Structural changes in Chinese Stock Market A review of Empirical Research

Structural Changes in Chinese Stock Market: A Review of Empirical Research

Jiajia FU, Haitian LU*

Abstract

China’s stock market has gone through major structural changes since its inception in early 1990s. In this survey article, we review the empirical literature that document these important structural changes and published in 15 leading accounting and finance journals from 1998 to 2013. In analyzing this literature we focus on the ‘distinctiveness’ of Chinese stock market compared with developed stock markets (e.g., U.S) and the research opportunities generated by the China setting. Key themes include China’s share issue privatization reforms, the political connections in private owned companies, characteristics of Chinese listed companies and their governance, the regulatory environment reforms in China, and the evolving role played by auditors and other information intermediaries.

JEL: D82 D86 G21 G30 G34 G38 M40 M41 M50 M52 M55

Keywords: China, Stock Market, Structural Change, Corporate Governance, Financial Accounting, Auditing, Executive Compensation, Financial Reporting

We thank the Chief editor Prof. C.S. Agnes Cheng, reviewer Louis Cheng, and Charles Lee, James Ohlson, Wayne Yu, Nancy Su, participants at the 2013 China Accounting and Finance Review (CAFR) conference for helpful comments on earlier versions of the paper. The authors are responsible for any remaining errors or omissions.

*Haitian Lu is an Associate Professor and Jiajia Fu is a Ph.D candidate both at School of Accounting and Finance, Hong Kong Polytechnic University.

Electronic copy available at: http://wendang.chazidian.com/abstract=2423022

1. Introduction

Since the market-oriented economic reform in 1978, China has entered into a stage of financial deregulation and liberalization. An important part of China’s financial development is the inception and growth of a stock market since 1991. Guided by the philosophy of “crossing the river by touching the stones”, the Chinese government has launched a series of reforms to nurture a stock market that is , These reforms, in conjunction with other distinctiveness of Chinese institutional environment, create bunches of important research questions and make Chinese stock market a natural laboratory in accounting and finance research.

The purpose of this paper is threefold: (1) we identify important structural changes in Chinese stock market since 1990s; (2) we highlight the salient features of Chinese stock market compared with developed market like the U.S. and research opportunities that are generated; (3) we review corresponding empirical evidence, summarize key research findings and identify potential areas for future research. As this is a survey article, to keep the scope of our review manageable, we only review papers other work when it helps to phrase the issue on a broader context. 1 The criteria for selection is described as follows: We first search articles whose title contains the word “China” or “Chinese” in these 15 journals from 1998 to 2013, and then manually identify those empirical research that use data from firms publicly traded in Chinese stock market. As our focus is on China’s stock market, we 95 articles and their distribution by year and by journal is listed in Figure 1.

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The rest of this paper proceeds as follows. Section 2 discusses the purpose and course of Share Issue Privatization (SIP), a giant step forward of state owned enterprise (SOE) reforms in the 1990s. We review a vast SIP literature that focus on the ownership structure of privatized SOEs and the efficacy of SIP. We also discuss China’s unique reform of non-tradable shares initiated in 2005 that aims at solving 1 These journals include: The Accounting Review (TAR), Journal of Accounting & Economics (JAE), Journal of Accounting Research (JAR), Contemporary Accounting Research (CAR), Review of Accounting Studies (RAS), Journal of Accounting and Public Policy (JAPP), Journal of Accounting, Auditing & Finance (JAAF); Journal of Finance (JF), Journal of Financial Economics (JFE), Review of Financial Studies (RFS), Journal of Financial and Quantitative Analysis (JFQA), Journal of Business (JB), Journal of Banking & Finance (JBF), Journal of Corporate Finance (JCF), Journal of International Money and Finance (JIMF).

Electronic copy available at: http://wendang.chazidian.com/abstract=2423022

the fundamental corporate governance problems and booming the stock market. Another equally interesting question we analyze in this section concerns the puzzle of A-B/A-H share price discount and the investor protection environment disparity between A share market and H share market. Section 3 discusses the role of political connections in China and its implications on a number of capital market activities. We begin by illustrating the structural changes on firms’ access to the capital market, and then outline various ways in which political connections are valuable or costly to firms. In Section 4 we outline the nature of agency problem and review the literature on corporate governance in publicly traded firms in China with an emphasis on the Type II agency problem through related party transaction, their board structure, executive compensation, CEO turnover, and dividend pay-out, etc. Section 5 focuses on the evolution of regulatory environment in China, especially on a comprehensive list of corporate governance issues aiming at enhancing investor protection, litigation risk, and accounting standard reform. We begin by several examples examining the efficacy of corporate governance regulations. We then show the timeline of litigation risk evolution in China. Finally, we discuss the financial reporting incentives and disclosure environment in China, and evaluate the efficacy of the accounting standard reform. Section 6 considers the external monitoring mechanism through auditors and other financial institutions. We outline salient features of the auditing market in China and then turn to discuss the auditing research on audit quality and auditors’ independence. We also address the monitoring role and the information role of other information intermediaries such as institutional investors and financial analysts. Section 7 concludes and suggests directions for future research.

2. Share Issue Privatization (SIP)

Share issue privatization (SIP), in which the government sells shares in SOEs to private investors, has been the most popular method of privatization and been successful in improving firm efficiency and profitability (Megginson and Netter 2001, Gupta 2005, Shleifer 2005). The development of Chinese stock market must be understood in the context of the “partial privatization” process of SOEs in the 1990s. Early in 1980s, the Chinese government launched the SOE reform with the desire to promote the market by decentralizing the central government’s managerial decision rights in SOEs. In the 1990s, the government allowed SOEs to be partially privatized by issuing new and minority shares to individual investors, who could trade their shares freely in newly developed Shanghai and Shenzhen stock markets set up in early 1990 and 1991, respectively. Fan et al. (2012) describe this reform as an ‘exogenous shock’, in the sense that it was politically motivated, aimed at creating a stock market that is representative of various geographical regions and industries in China. The central government decided which subset of the SOE to be carved out and listed and the firms themselves had little say in that process. However, this partial privatization process prohibited the government from selling its controlling stake in the firms. This created a unique dichotomy between tradable (or negotiable) and non-tradable (or non-

negotiable) shares. In other words, the (minority) shares held by public investors are freely tradable on the stock market, whilst (majority) shares held by the state and legal persons that are not tradable. On the other hand, the booming private sector has generated large numbers of private-owned companies that also tap the stock market. La Porta, Lopez-de-Silanes and Shleifer (1999) surveyed the ownership of large listed companies around the world and find it is mostly concentrated in the hand of families and/or the state except in the United Kingdom and the United States where such ownership is dispersed. In China we have a laboratory where companies of these two types of ownership co-exist and are competing on efficiency grounds.

2.1 The ownership structure in privatized SOE

China has adopted a two-step approach to privatization. The first step was ‘partial’ privatization, which involves the SOEs sell minority stake to public investors which are listed on the stock market. The second step is a ‘complete’ privatization in which the government sells its controlling rights to private investors in selected SOEs.

One salient feature of the ownership structure in partial privatization is that the government remains the largest controlling shareholder in privatized firms (Sun and Tong, 2003), and usually its ownership far exceeds that of the second largest shareholder. Specifically, on average, state-owned shares and legal person shares (indirectly owned by the government) account for 70% of the total number of shares in Chinese listed firms during the sample period 1998-2004 (before the reform of non-tradable shares). In a typical partially privatized Chinese SOE, the largest stockholder owns, on average, more than 40% of a firm’s shares while the second largest stockholder owns less than 10% (Peng, Wei and Yang 2011). As such, an equally important research question is the identity of large shareholders. A vast literature on state ownership implicitly assumes there is just one type of state owner. However, the state ownership of listed firms in China is undertaken by different type of agencies with various degrees of political intervention and different objectives. Therefore, using share type as a proxy for owner type is not valid and can lead to erroneous conclusions. Indeed, the government ownership is represented by various entities such as government agencies (the state asset management bureau at various levels), state asset holding/management companies, and SOEs. By tracing the identity of ultimate controller, Chinese listed companies can be grouped into those SOEs controlled by state asset management bureaus (SAMB), SOEs affiliated to the central government, SOEs affiliated to the local government (Chen, Firth and Xu, 2009).

2.2 The effect of China’s partial privatization

Gupta (2005) argues that although partial privatization does not transfer control to private owners, there is a role that stock market can play in monitoring and rewarding managerial performance. It is an

interesting empirical question that how effective is China’s partial privatization on the value, performance, and behavior of firms. We survey the findings of this empirical literature in Table 1.

[Insert Table 1]

Table 1 shows the empirical results generally consistent with the hypothesis of an efficiency gain after SOE’s partial privatization. The increasing minority private ownership is shown to be associated with higher perceived value of the firm (Wei, Xie and Zhang 2005), higher profit reinvestment rate (Cull and Xu 2005), higher discount rate in making investment decisions (Liu and Siu 2011), improved firm’s earnings ability, real sales, and workers’ productivity (Sun and Tong 2003), better transparency of firm’s specific information (Gul, Kim and Qiu 2010), lower earnings management (Chen et al. 2011), higher pay-performance sensitivity (Cao, Pan and Tian 2011), higher accounting conservatism (Chen et al. 2010), and the choice of higher quality auditors (Wang, Wong and Xia, 2008). The primary argument is that the stock market provides incentives for investors to gather information that is reflected in share price, and this information can improve managerial incentives in a number of ways.

However, partial privatization has its limitations from at least two perspectives. First, due to unique institutional background (such as weak legal enforcement, overall poor corporate governance, etc.), the monitoring role of private ownership over companies is questioned. For example, although most studies on developed market agree that direct bank ownership provides better capital access to and better monitoring on companies (Diamond 1984; Barth et al. 2006), Lin, Zhang and Zhu (2009) document that bank ownership in China is associated with poorer operating performance possibly due to inefficient investments.

Second, the management in partially privatized SOEs generally has a very small or even nonexistent ownership stake, and this distinctive shareholding structure fails to align the incentives of managers with firm performance. Specifically, managerial ownership, foreign ownership, and employee ownership represent less than 2% of the outstanding shares and so they do not constitute major voting blocks (Chen, Firth and Xu 2009). Regarding managerial ownership, for a sample of 5284 publicly traded Chinese firms, Wei et al. (2005) report an average stock holding of only 0.015% by senior managers and directors for partially privatized SOEs. Due to such low managerial ownership, most related literature on ownership structure has unanimously ignored managerial shares. Using a unique sample of non-listed Chinese firms, Hu and Zhou (2008) find that firms of significant managerial ownership outperform firms whose managers do not own equity shares. As for employee shares, China introduced employee stock ownership plans (ESOP) in 1992 purely as an employee incentive scheme, and it was abruptly terminated 2 years after initiation. This creates an opportunity to investigate the impact of ESOP on corporate performance. Meng et al. (2011) exploit this policy experiment and find that ESOP does not appear to have effect on firm value and performance.