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An Empirical Study on Corporate Governance and Market Valuation in China

An Empirical Study on Corporate Governance and Market Valuation in China

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DOI 10.1007/s11459-005-0011-0RESEARCH ARTICLE
BAI Chong-En, LIU Qiao, LU Joe, SONG Frank M., ZHANG Junxi
 An Empirical Study on Corporate Governanceand Market Valuation in China
Higher Education Press and Springer-Verlag 2006
This paper empirically studies the relationship between the governance mech-anisms and the market valuation of publicly listed firms in China. The authors construct measures for corporate governance mechanisms and measures of market valuation for all publicly listed firms on the two stock markets in China by using data from the firm
s annualreports. They then investigate how the market-valuation variables are affected by thecorporate governance variables while controlling for a number of factors commonlyconsidered in market valuation analysis. A corporate governance index is also constructed tosummarize the information contained in the corporate governance variables. The index isfound to have statistically and economically significant effects on market valuation. Theanalysis indicates that investors pay a significant premium for well-governed firms in China, benefiting firms that improve their governance mechanisms.
corporate governance mechanisms, market valuation, corporate governanceindex, corporate governance premium
JEL Classification
G34, G32
Translated from
Economic Research Journal 
, 2005, 2 (in Chinese)BAI Chong-En (
)School of Economics and Management, Tsinghua University, Beijing 100084, PRCand Faculty of Business and Economics, The University of Hong Kong, Hong Kong, China E-mail: baichn@em.tsinghua.edu.cn
LIU Qiao, LU Joe, SONG Frank M., ZHANG JunxiFaculty of Business and Economics, The University of Hong Kong, Hong Kong, ChinaFront. Econ. China (2006) 1: 83
The Asian financial crisis has rekindled worldwide interest on the issue of corporategovernance. In recent years, pushing for higher governance standard has become a regular campaign, with the participation of an increasing number of parties: academics, media,regulatory authorities, corporations, institutional investors, international organizations,shareholder rights watchdogs, etc.
 Numerous initiatives have also been proposed by Asiancountries to enhance their corporate governance practice, e.g., new listing/disclosure rules,mandatory training for board directors, enforced codes of governance, etc. Internationalorganizations are also very keen on governance issues. The International Monetary Fund hasdemanded that governance improvements should be included in its debt relief program. In1998, the Organization of Economic Cooperation and Development (OECD) issued itsinfluential
OECD Principles of Corporate Governance
, which is intended to assist member and nonmember countries in their efforts to evaluate and improve the legal, institutional, andregulatory framework for better corporate governance. In addition, private companies, suchas Standard & Poor, California Public Employees
Retirement Pension System (Calpers),CLSA, and McKinsey, are also calling for sweeping reforms of governance practice inemerging economies [1]. Corporate governance has also gained unparalleled importance inChina. The Chinese government opened stock exchanges in the early 1990s to raise capitaland improve operating performance for state-owned enterprises (SOEs). In less than12 years, China
s stock markets have grown into the eighth largest in the world, with market capitalization of over US$500 billion. Chinese companies, especially SOEs, have benefitedtremendously from the rapid growth in issuance and the general public
s enthusiasm onequity market. Meanwhile, the regulations over stock markets have been evolving to addressthe tradeoff between growth and control: a liberal approach that will lead to fast growth vs acontrolled approach that will lead to slower growth. Although issuance approval, pricing, and placement systems have been significantly liberalized, they are still tightly controlledcompared with that of other Asian markets. As controlled as it is, poor governance practicesare still rampant among companies listed in China. For example, several listed companieshave been placed on the spotlight due to their poor governance practices. In 2001, the largest shareholder of Meierya, a one-time profitable listed company, colluded with other related parties and collectively embezzled US$44.6 million, 41% of the listed company
s totalequity. In the same year, Sanjiu Pharma
s largest shareholder extracted US$301.9 million,96% of the listed company
s total equity.
While Chinese companies, especially the SOEs, acquire a huge amount of capital from the public through either the banking system or the capital market, they remain extremelyinefficient. For example, recent official statistics suggest that about one third of all SOEs areloss makers, another third either break even or are plagued with implicit losses, while theremaining onethird are marginally profitable. Ineffectivegovernance system hasbeen widely
A recent research by McKinsey finds that articles featuring corporate governance in major internationaleconomics/finance newspapers or magazines, such as
Financial Times
Asian Wall Street Journal 
Far-East  Economic Review
, etc, have increased 10-fold from precrisis 1996
1997 to 2001
2001 (see [1]). In academics,the rebirth has spawned a voluminous body of research on governance-related issues, especially in emergingmarkets.
Liu and Lu [2] finds that majority of Chinese listed companies manage their earnings as a response to avariety of regulatory loopholes. However, the incentives are stronger for firms with poorer governance practice.84
Front. Econ. China (2006) 1: 83
 believed as the root cause of the lackluster performance of China
s corporate. Improvingcorporate governance is one of the most important tasks of China
s further reform.To improve corporate governance, the government obviously has an important role to play. It should strengthen laws that protect shareholder interests and beef up the enforcement of such laws and regulations. It is also important for the firms to take action on voluntary basis. The question, however, is: Do the firms have incentives to do so? This depends on theanswer to the next question: Does a firm
s corporate governance practice have a positiveeffect on its market value? If the answer is yes, then firms will have incentives to improvetheir governance, because by doing so, they increase their market value and reduce their future cost of investment. This paper attempts to answer this question empirically.The answer to the question is not obvious. For a firm
s corporate governance practice tohave a positive effect on its market value, two conditions need to be satisfied. The first is that good governance should increase the returns to the shareholders of the firm and the second isthat the stock market should be sufficiently efficient that the share prices reflect thefundamental values. These conditions are most likely to be valid in mature markets, but it is by no means clear whether they are also valid in emerging markets. In fact, many people believe that share prices on China
s stock markets are purely driven by speculative activitiesand bear no relationship to the fundamentals of the firms.Practitioners seem to believe that good governance does increase the firm
s market valuation. Recently, McKinsey has conducted a series of surveys on institutional investorsand private equities with investment focus on emerging markets and found that 80% of themare willing to pay a premium to well-governed firms.
Several other studies have alsodocumented a positive correlation between performance measures and the governance level.
In this paper, we plan to conduct a systematic study of this issue for publicly listed firms inChina; we perform an econometric analysis of the effects of corporate governance practiceson the market valuation of these firms based on data from their annual reports (as opposed tosurvey data) about their actual corporate governance practices. We will investigate how thefirm
s Tobin
values and their market-to-book ratios are determined by the their corporategovernance practices while controlling for a number of variables that are typically used in thestudies of market valuations of firms. In our analysis, we will pay particular attention to animportant characteristic of China
s firms, namely, the dominance of state-owned shares.To help policy makers and investors evaluate the relative quality of the governance of thelisted firms, we also develop a corporate governance index, called the G index, for China
sstock markets. Such an index should summarize the information contained in the variablesmeasuring various governance mechanisms adopted by the firms in the most efficient way.For this purpose, we conduct a principal component analysis (PCA) of the corporategovernance variables and define the corporate governance index as the first principalcomponent of these variables. We find that this index affects the market valuation of the firmsin both statistically and economically significant ways. In evaluating the economicsignificance of the effect of the corporate governance index on market valuation, we find that investors in China pay significant premium to well-governed firms.There is a large body of literature studying issues related to corporate governance inChina. For example, Qian [4] is one of the first to offer a comprehensive discussion of corporate governance issues in China. Groves et al. [5] and Li [6] present evidence that 
McKinsey Surveys on International Institutional Investors and Private Equities, 1999, 2000, 2001 and 2002.
For example, see
Saints and Sinners: Who
 s Got Religion?
Front. Econ. China (2006) 1: 83

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