chinese underwriters are well connected to the regulator, the

underwriting fees provide incentives for the underwriters lobby some CSRC officials and

get the firms listed earlier. When the issuers pay higher underwriting fees, the

underwriters are better motivated to lobby and the listing time lag therefore becomes

shorter.

168

The underwriting cost is the other dimension that blurs the effect of issuers' types.

When I control for the underwriting cost per share in column 4, the coefficients of POE

and IOE become significant. The coefficient of POE is 0.94 and IOE 0.18, significant at

the 5% level. It means that, if the underwriting costs were the same and the SOE issuers

needed one week to be floated onto the stock exchange, private-owned firms had to wait

in the queue for 1.94 weeks and institutions-owned finns waited for 1.18 weeks.

The government-owned enterprises are not priced lower than other enterprises,

but they are listed earlier than other enterprises, ceteris paribus. It possibly comes from

the preferential treatments for the government regulator towards the firms owned by the

government. This favoritism of the CSRC is consistent with Tian's argument (2000) on

the helping hand of a large government shareholder, which offsets the grabbing risks in

SIPS.

However, when the private owned enterprises pay a higher underwriting fee for

intensive lobbying, the favoritism of the CSRC disappears. The median of underwriting

fees paid by the POEs is 0.23 per share; IOEs 0.15 and SOEs 0.14. This pecking order is

significant in terms of the Student T statistics for the means and the ranksum, statistics for

the medians.

Column 6 pools the effects of insider shares and lobbying costs together and my

arguments hold. Table 8 and table 9 therefore show that both the benefits for some

individuals and lobbying efforts help to get listing earlier. There is some gamesmanship

in managing listing time lags.

4.5.3.4 Market Cycles

169

The above two sections show that private benefits are a determinant of listing

time lags. I further examine whether the CSRC uses the lockup as a lever to develop the

stock market.

Table I shows the market cycle in China. In the Shanghai Stock Exchange, the

P/E ratio was 23.5 in 1994,15.7 in 1995, and over 30 from 1996 to 1998. The market was

bearish in 1994 and 1995. The stock index has a similar pattern of ups and downs. If the

government regulator is devoted to financial market development, the stability of the

stock market is a goal to pursue. One shall see that regulators float firrns with a long time

gap during the bear market and the firms with a short time gap during the hot market.

Column 7 investigates whether there is a market-cycle effect. I find that the firms

floated in 1995 have a significantly longer listing time lag. Because a long lag boosts the

initial returns, this arrangement helps to advance the stock index and attract investors. In

the hot markets of 1997 and 1998, the firms floated have a significantly shorter time gap.

It helps to cool down the market. Choosing by different time gaps, the timing to float a

firm on the stock exchange can also be a policy tool to achieve its political goals.

4.6 Determinants ofInitial Retums

The above section suggests that the variable of listing time lags has to be

instrumented in the multivariate regressions of initial returns. With this instrumental

variable, table 9 pools the hypothesized variables to investigate the determinants of initial

retums.

Some dependent variables of initial returns in table 9 are adjusted by market

indexes and industries. Ile SSE composite index is used to adjust the initial returns of

170

the firms listed on the Shanghai Stock Exchange and the SZSE composite index used for

the firms listed on the Shenzhen Stock Exchange. The industrial code is the 21-industry

classification by the Securities Times. Numerically, table 9 is not necessarily

straightforwardly correspondent to table 5.

The regression method used in the multivariate analyses is mainly the

instrumental variable robust regression with bootstrapped standard errors. The first stage

regression is to control the endogeneity of listing time lag, which has similar results to

table 8, and it is not reported here to save the space. I use the pricing cap as the constant.

As for the IPO eaming multipliers, the Tobit method is used.

Column I reports the significance of pricing caps. The dependent variable is

unadjusted initial returns in order to report the magnitude of the pricing-cap effect. I find

that the pricing caps raise initial returns by 134.7%. Section 2.3 reports that, after

deregulation of the pricing cap, the average initial returns decrease by 133.5%. Iberefore,

the pricing cap roughly brings about 134% of IPO underpricing. As the average

underpricing from 1992 to 2000 is 267%, the regulation of pricing cap counts for a half

of severe Chinese underpricing.

171

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Besides the pricing cap, column 2 examines the effects of issuing sizes, IPO

multipliers, and oversubscription rates. The findings in rows 11,12, and 13 of table 5 are

confirmed here. Issuing sizes, which are the supplies of IPO shares, are a negative

determinant of initial returns. Under the pricing cap, the price gap of PB Pm reduces

when the supply curve shifts rightward. The choice of an IPO multiplier also sends a

positive signal to the market on the quality of the firm management. Oversubscription

rates positively influence on adjusted initial returns. Similar results are found in columns

7,8,9,10. In summary, the multivariate regressions support that financial regulations are

a main cause of IPO underpricings in China.

Column 3 shows that corporate size is a negative determinant of initial returns,

but corporate age is positive. Similar to the contradictory findings in rows 3 and 4 of

table 5, the hypothesis of informational risks is supported only by the test of corporate

sizes, but rejected by the test of corporate ages. However, I find that corporate age is

48.3% correlated to the listing time lag, which is significant at 99% level in the pairwise

correlation test. When including the variable of listing time lag, the whole regression

becomes insignificant in column 4. Column 5 further includes the institutional setting of

the pricing cap. Interestingly, the coefficient of corporate age becomes negative. That is,

under the settings of a long lockup period and the pricing cap, corporate age is a negative

determinant of initial returns. An elder firin is better known and the market requires a less

discount of informational risks. Column 6 supports the theory of asymmetric information.

However, the coefficient of corporate age becomes insignificant in column 10. It should

be admitted that the test of corporate age is therefore less robust, but there are no strong

evidences to reject the hypothesis 1.1, either. One reasonable conjecture is that most of

175

Chinese public listed companies are newly founded or restructured and the variance of

corporate ages is small. Therefore, the magnitude of informational asymmetry may not be

well approximated by corporate age. Given that corporate asset is a significant negative

determinant of initial returns, I have some evidences that the risk of informational

asymmetry on corporate quality plays a role in deciding initial returns. Only interpreting

0.5% variance of initial returns, informational risks shall not be a big concern of the

Chinese IPO subscribers in a strong sellers' market.

Column 7 reports the effect of the instrumented listing time lag. 'Me firms with

longer lockup periods have higher initial returns. The hypothesis of lockup risk is

supported.

Column 8 examines tunneling risks with controlling for financial regulations and

lockup periods. The negative coefficient of block shareholdings is weakly significant.

That is, a larger sized shareholding block is associated with a lower initial returns and a

lower discount of tunneling risk. It, however, becomes insignificant in column 10.

Consistent with the univariate analysis, there is no significant effect of managerial

shareholding on IPO underpricing. The coefficient of insider shareholding is significantly

negative. A further alignment of insider interests with corporate interests decreases the

discount of tunneling risk and reduces IPO underpricing. As for the tunneling of

underwriters, the coefficient of underwriting costs is not significant coefficient, although

it remains negative. The effect of lobbying intensities does not seem to hold here. It may

come from the correlation to the listing time lag, which has captured underwriting costs

in its instruments. In summary, insider shareholdings provides the evidence of tunneling

risk in column 8.

176

Controlling for financial regulations and lockup periods, column 9 examines the

grabbing risk. The dummy variable of private issuers is 1 when the issuer is private-

owned; otherwise, it is 0. Institutional issuer is I when the issuer is owned by a non-

government institution. Columns 9 and 10 show that there is no significant relation

between the issuers' types and adjusted initial returns in the multivariate regressions. The

coefficient of the size of state shareholding is not significant, either. As. discussed, the

government shareholder has double faces and the grabbing risk cannot be projected by a

monotonic analysis. The types of issuers' ownership are not a direct determinant of initial

returns.

5. Further Discussion

Table 9 finds that there is no significant difference in pricing state-owned

enterprises (SOEs), institution-owned enterprises (IOEs) and private-owned enterprises

(POEs). Comparing with the non-government issuers, the government issuers have the

same motivation to pursue the offering proceeds (Perotti 1995). SOEs are therefore

priced about the same as POEs. It is consistent with the Chinese policy goal that the stock

market should serve to provide new capital to the former state-owned enterprises.

However, the indifference of pricing between SOEs and commercial enterprises

do not stop from severe TO underpricing, on the whole. The above empirical analyses

clearly show that the Chinese government uses IPO quotas, pricing caps, and listing time

lags to increase TO underpricing. Why does the government push towards severe

underpricing with financial regulations? Schmidt (2000), and Biais and Perotti (2001)

argue that, to ensure the political power, a market-oriented government should underprice

177

shares in fixed-price offers and then ration the shares to median-class voters. The Chinese

stock market was set up as an experiment in a communist regime and the reform-minded

leaders need gain political supports and reach a social consensus for the stock market

ruled by capital and for gradual privatizations. It makes sense for the goverru-nent to

pursue its political interests at the expense of its financial interests, which are maximized

under the regulatory framework. In fact, with severe IPO underpricing, China's stock

market develops so fast to become the Asian second largest stock market in less than a

decade. It attracts millions of investors in a short time. The community of shareholders is

widespread and very quickly reaches down to the grassroots. It helps China to transform

from a labor-led society to an investor-centered one. Even privatization gradually

becomes viable and popular in this country, which is controlled by the same communist

government. Regulatory underpricing can be a political maneuver.

With severe IPO underpricing under the regulatory framework, the Chinese

government pursues its political interests. Free riding on the government, some social

elites pocket personal gains in IPO underpricings. There are some gamesmanship and

rent-seeking activities associated with regulatory underpricing, although my dataset

prevents me from carrying on a detailed study of private benefits in China's primary

market. The complex web of political and financial interests of the government and

private benefits of some elites in power shall be the fundamental motivation to produce

267% IPO underpricing from 1991 to 1999 in China.

178

6. Conclusion

This chapter documents severe IPO underpricing in China and rationalizes it with

studying its determinants. The first-day return of 1124 new issues from 1991 to 2000 is

267% on the average and 133% for the median. Providing an original analytical

framework, this chapter proposes the institutional hypotheses of financial regulations and

investment risks.

The government regulator stipulates IPO quotas and pricing caps. The IPO quota

restricts the supplies of IPO shares. The pricing caps bring about a demand gap and it

boosts the buying of shares in the first-day of public trading. Empirically, these

regulations count for more than a half of severe underpricing in China.

Similar to Anglo-American markets, asymmetric information on the quality of the

firm causes IPO underpricing, but it is far from being a major determinant of initial

returns in China. Besides the effects of Chinese financial regulations, I find that the

Chinese-specific investment risks also largely contribute to severe underpricing. After

going public, the IPO firms have to wait in a long queue to go for flotation. This

illiquidity induces lockup risks. During the long lockup period, IPO subscribers are

concerned on tunneling risks and require a discount of IPO shares. The personal interests

of corporate insiders, underwriters and regulators, can influence the length of the lockup

period. During the long lockup period, I find that the IPO investors also require a

discount of tunneling risks. Due to the double faces of the government shareholder, there

is no concrete evidence of grabbing risks in the primary market.

Why are the Chinese IPO underpricings so substantial? It comes from the Chinese

financial regulations and the Chinese investment risks. Behind the veil of regulatory

179

underpricing, one shall see the complex web of the govemment's political and financial

interests and private benefits.

180

Conclusion

"The whole duty ofgoverntnent is to prevent crinze and to preserve contracts. " - Lord Melbourne (English statesman, prime minister, 1779-1848)

Discussing the issues of ownership and control, capital structures and initial public

offerings in China's stock market, this thesis documents the profound role of the

government in corporate governance and financial development and contributes to

corporate finance and political economy literature. The empirical findings and

theoretical arguments of this thesis have some policy implications for developing

corporate China as well as for other new and emerging economies.

Review

In Chapter 1,1 document the ultimate shareholding structure of the firms

traded on China's stock market and find that government shareholding is notably

large. I further examine the relation between the size of government shareholding and

corporate value. The total effect of government ownership on corporate performance

is negative, but it is non-monotonic. When the government is a small shareholder,

corporate value decreases as the size of government shareholding stake increases.

When the government is a large shareholder, corporate value increases with a larger

size of government shareholding. Interpreting this U-shaped finding, I develop the

two-hand view of the government. To comply with its political interests, the

government has a grabbing hand to seize corporate wealth. The influence of this

grabbing hand depends on the voting rights of the government shareholder. When the

181

cash flow rights of the government are sufficiently large, the government gives the

firm a helping hand via preferential treatments and some efforts of equity governance.

In Chapter 2,1 document the capital structures of China's public listed

companies and examine the role of debt in corporate governance by setting up a

conceptual framework of managerial exploitation. I find that managerial perks and

free cash flows are larger in finns with a higher financial leverage, but bank loans

have no significant influence on the problem of managerial entrenchment. Corporate

efficiency and value decrease as financial leverage increases. I also find that the

relation between financial leverage and managerial exploitation varies into the

ownership type of the firms. When the government is a large shareholder, bank loans

significantly promote managerial exploitation. When a commercial entity is a large

shareholder, debt does not reduce managerial exploitation, but the facilitator role of

debt is not evident. I argue that the failure of debt governance results from the

institutional setting of China: the govem-ment owns both large banks and firms.

In Chapter 3,1 show that the pursuits of government's political and financial

interests and social elites' private benefits can coexist. This chapter documents severe

underpricing and the extensive share issue privatizations in China's primary market.

The Chinese institutions, including financial regulations and specific investment risks,

rationalize the severe Chinese IPO undcrpricing. The severe underpricing is

regulatory underpricing and forced by the govenunent regulator, which is conjectured

as being motivated by the political interests of the reformist government to develop

the capitalist stock market and transform the society. However, the government also

pursues its financial interests to maximize the offering revenues under its own

regulatory framework, which is supported with the finding that share issue

privatizations are priced at the same level as privately owned enterprises. Meanwhile,

lobbying costs and insider shares affect the length of listing time lags. It may suggest

182

that some bureaucrats play the time game of flotation to pocket personal gains, but

this flotation time game is not at the immediate expense of the government.

Summary

Examining the issues of ownership and control, capital structures, and initial

public offerings, this thesis illustrates the picture that an intelligent government

maximizes its financial and political interests and some sophisticated social elites

exploit the business interests of the government for private benefits in an emerging

market, where the government calls the shots due to a weak legal infrastructure.

The Chinese government is intelligent. Using both a grabbing hand and a

helping hand to influence the firms, the government attempts to maximize its utility

function that consists both of financial interest and of political interest. This argument

is supported by the evidence of the U-shaped relationship between the size of

government shareholding and corporate value and the evidence of the authoritarian

underpricing in the primary market. Meanwhile, sophisticated individuals take

advantage of the government. Some bureaucrats not only work for the interests of the

government, but also attempt to pocket personal gains by setting the rents. Managerial

exploitation is perhaps more noticeable than the flotation time game played by some

bureaucrats. In the widespread business empire of the government, some firm

managers capture the government-owned banks and debt governance becomes a

failure. In summary, the government can be helpful on corporate governance and

financial development even with extensive rent-seeking activities of some social elites,

but the businesses of the government damage market competition and cause the

failure of debt governance.

183

Contributions

This thesis covers a wide range of literature and makes some original

contributions. The U-shaped finding and two-hand view of the government enriches

the government ownership literature (e. g., Shleifer and Vishny 1998) and these new

evidences from China are also related to the Chinese puzzle in the transition

economics literature (e. g., Blanchard and Shleifer 2000). The finding of debt

governance's failure integrates the soft budget constraints literature into corporate

finance literature (e. g., Jensen and Meckling 1976, and Harris and Raviv 1991). The

investigation of severe underpricing in the primary market and the argument of

private benefits develop the share issue privatization literature (e. g., Perotti 1995,

Biais and Perotti 2002) as well as the initial public offerings literature (e. g., Ritter and

Welch 2002). 1 believe some of the future research on emerging-market corporate

finance will follow the line of understanding the role of the government.

This thesis is also an extensive exercise in state-of-art econometric methods.

The robust OLS regressions, maximum log-likelihood panel regressions, Arellano-

Bond GMM regressions, bootstrap regressions and instrumental variable regressions

are reported in three chapters.

Policy Suggestions

By investigating corporate finance issues in China, the empirical findings and

theoretical arguments of this thesis can generate some general policy implications,

although it is well beyond the academic studies of this thesis. With its widespread

184

business activities, the government has been making a significant contribution to the

grand Chinese refonn starting in 1978, but the final success of the transition toward a

mature market economy requires the government to retreat from owning or doing

businesses.

The government is the driving force of China's grand reform. With its firms

and banks, the government gradually wipes out the legacy of the planned economic

system, builds up the institutions of market competition, and maintains the stability of

the society in this massive transformation. An active government in business is

helpful during the transition period in cultivating institutions, such as the stock market.

However, it comes with a cost, in a long term view. Taking advantage of the

government's magisterial power, the sophisticated social elites inevitably pursue

private benefits in the extensive business empire of the government, which destroys

corporate value and social welfare, distorts the mechanisms of market competition,

and can eventually bring down the emerging Chinese economy in a manner

resembling what happened in other Asian emerging economies in 1997.

When the institutions of market competition are installed, the Chinese

government has to fundamentally change its role to let the market function properly.

The government's two hands should be tied up to prevent misuse by corrupt elites,

which can be achieved through privatizing the government's business. This thesis

shall guide to a general policy suggestion that the government should finally retreat

from corporate sectors and cease to play a major role in business, which is essential as

for the success of the Chinese grand transition towards a market economy.

185

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