Institutional Causes of Corporate Finance and Governance in Asia Joseph P.H. Fan ( Professor, School of Accountancy and Department of Financehttp://ihome.cuhk.edu.hk/~b109671/index.html Deputy Director, Center for Institutions and Governance ( The Chinese University of Hong Kong Prepared for the 2005 AAA Meeting, San Francisco

Joseph FanInstitutions Outline  Research framework  Asia’s institutional environments  How rent seeking affects corporate behaviors  Conclusions

Joseph FanInstitutions A Top-down Framework Country Institutions The legal system (the court and the law) The government (regulations, public sector governance) The society (religion, ideology, custom, social norm) Markets Product, labor, manager, raw material, financial capital Firms Firm boundary (vertical integration, diversification) Ownership and control structures Governance structures (accounting, boards of directors, executive compensation, reputation mechanisms)

Joseph FanInstitutions Theoretical Framework Economics of Property Rights Economics of Transaction Costs Agency Theory

Joseph FanInstitutions Asia ’ s Business Environments  Incomplete or weakly enforced laws and property rights  Government regulations / interventions in market activities  Corruption problems in a few economies  Crony capitalism: some governments allocate business privileges by connections rather than by the market rule  Relationship-based transactions, Confucianism, low trust society

Joseph FanInstitutions Property Rights Protection in Asia (Source: Property Rights Index, Heritage Foundation, 2001)

Joseph FanInstitutions Protection of Property Rights across China ’ s Different Regions High MiddleLowMissing

Joseph FanInstitutions Asia - A Rent Seeking Society  Business tycoons seeking rents from governments  Politicians seeking rents from business  Vast grey areas of laws and weak (selective) enforcement make rent seeking highly rewarding  Perceived corruption levels of a few Asian economies are high

Joseph FanInstitutions Corruption in Asian Economies (Source: Transparency International: mean Corruption Perception Index )

Joseph FanInstitutions Pervasive Corruption in China  According to China’s official record, during , there are totally corruption cases under investigation corruption cases concluded people punished by communist laws, of which expelled from the communist party Among the punished communist party members,  county （县） level  2422 intermediate （厅, 局） level  98 provincial （省, 部） level or above

Joseph FanInstitutions Rent Seeking and Corporate Behaviors  The quality of public sector governance is of the first order importance in shaping the behavior of Asia’s corporate sector  However, it is often ignored in corporate sector debates in Asia and around the world  In the following we present our research progress on the roles of rent seeking in Stock valuation Corporate finance Governance and professionalism Corporate transparency Organizational structure

Joseph FanInstitutions I. Low Stock Valuation  Asian share investors are subject to expropriation by politicians and/or managers  Investors not able to fully enforce their property rights results in low valuation of shares

Joseph FanInstitutions Claessens, Djankov, Fan, Lang (2002)

Joseph FanInstitutions Price Protection by Minority Shareholders in Asia Claessens, Djankov, Fan, Lang (2002)

Joseph FanInstitutions Post-IPO stock return performance (CAR) of 625 China ’ s partially privatized firms (Fan and Wong, 2005) Cumulative market-adjusted compound stock returns

Joseph FanInstitutions Chinese companies ’ post-IPO stock return performance (CAR) distinguished by whether CEOs are politically connected (Fan and Wong, 2005) Cumulative market-adjusted compound stock returns

Joseph FanInstitutions Firm Behavior II: High Financial Leverage  Companies in Asia rely on debt much more than equity to finance their investment  Moreover, they rely on short-term debt, even when they engage in long-term investment  Banks, not capital markets, are the primary sources of funds for firms in Asia and other developing countries  Why are these? Owners ’ desire to maintain control More fundamentally caused by institutional factors

Joseph FanInstitutions Cross Country Pattern of Corporate leverage (Fan, Titman, Twite, 2004)

Joseph FanInstitutions Cross Country Pattern of Corporate Debt Maturity (Fan, Titman, Twite, 2004)

Joseph FanInstitutions Rent seeking and Corporate Finance  In a corrupted country, the government is a weak enforcer (or even a violator) of property rights, and debt (bank loans) provide better protection than equity  Politicians/bureaucrats channel funds to their favored firms through banks they control  We are investigating the effects of government officers corrpution on corporate finance in China (Fan, Rui, Zhao, in progress)

Joseph FanInstitutions Cumulative abnormal stock return around initial disclosure of corruption cases (Daily CAR[-10, 20]) The sample include China ’ s listed companies whose senior managers were found to have bribed the caught politicians

Joseph FanInstitutions Cumulative abnormal stock return around initial disclosure of corruption cases (Daily CAR[-10, 20]) The sample include China ’ s listed companies whose senior managers were former or current colleagues of corrupted politicians

Joseph FanInstitutions Corruption and Firm Leverage in China (Fan, Rui, Zhau, in progress)

Joseph FanInstitutions Corruption and Long-term Debt Financing in China (Fan, Rui, Zhau, in progress)

Joseph FanInstitutions Corruption and Corporate Debt Maturity in China (Fan, Rui, Zhau, in progress)

Joseph FanInstitutions Corruption and Short-term Debt Financing in China (Fan, Rui, Zhau, in progress)

Joseph FanInstitutions Rent Seeking and Firm Leverage in China

Joseph FanInstitutions Rent Seeking and Corporate Debt Maturity in China

Joseph FanInstitutions Rent Seeking and Long-term Debt Financing in China

Joseph FanInstitutions Rent Seeking and Corporate Short- term Debt Financing in China

Joseph FanInstitutions Firm Behavior III: Weak Internal Governance and Low Professionalism  Weak governance and low professionalism of Chinese firms Over a decade since China ’ s opening up its stock markets, the governance function and the degree of professionalism of listed companies ’ management and boards of directors remain weak compared to the western standard.  Chinese boards are populated with politicians (current or ex-government bureaucrats)

Joseph FanInstitutions Firm Behavior III: Boards of directors are weak in governance: the case of China (Chen, Fan, Wong, 2004) Board size 9.22 (range 5 to 19) Manager directors34% Largest shareholder53% Minority shareholders0% Politicians32% Central govt4% Local govt19% Others9%

Joseph FanInstitutions Firm Behavior III: Low Director Professionalism in China ( Chen, Fan, Wong, 2004) Directors from unaffiliated firms (outside experts)18% Accountants, lawyers, finance experts5% Academics14% Woman directors5% Age 47 EducationBetween Junior college and university

Joseph FanInstitutions Corruption and board professionalism Shougang Group in China Percentage of Directors that Are Professionals – Corruption Case

Joseph FanInstitutions Firm Behavior IV: Opaqueness  Why are Asian companies opaque? Complex organizational and ownership structures Covering up: difficulties of putting investors ’ interests before family interest Relationship-based business dealings, rent seeking, or even corruption Prevent predation and expropriation (sometimes by governments) in weak property rights systems  If these institutional constraints cannot be relieved, it would be difficult to improve corporate transparency even with new accounting standards, laws, and regulations

Joseph FanInstitutions Opacity Premium in Asia Source: PricewaterhouseCoopers

Joseph FanInstitutions Corruption in Asian Economies (Source: Transparency International: mean Corruption Perception Index )

Joseph FanInstitutions Firm Behavior V: Complex Organizational Structures  Business group A corporate organization where a number of firms are linked through stock-pyramids and cross-ownership Groups are the dominant form of corporate organizations in Asia. About 70 percent of publicly traded companies in Asia are group affiliated (Claessens, Fan, Lang, 2005)  Diversification Asian companies are known for extensive diversification of their businesses (Claessens, Fan, Lang, 2004)

Joseph FanInstitutions Figure 1: Organization Framework of Fusun Group 20 ％ Iron&Steel 25 ％ (2) Commerce Medicine ％ Estate 10% 22% 5% 11.95%(2) 10 ％ 58% 95% ％ 90.3% 20 ％ 90 ％ 1.94 ％ 10 ％ 49 ％ (2) ％ (2) ％ (1) ％ ％ 8.81 ％ ％ ％ (2) 30 ％ 3.77 ％ 30 ％ ％ ％ (1) 48 ％ (2) 20 ％ 21 ％ Shanghai Guangxin Technology Development Co. Ltd. Shanghai Fusun High Technology (Group) Co. Ltd. NISC (600282) FORTE (HK2337) YYTM (600655) ％ Nanjing Iron &Steel United Co.,Ltd. Shanghai Fusun Pharmaceutical Development Co. Ltd. Shanghai Fusun I.T. Development Co. Ltd. (Subsidiary) LRGF (600285) Tianjin Pharmaceutical Holdings, Ltd. TJPC (600488) 中国医药控股有限公 司. ACCORD PHARM (000028) Shanghai Friendship- Fusun (holding) Co. Ltd. SFGIC (600827) Tangshan Jianlong Steel Co. Ltd. Lianhua Supermarket (HK0980) Fusun Pharm (600196) Zhaojin Mining Co. Ltd. JianMin Pharm (600976) Shanghai Fusun High Technology Co. Ltd. Shanghai Fusun Business Investment Co. Ltd. Liang Xinjun GUO Guangchang Wang QunbinFan Wei

Joseph FanInstitutions Wei Qiao Group (China) Textile Industry Cotton Process Spinning and Fabric Weaving Printing and Dyeing No. 2, 4, 5 and 6 Oil and Cotton Factory COMPANY Weiqiao Bleach Weilian Print Weiqiao Dyeing Electricity Industry Power Generating Metal Melting Binzhou Weiqiao Thermoelectricity Co., Ltd. Binzhou Weiqiao Aluminum Co., Ltd. GROUPGROUP

Joseph FanInstitutions Number of business lines of listed companies in China (2003)

Joseph FanInstitutions Chinese Corporate Pyramids (Fan, Wong, Zhang, 2005) Number of Pyramida l Layers Local Government- controlled Firms Entrepreneur- controlled Firms NPercentage(%)NPercentage(%) >= Total

Joseph FanInstitutions Why are diversification and group affiliation popular in Asia?  Creating internal factor markets to circumvent external markets subject to distortions and high transaction costs. These factor markets include financial capital, labor, raw materials and product markets. The distortions are caused by regulations, taxations, or weak legal protections.  Risk reduction through cross-subsidization  Agency problem Diversification and group formation could be means for controlling owners to expropriate outside investors  Rent seeking can be more important than professionalism when competing in weak institutional environments

Joseph FanInstitutions Conclusions  Asian companies ’ behaviors are fundamentally shape by their institutional environments  Focusing only on firm level factors is not enough  Top-down approach that examines the interactions between firms and institutions will be fruitful  What should be the focus of corporate sector reforms? No firm-level quick fix please No more new laws and regulations cut-and- pasted from formula books Focusing on institutional factors, such as fighting corruption, will more likely payoff