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Corporate governance and tunneling: Empirical evidence from China☆
Lei Gao a,1 , Gerhard Kling b,⁎
a

Nanjing University of Information Science & Technology, School of Finance, Nanjing Pukou 114, 210044, PR China b Bristol Business School, University of the West of England, Coldharbour Lane, Bristol BS16 1QY, UK Received 3 January 2006; accepted 28 September 2007

Abstract We analyze asset appropriation by principal shareholders in China and uncover the following relationships: (1) outsiders in the board of directors, audit without non-clean opinion, and dispersed ownership prevent operational tunneling; (2) belonging to a business group and issuing B or H share exacerbate asset appropriation. Institutional ownership does not prevent the embezzlement of assets and is endogenous, as investors select companies with good governance. Besides governance mechanisms, stock characteristics matter in that larger firms exhibit less tunneling, whereas highly leveraged firms experience the opposite. We find a decline of tunneling in 2001, which might be due to economic reforms. © 2007 Elsevier B.V. All rights reserved.
JEL classification: G34; G38 Keywords: Corporate governance; China; Operational tunneling

1. Introduction In China, a series of scandals related to the embezzlement of assets by principal shareholders have been brought to light recently. From the incident of ‘Qiongminyuan’ in 1997 to the scandal of the ‘Sanjiu Group’ in 2005, plenty of anecdotal evidence demonstrates the extent with which resources of companies have been abused by principal shareholders. This serious corporate governance problem
☆ This paper was financially supported by the Key Project of the National Natural Science Foundation of China (Project Number: 70532001, Chef Scientist: Weian Li) and the Project of the National Social Science Fund of China (Project Number: 07CJY001). ⁎ Corresponding author. Tel.: +44 11732 83418. E-mail addresses: drgaolei@126.com (L. Gao), gerhard.kling@uwe.ac.uk (G. Kling). 1 Tel.: +86 754 2902383; fax: +86 754 2903442.

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could hinder economic development (see Li et al., 2004), which raises the question: how to prevent tunneling and protect the interests of small investors? To improve corporate governance, we need to identify which corporate governance mechanisms fail and hence facilitate asset appropriation in China. Chinese scholars have already conducted valuable research on the extent of operational tunneling (see Li et al., 2004; Tang et al., 2004). Yet, the interrelation of corporate governance mechanisms and operational tunneling has not been studied. Besides corporate governance measures, we incorporate firm characteristics (e.g. size, financial leverage, industry specific effects) and account for regional development (e.g. coastal area, regional GDP growth). Our study refers to a panel data set of all listed companies on the Shanghai and Shenzhen Stock Exchange from 1998 to 2002. Based on panel OLS fixed-effects estimation and more elaborate techniques, namely censored-normal regressions, ordered logit, and quantile regressions, we can assess the impact of governance, ownership structures, firm characteristics, industry effects, and macroeconomic variables on the extent of tunneling. Moreover, we address the inherent endogeneity issue, for corporate governance measures might affect firm behavior (e.g. tunneling)—but asset appropriation in turn influences governance structures. The concept of Granger causality and panel vector autoregressions uncover the underlying causal relationships clearly. In recent years, the exploitation of minority shareholders by large shareholders has attracted scholars' widespread attention. Shleifer and Vishny (1986) detected that when large stockholders control firms, the main problem is no longer the conflict of interests between management and shareholders, but preventing principal shareholders from exploiting minority shareholders. Johnson et al. (2000b) coined the term ‘tunneling’ to describe asset appropriation by large shareholders, which legally or illegally transfer assets and profits to themselves. Tunneling not only hurts the interests of small shareholders, but also seriously hinders stock markets' development (see Johnson et al., 2000b; Wurgler, 2000; Bertrand et al., 2002). Johnson et al. (2000a) argued that unrestrained tunneling was the main reason for the Asian financial crisis from 1997 to 1999. During financial crises, many facts proved that emerging markets suffer from tunneling more severely than mature markets. To enhance the development of emerging financial markets, one has to identify internal and external governance mechanisms that prevent tunneling. Our paper tries to detect mechanisms and provides policy recommendations to strengthen corporate governance not only in China—but also in other emerging markets. Our paper is organized as follows: the literature review highlights different forms of tunneling and their relevance in China. Focusing on operational tunneling, we analyze interrelations between corporate governance mechanisms and asset appropriation and derive hypotheses. The third part describes our dataset followed by our model specification. Based on panel OLS, censored-normal regressions, ordered logit, and quantile regressions, we present our findings and discuss policy implications. 2. Literature review 2.1. Tunneling in China Tunneling is also the focus of current Chinese corporate governance research, which provides evidence that principal shareholders tunnel assets; however, these studies only describe the problem without uncovering the underlying causes inherent with internal and external corporate governance mechanisms. Li et al. (2004) collected evidence on tunneling of big shareholders focusing on the embezzlement of funds and asset transfers related to mergers and acquisition; thus, operational tunneling due to related party transactions has not been considered. They found that concentrated ownership enhances asset appropriation by block-holding shareholders. In
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particular, companies controlled by the government or business groups experienced the most severe form of tunneling. Jian and Wong (2003) reported that related lending transactions, commonly referred to as financial tunneling, negatively correlates with firm value. This study relied on data of 131 Chinese companies in materials industry. Besides their scope, these studies suffer from inherent endogeneity issues, as the direction and causality of impact is not analyzed. The literature distinguishes between financial and operational tunneling. In particular, financial tunneling refers to freeze-outs and dilution—both are less relevant for China due to the overwhelming influence of the state. Freeze-outs (see Gilson and Gordon, 2003; Bates et al., 2006; Subramanian, 2004) describe a situation of delisting due to a tender offer that is relatively low compared to the actual market value of the company, which affects minority shareholders negatively. In China, an effective delisting mechanism does not exist and the state is usually a dominating shareholder. Hence, freezeouts are not essential in China—but so-called uncompensated transactions in the case of mergers and acquisitions are important (see Gao and Kling, in press). However, uncompensated transactions are mainly common when the state restructures state-owned enterprises (SOEs) and other related SOEs are not fully compensated for acquisitions. Consequently, minority shareholders are less affected. Dilution (see Black and Kraakman, 1996), which describes a considerable increase in equity capital is less likely in China, as the state tries to keep control of publicly listed companies and issuing new shares is not easily absorbed by the notoriously thin Chinese stock markets. In contrast, operational tunneling through transfer pricing (see Johnson et al., 2000b) and other unjustified transfers, i.e. related party transactions of intangibles (see Cheung et al., 2006) seem to be more relevant in China (see Li et al., 2004; Tang et al., 2004). Accordingly, our paper focuses on operational tunneling and tries to measure the extent of unjustified asset transfers based on annual reports of listed companies. 2.2. Theoretical hypotheses The research focus of corporate governance has shifted from the problem between shareholders and management to that between major shareholders and minority shareholders (see Shleifer and Vishny, 1997; Johnson et al., 2000b; Denis and McConnell, 2003). To solve the problem that block-holding shareholders hurt the interests of small shareholders, one should improve the following two kinds of corporate governance mechanisms (see Denis and McConnell, 2003): (1) internal mechanisms include the structure of the board of directors, incentive systems of senior management, ownership structure, type of block-holding shareholders, institutional investors' ownership, and corporate transparency. (2) External mechanisms include market competition for corporate control, legal environment, protection of minority shareholders, market development, and competition on the product market. To assess the structure of the board of directors, we use the percentage of outsiders, who have not been related to the company before becoming board members. Internal board members are familiar with the firm's operations (see Yermack, 1996). This can enhance the efficiency and decisionmaking of the board of directors. However, the higher the percentage of internal board members, the easier the firm can be controlled by the management, which leads to the first hypothesis. Hypothesis 1. A high percentage of outsiders in the board of directors prevents asset appropriation by block-holding shareholders. The size of the board of director matters, as Jensen and Murphy (1990) argued that reasonably increasing the number of board members could improve the board's efficiency because directors come from more diverse backgrounds. Consequently, it is more difficult for the CEO or senior
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managers to manipulate the board. Thus, the board can better function to coordinate and balance the interests of all parties and can resist tunneling. However, when the board is too big, communication would become difficult and the efficiency of the board decreases (see Yermack, 1996). Hypothesis 2. In a reasonable range, more board members help to reduce asset appropriation. The frequency of board meetings indicates the importance of the board in firm's decisionmaking. Hence, more meetings would indicate a stronger position of the board and might prevent asset appropriation. In China, from 1998 to 2002, on average boards hold 5.9 board meetings. There is considerable variation between companies and years. Some firms convene as few as once per year, while some firms hold as many as 37 meetings.2 Nevertheless, one could argue that distressed companies suffering from tunneling hold more meetings due to their state of emergency; hence, section five has to address an inherent endogeneity issue. Hypothesis 3. The number of board meetings indicates the importance in the decision process, which should reduce tunneling. Holding stocks makes senior managers also owners of the firm and hence works as an incentive mechanism. This arrangement aligns the interests of managers and shareholders. As long as managers are minority shareholders, who they usually are, it might also mitigate the danger of tunneling. Hypothesis 4. If managers own stocks, they act in the interest of minority shareholders. Concentration of ownership could facilitate asset appropriation (see Gomes and Novaes, 2001), as major shareholders not only dominate shareholder gatherings and the board of directors, but also determine firm's daily operation by appointing their ‘own candidate' as CEO. Shi and Shitu (2004) found that in 2001, block-holding shareholders selected 82.9% of all CEOs.3 Furthermore, they found that 52.4% of board directors or CEOs had positions at block-holding shareholders' companies. Due to this dependency, it seems to be likely that CEOs decide in the interest of major shareholders. In firms with several major shareholders, major shareholders have to negotiate; thus, some decisions that damage small shareholders could possibly be avoided (see Zwiebel, 1995). Bloch and Hege (2001) argued that if there are several shareholders struggling for control, then the return for holding is relatively low.4 Hypothesis 5. Firms with a single block-holding shareholder exhibit more tunneling compared to a structure with several principal shareholders. When principal shareholders and listed firms can conduct related party transactions, tunneling is more likely (see Khanna and Palepu, 2000a,b; Jian and Wong, 2003). Conducting transactions is easier when the block-holding shareholder is organized as corporation in contrast to state agencies and non-profit organizations. In particular, business groups, in which principal shareholders control
Yet abnormal conditions in the firm's operation might cause a higher number of meetings. About 8.78% firms hold more than ten meetings in a year. Obviously, these firms are abnormal in terms of meetings. In our analysis, we accounted for abnormally high number of meetings, but we did not find any significant impact on asset appropriation. 3 Actually, the state directly or indirectly appoints 69% of all directors and CEOs based on figures for 2001; hence, becoming a CEO is mainly politically determined (see Quiang, 2003). 4 Highly dispersed ownership structure is rather rare in China—but it can serve as reference group. Please cite this article as: Gao, L., Kling, G., Corporate governance and tunneling: Empirical evidence from China, Pacific-Basin Finance Journal (2007), doi:10.1016/j.pacfin.2007.09.001
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the member companies by a pyramid ownership structure, are very common in emerging markets. The internal capital and factor markets of business groups become the best venue for big shareholders to tunnel (see Khanna and Palepu, 2000a). There are strong incentives and multiple measures to appropriate member companies' resources; therefore, tunneling in business groups is more severe (see Jian and Wong, 2003). Hypothesis 6. Firms with block-holding shareholders in the form of business groups suffer more from tunneling. Most Chinese publicly listed companies are transformed from SOEs. In the case of privatizations, well-performing units of companies are separated and listed, while the remaining inferior part serves as parent company. Consequently, when the parent company encounters difficulties, it commonly uses the resources of the listed company to maintain its operations. Bai et al. (2004) argued that firms controlled by the state are likely to suffer more from tunneling. Hypothesis 7. Firms with the state as block-holding shareholder face more serious asset appropriation. Jarrell and Poulsen (1987), Shleifer and Vishny (1986), and McConnell and Servaes (1990) and Brickley, Lease and Smith (1988) uncovered that institutional investors tend to oppose firm's actions that destroy shareholder value. In contrast to findings for other countries, Tang, Luo, and Wang (2004) found that Chinese listed companies whose second largest shareholder is institutional investor badly suffer from tunneling.5 Yet Xiao and Wang (2004) showed that Chinese institutional investors invest in firms with superior governance structures. Hence, one can argue that institutional investors select companies with good corporate governance, which indicates an alleged endogeneity bias (see section five). Hypothesis 8. A high percentage of institutional investors enhances good corporate governance practices; thus, companies suffer less severely from asset appropriation. Annual reports are the most important financial information disclosed by listed firms, and independent audit directly affects the quality of financial information. Audit firms can issue a nonclean opinion, which is usually done when the company faces financial difficulties. Henceforth, audits without non-clean opinion indicate a stable financial situation and signal good corporate governance. Hypothesis 9. Audits without non-clean opinion signal good governance and hence tunneling should be less severe. Generally, larger audit firms and firms with international reputation offer superior audits and more reliable audit opinions. According to signaling games, when listed firms hire audit firms that charge high fees and offer high-quality audit opinions, they give the signal that the firm has sound corporate governance structures. Obviously, hiring one of the top five audit firms might be endogenously determined and has to be analyzed in section five.

We think that the reason for this finding is that they included private funds as institutional investors; however, private funds in China cannot be regarded as institutional investors. Please cite this article as: Gao, L., Kling, G., Corporate governance and tunneling: Empirical evidence from China, Pacific-Basin Finance Journal (2007), doi:10.1016/j.pacfin.2007.09.001

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Hypothesis 10. If the leading five international audit firms prove annual reports, asset appropriation becomes less severe. The legal system is an effective external mechanism to protect minority shareholders. La Porta et al. (1998) uncovered that in common law countries, the level of corporate governance is high, and interests of small shareholders are well protected. In contrast, in civil law countries, the protection of small shareholders is usually weak. In China, the stock market is segmented into A and B-shares, and some companies can issue stocks listed on foreign exchanges (such as H-share in Hong Kong, and ADR in the USA). These mature markets have strict regulations and developed legal systems. Hypothesis 11. Firms issuing B-share or H-share are subject to the legal system in more developed markets. Therefore, the extent of tunneling should be low. In the corporate governance evaluation system of Standard & Poor's, the country's market development is an important indicator regarding country's grade. Due to regional disparities concerning economic development in China, the eastern costal area has a higher level of market development than other regions. This would imply that corporate governance is more advanced when companies are located in leading economic regions. Besides using this simple regional division, we incorporate GDP growth rates and GDP per capita for regions into our regression framework. Hypothesis 12. Compared to firms in western and central China, firms located in the eastern coastal region exhibit better corporate governance structures, which could prevent tunneling. One important external mechanism is competition on the product market. If managers waste resources, firms would ultimately lose in the product market. Fierce competition in the product market could limit inefficient actions and reduce the risk of tunneling. In China, some industries are protected, and firms operating in these industries face less competition; thus, these firms might suffer more from asset appropriation.6 Hypothesis 13. Firms operating in protected industries suffer more from tunneling. 3. Data Our study uses data provided by the China Center for Economic Research (CCER) database on operational tunneling, company characteristics (sales and financial leverage), and corporate governance mechanisms from 1998 to 2002 of all firms listed at Shanghai and Shenzhen stock exchanges. Due to newly listed companies, the number of observations increases from 695 in 1998 to 1108 in 2002. To analyze the extent of tunneling, we determine the difference between accounts receivable and payable that are based on related party transactions. When listed companies have transactions with one of their block-holding shareholders, we regard these transactions as related party transactions, which have to be disclosed in annual reports. In general, related party transactions are the gateway for operational tunneling (see Johnson et al., 2000b). Albeit not all related party transactions lead to asset appropriation, the risk of operational tunneling is much higher in case of extensive transactions. Section five discusses the measurement problems and related issues in detail.

6

We follow the definition of industries protected by the state in Chen et al. (2005).

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L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 1 Basic descriptive statistics Years Tunneling Cases of tunneling/observations Single Multi Board size Meetings Outsider Shares Audit Big five HB shares State Group Fund share Protected Ln(Sales) Leverage Observations 1998 0.057 0.672 0.603 0.111 9.757 4.212 0.003 0.001 0.853 0.030 0.117 0.860 0.796 0.004 0.109 8.595 0.407 695 1999 0.056 0.698 0.599 0.128 9.634 4.863 0.005 0.001 0.826 0.031 0.111 0.868 0.813 0.009 0.105 8.641 0.422 782 2000 0.058 0.676 0.578 0.139 9.481 5.393 0.011 0.001 0.852 0.036 0.097 0.850 0.821 0.007 0.112 8.687 0.432 936 2001 0.038 0.492 0.567 0.139 9.450 6.256 0.061 0.001 0.886 0.057 0.099 0.843 0.814 0.005 0.111 8.718 0.455 1038 2002 0.040 0.450 0.560 0.148 9.922 8.498 0.237 0.003 0.904 0.090 0.097 0.814 0.799 0.007 0.114 8.759 0.498 1108 All 0.049 0.573 0.578 0.135 9.650 6.073 0.075 0.001 0.868 0.052 0.103 0.845 0.809 0.006 0.111 8.689 0.448 4559 7

Explanatory variables are constructed as follows and summarized in Table 1. To determine the concentration of ownership, namely single or several major shareholders, we follow the definitions by Zhao and Yang (2003). The percentage of stocks held by senior managers is based on stocks hold by all board members and top management members. Percentage of stocks held by institutional investors refers to stocks owned by public funds including open and closed-end funds. To obtain a proxy for the prestige of audit firms, we use a dummy that takes value one if one of the leading five international firms are involved. The big five consists of Anderson, KPMG LLP, Ernst & Young, De-loitte & Touche, and PriceWaterCooper. In 2002, Anderson withdrew from the audit business; hereafter, we focus on the four remaining international accounting firms. Determining the extent of state control is difficult, as the state controls only 8.5% directly. However, due to ‘pyramid shareholding schemes’, the state can ultimately control 84% of equity in 2001 (see Quiang, 2003). To identify the type of blockholding shareholders, we follow the definition of Tang et al. (2004) in that non-corporation groups refer to management agencies of state assets, research institutions, institutions of higher education, social groups, banks, insurance companies, and investment companies. We follow the definition of industries protected by the state in Chen, Chen, and Wan (2005). This includes the petroleum and chemical industry, energy and raw material production. To account for regional disparities regarding market development, we insert a regional dummy variable for the eastern coastal area. Beijing, Tianjin, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong and Guangdong belong to the developed eastern coastal region, which might exhibit better governance structures and less tunneling. Besides this straightforward geographical division, we use regional GDP to quantify market development. To illustrate the extent of tunneling and obtain a relative measure, we divided the difference between accounts receivable and payable by the total assets. About 5.68% of total assets were lost in related party transactions in 1998 compared to 4.04% 4 years later; hence, tunneling is still a considerable problem. Besides the decline in the extent of tunneling, the frequency of asset appropriation declined from 67.19% to 45.04%. In spite of this considerable improvement, tunneling is still quite common. Table 2 summarizes descriptive statistics of the dependent and explanatory variables. The drop in asset appropriation in 2001 and 2002 is accompanied by an increase in the number of board
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8 L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 2 Definition and computation of variables Name Definition and computation Type Continuous Dummy

Tunneling Proxy: difference of accounts payable and receivable divided by total assets. Accounts payable / receivable refer to related party transactions, which are disclosed in annual reports Single Dummy is equal to one, if one shareholder controls more than 50% of equity. If the ownership is between 40% and 50% and higher that the sum of the shares held by the second to fifth largest shareholder, we regard the largest shareholder still as single major shareholder Multi Dummy is equal to one if largest shareholder holds between 10% and 50%, second largest at least 10%, and the percentage of the largest is smaller than the summed percentage of the second to the fifth largest shareholder Board Number of board members size Meetings Number of board meetings per year Outsider Percentage of outsiders in the board of directors

Dummy

Continuous

Continuous Continuous between [0,1] Shares Percentage of stocks held by senior managers (board members and top management) Continuous between [0,1] Audit Dummy variable that takes the value one if an audit without non-clean opinion is issued Dummy Big five Dummy that is equal to one if the five leading audit firms are in charge Dummy HB Dummy that is equal to one if the firm issues B or H shares or other shares not traded on the Dummy shares Shanghai and Shenzhen Stock Exchange State Dummy that is equal to one if the state ultimately controls the company. Control is based on Dummy the pyramid ownership structure Group Dummy that is equal to one if block-holding shareholders are business groups Dummy Fund Percentage of stocks held by institutional investors Continuous share between [0,1] Protected Dummy that is equal to one if the firm operates in a protected industry Dummy Coast Dummy that is equal to one if the firm is located in the eastern coastal region Dummy Ln(Sales) The natural log of firm's net sales is a proxy for firm size Continuous Leverage To assess the capital structure, we divide long-term debts by total assets Continuous

meetings, the percentage of outsiders as board members, the percentage of stock held by managers and institutional investors, and annual reports checked by audit firms with international reputation. These changes in explanatory variables could be responsible for lower levels of tunneling. 4. Empirical analysis We try to explain the extent of tunneling by panel data analyses. Based on our theoretical hypotheses, we can focus on the following regression model. Tunneling ¼ ai þ b1 Á Singleit þ b2 Á Multiit þ b3 Á Board Sizeit þ b4 Á Meetingsit þb5 Á Outsiderit þ b6 Á Sharesit þ b7 Á Auditit þ b8 Á Big Fiveit þb9 Á HB Shareit þ b10 Á Stateit þ b11 Á Groupit þ b12 Á Fund Shareit þb13 Á Protectedit þ b14 Á Coastit þ b15 Á GDPit þ b16 Á Growthit þb17 Á lnðSalesÞit þ b18 Á Leverageit þ eit ð1Þ Before carrying out any regressions, one should be aware of potential multicollinearity. Yet correlation coefficients between explanatory variables are rather small; hence, multicollinearity
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does not affect our results.7 As we deal with panel data, we embed firm specific effects in the constant term (fixed-effects model). To improve our measure of regional development, we used the level of GDP per capita, and GDP growth rates for every province to measure the degree of economic development. To distinguish between highly developed and less developed provinces, we calculated the deviation of GDP per capita and GDP growth rate from the national trend.8 However, the results in Table 3 do not indicate that regional effects matter, as the dummy variable for coastal provinces is not significant. In addition, neither GDP per capita nor GDP growth of a province has a significant influence on asset appropriation. To obtain reference estimates of Eq. (1), we use a panel OLS estimation without considering time or firm specific effects (see models 1 and 2). Model 3 incorporates time effects using a fixedeffect approach, whereas model 4 accounts for firm specific effects based on a fixed-effects model. Audits without non-clean opinion have in all models a significantly negative effect on the extent of asset appropriation. Regional variables, namely the dummy for coastal provinces, relative GDP per capita, and relative GDP growth do not possess any relevant impact on corporate governance. In all specifications, firm size as measured by sales reduced asset appropriation, whereas a high financial leverage enhanced it. Ownership structure matters in that a higher extent of concentration (single major shareholder) increases tunneling. The more outsiders are represented in the board of directors the lower the level of asset appropriation. Interestingly, controlling for firm specific effects (see model 4) shows that institutional ownership and being in a protected industry are not relevant drivers for asset appropriation as suggested by models 1–3. However, there are two main shortcomings of our OLS estimates that should be clarified before claiming that our results are robust: (1) our proxy for tunneling is censored, as only about 50% of all firms exhibit asset appropriation. To account for a truncated distribution of our dependent variable, we use a censored-normal regression model (see Tobin, 1958). (2) Besides observing many cases without tunneling, some observations are extreme values, for instance some companies lost 48.04% of total assets in related party transactions.9 These extreme cases of tunneling deviate strongly from the median of our measure, which reaches only 0.44%. To explain severe forms of asset appropriation, we apply quantile regressions for the 90 and 95 percentile (see Koenker and Hallock, 2001). (3) An alternative approach is constructing ranks for tunneling, which can be based on 10 or 20 percentiles. Hence, the continuous measure of tunneling is transformed into an ordinal variable with five or ten ranks. To analyze a ranked dependent variable, we apply an ordered logit approach (see Zavoina and McElvey, 1975). Table 4 provides the result of the censored-normal regression, quantile regressions, and ordered logit models. As coefficients of the panel OLS and the more advanced methods are not easily comparable, we illustrate the average contribution of every corporate governance variable on the extent of tunneling in Table 5.10 The steps are as follows: (1) we determine the predicted values of tunneling based on the respective estimation technique.11 (2) Then, we compute the partial
7 The largest correlation coefficient of –0.4625 can be detected between the dummies for a single principal shareholder and several principal shareholders. Note that highly dispersed ownership structure is the reference group for our discussion concerning concentration of ownership. 8 This approach also avoid trend correlation and stationarity problems of GDP time series, as we compare regional GDP figures with national levels in every year. As regional and national GDP time series exhibit a comovement, calculating a relative measure yields a stationary time series that indicates relative development of provinces. 9 This value is based on the 99% percentile. 10 We use average values of explanatory variables to determine the effect on tunneling for a representative firm. To derive the partial impact, we compute marginal effects (elasticity). 11 Note that all models suggest a lower level of tunneling if a company reaches the mean of all explanatory variables.

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10 L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 3 Panel OLS with and without fixed-effects Years Model (1) Panel OLS Single Multi Board size Meetings Outsider Shares Audit Big five HB shares State Group Fund share Protected Coast GDP growth GDP per capita Ln(Sales) Leverage Year 1999 Year 2000 Year 2001 Year 2002 Constant Observations Adjusted R2 0.008⁎⁎ − 0.007 0.000 0.000 − 0.059⁎⁎⁎ − 0.053 − 0.052⁎⁎⁎ − 0.011 0.017⁎⁎⁎ 0.007⁎ 0.014⁎⁎⁎ − 0.363⁎⁎⁎ 0.018⁎⁎⁎ 0.000 − 0.025⁎⁎⁎ 0.051⁎⁎⁎ Model (2) Panel OLS 0.008⁎⁎ −0.007 0.000 0.001 −0.059⁎⁎⁎ −0.055 −0.052⁎⁎⁎ −0.010 0.017⁎⁎⁎ 0.007⁎ 0.014⁎⁎⁎ −0.365⁎⁎⁎ 0.017⁎⁎⁎ 0.000 0.000 −0.024⁎⁎⁎ 0.051⁎⁎⁎ Model (3) Year effects 0.007⁎⁎ − 0.007 − 0.000 0.001 − 0.064⁎⁎⁎ − 0.055 − 0.051⁎⁎⁎ − 0.010 0.017⁎⁎⁎ 0.007⁎ 0.014⁎⁎⁎ − 0.386⁎⁎⁎ 0.018⁎⁎⁎ 0.000 − 0.024⁎⁎⁎ 0.051⁎⁎⁎ − 0.001 0.004 − 0.013⁎⁎ 0.001 0.264⁎⁎⁎ 4566 0.11 Model (4) Firm effects 0.002 −0.016⁎⁎ −0.001 0.001 −0.032⁎⁎ −0.094 −0.014⁎⁎⁎ 0.005 0.026 0.014 0.012⁎ −0.053 −0.011 −0.007 −0.044⁎⁎⁎ 0.046⁎⁎⁎

0.264⁎⁎⁎ 4566 0.11

0.234⁎⁎⁎ 4566 0.11

4566 0.60

⁎ Significance at the 0.10 level. ⁎⁎ Significance at the 0.05 level. ⁎⁎⁎ Significance at the 0.01 level.

contribution of every explanatory variable to the predicted value of asset appropriation. Table 5 shows the partial contribution in percentage points. This method helps to identify not just statistically but also ‘economically` significant external and internal governance mechanisms.12 In all models, audits without non-clean opinion have a negative and statistically significant impact on tunneling; however, the economic impact is rather limited, as it reduces tunneling only by 2.83% to 14.69%. At a first glance, the most effective governance tool is the percentage of institutional investors, which can reduce asset appropriation by at least 43.91% (lowest estimate). Especially, for severe cases of embezzlement explained by the quantile regressions, institutional ownership seems to prevent (reduction of 85.37% and 87.19%) belonging to the 90 and 95 percentile. In spite of the alleged impact of institutional ownership, endogeneity issues could distort the picture discussed in the next section. Another key-element for improving corporate governance is shares held by managers, which leads to a decline in predicted asset appropriation by at least 45.21%. However, managers' ownership is less relevant for extreme cases, as the partial contribution reaches only 6.62% to 6.85% in the quantile regressions. Company specific factors, namely firm size (measured by log net sales) and financial leverage, are in all models highly significant—but the economic relevance is rather limited. In particular, larger companies
By ‘economically’ significant, we mean that the magnitude of impact of the respective explanatory variable on tunneling is high.
12

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L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 4 Censored-normal regression, ordered logit, and quantile regressions Years Single Multi Board size Meetings Outsider Shares Audit Big five HB shares State Group Fund share Protected Coast Ln(Sales) Leverage Year 1999 Year 2000 Year 2001 Year 2002 Constant Observations Censored regression − 0.000 − 0.025⁎⁎⁎ − 0.000 0.002⁎⁎ − 0.153⁎⁎⁎ − 0.895⁎⁎ − 0.066⁎⁎⁎ − 0.027⁎⁎ 0.031⁎⁎⁎ 0.011⁎ 0.025⁎⁎⁎ − 0.823⁎⁎⁎ 0.024⁎⁎⁎ 0.001 − 0.030⁎⁎⁎ 0.064⁎⁎⁎ 0.003 0.004 − 0.037⁎⁎⁎ − 0.014 0.274⁎⁎⁎ 4559 Ordered logit (10 percentile) − 0.070 − 0.379⁎⁎⁎ 0.003 0.021⁎⁎ − 1.855⁎⁎⁎ − 10.295⁎⁎ − 0.717⁎⁎⁎ − 0.357⁎⁎ 0.381⁎⁎⁎ 0.146⁎ 0.306⁎⁎⁎ − 10.377⁎⁎⁎ 0.278⁎⁎⁎ − 0.049 − 0.247⁎⁎⁎ 0.441⁎⁎⁎ − 0.039 − 0.075 − 0.671⁎⁎⁎ − 0.446⁎⁎⁎ 4559 Ordered logit (20 percentile) − 0.074 − 0.391⁎⁎⁎ − 0.002 0.022⁎⁎ − 1.811⁎⁎⁎ − 10.622⁎⁎ − 0.640⁎⁎⁎ − 0.366⁎⁎⁎ 0.395⁎⁎⁎ 0.127 0.283⁎⁎⁎ − 9.944⁎⁎⁎ 0.263⁎⁎⁎ − 0.059 − 0.208⁎⁎⁎ 0.381⁎⁎⁎ − 0.017 − 0.079 − 0.674⁎⁎⁎ − 0.450⁎⁎⁎ 4559 Quantile regression (95%) 0.011 −0.035⁎ −0.002 0.002 −0.094 −0.098 −0.178⁎⁎⁎ −0.044⁎ 0.031 0.006 0.056⁎⁎⁎ −1.294⁎⁎⁎ 0.052⁎⁎⁎ 0.003 −0.073⁎⁎⁎ 0.174⁎⁎⁎ 0.019 0.001 −0.020 −0.009 0.898⁎⁎⁎ 4559 Quantile regression (90%) 0.016⁎ −0.021⁎ −0.000 0.000 −0.049 −0.065 −0.139⁎⁎⁎ −0.029 0.024⁎ −0.002 0.035⁎⁎⁎ −0.809⁎⁎ 0.040⁎⁎⁎ −0.001 −0.046⁎⁎⁎ 0.099⁎⁎⁎ −0.014 −0.015 −0.052⁎⁎⁎ −0.035⁎ 0.616⁎⁎⁎ 4559 11

⁎ Significance at the 0.10 level. ⁎⁎ Significance at the 0.05 level. ⁎⁎⁎ Significance at the 0.01 level.

tend to suffer less from asset appropriation, whereas firms with high financial leverage exhibit more tunneling. Besides the impact of governance mechanisms and firm characteristics, we confirm a general decline of tunneling in 2001 indicated by significant dummy variables (see Table 4). This might be due to economic reforms in 2001, for China has tried to sell state-owned stocks and to improve corporate governance (see Quiang, 2003). 5. Endogeneity issues and robustness checks To check whether our results are robust, we have to address a potential endogeneity bias that might arise. In particular, the number of board meetings and institutional ownership could be endogenous. The number of board meetings might increase due to a high number of related party transactions that need approval; hence, asset appropriation could cause more board meetings. Nevertheless, a high number of board meetings can be interpreted as a signal for a high importance of the board and hence a sound corporate governance. As both arguments are valid from a theoretical point of view, we have to test the endogenous relationship between corporate governance and board meetings to uncover the causal relationship. In addition, institutional investors may choose to invest in firms with good corporate governance as shown by Xiao and Wang (2004); therefore, the reduction of tunneling may be due to the good corporate governance and not driven by institutional investors' engagement. Furthermore, there could be a self-selection bias in the case of the variable ‘big five auditors’, for companies might hire these leading audit firms because they believe they do not suffer from asset appropriation. To address this alleged self-selection bias and endogeneity issues, we apply a two-stage least squares model.
Please cite this article as: Gao, L., Kling, G., Corporate governance and tunneling: Empirical evidence from China, Pacific-Basin Finance Journal (2007), doi:10.1016/j.pacfin.2007.09.001

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12 L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 5 Illustration of results for a representative firm Years Single Multi Board size Meetings Outsider Shares Audit Big five HB shares State Group Fund share Protected Coast Ln(Sales) Leverage Censored regression − 0.02 − 1.35 − 0.01 0.09 − 8.22 − 48.04 − 3.56 − 1.43 1.65 0.61 1.32 −44.18 1.26 0.03 − 1.59 3.43 Ordered logit (10 percentile) − 0.31 − 1.67 0.01 0.09 − 8.15 − 45.21 − 3.15 − 1.57 1.67 0.64 1.34 − 45.57 1.22 − 0.22 − 1.08 1.94 Ordered logit (20 percentile) − 0.33 − 1.73 − 0.01 0.10 − 8.00 − 46.91 − 2.83 − 1.62 1.75 0.56 1.25 − 43.91 1.16 − 0.26 − 0.92 1.68 Quantile regression (95%) 0.74 − 2.35 − 0.14 0.10 − 6.32 − 6.62 − 11.99 − 2.98 2.10 0.40 3.79 − 87.19 3.48 0.18 − 4.93 11.73 Quantile regression (90%) 1.67 −2.26 −0.02 0.00 −5.17 −6.85 −14.69 −3.04 2.53 −0.20 3.74 −85.37 4.18 −0.11 −4.85 10.43 POLS 1.41 − 9.51 − 0.61 0.49 − 19.82 − 57.67 − 8.47 3.01 15.71 8.53 6.69 − 30.74 − 6.75 − 3.87 − 26.81 28.40

This table shows the contribution of one specific variable to the predicted level of tunneling. These contributions are expressed in percentage points, which provide an indication for the economic relevance of the respective variable. All models predict lower values of tunneling for the average firm; hence, negative values indicate a reduction of tunneling.

A two-stage least squares approach, however, requires finding appropriate instruments for the three allegedly endogenous variables. Hence, we used all potential sets of instruments based on our explanatory variables (see Eq. (1)). Regardless which specification is used, Wu-Hausman Ftests and Durbin-Wu-Hausman Chi-squared tests cannot reject the null hypothesis that the variables board meetings, institutional ownership and ‘big five auditors’ are exogenous. To avoid inherent specification problems of a two-stage least squares approach, we use our time series observations to test for Granger causality. Henceforth, we use a panel vector autoregression and estimated the model with system OLS. Table 6 shows the results and highlights that the extent of asset appropriation is not Granger caused by the number of board meetings, institutional ownership or choosing one of the “big five” audit firms. In contrast, sound corporate governance with low levels of tunneling stimulates stock purchases from institutional investors. Besides endogeneity problems, the measurement of asset appropriation is not straightforward, for direct measures cannot be observed from public sources (e.g. annual reports). Based on Johnson et al. (2000b), we use related party transactions to quantify the extent of tunneling. The notes in annual reports indicate related party transactions; hence, we focus on the accounts payable and receivable due to transactions between the respective company and another company that is a principal shareholder of the former. To obtain a relative measure that accounts for firm size, we divide the difference between accounts receivable and accounts payable by total assets. This serves as a proxy for asset appropriation, as related party transaction with a high imbalance between accounts payable and receivable could indicate that the dependent company loses in these transactions. As a matter of fact, this accounting measure exhibits some inherent disadvantages. First, the measure is noisy in that asset appropriation cannot be directly observed, and related party transactions are just one potential source of asset appropriation. Henceforth, it is difficult to distinguish between normal related party transactions and transactions used for operational tunneling. Second, the accruals may be a result of prior earning management and do not indicate
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L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx Table 6 Granger causality tests Null hypotheses Board meetings, institutional ownership and the “big five” audit firms do not Granger cause asset appropriation Asset appropriation does not Granger causes the number of board meetings Asset appropriation does not Granger causes choosing one of the “big five” audit firms Asset appropriation does not Granger causes institutional stockholding F-test 0.81 0.88 0.44 4.36 P-value 0.488 0.348 0.506 0.037 13

tunneling. Third, an increase in accounts receivable can also imply that the large shareholder is embezzling assets from the listed company, for the listed company is facing a risk of failing to collect accounts receivable in future. Besides accounting measures, empirical measures based on financial and stock market performance have been used (Bae et al., 2002; Cheung et al., 2006). However, the main problem with these measures is that they require an efficient stock market with high liquidity so that stock performance really reflects financial and operational aspects. The most crucial shortcoming is that by testing the impact of tunneling on stock performance additional factors (e.g. firm specific effects, institutional ownership) are usually not considered, which biases the results. Accordingly, we suggest using an accounting based measure; however, we test for its relevance on firm performance and valuation levels. Tobin's Q defined as the market value of firm assets divided by the repurchase value of firm assets indicates whether a company's valuation level is higher than the repurchase value of its assets. Putting this differently, a company with a Tobin's Q exceeding one creates value by combining its resources, whereas a company with a ratio below one should be acquired or liquidated. Accordingly, companies with a high Tobin's Q seem to have desirable resources and could be an attractive prey for asset appropriation. In turn, asset appropriation should reduce Tobin's Q in future, as essential resources disappear, which lowers value creation potential. If our proxy for asset appropriation is an adequate indicator for asset appropriation, we should observe the following relationships: (1) companies with high Tobin's Q should be a preferred target for asset appropriation; thus, the accounting proxy should have high values; (2) when highly valued assets disappear indicated by a high value of our proxy, companies should exhibit a lower Tobin's Q in future. Fixed-effects models show that a high Tobin's Q causes more asset appropriation (p-value: 0.000), and asset appropriation reduces Tobin's Q in the following year (p-value: 0.025). Consequently, our proxy for asset appropriation exhibits the pattern one would expect. 6. Conclusion Our study uncovered a high extent of operational tunneling in China, as about 4% of total assets are embezzled. Yet the situation has improved because the extent of tunneling declined from 1998 to 2002 from 5.68% to 4.04%, and only 45.04% of the firms suffer from asset appropriation in 2002 compared to 67.19% in 1998. Our empirical analysis identified four keymechanisms of corporate governance that could help to significantly improve internal and external governance structures in China and reduce tunneling. Audits without non-clean opinion signal financial health and sound governance lowering the extent of asset appropriation by 2.83% to 14.69%. Consequently, minority shareholders should be alarmed when audit firms issue nonclean opinions, and auditors in turn have a crucial function in detecting irregularities. In addition, stock ownership of senior managers is a guarantee for preventing tunneling. Henceforth, enhancing
Please cite this article as: Gao, L., Kling, G., Corporate governance and tunneling: Empirical evidence from China, Pacific-Basin Finance Journal (2007), doi:10.1016/j.pacfin.2007.09.001

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14 L. Gao, G. Kling / Pacific-Basin Finance Journal xx (2007) xxx–xxx

stock ownership (i.e. by stock option plans) is our second policy recommendation. In contrast, institutional ownership alone does not foster internal governance mechanisms to reduce operational tunneling. Granger causality tests reveal that institutional investors pick stocks of companies with sound governance. Thus, the argument that institutional ownership should be stimulated to install better governance mechanisms cannot be confirmed. Nevertheless, we disagree with Tang et al. (2004), who found that institutional ownership enhances tunneling. Noteworthy, the state or SOEs as principal shareholders do not significantly affect asset appropriation; hence, tunneling seems not be driven by the influence of the state as principal shareholder. Nevertheless, several block-holding shareholders that compete for controlling a company make embezzlement less likely—albeit the economic impact is relatively low. Accordingly, our results do not confirm the pessimistic view of Chen et al. (2005) that the state as principal shareholder facilitates tunneling. We uncover that in the year 2001, in which economic reforms occurred (see Quiang, 2003), tunneling declined. Hence, economic reforms like the attempt to improve corporate governance and to limit the influence of the state in publicly listed companies are recommended and will help to further improve corporate governance principles in future. Reference
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