Chinese Listed Companies: Ownership Structure and Performance

Introduction

Chinese listed companies have different ownership structures. They can be broadly classified as those majority owned by the state, Sino-foreign joint ventures, and private enterprises. The performance of these companies is also influenced by the fact that not all shares were freely transferable on the open market. The Chinese government has been allowing these so-called "legal person shares" to become formally transferable — a process that implies greater liquidity. Although most of these shares remain ultimately controlled by the Chinese government, the presence of institutional shares is believed to exert a positive effect on firm performance (Stiglitz 2001).

Whether these influences also affect firm performance as reflected by share prices remains an open question, and this gap in the literature forms the focus of the study proposed herein. The research topic is to study the relationship of Chinese listed state-owned companies before and after the stock reform program. The program was designed to gradually and orderly unlock and free up "legal person" shares — which were previously non-transferable — so that they would become freely tradeable on the stock market. In addition, the study compares the performance of these state-owned companies with the market performance of their peers.

The growth of the Chinese stock market during the 1990s was highly impressive, and its performance was all the more noteworthy because of the environment in which this growth took place. According to Wong (2006), "For more than 30 years after 1949, China was a centrally planned economy in which virtually all enterprises were state owned or collectively owned. Investments were centrally planned and funded by government fiscal grants as well as by loans from the state-owned monobank system as dictated by the government's central credit plan" (p. 389).

Overview of Literature

This framework began to undergo profound changes during the late 1980s, and a number of enterprise reforms were implemented as part of the larger framework being used for China's gradual transition into a market economy (Wong 2006). Local governments took the opportunity to experiment with selling shares of collectively owned enterprises directly to Chinese consumers in an effort to generate equity capital. Curbed trading of enterprise shares was followed by over-the-counter trading in various stock exchanges that were better organized but still informal (Wong 2006). This changed in 1991, when two stock exchanges were created: the first by the Shanghai municipal government and the second by the Shenzhen municipal government, following formal approval by the Chinese government (Wong 2006).

Moreover, China's 1996 shift from an economy of shortage to one of surplus reduced rent-seeking opportunities for local officials and managers arbitrating between the plan and the market. The practice of diverting goods from the planned sector to sell at higher market prices was no longer viable. Furthermore, local market niches became unsustainable despite protectionist efforts by local cadres (Lin 2008). Widespread privatization of town and village enterprises followed, and state-owned enterprises began to cut their losses by discharging workers and experimenting with mergers and other market consolidation options (Lin 2008). During the eleven-year period between 1992 and 2003, the Chinese market generated a total of 796.79 billion yuan (approximately US$125.81 billion) of equity capital (Wong 2006). By the end of 2003, the Chinese stock market had more than 70 million investor accounts and 1,287 listed enterprises (Wong 2006).

After nearly two decades of economic reform that ushered in sustained double-digit growth unprecedented in Chinese history, the restructuring of state-owned enterprises (SOEs) became the key to the success of the Chinese economy in the subsequent decade. In contrast to the radical ownership privatization approach widely adopted in Russia and Eastern Europe, China's reform of SOEs started with the market approach. This market-oriented approach posits that if competitive markets are created for products and factors of production, SOEs can be successfully transformed from loss-making cost centers into profitable, return-oriented investment centers without radical changes in ownership structure (Qi et al. 1999).

Although this approach contributed significantly to the growth of the overall Chinese economy, it largely failed to enhance the performance of SOEs, as evidenced by the increasing percentage of SOEs operating in deficit. Consequently, systematic ownership reform became the dominant theme behind two new initiatives for SOE restructuring. While unprofitable small- and medium-sized SOEs were privatized or merged, large SOEs were converted into shareholding companies with limited liabilities, and a selected few were listed on China's two stock exchanges. Behind these strategic moves was the belief that transformed SOEs could be protected from government interference in their daily operations, clarify their property rights, raise new capital, and make management more accountable for its decisions. Improved corporate performance would follow, and the state could benefit through its shareholding in these SOE-transformed companies (Qi et al. 1999).

The performance of SOEs cannot necessarily be improved by setting up shareholding companies alone, however, for several reasons:

First, severe agency problems arising from the separation of ownership and control continue to exist in SOE-transformed companies if the state remains the controlling shareholder. Because the state and its representatives have inadequate resources and expertise for monitoring and disciplining management, the conflict of interests between the state and management persists. In fact, management enjoys more autonomy after corporatization and effectively controls shares owned by the state.

Second, it is not always clear that the objective function of the state and its representatives is to maximize shareholder value. For example, the state may seek to keep redundant workers on the payroll of SOEs and SOE-transformed companies to preserve social stability, even though such a policy renders them less profitable.

Third, diffused shareholders are not adequately motivated to monitor management decisions closely because of the free-rider problem. Therefore, the performance of SOE-transformed firms may be significantly affected by their ownership structure (Qi et al. 1999).

Across the board, the Chinese experiment with shareholding exceeded even the liberal model recommended by the World Bank (Cao 2000). According to Wong (2006), the Chinese State Council promulgated regulatory guidance in May 1992 that categorized the shares of a shareholding enterprise into three types: (1) state and legal person shares, owned either directly or indirectly by the state, which cannot be traded freely on the stock exchanges but can be transferred only with administrative approval; (2) A-shares, which are yuan-denominated and available for trading by domestic private shareholders on the stock exchanges; and (3) B-shares, which are available for trading by foreign investors in foreign currencies on the stock exchanges.

This regulation effectively codified an important feature of China's stock market: three distinct markets exist for the stocks of a listed enterprise — the one-way transfer market for state-owned shares, the A-shares market for domestic private shareholders, and the B-shares market for foreign investors (Wong 2006). In this regard, Qi, Wu, and Zhang (1999) report that "equity ownership in a listed Chinese firm can have as many as five different classes: state-owned shares, legal-person shares, tradable A-shares, employee shares, and shares only available to foreign investors, a phenomenon that is unique to the Chinese equity market" (p. 1). With reform proceeding, the foreign and private sectors of the economy developed greatly, giving rise to diversified forms of ownership and operation. Realizing the competitive disadvantages of state-owned enterprises, the government took various measures in reforming them. Thousands of SOEs became stock companies, and foreign investors were even permitted to purchase small-scale state-owned enterprises after they were restructured into stock companies (Wang 2000, p. 80).

Laws and regulations were also enacted for enterprises to "corporatize" into entities established on the basis of a stock ownership system. At the national level, the State Commission for Restructuring the Economic System and other relevant government departments jointly issued the Share Enterprise Trial Measures on 15 May 1992. Pursuant to these Measures, the Commission issued regulations known as the Opinion on Standards for Companies Limited by Shares, setting out guidelines for establishing stock companies. At the local level, Shanghai and Shenzhen each enacted their own separate guidelines for the establishment of stock companies (Wang 2000, p. 218).

Pursuant to the 1992 Opinion on Standards for Companies Limited by Shares, while a Chinese company is permitted to issue common or preferred shares comparable to those issued in the United States, these shares must be further divided into categories based on the shareholder's status: state shares, legal person shares, and individual shares. The last category is further divided into A-shares (purchasable by Chinese citizens in yuan) and B-shares (purchasable only by foreign investors in foreign currencies) (Cao 2000). State shares are purchased with state assets by governmental departments and usually constitute fifty percent or more of all issued shares, making the state a majority shareholder in most instances. Legal person shares are owned by entities such as companies and institutions — usually other state enterprises (Cao 2000).

By contrast, individual shares are held by employees or individual investors from the general public. Only individual shares of listed companies can be traded on the stock exchanges. State shares and legal person shares are nontransferable, ensuring that the state and its agencies retain their respective dominance. For example, in 1996, when the Shanghai-listed Beijing Light Bus sold a twenty-five percent stake in non-transferable legal person shares to two Japanese companies — Isuzu Motors and Itochu — the government allowed the transaction only reluctantly and promptly decreed that no similar transactions would be permitted in the future (Cao 2000).

Similarly, when the board of directors of Harbin Pharmaceutical, a Shanghai-listed company, approved a transfer of fifty-two million state shares to individual shareholders in 1993, the CSRC allowed the transfer only after issuing a stern warning and determining that the company had acknowledged its mistake. State shares represented 74 percent of Harbin's total shares (Cao 2000). Consequently, the illiquidity of state-owned shares "makes it difficult for stock markets to exercise their function of adjusting state owned assets structurally, causing the market to be marked by excessive state domination" (Cao 2000, p. 13).

Although there remains a dearth of relevant research in this area, a seminal study by Wang and Xu (1997) on the role of institutional shareholders in the performance of publicly listed Chinese companies found that the effect of ownership concentration is greater for companies dominated by legal person shares than for those dominated by the state.

Research Questions and Hypotheses

The proposed study is guided by the following research questions, together with any additional questions that emerge during the research process:

RQ1: What is the relationship between Chinese listed state-owned companies before and after the stock reform program of 1992?

RQ2: How does the performance of these state-owned companies compare with the market performance of their peers?

The effects of managerial ownership on firm value have been of particular research interest in the corporate finance literature (Denis & McConnell 2003). There is a growing consensus that managers' and shareholders' interests are not fully aligned. This conflict of interest produces agency problems that reduce firm value. An increase in managerial ownership helps to align the interests of insiders and shareholders, leading to better decision-making and higher firm value. However, when equity owned by management reaches a certain level, further increases may provide managers with sufficient shares to pursue their own interests without concern for declining firm value. When managerial ownership approaches a considerably high level, the agency problem can be largely mitigated through full alignment of manager and shareholder interests. It is therefore hypothesized that among Chinese listed companies, managerial ownership and firm value have a nonlinear relationship (Ruan, Tian & Ma 2011).

This hypothesis is consistent with the fact that while managerial ownership is one of the ways Chinese companies adopt Western corporate governance practices, the proportion of managerial ownership is quite small among state-owned companies, with a mean value during 2002–2007 of just 0.0929 percent. In contrast, the mean value of managerial ownership for civilian-run companies was 9.31 percent. Compared to state-owned enterprises, civilian-run firms have much more autonomy and profit retention, and managers are more often appointed on merit and ability rather than political patronage. Most civilian-run firms adopt a managerial-ownership governance approach, giving their managers more discretion over funding, pricing, and labor practices (Ruan et al. 2011).

Hypothesis 1: The performance of Chinese firms having the state as a controlling shareholder is lower than that of other listed companies. The state remains the largest shareholder in most Chinese companies, and it is hypothesized that government bureaucrats acting as agents of state-owned shares will be less proficient in overseeing company operations.

Hypothesis 2: The performance of a company is negatively related to the relative shareholding of its largest shareholder. Hu and Hu (2004) and Su and Zhu (2003) find that the controlling shareholders of Chinese listed companies engage in the expropriation of minority shareholders in ways no different from their overseas counterparts. Yu and Xia (2003) discover that the market value of Chinese companies with a controlling shareholder is significantly lower than that of companies without one. This hypothesis is tested to verify this negative relationship.

Hypothesis 3: There is a positive relationship between firm performance and the square of the relative percentage shareholding of the largest shareholder. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1999) identify expropriation of minority shareholders by controlling shareholders as an agency problem worldwide. However, as the largest shareholder's proportion increases and approaches 100 percent, the incentive for expropriation diminishes as their interests become more aligned with those of minority shareholders. Because the relationship may be nonlinear, the square of the shareholding proportion is used to control for non-linearity.

Hypothesis 4: The performance of Chinese companies with foreign shareholders is better than that of those without. Huang and Song (2002) explain that foreign shareholders bring value to Chinese companies by providing additional funds, demanding higher corporate governance standards, and contributing technical know-how and management expertise.

A positivist research philosophy has been adopted in this study, given that its main purpose is to examine correlations among variables using quantitative measures. Patton (1990) argues that a quantitative, positivist mode guides the researcher toward a quest for certainty and objectivity. The research rests on the scientific method, hypothesis testing, quantitative tests, and standardized research tools (Burrell and Morgan 1979).

Quantitative methods are used to test and verify the hypotheses under a positivist paradigm (Gephart 1999; Pallant 2001). Using pooled data for Chinese listed companies, regressions of performance variables on concentration of ownership are run. The financial indicators of Return on Assets (ROA) and Adjusted Return on Assets (CROA) are both used to measure performance. ROA is the ratio of net operating profit before tax to total assets — a measure of accountability considered superior to ROE (Wu 2004). CROA uses only operating profit from core operations, excluding profit from non-core activities, thereby measuring core operational performance more objectively. The general regression equation is: