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1

China's Corporate Governance Development

(to be published in Christine A. Mallin (ed), Handbook on International Corporate

Governance (2011), Cheltenham, UK and Northampton, MA, USA: Edward Elgar )

On Kit Tam and Celina Ping Yu

RMIT University, Melbourne Australia

(Version 6 May 2010)

Introduction

Corporate governance development in China is entering a new phase where effective

corporate governance mechanisms and practices have become a necessary condition for

the country's quest to achieve enduring prosperity through an open market economy

that can compete globally. Whereas Chinese corporate governance might have been

considered as an esoteric topic purely for the regulators and academics over a decade

ago, it is very much part of the business language for the diverse group of corporate

stakeholders including investors, managers, company directors, as well as government

and non-government organisations. For China to sustain its remarkable economic

growth momentum, developing creditable and effective corporate governance in

China's increasingly diverse forms of business organisations that must compete or

operate globally can no longer be an afterthought.

2

As argued earlier by Tam (1999), for China's adapted version of the Anglo-American

model of corporate governance to work effectively, the accompanying formal and

informal market and social institutions would need to be developed and functioning

effectively. While an impressive range of modern corporate governance mechanisms

and practices have continued to be adapted and introduced in China, there are some

inherent systemic issues affecting the emergence of a fully effective system of

corporate governance in the country. These issues include for example the now familiar

problems of the governance consequences from the dominance of state ownership in

listed companies, major banks and unlisted enterprises; insider control; poor disclosure

and monitoring; the exercise and protection of shareholder's rights; the effectiveness of

the board of directors; and the often weak and uneven enforcement of law and

regulations. There are other major challenges such as the corporate governance role of

the Communist Party organisation and issues of multiple regulators, transparency,

executive compensation, and the progress in developing well functioning market and

social institutions, as well as a corporate culture that is compatible with a modern

system of corporate governance that the Chinese government is attempting to build.

In many ways, the development of corporate governance in China can serve as a nexus

and driver for reforms that envelop other key areas in the economy and regulatory

environment. For example, the listing in recent years of major state-owned enterprises

and banks in overseas stock exchanges has provided much needed impetus for ensuring

governance and management changes that the Chinese authorities would find

convenient to their advantage because foreign investors and regulators will demand

compliance with higher international standards.

3

This study will examine some of the major mile stones and key issues in the more recent

development of China's corporate governance. China is currently at a crucial new phase

in the development of its corporate governance system where the major concern is

shifting from a focus on the introduction of formal rules and regulations to more

comprehensive institution building to make the system work in the interest of all types

of stakeholders. They include commercial organisations that are increasingly diverse in

their ownership and organisational structure, as well as key stakeholders including

shareholders, managers, customers, professional organisations, and regulators.

The initial emphasis of China's corporate governance development was quite rightly on

setting up the formal framework primarily for the country's most modern form of

commercial organisation – the publicly listed companies. After nearly two decades of

development, there is now an urgent need for more fundamental reform and

development in the country's financial system to give support to the pressing and

changing demands from the household and corporate sectors to access and use capital

more efficiently, and from the public sector to have the necessary financial institutions

and instruments to exercise indirect control over the economy. For all these to work,

effective corporate governance in business enterprises as well as financial institutions,

particularly the dominant state owned banks, is a necessary condition.

After over two decades of enterprise reform, the Chinese government has declared it is

moving away from direct interventions in the routine operational management of the

still significant arrays of enterprises that the state owns. Instead, the new approach is

meant to concentrate on guiding and controlling what it considers to be nationally

strategic industries by promoting a select group of large scale enterprises directly

4

owned by the central government (central enterprises) to make them the industry

leaders either by virtue of their size or their natural/regulatory monopoly position. To

attain this goal, the state owned banks will be a key strategic conduit for the

government to exercise discretionary macroeconomic initiatives to steer the growth

path of the Chinese economy. The massive expansion of bank lending injected within a

short period of time as China's stimulus response to the global financial crisis during

2009 was a conspicuous manifestation of this government-led framework. This, and the

experience from the spate of bank scandals and the restructuring of the Chinese state

owned banks in separating out the massive non-performing loans, has highlighted the

importance of good corporate governance in ensuring that the banking industry can

deliver the outcomes. This study will discuss the complementarity between corporate

governance development and the development of China's financial system to better

understand the path of change dynamics in this infusion of reinforcing influences.

This chapter provides an update on China's corporate governance development. It will

examine the progress and key issues for Chinese corporate governance to play its

crucial role in creating a modern and competitive corporate sector to help sustain

China's development for the well being of its population.

The chapter is organised as follows. Section 2 discusses the critical role of corporate

governance in deepening the reform and development of China's financial system

which is in need of urgent transformation to be made more efficient to support China's

economic growth. Section 3 examines major issues and milestones in corporate

governance development over the last decade. It will also discuss corporate governance

5

issues in China's commercial banks as an illustration. Section 4 provides some

conclusions.

Corporate Governance and China's Financial Development

By 2009, sixty years after the People's Republic of China was established, China has

emerged to become a significant economy on the world stage because of its size,

continuing fast growth, and the status as the world's largest exporter with the world's

largest foreign reserves. These achievements are clearly a product of the country's

success in economic reform and opening up to the world markets. There remain

however serious issues that could threaten the stability and sustainability of this

remarkable result if not properly addressed and resolved. One of the major challenges

is the pace and quality of the country's financial development. Well functioning capital

market and effective corporate governance at the firm level are widely accepted as

mutually reinforcing. Taking a macroeconomic perspective of China's current stage of

reform and modernisation, it is argued in this study that deepening the country's

financial development will help drive the building of stronger and more effective

corporate governance.

For a long time, the pace and extent of reform in China's financial system have lagged

behind other key sectors of the economy. With the rapid transformation into a market-

oriented economic system with a very high level of international trade and investment,

the need to speed up China's financial development is urgent because China cannot

afford to be simply a bystander in the globalisation process wh ere massive volume of

cross-border flows of goods, services and investment funds must be efficient and

6

orderly. From China's national economic perspective, the reasons for a more rapid pace

in financial development are even more compelling. With the world's highest national

savings rate at over 50 per cent of GDP, the task of turning such savings into productive

investment can only be accomplished by a highly efficient financial system. A critical

determinant for success in financial development is the establishment of a well

functioning and effective system of corporate governance.

As Table 1 indicates, while household savings remain strong, corporate savings have

surpassed household savings in recent years. Household savings have traditionally

provided cheap and easy source of funds for China's banks in the form of bank deposits

under regulated low interest rates, which have in turn allowed Chinese banks to rely on

interest differentials as a major source of income. It has long been recognised that there

is a need to address the lack of alternative financial investment channels for most

households other than low yielding bank deposits or investing in the more volatile stock

markets. The rising corporate savings, primarily in retained earnings, provide another

impetus for broader and deeper reform of China's financial system to provide more

varieties of financial products and services for companies and households to obtain

better returns for their investments.

[Table 1 here]

For the purpose of this study, financial development can be defined as the 'factors,

policies, and institutions that lead to: effective financial intermediation and financial

markets; deep and broad access to capital and financial services' (World Economic

Forum 2009). In its attempt to measure a country's financial development, the World

Economic Forum identifies some key criteria for the necessary institutional and

business environment which include:

7

• Capital account liberalisation

• Domestic financial sector liberalisation

• Extent of incentive-based compensation

• Efficacy of corporate boards

• Reliance on professional management

• Strength of auditing and reporting standards

• Protection of minority shareholders' interests

• Regulation of securities exchanges

• Property rights

• Judicial independence

Most of these elements also belong to the set of essential internal and external

governance mechanisms required for an effective corporate governance system.

Clearly as a country's financial system must provide increasingly specialised services

for investors and savers to manage their funds in the most efficient manner to optimise

their positions, the development of these essential elements is tantamount to the

building of an effective corporate governance system. While much progress has been

made in strengthening property rights, establishing regulations of securities exchanges,

and improving disclosure in publicly listed companies, much remain to be

accomplished in these and other key areas. China's predominantly state-owned

banking system has traditionally been made to serve the state industrial sector, resulting

in a range of attendant problems that are well known. The corporate governance

practices in China's financial institutions have not kept pace with the rich set of

management techniques and instruments that have been introduced in recent years.

Given the still overwhelming majority shareholding of the state in China's four major

8

banks, it is perhaps not surprising that the corporate governance problems in many of

China's publicly listed companies are just as relevant in the banking sector. However,

because of the pivotal role of the banking sector, and the potential systemic risks that

bank failures could inflict on the economy, the importance of having good corporate

governance is even more urgent and relevant.

With China's fixed exchange rate system and mounting foreign exchange reserves, the

resultant monetary expansion certainly requires careful monetary management

predicated on an effective banking and financial system. The continuing injection of

liquidity created by the rising foreign reserves can fuel asset price inflation in real

estate and equity shares, resulting in serious distortions in bank lending composition

and resource allocation in general. Unfortunately, given the status of financial

development in China, the scope for central bank interventions to sterilise such liquidity

expansion is quite limited (Wu 2007). The need for China's financial system to build

up the capacity to more efficiently handle such systemic stresses is urgent. There is

therefore another factor pushing for progress in corporate governance development.

The second major building block in the development of a modern financial system in

China is the equity market through which state owned enterprises have undergone

transformation by public listing in partial privatisation, initially to raise capital funding

to revitalise capacity, but more recently and more significantly as a means to institute

corporate governance reform. As Figure 1 shows, China's stock market capitalization

as percentage of GDP has experienced some significant volatility over the last two

decades. What is particularly noteworthy is that the proportion of tradeable share (bars

on the right in chart) remains at about one third of market capitalisation for most years

9

until 2009 when the shareholding reform started in 2006 began slowly to phase in the

trading of the other two thirds of issued shares that were formerly non-tradeable and

were held by the state and other state organisations in the form of 'legal person' shares.

The dominant non-tradable shareholding by the state was one of the main underlying

problems for the development of corporate governance in China's most modern form of

business organisations, the publicly listed companies.

[Figure 1 here]

The dominance of the state as direct and indirect owner holding two thirds of issued

shares in over eighty per cent of the country's listed companies has compounded the

governance issues that a public company will normally have to address. The fact that

shares held by the state and state organisations cannot be traded, coupled with the

widely acknowledged insider control problems in many of these companies (Shanghai

Stock Exchange, SSE 2006), have combined to produce a range of familiar as well as

China-specific problems in corporate governance practices and outcomes. A rich

literature consisting of empirical studies on testing various corporate governance and

ownership characteristics and their possible impacts on firm performance in Chinese

companies has appeared in recent years (Xu and Wang 1999, Qi et al.2000, Sun et al.

2002, Wei and Varela 2003, Chong and Eggleton 2007).

[Table 2 here]

As Table 2 shows, in 2009, China has over 1700 listed companies in the two stock exchanges,

with 120 million shareholders. These markets have seen numerous scandals and corporate

governance failures in big and small companies over the years. These problems constitute the

weak links of China's financial system to which more effective corporate governance can

contribute in strengthening and vitalising.

10

The future of Chinese capital market development is moving beyond opening up to the world as

the size has rapidly reached a level commensurate with China's global economic position. In

this context, the Chinese authorities now see their key task is to introduce into Chinese capital

market the world's most advanced mechanisms to integrate into China's environment for

improving the country's capital market system and raising the standards of operations (Qi,

2009).

In China's economic reform environment, where the building of market institutions and

practices of the rule of law are to varying extent still a work in progress, the efficacy of financial

system is inseparable from progress in other key areas including reforms in public and corporate

finance, the legal system, and regulatory regimes governing market entry and operation of both

domestic and foreign participants. In both direct finance and financial intermediation, the

effectiveness of the state-dominated financial system in China has been found wanting.

Regardless of the pace at which the Chinese government will liberalise foreign exchange

controls over its capital account, there is no question that to fully develop the banking system,

the stock markets and their listed companies, the standards and performance of corporate

governance arrangements and practices must be lifted.

.

Milestones and Challenges

At the beginning of the process, the Chinese Government has adopted a top-down approach to

developing corporate governance (Tam 1999). The past decade suggests the work by regulatory

and government agencies such as the China Securities Regulatory Commission (CSRC) and the

State-owned Assets Supervision and Administration (SASAC) have turned out to be

instrumental in promoting the development of effective corporate governance practices among

11

Chinese companies and state owned enterprises. Indeed without such regulatory push, the

considerable progress in creating many of the necessary conditions for such practices to work

would have been untenable.

A considerable literature based on agency theory has examined a multitude of issues arising

from the conflict of interest between shareholders and company managers, although the

dominant agency theory in corporate governance research is increasingly being challenged

(Judge 2009). With the prevalence of block holders in Europe and Asia, the issue of protection

of minority shareholder interest has attracted increasing attention from researchers (Shleifer and

Vishny 1997). Recent finance theory (La Porta, et al 1999, 2000) has shifted and extended the

analytical perspective of the dominant agency theory centred on the conflict between principal

(shareholders) and agent (managers) to increasing concern over the expropriation of minority

shareholder interest by controlling shareholders in large companies. For countries with weak

investor protection, ownership concentration is seen as an internal governance mechanism to

substitute for the inadequacy of external governance institutions.

In East Asia where investor protection is generally found to be weak, the concentration of

family ownership supported variously by cross shareholding, stock pyramids and nominee

companies is a common strategy adopted by company founders as a substitute for legal

protection of investors (Bebchuk et al 2000; Claessens et al 2000). In China where

concentration of state ownership is high, the major governance problems are generally centred

around the issue of state ownership, insider control, and the weak enforcement of law and

regulations. Indeed, state ownership of Chinese enterprises and the associated governance

issues it raises have preoccupied researchers' attention for some years (Jefferson et al. 2003,

Han et al.2004, Bai et al. 2004, Tian and Estrin 2008).

The Chinese government has transformed thousands of SOEs by withdrawal or privatisation

over the last two decades. However, it is widely recognised that the reform has not always

12

provided the desired performance outcomes. Based on an international survey of corporate

governance in state owned enterprises (SOE) by the OECD (2005), two common problems for

the state in carrying out its ownership responsibilities are identified: undue hands-on and

politically motivated interference; or totally passive or distant ownership. Evidence from the

literature indicates that China notably suffers from the first problem. For example, it is found

that over one quarter of the CEOs in a sample of 790 newly partially privatized firms in China

are former or current government bureaucrats (Fan, et al 2007). However, with the pervasive

insider control problem (Qian 1995, Lee and Hahn 2001) that is often intertwined with collusion

with government officials, the second problem has manifested itself in the form of absentee

state as true owner phenomenon widely discussed in China during the 1990s.

To better understand the significance of the milestones in China's corporate governance

development, the rationale and implications in terms of the key governance issues involved will

be examined in this section. The corporate governance challenges for the state owned

commercial banks will also be discussed to illustrate the relevance of some of these issues.

In adopting modern corporate governance as a means to improve SOE performance, the

Chinese authorities therefore affirm their belief that SOEs can operate effectively and

competitively (Li 2006). However, many scholars argue that only the complete restructuring of

state ownership and privatisation can truly turn SOE into efficient business entities because

state ownership dilution is seen to have had only a limited impact (Tenev and Zhang 2002).

Recent literature shows that the performance of China's partially privatised companies usually

deteriorated during the year after privatisation, and that poor governance is a major contributing

factor (Allen et al.2005). An alternative view is that state-owned enterprises can perform

efficiently if modern corporate governance and management practices are adopted and

effectively implemented (Liu and Sun 2005). It has been argued that the effect of state

ownership on corporate value is U-shaped so that beyond a certain threshold, the government

can actually improve corporate value (Tian and Estrin 2008). This result was attributed to the

13

result of ownership concentration and government partiality. Despite the corporatisation and

privatisation in China's enterprise reform, clearly the Chinese government holds the view that

the state still has a role in maintaining state ownership of enterprises.

Indeed, in an apparent new policy move, since 2002 the Chinese government has started to

consolidate and merge the country's largest SOEs into super size central enterprise groups in

designated industries. The government also decided at the same time to impose modern

corporate governance mechanisms in these enterprises to more effectively exercise state

ownership rights and to achieve better firm performance. The Chairman of SASAC, Li

Rongrong, declares that the improvement of corporate governance is the core and most difficult

problem in the system reform of state owned enterprises (Li 2009).

[Table 3 here]

Institutional and Regulatory Milestones in Corporate Governance Development

When the CSRC was established in 1992 and the Company Law was passed by the

National People's Congress in 1993, most SOE in China were still at the start of

corporatisation and a long process of modernisation and partial privatisation. Both the

notion and practices of corporate governance were quite alien to the newly emerging

corporate sector. The focus of policy debate and academic discussion within China at

the same time was on issues of enterprises withdrawing from the social welfare

responsibilities inherited from the days of socialist planned model, and the clarification

of the property rights and responsibilities between enterprises management and

government ministries. There are substantive studies on these developments in the

period up to the late 1990s (for example, Tam 1999, Tenev et al 2002) and is not the

focus of for this update. At the same time, an increasing number of empirical studies

started to investigate the possible links between types of ownership, particularly state

14

ownership, and firm performance (Xu and Wang 1999, Sun et al 2002, Wei, et al 2003).

Suffice to note that the gradual approach to market oriented reform based on opening

up the Chinese economy has continued to be the guiding principle. In terms of

corporate governance development, the Chinese government has maintained its pro-

active and top-down approach to introduce formal governance rules and framework and

to enhance practices. Table 3 provides some key legislative and regulatory milestones

in China's corporate governance development. It is not meant to be an exhaustive list

but is constructed to highlight the significance of major initiatives and measures that

can be expected to produce more profound and far reaching impact on China's

corporate governance system and practices.

National Laws

The late 1990s heralded a spate of new regulatory measures and important laws on

securities (1998) and accounting (1999) that provided and formalised additional key

components of the legal foundation for the development of a modern corporate sector

and financial markets. Listing rules of the Shanghai Stock Exchange are clearly an

important piece of the institution building jigsaw for the development of effective

corporate governance. Indeed the Shanghai Stock Exchange has also taken an active

role in promoting better corporate governance by publishing an annual report on

Chinese corporate governance since 2002.

Another often overlooked administrative measure that has quite an impact on the way

Chinese corporate governance practices is conducted is the 'Administrative Rules for

the Registration of the Legal Representative of Enterprise' promulgated by the State

15

Bureau of Industry and Commerce Administration in 1998. The Rules established the

position of the chairman of the board as the legal representative of a company, thus

creating unwittingly the condition of a powerful corporate leader with potential

capacity to intervene in company management. It is commonly recognised in China

that board chairmen often utilise such a capacity (Shenzhen Business Daily , 6 June

2008). However, not much is known about the extent and impact, and there is scant

scholarly research on this important area of board dynamics and processes.

Corporate Governance Code and Role of the Board and Independent Directors

New regulatory measures directed specifically at developing corporate governance

were introduced by CSRC between 2000 and 2002. The most significant ones in this

context were the Code of Corporate Governance for Listed Companies introduced

jointly by CSRC and the State Economic and Trade Commission in 2002, and the other

was CSRC's 2001 requirement for listed companies to have independent directors on

the board and to reach one third of board memberships by 2003. These two initiatives

together set a more systematic and comprehensive course of actions for Chinese

companies to effect corporate governance reform.

CSRC also initiated two other measures to help support the implementation of such

changes: 'Opinions on Strengthening Work on Monitoring and Regulating Listed

Companies' (2000) and , given the important role of board chairman in China's

corporate structure and in governance practices, the document on 'Implementing the

System of Interview Discussion with Board Chairman of Listed Companies' (2001).

Indeed, research interest in the various relations and impact of independent directors

and board structure has greatly increased with the publications of many studies both

16

within and outside China (Chen, et al 2006, Clarke 2006, Lin, et al 2009, Lo, et al

2009). In 2002, the China Banking Regulatory Commission (CBRC) also issued two

similar documents on corporate governance guidelines and independent directors for

joint stock commercial banks, thus widening the coverage to the important banking

sector. In 2005, CBRC also announced guidelines for board directors and a code of

conduct for commercial banks. A year later, CSRC announced Corporate Governance

Code for fund management companies when the country's Securities Law were also

amended.

SASAC and Central EnterpriseGovernance

During this period another important institution, the State-owned Asset Supervision and

Administration Commission (SASAC) was established in 2000. This new institution is

charged with the responsibility of exercising the ownership rights on behalf of the state

over the country's largest state owned enterprises - the central enterprise groups. The

earliest predecessor of SASAC was initially established as a Bureau of State Assets

Administration under the Ministry of Finance in 1988 with limited supervisory power.

By 2004, SASAC started to initiate its 'strategic adjustment' of central enterprises by

separations and mergers to speed up the creation of the governme nt's desired profile

and structure of the national economy through strengthening influence and control over

central enterprises. In a significant but largely overlooked move at the time, SASAC

announced in 2004 its first list of core businesses for 49 central enterprises in

November.

17

Defining core business is important because of the need to ensure that these strategic

enterprises deliver the market outcomes to help achieve national development goals.

Equally important is the government's concern over many central enterprises' tendency

to digress into profitable property development business which diverts them from their

mission to become efficient and globally competitive in their designated industry

sectors. By engaging in risky but high profit property development, coupled with their

advantaged access to bank credits, state owned enterprises will not only distort resource

allocation but can hide poor performance in the core business for which they receive

considerable resource and regulatory support. From a corporate governance perspective,

easy profit can disguise governance failures. However, defining core business for these

huge conglomerate groups was highly contentious and political because of the

multitude of parties with vested interest. One of the most powerful 'stakeholder' in this

contest, apart from the enterprises concerned, is the local level governments which

derive substantial part of their budget revenue from property development activities in

their jurisdiction.

It is interesting to note that only two central enterprises were allowed to list property

development as core business in this first list of 49 central enterprises (China

Construction Engineering Group and China Grains, Oils and Food Group). However,

within a year SASAC's list of enterprises that had property development as core

business had grown rapidly to 13. By the end of 2009 that number has gone up to 16

out of a total of 128 central enterprises. It can be surmised that SASAC may have been

under pressure from a range of interested parties thus making its task difficult to

accomplish. It is because SASAC is in reality one out of many ministerial level

government agencies, and the economic logic of state enterprises making profit as a

18

commercially driven entity was after all not inconsistent with the official rhetoric

although whether so many state owned and supported enterprises should all be

competing in this business has certainly been questioned. Formal designation of core

business however does not mean that enterprises not having property development as

core business will not engage in it. SASAC in its latest attempt announced on 23 March

2010 that those enterprises which do not have property development listed as core

business must make plans for withdrawal from such activities.

Shareholders' Rights

With the number of domestic shareholders and the number of publicly listed Chinese

enterprises on the rise, the national government and CSRC have introduced a series of

rules and measures aimed at improving the rights of shareholders and enhancing the

exercise of such rights. There are two particularly significant ones. One is the Revised

Company Law of 2005, the other was the government's decision on the share structure

reform to transform non-tradable shares in listed companies, which accounted for

nearly two thirds of total shares, into tradable shares. The Revised Company Law

updates and brings in new provisions aimed at giving minority shareholders more

protection. For instance, it introduces the notion of fiduciary duties, the option of proxy

voting and cumulative voting system for election of board directors. It also allows

minority shareholders rights to examine company's financial records and rights to

request company to purchase their shares at reasonable prices in various circumstances.

Directors are required to abstain from voting on matters with conflict of interest. The

Regulations on Strengthening Protection of Shareholder's Rights of the General Public

19

released by the CSRC in 2004 aims to provide more specific requirements on the

company to help protect shareholders' rights.

The decision to phase in the reform for the changeover of non-tradable shares to

tradable share is not only significant for freeing two-thirds of issued shares in China's

stock markets, but could also in time diminish the dominant position of the state as

owner of listed companies. The issue of compensation for existing holders of tradable

shares in this reform (Yeh et al 2009) seems to have been resolved satisfactorily. More

importantly, as a result the reform, some of the corporate governance issues associated

with dominant state ownership such as insider control and ineffective monitoring

through a chain of distinct government agencies can be alleviated. A potentially more

liquid share market can also be expected, thus creating condition for an active market

for corporate control through mergers and acquisitions, satisfying an important

prerequisite for the effective functioning of modern corporate governance arrangements

that China is adapting for its development.

Performance Based Executive Compensation

The traditional agency theory calls for performance-based executive compensation to

better align the interest of managers and shareholders. After much debates on the

subject among policy makers and scholars within China since the mid 1990s, CSRC

was in a position in 2005 to announced measures to enable the use of stocks or stock

option as incentive for senior managers ('Administrative Rules on Stock Incentives in

Listed Company (Trial)').

20

For central enterprises, SASAC first introduced in 2004 interim calculating methods for

state asset value maintenance and growth in these large conglomerate groups. Five

year later in 2009, SASAC announced the 'Interim Rules for Performance Appraisal of

Responsible People for Central Enterprises', with performance measurements based

only on the designated core business, using more sophisticated method of calculating

performance indicators. From the perspective of corporate governance development

this represents a significant step forward and improvement over SASAC's (2000) and

2004 interim calculating methods as it links incentive, compensation to more

objectively determined performance indicators and responsibilities. It also reinforces

the policy intention of encouraging managers to focus on core business.

Property Rights Law; Internal Control

The long awaited Property Rights Law was finally enacted in 2007. It is expected to

provide the basic framework for protection of property rights which is commonly

regarded as a cornerstone for the effective functioning of competitive markets. The

importance and relevance of this law for building China's corporate governance is

therefore non-trivial. However, some scholars consider the Law merely consolidates

and makes concrete existing regulations ( Rehm and Julius (2009). It has also been

argued that that property rights are really not yet in place in China because of the

disconnect between the law and the processes unfolding on the ground (Mertha 2009).

Another related development was the introduction of the Basic Regulations on

Enterprise Internal Control in 2008. It signifies an important attempt to operationalise

in a systematic framework of management and governance practices that will contribute

21

to the entrenchment of more transparent mechanisms and embedded accountability to

enhance risk management and performance outcomes.

The above outline of governance milestones captures some key initiatives considered to

be of more fundamental to building the country's corporate governance system. In the

meantime, regulators such as the CSRC seems to be able to continue developing formal

rules and practical mechanisms to promote more effective corporate governance

practices and outcomes. For example, it has been extensively using its investigative

power to demand reports and impose monitoring and audit processes onto companies as

well as financial institutions. It now regularly publishes lists of companies, directors

and managers who have been investigated and fined by CSRC. Details of their

misdemeanours such as failure to provide proper disclosure of company information,

and the administrative penalties (ranging from a warning to fine) are detailed and

publicly available on CSRC's websites. Multilateral agencies such as the International

Finance Corporation, OECD, Asian Development as well as some foreign investors

have also been active in providing input to help promote the development of good

corporate governance practices in China. The persistent efforts from such organisations

augurs well for the future of corporate governance development in the country although

many problems still remain, some of which are discussed as follows.

In China there exist multiple overlapping government organisations that exercise direct

and indirect regulatory and administrative power over companies, particularly state

owned enterprises. The following key national level organisations have varying scope

and degree of responsibilities over publicly listed companies, state owned enterprises

22

and financial institutions in determining corporate governance rules, procedures and

practices:

• China Securities Regulatory Commission (CSRC);

• China Banking Regulatory Commission (CBRC);

• China Insurance Regulatory Commission (CIRC);

• State-owned Assets Supervision and Administration Commission (SASAC);

• Central Huijin Holding Ltd

• Chinese Communist Party

• People's Bank of China

• Ministry of Commerce;

• State Administration for Industry and Commerce;

• Ministry of Finance;

• Shanghai Stock Exchange and Shenzhen Stock Exchange.

Within these national bodies, most would normally have layers of local administration

branches that are delegated to implement and enforce monitoring and control functions

often with varying degree of rigor and capability. There is a need to clarify, streamline

and re-configure the roles and responsibilities of various government agencies and

ministries so that clear delineation of accountability and responsibilities can be

established and regulatory enforcement effectively acted upon.

For instance, if SASAC were to act as the owner of state-owned enterprises, should the

Chinese government allow it to exercise the usual rights of a shareholder including

having the commensurate power in the appointment of CEO and board directors?

23

Should various forms of monitoring and supervision power over state owned enterprises

be streamlined and coordinated by one main organisation? Or as an OECD report (2005)

on SOE corporate governance has suggested, how should SASAC be 'acting as a

fiduciary for the Chinese people' and committed to accomplishing priorities which

include difficult challenge such as 'restricting irregular behaviour by the state as a

shareholder'.

In reality, SASAC's actual role is quite different from what it might ideally seek to

achieve or initially intended by the government. In respect of one of the key governance

role relating to the appointment, compensation and dismissal of senior managers, board

chairman and directors of central enterprises and their subsidiaries including publicly

listed companies, the final decisions on these matters still rest firmly with the Chinese

Communist Party organisation. The Party might have over 90 millions members that

include most the elite of the society so that it could be argued that it is capable of

creating a large enough pool of talent that could presumably mimic a form of internal

market competition to produce the best qualified people for whatever positions.

However, without truly open and competitive markets for managerial talents, it would

be difficult for the kind of corporate governance model that China is building to work

effectively. Within Chinese companies, in addition to the role of the Chinese

Communist Party, the supervisory board ever since its establishment in the early 1990s,

has also added to the complex duplicity of the less transparent governance arrangements.

The supervisory board has however been found to be generally ineffectual (Tam and Hu

2006) although ways to improve their true governance functions were suggested in an

earlier study by Tam (1999).

24

Bank Corporate Governance

The banking sector's focus on serving the state-owned sector has meant that their

corporate governance and risk management can be severely undermined and weakened.

In Chinese state owned banks, corporate governance and management are in fact more

intertwined than other types of business organisations. While credit risk is commonly

considered as the most important area of Chinese bank management, in the Chinese

environment operational risk and credit risk are often closely linked. Operational risk is

usually multi-faceted and does not readily lend itself to the sophisticated quantitative

modelling routinely applied to managing credit and market risk for example.

Operational risk is in fact often the result of poor corporate governance in Chinese

banks. While the role of corporate governance in reducing debt financing cost is well

recognised, there is also evidence that good corporate governance can serve as

organization collateral to facilitate access to bank loans in China (Firth et al 2009).

One of the most conspicuous features of the malaise of China's banking system for

many years was the huge proportion of non-performing loans in the four major state

banks- Bank of China, China Construction Bank, the Industrial and Commercial Bank

of China and the Agricultural Bank of China. The fact that top leaders of Chinese state

owned banks are also government officials provided a strong basis for the government

to maintain its ability to manipulate changes in bank credit volume and lending

direction to support policy initiatives. The numerous publicly repor ted lending scandals

involving individual bank officials from lower level county branch managers to the top

leaders of state banks highlight the result of an environment where commercial

objectives are still subordinate to political imperatives (Tam and Yu 2009). The

operational risks from such misdemeanours can render carefully crafted credit risk

25

management practices ineffectual in a bank's performance outcomes. In this respect,

well functioning governance structures supported by effective risk management are

essential.

The fact that the government is the owner with a readiness to regularly exercise

influence over the business operation of banks, and at the same time being their

regulator, has certainly complicated the process of corporate governance development

in these financial institutions. The result is that the four Chinese state owned

commercial banks are found to be less profitable and less efficient, and have worse asset

quality than other types of banks (Lin and Zhang 2009). These banks are also found to

be less prudent in their lending practices (Jia 2009). To remedy the weakened

governance in Chinese state owned banks, some observers have pointed to the potential

positive contribution by foreign investors who are expected to help introduce better

governance practices. Luo and Yao (2009) conclude that the most significant

development in Chinese banks before the Global Finance Crisis of 2008-9 was

ownership diversification that aimed to improve corporate governance and performance.

Another view (Kwan 2009) argues that the most critical step in Chinese bank reform is

their public listing on domestic and overseas stock markets because they are not just a

fund raising exercise.

Since 1999, in order to meet the challenges brought on by China's entry into the WTO,

state-owned commercial banks, as well as joint-stock commercial banks and city

commercial banks, began to quicken the shareholding system reform and public listing.

Foreign strategic investors taking long term minority shareholding were being

introduced in Chinese banks. The introduction of overseas strategic investors are

expected to promote the value of commercial banks of China in two ways: on the one

26

hand, they help to enhance the confidence of international capital market in Chinese

banks, which in turn increases the volume of shares issued and the raises the price of

the shares. On the other hand, overseas strategic investors may promote the value of

China's commercial banks by introducing new technology and management expertise,

development of overseas business, reduction of risks and increase of the global brand

images of China's commercial banks. These expected outcomes are consistent with

findings by Ferris et al (2009) on the corporate governance impact of crosslisting in

foreign stock markets.

However, Kudrna (2007) questions the real governance impact of foreign 'strategic

investors' in China's state owned banks. Kudrna observes that these investors had

limited say in the bank's governance and no formal influence on bank management and

lending decisions. Their investment is essentially medium-term portfolio investment

attached with some technical assistance and training. He argues that China's new

standards and regulations were only implemented selectively with the result that the

largest banks remain under firm state control to serve as development policy tools.

The existing corporate governance literature usually separates non-financial from

financial firms and focus on uncovering relation between certain governance

characteristics and manager/director behaviour and/or firm performance based on

isolated firm-level data. Given China's circumstances, and the prevalent dependency on

bank credit for corporate finance, there is a need for a more integrated analytical

framework that takes into account the organic links between non-financial and financial

firms in terms of their governance practices and firm performance outcomes, especially

when dominant state ownership is a common factor.

28

Conclusion

As in other areas of economic reform in China, the development of corporate

governance has taken on a gradual process, seeking and experimenting with ideas and

modalities from abroad and within to create its own system to serve the country's

aspiration for economic growth and modernisation. While rural reforms and the

deregulation of centralised production quotas and prices are often driven by the

apparent logic of market forces for example, China's approach in this important area of

corporate governance development is primarily led by policy makers and regulators to

assist the building of modern corporate and financial sectors. Since the Chinese

government began in the early 1990s its top-down approach to corporate governance

development, there has been considerable progress in creating many key elements and

mechanisms needed.

The spate of formal laws and regulations introduced since the mid 1990s will play their

full role in establishing more effective corporate governance arrangements as the

country undergoes further reforms to create more of the economic and social

institutions and the commercial culture for such arrangement to work effectively.

Attempts by the government to remove some of the obvious impediments such as the

initiative to allow the largely state owned non-tradable shares to become tradable

represents a recognition by the Chinese authorities of the importance of corporate

governance development and signals a more pro-active stand in making the corporate

governance platform already created to work better.

29

Clearly, as discussed in this chapter, there are still considerable challenges in building a

well functioning corporate governance system in China. With the sustained rapid

economic growth in China, reports of corporate scandals and misconducts particularly

at the top level have also become common in recent years. Some of these scandals

involved top leaders of the country's largest business enterprises including its major

state-owned banks. These are certainly symptoms of inadequacies and failures in the

country's corporate governance arrangements. As observed by an IFC (2005) report,

part of the problem is that, even with companies committed to good governance, the

outcomes are often found to fall short of the expected best practices because of the

absence of the deeply embedded business tradition and corporate culture in China.

Moreover, the effectiveness and professionalism of the multitude of regulators are

questionable (Cai 2007), and the traditional issue of who monitors the monitor needs to

be addressed. However, China has not displayed the phenomenon found in some

developing countries where formal governance mechanisms are established solely for

external constituencies to gain legitimacy and not put into practice (Wanyama et al

2009). Indeed given that corporate governance may be institution-specific (Yoshikawa

2009), its development in China will require continuing vigilance and perseverance

from all key stakeholders to shape the system and to make it work.

From the perspective of research that can offer new thinking and insights into

theoretical and empirical issues of corporate governance in general and China's

development experience in particular, there are excellent opportunities. For instance,

while state owned enterprises still dominates the commanding heights of strategic

industries in China, the private business sector which is about 90 per cent owned by

30

families (Zhang et.al. 2002), is growing in their importance in China's economic

growth.

In 2009, private enterprises created 11.4 million new jobs contributing to more than 90

percent of all urban new employments (China Daily , 5 April 2010). Indeed, private

enterprises employed over 72 million people in 2007, exceeding the 61 million workers

employed by state-owned enterprises (State Statistical Bureau). At the end of 2008,

family controlled firms are estimated to account for 31 per cent of China's publicly

listed companies (Zhou et.al. 2010). Family firms are of course not just prevalent in

Asia but rival in numbers to widely-held and other nonfamily firms in Europe, Middle

East and South America (Claessens et.al. 2000, Faccio and Lang 2002, La Porta et.al.

1999). While family firms are gaining increasing importance to the Chinese economy,

their corporate governance development is often neglected and not well understood and

researched. Given their growth potential, studying what will make their corporate

governance work better in the world's largest and fastest growing economy will be

particularly relevant and promising.

31

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38

Table 1 China's National Savings Rate

National

savings rate Government Corporations Households

199539.4 4.6 15.819

199638 5.1 12.820.1

199738.3 5.3 13.719.3

199836.6 4.8 13.118.7

199934.9 5.2 12.916.7

200034.5 5.7 1414.8

200134.2 6.7 13.314.2

200235.1 6.3 12.516.3

200337.3 8.1 13.515.8

200446.6 6.1 2218.5

200548.2 6.4 20.421.5

200650.7 7 28.315.4

Source: Asian Development Bank

39

Figure 1 Stock Market Capitalization in China

Source: Wind Database, China Statistical Yearbook , Shanghai Stock Exchange,

Shenzhen Stock Exchange

0

20

40

60

80

100

120

140

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

1993‐2009 Chinese Stock Market Capitalization ( Percentage of GDP)

Total Stock Market Capitalization/GDP

Negoti a bl e Stoc k Capitalization/GDP

40

Table 2 China Stock Markets

2008 2009

Number of listed companies

(A and B Shares) 1625 1718

Total shares issued ( billion shares) 2452 2616

Of which： Tradeable shares (billion

shares) 1258 1976

Market capitalisation (billion yuan) 12137 24394

Of which: Tradeable shares capitalisation

(billion yuan) 4521 15126

Valid number of shareholders (million) 104 120

Source: CSRC

41

Table 3

Law, Regulations and Administrative Guidelines Relating to Corporate Governance

System Development and Practices

1992 China Securities Regulatory Commission (CSRC) established

1993 Company Law of the People's Republic of China

1998 Securities Law of the People's Republic of China

1998 Shanghai Stock Exchange Listing Rules (revised six times, latest revision 2008)

1998 State Bureau of Industry and Commerce Administration, Administrative Rules for the

Registration of the Legal Representative of Enterprise

1999 Accounting Law of the People's Republic of China

2000 CSRC, Opinions on Strengthening Work on Monitoring and Regulating Listed Companies

2000 Establishment of State-owned Assets Supervisory and Administration Commission (SASAC)

2001 CSRC, Implementing the System of Interview Discussion with Board Chairman of Listed

Companies

2001 CSRC, Guidelines for the Establishment of the System of Independent Directors in Listed

Companies.

(Independent directors to reach at least one third board membership in three years)

2002 CSRC and State Economic and Trade Commission, Code of Corporate Governance for Listed

Companies

2002 CBRC, Guidelines on Corporate Governance of Joint Stock Commercial Banks;

Guidelines on Independent Directors and External Supervisors of Joint Stock Commercial

Banks

2004 Establishment of Central Hui Jin as Holding Company for China's Four State Owned

Commercial Banks

2004 Small & Medium Enterprises Board, launched in Shenzhen Stock Exchange

2004 CSRC, Regulations on Strengthening Protection of Shareholder's Rights of the General Public

2004 SASAC, Notice on the Publication of Central Enterprises Core Business (First Group)

2004 SASAC, Interim Methods for Confirmation of Enterprise State Capital Value Protection and

Augmentation

2005 Revised Company Law

(Introduced proxy voting and cumulative voting system for election of board directors)

2005 CSRC, Measures on the Administration of Split share Structure Reform of Listed Companies

2005 CSRC, Administrative Rules on Stock Incentives in Listed Companies (Trial)

Stock s or stock options to senior managers as incentives

2005 CSRC, Guidelines for Investors Relations Work of Listed Companies

2005 CBRC, Guidelines for Boards of Directors Code of Conduct of Joint Stock Commercial Banks

2006 Amendments to Securities Law

2006 CSRC, Corporate Governance Code for Securities Investment Companies (Trial)

2006 CSRC, Administrative Rules for Takeovers of Listed Companies (Revised 2008)

2007 Property Rights Law of the People's Republic of China

2007 CSRC, Guidelines for Permission to Issue New Shares by Publicly Listed Companies

2008 Ministry of Finance, CSRC, Audit Bureau, CBRC, CIRC, Basic Regulations on Enterprise

Internal Control

2009 Shenzhen Stock Exchange Growth Enterprise Market Listing Rules

2009 SASAC, Interim Method for Performance Appraisal of Responsible People of Central

Enterprises

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The objective of this research is to identify the corporate governance practices applied by family and non-family businesses in Colombia in comparison with codes of corporate governance' recommendations. 22 corporate governance codes from 17 countries were studied, common practices of corporate governance were identified, then has been designed a survey, was applied to 202 employers and responses were analyzed using the Z test. Results reveal a high concentration of power in the first generation of family businesses because the founder does not delegate responsibilities and functions. Second and older generations tend to behave more like non-family businesses on issues related to corporate governance. Future research should identify which corporate governance practices influence in organizations and their performance.

  • On Kit Tam On Kit Tam

This book examines how corporate governance has and should be developed in China to meet the challenges of enterprise and financial reform. It critically assesses China's development in terms of Western debates in relation to the role, practices and evolution of corporate governance arrangements. The author shows with empirical evidence how the Chinese government has adopted a top-down legalistic approach combined with a market based Anglo-American model in developing the country's corporate governance system. A more effective model of corporate governance better suited to the economic and political environment of China is also presented.

Manuscript Type: Review Research Question/Issue: Convergence in corporate governance across countries has been a subject of interest and controversy in a variety of disciplines. We attempt to address a number of related research questions: (1) what constitutes convergence? (2) what are the drivers that propel corporations in different nations towards convergence? (3) what are the major impediments that stand in the way of convergence? (4) what empirical evidence do we have to suggest that we are moving towards or away from convergence? and (5) what would be some productive avenues for further research on this topic? Research Findings/Results: Despite the vigorous intellectual position of the proponents of convergence, there is only limited evidence to indicate that such convergence is actually occurring. Even when there is ostensible convergence, much of it is convergence in form rather than substance, and governance convergence is not a context-free phenomenon. Theoretical Implications: Our review of the past literature suggests that increasing integration of product and capital markets is leading to changes in corporate governance around the world, but there is only limited evidence that such changes constitute convergence. Governance changes seem to be primarily attributable to the quest for greater efficiency in governance and enhanced legitimacy in capital markets. However, local forces such as institutional embeddedness and politics can hinder governance changes or create "hybrid" practices. Practical Implications: The ideal corporate governance may be institution- and firm-specific and an imposition of new practices or standards may not lead to intended policy or performance outcomes.

  • Chunxin Jia

Although the relationship between bank ownership and performance is the current focus of much research, this paper investigates the relationship between ownership and the prudential behavior of banks. Using Chinese data, I show that lending by state-owned banks has been less prudent than lending by joint-equity banks, but has improved over time. This is consistent with the hypothesis that accountability to shareholders and depositors gives joint-equity banks a better incentive than state-owned banks to engage in prudent lending, and with the hypothesis that the reform of the banking system has improved the incentive for state-owned banks to behave more prudently in their lending.

The current financial crisis hit the banking giants of the world really hard. It is striking to note that some of the large Chinese commercial banks have emerged to be the biggest winners as a result of the crisis thanks to reforms over the last 10 years. The most significant reform before the crisis was ownership diversification, aiming to improve corporate governance and efficiency. Within one year from October 2005, three of the four biggest state-owned banks (SOBs) were listed on the stock exchanges. This paper will study whether this reform has really improved bank efficiency. Adopting the DEA (data envelopment analysis) approach, this paper examines whether IPO (initial public offering) is effective in enhancing bank performance. Using data of 14 listed banks during 1999-07, the results show that on average, bank efficiency increased by almost 10% after listing. Despite joint equity banks (JEBs) still perform better than SOBs, the latter manage to catch up and reduce the efficiency gap with the former during the past few years. This in part explains why the Chinese banking system has been less affected by the current world financial crisis than their western counterparts, leading to an important conclusion that SOB reforms in China over the last 10 years have produced remarkable results.

  • Hua Cai

Protection of minority shareholders is crucial to developing a strong capital market. Yet, formal legal enforcement is one, but not the only effective mechanism to offer this protection. When a country's formal legal enforcement is weak, to attract investment, entrepreneurs have incentives to develop functional alternatives to assure minority shareholders' interests are protected, and, as such, entrepreneurs may voluntarily "bond" themselves. China's experience provides many examples of company-initiated "bonding" practices. Among the various bonding mechanisms that have been utilized, diversifying the ownership structure and cross-listing are so far the most effective. As such, to improve corporate governance in China is not only a question of improving the quality of legal enforcement mechanisms, but also a challenge of finding ways to encourage, facilitate, and support voluntary bonding practices. In this article, three polices are proposed to improve corporate governance, with the common theme of facilitating voluntary bonding practice. First, companies who are willing to bond themselves and improve their corporate governance should be encouraged to cross-list their stock overseas and voluntarily subject themselves to higher disclosure standards and more stringent legal liability. Second, China should facilitate competition between exchanges within its jurisdiction and allow more non-state-owned enterprises to go public. And finally, the corporate law in China should follow the self-enforcing model, where private enforcement is emphasized and encouraged.

We analyze the ultimate ownership and control of 3,740 corporations in five Western European countries. We document that families are the most pronounced type of controlling shareholders in Western Europe. In fact, they control 43.9 percent of Western European firms. We also document a significant concentration of wealth within a small number of families. We report that, in Western Europe, pyramids and cross-holdings are used to gain control, and hence a significant separation of ownership from control is achieved but not to the benefit of controlling owners.

  • Chong-En Bai Chong-En Bai
  • Qiao Liu
  • Joe Zhou Lu
  • Junxi Zhang

This paper studies the relationship between the governance mechanisms and the market valuation of publicly listed firms in China empirically. We 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 annual reports. We then investigate how the market-valuation variables are affected by the corporate governance variables while controlling for a number of factors commonly considered in market valuation analysis. A corporate governance index is also constructed to summarize the information contained in the corporate governance variables. The index is found to have statistically and economically significant effect on market valuation. The analysis indicates that investors pay a significant premium for well-governed firms in China, benefiting firms that improve their governance mechanisms.